International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

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  (see 4.6 below).

  4.5.6 Economic

  compulsion

  The discussion in 4.5.1 to 4.5.5 above illustrates that, while IAS 32 requires the issuer of

  a financial instrument to classify a financial instrument by reference to its substance

  rather than its legal form, in reality the substance is determined, if not by the legal form,

  then certainly by the precise legal rights of the holder of the financial instrument

  concerned. Ultimately, the key determinant of whether an instrument is a financial

  liability or an equity instrument of the issuer is whether the terms of the instrument give

  the holder a contractual right to receive cash or other financial assets which can be sued

  for at law, subject only to restrictions outside the terms of the instrument (e.g. statutory

  dividend controls).

  By contrast, terms of an instrument that effectively force the issuer to transfer cash or

  other financial assets to the holder although not legally required to do so (often referred

  to as ‘economic compulsion’), are not taken into account.

  In response to a submission for a possible agenda item, in March 2006 the

  Interpretations Committee discussed the role of contractual and economic obligations

  in the classification of financial instruments under IAS 32.

  The Interpretations Committee agreed that IAS 32 is clear that, in order for an

  instrument to be classified as a liability, a contractual obligation must be established

  (either explicitly or indirectly) through the terms and conditions of the instrument.

  Economic compulsion, by itself, would not result in a financial instrument being

  classified as a liability.

  The Interpretations Committee also noted that IAS 32 restricts the role of ‘substance’ to

  consideration of the contractual terms of an instrument, and that anything outside the

  contractual terms is not considered for the purpose of assessing whether an instrument

  should be classified as a liability under IAS 32.14

  Financial instruments: Financial liabilities and equity 3511

  4.5.7 ‘Linked’

  instruments

  An entity may issue an instrument (the ‘base’ instrument) that requires a payment to be

  made if, and only if, a payment is made on another instrument issued by the entity (the

  ‘linked’ instrument). An example of such an instrument would be a perpetual instrument

  with a ‘dividend blocker’ clause (see 4.5.3.A above), on which the issuing entity is

  required to pay a coupon only if it pays a dividend to ordinary shareholders. Absent

  other terms requiring the perpetual instrument to be classified as a liability, it is classified

  as equity on the basis that the event that triggers a contractual obligation to make a

  payment (i.e. payment of an ordinary dividend) is itself not a contractual obligation.

  If, however, where payments on the linked instrument are contractually mandatory

  (such that the linked instrument contains a liability), it is obvious that the base

  instrument must also contain a liability. This is due to the fact that, in this case, the event

  that triggers a contractual obligation to make a payment on the base instrument (i.e. a

  payment on the linked instrument) is a contractual obligation that the issuing entity

  cannot avoid. This analysis was confirmed by the Interpretations Committee in

  March 2006 following discussion of linked instruments with similar terms to these.15

  This issue had arisen in practice in the context that the linked instrument was often very

  small and callable by the issuer, but on terms that required its classification as a liability

  under IAS 32. This would allow the issuer, with no real difficulty, to redeem the linked

  instrument at will and thus convert the base instrument from a liability to equity at any time.

  This had led some to argue that only the linked instrument should be classified as a liability.

  4.5.8

  ‘Change of control’, ‘taxation change’ and ‘regulatory change’

  clauses

  A number of entities have issued instruments with ‘dividend blocker’, ‘dividend pusher’

  and ‘step-up’ clauses (see 4.5.3 and 4.5.4 above), which would otherwise have been

  treated as equity by IAS 32, but have wished to account for them as liabilities, perhaps

  because they can then be hedged in a way that allows hedge accounting to be applied

  (see 10 below). Methods of achieving this have included the use of a de minimis linked

  liability instrument, or the inclusion of a clause requiring the repayment of the

  instrument in the event of a change of control. This raises the question of whether a

  change of control is within the control of the entity (such that the instrument is equity)

  or not (such that the instrument is debt), which is discussed in more detail at 4.3.3 above.

  Another common method of converting an instrument that would otherwise be

  classified by IAS 32 as equity into debt is to add a clause requiring repayment of the

  instrument in the event of a fiscal or regulatory change (that in reality may be a remote

  possibility) – see 4.3.1 above.

  4.6

  Puttable instruments and instruments repayable only on

  liquidation

  4.6.1 The

  issue

  A ‘puttable instrument’ is essentially a financial instrument that gives the holder the right

  to put the instrument back to the issuer for cash or another financial asset (see 3 above).

  Prior to its amendment in February 2008 (see 1.2 above), IAS 32 classified any puttable

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  instrument as a financial liability, including instruments the legal form of which gives

  the holder a right to a residual interest in the assets of the issuer.

  This classification produced what some regarded as an inappropriate result in the

  financial statements of entities such as open-ended mutual funds, unit trusts,

  partnerships and some co-operative entities. Such entities often provide their unit

  holders or members with a right to redeem their interests in the issuer at any time for

  cash. Under IAS 32, prior to the February 2008 amendment, an entity whose holders

  had such rights might report net assets of nil, or even negative net assets, since what

  would, in normal usage, have been regarded as its ‘equity’ (i.e. assets less external

  borrowings) was classified as a financial liability.

  For example, the owners of some co-operatives and professional partnerships are

  entitled to have their ownership interests repurchased at fair value. However, such

  entities typically do not reflect that fair value in their financial statements, because a

  significant part of the value may be represented by property accounted for at cost rather

  than fair value or by internally generated goodwill which cannot be recognised in

  financial statements prepared under IFRS.

  Clearly, if such an entity were to recognise a liability for the right of its owners to be

  bought out at fair value, it would show net liabilities, which would increase (creating

  accounting losses) the more the fair value of the entity increases, and decrease (creating

  accounting profits) the more the fair value decreases. Moreover, any distributions to the

  owners of such entities would be shown as a charge to, rather than a distribution of, profit.

  Similar concerns were raised in relation to limited-life entities. In some
jurisdictions,

  certain types of entity are required to be wound up after a certain period of time, either

  automatically, or unless the members resolve otherwise. Some entities may also have a

  limited life under their own governing charter, or equivalent document. For example:

  • a collective investment fund might be required to be liquidated on, say, the tenth

  anniversary of its foundation; or

  • a partnership might be required to be dissolved on the death or retirement of a partner.

  Such an entity arguably had no equity under IAS 32 prior to the February 2008

  amendment, since its limited life imposes an obligation, outside the entity’s control, to

  distribute all its assets. Again, some questioned whether it was very meaningful to show

  such an entity as having no equity.

  In order to deal with these concerns, IAS 32 was amended in February 2008. In the

  meantime, the Interpretations Committee had published IFRIC 2 which addresses the

  narrower issue of the classification of certain types of puttable instrument typically

  issued by co-operative entities (see 4.6.6 below).

  The effect of the amended standard is that certain narrowly-defined categories of

  puttable instruments (see 4.6.2 below) and instruments repayable on a pre-determined

  liquidation (see 4.6.3 below) are classified as equity, notwithstanding that they have

  features that would otherwise require their classification as financial liabilities.

  Moreover, as discussed further at 4.6.5 below, one of the criteria for classifying such an

  instrument as equity, is that it is the most subordinated instrument issued by the

  reporting entity. This represents a significant, and controversial, departure from the

  Financial instruments: Financial liabilities and equity 3513

  normal approach of IAS 32 that the classification of an instrument should be determined

  only by reference to the contractual terms of that instrument, rather than those of other

  instruments in issue. This may mean that two entities may classify an identical

  instrument differently, if it is the most subordinated instrument of one entity but not of

  the other. It may also mean that the same entity may classify the same instrument

  differently at different reporting dates.

  It was essentially these departures from the normal requirements of IAS 32 that led two

  members of the IASB to dissent from the amendment. In their view, it is not based on a

  clear principle, but comprises ‘several paragraphs of detailed rules crafted to achieve a

  desired accounting result ... [and] ... to minimise structuring opportunities’.16

  Where the exceptions in 4.6.2 and 4.6.3 below do not apply, IAS 32 takes the view that

  the effect of the holder’s option to put the instrument back to the issuer for cash or

  another financial asset is that the puttable instrument meets the definition of a financial

  liability, [IAS 32.18(b)], (see 3 above).

  The IASB believes that the accounting treatment required by IAS 32 for instruments not

  subject to the exceptions in 4.6.2 and 4.6.3 below is appropriate, but points out that the

  classification of members’ interests in such entities as a financial liability does not preclude:

  • the use of captions such as ‘net asset value attributable to unitholders’ and ‘change in

  net asset value attributable to unitholders’ on the face of the financial statements of

  an entity that has no equity capital (such as some mutual funds and unit trusts); or

  • the use of additional disclosure to show that total members’ interests comprise

  items such as reserves that meet the definition of equity and puttable instruments

  that do not. [IAS 32.18(b), BC7-BC8].

  The illustrative examples appended to IAS 32 give specimen disclosures to be used in

  such cases – see Chapter 50 at 7.4.6.

  4.6.2 Puttable

  instruments

  As noted above, a puttable financial instrument includes a contractual obligation for the

  issuer to repurchase or redeem that instrument for cash or another financial asset on

  exercise of the put. IAS 32 classifies a puttable instrument as an equity instrument if it

  has all of the following features: [IAS 32.16A-16B]

  (a) It entitles the holder to a pro rata share of the entity’s net assets in the event of the

  entity’s liquidation. The entity’s net assets are those assets that remain after

  deducting all other claims on its assets. A pro rata share is determined by:

  (i) dividing the entity’s net assets on liquidation into units of equal amount; and

  (ii) multiplying that amount by the number of the units held by the financial

  instrument holder.

  (b) The instrument is in the class of instruments that is subordinate to all other classes

  of instruments. To be in such a class the instrument:

  (i)

  has no priority over other claims to the assets of the entity on liquidation; and

  (ii) does not need to be converted into another instrument before it is in the class

  of instruments that is subordinate to all other classes of instruments.

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  (c) All financial instruments in the class of instruments that is subordinate to all other

  classes of instruments have identical features. For example, they must all be

  puttable, and the formula or other method used to calculate the repurchase or

  redemption price is the same for all instruments in that class.

  (d) Apart from the contractual obligation for the issuer to repurchase or redeem the

  instrument for cash or another financial asset, the instrument does not include any

  contractual obligation to deliver cash or another financial asset to another entity,

  or to exchange financial assets or financial liabilities with another entity under

  conditions that are potentially unfavourable to the entity, and it is not a contract

  that will or may be settled in the entity’s own equity instruments as set out in

  subparagraph (b) of the definition of a financial liability (see 3 above).

  (e) The total expected cash flows attributable to the instrument over the life of the

  instrument are based substantially on the profit or loss, the change in the

  recognised net assets, or the change in the fair value of the recognised and

  unrecognised net assets of the entity over the life of the instrument (excluding any

  effects of the instrument). [IAS 32.16A]. Profit or loss and the change in recognised

  net assets must be determined in accordance with relevant IFRSs. [IAS 32.AG14E].

  (f) In addition to the instrument having all the features in (a) to (e) above, the issuer

  must have no other financial instrument or contract that has:

  (i) total cash flows based substantially on the profit or loss, the change in the

  recognised net assets or the change in the fair value of the recognised and

  unrecognised net assets of the entity (excluding any effects of such instrument

  or contract); and

  (ii) the effect of substantially restricting or fixing the residual return to the

  puttable instrument holders.

  In applying this condition, the entity should not consider non-financial contracts

  with a holder of an instrument described in (a) to (e) above that have contractual

  terms and conditions that are similar to the contractual terms and conditions of an

  equivalent contract that might occur between a non-instrument holder and the

/>   issuing entity. If the entity cannot determine that this condition is met, it should

  not classify the puttable instrument as an equity instrument. [IAS 32.16B].

  Some of these criteria raise issues of interpretation, which are addressed at 4.6.4 below.

  4.6.3

  Instruments entitling the holder to a pro rata share of net assets only

  on liquidation

  Some financial instruments include a contractual obligation for the issuing entity to

  deliver to another entity a pro rata share of its net assets only on liquidation. The

  obligation arises because liquidation either is certain to occur and outside the control of

  the entity (for example, a limited life entity) or is uncertain to occur but is at the option

  of the instrument holder. IAS 32 classifies such an instrument as an equity instrument if

  it has all of the following features: [IAS 32.16C-16D]

  (a) It entitles the holder to a pro rata share of the entity’s net assets in the event of the

  entity’s liquidation. The entity’s net assets are those assets that remain after

  deducting all other claims on its assets. A pro rata share is determined by:

  Financial instruments: Financial liabilities and equity 3515

  (i) dividing the net assets of the entity on liquidation into units of equal amount;

  and

  (ii) multiplying that amount by the number of the units held by the financial

  instrument holder.

  (b) The instrument is in the class of instruments that is subordinate to all other classes

  of instruments. To be in such a class the instrument:

  (i)

  has no priority over other claims to the assets of the entity on liquidation; and

  (ii) does not need to be converted into another instrument before it is in the class

  of instruments that is subordinate to all other classes of instruments.

  (c) All financial instruments in the class of instruments that is subordinate to all other

  classes of instruments must have an identical contractual obligation for the issuing

  entity to deliver a pro rata share of its net assets on liquidation. [IAS 32.16C].

  (d) In addition to the instrument having all the features in (a) to (c) above, the issuer

  must have no other financial instrument or contract that has:

  (i) total cash flows based substantially on the profit or loss, the change in the