(see 4.6 below).
4.5.6 Economic
compulsion
The discussion in 4.5.1 to 4.5.5 above illustrates that, while IAS 32 requires the issuer of
a financial instrument to classify a financial instrument by reference to its substance
rather than its legal form, in reality the substance is determined, if not by the legal form,
then certainly by the precise legal rights of the holder of the financial instrument
concerned. Ultimately, the key determinant of whether an instrument is a financial
liability or an equity instrument of the issuer is whether the terms of the instrument give
the holder a contractual right to receive cash or other financial assets which can be sued
for at law, subject only to restrictions outside the terms of the instrument (e.g. statutory
dividend controls).
By contrast, terms of an instrument that effectively force the issuer to transfer cash or
other financial assets to the holder although not legally required to do so (often referred
to as ‘economic compulsion’), are not taken into account.
In response to a submission for a possible agenda item, in March 2006 the
Interpretations Committee discussed the role of contractual and economic obligations
in the classification of financial instruments under IAS 32.
The Interpretations Committee agreed that IAS 32 is clear that, in order for an
instrument to be classified as a liability, a contractual obligation must be established
(either explicitly or indirectly) through the terms and conditions of the instrument.
Economic compulsion, by itself, would not result in a financial instrument being
classified as a liability.
The Interpretations Committee also noted that IAS 32 restricts the role of ‘substance’ to
consideration of the contractual terms of an instrument, and that anything outside the
contractual terms is not considered for the purpose of assessing whether an instrument
should be classified as a liability under IAS 32.14
Financial instruments: Financial liabilities and equity 3511
4.5.7 ‘Linked’
instruments
An entity may issue an instrument (the ‘base’ instrument) that requires a payment to be
made if, and only if, a payment is made on another instrument issued by the entity (the
‘linked’ instrument). An example of such an instrument would be a perpetual instrument
with a ‘dividend blocker’ clause (see 4.5.3.A above), on which the issuing entity is
required to pay a coupon only if it pays a dividend to ordinary shareholders. Absent
other terms requiring the perpetual instrument to be classified as a liability, it is classified
as equity on the basis that the event that triggers a contractual obligation to make a
payment (i.e. payment of an ordinary dividend) is itself not a contractual obligation.
If, however, where payments on the linked instrument are contractually mandatory
(such that the linked instrument contains a liability), it is obvious that the base
instrument must also contain a liability. This is due to the fact that, in this case, the event
that triggers a contractual obligation to make a payment on the base instrument (i.e. a
payment on the linked instrument) is a contractual obligation that the issuing entity
cannot avoid. This analysis was confirmed by the Interpretations Committee in
March 2006 following discussion of linked instruments with similar terms to these.15
This issue had arisen in practice in the context that the linked instrument was often very
small and callable by the issuer, but on terms that required its classification as a liability
under IAS 32. This would allow the issuer, with no real difficulty, to redeem the linked
instrument at will and thus convert the base instrument from a liability to equity at any time.
This had led some to argue that only the linked instrument should be classified as a liability.
4.5.8
‘Change of control’, ‘taxation change’ and ‘regulatory change’
clauses
A number of entities have issued instruments with ‘dividend blocker’, ‘dividend pusher’
and ‘step-up’ clauses (see 4.5.3 and 4.5.4 above), which would otherwise have been
treated as equity by IAS 32, but have wished to account for them as liabilities, perhaps
because they can then be hedged in a way that allows hedge accounting to be applied
(see 10 below). Methods of achieving this have included the use of a de minimis linked
liability instrument, or the inclusion of a clause requiring the repayment of the
instrument in the event of a change of control. This raises the question of whether a
change of control is within the control of the entity (such that the instrument is equity)
or not (such that the instrument is debt), which is discussed in more detail at 4.3.3 above.
Another common method of converting an instrument that would otherwise be
classified by IAS 32 as equity into debt is to add a clause requiring repayment of the
instrument in the event of a fiscal or regulatory change (that in reality may be a remote
possibility) – see 4.3.1 above.
4.6
Puttable instruments and instruments repayable only on
liquidation
4.6.1 The
issue
A ‘puttable instrument’ is essentially a financial instrument that gives the holder the right
to put the instrument back to the issuer for cash or another financial asset (see 3 above).
Prior to its amendment in February 2008 (see 1.2 above), IAS 32 classified any puttable
3512 Chapter 43
instrument as a financial liability, including instruments the legal form of which gives
the holder a right to a residual interest in the assets of the issuer.
This classification produced what some regarded as an inappropriate result in the
financial statements of entities such as open-ended mutual funds, unit trusts,
partnerships and some co-operative entities. Such entities often provide their unit
holders or members with a right to redeem their interests in the issuer at any time for
cash. Under IAS 32, prior to the February 2008 amendment, an entity whose holders
had such rights might report net assets of nil, or even negative net assets, since what
would, in normal usage, have been regarded as its ‘equity’ (i.e. assets less external
borrowings) was classified as a financial liability.
For example, the owners of some co-operatives and professional partnerships are
entitled to have their ownership interests repurchased at fair value. However, such
entities typically do not reflect that fair value in their financial statements, because a
significant part of the value may be represented by property accounted for at cost rather
than fair value or by internally generated goodwill which cannot be recognised in
financial statements prepared under IFRS.
Clearly, if such an entity were to recognise a liability for the right of its owners to be
bought out at fair value, it would show net liabilities, which would increase (creating
accounting losses) the more the fair value of the entity increases, and decrease (creating
accounting profits) the more the fair value decreases. Moreover, any distributions to the
owners of such entities would be shown as a charge to, rather than a distribution of, profit.
Similar concerns were raised in relation to limited-life entities. In some
jurisdictions,
certain types of entity are required to be wound up after a certain period of time, either
automatically, or unless the members resolve otherwise. Some entities may also have a
limited life under their own governing charter, or equivalent document. For example:
• a collective investment fund might be required to be liquidated on, say, the tenth
anniversary of its foundation; or
• a partnership might be required to be dissolved on the death or retirement of a partner.
Such an entity arguably had no equity under IAS 32 prior to the February 2008
amendment, since its limited life imposes an obligation, outside the entity’s control, to
distribute all its assets. Again, some questioned whether it was very meaningful to show
such an entity as having no equity.
In order to deal with these concerns, IAS 32 was amended in February 2008. In the
meantime, the Interpretations Committee had published IFRIC 2 which addresses the
narrower issue of the classification of certain types of puttable instrument typically
issued by co-operative entities (see 4.6.6 below).
The effect of the amended standard is that certain narrowly-defined categories of
puttable instruments (see 4.6.2 below) and instruments repayable on a pre-determined
liquidation (see 4.6.3 below) are classified as equity, notwithstanding that they have
features that would otherwise require their classification as financial liabilities.
Moreover, as discussed further at 4.6.5 below, one of the criteria for classifying such an
instrument as equity, is that it is the most subordinated instrument issued by the
reporting entity. This represents a significant, and controversial, departure from the
Financial instruments: Financial liabilities and equity 3513
normal approach of IAS 32 that the classification of an instrument should be determined
only by reference to the contractual terms of that instrument, rather than those of other
instruments in issue. This may mean that two entities may classify an identical
instrument differently, if it is the most subordinated instrument of one entity but not of
the other. It may also mean that the same entity may classify the same instrument
differently at different reporting dates.
It was essentially these departures from the normal requirements of IAS 32 that led two
members of the IASB to dissent from the amendment. In their view, it is not based on a
clear principle, but comprises ‘several paragraphs of detailed rules crafted to achieve a
desired accounting result ... [and] ... to minimise structuring opportunities’.16
Where the exceptions in 4.6.2 and 4.6.3 below do not apply, IAS 32 takes the view that
the effect of the holder’s option to put the instrument back to the issuer for cash or
another financial asset is that the puttable instrument meets the definition of a financial
liability, [IAS 32.18(b)], (see 3 above).
The IASB believes that the accounting treatment required by IAS 32 for instruments not
subject to the exceptions in 4.6.2 and 4.6.3 below is appropriate, but points out that the
classification of members’ interests in such entities as a financial liability does not preclude:
• the use of captions such as ‘net asset value attributable to unitholders’ and ‘change in
net asset value attributable to unitholders’ on the face of the financial statements of
an entity that has no equity capital (such as some mutual funds and unit trusts); or
• the use of additional disclosure to show that total members’ interests comprise
items such as reserves that meet the definition of equity and puttable instruments
that do not. [IAS 32.18(b), BC7-BC8].
The illustrative examples appended to IAS 32 give specimen disclosures to be used in
such cases – see Chapter 50 at 7.4.6.
4.6.2 Puttable
instruments
As noted above, a puttable financial instrument includes a contractual obligation for the
issuer to repurchase or redeem that instrument for cash or another financial asset on
exercise of the put. IAS 32 classifies a puttable instrument as an equity instrument if it
has all of the following features: [IAS 32.16A-16B]
(a) It entitles the holder to a pro rata share of the entity’s net assets in the event of the
entity’s liquidation. The entity’s net assets are those assets that remain after
deducting all other claims on its assets. A pro rata share is determined by:
(i) dividing the entity’s net assets on liquidation into units of equal amount; and
(ii) multiplying that amount by the number of the units held by the financial
instrument holder.
(b) The instrument is in the class of instruments that is subordinate to all other classes
of instruments. To be in such a class the instrument:
(i)
has no priority over other claims to the assets of the entity on liquidation; and
(ii) does not need to be converted into another instrument before it is in the class
of instruments that is subordinate to all other classes of instruments.
3514 Chapter 43
(c) All financial instruments in the class of instruments that is subordinate to all other
classes of instruments have identical features. For example, they must all be
puttable, and the formula or other method used to calculate the repurchase or
redemption price is the same for all instruments in that class.
(d) Apart from the contractual obligation for the issuer to repurchase or redeem the
instrument for cash or another financial asset, the instrument does not include any
contractual obligation to deliver cash or another financial asset to another entity,
or to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity, and it is not a contract
that will or may be settled in the entity’s own equity instruments as set out in
subparagraph (b) of the definition of a financial liability (see 3 above).
(e) The total expected cash flows attributable to the instrument over the life of the
instrument are based substantially on the profit or loss, the change in the
recognised net assets, or the change in the fair value of the recognised and
unrecognised net assets of the entity over the life of the instrument (excluding any
effects of the instrument). [IAS 32.16A]. Profit or loss and the change in recognised
net assets must be determined in accordance with relevant IFRSs. [IAS 32.AG14E].
(f) In addition to the instrument having all the features in (a) to (e) above, the issuer
must have no other financial instrument or contract that has:
(i) total cash flows based substantially on the profit or loss, the change in the
recognised net assets or the change in the fair value of the recognised and
unrecognised net assets of the entity (excluding any effects of such instrument
or contract); and
(ii) the effect of substantially restricting or fixing the residual return to the
puttable instrument holders.
In applying this condition, the entity should not consider non-financial contracts
with a holder of an instrument described in (a) to (e) above that have contractual
terms and conditions that are similar to the contractual terms and conditions of an
equivalent contract that might occur between a non-instrument holder and the
/> issuing entity. If the entity cannot determine that this condition is met, it should
not classify the puttable instrument as an equity instrument. [IAS 32.16B].
Some of these criteria raise issues of interpretation, which are addressed at 4.6.4 below.
4.6.3
Instruments entitling the holder to a pro rata share of net assets only
on liquidation
Some financial instruments include a contractual obligation for the issuing entity to
deliver to another entity a pro rata share of its net assets only on liquidation. The
obligation arises because liquidation either is certain to occur and outside the control of
the entity (for example, a limited life entity) or is uncertain to occur but is at the option
of the instrument holder. IAS 32 classifies such an instrument as an equity instrument if
it has all of the following features: [IAS 32.16C-16D]
(a) It entitles the holder to a pro rata share of the entity’s net assets in the event of the
entity’s liquidation. The entity’s net assets are those assets that remain after
deducting all other claims on its assets. A pro rata share is determined by:
Financial instruments: Financial liabilities and equity 3515
(i) dividing the net assets of the entity on liquidation into units of equal amount;
and
(ii) multiplying that amount by the number of the units held by the financial
instrument holder.
(b) The instrument is in the class of instruments that is subordinate to all other classes
of instruments. To be in such a class the instrument:
(i)
has no priority over other claims to the assets of the entity on liquidation; and
(ii) does not need to be converted into another instrument before it is in the class
of instruments that is subordinate to all other classes of instruments.
(c) All financial instruments in the class of instruments that is subordinate to all other
classes of instruments must have an identical contractual obligation for the issuing
entity to deliver a pro rata share of its net assets on liquidation. [IAS 32.16C].
(d) In addition to the instrument having all the features in (a) to (c) above, the issuer
must have no other financial instrument or contract that has:
(i) total cash flows based substantially on the profit or loss, the change in the
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