In our view, the liability component of the bond representing the obligation to deliver
a variable number of equity instruments on 31
December 2020 expires on
31 December 2017. This liability component must therefore be derecognised (see
Chapter 48 at 6), to be replaced with an equity component (see the discussion at 7 below
of the appropriate accounting treatment in such circumstances).
Changes of circumstances for reasons other than the passage of time are more
challenging. For example, an entity might issue a convertible bond denominated in
its functional currency at that time. Such a bond would have an equity component
(see 6 below). Subsequently, the entity’s functional currency changes but the bond
remains outstanding, now denominated in a currency other than the entity’s
functional currency. If a bond with these terms were issued after the change in
functional currency, it would be classified in its entirety as a financial liability, since
the principal of the bond would not be a ‘fixed’ amount by reference to the entity’s
functional currency (see 5.2.3 below). This raises the question of whether the equity
component of the bond should be reclassified as a financial liability on the change in
functional currency.
In our view, there are arguments both for and against reclassification. As the arguments
for reclassification are to some extent a rebuttal of those against reclassification, we
discuss the latter first.
3526 Chapter 43
4.9.2.A
Arguments against reclassification
The principal arguments against reclassification are:
(a) The requirement of paragraph 15 of IAS 32 to classify an instrument as a
financial liability or equity ‘on initial recognition’ (see 4 above) could be read as
implying that such classification occurs only on initial recognition and is not
subsequently revisited.
(b) The implementation guidance to IFRS 1 – First-time Adoption of International
Financial Reporting Standards – require a compound instrument to be analysed
into its components, based on the substance of the contractual arrangement, as at
the date on which the instrument first satisfied the recognition criteria in IAS 32.
[IFRS 1.IG 35, 36]. Changes to the terms of the instrument after that date are taken into
account on first-time adoption, but changes in circumstances are not.
This could be construed as establishing a more general principle that changes in
the terms of instruments should be accounted for but changes in circumstances
should not.
(c) IFRS 9 clarifies that the assessment of whether or not an embedded derivative is
required to be separated from its host contract is undertaken when the entity first
becomes party to the contract, and is not revisited in the light of any subsequently
changing circumstances (see Chapter 44 at 7). [IFRS 9.B4.3.1].
(d) IFRIC 2 and the provisions of IAS 32 requiring certain types of puttable and
redeemable instrument to be classified as equity (see 4.6 above) each require
accounting recognition to be given to some changes in the classification of a
financial instrument as the result of changing circumstances. This implies that,
absent such specific guidance, the ‘default’ position would be that there should be
no accounting consequences, an inference reinforced by the requirement that the
provisions of IAS 32 requiring certain types of puttable and redeemable instrument
to be classified as equity must not be applied by analogy to other transactions.
4.9.2.B
Arguments for reclassification
The principal arguments in favour of reclassification are:
(a) The definitions of financial liability and equity both use the present tense, implying
that the definitions are to be applied at each reporting date, absent any more
specific provision against doing so.
This is consistent with our view that some transactions falling within the scope of
IFRS 2 – Share-based Payment – should be reclassified from equity-settled to
cash-settled and vice versa in the light of changing circumstances (see Chapter 30
at 10.2.3). However, it could be argued that such an analogy is inappropriate given
the significant differences between the definitions of equity and financial liability
in IAS 32 and those of equity-settled and cash-settled share-based payment
transaction in IFRS 2 (see 5.1.1 below).
(b) The provisions of IFRS 1 referred to in (b) under 4.9.2.A above are contained in
implementation guidance, which is not part of the standard. Moreover, it refers
only to compound financial instruments, and appears to be implicitly addressing
changes in market interest rates that might alter the arithmetical split of the
Financial instruments: Financial liabilities and equity 3527
instrument into its financial liability and equity components (see 6 below), rather
than more general changes in circumstances.
(c) The fact that IFRS 9 (see (c) under 4.9.2.A above) was issued after IFRS 1
indicates that a general prohibition on reassessment should not be inferred from
IFRS 1. Had the IASB wished to clarify that this was the case, they could easily
have done so in IFRS 9.
However, it is equally difficult to argue that there is an implied ‘default’
requirement for reclassification, given the specific requirement for reclassification
of certain puttable and redeemable instruments on a change in circumstances
referred to in (d) in 4.9.2.A above.
What emerges from the analysis above is a lack of definitive general guidance as to
whether reclassification of an instrument is permitted, required or prohibited.
Accordingly, we believe that in some circumstances, such as a change in the entity’s
functional currency, the entity may choose, as a matter of accounting policy, either to
reclassify or not to reclassify an instrument following that change of circumstances
which, had it occurred before initial recognition of the instrument, would have changed
its classification. The policy adopted should, in our view, be followed consistently in
respect of all changes of circumstances of a similar nature.
However, some changes in circumstances can be more fundamental to the nature of the
contract. For example the change in circumstances could lead to the instruments
delivered under a contract ceasing to be equity instruments of the reporting entity. This
situation could arise where a parent had entered into a derivative involving delivery of
the equity instruments of a subsidiary and subsequently loses control of that subsidiary.
Here the former subsidiary’s equity instruments would now represent financial assets
rather than non-controlling interests (equity) of the group. In these circumstances, it may
be more difficult to argue that not reclassifying the derivative contract is appropriate.
5
CONTRACTS SETTLED BY DELIVERY OF THE ENTITY’S
OWN EQUITY INSTRUMENTS
This Section deals with contracts, other than those within the scope of IFRS 2 (see
Chapter 30), settled in equity instruments issued by the settler. Throughout the
discussion here at 5, ‘equity instrument(s)’ excludes certain puttable and redeemable
instruments classified as equity under the ex
ceptions discussed at 4.6.2 and 4.6.3 above
(any contract involving the receipt or delivery of such instruments is a financial asset or
liability – see 4.1 above).
In order for an instrument to be classified as an equity instrument under IAS 32, it is not
sufficient that it involves the reporting entity delivering or receiving its own equity (as
opposed to cash or another financial asset). The number of equity instruments delivered, and
the consideration for them, must be fixed – the so called ‘fixed for fixed’ requirement.
Contracts that will be settled other than by delivery of a fixed number of shares for a fixed
amount of cash do not generally meet the definition of equity. The IASB considered that to
treat any transaction settled in the entity’s own shares as an equity instrument would not deal
adequately with transactions in which an entity is using its own shares as ‘currency’ – for
example, where it has an obligation to pay a fixed or determinable amount that is settled in a
3528 Chapter 43
variable number of its own shares. [IAS 32.BC21(a)]. In such transactions the counterparty bears
no share price risk, and is therefore not in the same position as a ‘true’ equity shareholder.
Where such a contract is not classified as an equity instrument by IAS 32, it will be
accounted for in accordance with the general provisions of IFRS 9 as either a financial
liability or a derivative.
Broadly speaking:
• a non-derivative contract involving the issue of a fixed number of own equity
instruments is an equity instrument (see 5.1 below);
• a non-derivative contract involving the issue of a variable number of own equity
instruments is a financial liability (see 5.2.1 below);
• a derivative contract involving the sale or purchase of a fixed number of own
equity instruments for a fixed amount of cash or other financial assets is an equity
instrument (see 5.1 below);
• a derivative contract for the purchase by an entity of its own equity instruments,
even if for a fixed amount of cash or other financial assets (and therefore an equity
instrument) may give rise to a financial liability in respect of the cash or other
financial assets to be paid. However, the initial recognition of the liability results in a
reduction in equity and not in an expense (see 5.3 below). In other words, whilst
there is a liability to pay cash under the contract, the contract itself is an equity
instrument (and is therefore not subject to periodic remeasurement to fair value);
• a derivative contract involving the delivery or receipt of:
• a fixed number of own equity instruments for a variable amount of cash or
other financial assets;
• a variable number of own equity instruments for a variable amount of cash or
other financial assets; or
• an amount of cash or own equity instruments with a fair value equivalent to
the difference between a fixed number of own equity instruments and a fixed
amount of cash or other financial assets (i.e. a net-settled derivative contract),
is a financial asset or financial liability (see 5.2 below); and
• a derivative financial instrument with settlement options is a financial asset or
liability, unless all possible settlement options would result in classification as
equity (see 5.2.8 below).
There are some difficulties of interpretation surrounding the treatment of certain
contracts to issue equity (see 5.4 below).
In undertaking the analysis required by IAS 32, it is sometimes helpful, where the detailed
guidance in the standard is not entirely clear, to consider whether the instrument or
contract under discussion exposes the holder or the issuer to the risk of movements in the
fair value of the issuer’s equity. If the holder is at risk to the same degree as equity investors
in the entity, it is likely that the instrument or contract should be classified as equity. If,
however, the entity bears the risk of movements in the fair value of the entity’s equity, or
the holder bears some risk, but less than that borne by equity investors in the entity, it is
likely that the contract should be classified, at least in part, as a liability.
Financial instruments: Financial liabilities and equity 3529
5.1
Contracts accounted for as equity instruments
A contract that will be settled by the entity delivering or receiving a fixed number of its
own equity instruments in exchange for a fixed amount of cash (see 5 above) or another
financial asset is an equity instrument, although a liability may be recorded for any cash
payable, by the entity on settlement of the contract. An example would be an issued share
option that gives the counterparty a right to buy a fixed number of the entity’s shares for
a fixed price or for a fixed stated principal amount of a bond (see 6.3.2.A below). [IAS 32.22].
The fair value of such a contract may change due to variations in market interest rates
and the share price. However, provided that such changes in fair value do not affect the
amount of cash or other financial assets to be paid or received, or the number of equity
instruments to be received or delivered, on settlement of the contract, the contract is
an equity instrument and accounted for as such. [IAS 32.22].
Any consideration received (such as the premium received for a written option or
warrant on the entity’s own shares) is added directly to equity. Any consideration paid
(such as the premium paid for a purchased option) is deducted directly from equity.
Changes in the fair value of an equity instrument are not recognised in financial
statements. [IAS 32.22, AG27(a)].
IAS 32 requires some types of puttable instruments (see 4.6.2 above) and instruments
that impose an obligation to deliver a pro rata share of net assets only on liquidation
(see 4.6.3 above) to be treated as equity instruments. However, a contract that is
required to be settled by the entity receiving or delivering either of these types of equity
instrument is a financial asset or financial liability, even when it involves the exchange
of a fixed amount of cash or other financial assets for a fixed number of such
instruments. [IAS 32.22A, AG13].
5.1.1
Comparison with IFRS 2 – Share-based Payment
The approach in IAS 32 differs from that in IFRS 2. IFRS 2 essentially treats any transaction
that falls within its scope and can be settled only in shares (or other equity instruments) as
an equity instrument, regardless of whether the number of shares to be delivered is fixed
or variable (see Chapter 30 at 1.4.1). The two standards also differ as regards to:
• the classification of financial instruments that can be settled at the issuer’s option
in either equity instruments or cash (or other financial assets). Broadly, IFRS 2
requires the classification to be based on the likely outcome, whereas IAS 32
focuses on the strict legal obligations imposed by the contract; and
• the definition of equity instrument. IFRS 2 refers to the exchange of a ‘fixed or
determinable’ amount of cash, whereas IAS 32 refers to the exchange of a ‘fixed’
amount of cash. This means that written options to issue own equity with a foreign
currency strike price are typically equity instruments under IFRS 2
, but financial
assets or liabilities under IAS 32, subject to the limited exception for short-term
rights issues (see 5.2.3.A below).
The IASB offers some (pragmatic rather than conceptual) explanation for these
differences in the Basis for Conclusions to IFRS 2. First, it is argued that to apply
IAS 32 to share option plans would mean that a variable share option plan (i.e. one
where the number of shares varied according to performance) would give rise to
3530 Chapter 43
more volatile (and typically greater) cost than a fixed plan (i.e. one where the number
of shares to be awarded is fixed from the start), even if the same number of shares
was ultimately delivered under each plan, which would have ‘undesirable
consequences’. [IFRS 2.BC109]. This serves only to beg the question of why it is not
equally ‘undesirable’ for the same result to arise in accounting for share-settled
contracts within the scope of IAS 32 rather than IFRS 2. Second, it is noted that this
is just one of several inconsistencies between IFRS 2 and IAS 32 which will be
addressed in the round as part of the IASB’s review of accounting for debt and equity.
[IFRS 2.BC110]. As discussed further at 12 below, this review remains somewhat more
distant than was probably envisaged when IFRS 2 was issued in 2004.
5.1.2
Number of equity instruments issued adjusted for capital
restructuring or other event
Entities, particularly larger listed companies, routinely restructure their equity capital.
This may take many forms, including:
• structural changes in the issuer’s ordinary shares (such as a share split, a share
consolidation or a reclassification of the outstanding ordinary shares of the issuer);
• a repurchase of shares;
• a distribution of reserves or premiums, by way of extraordinary dividend;
• a payment of a dividend, or extraordinary dividend, in shares; or
• a bonus share or rights issue to existing shareholders.
Accordingly, contracts for the purchase or delivery of an entity’s own equity often
provide that the number of shares specified in the contract is modified in the event of
such a restructuring. This provides protection to both the holder of the contract and to
existing shareholders, by ensuring that their relative rights remain the same before and
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