FASB s Proposal to Narrow Equity: More Liabilities on Company Balance Sheets

Transcription

1 The Financial Reporting series presents: FASB s Proposal to Narrow Equity: More Liabilities on Company Balance Sheets Tom Linsmeier, Financial Accounting Standards Board (FASB) Robert Uhl, Deloitte & Touche LLP Magnus Orrell, Deloitte & Touche LLP Christopher Rogers, Deloitte & Touche LLP April 15, 2008

2 Agenda The FASB s Liability & Equity Project Existing Practice Issues Fixing the Problem Deep Dive Basic Ownership Approach (BOA) The Other Two Approaches Why the FASB Prefers the BOA The Impact on Financial Reporting Q&As

3 Learning Objectives At the conclusion of this Webcast, participants will have an understanding of: The contents of FASB s Preliminary Views (PV) The Basic Ownership Approach (BOA) Other approaches considered by the FASB Why the FASB prefers the BOA The potential impact on financial reporting

4 Poll question #1 What is your background? Preparer Auditor User Regulator None of the above Not applicable

5 The FASB s Liability & Equity Project Why did the FASB add this project? the line drawn between liabilities and equity is sometimes obscured in practice applying the definitions do not always produce clear-cut answers some financial instruments combine characteristics of both liabilities and equity the name given to a particular financial instrument may not accurately describe its essential characteristics FASB Discussion Memorandum, 1990

6 The FASB s Liability & Equity Project Discussion Memorandum (1990) Exposure Drafts (2000) Proposed Standard Revised conceptual definition FASB Statement No. 150 (2003) Completion of Phase 1 of the project Did not resolve all the issues Milestone Draft of Proposed Standard (2005) Preliminary Views (PV) document (2007)

7 The FASB s Liability & Equity Project Preliminary Views (PV) document issued for comment on November 30, 2007 Three alternative approaches: 1. Basic Ownership Approach (BOA) the FASB s preferred approach 2. Ownership-Settlement (O-S) Approach 3. Reassessed Expected Outcomes (REO) Approach Comments Due by May 30, 2008

8 Existing Practice Issues Complex patchwork of rules 60+ pronouncements Detailed rules Instrument-specific / form-driven Many application issues Numerous restatements Examples Equity derivatives, convertibles, redeemable securities

9 Poll question #2 Do you agree that current practice issues in accounting for instruments with liability and equity characteristics deserve focus by the FASB? Yes No Don t know/not applicable

10 Fixing the Problem Simplify and improve the accounting Reduce complexity Draw a clear line between liabilities and equity Develop a consistent classification framework Determination of net income Reduce structuring opportunities Avoid form-driven answers Prevent accounting arbitrage Provide understandable information that is useful to investors

11 Fixing the Problem "The Basic Ownership Approach (BOA) would represent a major change to current accounting and reporting. That change is needed to achieve two key objectives. 1. to provide investors with understandable information about the relative priority of individual claims on an entity's net assets and income 2. to develop a less complex approach, which also should reduce existing opportunities to structure arrangements to achieve a desired accounting result FASB News Release, November 30, 2007

12 Fixing the Problem Standard Setting Next Steps: Modified Joint Project with IASB IASB issued FASB s PV for comment IASB Comments due September 30, 2008 The Boards will jointly: Consider constituent comment letters Develop a principle based classification approach Reconsider the conceptual framework

13 Deep Dive - Basic Ownership Approach Overview of the FASB s preferred approach: Only the most residual/subordinate interest in an entity is classified within equity All instruments that reduce the net assets of an issuer are classified as liabilities Increases number of instruments classified as assets and liabilities remeasured at fair value What does this mean for your Balance Sheet?

14 Deep Dive - Basic Ownership Approach Company ABC Statement of Position Year Ended Dec 31 Assets Cash 500,000 Acct Rec 1,500,000 PPE 4,000,000 Total Assets 6,000,000 Liabilities Acct Pay 500,000 Long Term Debt 1,500,000 Total Liabilities 2,000,000 Puttable Common Shares 250,000 Stockholders' Equity 6,000,000 Class A Common Shares 1,000,000 Purchased Call Option (500,000) Class B Common Share 1,000,000 Series A Preferred Stock 600,000 Series B Preferred Stock 350,000 Equity Warrants 300,000 APIC 600,000 Retained Earnings 400,000 Total Stockholders' Equity 3,750,000

15 Deep Dive - Basic Ownership Approach Company ABC Company ABC Statement of Position Year Ended Dec 31 Statement of Position Year Ended Dec 31 Assets Assets Cash 500,000 Cash 500,000 Acct Rec 1,500,000 Acct Rec 1,500,000 PPE 4,000,000 Purchased Call Option 500,000 PPE 4,000,000 Total Assets 6,000,000 Total Assets 6,500,000 Liabilities Acct Pay 500,000 Liabilities Long Term Debt 1,500,000 Acct Pay 500,000 Long Term Debt 1,500,000 Total Liabilities 2,000,000 Puttable Common Shares 250,000 Class B Common Share 1,000,000 Puttable Common Shares 250,000 Series A Preferred Stock 600,000 Series B Preferred Stock 350,000 Stockholders' Equity 6,000,000 Equity Warrants 300,000 Class A Common Shares 1,000,000 Purchased Call Option (500,000) Total Liabilities 4,500,000 Class B Common Share 1,000,000 Series A Preferred Stock 600,000 Stockholders' Equity Series B Preferred Stock 350,000 Class A Common Shares 1,000,000 Equity Warrants 300,000 APIC 600,000 APIC 600,000 Retained Earnings 400,000 Retained Earnings 400,000 Total Stockholders' Equity 2,000,000 Total Stockholders' Equity 3,750,000

16 Deep Dive - Basic Ownership Approach Only the most residual claim is classified within equity Defined as the Basic Ownership Instrument A Basic Ownership Instrument has the following characteristics: A claim to a share of the assets in liquidation that have no priority over any other claim Is entitled to a percentage of the assets that remain after all higher priority claims have been satisfied Has no upper or lower limit

17 Deep Dive - Basic Ownership Approach So what is NOT a basic ownership instrument? Perpetual instruments (e.g., some preferred stock) Senior classes of common stock Limited partnership interest Redeemable instruments (other than at fair value) All equity derivatives (regardless of settlement provisions)

18 Deep Dive - Basic Ownership Approach Exceptions to general principle Redeemable Instruments Perpetual Redeemable Instruments are Basic Ownership Instruments if: Redemption amount equals share of net assets in liquidation Redemption doesn't impair the claims of higher priority instruments Includes perpetual instruments that are redeemable: Mandatorily or at the option of the holder; and At fair value or an approximation of fair value

19 Deep Dive - Basic Ownership Approach Initial Measurement Single Component Instruments: Measured at transaction price (whether asset, liability or equity) Issuance costs are expensed immediately as incurred Multiple component Basic Ownership Instruments: Separate into liability and equity component Allocate transaction price first to liability component at fair value Residual is allocated to the basic ownership instrument Sum of components must equal the initial transaction price

20 Poll question #3 Do you agree with the FASB s tentative decision to require all transaction costs including debt issuance cost to be expensed immediately to earnings rather than capitalized as part of the cost basis of the instruments? Yes No Don t know/not applicable

21 Deep Dive - Basic Ownership Approach Subsequent Measurement Instrument Type Basic Ownership Instrument Basic Ownership Instruments Redeemable at FV Liabilities with Variable or Uncertain Settlements Liabilities with Fixed Maturity and Settlements Equity Classification Not Remeasured Remeasured at Redemption Amount Liability Classification Amortized Cost Remeasured Through Earnings Liabilities not within the Scope of Other Applicable GAAP

22 Deep Dive - Basic Ownership Approach Subsequent Measurement What about perpetual instruments classified as liabilities? Three alternatives provided in Preliminary Views document: Alternative A: Don t remeasure but recognize dividends as an expense when declared Alternative B: Remeasure at fair value through earnings Alternative C: Measure at amortized cost based on expected retirement date and expected dividend payments

23 Poll question #4 What subsequent remeasurement methodology for perpetual instruments classified as liabilities do you prefer? Fair value through earnings Amortized cost based on expected term Historical cost None of the above Don t know/not applicable

24 Deep Dive - Basic Ownership Approach Separation of Multiple Component Instruments Separation is required if: An instrument requires a payment that is not consistent with a basic ownership instrument After the payment is made, a basic ownership instrument remains

25 Deep Dive - Basic Ownership Approach Separation of Multiple Component Instruments Example: Separation On December 31, 2007, Entity A issues Class A common shares that requires a fixed dividend payment to be paid on a quarterly basis Question: Does the fixed dividend payment require separation?

26 Deep Dive - Basic Ownership Approach Separation of Multiple Component Instruments Example: YES Separation is Required Answer: The fixed dividend obligation is a liability component that (1) requires a payment that does not meet the definition of a basic ownership instrument and (2) after the payment is made, a basic ownership instrument remains outstanding

27 Deep Dive - Basic Ownership Approach Linkage of Separate Instruments Two or more freestanding instrument would be linked and classified as a single instrument if: The instrument is part of the same arrangement; and Reporting the instruments separately results in different amount of net income or equity than comparable combined instrument

28 Deep Dive - Basic Ownership Approach Linkage of Separate Instruments Separate instruments are deemed part of the same arrangement (condition 1 in the previous slide) if: The instruments are contractually linked; or The instruments are: Entered into at/near the same time; With the same/related counterparty; and Achieve a similar economic result as a single instrument

29 Deep Dive - Basic Ownership Approach Linkage of Separate Instruments Example: Linkage On December 31, 2007, Entity A issues 1,000 class A common shares to Holder B. On January 1, 2008, Entity A writes an option that allows Holder B to put the 1,000 Class A common shares to Entity A for a fixed price Question: Are the common shares and put option required to be linked for classification purposes?

30 Deep Dive - Basic Ownership Approach Linkage of Separate Instruments Example: YES Linkage is required Answer: When the Class A common share and written put option are linked, the Class A common share is considered redeemable at a price other than fair value and is classified as a liability

31 Deep Dive - Basic Ownership Approach Substance of an instrument When determining classification, linkage, and separation, consider the following principle: Disregard stated terms that have a remote chance of impacting an instrument outcome in more than a minimal way Consider all stated and unstated terms that have more than a remote chance of affecting outcome in more than minimal way

32 Deep Dive - Basic Ownership Approach Substance of an Instrument Example: Substance On December 31, 2007, Entity A issues a warrant allow holders to acquire 1,000 class A common shares. That warrant has an exercise price of $0.01 and the Class A common share is currently trading at $100 Question: What is the substance of the penny warrant on Class A common shares?

33 Deep Dive - Basic Ownership Approach Substance of an Instrument Example: Substance is Common Stock Answer: The $0.01 exercise price is nonsubstantive compared to the share price and should be disregarded. The amount the issuer would require in exchange for the warrant is effectively the Class A common share price. The warrant should be classified within equity

34 Poll question #5 Do you believe that the Basic Ownership Approach reduces complexity in financial reporting? Yes No Don t know/not applicable

35 The Other Two Approaches The Ownership-Settlement (O-S) Approach More consistent with current definition of equity Form of settlement matters (cash or shares) Broader definition of equity including: Certain physically settled equity derivatives All perpetual instruments (e.g., preferred stock) Increased separation Convertible debt and preferred stock

36 The Other Two Approaches The O-S Approach Potential benefits: More consistent with current US GAAP and IFRS than the other approaches Establishes a more consistent and principles-based framework for classifying instruments than current GAAP Potential disadvantages: Increased complexity as a result of separation Increased opportunity to structure Form of settlement drives classification Instruments with similar economic profile may be classified differently

37 The Other Two Approaches The Reassessed Expected Outcomes (REO) Approach Completely new approach Classification based on expected outcome Broader definition of equity than BOA Broadest separation principle All hybrid instruments must be separated All equity derivatives must be separated into settlement components

38 The Other Two Approaches The REO Approach Potential benefits: Form of settlement does not impact classification Realistic representation of economics Potential disadvantages: Requires complex formula for measurement Increased separation of instruments all equity derivatives Constant reassessment of classification

39 Why the FASB Prefers the BOA The 2005 FASB Milestone Draft is based on the Ownership-Settlement (O-S) Approach The FASB Preliminary Views document supports the Basic Ownership Approach (BOA)

40 Why the FASB Prefers the BOA 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, and 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

41 Why the FASB Prefers the BOA 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

42 Why the FASB Prefers the BOA Considerations in supporting BOA: Simplicity (reducing complexity in financial reporting) There is a clear distinction between liabilities and equity Classification does not depend on form of settlement All derivatives on equity are classified as liabilities (or assets) Only interests that fully participate in the residual of an entity are classified within equity

43 Why the FASB Prefers the BOA Considerations in supporting BOA: Fewer accounting arbitrage opportunities Settlement does not affect classification No need to consider unstated cash settlement options Less need to apply linkage or substance requirements Because fewer accounting arbitrage opportunities Does not require a significant amount of separation Avoids issues about how to separate Easier to craft a simple conceptual definition Results in more instruments being measured at fair value through earnings

44 Why the FASB Prefers the BOA 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, or 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

45 Poll question #6 Of the approaches included in the FASB s Preliminary Views document and those listed, which approach do you favor? Basic Ownership Approach Ownership Settlement Approach Reassessed Expected Outcomes Approach A different approach Current practice Don t know/not applicable

46 The Impact on Financial Reporting Impact on the Balance Sheet: More items classified as liabilities Entities will appear significantly more leveraged Debt covenants may need to be renegotiated More Variable Interest Entities under FIN 46R More instruments that need to be fair valued

47 The Impact on Financial Reporting Impact on the Income Sheet: Dividends on preferred stock expensed through earnings Reduced net income More contracts fair valued through earnings (e.g., stock options) Potentially increased volatility in net income Gains on some contracts as value of equity decreases Decrease demand for derivatives indexed to common shares

48 The Impact on Financial Reporting Impact on Financial Analysis: Leveraged debt-equity ratios Potentially more volatile performance measures Subjectivity in determining some fair values

49 Poll question #7 Do you believe that the clear distinction between liabilities and equity in the Basic Ownership Approach provides decision useful information to investors? Yes No Don t know/not applicable

50 The Impact on Financial Reporting Example 1: On December 31, 2007, Entity A issues 1,000 Class B common shares that do not include any dividend or redemption requirements. The Class B common share has preferential treatment over Entity A Class A common share in liquidation and to any discretionary dividends. Question: Is the Class B common share classified within equity?

51 The Impact on Financial Reporting US GAAP IFRS BOA Class B Common Share Equity Equity US GAAP Equity classification under CON 6 IFRS Equity classification under IAS 32

52 The Impact on Financial Reporting US GAAP IFRS BOA Class B Common Share Equity Equity Liability US GAAP Equity classification under CON 6 IFRS Equity classification under IAS 32 BOA Liability classification Liquidation and dividend preference causes instrument to reduce net assets available to Class A shareholder

53 The Impact on Financial Reporting Example 2: On December 31, 2007, Entity A issues 1,000 Class A common shares that include an embedded put option that allows the holder of the share to put the share to Entity A for a fixed price. The put option requires physical settlement. Question: Is the puttable basic ownership instrument classified within equity?

54 The Impact on Financial Reporting US GAAP IFRS BOA Puttable Common Share Equity Liability US GAAP Equity classification Temporary equity under EITF Topic D-98 IFRS Liability classification under IAS 32

55 The Impact on Financial Reporting US GAAP IFRS BOA Puttable Common Share Equity Liability Liability US GAAP Equity classification Temporary equity under EITF D-Topic 98 IFRS Liability classification under IAS 32 BOA Liability classification Redemption feature is not at fair value

56 The Impact on Financial Reporting Example 3: On December 31, 2007, Entity A issues convertible debt that allows the holder to convert into 1,000 Class A common shares at any time after the 5 th year. Question: How is the convertible debt instrument classified? Is the equity conversion option separated?

57 The Impact on Financial Reporting US GAAP IFRS BOA Convertible Debt Instrument Liability Liability and Equity US GAAP Liability classification under APB 14 In some cases, separation (e.g., EITF 00-27, FAS 133) IFRS Liability and Equity under IAS 32 Separate the conversion option and classify as equity

58 The Impact on Financial Reporting US GAAP IFRS BOA Convertible Debt Instrument Liability Liability and Equity Liability US GAAP Liability classification under APB 14 In some cases, separation (e.g., EITF 00-27, FAS 133) IFRS Liability and Equity under IAS 32 BOA Liability classification Potentially bifurcate the conversion option under FAS 133

59 Questions & Answers

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62 Other Resources Heads Up/Roadmap Series D&T Heads Up FASB Proposes to Narrow Definition of Equity FASB Preliminary Views document Financial Instruments with Characteristics of Equity FASB Liabilities and Equity project webpage IASB Discussion Paper - Financial Instruments with Characteristics of Equity pdf ojects/liabilities+and+equity/liabilities+and+ Equity.htm

63 Contact Information Deloitte & Touche LLP Bob Uhl Magnus Orrell Chris Rogers FASB Tom Linsmeier

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