INFORMATION FOR OBSERVERS

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INFORMATION FOR OBSERVERS IASB BOARD MEETING 11
DECEMBER 2007, LONDON AGENDA PAPER 4B
Liabilities and Equity FASB Preliminary
Views Financial Instruments with Characteristics
of Equity
This document is provided as a convenience to
observers at IASB meetings, to assist them in
following the Boards discussion. It does not
represent an official position of the IASB.
Board positions are set out in Standards. These
notes are based on the staff papers prepared for
the IASB. Paragraph numbers correspond to
paragraph numbers used in the IASB papers.
However, because these notes are less detailed,
some paragraph numbers are not used.
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Financial Instruments with Characteristics of
Equity

• IASB Board Meeting
• December 11, 2007

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History of the Project

• Added to agenda in 1986
• Resulting FASB documents
• 1990 Discussion Memorandum
• Statement 150 and follow on FSPs
• ED proposing revisions to definitions in Concepts
  Statement No. 6
• Milestone Draft of Proposed Standard
• 2007 Preliminary Views (PV)
• Milestone draft based on ownership-settlement
  (O-S) approach
• PV supports basic ownership approach

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Problems in Developing O-S Approach

• Complexity
• To achieve classification based on forms of
  settlement, the following concepts were needed
• Perpetual, basic and indirect ownership
  instruments
• Separation
• Linkage
• Substantive Features
• Inconsistencies
• Single and multiple component instruments
  classified first based on equity characteristics
• Multiple component instruments measured first as
  debt equity is the residual
• Obligations first approach
• May result in unrealistic numbers

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Problems in Developing O-S Approach

• Opportunities for accounting arbitrage
  opportunities
• Instruments with similar economic outcomes are
  classified differently if settled differently
  (e.g., physical versus cash settlement for
  options, SARS, and convertible debt)
• Difficulty in developing Conceptual Framework
  definition of equity and liabilities
• Equity includes (a) the most residual
  instruments, (b) other perpetual instruments, and
  (c) instruments that change in value because the
  value of the most residual instruments changes
  and in the same direction as the most residual
  interests and is settled with the most residual
  instrument
• A liability is an obligation that is not equity

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Basic Ownership ApproachConceptual Reasons for PV

• Equity includes the most residual instrument(s)
  even if redeemable for fair value or an
  approximation
• Possible ways to define liabilities
• A present claim that an entity has little or no
  discretion to avoid and that has the potential to
  decrease the assets distributable to the most
  residual instruments
• A present claim that the entity has little or no
  discretion to avoid and that is not the most
  residual instrument
• OR
• A present obligation that will be settled with
  assets or equity
• Does not work for perpetual preferred shares
• Does not work for mandatorily redeemable shares

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Basic Ownership ApproachApplication Reasons for
PV

• Because settlement does not affect
  classification, there are fewer accounting
  arbitrage opportunities and no need to consider
  unstated cash settlement options
• Fewer accounting arbitrage opportunities mean
  less need to apply the linkage requirements and
  little or no need to apply the substance
  requirements
• Far fewer instruments are separated, which avoids
  most of the obligation first issues
• Easier to craft a simple conceptual definition

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Potential Challenges in Acceptance of Basic
Ownership Approach

• Approach has a greater impact on the income
  statement
• Changes accounting for stock options
• Changes accounting for convertible debt
• Observation Generally consistent with proposed
  accounting for puttable shares under IAS 32

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All Three Approaches
Basic Ownership Instrument (BOI)

• Most subordinate class or classes of instruments
• Percentage of assets after all other claims that
  must be satisfied
• Share must not be limited or guaranteed

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All Three Approaches
Basic Ownership Instrument (BOI)

• May be puttable or mandatorily redeemable for
  fair value or a book-value-based approximation
• May be callable (at any price)
• BOIs of subsidiaries are BOIs in consolidation
  (unless modified)

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All Three Approaches
Measurement Presentation

• Initial measurement at transaction price
• Mandatorily redeemable/puttable equity presented
  separately from other equity
• Presentation in PL not yet addressed

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Ownership-Settlement Approach
Classification

• BOIs and BO components are equity
• Other perpetual instruments are equity
• Certain indirect ownership instruments are equity
• All others are liabilities or assets

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Ownership-Settlement Approach
Indirect Ownership Instruments

• Not perpetual
• Fair value or cash flows linked to a BOI changes
  in same direction
• No contingent exercise based on
• A price not the price of the underlying BOI
• A price index not related solely to the reporting
  entitys operations

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Ownership-Settlement Approach
Indirect Ownership Instruments

• Written call options
• Purchased put options
• Debt convertible to BOIs
• Forward contracts to issue BOIs
• Stock appreciation rights (on BOIs)
• Warrants on BOIs

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Ownership-Settlement Approach
Indirect Ownership Instruments Classified as
Equity

• Settlement with the same BOI to which its value
  is linked

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Ownership-Settlement Approach
Indirect Ownership Instruments Classified as
Equity

• Physically settled written call options or
  warrants on BOIs
• Written call options settled net with BOIs
• Forward contracts to issue BOIs

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Ownership-Settlement Approach
Indirect Ownership Instruments Not Classified as
Equity

• Written call options net settled in cash
• Net cash settled forward contracts

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Ownership-Settlement Approach
Separation

• Two or more alternative or separate outcomes
  some equity and some not equity
• Settlements in different forms are separate
  outcomes
• Remaining outstanding is an outcome
• Only two components even if more outcomes

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Ownership-Settlement Approach
Obligation First Approach

• Asset/liability components measured at the fair
  value of a comparable freestanding instrument
  that is 100 likely to be settled
• Remainder of the transaction price allocated to
  the equity component

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Ownership-Settlement Approach
Instruments Separated

• Debt convertible to BOIs
• BOI puttable at a fixed price

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Ownership-Settlement Approach
Remeasurement

• Mandatorily redeemable or puttable BOIs at
  redemption value changes in equity
• Liabilities/assets with cash flows or fair values
  that vary with prices of BOIs at fair value
  changes in PL
• Same as current GAAP for others

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Ownership-Settlement Approach
Settlement, Expiration, Forgiveness, or Conversion

• Special provisions for accreted cost instruments
  and components not settled as assumed in the
  initial measurement
• Expiration or delayed settlement may change
  classification, separation, or accretion

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Ownership-Settlement Approach
Substance

• Ignore settlement provisions with remote
  probability or minimal effect
• Consider unwritten (cash) settlement alternatives
  with more than remote probability and more than
  minimal effect

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Ownership-Settlement Approach
Linkage

• Multiple instruments linked (accounted for as if
  a single instrument) if part of the same
  arrangement
• Issued near the same time with same counterparty
  interacting payoff structures
• Interdependent e.g., contractual link

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REO Approach

• BOIs and components (BOCs) are equity
• Other ownership instruments (preferred shares,
  etc) are liabilities
• Equity derivatives/hybrids separated into BOCs
  and debt using option pricing models
• Remeasurement/reseparation at each measurement
  date changes in PL

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Basic Ownership Approach
Classification

• BOIs and BOCs are equity
• All other financial instruments are assets or
  liabilities

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Basic Ownership Approach
Instruments Classified as Assets or Liabilities

• Convertible debt of all types
• Options and forwards of all types
• Puttable shares (unless BOIs)
• Preferred stock (and any other shares that are
  not BOIs)

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Basic Ownership Approach
Separation

• Only if a BOI remains outstanding after a
  required settlement
• (Probably rare)
• Obligation first approach

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Basic Ownership Approach
Instruments Separated

• BOI with a make whole requirement
• BOI with a registration rights penalty

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Basic Ownership Approach
Instruments Not Separated

• Convertible debt
• Puttable or callable stock

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Basic Ownership Approach
Remeasurement

• Mandatorily redeemable or puttable BOIs at
  redemption value changes in equity
• Liabilities/assets with cash flows or fair values
  that vary with prices of BOIs at fair value
  changes in PL
• Other liabilities/assets same as current GAAP

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Basic Ownership Approach
Instruments at Fair Value through PL

• Convertible debt
• Stock options
• Puttable stock (if not a basic ownership
  instrument)