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IFRS FOR INVESTMENT FUNDSFebruary 2012,Issue 3
Welcome to theseries
Our series o IFRS or
Investment Funds publications
addresses practical application
issues that investment unds
may encounter when applying
IFRS. It discusses the key
requirements and includes
guidance and illustrative
examples. The upcoming
issues will cover such topics
as air value measurement,
consolidation and IFRS 9
Financial Instruments.
This series considers
accounting issues arising
rom currently eectiveIFRS as well as orthcoming
requirements. Further
discussion and analysis
about IFRS is included in our
publication Insights into IFRS.
In this issue: Liability vs equityclassication or nancial instrumentsissued by investment unds
Investment unds requently issue shares or units with unique, entity-specic
characteristics. As a result, a signicant eort may be required in applying the IFRSguidance to the contractual terms o these instruments to determine whether they
should be classied as a liability or equity.
This publication ocuses on the classication o puttable instruments and
instruments that impose on the entity an obligation to deliver a pro rata share o the
entitys net assets only on liquidation (obligations arising on liquidation). These are
the most common types o nancial instruments issued by investment unds.
This issue covers the ollowing issues arising rom the application o 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 classiedas equity?
3. How do you classiy a component o an instrument that imposes an obligation
only on liquidation?
4. How do you classiy redeemable shares issued by umbrella structures?
5. When should a nancial instrument be reclassied between liability and equity?The scope o this publication is limited to non-derivative nancial instruments issued
by investment unds.
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1. Liability or equity? Where do you start theanalysis?
Shares or units issued by a und are classied as a nancial liability or equity on initial recognition. The table below outlines the
principal considerations or unds in determining whether an instrument meets the denition o equity or liability under the
general denitions in IAS 32.
Financial liability Equity
Key eatures Contains a contractual obligation to transer cash or other nancial assets.
The contractual obligation may arise rom 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 andconditions o the instrument.
In general, any contract that
evidences a residual interest
in the assets o an entity ater
deducting all o its liabilities.
The issuer has no contractual
obligation to deliver cash or
another nancial asset.
I settled in
own equity
instruments
Settlement in a variable number o the entitys own equity instruments. Settlement in a xed number
o the entitys own equity
instruments.
Features that
generally point
to liability
or equity
classication
o an
instrument or
a component
o an
instrument
Instruments with the ollowing eatures may still be classied as
equity i certain conditions are met (see Question 2):
redemption is at the option o the instrument holder
limited lie o a und
und liquidation is at the option o the instrument holder.
Redemption is triggered by an uncertain uture event that is beyond
the control o both the holder and the issuer o the instrument.
Non-discretionary dividends.
Non-redeemable shares or
units.
No specic 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 xed non-discretionary dividends eachperiod and a pro rata share o the unds net assets on its liquidation. B does not have a limited lie and its liquidation is not at
the option o the unit holders. The units do not have any other eatures that would preclude equity classication.
How does B classiy the units?
The unit issued by B is a compound instrument.
The obligation to pay xed non-discretionary dividends represents a contractual obligation that is classied as a nancial
liability in line with the general denitions in IAS 32.
The obligation to deliver a pro rata share o Bs net assets only on its liquidation is classied as equity because the liquidation
is neither certain to happen nor beyond the control o B.
However, i there were no mandatory dividend requirement and dividends were entirely at the discretion o B, then the units
would be classied wholly as equity providing all other criteria were met.
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An entity assesses the substance o a contractual arrangement, rather than its legal orm, when determining whether an instrument
meets the denition o a nancial liability or equity. As a result, it is possible that instruments that qualiy as equity or legal or
regulatory purposes may be classied as liabilities or the purpose o nancial reporting. In our view, in assessing the substance o
a contractual arrangement, actors not contained within the contractual arrangement should be excluded rom the assessment.
Economic compulsion should not be used as the basis or classication.
Instruments that are oten impacted and so may ail the denition o equity under IFRS include preerence shares and classes o
shares that have special terms and conditions.
I it is determined at initial recognition that an instrument, or in certain circumstances a component, meets the denition o a
nancial liability, then an investment und applies the fowchart below to determine whether the instrument, or a portion o it,should be presented as equity by exception. Presentation as equity by exception is required i:
the instrument meets the denition o a puttable instrument (see Question 2); or
the instrument, or a component, meets the denition o an instrument that imposes on the und an obligation to deliver a
pro rata share o the net assets o the und only on liquidation (see Question 2).
Yes
Is definition
(ii) met
part the
instrument?
for
of
The whole instrument is classified as
equity by exception
The whole instrument is classified as
a liability
That part is classified as equity by
exception and the balance is classified
as a liability
No
Yes
No
Yes
Step 1Is the financialinstrument a
inaccordance withthe generaldefinitions in IAS 32?
liabilityequityor
Step 2If 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
only on liquidation?assets
The instrument is
equity in its entirety
The instrument is a
liability in its entirety
The instrument
is a compound
instrument
No further analysis under Step 2
is required
Is the
definition
of (i) or (ii) met
for the whole
instrument?
Is the
definition
of (i) (ii) met
for the whole
compound
instrument?
or
Is definition
(ii) met the
entire liability
component?
for
Is definition
(ii) met for part
of liability
component?
the
The of the instrumentdefinition of equity in
accordance with the generalrequirements of IAS 32 is classified asequity. The remaining part is classifiedas a liability
componentmeeting the
The component of the instrumentmeeting the definition of equity inaccordance with the generalrequirements of IAS 32 and the part ofthe liability component meeting thedefinition of (ii) are classified as equity.
The remaining part is classified asa liability
No
No
Yes
No
Yes
The whole instrument is classified asequity by exception
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2. When are puttable instruments and obligationsarising on liquidation classied as equity?
Puttable instruments and obligations arising on liquidation are dened as ollows.
Financial instruments that give the holderthe right to put the instruments back to the
issuer or cash or another nancial asset, or
that are automatically put back to the issuer
on the occurrence o an uncertain uture
event.
Financial instruments that contain acontractual obligation or the entity to
deliver to the holder a pro rata share o its
net assets only on liquidation.
In this case, the obligation arises because
liquidation either is certain to happen and
is outside the control o the entity (e.g. alimited-lie entity) or is uncertain but is at
the option o the instrument holder (e.g.
some partnership interests).
Puttable
instruments
Obligations
arising on
liquidation
Such instruments are classied as equity by exception under IAS 32 i they meet certain conditions that are summarised inthe table below. The contractual terms and surrounding circumstances should be reviewed or each instrument to determine
the appropriate classication. The criteria or meeting the exception are restrictive and a und will have to meet all o them to
classiy the issued instruments as equity.
Conditions required or equity classication
Required
or puttable
instruments?
Required or
obligations
arising on
liquidation?
Examples
(on next ew
pages)
1 The nancial instrument entitles the holder to a pro rata share o
the entitys net assets in the event o the entitys liquidation. Yes Yes 2
2 The nancial instrument belongs to the most subordinate class oinstruments. Yes Yes 3
3a All nancial instruments in this most subordinate class have
identical eatures. Yes See 3b 4
3b All nancial instruments in this most subordinate class have an
identical contractual obligation to deliver a pro rata share o the
entitys net assets on liquidation. See 3a Yes -
4 Apart rom an obligation or the issuer to repurchase or redeem, the
instrument:
does not include any other contractual obligation to deliver cash
or another nancial asset or to exchange nancial assets ornancial liabilities under potentially unavourable conditions; and
is not a contract under which an entity is or may be obliged to
deliver a variable number o the entitys own equity instruments. Yes No 5
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Conditions required or equity classication
Required
or puttable
instruments?
Required or
obligations
arising on
liquidation?
Examples
(on next ew
pages)
5 Total expected cash fows attributable to the instrument over its lie
are based substantially on:
prot or loss;
change in recognised net assets; or
change in air value o recognised and unrecognised net assets o
the entity. Yes No 66 The issuer has no other nancial instrument or contract that has:
total cash fows based substantially on prot or loss, change in
recognised net assets, or change in air value o recognised and
unrecognised net assets o the issuer; and
the eect o substantially restricting or xing the residual return
to instrument holders. Yes Yes 7
The reason or the dierences between the conditions or a puttable instrument and an instrument that imposes on the entity
an obligation only on liquidation is the timing o settlement o the obligations. A puttable instrument can be exercised beore
liquidation; thereore, all contractual obligations that exist throughout its entire lie are considered to ensure that it alwaysrepresents the most residual interest. For an obligation that is settled only on liquidation, the ocus is on obligations that exist
at liquidation.
Example 2 Pro rata share o net assets on liquidation
Shares issued by limited-lie Fund C and Fund D have the ollowing eatures with respect to payments on liquidation.
Fund C Fund D
Fees payable on liquidation Fixed ee per unit Fixed ee per unit holder
Calculation basis or a pro rata share o net assets Pro rata share o total net assets Pro rata share o specic portionor component o net assets
How do the above eatures aect the classication o the units?
IAS 32 states that a pro rata share o the unds net assets on liquidation is determined by:
dividing the entitys net assets on liquidation into units o equal amount; and
multiplying that amount by the number o units held by the nancial instrument holder.
In our view, this means that each instrument holder has an entitlement to an identical monetary amount per unit on
liquidation.
Each eature o Ds units illustrated above results in unit holders not receiving an identical monetary amount per unit on
liquidation and so precludes equity classication.
C classies its units as equity providing that the remaining requirements are met.
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Example 3 Management shares: The most subordinate class
The holders o the redeemable shares o Fund E are entitled to a pro rata share o Es net assets in the event o its liquidation.
E has also issued a small amount o a dierent class o shares (management shares) to the und manager; these shares are
non-redeemable, have no entitlement to dividends and are the most subordinate class o instruments in liquidation.
Can redeemable shares be regarded as the most subordinated class?
IAS 32 does not preclude the existence o several types or classes o equity.
A nancial instrument is rst classied as a liability or equity instrument in accordance with the general requirements o
IAS 32. That classication is not aected by the existence o puttable instruments or instruments that impose an obligation
only on liquidation.
As a second step, a und considers whether a nancial liability also meets the exception or puttable instruments or
instruments that impose an obligation only on liquidation and so should be classied as equity.
In this example, the redeemable shares meet the denition o a liability in IAS 32. Also, in our view they ail the exception
or puttable instruments because even a small amount o management shares that are subordinate to redeemable sharesmeans that such redeemable shares are not subordinated to all other classes o instruments.
The existence o a puttable eature in the redeemable shares does not in itsel mean that the instrument is less subordinate
than management shares. The level o an instruments 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 o puttable instruments, all nancial instruments in the class o instruments that is subordinate to all other classeso instruments need to have identical eatures to qualiy or equity classication. In our view, this should be interpreted strictly
to mean identical contractual terms and conditions, including non-nancial eatures such as governance rights, related to the
holders o the instruments in their roles as owners o the entity.
Dierences in cash fows and contractual terms and conditions o an instrument attributable to an instrument holder in its role
as non-ownerare not considered to violate the identical eatures 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 o contractual eatures that would violate the identical eatures test include:
dierent rates o management ees;
a choice or holders on issuance whether to receive income or additional units as distributions (such that the distributive or
accumulative eature diers or each instrument ater they are issued);
dierent lock-up periods; and
dierent currencies in which the payments are denominated.
In our view, the ollowing terms do not violate the identical eatures test because there are no inherent dierences in the
eatures o each instrument within the most subordinate class:
administrative charges based on the volume o units redeemed beore liquidation, as long as all unit holders in the most
subordinate class are subject to the same ee structure;
dierent subscription ees payable on initial subscription, as long as all other eatures become identical once the subscription
ees are paid;
a choice to receive income or additional units as distributions on each distribution date, as long as the same ability is aorded
to all unit holders in the most subordinate class i.e. the choice is an identical eature; and
a term contained in identical instruments that carry equal voting rights that caps the maximum amount o voting rights that
any individual holder may exercise.
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Example 4 Identical eatures test: Additional inormation rights
Fund F issues redeemable shares that are the most subordinated class. Fund manager M holds 5% o the redeemable
shares in F. M also has access to certain inormation rights in its role as a manager that are not granted to other holders o
redeemable shares.
Does such access to additional inormation mean that not all redeemable shares have identical eatures?
I inormation rights are granted to M in its role as manager o the und (and not in its role as owner), then they are not
considered to violate the identical eatures test.
Example 5 Contractual distribution o net accounting prot
Unit Trust T issues redeemable units. In addition to the general redemption eature, T is contractually required to distribute to
the holders the net accounting prot annually.
How does an additional requirement to distribute the net accounting prot aect classication o redeemable shares?
In our view, the requirement to distribute the net accounting prot annually is an additional obligation to deliver cash and,thereore, the redeemable units do not qualiy or equity classication.
Example 6 Total expected cash fows attributable to the instrument
Fund G issues one class o redeemable shares that entitles each holder to a pro ratashare o Gs net assets and that is the
most subordinate class o 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 fows o the shares based substantially on prot or loss and change in net assets?
Usually, to meet this requirement, the redemption amount is calculated with reerence to net assets measured in
accordance with IFRS. This is not the case in this example, because the redemption value o the shares is calculated based
on local GAAP.
Nevertheless, G may still satisy this condition, depending on the circumstances. It may also be possible to argue that the
eect o dierences between local GAAP and IFRS is immaterial with regard to their application to G, or temporary andexpected to converge over the lie o the instrument, such that the total expected cash fows are based substantially on
IFRS prot or loss or change in recognised net assets.
In our view, the use o the terms expected and based substantially indicates that judgement should be exercised in
determining whether the requirement is met in each specic situation, including consideration o how local GAAP and IFRS
apply to the reporting entitys business and the terms o the instrument.
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3. How do you classiy a component o aninstrument that imposes an obligation only onliquidation?
The ollowing guidance applies only to components o instruments that impose on the entity an obligation to deliver a pro rata
share o its net assets only on liquidation. Puttable instruments are tested or equity classication as a whole (see fowchart in
Question 1).
Instruments or components o instruments that meet the denition o a liability in accordance with the general requirementso IAS 32 and that impose on the entity an obligation to deliver to another party a pro rata share o the net assets only on
liquidation are classied as equity i they meet the conditions set out in Question 2.
I the instrument that imposes an obligation on the entity to deliver a pro rata share o the net assets only on liquidation also
contains other contractual obligations, then these other obligations may need to be accounted or separately as liabilities in
accordance with the requirements o IAS 32. For example, the ollowing components could be present in an instrument:
an obligation to pay non-discretionary dividends i.e. a nancial liability component; and
an obligation to deliver a pro rata share o 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 fnancial instrument or contractthat has total cash fows based
substantially on the issuers prot or loss, change in recognised net assets, or change in air value o recognised and
unrecognised net assets.
In our view, when evaluating such a component (an obligation arising on liquidation) or equity classication by exception, a und
should choose an accounting policy, to be applied consistently, on whether the term other nancial instrument includes:
(i) other components o the evaluated instrument; or
(ii) only nancial instruments other than the one that contains the evaluated component.
I the unds policy is to view a mandatory dividend eature as another nancial instrument or this purpose, then equity
classication o the obligation arising only on liquidation would be precluded or this component o the instrument because themandatory non-discretionary dividends violate Condition 6 in Question 2 e.g. mandatory dividends based on prots.
However, i the unds policy is to consider or this test only nancial instruments other than the one that contains the obligation
arising on liquidation, then a mandatory dividend eature in itsel would not preclude equity classication o the obligationarising on liquidation because this eature is part o the same instrument and it could not violate Condition 6 in Question 2.
Example 7 Limited-lie entity pays non-discretionary dividends
Fund K is a limited-lie entity. K issues units that are redeemable only on its liquidation. The unit holders are entitled to annualnon-discretionary dividends equalling 90% o Ks prots and a pro rata share o the net assets on liquidation o K.
How does K classiy the components o the shares issued?
The obligation to pay xed non-discretionary dividends represents a contractual obligation that is classied as a nancial
liability (Component 1).
The classication o the obligation to deliver a pro rata share o the net assets on liquidation (Component 2) depends on theaccounting policy choice made by K.
I K chooses accounting policy (i) above, then Component 2 is classied as a liability.
I K chooses accounting policy (ii) above, and provided that all other criteria are met, then Component 2 is classied as equity.
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4. How do you classiy redeemable sharesissued by umbrella structures?
The term umbrella und structure is used in certain jurisdictions to describe a collective investment scheme that comprises
an umbrella und that operates one or more sub-unds. Investors buy instruments that entitle the holder to a share o the net
assets o a particular sub-und.
The umbrella und and sub-unds together orm a legal entity, although the assets and the obligations o individual unds are
ully or partially segregated. Each sub-und usually has its own investment objectives, ocusing on dierent markets.
The analysis in this question applies only to instances in which the assets and obligations o each sub-und are ring-encedsolely or investors o the respective sub-und.
The table below discusses the possible classication o puttable instruments and instruments that impose on the entity an
obligation to deliver to another party a pro rata share o the net assets only on liquidation, issued by an umbrella und structure.
Type o nancial statements
preparedConsiderations Classication
Individual nancial statements
prepared by each sub-und
Each sub-und assesses issued instruments or equity
classication separately.
Liability or equity
Separate nancial statements
o umbrella und structure
that include the assets and
liabilities o the sub-unds that
together orm a single legal
entity
Instruments issued by the sub-unds are assessed or equity
classication rom the perspective o the umbrella und
structure as a whole.
Instruments issued by each sub-und cannot qualiy or
equity classication because they could not meet the
pro rata share o the entitys net assets on liquidation
condition and, i they are puttable instruments, the identical
eatures test.
Liability
Consolidated nancial
statements with sub-unds as
subsidiaries
Instruments issued by sub-unds that qualiy or equity
presentation in the individual nancial statements o
each und and that represent non-controlling interests
are classied as liabilities in the consolidated nancial
statements.
Liability
Combined nancial
statements prepared by an
umbrella und structure,
expressed as prepared in
accordance with IFRS
In our view, puttable sub-und instruments would not qualiy
or equity classication in the combined nancial statements
or the reasons described above or both separate and
consolidated nancial statements.
Liability
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5. When should a nancial instrument bereclassied between liability and equity?
The classication o an instrument or its component parts as either a nancial liability or equity is made at initial recognition
and, with the exception o puttable instruments and instruments that impose on the entity an obligation only on liquidation,
is not generally revised as a result o subsequent changes in circumstances. However, a reclassication between liability and
equity or vice versa may be required ollowing changes to the contractual or eective terms o the instruments or changes inthe composition o the reporting entity. Puttable instruments and instruments or components that impose on the entity an
obligation only in liquidation are reclassied:
to nancial liability rom the date on which any o the equity classication criteria in Question 2 cease to be met; or
to equity rom the date on which all equity classication criteria in Question 2 are met.
This indicates a continuous assessment model under which a und re-assesses the classication whenever there are changesto the relevant circumstances e.g. changes to the capital structure, such as the issue o new classes o shares or redemptions
o existing share classes.
Puttable instruments or instruments that impose on the entity an obligation only on liquidation are measured on reclassication
as ollows.
Reclassication Measurement Accounting or carrying amount adjustment
From equity tonancial liability
Liability is measured initially at the instrumentsair value at the date o reclassication.
Any dierence between the carrying amount othe equity instrument and the air value o the
nancial liability at the date o reclassication
continues to be recognised in equity.
From nancial liability
to equity
Equity instrument is measured at the carrying
amount o the nancial liability at the date o
reclassication.
No adjustment to the carrying amount.
Accounting entries Reclassication rom equity to nancial liability
Assume that on the date o reclassication the carrying amount o an instrument previously classied as equity is 100 and its
air value is 90. The double entry on reclassication is as ollows.
Debit Credit
Equity1 90
Liability 90
Accounting entries Reclassication rom nancial liability to equity
Assume that on the date o reclassication the carrying amount o an instrument previously classied as equity is 100 and its
air value is 90. The double entry on reclassication is as ollows.
Debit CreditLiability 100
Equity 100
1 This example does not ocus on dierent components o equity.
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Other KPMG publicationsA more detailed discussion o the general accounting issues that arise rom the application o IFRS can be ound in our
publication Insights into IFRS. In addition, we have a range o publications that can help you urther, including:
Illustrative nancial statements: Investment unds
Illustrative nancial statements or interim and annual periods
IFRS compared to US GAAP
IFRS Handbooks, which include extensive interpretative guidance and illustrative examples to elaborate or clariy the
practical application o a standard, including IFRS Handbook: First-time adoption o 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 specic requirements o pronouncements
Disclosure checklist.
IFRS-related technical inormation is also available at kpmg.com/irs.
For access to an extensive range o accounting, auditing and nancial reporting guidance and literature, visit KPMGs
Accounting Research Online. This web-based subscription service can be a valuable tool or anyone who wants to stay inormed
in todays dynamic environment. For a ree 15-day trial, go to aro.kpmg.com and register today.
KPMGs Global Investment Management practice
Our member rms combine their depth o local knowledge with our global networks cross-border experience to deliver
practical, eective and insightul advice to our global investment management clients. Our proessionals in Audit, Tax
and Advisory are specialists in their elds and have deep experience in the issues and needs o investment management
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unds, private equity unds, real estate unds, inrastructure unds and other alternative investment unds (such as distressed
debt and environmental assets), as well as sovereign wealth unds and pension unds.
Acknowledgements
We would like to acknowledge the principal contributors to this publication. They are Ewa Bialkowska and Arina Tomiste o the
KPMG International Standards Group.
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Fund Centres IFRS Working Group
Andrew Stepaniuk
Leader Fund Centres IFRS Working Group
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Publication name: IFRS or Investment Funds
Publication number: Issue 3
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