Chronology
Timetable
Background
This project addresses the distinction between liabilities and equity.
This is a joint project with the FASB.
Discussion at the March 2005 IASB Meeting
The FASB presented to the IASB the approach being developed by the FASB regarding the accounting for instruments that could potentially be classified as liabilities or equity. The PowerPoint presentation is available on the IASB's website in the observer notes section and will be posted to FASB's website in due course.
Discussion at the April 2006 IASB Meeting
FASB staff conducted an educational session to update the IASB on status of the FASB's liabilities and equity project. The objective of the project is to establish a framework for classifying and measuring instruments with characteristics of equity and liabilities under US GAAP.
Staff noted that the approach being presented today encompasses not only the single-component financial instruments, which the Board discussed at its March 2005 meeting, but also multiple-component financial instruments.
Staff presented an accounting approach called the Ownership-Settlement Approach. The approach is based on 13 principles that deal with classification, initial measurement, subsequent measurement, separate reporting within equity, and extinguishment accounting. The presentation included a comparison of the approach to current IFRS literature.
In addition to this approach, the FASB will further develop two alternative approaches:
- The Dilution Approach. A narrower view of equity that bases its classification scheme on whether an instrument will or might dilute net assets belonging to existing shareholders.
- Reassessed Expected Outcomes (REO) Approach. This approach was presented to the IASB at its June 2004 meeting. REO is a probabilistic-based approach that applies contingent claims modelling techniques to determine classification based on the current economic conditions.
After choosing one approach, the FASB to publish a Preliminary Views document in the second quarter of 2007.
No decisions were made during this session.
Discussion at the January 2007 IASB Meeting
Project proposal
(The FASB staff joined the meeting by video link for this session.)
The Board discussed the latest project plan for the Liabilities and Equity project and its interaction with other projects, in particular the steps contemplated with respect to issuing the forthcoming FASB Preliminary Views document as an IASB Discussion Paper.
The staff noted that it intended to discuss with the IASB three models for distinguishing liabilities and equity in the FASB Preliminary Views document as well as a model being developed under the auspices of the European Financial Reporting Advisory Group. Other sessions would allow for a discussion of the FASB's Preliminary Views and associated Invitation to Comment.
Board members asked whether the EFRAG model was a new approach or a variant of one of the FASB models. It was suggested that it was a variant of the 'ownership/ settlement' model. Board members suggested that it would be highly beneficial to the IASB, FASB and the EFRAG working group if the EFRAG model was discussed before the FASB finalised their Preliminary Views document. The Board asked the staff to suggest that the item be added to the April IASB/FASB joint meeting agenda, provided that the EFRAG working group had completed their work.
Interaction with the conceptual framework project
The Board also noted that there was a potential overlap between the Liabilities and Equity project and the definitions part of the conceptual framework project. Board members noted that the Boards' current efforts in the conceptual framework project had been focussed on the definition of an asset; it was almost assumed that the Liabilities and Equity project would address the conceptual issues. It was noted that the staff summary (Observer Note 12B) was a very good summary of why the Liabilities and Equity project was the appropriate context in which to consider the conceptual issues involved.
Overview of IAS 32
The Board discussed a memorandum prepared by the staff that summarised and illustrated the difficulties in applying the current distinction between liabilities and equity in IAS 32 Financial Instruments: Presentation. The paper addressed issues such as the tension between legal form and economic substance, the overlapping nature of many hybrid instruments and the challenge faced by the IASB in developing further guidance, given the diversity of opinion about what constitutes 'equity'.
The Board commended the staff's work, but asked that before issuing the summary in final form, the staff should include arguments refuting commonly-presented 'problems' (such as 'economic compulsion'). In addition, the Board suggested other issues for inclusion and discussion.
Discussion at the February 2007 IASB Meeting – Educational Session
In this first education session on this topic, the Board discussed the three models for distinguishing liabilities and equity in the FASB Preliminary Views Document, namely:
- Ownership
- Ownership–settlement
- Reassessed expected outcome (REO)
The staff provided a detailed analysis and comparison of the three models covering the following aspects:
- Definition of equity
- Linkage and separation principles
- Initial and subsequent measurement
- Other issues: substantive features principle, separate presentation in equity, consolidation, reassessment and reclassification
- Illustrative examples for the equity/liability classification of different types of common stock, preferred stock, hybrid instruments and options/forwards
Further details are available in Observer Note 4 to 4H, available on the IASB Website.
The session consisted of Board members questioning the application of the three models, and comparing them with each other. The discussion particularly focused on the definition of equity, the treatment of convertible instruments, the linkage and separation criteria, and the definition of transaction price.
No decisions were made, and no strong views were expressed at this stage.
Discussion at the April 2007 Joint IASB-FASB Meeting
The Boards discussed an alternative view of the liability and equity distinction labelled as the Loss Absorption Approach.
The approach was prepared by staff of the Accounting Standards Committee of Germany on behalf of the European Financial Reporting Advisory Group (EFRAG) and the German Accounting Standards Board (GASB) under the Pro-active Accounting Activities in Europe Initiative (PAAinE) of EFRAG and the European National Standard Setters.
The staff pointed out that the basic principle for the classification of equity and liability has been established but that all other components still represent work-in-progress.
The core principles of the Loss Absorption Approach are:
- Dichotomous approach that classifies equity and liability from an entities perspective and seeks to define the term equity rather than the term liability.
- The distinction between equity (risk capital) and liabilities is based exclusively on the ability or inability of capital to absorb losses incurred by the entity with losses being tentatively understood as accounting losses.
- Accounting losses are defined as 'net negative total recognised income and expense before conditional servicing costs and related tax impact on and remeasurements of capital provided'.
- Both capital that is fully loss-absorbing and capital that is not fully loss-absorbing classifies as (partial) equity. If an instrument is not fully loss-absorbing, the instrument is bifurcated into a fully loss-absorbing portion and a non loss-absorbing portion (split accounting). Only the fully loss-absorbing portion is allocated to equity.
- An instrument is classified solely by reference to its terms and conditions and independently of the classification of other instruments, that is, all instruments within the same class of capital and across entities will be accounted for in the same way, thereby not taking into account what other instruments had been issued or at which point in time an investment was being made.
- Classification of an instrument would has to be made at inception and will not be changed unless either its terms and conditions are changed or settlement of the instrument gives rise to a new instrument. In particular, no reclassification is made over the term of the instrument following recognition of additional instruments, derecognition of existing instruments, or passage of time. Embedded conditional features (such as the exercise of a conversion option or a condition to absorb losses only if these exceed a certain threshold) would not be considered a change to the terms and conditions of the instrument. Rather, they are conditions already implicit in the terms and conditions that may come into force and that, hence, would have to be tested for each reporting date as to whether they have actually come into force.
- Retained earnings and measurement reserves such as revaluation reserves and cash flow hedging reserves are regarded to be loss-absorbing capital.
The session was held in form of an educational session with the Boards questioning the application of the model.
The discussion particularly focused on the following issues:
- The definition of accounting loss and the potential circularity in this definition
- The definition of loss absorption
- The treatment of convertible instruments and derivatives, in particular, the point in time at which these instruments fulfil the criterion of loss-absorbing capital
- The impact of the approach on the classification of puttable instruments
- The Boards identified various weaknesses in the approach and thought that, overall it was not superior to the approaches discussed by them so far. However, they noted that the Loss Absorption Approach was a 'work in progress' and encouraged the PAAinE/GASC group to continue its work. If there was a workable solution to one of accounting's most intractable problems, the Boards wanted to know about it.
No decisions were made.
Discussion at the December 2007 IASB Meeting
This project is part of the Memorandum of Understanding between the FASB and the IASB. On 30 November 2007, the FASB published for comment a preliminary views document. The document can be downloaded from the FASB's Website.
This session was split in two parts:
- The Board's strategy for the project
- An education session conducted by FASB staff members on the preliminary views document issued by the FASB
Strategy
The staff informed the Board that it plans to present a comprehensive analysis of the differences between the FASB's preliminary views and the current approach under IFRSs as set out in IAS 32 at the Board meeting in January or February (including a draft IASB Discussion Paper (DP) inviting comment on FASB's preliminary views). Staff noted that if the Board does issue amendments to IAS 32 regarding instruments puttable at fair value, that would be included in the analysis. The focus will be on the 'basic ownership' and 'ownership-settlement' approaches. The next step would be the publication of the IASB DP in March 2008. The DP would incorporate FASB's preliminary views document, possibly with additional material or questions, and invite public comments.
The Board agreed to the proposed schedule.
Education session
This was an education session and accordingly no decisions were made. The full presentation can be downloaded from the IASB's Website (Agenda Paper 4B).
The main topics of the presentation were:
- The FASB's preference is a basic ownership approach. A basic ownership instrument is the most subordinate class of claims that provides for a share of the assets after all other claims are satisfied – settlement would not be relevant for classification. In this approach (like in the other approaches) equity is defined first – liabilities are the residual.
The FASB staff highlighted the reduction of accounting arbitrage opportunities and its simplicity as the main advantages of this approach. Additionally, substance and linkage tests would be reduced. The major disadvantages are the greater impact on the income statement and the changes in accounting for convertible debt (especially compared to the current IAS 32 model) and stock options.
- The ownership-settlement approach seems less favourable, but still a feasible approach.
- The reassessed expected outcomes approach was found to be complex and hard to communicate to constituents. The FASB staff made clear that they would prefer not to analyse this approach any further as none of the FASB members voted in favour of it.
The Board discussed some types of instruments, especially those with put features, in the light of the previous discussions it had on the proposed puttable instruments amendments to IAS 32. Also, it discussed some types of preference shares. The FASB staff noted that the preliminary views document is not supposed to be close to a standard but more a discussion of the broader principles from which a standard could be developed.
One participant mentioned the possible impact of the equity definition on distributable profits if distributable profits are based on equity as measured in accordance with IFRSs.
Some Board members raised concerns that the proposed approach to distinguish liabilities and equity will not be in line with the current IASB Framework and asked if the FASB and IASB staff are communicating with the Framework's project team. It was noted that staff must ensure that both projects are aligned so that the liabilities/equity project does not present outcomes that contradict the results from the Framework project.
Discussion at the January 2008 IASB Meeting
At the December 2007 Board meeting the IASB decided to issue a Discussion Paper on Financial Instruments with Characteristics of Equity.
The objective of this session was to:
- Discuss the content of the staff draft of the IASB Invitation to Comment to be included in the Discussion Paper
- Discuss the questions for respondents included in the IASB Invitation to Comment
- Provide the Board with an oral summary of the FIWG discussions.
The staff informed the Board that the overall response from the FIWG was positive. The only area of concern was communication of the timeline of the project and the interaction if the IASB project with the progress of the FASB project. One Board member pointed out that, at this stage, this project is not on the active agenda of the IASB and that the Board will deliberate adding it to its agenda in due course. However, it would be welcomed that both Boards will move in tandem when they come to exposure draft stage. Another concern was that respondents should be asked about the interaction with other IASB projects.
The Board members seemed not to support this proposal. They saw it as the Board's duty to ensure proper interaction between Board projects.
While the Board agreed to the main body of the staff paper, except for some drafting proposals, the questions to respondents that were proposed in addition to the questions from the FASB document in Appendix B seemed to be more controversial. Two questions in the staff draft will be dropped:
- B1.b: How important is it that the IASB develops a common, high quality standard used in both US and IFRS jurisdictions in the short to medium term?
- B3: How would you address the interaction between this project and the IASB's other projects on the conceptual framework, financial instruments, and financial statement presentation? Are certain projects precedential?
It was also agreed that the question on the appropriateness of the principles set out for all types of entities and jurisdictions (B5) should be expanded to cover all approaches mentioned in the document. One Board member noted that respondents could also be asked if 'economic compulsion' should also be a principle and whether this should be addressed.
The staff informed the Board that they will prepare a pre-ballot draft based on the outcome of this meeting.
Discussion at the February 2008 IASB Meeting
The staff asked the Board whether there was agreement on acknowledging in the IASB's forthcoming discussion paper that the European Financial Reporting Advisory Group (EFRAG) had also issued a discussion paper on the distinction between equity and liabilities. Most Board Members disagreed with the staff's proposed wording and emphasised that the IASB should make it clear that it had not deliberated the final version of the EFRAG document, had therefore reached no final position on its merits and that the acknowledgement of the existence of the EFRAG paper should not be seen as the IASB endorsing the positions taken therein. It was decided to take the staff proposals offline to agree a suitable wording.
February 2008: Discussion Paper on how to define equity instruments
On 28 February 2008, the IASB published for comment a Discussion Paper (DP) on Financial Instruments with Characteristics of Equity. The DP has two parts – an Invitation to Comment and, as a separate document, the FASB's November 2007 Preliminary Views Financial Instruments with Characteristics of Equity. The IASB's Invitation to Comment includes background information and invites responses to the questions already included in the FASB document and to a number of additional questions raised by the IASB. IAS 32 is the current IASB standard that addresses the distinction between liabilities and equity. The DP notes two broad types of problems with IAS 32 – uncertainties on how the principles in IAS 32 should be applied and, perhaps more significantly, whether application of those principles results in an appropriate distinction between equity instruments and non-equity instruments.
The FASB document describes three approaches to distinguish equity instruments and non-equity instruments:
- basic ownership,
- ownership-settlement, and
- reassessed expected outcomes.
The FASB has reached a preliminary view that the basic ownership approach is the appropriate approach for determining which instruments should be classified as equity. The IASB has not deliberated any of the three approaches, or any other approaches, to distinguishing equity instruments and non-equity, and does not have any preliminary view.
The IASB's DP describes some implications of the three approaches in the FASB document for IFRSs. For instance:
- Significantly fewer instruments would be classified as equity under the basic ownership approach than under IAS 32.
- The ownership-settlement approach would be broadly consistent with the classifications achieved in IAS 32. However, under the ownership-settlement approach, more instruments would be separated into components and fewer derivative instruments would be classified as equity.
The goal of the Discussion Paper is to solicit views on whether FASB's proposals are a suitable starting point for the IASB's deliberations. If the project is added to the IASB's active agenda, the IASB intends to undertake it jointly with the FASB. The IASB requests responses to the DP by 5 September 2008. Click for Press Release PDF 52k).
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