## f16-subscription-rights - SECTION I: THE ISSUE

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### Background
- Subscription rights (SRs) are the rights corporate shareholders have to participate in the acquisition of shares newly issued by the corporation in order to raise additional funds.
- SRs are designed to offset any potential dilution effect in the value of the stake of current shareholders resulting from the terms of issuance: by exercising the rights, the investor maintains their percentage of ownership in the corporation buying a proportionate number of shares of the issuance.
- “Issuance of SRs” refers to the market and corporate practice of separating those particular rights from the original shares when a new equity issuance is announced so they become transferable and allow shareholders to obtain cash compensation for share dilution by selling them if they do not want to subscribe the additional capital.
- As a consequence of the separation of rights, each original share is split into two distinct assets: the ex-right share and the SR, which usually receives a separate ISIN code. The sum of the values of the ex-right share and the SR is equal at inception to the value of the original share; each individual value thereafter represents the market perception of the rights remaining in the separate assets.
- The value of the SRs at inception corresponds to the dilution in the value of the original individual shares caused by the terms of issuance of the new capital should the SRs not be exercised.
- The theoretical value at inception of a subscription right is 푠푠 = 푟푟(표표 − 푛푛)/(1 + 푟푟), where o is the value of the existing shares, n is the issuance price of the new shares and r is the ratio of new shares issued per existing share. This corresponds to the dilution in the value resulting from the issuance of new shares under the terms given by n and r.
- The sixth edition of the Balance of Payments and International Investment Position Manual (BPM6) and the System of National Accounts 2008 (2008 SNA) are silent on classification of SRs once detached from the original share. The “Handbook on National Accounting: Financial Production, Flows and Stocks in the System of National Accounts” (paragraph 4.205) indicates SRs are to be treated as financial derivatives as they are a “special kind of warrant”. The “Handbook on Securities Statistics” (paragraph 6.45) explicitly requires SRs to be treated as equity as they “represent a claim on the residual value of the corporation”.
- This Guidance Note examines the two alternative treatments (financial derivatives or equity), discusses pros and cons, clarifies accounting treatment in each case, and proposes a single treatment for update of the manuals.

### Issues for discussion — Option 1: Equity
- Relevant definition: 2008 SNA paragraph 11.81: “equity and investment fund shares have the distinguishing feature that the holders own a residual claim on the assets of the institutional unit that issued the instrument. Equity represents the owner’s funds in the institutional unit.”
- Reasoning for classifying SRs as equity:
  - Corporate value is the (market) value of accumulated and future earnings; equity is the accounting representation thereof. Separation of SRs does not change total expected earnings, so total equity liabilities should remain unaffected by the split.
  - For total equity to remain unchanged after SR issuance, both ex-right shares and SRs must be classified as equity. SRs would contain the value diluted from existing shares; added to diluted ex-right shares they sum to the original total corporate value before separation.
  - Main purpose of SRs is to ensure shareholders can maintain their percentage ownership and therefore maintain a claim on the assets of the corporation.
  - Analogy with bonus shares (2008 SNA, paragraph 11.89 and BPM6, paragraph 11.29): like bonus shares, SR separation needs no issuance transaction recorded; only sales of rights to third parties are booked as transactions in equity.
  - Analogy with stripped securities: economic rights get separated into assets corresponding to separate rights; individual stripped assets retain the same instrument category as the original asset.

### Issues for discussion — Option 2: Financial Derivatives
- Relevant definition: 2008 SNA paragraph 11.111 defines financial derivatives as assets “linked to a specific financial instrument” whose value “derives from the price of the underlying item.”
- SRs as call options:
  - SR holders have the right, not the obligation, to buy new shares; premium corresponds to dilution value at inception; strike price corresponds to issuance price for new shares.
  - Because exercising SRs leads to creation of new liabilities and dilution effects, they could be considered akin to (detachable) warrants (BPM6, paragraph 5.87).
  - SRs have much shorter maturity than typical warrants: SRs have around 15 to 60 days maturity, as opposed to 5 years or more for warrants.
- Similarities with employee stock options (ESO):
  - Both have option-like mechanics and give rise to newly issued shares and dilution effects. ESO are classified separately from financial derivatives but grouped with derivatives under “financial derivatives and employee stock options”.
- Arguments against equity characterization under this view:
  - SR holders cannot exercise other standard shareholder rights—they do not have rights to income (dividends), cannot participate in general meetings, and have expiration dates—unlike proper equity.
- Recording and interpretability challenges if SRs are treated as derivatives:
  - Treating SR issuance as issuance of a derivative would imply flows that are difficult to interpret (e.g., recording an income payment or “superdividend” to reflect dilution), potentially producing equity issuance transactions that equal market value of new shares rather than funds raised.
  - Alternatives include booking the emergence of SRs as other flows in financial derivatives offsetting ex-right share dilution; this would create claims with no debtor-to-creditor cash-flows attached and values that change only via holding gains/losses, which is seen as a statistical artefact.
  - Considering SRs as transfers (current or capital) from corporations to shareholders would introduce new categories of transfers and alter the interpretation of equity issuance flows.
- Footnote observations:
  - Warrants are usually issued with strike prices higher than current price; warrants can be issued independently of other instruments in exchange for a premium; these features make warrant dilution effects different from SRs.
  - If SRs were treated as dividends, paradoxical divergent treatments could arise across economically equivalent transactions (example comparing sale of equity vs. issuance of new shares 1:1 with issuance price 0).

### Outcomes — Recommendation and consequences
- Recommendation:
  - Option 1 (Equity) is recommended.
  - A majority of FITT members support including SRs within equity liabilities of the issuing corporation.
  - Rationale: Excluding SRs from equity would hamper interpretability of equity as market value of corporate own funds.
- Majority view details:
  - SR issuance (separation from the share) does not change the residual value of the corporation; detached assets represent part of that residual value.
  - SRs cover dilution caused to existing shares by terms of the new equity issuance; SRs plus ex-right shares make up total corporate value unchanged upon SR issuance.
  - SRs are intended to compensate for dilution and maintain shareholder rights, not to trade financial risks as financial derivatives do (2008 SNA, paragraph 11.112).
  - Cash flow structure and value determinants of SRs differ from standard financial derivatives: SR and ex-right share values are jointly determined and linked to corporate value determinants; issuance of SRs entails a dilution effect at inception that is not common in standard derivatives.
- FITT notes and dissenting views:
  - FITT acknowledges instruments that lack some derivative features are nevertheless classified under financial derivatives or “financial derivatives and employee stock options”, but SRs’ economic substance is not easily considered similar to those instruments.
  - One FITT member supported Option 2 on grounds of SR similarity to derivatives, preferring to treat their emergence as other flows. Another FITT member preferred Option 2 in theoretical terms (treating issuance as an income payment) but supported Option 1 for easier practical implementation given the short time between SR issuance and corresponding equity issuance.
- Consequences for accounting and recording if SRs are classified as equity:
  - When the subscription right is issued (separated) no flow is recorded.
  - Purchase of a subscription right by a third party is booked as transactions in equity between the old shareholder and the buyer, compensated with cash payments.
  - Values of subscription rights and ex-right shares experience holding gains and losses between SR issuance and issuance of new capital; these are booked as holding gains and losses in existing equity.
  - Issuance of new capital is recorded by the cash provided (funds raised) issued by the corporation and acquired by those holding and exercising the SRs.
  - SRs can be quoted or unquoted, similar to standard shares.

### Committee and AEG conclusions
- Most members of the IMF Committee on Balance of Payments Statistics and the Advisory Expert Group on National Accounts (AEG) expressed support for Option 1 (the classification and treatment of subscription rights as equity) on both theoretical and practical grounds relative to the alternative option of treating subscription rights as financial derivatives (Option 2).
- The AEG noted that, despite its support for Option 1, classification of subscription rights as equity could be potentially anomalous since equity has no expiry dates while subscription rights have, and that the wording of the manuals should accommodate this exception.
- During the review of the Guidance Note in preparation of the public consultation: three indicated support for Option 1 (equity) and one for Option 2 (financial derivatives).

### Annex I: Example of Recording Under Option 1 (Subscription Rights Are Equity)
- Corporate value before the SRs offer; 10
- IPO terms (dilution by 0.5):
  - Ratio capital increase; 1:1
  - New capital raised; 9
- SRs are sold to new investors; no change in corporate value occurs between issuance of SRs and capital issuance
- Highlights of the accounting entries:
  - No transaction is booked at inception
  - Only transactions in equity between investors are booked; the decline in the equity portfolio of the old shareholder is a transaction
  - Issuance of capital is valued by 9, the funds raised

### Annex II: Examples of Recording Under Option 2 (Subscription Rights Are Financial Derivatives)
- Corporate value before the SRs offer; 10
- IPO terms (dilution by 0.5):
  - Ratio capital increase; 1:1
  - New capital raised; 9
- SRs are sold to new investors; no change in corporate value occurs between issuance of SRs and capital issuance

- Sub-option 2.1: The Financial Derivative is the Counterpart of a Payment (Dividends, Current or Capital Transfers)
  - Highlights of the accounting entries:
    - Net lending/ net borrowing of the old shareholder and the corporation is affected by the dilation value
    - The decline in the equity portfolio of the old shareholder is a devaluation
    - Issuance of capital is valued by 9.5 (funds raised plus dilution value)

- Sub-option 2.2: The Financial Derivative is the Counterpart of Equity Withdrawals
  - Highlights of the accounting entries:
    - The decline in the equity portfolio of the old shareholder is a transaction
    - Issuance of capital is valued by 9.5 (funds raised plus dilution value), but, combined with the equity withdrawals of -0.5 (dilution value) at SRs inception, a total equity issuance of 9 (funds raised) is booked

- Sub-Option 2.3: Financial Derivative Changes in Value are Booked as Other Flows
  - Highlights of the accounting entries:
    - The decline in the equity portfolio of the old shareholder is a devaluation
    - Issuance of capital is valued by 9, the funds raised

- Sub-option 2.4: Financial Derivative Created as Other Flows; Extinction as Transaction Against Equity
  - Highlights of the accounting entries:
    - The decline in the equity portfolio of the old shareholder is a devaluation
    - Issuance of capital is valued by 9.5 (funds raised plus dilution value)

*Prepared by Barend DeBeer (South African Reserve Bank), Celestino Girón (European Central Bank), and Paula Menezes (Banco de Portugal).*

### SECTION I: THE ISSUE

### f16-subscription-rights - SECTION I: THE ISSUE

### Background
- Subscription rights (SRs) are the rights corporate shareholders have to participate in the acquisition of shares newly issued by the corporation in order to raise additional funds.
- SRs are designed to offset any potential dilution effect in the value of the stake of current shareholders resulting from the terms of issuance: by exercising the rights, the investor maintains their percentage of ownership in the corporation buying a proportionate number of shares of the issuance.
- “Issuance of SRs” refers to the market and corporate practice of separating those particular rights from the original shares when a new equity issuance is announced so they become transferable and allow shareholders to obtain cash compensation for share dilution by selling them if they do not want to subscribe the additional capital.
- As a consequence of the separation of rights, each original share is split into two distinct assets: the ex-right share and the SR, which usually receives a separate ISIN code. The sum of the values of the ex-right share and the SR is equal at inception to the value of the original share; each individual value thereafter represents the market perception of the rights remaining in the separate assets.
- The value of the SRs at inception corresponds to the dilution in the value of the original individual shares caused by the terms of issuance of the new capital should the SRs not be exercised.
- The theoretical value at inception of a subscription right is 푠푠 = 푟푟(표표 − 푛푛)/(1 + 푟푟), where o is the value of the existing shares, n is the issuance price of the new shares and r is the ratio of new shares issued per existing share. This corresponds to the dilution in the value resulting from the issuance of new shares under the terms given by n and r.
- The sixth edition of the Balance of Payments and International Investment Position Manual (BPM6) and the System of National Accounts 2008 (2008 SNA) are silent on classification of SRs once detached from the original share. The “Handbook on National Accounting: Financial Production, Flows and Stocks in the System of National Accounts” (paragraph 4.205) indicates SRs are to be treated as financial derivatives as they are a “special kind of warrant”. The “Handbook on Securities Statistics” (paragraph 6.45) explicitly requires SRs to be treated as equity as they “represent a claim on the residual value of the corporation”.
- This Guidance Note examines the two alternative treatments (financial derivatives or equity), discusses pros and cons, clarifies accounting treatment in each case, and proposes a single treatment for update of the manuals.

### Issues for discussion — Option 1: Equity
- 2008 SNA paragraph 11.81: “equity and investment fund shares have the distinguishing feature that the holders own a residual claim on the assets of the institutional unit that issued the instrument. Equity represents the owner’s funds in the institutional unit.”
- Reasoning for classifying SRs as equity:
  - Corporate value is the (market) value of accumulated and future earnings; equity is the accounting representation thereof. Separation of SRs does not change total expected earnings, so total equity liabilities should remain unaffected by the split.
  - For total equity to remain unchanged after SR issuance, both ex-right shares and SRs must be classified as equity. SRs would contain the value diluted from existing shares; added to diluted ex-right shares they sum to the original total corporate value before separation.
  - Main purpose of SRs is to ensure shareholders can maintain their percentage ownership and therefore maintain a claim on the assets of the corporation.
  - Analogy with bonus shares (2008 SNA, paragraph 11.89 and BPM6, paragraph 11.29): like bonus shares, SR separation needs no issuance transaction recorded; only sales of rights to third parties are booked as transactions in equity.
  - Analogy with stripped securities: economic rights get separated into assets corresponding to separate rights; individual stripped assets retain the same instrument category as the original asset.

### Issues for discussion — Option 2: Financial Derivatives
- 2008 SNA paragraph 11.111 defines financial derivatives as assets “linked to a specific financial instrument” whose value “derives from the price of the underlying item.”
- SRs as call options:
  - SR holders have the right, not the obligation, to buy new shares; premium corresponds to dilution value at inception; strike price corresponds to issuance price for new shares.
  - Because exercising SRs leads to creation of new liabilities and dilution effects, they could be considered akin to (detachable) warrants (BPM6, paragraph 5.87).
  - SRs have much shorter maturity than typical warrants: SRs have around 15 to 60 days maturity, as opposed to 5 years or more for warrants.
- Similarities with employee stock options (ESO):
  - Both have option-like mechanics and give rise to newly issued shares and dilution effects. ESO are classified separately from financial derivatives but grouped with derivatives under “financial derivatives and employee stock options”.
- Arguments against equity characterization under this view:
  - SR holders cannot exercise other standard shareholder rights—they do not have rights to income (dividends), cannot participate in general meetings, and have expiration dates—unlike proper equity.
- Recording and interpretability challenges if SRs are treated as derivatives:
  - Treating SR issuance as issuance of a derivative would imply flows that are difficult to interpret (e.g., recording an income payment or “superdividend” to reflect dilution), potentially producing equity issuance transactions that equal market value of new shares rather than funds raised.
  - Alternatives include booking the emergence of SRs as other flows in financial derivatives offsetting ex-right share dilution; this would create claims with no debtor-to-creditor cash-flows attached and values that change only via holding gains/losses, which is seen as a statistical artefact.
  - Considering SRs as transfers (current or capital) from corporations to shareholders would introduce new categories of transfers and alter the interpretation of equity issuance flows.
- Footnote observations:
  - Warrants are usually issued with strike prices higher than current price; warrants can be issued independently of other instruments in exchange for a premium; these features make warrant dilution effects different from SRs.
  - If SRs were treated as dividends, paradoxical divergent treatments could arise across economically equivalent transactions (example comparing sale of equity vs. issuance of new shares 1:1 with issuance price 0).

### Outcomes — Recommendation and consequences
- Recommendation: Option 1 (Equity) is recommended.
  - A majority of FITT members support including SRs within equity liabilities of the issuing corporation.
  - Rationale: Excluding SRs from equity would hamper interpretability of equity as market value of corporate own funds (see paragraphs 6 to 10).
- Majority view details:
  - SR issuance (separation from the share) does not change the residual value of the corporation; detached assets represent part of that residual value.
  - SRs cover dilution caused to existing shares by terms of the new equity issuance; SRs plus ex-right shares make up total corporate value unchanged upon SR issuance.
  - SRs are intended to compensate for dilution and maintain shareholder rights, not to trade financial risks as financial derivatives do (2008 SNA, paragraph 11.112).
  - Cash flow structure and value determinants of SRs differ from standard financial derivatives: SR and ex-right share values are jointly determined and linked to corporate value determinants; issuance of SRs entails a dilution effect at inception that is not common in standard derivatives.
- FITT notes and dissenting views:
  - FITT acknowledges instruments that lack some derivative features are nevertheless classified under financial derivatives or “financial derivatives and employee stock options”, but SRs’ economic substance is not easily considered similar to those instruments.
  - One FITT member supported Option 2 on grounds of SR similarity to derivatives, preferring to treat their emergence as other flows. Another FITT member preferred Option 2 in theoretical terms (treating issuance as an income payment) but supported Option 1 for easier practical implementation given the short time between SR issuance and corresponding equity issuance.
- Consequences for accounting and recording if SRs are classified as equity (summary of recording implications):
  - When the subscription right is issued (separated) no flow is recorded.
  - Purchase of a subscription right by a third party is booked as transactions in equity between the old shareholder and the buyer, compensated with cash payments.
  - Values of subscription rights and ex-right shares experience holding gains and losses between SR issuance and issuance of new capital; these are booked as holding gains and losses in existing equity.
  - Issuance of new capital is recorded by the cash provided (funds raised) issued by the corporation and acquired by those holding and exercising the SRs.
  - SRs can be quoted or unquoted, similar to standard shares.

*Prepared by Barend DeBeer (South African Reserve Bank), Celestino Girón (European Central Bank), and Paula Menezes (Banco de Portugal).*

### 25.      Most members of the IMF Committee on Balance of Payments Statistics and the Advisory

### f16-subscription-rights - 25.

### Committee and AEG conclusions
- Most members of the IMF Committee on Balance of Payments Statistics and the Advisory Expert Group on National Accounts (AEG) expressed support for Option 1 (the classification and treatment of subscription rights as equity) on both theoretical and practical grounds relative to the alternative option of treating subscription rights as financial derivatives (Option 2).
- The AEG noted that, despite its support for Option 1, classification of subscription rights as equity could be potentially anomalous since equity has no expiry dates while subscription rights have, and that the wording of the manuals should accommodate this exception.
- A few members of the AEG and the BPTT expressed their preference for one of the two options during the review of the GN in preparation of the public consultation: three indicated support for Option 1 (equity) and one for Option 2 (financial derivatives).

### Annex I: Example of Recording Under Option 1 (Subscription Rights Are Equity)
- Corporate value before the SRs offer; 10
- IPO terms (dilution by 0.5):
  - Ratio capital increase; 1:1
  - New capital raised; 9
- SRs are sold to new investors; no change in corporate value occurs between issuance of SRs and capital issuance
- Highlights of the accounting entries:
  - No transaction is booked at inception
  - Only transactions in equity between investors are booked; the decline in the equity portfolio of the old shareholder is a transaction
  - Issuance of capital is valued by 9, the funds raised

### Annex II: Examples of Recording Under Option 2 (Subscription Rights Are Financial Derivatives)
- Corporate value before the SRs offer; 10
- IPO terms (dilution by 0.5):
  - Ratio capital increase; 1:1
  - New capital raised; 9
- SRs are sold to new investors; no change in corporate value occurs between issuance of SRs and capital issuance

- Sub-option 2.1: The Financial Derivative is the Counterpart of a Payment (Dividends, Current or Capital Transfers)
  - Highlights of the accounting entries:
    - Net lending/ net borrowing of the old shareholder and the corporation is affected by the dilution value
    - The decline in the equity portfolio of the old shareholder is a devaluation
    - Issuance of capital is valued by 9.5 (funds raised plus dilution value)

- Sub-option 2.2: The Financial Derivative is the Counterpart of Equity Withdrawals
  - Highlights of the accounting entries:
    - The decline in the equity portfolio of the old shareholder is a transaction
    - Issuance of capital is valued by 9.5 (funds raised plus dilution value), but, combined with the equity withdrawals of -0.5 (dilution value) at SRs inception, a total equity issuance of 9 (funds raised) is booked

- Sub-Option 2.3: Financial Derivative Changes in Value are Booked as Other Flows
  - Highlights of the accounting entries:
    - The decline in the equity portfolio of the old shareholder is a devaluation
    - Issuance of capital is valued by 9, the funds raised

- Sub-option 2.4: Financial Derivative Created as Other Flows; Extinction as Transaction Against Equity
  - Highlights of the accounting entries:
    - The decline in the equity portfolio of the old shareholder is a devaluation
    - Issuance of capital is valued by 9.5 (funds raised plus dilution value)

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_Source: https://www.imf.org/-/media/files/data/statistics/bpm6/approved-guidance-notes/f16-subscription-rights.pdf_