Is it debt or equity? That is the question
James Nayler outlines proposals recently issued by the IASB and why they could impact how your financial performance and position is portrayed in the future.
Whether an instrument issued by an entity should be classified as equity or as a financial liability is critical because it impacts the amount presented for net assets, with changes in the carrying amount of financial liabilities affecting reported performance.
IAS 32 Financial Instruments: Presentation, which currently governs the appropriate classification, is generally straightforward to apply. However, it can sometimes prove problematic.
For example, an obligation to settle a contract in ordinary shares is only classified as equity if it results in a fixed number of shares being issued in exchange for a fixed amount of consideration (the ‘fixed for fixed’ criterion), but it is not always clear what is meant by ‘fixed for fixed’. It has also proved challenging when applied to contracts such as contingently convertible bonds and written put options over non-controlling interests, resulting in diversity in practice.
In June 2018, the International Accounting Standards Board (IASB) issued a discussion paper Financial Instruments with Characteristics of Equity proposing the introduction of a fundamental principle to distinguish financial liabilities from equity. Specifically, it suggests an instrument should be classified as a financial liability if it contains an unavoidable contractual obligation to transfer:
- cash or another financial asset prior to liquidation (liquidity test); or
- an amount independent of the issuer’s available economic resource (solvency test).
Although the current classification would be unaffected in many contracts as a result of applying this principle, notable exceptions are:
- instruments with cumulative returns, the timing of payments on which are at the discretion of the entity, would be classified as a financial liability. Under IAS 32 they are typically classified as equity.
- some (but by no means all) contracts to be settled in a variable number of equity shares would be classified as equity. Under IAS 32 they are typically classified as liabilities.
- certain net-share settled derivatives over own equity would be classified as equity. Currently, all such derivatives are classified as either financial assets or financial liabilities.
The discussion paper, which is open for comment until 7 January 2019, is available from the IASB’s website.
James Nayler from BDO LLP is member of the LSCA Technical Committee.
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