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

This publication focuses on the classiication 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

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classiication for inancial instruments issued by investment funds

Investment funds frequently issue shares or units with unique, entity-speciic characteristics As a result, a signiicant effort may be required in applying the IFRS guidance to the contractual terms of these instruments to determine whether they should be classiied as a liability or equity

This publication focuses on the classiication 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 inancial 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 classiied

as equity?

3 How do you classify a component of an instrument that imposes an obligation only on liquidation?

4 How do you classify redeemable shares issued by umbrella structures?

5 When should a inancial instrument be reclassiied between liability and equity? The scope of this publication is limited to non-derivative inancial instruments issued

by investment funds

1 Liability or equity? Where do you start the

analysis?

Shares or units issued by a fund are classiied as a inancial liability or equity on initial recognition The table below outlines the principal considerations for funds in determining whether an instrument meets the deinition of equity or liability under the general deinitions in IAS 32

Financial liability Equity

Key features Contains a contractual obligation to transfer cash or other inancial 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

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 inancial asset

If settled in

own equity

instruments

Settlement in a variable number of the entity’s own equity instruments Settlement in a ixed number

of the entity’s own equity instruments

Features that

generally point

to liability

or equity

classiication

of an

instrument or

a component

of an

instrument

• Instruments with the following features may still be classiied 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

• Non-redeemable shares or units

• No speciic 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 ixed 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 classiication

How does B classify the units?

The unit issued by B is a compound instrument

The obligation to pay ixed non-discretionary dividends represents a contractual obligation that is classiied as a inancial liability in line with the general deinitions in IAS 32

The obligation to deliver a pro rata share of B’s net assets only on its liquidation is classiied 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 classiied wholly as equity providing all other criteria were met

An entity assesses the substance of a contractual arrangement, rather than its legal form, when determining whether an instrument meets the deinition of a inancial liability or equity As a result, it is possible that instruments that qualify as equity for legal or regulatory purposes may be classiied as liabilities for the purpose of inancial 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 classiication

Instruments that are often impacted and so may fail the deinition 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 deinition of a inancial liability, then an investment fund applies the lowchart 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 deinition of a puttable instrument (see Question 2); or

• the instrument, or a component, meets the deinition 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)

Yes

Is definition (ii) met part the instrument?

for of

The whole instrument is classified as equity by exception

The whole instrument is classified as

a liability That part is classified as equity by exception and the balance is classified

as a liability No

Yes

No

Yes

Step 1

Is the financial

instrument a

in

accordance with

the general

definitions in IAS 32?

liability

equity

or

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 only on liquidation?

assets

The instrument is

equity in its entirety

The instrument is a

liability in its entirety

The instrument

is a compound

instrument

No further analysis under Step 2

is required

Is the definition

of (i) or (ii) met for the whole instrument?

Is the definition

of (i) (ii) met for the whole compound instrument?

or

Is definition (ii) met the entire liability component?

for

Is definition (ii) met for part

of liability component?

the

The of the instrument

definition of equity in accordance with the general requirements of IAS 32 is classified as equity The remaining part is classified

as a liability

component meeting the

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

No

No

Yes

No

Yes

The whole instrument is classified as equity by exception

2 When are puttable instruments and obligations

arising on liquidation classiied as equity?

Puttable instruments and obligations arising on liquidation are deined as follows

Financial instruments that give the holder

the right to put the instruments back to the

issuer for cash or another inancial 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)

Puttable

instruments

Obligations arising on liquidation

Such instruments are classiied 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 classiication 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 classiication

Required for puttable instruments?

Required for obligations arising on liquidation?

Examples (on next few pages)

1 The inancial instrument entitles the holder to a pro rata share of

the entity’s net assets in the event of the entity’s liquidation Yes Yes 2

2 The inancial instrument belongs to the most subordinate class of

3a All inancial instruments in this most subordinate class have

3b All inancial instruments in this most subordinate class have an

identical contractual obligation to deliver a pro rata share of the

-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 inancial asset or to exchange inancial assets or

inancial 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 Yes No 5

Conditions required for equity classiication

Required for puttable instruments?

Required for obligations arising on liquidation?

Examples (on next few pages)

5 Total expected cash lows attributable to the instrument over its life

are based substantially on:

• proit or loss;

• change in recognised net assets; or

• change in fair value of recognised and unrecognised net assets of

6 The issuer has no other inancial instrument or contract that has:

• total cash lows based substantially on proit or loss, change in

recognised net assets, or change in fair value of recognised and

unrecognised net assets of the issuer; and

• the effect of substantially restricting or ixing the residual return

The reason for the differences between the conditions for a puttable instrument and an instrument that imposes on the entity

an obligation only on liquidation is the timing of settlement of the obligations A puttable instrument can be exercised before liquidation; therefore, all contractual obligations that exist throughout its entire life are considered to ensure that it always represents the most residual interest For an obligation that is settled only on liquidation, the focus is on obligations that exist

at liquidation

Example 2 – Pro rata share of net assets on liquidation

Shares issued by limited-life Fund C and Fund D have the following features with respect to payments on liquidation

Fees payable on liquidation Fixed fee per unit Fixed fee per unit holder

Calculation basis for a pro rata share of net assets Pro rata share of total net assets Pro rata share of speciic portion

or component of net assets How do the above features affect the classiication of the units?

IAS 32 states that a pro rata share of the fund’s net assets on liquidation is determined by:

• dividing the entity’s net assets on liquidation into units of equal amount; and

• multiplying that amount by the number of units held by the inancial instrument holder

In our view, this means that each instrument holder has an entitlement to an identical monetary amount per unit on

liquidation

Each feature of D’s units illustrated above results in unit holders not receiving an identical monetary amount per unit on liquidation and so precludes equity classiication

C classiies its units as equity providing that the remaining requirements are met

Example 3 – Management shares: The most subordinate class

The holders of the redeemable shares of Fund E are entitled to a pro rata share of E’s net assets in the event of its liquidation

E has also issued a small amount of a different class of shares (‘management shares’) to the fund manager; these shares are non-redeemable, have no entitlement to dividends and are the most subordinate class of instruments in liquidation

Can redeemable shares be regarded as the most subordinated class?

IAS 32 does not preclude the existence of several types or classes of equity

A inancial instrument is irst classiied as a liability or equity instrument in accordance with the general requirements of IAS 32 That classiication is not affected by the existence of puttable instruments or instruments that impose an obligation only on liquidation

As a second step, a fund considers whether a inancial liability also meets the exception for puttable instruments or

instruments that impose an obligation only on liquidation and so should be classiied as equity

In this example, the redeemable shares meet the deinition of a liability in IAS 32 Also, in our view they fail the exception for puttable instruments because even a small amount of management shares that are subordinate to redeemable shares means that such redeemable shares are not subordinated to all other classes of instruments

The existence of a puttable feature in the redeemable shares does not in itself mean that the instrument is less subordinate than management shares The level of an instrument’s subordination is determined by its priority in liquidation In some instances, redeemable shares could be the most subordinated class – e.g when management shares have priority in

liquidation and there are no other more subordinate instruments issued

In respect of puttable instruments, all inancial instruments in the class of instruments that is subordinate to all other classes

of instruments need to have identical features to qualify for equity classiication In our view, this should be interpreted strictly

to mean identical contractual terms and conditions, including non-inancial features such as governance rights, related to the holders of the instruments in their roles as owners of the entity

Differences in cash lows and contractual terms and conditions of an instrument attributable to an instrument holder in its role

as non-owner are not considered to violate the identical features test, provided that the transaction is on similar terms to an equivalent transaction that might happen between a non-instrument holder and the issuing entity

Examples of contractual features that would violate the identical features test include:

• different rates of management fees;

• a choice for holders on issuance whether to receive income or additional units as distributions (such that the distributive or accumulative feature differs for each instrument after they are issued);

• different lock-up periods; and

• different currencies in which the payments are denominated

In our view, the following terms do not violate the identical features test because there are no inherent differences in the features of each instrument within the most subordinate class:

• administrative charges based on the volume of units redeemed before liquidation, as long as all unit holders in the most subordinate class are subject to the same fee structure;

• different subscription fees payable on initial subscription, as long as all other features become identical once the subscription fees are paid;

• a choice to receive income or additional units as distributions on each distribution date, as long as the same ability is afforded

to all unit holders in the most subordinate class – i.e the ‘choice’ is an identical feature; and

• a term contained in identical instruments that carry equal voting rights that caps the maximum amount of voting rights that any individual holder may exercise

Example 4 – Identical features test: Additional information rights

Fund F issues redeemable shares that are the most subordinated class Fund manager M holds 5% of the redeemable shares in F. M also has access to certain information rights in its role as a manager that are not granted to other holders of redeemable shares

Does such access to additional information mean that not all redeemable shares have identical features?

If information rights are granted to M in its role as manager of the fund (and not in its role as owner), then they are not

considered to violate the identical features test

Example 5 – Contractual distribution of net accounting proit

Unit Trust T issues redeemable units In addition to the general redemption feature, T is contractually required to distribute to the holders the net accounting proit annually

How does an additional requirement to distribute the net accounting proit affect classiication of redeemable shares?

In our view, the requirement to distribute the net accounting proit annually is an additional obligation to deliver cash and, therefore, the redeemable units do not qualify for equity classiication

Example 6 – Total expected cash lows attributable to the instrument

Fund G issues one class of redeemable shares that entitles each holder to a pro rata share of G’s net assets and that is the most subordinate class of instruments issued

Redemption amounts are based on net assets calculated in accordance with local GAAP (not IFRS)

The redeemable shares do not contain any other contractual obligations to deliver cash

Are the total expected cash lows of the shares based substantially on proit or loss and change in net assets?

Usually, to meet this requirement, the redemption amount is calculated with reference to net assets measured in

accordance with IFRS This is not the case in this example, because the redemption value of the shares is calculated based

on local GAAP

Nevertheless, G may still satisfy this condition, depending on the circumstances It may also be possible to argue that the effect of differences between local GAAP and IFRS is immaterial with regard to their application to G, or temporary and expected to converge over the life of the instrument, such that the total ‘expected’ cash lows are ‘based substantially’ on IFRS proit or loss or change in recognised net assets

In our view, the use of the terms ‘expected’ and ‘based substantially’ indicates that judgement should be exercised in

determining whether the requirement is met in each speciic situation, including consideration of how local GAAP and IFRS apply to the reporting entity’s business and the terms of the instrument

3 How do you classify a component of an

instrument that imposes an obligation only on liquidation?

The following guidance applies only to components of instruments that impose on the entity an obligation to deliver a pro rata share of its net assets only on liquidation Puttable instruments are tested for equity classiication as a whole (see lowchart in Question 1)

Instruments or components of instruments that meet the deinition of a liability in accordance with the general requirements

of IAS 32 and that impose on the entity an obligation to deliver to another party a pro rata share of the net assets only on liquidation are classiied as equity if they meet the conditions set out in Question 2

If the instrument that imposes an obligation on the entity to deliver a pro rata share of the net assets only on liquidation also contains other contractual obligations, then these other obligations may need to be accounted for separately as liabilities in accordance with the requirements of IAS 32 For example, the following components could be present in an instrument:

• an obligation to pay non-discretionary dividends – i.e a inancial liability component; and

• an obligation to deliver a pro rata share of the net assets on liquidation

In such cases, a question arises about whether the second component can ever meet Condition 6 set out in the table

in Question 2 that requires that the issuer has no other financial instrument or contract that has total cash lows based

substantially on the issuer’s proit or loss, change in recognised net assets, or change in fair value of recognised and

unrecognised net assets

In our view, when evaluating such a component (an obligation arising on liquidation) for equity classiication by exception, a fund should choose an accounting policy, to be applied consistently, on whether the term ‘other inancial instrument’ includes: (i) other components of the evaluated instrument; or

(ii) only inancial instruments other than the one that contains the evaluated component

If the fund’s policy is to view a mandatory dividend feature as another inancial instrument for this purpose, then equity

classiication of the obligation arising only on liquidation would be precluded for this component of the instrument because the mandatory non-discretionary dividends violate Condition 6 in Question 2 – e.g mandatory dividends based on proits

However, if the fund’s policy is to consider for this test only inancial instruments other than the one that contains the obligation arising on liquidation, then a mandatory dividend feature in itself would not preclude equity classiication of the obligation arising on liquidation because this feature is part of the same instrument and it could not violate Condition 6 in Question 2

Example 7 – Limited-life entity pays non-discretionary dividends

Fund K is a limited-life entity K issues units that are redeemable only on its liquidation The unit holders are entitled to annual non-discretionary dividends equalling 90% of K’s proits and a pro rata share of the net assets on liquidation of K

How does K classify the components of the shares issued?

The obligation to pay ixed non-discretionary dividends represents a contractual obligation that is classiied as a inancial liability (Component 1)

The classiication of the obligation to deliver a pro rata share of the net assets on liquidation (Component 2) depends on the accounting policy choice made by K

• If K chooses accounting policy (i) above, then Component 2 is classiied as a liability

• If K chooses accounting policy (ii) above, and provided that all other criteria are met, then Component 2 is classiied as equity

4 How do you classify redeemable shares

issued by umbrella structures?

The term ‘umbrella fund structure’ is used in certain jurisdictions to describe a collective investment scheme that comprises

an umbrella fund that operates one or more sub-funds Investors buy instruments that entitle the holder to a share of the net assets of a particular sub-fund

The umbrella fund and sub-funds together form a legal entity, although the assets and the obligations of individual funds are fully or partially segregated Each sub-fund usually has its own investment objectives, focusing on different markets

The analysis in this question applies only to instances in which the assets and obligations of each sub-fund are ring-fenced solely for investors of the respective sub-fund

The table below discusses the possible classiication of puttable instruments and instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets only on liquidation, issued by an umbrella fund structure

Type of inancial statements

prepared Considerations Classiication

Individual inancial statements

prepared by each sub-fund

Each sub-fund assesses issued instruments for equity classiication separately

Liability or equity

Separate inancial statements

of umbrella fund structure

that include the assets and

liabilities of the sub-funds that

together form a single legal

entity

Instruments issued by the sub-funds are assessed for equity classiication from the perspective of the umbrella fund structure as a whole

Instruments issued by each sub-fund cannot qualify for equity classiication because they could not meet the pro rata share of the entity’s net assets on liquidation condition and, if they are puttable instruments, the identical features test

Liability

Consolidated inancial

statements with sub-funds as

subsidiaries

Instruments issued by sub-funds that qualify for equity presentation in the individual inancial statements of each fund and that represent non-controlling interests are classiied as liabilities in the consolidated inancial statements

Liability

Combined inancial

statements prepared by an

umbrella fund structure,

expressed as prepared in

accordance with IFRS

In our view, puttable sub-fund instruments would not qualify for equity classiication in the combined inancial statements for the reasons described above for both separate and consolidated inancial statements

Liability

5 When should a inancial instrument be

reclassiied between liability and equity?

The classiication of an instrument or its component parts as either a inancial liability or equity is made at initial recognition and, with the exception of puttable instruments and instruments that impose on the entity an obligation only on liquidation,

is not generally revised as a result of subsequent changes in circumstances However, a reclassiication between liability and equity or vice versa may be required following changes to the contractual or effective terms of the instruments or changes in the composition of the reporting entity Puttable instruments and instruments or components that impose on the entity an obligation only in liquidation are reclassiied:

• to inancial liability – from the date on which any of the equity classiication criteria in Question 2 cease to be met; or

• to equity – from the date on which all equity classiication criteria in Question 2 are met

This indicates a continuous assessment model under which a fund re-assesses the classiication whenever there are changes

to the relevant circumstances – e.g changes to the capital structure, such as the issue of new classes of shares or redemptions

of existing share classes

Puttable instruments or instruments that impose on the entity an obligation only on liquidation are measured on reclassiication

as follows

Reclassiication Measurement Accounting for carrying amount adjustment

From equity to

inancial liability

Liability is measured initially at the instrument’s fair value at the date of reclassiication

Any difference between the carrying amount of the equity instrument and the fair value of the inancial liability at the date of reclassiication continues to be recognised in equity

From inancial liability

to equity

Equity instrument is measured at the carrying amount of the inancial liability at the date of reclassiication

No adjustment to the carrying amount

Accounting entries – Reclassiication from equity to inancial liability

Assume that on the date of reclassiication the carrying amount of an instrument previously classiied as equity is 100 and its fair value is 90 The double entry on reclassiication is as follows

Accounting entries – Reclassiication from inancial liability to equity

Assume that on the date of reclassiication the carrying amount of an instrument previously classiied as equity is 100 and its fair value is 90 The double entry on reclassiication is as follows

1 This example does not focus on different components of equity.