The headscratching world of liabilities versus equity

Here’s another issue recently discussed by CPA Canada’s IFRS Discussion Group:

• Paragraph 15 of IAS 32 Financial Instruments: Presentation states: “The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument.”
• The definitions of financial assets, financial liabilities and equity instruments are contained in paragraph 11 of IAS 32.
• Paragraph 16 of IAS 32 provides the conditions that must be met for a financial instrument to be classified as an equity instrument instead of a financial liability. Paragraph 16(b)(ii) of IAS 32 is referred to as the “fixed-for-fixed” condition. This paragraph states, in part, that “if the instrument will or may be settled in the issuer’s own equity instruments, it is a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.”
• Challenges may arise in interpreting the fixed-for-fixed condition because IAS 32 contains limited guidance on this condition.

The group discussed whether the condition would be met in various hypothetical circumstances. Some of these appear fairly well-established and uncontroversial, for instance: “A share purchase option is exercisable at $0.05 per share for the first year after issue and $0.10 in the second and third year after issue before expiring at the end of year 3.” In such a case: “the only variable affecting the exercise price is time (i.e., when the holder exercises the share option). At any point in time, the exercise price for immediate exercise is known. Hence, the terms of the contract do not introduce variability that is unknown at the inception of the contract.”

In contrast, take the following case: “A share purchase option is exercisable at $1 per share. The share option agreement provides for a reduction to the exercise price (or increase in the number of shares delivered under the option) in the event that shares are issued below $1 per share. Such a clause is often referred to as a “down-round” or “price-protection” clause. The intention of the adjustment clause is to protect the option holders from adverse movements in the share price. The existing shareholders do not receive a similar benefit.” This situation doesn’t meet the condition because “the relative rights of the shareholders and option holders are not maintained on equal footing…The adjustment clause has the potential to transfer value (in relative terms) from the existing ordinary shareholders to the option holders.”

It might be hard for some to get their heads around the significance of the “fixed for fixed” criterion. The underlying definition of an equity instrument is “any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.” You might take the view that if a holder holds an instrument that entitles him or her to acquire an entity’s stock, then it has some kind of residual interest regardless that the price of exercising that entitlement might vary. IAS 32 doesn’t do a particularly eloquent job of countering this thought. It describes a contract that an entity can settle by issuing a fluctuating quantity of its own shares and says: “It is not an equity instrument because the entity uses a variable number of its own equity instruments as a means to settle the contract. Accordingly, the contract does not evidence a residual interest in the entity’s assets after deducting all of its liabilities.” But that “accordingly” could likely use a bit more fleshing out.

The broad notion, although it doesn’t seem to be expressed in so many words, is that the residual interest entails complete certainty – based on the contractual arrangements currently in place – about the number of equity instruments that might be issued and about the amount of proceeds they might raise. This hardly eliminates all uncertainty – a convertible debt might or might not be converted, a warrant might or might not be exercised. But the equity concept requires that if they are, then the effects of that exercise or conversion should be entirely determinable. That’s fine in itself, but sometimes prompts questions about why a relatively minor form of adjustment to the exercise price should trigger an entirely different accounting approach. The discussion group touched on such questions, musing about situations where “the ‘not genuine’ condition in IAS 32 (whereby a contingent settlement provision can be overlooked for purposes of determining the treatment) would need to be invoked.” But it goes on: “Group members were reluctant to apply such a condition, noting that any potentially non-genuine clauses would generally be removed from an agreement before being signed. If one or both of the parties do not agree with its removal, this is evidence that the term is in fact genuine.”

As far as I can tell, it doesn’t seem likely that anything about the IASB’s ongoing project on financial instruments with characteristics of equity would change this basic approach. Where such analyses give rise to derivative liabilities, it will continue to be hard to get one’s head around what information content those liabilities represent, particularly as the fair values attaching to them often seem highly theoretical, if not outright outlandish….

The opinions expressed are solely those of the author