IN THIS ISSUE: LIABILITY VS EQUITY CLASSIFICATION FOR FINANCIAL INSTRUMENTS ISSUED BY INVESTMENT FUNDS

IFRS FOR INVESTMENT FUNDS February 2012, Issue 3 Welcome to the series Our series of IFRS for Investment Funds publications addresses practical application issues that investment funds may encounter when applying IFRS. It discusses the key requirements and includes guidance and illustrative examples. The upcoming issues will cover such topics as fair value measurement, consolidation and IFRS 9 Financial Instruments. This series considers In this issue: Liability vs equity classification for financial instruments issued by investment funds Investment funds frequently issue shares or units with unique, entity-specific characteristics. As a result, a significant effort may be required in applying the IFRS guidance to the contractual terms of these instruments to determine whether they should be classified as a liability or equity. This publication focuses on the classification of puttable instruments and instruments that impose on the entity an obligation to deliver a pro rata share of the entity’s net assets only on liquidation (‘obligations arising on liquidation’). These are the most common types of financial instruments issued by investment funds. This issue covers the following issues arising from the application of IAS 32 Financial Instruments: Presentation. 1. Liability or equity? Where do you start the analysis? 2. When are puttable instruments and obligations arising on liquidation classified as equity? 3. How do you classify a component of an instrument that imposes an obligation only on liquidation? accounting issues arising from currently effective 4. How do you classify redeemable shares issued by umbrella structures? 5. When should a financial instrument be reclassified between liability and equity? IFRS as well as forthcoming requirements. Further discussion and analysis about IFRS is included in our publication Insights into IFRS. The scope of this publication is limited to non-derivative financial instruments issued by investment funds. 2 | IFRS for Investment Funds 1. Liability or equity? Where do you start the analysis? Shares or units issued by a fund are classified as a financial liability or equity on initial recognition. The table below outlines the principal considerations for funds in determining whether an instrument meets the definition of equity or liability under the general definitions in IAS 32. Key features If settled in own equity instruments Features that generally point to liability or equity classification of an instrument or a component of an instrument Financial liability Contains a contractual obligation to transfer cash or other financial assets. The contractual obligation may arise from a requirement to repay principal or to pay interest or dividends. In our view, such a contractual obligation could be established explicitly or indirectly, but it should be established through the terms and conditions of the instrument. Settlement in a variable number of the entity’s own equity instruments. • Instruments with the following features may still be classified as equity if certain conditions are met (see Question 2): – redemption is at the option of the instrument holder – limited life of a fund – fund liquidation is at the option of the instrument holder. • Redemption is triggered by an uncertain future event that is beyond the control of both the holder and the issuer of the instrument. • Non-discretionary dividends. Equity In general, any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. The issuer has no contractual obligation to deliver cash or another financial asset. Settlement in a fixed number of the entity’s own equity instruments. • Non-redeemable shares or units. • No specific liquidation date. • Discretionary dividends. Example 1 – Non-discretionary dividends Fund B issues units that are not puttable and that give the unit holders a right to fixed non-discretionary dividends each period and a pro rata share of the fund’s net assets on its liquidation. B does not have a limited life and its liquidation is not at the option of the unit holders. The units do not have any other features that would preclude equity classification. How does B classify the units? The unit issued by B is a compound instrument. The obligation to pay fixed non-discretionary dividends represents a contractual obligation that is classified as a financial liability in line with the general definitions in IAS 32. The obligation to deliver a pro rata share of B’s net assets only on its liquidation is classified as equity because the liquidation is neither certain to happen nor beyond the control of B. However, if there were no mandatory dividend requirement and dividends were entirely at the discretion of B, then the units would be classified wholly as equity providing all other criteria were met. © 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. IFRS for Investment Funds | 3 An entity assesses the substance of a contractual arrangement, rather than its legal form, when determining whether an instrument meets the definition of a financial liability or equity. As a result, it is possible that instruments that qualify as equity for legal or regulatory purposes may be classified as liabilities for the purpose of financial reporting. In our view, in assessing the substance of a contractual arrangement, factors not contained within the contractual arrangement should be excluded from the assessment. Economic compulsion should not be used as the basis for classification. Instruments that are often impacted and so may fail the definition of equity under IFRS include preference shares and classes of shares that have special terms and conditions. If it is determined at initial recognition that an instrument, or in certain circumstances a component, meets the definition of a financial liability, then an investment fund applies the flowchart below to determine whether the instrument, or a portion of it, should be presented as equity by exception. Presentation as equity by exception is required if: • the instrument meets the definition of a puttable instrument (see Question 2); or • the instrument, or a component, meets the definition of an instrument that imposes on the fund an obligation to deliver a pro rata share of the net assets of the fund only on liquidation (see Question 2). Step 1 Is the financial instrument a liability or equity in accordance with the general definitions in IAS 32? The instrument is equity in its entirety Step 2 If the financial instrument is not equity in its entirety, then is it: (i) a puttable instrument; or (ii) an instrument or component that imposes an obligation to deliver a pro rata share of net assets only on liquidation? No further analysis under Step 2 is required The instrument is a liability in its entirety No Is the definition of (i) or (ii) met for the whole instrument? Yes No Is definition (ii) met for part of the instrument? Yes The whole instrument is classified as a liability That part is classified as equity by exception and the balance is classified as a liability The whole instrument is classified as equity by exception The instrument is a compound instrument No Is the definition of (i) or (ii) met for the whole compound instrument? Yes No Is definition (ii) met for the entire liability component? Yes Is definition No (ii) met for part of the liability component? Yes The component of the instrument meeting the definition of equity in accordance with the general requirements of IAS 32 is classified as equity.The remaining part is classified as a liability The component of the instrument meeting the definition of equity in accordance with the general requirements of IAS 32 and the part of the liability component meeting the definition of (ii) are classified as equity. The remaining part is classified as a liability The whole instrument is classified as equity by exception © 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. 4 | IFRS for Investment Funds 2. When are puttable instruments and obligations arising on liquidation classified as equity? Puttable instruments and obligations arising on liquidation are defined as follows. Puttable instruments Obligations arising on liquidation Financial instruments that give the holder the right to put the instruments back to the issuer for cash or another financial asset, or that are automatically put back to the issuer on the occurrence of an uncertain future event. Financial instruments that contain a contractual obligation for the entity to deliver to the holder a pro rata share of its net assets only on liquidation. In this case, the obligation arises because liquidation either is certain to happen and is outside the control of the entity (e.g. a limited-life entity) or is uncertain but is at the option of the instrument holder (e.g. some partnership interests). Such instruments are classified as equity by exception under IAS 32 if they meet certain conditions that are summarised in the table below. The contractual terms and surrounding circumstances should be reviewed for each instrument to determine the appropriate classification. The criteria for meeting the exception are restrictive and a fund will have to meet all of them to classify the issued instruments as equity. Conditions required for equity classification 1 The financial instrument entitles the holder to a pro rata share of the entity’s net assets in the event of the entity’s liquidation. 2 The financial instrument belongs to the most subordinate class of instruments. 3a All financial instruments in this most subordinate class have identical features. 3b All financial instruments in this most subordinate class have an identical contractual obligation to deliver a pro rata share of the entity’s net assets on liquidation. 4 Apart from an obligation for the issuer to repurchase or redeem, the instrument: • does not include any other contractual obligation to deliver cash or another financial asset or to exchange financial assets or financial liabilities under potentially unfavourable conditions; and • is not a contract under which an entity is or may be obliged to deliver a variable number of the entity’s own equity instruments. Required for puttable instruments? Yes Yes Yes See 3a Yes Required for obligations arising on liquidation? Yes Yes ... - tailieumienphi.vn