Equity or Liability - will it be clearer now?

Determining whether an instrument must be classified as equity or a liability has been a contentious issue for many years. There have been various projects on ‘the equity issue’ and the IASB has finally published a much anticipated exposure draft on Financial Instruments with Characteristics of Equity Classification. Does it make it easier to determine what is equity and what is a liability? We’ve summarised the issues covered in the exposure draft for you to consider, but you’ll need to work through the whole document to decide for yourself.

The exposure draft proposes amendments to the presentation and disclosure of financial instruments, impacting IAS 32 Financial Instruments: Presentation (‘IAS 32’), IFRS 7 Financial Instruments: Disclosure (‘IFRS 7’), and to IAS 1 Presentation of Financial Statements (‘IAS 1’). Comments are due by 29 March 2024.

For more detail please refer to IFRS.org or use the links provided below:

Exposure draft

Basis for Conclusions

Illustrative examples/Guidance

Snapshot

Classification

The effects of relevant laws or regulations

Issue

Proposed amendment

Do laws and regulations impact the contractual terms of a financial instrument, and if so, to what extent?

Only enforceable contractual terms that give rise to rights and obligations in addition to those established by law are considered in classifying a financial instrument (or its component parts).

Contractual terms shall be considered in their entirety i.e., contractual and non-contractual are not separated.

Settlement in an entity’s own equity instruments
Issue	Proposed amendment
Can variations/adjustments be made to the amount of cash/number of equity instruments without failing the ‘fixed-for-fixed’ (fixed amount of cash or other financial asset for a fixed number of the entity’s own equity instruments) condition.	Clarified that the ‘fixed-for-fixed’ condition is met if: ü Amount to be exchanged is denominated in the entity’s functional currency; and is either: ü Fixed; or ü Varies solely… To preserve the relative economic interests of future shareholders to an equal/lesser extent than current shareholders For passage-of-time adjustments that: are predetermined vary only with passage of time effectively fix the present value of the amount per equity instrument up front Derivatives giving a party a choice of settlement between classes of equity must be considered for each class.
How to classify instruments with share-for-share exchanges i.e., settled by the exchange of a fixed number of one class of equity instrument for a fixed number of another class of equity instrument.	Clarify that these contracts would also meet the fixed-for-fixed criteria and are not precluded from classification as equity.

Obligations to purchase an entity’s own equity instruments

Issue

Proposed amendment

How to account for obligations over own equity settled in a variable number of own equity.

Clarify that the entity must recognise a financial liability for the present value of the redemption amount (which equity component the liability is removed from and how to measure the liability is clarified)

Neither IAS 32 nor IFRS 10 Consolidated Financial Statements specify the accounting treatment on initial recognition

i.e., where does the debit entry go?

If the entity does not already have access to the returns associated with an ownership interest:

Obligation involves NCI?

Take debit entry to an equity component other than NCI

Other obligation to purchase own equity?

Take debit entry to an equity component other than share capital

How should these obligations be subsequently measured?

Initial + subsequent measurement of the liability = same approach

Ignore the probability and estimated timing of the holder exercising the option

Where to recognise the remeasurement adjustments?

Gains and losses must be recognised in profit or loss

The accounting treatment on expiry of a written put option on an own equity instruments without delivery.

Financial liability reclassified to the same equity component from which it was reclassified on initial recognition
Cumulative amount in retained earnings from remeasurement can be reclassified to another equity component

Written put options and forward contracts on own equity instruments to be gross physically settled.

Must be presented gross, not net.

Contingent settlement provisions

Issue

Proposed amendment

Whether financial instruments with contingent settlement features can be compound instruments

If so, how should these be recognised and measured if they are compound instruments?

How should financial instruments with contingent settlement provisions be subsequently measured?

Clarify that financial instruments with contingent settlement provisions can be compound instruments.

If liability component could require immediate settlement on occurrence of a contingent event

Measure at the full amount of conditional obligation

Payments at the discretion of the issuer

Always equity

Initial + subsequent measurement of the liability = same approach

Ignore the probability and estimated timing of the holder exercising the option

Definitions not clearly defined in IAS 32:

- Liquidation; and

- concept of ‘not genuine’

Liquidation

Process starting immediately after entity permanently ceases operations

Not-genuine

The assessment does not only consider the probability of the contingent event occurring. Based on specific facts and circumstances.

Shareholder discretion

Issue

Proposed amendment

Whether settlement at shareholder discretion gives the entity an unconditional right to avoid settlement.

Specifically...

Whether shareholder decisions are part of the entity’s operating and governance process,

Whether shareholders are acting in their individual capacity.

Judgement to be applied to facts and circumstances where shareholders discretion arises.

Proposed factors to consider:

Is it a routine decision typically made in ordinary course of business?
Does the decision relate to an action/transaction that would be initiated/proposed by management?
Would different classes of shareholders benefit differently?
Is the shareholder able to make a decision requiring the entity to redeem/pay a return on the shares in cash or another financial asset?

The IASB also proposes to provide guidance on applying the above.

Reclassification of financial liabilities and equity instruments

Issue

Proposed amendment

IAS 32 has no requirements on whether/when to reclassify between financial liabilities and equity.

The substance of a contractual arrangement may change without a modification to the contractual terms. This raises questions in practice:

Are these reclassifications required or allowed?

If so, how are these accounted for?

Reclassifications are only permitted when:

ü The substance of the contractual terms change (without any modification to the contract)

ü arising from changes in circumstances outside the contract (examples to be provided)

Reclassification date = the date of the change in circumstance; prospectively.

Financial liability reclassified from equity:

measure at fair value of the liability on date of reclassification
difference recognised in equity

Equity reclassified from a financial liability:

measure at the carrying value of the financial liability at that date (no gain or loss)

Transition

Subsidiaries without public accountability

Fully retrospective approach.

Transitional relief:

ü No requirement to restate information for more than one comparative period.

ü Fair value at beginning of earliest comparative period presented = amortised cost of the financial liability at that date if impracticable to apply the effective interest method retrospectively.

ü No need to separate liability and equity if the liability component of a compound instrument subject to contingent settlement provisions is no longer outstanding.

ü Relief from providing quantitative disclosures required by IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors paragraph 28(f).

No specific transition requirements for IAS 34 Interim Financial Reporting.

No additional transitional relief for First time IFRS adoption.

Disclose the nature and amount of any classification changes on initial application.

Proposed amendments to the draft standard:

ü Permit eligible subsidiaries to apply recognition, measurement and presentation in IFRS accounting standards; with

ü Reduced disclosure requirements.

Presentation and disclosure

Proposed amendments to IFRS 7 (disclosure)

Proposed amendments to IAS 1 (presentation)

Objective expanded

Information to allow users to understand:

how an entity is financed; and
its ownership structure; including
potential dilution to ownership structure

Scope

Remove reference to “derivatives that meet the definition of an equity instrument”

Paragraphs 80A and 136A move from IAS 1 into IFRS 7

Require separate disclosure of gains/losses on financial liabilities with a contractual obligation to make payments based on the entity’s performance/change in net assets.

Add disclosure requirements for compound financial instruments.

Disclose information about…

Nature and priority of claims on liquidation.
Terms and conditions of financial instruments:
with financial liability and equity features
that become/stop being effective due to passage of time
- Potential dilution of ordinary shares.
- Obligations to purchase own equity instruments.

Why? To make it clear which amounts are attributable to ordinary shareholders

How? Separate presentation for amounts attributable to ordinary shareholders from that to other owners of the parent:

Statement of financial position: Issued capital and reserves
Statement of comprehensive income: Allocation of profit/loss and comprehensive income
Statement of changes in equity: Each class of ordinary share capital and each class of other contributed equity
Dividend amounts

Authors:

Justine Lewis, IFRS Manager

08 February 2024