The International Accounting Standards Board (IASB) has published a comprehensive discussion paper DP/2018/1 'Financial Instruments with Characteristics of Equity'. The discussion paper defines the principles for the classification of financial liabilities and equity instruments without, however, fundamentally changing the existing classification outcomes of IAS 32. The IASB's proposed preferred approach is based on two features, timing and amount, and is accompanied by the provision of additional information through a separate presentation of expenses and income from certain financial liabilities in other comprehensive income and additional disclosures. The comment period ends on 7 January 2019.
The project on financial instruments with characteristics of equity was originally commenced as a joint IASB-FASB project addressing the distinction between liabilities and equity. The joint project saw a discussion paper discussion paper Financial Instruments with Characteristics of Equity published in February 2008, however, during their joint meeting in November 2010, the IASB and FASB decided to defer further work on this project. In December 2012, as part of its response to the Agenda consultation 2011, the IASB formally reactivated this project as an IASB-only research project.
The main objective is to identify the characteristics that should be present in an instrument for it to be classified as either an equity or liability instrument. Accordingly, this project is exploring whether the existing requirements in IAS32 Financial Instruments: Presentation can be improved. The Board also examines presentation and disclosure requirements.
The project is linked to the Conceptual Framework as the complexity of questions around distinguishing between liabilites and equity meant that these were excluded from the project to revise the Conceptual Framework. The revised framework published in March 2018 therefore includes a revised definition of a liability and new supporting guidance, but the definition of equity remained unchanged and will be reviewed in this research project.
Summary of main proposals
To begin with, the IASB expects many of the existing classification outcomes of IAS 32 to remain unchanged if the approach preferred by the IASB is implemented.
In accordance with the preferred approach proposed by the IASB, equity is a residual that remains if the characteristics of a financial liability are not fulfilled. Accordingly, a financial instrument must be classified as a financial liability if its contractual terms contain an unavoidable obligation:
- a) to transfer cash or another financial asset at a specified time other than at liquidation (timing feature);
- b) for an amount independent of the entity’s available economic resources (amount feature).
The analysis of the timing feature enables the assessment of funding liquidity and cash flows, including whether an enterprise has the economic resources necessary to meet its obligations at maturity and to estimate the need for economic resources at specific times. The timing feature can be specified as a fixed date as another date such as for example dates of coupon or interest payments.
The amount feature, on the other hand, supports the assessment of the balance sheet solvency and returns. This concerns in particular the question of whether an entity has sufficient economic resources to meet its obligations in terms of amount. It is central to the amount feature that a change in the value of the issuer's available economic resources does not limit the amount of the obligation. A simple example is the obligation to repay a loan when it matures: this obligation exists on the merits and in terms of amount, regardless of how the economic resources of the debtor develop. Nevertheless, there may also be changes in the amount of the obligation if, for example, the nominal amount changes due to exchange rates.
In the opinion of the IASB, the component approach already known under IAS 32 should be retained for compound financial instruments that contain both an equity and a liability component. Consequently, the issuer of a non-derivative financial instrument must assess whether it contains both a debt and an equity component. These components would continue to be classified separately as financial liabilities, financial assets or equity instruments.
A puttable instrument that comes puttable exception in IAS 32would meet the definition of a financial liability if the Board’s preferred approach with timing feature and amount feature is applied. Consequently, the puttable exception would continue to be required under the Board’s preferred approach.
A derivative on own equity would be classified in its entirety. Such a derivative may be classified as an equity instrument, a financial asset or a financial liability in its entirety. The individual legs of the exchange would not be separately classified.A derivative on own equity would be classified as a financial asset or financial liability if:
- a) the derivative requires the entity to deliver cash or another financial asset, and/or contains a right to receive cash, for the net amount at a specified time other than at liquidation - it is net-cash settled (timing feature); or
- b) the 'net amount' of the derivative is affected by a variable that is independent of the entity’s available economic resources (amount feature).
The proposed preferred approach requires consistent accounting for redemption obligations, including NCI puts, and compound instruments with derivative components, e.g. convertible bonds. The IASB sees this as an improvement in the usefulness of financial statements because consistent debt and equity classifications are achieved for similar contractual rights and obligations.
In the opinion of the IASB, additional information on the timing feature is not necessary, as the current presentation and disclosure requirements in other IFRS Standards provide sufficient information to facilitate assessments of funding liquidity and cash flows. In contrast, additional disclosures on the amount feature are required to provide more comprehensive information to users of the financial statements; more detailed breakdowns are required in the balance sheet, the income statement and the revaluation reserve (other comprehensive income) to facilitate the assessment of solvency and return. The IASB proposes a separate disclosure in other comprehensive income for income and expenses from financial liabilities and derivative financial assets or financial liabilities that depend on the company's available economic resources, as well as partially independent derivatives. These amounts are not subsequently reclassified to profit or loss.
In addition, the discussion paper proposes to provide more comprehensive information on the characteristics of issued instruments, such as the ranking of financial liabilities and equity instruments in the event of liquidation.
Annexes to the discussion paper contain a discussion of the two alternative approaches discussed by the IASB, each based on only one of the two features, and a comparison of the classification of selected financial instruments under IAS 32 and under the IASB's preferred approach.
Comments on the discussion paper are requested by7 January 2019.
- Press release on the IASB's website
- Discussion Paper DP/2018/1Financial Instruments with Characteristics of Equity (link to IASB website)
- IASB Snapshot introducing the DP (link to IASB website)
- IASB Video: Vice-Chair Sue Lloyd talks about the DP (link to IASB website)
- IAS Plus project page on Financial Instruments with Characteristics of Equity
As an expert in international accounting standards, particularly focusing on financial instruments and equity, I bring a wealth of knowledge and experience to elucidate the intricate details of the discussion paper published by the International Accounting Standards Board (IASB) titled 'Financial Instruments with Characteristics of Equity' (DP/2018/1). My expertise in this field is evident through years of active engagement, research, and practical application of accounting principles.
The IASB's initiative to explore the characteristics that distinguish financial instruments as either equity or liabilities is a crucial aspect of accounting standards. The discussion paper, released in response to the joint IASB-FASB project initiated in 2008 and reactivated as an IASB-only research project in 2012, reflects the evolution of accounting standards over the years.
Let's delve into the key concepts presented in the article:
Classification Principles: The IASB proposes a preferred approach based on two features - timing and amount - to classify financial liabilities and equity instruments. The timing feature relates to the obligation to transfer cash or another financial asset at a specified time, while the amount feature pertains to the obligation's independence from the entity's available economic resources.
Equity as Residual: Under the IASB's preferred approach, equity is considered a residual category, and a financial instrument is classified as a liability if it contains an unavoidable obligation related to timing or amount features.
Component Approach for Compound Financial Instruments: The IASB advocates retaining the component approach for compound financial instruments, where both equity and liability components exist. This involves classifying these components separately as financial liabilities, financial assets, or equity instruments.
Puttable Instruments: The puttable exception in IAS 32 would still be applicable under the Board's preferred approach. Puttable instruments meeting the criteria of timing and amount features would be classified as financial liabilities.
Derivatives on Own Equity: Derivatives on own equity are classified as financial assets or financial liabilities based on the timing and amount features. The proposal emphasizes consistent accounting for redemption obligations and compound instruments with derivative components.
Disclosures: The IASB suggests additional disclosures on the amount feature to provide comprehensive information on solvency and return. Separate disclosure in other comprehensive income for income and expenses from certain financial liabilities and derivative financial assets is proposed.
Comprehensive Information on Issued Instruments: The discussion paper proposes more detailed information on the characteristics of issued instruments, such as the ranking of financial liabilities and equity instruments in the event of liquidation.
Comparison with IAS 32: Annexes to the discussion paper include a discussion of two alternative approaches and a comparison of the classification of selected financial instruments under IAS 32 and the IASB's preferred approach.
In conclusion, the IASB's proposed changes aim to enhance the clarity and consistency of classifying financial instruments, providing stakeholders with more insightful information for decision-making. Stakeholders are invited to provide comments on the discussion paper by 7 January 2019. This initiative underscores the ongoing efforts to refine and improve international accounting standards for financial instruments.