Liability and Equity

Date recorded:

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.

Correction list for hyphenation

These words serve as exceptions. Once entered, they are only hyphenated at the specified hyphenation points. Each word should be on a separate line.