The IASB 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 already looked at various aspects of the exposure draft, but not at this one:

• The IASB proposes to clarify that:
• (a) only contractual rights and obligations that are enforceable by laws or regulations and are in addition to those created by relevant laws or regulations are considered in classifying a financial instrument or its component parts; and
• (b) a contractual right or obligation that is not solely created by laws or regulations but is in addition to a right or obligation created by relevant laws or regulations shall be considered in its entirety in classifying the financial instrument or its component parts.

This is intended to address questions that arise in practice about the interaction of contractual terms and laws and regulations in determining financial instrument classification: for example, when a law or regulation prevents the enforceability of one or more of the contractual rights and obligations. The IASB considered an ‘all-inclusive’ classification approach requiring the issuer of a financial instrument to consider contractual terms and rights as well as obligations established by relevant laws or regulations, but rejected this as being too expansive, and inconsistent with aspects of the requirements applying to financial assets. The above proposal reflects a focus on contractual rights and obligations that are in addition to those established by relevant laws or regulations because they “are subject to negotiation and agreement between the parties to the contract and, therefore, can be modified by mutual agreement. In contrast, a right or obligation solely created by laws or regulations applies to all similar instruments and cannot be negotiated or modified by the parties to the contract. A change in relevant laws or regulations would affect all instruments subject to those laws or regulations without any action required from the parties to the contract.” To illustrate:

• … the terms of ordinary shares might require the payment of dividends equaling at least 15% of an entity’s profit each year, whereas the minimum dividend required by law is 10%. For such instruments, the contractual obligation could be viewed as comprising two elements: the minimum dividend requirement of 10% established by relevant laws and an incremental contractual obligation of 5%.
• Accounting for the obligations separately could provide useful information to users of financial statements and assist them in understanding the incremental obligation established by the contractual terms of the instrument. In the Board’s view, this would also result in the minimum obligations arising from relevant laws being accounted for in the same way, irrespective of whether the instrument’s terms included any incremental obligation beyond that imposed by law. 

But based on a quick review of comment letters received to date, lots of respondents think that the IASB’s proposed cure would be worse than any existing disease, This is from IOSCO:

• We note that…identical financial instruments may be classified differently from jurisdiction to jurisdiction depending on whether the contractual rights or obligations are already established by local laws or regulations. We believe this difference in classification would not be useful for users, and in fact may be misleading to users since it could result in classification that is not aligned with the economic substance of a financial instrument. …(The proposals) may result in certain rights and obligations of financial instruments that are regulated by law in certain jurisdictions being unintentionally disregarded for purposes of classification of the financial instrument. For example, many loans and savings products offered by financial institutions include certain rights and obligations that are regulated by law (e.g., duration, amount, and repayment) in certain jurisdictions and therefore may or may not be explicitly included in the terms of the contract. If these rights and obligations regulated by law are disregarded in the classification determination, we believe some financial institutions would be required to classify substantially all of their financial instruments as equity under the proposed amendments.

ESMA made a similar point:

• In particular, bank loans and savings products such as mortgage loans, consumer loans, demand deposits and saving accounts are often strongly regulated by law in some jurisdictions. The main terms of such financial instruments (e.g. repayment, duration) are pre-defined by law and may only be incorporated by reference into the contractual terms. Therefore, only few contractual aspects would be considered additional to a right or obligation created by laws (e.g., interest). While we understand that it is not the intention of the IASB to introduce major changes to existing classification practice, the proposed wording may result in some financial institutions reclassifying almost all of their financial instruments as equity.

PricewaterhouseCoopers summed it all up by saying “we suggest the IASB does not proceed with this aspect of the proposals. Instead, we support requiring robust disclosures about the judgements that have been made in this regard.” That may well be where things end up…

The opinions expressed are solely those of the author.