Here’s a tentative agenda decision recently issued for comment by the IFRIC:
- The Committee received a request about the application of IAS 32 in relation to the reclassification of warrants. Specifically, the request described a warrant that provides the holder with the right to buy a fixed number of equity instruments of the issuer of the warrant for an exercise price that will be fixed at a future date. At initial recognition, because of the variability in the exercise price, the issuer in applying paragraph 16 of IAS 32 classifies these instruments as financial liabilities. This is because for a derivative financial instrument to be classified as equity, it must be settled by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments (‘fixed-for-fixed condition’). The request asked whether the issuer reclassifies the warrant as an equity instrument following the fixing of the warrant’s exercise price after initial recognition as specified in the contract, given that the fixed-for-fixed condition would at that stage be met.
- The Committee observed that IAS 32 contains no general requirements for reclassifying financial liabilities and equity instruments after initial recognition when the instrument’s contractual terms are unchanged. The Committee acknowledged that similar questions about reclassification arise in other circumstances. Reclassification by the issuer has been identified as one of the practice issues the Board will consider addressing in its Financial Instruments with Characteristics of Equity (FICE) project. The Committee concluded that the matter described in the request is, in isolation, too narrow for the Board or the Committee to address in a cost-effective manner. Instead, the Board should consider the matter as part of its broader discussions on the FICE project. For these reasons, the Committee [decided] not to add a standard-setting project to the work plan.
These kinds of instruments arise quite often in Canada, particularly among small companies, reflecting I suppose the range of negotiations with finance providers (the submission to IFRIC came though from the European Securities and Markets Authority (ESMA), recognizing diverse practice observed across European jurisdictions). The “other circumstances” referred to include warrants classified as financial liabilities because the amount of cash to be delivered is initially denominated in a currency other than the issuer’s functional currency (but then this changes), and (less commonly) instruments where the obligation to deliver cash depends on the occurrence of a contingent event (the nature of which then, say, changes to fall within the issuer’s control). In my experience, while preparers and others may be able to buy into the accounting in theory, it’s very unpopular in practice, given the difficulty in getting one’s head around what the financial liability really means. It’s not hard to imagine then that if and when the terms change in a way that seems to render the accounting unnecessary, companies might want to seize the opportunity to do that – I doubt I would have pushed back against any issuer that analyzed it as such.
But that shows you how much I know, because in an opposing view set out in the accompanying agenda paper:
- IAS 32 does not envisage reclassifying a financial instrument after initial recognition. In addition… in the fact pattern described in the submission, the derecognition requirements in IFRS 9 are not met when the exercise price is fixed because the liability is not extinguished. Furthermore, there has not been a substantial modification as described in IFRS 9 because the original contractual terms of the warrant specify the exercise price will be fixed at a future date. Accordingly, applying (this view), the issuer is prohibited from reclassifying or derecognizing the warrant in the fact pattern described in the submission. As a result, the warrant would continue to be classified as a financial liability when the exercise price is subsequently fixed.
While that may all be technically correct, it’s hard for me anyway to see how such an ongoing financial liability would provide any useful information. With that in mind, you might think either that a reclassification is required, or that an accounting policy choice exists, on the basis that IAS 32 doesn’t prevent an entity from reassessing the nature of a financial instrument and its classification to reflect changes in facts and circumstances. Under this line of thinking: “the substance of the warrant has changed into that of an equity instrument when the exercise price is subsequently fixed because the warrant would satisfy the fixed-for-fixed condition in IAS 32 if the condition was assessed at that date (and therefore) it would be misleading to continue to classify the warrant as a financial liability after the exercise price is fixed.”
But none of these questions are new – they’ve been identified in the past and are acknowledged in the publications of some of the big accounting firms. So, as noted above, the committee understandably decided to take a pass. In the meantime, issuers in such situations may perhaps reclassify away! Or not!
The opinions expressed are solely those of the author.