Background
The Board considered the issue of financial instruments that are puttable at a pro rata share of the fair value of the residual interest in the issuer. An example would be an open ended mutual fund, which gives unit holders the right to redeem their interests in the enterprise at any time for an amount of cash equal to their proportionate share of the net asset value of the entity.
The Board noted that financial instruments puttable at fair value are classified as liabilities under IAS 32, but this gives rise to strange accounting whereby the fair value of the entity differs from the reported carrying amount of the entity's net assets, for example, because of unrecognised assets (such as goodwill) and the measurement of some assets at cost.
At its July 2004 meeting, the Board rejected two possible solutions to this issue. The rejected options were:
- to continue to classify these instruments as liabilities but amend their measurement so that changes in their fair value would not be recognised; and
- to separate all puttable instruments into a put option and a host instrument.
The proposal
The Board's proposed solution is an amendment to IAS 32 to classify puttable instruments at fair value as equity. The proposed amendment will allow the entity to have other instruments classified as equity so long as the instruments rank above the puttable instruments and do not have an interest in the residual net assets of the issuer.
A board member pointed out that this solution would mean, for example, that 10-year bonds puttable at fair value are classified as equity, which is not really an acceptable answer. Whether the words of the proposal actually implied this, however, was debatable according to other board members.
Treatment of mandatorily redeemable instruments was considered due to feedback indicating that there is some confusion over whether 'puttable instruments' include puttable instruments with a fixed term.
IAS 32.18(b) suggests that a 'puttable instrument' does not include an instrument mandatorily redeemable on a fixed date. This contrasts with IAS 32.BC7, which argues that it makes no difference whether an instrument is puttable on only one date or on a variety of dates for deciding its classification as a financial liability. The latter view is the basis of the proposal.
As per the proposal, there are many examples of fixed period activities where the equity holders are sharing the residual risk of the activity. In the present case, allowing for a fixed date redemption should not increase the risk of financial engineering because the redemption event must be the same for all of the instruments.
Therefore the proposal suggested a consequential amendment to the definition of 'puttable instruments' in IAS 32.18(b) to clarify that the term 'puttable instrument' includes puttable instruments that have a fixed term such as mandatorily redeemable with a fixed term.
The Board accepted the need for guidance but raised several points for consideration:
- An entity could potentially end in a negative equity position if it has puttable options on equity also classified as such.
- The proposal was too rules-based, and could, therefore still lead to financial engineering.
- The FASB and the IASB are currently working on a project which considered classification between debt and equity issues. This proposal is not consistent with FASB's thinking so far.
- Perhaps the amendment should wait until the debt vs. equity project is finalised, or should be included in that project rather than considered separately.
- Why should only the lowest ranking classes apply the options? What if they were all similar, except for the redemption feature? There is no guidance in the proposal on which rank higher.
Staff were instructed to extend the scope to consider:
- Puttable minority interests.
- Partnership entities.
- Limited life entities.
- Different classes of shares.
Also, staff should consider the FASB project on debt vs equity.
