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.

We previously looked at the aspects of the exposure draft relating to the “fixed-for-fixed” criterion and to settlement in an entity’s own equity instruments. The exposure draft also proposes adding the following new paragraphs, applying to instruments other than “puttable instruments”:

• An entity shall not reclassify a financial liability or an equity instrument after initial recognition unless…the substance of the contractual arrangement changes because of a change in circumstances external to the contractual arrangement. If the substance of the contractual arrangement changes because of a change in circumstances external to the contractual arrangement, an entity shall reclassify any affected financial liability or equity instrument…
• Changes in circumstances external to the contractual arrangement arise from events not specified in the contract that have not been considered in classifying the financial instrument on initial recognition. Such events are not specific to a particular instrument, but would affect an entity’s business activities and operations, for example, a change in an entity’s functional currency or a change in an entity’s group structure.

The basis for conclusions lays out the background to these proposals, that IAS 32 doesn’t currently contain any general requirements on whether or when an instrument would be reclassified after initial recognition, leading to questions from stakeholders on whether or when such reclassifications are required, permitted or prohibited; nor on how to account for those reclassifications; nor on whether a change in the substance of a contractual arrangement that occurs without modification to the contractual terms could affect the classification. In developing the proposals in the current exposure draft, the Board considered generally prohibiting reclassification, on the somewhat legalistic basis that “if the International Accounting Standards Committee (IASC), the Board’s predecessor body that developed IAS 32, had generally intended a financial instrument to be reclassified after initial recognition, such requirements would have been included in IAS 32 when it was first issued.” It rejected this course because it “would not improve the information provided to users of financial statements about financial instruments issued by an entity.” It also considered requiring reclassification for all changes in the substance of the contractual arrangement, rejecting this in part because it would have required an entity to assess at each reporting date, for each financial instrument issued, whether there has been a change in substance affecting whether the instrument meets the definition of a financial liability or an equity instrument at that date.

The proposed approach has some of the conceptual advantages of that broad approach, and would provide more useful information to users of financial statements compared with prohibiting reclassification altogether. The Board considers that the proposal reduces the risk of opportunistic classifications from structuring the terms of the contract to achieve a particular classification outcome, and that it shouldn’t be overly onerous for preparers to apply because reclassification would be required in limited situations only. It also observes that it’s consistent with the approach used in IFRS 9 for reclassifying financial assets when there is a change in the business model for managing financial assets.

The board discussed whether the reclassification should be implemented at the date of the change in circumstances, at the end of the reporting period, or at some other date. It considered whether determining the date of change in circumstances would be difficult in some instances, concluding that in the most common cases – a change in the entity’s functional currency or in its group structure – the date would already have to be determined for other accounting purposes. The board therefore proposes implementing the reclassification at that date, noting this ensures users of financial statements receive information that faithfully represents the substance of the contractual arrangement throughout the reporting period, including at the reporting date.

The exposure draft also proposes that an entity measures a financial liability reclassified from equity at the fair value of that financial liability at the date of reclassification, recognizing in equity any difference between the carrying amount of the equity instrument and the fair value of the financial liability at that date. It recognizes an equity instrument reclassified from a financial liability at the carrying amount of the financial liability at the date of reclassification. In either case, there’s no recognition of a gain or loss. The board notes that there’s currently diversity in practice, with some entities (consistent with the accounting for a debt-to-equity swap) remeasuring an equity instrument reclassified from a liability at its fair value at the date of reclassification and recognizing any difference between that fair value and the carrying amount of the financial liability as a gain or loss in profit or loss. But the board found the approach it proposed to be more consistent with the standard as a whole.

Something of a balancing act then, but one which presumably will have most respondents largely on board…

The opinions expressed are solely those of the author.