Improving the conceptual framework…except for the bits about equity?

As we discussed here, the IASB has published for public consultation proposals to improve the Conceptual Framework for Financial Reporting, with comments to be received by October 26, 2015.

The proposals retain the current definition of equity, as “the residual interest in the assets of the entity after deducting all its liabilities,” adding a few words of further explanation:

  • “Equity claims are claims on the residual interest in the assets of the entity after deducting all its liabilities. In other words, they are claims against the entity that do not meet the definition of a liability. Such claims may be established by contract, legislation or similar means, and include (to the extent that they do not meet the definition of a liability): (a) shares of various types; and (b) rights to receive an equity claim.”

Many practitioners probably have problems from time to time in getting their heads around the concept of a “residual interest.” For example, IAS 32 discusses contracts that are financial liabilities of an entity even though the entity can settle them by delivering its own equity instruments, because it uses a variable number of its own equity instruments as a means to settle the contract: “accordingly,” says IAS 32.21, “the contract does not evidence a residual interest in the entity’s assets after deducting all its liabilities.” But the “accordingly” isn’t entirely supported, because the contract obviously evidences some kind of residual interest in those net assets. Although one can understand the distinction (something to do with the ability to precisely establish a contract’s potential impact on outstanding equity), it’s questionable whether it’s well-explained anywhere in the current standards.

Even stranger results sometimes flow from IAS 32.26: “When a derivative financial instrument gives one party a choice over how it is settled (e.g. the issuer or the holder can choose settlement net in cash or by exchanging shares for cash), it is a financial asset or a financial liability unless all of the settlement alternatives would result in it being an equity instrument.” This can mean, for instance, identifying as an embedded derivative a cash settlement option provided to a borrower on a convertible debt facility (to provide, say, a brake on the value of the conversion option, should the borrower’s share price go through the roof). Valuing the embedded derivative, in such a case, becomes an unusually mind-bending exercise. The theoretical object, as always, is to identify the derivative’s value on a stand-alone basis to a market participant, not its value to the borrower, but it’s hard even to articulate what such a market participant would actually have, let alone what he or she would be willing to pay for it, and it seems unlikely financial statement users get much out of such accounting treatments.

Anyway, the new proposals don’t address any of this, by design. The basis for conclusions document acknowledges the problem, noting that some respondents to the earlier discussion paper suggested changes to the concepts as they’re currently reflected in IAS 32, but says the IASB “will further explore how to distinguish between liabilities and equity in its (forthcoming) Financial Instruments with Characteristics of Equity research project. That research project…will consider various approaches to distinguishing between liabilities and equity, including approaches that could require changes to the definitions of a liability or equity in the Conceptual Framework.”

Two members of the IASB didn’t think this was good enough, noting: “a fundamental conceptual issue for the classification of financial instruments is not addressed. Without reconsidering this distinction, including the effect on an entity’s financial performance, Ms Lloyd and Mr Finnegan believe that the Conceptual Framework will fail to achieve the stated objective of ‘assist[ing] the IASB to develop the Standards when the issues at the Standards level relate to financial instruments that have characteristics of both liabilities and equity.” They don’t think it’s good enough to leave it for the later research project, because, among other things: “the research project is primarily a Standards-level project (and) a Standards-level project should ideally be based on applying or making considered departures from the Conceptual Framework, instead of being used to develop concepts that may subsequently be considered as changes to the Conceptual Framework.” Which seems true enough, if perhaps of a rather “”inside baseball” nature.

As I wrote before, many practitioners will probably see the conceptual framework project as something they can leave to the insiders and the geeks, and when you have some of the IASB’s own members telling you it’s skipped over some of the big issues, it doesn’t help to remedy that impression. On the other hand, perplexing as the current requirements may be, we’re mostly used to them by now, and some people may think the truest maxim in financial reporting is to be careful what you wish for…

The opinions expressed are solely those of the author

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