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| Home > Accounting Standards > Interpretations of Financial Reporting Standards 2003 > INT FRS 5 |
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Interpretation of Financial Reporting Standard
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INT FRS 5 |
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Classification of Financial Instruments - Contingent Settlement Provisions |
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| Paragraph 11 of FRS 1, Presentation of Financial Statements, requires that financial statements should not be described as complying with Financial Reporting Standards unless they comply with all the requirements of each applicable Standard and each applicable Interpretation of the Financial Reporting Standard. INT FRSs are not intended to apply to immaterial items. |
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Reference: FRS 32, Financial Instruments: Disclosure and Presentation |
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ISSUE |
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An enterprise may issue a financial instrument where the rights and obligations regarding the manner of settlement (i.e. in financial assets or by issuing its own equity instruments) depend on:
- the occurrence or non-occurrence of uncertain future events; or
- the outcome of uncertain circumstances that are beyond the control of both the issuer and the holder of the instrument. Examples of future events that may be used to determine contingent settlement provisions are included in the Appendix to this Interpretation.
- The form of such financial instruments can vary significantly. Depending on the outcome of a future event or circumstance, the instrument may require settlement in financial assets or in equity instruments or may provide the issuer or holder with a choice of the manner of settlement. Such an instrument could, for example, be issued in the form of a debenture or bond. The form also could be that of a preferred share or stock. In addition, the instrument may or may not have a specified maturity date and may or may not stipulate discretionary or mandatory periodic payments of interest or dividends. These instruments also may have certain other features such as an embedded conversion privilege, a put or call option or mandatory purchase requirements. The amount to be settled in financial assets or equity could be fixed or could be determined by reference to an index.
- Examples of such instruments include the following:
- shares issued under settlement terms that are dependent on the level of the issuer's future revenues. If the enterprise does not meet certain revenue goals in one year (e.g., revenues must exceed FF 2 billion), it is required to exchange the shares for bonds; and
- bonds that require the issuer to settle in shares if a market price or index exceeds a certain mark.
- The issue is whether such an instrument (or its component parts) should be classified as equity or a liability in the financial statements of the issuer. This Interpretation does not address instruments that are issued to compensate employees.
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CONSENSUS |
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| 5. |
Where the rights and obligations regarding the manner of settlement of a financial instrument depend on the occurrence or non-occurrence of uncertain future events or on the outcome of uncertain circumstances that are beyond the control of both the issuer and the holder, the financial instrument should be classified as a liability except to the extent that paragraph 6 of this Interpretation applies. |
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| 6. |
Where the possibility of the issuer being required to settle in cash or another financial asset is remote at the time of issuance, the contingent settlement provision should be ignored and the instrument should be classified as equity. |
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BASIS FOR CONCLUSIONS |
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| 7. |
FRS 32.18 requires the issuer of a financial instrument to classify the instrument, or its component parts, on initial recognition as a liability or equity, in accordance with the substance of the contractual arrangement and the definitions of a financial liability and an equity instrument. FRS 32.05 defines (a) a financial liability as a contractual obligation on the part of the issuer to deliver cash or another financial instrument or to exchange another financial instrument under conditions that are potentially unfavourable. It defines (b) an equity instrument as any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities. In accordance with FRS 32.19, the original classification continues until the financial instrument is removed from the balance sheet. |
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| 8. |
In the cases discussed, the rights and obligations regarding the manner of settlement either in financial assets or in the issuer's equity instruments depend on the occurrence or non-occurrence of uncertain future events or on the outcome of uncertain circumstances. At the time of initial recognition, the issuer and the holder do not control the manner of settlement. There is a contractual obligation to transfer economic benefits as a result of past events (i.e., the issuance of the instrument) since the issuer will be unable to avoid a settlement in financial assets depending on the outcome of the future event. Consequently, the instrument cannot be considered a residual interest in the assets of an enterprise (i.e., equity). Such financial instruments should, therefore, be classified as liabilities. |
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| 9. |
This Interpretation does not remove the need to consider all relevant terms and conditions of a financial instrument. FRS 32.22 explains that the substance of the contractual arrangement can be affected if the outcome of a future event is highly likely. For example, if a financial instrument labelled as a share gives the holder an option to require redemption upon the occurrence of a future event that is highly likely to occur, classification as a financial liability is appropriate. The same rationale applies to financial instruments where the rights and obligations regarding the manner of settlement depend on the outcome of uncertain future events. Where the possibility of uncertain future events or circumstances demonstrably is remote, there is no substantial uncertainty as to the manner of settlement. Settlement in cash may be remote if, for example, the issuance of shares depends merely on a formal approval by authorities or if the settlement depends on an index reaching an extreme level relative to its level prevailing on initial recognition. |
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Effective Date: INT FRS 5 comes into effect on 1 February 2003. |
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| Appendix |
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The appendix is illustrative only and does not form part of the Interpretation. The purpose of the appendix is to illustrate the application of the Interpretation to assist in clarifying its meaning. |
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| Examples Of Uncertain Future Events |
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The table shows conditions that may be stipulated to determine the manner of settlement. Examples of such conditions may include, but are not limited to, the following: |
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| Market Conditions |
Operations |
| Stock Market Index |
Revenues |
| Consumer Price Index |
Net Income or Loss |
| Interest Rates |
Total Assets or Liabilities |
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| None of the events given as examples above are considered to be under the control of the issuer or the holder. |
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