IAS 32: Accounting for the new activity in the market place

21 February 2014

By John Hitchins

Have you been following the 'non-viability' saga? If you answered no, don't worry; we are still in the early chapters and the story continues to unfold.  And although 'non-viability' instruments are currently trending in the financial services sector, you may have no choice but to become familiar with this topic given the billions of capital being (and ready to be) invested in these instruments.

Chapter 1. The story begins with regulators looking to strengthen the capital base of financial institutions in response to the financial crisis. For example, the European Banking Authority (EBA) set new regulatory capital requirements where a bank must be capitalised to a certain threshold. If these minimum capital requirements are breached and the bank suffers severe financial distress, a wider range of the bank’s investors and lenders should ‘absorb the loss’.  A common way financial institutions are complying with these new capital requirements is to cancel or forgive the instrument, or to issue instruments that convert into a variable number of the entity's own ordinary shares when the minimum regulatory capital requirement is breached.  This type of contingent feature is referred to as a ‘non-viability’ clause. Such clauses give rise to complex accounting questions from both an investor and issuer perspective. 

Chapter 2.  A specific non-viability instrument was raised to the IFRS IC in 2013.  The instrument requires the issuer to settle by delivering a variable number of its own shares when the non-viability event occurs.  Before conversion, the issuer could also pay discretionary dividends to the investor.  We all know the model in IAS 32 has its challenges; applying the guidance to this instrument is proving no easy task.   The key points of debate were around how to 'break down' the instrument (that is, is it liability or equity, or a combination of both), whether the timing of the non-viability event should be considered as part of the measurement and how to recognise the discretionary dividends. And by the way, these instruments are often issued in a foreign currency which creates an additional complexity. 

Chapter 3.  At the recent meeting in January, IFRS IC decided that the scope of issues for this instrument is too broad and could not address the matter efficiently.  

The next chapter.  So where does that leave us? Would solving the accounting for this instrument result in unintended consequences for other instruments in the market place?  Is it yet more evidence of IAS 32’s inability to deal adequately with increasingly complex capital instruments? The good news is that the IASB was made aware of the issue’s significance and agreed at the February board meeting to consider the accounting for these types of instruments. So watch out for the next chapter!    

Are you a character in this story or just a loyal reader? Have you seen these instruments before and if yes, how are you accounting for them?  

John Hitchins:
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