IFRS NEWSLETTER FINANCIAL INSTRUMENTS - KPMG

18 Pages·2015·1.23 MB·English

Issue 27, October 2015
IFR S LSWEN RETE
FINANCIAL INSTRUMENTS
Derivatives on ‘own
equity’ present complex
accounting challenges that
will continue to haunt the
Board’s efforts to renew its
approach to equity/liability
classifcation.
Chris Spall
KPMG’s global IFRS fnancial
instruments leader
The future of IFRS fnancial
instruments accounting
This edition of IFRS Newsletter: Financial Instruments
highlights the IASB’s discussions in October 2015 on its project
on fnancial instruments with characteristics of equity.
The IASB has continued its discussions on fnancial instruments with characteristics of
equity, having previously addressed the extent to which the requirements in IAS 32 Financial
Instruments: Presentation capture features that are relevant for users of fnancial statements,
and considered three possible classifcation approaches in the context of non-derivatives.
Highlights
Financial instruments with characteristics of equity
At its October meeting, the Board focused on the classifcation of derivatives on ‘own equity’. It discussed:
l    the challenges of accounting for them; and
l    how the IAS 32 requirements deal with those challenges.
Classifcation of specifc types of instruments such as contingent convertible bonds (CoCos) and put
options written on non-controlling interests (NCI puts) will be considered at a future meeting.
The next step for the project will be to further address the conceptual challenges of the ‘fxed-for-fxed’
condition in IAS 32.
Other matters discussed – Insurance and impairment
The Board continued its discussions on a package of temporary measures to address concerns about implementing
IFRS 9 Financial Instruments before the forthcoming insurance contracts standard comes into effect. This will
be discussed in Issue 49 of our IFRS Newsletter: Insurance (scheduled for publication at the end of October).
The Board was also provided with a summary of the activities of the Transition Resource Group for Impairment of
Financial Instrument (‘the ITG’) and informed about an issue relating to the measurement of expected credit losses
for revolving credit facilities. Read our web article to fnd out more.
The macro hedge accounting project was not discussed during the October meeting.
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FINANCIAL INSTRUMENTS WITH CHARACTERISTICS
OF EQUITY – RELEVANT FEATURES
The story so far …
IA S 23 Financial Instruments: Presentation includes reuq irements of r the classic� ation o f
n� ancial instruments betew en liabilities and euq ity. hT ese binary classic� ation reuq irements
result in signic� ant practice issues hw en applied to many n� ancial instruments iw th
characteristics o f euq ity – other than, of r eax mple, typical non - redeemable common shares
that pay discretionary dividends. In the past, the IFR S Interpretations oC mmittee has received
several uq eries in this area and in some cases aw s unable to reach a conclusion. hT e oC mmittee
reef rred some o f these issues to the IA,BS because the perceived issue reuq ired consideration
o f uf ndamental concepts in IFR.S
hT e oB ard issued a discussion paper PD( ) Financial Instruments with Characteristics of Equity in
200.8 oH ew ver, due to capacity issues the oB ard could not issue an epx osure dratf )DE( on the
topic and the proej ct aw s halted. iS nce then, the oB ard has discussed some o f the challenges
as part o f its proej ct on the Conceptual Framework for Financial Reporting1.
In cO tober 201,4 the oB ard resumed the proej ct on n� ancial instruments iw th characteristics o f
euq ity, deciding to split the proej ct into tow ow r k streams – classic� ation, and presentation and
disclosures. hT e oB ard noted that the proej ct may also result in amendments to the den� itions
o f liabilities and euq ity in the oC nceptual Frameow r.k It did not of rmally revisit the proej ct
until May2� 015, hw en it discussed the conceptual and application challenges in distinguishing
betew en liabilities ande� uq ity.
In uJ ne 2015, the oB ard identie� d ef atures that are relevant in measuring claims and in
distinguishing betew en liabilities and euq ity. It noted that a ef ature is relevant i f it has the
potential to aef f ct the prospects of r uf ture cash o� sw .
In uJ ly 2015, the oB ard analysed the relevance o f these ef atures of r assessments that users
might maek using inof rmation in the statements o f n� ancial position and perof rmance.
In eS ptember 2015, the oB ard of cused on the classic� ation o f nond- erivatives. It discussed the
etx ent to hw ich the reuq irements in IA S 23 capture the ef atures that users need to maek their
assessments. It also considered three possible classic� ation approaches.
Accounting What’s the issue?
for derivatives
hT e sta f f noted that the consistency, completeness and clarity o f the accounting reuq irements
on own equity of r derivatives on onw euq ity are o f the utmost importance, but are dic� f ult to achieve due to a
presents number o f challenges – including:
challenges • the iw de variety o f contracts;
in addition
• the ease iw th hw ich similar economic outcomes can be reproduced using dief f rent
to the issues combinations o f contracts ; and
discussed for
• the compleix ty – and in some cases ambiguity – o f the terms o f these contracts.
non-derivatives,
eD rivative n� ancial instruments contain contractual rights or obligations to ecx hange the
because
underlying n� ancial assets or n� ancial liabilities iw th another party. eD rivatives can be seen as
derivatives have ecx hange contracts iw th tow l‘ egs,’ iw th each leg representing one side o f the ecx hange.
other pertinent
hT e distinguishing characteristic o f derivatives on onw euq ity is that:
characteristics.
• one o f the underlying n� ancial instruments o f the ecx hange meets the den� ition o f euq ity t( he
euq ity leg ;) and
1. T he IA BS recently published the DE Conceptual Framework for Financial Reporting 2/DE( 015.)3/ Reef rences
to the oC nceptual Frameow r k in this nesw letter are reef rences to the eix sting Conceptual Framework for
Financial Reporting.
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• the other underlying n� ancial instrument could be either a n� ancial asset leg or a n� ancial
liability leg – e.g. a of raw rd contract to pay cash in ecx hange of r a specie� d number o f onw
euq ity shares.
hC anges in the none- uq ity leg meet the den� ition o f income and epx ense, hw ile changes in the
euq ity leg do not.
hT ereof re, regardless o f the distinction betew en liabilities and euq ity, accounting challenges arise
simply because derivatives on onw euq ity combine an underlying instrument that ow uld, on its onw ,
meet the den� ition o f euq ity iw th one that ow uld not.
What was the basis for this month’s discussions?
oT illustrate the conseuq ences o f distinguishing betew en claims, the sta f f used the of lloiw ng
eax mples o f instruments at the uJ ne , uJ ly and eS ptember 2015 meetings. eW have reproduced
the table epx laining these eax mples belo,w of r ease or�f eef rence.
Type of claim Explanation
Ordinary bonds hT e entity has an obligation to transef r an amount o f cash, euq al to an
amount specie� d in a particular currency, at a specie� d time beof re
liuq idation and senior to all other claims.
Shares hT e entity has an obligation to settle the claim iw th cash, at af ir value, at a
redeemable for specie� d time beof re liuq idation or on demand o f the holder.
their fair value
oH ew ver, liek ordinary shares s( ee belo,)w they do not speciyf the amount
o f economic resources and claims that the entity needs to pay – i.e.
the af ir value o f the shares ree� cts the total amount o f recognised and
unrecognised economic resources and otherc� laims.
Share-settled hT ese claims do not reuq ire the entity to settle the claim using economic
bonds resources – i.e. the entity uses a variable number o f its onw ordinary
shares o f an euq al value to the amount specie� d instead o f cash. oH ew ver,
liek ordinary bonds, they speciyf the amount or rate o f change in amount
that the entity reuq ires to settle the claims.
Cumulative hT ese claims are not reuq ired to be settled beof re liuq idation o f thee� ntity.
preference
oH ew ver, liek ordinary bonds, they speciyf the amount or rate o f change in
shares
amount that the entity reuq ires to settle the claims.
Ordinary shares hT e entity has no obligation other than the obligation to transef r at
liuq idation a share o f hw atever type, and amount, o f economic resources
remain under the entitys’ control atf er meeting all otherc� laims.
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hT e oB ard previously discussed three possible approaches of r classic� ation that it intends to
develop uf rther as the proej ct progresses. hT e of lloiw ng table provides an overvie w o f the three
approaches outlined by the sta,f f and highlights the ef atures used in distinguishing liabilities rf om
euq ity. It also illustrates ho w these distinctions apply to the eax mple instruments.
Approach Alpha Approach Beta Approach Gamma
Relevant iT ming o f the reuq ired Amount o f economic iT ming o f the reuq ired
features to settlement. resources reuq ired to settlement and
distinguish settle the claim. amount o f economic
between resources reuq ired to
liabilities and settle the claim.
equity
Application of lC assiyf as liabilities lC assiyf as liabilities lC assiyf as liabilities
distinguishing obligations to transef r obligations of r an obligations:
feature economic resources amount independent
• to transef r
beof re liuq idation. All o f the entitys’
economic
other claims ow uld be economic resources.
resources beof re
classie� d as euq ity. All other claims ow uld
liuq idation ; or
be classie� d as euq ity.
• of r an amount
independent o f the
entitys’ economic
resources.
All other claims ow uld
be classie� d as euq ity.
Classifcation of Liability Liability Liability
ordinary bonds
Classifcation of uqE ity uqE ity uqE ity
ordinary shares
Classifcation Liability uqE ity Liability
of shares
redeemable for
their fair value
Classifcation uqE ity Liability Liability
of share-settled
bonds
Classifcation uqE ity Liability Liability
of cumulative
preference
shares
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The staff What did the staff discuss?
discussed the
Different types of derivatives on own equity
challenges of
hT e sta f f identie� d that derivatives on onw euq ity can be distinguished in terms o:f
accounting for
derivatives on • the underlying ecx hange;
own equity. • conditionality ; and
• any ef atures that are relevant to the distinction betew en liabilities and euq ity.
The underlying exchange
hT ere are tow basic types o f ecx hange:
• assete/ uq ity ecx hange – in hw ich a n� ancial asset is received in ecx hange of r delivering onw
euq ity, hw en both items are not eix sting n� ancial instruments o f the entity ; and
• liabilitye/ uq ity ecx hange – in hw ich an eix sting n� ancial liability or euq ity instrument is
etx inguished in ecx hange of r delivering onw euq ity or a n� ancial liability.
Conditionality
hT e underlying ecx hange in a derivative could be either:
• unconditional – e.g. of raw rd contracts ; or
• conditional on:
– events iw thin the control o f the counterparty – e.g. rw itten options;
– events iw thin the control o f the entity – e.g. purchased options ; or
– events beyond the control o f both parties – e.g. contingent of raw rd contracts.
Features that are relevant to the distinction between liabilities and equity
hT e sta f f of cused their analysis on the timing o f the reuq ired settlement and the amount o f
economic resources reuq ired to settle the claim, in light o f the importance o f these ef atures to the
classic� ation approaches that are being developed.
Timing of the required settlement
eD rivatives typically reuq ire settlement beof re liuq idation. hT e of lloiw ng table shosw the
classic� ation o f derivatives under both Approaches Alpha and Gamma i f the distinction betew en
liabilities and euq ity is based only on the timing o f the reuq ired settlement.
Timing of transfer of
Settlement method Classifcation
economic resources
eN t in cash or another n� ancial asset eB of re liuq idation of r the iE ther a n� ancial asset or
– i.e. physical delivery or receipt o f entire derivative. a n� ancial liability in its
a variable amount o f cash or other entirety.
n� ancial assets euq al to the net
position.
eN t in onw euq ity – i.e. physical oN transef r o f economic uqE ity instrument in its
delivery or receipt o f a variable resources reuq ired beof re entirety.
number o f underlying euq ity liuq idation.
instruments depending on the
netp� osition.
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Timing of transfer of
Settlement method Classifcation
economic resources
Gross – i.e. physical delivery or eB of re liuq idation of r one hC allenging of r these
receipt o f the underlying euq ity part o f the transef r, but approaches, since part o f
instrument in ecx hange of r the non- not of r the other. the derivative ow uld be a
euq ity instrument. n� ancial asset or n� ancial
liability and the other
part ow uld be an euq ity
instrument.
Amount of economic resources required to settle the claim
eD rivatives can speciyf the amount o f underlying n� ancial instruments to ecx hange in dief f rent
aw ys. hT ese include:
• the ecx hange o f a ex� d amount o f the underlying n� ancial instruments – e.g. the receipt o f a
ex� d amount o f cash or other n� ancial assets in ecx hange of r the delivery o f a ex� d number o f
ordinary shares ;
• the ecx hange o f a variable amount o f one or both o f the underlying n� ancial instruments – e.g.
the receipt o f a ex� d amount o f cash or other n� ancial assets in ecx hange of r the delivery o f a
variable number o f ordinary shares ; and
• the ecx hange o f a variable amount o f one o f the legs iw th reef rence to the value o f the other
leg – e.g. a contract to ecx hange a variable amount o f cash of r a ex� d number o f ordinary shares
hw ere both legs are euq al to the value o f the ordinary shares.
hT e of lloiw ng table shosw the classic� ation o f derivatives under both approaches eB ta and
Gamma i f the distinction betew en liabilities and euq ity is based only on hw ether the amount is
independent o f the entitys’ economic resources.
Is the amount independent
How is the derivative
What is exchanged? of the entity’s economic
classifed?
resources?
Amounts o f underlying eY s – of r the entire derivative. iE ther a n� ancial asset or a
n� ancial instruments euq al n� ancial liability in its entirety,
to an amount independent regardless o f hw ether it
o f the entitys’ economic reuq ires the transef r o f
resources. economic resources or not.
Amounts o f underlying oN – of r the entire derivative. uqE ity instrument in its
n� ancial instruments euq al to entirety, regardless o f
an amount euq al to an entitys’ hw ether it reuq ires the
euq ity instruments. transef r o f economic
resources or not.
nO e leg o f the ecx hange – An eY s – of r one part o f the entire hC allenging of r these
amount independent o f the derivative, but not the other. approaches, since part o f the
entitys’ economic resources. derivative ow uld be a n� ancial
asset or a n� ancial liability
tO her leg o f the ecx hange –
and the other part ow uld be
An amount not independent
an euq ity instrument.
o f the entitys’ economic
resources.
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KPMG Insight
hT e stas’f f analysis highlighted that the accounting of r derivatives on onw euq ity that reuq ire
gross settlement ow uld present challenges of r all three approaches – i.e. Alpha, eB ta and
Gamma – because part o f the derivative ow uld be classie� d as a n� ancial asset or a n� ancial
liability and the other part ow uld be classie� d as an euq ity instrument.
eW note that the agenda paper is not entirely clear hw en reef rring to the a‘ mount ’ ef ature o f a
n� ancial instrument. Approaches eB ta and Gamma are described as of cusing on the a‘ mount
o f economic resources reuq ired to settle the claim.’ oH ew ver, hw en epx laining ho w the
approaches ow uld be applied i( ncluding to derivatives ) the paper reef rs to hw ether the amount
ecx hanged is independent o f the entitys’ economic resources, regardless o f hw ether the
derivative reuq ires the transef r o f economic resources. In other ow rds, a‘ mount ’ in this sense
seems to reef r to the value o f the economic resources or euq ity instruments reuq ired to settle
thei� nstrument.
hT e sta f f noted that dief f rent types o f derivatives can be distinguished based on their
conditionality. oH ew ver, they did not analyse at this meeting ho w conditionality ef atures in
derivatives ow uld aef f ct the three classic� ation approaches.
hT e sta f f briey� outlined the three settlement methods of r derivatives. IA S 23 also contains
guidance on settlement options hw en a derivative gives a party a choice over ho w it is settled
– e.g. the issuer or the holder can choose settlement net in cash or by ecx hanging shares of r
cash. hT e sta f f did not specic� ally discuss hw ether or ho w settlement options might impact
their analysis.
The staff Relevant requirements of IAS 32
analysed how
hT e sta f f noted that the of lloiw ng reuq irements are relevant of r derivatives on onw euq ity:
IAS 32 deals with
• the ex� dof- rex�- d condition t( his applies to assete/ uq ity and liabilitye/ uq ity ecx hanges ;) and
the challenges of
• the redemption obligations reuq irement t( his applies to liabilitye/ uq ity ecx hanges.)
accounting for
derivatives on Fixed-for-fxed condition
own equity.
hT e ex� dof- rex�- d condition is part o f the den� itions o f n� ancial instruments in IA S 23 . A derivative
is only classie� d as an euq ity instrument i:f
• the ex� dof- rex�- d condition is met – i.e. ecx hange o f a ex� d amount o f cash o( r another
n� ancial asset ) in the entitys’ uf nctional currency of r a ex� d number o f the entitys’ onw euq ity
instruments ; and
• the derivative is settled gross.
IA23 �S reuq ires an entity to classiyf derivatives on onw euq ity in their entirety as either euq ity
or none- uq ity. hT e ex� dof- rex�- d condition is subej ct to one ecx eption of r of reign currency
rightsi� ssues.
hT e sta f f illustrated the challenges and the pros and cons o f classic� ation based on the ex�’ d-
of rex�- d ’ condition, using the eax mple o f a simple of raw rd contract to receive cash in ecx hange
of r delivering a ex� d amount o f ordinary shares that is settled gross. hT e sta f f epx lored three
variations on this contract:
• axE mple 1 : Fiex dof- rex�- d
• axE mple 2 : Foreign currency rights issue ecx eption
• axE mple :3 oN t ex� dof- rex�- d : asset leg variability.
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Example 1: Fixed-for-fxed
An entity enters into a of raw rd contract to receive a ex� d amount o f cash 1( 00 ) in ecx hange
of r the delivery o f a ex� d number o f ordinary shares. At inception, the shares and the cash are
o f euq al value 1( 00 each ) so the contract is initially recognised at ez ro. hT e contract is settled
gross. uS bseuq ently, the values o f each o f the legs change as of llosw .
Value of cash Value of shares Net position of
Scenario
receivable deliverable contract
A 100 08 20
B 100 120 2( 0)
eB cause the ex� dof- rex�- d condition is met, the entire instrument is classie� d as euq ity.
hT e changes shonw in both scenarios result only rf om the change in the value o f the shares
deliverable t( he euq ity leg ) because the asset leg is ex� d. hT ese changes and the net position o f
the contract are not recognised in the n� ancial statements.
Example 2: Foreign currency rights issue exception
An entity enters into a of raw rd contract to receive a ex� d amount o f of reign currency – i.e. not
the entitys’ uf nctional currency – in ecx hange of r delivering a ex� d number o f ordinary shares.
hT e instrument is oef f red pro rata to all eix sting holders o f the same class o f onw nond- erivative
euq ity instruments and it meets the of reign currency rights issue ecx eption. At inception, the
shares and the cash are o f euq al value 1( 00 each ) so the contract is initially recognised at ez ro.
hT e contract is settled gross. uS bseuq ently, the values o f each o f the legs change as of llosw .
Value of cash Value of shares Net position of
Scenario
receivable deliverable contract
A 120 08 04
B 120 104 2( 0)
C 08 06 20
D 08 120 04( )
eB cause the instrument meets the of reign currency rights issue ecx eption, the entire
instrument is classie� d as euq ity. hC anges in the net position o f the contract result rf om
changes in the value o f the shares deliverable and changes in the uf nctional currency euq ivalent
o f the of reign currency cash receivable. oH ew ver, because the contract is classie� d as euq ity,
all changes in value and the net position o f the contract are not recognised.
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Example 3: Not fxed-for-fxed: asset leg variability
An entity enters into a of raw rd contract to receive a variable amount o f cash based on a
commodity inde x in ecx hange of r delivering a ex� d number o f ordinary shares. At inception, the
shares and the cash are o f euq al value 1( 00 each ) so the contract is initially recognised at ez ro.
hT e contract is settled gross. uS bseuq ently, the values o f each o f the legs change as of llosw .
Value of cash Value of shares Net position of
Scenario
receivable deliverable contract
A 120 08 04
B 120 104 2( 0)
C 08 06 20
D 08 120 04( )
hT e entire instrument is classie� d as either a n� ancial asset or a n� ancial liability because the
ex� dof- rex�- d condition is not met. hC anges in the net position o f the contract result rf om
changes in :
• the value o f the shares deliverable ; and
• the amount o f cash to be received based on changes in the commodity inde.x
All resulting changes in value are recognised as income ore� px ense.
aB sed on these eax mples, the sta f f identie� d the of lloiw ng pros and cons o f applying the ex� dof- r-
ex� d condition to derivatives on onw euq ity.
Pros • Using the ex� dof- rex�- d condition to classiyf a derivative in its entirety is a
pragmatic approach hw ich avoids the need to componentise a derivative into
its underlying legs.
• uS ch an approach ow uld ow r k of r an instrument that meets the ex� dof- r-
ex� d condition, because:
– the only source o f changes in the net position o f the contract is due to
changes in the value o f the underlying euq ity leg ; and
– these changes are not recognised in prot� or loss
Cons • I f an instrument af ils the ex� dof- rex�- d condition, then classiyf ing the
instrument in its entirety results in:
– some contracts iw th underlying euq ity instruments being accounted
of r as n� ancial assets or n� ancial liabilities, iw th all resulting changes in
value reported in prot� or loss – including changes in the underlying euq ity
instrument ; and
– some contracts iw th underlying n� ancial asset instruments being
accounted of r as euq ity instruments i( f they meet the of reign currency
rights issue ecx eption,) iw th changes in the underlying asset leg not being
recognised in prot� or loss.
• An application problem arises, because it is not alaw ys clear hw at the term
ex�‘ d ’ means in the ex� dof- rex�- d condition. For eax mple, it could mean
ex�‘ d ’ in terms o f the entitys’ uf nctional currency or ex�‘ d ’ in terms o f
volume or units o f n� ancial assets.
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Redemption obligation requirements
hT e redemption obligation reuq irements are derived rf om the den� ition o f a n� ancial liability, and
reuq ire an entity to classiyf any obligation to repurchase its onw euq ity as a n� ancial liability of r the
present value o f the redemption amount. hT is applies even i f the obligation is conditional on the
counterparty eex rcising a right to redeem. hT e redemption obligation reuq irements are subej ct to
one ecx eption of r puttable instruments and obligations arising on liuq idation, hw ich are classie� d
as euq ity i f certain conditions are met.
hT ese reuq irements and the compound instrument reuq irements in IA S 23 are related. hT ey result
in similar accounting of r all contracts that impose an outcome meeting the den� ition o f a n� ancial
liability, regardless o f the manner in hw ich the contracts are structured.
hT e sta f f illustrated the challenges and the pros and cons o f applying the redemption obligation
reuq irements using the of lloiw ng eax mples o f simple liabilitye/ uq ity ecx hanges:
• axE mple :4 iS mple convertible bond
• axE mple 5 : rW itten put option on onw euq ity
• axE mple :6 Foraw rd contract to etx inguish onw euq ity in ecx hange of r debt.
Example 4: Simple convertible bond
hT e entity issues a bond of r 100 that reuq ires it to pay to the holder an amount o f 110 in cash
one year atf er the issue date. At that date, the holder has the right to elect to receive 100
ordinary shares o f the entity instead o f the cash payment, but cannot receive both the 110
in cash and the 100 shares. hT e claim does not have any unconditional payments and is not
convertible or redeemable by the counterparty or the entity during the oney- ear period.
Under IA S 23 , the issuer ow uld account of r the convertible bond as a compound
instrument,a� nd:
• recognise a n� ancial liability of r the claim at an initial amount euq al to the af ir value o f the
same bond issued iw thout the conversion ef ature – e.g. 110 discounted to a present value
o59 �f ;
• recognise the dief f rence betew en the af ir value o f the n� ancial liability and the af ir value o f
the convertible bond at issue date in euq ity – i.e. residual o f 5 ;
• recognise the accrual over the year o f interest epx ense on the n� ancial liability o f 15 ; and
• at eex rcise date, either recognise the payment made 1( 10,) or reclassiyf the carrying amount
o f the n� ancial liability 1( 10 ) to euq ity, depending on the holders’ election.
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