Proposed amendments to IAS 32, IFRS 7 and IAS 1 (FICE project): a deep dive into the first three exposure draft topics

Keywords: Mazars, Thailand, IFRS, IASB, Amendments, IAS 1, IAS 32, IFRS 7, FICE project

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The amendments aim to clarify some of the principles governing whether financial instruments should be classified as liabilities or equity, and thus resolve some of the practical issues identified by the Board. However, the fundamental principles of IAS 32 will remain unchanged. The proposed amendments in the exposure draft can be grouped into ten topics, as follows:

1. how to account for rights and obligations arising from laws or regulations when classifying the instrument;  
2. accounting for instruments that are settled in an entity’s own equity instruments, and in particular how to assess whether the “fixed-for-fixed” condition is met in the case of derivatives;  
3. accounting for obligations that require an entity to purchase its own equity instruments (particularly puts on non-controlling interests);  
4. contingent settlement provisions, and in particular how these should be taken into account when measuring the liability component of a compound instrument;  
5. the factors to be taken into account to determine whether a shareholder decision should be treated as a company decision or a third-party investor’s decision, when this decision obliges the issuer to make a settlement in cash or by delivering another financial asset;  
6. the rules on reclassification of financial instruments between financial liabilities and equity instruments;  
7. disclosures on financial instruments with characteristics of equity;  
8. the introduction of new rules under IAS 1 that will require an entity to separately present the portion of equity and comprehensive income that is attributable to ordinary shareholders;  
9. the transition requirements for these amendments; 
10. the reduced disclosures to be provided by subsidiaries that are covered by the future Subsidiaries without Public Accountability: Disclosures standard.

In this special feature, we will look in more detail at the first three topics listed above. 

The effects of relevant laws or regulations  

IAS 32 identifies the ‘contract’, with its rights and obligations, as the key to identifying and classifying financial instruments. In this context, it is sometimes difficult to determine whether and how laws and regulations applicable to financial instruments affect the classification of those instruments.  

In particular, differences in accounting treatment can arise depending on whether a contract in a given jurisdiction: 

• includes the rights and obligations arising from laws or regulations within its text; or 
• does not explicitly include these rights and obligations, even if they implicitly apply to the contract. 

Within a given jurisdiction, the analysis of contractual rights and obligations may thus result in different accounting treatments for instruments with similar economic characteristics.   

The Board identified several types of instruments that are affected by laws or regulations and for which this issue frequently arises. These include: 

• instruments with ‘bail-in’ provisions, such as Additional Tier 1 instruments issued by banks. These are usually perpetual instruments with no redemption obligation unless the issuer goes into liquidation. However, they include a loss-absorption clause that is specifically required by law. This type of clause might require the conversion of the instrument into a variable number of ordinary shares, in the event of a trigger linked to the issuer’s capital ratio;  
• legal obligations in some jurisdictions (such as Brazil) to distribute a minimum percentage of the entity’s annual profits as dividends to ordinary shareholders;  
• obligations to repurchase non-controlling interests in the event of a tender offer by an entity. 

Thus, in these examples, if the legal or regulatory requirements were taken into account, the instruments would be classified as financial liabilities.  

To resolve this issue, the IASB is proposing to clarify the circumstances in which laws or regulations should be taken into account when classifying a financial instrument issued by the entity. The IASB is proposing to clarify that: 

• only contractual rights and obligations that are enforceable by laws or regulations and that are in addition to legal or regulatory rights or obligations should be taken into account in the classification of the instrument;  
• a right or obligation that is not solely created by laws or regulations must be taken into account in its entirety when classifying the financial instrument. For example, if a law requires the issuer to pay a dividend of 10% per ordinary share and the contract stipulates that the issuer must pay 15%, the issuer must consider the obligation to pay 15% in its entirety when quantifying the liability component of the hybrid instrument, not just the additional 5% that is required over and above the legal requirements. 

It thus follows that: 

• when a contract simply reproduces the legal requirements that would apply to the parties regardless of any agreement, whether or not they are specifically mentioned in the contract, these rights and obligations are not taken into account when classifying the instrument;  
• in contrast, if legal or regulatory requirements would prevent enforceability of a contractual clause, these should be taken into account in the analysis: for example, if an entity’s obligation to repurchase its own equity instruments is restricted by law. In this case, the contractual clause would only be legally enforceable to the extent permitted by law. The Board also noted that IFRIC 2, which covers the accounting treatment of shares in co-operative entities, is consistent with the new provisions and will not be called into question. 

Settlement in an entity’s own equity instruments  

“Fixed-for-fixed” condition  

IAS 32.16 specifies that derivatives that are settled in an entity’s own equity instruments (e.g. a written call option on the issuer’s own shares) shall be classified as equity if the contract specifies a fixed number of shares to be exchanged for a fixed amount of cash.  

In practice, questions arise about whether any variation in the terms of the exchange should automatically mean the “fixed-for-fixed” condition is not met. Examples of these grey areas include: 

• variation in the amount of consideration denominated in a foreign currency, due to changes in the exchange rate relative to the issuer’s functional currency;  
• variation in the amount of consideration per share due to adjustments in the contractual conversion ratio under certain circumstances, e.g. the application of anti-dilution clauses. 

The IASB is proposing to clarify the situations in which the “fixed-for-fixed” condition is deemed to be met. The amount of consideration to be exchanged must be: 

• denominated in the entity’s functional currency; and  
• fixed from the outset, or variable solely because of:  
     - “preservation” adjustments, which preserve the relative economic interests of future shareholders to an equal or lesser extent than those of current shareholders; and/or  
     - passage-of-time adjustments, if these adjustments: (i) are predetermined; (ii) vary with the passage of time only; and (iii) have the effect of fixing, on initial recognition, the present value of the amount of consideration exchanged for each of the entity’s own equity instruments.  

In the Basis for Conclusions of the exposure draft, the IASB provided some further clarifications on implementing these principles, which are worth mentioning.

Thus, for instruments denominated in foreign currencies, the IASB considers a situation in which an entity within a group issues a derivative over the equity instruments of another entity in the group with a different functional currency. In this specific case, the IASB concludes that the appropriate reference point is the functional currency of the entity whose equity instruments are to be exchanged, not the functional currency of the entity that issued the derivative.

Notwithstanding the terminology used in the section on passage-of-time adjustments, the Board explicitly states in the Basis for Conclusions and Illustrative Examples accompanying the exposure draft that adjustments to the strike price of a derivative based on an inflation index or an interest rate benchmark (such as Euribor) do not meet the criteria set out in the exposure draft and thus do not meet the “fixed-for-fixed” condition. 

These clarifications on passage-of-time adjustments could also mean that some instruments, such as convertible bonds that include conversion ratio adjustment clauses based on the remaining time value of the option, would in practice be reclassified as financial liabilities. More generally, if passage-of-time adjustments do not meet the three criteria set out above, they would not meet the “fixed-for-fixed” condition. 

Choice of settlement between different classes of an entity’s own equity instruments  

The IASB is proposing to clarify that, if the terms of a derivative over own equity instruments give one party a choice of settlement between two or more classes of an entity’s own equity instruments, the fixed-for-fixed condition is met if all settlement options meet this condition. 

For example, if one party has the choice between receiving 100 ordinary shares or 125 preference shares in exchange for consideration of €500, the fixed-for-fixed condition is met because both the options meet this condition: the exchange ratio is fixed in both cases (one share for €5 if the derivative is settled in ordinary shares, or one share for €4 if it is settled in preference shares). 

Share-for-share exchanges  

The IASB is proposing to clarify that a derivative that may be settled by the exchange of a fixed number of the entity’s own non-derivative equity instruments for a fixed number of another class of its own non-derivative equity instruments is an equity instrument. 

Thus, a put option issued by a parent company to a non-controlling shareholder of a subsidiary, which would be settled by the purchase of a fixed number of the subsidiary’s shares in exchange for a fixed number of the parent’s shares, would be classified as an equity instrument in the parent company’s consolidated financial statements. 

Obligations for an entity to purchase its own equity instruments  

A key principle set out in IAS 32.23 is that, if a contract contains an obligation for an entity to purchase its own equity instruments, the entity should recognise a financial liability for the present value of the redemption amount. In practice, such contracts are usually written puts on non-controlling interests, or forward contracts to purchase the entity’s own shares.  

In the absence of further clarifications, significance diversity in practice has arisen around which components of equity should be debited on initial recognition of the financial liability (the group share of equity vs. non-controlling interests) and where to recognise gains or losses on subsequent remeasurement of the financial liability (profit or loss vs. equity).  

Moreover, IAS 32.23 only explicitly refers to situations in which the contract is settled in exchange for cash or another financial asset. Situations where the issuer must deliver a variable number of its own equity instruments (e.g. delivery of a variable number of shares in the parent company to purchase a fixed number of shares in a subsidiary) are not covered by the current standard. 

The IASB is thus proposing the following clarifications on the accounting treatment for these obligations: 

• a financial liability should also be recognised when the purchase of own equity instruments is to be settled by delivering a variable number of a different class of equity instruments;  
• if the obligation to purchase own equity instruments does not give access to the rights and returns associated with ownership of the equity instruments on initial recognition (as defined in IFRS 10), the liability shall be recognised against a component of equity other than non-controlling interests or issued share capital (i.e. in practice, a component of the group share of equity);  
• when measuring the liability, the same approach should be used for initial and subsequent measurement: the liability is measured at the present value of the redemption amount at the earliest possible contractual redemption date, without taking account of the probability or estimated timing of the counterparty’s exercise of its redemption right;  
• gains and losses on remeasurement of the liability are recognised in profit or loss; 
• if the contract expires without the counterparty exercising its redemption right: 
   - the carrying amount of the liability is removed from financial liabilities and included in the same component of equity that was debited on initial recognition of the obligation;
  - the cumulative amount in retained earnings related to remeasuring the liability may not be reversed in profit or loss,but may be reclassified to another component of equity. 

The IASB is also proposing to clarify that written put options and forward purchase contracts on an entity’s own equity instruments that are settled gross (i.e. the consideration is exchanged for own equity instruments) must be presented at the gross amount of the obligation.  

The IASB’s proposals thus confirm the requirement to present a financial liability representing the obligation to purchase own equity instruments using a “gross” approach, in contrast to the “net” approach that would be used for a derivative, i.e. recognising an amount equal to the difference between the consideration paid and the fair value of the shares to be received to settle the contract. The IASB decided not to apply a “net” approach, firstly because gross presentation of the information is helpful to users of financial statements in assessing the entity’s exposure to liquidty risk, and secondly because it would require a substantial overhaul of IAS 32. 

As regards the allocation of the liability at initial recognition, the Board noted in the Basis for Conclusions that its approach was challenged by some stakeholders, who argued that this would result in double counting of non-controlling interests based on two mutually exclusive scenarios. Under the approach proposed in the exposure draft, non-controlling interests would be treated as both:

• existing shareholders via their shares in the company, giving them the right to a share of net assets, including the entity’s profits; and  
• third-party creditors of the group, via the financial liability representing their right to require the entity to repurchase their shares. 

In response, the Board argued that there is no double counting of non-controlling interests, because the investors’ right to require the entity to repurchase their shares does not replace their current rights – it is an additional right that should logically be recognised separately, giving rise to two units of account.

Given the diversity in practice regarding the corresponding debit from equity (group share of equity vs. non-controlling interests) and subsequent remeasurement of the liability (profit or loss vs. equity), the proposed amendments could incur significant consequences for entities that had previously applied a different accounting treatment. 

Thus, where an entity has an obligation to repurchase non-controlling interests, the proposed clarification would change the practice of many companies that currently recognise the financial liability by anticipating the eventual purchase (i.e. simulating the exercise of the option); that is, they recognise the liability against non-controlling interests first, and only recognise any excess against group equity if the amount exceeds the value of non-controlling interests.