The IASB has published for public comment a Discussion Paper on how companies issuing financial instruments should classify them in their financial statements.

Comments are to be received by January 7, 2019. Here’s how the accompanying news release summed up this initiative:

• IAS 32 Financial Instruments: Presentation currently sets out how a company that issues financial instruments should distinguish financial liabilities from equity instruments. That distinction is important because the classification of the instruments affects how a company’s financial position and performance are depicted.
• IAS 32 works well for most financial instruments. However, continuing financial innovation means that some companies find it challenging to classify some complex financial instruments that combine some features of both debt—liabilities—and ordinary shares—equity instruments.
• Challenges in classifying these instruments can result in diverse accounting in practice, which in turn makes it difficult for investors to assess and compare companies’ financial position and performance. In addition, investors have been calling for better information, particularly about equity instruments.
• The Board has responded to feedback from investors and others and has considered previous work on the topic to propose an approach that would:
•    – provide a clear rationale for why a financial instrument would be classified as either a liability or equity without fundamentally changing the existing classification outcomes of IAS 32; and
•    – enhance the information provided through presentation and disclosure.

A key aspect of this is the notorious “fixed for fixed” criterion. I wrote in the past about this criterion, and some of the difficulties it raises:

• 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 preferred approach set out in the discussion paper would classify a financial instrument as a financial liability if the instrument contains: (a) an unavoidable contractual obligation to transfer cash or other financial assets other than at liquidation (the ‘timing’ feature); and/or (b) an unavoidable contractual obligation for an amount independent of the issuer’s available economic resources (the ‘amount’ feature). Financial instruments would be classified as equity instruments if they do not contain either of these two features.

That may sound essentially simple, but of course it comes with a lot of underlying analysis and explanation. For illustration, this is how I think the approach would apply to the common examples of a straightforward warrant, and of a foreign currency warrant. An issuer’s “economic resources” doesn’t include its own equity interests. So the amount of an ordinary share with a right to participate in distributions and to a pro rata share of net assets at liquidation, would always depend on the residual cash flows from the entity’s economic resources minus all other claims. As the share has no entitlement to an amount independent of the entity’s available economic resources, it continues to be an equity instrument. For a simple equity option or warrant to acquire such a share, with a single strike price, the net amount of the derivative isn’t affected by a variable that is independent of the entity’s available economic resources, and this too is analyzed as equity. But where the strike price changes for reasons independent of the entity’s available resources – for example because it’s denominated in foreign currency – then it’s analyzed as a liability.

In this case, as in most (although not all) others, the analysis comes to the same place as the IAS 32 “fixed for fixed” criterion, but the premise, as noted, is that this proposed approach is more understandable (eventually anyway), and would be more likely to result in consistent application.

I guess it will take more reflection to form any kind of advanced view on the discussion paper’s merits. We’ll spend more time on it in the future…

The opinions expressed are solely those of the author