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

Published on: Mar 11, 2010

At today’s joint FASB/IASB meeting, the two boards made a number of tentative decisions about the classification of financial instruments as liabilities or equity. The staff also obtained permission to prepare a draft for balloting by Board members. The ED is expected to be exposed for comments by the end of June this year.

  • Derecognition requirements— The boards agreed to propose that when an equity instrument is issued upon exercise or conversion of an equity-classified instrument, an entity should provide information about any dilution to shareholders’ interests measured on the basis of the fair value of the issued instrument. The boards have also made the following decisions:
    • For a freestanding equity-classified derivative (e.g., option):
      • Classified as equity — The difference between the fair value of the shares issued and the carrying value of the instrument plus the cash received should be reported in the statement of changes in equity as a transfer of wealth between the two instruments (rather than as an adjustment to retained earnings or a separate equity account).
      • Classified as liability — The difference between the fair value of the shares and the carrying value of the instrument should be reported in net income
  • For a convertible debt separated into liability and equity components, for the liability component a gain or loss should be recognized equal to the difference between the carrying value of the liability component and the fair value of that component (which is equal to the fair value of a comparable freestanding instrument without an equity component). The difference between the total fair value of the shares and the fair value of the liability component would be reported in equity.

The boards also decided to require an additional supplemental schedule for public entities to present a statement of capitalization at fair value.

  • Reassessment of classifications and how to account for reclassifications— The boards agreed to propose that:
    • An instrument should be reclassified if events occur or circumstances change so that the instrument no longer meets the conditions for its existing classification.
    • However, if, at any time, the issuer does not have enough authorized shares to settle a share-settled instrument classified as equity, that instrument must be reclassified as a liability and remain a liability until the instrument is extinguished.
    • The reclassification should take place as of the date of the events that changed the classification.
    • The reclassified instrument should be remeasured according to the requirements for the new classification as if it were a newly issued instrument on the date of the reclassification.
    • If the instrument is reclassified from equity to a liability, any difference in measurement upon reclassification should be reported as an adjustment to a separate equity account and no gain or loss should be recognized in income. However, if the instrument is reclassified from a liability to equity, the difference would be recorded in profit and loss.
  • Economic compulsion The boards agreed to include in the ED a principle similar to the existing principle in IAS 32, Financial Instruments: Presentation. This principle would state that economic compulsion is not relevant to determining the classification of financial instruments as liabilities or equity.
  • Interaction with the fair value option The boards agreed that an entity cannot avoid separation of an instrument with a liability and equity component by electing the fair value option for the instrument in its entirety.  That is, the fair value option is not available for the combined instrument.
  • Scope exceptions and additions The boards agreed to propose that the scope of the new standard on financial instruments with characteristics of equity should carry forward the existing scope of IAS 32.
  • Transition requirements The boards agreed to propose limited retrospective application under which an entity would apply the new requirements to all instruments outstanding at the beginning of the first period presented in the first financial statements after the effective date. Under this alternative, net income would be restated for all periods presented but beginning retained earnings would not be adjusted. The IASB decided that the same transition requirements would apply to first-time adopters under IFRS 1, First-time Adoption of International Financial Reporting Standards.
  • Disclosures In addition to the disclosures currently required by U.S. GAAP and IFRSs, the boards decided to propose that entities provide disclosures about the nature and terms of the instruments, including information about settlement alternatives (assets or equity instruments). See the appendix for more information.
  • Comment periodThe boards agreed to allow for 120 days for the comment period.

 

Appendix

The boards agreed to propose the following disclosure requirements:

Entities with financial instruments within the scope of this [draft] Standard shall disclose the nature and terms of the instruments, including information about settlement alternatives—assets or equity instruments. That disclosure shall include:

(a)   The  identity of the entity that controls the settlement alternatives

(b)   The amount that would be paid, or the number of shares that would be issued and their fair value, determined under the conditions specified in the contract if the settlement were to occur at the reporting date

(c)    How changes in the fair value of the issuer's equity shares would affect those settlement amounts (for example, "the issuer is obligated to issue an additional X shares or pay an additional Y dollars in cash for each $1 decrease in the fair value of one share")

(d)   The maximum amount that the issuer could be required to pay to redeem the instrument by physical settlement, if applicable

(e)   The maximum number of shares that could be required to be issued, if applicable

(f)    That a contract does not limit the amount that the issuer could be required to pay or the number of shares that the issuer could be required to issue, if applicable

(g)   For a forward contract or an option indexed to the issuer's equity shares, all of the following:

i.      The forward price or option strike price

ii.     The number of issuer's shares to which the contract is indexed

iii.    The settlement date or dates of the contract, as applicable.

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