Liability or equity?

I have submitted a comment letter to the IASB on 2 aspects of its Exposure Draft Financial Instruments with Characteristics of Equity, available at IFRS – Exposure Draft and comment letters: Financial Instruments with Characteristics of Equity—Proposed amendments to IAS 32, IFRS 7 and IAS 1 The comment deadline is 26 March 2024.

The text of my comment letter is below.


Response to Exposure Draft Financial Instruments with Characteristics of Equity

This letter provides my comments on two aspects of Exposure Draft IASB/ED/2023/5Financial Instruments with Characteristics of Equity.

  • settlement in an entity’s own equity instruments (section1 below)
  • disclosure about participating and non-participating liabilities and equity (section 2)

I am not commenting on other aspects of the ED.

I write in a personal capacity. I was a member of the IASC staff and then IASB staff from 1994 to 2021.

1. Settlement in an entity’s own equity instruments

This section contains my response to question 2 of the Exposure Draft (settlement in an entity’s own equity instruments). My comments below cover:

  • the Exposure Draft proposal (section 1.1)
  • my response to question 2 (section 1.2)
  • rethinking the fixed-for-fixed rule (section 1.3)
  • finalising the amendments proposed in the Exposure Draft (section 1.4)
  • future developments (section 1.5)

1.1 Exposure Draft proposal

Paragraph 16(b)(ii) of IAS 32 Financial Instruments: Presentation uses a ‘fixed-for-fixed’ rule in classifying a derivative that will or may be settled in an issuer’s own equity instruments.  

The Exposure Draft proposes that two types of adjustment (preservation adjustments) and (passage-of-time adjustments) should be viewed as not breaching the fixed-for-fixed rule (paragraphs 22B–22C).  

The IASB also proposes to clarify how the fixed-for fixed rule applies:

  • to derivatives involving two classes of equity instruments (either a choice of settlement between two classes or an exchange of fixed numbers of two classes); and
  • to consideration denominated in a foreign currency.

1.2 Responses to question 2

In principle, I support the proposal that a preservation adjustment or a passage-of-time adjustment of the kinds discussed in the Exposure Draft should not prevent classification as a financial liability. A requirement to make to those adjustments does not create an obligation meeting the definition of a liability in the Conceptual Framework for Financial Reporting.

In principle, I also support the proposals on derivatives involving two classes of choices of equity instrument. They seem sensible and obvious applications of the basic idea of the fixed-for-fixed rule.

However, I do not favour treating consideration in foreign currency as breaching the fixed-for-fixed rule. That change could increase the number of financial instruments classified as financial liabilities even though they create no liability, as defined in the Conceptual Framework.   

Although I support proposals on preservation adjustments and passage-of-time adjustments and derivatives involving two classes of derivatives in principle, those proposals would pile yet more sub-rules on the fixed-for-fixed rule and—as the Exposure Draft shows—add great complexity to the drafting. Even with these changes, the Standard will still come nowhere near answering all reasonable questions about the fixed-for-fixed rule.

I am in no position to judge whether these targeted changes to the fixed-for-fixed rule would improve reporting outcomes enough to justify the resulting increase in the complexity of the Standard.

1.3 Rethinking the fixed-for-fixed rule

IAS 32’s classification approach for obligations (and options) to issue an entity’s equity instruments has two serious flaws:

  • IAS 32 classifies many of these obligations (and options) as financial liabilities, even though these obligations (and options) do not meet the Conceptual Framework’s definition of a liability.
  • when IAS 32 classifies these obligations (and options) as financial liabilities, it treats them as derivatives and measures them at fair value, with changes in fair value reported in profit or loss. Part of that change in fair value results from changes in the fair value of the underlying equity instruments that must (or may) ultimately be issued—and thus, in part, reflect possible future distributions to (future) holders of those underlying instruments. Distributions to holders of equity instruments do not meet the Conceptual Framework’s definition of an expense. Thus, remeasurements reflecting possible future distributions should be treated in the same way as distributions, and should not be recognised as expense or income.

Another feature of IAS 32 exacerbates those flaws. IAS 32 adopts the default position that obligations (and options) to issue an entity’s own equity instruments are derivatives and should, therefore, be measured at fair value through profit or loss. To avoid unintended consequences, exceptions to that default position are scoped as narrowly as possible, and are drafted tightly.

In my view, that default position leads to the wrong outcomes. Obligations (and options) to issue an entity’s own equity instruments are themselves equity claims not creating a liability, as defined in the Conceptual Framework. So, by default these obligations (and options) should also be classified as equity instruments.

I am not convinced that any exceptions to that position are needed. If any exception is needed, it should:

  • be based on the Conceptual Framework and targeted precisely;
  • probably not involve applying IFRS 9’s requirements for derivatives to obligations (and options) to issue an entity’s own equity instruments. Instead, the Board should develop measurement requirements appropriate for those obligations and options. Also, appropriate requirements may well differ from the requirements that already apply to an entity’s obligations (and options) to buy back its own equity instruments.
  • treat a remeasurement as relating to distributions (not as an expense) to the extent that the remeasurement reflects possible future payments to holders of the underlying equity instruments that will (or may) ultimately be issued.

1.4 Finalising the amendments proposed in the Exposure Draft

After spending several years thinking about how best to distinguish financial liabilities from equity instruments, the Board decided to make only targeted improvements to IAS 32’s approach to classification. The Board focused on those practice issues that it could resolve efficiently and effectively without changing IAS 32 fundamentally.

The Board often drafts targeted narrow-scope amendments as narrowly as possible, to avoid unintended consequences and to avoid unjustified scope creep. That is usually a good idea. But in finalising any classification amendments resulting from this Exposure Draft, that would be the wrong approach. The Board may face a choice between (a) convoluted and highly engineered amendments that define the fixed-for-fixed rule narrowly and (b) simpler amendments that classify somewhat more of these obligations (and options) as equity instruments. If so, the Board should choose the simpler option. There is no risk in choosing that option because it would also bring classification decisions closer to where I believe the Board should bring them in the longer term, which I discuss in sub-section 1.5 below.

1.5 Future developments

The Exposure Draft demonstrates clearly the drawbacks of continuing to rely on the fixed-for-fixed rule, which is arbitrary and has no anchor in the Conceptual Framework. In the long run, I believe the Board should move to a different approach for obligations (and options) to issue an entity’s own equity instruments. Such obligations (and options) create no liability, so:

  • the Board should remove the default presumption that they should be classified as a financial liability. Instead, the presumption should be that they create an equity instrument.
  • there may not be a need for any exceptions to that new presumption. If any exception is needed, experience has shown that the fixed-for-fixed rule is not suitable for that purpose, so the need for that rule would disappear.

Some of the pressures that originally led previous Board Members to misclassify some equity instruments as if they were financial liabilities came because Board Members apparently felt they had no better tools for distinguishing typical equity instruments (such as ordinary shares) from some other types of equity instrument that provide something more akin to a fixed return. However, as I discuss in section 2 below, I believe the Board has another tool it could use in future work—classifying those instruments as non-participating equity instruments.

2. Disclosure about participating and non-participating liabilities and equity

This section responds to question 7 of the Exposure Draft, dealing with disclosure. I comment only on disclosure about the terms and conditions of financial instruments with both financial liability and equity characteristics. I am not commenting on other aspects covered by question 7.

My comments below cover:

  • the Board’s proposal and my response (section 2.1)
  • participating and non-participating liabilities and equity (section 2.2)
  • benefits of distinguishing participating claims from non-participating claims (section 2.3)
  • defining participating and non-participating liabilities and equity (section 2.4)
  • comments on my working definitions (section 2.5)
  • ‘debt-like’ and ‘equity-like’ characteristics (section 2.6)
  • obligations to issue a variable number of shares (section 2.7)
  • remeasuring participating financial liabilities (section 2.8)
  • other types of participating liability (section 2.9)

2.1. The Board’s proposal and my response

The Board proposes to require entities to disclose, among other things, the terms and conditions of financial instruments with both financial liability and equity characteristics (draft paragraphs 30C–30E and B5B–B5H of IFRS 7 Financial Instruments: Disclosures).

I do not support that proposal in the current form. Draft paragraph 30D focuses too much on terms and conditions that determine accounting classification, and the rest of the wording is vague and generic. This is unlikely to result in useful information. Instead, the Board should require more focussed disclosures about participating financial liabilities and non-participating equity instruments. Roughly speaking:

  • participating financial liabilities are financial liabilities that share in profit in much the same way as, for example, ordinary shares.
  • non-participating equity instruments are equity instruments that do not share in profits, and provide a return similar to non-participating financial liabilities.

I suggest more precise definitions in section 2.4 below.

The required disclosure should focus on the participation (for participating financial liabilities) and on the lack of participation (for non-participating equity instruments). The Board should require entities to disclose:

  • the amounts recognised in the financial statements relating to participating financial liabilities and to non-participating equity instruments.
  • for participating financial liabilities—the same information as is required for equity instruments that participate in the same way as the financial liability. If they share in the same way, logically the disclosure needs must be the same.
    In addition, if the entity has an obligation (or option) to settle the liability by delivering its own equity instruments, the entity should disclose information about the instruments that would be delivered (perhaps covered by draft paragraphs 30G-30H).
  • for non-participating equity instruments—a description of the return provided by the equity instrument (for example, the dividend rate for preferences shares with a fixed rate). The description needs to make it clear that the equity instruments does not participate in profit (and in other changes in total equity).    

My suggestion would not result in disclosure about terms and conditions of subordinated debt and of instruments whose principal reduces to absorb losses. Requirements to disclose that information might be better placed in the section on ‘priority on liquidation’ (draft paragraph 30E).

2.2 Participating and non-participating liabilities and equity

Some financial liabilities give the creditor participation in the issuing entity’s profit or loss (or perhaps in other changes in its total equity) in a manner similar to typical equity claims. Conversely, some equity claims are designed to give the holder a return that is similar to the return on typical financial liabilities—and without giving the holder participation in the issuing entity’s profit or loss (or other changes in its total equity).

In my view, IFRS Accounting Standards should:

  • state explicitly that some items classified as financial liabilities meet both the Conceptual Framework’s definition of a liability and its definition of an equity claim.
  • state explicitly that some items classified as equity instruments meet the Conceptual Framework’s definition of definition of an equity claim, but give the holder no participation in changes in the issuing entity’s total equity beyond a return that is similar to the return from typical financial liabilities.
  • create clear, intuitive, plain-English labels for these subsets of financial liabilities and of equity claims. In this comment letter, I use the labels ‘participating’ and non-participating’.

Following that approach, there would still be two elements (liabilities and equity / equity claims). There would also be two classes of each of those elements: participating liabilities and non-participating liabilities; and participating equity claims and non-participating equity claims. Typical liabilities would be non-participating and typical equity claims would be participating.

2.3 Benefits of distinguishing participating claims from non-participating claims

Subclassifying all liabilities and equity claims as either participating or non-participating would have the following benefits:

  • it would provide a platform for developing focussed disclosure requirements (and perhaps presentation requirements) appropriate for participating liabilities and for non-participating equity claims.
  • using the label ‘participating’ (or some other equivalent intuitive plain-English label) prominently in the Standard would encourage preparers to use that label in their financial statements in describing the presence or absence of a participation feature. Using intuitive, plain-English labelling would enhance understanding by users of financial instruments.
  • clear thinking about the unusual cases when liabilities are participating (or about when equity claims are non-participating) may help resolve future standard-setting questions. For example, clear thinking about non-participating equity claims may enable the Board to replace the fixed-for-fixed rule.

Furthermore, clear thinking about participating liabilities may enable the Board to conclude that remeasurements of participating liabilities should (to the extent they are driven by the participation feature) be treated as relating to distributions, not as expense or income.  

In the short to medium term, the Board may well not yet wish to consider changing the requirements in IAS 32 for obligations (and options) to issue an entity’s own equity instruments. In the meantime, the Board might at least be able to build on the distinction between participating and non-participating claims to explain more clearly which kinds of variability breach the fixed-for-fixed rule.

2.4 Defining participating and non-participating liabilities and equity

I adopt the following working definition of the two atypical subclasses:

  • a participating liability is a financial instrument that IFRS Accounting Standards classify as a liability and that gives the holder a residual interest in the issuer’s assets after deducting all liabilities.
  • a non-participating equity claim is a financial instrument that IFRS Accounting Standards classify as an equity instrument but that gives the holder no participation in increases in the issuing entity’s total equity beyond a return that is similar to the return from non-participating financial liabilities.

A non-participating liability would be one that is not a participating liability, and a participating equity claim would be one that is not a non-participating equity claim.

2.5 Comments on my working definitions

I have designed the definitions for use in IAS 32, not in the Conceptual Framework.  

The definitions refer to how IFRS Accounting Standards classify items (as financial liabilities or as equity instruments), rather than to the elements (liability and equity) defined in the Conceptual Framework. That is important because, as discussed in section 1 above, IAS 32 classifies as financial liabilities some (participating) items that do not meet the definition a liability.

The definition of a participating liability closely mirrors the Conceptual Framework’s definition of an equity claim.

If the definition of a non-participating equity claim mirrored the Conceptual Framework’s definition of equity exactly, all equity claims would be participating. Instead, the definition focusses on whether the claim provides participation in increases in total equity (as defined in the Conceptual Framework) beyond a return that is similar to the return from non-participating financial liabilities.

That reference to increases in total equity distinguishes:

  • a claim providing a return that varies with, for example, profit; and
  • a claim providing a return similar to the return from non-participating financial liabilities—typically interest, but in some cases by reference to some index.

My working definition refers only to increases in total equity, not to decreases, but that aspect of the definition may need more investigation.

The holder of a non-participating financial liability may suffer a loss if the issuer’s assets are not sufficient to meet all its liabilities. Nevertheless, the amount of the holder’s claim on the issuer remains the same, even though the holder may not receive the full amount of its claim.

In contrast, for a participating liability or for participating equity, changes in the issuer’s total equity do ultimately change the amount of the holder’s claim. That is because those changes increase or decrease the size of the pool in which participating holders have a residual interest.  

2.5 ‘Debt-like’ and ‘equity-like’ characteristics

The Exposure Draft proposes, among other things, that an entity should disclose ‘debt-like characteristics’ of instruments classified as equity instruments and ‘equity-like characteristics’ of instruments classified as financial liabilities (draft paragraphs 30D and B5C–B5F).

The Exposure Draft’s distinction between ‘debt-like’ and ‘equity-like’ characteristics focuses on whether the nature, timing and amount of the cash flows are similar to those from financial liabilities (‘debt-like’) or similar to those from ordinary shares (‘equity-like’).

My proposed distinction between participating and non-participating financial instruments does not focus on the nature, timing and amount of cash flows. Instead, it focuses on whether holders of the instrument participate in increases in total equity. Thus, a participation feature is one type of ‘equity-like characteristic’ and the absence of a participation feature is one type of ‘debt-like’ characteristic.

One example of a participating financial liability is an ordinary share containing an option for the holder to sell the share back to the entity for an amount equalling the fair value of its assets less the fair value of its liabilities (a type of puttable instrument, not necessarily meeting the conditions in paragraph 16A of IAS 32). The Exposure Draft would classify such financial liability as containing ‘equity-like’ characteristics.

One example of a non-participating financial liability is subordinated debt—although the Exposure Draft would classify subordinated debt as having ‘equity-like’ characteristics. Even though changes in the issuer’s total equity might make it more likely or less likely that the issuer will be able to pay the holder’s claim in full, those changes will not change the amount of the holder’s claim.

In the following three examples, equity instruments have ‘debt-like characteristics’, and my definition would also classify them as non-participating. In each case, the entity can avoid paying the holder any more than the specified fixed amounts, so the holder has no present right to benefit from future increases in the issuer’s total equity:

  • an irredeemable preference share with fixed cumulative coupon amounts, specified coupon payment dates and a fixed principal amount;
  • a perpetual instrument with cumulative coupon payments at an interest rate that increases if the issuer chooses not to redeem the instrument on or before a specified date.
  • an equity instrument that gives the issuer a contractual right to settle or redeem the instrument for a fixed amount of cash at a fixed date.

Two examples of participating equity claims are:

  • ordinary shares; and
  • an obligation to issue a fixed number of shares for a fixed amount of cash. Holders already benefit (or suffer) from increases (or decreases) in the entity’s net assets, though they are typically not entitled to receive dividends paid before the underlying shares must be issued.

2.7 Obligations to issue a variable number of shares

An obligation to issue shares with a total value equalling a fixed amount of cash is classified today as a liability, though classifying it as an equity claim would be more consistent with the Conceptual Framework. Regardless of whether this instrument is classified as a financial liability or as an equity claim, it is non-participating: before the date when the number of shares to be issued is fixed, holders do not benefit (or suffer) from increases (or decreases) in the entity’s net assets. During that period, any change in the net assets per share is nullified by an equal and opposite change in the number of shares to be issued. Then, once the number of shares is fixed, the instrument becomes participating.

Classifying such obligations as non-participating equity claims (and providing appropriate disclosure) would distinguish them from ordinary shares and other participating equity claims more effectively than mis-classifying them as financial liabilities.

2.8 Remeasuring participating financial liabilities

Identifying participating financial liabilities as a subclass of financial liabilities would pave the way for rethinking how to deal with remeasurements of these items. So far, the Board (and previous Board Members) have always taken the view that changes in the carrying amount of these liabilities must be recognised as expense or income.

Identifying participating financial liabilities as being simultaneously both liabilities and equity claims leads to the conclusion that remeasurements resulting from the equity-claim part of their nature should be treated in the same way as distributions, not as expense or income. Of course, any remeasurement resulting from the liability part of their nature should continue to be treated as expense or income.

If the Board is not yet willing to consider treating measurements resulting from the equity-claim part in the same way as distributions (first choice), perhaps the Board could at least consider requiring them to be presented in other comprehensive income (second choice) or in a separate line item in profit or loss, immediately below the subtotal (perhaps profit or loss) that represents the items in which holders of that instrument share (third choice).

2.9. Other types of participating liability

Financial liabilities are not the only type of participating liability that exist. Other types include employee profit sharing and some participating insurance contracts.

Conclusion

I believe the Board should proceed with caution if it finalises the proposals for the fixed-for-fixed rule. I would welcome changes that decrease the number of instruments misclassified as liabilities when they create no liability as defined in the Conceptual Framework. But the Board should avoid creating unnecessary complexity.

The disclosure requirements for instruments with both ‘equity-like’ and ‘debt-like’ characteristics would benefit from a more focussed approach centred on participating financial liabilities and on non-participating equity claims. Identifying participating and non-participating classes explicitly and using those labels (or other intuitive, plain-English labels) will help guide preparers into giving more informative disclosure, packaged in a more understandable and accessible way.

In the longer term, the Board should aim to ensure that:

  • instruments creating no liability are not (mis-)classified as liabilities; and
  • remeasurements of participating liabilities reflecting changes in the fair value of the entity’s own underlying equity instrument are reported as changes in equity (like a distribution), not as expense or income.

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