As we summarized here, the IASB has published for public comment a Discussion Paper on how companies issuing financial instruments should classify them in their financial statements.
Last time we looked at this, I mentioned we’d return to the area of presentation. The discussion paper is hard to explain in any kind of plain language (I’m not claiming for a second that I achieved that in my two previous posts on it), and this aspect is no different. Rather than try to summarize the whole thing, I’ll just touch on a couple of areas to illustrate the kind of impact it might have.
I mentioned before that for purposes of the paper, the IASB identified “two broad assessments of financial position and financial performance that depend on information about different sets of features of claims”. They are:
- (a) assessments of funding liquidity and cash flows, including whether an entity will have the economic resources required to meet its obligations as and when they fall due. These assessments are driven by information about requirements to transfer economic resources at a specified time other than at liquidation …
- (b) assessments of balance-sheet solvency and returns (measured on an accrual basis), including whether an entity has sufficient economic resources required to meet its obligations at a point in time, and whether the entity has produced a sufficient return on its economic resources to satisfy the return that its claims oblige it to achieve. These assessments are driven by information about the amount of the obligation…
The first of these is probably fairly self-evident, and well-covered within existing disclosure requirements; therefore the discussion paper doesn’t have a lot to add on it. Regarding the second, the paper proposes that “arranging claims by priority on liquidation would help users of financial statements assess in more detail how any potential shortfall or surplus in economic resources is allocated among claims.” I’m not sure how often that’s a prominent concern in the mind of a typical user, but anyway, it’s an easy notion to understand.
Regarding the presentation of financial performance, and putting it very simplistically, the paper seeks to separately identify income or expenses flowing from instruments which have something tricky about them, relative to the concepts in the paper. Consider for example a financial liability arising from an obligation on an issuer’s part to redeem its own shares at their fair value. Currently, there’s no prescribed format for identifying such items in income, and it can therefore be difficult to track their impact on the statements. The problem is exacerbated as the accounting impacts of such instruments can often be famously counter-intuitive – for instance “when an entity performs poorly, the carrying amount of the liabilities decreases and a gain would be recognized on those liabilities.” Various kinds of derivatives raise related concerns. The paper proposes including changes in fair value of such instruments as part of other comprehensive income rather than profit or loss, concluding among other things that this would enhance the relevance of the basic profit/loss measure. It acknowledges that arguments exist against this – for example, it would bring yet more complexity to OCI. The paper doesn’t envisage that these amounts would ever be recycled to profit or loss, while acknowledging that this too might not be a clear-cut view.
IFRS isn’t currently very prescriptive about presentation within equity, largely allowing room for judgment on how and when to create additional categories or on what to allocate between them. In part, this reflects a reluctance to trip over different legal requirements that may exist between jurisdictions. The discussion paper muses a bit on this aspect of things. For (say) a warrant classified as equity, an issuer likely doesn’t at present make any adjustment to the initial carrying amount until the instrument is exercised, even though the warrant’s fair value certainly changes over its life to reflect changes in the price and volatility of the stock, among other things. The IASB thinks now that reflecting this change within equity might assist users in assessing the distribution of returns among equity instruments. It identifies a few different ways it might be done though – for example the amount allocated to such a warrant might reflect its full end of period fair value, or some measure of average fair value during the period, or a kind of weighted end of period approach. Or maybe the point should just be dealt with by disclosure. As always, arguments can be extended for and against each of these.
Funnily enough, this last aspect of the paper might be one of the more impactful for smaller entities, if assessed by its potential for requiring additional work. Even the simplest companies often raise money by issuing warrants or suchlike, and the calculated fair value of these instruments (at least as measured using the Black-Scholes model) often seems peculiar relative to the fair values of other equity instruments (this often seems to speak to an imperfect choice of measurement model, or to irrational pricing negotiations by the issuer, or both). If implemented (not that this would be any time soon), the ideas in the discussion paper might certainly increase the practical problems flowing from this….
The opinions expressed are solely those of the author.