The IASB has proposed introducing a new accounting element to help standardise the classification of complex financial instruments as debt or equity. Adam Deller reports
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This article was first published in the September 2018 international edition of Accounting and Business magazine.
The financial instruments with characteristics of equity (FICE) project has been on the workplan of the International Accounting Standards Board (IASB) for some time. FICE has arisen from the challenges of applying IAS 32, Financial Instruments: Presentation, which was written as a key way of classifying whether an instrument is debt or equity – a classification issue that has been a source of contention for many years.
When discussing whether an instrument was debt or equity, the advice dispensed by David Tweedie, the former chairman of the IASB, was that if it looks like a duck, walks like a duck and quacks like a duck, then it is a duck. It’s a nice soundbite and may still hold true in relation to the simpler financial instruments, but the landscape has changed since the noughties.
Continuing innovation has generated a growing number of complex financial instruments, leading to a continuing debate about the underlying rationale of the distinction between liabilities and equity. This has resulted in a diversity of accounting treatments in practice, making it difficult to assess how these financial instruments affect companies’ financial position and performance.
The FICE project aims to improve the information that companies provide in their financial statements about the financial instruments they have issued. It intends to do this by investigating the challenges in classifying instruments under IAS 32 and addressing them through clearer classification principles and enhanced presentation and disclosure requirements.
It is important to note that the FICE project is focusing on the classification of financial instruments from the perspective of the issuer, as financial liabilities or equity instruments. It is not addressing recognition and measurement requirements from IFRS 9, Financial Instruments, or the disclosure requirements in IFRS 7, Financial Instruments: Disclosures.
The aim of the FICE discussion paper issued by the IASB is not to change the classification of a vast number of items. The IASB is not looking to make unnecessary changes to IAS 32, and most simple financial instruments, including basic convertible instruments, will have no change in classification. For the more complex instruments, the aim is to provide a clearer rationale for classification and better information for the users of financial statements.
The discussion paper introduces two new elements in identifying whether an item is debt or equity. These elements are referred to as the timing feature and the amount feature.
The timing feature has been introduced because it is relevant to the assessment of whether an entity has sufficient resources to meet its obligations as they fall due. This would therefore also be relevant in the analysis of an entity’s liquidity.
The amount feature is relevant to the assessment of whether the entity has sufficient resources to meet its obligations at a point in time, and whether the entity has produced sufficient return to satisfy the claims against it.
The amount feature rather than the timing feature may be the one that the preparers of accounts need to give extra consideration to.
There are two key questions an entity needs to ask to determine whether an item is a timing or an amount feature:
- Can the issuer be required to hand over cash or another financial asset before liquidation? (timing feature)
- Has the issuer promised a return to the instrument’s holder regardless of the issuer’s own performance or share price? (amount feature)
If the answer to either question is yes, then the item is a financial liability. Otherwise, it is an equity instrument.
The example in the panel on this page shows how the application of these questions would work. The table on the opposite page gives further examples of how the questions would be applied; it shows that only those items that return a response of no to the two key questions above would be classified as equity.
Many of the items identified contain no surprises, such as classifying loans as liabilities or ordinary shares as equity. The example in the panel on this page shows why share-settled debt is a liability; some of the other items are discussed below.
Redeemable preference shares will continue to be classified as a liability. Irredeemable preference shares may be classified as equity or liability depending on whether they are cumulative preference shares or not. This echoes the treatment currently applied, but really is seeking to provide rationale as to the classification.
Cumulative preference shares roll any unpaid dividends over, increasing the amount payable. While this may not be payable until liquidation (the timing feature), the amount payable is independent of the entity’s own available resources (think net assets), making it a liability.
Perpetual preference shares where a payment can be skipped stay as equity. The amount repayable will not change, so therefore remains in equity.
Puttable shares are those that can be sold back to the company at a predetermined price. As they are at fair value, they will move in line with the entity’s own economic resources, and so return an answer of no to the amount feature question. They will still be classed as a liability, though, as the timing may be inconvenient to the entity and have a significant impact on its liquidity.
IAS 32 contained an exception that allowed certain puttable financial instruments to be classed as equity, even if they met the definition of a financial liability. The details are technical and will not be explored here, but the puttable exception remains under the new proposals.
Derivatives over own equity
The other major discussion in the paper is how to treat derivatives over your own equity, such as options that have been acquired. The proposed approach is that a derivative on your own equity would be a financial asset/liability only if either (or both) of the following conditions apply:
- it’s net-cash settled (timing feature)
- the net amount of the derivative is affected by a variable that is independent of the entity’s available economic resources (amount feature).
Sue Lloyd, the vice chairman of the IASB, says that the simplest way to think of these is to ask: ‘Are there any variables not to do with me? If so, it’s not equity. If there aren’t, it’s equity.’
An example of this approach is as follows. If someone has an option to purchase five shares for $100, then the share price is the only variable as to whether the option changes in value. However, if the option is to purchase five shares for 100 currency units in a foreign currency, then there are two variables: the share price and the foreign exchange rate. Therefore this option wouldn’t be equity.
In addition to classification, the discussion paper looks at improving the disclosures around equity. There is no doubt that this is a complex project, but the IASB is attempting to bring some clarity to the reasoning behind the classification rules and aiming to improve disclosures to aid the users.
The discussion paper on the project was issued in June 2018, and is open for comments until January 2019.
How the questions might be applied
|Contains obligation for an amount independent of the entity’s available economic resources
|Contains no obligation for an amount independent of the entity’s available economic resources(amount feature)|
Transfer of economic resources required at a specified time other than at liquidation
|Shares puttable at fair value that do not meet the puttable exception
|Transfer of economic resources required only at liquidation
|Share-settled debt (see company B example in panel opposite), cumulative preference shares
|Ordinary shares, vanilla warrants
Adam Deller is a financial reporting specialist and lecturer
CPD technical article
"There will be two new elements for identifying an item as debt or equity: the timing feature and the amount feature"