International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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which are therefore classified as financial liabilities if the strike price is denominated in
a foreign currency. The reason for the restricted scope of the amendment is that the
IASB countenanced an exception to the ‘fixed for fixed’ concept in IAS 32 for short-
dated rights issues only because the rights are distributed pro rata to existing
shareholders, and can therefore be seen as a transaction with owners in their capacity
as such. [IAS 32BC4I]. The IASB does not consider long-dated transactions as primarily
transactions with owners in their capacity as owners. [IAS 32.BC4K].
5.2.4
Instrument with equity settlement alternative of significantly higher
value than cash settlement alternative
A financial instrument is also a financial liability if it provides that on settlement the
entity will deliver either:
(a) cash or another financial asset; or
(b) a number of its own shares whose value is determined to exceed substantially the
value of the cash or other financial asset.
3536 Chapter 43
IAS 32 explains that, although the entity does not have an explicit contractual obligation
to deliver cash or another financial asset, the value of the share settlement alternative is
such that the entity will settle in cash. In any event, the holder has in substance been
guaranteed receipt of an amount that is at least equal to the cash settlement option.
[IAS 32.20].
5.2.5
Fixed number of equity instruments with variable value
A contract is a financial asset or financial liability if it is to be settled in a fixed number
of shares, the value of which will be varied (e.g. by modification of the rights attaching
to them) so as to be equal to a fixed amount or an amount based on changes in an
underlying variable. [IAS 32.AG27(d)].
5.2.6
Fixed amount of cash determined by reference to share price
An entity might enter into an option or forward contract to sell a fixed number of equity
shares for a fixed price, where the price is determined by reference to the share price.
For example, it might contract to sell 100 shares for £10 each if the share price is
between £0 and £10, and for £15 each if the price is higher than £10. Considered as a
whole, the contract provides for the exchange of a fixed number of equity instruments
for a variable amount of cash, and is therefore a derivative financial liability.
5.2.7
Net-settled contracts over own equity
The value of a contract over an entity’s own equity instruments at the date of settlement is
the difference between the value of the fixed number of equity instruments to be delivered
by one party and the fixed amount of cash (or other financial assets) to be delivered by the
other party. If such a contract allows for net settlement, it can then be settled by a transfer
(of cash, other financial assets, or the entity’s own equity) of a fair value equal to this
difference. It is inherent in the general definition of an equity instrument in IAS 32 that a
contract settled by a single net payment (generally referred to as net cash-settled or net
equity-settled as the case may be) is a financial asset or financial liability and not an equity
instrument. This is notwithstanding the fact that an economically equivalent contract
settled gross (i.e. by physical delivery of the equity instruments in exchange for cash or
other financial assets) would be treated as an equity instrument.
5.2.8
Derivative financial instruments with settlement options
A derivative financial instrument may have settlement options, whereby it gives one or
other party a choice over how it is settled (e.g. the issuer or the holder can choose
settlement net in cash, net in shares, or by exchanging shares for cash). A derivative that
gives one party a choice of settlement options is required to be treated as a financial
asset or a financial liability, unless all possible settlement alternatives would result in it
being an equity instrument. [IAS 32.26]. An example of a derivative financial instrument
with a settlement option that is a financial liability is a share option that the issuer can
decide to settle net in cash or by exchanging its own shares for cash. [IAS 32.27].
These provisions will apply mostly to contracts involving the sale or purchase by an
entity of its own equity instruments. However, they will also be relevant to those
contracts to buy or sell a non-financial item in exchange for the entity’s own equity
instruments that are within the scope of IAS 32 (rather than IFRS 2) because they can
Financial instruments: Financial liabilities and equity 3537
be settled either by delivery of the non-financial item or net in cash or another financial
instrument. Such contracts are financial assets or financial liabilities and not equity
instruments. [IAS 32.27].
5.3 Liabilities
arising
from
gross-settled contracts for the purchase
of the entity’s own equity instruments
The following discussion relates only to contracts that must be settled by the
counterparty delivering equity instruments (other than those classified as such under
the exceptions discussed at 4.6 above) and the entity paying cash (gross-settled
contracts). Contracts which can be settled net (i.e. by payment of the difference
between the fair value, at the time of settlement, of the equity instruments and that of
the consideration given) are accounted for as financial assets or financial liabilities
[IAS 32.AG27(c)] (see 5.2.8 above and 11 below).
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, AG27].
Entering into a gross-settled contract for the purchase of own equity instruments gives
rise to a financial liability in respect of the obligation to pay the purchase or redemption
price, [IAS 32.23, AG27(a)-(b)], (but resulting, on initial recognition, in a reduction of equity
rather than an expense). This treatment is intended to reflect the idea that a forward
contract or written option to repurchase an equity share gives rise to a liability similar
to that contained within a redeemable share (see 4.5 above). [IAS 32.BC12].
This is the case even if:
• the contract is an equity instrument;
• the contract is a written put option (i.e. a contract that gives the counterparty the
right to require the entity to buy its own shares) rather than a forward contract (i.e.
a firm commitment by the entity to purchase its own shares); or
• the number of shares subject to the contract is not fixed. [IAS 32.23, AG27(a)-(b)].
The final bullet point above might refer to a put option written by the entity whereby
the counterparty can require the entity to purchase between 1,000 and 5,000 of its own
equity share
s at €2 per share. In other words, the entity cannot avoid recognising a
liability for the contract on the argument that it does not know exactly how many of its
own shares it will be compelled to purchase.
When such a liability first arises it must be recognised, in accordance with IFRS 9, at its
fair value, i.e. the net present value of the redemption amount. Subsequently, the
financial liability is measured in accordance with IFRS
9 (see Chapter
46).
[IAS 32.23, AG27(b)]. IAS 32 offers no guidance as to how this is to be calculated when, as
might be the case with respect to a written put option such as that described in the
previous paragraph, the number of shares to be purchased and/or the date of purchase
is not known.
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In our view, it would be consistent with the requirement of IFRS 13 that liabilities with
a demand feature such as a demand bank deposit should be measured at the amount
payable on demand, [IFRS 13.47], (see Chapter 14 at 11.5) to adopt a ‘worst case’ approach.
In other words, it should be assumed that the purchase will take place on the earliest
possible date for the maximum number of shares. This is also consistent with IAS 32’s
emphasis, in the general discussion of the differences between liabilities and equity
instruments, on a liability arising except to the extent that an entity has an
‘unconditional’ right to avoid delivering cash or other financial assets (see 4.2 above).
The treatment proposed in the previous paragraph would lead to a different accounting
treatment for written ‘American’ put options (i.e. those that can be exercised at any time
during a period ending on a future date) and written ‘European’ put options (i.e. those
that can be exercised only at a given future date). In the case of an American option, a
liability would be recorded immediately for the full potential liability. In the case of a
European option, a liability would be recorded for the net present value of the full
potential liability, on which interest would be accrued until the date of potential
exercise. If this interpretation is correct, it has the effect that:
• a gross-settled written American put option that is an equity instrument has no
effect on profit or loss (because the full amount payable on settlement would be
charged to equity on inception of the contract); but
• a gross-settled European put option that is an equity instrument does affect profit
or loss (because the net present value of the amount payable on settlement would
be charged to equity on inception of the contract and accrued to the full settlement
amount through profit or loss).
If the contract expires without delivery of the shares, the carrying amount of the
financial liability is reclassified to equity. This has the rather curious effect that a share
purchase contract that expires unexercised (and therefore has no impact on the entity’s
net assets, other than the receipt or payment of the option premium) can nevertheless
give rise to a loss to the extent that interest has been recognised on the liability between
initial recognition and its transfer to equity (see Example 43.21 at 11.3.2 below).
5.3.1
Contracts to purchase own equity during ‘closed’ or ‘prohibited’
periods
Financial markets often impose restrictions on an entity trading in its own listed
securities for a given period (sometimes referred to as a ‘closed’ or ‘prohibited’ period)
in the run-up to the announcement of its financial results for a period. However, an
entity may well wish to continue to purchase its own listed equity throughout the closed
period, for example as part of an ongoing share-buyback programme.
One method of achieving this may be for the entity, in advance of the closed period, to
enter into a contract with a counterparty (such as a broker) whereby the counterparty
purchases shares in the entity, which the entity is then obliged to acquire from the
counterparty. Such a contract will give rise to a financial liability for the entity from the
day on which it is entered into. As discussed above, this would initially be recorded at
the net present value of the amount to be paid, with the unwinding of the discount on
that liability recorded as a finance charge in profit or loss.
Financial instruments: Financial liabilities and equity 3539
In addition, if the contract is for the purchase of a fixed number of shares for their
market price (as opposed to the exchange of a fixed amount of cash for as many shares
as are worth that amount), it will be necessary to remeasure the liability to reflect
movements in the share price.
5.3.2
Contracts to acquire non-controlling interests
IFRS 10 requires non-controlling interests to be shown within equity in consolidated
financial statements (see Chapter 7 at 4.3). Accordingly, the requirements of IAS 32 relating
to contracts over own equity instruments also generally apply, in consolidated financial
statements, to forward contracts and put and call options over non-controlling interests.
This analysis was confirmed by the Interpretations Committee in November 2006,
when it considered a request to clarify the accounting treatment of contracts to acquire
non-controlling interests that are put in place at the time of a business combination. It
is arguable that such contracts are more appropriately accounted for under the
provisions of IFRS 3 – Business Combinations – relating to deferred consideration. It
may also be the case that such contracts have the effect that, while there is a non-
controlling interest as a matter of law, the relevant subsidiary is nevertheless regarded
by IFRS 10 as wholly-owned, in which case the acquirer also recognises a financial
liability for the price payable to the non-controlling interest. A further discussion of
these issues may be found in Chapter 7 at 5.
The Interpretations Committee agreed that there was likely to be divergence in practice
in how the related equity is classified, but did not believe that it could reach a consensus
on this matter on a timely basis. Accordingly, the Interpretations Committee decided
not to add this item to its agenda.
However, the Interpretations Committee noted that the requirements of IAS 32 relating
to the purchase of own equity apply to the purchase of a minority interest. After initial
recognition any liability, to which IFRS 3 is not being applied, will be accounted for in
accordance with IFRS 9. The parent will reclassify the liability to equity if a put expires
unexercised.21 Whilst this comment was made in the context of the original version of
IFRS 3 (issued in 2004), it would be equally applicable where the current version (issued
in 2008) is applied.
5.3.2.A
Put options over non-controlling interests – Interpretations Committee
and IASB developments
The accounting for put options over non-controlling interest has been the subject of
much debate over the years and is one of the issues being addressed in the FICE DP
(see 12 below). For a summary of the Interpretations Committee and IASB
developments on this issue see Chapter 7 at 5.
5.4
Gross-settled contracts for the sale or issue o
f the entity’s own
equity instruments
The following discussion in 5.4 relates only to contracts which must be settled by the
entity delivering its own equity instruments (other than those classified as such under
the exceptions discussed at 4.6 above) and the counterparty paying cash (gross-settled
contracts). Contracts which can be settled net (i.e. by payment of the difference
3540 Chapter 43
between the fair value, at the time of purchase, of the shares and that of the
consideration given) are accounted as financial assets or financial liabilities (see 5.2.7
above). [IAS 32.AG27(c)].
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, AG27].
If an entity enters into a gross-settled contract to sell its own equity instruments, the
contract is economically the ‘mirror image’ of a contract for the purchase of own
equity. However, there is no provision in IAS 32 that the contract gives rise to a
financial asset in respect of the cash to be received from the counterparty, as
compared to the specific provision that a contract to purchase own equity gives rise
to a financial liability in respect of the cash to be paid to the counterparty (see 5.3
above). Consequently, it appears that such contracts give rise to no accounting entries
until settlement. This analysis is confirmed by an illustrative example to IAS 32 (see
Example 43.17 at 11.1.2 below).
Contracts for the sale or issue of an entity’s own equity arise in situations such as those
in Examples 43.2 and 43.3 below.
Example 43.2: Share issue payable in fixed instalments
A government intends to privatise a nationalised industry with a functional currency of euro through an initial
public offering (IPO) at €5 per share. In order to encourage widespread share ownership, the terms of the issue