Sale Of Equities Subject To Call Option – FAQ | IFRS

Sale of equities subject to call option

This is an illustration of how derecognition is applied in practice. The objective is to present the mechanics of applying the IFRS 9 requirements for derecognition of financial assets, starting with an analysis of the transaction using the flowchart [IFRS 9 B3.2.1], and culminating with the initial and subsequent accounting entries for both the transferor and transferee.

Background and assumptions

Entity C holds a 0.1% shareholding in a construction company it bought one year ago for €58 million and that is classified as asset at fair value through profit or loss. C enters into an agreement with bank D in which, in exchange for a cash payment of €65 million, C agrees to sell those shares to D. The shares are sold subject to a call option that allows C to repurchase the shares for €70 million, at anytime during the next three years. The shares are quoted in an active market.

Additional information:

  • Fair value of shares at date of transfer – €68 million
  • Amount of gain previously recognised in profit or loss – €10 million
  • Fair value of call option on date of transfer – €3 million (only time value, no intrinsic value and neither deeply in nor deeply out of the money)

Analysis using the flowchart [IFRS 9 B3.2.1]

Step 1 Consolidate all subsidiaries

This step is not applicable in this example.

Step 2 Determine whether the derecognition model should be applied to part of a financial asset (or a group of similar financial assets) or a financial asset (or a group of similar financial assets) in its entirety.

The asset being transferred is the shares in their entirety.

Step 3 Have the rights to the cash flows expired?

No, the rights to dividends continues to exist as the shares are still outstanding.

Step 4 Is there a transfer?

Yes, entity C has sold the shares to bank D.

Step 5 Risks and rewards analysis

Entity C has neither transferred nor retained substantially all the risks and rewards of the shares, as the call option is neither deeply in nor deeply out of the money.

Step 6 Control

As the shares are quoted in an active market, D has the practical ability to sell them, and C has lost control. Hence it should derecognise the shares and recognise the call option.

Helpful hint – alternatives relating to call options

If an entity holds a call option on an asset that is readily obtainable in the market and the option is neither deeply in the money nor deeply out of the money, the asset is derecognised. This is because the entity (a) has neither retained nor transferred substantially all the risks and rewards of ownership, and (b) has not retained control. However, if there is no market for the asset, derecognition is precluded to the extent of the amount of the asset that is subject to the call option because the entity has retained control of that amount of the asset.

If a transferred financial asset can be called back by the transferor and the call option is deeply in the money, the transfer does not qualify for derecognition regardless of whether there is a market for the asset. This is because the transferor has retained substantially all the risks and rewards of ownership. Conversely, a financial asset that is transferred subject only to a deep out-of-the-money call option held by the transferor is derecognised regardless of whether there is a market for the asset. This is because the transferor has transferred substantially all the risks and rewards of ownership. A transfer of a financial asset that is subject only to a call option agreement that has an exercise or repurchase price equal to the fair value of the financial asset at the time of repurchase also results in derecognition regardless of whether there is a market for the asset. This is because the transferor has transferred substantially all the risks and rewards of ownership.

Transferor’s accounting

On the date of the transfer

Entity C derecognises the shares in their entirety and recognises a new financial asset (the purchased call option) at fair value. C should calculate the gain or loss on the sale of its shares. The gain or loss on sale is calculated as the difference between:

  • the carrying amount of €68 million, and
  • the sum of the consideration received of €68 million (ie, €65 million cash plus the new call option obtained whose fair value is €3 million) and any cumulative gain or loss that had been recognised directly in equity (€10 million).

€ millions

Carrying amount

68

Consideration received

68

Cumulative gain or loss in equity

10

Gain on derecognition

10

 

Accounting entries on the date of the transfer

(in € millions)

DR

CR

Cash

65

Written call option

3

\ Shares

68

OCI – Items that may be reclassified to profit or loss – Realised result on securities

10

\ Gain on derecognition (in profit or loss)

10

To recognise the cash received for sale of the shares and to recognise the purchased call option and gain of €10 million.

Subsequently, entity C will measure its call option at fair value through profit and loss. If the price of the shares never reaches €70 million, the time value of the option will be recognised in profit and loss during the next three years. If the price of the shares rises above €70 million, C has the right to exercise its call option and pay cash of €70 million to D to obtain back the shares.

Transferee’s accounting

On the date of the transfer

As entity C derecognised the shares, D will recognise them. D will also recognise a liability for its written call option to C.

(in € millions)

DR

CR

Shares

68

Cash

65

\ Written call option

3

To recognise the purchase of shares and the writing of the call option.

Subsequently, D will measure the shares at fair value. They are classified as fair value through profit and gains or losses are recognised through profit or loss. D will also have to measure the written call option at fair value through profit or loss. It cannot achieve hedge accounting, as the hedging instrument is a written option. As the shares are quoted in an active market, D is free to sell the shares and can buy back equivalent shares from the market should C exercise its call.

Alternative scenario and accounting consequences – no market for the shares

Assume that the shares are not quoted in an active market but are privately held and that they represent 15% of the construction entity (rather than 0.1%). As there is no market for the asset, derecognition is precluded to the extent of the amount of the asset that is subject to the call option because the entity has retained control of the asset.

Transferor’s accounting

On the date of the transfer

Where a purchased call option is the cause of the continuing involvement, and the asset was previously measured at fair value, the transferred asset continues to be measured at fair value. The net amount of the asset and associated liability is always the fair value of the option. The associated liability is the balancing number and is measured at (a) the option exercise price less the time value of the option if the option is in or at the money, or (b) the fair value of the transferred asset less the time value of the option if the option is out of the money. Subsequently, any changes in the fair value of the transferred asset and associated liability are accounted for consistently with each other.

Accounting entries on the date of the transfer

(in € millions)

DR

CR

Cash Sale of equities subject to call option

65

Liability Sale of equities subject to call option

65

The amount of the liability (665 million) is the fair value of the transferred asset (668 million) less the time value of the option (63 million) as the option is out of the money.

Subsequent accounting

At the next reporting date, assume the fair value of the shares has increased to 669 million and the fair value of the option has decreased to 62 million (still all time value). The entries would be as follows:

(in € millions) Sale of equities subject to call option

DR

CR

Asset Sale of equities subject to call option

1

OCI – Items that may be reclassified to profit or loss – Realised result on securities

To continue to recognise the asset at fair value

1

OCI – Items that may be reclassified to profit or loss – Realised result on securities

2

Liability Sale of equities subject to call option

2

To adjust the liability for the change in the time value of the option and the change in fair value of the shares.

The liability now has a carrying value of 667 million which is comprised of the fair value of the asset (669 million) less the value of the option(62 million) as the option is still out of the money.

At the next reporting date, assume the fair value of the shares has increased to 672 million and C exercises its call option.

(in € millions) Sale of equities subject to call option

DR

CR

Asset Sale of equities subject to call option

3

OCI – Items that may be reclassified to profit or loss – Realised result on securities

To continue to recognise the asset at fair value

3

Liability Sale of equities subject to call option

67

\ Cash Sale of equities subject to call option

70

OCI – Items that may be reclassified to profit or loss – Realised result on securities

3

To record the exercise of the option and the receipt of 672 million from Company C.

It is worth noting that the net effect is:

  • Cr Cash 5 (net of 65 received on sale and 70 paid on repurchase)
  • Dr Asset 4 (increase in value from 68 to72)
  • Cr OCI 1 (increase in value of asset less time value of the option)

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