Message from the CEO, Nina Schindler
Fast pace of technological innovation in finance, rapid integration of economies, and growing complexity of financial regulations, have led to a rise in complex financial instruments with characteristics of both equity and liability. This poses a challenge for investors – for one thing, it becomes increasingly difficult to assess the impact of such instruments on a company's financial performance. In response to this issue, the International Accounting Standards Board (IASB) has published an exposure draft on Financial Instruments with Characteristics of Equity (FICE) that puts forward amendments to the principles laid out in IAS 32 Financial Instruments: Presentation, aiming to align accounting standards with the dynamic transformations occurring in the financial landscape.
Different to many other instruments governed by IAS 32, cooperative shares never gave regulators a reason to question the stability and the loss absorbing capacity of cooperative share capital. Notably, during the financial crisis cooperative credit institutions remained resilient. For cooperative banks, the equity presentation of cooperative shares and certificates is essential: recognising these financial instruments as equity on a balance sheet is a fundamental requirement for regulatory capital under the global framework for banks established by the Basel Committee. The EACB places top priority to this matter and will make sure that the amendments introduced by the IASB preserve the existing classification of all cooperative members’ shares and certificates in Europe as equity.
3 Questions to Mr Wolf KLINZ, Chair, EFRAG Financial Reporting Board
Mr Wolf Klinz has been EFRAG Financial Reporting Board Chair since November 2022. Wolf Klinz transitioned from an illustrious banking career to European politics in 2004. He was an MEP for the FDP in the European Parliament for 12 years. A former McKinsey & Company Partner, he held executive roles in Swiss & German corporations and the Treuhandanstalt. He served as President of IHK Frankfurt from 2000-2004 and VP of Eurochambres Brussels from 2003-2004.
__________________________
- What are the key changes introduced in the IASB's exposure draft? How do these proposed amendments aim to address existing challenges in financial reporting on instruments with both debt and equity features?
Financial Instruments with Characteristics of Equity is a long-standing project of the IASB aimed at introducing improvements to the requirements of IAS 32 Financial Instruments: Presentation regarding classification of financial instruments as a financial liability or equity instrument, as well as related disclosure and presentation requirements. Based on feedback on the IASB's 2018 Discussion Paper, the IASB concluded that IAS 32 works well for most financial instruments and fundamental changes to its classification requirements are unnecessary. However, stakeholders asked the IASB to clarify the classification requirements and resolve known practice issues that arise in applying IAS 32.
Consequently, the IASB decided to develop proposals focused on:
- clarifying the requirements, including underlying principles, for classifying a financial instrument as a financial liability or an equity instrument;
- resolving known application issues, thereby improving comparability of financial statements, and reducing diversity in practice. For example, relating to instruments with an obligation to purchase a company's own equity instruments or with contingent settlement provisions; and
- improving how an entity presents and discloses information about its financial liabilities and equity instruments in the financial statements.
The classification of financial instruments as either financial liabilities or equity instruments in the statement of financial position could affect key financial ratios of an entity, such as solvency (e.g., Tier 1 capital) and liquidity ratios. In addition, the proposals may impact other common financial key performance indicators and ratios, including but not limited to Earnings per share (EPS), return on equity, debt/equity ratio, etc. Furthermore, the proposals could impact the presentation under IFRS 9 by holders of financial instruments whose classification might change from debt to equity or vice versa.
EFRAG is currently conducting a survey and will participate in outreach events to better assess possible implications of the IASB's proposals.
- What are EFRAG's preliminary views on the ED? What are the key messages underlined in the comment letter recently published by EFRAG?
EFRAG's draft comment letter was published on 15 January.
EFRAG welcomes the IASB's efforts and approach to addressing issues that arise in practice.
EFRAG suggests that the IASB should:
- avoid classification changes that do not raise concerns in practice in order to avoid unintended consequences;
- consider whether a liability should be recognised for a Mandatory Tender Offer;
- more comprehensively discuss measurement issues of financial liabilities under the scope of IAS 32, such as those that arise from obligations to redeem own equity instruments and financial instruments with contingent settlement provisions;
- reconsider the initial accounting within equity for written put options on non-controlling interests (NCI written put). EFRAG disagrees with the IASB's proposal to continue recognising NCI on initial recognition and considers that the debit entry should be against NCI, if the NCI holder retains access to the rights and returns associated with ownership of the equity instruments;
- consider than many stakeholders disagree with presenting subsequent changes to the carrying amount of the resulting financial liability in profit or loss;
- explore the alternative model to treat contacts which meet the definition of a derivative as a stand-alone derivative at fair value through profit and loss; and
- allow reclassification of ‘passage-of-time changes'.
EFRAG welcomes the proposed improvements to disclosures in IFRS 7, but expresses some concerns and suggestions in the following areas:
- disclosures on an entity's contractual nature and priority on liquidation, especially on separation between subordinated and unsubordinated claims; and
- suggestion to provide disclosures on the effects of law on the classification as financial liabilities or equity instruments.
EFRAG supports the IASB's proposal to separately present the amounts attributable to ordinary shareholders from the amounts of other owners of the parent in the primary financial statements.
EFRAG expects to have its final position on the IASB's proposals on 10 April 2024.
- Considering the reference to IFRIC 2 in the Basis for Conclusions of this ED, how does the proposed clarification align with the classification of cooperative shares as equity instruments, and what implications might these adjustments have for cooperative banks?
There have been questions in practice about relevant laws or regulations that might prevent the enforceability of a contractual right or obligation included in an instrument's terms and conditions.
The IASB's proposals stipulate that an entity would be required to classify financial instruments as financial liabilities or equity instruments by considering enforceable contractual terms that give rise to rights and obligations in addition to, or more specific than, those established by applicable law. This means that obligations derived from the law that exist regardless of whether they are explicitly included in a contract or not, should not affect the classification.
Only contractual rights and obligations enforceable by laws or regulations are considered when classifying a financial instrument as a financial liability or equity instrument.
In paragraph BC 30 of the Basis for Conclusions that accompany the ED, the IASB considers this classification, that an entity should consider enforceable contractual terms, to be consistent with IFRIC 2. That is, if redemption of an instrument is unconditionally prohibited by local law, regulation or an entity's governing charter, the instrument is classified as equity.
Therefore, EFRAG does not expect that applying the proposed clarification would result in significant classification changes in practice relating to financial instruments in scope of IFRIC 2. However, EFRAG is conducting a survey and will participate in outreach events to gather information on the likely effects of the IASB's proposals, including for financial instruments, in the scope of IFRIC 2.
Second Opinion from Ms Isabelle FERRAND, Chief Executive Officer, CNCM
Ms Isabelle Ferrand, Vice-President of the EACB, is the Chief Executive Officer of the Confédération Nationale du Crédit Mutuel (CNCM). She is also Board member of the National, European and International Cooperative Alliance since 2017. Prior to her current role, Ms Ferrand occupied several positions at CNCM including Inspector at the General Inspection department, Accounting and Prudential standards Manager, Chief Financial Officer and Deputy Chief Executive Officer.
______________________________________________
The current economic context has shown the robustness of cooperative banks. This resilience rests on the fact that they are not listed on the market, but also on their business model in which members participate directly in the governance, strategy and risk management processes as they hold capital in the form of cooperative shares. For Crédit Mutuel, members' shares represent 17% of our CET1 own funds as of June 30th, 2023.
The classification of member shares of cooperatives banks within the scope of IAS 32 relies on IFRIC 2. This interpretation states that the interests of mutual shareholders are classified as equity if the entity has the unconditional right to refuse to redeem such interests (condition 1), or if there are legal or statutory provisions that prohibit or significantly limit such redemption (condition 2). For Crédit Mutuel, the equity designation of member shares relies on the second condition, as generally for main cooperative banks.
Accordingly, any evolution of IAS 32 standard is always closely monitored by cooperative banks because it presents a major issue in the qualification of financial instruments, that may have a fatal impact on our equity.
The FICE exposure draft proposes minor amendments to IAS 32 in order to provide more guidance for classifying and presenting financial instruments as financial liabilities or equity, and to reduce diversity in practice. It also includes disclosures requirements, thereby improving information on features not directly captured in the classification.
Crédit Mutuel supports this initiative within the context of challenges due to financial sector regulations and the growing number of complex financial instruments being issued with debt-like and equity-like characteristics. Crédit Mutuel notes several sensitive points in the FICE exposure draft.
Concerning the assessment of the effects of law and regulation under IAS 32 classification, the exposure draft includes a clarification whose purpose is to facilitate the qualification on financial instruments with bail-in provisions, such as Additional Tier 1 capital instruments issued by banks, or ordinary shares with statutory minimum distribution dividends required by law.
The IASB’s approach is to consider only enforceable contractual clauses giving rise to rights and obligations that are more extensive or more specific than those established by applicable law; and not consider rights or obligations arising from applicable laws or regulations, which would exist regardless of whether the right or obligation is specified in the contractual agreement or not.
Nevertheless, we believe that cooperative banks should have a close-up look at this proposition. The recognition of member shares as equity instruments is a sensitive topic, and we believe that it would be useful to specify directly in the IAS 32 amendments and not only, as currently, in the basis of conclusion, that this approach would be consistent with the principles of IFRIC 2 and to explicit the reason of this alignment.
Moreover, we think the IASB’s proposal should be reviewed to avoid any uncertainties on the classification of French regulated financial products. The main issue concerns the written put option on non-controlling interest holders, as this project would lead to a reduction of equity and would affect the level of prudential own funds. However, this issue has a limited impact on cooperatives.
Finally, cooperative banks should carefully review the IASB’s proposals to determine the granularity of disclosures, and the cost of compliance, while assessing whether it is applicable.