The IASB has issued the Exposure Draft Financial Instruments with Characteristics of Equity—Proposed amendments to IAS 32, IFRS 7 and IAS 1, with a comment deadline of March 29, 2024.

The backdrop as set out in the basis for conclusions is that “financial innovation, market forces and changes to financial sector regulations have resulted in a growing number of financial instruments with characteristics of equity that present challenges to entities in applying IAS 32. Users of financial statements who wish to understand the effects of these financial instruments on an entity’s financial position and financial performance have raised questions about their classification. The Board has also become aware of IAS 32 application challenges faced by entities that have been highlighted in submissions to the IFRS Interpretations Committee. The Committee was unable to reach a consensus on some of these submissions because it was difficult to identify a clear and consistent classification principle in IAS 32…”

One of the areas of focus is the so-called “fixed for fixed” criterion, currently set out as follows in paragraph 22 of IAS 32 (leaving aside an exception relating to puttable instruments):

• …a contract that will be settled by the entity (receiving or) delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset is an equity instrument. For example, an issued share option that gives the counterparty a right to buy a fixed number of the entity’s shares for a fixed price or for a fixed stated principal amount of a bond is an equity instrument…

The broad notion is that identifying an equity interest – a residual interest in an entity’s assets after deducting all its liabilities – requires eliminating most kinds of computational uncertainty over what that residual interest might actually be. It can sometimes be hard to grasp though why or when relatively minor changes in the terms of an instrument should trigger an entirely different approach to accounting for them. The exposure draft proposes amending the above passage to read as follows:

• …a contract that will be settled by the entity (receiving or) delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash, a fixed amount of another financial asset, or settling a fixed amount of its financial liability (often referred to as the ‘fixed-for-fixed’ condition) is an equity instrument…

The exposure draft specifies that to correspond to this concept, the amount of consideration to be exchanged for each of an entity’s own equity instruments is required to be denominated in the entity’s functional currency, or else to be variable solely because of a preservation adjustment or a passage-of-time adjustment or both; these terms are new to IAS 32. A preservation adjustment is (get ready…) “an adjustment to the amount of consideration exchanged for each of an entity’s own equity instruments (made by adjusting either the amount of consideration to be exchanged or the number of the entity’s own equity instruments used to settle the derivative) that is made upon the occurrence of a contractually specified event(s) that affects the economic interests of the current holders of the entity’s own equity instruments (current equity instrument holders); and preserves the economic interests of the future holders of the entity’s own equity instruments (the future equity instrument holders) to an equal or lesser extent, relative to the economic interests of the current equity instrument holders.” It may feel like there should have been a more concise way of expressing that, but then that’s been the whole problem, that interpreting fixed-for-fixed, in the absence of very much specificity, has too often come down to knowing it when you see it. Anyway, a common example of that kind of adjustment would be a straight stock split.

A passage of time adjustment is an adjustment that is predetermined at the inception of the contract, varies with the passage of time only, and has the effect of fixing on initial recognition the present value of the amount of consideration exchanged for each of the entity’s own equity instruments: any difference in the amounts of consideration to be exchanged on each possible settlement date represents compensation proportional to the passage of time. For example:

• Entity X issues a five-year interest-bearing convertible bond of CU100. Entity X has the right to add unpaid coupons to the principal amount. At maturity, the bondholder can choose to receive a cash amount equal to the bond’s principal amount plus accrued interest, or to convert that amount into Entity X’s ordinary shares. The contract specifies the conversion ratio as one ordinary share per CU1 amount outstanding of the convertible bond.
• If the holder exercises the conversion option, the amount of consideration (in the form of settling Entity X’s financial liability) to be exchanged for each of Entity X’s own shares is fixed. Although the total amount outstanding of the financial liability might vary depending on the amount of interest accrued over the life of the bond, the conversion ratio is fixed from inception of the bond…

One imagines there’ll be general support for that portion of the exposure draft. We’ll look at other pieces of it in the future.

The opinions expressed are solely those of the author.