IFRS FOR INVESTMENT FUNDS

February 2012, Issue 3

Welcome to the
series
Our series of IFRS for
Investment Funds publications
addresses practical application
issues that investment funds
may encounter when applying
IFRS. It discusses the key
requirements and includes
guidance and illustrative
examples. The upcoming
issues will cover such topics
as fair value measurement,
consolidation and IFRS 9
Financial Instruments.
This series considers
accounting issues arising
from currently effective
IFRS as well as forthcoming
requirements. Further
discussion and analysis
about IFRS is included in our
publication Insights into IFRS.
In this issue: Liability vs equity
classication for nancial instruments
issued by investment funds
Investment funds frequently issue shares or units with unique, entity-specic
characteristics. As a result, a signicant effort may be required in applying the IFRS
guidance to the contractual terms of these instruments to determine whether they
should be classied as a liability or equity.
This publication focuses on the classication of puttable instruments and
instruments that impose on the entity an obligation to deliver a pro rata share of the
entitys net assets only on liquidation (obligations arising on liquidation). These are
the most common types of nancial instruments issued by investmentfunds.
This issue covers the following issues arising from the application of IAS 32
Financial Instruments: Presentation.
1. Liability or equity? Where do you start the analysis?
2. When are puttable instruments and obligations arising on liquidation classied
as equity?
3. How do you classify a component of an instrument that imposes an obligation
only on liquidation?
4. How do you classify redeemable shares issued by umbrella structures?
5. When should a nancial instrument be reclassied between liability and equity?
The scope of this publication is limited to non-derivative nancial instruments issued
by investment funds.
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1. Liability or equity? Where do you start the
analysis?
Shares or units issued by a fund are classied as a nancial liability or equity on initial recognition. The table below outlines the
principal considerations for funds in determining whether an instrument meets the denition of equity or liability under the
general denitions in IAS 32.
Financial liability Equity
Key features Contains a contractual obligation to transfer cash or other nancial assets.
The contractual obligation may arise from a requirement to repay
principal or to pay interest or dividends.
In our view, such a contractual obligation could be established explicitly
or indirectly, but it should be established through the terms and
conditions of the instrument.
In general, any contract that
evidences a residual interest
in the assets of an entity after
deducting all of its liabilities.
The issuer has no contractual
obligation to deliver cash or
another nancial asset.
If settled in
own equity
instruments
Settlement in a variable number of the entitys own equity instruments. Settlement in a xed number
of the entitys own equity
instruments.
Features that
generally point
to liability
or equity
classication
of an
instrument or
a component
of an
instrument
Instruments with the following features may still be classied as
equity if certain conditions are met (see Question 2):
redemption is at the option of the instrument holder
limited life of a fund
fund liquidation is at the option of the instrument holder.
Redemption is triggered by an uncertain future event that is beyond
the control of both the holder and the issuer of the instrument.
Non-discretionary dividends.
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 each
period and a pro rata share of the funds net assets on its liquidation. B does not have a limited life and its liquidation is not at
the option of the unit holders. The units do not have any other features that would preclude equity classication.
How does B classify 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 of Bs net assets only on its liquidation is classied as equity because the liquidation
is neither certain to happen nor beyond the control of B.
However, if there were no mandatory dividend requirement and dividends were entirely at the discretion of B, then the units
would be classied wholly as equity providing all other criteria were met.
IFRS for Investment Funds | 3
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An entity assesses the substance of a contractual arrangement, rather than its legal form, when determining whether an instrument
meets the denition of a nancial liability or equity. As a result, it is possible that instruments that qualify as equity for legal or
regulatory purposes may be classied as liabilities for the purpose of nancial reporting. In our view, in assessing the substance of
a contractual arrangement, factors not contained within the contractual arrangement should be excluded from theassessment.
Economic compulsion should not be used as the basis for classication.
Instruments that are often impacted and so may fail the denition of equity under IFRS include preference shares and classes of
shares that have special terms and conditions.
If it is determined at initial recognition that an instrument, or in certain circumstances a component, meets the denition of a
nancial liability, then an investment fund applies the owchart below to determine whether the instrument, or a portion of it,
should be presented as equity by exception. Presentation as equity by exception is required if:
the instrument meets the denition of a puttable instrument (see Question 2); or
the instrument, or a component, meets the denition of an instrument that imposes on the fund an obligation to deliver a
prorata share of the net assets of the fund 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 1
Is the financial
instrument a
in
accordance with
the general
definitions in IAS 32?
liability
equity or
Step 2
If the financial instrument is not equity in its entirety, then is it:
(i) a puttable instrument; or
(ii) an instrument or component that imposes an obligation to deliver a pro rata share of net
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 instrument
definition of equity in
accordance with the general
requirements of IAS 32 is classified as
equity. The remaining part is classified
as a liability
component
meeting the
The component of the instrument
meeting the definition of equity in
accordance with the general
requirements of IAS 32 and the part of
the liability component meeting the
definition of (ii) are classified as equity.
The remaining part is classified as
a liability
No
No
Yes
No
Yes
The whole instrument is classified as
equity by exception
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2. When are puttable instruments and obligations
arising on liquidation classied as equity?
Puttable instruments and obligations arising on liquidation are dened as follows.
Financial instruments that give the holder
the right to put the instruments back to the
issuer for cash or another nancial asset, or
that are automatically put back to the issuer
on the occurrence of an uncertain future
event.
Financial instruments that contain a
contractual obligation for the entity to
deliver to the holder a prorata share of its
net assets only onliquidation.
In this case, the obligation arises because
liquidation either is certain to happen and
is outside the control of the entity (e.g. a
limited-life entity) or is uncertain but is at
the option of the instrument holder (e.g.
some partnership interests).
Puttable
instruments
Obligations
arising on
liquidation
Such instruments are classied as equity by exception under IAS 32 if they meet certain conditions that are summarised in
the table below. The contractual terms and surrounding circumstances should be reviewed for each instrument to determine
the appropriate classication. The criteria for meeting the exception are restrictive and a fund will have to meet all of them to
classify the issued instruments as equity.
Conditions required for equity classication
Required
for puttable
instruments?
Required for
obligations
arising on
liquidation?
Examples
(on next few
pages)
1 The nancial instrument entitles the holder to a pro rata share of
the entitys net assets in the event of the entitys liquidation. Yes Yes 2
2 The nancial instrument belongs to the most subordinate class of
instruments. Yes Yes 3
3a All nancial instruments in this most subordinate class have
identical features. Yes See 3b 4
3b All nancial instruments in this most subordinate class have an
identical contractual obligation to deliver a pro rata share of the
entitys net assets on liquidation. See 3a Yes -
4 Apart from an obligation for the issuer to repurchase or redeem, the
instrument:
does not include any other contractual obligation to deliver cash
or another nancial asset or to exchange nancial assets or
nancial liabilities under potentially unfavourable conditions; and
is not a contract under which an entity is or may be obliged to
deliver a variable number of the entitys own equity instruments. Yes No 5
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Conditions required for equity classication
Required
for puttable
instruments?
Required for
obligations
arising on
liquidation?
Examples
(on next few
pages)
5
Total expected cash ows attributable to the instrument over its life
are based substantially on:
prot or loss;
change in recognised net assets; or
change in fair value of recognised and unrecognised net assets of
the entity. Yes No 6
6
The issuer has no other nancial instrument or contract that has:
total cash ows based substantially on prot or loss, change in
recognised net assets, or change in fair value of recognised and
unrecognised net assets of the issuer; and
the effect of substantially restricting or xing the residual return
to instrument holders. Yes Yes 7
The reason for the differences between the conditions for a puttable instrument and an instrument that imposes on the entity
an obligation only on liquidation is the timing of settlement of the obligations. A puttable instrument can be exercised before
liquidation; therefore, all contractual obligations that exist throughout its entire life are considered to ensure that it always
represents the most residual interest. For an obligation that is settled only on liquidation, the focus is on obligations that exist
atliquidation.
Example 2 Pro rata share of net assets on liquidation
Shares issued by limited-life Fund C and Fund D have the following features with respect to payments on liquidation.
Fund C Fund D
Fees payable on liquidation Fixed fee per unit Fixed fee per unit holder
Calculation basis for a pro rata share of net assets Pro rata share of total net assets
Pro rata share of specic portion
or component of net assets
How do the above features affect the classication of the units?
IAS 32 states that a pro rata share of the funds net assets on liquidation is determined by:
dividing the entitys net assets on liquidation into units of equal amount; and
multiplying that amount by the number of 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 feature of 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 of the redeemable shares of Fund E are entitled to a pro rata share of Es net assets in the event of its liquidation.
E has also issued a small amount of a different class of shares (management shares) to the fund manager; these shares are
non-redeemable, have no entitlement to dividends and are the most subordinate class of instruments in liquidation.
Can redeemable shares be regarded as the most subordinated class?
IAS 32 does not preclude the existence of several types or classes of equity.
A nancial instrument is rst classied as a liability or equity instrument in accordance with the general requirements of
IAS32. That classication is not affected by the existence of puttable instruments or instruments that impose an obligation
only on liquidation.
As a second step, a fund considers whether a nancial liability also meets the exception for 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 of a liability in IAS 32. Also, in our view they fail the exception
for puttable instruments because even a small amount of management shares that are subordinate to redeemable shares
means that such redeemable shares are not subordinated to all other classes of instruments.
The existence of a puttable feature in the redeemable shares does not in itself mean that the instrument is less subordinate
than management shares. The level of an 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 of puttable instruments, all nancial instruments in the class of instruments that is subordinate to all other classes
of instruments need to have identical features to qualify for equity classication. In our view, this should be interpreted strictly
to mean identical contractual terms and conditions, including non-nancial features such as governance rights, related to the
holders of the instruments in their roles as owners of the entity.
Differences in cash ows and contractual terms and conditions of an instrument attributable to an instrument holder in its role
as non-owner are not considered to violate the identical features test, provided that the transaction is on similar terms to an
equivalent transaction that might happen between a non-instrument holder and the issuing entity.
Examples of contractual features that would violate the identical features test include:
different rates of management fees;
a choice for holders on issuance whether to receive income or additional units as distributions (such that the distributive or
accumulative feature differs for each instrument after they are issued);
different lock-up periods; and
different currencies in which the payments are denominated.
In our view, the following terms do not violate the identical features test because there are no inherent differences in the
features of each instrument within the most subordinate class:
administrative charges based on the volume of units redeemed before liquidation, as long as all unit holders in the most
subordinate class are subject to the same fee structure;
different subscription fees payable on initial subscription, as long as all other features become identical once the subscription
fees are paid;
a choice to receive income or additional units as distributions on each distribution date, as long as the same ability is afforded
to all unit holders in the most subordinate class i.e. the choice is an identical feature; and
a term contained in identical instruments that carry equal voting rights that caps the maximum amount of voting rights that
any individual holder may exercise.
IFRS for Investment Funds | 7
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Example 4 Identical features test: Additional information rights
Fund F issues redeemable shares that are the most subordinated class. Fund manager M holds 5% of the redeemable
shares in F.M also has access to certain information rights in its role as a manager that are not granted to other holders of
redeemable shares.
Does such access to additional information mean that not all redeemable shares have identical features?
If information rights are granted to M in its role as manager of the fund (and not in its role as owner), then they are not
considered to violate the identical features test.
Example 5 Contractual distribution of net accounting prot
Unit Trust T issues redeemable units. In addition to the general redemption feature, T is contractually required to distribute to
the holders the net accounting prot annually.
How does an additional requirement to distribute the net accounting prot affect classication of redeemable shares?
In our view, the requirement to distribute the net accounting prot annually is an additional obligation to deliver cash and,
therefore, the redeemable units do not qualify for equity classication.
Example 6 Total expected cash ows attributable to the instrument
Fund G issues one class of redeemable shares that entitles each holder to a pro rata share of Gs net assets and that is the
most subordinate class of instruments issued.
Redemption amounts are based on net assets calculated in accordance with local GAAP (not IFRS).
The redeemable shares do not contain any other contractual obligations to deliver cash.
Are the total expected cash ows of the shares based substantially on prot or loss and change in net assets?
Usually, to meet this requirement, the redemption amount is calculated with reference to net assets measured in
accordance with IFRS. This is not the case in this example, because the redemption value of the shares is calculated based
on local GAAP.
Nevertheless, G may still satisfy this condition, depending on the circumstances. It may also be possible to argue that the
effect of differences between local GAAP and IFRS is immaterial with regard to their application to G, or temporary and
expected to converge over the life of the instrument, such that the total expected cash ows are based substantially on
IFRS prot or loss or change in recognised net assets.
In our view, the use of the terms expected and based substantially indicates that judgement should be exercised in
determining whether the requirement is met in each specic situation, including consideration of how local GAAP and IFRS
apply to the reporting entitys business and the terms of the instrument.
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3. How do you classify a component of an
instrument that imposes an obligation only on
liquidation?
The following guidance applies only to components of instruments that impose on the entity an obligation to deliver a pro rata
share of its net assets only on liquidation. Puttable instruments are tested for equity classication as a whole (see owchart in
Question 1).
Instruments or components of instruments that meet the denition of a liability in accordance with the general requirements
of IAS 32 and that impose on the entity an obligation to deliver to another party a pro rata share of the net assets only on
liquidation are classied as equity if they meet the conditions set out in Question 2.
If the instrument that imposes an obligation on the entity to deliver a pro rata share of the net assets only on liquidation also
contains other contractual obligations, then these other obligations may need to be accounted for separately as liabilities in
accordance with the requirements of IAS 32. For example, the following components could be present in an instrument:
an obligation to pay non-discretionary dividends i.e. a nancial liability component; and
an obligation to deliver a pro rata share of the net assets on liquidation.
In such cases, a question arises about whether the second component can ever meet Condition 6 set out in the table
in Question 2 that requires that the issuer has no other nancial instrument or contract that has total cash ows based
substantially on the issuers prot or loss, change in recognised net assets, or change in fair value of recognised and
unrecognised net assets.
In our view, when evaluating such a component (an obligation arising on liquidation) for equity classication by exception, a fund
should choose an accounting policy, to be applied consistently, on whether the term other nancial instrument includes:
(i) other components of the evaluated instrument; or
(ii) only nancial instruments other than the one that contains the evaluated component.
If the funds policy is to view a mandatory dividend feature as another nancial instrument for this purpose, then equity
classication of the obligation arising only on liquidation would be precluded for this component of the instrument because the
mandatory non-discretionary dividends violate Condition 6 in Question 2 e.g. mandatory dividends based on prots.
However, if the funds policy is to consider for this test only nancial instruments other than the one that contains the obligation
arising on liquidation, then a mandatory dividend feature in itself would not preclude equity classication of the obligation
arising on liquidation because this feature is part of the same instrument and it could not violate Condition 6 in Question 2.
Example 7 Limited-life entity pays non-discretionary dividends
Fund K is a limited-life entity. K issues units that are redeemable only on its liquidation. The unit holders are entitled to annual
non-discretionary dividends equalling 90% of Ks prots and a pro rata share of the net assets on liquidation of K.
How does K classify the components of the shares issued?
The obligation to pay xed non-discretionary dividends represents a contractual obligation that is classied as a nancial
liability (Component 1).
The classication of the obligation to deliver a pro rata share of the net assets on liquidation (Component 2) depends on the
accounting policy choice made by K.
If K chooses accounting policy (i) above, then Component 2 is classied as a liability.
If K chooses accounting policy (ii) above, and provided that all other criteria are met, then Component 2 is classied as equity.
IFRS for Investment Funds | 9
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4. How do you classify redeemable shares
issued by umbrella structures?
The term umbrella fund structure is used in certain jurisdictions to describe a collective investment scheme that comprises
an umbrella fund that operates one or more sub-funds. Investors buy instruments that entitle the holder to a share of the net
assets of a particular sub-fund.
The umbrella fund and sub-funds together form a legal entity, although the assets and the obligations of individual funds are
fully or partially segregated. Each sub-fund usually has its own investment objectives, focusing on different markets.
The analysis in this question applies only to instances in which the assets and obligations of each sub-fund are ring-fenced
solely for investors of the respective sub-fund.
The table below discusses the possible classication of puttable instruments and instruments that impose on the entity an
obligation to deliver to another party a pro rata share of the net assets only on liquidation, issued by an umbrella fund structure.
Type of nancial statements
prepared
Considerations Classication
Individual nancial statements
prepared by each sub-fund
Each sub-fund assesses issued instruments for equity
classication separately.
Liability or equity
Separate nancial statements
of umbrella fund structure
that include the assets and
liabilities of the sub-funds that
together form a single legal
entity
Instruments issued by the sub-funds are assessed for equity
classication from the perspective of the umbrella fund
structure as a whole.
Instruments issued by each sub-fund cannot qualify for
equity classication because they could not meet the
prorata share of the entitys net assets on liquidation
condition and, if they are puttable instruments, the identical
features test.
Liability
Consolidated nancial
statements with sub-funds as
subsidiaries
Instruments issued by sub-funds that qualify for equity
presentation in the individual nancial statements of
each fund and that represent non-controlling interests
are classied as liabilities in the consolidated nancial
statements.
Liability
Combined nancial
statements prepared by an
umbrella fund structure,
expressed as prepared in
accordance with IFRS
In our view, puttable sub-fund instruments would not qualify
for equity classication in the combined nancial statements
for the reasons described above for both separate and
consolidated nancial statements.
Liability
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5. When should a nancial instrument be
reclassied between liability and equity?
The classication of an instrument or its component parts as either a nancial liability or equity is made at initial recognition
and, with the exception of puttable instruments and instruments that impose on the entity an obligation only on liquidation,
is not generally revised as a result of subsequent changes in circumstances. However, a reclassication between liability and
equity or vice versa may be required following changes to the contractual or effective terms of the instruments or changes in
the composition of the reporting entity. Puttable instruments and instruments or components that impose on the entity an
obligation only in liquidation are reclassied:
to nancial liability from the date on which any of the equity classication criteria in Question 2 cease to be met; or
to equity from the date on which all equity classication criteria in Question 2 are met.
This indicates a continuous assessment model under which a fund re-assesses the classication whenever there are changes
to the relevant circumstances e.g. changes to the capital structure, such as the issue of new classes of shares or redemptions
of existing share classes.
Puttable instruments or instruments that impose on the entity an obligation only on liquidation are measured on reclassication
as follows.
Reclassication Measurement Accounting for carrying amount adjustment
From equity to
nancial liability
Liability is measured initially at the instruments
fair value at the date of reclassication.
Any difference between the carrying amount of
the equity instrument and the fair value of the
nancial liability at the date of reclassication
continues to be recognised in equity.
From nancial liability
to equity
Equity instrument is measured at the carrying
amount of the nancial liability at the date of
reclassication.
No adjustment to the carrying amount.
Accounting entries Reclassication from equity to nancial liability
Assume that on the date of reclassication the carrying amount of an instrument previously classied as equity is 100 and its
fair value is 90. The double entry on reclassication is as follows.
Debit Credit
Equity
1
90
Liability 90
Accounting entries Reclassication from nancial liability to equity
Assume that on the date of reclassication the carrying amount of an instrument previously classied as equity is 100 and its
fair value is 90. The double entry on reclassication is as follows.
Debit Credit
Liability 100
Equity 100
1 This example does not focus on different components of equity.
IFRS for Investment Funds | 11
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Other KPMG publications
A more detailed discussion of the general accounting issues that arise from the application of IFRS can be found in our
publication Insights into IFRS. In addition, we have a range of publications that can help you further, including:
Illustrative nancial statements: Investment funds
Illustrative nancial statements for interim and annual periods
IFRS compared to US GAAP
IFRS Handbooks, which include extensive interpretative guidance and illustrative examples to elaborate or clarify the
practical application of a standard, including IFRS Handbook: First-time adoption of IFRSs
New on the Horizon publications, which discuss consultation papers
First Impressions publications, which discuss new pronouncements
Newsletters, which highlight recent accounting developments
IFRS Practice Issues publications, which discuss specic requirements of pronouncements
Disclosure checklist.
IFRS-related technical information is also available at kpmg.com/ifrs.
For access to an extensive range of accounting, auditing and nancial reporting guidance and literature, visit KPMGs
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Acknowledgements
We would like to acknowledge the principal contributors to this publication. They are Ewa Bialkowska and Arina Tomiste of the
KPMG International Standards Group.
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Peter Hayes
KPMG in Canada
T: +1 416 777 3939
E: phayes@kpmg.ca
Vivian Chui
KPMG in Hong Kong
T: +85 22 978 8128
E: vivian.chui@kpmg.com.hk
Manoj Kumar Vijai
KPMG in India
T: +91 22 3090 2493
E: mkumar@kpmg.com
Frank Gannon
KPMG in Ireland
T: +353 1410 1552
E: fgannon@kpmg.ie
Victor Chan Yin
KPMG in Luxembourg
T: +352 22 51 51 6514
E: victor.chanyin@kpmg.lu
Winand Paulissen
KPMG in the Netherlands
T: +313 06 58 24 31
E: paulissen.winland@kpmg.nl
Llewellyn Smith
KPMG in South Africa
T: +27 21 408 7346
E: llewellyn.smith@kpmg.co.za
Patricia Bielmann
KPMG in Switzerland
T: +41 44 249 4884
E: pbielmann@kpmg.com
Gareth Horner
KPMG in the UK
T: +44 131 527 6951
E: gareth.horner@kpmg.co.uk
kpmg.com/ifrs
2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.
The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.
Publication name: IFRS for Investment Funds
Publication number: Issue 3
Publication date: February 2012
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