Similarly, if the terms of an instrument provide for its settlement in a fixed number of
the entity’s equity instruments, but there are circumstances, beyond the entity’s control,
in which such settlement may be contractually precluded, and settlement in cash or
other assets required instead, those circumstances can be ignored if there is ‘no genuine
possibility’ that they will occur. In other words, the instrument continues to be regarded
as an equity instrument and not as a financial liability. [IAS 32.AG28].
Guidance in IAS 32 on the meaning of ‘not genuine’ in this context is unfortunately
restricted to the thesaurus of synonyms (‘extremely rare, highly abnormal and very unlikely
to occur’) above. It is, however, helpful to consider the changes made when, in 2003, SIC-5
– Classification of Financial Instruments – Contingent Settlement Provisions8 – was
withdrawn, and its substance incorporated in these provisions of IAS 32. SIC-5 had
previously required redemption terms to be ignored if they were ‘remote’. Examples given
by SIC-5 were where the issue of shares is contingent merely on formal approval by the
authorities, or where cash settlement is triggered by an index reaching an ‘extreme’ level
relative to its level at the time of initial recognition of the instrument.9
IAS 32 deliberately did not reproduce the reference to, or the examples of, ‘remote’ events
in SIC-5. In the Basis for Conclusions to IAS 32 the IASB states that it does not believe it is
appropriate to disregard events that are merely ‘remote’. [IAS 32.BC17]. Thus it is clear that,
under the revised version of IAS 32, it is not appropriate to disregard a redemption term that
is triggered only when an index reaches an extreme level. This suggests that it is not open to
an entity to argue (for example) that a bond that is redeemed in cash only if the entity’s share
price falls below, or fails to reach, a certain level can be treated as an equity instrument on
the grounds that there is no genuine possibility that the share price will perform in that way.
In general, terms are included in a contract for an economic purpose and therefore are
genuine. The current reference in IAS 32 to terms that are ‘not genuine’ is presumably
intended to deal with clauses inserted into the terms of financial instruments for some
legal or tax reason (e.g. so as to make conversion technically ‘conditional’ rather than
mandatory) but having no real economic purpose or consequence.
An example of a clause that has caused some debate on this point is a ‘regulatory change’
clause, generally found in the terms of capital instruments issued by financial institutions
such as banks and insurance companies. Such entities are generally required by local
regulators to maintain certain minimum levels of equity or highly subordinated debt
(generally referred to as regulatory capital) in order to be allowed to do business.
A ‘regulatory change’ clause will typically require an instrument which, at the date of
issue, is classified as regulatory capital to be repaid in the event that it ceases to be so
classified. The practice so far of the regulators in many markets has been to make
changes to a regulatory classification with prospective effect only, such that any
instruments already in issue continue to be regarded as regulatory capital even though
they would not be under the new rules.
Financial instruments: Financial liabilities and equity 3501
This has led some to question whether a ‘regulatory change’ clause can be regarded as a
contingent settlement provision which is ‘not genuine’.10 This is ultimately a matter for the
judgement of entities and their auditors in the context of the relevant regulatory
environment(s). This judgement has not been made easier by the greater unpredictability
of the markets (and therefore of regulators’ responses to it) since the last financial crisis.
4.3.2
Liabilities that arise only on liquidation
As noted in 4.3 above, IAS 32 provides that a contingent settlement provision that comes
into play only on liquidation of the issuer may be ignored in determining whether or not
a financial instrument is a financial liability. IAS 32 refers specifically to ‘liquidation’. In
other words, if an instrument provides for redemption on the occurrence of events that
are a possible precursor of liquidation (e.g. extreme insolvency, the financial statements
not being prepared on a going concern basis, or the entity being placed under the
protection of Chapter 11 of the United States Bankruptcy Code) but falling short of formal
liquidation, the instrument must be treated as a financial liability. Also where liquidation
is in the control of the holder, the instrument will be a liability as this exception only
applies to contingencies beyond the control of both the issuer and the holder.
4.3.3
Liabilities that arise only on a change of control
A number of entities have issued instruments on terms that require the issuing entity to
transfer cash or other financial assets only in the event of a change in control of the issuing
entity. This raises the question of whether such an event is outside the control of the
issuing entity, with the effect than any instrument containing such a provision would be
classified as a liability to the extent of any obligations arising on a change of control.
This issue is far from straightforward. As noted at 4.2.1 above, it is our view that, where
the power to make a decision is reserved for the members of an entity in general
meeting, for the purposes of such a decision, the members and the entity are one and
the same. Therefore, we consider that any change of control requiring the approval of
the members in general meeting should be regarded as within the control of the entity.
Conversely, in our view, a change of control is not within the control of the entity where
it can be effected by one or more individual shareholders without reference to the
members in general meeting, for example where a shareholder holding 40% of the
ordinary equity sells its shares to another party already owning 30%.
However, we recognise that such a distinction is not as clear-cut as might at first sight
appear, and indeed in some situations may give rise to what could be regarded as a
purely form-based distinction, as illustrated by Example 43.1 below.
Example 43.1: Change of control
X plc is owned by:
• two wealthy individuals A and B, who own, respectively, 48% and 42% of X’s equity, together with
• a number of private individuals with small shareholdings totalling 10% of the equity.
In practical terms, if A and B agree that B will sell his shares to A, thus giving A a 90% controlling stake in the
entity, it makes very little difference whether this is achieved by a private sale treaty between A and B or a general
meeting of the company (at which A and B would be able to cast 90% of available votes in favour of the transaction).
3502 Chapter 43
In a situation such as that in Example 43.1 it would seem strange to say that a sale by
private treaty is not within the control of X plc, but a sale agreed in general meeting is,
when in either case all that matters is the intentions of A and B.
In our view, this is an area on which it would be useful for t
he IASB or the
Interpretations Committee to issue guidance. It may be that such guidance would need
to be based on ‘rules’ rather than principles.
4.3.4
Some typical contingent settlement provisions
The matrix below gives a number of contingent settlement provisions that we have
encountered in practice – some common, some rather esoteric – together with our
view as to whether they should be regarded as outside the control of the reporting
entity. If a contingent settlement provision is regarded as outside the control of the
issuing entity, the instrument will be classified as a liability by the issuer. If a contingent
settlement provision is regarded as within the control of the reporting entity, the
instrument will be classified as equity, provided that it has no other features requiring
its classification as a liability and that the contingent settlement event is also outside the
control of the holder.
Contingent settlement event
Within the issuer’s control?
Issuer makes a distribution on ordinary shares.
Yes. Dividends on ordinary shares are discretionary
(see also 4.2 above).
Upon the successful takeover of the issuer
It depends. See 4.3.3 above.
(i.e. a ‘control event’).
Event of default under any of the issuer’s debt
No.
facilities.
Appointment of a receiver, administrator, entering a No. Whether this leads to the instrument being
scheme of arrangement, or compromise agreement
classified as equity or liability will depend on the
with creditors.
respective requirements in each jurisdiction. In
cases when these events do not necessarily result in
liquidation of the issuer, this leads to classification
as a liability (see 4.3.2 above).
Upon commencement of proceedings for the
No, but this does not lead to classification as a liability
winding up of the issuer.
due to the requirement to ignore settlement provisions
arising only on liquidation (see 4.3.2 above).
Incurring a fine exceeding a given amount, or
No.
commencement of an investigation of the issuer by,
a government agency or a financial regulator.
A change in accounting, taxation, or regulatory
No.
regime which is expected to adversely affect the
financial position of the issuer.
Suspension of listing of the issuer’s shares from
Probably not, but it will depend on the jurisdiction
trading on the stock exchange for more than a
and whether the reasons for suspension are always
certain number of days.
within the control of the entity.
Commencement of war or armed conflict.
No.
Financial instruments: Financial liabilities and equity 3503
Issue of a subordinated security that ranks equally
Yes.
or in priority to the securities.
Issue of an IPO prospectus prior to the conversion
Yes.
date.
Execution of an effective IPO.
No. The execution of a successful IPO is not within
the control of the issuer.
Disposal of all or substantially all of the issuer’s
Yes.
business undertaking or assets.
Change in credit rating of the issuer.
No.
4.4
Examples of equity instruments
4.4.1 Issued
instruments
Under the criteria above, equity instruments under IAS 32 will include non-puttable
common (ordinary) shares and some types of preference share (see 4.5 below).
[IAS 32.AG13].
Whilst non-puttable shares are typically equity, an issuer of non-puttable ordinary
shares nevertheless assumes a liability when it formally acts to make a distribution and
becomes legally obliged to the shareholders to do so. This may be the case following
the declaration of a dividend, or when, on a winding up, any assets remaining after
discharging the entity’s liabilities become distributable to shareholders. [IAS 32.AG13]. For
example, if an entity has issued €100 million of equity instruments on which it declares
a dividend of €2 million, it recognises a liability of only €2 million. Whether or not a
liability arises on declaration of a dividend will depend on local legislation or the terms
of the instruments or both.
IAS 32 also treats as equity instruments some puttable instruments (see 4.6.2 below) and
some instruments that impose an obligation on the issuer to deliver a pro rata share of
net assets only on liquidation (see 4.6.3 below) that would otherwise be classified as
financial liabilities. However, a contract that is required to be settled by the entity
receiving or delivering either of these types of ‘deemed’ 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].
4.4.2
Contracts to issue equity instruments
A contract settled using equity instruments is not necessarily itself regarded as an equity
instrument. The classification of contracts settled using issued equity instruments is
discussed further at 5 below.
Warrants or written call options that allow the holder to subscribe for or purchase a
fixed number of non-puttable common (ordinary) shares in the issuing entity in
exchange for a fixed amount of cash or another financial asset, or the fixed stated
principal of a bond, are classified as equity instruments. [IAS 32.22, AG13]. The meaning of
a ‘fixed’ amount of cash is not as self-evident as it might appear and is discussed further
at 5.2.3 below. The meaning of the ‘fixed stated principal’ of a bond is discussed further
at 6.3.2.A below.
3504 Chapter 43
Conversely, an instrument is a financial liability (or financial asset) of the issuer if it gives
the holder the right to obtain:
• a variable number of non-puttable common (ordinary) shares in the issuing entity
in exchange for a fixed amount of cash or another financial asset; [IAS 32.21] or
• a fixed number of non-puttable common (ordinary) shares in the issuing entity in
exchange for a variable amount of cash or another financial asset. [IAS 32.24].
An obligation for the entity to issue or purchase a fixed number of its own equity
instruments in exchange for a fixed amount of cash or another financial asset is classified
as an equity instrument of the entity. However, if such a contract contains an obligation
– or even a potential obligation – for the entity to pay cash or another financial asset, it
gives rise to a liability for the present value of the redemption amount (which results in
a reduction of equity, not an expense – see 5.3 below). [IAS 32.23, AG13].
A purchased call option or other similar contract acquired by an entity that gives it
the right to reacquire a fixed number of its own equity instruments in exchange for
delivering a fixed amount of cash or another financial asset is not a financial asset
of the entity. Rather, it is classified as an equity instrument, and any consideration
[IAS 32.22, AG14]. This requirement refers only to contracts which require the entity
to settle gross (i.e. the entity pays cash in exchange for its own shares). Contracts
which can be net settled (i.e. the party for whom the contract is loss-making
delivers cash or shares equal to the fair value of the contract to the other party) are
generally treated as financial assets or financial liabilities. This is discussed in more
detail at 11 below.
4.5
Preference shares and similar instruments
Whilst some of the discussion below (and the guidance in IAS 32) is, for convenience,
framed in terms of ‘preference shares’, it should be applied equally to any financial
instrument, however described, with similar characteristics. In practice, many such
instruments are not described as shares (possibly to avoid weakening any argument that,
for fiscal purposes, they are tax-deductible debt rather than non-deductible equity).
Preference shares may be issued with various rights. In determining whether a
preference share is a financial liability or an equity instrument, IAS 32 requires an issuer
to assess the particular rights attaching to the share to determine whether it exhibits the
fundamental characteristic of a financial liability. [IAS 32.AG25].
IAS 32 does this in part by drawing a distinction between:
• instruments mandatorily redeemable or redeemable at the holder’s option
(see 4.5.1 below); and
• other instruments – i.e. those redeemable only at the issuer’s option or not
redeemable (see 4.5.2 to 4.5.4 below).
Financial instruments: Financial liabilities and equity 3505
4.5.1
Instruments redeemable mandatorily or at the holder’s option
A preference share (or other instrument) that:
• provides for mandatory redemption by the issuer for a fixed or determinable
amount at a fixed or determinable future date; or
• gives the holder the right to require the issuer to redeem the instrument at or after
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 692