When determining the issuer’s classification of a derivative on its own shares, IFRS looks at whether the equity derivative meets a fixed-for-fixed requirement, while US GAAP uses a two-step model. Although Step 2 of the US GAAP model uses a similar fixed-for-fixed concept, the application of the concept differs significantly between US GAAP and IFRS.
These differences can impact classification as equity or a derivative asset or liability (with derivative classification more common under IFRS).
Equity derivatives need to be indexed to the issuer’s own shares to be classified as equity. The assessment follows a two-step approach under ASC 815-40-15.
Step 1—Considers whether there are any contingent exercise provisions, and if so, they cannot be based on an observable market or index other than those referenced to the issuer’s own shares or operations.
For derivatives, only contracts that provide for gross physical settlement and meet the fixed-for-fixed criteria (i.e., a fixed number of shares for a fixed amount of cash) are classified as equity. Variability in the amount of cash or the number of shares to be delivered results in financial liability classification.
Step 2—Considers the settlement amount. Only settlement amounts equal to the difference between the fair value of a fixed number of the entity’s equity shares and a fixed monetary amount, or a fixed amount of a debt instrument issued by the entity, will qualify for equity classification.
If the instrument’s strike price (or the number of shares used to calculate the settlement amount) is not fixed as outlined above, the instrument may still meet the equity classification criteria; this could occur where the variables that might affect settlement include inputs to the fair value of a fixed-for-fixed forward or option on equity shares and the instrument does not contain a leverage factor.
For example, a warrant issued by Company X has a strike price adjustment based on the movements in Company X’s stock price. This feature would fail the fixed-for-fixed criterion under IFRS, but the same adjustment would meet the criteria under US GAAP.
Down round features (as defined) do not cause a freestanding equity-linked financial instrument (or an embedded conversion option) to fail equity accounting when assessing whether the instrument is indexed to an entity’s own stock. Once the down round is triggered, the change in the fair value of the instrument as a result of the change in strike price is recognized as a reduction of income available to common shareholders in basic EPS.
IFRS does not provide an exception related to down round features. Freestanding warrants and embedded conversion options in debt instruments containing down round features require liability classification.
In case of rights issues, if the strike price is denominated in a currency other than the issuer’s functional currency, it should not be considered as indexed to the entity’s own stock as the issuer is exposed to changes in foreign currency exchange rates. Therefore, rights issues of this nature would be classified as liabilities at fair value through profit or loss.
There is a narrow exception to the fixed-for-fixed criterion in IAS 32 for rights issues. Under this exception, rights issues are classified as equity if they are issued for a fixed amount of cash regardless of the currency in which the exercise price is denominated, provided they are offered on a pro rata basis to all owners of the same class of equity.
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