9.1.1 Hedging Investments Consolidated under Equity Method

IFRS 9 prohibits designating an investment accounted for by the equity method as a hedged item to avoid conflicts with existing accounting requirements for that item. Under the equity method of accounting, the investor records its share of the investee's gains or losses from its investment. It does not account for changes in the price of the equity shares, which would become part of the basis of an equity method investment if fair value hedge accounting were permitted. Changes in earnings of an equity method investee presumably would affect the fair value of its equity shares. Applying fair value hedge accounting to an equity method investment thus could result in some amount of “double counting” of the investor's share of the investee's earnings. The IASB believed that result was inappropriate. In addition, the IASB was concerned that it would be difficult to develop a method of implementing fair value hedge accounting, including measuring hedge ineffectiveness, for equity method investments and that the results of any method would be difficult to understand. For similar reasons, IFRS 9 prohibits fair value hedge accounting for a firm commitment to acquire or dispose of an investment accounted for using the equity method.

9.1.2 Impairment of Equity Investments

Because unconsolidated equity investments are measured at fair value, there is no need to test them for impairment. If an investment has experienced a significant and prolonged decline in its fair value, such decline would already be presented in the entity's financial statements when fair valuing the asset.

9.2.1 Recognition as a Liability

A fundamental characteristic of a financial liability is a present contractual obligation to transfer assets to the holder of the instrument, over which the issuer has no discretion. A financial instrument is a liability if there is a contractual obligation:

• to deliver cash or another financial asset to another entity; or
• to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.

9.2.2 Recognition as an Equity Instrument

An equity instrument represents a residual interest in the net assets of the issuer. More precisely, a financial instrument is considered an equity instrument if either of the following conditions is met:

1. There is no contractual obligation to deliver cash or another financial asset to another entity; or to exchange financial assets or liabilities under conditions that are potentially unfavourable to the issuer.
2. The instrument will or may be settled in the issuer's own equity shares: a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or a derivative that will be settled by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.

The IASB issued a remarkably narrow amendment in 2008 whereby certain instruments that would otherwise meet the definition of a liability (because of the obligation to redeem the instrument at the option of the holder) could be classified as equity if very strict criteria were met. One of those criteria is that the puttable share is the most subordinate instrument. A puttable instrument is one that requires the issuer to repurchase or redeem the instrument for cash or some other financial asset on exercise of the put.

Not all instruments are classified as either only debt or only equity. The following table summarises the classification of the most common hybrid and equity instruments:

9.3.1 Contractual Discretion

An instrument will be considered an equity instrument if the entity has a contractual “discretion” over whether to make any cash payments. A strong economic incentive to make payments does not amount to a contractual obligation and is therefore not sufficient for liability classification. Anything outside the contractual terms is not considered when classifying an instrument under IAS 32. Therefore, contractual discretion is not affected by the following:

• a history of making distributions or an intention or ability to make distributions in the future;
• the amount of the issuer's reserves;
• the entity's expectation of a profit or loss for the period;
• the ability or inability of the issuer to influence the amount of its profit or loss for the period, any economic compulsion to make distribution or the ranking of the instrument on the liquidation of the entity;
• a possible negative impact on the price of ordinary shares of the issuer if dividends are not paid to ordinary shares (because of restrictions on paying dividends on the ordinary shares if dividends are not paid on the preference shares).

9.3.2 Economic Compulsion

Economic compulsion takes place when an entity has an economic motivation, but is not obliged, to make a specific decision. For example, an issuer of a callable bond may have a strong motivation to call the bond on the call date if the bond pays a much higher than market interest rate.

In general, economic compulsion does not play a role in the classification decision under IAS 32. For example, a sold call option on an entity's own shares may be classified as either equity or liability depending on its form of settlement. The option will be considered as equity if upon exercise the issuer of the shares is obliged to deliver a fixed number of shares in exchange for a fixed amount of cash. The option will be considered as a liability if the option can only be settled in cash or if either of the two parties to the option has the right to choose between cash (or an equivalent variable number of shares) and physical settlement. Whilst there might be a strong economic compulsion to physically settle the option (e.g., because the entity owns sufficient treasury shares to meet the exercise), the existence of a right on the part of either of the two parties to choose cash settlement would cause it to be classified as a liability.

However, once a financial obligation has been established through the terms and conditions, economic compulsion may be relevant in special circumstances. One example in which economic compulsion may play a role in the instrument's classification would be an undated preference share issue with a contractually accelerating dividend, whereby in the foreseeable future the dividend yield was scheduled to be so large that the issuer would be economically compelled to redeem the instrument. In these circumstances, classification as a financial liability was appropriate because the issuer had little, if any, discretion to avoid redeeming the instrument.

9.3.3 Degree of Subordination

IAS 32 does not take into account the level of seniority of payment of the instrument when classifying it as equity or liability. For example, an instrument can be pari passu with all the senior debt and be classified as equity. Similarly, an instrument can be pari passu with all other preference shares and be classified as liability. The seniority of payment is only relevant on liquidation of the entity and does not play a role in indicating whether the issuer has discretion to make payments under the instrument.

9.3.4 Legal Form

When deciding the classification of a financial instrument between liability and equity, attention should be paid to the underlying substance and economic reality of the contractual obligation and not just its legal form. For example, the mere fact that a financial instrument has the legal title of “shares” does not mean that the instrument should be classified as equity.

In general, the rule of thumb regarding the classification of preference shares as a liability or as equity is as follows:

• Preference shares which are mandatorily redeemable on a specific date or at the option of the holder: the principal would be classified as a liability.
• Non-redeemable preference shares: the principal would be classified as equity.
• Preference shares which carry non-discretionary dividend obligations whether cumulative or non-cumulative: the dividends would be classified as a liability and would be taken to profit or loss as financial expenses.

9.3.5 Entity's Historical Trend or Ability to Make Distributions

The entity's history of making distributions in prior years or its ability to make distributions does not impact the classification of an instrument.

9.4.1 Convertible Bonds Denominated in the Entity's Functional Currency – Fixed for Fixed

If a convertible bond allows the holder to convert the bond into a fixed number of the entity's equity instruments in exchange for a fixed amount of cash (or other assets), the written option is an equity instrument from an issuer's perspective. This instrument is called a compound instrument (Figure 9.4), and from an accounting standpoint is split into a liability component (the host contract) and an equity component.

On the issue date, the fair value of the liability component is determined using a market interest rate for an equivalent non-convertible bond. This amount is recorded as a liability on an amortised cost basis until extinguished on conversion or redemption of the bond. The remainder of the proceeds of the issue is allocated to the equity component (see Figure 9.5). No gain or loss arises from initially recognising the components of the instrument separately. The equity part is recognised in shareholders' equity, net of income tax effects.

9.4.2 Convertible Bonds Denominated in the Entity's Functional Currency – Fixed for Variable

If a convertible bond allows the holder to convert the bond into anything other than a fixed number of the entity's equity instruments in exchange for a fixed amount of cash (or other assets), the written option is a derivative from the issuer's perspective. This instrument is called a “hybrid instrument” (Figure 9.6) and from an accounting standpoint is split into a liability component (the host contract) and a derivative component.

On the issue date, the fair value of the liability component is determined using a market interest rate for an equivalent non-convertible bond. This amount is recorded as a liability on an amortised cost basis until extinguished on conversion or redemption of the bond. The remainder of the proceeds of the issue is allocated to the derivative component (see Figure 9.7). No gain or loss arises from initially recognising the components of the instrument separately. The derivative part is recognised as a liability and fair valued at each reporting date.

9.4.3 Convertible Bonds Denominated in a Foreign Currency

Suppose that an entity whose functional currency is the EUR issues a USD-denominated convertible bond that can be converted into a fixed number of the entity's shares for a fixed amount of USD. Because the amount is fixed in USD, it is a variable in the functional currency of the issuer (EUR).

IAS 32 states that a contract that will be settled by the entity delivering a fixed number of its own equity instruments in exchange for a variable amount of cash is a financial liability. Consequently, the written option should be classified as a liability, from an issuer perspective.

This treatment would result in reporting gains and losses arising from the entity's own equity through profit or loss, along with the currency gains and losses. Therefore, IFRS 9 permits cash flow hedges of such FX exposure.

9.6.1 Hedging Own Equity Instruments

IFRS 9 prohibits an equity instrument classified by an entity in its shareholders' equity in the statement of financial position from being designated as a hedged item. For example, an equity instrument does not meet the following hedge accounting requirements: (a) that a hedged item is a firm commitment, a highly expected forecast transaction or an already recognised asset or liability (the equity instrument is not an asset or liability, but an element of shareholders' equity); and (b) that the hedged item represents an exposure to changes in fair value that could affect reported profit or loss, or OCI in the case of investments at FVOCI (an equity instrument is not fair valued, and its repurchase/reissuance does not affect profit or loss). This prohibition does not apply to the holder of the equity instrument.

9.6.2 Derivatives on Own Equity Instruments

A derivative on an own equity instrument may be accounted for as a derivative instrument or an equity instrument, depending on the type of derivative and method of settlement.

• Derivatives on own equity that result in the delivery of a fixed amount of cash or other financial assets for a fixed number of the entity's own equity instruments are classified as equity instruments. All other derivatives on the entity's own equity are treated as derivatives and accounted for as such under IFRS 9.
• Derivatives on own equity where the counterparty or the issuer has a choice between cash settlement and physical delivery) are recognised as derivatives.

The following table illustrates whether a derivative on own shares is a financial liability or an equity instrument:

Notes:

(1) Assuming the settlement is made by exchanging a fixed amount of cash for a fixed number of the entity's own shares

(2) In a net share settlement, a variable number of shares is delivered/received having a fair value equivalent to the derivative's fair value at the time of exercise

9.7.1 Accounting Entries

Suppose that ABC reported its financial statements quarterly, at the end of each March, June, September and December. The required journal entries were as follows:

1. To record the DEF share loan and the collateral received on 1 April 20X0

   The DEF shares were classified at FVTPL. The 40 million DEF shares were fair valued by ABC on the previous reporting date (31 March 20X0) at EUR 9.00 per share. When an entity lends its securities, it reports these securities as pledged assets in its statement of financial position (i.e., balance sheet). The shares remained on ABC's asset side.

2. The cash collateral that ABC received on the securities lending transaction was recognised. Because the collateral had to be returned in the future, ABC also recognised a liability.
3. To record the fair valuation and the accrued interest on 30 June 20X0

   The DEF shares were trading at EUR 11.00 on 30 June 20X0. ABC classified the investment in DEF shares at FVTPL. On the previous reporting date (30 March 20X0), the shares were fair valued at EUR 9.00 per share. The change in fair value of the shares represented a EUR 80 million (=40 million × (11 – 9)) gain.

4. The collateral was invested in a deposit yielding 5% on an actual/360 basis. The interest to be received was recognised on an accrual basis and recorded as interest income. The number of days elapsed since 1 April 20X0 was 90. The accrued interest amount was EUR 5,000,000 (=400 million × 5% × 90/360).
5. Under the lending agreement, ABC was obliged to pass the interest received less a margin of 50 bps. The interest to be paid to the financial institution was recognised on an accrual basis and recorded as interest expense. The number of days elapsed since 1 April 20X0 was 90. The accrued interest amount was EUR 4,500,000 (=400 million × (5% – 0.50%) × 90/360).
6. To record the amount equivalent to the dividend received on 15 July 20X0

   The DEF 40 million shares paid a EUR 20 million dividend (EUR 0.50 per share) on 15 July 20X0. Under the lending agreement, XYZ Bank was required to pass the dividend to ABC on the dividend payment date.

7. To record the end of the lending agreement on 1 August 20X0

   The number of days elapsed since 30 June 20X0 was 32. Thus, the deposit accrued interest amount was EUR 1,778,000 (=400 million × 5% × 32/360).

8. On 1 August 20X0, the deposit paid 122 days' interest at an annual rate of 5% (122 days having elapsed since 1 April 20X0). The interest amount was EUR 6,778,000 (=400 million × 5% × 122/360).
9. The number of days elapsed since 30 June 20X0 was 32. Thus, the accrued amount of the interest to be paid by ABC to XYZ Bank was EUR 1,600,000 (=400 million × (5%-0.50%) × 32/360).
10. ABC had to pay 122 days' interest at an annual rate of 4.50% interest to XYZ Bank (122 days having elapsed since 1 April 20X0). The interest amount was EUR 6,100,000 (=400 million × (5% – 0.50%) × 122/360).
11. XYZ bank returned to ABC the borrowed 40 million DEF shares.
12. ABC returned the EUR 400 million cash collateral.

9.7.2 Final Remarks

Looking at ABC's profit or loss statement during the life of the lending agreement, it can be noted that the rationale behind the lending of DEF shares was to enhance the yield on the investment. ABC obtained 50 basis points for lending DEF shares (or EUR 678,000). ­Figure 9.12 compares the pre-tax profit or loss statements of ABC without and with the lending agreement in place.

The transaction, however, had two major disadvantages. Firstly, ABC lost the voting rights on the DEF shares during the life of the transaction. Secondly, ABC received an interest amount equivalent to the gross dividend of DEF shares, but could not claim any tax deductions related to such dividend.

Finally, two particular comments are worth noting. Firstly, in our case study the amount of collateral was based on the market value of the DEF shares at the beginning of the lending agreement, and this amount remained unchanged during the life of the agreement. Commonly, the collateral amount changes in order to eliminate credit exposure of the lender (ABC) to the borrower (XYZ Bank). The lender monitors the market value of the shares lent on a daily basis and requests additional collateral or returns surplus collateral in accordance with the market value of the lent/borrowed shares. The corresponding accounting entries are then produced on a daily basis to record the additional collateral received or returned, a substantial operational burden. Secondly, lending agreements usually do not have a fixed maturity. At any time, either the lender or the borrower can terminate the agreement by providing notice to the other party.

9.8.1 Accounting for a Fixed Parity Mandatory Convertible Bond

Let us assume that on 1 January 20X0 ABC issued a fixed-parity mandatory convertible bond on its own shares with the following terms:

Let us also assume that, at bond maturity, ABC issued 10 million ordinary shares with a par value of EUR 1.00 each. The issue value was EUR 10.00 per share. Therefore, the share premium was EUR 9.00 per share.

Two are the potential accounting treatments of mandatory convertibles depending whether the conversion implies the delivery of a fixed number for a fixed amount of cash (or its equivalent in other assets).

Mandatory convertibles which upon conversion the issuer has an obligation to deliver a fixed number of its own shares, are compound instruments that have both debt and equity characteristics. Under IFRS, the components of a mandatory convertible are bifurcated at the time of issuance into a debt component and an equity component. The initial carrying amount of the debt component is calculated as the present value of the bond cash flows for which the entity has a potential obligation to pay. The cash flows are discounted using the prevailing yield of similar debt without the conversion feature. The equity component represents the requirement to convert the mandatory convertible into ABC shares. Its initial value is calculated as the difference between the issue proceeds and the debt component. There is no subsequent fair valuation for either component, assuming that the debt component is recognised at amortised cost. This was the situation in our case.

Let us assume that when the mandatory convertible bond was issued, the prevailing yield of similar debt without the conversion feature was 5.70%. The debt component, EUR 98.12 million, was determined as the present value of the bond cash flows, assuming that the bond does not have the equity conversion feature. The calculation of the carrying amount of the debt component was performed as follows (amounts in EUR millions):

As the proceeds of the mandatory convertible issue were EUR 99.5 million, the equity component represented EUR 86.06 million (=99.5 mn – 13.44 mn), as shown in Figure 9.13. Therefore, the bifurcation resulted in a positive value being ascribed to the equity component and a lower value (discount) to the debt component. This discount was amortised as an adjustment (increase) to interest expense over the term of the mandatory convertible.

The amortised cost and interest expense of the liability component at each accounting date was determined as follows:

(*) The calculation was in reality 270,000. The difference was due to rounding. The figure 271,000 was used to reach a EUR 100 million redemption amount

9.8.2 Accounting for a Variable Parity Mandatory Convertible Bond

In the previous example, the embedded equity conversion was recognised as an equity instrument because the conversion feature implied the issuer delivering a fixed number of own shares in exchange for a fixed amount of cash (i.e., it met the “fixed-for-fixed” requirement for equity instruments). Next I will cover a mandatory convertible in which the number of own shares to be delivered was variable.

Suppose that on 1 January 20X0 ABC issued a mandatorily convertible bond on its own shares with the following terms:

On maturity the issuer had the obligation to deliver a variable number of shares. The number of shares to be delivered was equal to the bond principal (i.e., EUR 100 million) divided by the share price at conversion (i.e., the bondholder had no equity price risk). The fair value of the embedded conversion was nil during the life of the mandatory convertible and, as result, the instrument was initially recognised as a liability without any embedded option (see Figure 9.14). In other words, the mandatory convertible was theoretically equivalent to (i) the issuance of a straight bond (i.e., a bond without any conversion features), (ii) the issuance of shares at maturity and (iii) the redemption of the straight bond using the proceeds from the share issuance.

The bond was recognised at amortised cost using the effective interest rate (EIR) method. The bond's EIR was 5.887%. The EIR was determined by taking into account the EUR 99.5 million issue proceeds and the EUR 5.7 million annual coupon, as follows:

The liability's amortised cost and interest expense at each accounting date was determined as follows:

(*) The calculation was in reality 5,880,000. The difference was due to rounding. The figure 5,875,000 was used to reach the EUR 100 million redemption amount

9.9.1 Accounting for a Fixed-for-Fixed Convertible Bond

In this first example, upon conversion the issuer would deliver a fixed number of the issuer's shares. Suppose that, on 1 January 20X0, ABC issued a convertible bond on its own shares with the following terms:

At maturity the bondholders had the right to receive shares of ABC rather than receiving the EUR 100 million principal. Were the bondholders to exercise their conversion right, ABC would deliver 10 million (= Principal/Conversion rate = EUR 100 mn/EUR 10 per share) own shares. In the situation where, when exercised by the holder, the issuer has the obligation to deliver a fixed number of shares, convertibles are compound instruments that have both debt and equity characteristics. The fixed-for-fixed criterion is met as following conversion the holder receives a fixed number of shares in exchange for the bond's principal (i.e., in exchange for a fixed amount of cash – or other assets worth a fixed amount).

From an issuer's perspective, the components of fixed-for-fixed convertibles are bifurcated at the time of issuance into a debt component and an equity component (see Figure 9.7). The initial carrying amount of the debt component is calculated as the present value of the bond cash flows assuming that the bond's conversion right is not exercised. The cash flows are discounted using the prevailing yield of similar debt without the conversion feature (i.e., a straight bond issued by the issuer with similar maturity). The equity component represents the option to convert the bond into ABC shares. It is calculated as the difference between the issue proceeds and the debt component. There is no subsequent fair valuation for either component.

Suppose also that at the time of issuance, the prevailing yield for ABC debt with a 3-year term but without a conversion option was 5%. The initial carrying amount of debt component was EUR 91.83 million, calculated as the present value of the bond cash flows (i.e., the EUR 2 million annual coupons and the EUR 100 million redemption amount) discounted using the 5% yield for similar straight debt of the issuer, as follows:

The remainder of the proceeds of the issue were allocated to the equity component. As the proceeds of the convertible issue were EUR 99.5 million, the equity component was EUR 7.67 million (=99.5 mm – 91.83 mn), as shown in Figure 9.15. Therefore, the bifurcation resulted in a positive value being ascribed to the equity component and a lower value (discount) to the debt component. This discount was amortised as an adjustment (increase) to interest expense over the term of the convertible bond.

The liability discount (i.e., the difference between the EUR 100 million redemption amount and the EUR 91.83 million initial carrying amount) was amortised as an adjustment (increase) to interest expense over the term of the convertible. The amortised cost and interest expense of the liability at each accounting date were calculated as follows:

9.9.2 Accounting for a Fixed-for-Variable Convertible Bond

In a second example, I will cover a convertible bond in which, following conversion by the bondholders, the issuer may deliver a fixed amount of shares (physical settlement), a cash amount (cash settlement) or a combination of cash and shares (net share settlement). Suppose that, on 1 January 20X0, ABC issued a convertible bond on its own shares with the following terms:

Convertible bond terms
Issue date	1 January 20X0
Issuer	ABC
Issue proceeds	EUR 99.5 million
Principal	EUR 100 million
Redemption amount	100% of the principal amount
Maturity	3 years (31 December 20X2)
Interest	2% annually, payable on 31 December
Conversion	At the holder's option, on maturity. If holder exercises conversion right, issuer my choose to deliver either: 10 million new ABC shares (physical settlement); a cash amount equivalent to the market value of the convertible at maturity (cash settlement); or a cash amount equal to the redemption amount plus a number of shares such that the total consideration is equal to the market value of the convertible at maturity (net share settlement)
Conversion rate	EUR 10 per share
Current price of ABC shares	EUR 7 per share

In the situation where, upon conversion, the issuer is under no obligation to deliver a fixed number of its own shares, convertibles are hybrid instruments that have both debt and equity derivative characteristics. Under IFRS, the components of convertibles of this type are bifurcated at the time of issuance into a debt (liability) component and a derivative component.

• The debt (liability) component represents the bond's feature as a debt instrument if it is not converted. The initial carrying amount of the debt component is calculated as the present value of the bond cash flows assuming that the bond does not have the equity conversion feature. The cash flows are discounted using the prevailing yield of debt of the issuer with the same maturity and without the conversion feature. The liability component is commonly measured at amortised cost.
• The derivative component represents the conversion right. Its initial value is calculated as the difference between the issue proceeds and the debt component. There is a subsequent fair valuation of the derivative component at each reporting date.

The calculation of the debt (liability) component (EUR 91.83 million) was identical to that in the previous fixed-for-fixed convertible example. The remainder of the proceeds of the issue was allocated to a derivative component. As the proceeds of the convertible issue were EUR 99.5 million, the initial carrying amount of the derivative component was EUR 7.67 million (=99.5 mm – 91.83 mn), as shown in Figure 9.16.

The amortised cost and interest expense of the liability component at each accounting date were identical to those of the previous fixed-for-fixed convertible example:

Year	Amortised cost at beginning year (a)	Interest expense (b) = (a) × 5%	Cash payment (c)	Amortised cost at end of year (d) = (a) + (b) – (c)
1	91,830,000	4,592,000	2,000,000	94,422,000
2	94,422,000	4,721,000	2,000,000	97,143,000
3	97,143,000	4,857,000	2,000,000	100,000,000

The derivative component had to be fair valued at each reporting date. The change in fair value was recognised in profit or loss. Suppose that the derivative's fair values were as follows:

Year	ABC's share price	Derivative component fair value	Change in fair value
Inception	7.00	7,670,000
1	9.00	8,380,000	710,000
2	10.00	9,450,000	1,070,000
3	13.00	30,000,000	20,550,000

Accounting Entries

1. Accounting entries on the issue date (1 January 20X0)
2. Accounting entries on the first reporting and coupon payment date (31 December 20X0)
3. Accounting entries on the next reporting and coupon payment date (31 December 20X1)
4. Accounting entries on maturity date (31 December 20X2) to record the interest expense, coupon payment and derivative revaluation:

6. At maturity ABC shares were trading at EUR 13, above the EUR 10 conversion rate. As a result, the bondholders exercised their conversion right. Let us cover next three different scenarios, one for each type of conversion.

   Scenario 1: Conversion in shares only. Under this scenario, ABC issued 10 million ordinary new shares with a par value of EUR 1.00 each. The share issue value was EUR 13.00 per share or EUR 130 million. Therefore, the share premium was EUR 12.00 per share or EUR 120 million. The related accounting entries would be as follows:

8. Scenario 2: Conversion in cash only. Under this scenario, ABC paid the market value of the convertible bond (i.e., EUR 130 million) in cash. The related accounting entries would be as follows:
10. Scenario 3: Conversion in cash and shares (net share settlement). Under this scenario, ABC paid bondholders a mixture of cash and shares. The amount of cash paid was EUR 100 million, representing the redemption amount. The number of new shares delivered was 2,308,000 (=30 mn/13.00 per share) representing the excess of the bond's EUR 130 million market value over its redemption amount. The related accounting entries were as follows:

9.10 CASE STUDY: HEDGING STEP-UP CALLABLE PERPETUAL PREFERENCE SHARES

The aim of this case study is to illustrate the process of deciding whether an instrument, a step-up callable perpetual preference share, is classified as equity or as a liability. It also highlights the challenge of hedging equity instruments.

A perpetual step-up instrument is an irredeemable callable financial instrument with fixed or floating dividend payments. The instrument includes a “step-up” dividend clause that would increase the dividend at a predetermined date in the future unless the instrument has previously been called by the issuer. Suppose that on 1 January 20X0, ABC issued the following step-up callable perpetual preference shares:

First of all, let us analyse whether the elements of the instrument were classified as debt or equity. In our preference shares, ABC had potentially two types of payments to the holder of the preference shares: principal and dividends.

• Regarding the principal, ABC had no contractual obligation to redeem the instrument. The fact that ABC was expected to call the instrument in December 20X2 so as to avoid the above market payments (this is commonly referred to as “economic compulsion”) was not considered relevant in the classification. Therefore, the principal was not considered a liability as ABC had no contractual obligation to deliver cash, or any other financial asset, to the holder under conditions that were potentially unfavourable to the entity. Thus, the principal was classified as equity.
• Regarding the dividends, they were payable only if dividends were paid on ordinary shares (which themselves were payable at the discretion of ABC). As a consequence, ABC had no contractual obligation to ever pay a dividend. Thus, the dividends were classified as equity.

IAS 32 considers that the seniority of payment of an obligation, which arises only on liquidation of the entity, does not affect the classification of the financial instrument. So in our case, the seniority of the preference shares between subordinated debt and ordinary shares did not affect the liability/equity classification. Similarly, the legal definition of the instrument as “shares” had no impact on the classification. Substance rather than legal form rules the liability/equity classification.

The instrument was classified as equity under IAS 32, as the entity could choose not to redeem the instrument and to pay no distributions on it in perpetuity. Whilst a consequence of a non-payment of interest was that the entity could not pay an ordinary dividend, this restriction did not amount to a contractual obligation.

9.10.4 Concluding Remarks

The main objective of the hedge was to fix the expected cash flow to be paid each year under the preference shares. Figure 9.17 highlights the resulting cash flow from the strategy during the year ending on 31 December 20X2. ABC paid a combined EUR 10.2 million fixed amount (an overall yield of 5.1%).

The secondary objective was to avoid recording the mark-to-market of the hedging strategy in profit or loss. This objective was also achieved as none of the three instruments was marked-to-market.

Whilst the two objectives were achieved, there were some effects that made the hedging strategy far from optimal. Firstly, the balance sheet was notably enlarged and some ratios deteriorated because of the hedge (e.g., ABC's return on assets). Secondly, there was an additional cost because the funding level of the bond was higher than the yield of the deposit. Thirdly, there could be a potential mismatch of cash flows as the dividend payment may not be paid (e.g., because a dividend was not distributed to the ordinary shareholders) while the deposit and bond cash flows always took place. Finally, ABC's profit or loss statement showed an exposure to interest rate risk (see Figure 9.18), to rising Euribor 12-month rates when dividends were not distributed to the preference shareholders.

9.11 CASE STUDY: BASE INSTRUMENTS LINKED TO DEBT INSTRUMENTS

This case study shows an obsolete strategy –a base instrument linked to a debt instrument – to achieve equity recognition for dividends of an instrument that otherwise would have been recognised as a liability, enhancing an entity's capital position. This loop was closed by the IFRS Interpretations Committee (IFRIC) but allows me to provide an interesting short example on debt versus equity classification.

Assume that a “base” instrument consisted of irredeemable (i.e., perpetual) callable preference shares with dividends that had to be paid if interest was paid on another (the “linked”) instrument, as shown in Figure 9.19. The terms of the linked instrument obliged the issuer to make interest payments, and hence the “linked” instrument was classified as a liability. The linked instrument was callable by the issuer at any time, and had a small notional.

In the old days, this strategy's preference shares dividends were classified as equity because the base instrument (i.e., the preference shares) did not have a contractual obligation to deliver cash (or any other financial asset). After an opinion issued by the IFRIC, these dividends were classified as a liability because the linkage to the linked instrument created an implicit contractual obligation for the entity to pay dividends on the base instrument.

The linked instrument frequently had a small face value compared to the base instrument. This insignificant value did not impact the liability classification. It did not eliminate the fact that the issuer had no discretion over the payment of the dividend on the base instrument (i.e., the linking created a contractual obligation with regard to the base instrument).

If the linked instrument was callable by the issuer at any time, the issuer could avoid paying interest on the base instrument. However, until the linked instrument was called, a contractual obligation to pay interest on the base instrument existed.

9.12 CASE STUDY: PARKING SHARES THROUGH A TOTAL RETURN SWAP

This case study covers a transaction to monetise an existing investment in shares of another company. It may be used to finance the acquisition of shares as well. An equity total return swap (TRS) may allow for cash settlement, physical settlement or a combination of both. A TRS involves receiving the total return on a specified reference asset in exchange for a string of interest payments. The total return is the capital gain or loss on the reference asset, plus any interim dividends. The TRS allows an entity to derive the economic benefit of owning an asset without having to commit cash resources to it.

TRSs have many potential uses. For example, through a TRS an entity may postpone a monetary gain, may comply with ownership regulations, or may raise collateralised financing. A TRS can also be used as an investment tool to get exposure to the appreciation (and depreciation) of a group of shares. This last use of TRSs is quite uncommon among corporates but quite popular among hedge funds.

Suppose that ABC was a highly leveraged entity and did not want to use the debt capital markets to raise new financing. ABC had an investment in shares of DEF – an unrelated company – and decided to raise financing by monetising its investment in DEF. The investment was classified at fair value through OCI. As part of the strategy, ABC entered into the following TRS:

9.12.1 Asset Monetisation Strategy

At the beginning of the transaction, ABC sold 20 million DEF shares to XYZ Bank at market value. As DEF shares were trading at EUR 10 on that date, ABC received EUR 200 million for the sale. Figure 9.20 highlights the initial flows of the monetisation strategy. Legal ownership of the DEF shares was transferred to XYZ Bank.

During the term of the TRS, ABC paid Euribor plus 50 bps annually on the notional amount, as shown in Figure 9.21.

DEF distributed a dividend periodically to its shareholders. Suppose that on 31 December 20X0 ABC declared and simultaneously paid a EUR 0.10 dividend per share, and on 31 December 20X1 a EUR 0.12 dividend per share. Because XYZ Bank was the legal owner of the shares, it received the dividends. Through the TRS, XYZ Bank was obliged to pass to ABC an amount equal to the dividends received on the underlying DEF shares. Figure 9.22 shows the cash flows related to the dividends.

At the end of the transaction, ABC could choose either to buy back the shares (physical settlement), or to cash settle the TRS. ABC would choose the latter if it were not interested in continuing to own the DEF shares. Under the cash settlement alternative, the closing price of the DEF shares prevailing on the TRS maturity date (the “final price”) would be determined. If the final price was greater than the initial price, XYZ Bank would pay to ABC the appreciation of the shares. The cash settlement amount would be calculated as:

Final amount = Number of shares × (Final price–Initial price)

If the final price was lower than the initial price, ABC would pay to XYZ Bank the depreciation of the shares. The cash settlement amount would be calculated as:

Final amount = Number of shares × (Initial price–Final price)

Suppose that the closing price of DEF shares on 31 December 20X1 was EUR 13.00 and that ABC opted for cash settlement. As a consequence, XYZ Bank was obliged to pay to ABC the appreciation of the DEF shares, or EUR 60 million (=20 million shares × (13 – 10)). In reality, and in order not to be exposed to the price of the DEF shares, XYZ Bank would have sold the shares in the market near the close of the trading session. As a consequence, XYZ Bank would have received EUR 260 million (=20 million shares × 13) for selling the shares in the market. Figure 9.23 shows the different flows taking place at maturity.

9.13 CASE STUDY: HEDGING AN EQUITY INVESTMENT WITH A PUT OPTION

The aim of this case study is to illustrate the application of hedge accounting when hedging the market risk of an equity investment classified at FVOCI using a purchased put option.

Suppose that on 31 January 20X7, ABC purchased 10 million shares in DEF at EUR 10 per share. ABC classified this investment at FVOCI. To protect the investment from a decline in DEF's share price during the next 4 months, ABC purchased a put option on 31 January 20X7. The main terms of the put option were as follows:

ABC designated the put option as the hedging instrument in a fair value hedge of its equity investment. Two alternatives are discussed below. In the first the time value of the put option was excluded from the hedging relationship (i.e., only the option's intrinsic value was designated as the hedging instrument), an alternative that was arguably inefficient from an operational perspective. In the second, the put option in its entirety was designated as the hedging instrument, the preferred choice.

9.13.1 Accounting Treatment of the Put Time Value when Excluded from the Hedging Relationship

When an entity designates only the intrinsic value of a purchased option (or an option combination) as the hedging instrument in a hedge accounting relationship, the change in fair value of an option's time value is recognised in OCI to the extent that it relates to the hedged item. Under IFRS 9, the accounting treatment of an option time value depends on whether the hedged item is transaction related or time-period related (see Section 2.10.3).

In this case, we are dealing with a time-period related hedged item because ABC hedged the fair value of the DEF shares over a period of time (4 months). As a result, the accounting for the time value of the put option was recorded in a two-step process:

• The first step encompassed amortising the “aligned” initial time value over the life of the hedging relationship. The aligned time value was determined using the valuation of an option that had critical terms (nominal, term and underlying) that perfectly matched the hedged item. In this case the terms of the “aligned” option were identical to those of the hedging instrument, except that the counterparty to the aligned option was assumed not to expose ABC to credit risk. We assume that because derivative transactions between ABC and XYZ Bank were fully collateralised, both the actual and aligned time values were EUR 6 million at inception of the hedging relationship. Whilst IFRS 9 does not prescribe an accounting method when both time values are identical, ABC decided to use the guidelines for when an actual time value exceeds an aligned time value, amortising the initial time value based on the aligned time value. IFRS 9 does not prescribe the amortisation method to be used; commonly entities use a straight-line amortisation.
• In this case, both the aligned and actual time values were identical. The second step consisted in deferring in the time value reserve of OCI the excess/deficit of the change in time value of the hedging instrument over/below the period amortised amount. Were the initial aligned time value to exceed the actual time value, the initial actual time value would have been amortised to the extent that it related to the aligned time value, the deviation of the aligned time value relative to the amortised amount, and any difference between the actual and the aligned time values would have been recorded in equity (e.g., in retained earnings).

The following table and Figure 9.24 detail the amortisation of the aligned time value:

Date	Days in period	Time value amortisation (a)	Change in time value (b)	Time value reserve entry (a) – (b)
31 January 20X7	—
31 March 20X7	59	<2,950,000> (1)	<1,000,000>	1,950,000 (2)
31 May 20X7	61	<3,050,000>	<5,000,000>	<1,950,000>
Total	120	<6,000,000>	<6,000,000>	0

Notes:

(1) <2,950,000> = 59/120 × <6,000,000>

(2) 1,950,000 = <1,000,000> – <2,950,000>

Hedging Relationship Documentation

At its inception, the hedging relationship was documented as follows:

Hedging relationship documentation
Risk management objective and strategy for undertaking the hedge	The objective of the hedge is to protect the EUR value of 10 million shares of DEF against unfavourable movements in DEF's share price below EUR 9.00. This hedging objective is consistent with ABC's overall risk management policy of reducing the variability of its profit or loss statement using options
Type of hedge	Fair value hedge
Hedged item	10 million DEF shares classified at FVOCI
Hedging instrument	The cash settled put option contract with reference number 023547, traded on 31 January 20X7 with strike EUR 9.00 on 10 million DEF shares. The counterparty to the option is XYZ Bank
Hedge effectiveness assessment	See below

Hedge Effectiveness Assessment

Only the intrinsic value of the hedging instrument is designated in the hedging relationship. Hence, the time value of the hedging instrument is excluded from the hedging relationship.

• The change in intrinsic value of the hedging instrument will be recognised in OCI to the extent that it relates to the hedged item.
• The change in fair value of the hedged item for price decreases below the protected price of EUR 9.00 per share will also be recognised in OCI.
• The change in time value of the option will be amortised to retained earnings in equity to the extent that they relate to an aligned time value.

The “aligned” option would be an option with terms identical to those of the hedging instrument, except that the counterparty to the aligned option is assumed not to expose the entity to credit risk. Because both the actual and aligned time values were identical at inception of the hedging relationship, the entity has decided to use the guidelines for cases in which actual time values exceed aligned time values, amortising the initial time value based on the aligned time value. The amortisation method to be used is the straight-line amortisation.

Hedge effectiveness will be assessed prospectively at hedging relationship inception and on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is an asset that exposes the entity to fair value risk, impacts OCI and it is reliably measurable. The hedging instrument is eligible as it is a derivative and it does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. The hedge ratio should not be intentionally weighted to create ineffectiveness

Whether there is an economic relationship between the hedged item and the hedging instrument would be assessed on a qualitative basis by comparing the critical terms of the hedging instrument and the hedged item. The critical terms considered would be the number of shares, the strike price, the term and the underlying.

Because the hedging instrument will only have intrinsic value when the share price of DEF shares is below EUR 9.00, effectiveness will be assessed only during those periods in which the put option has an intrinsic value. The effective and ineffective amounts of the change in intrinsic value of the hedging instrument would be computed by comparing the cumulative change in intrinsic value of the hedging instrument with that of the hedged item. Any part of the cumulative change in intrinsic value of the hedging instrument that does not offset a corresponding cumulative change in the fair value of the hedged item would be treated as ineffective and recorded in OCI.

Fair Valuations of Hedging instrument and Hedged Item

DEF share prices, in EUR, on the relevant dates were as follows:

Date	DEF share price
31 January 20X7	10
31 March 20X7	8
31 May 20X7	6

The fair value of the hedging instrument was calculated using the Black–Scholes model, ignoring counterparty credit risk. The option intrinsic value was calculated using the spot rates. The time value of the option was calculated as the difference between the option fair value and the option intrinsic value. This fair valuation did not take into account XYZ Bank's credit risk.

Option fair values (EUR)	31-Jan-X7	31-Mar-X7	31-May-X7
Share price	10	8	6
Fair value	6,000,000	15,000,000	30,000,000
Undiscounted intrinsic value	-0- (1)	10,000,000 (2)	30,000,000 (3)
Discount factor		1.00 (4)	1.00
Intrinsic value (discounted)	-0-	10,000,000	30,000,000
Time value	6,000,000	5,000,000 (5)	-0-
Change in intrinsic value	—	10,000,000 (6)	20,000,000
Change in time value	—	<1,000,000>	<5,000,000> (7)

Notes:

(1) 10 million shares × max [0, Strike – Spot] = 10 million × max [0; 9 – 10] = 0

(2) 10 million shares × max [0, Strike – Spot] = 10 million × max [0; 9 – 8] = 10,000,000

(3) 10 million shares × max [0, Strike – Spot] = 10 million × max [0, 9 – 6] = 30,000,000

(4) Assumed to be 1.00 due to the notably short term remaining life

(5) Fair value – Intrinsic value = 15,000,000 – 10,000,000 = 5,000,000

(6) Intrinsic value_Current – Intrinsic value_Previous = 10,000,000 – 0 = 10,000,000

(7) Time value_Current – Time value_Previous = 0 – 5,000,000 = <5,000,000>

According to the previous table, on 31 March 20X7 the fair value of the put option was EUR 15 million. This fair value did not take into account XYZ Bank's credit risk because the transaction was fully collateralised.

Suppose as an exercise that the transaction was uncollateralised and that on 31 March 20X7 ABC assessed whether the adjustment for counterparty credit risk had a material impact on the option fair valuation. The EUR 15 million fair value was the present value of the option's expected payoff discounted at Euribor. The option had two months (i.e., 61 days) to expiry and Euribor for such maturity was trading at 3.10%. Therefore, the expected payoff of the option was calculated as the future value of the EUR 15 million:

Expected payoff = 15 million × (1 + 3.10% × 61/360) = 15,079,000 (rounded)

Two-month EUR-denominated CDs issued by XYZ Bank were trading at 20 bps over 2-month Euribor. The option's credit adjusted fair value was calculated as the present value of the expected payoff using XYZ Bank's credit spread:

The difference between the credit adjusted and the unadjusted fair values was an immaterial EUR 5,000 (=15,000,000 – 14,995,000). Therefore, even in the case of an uncollateralised transaction, assumption of identical actual and aligned time values would have been reasonable.

The share fair value calculation was as follows:

Share fair values (EUR)	31-Jan-X7	31-Mar-X7	31-May-X7
Share price	10	8	6
Number of shares	10,000,000	10,000,000	10,000,000
Fair value	100,000,000	80,000,000 (1)	60,000,000
Change in fair value	—	<20,000,000>	<20,000,000> (2)

Notes:

(1) 10 million shares × EUR 8 per share = 80,000,000

(2) Fair value_Current – Fair value_Previous = 60,000,000 – 80,000,000 = <20,000,000>

Hedge Effectiveness Assessment Performed at Inception of the Hedging Relationship

The hedge qualified for hedge accounting as it met the three effectiveness requirements:

1. Because the critical terms (such as number of shares, strike price, maturity and underlying) of the hedging instrument and the hedged item matched the entity concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions (for share prices below or at EUR 9.00 per share), and hence that an economic relationship existed between the hedged item and the hedging instrument.
2. Because the credit rating of entity and the counterparty to the hedging instrument was relatively strong (XYZ Bank is rated A+ by Standard & Poor's) and the transaction was fully collateralised, the effect of credit risk did not dominate the value changes that result from that economic relationship.
3. The hedge ratio designated (1:1) was the one actually used for risk management and it did not attempt to avoid recognising ineffectiveness. Therefore, it was determined that a hedge ratio of 1:1 was appropriate.

Potential sources of ineffectiveness are a change in the credit collateral agreement generating substantial credit risk, or a change in the holding of the shares below the number of shares underlying the put option.

Another effectiveness assessment was also performed on 31 March 20X7, yielding similar conclusions.

Accounting Entries

1. To record the share and option purchases for EUR 100 million and EUR 6 million respectively, on 31 January 20X7
2. To record the closing of the accounting period on 31 March 20X7

   The change in the fair value of the shares represented a EUR 20 million loss, split between an effective part and an excess part. The effective part, EUR 10 million, was recognised in retained earnings. The excess, EUR 10 million, was recognised in OCI as the equity investment was recognised at FVOCI.

   The change in fair value of the option produced a EUR 9 million gain. Of this amount, a EUR 10 million gain and a EUR 1 million loss were related to the option's intrinsic value and time value, respectively. The change in intrinsic value was 100% effective because the hedged item's fair value for share prices below EUR 9.00 had an identical behaviour to the put option's change in intrinsic value. The change in time value produced a EUR 1 million loss, split between a EUR <2,950,000> amortisation and a EUR 1,950,000 excess. The latter amount was recognised in the time value reserve in OCI.

3. To record the expiry of the option and the end of the hedging relationship on 31 May 20X7

   The change in the fair value of the shares produced a EUR 20 million loss, split between an effective part and an excess part. The effective part, EUR 20 million, was recognised in retained earnings. There was no excess amount.

   The change in fair value of the option produced a EUR 15 million gain. Of this amount, a EUR 20 million gain and a EUR 5 million loss were related to the option's intrinsic value and time value, respectively. The change in intrinsic value was 100% effective because the hedged item's fair value for share prices below EUR 9.00 had an identical behaviour to the put option's change in intrinsic value. The change in time value produced a EUR 5 million loss, split between a EUR <3,050,000> amortisation and a EUR <1,950,000> excess. This latter amount was recognised in the time value reserve in OCI.

   The put option was cash settled. XYZ Bank paid to ABC the option's EUR 30 million fair value (i.e., its intrinsic value).

   As the hedging relationship ended on 31 May 20X7, any subsequent changes in the fair value of DEF shares were recognised in OCI.

Concluding Remarks

ABC's investment in DEF shares did not expose the entity to a more volatile profit or loss because the shares were recognised at FVOCI. However, the volatility of ABC's OCI could potentially increase due to the revaluation of the equity investment at each reporting date. If the shares had a prolonged decline, ABC's OCI position could suffer a severe decline.

In our example, had ABC not hedged its investment, the equity investments reserve account in OCI would have shown a EUR 40 million decline (see Figure 9.25).

Fortunately, ABC was cautious and hedged its investment. At the end of the hedge term, the equity investments reserve account showed a EUR 10 million decline, an amount considerably lower than EUR 40 million. However, because ABC wanted to benefit from full appreciation of the shares, the EUR 6 million cost of the protection ended up reducing ABC's capital position.

Note that ABC used the retained earnings account to record the effects of the hedge. IFRS 9 does not specify which equity account to use for this purpose. ABC could have chosen a capital account such as “share premium”.

My final comment is to question the decision to exclude the option time value from the hedging relationship that caused an arguably “unnecessary” operational burden. In the next subsection I will cover the accounting mechanics when an option time value is included in the hedging relationship, an operationally easier approach.

9.14 CASE STUDY: SELLING A FORWARD ON OWN SHARES

The aim of this case study is to illustrate the accounting implications of selling a forward on own shares. I begin with a forward that allows for physical settlement only, which is recognised as an equity instrument. Then I will turn to a forward that can be other than physically settled, which is recognised as a derivative.