Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (Issued 5/03)
This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. Some of the provisions of this Statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements. The remaining provisions of this Statement are consistent with the Board’s proposal to revise that definition to encompass certain obligations that a reporting entity can or must settle by issuing its own equity shares, depending on the nature of the relationship established between the holder and the issuer. While the Board still plans to revise that definition through an amendment to Concepts Statement 6, the Board decided to defer issuing that amendment until it has concluded its deliberations on the next phase of this project. That next phase will deal with certain compound financial instruments including puttable shares, convertible bonds, and dual-indexed financial instruments.
This Statement concludes the first phase of the Board’s redeliberations of the Exposure Draft, Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both.
Scope and Requirements of This Statement
This Statement requires an issuer to classify the following instruments as liabilities (or assets in some circumstances):
- A financial instrument issued in the form of shares that is mandatorily redeemable—that embodies an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur
- A financial instrument, other than an outstanding share, that, at inception, embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation, and that requires or may require the issuer to settle the obligation by transferring assets (for example, a forward purchase contract or written put option on the issuer’s equity shares that is to be physically settled or net cash settled)
- A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares, if, at inception, the monetary value of the obligation is based solely or predominantly on any of the following:
- A fixed monetary amount known at inception, for example, a payable settleable with a variable number of the issuer’s equity shares
- Variations in something other than the fair value of the issuer’s equity shares, for example, a financial instrument indexed to the S&P 500 and settleable with a variable number of the issuer’s equity shares
- Variations inversely related to changes in the fair value of the issuer’s equity shares, for example, a written put option that could be net share settled.
The requirements of this Statement apply to issuers’ classification and measurement of freestanding financial instruments, including those that comprise more than one option or forward contract.
This Statement does not apply to features that are embedded in a financial instrument that is not a derivative in its entirety. For example, it does not change the accounting treatment of conversion features, conditional redemption features, or other features embedded in financial instruments that are not derivatives in their entirety. It also does not affect the classification or measurement of convertible bonds, puttable stock, or other outstanding shares that are conditionally redeemable. This Statement also does not address certain financial instruments indexed partly to the issuer’s equity shares and partly, but not predominantly, to something else. Financial instruments with characteristics of both liabilities and equity not addressed in this Statement will be addressed in the next phase of the project. Guidance currently in effect for those instruments continues to apply. In applying the classification provisions of this Statement, nonsubstantive or minimal features are to be disregarded.
Forward contracts to repurchase an issuer’s equity shares that require physical settlement in exchange for cash are initially measured at the fair value of the shares at inception, adjusted for any consideration or unstated rights or privileges, which is the same as the amount that would be paid under the conditions specified in the contract if settlement occurred immediately. Those contracts and mandatorily redeemable financial instruments are subsequently measured at the present value of the amount to be paid at settlement (discounted at the rate implicit at inception), if both the amount of cash and the settlement date are fixed, or, otherwise, at the amount that would be paid under the conditions specified in the contract if settlement occurred at the reporting date. Other financial instruments within the scope of this Statement are initially and subsequently measured at fair value, unless required by this Statement or other generally accepted accounting principles to be measured differently. Disclosures are required about the terms of the instruments and settlement alternatives.
Reasons for Issuing This Statement
This Statement was developed in response to concerns expressed by preparers, auditors, regulators, investors, and other users of financial statements about issuers’ classification in the statement of financial position of certain financial instruments that have characteristics of both liabilities and equity but that have been presented either entirely as equity or between the liabilities section and the equity section of the statement of financial position. This Statement also addresses questions about the classification of certain financial instruments that embody obligations to issue equity shares. Previously, under Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” an issuer of a contract to repurchase its equity shares generally accounted for that contract as equity if the issuer must or could settle it by delivering its equity shares (net share settled). Additionally, certain obligations settleable by delivery of the issuer’s equity shares but not indexed to the issuer’s shares may have been classified as equity. Under this Statement, those obligations are accounted for as liabilities.
How the Changes in This Statement Improve Financial Reporting and How the Conclusions in This Statement Relate to the Conceptual Framework
FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises, states that financial reporting should provide information that is useful in making business and economic decisions. The changes in this Statement will result in a more complete depiction of an entity’s liabilities and equity and will, thereby, assist investors and creditors in assessing the amount, timing, and likelihood of potential future cash outflows and equity share issuances.
FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, identifies the characteristics of financial information that make it useful: relevance and reliability and their components. The changes in this Statement will enhance the relevance of accounting information by providing more information about an entity’s obligations to transfer assets or issue shares, thus, improving its predictive value to users. Reliability of accounting information will be improved by providing a portrayal of an entity’s capital structure that is unbiased, verifiable, and more representationally faithful than information reported prior to issuance of this Statement. Because restatement on transition is prohibited, the initial and ongoing costs of those changes have been minimized. Overall, in the Board’s opinion, the benefits of this Statement in terms of improved decision usefulness, relevance, and reliability justify the costs.
Concepts Statement 6 defines liabilities and equity. This Statement requires that certain obligations that require a transfer of assets and that meet the definition of liabilities in Concepts Statement 6 and other recognition criteria in FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, be reported as liabilities. This Statement also requires that certain obligations that could be settled by issuance of an entity’s equity but lack other characteristics of equity be reported as liabilities even though the obligation does not meet the definition of liabilities in Concepts Statement 6. The Board expects to amend Concepts Statement 6 to eliminate that inconsistency in the next phase of this project.
The Effective Date of This Statement
This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. Restatement is not permitted.
For nonpublic entities, mandatorily redeemable financial instruments are subject to the provisions of this Statement for the first fiscal period beginning after December 15, 2003.