PORTFOLIO OF WORK DONE:

ACCOUNTING TREATMENT FOR THE

ISSUE OF A CALL OPTION OVER THE
SHARES OF A SUBSIDIARY (IFRS)

Rationale
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Example Accounting treatment for an option

In the example below, a company received a significant option fee of $8m after issuing a call option
over the shares of a subsidiary (X). The key question: should the company recognise the option
fee as income in the income statement (P&L)? or should it be held on the balance sheet?

We have redacted the original document, so removed names etc and used Seller for the company
issuing the option, and Buyer for option holder, and also changed amounts slightly, and deleted
sections so may not read smoothly.
Background
Seller entered into an option agreement (Option) with Buyer.

In return for a non-refundable upfront cash payment of US$8 million (the "Option Fee") Buyer was
granted the Option to purchase the entire issued share capital held by Seller of X (a subsidiary) for
a further cash sum of US$80 million (the "Exercise Price").

The Option may be exercised by Buyer at any time until 31 xx 20xx.

Does the option give rise to income? - conclusion

The deposit received of $8m is non-refundable and was paid by Buyer to grant them the right to
purchase X from Seller, but not the obligation. Therefore, it is not consideration in relation to the
sale of any asset, goods or services, and hence does not meet the recognition criteria for income
under IAS 18 Revenue or IFRS 3 Business Combinations.

As discussed below, the Option was found to be a financial liability to be measured at cost. It is not
possible, therefore, to recognise the $8m on a straight line basis over the life of the exercise period.

The Option is treated as deferred income until 30 xx 20xx as the risks and rewards of ownership of
X will not be transferred until Buyer exercises the option or it lapses. It is therefore classified as a
non-derivative financial liability(A1) that met the recognition criteria during the financial year ended
30 xx 20xx(A2).

Accordingly, the Option was initially measured at fair value less transaction costs(A3), and is
subsequently measured at amortised cost(A4).

At the point of recognition, and at 30 Juxx 20xx, the fair value and amortised cost were both
deemed to be $8m less costs of 1m, giving a net balance recorded in the 30 xx 20xx financial
statements of $6m.

Initial classification of the option

IAS 32 paragraph 11 has the following key definitions:

A financial liability is any liability that is:

(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are
potentially unfavourable to the entity;

An equity instrument is any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.

A financial asset is any asset that is:

(b) an equity instrument of another entity; (so an equity instrument could be a type of financial
asset)
Is the option a Financial liability?
From the above definitions, it may seem at first that Seller dont have a legal contractual obligation
at the outset as the sale of X is contingent upon Buyer exercising the option.

Under IAS 32 paragraph 15, however, the substance of the contractual arrangement has to be
considered on initial recognition, not just the legal form. Paragraphs 17-19 also indicate that the
substance of the Option is that of a financial liability. In particular, IAS 32 19(b) mentions that:

a contractual obligation that is conditional on a counterparty exercising its right to redeem is a

financial liability because the entity does not have the unconditional right to avoid delivering cash
or another financial asset

Is the option an equity instrument?

The option involves the shares of X, which are an equity instrument, however paragraph 16(a)
requires that to be an equity instrument the instrument includes no contractual obligation. This is
not the case as discussed below, and the option is therefore, not an equity instrument.

(A1) Specific clauses in the Option Agreement that require classification as a financial liability
If BUYER exercises its right under s.x.x of the Option, then SELLER would have a contractual
obligation to sell its shares in X and SELLER would not have any unconditional right to avoid this
obligation.

We also understand that the possibility of the Option being terminating by SELLER (for a fee of
$xxk) only applies during the Exclusivity Period under s.x.x, and this would appear to have expired
once SELLERs shareholders approved the Option.

Therefore, the Option is a financial liability.

We also note that under s.x.x, BUYER can dispose of its entire right under the Option (but not part
of) to another single person. BUYER could potentially sell the Option to an interested Buyer who
could then purchase at the exercise price, rather than market value. We also note that under s.7.7a
SELLER cannot allow any Controlled Matter to occur. These are listed in item 5 of Schedule 1, and
include disposing of the shares in X.

(A2) Initial Recognition and Measurement

IAS 39 paragraph 14 mentions that:

An entity shall recognise a financial asset or a financial liability in its statement of financial
position when, and only when, the entity becomes a party to the contractual provisions of the
instrument.

The Option was executed on xxx 20xx and shareholder approval was duly obtained prior to the
Latest Date.

The Option was therefore recognised as a financial liability during the year to 30 xx 20xx.
(A3) Initial Measurement
Fair Value
As the Option is a financial liability, it needs to be measured at fair value upon recognition under
IAS 39 paragraph 43 which mentions that:

When a financial asset or financial liability is recognised initially, an entity shall measure it at
its fair value plus, in the case of a financial asset or financial liability not at fair value through
profit or loss, transaction costs that are directly attributable to the acquisition or issue of the
financial asset or financial liability.

Fair value is defined in IAS 39 paragraph 9: Fair value is the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length
transaction

Therefore, the fair value of the Option would appear to be the Option Fee as it appears to be an
arm's length exchange motivated by normal business considerations as BUYER and SELLER are
not related parties and appear to be knowledgeable and willing parties.

(A4) Subsequent measurement

IAS 39 Paragraph 47 mentions that:

After initial recognition, an entity shall measure all financial liabilities at amortised cost using
the effective interest method, except for:
(a) financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that
are liabilities, shall be measured at fair value except for a derivative liability that is linked to and
must be settled by delivery of an unquoted equity instrument whose fair value cannot be reliably
measured, which shall be measured at cost.

As the option fee is a financial liability, it would be held at amortised cost.