In June 2018, the International Financial Standards Board (IASB) published its discussion paper on financial instruments with characteristics of equity (FICE). As part of its conceptual framework project, the discussion paper deals with improvements of IAS 32 Financial Instruments: Presentation with special regard to complex financial instruments.
The IASB found that the implementation of IAS 32 has gone well for most of the standard financial instruments ( read our article on IAS 32's classification requirements for preference shares). However, rapid innovation in recent years has caused the structure of financial instruments to grow more complex, creating challenges in applying the requirements of the standard and consequently leading to varying accounting treatments. Due to this variance, it became harder for investors to assess how these financial instruments may affect companies' financial positions and performances.
Therefore, the IASB took action by:
- formulating a clear rationale for the principles of classifying financial instruments as either financial liabilities or equity
- improving the clarity and consistency of the classification requirements for the more complex financial instruments that create a challenge in practice (e.g. derivatives on equity)
- enhancing the presentation and disclosures concerning financial liabilities and equity
With a new pair of proposed amendments, the IASB aims to—without changing the requirements for the more standard financial instruments—provide preparers with a clearer rationale for classification, and investors with richer and more comparable information for the more complex instruments.
The changes take the form of a new classification principle as well as "timing" and "amount" features:
The main goal of these amendments is two sided: on the one hand they allow financial statement preparers determine if the company has an obligation to transfer either cash or another financial asset at a fixed date or only at liquidation ("timing feature"), and on the other hand to determine if the obligation is dependent on the company's available economic resources or not ("amount" feature).
Classifying preference shares may serve as an area in which to illustrate the new requirements. Let's assume that irredeemable fixed-rate cumulative preference shares have been acquired: under the current requirements of IAS 32, the instrument would most probably be classified as equity, as the entity could avoid any payments upon liquidation (read my article on IAS 32). When applying the new concept, however, this instrument would be classified as financial liability, as the amount is independent of the issuer's available economic resources ("amount" feature). The timing feature can be left aside as the result would be the classification as liability anyway, as illustrated in the table above.
The IASB believes that the introduction of the timing feature addresses the existing issues of assessing whether the company has sufficient resources to meet its obligations and when these obligations will be due; additionally, that it will enable users to identify any maturity mismatches and concentration risks. As a fortunate side effect, the analysis of the liquidity of a company will be much easier than before.
The rationale for the amount feature was to ease the assessment of a company's balance-sheet solvency and its allocation of returns. This is why the distinction of amounts being dependent or independent from an entity's available economic resources is critical. This feature would therefore allow users of financial statements to assess various pay-offs and analyse different ratios in the future.
Make your statement
The discussion paper is open to feedback until 7 January 2019. Don't hesitate to send your comments, as constructive and challenging input is essential in delivering high-quality and decisive updates.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.