International Accounting Standard (IAS) 32 Financial Instruments: Presentation sets out how a company that issues financial instruments should distinguish debt instruments from equity instruments. This distinction is important because the classification of financial instruments affects the depiction of a company’s financial position and performance. IAS 32 works well for most financial instruments. However, financial instruments have evolved to be more complex since IAS 32 was initially issued and present new reporting challenges for companies. Companies’ solutions to the reporting challenges differ, resulting in diverse accounting practices that make it difficult for investors to assess and compare companies’ financial position and performance. In addition, investors are calling for better information, particularly about equity instruments.
To address these challenges, the International Accounting Standards Board (IASB) published an exposure draft (ED) in November 2023 to propose:
- Clarifying the underlying classification principles of IAS 32 to help companies distinguish between debt and equity;
- Requiring companies to provide disclosures that further explain the complexities of instruments that have both debt and equity characteristics; and
- Adding new presentation requirements for amounts – including profit and total comprehensive income – attributable to ordinary shareholders separately from the amounts attributable to other holders of equity instruments.
In March, the Institute’s Standard Setting Department responded to the ED. This article highlights our major comments set out in our submission. The full response is available on our website.
Overall, we appreciate the IASB’s endeavours to clarify the classification principles in IAS 32 to address known practice issues. We also support the IASB’s objective of enhancing the presentation and disclosure of information about financial liabilities and equity instruments to improve transparency and understandability of financial statements, as well as to meet the information needs of financial statement users. Nevertheless, we have significant concerns regarding the following aspects of the IASB proposals.
Settlement in an entity’s own equity instruments
We have significant concerns regarding the application of the proposed preservation adjustments and passage-of-time adjustments to common contractual terms in Hong Kong, which are widely accepted by the market as anti-dilutive and meeting the fixed-for-fixed condition. Firstly, it is common for entities to adjust the conversion ratio of convertible bonds (CB) to compensate CB holders for dilution loss when shares are issued to investors below market price. Secondly, anti-dilutive adjustments are often calculated using the volume weighted average share price over a specified period before the diluting event occurs. Applying the proposals in the ED, these adjustments would not qualify as preservation adjustments and would therefore fail the fixed-for-fixed condition because they could arguably preserve the economic interests of the future equity holders to a larger extent relative to the economic interests of the current equity holders.
The proposed passage-of-time adjustments would also impact the current practice on CBs that carry an interest rate benchmark and those with protective clauses that compensate holders for loss of an option’s time value through an enhanced conversion ratio when there is a change of control of the issuer (i.e. change of control provisions). Applying the proposals, these adjustments would fail the fixed-for-fixed condition because they are linked to a variable (e.g. an interest rate benchmark), or include inputs (e.g. share price and volatility in the time value of option) to the predetermined formula that do not vary solely based on passage of time. Furthermore, the adjustments may not represent compensation proportional to the passage of time as stated in the ED, since the adjustments for change of control provisions may not always be linear over time.
Given that the majority of the CBs issued in Hong Kong include the aforementioned adjustments in their contracts, the IASB proposals, if implemented, would result in the retrospective reclassification of the conversion options of these CBs from equity to derivative liabilities. In light of the significance and pervasiveness of this matter, we strongly recommend the IASB carefully consider the implications and the potential impact of the proposals on existing market practices and provide clarification on the application of the preservation adjustments and passage-of-time adjustments to common contractual terms in Hong Kong.
The effects of relevant laws and regulations
We consider that the proposals lack a guiding principle in considering the effects of laws and regulations in the classification of financial instruments. Specifically, we question why a law that prevents enforceability should be considered in the classification, while a law that creates an obligation should be disregarded. Moreover, the proposals require a clear identification of laws and regulations that are relevant to the financial instruments, but the boundaries may not always be clear due to varying legal systems across different jurisdictions, resulting in practical challenges in determining whether particular rights and obligations stem from the contract or from law or regulation. This issue is particularly relevant for multinational groups operating in multiple jurisdictions with different legal requirements.
The effects of laws and regulations are an important yet complex issue that has broad implications. They either interact with or have implications for other existing International Financial Reporting Standards (IFRS). We also understand that a complete alignment of the accounting classification with the legal view would fundamentally change the existing requirements in IAS 32 and IFRS 9 Financial Instruments, which is not the objective of this project. In light of these considerations, we recommend the IASB seriously reassess the feasibility of the proposals, conduct field tests to assess the impact and clarity of the proposals on different financial instruments, and evaluate whether the outcomes reflect the substance of the instruments and provide relevant information. If the IASB were to proceed with the proposals, we recommend the IASB clarify the boundaries of laws and regulations for the purpose of determining the classification of financial instruments, and provide supporting guidance, such as illustrative examples of common financial instruments, to ensure consistent application of the proposals.
Contingent settlement provisions
We have concerns about the lack of clarity regarding the scope of financial instruments with contingent settlement provisions that would be subject to the proposed amendments to IAS 32.25 and 25A. The current wording of the proposed amendments seems to imply that the measurement requirements in IAS 32.25A would apply to all financial instruments with contingent settlement provisions, including those that are currently measured solely under IFRS 9 (such as derivatives for written puts other than over own equity instruments, and debt instruments with loan covenants). Such an application could result in unexpected outcomes and create unintended consequences.
In addition, our respondents expressed divergent views on the proposed measurement requirements in IAS 32.25A. Some agreed with the proposals to ignore the probability and estimated timing of the contingent events. Others considered that entities should take those two factors into account in measuring the obligations (i.e. the probability-weighted measurement approach) as this would better reflect the economics of the transaction and provide useful financial information. Moreover, they noted that the probability-weighted measurement approach has worked well when entities measure similar instruments with contingent settlement clauses under other IFRS Accounting Standards.
To address the above concerns, we strongly recommend the IASB clearly define the scope of financial instruments with contingent settlement provisions that are subject to IAS 32.25 and 25A to avoid diversity in practice and unintended consequences. Additionally, we suggest the IASB conduct field tests on a broad range of contingent settlement clauses using both measurement approaches to determine which approach would best provide relevant financial information.
Reclassification of financial liabilities and equity instruments
We disagree with the proposal that prohibits reclassification when there is a change in the substance of the contractual arrangement due to the passage of time. We believe that prohibiting reclassification that would occur as a result of contractual terms that become or stop being effective with the passage of time (such as the expiry of a contingent settlement provision) would misrepresent the substance of the financial instrument and the entity’s situation, potentially resulting in misleading information. We are also not convinced by the IASB’s view that reclassification would increase costs and complexity for preparers. Preparers already need to monitor whether certain contractual terms have expired or stopped being effective when measuring the instruments and preparing the proposed disclosures in paragraph 30F of IFRS 7 Financial Instruments: Disclosures at the reporting date. Furthermore, we consider that addressing the issues arising from the prohibition by introducing additional disclosures in IFRS 7.30F is not the appropriate approach and is inconsistent with paragraph 18 of IAS 1 Presentation of Financial Statements. Given these concerns, we strongly recommend that the IASB reconsider its reclassification proposal relating to the passage of time and remove the related prohibition.
Another key concern is the lack of clarity in the proposal regarding whether subsequent changes to laws and regulations would constitute a change in the substance of the contractual arrangement due to “changes in circumstances external to the contractual arrangement”, in which case reclassification of financial instruments would be required under the proposal. We consider that the associated core questions are whether reclassification would be required: 1) when a change in law creates incremental contractual obligations; and 2) when a change in law prevents the enforceability of the contract. We recommend that the IASB provide clarification on these matters and consider the proposals on reclassification and the effects of laws and regulations together to ensure that their interactions are adequately addressed.
This article was contributed by Carrie Lau and Kennis Lee, Associate Directors of the Institute’s Standard Setting Department. Visit our “What’s new” webpage for our latest publications, and follow us on LinkedIn for upcoming activities.
