IASB Exposure Draft Financial Instruments with Characteristics of Equity (Proposed amendments to IAS 32, IFRS 7 and IAS 1)

Page 1 of 20Our Ref.: C/FRSCSent electronically through the IASB Website (www.ifrs.org)

28 March 2024Dr Andreas BarckowInternational Accounting Standards BoardColumbus Building7 Westferry CircusCanary WharfLondon E14 4HDUnited KingdomDear Andreas,IASB Exposure DraftFinancial Instruments with Characteristics of Equity(Proposed amendments to IAS 32, IFRS 7 and IAS 1)

The Hong Kong Institute of Certified Public Accountants (HKICPA) is the only bodyauthorised by law to set and promulgate standards relating to financial reporting, auditing,ethics and sustainability disclosures for professional accountants in Hong Kong. We aregrateful for the opportunity to provide our comments on this Exposure Draft (ED).The HKICPA appreciates the IASB’s endeavours to clarify the classification principles inIAS 32 Financial Instruments: Presentation to address known practice issues. TheHKICPA also supports the IASB’s objective of enhancing the presentation anddisclosure of information about financial liabilities and equity instruments to improvetransparency and understandability, as well as to meet the information needs of usersof financial statements. Nevertheless, we have significant concerns about certainaspects of the proposals. We provide detailed comments in the Appendix andsummarise our primary concerns and recommendations below.Settlement in an entity’s own equity instrumentsWe have significant concerns regarding the application of the proposed preservationadjustments and passage-of-time adjustments to common contractual terms in HongKong, which are widely accepted by the market as anti-dilutive and meeting the fixed-for-fixed condition. Firstly, it is common for entities to adjust the conversion ratio ofconvertible bonds (CB) to compensate CB holders for dilution loss when shares areissued to investors below market price. Secondly, anti-dilutive adjustments are oftencalculated using the volume weighted average share price over a specified period beforethe diluting event occurs. Applying the proposals in the ED, these adjustments would notqualify as preservation adjustments and would therefore fail the fixed-for-fixed conditionbecause they could arguably preserve the economic interests of the future equity holdersto a larger extent relative to the economic interests of the current equity holders.The proposed passage-of-time adjustments would also impact the current practice onCBs that carry an interest rate benchmark and those with protective clauses thatcompensate holders for loss of an option’s time value through an enhanced conversionratio when there is a change of control of the issuer (i.e. change of control provisions).Applying the proposals, these adjustments would fail the fixed-for-fixed conditionbecause they are linked to a variable (e.g. an interest rate benchmark), or include inputs(e.g. share price and volatility in the time value of option) to the predetermined formulaPage 2 of 20that do not vary solely based on passage of time. Furthermore, the adjustments may notrepresent compensation proportional to the passage of time as stated in the ED, sincethe adjustments for change of control provisions may not always be linear over time.Given that the majority of the CBs issued in Hong Kong include the aforementionedadjustments in their contracts, the IASB proposals, if implemented, would result in theretrospective reclassification of the conversion options of these CBs from equity toderivative liabilities. In light of the significance and pervasiveness of this matter, westrongly recommend the IASB carefully consider the implications and the potentialimpact of the proposals on existing market practices and provide clarification on theapplication of the preservation adjustments and passage-of-time adjustments tocommon contractual terms in Hong Kong.The effects of relevant laws and regulationsWe consider that the proposals lack a guiding principle in considering the effects of lawsand regulations in the classification of financial instruments. Specifically, we questionwhy a law that prevents enforceability should be considered in the classification, while alaw that creates an obligation should be disregarded. Moreover, the proposals require aclear identification of laws and regulations that are relevant to the financial instruments,but the boundaries may not always be clear due to varying legal systems across differentjurisdictions, resulting in practical challenges in determining whether particular rights andobligations stem from the contract or from law or regulation. This issue is particularlyrelevant for multinational groups operating in multiple jurisdictions with different legalrequirements.The effects of laws and regulations are an important yet complex issue that has broadimplications. They either interact with or have implications for other existing IFRSAccounting Standards. We also understand that a complete alignment of the accountingclassification with the legal view would fundamentally change the existing requirementsin IAS 32 and IFRS 9, which is not the objective of this project. In light of theseconsiderations, we recommend the IASB seriously reassess the feasibility of theproposals, conduct field tests to assess the impact and clarity of the proposals ondifferent financial instruments, and evaluate whether the outcomes reflect the substanceof the instruments and provide relevant information. If the IASB were to proceed with theproposals, we recommend the IASB clarify the boundaries of laws and regulations forthe purpose of determining the classification of financial instruments, and providesupporting guidance, such as illustrative examples of common financial instruments, toensure consistent application of the proposals.Contingent settlement provisionsWe have concerns about the lack of clarity regarding the scope of financial instrumentswith contingent settlement provisions that would be subject to the proposedamendments to IAS 32.25 and 25A. The current wording of the proposed amendmentsseems to imply that the measurement requirements in IAS 32.25A would apply to allfinancial instruments with contingent settlement provisions, including those that arecurrently measured solely under IFRS 9 (such as derivatives for written puts other thanover own equity instruments, debt instruments with loan covenants). Such an applicationcould result in unexpected outcomes and create unintended consequences.In addition, our respondents expressed divergent views on the proposed measurementrequirements in IAS 32.25A. Some agreed with the proposals to ignore the probabilityand estimated timing of the contingent events. Others considered that entities shouldtake those two factors into account in measuring the obligations (i.e. the probability-Page 3 of 20weighted measurement approach) as this would better reflect the economics of thetransaction and provide useful financial information. Moreover, they noted that theprobability-weighted measurement approach has worked well when entities measuresimilar instruments with contingent settlement clauses under other IFRS AccountingStandards.To address the above concerns, we strongly recommend the IASB clearly define thescope of financial instruments with contingent settlement provisions that are subject toIAS 32.25 and 25A to avoid diversity in practice and unintended consequences.Additionally, we suggest the IASB conduct field tests on a broad range of contingentsettlement clauses using both measurement approaches to determine which approachwould best provide relevant financial information.Reclassification of financial liabilities and equity instrumentsWe disagree with the proposal that prohibits reclassification when there is a change inthe substance of the contractual arrangement due to the passage of time. We believethat prohibiting reclassification that would occur as a result of contractual terms thatbecome or stop being effective with the passage of time (such as the expiry of acontingent settlement provision) would misrepresent the substance of the financialinstrument and the entity’s situation, potentially resulting in misleading information. Weare also not convinced by the IASB’s view that reclassification would increase costs andcomplexity for preparers. Preparers already need to monitor whether certain contractualterms have expired or stopped being effective when measuring the instruments andpreparing the proposed disclosures in IFRS 7.30F at the reporting date. Furthermore,we consider that addressing the issues arising from the prohibition by introducingadditional disclosures in IFRS 7.30F is not the appropriate approach and is inconsistentwith IAS 1.18. Given the above concerns, we strongly recommend that the IASBreconsider its reclassification proposal relating to the passage of time and remove therelated prohibition.Another key concern is the lack of clarity in the proposal regarding whether subsequentchanges to laws and regulations would constitute a change in the substance of thecontractual arrangement due to ‘changes in circumstances external to the contractualarrangement’, in which case reclassification of financial instruments would be requiredunder the proposal. We consider that the associated core questions are whetherreclassification would be required: 1) when a change in law creates incrementalcontractual obligations; and 2) when a change in law prevents the enforceability of thecontract. We recommend that the IASB provide clarification on these matters andconsider the proposals on reclassification and the effects of laws and regulationstogether to ensure that their interactions are adequately addressed.If you have any questions regarding the matters raised in this letter, please contactKennis Lee (kennislee@hkicpa.org.hk) or Carrie Lau (carrie@hkicpa.org.hk), AssociateDirectors of the Standard Setting Department.Sincerely,Cecilia KweiDirector of Standard SettingPage 4 of 20Work undertaken by the HKICPA in forming its views:

The HKICPA:

(a) issued an Invitation to Comment on the ED on 30 November 2023 to its membersand other stakeholders;

(b) sought input from its Financial Instruments Advisory Panel and Small and MediumPractices Committee and its Technical Issues Working Group, which mainlycomprise technical and industry experts from large as well as small and mediumaccounting firms (collectively, Practitioners);

(c) held a public roundtable discussion for local stakeholders, including Practitioners,preparers and other interested parties on 22 January 2024;

(d) developed its views through its Financial Reporting Standards Committee, havingreflected on its respondents’ views. The Committee comprises preparerrepresentatives from various industry sectors, regulators, as well as technical andindustry experts from small, medium and large accounting firms.Detailed comments on the IASB EDQuestion 1: The effects of relevant laws or regulations(paragraphs 15A and AG24A-AG24B of IAS 32)

1.We appreciate the endeavours undertaken by the IASB in addressing the intricaciessurrounding the effects of relevant laws or regulations in classifying financialinstruments as financial liabilities or equity instruments. However, our respondentshave expressed the following concerns.A. Lack of a guiding principle in considering the effects of laws or regulations

2.Some respondents were concerned that the proposals lack a guiding principle andprimarily focus on accommodating specific practice issues without addressing thecore issue of the effects of laws or regulations on the classification of financialinstruments. Specifically, they questioned why a law that prevents enforceability ofa contractual right or obligation should be considered in the classification, but a lawthat creates an obligation should be disregarded. They contended that both the legaland contractual obligations should be considered in their entirety by the issuer, asfinancial instruments are governed by contracts that are entered into within a legalframework. This approach also aligns with paragraph 4.60 of the ConceptualFramework and IFRIC 2 Members’ Shares in Co-operative Entities and SimilarInstruments, whereby the relevant laws and regulations are considered indetermining the rights and obligations arising from the contracts.B. Boundaries of relevant laws or regulations for classification purposes

3.Our respondents considered that the proposals require a clear identification of lawsor regulations that are relevant to the financial instruments. However, the ED doesnot provide explicit guidance about the interactions between laws, regulations andcontracts, or the extent of how laws and regulations should be considered in theproposals. They highlighted that different jurisdictions have different legal systems,and different laws and regulations may have different legal implications. Thispresents practical challenges when determining whether particular rights andobligations stem from the contract or from law or regulation. This issue is particularlyrelevant for multinational groups operating in multiple jurisdictions with varying legalrequirements (with some jurisdictions having a legal system based on civil lawwhere the key terms of instruments are already codified in the law, while othersAppendixPage 5 of 20having a legal system based on common law where there are no such provisions inthe law and therefore the comparable terms must necessarily be contained in thecontractual terms of instruments).For example, the Real Estate Investment Trusts (REIT) established in Hong Kongare subject to minimum dividend requirements pursuant to the trust deed and REITCode issued by the Securities and Futures Commission (SFC) of Hong Kong. TheREIT Code specifies the minimum dividend payout ratio for all the REITs regulatedby the SFC. The REIT Code provides a framework through which the SFC may takeactions (e.g. sanctions or penalties) against the REITs, without creating legalenforceability of the minimum dividends. Instead, the trust deed of each REIT setsout the minimum dividend payout ratio, which provides the legal enforceability onthe minimum dividends.Under this situation, our respondents questioned whether the REIT Code should betreated as laws and regulations that create the rights and obligations for theminimum dividends. This question is crucial because it would have a determinativeimpact on the classification of the units issued by REITs in Hong Kong:

-If the REIT Code is considered as part of laws and regulations under the ED,units issued by REITs could be classified as equity (assuming that the trust deeddoes not contain any clauses that would classify the units as financial liabilities).-However, if the REIT Code is not considered as part of laws and regulations, theminimum dividend obligation specified in the trust deed would trigger theclassification of the units (or their component part) as financial liabilities.C. Recognition and measurement of the rights and obligations disregarded in theclassification

4.Some respondents expressed concerns that the proposals in IAS 32.15A(b) wouldcreate ambiguity in the recognition and measurement of the contractual rights andobligations arising from relevant laws and regulations that are proposed to bedisregarded in classifying a financial instrument. In the absence of sufficientguidance in the ED, this ambiguity could result in the following application issuesand pose challenges in determining the appropriate measurement requirements forthese contractual terms.For instance, consider the case of ordinary shares that include a contractualprovision to mirror the statutory minimum dividend of 10%. Applying the proposalsin the ED, these shares would be classified as equity instruments as the contractualdividend is disregarded. However, the following questions arise:

-Should entities apply IAS 37 Provisions, Contingent Liabilities and ContingentAssets to account for the contractual obligation to pay the minimum dividend atinitial recognition and for subsequent periods?-If the statutory minimum dividend subsequently decreases from 10% to 5% whilethe contractual dividend remains at 10%, would the change in laws andregulations constitute ‘a change in circumstances external to the contractualarrangement’ and trigger reclassification under the proposed requirements inIAS 32.32B? Our respondents are concerned about the potential complexity thatmay arise if reclassification is required whenever such changes occur, eventhough they may not be frequent.Page 6 of 20D. Classification of an incremental contractual right and obligation in its entirety

5.Some respondents found the proposal in IAS 32.AG24B to be counter-intuitive anddifficult to comprehend. Applying the proposal, an ordinary share with statutoryminimum dividend of 10% is classified as an equity instrument, while anotherordinary share subject to the same statutory requirement but containing acontractual dividend of 10.1% is classified entirely as a financial liability, instead ofbeing classified as an equity instrument of 10% and a financial liability of 0.1%. Ourrespondents noted that the different classification resulting from such a small butgenuine difference in the dividend payout ratio would not provide meaningfulinformation, would impede comparability between different entities, and potentiallycreate structuring opportunities.We acknowledge that there are certain situations where separating a contractualobligation and accounting for each element individually might be complex. However,for the reasons stated in BC24 of the ED, we consider that entities should separatelyaccount for the regulatory obligation and the incremental contractual obligation,unless it is impracticable to do so, in which cases entities would classify the entireobligation as a financial liability and provide additional disclosures. Such approachwould provide useful information to users of financial statements and would beconsistent with the concept of bifurcation in IAS 32.E. Our recommendations

6.Overall, we consider that the effects of laws and regulations are an important yetcomplex issue that has broad implications. They either interact with or haveimplications for other existing IFRS Accounting Standards (e.g. IFRS 9 FinancialInstruments, IAS 37 and IFRIC 2). We also understand that a complete alignmentof the accounting classification with the legal view would fundamentally change theexisting requirements in IAS 32 and IFRS 9, which is not the objective of this project.In light of this and our respondents’ concerns, we recommend the IASB seriouslyreassess the feasibility of the proposals, conduct field tests to assess the impactand clarity of the proposals on different financial instruments, and evaluate whetherthe outcomes reflect the substance of the instruments and provide relevantinformation considering the different legal systems between jurisdictions,particularly between those based on civil law versus common law.

7.If the IASB were to proceed with the proposals, we recommend the IASB undertakethe following actions:

-Clarify the extent of laws and regulations that should be considered indetermining the classification of financial instruments;

-Clarify the initial recognition and subsequent measurement of contractualdividend that would be disregarded in the classification;

-Consider accounting for regulatory obligation and incremental contractualobligations separately, unless it is impracticable to do so; and-Provide supporting guidance (e.g. illustrative examples on common instruments)

to avoid potential diversity in application and unintended consequences.Page 7 of 20Question 2: Settlement in an entity’s own equity instruments(paragraphs 16, 22, 22B-22D, AG27A and AG29B of IAS 32)

8.We generally welcome the proposals to clarify the principles in IAS 32 regarding thefixed-for-fixed condition. However, we have significant concerns about theaccounting implications of applying the proposals to certain common contractualterms in Hong Kong. Our concerns and recommendations are summarised asfollows.A. Preservation adjustments for issue of new shares below market price

9.Several respondents from large accounting firms expressed significant concerns thatthe proposals in IAS 32.22C(a)(ii) would impact the current practice in respect ofclassification of conversion options in convertible bonds (CBs) whose terms providefor an adjustment to the conversion ratio when an entity issues shares to newinvestors below market price in order to compensate the CB holders for the dilutionloss.

10.Currently, the market widely accepts such adjustment to conversion price as anti-dilutive and meeting the fixed-for-fixed condition because:

-The adjustment protects the rights of CB holders relative to the current and futureequity holders taken together. It focuses on preserving the CB holders’ interestswithout regard to whether such a preservation would be to the detriment ofcurrent equity holders. As such, whether the current shareholders’ interests getpreserved is not a consideration in the formula.-In addition, the current shareholders can exercise their rights to preserve theirinterests by voting for or against issuing shares at below market price, while CBholders, who cannot vote, are compensated for the potential dilution lossthrough an enhanced conversion ratio. Also, issuing a large number of sharesat a discount to improve liquidity of the shares also makes commercial sense.

11.However, such adjustment may cause the CBs to fail the fixed-for-fixed conditionunder the proposals in IAS 32.22C(a)(ii) because the CB holders are compensatedwhereas the current shareholders are not, meaning that the economic interests ofthe CB holders are preserved to a larger extent relative to the current shareholders(AG27A(c) of the ED).

12.Given that the vast majority of the CBs issued by Hong Kong issuers include suchan adjustment in their contracts, the IASB proposals, if implemented, would resultin the retrospective reclassification of the conversion options of these CBs fromequity to derivative liabilities. Furthermore, we understand that the guidancepublished by certain large international accounting firms treats such adjustment asanti-dilutive. Hence, the proposals would also affect the current practice in othermarkets where we understand such instruments are also issued.

13.Considering the significance and pervasiveness of the potential change of theclassification of CB’s conversion options in Hong Kong, we strongly recommend theIASB carefully consider the implications of the proposals on existing market practicesand provide clarification. In order to ensure that such clauses are not an impedimentto equity classification of affected CBs, the IASB could consider clarifying themeaning of ‘current holders of equity instruments’ so as to include all equityinstrument holders at the date of, and arising from, the ‘contractually specified event’Page 8 of 20in proposed paragraph IAS 32.22C(a) which leads to the dilution of future equityinstrument holders.B. The use of a volume weighted average share price to adjust a conversion ratio

14.Another concern is related to the accounting implications of the conclusion inExample 17 in the ED on the use of a volume weighted average share price (VWAP)

to adjust the conversion ratio in CBs. We noted that, in practice, the share priceused to determine the extent of dilution arising from right issues or share issuesbelow market price is often calculated as the VWAP over a specified period beforethe diluting event occurs, instead of using the share price at a point in time justbefore that event occurs. For reasons ranging from corporate governance tosecurities law, this approach is adopted to avoid outliers or price spikes and isgenerally considered meeting the fixed-for-fixed condition by the market.

15.However, Example 17 states that the use of the average share price to determinethe conversion price of a CB does not meet the fixed-for-fixed condition because itwould favour the CB holders with additional shares at the expense of the ordinaryshareholders if the average share price decreases. Based on the rationale inExample 17, we questioned whether using VWAP as a basis for determining theadjustment to a conversion ratio would no longer be considered a preservationadjustment in the ED. To illustrate our concern, consider an example where newshares are sold to existing shareholders at $5 per share when the last share pricebefore the announcement was $7 per share, resulting in a dilution of $2 per share.According to the ED, a preservation adjustment could be up to $2 to meet the fixed-for-fixed condition. However, if a 20-day VWAP is adopted in the preservationadjustment calculation, the share price used for the adjustment could be $8,resulting in an adjustment of $3 instead of $2. Consequently, the CB holder isarguably favoured with additional shares at an enhanced conversion ratio when a20-day VWAP is used.

16.Considering the common use of VWAP in Hong Kong as a measure to preventpotential market manipulation and the existence of differing practices in determiningthe period for a VWAP calculation, we strongly recommend the IASB clarify theapplication of the proposals to VWAP, particularly whether VWAP clauses can meetthe fixed-for-fixed condition. Furthermore, acknowledging the challenges indesigning a preservation adjustment that would completely eliminate any possibilityof overcompensating CB holders relative to current equity holders, the IASB couldconsider the relative merits of changing the proposed criteria for preservationadjustments in IAS 32.22C(a)(ii) so it reads:

-‘preserves the economic interests of the future holders of the entity’s own equityinstruments (the future equity instrument holders) to an approximately equal orlesser extent…’ (which would likely require a qualitative test), or-‘is designed to preserve the economic interest of the future holders of the entity’sown entity instruments (the future equity holders) to an equal or lesser extent’(which would amount to a qualitative assessment).In addition to its own considerations, the IASB may wish to conduct field test ordiscuss with preparers or users the proposals and how the market currentlyconsiders such adjustments.Page 9 of 20C. Passage-of-time adjustments

17.Our respondents raised concerns about the application of the proposed passage-of-time adjustments on the following two common contractual terms:

-CBs carrying an interest rate benchmark: Currently, entities generallyconsider CBs with an interest rate benchmark as meeting the fixed-for-fixedcondition because they consider that the ‘fixed amount of cash’ requirement inIAS 32.22 is met whenever the contract has a ‘fixed stated principal amount’. Inaddition, IAS 32.22 further specifies that ‘changes in the fair value of a contractarising from variations in market interest rates that do not affect the amount ofcash or other financial assets to be paid or received…on settlement of thecontract’ do not preclude equity classification. However, Example 20 and BC 57of the ED state that an adjustment linked to a variable, such as an interest ratebenchmark, would not be considered a passage-of-time adjustment becausesuch an adjustment does not solely vary with the passage of time. Consequently,the proposals appear to change the current practice of classifying the conversionoptions as equity to derivative liabilities. On the other hand, Example 14 in theED describes a CB with accrued interest where the conversion option passesIAS 32.22B (assuming there are no other features that fail equity classification).Example 14 does not state whether the interest rate that accrues is fixed orfloating so it is ambiguous whether a floating rate of interest in this case is apassage-of-time adjustment that passes the criteria in IAS 32.22C(b).In any case we believe that the idea of a ‘passage-of-time adjustment’ for thesepurposes should extend to either compensation for passage of time based onbenchmark interest rates over periods of time (which could change) or a locked-in interest rate over that same period at contract inception.-Change of control provisions: These provisions are common as protectiverights for CB or derivative holders, as they allow for adjustments to theconversion ratio to compensate for the loss of time value in the option and theloss of optionality following a change of control event, such as when a listedcompany is being privatised. The inputs used to estimate an option value couldinclude other parameters, such as share price and share price volatility, whichvary based on the remaining option life. These inputs are inter-dependent incalculating the time value of an option. Currently, the market treats many of theseprovisions as anti-dilutive adjustments.However, IE 80 of the ED explicitly states that if the predetermined formula forthe adjustment to a conversion ratio includes the share price as an input, suchan adjustment would not be a passage-of-time adjustment. Therefore, theproposals could cause some of the cases that currently meet the fixed-for-fixedcondition to fail under the proposed passage-of-time requirement in IAS

32.22C(b) because:

They may not be predetermined at the inception of the contract (IAS

32.22C(b)(i));

They may not vary with the passage of time only (IAS 32.22C(b)(ii)); andThey may not always be linear and proportionate over time (IAS 32.22C(b)(iii))

even though the adjustment is anti-dilutive.Page 10 of 20

18.In light of the above concerns, we recommend the IASB:

-Clarify and reconsider whether financial instruments linked to interest ratebenchmark would still meet the fixed-for-fixed condition under the ED; and-Clarify and explain its expectation of the calculation of a passage-of-timeadjustment for change of control provisions through illustrative examples.Question 3: Obligations to purchase an entity’s own equity instruments(paragraphs 23 and AG27B-AG27D of IAS 32)

19.We generally agree with the proposed clarifications on the requirements forcontracts containing an obligation for an entity to purchase its own equityinstruments.

20.Nevertheless, some respondents have expressed concerns about the proposalsregarding the initial and subsequent measurement of this obligation in IAS 32.23 ofthe ED. Given the proposed measurement principles are largely the same as thosein IAS 32.25 and 25A for contingent settlement provisions, the comments providedby the respondents are summarised in Part C of Question 4 below (see in particularparagraphs 31 and 33 of our response below).Question 4: Contingent settlement provisions(paragraphs 11, 25, 25A, 31, 32A, AG28 and AG37 of IAS 32)

21.We appreciate the efforts made by the IASB to clarify this important area. However,we have the following concerns about the proposals.A. Scope of financial instruments subject to IAS 32.25 and 25A

22.Our respondents raised concerns about the potential implications of the proposedamendments to IAS 32.25 and 25A. Specifically, the current wording of theamendments seem to imply that the measurement requirements in IAS 32.25Awould apply to all financial instruments with contingent settlement provisions,including those that are currently measured solely under IFRS 9, and this couldresult in unintended consequences.

23.Consider a written put option (other than over own equity instruments) that iscontingently exercisable if the stock market index rises by a certain percentage.Applying the proposals, such a written put option would be measured at the fullsettlement amount instead of at its fair value. This would inadvertently result in aday-1 loss for the option writer whenever the option premium received (which equalsthe option’s fair value on initial recognition) is lower than the full settlement amount.Another example relates to debt instruments with contingent settlement provisions.Consider a three-year fixed rate loan that includes an early redemption optionexercisable by the holder at 105% of its par value in the event of a change of controlover the issuer. Applying the proposals, the loan would be initially recognised at105% of par, even if the loan is issued at market rate (and thus has an initial fairvalue equal to par) and the likelihood of a change of control is low. The accountingoutcomes of these two examples would be different from the current practice whereIFRS 9 measurement is applied. We believe that the IASB does not intend for suchaccounting outcomes, but the proposals in the ED are not clear in this regard.Page 11 of 20

24.We consider that the lack of clarity and guidance on the scope of financialinstruments subject to IAS 32.25 and 25A poses a risk of misapplication of theproposed measurement on derivatives for written puts other than over own equityinstruments and debt instruments with contingent settlement clauses, leading tounintended outcomes. Hence, we strongly recommend the IASB clearly define thescope to avoid diversity in practice and to minimise the risk of misapplication.B. Measurement approach in IAS 32.25A

25.Our respondents expressed divergent opinions on the measurement principleproposed in IAS 32.25A. Some respondents agreed with the proposals to measurethe financial liability at its full amount without considering the probability andestimated timing of settlement. They formed their views based on BC11-12 of IAS32 that IAS 32.23 and IAS 32.25 have the sole purpose of creating a gross liabilityfor obligations that are conditional on events or choices that are beyond the controlof the issuer. This is different from a typical financial liability, such as a bank loanrecognised under IFRS 9, which represents an economic burden for an entity.

26.However, other respondents disagreed with the proposals to ignore the probabilityand estimated timing of the contingent events in measuring the financial liabilitieswith contingent settlement provisions. One of these respondents pointed out thatthe measurement requirements for compound financial instruments in existing IAS

32.30-32 provide a more suitable framework for determining the measurementrequirements of compound financial instruments with contingent settlementprovisions. Measuring the liability component at fair value is also consistent with themeasurement principle for contingent consideration that meets the definition of afinancial liability, as required under IFRS 3 Business Combinations (IFRS 3.39 and58). This would better reflect the economics of the transaction and provide usefulfinancial information, for example, in the following cases:

-Entity X issued redeemable preferred shares that include contingent settlementclauses. In the event that Entity X fails to meet a specific condition, such asachieving a specified level of net income, the preferred shares becomeimmediately payable. In addition, the distribution to preferred shareholders isdiscretionary. Applying the proposals, Entity X would be required to initiallymeasure the liability component at the full settlement amount, assuming abreach of that condition had occurred. However, this respondent considered thatit would be more sensible to assess the likelihood of a condition being breached(a contingent event) and measure the liability component of the preferred sharesaccordingly. This approach is consistent with the measurement of bank loansthat are subject to the same condition applying IFRS 9. In practice, entitiesconsider the probability of a breach of a condition when measuring such loans,rather than assuming an immediate breach of the covenant.-Entity Y issued preferred shares with a coupon rate equivalent to that of ordinaryshares. These shares would be converted into a fixed number of Entity Y’sordinary shares if Entity Y successfully completes an initial public offering withina 5-year period. Holders of these shares also have the option to redeem themat their principal amount and interest in the 5th year. However, if Entity Y fails tomeet the profit targets, the redemption amount would become 120% of theprincipal amount and interest. Applying the proposals, Entity Y would berequired to measure the liability component at the present value of 120% of theprincipal amount and interest. However, entities generally considered it morereasonable to factor in the likelihood of meeting the profit targets in determiningPage 12 of 20the liability host contract and then bifurcate the embedded derivatives to bemeasured at fair value before recognising the equity components.

27.We note the IASB’s intention to align the measurement approach (i.e. full amountpayable at the earliest possible date) with the requirements in IAS 32.23. We alsonote the IASB’s concern about the complexity of the probability-weightedmeasurement approach (BC101 of the ED). However, some of our respondentsbelieve that the probability-weighted approach has worked well when measuringsimilar instruments with contingent settlement clauses. In their view, the currentpractice also provides relevant financial information to users of financial statements.

28.In light of the differing views expressed by our respondents, we recommend theIASB conduct field tests using both measurement approaches on a broad range ofcontingent settlement clauses. By evaluating the accounting outcomes resultingfrom these tests, the IASB can make an informed decision on whether a singlemeasurement approach or a combination of approaches would best providerelevant financial information.C. Potential practice issues of IAS 32.25A

29.In relation to the proposals in IAS 32.25A to measure the financial liability at thepresent value of the settlement amount at the earliest possible settlement date, wehave identified a few practice issues that warrant attention and further considerationby the IASB. We recommend the IASB provide guidance or clarifications, should itproceed with the proposals. These issues are summarised as follows.

30.Firstly, making the assumption to settle at the earliest possible date may not alwaysreflect the maximum exposure and depict the liquidity risk of the issuer, for example,in the following cases:

-A holder of a written put option can exercise his right to redeem at $100 at anytime, but the redemption amount increases to $100 million if it is redeemed in the5th year. The liability of $100 on initial recognition has little substance butrepresents a clearly genuine clause (something could happen to make it worthexercising, although the likelihood is low). As the issuer would only remeasurethe liability to $100 million in the 5th year under the proposals, it has arguablyinappropriately benefitted from a higher net asset value for the intervening period.-Contracts with multiple settlement provisions may have the highest settlementamount (even on a present value basis) occurring at a later possible settlementdate.-Contracts with a redemption obligation that is subject to growth at a rate of x%,but the discount rate is lower than x%, assuming settlement at later dates aremore likely in this case.

31.Secondly, the ED has not provided any guidance on determining the discount ratefor calculating the present value of the settlement amount. Unlike IFRS 9, where thediscount rate can be derived from the fair value and undiscounted contractual cashflows of the financial liability at initial recognition, the financial liability for theobligation in question is not initially recognised at fair value under the proposals.Hence, the discount rate is an input instead of an output (as it is in the case of theeffective interest method). However, the ED does not provide guidance on how toselect or develop the discount rate, and whether it needs to be updated insubsequent reporting periods.Page 13 of 20

32.Thirdly, the ED lacks clarity on the measurement of the financial liability when thecontingent settlement clause is not settled by cash but by another financialinstrument that is also subject to contingent settlement provisions. The followingexample illustrates this issue:

-A group has two companies that have issued preference shares. Company Aissued Type A preference shares that are the same as its ordinary shares except:

In case of Event A1, the share is redeemable at $100, which was its issueprice.In case of Event A2, the share is convertible into one Type B preferenceshare of Company B.-Company B issued Type B preference shares that are the same as its ordinaryshares except that in case of Event B, the share is redeemable at $120.-All the Events (A1, A2 and B) are beyond the control of the issuer and the holder,and could occur at any time. At the reporting date, the fair value (as defined inIFRS 13 Fair Value Measurement) of both Type A and Type B preference sharesis $100 per share.Questions arise as to how the liability arising from a Type A preference share shouldbe measured in the consolidated financial statements of the group. Should theliability be measured at $100, being the fair value of a Type B preference share, orshould it be measured at $120, being the settlement outcome that the issuer ‘doesnot have the unconditional right to avoid’? If Events A2 and B happened inimmediate succession, the issuer could not avoid delivering $120.

33.Lastly, the ED lacks clarity on how the remeasurement of financial liability shouldbe conducted for contracts with multiple contingent settlement provisions and thetriggers for settlement are mutually exclusive.For example, an entity issued a preference share which is the same as an ordinaryshare except that it is redeemable at $10 in case of a change of control event (EventX), and at $15 if the founders leave the entity within 5 years of issuance of thepreference shares (Event Y). Both events can happen at any time. The issuer wouldinitially recognise the gross liability at the higher of the two liabilities, i.e. $15, todepict the liquidity risk of the issuer.If the preference share remains unsettled after 5 years, the liability of $15 ceases toexist because Event Y can no longer occur. Since IAS 32.25 and 25A do not providespecific guidance for contracts with multiple contingent settlement provisions,questions arise as to whether the issuer should follow the principle in IAS 32.23 forreason specified in paragraph 25 above. If the principle in IAS 32.23 is applied, theissuer would remove the gross liability of $15 and include the amount in equity whenEvent Y expires. However, as the gross liability of $10 for Event X still exists, theissuer would reclassify only $5 to equity and retain a liability of $10.Some respondents disagreed with presenting the $5 as a remeasurement gain inprofit or loss based on the proposals in IAS 32.25A for the following reasons:

-The $5 arose from the expiry of an obligation that was accounted for as a grossliability (i.e. Event Y), not a normal financial liability; and-The gross liability does not represent a present economic burden of the issuerat the date of derecognition and the reduction of $5 in the gross liability does notPage 14 of 20represent an economic gain for the issuer (i.e. there was no loss for the otherparty). This is different from a scenario where an issuer has a bank loan of $10that ‘expires’ without having to be repaid, in which case it would be a faithfulrepresentation of the event to recognise a gain of $10 upon derecognitionbecause the issuer is relieved from the economic burden of the bank loan ‘forfree’.This issue would also occur in conjunction with IAS 32.23 when the written putoption is contingently exercisable at different exercise prices for different triggeringevents.Question 5: Shareholder discretion(paragraphs AG28A-A28C of IAS 32)

34.We acknowledge the challenge of providing guidance on determining whethershareholder discretion should be treated as an entity’s decision, considering thatdifferent jurisdictions have their own laws, regulations and legal frameworks.Consistent with the majority of our respondents’ views, we generally support theIASB’s approach to establishing several broad factors to assist entities in makingthis determination. We consider that the proposal provides guidance and anappropriate level of flexibility for entities to exercise judgement when determiningthe classification based on their specific circumstances, and at the same time, it alsohelps reduce diversity in practice.

35.Nevertheless, a respondent who disagreed with the proposal questioned thefeasibility of using the four proposed factors to determine whether shareholderdiscretion should be treated as an entity’s decision. This respondent illustrated hisconcerns by explaining how the factors could be applied in an example of a capitalreduction of ordinary shares with subsequent pay-outs of the reduced amount:

-1st factor: Capital reduction is not considered a routine decision and occurs onlyoccasionally for certain entities.-2nd factor: In some major jurisdictions, shareholders can propose capitalreduction themselves with management’s assistance in enforcing the proposal.-4th factor: Exercising shareholders’ decision-making right would enable theshareholders to require the entity to make the pay-outs.Accordingly, depending on how an entity applies the factors, it is possible for anentity to arrive at a conclusion that shareholder decision is unlikely to be treated asan entity’s decision, resulting in the classification of ordinary shares as financialliabilities. This outcome apparently contradicts the market practice that ordinaryshares are equity instruments.

36.We note that the proposed IAS 32.AG28B explicitly states that the four factors arenot exhaustive. It emphasises the importance of exercising judgement in assessingthese factors and considering other relevant factors based on the entities’ owncircumstances. However, in light of the potential issue raised by the respondent (seeparagraph 35), we suggest that the IASB explore providing illustrative examples todemonstrate the application of the four factors, identification of other relevant factors,and determination of their weightings in different scenarios. These examples couldspecifically address the situation of capital reduction of ordinary shares that waspreviously mentioned. We believe that the IASB could explore the usefulness ofdeveloping such illustrative examples, taking into account the benefits of clarifyingPage 15 of 20the treatment in common scenarios and the risk of needing to illustrate very specificand limited circumstances that may not be suitable for illustrative examples.Question 6: Reclassification of financial liabilities and equity instruments(paragraphs 32B-32D and AG35A of IAS 32)

37.We welcome the IASB’s efforts to address this important area, as currently IAS 32does not contain any specific requirements on whether and when to reclassify aninstrument after initial recognition. However, we have significant concerns about thefollowing two major areas in the proposal.A. Prohibition of reclassification of a financial instrument when there is a change in thesubstance of contractual arrangement due to passage of time

38.We disagree with the proposal that prohibits reclassification when there is a changein the substance of the contractual arrangement due to the change in the passageof time (‘Prohibition’) for the following reasons:

-IAS 32 establishes classification requirements that are definition-driven.Therefore, if a financial instrument no longer meets the definition of a liability orequity, a change in its classification should be warranted. However, theProhibition would require an entity to retain the classification of the instrument asa financial liability, even though the definition of ‘financial liability’ under IAS 32is not met. Accounting for the instrument as such might misrepresent thesubstance of the financial instrument and the entity’s situation, potentiallytriggering the ‘true and fair’ override to achieve a fair presentation of the financialstatements.-The proposal could create potential structuring opportunities for entities torecognise gains in profit or loss without the occurrence of a performance event.Consider the case of a preference share with a contingent settlement provision.Initially, the issuer recognises a gross liability under IAS 32.25A. When thecontingent settlement provision stops being effective due to the passage of time,the Prohibition would prevent reclassification of the preference share to equity.The preference share which is still accounted for as a gross liability would beremeasured to nil under IAS 32.25A and BC143. Consequently, a gain equal tothe carrying amount of the gross liability would be recognised in profit or loss atthe remeasurement date, although there is no performance event.-We are not convinced by the IASB’s assertion in BC138-139 and 145 of the EDthat reclassification would increase cost and complexity for preparers due to theneed to assess whether an instrument should be reclassified at each reportingdate, and this assessment could be onerous for preparers. Preparers alreadyneed to monitor whether certain contractual terms have expired / stopped beingeffective when remeasuring the instruments and preparing the proposeddisclosures under IFRS 7.30F. Furthermore, reclassification is beneficial forusers in understanding the financial statements, as it appropriately reflects thechange in the substance of the contractual arrangement.-We do not support the IASB’s approach of requiring entities to disclose thecontractual terms and conditions of financial liabilities that become or stop beingeffective with the passage of time as a means to compensate for the Prohibition.We do not think this is the appropriate approach to address this issue, based ona view similar to the requirement in IAS 1.18, which states that ‘[a]n entity cannotPage 16 of 20rectify inappropriate accounting policies either by disclosure of the accountingpolicies used or by notes or explanatory material’.In view of the above, we strongly recommend the IASB reconsider its reclassificationproposal relating to the passage of time, and remove the Prohibition.

39.If the IASB decides to proceed with the proposal of Prohibition, we suggest that theIASB:

-State explicitly in the body of the standard that the derecognition requirements ofIFRS 9 do not apply to situations when the terms and conditions in a contractualarrangement have expired or become ineffective due to the passage of time. Thisclarification is necessary because several respondents raised this question,despite BC128 of the ED having already set out the IASB’s relevantconsiderations; and-Include a reference to the ‘gross liability’ model under IAS 32.25 and 25A inBC143. This reference is important because the Prohibition would generallyapply to obligations that are measured using the ‘gross liability’ model, and thismodel differs from the ‘amortised cost’ and ‘fair value’ models under IFRS 9,which are currently referred to in BC143.B. Interactions between the proposals on reclassification and the effects of laws andregulations

40.We consider that the proposal also lacks clarity regarding whether a subsequentchange to laws and regulations would constitute a change in the substance of thecontractual arrangement due to ‘changes in circumstances external to thecontractual arrangement’. As mentioned in paragraph 4 above, the proposal isunclear whether reclassification would be required when there is a change in thelaw that creates incremental contractual obligations. It is also unclear whetherreclassification would be required when a change in law prevents the enforceabilityof the contractual rights and obligations.

41.Therefore, we are of the view that the proposal on reclassification interacts with theproposal on the effects of laws and regulations. Accordingly, we stronglyrecommend that the IASB consider the two proposals together and ensure that theirinteractions are adequately considered and addressed.Question 7: Disclosure(paragraphs 1, 3, 12E, 17A, 20, 30A-30J and B5A-B5L of IFRS 7)

42.We acknowledge the IASB’s efforts in responding to the information needs of usersand improving the quality of disclosures related to financial instruments withcharacteristics of equity. Although many of the proposed disclosures individually arebeneficial, we consider it crucial to strike a balance between the potential costs andbenefits associated with the disclosures as a whole. We are concerned that theexpected costs associated with implementing the proposed new disclosures as awhole would outweigh the potential benefits. Accordingly, we recommend the IASBperform field testing of the proposals for entities of different sizes, particularlymultinational entities with complex financial instruments, to assess the associatedcosts and benefits. In addition, we have comments and recommendations on thefollowing specific disclosures proposed by the IASB.Page 17 of 20A. Disclosure on the nature and priority of claims against the entity on liquidation, arisingfrom its financial liabilities and equity instruments [IFRS 7.30A-30B, IG14B-14C]

43.Our respondents questioned the usefulness and practicability of disclosing thenature and priority of claims in the consolidated financial statements in complexsituations, such as in a group where various claims arise from subsidiaries indifferent jurisdictions with different legal framework on liquidation. Summarising theclaims against subsidiaries in a single note to the consolidated financial statementsmay not provide meaningful information to investors to understand the priority ofclaims of their investments.

44.In addition, although the ED has provided an illustrative example in IG14C on theapplication of the proposed disclosure requirement, that example only demonstratesa simple scenario. We anticipate that complexities and operational challenges inpractice would exist as mentioned above.

45.In this regard, we suggest the IASB consider adopting a similar approach to that inIFRS 12.12, which would require entities to provide disclosures about the natureand priority of claims for each of their subsidiaries that have financial instrumentswith characteristics of equity that are material to the reporting entity.B. Disclosure on potential dilution of ordinary shares [IFRS 7.30G-3H, B5I-5L, IG14H]

46.Some respondents considered it more appropriate to propose the disclosure onpotential dilution of ordinary shares in IAS 33 Earnings per Share, instead of IFRS7, given that IAS 33 already includes similar disclosures, such as diluted earningsper share (EPS). Others are concerned that the proposed new disclosure,regardless of its location in IAS 33 or IFRS 7, could potentially confuse users,particularly in terms of how it is different from the determination of the denominatorin the calculation of diluted EPS in IAS 33. Accordingly, we suggest the IASBconsider adding disclosures to reconcile the new disclosure with diluted EPS inorder to avoid such confusion, if the IASB decides to proceed with the proposal.

47.In addition, a few respondents questioned the practicability of disclosing adescription of contracts or other commitments to repurchase ordinary shares andthe minimum number of each class of ordinary shares the entity is required torepurchase as proposed in IFRS 7.30G(b), particularly in the case of ‘Share buy-back’ as illustrated in Table 1 in IG14H. They explained that in practice, entities donot know the exact number of shares to be repurchased in the future, as share buy-back transactions are usually framed in terms of dollar amount expected to be spent,rather than the number of shares planned to be repurchased. Furthermore, anannounced share buy-back only indicates an entity’s intent and does not representa legal commitment. In view of this, we suggest categorising the item of ‘Share buy-back’ in the illustrative disclosure as ‘Unknown number of share buy-back’, on thecondition that the entity has entered into contracts or commitment to repurchase itsordinary shares.C. Disclosure on information about financial instruments that include an obligation foran entity to purchase its own equity instruments [IFRS 7.30J]

48.Some respondents questioned the usefulness of adding the proposed disclosuresin IFRS 7.30J, as IAS 1 already sets out similar requirements to provide the relevantinformation. Specifically, the proposed disclosure on equity movements for the entityto repurchase its own equity instrument duplicates the information alreadypresented in the statement of changes in equity. Furthermore, the proposedPage 18 of 20disclosures on remeasurement gains or losses recognised during the period andgains or losses on settlements should have been presented as separate line itemsunder IAS 1.85 if the amounts are material. Introducing these duplicated disclosurerequirements in IFRS 7 would not only result in increased costs for preparers butwould also lead to excessive amount of information, potentially obscuring othermaterial information. Given these concerns, we recommend the IASB reassess thecosts and benefits associated with adding these disclosure requirements.D. Disclosure on information about terms and conditions [IFRS 7.30D]

49.We consider that the proposed disclosure in IFRS 7.30D(a) regarding the terms andconditions of financial instruments that determine their classification as financialliabilities or equity instruments, as well as the proposed disclosures in IFRS

7.30D(b)(i) and (ii) regarding the cash flow characteristics that are notrepresentative of the classification of financial liabilities or equity instruments but arerelevant to an understanding of the nature of those financial instruments, areparticularly useful in helping users gain a better understanding of the nature of ‘debt-like’ instruments classified as equity instruments and ‘equity-like’ instrumentsclassified as financial liabilities. These disclosures are especially relevant forsignificant investments made by pre-IPO investors or other investors with complexarrangements. Accordingly, we recommend the IASB retain these disclosures whenreassessing the proposed disclosures in the ED during the finalisation of theproposal.Question 8: Presentation of amounts attributable to ordinary shareholders(paragraphs 54, 81B and 107-108 of IAS 1)

50.We have concerns about the usefulness and the practicability of implementing theproposed presentation of amounts attributable to ordinary shareholders separatelyfrom amounts attributable to other holders of the entity’s own equity instruments.

51.From a usefulness perspective, we noted that BC256 of the ED indicates that thepresentation of equity attributable to ordinary shareholders and other equity holdersis based on the contractual terms applicable at the reporting date. It does not includeamounts expected to become attributable to those equity holders upon theoccurrence of future events. This means that the allocation is solely determinedbased on the circumstances at the reporting date, without the need for any forward-looking estimation. However, we question whether the presented amounts canprovide useful and meaningful information to users in this case. This is becausethese amounts can be subject to various future changes in the entity’scircumstances, but their determination does not take into account any forward-looking estimation of these changes, which could significantly impact the amounts.

52.From a practical perspective, our respondents emphasised the practical difficultiesinvolved in determining an appropriate allocation of various types of reserves, otherthan retained earnings, between ordinary shareholders and other owners in theconsolidated financial statements. Examples of such reserves include foreignexchange reserve and fair value reserve of financial instruments measured at fairvalue through other comprehensive income. The respondents did not consider theallocation to be a simple apportionment exercise. They also questioned whethermanagement would need to make assumptions based on the applicable contractualterms in determining the allocation. If so, the process could be difficult andchallenging, depending on the circumstances of the entity.Page 19 of 20

53.In light of the above concerns, we recommend that the IASB reassess the costs andbenefits of the proposal and reconsider whether to proceed with the proposal. If theIASB decides to proceed with the proposal, we suggest the IASB:

-Provide guidance and illustrative examples to explain how the allocation shouldbe performed under different scenarios (e.g. foreign exchange reserve, fair valuereserve) based on some common fact patterns in practice; and-Clarify in the body of the standard that the proposed allocation of reserves doesnot require the use of forward-looking information (BC256 of the ED). Thisclarification is necessary as some respondents have misinterpreted that theallocation involves estimation of occurrence of future events.Question 9: Transition(paragraphs 97U-97Z of IAS 32)

54.We support the IASB’s proposal of applying a full retrospective approach for theproposed amendments. In particular, we agree that the retrospective application ofthe proposed amendments would ensure consistency of financial informationbetween periods and facilitate analysis and understanding of comparativeinformation.

55.Considering that the proposed amendments may result in changes to theclassification and measurement of certain complex financial instruments, werecommend that the IASB allow sufficient time for entities to implement the proposalwhen it determines the effective date of the amendments.Question 10: Disclosure requirements for eligible subsidiaries(paragraphs 54, 61A-61E and 124 of [IFRS XX])

56.Our respondents consider that the proposal does not provide an appropriate levelof relief to eligible subsidiaries without public accountability (‘Eligible Subsidiaries’),despite the objective of IFRS XX being to simplify and reduce the cost of financialreporting for these subsidiaries through reduced disclosures. In particular,-As explained in paragraph 48 above, certain proposed disclosures in relation tofinancial instruments that include an obligation for an entity to purchase its ownequity instruments appear to duplicate the existing requirements in IAS 1, andtherefore are excessive.-Some respondents expressed the view that the disclosures concerning thenature and priority of claims on liquidation arising from financial instruments havelimited usefulness for Eligible Subsidiaries, especially those that are private,closely-held subsidiaries with sophisticated investors, such as private equityfunds. These respondents considered that these investors would have acomprehensive understanding of the contracts when making their investments.

57.We conducted a high-level comparison between the proposals in IFRS 7 and theconsequential amendments to IFRS XX. It appears that the main relief provided toEligible Subsidiaries is the exemption from providing disclosures on the potentialdilution of ordinary shares. In light of this, we are concerned that the costsassociated with implementing all the proposed additional disclosures for IFRS XXmight undermine the objective of simplifying and reducing the cost of financialreporting for Eligible Subsidiaries, and that these costs may outweigh the associatedbenefits.Page 20 of 20

58.Considering the nature of Eligible Subsidiaries and the need to balance costs andbenefits, we suggest the IASB conduct further analysis or test the proposals onsome common types of Eligible Subsidiaries to assess the potential significance andrelevance of each proposed disclosure.~ End ~