Sasha Govender CA(SA)
With financial markets changing rapidly and innovation taking place, financial instruments with both debt and equity features have become more complex and prevalent. IAS 32 – Financial Instruments: Presentation classification of these instruments is not always clear cut, resulting in diversity in practice and reduced comparability of financial statements.
To tackle these challenges, the IASB published its Exposure Draft: Financial Instruments with Characteristics of Equity. This move aims to address the classification challenges posed by complex financial instruments that possess both debt and equity features. These challenges have led to inconsistencies and reduced comparability in financial statements under the current IAS 32 standard.
Let’s unpack the proposals and considerations raised by the fraternity on the exposure draft.
The effect of relevant laws and regulations
The IASB proposes that only contractual rights and obligations that are enforceable by laws or regulations, and that are in addition to those created by relevant laws or regulations, should be considered in the classification of the financial instrument. This clarification aims to streamline the classification process but could lead to inconsistencies across different jurisdictions with varying regulatory requirements.
Fixed-for-fixed condition
If a contract will be settled by an entity with a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset, it qualifies as an equity instrument. In practice it isn’t clear whether the condition would be violated if there is variation in the consideration or the number of the entity’s own equity instruments.
The proposal firstly clarifies that the fixed-for-fixed condition may be achieved if the currency of the consideration is denominated in the entity’s functional currency. Entities with shares in multiple currencies may have to consider whether they continue to meet the fixed-for-fixed conditions on existing complaint instruments that are denominated in a currency that is different from its functional currency.
Secondly, variability in the consideration is permitted per the proposals if it is limited to preservation and passage-of-time adjustments. The exposure draft provides new guidance and examples on these adjustments but on the face of it these adjustments could add complexity in assessing the fixed-for-fixed condition.
Obligations to purchase an entity’s own equity instruments
Contracts obligating an entity to purchase its own equity instruments, including forward purchase contracts and written put options, are classified as financial liabilities.
The proposals clarify when to derecognise equity instruments subject to these purchase obligations and mandates that it should be removed from a component of equity other than share capital or non-controlling interest. Mixed views have been expressed on whether this debit should preclude non-controlling interests.
The proposed measurement of the financial liability should ignore the probability and estimated timing of the redemption and it should be remeasured in profit or loss. Financial instrument measurement is governed by IFRS 9 – Financial Instruments and there is concern that the proposals may create disparity with the IFRS 9 general measurement principles by ignoring timing and probability.
These amendments would apply equally to obligations that will be settled using a different type of own equity instruments.
Contingent settlement provisions
For instruments with settlement contingent on uncertain future events, the proposals clarify that these should be classified as financial liabilities unless the settlement provisions are non-genuine, or settled like a financial liability only in liquidation.
The proposals provide guidance on the meaning of non-genuine and liquidation and clarifies that the measurement of the financial liability should ignore the probability and estimated timing of the contingent event.
Shareholder discretion
In distinguishing between a financial liability and equity instrument, an entity considers whether it has an unconditional right to avoid delivering cash or another financial asset. In some instances, settlement is at the discretion of the shareholders and there is ambiguity whether these shareholder decisions can be treated as entity decisions. The proposal prescribes new factors to consider when evaluating the shareholder decisions, although in essence the assessment would still require significant judgement.
Reclassification of financial liabilities and equity instruments
IAS 32 does not include any guidance on reclassification of financial liabilities and equity instruments after initial recognition. Under the proposals. a reclassification would be permitted when the substance of a contract changes because of a change in circumstance external to the contract for example, a change in an entity’s functional currency or a change in an entity’s group structure. The proposed amendments also specify how the reclassifications should be accounted for.
Disclosure
Investors seek for more transparency about an entity’s capital structure. To respond, the IASB proposes to improve IFRS 7 by introducing new disclosure that focuses on the nature and priority of claims on liquidation, terms and conditions of financial instruments, potential dilution of ordinary shares, financial instruments with an obligation for a company to purchase its own equity instruments, and other proposed disclosure. The amendments to IAS 1 target the distribution of profits among equity holders and requires additional information about amounts attributable to ordinary shareholders in the financial statements.
Enhancing the quality of disclosures is always welcomed, however the sheer volume of the proposed disclosure is quite onerous. The relevance of some of the proposed disclosure is doubtful for example the usefulness of the liquidation disclosure for highly regulated industries which may pose challenges for multinational entities that operate in various jurisdictions.
Transition and effective date
The IASB has proposed a fully retrospective approach to the amendments limited to one comparative period. This approach could pose practical implementation challenges with entities having to reassess numerous contracts that may prove to be difficult. There is no proposed effective date as this will be decided once the IASB has considered the feedback on the proposals.
I hope to have shed some light on the exposure draft. Generally, these much-awaited proposals are welcomed, and we look forward to further developments from the IASB.
