Following on from our ‘A Closer Look’ feature on the Financial Instruments with Characteristics of Equity (FICE) Discussion Paper in the July-August issue of Beyond the GAAP, this month’s feature will look specifically at put options granted to minority shareholders (‘Puts on non-controlling interests’).
How did the current accounting treatment come about?
When IFRS standards were first implemented in 2005, they did not yet include provisions on changes in percentage holdings in a subsidiary, and the requirement to immediately recognize a liability for their obligation to buy back equity instruments in the future came as a surprise to French companies.
IAS 32 required (and still requires) that put options granted to minority shareholders should be recognized as liabilities at the present value of the strike price of the put option but did not give any further guidance on the contra journal entry. This has resulted in diversity in practice, both at the date of initial recognition and subsequently.
At initial recognition, entities have generally chosen one of two approaches, both of which anticipate the eventual buyback of the shares by the entity:
- an approach that involves recognizing an additional goodwill for the difference between the liability and the value of the shares likely to be repurchased; or
- an approach that involves recognizing the difference in group equity, on the assumption that this is permissible in the absence of any clarifications to the contrary.
Similarly, a variety of different accounting methods have been used for subsequent changes in the value of the liability:
- recognition in profit or loss, based on the general assumption that changes in the value of a financial liability have an impact on profit or loss;
- recognition in equity, based on the argument that an obligation relating to own shares should not have an impact on profit or loss (particularly if the strike price depends on the fair value of the underlying shares, which is quite often the case); or
- recognition in goodwill using the ‘partial goodwill’ method, which is consistent with the approach mentioned above that anticipates the buyback of the shares (all other things being equal).
The French Securities Regulator, the AMF, noted this diversity in practice, stating in its 2005 year-end recommendations that entities should give details of the accounting treatment used at initial recognition of the liability and for subsequent changes in its value.
The IFRIC (now the IFRS IC) also tackled the issue, trying to reach a consensus but failing. Consequently, it decided in 2006 not to add the topic to its agenda.
In 2008, phase II of the Business Combinations project brought us a step further towards the current accounting treatment for puts on non-controlling interests, by reducing the number of permitted approaches. After this, IAS 27 was amended to stipulate that the impact of changes in percentage holdings in subsidiaries should be recognized in equity.
Logically, following these amendments, the AMF’s year-end recommendations for 2009 clarified that the use of the ‘partial goodwill’ method at initial recognition could still be retained for existing puts, but would no longer be permissible for new put issues. The AMF also stated that its preferred approach for subsequent changes in the value of the liability was recognition in equity, rather than in profit or loss; however, both approaches were still permissible.
In March 2011, the IFRIC tried to resolve the practical issues submitted to it by proposing to exclude put options written on non-controlling interests of subsidiaries, to be settled by the physical delivery of shares, from the scope of IAS 32. This would have meant that these puts would be accounted for under IAS 39 (now IFRS 9) in line with all other derivative instruments, i.e. at fair value through profit or loss.
A few months later, in September 2011, this proposal was rejected by the IASB.
The IFRIC continued its discussions on the subject and in March 2012 it published a draft interpretation that would require subsequent changes in the value of the liability to be recognized in profit or loss.
In January 2013, after receiving comments on the draft interpretation, the IFRIC stated that the draft was a correct interpretation of the existing standard (and specifically of paragraph 23 of IAS 32) but that it remained convinced that its proposal from March 2011 – that these put options should be accounted for like any other derivative – would provide better quality financial information. With this in mind, the IFRIC asked the IASB to reconsider its position on paragraph 23 of IAS 32.
In March 2013, the Board responded by cancelling the IFRIC’s draft interpretation, putting a halt to its efforts to clarify the issue.
Since then, the IFRS IC has still not reached a conclusion, despite receiving further requests for clarification, particularly as regards the accounting treatment of written put options to be settled by a variable number of the parent company’s shares (in 2016). The IFRS IC noted at the time that the issue was too broad for it to address, and that the Board’s ongoing work on the FICE project could provide some answers.
Against this background, this summer’s FICE Discussion Paper (DP) proposes a new approach for determining what shall be classified as a liability, applicable to both derivatives and non-derivative instruments. Here, we analyzes the potential repercussions of the DP.
What does the FICE DP say about puts on non-controlling interests?
Let’s begin with a reminder of the Board’s preferred approach: an instrument would be classified as a liability if a) the entity has an obligation to transfer economic resources before liquidation (timing feature) or b) the entity has an obligation to transfer an amount independent of the entity’s economic resources (amount feature).
In addition, the Board is proposing a specific accounting treatment for derivatives that are physically settled in the entity’s own shares (meaning they are extinguished in accounting terms). Under the proposed accounting treatment, written put options would be classified together with the underlying own shares as a single transaction.
Thus, in the case of puts on non-controlling interests (NCI puts), the Board notes that the entity faces two potential outcomes:
- either the minority shareholders exercise their put options and the entity is obliged to repurchase its own shares at the price agreed in the contract, resulting in the extinguishment of its own shares;
- or the minority shareholders do not exercise their put options and the shares are not extinguished.
In this case, as the exercise of the puts is at the option of the minority shareholders, it is possible that the entity will have an obligation to transfer economic resources before liquidation. Under the Board’s preferred approach, this would mean that the instrument meets the criterion for the timing feature, and thus should be recognized as a liability. The contra journal entry for the liability would be the extinguishment of the shares held by the non-controlling interests, at the date when the entity issues the put options.
The Board proposes that the existence of NCI puts should be viewed in the same way as a bond convertible to own shares, as both have the same outcomes: either an obligation to transfer economic resources, or own shares still outstanding. The Board believes that this justifies using the same accounting treatment. It should however be noted that this approach ignores one difference: the shares already exist in the case of shares + NCI puts, but are yet to be issued in the case of convertible bonds.
Having looked at the accounting treatment at initial recognition, how should an entity account for subsequent changes in the value of the liability it has recognized? It is interesting, in the light of the past discussions reviewed above, that the Board is proposing that they should by default be booked to profit or loss.
However, the Board has also introduced a new presentation requirement. Liabilities that do not meet the criterion for the amount feature (i.e. the amount transferred is dependent on the entity’s economic resources) are to be presented separately in the balance sheet. Subsequent changes in the value of these instruments would then be recognized in other comprehensive income (OCI) without recycling to profit or loss.
The Board suggests that the separate presentation principle should be applied consistently to derivatives that do not have an underlying variable that is independent of the entity’s economic resources (with the exception of interest rates, which by definition affect all derivatives, and foreign currency exposures under certain circumstances).
Thus, if an entity issues put options on its non-controlling interests with a strike price equal to the fair value of the shares, the separate presentation requirement would de facto apply.
The accounting treatment would thus be as follows:
- at the date when the puts are issued, the entity recognizes a liability for the fair value of the shares (the strike price of the puts) with a contra journal entry for an equivalent reduction in equity. The liability is presented separately in the balance sheet;
- subsequent changes in the share price will require the entity to remeasure the liability, with a contra journal entry as a separate line item in OCI (not recyclable).
To cover all the bases, we also need to look at the accounting treatment for fixed-price puts on non-controlling interests. Once again, we start by analyzing the rights and obligations of the instruments in conjunction with the underlying shares. Effectively, these are treated as fixed-price puttable shares; the holders (i.e. the minority shareholders) have the option of putting them back to the entity. As the entity cannot avoid the obligation to transfer a fixed amount of economic resources, the IASB’s position in the DP is that the entity should recognize a liability for the present value of the strike price.
The Board also believes that underlying own equity should be reduced by an amount equal to the fair value of the shares at the issue date of the put. In the previous case, the amount of the liability was equal to the amount of equity extinguished. But in this case, there is a discrepancy.
The Board acknowledges that it is also possible that the minority shareholders will not exercise the put option. Economically speaking, there is no incentive for a minority shareholder to put its shares back to the entity at a price that is lower than their actual value. Therefore the shares could remain outstanding. Attempting to represent this in financial terms would effectively give us a written call option. The Board considers that the residual amount is a component of the call option, which is a component of equity.
We can represent this as follows:
Written put option (original instrument) = forward contract (represented by a liability for the amount of the strike price) + written call option (representing the possibility that the put may not be exercised)
It is also interesting to note that recognizing a liability and a written call option in this way corresponds exactly to the accounting treatment of a convertible bond; thus, the Board’s analogies are consistent.
In summary, a fixed-price, physically-settled put on non-controlling interests would be accounted for, under the Board’s proposed approach, as follows:
- the extinguishment of the shares held by the non-controlling interests at an amount equal to the fair value of the shares at the issue date of the put
- recognition of a liability for an amount equal to the present value of the strike price of the put
- a call option written on own shares, with an initial value of the difference between i) and ii).
In conclusion, this Discussion Paper represents a shift in the Board’s position on the complex issue of NCI puts with a strike price equal to the fair value of the underlying shares. In this case, the Board is moving towards the position put forward by the AMF in 2009. In contrast, the Board’s proposal for fixed-price NCI puts is more innovative. We have no doubt that many comments on this topic will be submitted to the Board before the closing date of its consultation on 7 January 2019!
Key Points to Remember
- A lot of ink has been spilt on the topic of puts on non-controlling interests since IFRS came into effect in 2005, and in the absence of clear guidance on the subject, a diverse range of accounting methods have been used.
- The IASB has proposed a new accounting treatment as part of its FICE project, differentiating between NCI puts with a strike price equal to the fair value of the underlying shares, and fixed-price NCI puts.
- For NCI puts with a strike price equal to the fair value of the underlying shares, an entity would recognize a liability (presented separately) for the fair value of the shares, with a contra journal entry for a reduction in equity, at the date when the put is issued. Subsequent changes in the value of the liability would be recognized in OCI without recycling to profit or loss.
- For fixed-price, physically-settled NCI puts, an entity would recognize a liability for an amount equal to the present value of the strike price of the put, with a contra journal entry for the extinguishment of the shares held by the non-controlling interests at an amount equal to the fair value of the shares at the issue date of the put, and a call option written on own shares for an amount equal to the difference between the first two components.