In this issue: Liability vs equity classification for financial instruments issued by investment funds. Welcome to the series

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1 IFRS FOR INVESTMENT FUNDS February 2012, Issue 3 Welcome to the series Our series of IFRS for Investment Funds publications addresses practical application issues that investment funds may encounter when applying IFRS. It discusses the key requirements and includes guidance and illustrative examples. The upcoming issues will cover such topics as fair value measurement, consolidation and IFRS 9 Financial Instruments. This series considers accounting issues arising from currently effective IFRS as well as forthcoming requirements. Further discussion and analysis about IFRS is included in our publication Insights into IFRS. In this issue: Liability vs equity classification for financial instruments issued by investment funds Investment funds frequently issue shares or units with unique, entity-specific characteristics. As a result, a significant effort may be required in applying the IFRS guidance to the contractual terms of these instruments to determine whether they should be classified as a liability or equity. This publication focuses on the classification of puttable instruments and instruments that impose on the entity an obligation to deliver a pro rata share of the entity s net assets only on liquidation ( obligations arising on liquidation ). These are the most common types of financial instruments issued by investment funds. This issue covers the following issues arising from the application of IAS 32 Financial Instruments: Presentation. 1. Liability or equity? Where do you start the analysis? 2. When are puttable instruments and obligations arising on liquidation classified as equity? 3. How do you classify a component of an instrument that imposes an obligation only on liquidation? 4. How do you classify redeemable shares issued by umbrella structures? 5. When should a financial instrument be reclassified between liability and equity? The scope of this publication is limited to non-derivative financial instruments issued by investment funds.

2 2 IFRS for Investment Funds 1. Liability or equity? Where do you start the analysis? Shares or units issued by a fund are classified as a financial liability or equity on initial recognition. The table below outlines the principal considerations for funds in determining whether an instrument meets the definition of equity or liability under the general definitions in IAS 32. Key features If settled in own equity instruments Features that generally point to liability or equity classification of an instrument or a component of an instrument Financial liability Contains a contractual obligation to transfer cash or other financial assets. The contractual obligation may arise from a requirement to repay principal or to pay interest or dividends. In our view, such a contractual obligation could be established explicitly or indirectly, but it should be established through the terms and conditions of the instrument. Settlement in a variable number of the entity s own equity instruments. Instruments with the following features may still be classified as equity if certain conditions are met (see Question 2): redemption is at the option of the instrument holder limited life of a fund fund liquidation is at the option of the instrument holder. Redemption is triggered by an uncertain future event that is beyond the control of both the holder and the issuer of the instrument. Non-discretionary dividends. Equity In general, any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. The issuer has no contractual obligation to deliver cash or another financial asset. Settlement in a fixed number of the entity s own equity instruments. Non-redeemable shares or units. No specific liquidation date. Discretionary dividends. Example 1 Non-discretionary dividends Fund B issues units that are not puttable and that give the unit holders a right to fixed non-discretionary dividends each period and a pro rata share of the fund s net assets on its liquidation. B does not have a limited life and its liquidation is not at the option of the unit holders. The units do not have any other features that would preclude equity classification. How does B classify the units? The unit issued by B is a compound instrument. The obligation to pay fixed non-discretionary dividends represents a contractual obligation that is classified as a financial liability in line with the general definitions in IAS 32. The obligation to deliver a pro rata share of B s net assets only on its liquidation is classified as equity because the liquidation is neither certain to happen nor beyond the control of B. However, if there were no mandatory dividend requirement and dividends were entirely at the discretion of B, then the units would be classified wholly as equity providing all other criteria were met.

3 IFRS for Investment Funds 3 An entity assesses the substance of a contractual arrangement, rather than its legal form, when determining whether an instrument meets the definition of a financial liability or equity. As a result, it is possible that instruments that qualify as equity for legal or regulatory purposes may be classified as liabilities for the purpose of financial reporting. In our view, in assessing the substance of a contractual arrangement, factors not contained within the contractual arrangement should be excluded from the assessment. Economic compulsion should not be used as the basis for classification. Instruments that are often impacted and so may fail the definition of equity under IFRS include preference shares and classes of shares that have special terms and conditions. If it is determined at initial recognition that an instrument, or in certain circumstances a component, meets the definition of a financial liability, then an investment fund applies the flowchart below to determine whether the instrument, or a portion of it, should be presented as equity by exception. Presentation as equity by exception is required if: the instrument meets the definition of a puttable instrument (see Question 2); or the instrument, or a component, meets the definition of an instrument that imposes on the fund an obligation to deliver a pro rata share of the net assets of the fund only on liquidation (see Question 2). Step 1 Is the financial instrument a liability or equity in accordance with the general definitions in IAS 32? Step 2 If the financial instrument is not equity in its entirety, then is it: (i) a puttable instrument; or (ii) an instrument or component that imposes an obligation to deliver a pro rata share of net assets only on liquidation? The instrument is equity in its entirety No further analysis under Step 2 is required The instrument is a liability in its entirety No Is the definition of (i) or (ii) met for the whole instrument? No Is definition (ii) met for part of the instrument? Yes The whole instrument is classified as a liability That part is classified as equity by exception and the balance is classified as a liability Yes The whole instrument is classified as equity by exception The instrument is a compound instrument No Is the definition of (i) or (ii) met for the whole compound instrument? No Is definition (ii) met for the entire liability component? Yes Is definition (ii) met for part of the liability component? Yes No The component of the instrument meeting the definition of equity in accordance with the general requirements of IAS 32 is classified as equity. The remaining part is classified as a liability The component of the instrument meeting the definition of equity in accordance with the general requirements of IAS 32 and the part of the liability component meeting the definition of (ii) are classified as equity. The remaining part is classified as a liability Yes The whole instrument is classified as equity by exception

4 4 IFRS for Investment Funds 2. When are puttable instruments and obligations arising on liquidation classified as equity? Puttable instruments and obligations arising on liquidation are defined as follows. Puttable instruments Financial instruments that give the holder the right to put the instruments back to the issuer for cash or another financial asset, or that are automatically put back to the issuer on the occurrence of an uncertain future event. Obligations arising on liquidation Financial instruments that contain a contractual obligation for the entity to deliver to the holder a pro rata share of its net assets only on liquidation. In this case, the obligation arises because liquidation either is certain to happen and is outside the control of the entity (e.g. a limited-life entity) or is uncertain but is at the option of the instrument holder (e.g. some partnership interests). Such instruments are classified as equity by exception under IAS 32 if they meet certain conditions that are summarised in the table below. The contractual terms and surrounding circumstances should be reviewed for each instrument to determine the appropriate classification. The criteria for meeting the exception are restrictive and a fund will have to meet all of them to classify the issued instruments as equity. Conditions required for equity classification Required for puttable instruments? Required for obligations arising on liquidation? Examples (on next few pages) 1 The financial instrument entitles the holder to a pro rata share of the entity s net assets in the event of the entity s liquidation. Yes Yes 2 2 The financial instrument belongs to the most subordinate class of instruments. Yes Yes 3 3a 3b All financial instruments in this most subordinate class have identical features. Yes See 3b 4 All financial instruments in this most subordinate class have an identical contractual obligation to deliver a pro rata share of the entity s net assets on liquidation. See 3a Yes - 4 Apart from an obligation for the issuer to repurchase or redeem, the instrument: does not include any other contractual obligation to deliver cash or another financial asset or to exchange financial assets or financial liabilities under potentially unfavourable conditions; and is not a contract under which an entity is or may be obliged to deliver a variable number of the entity s own equity instruments. Yes No 5

5 IFRS for Investment Funds 5 Conditions required for equity classification Required for puttable instruments? Required for obligations arising on liquidation? Examples (on next few pages) 5 Total expected cash flows attributable to the instrument over its life are based substantially on: profit or loss; change in recognised net assets; or change in fair value of recognised and unrecognised net assets of the entity. Yes No 6 6 The issuer has no other financial instrument or contract that has: total cash flows based substantially on profit or loss, change in recognised net assets, or change in fair value of recognised and unrecognised net assets of the issuer; and the effect of substantially restricting or fixing the residual return to instrument holders. Yes Yes 7 The reason for the differences between the conditions for a puttable instrument and an instrument that imposes on the entity an obligation only on liquidation is the timing of settlement of the obligations. A puttable instrument can be exercised before liquidation; therefore, all contractual obligations that exist throughout its entire life are considered to ensure that it always represents the most residual interest. For an obligation that is settled only on liquidation, the focus is on obligations that exist at liquidation. Example 2 Pro rata share of net assets on liquidation Shares issued by limited-life Fund C and Fund D have the following features with respect to payments on liquidation. Fund C Fund D Fees payable on liquidation Fixed fee per unit Fixed fee per unit holder Calculation basis for a pro rata share of net assets Pro rata share of total net assets Pro rata share of specific portion or component of net assets How do the above features affect the classification of the units? IAS 32 states that a pro rata share of the fund s net assets on liquidation is determined by: dividing the entity s net assets on liquidation into units of equal amount; and multiplying that amount by the number of units held by the financial instrument holder. In our view, this means that each instrument holder has an entitlement to an identical monetary amount per unit on liquidation. Each feature of D s units illustrated above results in unit holders not receiving an identical monetary amount per unit on liquidation and so precludes equity classification. C classifies its units as equity providing that the remaining requirements are met.

6 6 IFRS for Investment Funds Example 3 Management shares: The most subordinate class The holders of the redeemable shares of Fund E are entitled to a pro rata share of E s net assets in the event of its liquidation. E has also issued a small amount of a different class of shares ( management shares ) to the fund manager; these shares are non-redeemable, have no entitlement to dividends and are the most subordinate class of instruments in liquidation. Can redeemable shares be regarded as the most subordinated class? IAS 32 does not preclude the existence of several types or classes of equity. A financial instrument is first classified as a liability or equity instrument in accordance with the general requirements of IAS 32. That classification is not affected by the existence of puttable instruments or instruments that impose an obligation only on liquidation. As a second step, a fund considers whether a financial liability also meets the exception for puttable instruments or instruments that impose an obligation only on liquidation and so should be classified as equity. In this example, the redeemable shares meet the definition of a liability in IAS 32. Also, in our view they fail the exception for puttable instruments because even a small amount of management shares that are subordinate to redeemable shares means that such redeemable shares are not subordinated to all other classes of instruments. The existence of a puttable feature in the redeemable shares does not in itself mean that the instrument is less subordinate than management shares. The level of an instrument s subordination is determined by its priority in liquidation. In some instances, redeemable shares could be the most subordinated class e.g. when management shares have priority in liquidation and there are no other more subordinate instruments issued. In respect of puttable instruments, all financial instruments in the class of instruments that is subordinate to all other classes of instruments need to have identical features to qualify for equity classification. In our view, this should be interpreted strictly to mean identical contractual terms and conditions, including non-financial features such as governance rights, related to the holders of the instruments in their roles as owners of the entity. Differences in cash flows and contractual terms and conditions of an instrument attributable to an instrument holder in its role as non-owner are not considered to violate the identical features test, provided that the transaction is on similar terms to an equivalent transaction that might happen between a non-instrument holder and the issuing entity. Examples of contractual features that would violate the identical features test include: different rates of management fees; a choice for holders on issuance whether to receive income or additional units as distributions (such that the distributive or accumulative feature differs for each instrument after they are issued); different lock-up periods; and different currencies in which the payments are denominated. In our view, the following terms do not violate the identical features test because there are no inherent differences in the features of each instrument within the most subordinate class: administrative charges based on the volume of units redeemed before liquidation, as long as all unit holders in the most subordinate class are subject to the same fee structure; different subscription fees payable on initial subscription, as long as all other features become identical once the subscription fees are paid; a choice to receive income or additional units as distributions on each distribution date, as long as the same ability is afforded to all unit holders in the most subordinate class i.e. the choice is an identical feature; and a term contained in identical instruments that carry equal voting rights that caps the maximum amount of voting rights that any individual holder may exercise.

7 IFRS for Investment Funds 7 Example 4 Identical features test: Additional information rights Fund F issues redeemable shares that are the most subordinated class. Fund manager M holds 5% of the redeemable shares in F. M also has access to certain information rights in its role as a manager that are not granted to other holders of redeemable shares. Does such access to additional information mean that not all redeemable shares have identical features? If information rights are granted to M in its role as manager of the fund (and not in its role as owner), then they are not considered to violate the identical features test. Example 5 Contractual distribution of net accounting profit Unit Trust T issues redeemable units. In addition to the general redemption feature, T is contractually required to distribute to the holders the net accounting profit annually. How does an additional requirement to distribute the net accounting profit affect classification of redeemable shares? In our view, the requirement to distribute the net accounting profit annually is an additional obligation to deliver cash and, therefore, the redeemable units do not qualify for equity classification. Example 6 Total expected cash flows attributable to the instrument Fund G issues one class of redeemable shares that entitles each holder to a pro rata share of G s net assets and that is the most subordinate class of instruments issued. Redemption amounts are based on net assets calculated in accordance with local GAAP (not IFRS). The redeemable shares do not contain any other contractual obligations to deliver cash. Are the total expected cash flows of the shares based substantially on profit or loss and change in net assets? Usually, to meet this requirement, the redemption amount is calculated with reference to net assets measured in accordance with IFRS. This is not the case in this example, because the redemption value of the shares is calculated based on local GAAP. Nevertheless, G may still satisfy this condition, depending on the circumstances. It may also be possible to argue that the effect of differences between local GAAP and IFRS is immaterial with regard to their application to G, or temporary and expected to converge over the life of the instrument, such that the total expected cash flows are based substantially on IFRS profit or loss or change in recognised net assets. In our view, the use of the terms expected and based substantially indicates that judgement should be exercised in determining whether the requirement is met in each specific situation, including consideration of how local GAAP and IFRS apply to the reporting entity s business and the terms of the instrument.

8 8 IFRS for Investment Funds 3. How do you classify a component of an instrument that imposes an obligation only on liquidation? The following guidance applies only to components of instruments that impose on the entity an obligation to deliver a pro rata share of its net assets only on liquidation. Puttable instruments are tested for equity classification as a whole (see flowchart in Question 1). Instruments or components of instruments that meet the definition of a liability in accordance with the general requirements of IAS 32 and that impose on the entity an obligation to deliver to another party a pro rata share of the net assets only on liquidation are classified as equity if they meet the conditions set out in Question 2. If the instrument that imposes an obligation on the entity to deliver a pro rata share of the net assets only on liquidation also contains other contractual obligations, then these other obligations may need to be accounted for separately as liabilities in accordance with the requirements of IAS 32. For example, the following components could be present in an instrument: an obligation to pay non-discretionary dividends i.e. a financial liability component; and an obligation to deliver a pro rata share of the net assets on liquidation. In such cases, a question arises about whether the second component can ever meet Condition 6 set out in the table in Question 2 that requires that the issuer has no other financial instrument or contract that has total cash flows based substantially on the issuer s profit or loss, change in recognised net assets, or change in fair value of recognised and unrecognised net assets. In our view, when evaluating such a component (an obligation arising on liquidation) for equity classification by exception, a fund should choose an accounting policy, to be applied consistently, on whether the term other financial instrument includes: (i) other components of the evaluated instrument; or (ii) only financial instruments other than the one that contains the evaluated component. If the fund s policy is to view a mandatory dividend feature as another financial instrument for this purpose, then equity classification of the obligation arising only on liquidation would be precluded for this component of the instrument because the mandatory non-discretionary dividends violate Condition 6 in Question 2 e.g. mandatory dividends based on profits. However, if the fund s policy is to consider for this test only financial instruments other than the one that contains the obligation arising on liquidation, then a mandatory dividend feature in itself would not preclude equity classification of the obligation arising on liquidation because this feature is part of the same instrument and it could not violate Condition 6 in Question 2. Example 7 Limited-life entity pays non-discretionary dividends Fund K is a limited-life entity. K issues units that are redeemable only on its liquidation. The unit holders are entitled to annual non-discretionary dividends equalling 90% of K s profits and a pro rata share of the net assets on liquidation of K. How does K classify the components of the shares issued? The obligation to pay fixed non-discretionary dividends represents a contractual obligation that is classified as a financial liability (Component 1). The classification of the obligation to deliver a pro rata share of the net assets on liquidation (Component 2) depends on the accounting policy choice made by K. If K chooses accounting policy (i) above, then Component 2 is classified as a liability. If K chooses accounting policy (ii) above, and provided that all other criteria are met, then Component 2 is classified as equity.

9 IFRS for Investment Funds 9 4. How do you classify redeemable shares issued by umbrella structures? The term umbrella fund structure is used in certain jurisdictions to describe a collective investment scheme that comprises an umbrella fund that operates one or more sub-funds. Investors buy instruments that entitle the holder to a share of the net assets of a particular sub-fund. The umbrella fund and sub-funds together form a legal entity, although the assets and the obligations of individual funds are fully or partially segregated. Each sub-fund usually has its own investment objectives, focusing on different markets. The analysis in this question applies only to instances in which the assets and obligations of each sub-fund are ring-fenced solely for investors of the respective sub-fund. The table below discusses the possible classification of puttable instruments and instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets only on liquidation, issued by an umbrella fund structure. Type of financial statements prepared Individual financial statements prepared by each sub-fund Separate financial statements of umbrella fund structure that include the assets and liabilities of the sub-funds that together form a single legal entity Consolidated financial statements with sub-funds as subsidiaries Combined financial statements prepared by an umbrella fund structure, expressed as prepared in accordance with IFRS Considerations Each sub-fund assesses issued instruments for equity classification separately. Instruments issued by the sub-funds are assessed for equity classification from the perspective of the umbrella fund structure as a whole. Instruments issued by each sub-fund cannot qualify for equity classification because they could not meet the pro rata share of the entity s net assets on liquidation condition and, if they are puttable instruments, the identical features test. Instruments issued by sub-funds that qualify for equity presentation in the individual financial statements of each fund and that represent non-controlling interests are classified as liabilities in the consolidated financial statements. In our view, puttable sub-fund instruments would not qualify for equity classification in the combined financial statements for the reasons described above for both separate and consolidated financial statements. Classification Liability or equity Liability Liability Liability

10 10 IFRS for Investment Funds 5. When should a financial instrument be reclassified between liability and equity? The classification of an instrument or its component parts as either a financial liability or equity is made at initial recognition and, with the exception of puttable instruments and instruments that impose on the entity an obligation only on liquidation, is not generally revised as a result of subsequent changes in circumstances. However, a reclassification between liability and equity or vice versa may be required following changes to the contractual or effective terms of the instruments or changes in the composition of the reporting entity. Puttable instruments and instruments or components that impose on the entity an obligation only in liquidation are reclassified: to financial liability from the date on which any of the equity classification criteria in Question 2 cease to be met; or to equity from the date on which all equity classification criteria in Question 2 are met. This indicates a continuous assessment model under which a fund re-assesses the classification whenever there are changes to the relevant circumstances e.g. changes to the capital structure, such as the issue of new classes of shares or redemptions of existing share classes. Puttable instruments or instruments that impose on the entity an obligation only on liquidation are measured on reclassification as follows. Reclassification Measurement Accounting for carrying amount adjustment From equity to financial liability From financial liability to equity Liability is measured initially at the instrument s fair value at the date of reclassification. Equity instrument is measured at the carrying amount of the financial liability at the date of reclassification. Any difference between the carrying amount of the equity instrument and the fair value of the financial liability at the date of reclassification continues to be recognised in equity. No adjustment to the carrying amount. Accounting entries Reclassification from equity to financial liability Assume that on the date of reclassification the carrying amount of an instrument previously classified as equity is 100 and its fair value is 90. The double entry on reclassification is as follows. Debit Credit Equity 1 90 Liability 90 Accounting entries Reclassification from financial liability to equity Assume that on the date of reclassification the carrying amount of an instrument previously classified as equity is 100 and its fair value is 90. The double entry on reclassification is as follows. Debit Credit Liability 100 Equity This example does not focus on different components of equity.

11 IFRS for Investment Funds 11 Other KPMG publications A more detailed discussion of the general accounting issues that arise from the application of IFRS can be found in our publication Insights into IFRS. In addition, we have a range of publications that can help you further, including: Illustrative financial statements: Investment funds Illustrative financial statements for interim and annual periods IFRS compared to US GAAP IFRS Handbooks, which include extensive interpretative guidance and illustrative examples to elaborate or clarify the practical application of a standard, including IFRS Handbook: First-time adoption of IFRSs New on the Horizon publications, which discuss consultation papers First Impressions publications, which discuss new pronouncements Newsletters, which highlight recent accounting developments IFRS Practice Issues publications, which discuss specific requirements of pronouncements Disclosure checklist. IFRS-related technical information is also available at kpmg.com/ifrs. For access to an extensive range of accounting, auditing and financial reporting guidance and literature, visit KPMG s Accounting Research Online. This web-based subscription service can be a valuable tool for anyone who wants to stay informed in today s dynamic environment. For a free 15-day trial, go to aro.kpmg.com and register today. KPMG s Global Investment Management practice Our member firms combine their depth of local knowledge with our global network s cross-border experience to deliver practical, effective and insightful advice to our global investment management clients. Our professionals in Audit, Tax and Advisory are specialists in their fields and have deep experience in the issues and needs of investment management businesses. We offer professional services to a wide range of industry participants at a local, national and global level. Our clients include investment managers, wealth managers, fund administrators and service providers who focus on retail/mutual funds, hedge funds, private equity funds, real estate funds, infrastructure funds and other alternative investment funds (such as distressed debt and environmental assets), as well as sovereign wealth funds and pension funds. Acknowledgements We would like to acknowledge the principal contributors to this publication. They are Ewa Bialkowska and Arina Tomiste of the KPMG International Standards Group.

12 12 IFRS for Investment Funds Contacts Global investment management contacts Wm David Seymour Global Head Americas region KPMG in the US T: E: Bonn Liu ASPAC region KPMG in Hong Kong T: E: Tom Brown EMA region KPMG in the UK T: E: Neale Jehan Fund Centres Group KPMG in the Channel Islands T: E: Tony Rocker Infrastructure Funds KPMG in the UK T: E: Jonathan Thompson Real Estate Funds KPMG in the UK T: E: Mikael Johnson Hedge Funds KPMG in the US T: E: Rustom Kharegat Private Equity Funds Sovereign Wealth Funds KPMG in the UK T: E: John Hubbe Pensions KPMG in the US T: E: Gerold Hornschu Audit KPMG in Germany T: E: Hans-Jürgen Feyerabend Tax KPMG in Germany T: E: Alain Picquet Advisory KPMG in Luxembourg T: E: alain.picquet@kpmg.lu James Suglia Advisory KPMG in the US T: E: jsuglia@kpmg.com Mireille Voysest Global Executive Investment Management KPMG in the UK T: E: mireille.voysest@kpmg.co.uk

13 IFRS for Investment Funds 13 Fund Centres IFRS Working Group Andrew Stepaniuk Leader Fund Centres IFRS Working Group KPMG in the Cayman Islands T: E: Paul Reid KPMG in Australia T: E: pmreid@kpmg.com.au Craig Bridgewater KPMG in Bermuda T: E: craigbridgewater@kpmg.bm Lino Junior KPMG in Brazil T: E: lmjunior@kpmg.com.br Winand Paulissen KPMG in the Netherlands T: E: paulissen.winland@kpmg.nl Llewellyn Smith KPMG in South Africa T: E: llewellyn.smith@kpmg.co.za Patricia Bielmann KPMG in Switzerland T: E: pbielmann@kpmg.com Gareth Horner KPMG in the UK T: E: gareth.horner@kpmg.co.uk Peter Hayes KPMG in Canada T: E: phayes@kpmg.ca Vivian Chui KPMG in Hong Kong T: E: vivian.chui@kpmg.com.hk Manoj Kumar Vijai KPMG in India T: E: mkumar@kpmg.com Frank Gannon KPMG in Ireland T: E: fgannon@kpmg.ie Victor Chan Yin KPMG in Luxembourg T: E: victor.chanyin@kpmg.lu

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