Download Financial Instruments with Characteristics of Equity The ABI`s

Financial Instruments with Characteristics of Equity
The ABI’s response to the IASB’s Discussion Paper
Introduction
1.
The Association of British Insurers (ABI) represents nearly 400 member companies,
which between them provide 91% of the UK’s domestic insurance. It works on
behalf of the UK insurance industry to keep standards high and to make the
insurance industry’s voice heard. As institutional investors, with some £1.5 trillion of
funds under management across all asset classes, they are important capital
providers and users of accounts who have a key interest in high quality financial
reporting.
2.
The ABI is grateful for the opportunity to respond to the International Accounting
Standards Board’s Discussion Paper Financial Instruments with Characteristics of
Equity. The ABI has also worked closely with the Comite Europeen des Assurances
(CEA) and CFO Forum in considering the European insurance industry’s response
to the discussion paper. The ABI has agreed the joint CEA/CFO Forum response to
the discussion paper and fully supports the positions set out in that paper as
reflecting its perspective as preparers of accounts.
3.
We highlight the significance in the UK of participating contracts in with-profits funds.
Consistent with the CEA/CFO Forum response, we believe that these should
continue to be covered by the accounting standard for insurance contracts rather
than by IAS 32. We expand on this point in the appendix to this letter, in our
response to question B3 in Appendix B.
4.
The rest of our response focuses on issues that are not discussed in depth in the
CEA/CFO Forum letter but are relevant to our members in their capacity as
investors.
General comments
5.
Our overall view is that the FASB’s proposals, whilst having the relative merit of
seeking simpler standards, do not resolve a number of issues that need to be
addressed instead in the Board’s conceptual framework project.
6.
The Board’s Framework conceptual framework project has produced a tentative
definition of a liability. We are concerned that there is a risk of overlaps or gaps
between that and any definition of equity that the Board may propose. We consider
that the one should be defined and the other left as a default. Further, we suggest
that it is conceptually difficult – perhaps as the FASB’s discussion quite clearly
shows – to define equity. Identifying liabilities rather than equity instruments is
easier to accomplish and, accordingly, we prefer the latter approach with equity left
as the residual. In addition, we consider that the Board should include, in the
development of its project, a full evaluation of the impact on performance reporting.
This is a dimension that is underplayed in the discussion paper.
7.
If a defining characteristic is nevertheless to be sought for distinguishing what a
liability is, and what an equity instrument is not, what seems to us to be
economically meaningful is the likelihood of settlement leading to cash or asset
outflows from the entity. These are real resources for which sacrifice represents a
cost to the entity. Outflow of economic benefits is rather a wider concept by
comparison. In particular, we are concerned about settlement of claims against an
entity through of dilution of the existing shareholder interest through share issuance
being treated in the same way as the proper discharge of liabilities through the
appropriation and delivery of real assets of the requisite value.
8.
We do not, in any case, consider that any of the three main options presented in the
paper provide, as they stand, an appropriate approach to recognising equity
interests for accounting purposes. Even though the preferred option, the Basic
Ownership Approach, has the greatest merit of simplicity and would reduce
structuring opportunities, it suffers from a number of drawbacks which we identify in
our detailed comments on the consultation questions and summarise as follows:
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changes in an issuer's share price would affect its income
changes in the value of instruments would be recognised where there is no
economic significance to the entity
many more financial instruments would need to be fair valued
there would be inconsistencies in the treatment of hedged positions
perpetual instruments for which there are no settlement requirements would
be classified as liabilities
9.
The Ownership-Settlement Approach which, arguably, is more consistent with the
Board’s current accounting requirements, appears to be more rules-based and
would need modification before it could be adopted.. Our focus on the
meaningfulness of cash and other economic resources leads us to conclude that
mode of settlement which is critical to distinguishing equity from liability under the
ownership-Settlement Approach is not the right defining feature. In this regard we
share the recognition in the discussion paper that cash and equity instruments are
ready substitutes for each other, at least in a liquid market environment.
10.
We do not consider that the Reassessed Expected Outcomes (REO) Approach or
two other approaches mentioned, the Mezzanine and Claims approaches provide an
appropriate way forward. Another approach not considered in detail in the paper, the
Loss Absorption Approach, also appears to have some merit and we suggest that
proper consideration be given to it before final conclusions are drawn.
The relevance of ownership versus entity perspectives
11.
The concept of ownership is explicitly relevant to at least two of the three presented
options in the paper though the paper shies away from recognising legal ownership
rights as a prime distinguishing characteristic. However, distinctions of legal form
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and economic substance may well coincide. If, as the discussion paper suggests,
there is no natural line of distinction that is obvious to all then the case for following
the distinction of legal form is enhanced.
12.
We have more detailed comments to make in respect of some of the consultation
questions which we annex to this letter.
Association of British Insurers
12 September 2008
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Annex
Specific responses on the consultation questions
Questions on the Basic Ownership Approach
Q1.
Do you believe that the basic ownership approach would represent an
improvement in financial reporting? Are the underlying principles clear and
appropriate? Do you agree that the approach would significantly simplify the
accounting for instruments within the scope of this Preliminary Views and provide
minimal structuring opportunities?
In principle, we would support an aim to simplify financial reporting requirements.
Further, we note that the basic ownership approach would serve to reduce
structuring opportunities, and in this respect we support it; i.e. to deal with
instruments which in nature are liabilities but are structured to qualify as equity. But
we are concerned that complexity may be only displaced thereby, to be reflected
instead in measurement and presentation.
The Basic Ownership Approach suffers from three particularly significant defects:
i)
As the discussion paper recognises, changes in an issuer’s share price
would affect income. We do not consider that it can be right that income is
reduced or that, until settlement, the entity’s net assets should be recorded
as reduced consequent merely upon a rise in the entity’s share price, unless
this reflects a reality of higher cash or asset outflow to effect the settlement.
ii)
If instruments in the nature of warrants and the embedded options within
convertibles are treated as liabilities, until exercised or converted
respectively, this will mean that the impact on the entity’s net income and
performance will ultimately depend on the value of the instrument at the date
of exercise or conversion even though these events might long have been
certain to occur. Making the accounting depend on the arbitrary choice of
when the instrument is exercised or converted simply does not reflect the
economic substance of the transaction or relationship between the entity and
the holder.
iii)
An entity could choose to create a class of share than its ordinary share with
entitlements to dividend participation and to asset participation on a winding
up that only kick in at implausibly high levels. Such shares would certainly
rank behind the ordinary shares but in no meaningful sense could they be
said to constitute the equity of the entity. Since use of deferred shares of
this type can constitute an expedient manner for effecting corporate
reconstructions in some circumstances our concern is not merely
hypothetical1.
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Such instruments might be disregarded under a rule embodying the principle expounded in Paragraph 44 of the
Discussion Paper that a stated term would not affect classification if the term has only a remote chance of
affecting the outcome in more than a minimal way. The fact remains, however, that an entity could reach the
same result through continually dividing its existing equity capital into preferred and deferred portions.
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There are also two important practical matters that make the adoption of the basic
ownership approach challenging.
i)
We are concerned that the effect of adopting the basic ownership approach
would be to increase the number of instruments needing to be remeasured
to fair value. An example would be convertible instruments whose direct
financing costs to the entity represented by interest payment obligations are
lower than would be the case on straight debt. The corollary is that holders
benefit from the equity interest provided by the embedded option. This
element must be accounted for in one of three ways: i.e. treatment as
creation of equity with ex ante valuation and charge against profits, treatment
as a liability with accretion of the implicit discount on the fixed interest
liability, or treatment as a liability the value of which would captured through
remeasurement of the instrument as a whole over the time until conversion
or redemption. Although increased volatility of earnings will unwelcome to
some we suggest that the concern for accounting standards setters should
be to establish whether the foundations of fair value accounting are
sufficiently robust to take the additional strain of a potentially considerable
increase in the size of balance sheet elements requiring recognition as
liabilities and remeasurement up to point of settlement.
ii)
There is a need for coherence of treatment of each side of hedged positions.
Where entities have exposure to instruments whose economic
characteristics from the perspective of the counterparty reflect the returns
accruing to equity the entity may well seek to hedge fully or partly this
exposure by purchasing the requisite number of shares from the market.
These shares in turn may, in some circumstances, be used to effect the
ultimate settlement of the instrument. Since shares bought from the market
at fair value, whether cancelled or held as treasury shares, are under current
accounting standards not held as assets but deducted from equity this will
not provide accounting consistent with that of the instrument that it is held to
match as a liability. This consistency would only be achieved by treatment of
the instrument as an equity interest or else by treatment of the treasury
shares in such cases as assets to match the corresponding liability on the
instrument.
We are concerned that adoption of the basic ownership approach would be
inconsistent with the accounting treatment of share-based payment under IFRS2
which recognises the creation of an equity instrument and the need to value this at
point of grant. This reflects the nature of the transaction. Although we believe there
could be circumstances in which such obligations might be better accounted for as
liabilities ab initio we believe that recognition of the creation of equity instruments,
with consequent ex ante valuation, is the right default methodology. Continued
recognition as liabilities until final conversion into basic ownership equity would not
logically be consistent with ex ante valuation.
We do not accept the suggestion that those who recognise, as we do, the
importance of the proprietary rather than entity view in financial reporting, should be
naturally drawn to the basic ownership approach. It is indeed the entity whose
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financial performance and position are being accounted for, including the
implications of creation of equity instruments that dilute the interests of existing
shareholders, but it is the proprietors to whom the information should be addressed.
This formulation does not, however, answer the question as to where the line is to
be drawn between proprietorial and non-proprietorial interests.
Q2.
Under current practice, perpetual instruments are classified as equity. Under
the basic ownership approach (and the REO approach, which is described in
Appendix B) certain perpetual instruments, such as preferred shares, would be
classified as liabilities. What potential operational concerns, if any, does this
classification present?
We do not generally support the classification of perpetual instruments as liabilities.
Where settlement cannot be enforced by the holder and typically does not occur in
the normal course of business through transfers of assets or services, perpetual
instruments are, in our view, better normally considered as equity – both as
reflecting the going concern basis of accounting and being consistent with the
Board’s conceptual basis for the recognition of a liability. Entitlements that may be
enforced by holders of perpetual instruments on a liquidation do not appear
particularly germane to accounting that proceeds from a going concern assumption.
Preference shareholders’ interest should in most cases be viewed as forming part of
the proprietorial capital of the entity. It is by the terms of the agreement between
ordinary and preference shareholders that some of the essential characteristics of
the equity are concentrated in the returns to ordinary shareholders but this does not
mean that the capital committed by the preference shareholders is any less a part of
total shareholders’ capital which represents the residual.
Q3.
The Board has not yet concluded how liability instruments without settlement
requirements should be measured. What potential operational concerns, if any, do
the potential measurement requirements in paragraph 34 present? The Board is
interested in additional suggestions about subsequent measurement requirements
for perpetual instruments that are classified as liabilities.
Remeasurement would be particularly inappropriate in respect of an ownership
instrument such as preferred stock as entities do not create income at the expense
of their members and of shareholder value. In so far as perpetual instruments are
classified as liabilities, we think that they should be measured on bases consistent
with those for other liabilities. Reporting dividends or other financing income as paid
or declared as an expense seems the most appropriate approach in respect of any
perpetual instrument classified as a liability. This will most obviously work best in
the case of floating rate instruments but will not be inappropriate for others.
Questions on the Ownership-Settlement Approach
Q1. Do you believe the ownership-settlement approach would represent an
improvement in financial reporting? Do you prefer this approach over the basic
ownership approach? If so, please explain why you believe the benefits of the
approach justify its complexity.
The chief objection to this approach is that mode of settlement should not be the
defining feature of classification between liability and equity interest. We share this
concern but would suggest that the approach might be made acceptable if a
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distinction were instead to be drawn between settlement through rights to subscribe
for fresh equity on given terms and settlement (whether in the form of cash or
equity) which actually leads to an outflow of cash resources from the entity. This
reflects the understanding in UK law that the creation of an equity security and of
dilution occurs at the point of grant of a right to subscribe, not at the point of the
exercise of that right.
It is the characteristics of an instrument from the entity’s perspective that should be
of defining relevance, rather than the way in which that instrument is perceived by
the counterparty. Thus, for example, a call option over shares at a specified share
price will feel like much the same instrument from the counterparty’s perspective
whether this is settled through delivery of shares bought in the market by the entity
or the subscription of new shares. In each case the counterparty needs to pay the
cash call to access the entitlement. However, it is quite different from the
perspective of the entity since in the first case there is a likely cash outflow and in
the second a likely cash inflow. From the perspective of the existing shareholders
the effect is also different as in the case of new issue shares they will suffer dilution.
For clarity, we do not consider that settlement through subscription for new shares
on variable terms reflects the creation of an equity instrument. An example would
be for delivery of whole shares of a value equal to the notional gain on an option
over the company’s shares at point of exercise. This is a difficult boundary example
but we consider that the substance of the situation in this case is best seen as a
genuine liability to the entity and its shareholders that will be satisfied by the sale of
shares at a future date on unknown terms. An alternative theoretical approach
would be to make the accounting coherent with the notional hedging an entity might
undertake in order to hold the shares or economically equivalent rights that would
allow settlement through market-purchased shares. Such treatment, which seems
to reflect elements of the REO approach (below), could be seen as overly complex
for accounting purposes.
We think that, of the three main approaches considered in the discussion paper, the
ownership-settlement approach is most likely to result in instruments being classified
according to their substance. We note that it would be likely to require more rules
and entail greater complexity than the basic ownership approach. However, we
consider that may often simply reflect the complexity of the instruments involved.
Questions on the REO Approach
Q1. Do you believe that the REO approach would represent an improvement in
financial reporting? What would be the conceptual basis for distinguishing between
assets, liabilities, and equity? Would the costs incurred to implement this approach
exceed the benefits? Please explain.
This approach takes the concept of the company as a market participant to its
logical conclusion. Whilst it is an interesting theoretical approach we do not
consider it an appropriate basis for financial reporting purposes.
Other Alternatives
Q1.
Some other approaches the Board has considered but rejected are
described in Appendix E. Is there a variation of any of the approaches described in
this Preliminary Views or an alternative approach that the Board should consider?
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How would the approach classify and measure instruments? Why would the
variation or alternative approach be superior to any of the approaches the Board has
already developed?
Loss absorption approach
In its discussion paper of January 2008, the Pro-Active Accounting Activities in
Europe (PAAinE) group sets out proposals for an alternative ‘loss absorption’
approach for the identification of equity. We consider that the PAAinE’s proposals
are interesting and could be considered further by the IASB were these proposals to
be developed further to meet concerns already expressed by the IASB, for example
at the PAAinE working group education session on 22 July.
This approach does suffer from the difficulty that it appears to recognise greater
relevance in the loss absorptive rather than the profit participatory nature of equity.
In reality both are equally relevant. This approach is nevertheless helpful in that it
focuses on the key characteristic of those instruments that seem to pose the
greatest challenge in determining the appropriate classification. This characteristic
of loss absorption is in fact just one facet of what we consider the defining features
of equity.
Loss absorption may also be a design characteristic of contracts between the entity
and its counterparties but where these relationships may be far removed from that of
commitment of capital. Absence of any form of actual or prospective ownership
interest would seem to make recognition as a component of equity capital
inappropriate.
Mezzanine approach
Although this approach has some attraction it appears to overlook the need to
classify an instrument on one side or other of the accounting equation. Unless a
claims approach is adopted (see below) either the recognised value pertaining to the
instrument is added to the total equity or else a liability must be recognised that is
netted off against the entity’s assets. The accounting cannot simply leave it out of
the equation altogether. The mezzanine approach might, though, have some merit
if it is used to separate out, for example, the basic ownership interest from other
portions of the overall equity interest.
The idea of recognising an intermediate grouping of instruments part way between
equity and liabilities would involve treating in a similar fashion instruments with very
different characteristics. Preference shares would be placed in the intermediate
category essentially because some of the defining characteristics of equity are
repressed and the instruments have a more neutral quality such that, under the
mezzanine framework, they would qualify for neither equity nor liability status.
Convertibles, by contrast, would be placed in this category because they have the
characteristics of both equity and liability. We suggest that the latter instrument
needs to be bifurcated into its two parts, one being clearly a liability and one a
component of equity.
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Claims Approach
We believe that accounting should identify the residual being the difference between
assets and liabilities and we do not believe that accounting in the nature of a zero
sum game would be appropriate. The financial position of the company does not
boil down to nothing with every asset being merely represented by a corresponding
claim. This seems to be a case of taking denial of the significance of ownership and
of the stewardship dimension of accounting to its most extreme extent. The claims
approach has relevance in the circumstances of a liquidation but we do not believe
that this is germane to accounting based on a going concern assumption.
Appendix B
Additional questions for respondents
B3 Are the principles behind the basic ownership instrument inappropriate to any
types of entities or in any jurisdictions? If so, to which types of entities or in which
jurisdictions are they inappropriate, and why?
Of particular significance for insurance companies in the UK are contracts with
discretionary participation features (“participating contracts”), especially with-profits
funds. Traditionally the profits from these funds are allocated 90:10 in favour of
policyholders with shareholders only benefiting when allocations are made to
policyholders in the form of bonuses. Neither policyholders nor shareholders have a
right to the profits until these are allocated by way of bonus.
An important feature of with-profits contracts is "smoothing" whereby an element of
the return in good years is held back by the company in order to protect bonuses in
years where returns are poor. In broad terms, the inherited estate is the amount
held in the fund which is in excess of the liability to policyholders, having taken full
account of expected payments of non-guaranteed bonuses, and which has not been
allocated to either policyholders or shareholders. Over time, this has contributed to
the build up of the inherited estate as a significant source of capital within the withprofits funds of UK life insurers. For those UK companies affected the inherited
estate attaching to such funds is a material and fundamental part of their balance
sheets. By way of example, as at 31 December 2006, the combined unallocated
surplus of just a few of the leading UK companies amounted to over £20bn.
Participating contracts are currently excluded from IAS 32 and are covered instead
by IFRS 4. IFRS 4 addresses the classification of participating contracts, and
permits initial recognition of such contracts either wholly as a liability or as separate
liability and equity components.
Consistent with the views presented in the CEA/CFO Forum comment letter on the
Preliminary Views on Insurance Contracts discussion paper, we believe
participating contracts should be addressed within the scope of the final Insurance
Contracts standard and hence should continue to be scoped out of any revisions to
IAS 32, whether these are based on the basic ownership instrument approach or
otherwise. This would allow the new Insurance Contracts standard to be the
definitive guidance on both the initial classification and the measurement of these
contracts.
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B5
Please provide comments on any other matters raised by the discussion paper.
One type of instrument not included in the Classification Examples in Appendix 3 of
the FASB paper is the so called ‘Conversion’ or ‘C’ share’ issued by investment trust
companies in the UK. Typically, ‘C’ Shares are created when an investment
company issues additional shares which do not immediately rank pari passu with the
existing class of shares in terms of dividend entitlements and asset values but,
rather, convert into those shares at a later date on specified terms.
The net funds raised from the ‘C’ Share issue are ‘ring fenced’ and invested in
separate and discrete assets as set out in the issue documentation – these sit
alongside the existing assets of the Company. Once the conditions specified on
issue have been met (such as the funds have been fully, or largely, invested), the
ring-fenced and existing portfolios are valued and a conversion rate established.
Following conversion, the portfolios are effectively amalgamated and run on a single
basis.
The ‘C’ Share fund will be accounted for separately from the existing assets of the
Company until the ‘C’ Shares are converted into the existing share class. ‘C’
Shareholders will be entitled to receive such dividends as the directors of the
Company may resolve to pay out of the net assets attributable to the ‘C’ Shares and
from income received and accrued which is attributable to the ‘C’ Shares. As
regards subordination both classes of equity have identical rights.
Until recently, it has been entirely normal practice for ‘C’ Shares to be classified as
equity. However doubts have been raised based on interpretations of standards
wording that purports to exclude from definition of equity those instruments where
the entitlement is delivery of a variable number of the entity’s own equity
instruments. However, the variability in the number of existing shares to be issued
in exchange for a ‘C’ Share will is dependent on the relative net asset values of the
two separate portfolios at the conversion date, ensuring that there is no dilution and
that the interests of the continuing class of equity shareholders remain unaffected.
We consider that the economic substance of the ‘C’ share structure is entirely
consistent with these being treated as equity instruments of the entity from their
inception and that changes both in net asset value and fair value (if quoted) do not
represent changes in the valuation of liabilities of the entity. As perpetual
instruments we presume that these would be classified as equity under the
‘ownership-settlement’ approach but it is unclear how they would be treated under
the Board’s preferred basic ownership approach.
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