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Financial instruments with characteristics of equity

Financial instruments with characteristics of equity

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In its discussion paper entitled “Financial Instruments with Characteristics of Equity”, last year, the IASB presented an entirely new taxonomy on how to classify equity and debt, meant to replace the current procedures under IAS 32. The objective of the new approach is specifically to increase the meaningfulness of financial statements in regard to available liquidity and solvency according to the balance sheet. Once the consultation period came to a close, the comments were analyzed in June 2019. This article will set out the approach as planned by the IASB, and demonstrate how it will hit the ground, using a convertible bond issue and an equity-replacement loan as an example.

The IASB’s preferred approach

The scope of application of the classification rules remain the same as under IAS 32. This means the definition of financial instruments will still be based on the contractually defined rights and duties, i.e. the situation where one contractual party will have a financial asset whilst the other has a financial obligation or owes an equity share. Similarly, the binary differentiation between equity and debt will remain intact. Therefore, no further category of financial instruments in the form of mezzanine capital is introduced, which would only make things even more complex. 

According to the preferred approach promoted by the IASB, a non-derivative financial instrument would be a financial obligation, provided at least one of the following two conditions has been fulfilled:

  • There is a non-avoidable contractual obligation to remit economic resources at a point in time other than at the time of the company’s liquidation (timing feature).
  • There is a non-avoidable contractual obligation to remit an amount, which is not dependent on the available economic resources of the company (amount feature).

In order to take account of the special features of derivative financial instruments on own equity securities, the IASB has developed separate classification rules to apply the preferred approach to such financial instruments. According to this, a derivative on own equity securities will be classified as a financial asset or a financial obligation in its entirety if:

  • a net cash settlement exists, i.e. there is a non-avoidable contractual obligation to remit economic resources in the amount of the net value of the derivative at a point in time other than at the time of the company’s liquidation (timing feature).
  • the net amount does not depend on the company’s available economic resources (amount feature).

The proposed classification therefore always depends on a timing feature and an amount feature. The table below shows the application of the two new classification principles, using examples.

Timing / Amount Feature Amount independent of the available economic resources Amount not independent of the available economic resources
Obligation to remit resources at a point in time other than the company’s liquidation Liabilities, for instance simple bonds Liabilities, e.g. preferred shares repayable at fair value
No obligation to remit resources at a point in time other than the company’s liquidation Liabilities, e.g. bonds that are repayable with a variable number of own units, representing a predefined value Shareholders' equity, e.g. ordinary shares

Basically, the timing feature is no different from the previous procedure under IAS 32.16, which required that an outflow of funds was only allowed at the time of liquidation if the instrument was to be classified as equity. The amount feature on the other hand can cause various classifications and may cause challenges to accountants preparing financial statements due to the new concept of the dependency on the availability of economic resources. Having said that, the introduction of the amount feature removes the up-to-now required interpretation of the fulfillment of the fixed-for-fixed criterion of IAS 32.16(b)(ii). However, the IASB expects that the application of its preferred method will basically come up with the same classification as it did under IAS 32.

Example 1: Convertible bonds

In view of the conversion right, convertible bonds represent composite financial instruments, which have to be classified under their individual components, just as under IAS 32 up to now. As described above, the IASB expects that the application of the amount feature in lieu of the fixed-for-fixed criterion does not change the classification of convertible bonds. Due to the timing feature, the bond component will normally be classified as debt because a repayment of the nominal amount takes place before the actual point of liquidation. The right to convert must be tested with the amount feature. As such it may not depend on a variable that is independent of the available economic resources of the entity. The IASB always sees the following variables as independent, which means that they must be classified as debt:

  • Currencies that are not the functional currency;
  • Fixed shares in financial assets;
  • Variables that depend on the entity’s available economic resources before all the claims made of the entity have been met (e.g. EBIT).

If the strike price of a conversion option is denominated in a currency other than the functional currency of the issuer, the net value of the conversion option depends on the development of the exchange rate between these two currencies. In turn, this exchange rate development does not depend on the entity's available economic resources so that a classification as debt is justified by the amount feature.

Example 2: equity-replacing loans

The special case resulting from the preferred IASB approach concerning certain equity-replacing loans, i.e. so-called perpetuals, deviates from current accounting practice. These are loans where it is at the discretion of the debtor to extend the repayment (including interest) into the future as much as they like. This solution is especially often used in partially consolidated financial statements in order to avoid capital contributions whilst maintaining the wished-for equity ratio. 

In the case of perpetuals, there is no obligation to pay funds so that under IAS 32, it is possible to classify them as equity. In application of the IASB’s preferred approach, both the timing as well as the amount features must be tested. The timing feature can be deemed as fulfilled because the entity can postpone the repayment of economic resources up to the point of liquidation. In principle, there is nonetheless an obligation to transfer economic resources in the form of a repayment. Such a repayment is an amount that does not depend on the entity’s available economic resources but instead is a nominal amount fixed by the loan. Therefore, the application of the IASB's preferred approach leads to a classification as debt, and thus a different accounting than under the previous practice of IAS 32.

Source: KPMG Corporate Treasury News, Edition 93, July - August 2019

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