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Journal entry — FASB and IASB make decisions about financial instruments with characteristics of equity

Published on: Feb 18, 2010

At today’s joint FASB/IASB meeting, the two Boards clarified and reaffirmed previous decisions made in connection with their joint project on financial instruments with characteristics of equity, and they tentatively agreed on the classification of puttable shares and convertible debt instruments. The Boards tentatively plan to publish an exposure draft in the second quarter of 2010.

Previous Decisions

The Boards clarified their previous decisions on the following matters (key decisions the Boards reached previously are summarized in the Appendix):

  • Instruments Issued by Limited-Life Entities — The Boards agreed that nominally perpetual instruments issued by limited-life entities should be classified as equity in the separate financial statements of the issuer.
  • Contracts That Require Specified-for-Specified Issuances of Equity Instruments — Consistently with previous decisions, the Boards agreed that contracts that require issuance of a specified number of equity-classified instruments for a specified price (including contracts over equity-classified puttable and mandatory redeemable instruments and equity-classified derivatives) would be classified as equity. On the other hand, contracts over puttable instruments that would be bifurcated into liability and equity components when issued would be classified as liabilities.
  • Contracts That Require an Entity to Issue a Specified Number of Equity Instruments in Exchange for No Future Compensation — Contracts that require an entity to issue a specified number of equity instruments in exchange for no future compensation (prepaid instruments) would be classified consistently with contracts that require specified-for-specified issuance of equity instruments (see above).
  • Convertible Preferred Shares — The Boards also agreed that mandatorily convertible preferred shares convertible into a specified number of perpetual equity instruments or a specified number of equity-classified puttable or mandatory redeemable instruments would be classified as equity.
  • Classification of Subsidiary Instruments in Consolidated Financial Statements — Finally, both Boards agreed that the classification in subsidiary financial statements should be carried over into the consolidated financial statements unless the nature of the instrument changes in consolidation because of arrangements between the instrument holder and a member of the consolidated group. If the nature of the instrument changes in consolidation, classification should be reconsidered in the consolidated financial statements.

Puttable Shares and Gross Up of Freestanding Written Put Options

The Boards decided that puttable shares should be separated into a share and a written put option and that the written put option be reported net as a liability even if the exchange is specified-for-specified. The Boards further decided that all freestanding written put options should be reported net as liabilities.

One Board member preferred grossing up of the separated put option because he believed that the agreed solution could facilitate structuring of debt as equity. Nonetheless, most of the Boards’ members disagreed because they believed that any alternative that contains grossing could be counterintuitive and complex to implement. To alleviate the concerns, the Boards agreed to add anti-abuse provisions (e.g., issuing shares and an in-the-money put option at the same time to the same party should be linked and treated as a single debt instrument).

Convertible Debt

The Boards considered bifurcation of convertible debt. The IASB preferred bifurcation of convertible debt because IASB members believed that such treatment is more consistent with the overall IASB model. Moreover, the IASB members believed that requirements for bifurcation of convertible debt are well known, used in practice, and perceived as decision-useful. As one IASB member noted, even if convertible debt was classified as liability in its entirety under this project, it would be bifurcated under the IASB’s tentative approach for classification and measurement of financial liabilities. On this basis, the IASB decided to retain the conditions for bifurcation of convertible debt.

The FASB was split, with some members preferring measurement of convertible debt at fair value through net income in its entirety and some members preferring bifurcation. Finally, the FASB narrowly decided to proceed with bifurcation of convertible debt into liability and equity components.

The Boards also considered the methodology for bifurcation. Some Board members preferred a simplified bifurcation method in which the debt component would be allocated on the basis of a plain-vanilla instrument with the same maturity date and in which the interest rate would be the rate of nonconvertible bond of comparable credit quality from the same issuer (with the remainder allocated to the equity component). Other Board members preferred retaining the IAS 32 bifurcation method, in which any interdependency is allocated to the liability component. Most Board members preferred the simplified method, subject to additional analysis by each Board’s staff.

Appendix

The meeting minutes noted that key decisions made by the Boards in previous meetings are as follows:

(a)  Instruments currently accounted for under IFRS 2, Share-based Payment, and Topic 718 of the FASB Accounting Standards Codification (originally issued as Statement 123 (R), Share-Based Payment), are not within the scope of this project.

(b)  Perpetual instruments (instruments not required to be redeemed unless the entity decides to or is forced to liquidate its assets and settle claims against the entity) issued by entities without specified limits to their lives will be classified as equity in their entirety. (That includes both ordinary and preferred shares.)

(c) The following mandatorily redeemable and puttable instruments will be classified as equity in their entirety:

(i) Instruments with terms that require, or permit the holder or issuer to require, redemption to allow an existing group of shareholders, partners, or other participants to maintain control of the entity when one of them chooses to withdraw.

(ii) Instruments that the holder must own in order to engage in transactions with the entity or otherwise participate in the activities of the entity and whose terms require, or permit the holder or issuer to require, redemption when the holder ceases to engage in transactions or otherwise participate.

(d) All other mandatorily redeemable instruments (instruments that an entity is required to redeem on a certain date or on the occurrence of an event that is certain to occur) will be classified as liabilities.

(e) Contracts that require or may require an entity to issue a specified number of its own perpetual equity instruments in exchange for a specified price (for example, options, forwards, rights issues, and purchase warrants) will be classified as equity. (For this purpose, the specified number must be either fixed or vary only so that the counterparty will receive a specified percentage of total shares that were outstanding on the issuance date for a specified price. The specified price must be fixed in the reporting entity’s currency unless the domestic currency of the shareholder that holds the derivative (or functional currency if the shareholder is a reporting entity or a unit of a reporting entity) is different from the currency in which the issuing entity issues equity instruments to domestic shareholders. In that case, the price may be specified in the currency of the shareholder instead of in the currency of the issuer.

(f) Instruments that require an entity to issue a specified number of its own perpetual equity instruments for no further compensation will be classified as equity (for example, prepaid forward contracts to issue shares).

(g) The entity’s ability to issue its own perpetual equity instruments to settle share-settled instruments classified as equity will be assessed at the date that each instrument is issued and at each reporting date thereafter. If, at any time, the entity does not have enough shares to settle a share-settled instrument classified as equity, that instrument will be reclassified as a liability and left there for the remainder of its life.

(h) Preferred shares required to be converted into a specified number of common shares on a specified date or on the occurrence of an event that is certain to occur will be classified as equity.

(i) Contracts that require an entity to repurchase its own shares on a specified date or on the occurrence of an event that is certain to occur will be separated into a liability representing the amount to be paid (measured according to standards for similar freestanding instruments) and an offsetting debit to equity (grossed up).

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