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INFORMATION FOR OBSERVERSIASB BOARD MEETING: 11 DECEMBER 2007, LONDONAGENDA PAPER 4B

This document is provided as a convenience to observers at IASB meetings, to assist them in following the Board’s discussion. It

does not represent an official position of the IASB. Board positions are set out in Standards.

These notes are based on the staff papers prepared for the IASB. Paragraph numbers correspond to paragraph numbers used in

the IASB papers. However, because these notes are less detailed, some paragraph numbers are not used.

Liabilities and Equity

FASB Preliminary ViewsFinancial Instruments with Characteristics of Equity

Financial Instruments with Characteristics of Equity

IASB Board Meeting

December 11, 2007

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History of the Project

• Added to agenda in 1986

• Resulting FASB documents– 1990 Discussion Memorandum– Statement 150 and follow on FSPs– ED proposing revisions to definitions in Concepts

Statement No. 6– Milestone Draft of Proposed Standard– 2007 Preliminary Views (PV)

• Milestone draft based on ownership-settlement (O-S) approach

• PV supports basic ownership approach

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Problems in Developing O-S Approach

• Complexity– To achieve classification based on forms of

settlement, the following concepts were needed• Perpetual, basic and indirect ownership instruments• Separation• Linkage• Substantive Features

• Inconsistencies– Single and multiple component instruments

classified first based on equity characteristics– Multiple component instruments measured first as

debt; equity is the residual • Obligations first approach• May result in unrealistic numbers

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Problems in Developing O-S Approach

• Opportunities for accounting arbitrage opportunities– Instruments with similar economic outcomes are classified

differently if settled differently (e.g., physical versus cash settlement for options, SARS, and convertible debt)

• Difficulty in developing Conceptual Framework definition of equity and liabilities– Equity includes (a) the most residual instruments, (b) other

perpetual instruments, and (c) instruments that change in value because the value of the most residual instruments changes and in the same direction as the most residual interests and is settled with the most residual instrument

– A liability is an obligation that is not equity

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Basic Ownership ApproachConceptual Reasons for PV

• Equity includes the most residual instrument(s) even if redeemable for fair value or an approximation

• Possible ways to define liabilities:– A present claim that an entity has little or no discretion to

avoid and that has the potential to decrease the assets distributable to the most residual instruments

– A present claim that the entity has little or no discretion to avoid and that is not the most residual instrument

OR– A present obligation that will be settled with assets or equity

• Does not work for perpetual preferred shares• Does not work for mandatorily redeemable shares

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Basic Ownership ApproachApplication Reasons for PV

• Because settlement does not affect classification, there are fewer accounting arbitrage opportunities and no need to consider unstated cash settlement options

• Fewer accounting arbitrage opportunities mean less need to apply the linkage requirements and little or no need to apply the substance requirements

• Far fewer instruments are separated, which avoids most of the “obligation first” issues

• Easier to craft a simple conceptual definition

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Potential Challenges in Acceptance of Basic Ownership Approach

• Approach has a greater impact on the income statement

• Changes accounting for stock options• Changes accounting for convertible debt

Observation: Generally consistent with proposed accounting for puttable shares under IAS 32

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All Three Approaches

• Most subordinate class or classes of instruments

• Percentage of assets after all other claims that must be satisfied

• Share must not be limited or guaranteed

Basic Ownership Instrument (BOI)

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All Three Approaches

• May be puttable or mandatorily redeemable for fair value or a book-value-based approximation

• May be callable (at any price)

• BOIs of subsidiaries are BOIs in consolidation (unless modified)

Basic Ownership Instrument (BOI)

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All Three Approaches

• Initial measurement at transaction price

• Mandatorily redeemable/puttable equity presented separately from other equity

• Presentation in P&L not yet addressed

Measurement & Presentation

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Ownership-Settlement Approach

• BOIs and BO components are equity

• Other perpetual instruments are equity

• Certain indirect ownership instruments are equity

• All others are liabilities or assets

Classification

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Ownership-Settlement Approach

• Not perpetual

• Fair value or cash flows linked to a BOI; changes in same direction

• No contingent exercise based on:

– A price not the price of the underlying BOI

– A price index not related solely to the reporting entity’s operations

Indirect Ownership Instruments

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Ownership-Settlement Approach

• Written call options

• Purchased put options

• Debt convertible to BOIs

• Forward contracts to issue BOIs

• Stock appreciation rights (on BOIs)

• Warrants on BOIs

Indirect Ownership Instruments

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Ownership-Settlement Approach

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

Indirect Ownership Instruments Classified as Equity

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Ownership-Settlement Approach

• Physically settled written call options or warrants on BOIs

• Written call options settled net with BOIs

• Forward contracts to issue BOIs

Indirect Ownership Instruments Classified as Equity

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Ownership-Settlement Approach

• Written call options net settled in cash

• Net cash settled forward contracts

Indirect Ownership Instruments Not Classified as Equity

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Ownership-Settlement Approach

• Two or more alternative or separate outcomes; some equity and some not equity

– Settlements in different forms are separate outcomes

– Remaining outstanding is an outcome

• Only two components even if more outcomes

Separation

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Ownership-Settlement Approach

• Asset/liability components measured at the fair value of a comparable freestanding instrument that is 100% likely to be settled

• Remainder of the transaction price allocated to the equity component

Obligation First Approach

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Ownership-Settlement Approach

• Debt convertible to BOIs

• BOI puttable at a fixed price

Instruments Separated

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Ownership-Settlement Approach

• Mandatorily redeemable or puttable BOIs at redemption value; changes in equity

• Liabilities/assets with cash flows or fair values that vary with prices of BOIs at fair value; changes in P&L

• Same as current GAAP for others

Remeasurement

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Ownership-Settlement Approach

• Special provisions for accreted cost instruments and components not settled as assumed in the initial measurement

• Expiration or delayed settlement may change classification, separation, or accretion

Settlement, Expiration, Forgiveness, or Conversion

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Ownership-Settlement Approach

• Ignore settlement provisions with remote probability or minimal effect

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

Substance

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Ownership-Settlement Approach

• Multiple instruments linked (accounted for as if a single instrument) if part of the same arrangement

– Issued near the same time with same counterparty; interacting payoff structures

– Interdependent; e.g., contractual link

Linkage

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REO Approach

• BOIs and components (BOCs) are equity

• Other ownership instruments (preferred shares, etc) are liabilities

• Equity derivatives/hybrids separated into BOCs and debt using option pricing models

• Remeasurement/reseparation at each measurement date; changes in P&L

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Basic Ownership Approach

• BOIs and BOCs are equity

• All other financial instruments are assets or liabilities

Classification

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Basic Ownership Approach

• Convertible debt of all types

• Options and forwards of all types

• Puttable shares (unless BOIs)

• Preferred stock (and any other shares that are not BOIs)

Instruments Classified as Assets or Liabilities

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Basic Ownership Approach

• Only if a BOI remains outstanding after a required settlement

(Probably rare)

• Obligation first approach

Separation

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Basic Ownership Approach

• BOI with a “make whole” requirement

• BOI with a registration rights penalty

Instruments Separated

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Basic Ownership Approach

• Convertible debt

• Puttable or callable stock

Instruments Not Separated

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Basic Ownership Approach

• Mandatorily redeemable or puttable BOIs at redemption value; changes in equity

• Liabilities/assets with cash flows or fair values that vary with prices of BOIs at fair value; changes in P&L

• Other liabilities/assets same as current GAAP

Remeasurement

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Basic Ownership Approach

• Convertible debt

• Stock options

• Puttable stock (if not a basic ownership instrument)

Instruments at Fair Value through P&L