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IAS 32 and IAS 39 — Classification of instruments to convert into a variable number of shares upon a ‘non-viability’ contingent event

Date recorded:

Background

The Committee received a request to address the accounting for a particular financial instrument that converts into a variable number of the issuer’s own equity instruments contingent on the occurrence of an uncertain future event, which is beyond the control of both the issuer and the holder of the instrument.

In the wake of the financial crisis, regulators are looking to strengthen the capital base of financial institutions, particularly in the banking sector. Some financial institutions are complying with these new regulatory requirements by issuing financial instruments that convert into a variable number of the issuer’s own ordinary shares if the institution breaches a minimum regulatory requirement. This type of contingent event is called a ‘non-viability’ event. The submission asked how the issuer should classify such a contingently convertible financial instrument in accordance with IAS 32 Financial Instruments: Presentation. The mandatorily convertible instrument does not have a stated maturity date and it has a stated interest which the issuer can cancel at any time on a non-cumulative basis. In addition, if the issuer breaches the “Tier 1 capital ratio” the instrument mandatorily converts into a variable number of the issuer’s own ordinary shares, at par value. The submission states that the contingent non-viability event is genuine. Paragraphs 25 and AG28 of IAS 32 state that a contingent settlement feature does not affect classification if that feature is ‘not genuine’. A contingent settlement feature is not genuine if it is extremely rare, highly abnormal and very unlikely to occur.

Below are the five alternative views that were presented as being applied in practice:

  1. The instrument is a liability in its entirety as the issuer has a contractual obligation to deliver a variable number of shares of its own equity instruments should a contingent non- viability event occurs.
  2. The instrument is a compound instrument – a liability component reflecting the issuer’s obligation as discussed above, and an equity component for the discretionary interest payments;
  3. The instrument is a compound instrument – a liability component and an equity component for the discretionary interest payments measured at zero;
  4. The instrument is a compound instrument – a liability component and an embedded derivative for the conversion feature that obliges the issuer to settle by delivering a variable number of its own shares; or
  5. The instrument is equity in its entirety as the instrument has no stated or pre-determined maturity date and represents a residual interest in the entity’s net assets.

Based on the guidance within IAS 32 staff believe view three to be the most appropriate as the liability reflects the issuer’s obligation to deliver a variable number of shares of its own equity if a contingent event occurs, which is in line with paragraph 25 of IAS 32. In addition, with the event being contingent and therefore it could occur immediately, plus it is outside the control of the issuer. Therefore, the liability component must be measured at the amount the issuer could be required to repay immediately. The equity component (discretionary distributions) would be measured as a residual and thus would have a value of zero. Therefore, staff recommended no formal change to IAS 32, and the Committee should not take this on to their agenda. Staff also recommended tentative wording of the agenda decision.

Committee members at first were spilt between the various options namely view one, two and three. A Committee member highlighted that IAS 32 was ambiguous and based on that the agenda decision was unclear as to whether the instrument was a compound instrument and hence should be measured at fair value. After discussion a number of the Committee members agreed view two being most appropriate however raised that there may unintended consequences in relation to this. On further deliberation, a Committee member highlighted the contents of paragraph 25 of IAS 32 and stated that it was clear that the instrument has a liability component as it was required to settled by the delivery of equity instruments, and therefore view three seemed most appropriate. Staff emphasised they found no ambiguity within IAS 32 and were clear about the treatment of a contingent liability in line with BC12 of IAS 32 where it is outside the control of the holder. Their concern was with the measurement of the components.

The Chairmen called for a vote, and the majority of members voted for view three.  The Committee agreed with Staff’s analysis of the classification of a financial instrument that it is mandatorily convertible into a variable number of shares upon a contingent “non-viability” event. The Committee members also agreed that the tentative agenda decision should be based on view 3.

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