after the restructuring. For example, an entity with shares with a nominal (par) value of
€1 might enter into an agreement that requires it to issue ‘100 shares’. If, before
execution of that agreement, the entity has split each €1 share into ten €0.10 shares, it
must issue 1,000, not 100, shares in order to give effect to the intention of the contract.
Such adjustment formulae are most commonly seen in the terms of convertible
instruments (see 6 below for convertible instrument classification), so that the number
of shares into which the bonds eventually convert will take account of any capital
restructuring between issue and conversion of the bond, with the broad intention of
putting the holders of the bond in the same position with respect to other equity holders
before and after the restructuring. In addition, the terms of many convertible
instruments provide for similar adjustment upon the occurrence of other actions or
events which would affect the position of the convertible bondholders relative to other
equity holders. Such actions or events may include, for example:
• the payment of ordinary dividends;
• an issue of equity at less than current market value;
• the repurchase of equity at more than current market value;
• the issue of further convertible securities at less than fair market value; or
• the acquisition of assets in exchange for equity at more than fair market value.
Financial instruments: Financial liabilities and equity 3531
This raises the question of whether a contract with any such terms can be classified as
equity under IAS 32, since the number of shares ultimately issued on conversion is not
fixed at the outset, but may vary depending on whether a restructuring or other event
occurs before conversion. In our view, an adjustment to the number of equity
instruments issued in such circumstances should not be considered to result in the issue
of a variable number of shares, where its purpose is to ensure that the bondholder’s
equity interest is not diluted or augmented. In other words, if the adjustment attempts
to put the holders of the instruments into the same economic position relative to
ordinary shareholders after the restructuring as they were in before the restructuring,
then the fixed for fixed criterion is still met. We consider that the potential dilution or
augmentation in the bondholder’s equity interest which is to be adjusted for should be
determined in comparison to the effect of the event on the other equity holders in
aggregate. Thus, if shares are issued to new shareholders at a discount, the dilution
suffered by the bondholders should be calculated by reference to the total number of
shares in existence following the new issue.
The effect of such an adjustment is that the risks and rewards of the bondholder are
more closely aligned to those of a holder of ordinary shares. IAS 32 generally treats
contracts involving a variable number of equity instruments as a financial liability
because the effect of the variability is that the counterparty is not exposed to any
movement in the fair value of the equity instruments between the inception and
execution of the contract. In this case, however, the variability is introduced so as
to ensure that the counterparty remains exposed to any movement in the fair value
of the equity instruments, and maintains the same interest in the equity relative to
other shareholders.
The same question arises in circumstances where a convertible bond is convertible into
a fixed percentage of equity. This is discussed at 6.6.6 below.
However not all convertible securities with adjustable conversion ratios can be
classified as equity. Where a convertible security has a contractual feature for the
conversion ratio to be adjusted down to the lower price of any later issue in the
underlying shares, the instrument will fail equity classification. The modification feature
is not fixed for fixed and therefore the conversion option is a financial liability.
[IAS 32.11(b)(ii)]. As such it is an embedded derivative of a debt host rather than an equity
component. The entity’s ability to control the non-fixed for fixed settlement is not
relevant to the assessment. This is because a derivative instrument that gives either
party the choice over settlement is a financial asset or liability unless all of the settlement
alternatives would result in it being an equity instrument. [IAS 32.26]. The conversion
option will therefore be treated as a derivative liability. This is discussed in more detail
at 6.6.7 below.
The Interpretations Committee considered a number of ‘fixed for fixed’ issues raised by
constituents at its November 2009 meeting. However, the Interpretations Committee
concluded that the Board’s project Financial Instruments with Characteristics of Equity
was expected to address issues relating to the fixed for fixed condition, and that the
Interpretations Committee would therefore not add this to its agenda. As discussed
further at 12 below, work on this project was suspended between October 2010 and
October 2014, but has now restarted.
3532 Chapter 43
5.1.3
Stepped up exercise price
Another type of adjustment which is commonly found is where an entity issues
subscription shares that have a stepped exercise price, which is fixed at inception and
increases with the passage of time. Such subscription shares are typically issued as
bonus shares on a pro rata basis to existing shareholders and give the holder the right
(but not the obligation) to subscribe for a certain number of ordinary shares, at a certain
price and at a certain time in the future. Our view is that subscription shares that have a
stepped exercise price meet the ‘fixed for fixed’ condition only if the exercise prices are
fixed at inception and for the entire term of the instrument, such that at any point in
time the exercise price is pre-determined at the issuance of the subscription shares. If
the exercise price per share is linked to an index of any kind, the ‘fixed for fixed’
condition is not met and the contract to issue the shares would not be classified as an
equity instrument.
5.1.4
Exchange of fixed amounts of equity (equity for equity)
As discussed above, IAS 32 requires a contract settled in own equity to be classified as
equity if, inter alia, it involves the exchange of a fixed amount of cash (or other financial
assets) for a fixed amount of equity. This begs the question of how to classify a contract
that provides for the exchange of a fixed amount of one class of the entity’s equity for a
fixed amount of another class. Examples might be:
• a warrant allowing the holder of a preference share classified as equity (see 4.5
above) to exchange it for an ordinary equity share; or
• in consolidated financial statements, an option for a shareholder of a partly-owned
subsidiary (classified within equity in the consolidated financial statements) to
exchange a fixed number of shares in the subsidiary for a fixed number of shares
in the parent.
One view might be that, as such a contract does not fall within the definition of an ‘equity
instrument’ in accordance with IAS 32 it must therefore be account
ed for as a derivative.
The contrary view would be that the contract is so clearly an equity instrument that it
should be accounted for as such. Those who hold this view would argue that the absence
of any reference to such ‘fixed equity for fixed equity’ contracts in IAS 32 does not
reflect a conscious decision by the IASB, but rather indicates that the IASB never
considered such contracts at all.
A third view might be that the analysis may depend upon the specific terms of the equity
instruments. For example, if the equity instrument being exchanged has debt-like
features (e.g. it pays regular, but discretionary, coupons), and is denominated in the same
currency as the entity’s functional currency, the contract would be classified as equity,
but if it were denominated in a different currency, the contact would, for the reasons
discussed at 5.2.2 below, be classified as a derivative.
5.2
Contracts accounted for as financial assets or financial liabilities
5.2.1
Variable number of equity instruments
An entity may have a contractual right or obligation to receive or deliver a number of
its own shares or other equity instruments that varies so that the fair value of the entity’s
Financial instruments: Financial liabilities and equity 3533
own equity instruments to be received or delivered equals the amount of the contractual
right or obligation.
The right or obligation may be for:
• a fixed amount – e.g. as many shares as are worth £100; or
• an amount that fluctuates in part or in full in response to changes in a variable other
than the market price of the entity’s own equity instruments, such as movements
in interest rates, commodity prices, or the price of a financial instrument – e.g. as
many shares as are worth:
• 100 ounces of gold;
• £100 plus interest at LIBOR plus 200 basis points;
• 100 government bonds; or
• 100 shares in a particular entity.
Such a contract is a financial asset or liability. Even though the contract must, or may,
be settled through receipt or delivery of the entity’s own equity instruments, the number
of own equity instruments required to settle the contract will vary. The contract will
therefore not fulfil the requirements of an equity instrument, and is therefore a financial
asset or financial liability. [IAS 32.21, AG27(d)].
5.2.2
Fixed number of equity instruments for variable consideration
A contract that will be settled by the entity delivering or receiving a fixed number of its
own equity instruments in exchange for a variable amount of cash or another financial
asset is a financial asset or financial liability. An example is a contract for the entity to
deliver 100 of its own equity instruments in return for an amount of cash calculated to
equal the value of 100 ounces of gold, [IAS 32.24], or 100 specified government bonds. As
discussed at 5.2.3 below, it would also include a contract for the entity to deliver 100 of
its own equity instruments in return for a fixed amount of cash denominated in a
currency other than its own functional currency.
5.2.3
Fixed amount of cash (or other financial assets) denominated in a
currency other than the entity’s functional currency
Some contracts require an entity to issue a fixed number of equity instruments in
exchange for a fixed amount of cash denominated in a currency other than the entity’s
functional currency. Such contracts raise a problem of interpretation illustrated by the
example in paragraph 24 of IAS 32 (referred to in 5.2.1 above) of a contract being a
financial asset or financial liability where the reporting entity is required ‘to deliver 100
of its own equity instruments in return for an amount of cash calculated to equal the
value of 100 ounces of gold’. If one substitutes ‘100 US dollars’ for ‘100 ounces of gold’,
the latent problem becomes apparent.
Suppose a UK entity (with the pound sterling as its functional currency) issues a £100
bond convertible into a fixed number of its equity shares. As discussed in more detail
at 6 below, IAS 32 requires this to be accounted for by splitting it into a liability
component (the obligation to pay interest and repay principal) and an equity component
(the holder’s right to convert into equity). In this case the equity component is the right
3534 Chapter 43
to convert the fixed stated £100 principal of the bond (see 6.3.2.A below) into a fixed
number of shares.
Suppose instead, however, that the UK entity (with the pound sterling as its functional
currency) issues a 100 US dollar bond convertible into a fixed number of its shares. The
conversion feature effectively gives the bondholder the right to acquire a fixed number
of shares for a fixed stated principal (see 6.3.2.A below) of $100 – is this a ‘fixed amount’
of cash, or is it to be regarded as being just as variable, in terms of its conversion into
the functional currency of the pound sterling, as 100 ounces of gold?
If the conclusion is that $100 is a fixed amount of cash, the conversion right is accounted
for as an equity component of the bond – in other words a value is assigned to it on
initial recognition and it is not subsequently remeasured (see 6.2.1 below). If, on the
other hand, the conclusion is that $100 is not a fixed amount of cash, then the conversion
right (as an embedded derivative not regarded by IFRS 9 as closely related to the host
contract – see Chapter 42 at 4) is accounted for as a separate derivative financial
liability, introducing potentially significant volatility into the financial statements.
There is no obvious answer to this. A contention that the $100 is a ‘fixed amount’ of
cash is hard to reconcile with the fact that a contract to issue shares for ‘as many pounds
sterling as are worth $100’ would clearly involve the issue of a fixed number of shares
for a variable amount of cash and would therefore not be an equity instrument.
The Interpretations Committee considered this issue at its meeting in April 2005. The
Committee noted that although this matter was not directly addressed in IAS 32, it was
clear that, when the question is considered in conjunction with guidance in other
standards, particularly IFRS 9, any obligation denominated in a foreign currency
represents a variable amount of cash. Consequently, the Interpretations Committee
concluded that a contract settled by an entity delivering a fixed number of its own equity
instruments in exchange for a fixed amount of foreign currency should be classified as
a liability.20
5.2.3.A
Rights issues with a price fixed in a currency other than the entity’s
functional currency
In July 2009, as a result of a recommendation from the Interpretations Committee, the
IASB reconsidered this matter in the specific context of rights issues (options to
purchase additional shares at a fixed price) where the price is denominated in a currency
other than the entity’s functional currency. The IASB was advised that the
Interpretations Committee’s conclusion was being applied to rights issues, with the
result that the rights were being accounted for as derivative liabilities with cha
nges in
fair value being recognised in profit or loss. HSBC explained that such accounting would
result in the recognition of a loss of $4.7 billion in the first quarter of 2009.
Financial instruments: Financial liabilities and equity 3535
Extract 43.2: HSBC Holdings plc (2009)
Interim Management Statement Q1 2009 [extract]
Accounting impact of HSBC’s Rights Issue [extract]
On 2 March 2009, HSBC announced a 5 for 12 Rights Issue of 5,060 million new ordinary shares at 254 pence per
share, which was authorised by the shareholders in a general meeting on 19 March 2009. The offer period commenced
on 20 March 2009, and closed for acceptance on 3 April 2009. Under IFRSs, the offer of rights is treated as a
derivative because substantially all of the issue was denominated in currencies other than the Company’s functional
currency of US dollars, and accordingly HSBC was not able to demonstrate that it was issuing a fixed number of
shares for a fixed amount of US dollars, which is the criterion under IFRSs for HSBC to account for the offer of rights
in shareholders’ equity. The derivative liability was measured at inception of the offer as the difference between the
share price at that date and the rights price, with a corresponding debit to shareholders’ equity. The revaluation of
this derivative liability over the offer period, arising from an increase in the share price, has resulted in the recognition of a loss in the income statement of US$4.7 billion. The derivative liability expired on acceptance of the offer, and
the closing balance was credited to shareholders’ equity. Accordingly, there is no overall impact on the Group’s
shareholders’ equity, capital position or distributable reserves.
Consequently, in October 2009, the IASB made a limited amendment to IAS 32 so as to
require a rights issue granted pro rata to an entity’s existing shareholders for a fixed
amount of cash to be classified as equity, regardless of the currency in which the
exercise price is denominated. [IAS 32.11].
This amendment does not apply to other instruments that grant the holder the right to
purchase the entity’s own equity instruments, such as the conversion feature in a
convertible bond. It also does not apply to long-dated foreign currency rights issues,
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