Distinguishing Liabilities and Equity

Transcription

1 Distinguishing Liabilities and Equity A project to distinguish between liability and equity instruments was added to the FASB s agenda in An Exposure Draft, Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both was issued in That Exposure Draft was preceded in 1990 by a Discussion Memorandum with the same title. Concurrent with the Exposure Draft issued in 2000 the FASB also proposed a change to the definition of liabilities in Statement of Financial Accounting Concepts No. 6 (SFAC 6). The SFAC 6 definition of liabilities has proven to be ineffective in resolving liability and equity distinctions at the standards level. SFAC No. 6, Elements of Financial Statements, defines liabilities as follows: Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. [Paragraph 3; footnote references omitted.] That definition requires that an entity have a present obligation to provide services or transfer an asset of the entity to create a liability. (SFAC 6 paragraph 36). The FASB has not been willing to apply that definition in resolving the accounting for certain instruments that either require or permit settling an obligation by issuing the entity s shares. In particular in certain circumstances an obligation or option to issue a variable number of shares has been required to be a liability in standards level decisions. The proposal in the Exposure Draft to modify the definition of a liability would have added a footnote and a sentence to SFAC 6. (a) The following footnote was proposed to be added to the word assets in paragraph 3. *Certain obligations, primarily financial instruments or components of compound financial instruments, require or permit settlement by issuance of equity shares. If those financial instrument components establish a relationship between the issuer and the holder that is not an ownership relationship, they are liabilities. References FRIC Conference 2017 Page 1

2 throughout this Concepts Statement to liabilities as requiring a transfer or sacrifice of assets also include those limited situations in which an obligation that can or must be settled by issuance of the reporting entity s equity shares does not establish an ownership relationship. A financial instrument component establishes an ownership relationship if it (1) is an outstanding equity share that is not subject to mandatory redemption provisions or (2) is an obligation that can or must be settled by issuance of the issuer s equity shares and, to the extent the value that must be conveyed to the holder of the financial instrument upon settlement of the obligation at its maturity changes, the change is attributable to, equal to, and in the same direction as the change in fair value of the issuer s equity shares. (b) The following sentence was proposed to be added to the end of para 196 of SFAC 6. Additionally, certain obligations require or permit settlement by issuance of equity shares but do not establish ownership relationships. In those circumstances, shares of an entity s stock are essentially being used in lieu of assets to settle an obligation that meets the definition of a liability. These two amendments to SFAC 6 were not adopted when SFAS 10 Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity was issued. The basis for conclusions in that document indicates that ownership relationship is important in distinguishing liabilities from equity. The Board stated that: An amendment to Concepts Statement No. 6 to revise the definition of liabilities is necessary and that the amendment should incorporate the absence of an ownership relationship into the definition of liabilities the proposed amendment to Concepts Statement 6 needs further refinements and that the refinements could not be completed until the Board has considered, in further detail, certain instruments with liability and equity characteristics that are beyond the scope of this limited-scope Statement. The Board plans to deal with those instruments, including compound financial instruments, puttable shares, and dualindexed financial instruments, in the next phase of this project. (SFAS 10 para B-17) The next phase of the project has not been completed. There is no evidence that ownership relationship can be made operational as a criterion for distinguishing liabilities from equity. Over the past 30 years there have been several attempts to simplify the accounting standards for instruments that challenge the distinction between liabilities and equity. Past FRIC conference discussions demonstrated the difficulty in using the present definition of FRIC Conference 2017 Page 2

3 liabilities in distinguishing liabilities from equity, including defining an ownership relationship. At this conference participants will be asked to assume that (1) to have a liability an entity must have a present obligation: (2) form of settlement of that obligation is not relevant in distinguishing liabilities from equity: and (3) there is no independent equity definition (equity is assets less liabilities). Specifically, conference participants will be asked to apply the current SFAC 6 liability definition, with one change. The requirement to deliver an asset would be modified to make clear the settlement of a liability (present obligation) would be by providing services or delivering an asset from the perspective of the recipient (transferee). Participants will be asked to analyze 4 separate instruments by applying that hypothetical definition of a liability. Directions for completing the following questionnaire are on page 8 of these materials. The 4 instruments on the participant questionnaire and analyzed in terms of present in the Background Reading will not be discussed at the conference. These instruments are used to illustrate the range of rights, obligations and circumstances that create these rights and obligations. To be an effective liability definition that distinguishes a liability from equity all of these situations need to be accommodated. FRIC Conference 2017 Page 3

4 Alternatives for Distinguishing Liability and Equity Participants are asked to classify forty five instruments in terms of a hypothetical definition of liabilities that was indifferent to the form of settlement of a present obligation. The hypothetical definition of liabilities relies on a single notion of being presently obligated to meet the definition of a liability. Some may have concluded that factors other than being obligated should be included in a liabilities definition. Participants are asked to be prepared to discuss, at the conference, factors that influenced their decision to make an exception to the proposed definition. The following additional considerations and questions ask participants to analyze potential concerns that have been expressed in the past about the hypothetical liabilities definition. 1) Form of settlement must matter. Obligations that can be settled in shares should not be liabilities. This perspective raises the following questions: a) Should obligations to issue a fixed and a variable number of shares receive the same classification? b) Should a right to issue shares receive the same classification as an obligation to issue shares? c) Does it matter whether, on the settlement date of an arrangement, an entity may not have issuable shares to permit share settlement of an obligation? If yes, how can one know in advance of settlement if shares will be available? 2) Changes in the price of an entity s own shares should not be included in measuring income of the entity. This perspective raises the following questions: a) How should an arrangement that pays employees a cash bonus equal to a multiple of the change in the price of the entity s common shares be classified? b) If perpetual instruments (common or preferred shares of the entity) are placed in the entity s defined benefit pension plan how should the change in share price be accounted for? 3) There are differing views about how to classify perpetual instruments (common or preferred stock of the entity) that have all the characteristics of ownership except the instrument is either callable or puttable. a) How should those instruments (shares) that the entity might get back because of the call or a written put be classified? b) Do instruments that obligate or entitle an entity to issue shares of the entity create an ownership interest? FRIC Conference 2017 Page 4

5 c) Do instruments that obligate or entitle the holder of that instrument to require an entity to acquire its own shares create an ownership interest? 4) There is a view that if the present obligation in an arrangement can be expressed in terms of a monetary value the obligation should be a liability. As suggested in the proposed amendment to SFAC 6 that accompanied the Exposure Draft that resulted in SFAS 10, the concern is expressed as shares of an entity s stock are essentially being used in lieu of assets to settle an obligation that meets the definition of a liability. Monetary value is defined in SFAS 10 as:... what the fair value of the cash, shares, or other instruments that a financial instrument obligates the issuer to convey to the holder would be at the settlement date under specified market conditions. (para 4) The perspective that monetary value should be determinative in distinguishing a liability from equity raises the following questions: a) Under this determinative factor would warranties or guaranties be classified as liabilities if there is not a fixed monetary obligation? b) Would contracts to deliver specified units of a physical commodity be classified as liabilities? Alternative Classification Exercise Instructions: 1. Fill in the following table with instruments you believe are improperly classified under the revised definition (those instruments which you checked under the column exception preferred in the participant questionnaire) and indicate your preferred classification for the instrument. 2. Under the Characteristic of Instruments columns, briefly note the characteristic for each instrument that may have suggested an exception is necessary. 3. For each instrument, rank these characteristics in order of how much they contributed to your conclusion on a preferred classification (1 is most important, is least important). 4. For each of the exceptions considered to be desirable to the hypothetical definition can that exception be consistently applied across all instruments? FRIC Conference 2017 Page

6 Alternative Classification Exercise Worksheet Instrument # Example: Preferred Classification Form of Settlement Value of Settlement Dependent on Characteristics of Instruments Who Controls Settlement Counterparty subject to share price risk Others? 21. Net-sharesettled written call Equity Shares Entity s own equity shares Entity Yes N/A Classification Rank Classification Rank Classification Rank Classification Rank Classification Rank FRIC Conference 2017 Page 6

7 Presentation and Measurement The classification of the 4 instruments raise questions about presentation. Either remeasurement or settlement of the obligation results in gains or losses. 1) What is the basis for concluding a gain or loss from re-measurement or settlement of an instrument should be separately presented? 2) If an instrument creates a right that meets the definition of an asset what is the basis for either not recognizing that asset or recognizing the asset as contraequity? 3) What characteristics of an instrument make bifurcation necessary for recognition, measurement, or presentation? 4) How should transactions be measured that are considered to be investments by owners? For example, if common shares are sold to an investor for $ when the shares have a fair value of $1 how should that issuance of shares be recognized and measured? ) How should transactions be measured that are considered to be a distribution to owners? For example, if common shares held by the entity as investment securities with a fair value of $1 and a carrying value of $ are distributed to owners how should that distribution be recognized and measured? 6) Are there any other presentation or measurement issue that arose in answering the questionnaire? 7) Have your responses provided a consistent basis for clarification, measurement and presentation for the 4 instruments? FRIC Conference 2017 Page 7

8 Instructions for Completing the Classification Exercise The first two columns of the attached questionnaire classify 4 instruments in accordance with present US and ask whether that classification is consistent with the definition of liabilities in SFAC 6. The next four columns ask participants to: 1) Classify each instrument in accordance with a hypothetical liabilities definition that is based on a present obligation to transfer an asset from the perspective of the transferee. That means once presently obligated the liability definition is indifferent to the forms of settlement. 2) Indicate whether there should be an exception to classification based on that revised definition (and if so, why)? 3) Indicate whether there are circumstances in which the instrument should be bifurcated, and indicate why that bifurcation is desirable. 4) Indicate whether recognition of the instrument produces a debit, if so whether that debit should be classified as an asset or a debit in equity (contra equity). The final two columns seek to determine how the instruments should be measured and whether any special presentation is necessary. For example, if a gain or loss from either remeasurement or settlement occurs should the gain or loss be excluded from net income, excluded from comprehensive income or otherwise separately identified. FRIC Conference 2017 Page 8

9 Financial Instruments Participant Questionnaire Alphabetical Index of Instruments 1 Instrument # Callable Common Stock at a Fixed Price (E14)...1 Callable Preferred Stock at a Fixed Price with an Increasing Rate Dividend (E17)...2 Convertible Debt (Convertible into a Fixed Number of Shares) (D2)...3 Convertible Debt (Convertible into a Fixed Number of Shares) or the Equivalent Amount of Cash (D4)...4 Convertible Preferred Stock (Fixed Shares) (E)... Common Share (E2)...6 Debt (or Note Payable) Convertible into a Variable Number of Shares Based on a Known or Calculable Monetary Amount (Par) (D1)...7 Mandatorily Converting Instrument That Converts into a Fixed Number of Shares (D3)...8 Mandatorily Converting Instrument That Converts into a Variable Number of Shares (E16)...9 Mandatorily Redeemable Noncontrolling Interests at a Fixed Price Settled with Assets (E7)... Mandatorily Redeemable Noncontrolling Interests at Fair Value (of the Subsidiary s Shares, Most Subordinate) Settled with Assets (E8)...11 Mandatorily Redeemable Share at Fair Value (Not Most Subordinated Interest) or Indexed Debt Settled with Assets (E9)...12 Mandatorily Redeemable Share at Fixed Price Settled with Assets (E6)...13 Mandatorily Redeemable Share of a Nonpublic Entity, Redeemable at Fair Value upon Retirement of the Holder (E13)...14 Most Subordinated Interest That Is Mandatorily Redeemable at Book Value or a Formula Highly Correlated to Fair Value Settled with Assets (No Provision to Share in the Residual Net Assets upon Liquidation) (E)...1 Most Subordinated Interest That Is Mandatorily Redeemable at Book Value or a Formula Highly Correlated to Fair Value Settled with Assets (with a Provision to Share in the Residual Net Assets upon Liquidation) (E11)...16 Most Subordinated Interest That Is Mandatorily Redeemable at Fair Value Settled with Assets (E12)...17 Net-cash-settled Forward Sale Contract (at a Fixed Price) (EC3)...18 Net-cash-settled Written Call Option (Cash SAR) (EC9)...19 Net-share-settled Forward Sale Contract (at a Fixed Price) (EC2) The numerical references at the end of each instrument name (for example, E1, D1, EC1, etc) refer to the instrument s location in the Background Reading materials. Participants may use this indexing to refer back to the Background Reading to read the classification analysis under current. An instrument with an index number beginning with E is located in the Equity Host Instrument materials, D is located in the Debt Host Instrument materials, and EC is located in the Contracts in an Entity s own Equity materials. PQ 1

10 Net-share-settled Written Call Option (Stock SAR) (EC8)...21 Note Receivable for Fixed Number of Shares (Prepaid Forward Purchase) (EC22)...22 Note Receivable That Will Be Settled with Cash or a Variable Number of Shares (EC21)...23 Perpetual Preferred Stock (E3)...24 Physically or Net-settled-forward Purchase Contract (at a Fixed Price) (EC6)...2 Physically Settled Forward Sale Contract (at a Fixed Price) (EC1)...26 Physically Settled Written Call Option (Stock Option) (EC7)...27 Prepaid Put Option for Fixed Shares (EC18)...28 Proprietorship Interest (E1)...29 Purchased Call Option (Physically, Net Cash, or Net Share Settled) (EC19)...30 Purchased Put Option (Physically, Net Cash, or Net Share Settled) (EC20)...31 Puttable and Callable Convertible Debt (Convertible into a Fixed Number of Shares) (D)...32 Puttable Common Stock at Fair Value or Fixed Price (E1)...33 Shares in Exchange for a Note Receivable (EC23)...34 Treasury Stock (E4)...3 Variable Share Forward Sale Contract (EC4)...36 Variable Share Forward Combined with Debt (Mandatorily Converting with Varying Shares) (EC)...37 Warrant on Puttable Common Shares at a Fixed Price (EC11)...38 Warrant on Mandatorily Redeemable Shares at a Fixed Price (EC12)...39 Written Call Option Indexed to Shares and Gold Affecting the Counterparty s Payoff (Settled with Shares) (EC14)...40 Written Call Option with a Cash Settled Make-whole Provision (EC16)...41 Written Call Option with a Ceiling (EC13)...42 Written Call Option with a Registration Rights Penalty (EC1)...43 Written call option with an adjustable strike price based on future down-round equity issuances (EC17)...44 Written Put Option (Physically, Net Cash, or Net Share Settled) (EC)...4 PQ 2

11 1. Callable common stock at a fixed price (E14) Equity Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An instrument in which the receives participation in profits and losses of an entity in exchange for its contribution, and the issuer of the instrument has the right to redeem the stock at a fixed price. For example, the buys 1 share of callable common stock from the issuer for $9, and the issuer can call or buy back the stock at a set price of $ any time after 1 year. 2. Callable preferred stock at a fixed price with an increasing rate dividend (E17) Equity An instrument in which the receives participation in profits and losses of an entity in exchange for its contribution, and the issuer of the instrument has the right to redeem the stock at a fixed price. Also, the terms of the stock state that the dividend rate shall increase each year. For example, the buys 1 share of callable common stock from the issuer for $9, and the issuer can call or buy back the stock at a set price of $ any time after 1 year. The dividend rate is initially set at %, and increases by % each year hence (% in year 1, 1% in year 2, 2% in year 3, and so on). PQ 3

12 3. Convertible debt (convertible into a fixed number of shares) (D2) Debt host: Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? A loan that converts into a fixed number of shares at the s option. For example, the gives the entity $9 in return for a debt instrument that matures in years at $, with the option to convert the instrument into.83 shares of common stock (conversion price = $12/share). Conversion feature: If common share value is greater than $11 at issuance Equity (BCF) Otherwise, not separately accounted for 4. Convertible debt (convertible into a fixed number of shares) or the equivalent amount of cash (D4) Debt host: Liability A loan that converts at the s option into either a fixed number of shares or cash equal to the fair value of the shares. Conversion feature: Equity For example, the gives the entity $9 in return for a debt instrument that matures in years for $, with the option to convert the instrument into.83 shares of common stock or cash equal to the fair value of the shares. PQ 4

13 . Convertible preferred stock 2 (fixed shares) (E) An instrument that may remain outstanding indefinitely in which the may receive a fixed return for an indefinite period of time. The instrument includes a feature that allows the to convert it into a fixed number of shares at the s option. For example, the gives the entity $ in return for an instrument that pays a discretionary preferred dividend of 1 percent per year for the life of the entity. The can convert the instrument into.83 shares of common stock at its option. Equity host: Equity Conversion feature: If common share value is greater than $12 at issuance Equity (BCF) Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? 6. Common share (E2) Otherwise, not separately accounted for Equity An instrument in which the receives participation in profits and losses of an entity in exchange for its contribution. The instrument does not have any preferential rights relative to other instruments of the entity and is the most subordinated of all the entity s securities. The s losses are limited to its investment. For example, the gives $ and receives 1 common share. 2 Unless notated otherwise, the preferred stock in these examples is perpetual preferred stock with a fixed return (not an ownership instrument). Additionally, assume that there is no mandatory redemption feature. PQ

14 7. Debt (or note payable) convertible 3 into a variable number of shares based on a known or calculable monetary amount (par) (D1) Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? A loan (or note payable) that converts into a variable number of shares, based on a known or calculable monetary amount, at the s option. For example, the gives the entity $8 in return for an instrument that matures in years for $ with an option that allows the to convert the instrument into common stock worth $. 8. Mandatorily converting instrument that converts into a fixed number of shares (D3) Debt host: Liability An instrument that is issued in the form of debt and must convert upon an event certain to occur into a fixed number of shares. For example, the gives the issuer $ for a note payable at inception and will receive 1 share of common stock in years. Conversion feature: If common share value is greater than $ at issuance Equity (BCF) Otherwise, not separately accounted for 3 Convertible in these examples means convertible into ownership instruments. Shares and stock also refer to ownership instruments unless notated otherwise. PQ 6

15 9. Mandatorily converting instrument that converts into a variable number of shares (E16) Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An instrument issued in the form of a share, which converts at a date or an event certain to occur into a variable number of common shares (based on a fixed monetary amount). For example, the gives the issuer $8 for a preferred share and will receive common stock in years with a value of $.. Mandatorily redeemable noncontrolling interests at a fixed price settled with assets (E7) Liability An instrument that the issuer must redeem by giving the an amount of assets fixed at inception on the redemption date. The instrument is issued by the reporting entity s consolidated subsidiary to the subsidiary s minority owners. For example, the gives the subsidiary $8 at inception in return for an instrument that will be redeemed in years for $. 11. Mandatorily redeemable noncontrolling interests at fair value (of the subsidiary s shares, most subordinate) settled with assets (E8) Liability An instrument that the issuer must redeem by giving the assets equal to the fair value of the instrument at the redemption date. The instrument is issued by the reporting entity s consolidated subsidiary to the subsidiary s minority owners. The shares do not have any preferential rights relative to other instruments of the entity (subsidiary) and are the most subordinated of all the entity s securities. For example, the gives the subsidiary $ in return for an instrument that will be redeemed upon the holder s death for the then-fair value. PQ 7

16 12. Mandatorily redeemable share at fair value (not most subordinated interest) or indexed debt settled with assets (E9) Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An instrument that the issuer must redeem by giving the assets equal to the fair value of the instrument at the redemption date. The instrument has preferential rights relative to other instruments of the entity and is not the most subordinated of all the entity s securities. For example, the gives the issuer $ in return for an instrument that will be redeemed at the holder s death for the instrument s then-fair value. 13. Mandatorily redeemable share at a fixed price settled with assets (E6) Liability An instrument that the issuer must redeem by giving the an amount of assets fixed at inception on the redemption date. For example, the gives the issuer $8 at inception in return for an instrument that will be redeemed in years for $. 14. Mandatorily redeemable share of a nonpublic entity, redeemable at fair value upon retirement of the holder (E13) Equity An instrument that the issuer must redeem by giving the assets equal to the fair value of the instrument at the redemption date. The instrument s redemption date shall be the date of the retirement of the holder. For example, the gives the issuer $ in return for an instrument that will be redeemed at the holder s retirement for the instrument s then-fair value. PQ 8

17 1. Most subordinated interest that is mandatorily redeemable at book value or a formula highly correlated to fair value settled with assets (no provision to share in the residual net assets upon liquidation) (E) Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An instrument that the issuer must redeem by giving the assets equal to the book value of the entity or a formula highly correlated with the fair value of the instrument at the redemption date. For example, the gives the issuer $ in return for an instrument that will be redeemed at the holder s death at the instrument s then-fair value as estimated by a multiple of net income. 16. Most subordinated interest that is mandatorily redeemable at book value or a formula highly correlated to fair value settled with assets (with a provision to share in the residual net assets upon liquidation) (E11) Liability An instrument that the issuer must redeem by giving the assets equal to the book value of the entity or a formula highly correlated with fair value of the instrument at the redemption date. For example, the gives the issuer $ in return for an instrument that will be redeemed at the holder s death at the instrument s then-fair value as estimated by a multiple of net income. 17. Most subordinated interest that is mandatorily redeemable at fair value settled with assets (E12) Liability An instrument that the issuer must redeem by giving the assets equal to the fair value of the instrument at the redemption date. The instrument does not have any preferential rights relative to other instruments of the entity and is the most subordinated of all the entity s securities. For example, the gives the issuer $ and receives an instrument that will be redeemed at the holder s death for the instrument s then-fair value. PQ 9

18 18. Net-cash-settled forward sale contract (at a fixed price) (EC3) Liability / Asset Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An agreement to issue the reporting entity s own common shares (direct ownership interests) at an event or a date certain to occur for a fixed price that will be net cash settled. For example, both parties enter into a forward contract for no initial consideration in which the reporting entity (issuer) will sell (issue) 1 share of its own common stock to the in 2 years for $. Upon settlement, if the share price is greater than $, the issuer will give the cash in an amount equal to the difference between $ and the stock price on the settlement date. If the share price is less than $, the will give the issuer cash in an amount equal to the difference between $ and the stock price on the settlement date. 19. Net-cash-settled written call option (cash SAR) (EC9) Liability An instrument in which the reporting entity stands ready to give cash to the holder based on the difference between a fixed price (strike) and the market price at the settlement date based on a specified quantity of its own shares. For example, an option is sold to the for $1 and obligates the issuer to stand ready to pay cash to the holder in an amount equal to the difference between $ and the stock price at the settlement date. If the stock price does not go above $, the option is expected to expire unsettled. PQ

19 20. Net-share-settled forward sale contract (at a fixed price) (EC2) Equity Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An agreement to issue the reporting entity s own common shares (direct ownership interests) at an event or date certain to occur at a fixed price that will be net share settled. For example, both parties enter into a forward contract for no initial consideration in which the reporting entity (issuer) will issue 1 share of its own common stock to the in 2 years for $. Upon settlement, if the share price is greater than $, the issuer will give the shares with a value equal to the difference between $ and the stock price on the settlement date. If the share price is less than $, the will give the issuer shares with a value equal to the difference between $ and stock price on the settlement date. 21. Net-share-settled written call option (stock SAR) (EC8) Equity An instrument in which the reporting entity stands ready to issue shares to the holder with a total value equal to the difference between a fixed price (strike) and the market price at the settlement date based on a specified quantity of its own shares. For example, an option is sold to the for $1 that obligates the issuer to stand ready to issue shares to the holder with a value equivalent to the difference between $ and the stock price at the settlement date. If the stock price does not go above $, the option is expected to expire unsettled. 22. Note receivable for fixed number of shares (prepaid forward purchase) (EC22) An instrument in which the reporting entity will receive a fixed number of its own shares (direct ownership instruments) at a date or an event certain to occur. For example, the reporting entity gives the $ cash at inception in return for an instrument that the will settle by giving the reporting entity 1 share of its own stock in years. Generally, contraequity PQ 11

20 23. Note receivable that will be settled with cash or a variable number of shares (EC21) An instrument that gives the reporting entity the right to receive cash or its own shares equal to a fixed monetary amount at a date or an event certain to occur. The note may be in exchange for cash or shares at inception. For example, the reporting entity gives the $8 at inception (or 1 share with a fair value of $8) in return for an instrument in which the will give the reporting entity $ in cash for the equivalent amount of the issuer s own shares in years. 24. Perpetual preferred stock (E3) Asset (if settled in cash) Measurement? Contraequity (if settled in shares) Equity Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Presentation of Gain/Loss? An instrument that will remain outstanding indefinitely and in which the holder may receive a stated return for an indefinite period of time. For example, gives the entity $ in return for an instrument that pays $1 per year for the life of the entity. (Assume $1 in perpetuity is equivalent to a $ fair value.) The instrument has a preference in liquidation. 2. Physically or net-settled-forward purchase contract (at a fixed price) (EC6) Liability / Asset An agreement to repurchase the reporting entity s own common shares (direct ownership instruments) at an event or a date certain to occur for a fixed price that will be physically, net cash, or net share settled. For example, both parties enter into a forward contract for no initial consideration in which the reporting entity (issuer) will repurchase (retire) 1 share of its own common stock from the in 2 years for $. Upon settlement, the issuer will either (a) give the cash of $ and receive 1 share of stock or (b) give/receive cash or the equivalent amount of shares equal to the difference between $ and the stock price on the settlement date. PQ 12

21 26. Physically settled forward sale contract (at a fixed price) (EC1) Equity Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An agreement to issue the reporting entity s own common shares (direct ownership instruments) upon an event or date certain to occur for a fixed price that will be physically settled. For example, both parties enter into a forward contract for no initial consideration in which the reporting entity (issuer) will issue 1 share of its common stock to the in 2 years for $. 27. Physically settled written call option (stock option) (EC7) Equity An instrument in which the reporting entity stands ready to sell (issue) a specified quantity of its own shares at a fixed price. For example, an option is sold to the for $1 and obligates the issuer to stand ready to issue 1 share for $. If the stock price goes above $, the is expected to exercise the option, pay $, receive 1 share of stock, and realize an economic gain. If the stock price does not go above $, the option is expected to expire unsettled. PQ 13

22 28. Prepaid put option for fixed shares (EC18) An option written by the issuer of the shares that allows the to put those shares back to the issuer at a fixed strike price. However, the issuer pays the the strike price less the option premium at inception of the contract. At the settlement date, if the stock price is at or below the strike price, the option will be exercised and the issuer will receive shares. If the stock price is above the strike price, the option will not be exercised and the issuer will receive cash equal to the strike price. For example, the issuer pays the $8 for an instrument in which the has the option to put back 1 share of the reporting entity s common stock 2 years after issuance at $. Upon settlement, if the share price is equal to or less than $, the issuer will receive 1 share of common stock from the. If the share price is above $, the issuer will receive $ from the. 29. Proprietorship interest (E1) Measurement? Contraequity Equity Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Presentation of Gain/Loss? An instrument in which the receives full participation in all profits and losses of an entity in exchange for its contribution. The instrument does not have any preferential rights relative to other instruments of the entity and is the most subordinated of all the entity s securities. The s liability for potential losses is not limited to its investment; therefore, there are no boundaries. For example, the gives $ and receives 1 share of proprietorship interest. PQ 14

23 30. Purchased call option (physically, net cash, or net share settled) (EC19) An instrument in which the reporting entity has the right to repurchase a specified quantity of its own shares from the at a fixed price. For example, an option purchased by the reporting entity for $1 in which the reporting entity has the right to repurchase 1 share of its own stock from the at a price (strike price) of $. Upon settlement, the reporting entity will either (a) give the $ and receive 1 share of stock or (b) receive cash or stock equal to the difference between $ and the stock price at the settlement date. If the stock price goes below $, the option is expected to expire unsettled. 31. Purchased put option (physically, net cash, or net share settled) (EC20) An instrument in which the reporting entity has the right to issue to the a specified quantity of its own shares at a fixed price. For example, an option purchased by the reporting entity for $1 that gives the reporting entity the right to issue 1 share with a strike price of $. Upon settlement, the reporting entity will either (a) give the 1 share of stock and receive $ or (b) receive cash or shares from the with a value equivalent to the difference between $ and the stock price at the settlement date. If the stock price goes above $, the option is expected to expire unsettled. Measurement? Contraequity (if physically or net share settled) Asset (if net cash settled) Contraequity (if physically or net share settled) Asset (if net cash settled) Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Presentation of Gain/Loss? PQ 1

24 32. Puttable and callable convertible debt (convertible into a fixed number of shares) (D) Debt host: Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? A loan that converts into a fixed number of shares at the s option. The holds the loan and can put the loan back (request immediate repayment). The issuer can call the loan (prepay the loan). Typically, this call results in immediate conversion by the. For example, the gives the reporting entity $8.0 in return for a puttable, callable instrument that matures in years for $ (yielding 3.28 percent) with the option to convert the instrument into.83 shares of common stock. The instrument (with the conversion option) can be put back to the issuer or called by the issuer at or any time after year 3 for the then-accreted value based on the yield ($9.37 at year 3). If the share price is above $12, the issuer will likely call the instrument forcing the holder to convert the instrument into shares. If the share price is below $12, the will either put the instrument or hold it to maturity. Redemptio n features: Not separately accounted for Conversion feature: If common share value is greater than $ at issuance Equity (BCF) Otherwise, not separately accounted for PQ 16

25 33. Puttable common stock at fair value or a fixed price (E1) Equity Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An instrument in which the receives participation in profits and losses of an entity in exchange for its contribution, but has the right to put the instrument back to the issuer at fair value or a fixed price. Fair value example: The gives $ and receives 1 common share with the option to put back the share at fair value. Fixed price example: The gives $8 and receives 1 share of common stock with the option to put back the share at $ in 3 years. The issuer also has the right to call the share at $ in 3 years. 34. Shares in exchange for a note receivable (EC23) An arrangement in which the issuer receives a note, rather than cash, as a contribution to its equity. For example, the issuer gives the 1 share of stock, which obligates the to pay the issuer $ or 1 share of the issuer s stock in 2 years. 3. Treasury stock (E4) The reporting entity repurchases its own stock at its fair value on the date of the repurchase. Contraequity Contraequity PQ 17

26 36. Variable share forward sale contract (EC4) An agreement to issue the reporting entity s own common shares (direct ownership instruments) upon an event or a date certain to occur for a fixed price that will be settled with a variable number of shares depending on the stock price at the settlement date. For example, the reporting entity (issuer) agrees to issue a variable number of its own common shares to the for $ in 2 years as follows: If the fair value of the share is between $8 and $12, the pays $ and receives a variable number of shares equivalent to $. If the fair value of the stock is below $8, the receives 0.8 shares and pays $. If the fair value of the stock is above $12, the receives shares and pays $. Generally, equity unless the payoff related to the variable share forward component is determined to be predomina nt at inception. Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? PQ 18

27 37. Variable share forward combined with debt (mandatorily converting with varying shares) (EC) Debt: Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An agreement to issue the reporting entity s own common shares (direct ownership instruments) upon an event or a date certain to occur for a fixed price that will be settled with a variable number of shares depending on the stock price at the settlement date collateralized with a debt. For example, the reporting entity (issuer) agrees to issue 1 share of its own common stock to the for $ in 2 years and the $ debt can be used to satisfy its obligation. If the fair value of the share is between $ and $12, the pays $ (or tenders the note as payment) and receives a variable number of shares equivalent to $. The contract is collateralized with a $ note payable to the. If the fair value of the stock is below $, the receives 1 share and tenders the $ note as payment. If the fair value of the stock is above $12, the receives.83 shares and tenders the $ note as payment. Variable share forward: Generally, equity unless the payoff related to the variable share forward component is determined to be predomina nt at inception. 38. Warrant on puttable common shares at a fixed price (EC11) Liability An instrument that allows the to purchase one share of the issuer s common stock (with an attached put option at a fixed price). For example, the gives the entity $2 for an instrument that allows the to purchase 1 share of common stock for $. The share to be delivered has a put feature that allows the to put the share back to the issuer for $8, which limits the s loss to $2 after the warrant is exercised. The would exercise the warrant when the stock price is at or above $. PQ 19

28 39. Warrant on mandatorily redeemable shares at a fixed price (EC12) Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An instrument that allows the to purchase one share of the issuer s mandatorily redeemable shares that are redeemed at a fixed price. For example, the gives the entity $1 for an instrument that allows the to purchase 1 mandatorily redeemable share (that is redeemable in 3 years at $) for $ Written call option indexed to shares and gold affecting the s payoff (settled with shares) (EC14) Liability / Asset An instrument that gives the the right to buy the entity s shares and is indexed to two underlyings that affect payoff. For example, the gives the entity $2 for an instrument that obligates the issuer to stand ready to issue 1 share of common stock in exchange for 1 ounce of gold. The contract can be physically or net share settled. 41. Written call option with a cash settled make-whole provision (EC16) Liability An instrument in which the reporting entity stands ready to sell (issue) a specified quantity of its own shares at a fixed price on a future date. However, the issuer is obligated to reimburse the for any subsequent decrease in the share price after the exercise of the option. For example, the gives the issuer $3 and receives an instrument that obligates the issuer to stand ready to issue 1 share for $. The make-whole provision obligates the issuer to reimburse the for any decrease in the share price below $ after the option is exercised. PQ 20

29 42. Written call option with a ceiling (EC13) An instrument in which the reporting entity stands ready to sell (issue) a specified quantity of its own shares at a fixed price. However, the is limited to buying a certain value of shares. For example, the purchases a call option from the issuer for $1 that allows the holder to purchase 1 share of common stock for $. However, if the fair value of the stock rises above $1, then the total value of the shares to be purchased is capped at a ceiling of $1. Thus, if the share price is at or above $1, the issuer would deliver a variable number of shares equal to a fair value of $1 in exchange for $ (or $ worth of shares). Generally, equity unless the payoff related to the net share settled purchased put component is determined to be predomina nt at inception. Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? 43. Written call option with a registration rights penalty (EC1) An instrument in which the reporting entity stands ready to sell (issue) a specified quantity of its own shares at a fixed price on a future date. However, the issuer is obligated to pay the a penalty if the issuer fails to file a registration statement for the underlying shares. For example, the gives the issuer $2 and receives an instrument that obligates the issuer to stand ready to issue 1 share for $. The registration rights penalty requires the issuer to pay the $1 per month until the registration statement is declared effective or effectiveness is maintained. Written call option: Equity Registratio n right penalty component: Liability (accounted for as a contingenc y under Subtopic 40-20) PQ 21

30 44. Written call option with an adjustable strike price based on future down-round equity issuances (EC17) Liability Meets Present Definition of a Liability? Meets Hypothetical Definition of a Liability? Exception Preferred? Bifurcation Preferred? Asset? Measurement? Presentation of Gain/Loss? An instrument in which the reporting entity stands ready to sell (issue) a specified quantity of its own shares at a fixed price on a future date. However, the option contains a provision stating that if the entity conducts a future equity offering at a price less than the strike price of the option, the strike price will reset to the future equity offering price. For example, the pays the issuer $1 for an instrument which obligates the issuer to stand ready to sell 1 share of its common stock for $ any time after Year 2. In Year 1, the issuer does an equity financing in which it sells it s commons stock for $ a share. The strike price on the call option will be reduced from $ to $. 4. Written put option (physically, net cash, or net share settled) (EC) Liability An instrument in which the reporting entity stands ready to repurchase a specified quantity of its own shares at a fixed price. For example, an option is sold to the for $1 that obligates the reporting entity to stand ready to repurchase 1 share at a price of $. Upon settlement, the reporting entity will pay $ cash and receive 1 share of its own stock or give the cash/shares equal to the difference between $ and the stock price at the settlement date. If the stock price goes above $, the option is expected to expire unsettled. PQ 22

31 Intangible Assets The business press, academic literature and political officials sometimes comment that a shortcoming of US is that intangible assets that are internally developed are not recognized in financial statements and that present financial reporting requirements have not kept up with changes in the business environment. Those commentators usually suggest these deficiencies have two consequences: (1) they understate assets and equity, and (2) they are a disincentive to innovation, specifically, spending on research and development. The FASB addressed the financial reporting of research and development costs when it issued Statement of Financial Accounting Standards No. 2 Accounting for Research and Development Costs (SFAS 2). At the time, the definition of an asset was the APB asset definition from APB Statement No. 4. Assets economic resources of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Assets also include certain deferred charges that are not resources but that are recognized and measured in conformity with generally accepted accounting principles. (APB Statement No. 4 para 132) This definition was not considered helpful in resolving accounting for research and development costs. Accounting for research and development costs involves distinguishing costs that result in an asset acquisition from costs that result in an expense of the period. The FASB concluded that all research and development costs, as defined in SFAS 2, should be charged to expense as incurred (SFAS 2 para 12). The primary bases for that conclusion were (1) the significant uncertainty of the future benefits from having incurred the costs and (2) the lack of any causal relationship between expenditures and benefits (SFAS 2 para 39-41). The basis for conclusions of SFAS 2 does not clearly specify the nature of the uncertainty, for example, uncertainty about the existence of future economic benefits or uncertainty about the amounts of those benefits. Six years after the issuance of SFAS 2 in 1974 the FASB added Concepts Statement No. 3 to the Conceptual Framework, which included the definition of an asset. That definition is now in FRIC Conference 2017 Page 9