This Comment Letter was sent by BDO Global Coordination B.V., on behalf of BDO International, to the International Accounting Standards Board in September 2008:
Dear Sir,
Financial Instruments with Characteristics of Equity
We are pleased to have the opportunity to respond on behalf of BDO International1 to the IASB’s invitation to comment on the Preliminary Views document, Financial Instruments with Characteristics of Equity, which was issued by the U.S. Financial Accounting Standards Board in November 2007, and the IASB’s own Discussion Paper, Financial Instruments with Characteristics of Equity, which was issued in February 2008.
We are supportive of the IASB’s efforts to improve accounting in this area. However, we do not fully support any of the proposed approaches in the Preliminary Views document and believe that any new accounting standard that deals with the approach to be followed in accounting for liabilities and equity needs to be based on, and be developed after, the issue of a conceptual framework which properly sets out and defines what a liability, and equity, are and represent.
In consequence, we are strongly of the view that the Boards should undertake a joint and comprehensive project starting at a conceptual level, which distinguishes between and defines liabilities and equity, with this linking to the development of guidance which then implements the concepts that have been established. We believe that it would be inappropriate to progress a liabilities and/or equity project without having determined and defined precisely what liabilities and equity are as part of the ongoing review of the conceptual framework. We believe that the development of a new accounting standard, which is followed by the ‘engineering’ of a conceptual framework in order that its concepts and definitions then support that new accounting standard, is an inappropriate approach.
We appreciate that the Boards may have a degree of focus on short term convergence of IFRS and US GAAP in this area, where there are differences in current literature, and understand that it may be attractive to move directly to a new model. However, we believe that any of the approaches set out in the Preliminary Views would require extensive field testing in a wide range of jurisdictions and that it is quite possible that significant difficulties would be encountered. We note that the Preliminary Views has been developed by the FASB in the context only of existing US requirements. This would suggest that account may not have been taken of the wide range of financial instruments and structures, and associated issues, that exist in other jurisdictions, some of which the IASB has sought to address through amendments to IAS 32. In consequence, if the Boards do decide to progress with one or more of the models suggested in the Preliminary Views, we are concerned that the amount of time required to complete the project may be substantially longer than the two Boards might wish and that the completion date could well be later than 2011.
If short term convergence is a significant factor in the Boards’ thinking, in our view this convergence should be either to existing, or improved existing, guidance. In this context, we believe that the guidance set out in IAS 32 is superior to existing US GAAP guidance. As the IASB has indicated in its own Discussion Paper, aspects of IAS 32 that can be criticised are well known, and certain of these could be addressed in the short term with amendments being released in time to form part of the standards to be published by the end of 2011. This would then permit the Boards to take sufficient time to develop new concepts and definitions of liabilities and equity, with these then being taken forward and forming the basis for a robust (from both conceptual and practical perspectives) new standard.
If the Boards insist on adopting one of the models set out in the Preliminary Views as the basis for a new converged standard to be published in the short term, then we would tentatively support further consideration of either the Basic Ownership Approach or the Ownership-Settlement Approach, although the question of our ultimate support would depend on the detailed requirements of each of these approaches. Our tentative support for the Basic Ownership Approach is based largely on its relative simplicity and on it having an element of a principles based approach to equity (with this being the instrument with the most residual claim). However, we believe that the Boards would be likely to encounter significant issues similar to those which have already been experienced with IAS 32, certain of which led to the amendments for puttable instruments.
We also note that it is extremely difficult to express precise views about three models when there are many unanswered questions. It is not clear whether consideration has been given to, for example, whether the suggested distinctions between liabilities and equity would apply to the very wide range of capital structures (including country specific structures) and industries that exist, in a way that provides meaningful information to investors and other users of financial statements.
In this context, it is debatable whether analysts and investors would find volatility arising from remeasurement of instruments that are linked to an entity’s own share price of significant value. This is particularly the case for entities that might have relatively little equity but significant equity related liabilities, as movements in the entity’s share price alone could result in the entity reporting net liabilities. This brings into sharper focus the need for appropriate consideration of any new model, including linkage to the Financial Statement Presentation project.
It would also appear likely that any new standard may well have significant consequential effects on a range of other existing standards, some of which (such as IAS 37) are already being covered by major projects which are scheduled to result in the issue of new accounting standards over the next two to three years. It would seem inappropriate for potentially significant new requirements to be issued, only to be replaced again or substantially overhauled within a short period.
We hope that you will find our comments and observations helpful. If you would like to discuss any of them further, please contact either Helen Thomson at + 32 2 778 0134 or Andrew Buchanan at +44 (0)20 7893 3300.
Yours faithfully,
BDO Global Coordination B.V.
FASB’s Preliminary Views:
Responses to Questions on the Basic Ownership Approach
Question 1
Do you believe that the basic ownership approach would represent an improvement in financial reporting? Are the underlying principles clear and appropriate? Do you agree that the approach would significantly simplify the accounting for instruments within the scope of this Preliminary Views and provide minimal structuring opportunities?
While it would appear that the Basic Ownership Approach might simplify certain elements of financial reporting, it is not altogether clear that this in itself would bring an improvement in financial reporting. We are not wholly convinced, nor do we believe that the suggested approach would give little opportunity for structuring.
While we agree that the classification of financial instruments might be simplified, we are concerned that this might result in complexity shifting rather than elimination. For the wide range of instruments that would be classified as liabilities under the Basic Ownership Approach (rather than equity at present), there would seem to be potential for difficulties and issues to arise in the presentation of those instruments in the financial statements. In addition, many financial instruments would be required to be measured at fair value; the Boards have already encountered significant difficulties elsewhere in the fair value measurement of liabilities.
We also note that equity classification would be available only to the instrument with the most residual claim on an entity’s assets. This gives scope for an entity which is otherwise identical to another to issue a small number of instruments with a lower claim on assets than others, meaning that the other instruments (classified as equity by the other entity) would be classified as liabilities. Similarly, the entity which had issued the instruments with a lower claim on assets could buy them back in one period and reissue them in another, depending on the balance sheet and income statement presentation that was considered more desirable at that point.
Question 2
Under current practice, perpetual instruments are classified as equity. Under the basic ownership approach (and the REO approach, which is described in the Appendix B) certain perpetual instruments, such as preferred shares, would be classified as liabilities. What potential operational concerns, if any, does the classification present?
We believe that the proposals would be likely to confuse users of financial statements and would provide financial information that does not reflect economic reality. In the context of whether an entity has an obligation to transfer resources (which is a common view of what represents a liability), the classification of a mandatorily redeemable instrument which is subordinate on liquidation as equity seems very odd, as does the classification as a liability of a perpetual instrument with discretionary coupons and therefore no compulsion to pay anything.
We assume that the intention would be to present financial instruments in a form of ‘liquidation preference’. This again links back to the issues associated with the presentation of financial statements and how the information will be useful to users, as well as the overriding need properly to define liabilities and equity.
Question 3
The Board has not yet concluded how liability instruments without settlement requirements should be measured. What potential operational concerns, if any, do the potential measurement requirements in paragraph 34 present? The Board is interested in additional suggestions about subsequent measurement requirements for perpetual instruments that are classified as liabilities.
Of the three potential methods set out in paragraph 34, our preference would be for the instrument not to be remeasured, with dividends being reported as an expense when declared or become a legally binding obligation of the issuer.
The two other alternatives suggested would involve subjective estimates for both future coupon payments and hypothetical liquidation dates, the latter being somewhat inconsistent with the view normally taken that an entity normally operates as a going concern. It seems inappropriate to report fair value gains and losses arising from changes in expected ‘settlement’ dates for an instrument which will, in fact, never settle.
Question 4
Basic ownership instruments with redemption requirement may be classified as equity if they meet the criteria in paragraph 20. Are the criteria in paragraph 20 operational? For example, can compliance with criterion (a) be determined?
Whether the criteria in paragraph 20 are operational or not depends on the Boards’ intentions. Certain redeemable instruments are redeemable at amounts based on historic earnings which, although designed to arrive at an approximate fair value, may not do so, depending on events (such as litigation or legislative changes). Is the intention that the redemption formula would be designed to approximate fair value most of the time and in the absence of unexpected events? If so, this might be operational but would be likely to result in significant demands for application guidance.
It is also not clear what is meant in paragraph 20b by an impairment in the claims of any instruments with higher priority than basic ownership instruments. Any amount paid to the holders of the redeemable instruments would seem automatically to reduce the assets available to the claims of other instrument holders. Is ‘impairment’ in the context of a solvency or capital adequacy test, where there is no impairment unless the entity would, as a result of the payment to the holders of redeemable instruments, be unable to pay amount(s) due to the holders of those instruments with a priority higher than basic ownership instruments?
Question 5
A basic ownership instrument with a required dividend payment would be separated into liability and equity components. That classification is based on the Board’s understanding of two facts. First the dividend is an obligation that the entity has little or no discretion to avoid. Second, the dividend right does not transfer with the stock after a specified ex-dividend date, so it is not necessarily a transaction with a current owner. Has the Board properly interpreted the facts? Especially, is the dividend an obligation that the entity has little or no discretion to avoid? Does separating the instrument provide useful information?
We agree that it is appropriate to account for a mandatory dividend as a liability component. However, the Preliminary Views does not address a number of concerns.
In particular, it would be necessary to define clearly what is meant by a ‘required dividend payment’. In legal form, dividends typically only become obligations once declared and, even if an instrument requires payment of a coupon, this may be precluded due to legal constraints (for example, an entity might have insufficient distributable profits and hence legally be precluded from declaring a dividend).
Certain entities also issue instruments which require dividends to be paid unless this requirement is waived by the shareholders. In such cases, in particular where the majority shareholders also form the Board, would the association of the shareholders with the entity mean that the dividends would not be regarded as being mandatory?
We disagree with the view that a dividend right is not necessarily a transaction with a current owner. The dividend is payable to whoever happens to be the owner at the point at which the dividend is declared; ‘current owner’ should be interpreted in that context.
Question 6
Paragraph 44 would require an issuer to classify an instrument based on its substance. To do so, an issuer must consider factors that are stated in the contract and other factors that are not stated in the terms of the instrument. That proposed requirement is important under the ownership-settlement approach, which is described in Appendix A. However, the Board is unaware of any unstated factors that could affect an instrument’s classification or measurement under the basic ownership approach. Is the substance principle necessary under the basic ownership approach? Are the factors or circumstances other than the stated terms of the instrument that could change an instrument’s classification or measurement under the basic ownership approach? Additionally, do you believe that the basic ownership approach generally results in classification that is consistent with the economic substance of the instrument?
We believe that the substance principle is necessary. However, if the Boards wish to include this principle, it will be necessary fully to address the question of economic compulsion in the context of instruments such as those with dividend blocker terms, or stepped coupon payments that make it economically certain that an entity will redeem the instrument regardless of its stated terms.
We are also concerned that the guidance would give simple structuring opportunities. As an example, assume that an entity with a large number of ordinary shares in issue (which are the instruments with the lowest priority claim on the entity’s assets and are therefore classified as equity instruments) issues a small number of shares with a lower claim on the entity’s assets. Would that issue of shares result in the instruments previously classified as equity being reclassified as liabilities?
We also note that it is common for entities to issue relatively worthless deferred shares, which rank behind those entities’ ordinary shares (sometimes referred to as ‘deferred shares’). It is important that equity classification for the ordinary shares is not precluded if they do, in substance, represent the entity’s equity.
Question 7
Under what circumstances, if any, would the linkage principle in paragraph 41 not result in classification that reflects the economics of the transaction?
It is difficult to answer this question without understanding how consequential amendments might be made to existing guidance. For example, IAS 39 contains guidance which prohibits ‘synthetic’ accounting for, say, a fixed rate loan and a fixed to floating swap taken out at the same point with the same counterparty. Would IAS 39 be modified, or would inconsistencies in approach be introduced among different accounting standards?
It is also possible that there may be unintended consequences of the linkage guidance, as there is no mention of intent. As an example, a bank may have a number of trading desks which transact with the same counterparties. Independently of each other, these desks might enter into separate transactions with a counterparty that would meet the linkage criteria in paragraphs 41 to 43. This would imply that the transactions would need to be linked and combined.
Question 8
Under current accounting, many derivatives are measured at fair value with changes in value reported in net income. The basic ownership approach would increase the population of instruments subject to those requirements. Do you agree with that result? If not, why should the change in value of certain derivatives be excluded from current-period income?
We agree that derivatives should be measured at fair value with changes reported in profit or loss. If additional derivatives are identified, this is the appropriate accounting approach. We have not identified derivatives which should be accounted for differently.
Question 9
Statement of financial position. Basic ownership instruments with redemption requirements would be reported separately from perpetual basic ownership instruments. The purpose of the separate display is to provide users with information about the liquidity requirements of the reporting entity. Are additional separate display requirements necessary for the liability section of the statement of financial position in order to provide more information about an entity’s cash requirements? For example, should liabilities required to be settled with equity instruments be reported separately from those required to be settled with cash?
We consider that it would be appropriate for instruments with different characteristics to be identified separately to provide users of financial statements with additional liquidity information. We agree that this separate display should be extended to include a distinction between instruments to be settled in cash, and those to be settled through the issue of equity instruments.
Question 10
Income statement. The Board has not reached tentative conclusions about how to display the effects of net income that are related to the change in the instrument’s fair value. Should the amount be disaggregated and separately displayed? If so, the Board would be interested in suggestions about how to disaggregate and display the amount. For example, some constituents have suggested that interest expense should be displayed separately from the unrealised gains and losses.
We agree that it may be helpful to separate certain components of amounts that would be included in the income statement. An appropriate separation might be to identify finance costs (including accretions) separately from changes in the recorded fair value of financial instruments. A further element that we believe should be identified separately is the amount of the change in fair value that arises from changes in an entity’s own credit rating.
Otherwise, we believe that the existing requirements should be applied and, in particular, there should be no question of any amounts being included in the Statement of Recognised Income and Expense or the Statement of Changes in Equity rather than the income statement itself.
Question 11
The Board has not discussed the implications of the basic ownership approach for the EPS calculation in detail; however, it acknowledges that the approach will have a significant effect on the computation. How should equity instruments with redemption requirements be treated for EPS purpose? What EPS implications related to this approach, if any, should the Board be aware of or consider?
We agree that the Basic Ownership Approach would result in significant changes to EPS calculations. In particular, these would need to accommodate fair value changes recorded in profit or loss arising from instruments covered by the guidance, and for other instruments such as participating shares that were classified as liabilities and certain derivative contracts.
It is likely that the significant changes to accounting that would be introduced by the Basic Ownership Approach would also be more appropriately addressed by the development of a new EPS standard rather than the changes being made to existing guidance.
Other comments
We note that paragraphs 37 et seq mandate the use of a probability weighted settlement date for liabilities, which may affect the effective interest rate and (presumably) the maturity analysis. We do not agree with the suggested approach; in particular, the probability weighted maturity and effective interest rate will never equal the actual maturity and associated effective interest rate.
Responses to Questions on the Ownership-Settlement Approach
Question 1
Do you believe the ownership-settlement approach would represent an improvement in financial reporting? Do you prefer this approach over the basic ownership approach? If so, please explain why you believe the benefits of the approach justify its complexity.
The Ownership-Settlement Approach shares the shortcomings of all three of the approaches suggested in the Preliminary Views, in that there is no clear principle or definition of equity, nor does the paper address how it will interact with the definitions that may be included in the revised conceptual framework.
We note that the Ownership-Settlement Approach does, in contrast to the other approaches set out in the Preliminary Views, make a distinction between instruments that provide a choice of settlement to the holder, and those which provide a choice of settlement to the issuer. It is appropriate for this distinction to be made, as this feature may have a significant effect on whether the entity will be required to transfer assets to the holder of the instrument.
We note that the Ownership-Settlement Approach is closest of the three alternatives to the existing IAS 32. However, the suggested approach seems to do little more than add additional rules-based guidance to the Basic Ownership Approach and, until and if these rules were clarified and subject to detailed and extensive field testing, it is difficult to conclude whether it would represent an improvement in comparison with IAS 32. If it were to be concluded that the Ownership-Settlement Approach was the most favoured of the three approaches set out in the Preliminary Views, we can see little point in progressing the project in favour of the IASB and FASB converging through the adoption of a revised and improved IAS 32.
Question 2
Are there ways to simplify the approach? Please explain.
We see little potential for simplification.
Question 3
Paragraph A40 describes how the substance principle would be applied to indirect ownership instruments. Similar to the basic ownership approach, an issuer must consider factors that are stated in the contract and other factors that are not stated in the terms of the instruments. Is this principle sufficiently clear to be operational?
We believe that the issues discussed in response to question 6 to the Basic Ownership Approach are relevant, specifically those in respect of economic compulsion.
Question 4
Statement of financial position. Equity instruments with redemption requirements would be reported separately from perpetual equity instruments. The purpose of the separate display is to provide users with information about the liquidity requirements of the reporting entity. What additional, separate display requirements, if any, are necessary for the liability section of the statement of financial position in order to provide more information about an entity’s potential cash requirements? For example, should liabilities required to be settled with equity instruments be reported separately from those required to be settled with cash?
Our responses to questions 9 and 10 to the Basic Ownership Approach are also relevant here.
Question 5
Are the proposed requirements for separation and measurement of separated instruments operational? Does the separation result in decision-useful information?
In principle, the suggested approach does not appear inappropriate, although additional guidance and examples of common instruments would assist in a fuller analysis of how this might operate in practice.
Question 6
The Board has not discussed the implications of the ownership-settlement approach for the EPS calculation in detail. How should equity instruments with redemption requirements be treated for EPS purposes? What EPS implications related to this approach, if any, should the Board be aware of or consider?
Our responses to question 11 under the Basic Ownership Approach are also relevant here. However, we note that the Ownership-Settlement Approach is not wholly dissimilar to the current accounting for equity and liabilities and, in consequence, a wholly new EPS standard might not be required.
Question 7
Are the requirements described in paragraphs A35-A38 operational? Do they provide meaningful results for users of financial statements?
We find the guidance set out in these paragraphs extremely difficult to understand and, in consequence, it is difficult to answer the question. It would be helpful if an example could be provided, including a comparison with the approach that would be required by the existing IAS 32 in order that differences in approach could be highlighted.
Responses to Questions on the Reassessed Expected Outcomes Approach
We found the guidance difficult to follow and extremely complex, and question whether users of financial statements would find information produced under this approach comprehensible. We agree with the Boards that this approach is overly complex, expensive to implement and inappropriate, and that it should not be pursued further.
Other alternatives
Some other approaches the Board has considered but rejected are described in Appendix E. Is there a variation of any of the approaches described in this Preliminary Views or an alternative approach that the Board should consider? How would the approach classify and measure instruments? Why would the variation or alternative approach be superior to any of the approaches the Board has already developed?
Appendix E lists a number of other approaches that are not currently being considered. Among these, we believe that the loss absorption approach (which has been analysed in the Pro-active Accounting Activities in Europe paper) and the claims approach should be analysed in further detail before they are discarded.
Other comments
We believe that this project does provide the Boards with an opportunity comprehensively to revisit the distinction between equity and liabilities. However, as we have noted above, without the development of a robust conceptual framework which includes clear definitions of what liabilities and equity represent, there is a risk that the Boards will select an approach which is difficult for preparers to implement, and does not provide the best possible information to users of financial statements.
In the meantime, as discussed in our covering letter, if the Boards wish to converge the requirements of US GAAP and IFRS in the relatively short term, we are of the view that this should be to an amended and improved version of the current IAS 32.
IASB’s Discussion Paper
Responses to Questions
B1 Are the three approaches expressed in the FASB Preliminary Views document a suitable starting point for a project to improve and simplify IAS 32? If not, why?
a) Do you believe that the three approaches would be feasible to implement? If not, what aspects do you believe could be difficult to apply, and why?
b) Are there alternative approaches to improve and simplify IAS 32 that you would recommend? What are those approaches and what would be the benefit of those alternatives to users of financial statements?
While a number of aspects of IAS 32 that could be improved, which the IASB has acknowledged in its discussion paper, we do not believe that any of the three approaches suggested in the FASB paper represent a suitable starting point for the improvement and simplification of IAS 32. We believe that the likely result would be additional complexity rather than a reduction.
B2 Is the scope of the project as set out in paragraph 15 of the FASB Preliminary Views document appropriate? If not, why? What other scope would you recommend and why?
We do not believe that is it appropriate to refer to the concept of legal form. While the reference may be appropriate in the context of US requirements, any accounting standard that resulted from this project would be applied in many jurisdictions, which will inevitably bring differing legal requirements.
B3 Are the principles behind basic ownership instrument inappropriate to any types of entities or in any jurisdiction? If so, to which types of entities or in which jurisdictions are they inappropriate, and why?
We believe that there are certain instruments and jurisdictions where the principles of the Basic Ownership Approach may be inappropriate. In particular, we note that the IASB has incorporated certain amendments to IAS 32 in order that some instruments that would previously have been classified as liabilities are instead classified as equity. It appears likely that at least some of these would be classified as liabilities under the Basic Ownership Approach.
B4 Are the other principles set out in the FASB Preliminary Views document inappropriate to any types of entities or in any jurisdiction? (Those principles include separation, linkage and substance.) If so, to which types of entities or in which jurisdictions are they inappropriate, and why?
We consider that the principles of separation, linkage and substance are broadly appropriate. However, we have raised some questions about their operation in our responses to questions raised by the FASB in the Preliminary Views. In particular, we believe that the question of economic compulsion needs satisfactorily to be addressed; this is a significant flaw in the current IAS 32 where certain instruments that (in substance) have the characteristics of debt are classified as equity.
1) BDO International is a world wide network of public accounting firms, called BDO Member Firms, serving international clients. Each BDO Member Firm is an independent legal entity in its own country.
The network is coordinated by BDO Global Coordination B.V., incorporated in the Netherlands, with an office in Brussels, Belgium, where the Global Coordination Office is located.
Discussion Paper, Comments due 5 September 2008:
DP Financial Instruments with Characteristics of Equity.pdfFASB Preliminary Views - Fin Instr with Characteristics of Equity.pdf