IFRS vs. US GAAP: Liability/ equity classification

From the IFRS Institute - May 2017

Capital structures can be complex, containing a number of features and performance characteristics. Classification of a financial instrument as financial liability or equity under IFRS can be challenging. Also, IFRS differs from US GAAP in this area and their respective requirements can be easily confused.

The general principles that drive the classification of a financial instrument as a financial liability or as equity under IFRS are outlined below.

Basic liability/equity classification requirements under IFRS

Under IAS 32, Financial Instruments: Presentation, a financial liability is defined as a contractual obligation to transfer cash or another financial asset. A financial instrument is also classified as financial liability if it will or may be settled in a variable number of the entity’s own equity instruments. A non-derivative contract that will be settled by an entity delivering its own equity instruments is an equity instrument if, and only if, it will be settled by delivering a fixed number of its own equity instruments. A derivative contract that will be settled by the entity delivering a fixed number of its own equity instruments for a fixed amount of cash is an equity instrument. Certain exceptions exist for several instruments including preference shares and puttable instruments, which are discussed below.

There is no concept of ‘temporary equity’ under IFRS. Many instruments that are classified as a financial liability under IFRS could be classified as equity or temporary equity under US GAAP, and certain instruments that are equity under IFRS could be classified outside equity under US GAAP. For further discussion on the differences between IFRS and US GAAP, see KPMG’s publication, IFRS compared to US GAAP.

Preference shares

The proper classification of preference shares depends on their respective terms and conditions. For example, preference shares that provide for redemption at the option of the holder give rise to a contractual obligation and therefore are classified as financial liability.

If dividend rights attached to the preference share are discretionary, the preference share is classified as equity. If they are not, then the preference share or a portion of it is classified as a financial liability. A preference dividend in which the contractual dividend payment is contingent on the availability of future distributable profits differs from a discretionary dividend. With a discretionary dividend, the issuer is able to avoid the payment of dividends indefinitely.

However, the payment of a contingent dividend cannot be avoided indefinitely. Consequently, contingent dividends are classified as a financial liability.

Puttable financial instruments and limited-life entities

Particularly in the case of limited-life entities (e.g. many investment funds and non-revolving securitization vehicles), care is required in evaluating the liability/equity classification criteria before concluding that financial instruments that are in the form of equity qualify for equity classification under IFRS.

The basic principle is that puttable financial instruments and limited-life entities are classified as financial liabilities. However, IFRS also has an exception for the classification of puttable instruments and obligations arising on liquidation. Certain puttable instruments and instruments that impose on the entity an obligation to deliver to the holder a pro rata share of the entity’s net assets only on liquidation are classified as equity if certain conditions are met. However, for many limited-life entities, the instruments fail these conditions because there is a form of subordination as a consequence of the distribution waterfall; as a result, the financial instruments issued by these entities generally do not qualify for equity classification under IFRS.

IASB’s Financial Instruments with Characteristics of Equity (FICE) project

Applying IAS 32 to types of instruments not directly addressed by the requirements is difficult – e.g. some instruments contingently convertible to ordinary shares. Continuing discomfort over classification outcomes also raises concerns. The IASB therefore started its FICE research project in 2014.

As part of this project, the IASB plans to reinforce the underlying rationale of classification between liabilities and equity. It will provide clarification of liability/equity distinction under IAS 32, in particular for derivatives on own equity. The Board does not expect a significant change to classification outcomes compared with the current IAS 32 application. A FICE discussion paper is expected toward the end of 2017.

Meanwhile, the FASB will conduct additional research to decide whether it should add the topic of distinguishing liabilities from equity to its agenda, and if so, whether it should consider just specific issues and features or carry out a comprehensive reconsideration of the existing guidance. However, the outcome of the Boards’ respective projects is unlikely to result in any significant degree of convergence.