Liabilities and equity – how one may become the other

As we summarized here, the IASB has published for public comment a Discussion Paper on how companies issuing financial instruments should classify them in their financial statements.

One of the best ways of getting one’s head (somewhat) around the concepts is to focus on instruments for which the proposals would generate a different classification. Here’s one:

  • net-share settled derivatives to deliver a fixed number of an entity’s own shares in exchange for receiving a variable number of its own shares with a total value equal to a fixed amount of the entity’s functional currency would be classified as equity instruments under the Board’s preferred approach, but are classified as financial assets or financial liabilities under IAS 32. The Board’s preferred approach considers whether there is a contractual obligation to transfer economic resources (NB an entity’s “economic resources” excludes its own equity instruments) at a specified time other than at liquidation and as a result, gross physically settled instruments and ‘net-share settled’ instruments are classified consistently given that neither require the transfer of economic resources. Thus, if both types of instruments also have net amounts that are unaffected by a variable that is independent of the entity’s available economic resources, the Board’s preferred approach would classify both as equity instruments whereas IAS 32 classifies only ‘gross-settled’ derivatives as equity instruments.

For clarity, what’s being described here, I believe, is a so-called cashless exercise. Suppose an individual has a contract to buy 100 shares of a company at $10 per share. If the share price increases to $20, the contract may allow the option, instead of having to pay $1,000 to obtain 100 shares, of paying nothing and receiving just 50 shares. This is a prime example of an instrument for which it’s always been hard to rationally explain (to yourself or to others) what liability treatment actually means, given that the company will never have to pay cash to the holder under any scenario. The proposed approach places more weight on that fact, and on the fact that the settlement formula depends only on the company’s own share price. It’s hard to see how any meaningful insight would be lost by allowing equity treatment for such instruments.

On the other hand…

  • foreign currency rights issues that meet the exception in IAS 32 would be classified as financial assets or financial liabilities applying the Board’s preferred approach. Such classification is consistent with derivatives on own equity whose net amount is affected by other independent variables, including other derivatives in foreign currency such as the embedded conversion option in a foreign currency convertible bond.

The IAS 32 definition of a liability states that “rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments.” This reflects the Board’s past determination that “classifying rights as derivative liabilities was not consistent with the substance of the transaction” and that such pro rata issues are transactions with an entity’s owners in their capacity as owners. On the other hand, it’s always been clear that such foreign currency rights issues carry a heavy flavour of liabilities, as they don’t result in the entity receiving a fixed amount of cash. The Board is now inclined to place more weight on consistency, finding that such narrow-scope exceptions only blur the underlying principles and help to create application problems.

One more example – irredeemable fixed-rate cumulative preference shares:

  • IAS 32 classifies such cumulative preference shares as equity instruments because there is no contractual obligation to transfer cash or another financial asset or to deliver a variable number of shares at a specified time other than at liquidation. In contrast, the Board’s preferred approach would classify such cumulative preference shares as financial liabilities because the entity has an obligation for an amount independent of the entity’s available economic resources. This is because the fixed-rate dividends accumulate over time and changes in the entity’s available economic resources will not result in changes in the amount of the obligation for the cumulative preference shares, even though the entity is only required to transfer economic resources at liquidation.

The premise appears to be in part that even if the amount attaching to such preferred shares doesn’t have to be paid out before liquidation, the accumulation of the amount over time will affect the economic resources available to others at that time, and so liability treatment provides a better sense of balance-sheet solvency and returns (the paper identifies this as one of the “two broad assessments of financial position and financial performance (made by users) that depend on information about different sets of features of claims”). The IASB concedes though that such instruments aren’t as relevant for assessments of funding liquidity and cash flows (this being the second broad assessment made by users). This leads it to some thoughts about presentation, which we’ll look at in the future.

The opinions expressed are solely those of the author

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