The anticipated amendment to IAS 32, which addresses the critical distinction between equity and financial liabilities, should tackle a fundamental distortion in the standard regarding the classification of derivatives on derivatives. Under the standard as currently drafted, and in contrast to US GAAP, a commitment to issue an “equity option” in the future results in the recognition of a financial derivative until the “equity option” is actually issued, even though there is no doubt that the transaction is, in its entirety, an equity transaction. The distortion can be even more severe in a forward transaction to issue a package comprising shares and options, because the distorting requirement to measure the option component of the forward at fair value may drag the share component of the forward into similar treatment. Beyond the distortion in the statement of financial position, since the derivative is measured at fair value through profit or loss, the classification can create a significant distortion in the measurement of reported results. Although the rationale of “fixed-for-fixed” is understandable and sound, the distortions arising from this rule, which may also influence companies’ business conduct, must be eliminated.
In the second half of 2026, an amendment to IAS 32 addressing the important distinction between equity and financial liabilities is expected to be published. Beyond the significant impact of the classification on financial ratios such as financial leverage and return on equity, classifying an issued instrument as equity or as a financial liability also determines whether payments on the instrument are treated as dividend distributions to equity holders or as interest expense payable to creditors, respectively. This saga, which appears to be nearing its conclusion, began more than a decade ago, when in 2012 the IASB published an agenda paper identifying economic problems and distortions arising, inter alia, from the “fixed-for-fixed” requirement for classifying an issued instrument as equity.
The starting point for the “fixed-for-fixed” requirement is the perspective of the holder, based on the rationale that when the issuer uses its own equity instruments as currency, the instrument shall be classified as a financial liability. This reasoning is relevant to cases where the holder is entitled to receive a variable number of shares whose aggregate value at the settlement date equals a fixed amount of cash. In such cases, there is some justification for classifying the instrument as a financial liability, since prior to settlement the holder is indifferent to changes in the fair value of the shares, and its economic position differs fundamentally from that of a shareholder. The problem lies in the fact that, to plug a small gap and prevent the classification as equity of such an instrument, IAS 32 blocked the entire passage — including, for example, cases involving the issuance of an option whose exercise price is denominated in a foreign currency. As a result, workaround exceptions have developed in practice, such as anti-dilution provisions, which the forthcoming amendment seeks to address.
Derivative on an Equity Derivative
The problem is that the anticipated amendment does not address a fundamental economic distortion in the fixed-for-fixed requirement as it applies to derivatives on derivatives. IAS 32 establishes an exception to the rule whereby a derivative instrument settled by the issuance of a fixed number of own equity instruments in exchange for a fixed amount of cash is classified as equity. Under the exception, if upon settlement of the original instrument a further instrument is issued that constitutes a contract for the future delivery of shares, the original instrument may not be classified as equity. The Basis for Conclusions accompanying the standard notes that the intention was to prevent equity classification in cases of derivatives on derivatives on own equity, without elaborating on the basis for this intention or the rationale for classifying such an instrument as a financial liability.
Consider, for example, a case in which an investor wishes to acquire an “equity option”, exercisable into one share for a fixed amount of cash denominated in the functional currency. However, the investor requests that payment of the consideration for the option be deferred to a future date. Thus, the investor enters into a binding forward transaction with the company to issue the option in one year in exchange for a fixed amount of cash denominated in the functional currency. Under the standard as currently drafted, although there is no doubt that this is, in its entirety, an equity transaction for the future issuance of an “equity option”, the original instrument must be classified by the issuer as a financial derivative and measured at fair value through profit or loss until the date of its settlement and the issue of the “equity option”.
To illustrate the distortion, assume that at the beginning of Year 1 a company wishes to issue two options to two holders, exercisable into two shares in Years 2–3 for a fixed amount of cash denominated in the functional currency (CU). Holder A pays CU100 on day one, and receives the option, while Holder B undertakes to pay the issuer CU105 at the beginning of Year 2 in exchange for receiving the option at the time of payment. In this case, aside from the financing arrangement with Holder B, the position of both holders is identical in terms of their exposure to changes in the share price. Nevertheless, the option issued to Holder A is treated as an “equity option” and classified as equity from day one, whereas the obligation to issue an option to Holder B is treated as a “derivative on a derivative” and classified as a financial derivative, an outcome that is inconsistent with the economic substance of the instrument issued.
Forward Transaction to Issue a Package
Furthermore, in the case of a forward transaction to issue a package comprising shares and “equity options” the distortion can be even more extreme. In this case, the entire package reflects in substance an equity transaction, because the holder is exposed from day one to changes in the share price in respect of both the share component as well as the option component, just like any other shareholder. However, assuming the package as a whole constitutes a single unit of account, classifying the forward transaction as a financial derivative would result in fair value measurement not only of the option component of the forward but also of the share component of the forward.
It is important to note that in any issuance of an “equity option”, one could arguably contend that settlement would not occur by issuing a fixed number of shares in exchange for a fixed amount of cash. This is because, by the very definition of an “equity option” as an option, it has two possible outcomes — the issuance of a fixed positive number of shares in exchange for receipt of a fixed positive amount of cash assuming exercise, or, alternatively, the issuance of zero shares and receipt of zero cash assuming expiry. Nonetheless, there is no dispute that in such a case the option should be classified as equity. Similarly, a forward transaction on an option — even though technically defined as a “derivative on a derivative” — may, viewed holistically, give rise to only two possible contractual outcomes, exercise or expiry of the option, and should therefore be classified as equity from day one.
Impact on Business Conduct
It is worth highlighting the range of economic distortions that exist under the current situation. First, during the period in which the original instrument is classified as a financial derivative and measured at fair value, the instrument’s impact on profit or loss is counterintuitive. The more the issuer’s business performance improves, and consequently the value of its shares and “equity options” rises, the higher the fair value of the original instrument recognised as a liability — resulting in the recognition of expenses in profit or loss that reduce the issuer’s earnings precisely during a period of improving business performance. In addition, when the original instrument is settled and the “equity option” is issued, the instrument must arguably be reclassified from financial liability to equity, at which point the “cost of equity” is determined as the fair value of the original instrument at the settlement date. This is in contrast to the fact that the holder was and remains exposed to changes in the value of the shares, both before and after settlement of the original instrument, in the same manner as any other holder of an “equity option”.
The current situation leads to an unequivocal recommendation to companies applying IFRS not to enter into such arrangements. A situation in which companies alter their conduct as a result of accounting rules is undesirable — accounting is a language that should reflect business reality, not one that shapes it.
It should be noted that US GAAP contains no equivalent provision, and accordingly a forward on an option is classified as equity, assuming both derivatives individually satisfy the requirements for classification as an equity instrument.
In conclusion, and although it appears that there is no intention to address this distortion in the forthcoming amendment to IAS 32, a final opportunity has arisen to correct it. The amendment should lead to the classification of the original instrument as equity, thereby providing more relevant information to users of financial statements. Regrettably, should the significant amendment to IAS 32 — after more than a decade of deliberation — fail to address this distortion, the effect will be the opposite: it will serve to perpetuate the distortion.
(*) Written by Shlomi Shuv