IASB Discussion Paper DP/2018/1 Financial Instruments with Characteristics of Equity

Our Ref.: C/FRSCSent electronically through the IASB Website (www.ifrs.org)

8 January 2019Mr Hans HoogervorstInternational Accounting Standards BoardColumbus Building7 Westferry CircusCanary WharfLondon E14 4HDUnited KingdomDear Hans,IASB Discussion Paper DP/2018/1Financial Instruments with Characteristics of EquityThe Hong Kong Institute of Certified Public Accountants (HKICPA) is the only bodyauthorised by law to set and promulgate standards relating to financial reporting,auditing and ethics for professional accountants, in Hong Kong. We are grateful for theopportunity to provide you with our views on this Discussion Paper (DP).The HKICPA supports the IASB’s initiative and efforts to address various challengesthat have arisen from the application of IAS 32 Financial Instruments: Presentation tofinancial instruments with characteristics of equity.However, the HKICPA does not support the IASB’s preferred classification approachas set out in the DP.The HKICPA considers the DP has not justified why the benefits outweigh the costs ofadopting the classification proposals when the outcomes are predominantly similar tothose under IAS 32 but use new terminology and wordings that are difficult tounderstand and apply. Many of our stakeholders have voiced concerns that theproposals would cause disruption and give rise to more interpretation problemsbecause of new terminology and the drafting of some areas of the DP such as 'amountindependent/partly independent of an entity's available economic resource'. Therefore,the HKICPA considers that the IASB's preferred approach is unlikely to be the solutionto the challenges posed by financial instruments with debt and equity characteristics.Some areas of the DP lack conceptually sound and clearly explained principles, forexample, the focus on 'liquidation' in the timing feature, the retention of the puttableexception and the use of other comprehensive income to present income andexpenses of financial liabilities. The HKICPA considers the 2018 ConceptualFramework for Financial Reporting (2018 CF) would be a logical starting place indeveloping principles to distinguish financial liabilities from equity. For example,guidance in the 2018 CF provides the conceptual rationale for the classification ofinstruments settled in an entity's own shares, whether of a fixed or a variable amount.The 2018 CF also provides the principles about the use of other comprehensiveincome to present income and expenses. If using the concepts in the 2018 CF as astarting point proves unsuccessful, there should be a clear explanation of the reasonswhy those concepts have not been applied.Page 2 of 2110 years ago in its response to the IASB’s 2008 Discussion Paper on FinancialInstruments with Characteristics of Equity, the HKICPA said it was not persuaded thatthe shortcomings in IAS 32 warranted the development of a substantially newconceptual approach to equity and liabilities at that time. With the passage of time, thecontinuous development of new innovative instruments and the 2018 CF, the HKICPAconsiders that the time has come for the IASB to carry out a fundamental review of theunderlying concepts and what constitutes an entity’s equity.The HKICPA understands that a fundamental review of concepts is unlikely to beconcluded quickly and thus the HKICPA recommends that the IASB urgentlyaddresses users’ needs for improved information on financial liabilities and equityinstruments by first developing some of the DP’s proposals on presentation anddisclosure. Priority should be given to improving transparency by developingdisclosures about terms and conditions of instruments and introducing separate lineitem presentation in the statement of financial position of relevant sub-classes offinancial liabilities and equity instruments that are not straightforward in theirclassification. The HKICPA considers that disclosures dealing with the priority of claimsand potential dilution of shares would also provide useful information to users if entitiesalso disclose the basis and assumptions used in preparing the disclosures.The HKICPA does not support developing the proposals on attributing totalcomprehensive income to equity instruments. The HKICPA agrees with the sentimentsin paragraph 6.95 of the DP that all the attribution approaches are complex and costly.Our investors and analysts also doubt the quality and usefulness of information thatcould be derived from the proposed fair value based attribution approaches. Therefore,instead of developing the proposals on attribution, disclosures about financialinstruments should be improved to help users of financial statements to assess thedistribution of returns among equity instruments and how such distribution may changein the future.Our detailed responses to the questions raised in the DP are in the Appendix.If you have any questions regarding the matters raised in this letter, please contact meor Eky Liu (eky@hkicpa.org.hk), Associate Director of the Standard SettingDepartment.Sincerely,Christina NgDirector, Standard Setting DepartmentEncl.APPENDIXPage 3 of 21Work undertaken by HKICPA in forming its viewsThe HKICPA:

(a)

issued an Invitation to Comment on the DP on 3 July 2018 to our members andother stakeholders;

(b)

held an education session with financial institution preparers on 24 October2018;

(c)

met with preparers on 30 October 2018, comprising representatives of listedcompanies in Hong Kong;

(d)

held a roundtable discussion for investors and analysts on 1 November 2018,comprising representatives from asset managers, and private equity investmentand securities firms;

(e)

sought input from its Financial Instruments Advisory Panel and Small andMedium Practitioners Technical Issues Working Group comprising technicaland industry experts and auditors from large as well as small and mediumaccounting firms (collectively, Practitioners); and(f)

developed its views through its Financial Reporting Standards Committee,having reflected on its stakeholder feedback. The Committee comprisesacademics, preparer representatives from various industry sectors, regulators,and technical and industry experts from small, medium and large accountingfirms.This submission outlines the HKICPA's views as well as most of our stakeholders'comments on the DP. You may access our stakeholder responses to the DP here:

https://www.hkicpa.org.hk/en/Standards-and-regulation/Standards/Our-views/pcd/financial-reporting-submissions/2019Detailed comments on the DPQuestion 1 – Objective, scope and challengesStakeholders' viewsChallenges of applying IAS 32Our stakeholders generally agree with the challenges and their causes as described inthe DP.Practitioners from large accounting firms consider that there are other challenges notexplicitly addressed by the DP, which include:

(a)

inconsistencies between the definition of a financial liability in IAS 32 and thedefinition of a liability in the 2018 CF and IFRS 2 Shared-based Payment. In the2018 CF, IFRS 2 and IAS 32, an entity classifies a claim as a liability when ithas an obligation to transfer cash or other assets. But under IAS 32, anobligation to deliver a variable number of its own shares would also beclassified as a liability.(b)

the definition of 'the entity' and when an entity's shareholders are considered tobe acting as 'the entity' through its governing body. This is important whendeciding what is or not in the control of the entity (for example, if payments areat the ultimate discretion of the entity’s shareholders, does this mean the entityhas an unconditional right to avoid payment?).Page 4 of 21(c)

measurement under IFRS 9 Financial Instruments of the financial liabilitiescreated by IAS 32. Confusion arises where IAS 32 imposes its ownmeasurement rules to financial liabilities, in conjunction with, or in substitutionfor, IFRS 9 requirements, for example, the grossing up of the legs of a writtenput option over own shares.(d)

currently there is no guidance under existing standards about reclassificationsbetween financial liabilities and equity and vice versa, and thus there isdiversity in practice.Financial institution preparers consider that there are application challenges inaccounting for instruments with contingent settlement options under paragraph 25 ofIAS 32, for example how to assess whether an event is beyond the control of the entityand/or the holder of the instrument and how to measure the liability component of suchinstruments.Investors and analysts consider that there is generally a lack of sufficientinformation/disclosures about the claims in the financial statements. With only limiteddisclosures, they cannot get a full picture about the claims, and hence understand theeconomic consequences of the claims on the issuers' financial position andperformance.Standard-setting activityFinancial institution preparers believe that the challenges could be addressed by someamendments and clarifications to IAS 32, such as requiring additional disclosure ofterms and conditions of instruments where these are not already provided andincluding additional guidance to deal with contingent settlement options underparagraph 25 of IAS 32.Practitioners say that they are already familiar with the principles in IAS 32 and theapplication issues arise from a lack of guidance in certain areas. They consider that theIASB should develop guidance to address the application challenges under IAS 32.HKICPA analysis and recommendationObjective and scopeThe HKICPA notes the objective of the FICE project is 'to articulate the principles forthe classification of financial liabilities and equity instruments with a clear rationale, butwithout fundamentally changing the existing classification outcomes of IAS 32'. TheHKICPA interprets this to mean that the IASB’s preferred classification principles havebeen reverse engineered to fit, or almost fit, the existing outcomes. This is an unusualapproach because the principles should drive the outcomes, rather than the other wayaround. The HKICPA disagrees with the objective as stated although the HKICPAagrees that a clear rationale is required to support any classification requirements.Challenges of applying IAS 32The HKICPA agrees with the description of the practical challenges and their causesbut also notes that there are several others that are not explicitly addressed asindicated by our practitioners.Page 5 of 21Standard-setting activityThe HKICPA considers that the challenges identified in the DP and those highlightedby our stakeholders that we have set out above are important and warrant attention bythe IASB. However, the HKICPA does not support the IASB’s preferred classificationapproach for reasons explained in our responses to Questions 2 and 3. Instead, theHKICPA recommends starting with the definitions of liabilities and equity in the 2018CF because they provide a conceptual basis for the IASB to develop IFRS Standards.Also, the HKICPA suggests the IASB should concentrate first on additional andimproved disclosure of terms and conditions of financial instruments to urgentlyremedy the current lack of disclosures on equity instruments and improve thepresentation of financial liabilities and equity instruments.Question 2 – The IASB's preferred approach and classification of non-derivativefinancial instrumentsStakeholders' viewsFinancial institution preparers expressed the following concerns about the IASB’spreferred approach to classification:

(a)

The IASB's preferred approach might lead to changes in classification outcomefor some financial instruments. For example, the classification of irredeemablefixed-rate cumulative preference shares would change from equity under IAS32 to financial liabilities under the IASB's preferred approach. Financialinstitution preparers question why this is a better accounting outcome. They arealso concerned that considering events at liquidation is inconsistent with thegoing concern basis on which financial statements are prepared.(b)

Additional effort would be required for the issuer to reconsider its pastclassification decisions. Accordingly, a careful weighing of potential cost andbenefit should be performed by the IASB.(c)

The change in classification outcome of some financial instruments, forexample, additional tier 1 (AT 1) instruments, would have a knock-on impact onthe holders of those financial instruments and require them to revisit theclassification and measurement of these financial assets. For example, aninstrument may need to be measured at fair value through profit or loss underIFRS 9 Financial Instruments instead of being treated as an investment insubsidiaries under IAS 27 Separate Financial Statements.(d)

The IASB's preferred approach introduces new terminologies in thedescriptions of the timing and amount features which are difficult to understandand apply, in particular, the notion of 'an amount independent of the entity’savailable economic resources'. For example, it is unclear how an amount couldbe considered as independent based on only a qualitative assessment. It isalso confusing that the DP states that the entity's share price is dependent onan entity’s economic resources when the entity's share price is also affected bymarket conditions. Even if the IASB provides lengthy guidance that helps tointerpret these new terminologies, this may still not result in consistentapplication of the IASB's preferred approach.(e)

The timing feature currently focuses on liquidation, but for banks, the issuecould be more related to 'resolution' instead of 'liquidation'. Therefore, it isPage 6 of 21recommended that the IASB takes into account the concept of 'resolution' inconsidering the timing feature.Financial institution preparers agree that information about other features of claimsshould be provided through presentation and disclosure to help financial statementusers to understand the economic substance of different claims.Practitioners from large firms share the same concerns as financial institutionpreparers on the use of new terminologies and the lack of clarity in the description ofthe amount feature. They consider that uncertainty as to how the terminology shouldbe interpreted could lead to new application issues and may open up structuringopportunities. One practitioner questions the relevance of classifying a claim as aliability based on an entity's obligation at liquidation. This practitioner considers thatdiscounting the contractual amount of such an obligation from indefinite future topresent would lead to an insignificant carrying amount that does not reflect theeconomics of the obligation and how commercial decisions are made.Investors and analysts consider that given the rapid financial innovations, it would bedifficult to predict what new claims would appear and how they should be classified inthe financial statements. Therefore, it would be more important and useful to disclosethe terms and conditions of the claims.HKICPA analysis and recommendationThe HKICPA considers that a better articulation of IAS 32’s underlying principles mayhave advantages in improving understanding and application of those principles.However, the HKICPA shares the same concerns as its stakeholders about using newterminologies in the IASB's preferred classification approach, which is more likely tocause disruption and create new interpretive and application challenges.Concerns with new terminologiesParticular examples of the articulation and new terminologies that are causingconcerns and difficulties include:

(a)

the focus on ‘liquidation’ in the timing feature when entities prepare theirfinancial statements on a going concern basis. In reality, entities do notnecessarily go straight into liquidation but may well pass through other forms ofinsolvency such as administration, receivership or, in the case of regulatedfinancial institutions, ‘resolution’. In particular, the concept of resolution shouldbe taken into account when considering financial institutions’ AT1 instruments.The holders of such instruments also participate in the losses that would arise ifthe financial institution is liquidated.(b)

the notions in the amount feature of ‘an amount independent of the entity’savailable resources’ and ‘an amount that could exceed the entity’s availableeconomic resources’. The DP uses the former term when defining a financialliability and for separate presentation requirements of financial liabilities. TheHKICPA and its stakeholders are confused about the meaning of 'independent'used in the DP. In some cases, the DP uses the term to mean 'totallyindependent' of an entity’s available economic resources and therefore thePage 7 of 21instrument should be classified as a financial liability. In other cases, the term isused where there is only partial independence (for example, foreign currencywritten call options) but still leads to a financial liability classification. A logicalinterpretation of something being 'partly independent' is that it is not 'totallyindependent' and thus the instrument 'cannot be independent of the entity’available economic resources' (i.e. it is dependent on those resources) and itsclassification is equity. This confusion is particularly apparent when dealing withderivatives whose net amount partly depends on the entity’s availableeconomic resources.Alignment with the principles in 2018 CFThe HKICPA considers that the amount feature should focus on obligations arisingduring the life of the entity (not at liquidation). The HKICPA thinks that a requirement totransfer economic resources / settlement only at liquidation should not result in liabilityclassification, regardless of whether the amount is or is not independent of the entity’savailable economic resources. This is consistent with the going concern principle in the2018 CF. The HKICPA considers that information about relative rankings of liabilitiesand equity instruments at liquidation is best conveyed through presentation and/ordisclosure.If the suggestion above is accepted and claims only at liquidation (for example,irredeemable cumulative preference shares) are not recognised as financial liabilitiesthen for non-derivatives, the DP’s proposals (updated for this suggestion) would beequivalent to the current IAS 32 requirement (obligation to pay cash or anotherfinancial asset). Generally, this requirement is sound and well understood underIAS 32. Accordingly, introducing new terminology would not be necessary.IAS 32 has a second feature resulting in a financial liability classification (an obligationto deliver a variable number of equity instruments). However, this feature is contrary tothe definition of a liability in the 2018 CF because an obligation to transfer a variableamount of equity is not a transfer of economic resources1 and therefore, such anobligation, whether of a fixed amount or a variable amount, cannot be a liability.Aligning the definitions of liabilities and equity in IAS 32 with those in the 2018 CFwould eliminate the current anomaly and all transfers of equity, whether of fixed orvariable amount, would be equity.Question 4 – Puttable exceptionStakeholders' viewsFinancial institution preparers generally agree that the exception should be retained forthe same reasons set out in paragraph 3.37 of the DP. However, they think that itwould be helpful to understand if any other proposals were considered that would haveaddressed all of the key concerns set out in paragraph 3.31 of the DP without the needfor an exception, and, if so, why those proposals are not the IASB’s preferred approach.1 Equity instruments issued by an entity are not economic resources of the entity (paragraph

4.10 of the 2018 CF)

Page 8 of 21Practitioners from large firms mostly disagreed with the proposal to retain theexception largely because of the application issues encountered when applying thecriteria in paragraphs 16A to 16D of IAS 32. For example, some funds have ‘FoundersShares’ or 'Management Shares', which legally may be the lowest subordinated claim.However, they are usually of a minimal amount, have no voting and distribution rightsand merely exist to facilitate start up of the fund. Presenting these shares as the equityof the funds is considered misleading as they are not considered to be the 'real equity'of the funds.Practitioners also note that funds’ financial position is not evaluated by users offinancial statements based on the equity/liability classification under the puttableexception. Instead the presentation of the statement of financial position provided byExample 7 in the Implementation Guidance to IAS 32 gives sufficient useful informationto users of financial statements.HKICPA analysis and recommendationThe HKICPA, in general, does not like exceptions to principles. The HKICPA wouldprefer not to retain the puttable exception. The need for an exception is indicative thatthe principles underlying the IASB’s preferred classification approach may not be fit forpurpose.The HKICPA notes that paragraph 3.37(c) of the DP states that 'the Board is not awareof any issues with the application of the puttable exception as set out in paragraphs16A-16B and 16C-16D of IAS 32'. However, the HKICPA notes that there have beenseveral requests made to the IFRS Interpretation Committee arising from application ofparagraphs 16A to 16F of IAS 32.The HKICPA suggests that the IASB establishes the extent to which the exception isused in practice, the application challenges arising from it and whether potentialimprovements to paragraphs 16A to 16D of IAS 32 can be identified before decidingwhether to retain the exception.The HKICPA considers that the disclosure requirements in paragraph 136A of IAS 1Presentation of Financial Statements about puttable instruments provide usefulinformation to users about expected future cash flows from these instruments. Thesedisclosure requirements should be retained irrespective of whether the puttableexception is retained or not.Question 5 – Classification of derivative financial instrumentsStakeholders' viewsFinancial institution preparers consider that the analysis of the individual legs of thederivative when assessing whether the individual legs are affected by independentvariables is confusing as the proposed classification principle is whether the netamount is affected by a variable that is independent of the entity’s available economicresources. Instead of developing the IASB's proposal, they consider that disclosureson the potential outcome of different types of derivatives on own equity may be aneffective way to provide information to investors.Page 9 of 21Financial institution preparers also noted that in paragraph 4.42(a) of the DP, net-sharesettled derivatives to deliver a fixed number of an entity's own shares in exchange forreceiving a variable number of own shares with a total value equal to a fixed amount ofthe entities’ functional currency would be classified as equity while the reverse (asnoted in footnote 50 of the DP) would be financial assets or financial liabilities. Theythink that these proposals would lead to an inconsistent outcome because the netresult of both instruments is that the entity either receives or delivers shares dependingon the movement of the share price.Moreover, financial institution preparers have concerns about the removal of theforeign currency rights issue exception because it seems counterintuitive for entitiesthat issue equity instruments in a foreign currency to have to classify derivatives onthose equity instruments as financial assets or liabilities rather than equity if the sameinstruments would be equity in the functional currency.Financial institution preparers suggest that the IASB should further analyse thepossibility of accounting for all derivatives on own shares as derivative financial assetsand financial liabilities within the scope of IFRS 9 to facilitate the accounting forderivatives.A large firm practitioner commented that the DP does not address the fundamentalquestion of why executory contracts to exchange equity in the future (i.e. derivativesover own equity) should be classified as equity prior to them being settled. Thepractitioner also notes that in practice most IAS 32 interpretive problems that relate toclassifying derivatives on own equity are about the fixed-for-fixed condition. It would bepreferable to retain the current IAS 32 position but provide a better explanation of 'fixedamount of cash' and 'fixed number of own shares' and circumstances in whichvariability of cash or number of shares is acceptable. For example, would a simplewritten call/warrant over the entity's own shares that is exercisable through anexchange of a fixed amount of cash in the entity's functional currency for a fixednumber of shares that is adjusted only for anti-dilutive type events, for example, bonusissues of shares, share splits, etc result in equity classification? The practitioner thinksthat retention of IAS 32 with improved application guidance is preferable to theproposal in the DP. If the model was finalised as proposed in the DP, the economicresources test will introduce a different set of interpretative questions (for example,what are available economic resources, what does dependent/independent mean, howto value economic resources in a private company etc). In effect the DP will replaceone set of interpretative questions for another and so it would not be an improvement.Some practitioners think that all derivatives over own shares should be treated asfinancial assets or liabilities at fair value through profit or loss, like other derivatives.They support this treatment both on practical grounds of eliminating interpretationalcomplexity of which derivatives over own shares should be treated as equityinstruments, and on conceptual grounds that the counterparty to these arrangements isa future equity owner and to classify the instruments as equity before they becomeequity owners is inappropriate. They consider that the gains and losses onremeasurement should be disclosed in a separate line item in the income statement.Page 10 of 21These practitioners consider this approach would also overcome the need for a 'fixed-for-fixed' or 'independent of available economic resources' test.HKICPA analysis and recommendationThe HKICPA considers that the proposed classification principles for derivatives overown equity are not an improvement to the current principles in IAS 32. The DP appearsto be replacing one set of interpretational difficulties with another based on differentprinciples.Foreign currency rights issue exceptionThe HKICPA has concerns with the discussion in the DP about foreign currency andthe foreign currency rights issue exception. The DP promotes the view that foreigncurrency is a variable that is always independent of an entity’s available economicresources and, consequently, under the IASB’s preferred approach a foreign currencyinstrument would be classified as a financial liability. The HKICPA questions whetherforeign currency should always be treated as an independent variable. Many issuersoperate in multiple jurisdictions and are required, by law or regulation, to raise funds ina currency other than their functional currency. Consequently, treating foreign currencyas an independent variable has a harsh effect on those issuers. The HKICPAconsiders that there should be consideration of the economic and commercial reasonsfor entities raising funds in a foreign currency when determining whether it is a variabledependent on, or independent of, the entity’s available economic resources.Some practitioners have noted that foreign currency risk is not a feature of aninstrument’s contractual terms but of the circumstances in which the entity operates.Accordingly, if an entity issues a fixed number of own equity instruments the foreigncurrency risk should not matter. This would seem to be supported by the definition of aliability in the 2018 CF under which an obligation to transfer an entity's own equitycannot be a liability. Consequently, a foreign currency rights issue exception would notbe required to achieve equity classification and the conversion feature in a foreigncurrency convertible bond would similarly achieve equity classification; hence removingthe noted anomaly. The HKICPA sees merit in this approach and recommends that theIASB should explore this further.The HKICPA normally does not support exceptions to principles. However, in this casethe foreign currency rights issue exception is required until the IASB addresses theissues that gave rise to the creation of the exception in 2009. For example, theHKICPA considers that the removal of the exception contradicts:

(a)

the IASB’s previous conclusion that such transactions are transactions withowners in their capacity as owners that should be recognised in the statementof changes in equity in accordance with IAS 1 Presentation of FinancialStatements (paragraph BC4H of IAS 32); and(b)

another IASB conclusion that classifying rights as derivative liabilities was notconsistent with the substance of the transaction (paragraph BC4F of IAS 32).Page 11 of 21Question 6 – Compound instruments and redemption obligation arrangementsStakeholders' viewsFinancial institution preparers acknowledge that the IASB’s preferred approach tocompound instruments and redemption obligation arrangements will ensure thatarrangements with the same liability and equity outcomes are classified consistentlyregardless of how they are structured, and it also provides financial statement userswith better visibility of the obligation.However, financial institution preparers are not convinced that written put options onown shares are similar to convertible bonds and thus should be treated similarly. In thecase of a written put option on own shares, the entity has already issued shares, butmight be required to repurchase them. In addition, the holder of the put option may bedifferent from the party holding the entity’s shares. However, in the case of aconvertible bond, the entity might be required to issue shares in the future to settle theclaim and the holder of the convertible bond would be the same party who receives theentity’s shares should the bonds be converted.A large firm practitioner also highlighted an important difference between a convertibledebt and a written put option over own shares. In the case of a convertible debt, thereis a liability for the funds borrowed at the issuance of the convertible debt. In contrast,a written put option may or may not be exercised in the future and only if exercised willresult in an exchange of cash for a fixed number of shares. The issuer will only havethe obligation to pay (i.e. a liability) at that time.Financial institution preparers commented on the new guidance on accounting withinequity for written put options on own shares. They note that it introduces a newconcept of derecognising equity which may potentially cause confusion since legallythe shares are still outstanding and the entity still has to pay dividends on them ifdividends are declared. The DP notes that derecognition on issuance of a written putoption does not mean that the equity instruments have been extinguished, but that itmerely reflects the change in the characteristics of the equity instruments because ofthe presence of a written put option. However, it is not clear what, if any, implicationsthis new type of derecognition would have.Amongst large firm practitioners there are split views on whether measuring written putoptions over own shares (including over non-controlling interests (NCI)) on a grossbasis should be retained. Those who do not agree with gross accounting do so on thebasis that all derivatives over own shares should be accounted for as executorycontracts and measured on a net basis.HKICPA analysis and recommendationRedemption obligation arrangementsThe HKICPA agrees with the IASB’s aim to achieve consistency between theclassification of all arrangements that have the same settlement outcomes regardlessof how an entity has structured the rights and obligations under those arrangements.However, the HKICPA agrees with its stakeholders about the differences in thesettlement outcomes between written put options on own shares and convertible bonds,Page 12 of 21and therefore that they should not be accounted for in the same way. Consequently,the HKICPA disagrees with the examples in paragraphs 5.33 to 5.35 of the DP. TheHKICPA recommends that the IASB reconsiders its approach for these instruments.The HKICPA generally supports the IASB’s proposals for redemption obligations byfocusing on whether an entity has an unavoidable right to avoid a settlement outcome(as set out in paragraph 5.48 of the DP). However, the HKICPA doubts that theconcepts from paragraph 5.48 could be easily embedded in IAS 32 because it is notintuitive that a standalone derivative to extinguish an equity instrument should beanalysed for classification purposes in the same way as a compound instrument.The HKICPA is supportive of the IASB's efforts to address the question of accountingfor written put options over own shares, including over non-controlling interests (NCI) inan entity’s consolidated financial statements, which has proved problematical underparagraph 23 of IAS 32. However, the HKICPA has concerns over the proposedaccounting within equity. In particular the HKICPA:

(a)

has concerns about the complexity of the debit entries in equity and the newconcept that derecognition of equity is not an extinguishment of the shares;

(b)

disagrees with the proposed use of other comprehensive income (OCI) forgains and losses on the redemption liability for fair value puts for the reasonsdiscussed in question 7; and(c)

is disappointed by the lack of discussion of certain conceptual and applicationissues that were raised in the past related to written puts over NCI, including:

(i) why changes to the redemption amount (especially for written puts at fairvalue) should be recognised in profit or loss under IFRS 9 rather than in thestatement of changes in equity under IFRS 10 Consolidated FinancialStatements and IAS 1 as transactions between equity holders.(ii) the treatment of profit allocation and dividends paid to NCI under IFRS 10when the NCI have been derecognised.(iii) the implication on the calculation of basic earnings per share and dilutedearnings per share under IAS 33 Earnings per Share when the NCI havebeen derecognised.(iv) whether the accounting should differ based on whether the written putforms part of a business combination or whether it was entered intoseparately.The HKICPA recommends that the IASB reconsiders its proposals for accounting forwritten puts over own shares and NCI to simplify the accounting and resolve thevarious conflicts with other standards as indicated above.Financial instruments with alternative settlement outcomesThe HKICPA considers that for instruments with alternative settlement outcomes thatare contingent on an uncertain future event beyond the control of the entity, adistinction should be made between events that are in the control of the holder andthose that are beyond the control of both the entity and the holder (for example, achange in control of the entity). If the settlement outcomes are within the control of theholder, the HKICPA supports the approach in paragraphs 5.10 and 5.21 of the DP.However, when the outcomes are contingent on an uncertain future event beyond thePage 13 of 21control of both the entity and holder, the HKICPA and some of its stakeholders thinkthe conditionality should be factored into the initial measurement of the non-derivativeliability rather than, as suggested in the DP, included in the derivative representing theremaining rights and obligations. The DP’s approach would mean that the liabilitywould be measured at the full amount that the entity could be required to payimmediately. The HKICPA has sympathy with those stakeholders who supportfactoring the conditionality into the measurement of the non-derivative liability and thinkthat this approach is conceptually stronger because it reflects the characteristics of theliability and how future cash flows of the entity could be affected. It also fits better withthe measurement requirements in IFRS 9.The HKICPA recommends that the IASB reconsiders its proposals for instruments withalternative settlement outcomes that are contingent on uncertain future events that arebeyond the control of both the entity and the holder. It is essential that themeasurement aspect of the conditionality is properly resolved, and conceptually soundguidance is produced. This is particularly important as concerns remain unresolvedaround the measurement of the liability component in certain ‘non-viability’ contingentconvertible securities that are mandatorily convertible into a variable number of sharescontingent upon a ‘non-viability’ event that is considered to be remote. The IFRSInterpretation Committee discussed a submission detailing these concerns in January2014 but determined that the scope of the issues were too broad for it to address in anefficient manner.Question 7 – Presentation of financial liabilitiesStakeholders' viewsFinancial institution preparers consider that the IASB's proposals of separatepresentation of financial liabilities identified in paragraph 6.53 of the DP wouldintroduce significant operational complexity because financial institutions do notgenerally track derivatives based on whether their net amounts are affected bydependent or independent variables. The IASB's proposals may lead to systemchanges or involve significant manual efforts. They consider that such separatepresentation should be limited to embedded derivatives that are separated from thehost and the amount of hybrid instruments that, as a whole, is not affected by avariable independent of an entity's available economic resources. They also suggestedthat the IASB considers providing an option for entities to separately present thecarrying amounts of the financial liabilities, either in the statement of financial positionor in the notes to the financial statements, depending on their size, nature andamounts.Some investors agreed with the IASB's proposals to require presentation of incomeand expenses arising from financial liabilities with equity-like returns in OCI withoutsubsequent recycling. They think that such income and expenses are not related to thecore operation of the issuers and therefore, should not affect profit or loss. In addition,they agree that income and expenses recognised in OCI should not be subsequentlyrecycled to profit or loss so as to avoid potential manipulation of earnings.Page 14 of 21Practitioners do not support the expanded use of OCI. They think that an exception topresent income and expenses arising from financial liabilities in profit or loss impliesthat the underlying principles of classification may not be appropriate. They alsoquestion whether presentation in OCI is consistent with the principles about the use ofOCI in paragraphs 7.17 and 7.19 of the 2018 CF.HKICPA analysis and recommendationThe HKICPA supports the IASB’s preliminary view that there should be separatepresentation in the statement of financial position of subclasses of financial liabilitiesthat are not straightforward in their classification. Separate presentation providesuseful information and could alleviate some of the concerns with the liabilityclassification of more complex instruments. The subclasses warranting separatepresentation should be those where disclosure of their terms and conditions is neededto assist users’ understanding of their classification. The HKICPA would expect thatthese subclasses would potentially be the same as those identified in paragraph

6.53(a)(i) to (iii) of the DP but that they should be described using more familiarterminology than that taken from the IASB’s preferred classification principles in the DP.However, the HKICPA does not agree with presenting income and expenses offinancial liabilities identified in paragraph 6.53(b) of the DP in OCI, including financialinstruments that currently meet the foreign currency rights issue exception. TheHKICPA considers that the proposals inappropriately expand the use of OCI without astrong logic. Presentation in OCI is not an appropriate solution to the issues identifiedin paragraph 6.12 of the DP, which essentially are about the effect of ‘non-operating’items on financial performance. The HKICPA believes that if financial instruments havebeen properly classified as financial liabilities then gains and losses arising on suchliabilities should not be in OCI. The HKICPA considers that to report these gains andlosses in OCI would be the start of a slippery slope to including any 'non-operating'items in OCI—a position that the HKICPA does not support. The HKICPA considersthat the gains and losses should instead be presented as a separate line item in thestatement of comprehensive income in arriving at profit or loss. The HKICPA believessuch presentation would be useful to users of financial statements in making theirassessment of the impact of these instruments on an entity’s financial performance.Question 8 – Presentation of equity instrumentsStakeholders' viewsFinancial institution preparers generally agree that the attribution approaches havesome benefits in providing information about distribution of returns among the differenttypes of classes of equity. However, they have concerns about whether the benefits ofthe information provided by the attribution approaches would exceed theimplementation costs. For example, attribution approaches (a) to (c) for derivativeequity instruments require the fair values of equity derivatives to be determined, whichcould be difficult if those fair values are not observable and additional cost of preparingthe information would be needed.Some investors and analysts expressed concern about the reliability of the fair valuesof derivative equity instruments because measuring the fair value of such instrumentsPage 15 of 21involves the use of management assumptions and valuation models. They doubted theusefulness of information provided by attributing total comprehensive income based onthose fair values. They generally preferred approach (d), i.e. a disclosure onlyapproach.Practitioners are of the view that the proposed attribution approaches would becomplex, costly and not well understood by preparers, particularly, those in unlistedentities, and thus the quality and usefulness of the information would be questionable.One practitioner considers that the proposed attribution approaches are fundamentallyflawed because equity instruments, by nature, have no claim on the entity's reservesuntil the entity declares dividends or is liquidated. It is also inconsistent with the goingconcern principle in the 2018 CF.HKICPA analysis and recommendationSeparate presentation of equity instrumentsThe HKICPA agrees that better information about the different features of equityinstruments (as set out in paragraph 6.56(a) to (c) of the DP) would be useful to usersof financial statements. Of the choices provided in paragraph 6.58 of the DP, theHKICPA considers that improving disclosure requirements about equity instruments isthe preferable approach.Attribution of income and expenses to some equity instruments other than ordinarysharesThe HKICPA has concerns that the various attribution methods detailed in the DP thatcould be used for different subclasses of equity in an enhanced presentation approachwould introduce significant complexity, create confusion for users in understanding theinformation and, not least, increase costs for preparers.Paragraph 6.63 of the DP contends that the attribution of comprehensive income toequity instruments other than ordinary shares would be similar to the presentation ofNCI, i.e. the carrying amount is updated for the amount of total comprehensive incomeattributed to it and such changes in carrying amounts are presented in the statement ofchanges in equity. However, the presentation of NCI is not intended to reflect therelative interests of NCI. The HKICPA considers that the objective of showing ‘acomplete picture of how equity instruments affect each other’s returns’ is conceptuallyand economically different from existing guidance on attribution in relation to thepresentation of NCI.Under existing attribution guidance, the presentation of NCI simply reflects changes inthe part of a group’s net assets owned by the NCI or changes in the proportion of suchnet assets held by the NCI. It is not a separate measurement method for the equityinstruments encapsulated in NCI. The allocation of comprehensive income to NCI andthe owners of the parent is a consequence of the requirements of IAS 1 and theconsolidation method set out in IFRS 10. It is notable that IFRS 10 only permits theuse of existing ownership interests and excludes the possible exercise or conversion ofpotential voting rights and other derivatives.Page 16 of 21Attribution approach for non-derivative equity instruments based on the existingrequirements of IAS 33While the HKICPA does not support using an attribution method, the HKICPAconsiders that an attribution method based on the existing requirements of IAS 33could be applied in practice. However, the population of entities that would be requiredto apply this attribution method is broader than the population within the scope of IAS

33.Accordingly, there will be a lack of familiarity with the concepts of IAS 33 and thusrisks misapplication of the attribution method.Attribution approach for derivative equity instrumentsAs noted above, the HKICPA prefers a disclosure approach rather than a presentationapproach involving attribution methods.The HKICPA does not consider that any of the three attribution approaches discussedin paragraphs 6.74 to 6.86 of the DP provide a satisfactory answer from a cost-benefitperspective. A full fair value approach would appear to provide an understandable‘measurement’ basis for the fair value of equity instruments other than ordinary shares(and NCI) and would align with the ‘measurement’ basis for the fair value of derivativeson own equity that are classified as financial liabilities or financial assets. However, theHKICPA considers that fair valuing all equity derivatives just for purposes of attributingnet income is burdensome and costly especially for hard to value derivatives. TheHKICPA also questions the relevance of allocating net income to equity derivativesusing fair value information.The HKICPA considers that the other two attribution methods (b) and (c) would also becomplex and costly to apply as they require an entity to calculate the relative fairvalues of its own equity instruments.Disclosure onlyThe HKICPA sees the advantage of providing information about the effect of derivativeequity instruments on ordinary shares through diluted earnings per share and otherdisclosures. However, the HKICPA is unconvinced about extending the existingdisclosures in IFRS 7 Financial Instruments: Disclosures about fair values to equityinstruments other than ordinary shares. The HKICPA shares the same concerns as itsstakeholders over the cost, difficulties and usefulness of fair valuing derivative equityinstruments. The HKICPA understands that many users would prefer to do their owncalculations rather than to have the values calculated by management with little detailon the assumptions and inputs used. A disclosure requirement to provide informationabout the terms and conditions of the instruments would be more effective in providinguseful information to users.Improving information provided to users of financial statementsThe HKICPA suggests that the IASB improves information provided to users offinancial statements by disaggregating equity using additional line items, subtotals andcategories, for example, financial instruments that will or may be settled in the issuer’sown equity instruments (distinguishing between existing vs. potential shareholders)

and improving the existing requirements and disclosures of IAS 33 as discussed in ourresponse to Question 9.Page 17 of 21Question 9 – DisclosureStakeholders' viewsFinancial institution preparers agree that disclosures are a key part of the project andwelcome the IASB’s discussions. However, they consider that further guidance on howto apply the proposed disclosure in relation to the terms and conditions of the claims isneeded, for example, how banks could leverage on the existing Pillar 3 disclosurerequirements under the Basel Committee on Banking Supervision in order to avoidunnecessary duplications or confusions due to overlapping disclosures.Other stakeholders also generally welcome the proposed disclosures. However, someinvestors and practitioners have expressed the following views on the list of priority ofclaims on liquidation:

(a)

Issuers, particularly multinational groups, may have to incur significant costs(including legal costs) in preparing the list. It is questionable whether thebenefits of the information provided by the list could outweigh its preparationcosts.(b)

It is questionable whether the list is useful without including non-financialliabilities and if the issuer does not have a going concern problem.(c)

The increased transparency of the priority of claims could lead to an increase inan issuer’s cost of funding as credit investors would demand better returns ifthe relative ranking of the claim in the list is low.Investors and analysts would like disclosures about the terms and conditions that mayaffect the priority of claims on liquidation and the use of assumptions when preparingthe list. Some investors would also like disclosures about the voting rights of equityinstruments.HKICPA analysis and recommendationThe HKICPA supports improvement of disclosures about equity instruments. TheHKICPA agrees that there is a significant gap between the information provided forequity instruments compared to that provided for financial liabilities. The imbalance indisclosures should be addressed by the IASB. However, as indicated above, thisshould not include fair value disclosure of equity instruments.Disclosure of priority of financial liabilities and equity instruments on liquidationThe HKICPA supports providing a disclosure that provides a ranking of an entity’sclaims arising from its financial liabilities and equity instruments. The HKICPA is notconvinced that the ranking necessarily should be one based on liquidation (even ahypothetical one). For example, for financial institutions one based on resolution maybe more appropriate.Furthermore, any ranking of priority, other than on a going concern basis, would be acontradiction with financial statements prepared on a going concern basis. This isparticularly so if the information is provided on the face of the statement of financialposition where it would be difficult, if not impossible, to reconcile with the existing IAS 1requirement for the statement of financial position to be organised on a current / non-current basis. Similar issues would arise for those financial institutions that organisePage 18 of 21their statements of financial position based on the liquidity of their assets and liabilitiesas permitted by the exception in paragraph 60 of IAS 1. Consequently, the HKICPArecommends that any ranking disclosure should be provided in the notes to financialstatements. This would be less disruptive than presentation on the statement offinancial position.The HKICPA acknowledges that providing any ranking of claims will involve practicalchallenges, particularly, defining priority within consolidated financial statements wherethe group operates in multiple jurisdictions with different contract and insolvency laws.Nevertheless, the HKICPA agrees that information about the priority of an entity’sfinancial liabilities and equity instruments would be useful even if such information isprepared with some limitations. For example, when considering disclosure for anentity’s consolidated financial statements it may be appropriate to frame the disclosurearound significant subsidiaries or sub-groups in the same jurisdiction rather than oneconsolidated list which could involve arbitrary judgements of which claims underdifferent laws took precedence.The HKICPA considers that any ranking disclosure should use the carrying amounts inthe statement of financial position and not fair value amounts. This would ensure that auser could easily reconcile the numbers between the disclosure and the statement offinancial position.Potential dilution of ordinary sharesThe HKICPA agrees that additional information about the potential dilution of ordinaryshares is warranted. The HKICPA agrees with the disclosure objective and theproposed disclosure in paragraphs 7.21 and 7.22 of the DP. The HKICPA agrees thatthe information discussed in paragraph 7.22 could be integrated with existingdisclosures required by IAS 1 about outstanding shares. The HKICPA considers thatthe example in paragraph 7.23 of the DP is useful.In addition, the HKICPA suggests that the IASB improves existing requirements of IAS33 based on the shortcomings that the IASB has identified in paragraphs 7.13 to 7.15of the DP, aligns the definitions in IAS 33 with the definitions in IAS 32 and IAS 1, andaddresses issues that arise in practice (for example, the lack of transparency about thecalculation of weighted average number of ordinary shares).Contractual terms and conditionsThe HKICPA agrees that additional information should be provided about the termsand conditions of financial liabilities and equity instruments that affect the amount andtiming of cash flows, such as that discussed in paragraph 7.27 of the DP.However, the HKICPA notes the challenges in preparing such disclosures. Theaggregation issue described in paragraph 7.29 of the DP is difficult to solve, asaggregating at an inappropriate level could lead to important information being lost.Therefore, on top of providing a summary of terms and conditions in the notes to thefinancial statements, the HKICPA recommends that the IASB encourages entities toprovide more details about individual instruments’ terms and conditions on theirwebsites to which users of financial statement could be referred. For example, anyPage 19 of 21offering documents that contain the terms and conditions for issued instruments couldbe made available on the entity’s website.Question 10 – Contractual termsStakeholders' viewsEconomic incentives and compulsion that might influence the issuer’s decision toexercise its rightsFinancial institution preparers agree with the proposal in the DP to clarify thateconomic incentives that might influence the issuer’s decision to exercise its rightsshould not be considered when classifying a financial instrument as a financial liabilityor equity instrument. This is because different issuers may have differentconsiderations and hence any such requirement would impair comparability of financialstatements.For the same reasons, investors and analysts generally agree that economicincentives and the effect of laws and regulations should not be considered. However,they requested disclosures about whether and how economic incentives and laws andregulations could affect the settlement outcomes, for example, disclosures about thelikelihood of conversion into shares and the expected cash payment based on theconditions as at the reporting date. They consider that companies should also disclosemanagement assumptions and observable data used in assessing the potentialsettlement outcomes.Indirect obligationsFinancial institution preparers considered that retaining and improving the indirectobligations requirements in paragraph 20 of IAS 32 would help to clarify some of theissues related to economic compulsion, for example, whether an entity is legallyprohibited from exercising one of the settlement alternatives.HKICPA analysis and recommendationEconomic incentives and compulsion that might influence the issuer’s decision toexercise its rightsThe HKICPA agrees that the concept of economic compulsion is challenging to applyin practice because of the highly judgmental nature of the assessment.The HKICPA believes that a concept of constructive obligation (similar to that in IAS 37Provisions, Contingent Liabilities and Contingent Assets) could be applied to theclassification of financial instruments. This concept is also discussed in paragraph 4.31of the 2018 CF. When an entity is selling its financial instruments, it will, through itsstatements and actions, create a valid expectation that the holders will be paid; entitieswould never sell their securities without holders having this expectation. Theapplication of a constructive obligation concept would catch obligations in situationswhere the entity does not have a realistic economic alternative. For example, in thecase of callable step-up preference shares, where the cost of not calling the instrumentwould be much higher than the cost of capital. In addition, disclosures could be usedto provide information where a 'constructive obligation' exists, such as details of theeconomic incentives for payment that exist at the reporting date, the reasons whyPage 20 of 21payment has or has not been made and the effect this has on the statement offinancial position. The HKICPA has not fully tested the ‘constructive obligation’ conceptto financial instruments and whether it would achieve the desired classificationoutcome. However, the HKICPA recommends that the IASB explores this concept in itsdeliberations on economic incentives and compulsion.Indirect obligationsThe HKICPA agrees that the requirements in paragraph 20 of IAS 32 should beretained. Retention of the requirements is necessary to prevent structuring to achievedesired classification outcomes. It is a necessary anti-abuse provision.The HKICPA recommends that the indirect obligations requirements could be improvedby incorporating the notion of ‘no commercial substance’, which is found in paragraph41 of IFRS 2 Share-based Payment, and reflect the IFRS Interpretation Committee’sdiscussions in January 2014 on whether a possible settlement option is substantive.The consideration of the substance in the contractual terms is also discussed inparagraphs 4.60 and 4.61 of the 2018 CF. Incorporating such notion could ensure thatwhen the terms and conditions of a financial instrument provide the entity with thechoice between an equity or a liability settlement, the entity is required to considerwhether one of the settlement alternatives:

(a)

has no economic substance (for example, the equity settlement outcome isstructured so that its value would always exceed that of the liability settlementoutcome); or(b)

has no commercial substance (for example, the entity is legally prohibited fromissuing the shares required for the equity settlement outcome).Question 11 – Relationship between contracts and lawStakeholders' viewsOur stakeholders generally support retaining the approach in paragraph 15 of IAS 32,which focuses on the substance of the contractual arrangement.Nevertheless, financial institution preparers consider that guidance is still required toaddress practical challenges arising from the interaction between the contractual rightsand obligations and laws and regulations regarding innovative financial instrumentssuch as contingent convertible bonds designed for banking capital requirements.HKICPA analysis and recommendationThe HKICPA considers that the interaction between contractual rights and obligationsand regulatory and legal requirements is an important issue. Contractual rights andobligations should be considered in the context of the law. They are inseparable fromthe legal requirements. Contracts arise under law and the law can impose features of acontract from which the parties are not at liberty to deviate but that does not makethose features ‘non-contractual’.Currently, IFRS Standards are not consistent when dealing with contractual rights andobligations and regulatory and legal requirements. For example, within the financialinstruments suite of standards IFRIC 2 Members' Shares in Co-operative Entities andPage 21 of 21Similar Instruments takes into account legislative requirements for classificationpurposes while IFRS 9 and IAS 32 do not. Outside of financial instrument standards,IFRS 15 Revenue from Contracts with Customers and IFRS 17 Insurance Contractsrequire consideration of contract law and regulation.Furthermore, paragraph 4.31 of the 2018 CF states that many obligations areestablished by contracts, legislation or similar means. The HKICPA understands thisto mean that even if contracts would not establish an obligation, the obligation couldarise as a result of legislation.The introduction of new financial products, such as ‘bail-in’ and other ‘non-viability’instruments as discussed in our response to Question 6, for financial institutionsfollowing the financial crisis highlights the challenges that arise in practice from theinteraction between the contractual rights and obligations and legislation and regulation.When these interactions apply entities can face challenges in determining whetherparticular requirements stem from the contract or from related law or regulation. Acontract might state that the entity is under the scope of specific legislation, include ageneral reference to legislation or replicate the wording of the legislation. The HKICPAhas heard concerns about the potential different outcomes from essentially identicalcontracts where one contract incorporates the relevant law in its terms while anotherdoes not.Accordingly, the HKICPA recommends that the IASB develops guidance to assistentities to address the challenges that rise in practice, particularly with ‘bail-in’legislation. The HKICPA considers such guidance could cover the distinction betweencontractual and legal obligations and additional disclosures about legislation that arerelevant for investors to understand the substance of the contractual arrangement of afinancial instrument, which could be combined with disclosures about the terms andconditions of the instrument.If the IASB were to develop its proposals as set out in the DP, the HKICPA agrees thatthe IASB should not reconsider the guidance in IFRIC 2.~ End ~