Defining Liabilities. Deloitte Foundation/Federation of Schools of Accountancy Faculty Consortium May Katherine Schipper Duke University

Transcription

1 Defining Liabilities Deloitte Foundation/Federation of Schools of Accountancy Faculty Consortium May 2014 Katherine Schipper Duke University 1

2 Overview Why do standard setters periodically reconsider the accounting definition of a liability? Part of the now-inactive joint IASB-FASB conceptual framework project Part of the IASB s independent reconsideration of its conceptual framework Why do standard setters (and others) have difficulty distinguishing liability from equity? The distinction matters for financial statement analysis (leverage analysis), for valuation and for calculating income US GAAP contains over 60 pieces of relatively narrow, often-complex, rules-based guidance The FASB staff is rewriting the Codification sections that address this topic The FASB issued a Discussion Memorandum on this topic in 1990 and an Exposure Draft in Neither resulted in a broad scope standard In SFAS 150 para. 6 the FASB indicated a plan to amend the liabilities definition to encompass certain obligations settled in shares A liabilities and equities project was part of the 2006 Memorandum of Understanding joint IASB-FASB convergence projects but was (apparently) abandoned in 2010 As of January 29, 2014, the FASB has reconstituted its own conceptual framework project, including reconsideration of the definitions of financial statement elements 2 (but there are no project updates after 2010)

3 Existing liability definitions; the IASB s proposal FASB Concepts Statement 6 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 IASB Framework (2010) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. IASB s Conceptual Framework Discussion Paper (July 2013) A liability of an entity is a present obligation of the entity to transfer an economic resources as a result of past events; an economic resource is a right, or other source of value, that is capable of producing economic benefits 3

4 Components of liability definition Existence of obligation that arises from past event or transaction Requires consideration of what qualifies as an obligation Expectation of outflow from the entity The FASB s definition specifies a probable sacrifice in the form of a transfer of assets or provision of services Concepts Statement 6, note 21, clarifies that probable refers to that which can reasonably be expected but which is neither certain nor proved, and distinguishes this usage from the usage in SFAS 5. The IASB s current definition specifies an expected outflow of resources The IASB s proposed definition does not specify an expectation of outflows but instead specifies an obligation to transfer resources Form of outflow from the entity The FASB s definition specifies transfer of assets or provision of services The IASB s current definition specifies outflow of resources embodying economic benefits The IASB s proposed definition specifies transfer of economic resources (a right or other source of value that can produce economic benefits) 4

5 Components of liability obligation Existence of obligation that arises from past event or transaction Would include legally enforceable arrangements What about constructive obligations? Arise from an entity s counterparties valid expectations, based on the entity s past practices, published policies or specific current statements Described in Concepts Statement 6, para. 40, as binding because of social or moral sanctions or custom Requires an analysis of expectations held by others, outside the entity Example: Para. 40 of Concepts Statement 6: Providing vacation time or bonuses every year can create an expectation that the entity will continue to do so Question to consider: Is the unvested portion of the projected benefit obligation in a defined benefit pension arrangement a constructive obligation? What about economic compulsion? Based on the idea that an entity would find it economically impracticable not to meet an explicit or implied obligation Unclear how broadly this might be applied; for example, does the anticipated need to replace aging fixed assets create a form of economic compulsion? 5

6 Components of liability outflows Expectation of outflow from the entity/probable outflow Key issue: Conflates the existence of an obligation with the amounts at which that obligation might be settled Some obligations can be settled without transferring any assets or other things of value or performing any services Example 1: A financial guarantee in which the guaranteed party makes the specified payment and the guarantor s obligation ends without any transfer of assets Example 2: An entity determines it is probable that it will make a payment to settle litigation and therefore recognizes a contingent obligation; in the end, the entity prevails and no payment is made Example 3: An entity incurs an obligation to pay contingent consideration in a business combination, and the conditions for payment are not met Current guidance adds confusion by applying mixed measurements to obligations that may be settled without any transfer of assets Warranties and certain other contingent obligations: most likely amount Contingent consideration classified as a liability: fair value 6

7 Observations and questions to consider about combining obligation with outflows In evaluating the IASB s proposed liability definition, EFRAG (European Financial Reporting Advisory Group) comments: The proposed definition seems more remote from.outflows of economic benefits than the current definitions. (red font added) EFRAG questions whether liabilities should include obligations that are unlikely (or not likely) to require a payment in settlement Observation: The EFRAG commentary s focus on flows suggests the idea of an implicit recognition threshold in the definition of liability. An obligation with a sufficiently unlikely outflow would not be recognized. Questions to consider: If a liability is defined as a present obligation of an entity, what is the purpose of adding the outflow (or transfer) condition? Does adding the outflow/transfer condition cause rather than remove confusion? If a liability is defined as a present obligation, wouldn t the possible settlement amounts (potentially including zero) and their related probabilities be the basis for measuring the obligation? 7

8 Components of liability form of outflow Transfer assets/perform services versus transfer shares: Focus on solvency/liquidity versus focus on dilution If the focus is on solvency/liquidity, an obligation to transfer the entity s own shares cannot be a liability Transferring shares does not make an entity insolvent; transferring assets/providing services can Threshold issue: what if the entity lacks the ability to deliver all the shares necessary to settle the obligation without incurring a cost? Pay cash to buy treasury shares Obtain shareholder approval for more authorized shares If the focus is on dilution, an obligation settled by transferring the entity s own shares can be a liability Dilution => settlement by transferring shares that increases existing share ownership on terms other than transfer in exchange for services or assets at current fair value Share-based payment arrangements with employees: Dilutive and usually classified as equity Net share-settled written put: Dilutive and classified as liability Obligation to transfer a variable number of shares with fixed monetary value 8 known at inception: Possibly dilutive and classified as liability

9 Observations and questions to consider about form of outflow Observations: US GAAP (e.g., SFAS 150) indicates uneasiness about share settled arrangements that require a fixed number of shares versus a variable number of shares. Issuing a variable number of shares cannot, in and of itself, cause a solvency issue but can cause a substantial dilution issue From the counterparty s (Transferee s) perspective, Transferor shares are an asset and will be recognized as such. To the Transferee, an obligation of the Transferor to deliver its own shares is an obligation to deliver an asset. Questions to consider: To what extent is uneasiness about certain share-settled obligations due to: Fixed number of shares versus variable number of shares Difference in perspectives between a Transferor who delivers its own shares and the counterparty (Transferee) who receives those shares Can (should) share settlement versus cash settlement change the classification of an arrangement from liability to equity and vice versa? Example: ASC : If an entity that has a choice of settling a share based payment arrangement in cash or shares usually settles in cash, the entity is 9 settling a substantive liability.

10 Distinguishing liability from equity A consequential distinction for both balance sheet and income statement Assets Liabilities = Equity (or Net Assets) Comprehensive income is defined in terms of changes in Net Assets Liability items are subject to remeasurement; equity is seldom remeasured Interest expense paid to liability holders reduces income; dividends paid to equity holders do not Settlements of liabilities can result in gain/loss; equity repurchases/sales do not Some financial instruments contain components that seem (intuitively) associated with equity and components that seem (intuitively) associated with liability Existing guidance reflects confusion Is equity is uniquely associated with ownership relationships (however defined) Are solvency considerations, specifically, the possibility that the entity would be required to transfer cash or other assets, sufficient for an arrangement to be liability Example to consider: The entity would have to pay cash to buy its own shares in order to have sufficient shares to settle the obligation Whether linked arrangements should be combined for accounting Whether compound arrangements should be separated for accounting 10

11 Distinguishing liability from equity examples 1. How should the following instruments be classified? Common shares that are puttable or callable Arrangements to buy or sell the entity s own shares Puts, calls and forwards both written and held Compound instruments that combine two or more components and that will be settled as either a liability (transfer cash) or equity Example: Convertible debt 2. How should concepts/definitions deal with linked arrangements that act like compound instruments? Example 1: Puttable common stock versus common stock with a separate written put Example 2: Written put versus convertible debt + share repurchase The arrangements are economically similar but the accounting differs If issuer share price declines the issuer has net increase in treasury shares and economic loss If issuer share price increases issuer has no net increase in treasury shares and benefits from the premium 11

12 Concluding comments/questions to consider The current definition of liability in US GAAP and IFRS includes both existence of an obligation and expected outflow of assets/provision of services Should the definition be revised to focus only on a present (existing) obligation, eliminating the idea of outflows? Should the pattern of outflows, regardless of their form, be used only to measure an arrangement that qualifies as an obligation? Should the idea of a probable outflow be retained or discarded? Should the notion of obligation be restrictive or broad? Should the outflows include an outflow of the entity s shares? Projects to distinguish liability from equity have existed, intermittently, for many years, without much success Existing standards-level guidance is complex, voluminous and inconsistent Exact nature of standards-level issues shifts as new instruments and new commercial arrangements are created The preferred conceptual solution is not clear: both a solvency/liquidity approach and a dilution approach are conceptually defensible Constituents may object to conceptually sound proposals for pragmatic reasons, such as 12 income volatility or measurement difficulties