EFRAG Working Group on „Equity & Liabilities“
Pro-active Accounting Activities in Europe
Staff contacts:
Liesel Knorr, German Accounting Standards Committee, +49 (0) 30 206412-11 knorr@drsc.de
Martin Schmidt, German Accounting Standards Committee, +49 (0) 30 206412-30, schmidt@drsc.de
Project Proposal / Work Plan
(1)
In the meeting (September) with the National Standard Setters (NSS) EFRAG discussed
European developments – Pro-active Accounting Activities in Europe and potential agenda
items for the pro-active accounting work that Europe will be carrying out to improve Europe's
contribution to the global debate on international standards. It was agreed that one of the
projects would be a working group on “equity & liabilities” and that this project would be led
by staff of the German Accounting Standards Committee.
(2)
This paper is a first outline of possible questions and topics that could be addressed in this
project. It is not meant to be a draft work plan, but a brief summary of possible issues. The
paper is organized as follows: Paras. (3) – (8) give background on the IASB’s project, (9) –
(11) lay out some background on the problems European companies could be faced with,
par. (12) suggest some possible ways to approach the topic.
(3)
(4)
Current Problems with the distinction between equity & liabilities of IAS 32 – the
IASB’s view and the short-term project
In contrast to approaches in other standards, IAS 32’s distinction between equity & liabilities
is based on one criterion: A contractual obligation of the entity is always classified as a
liability. This refers not only to financial instruments with a fixed maturity, but also to
instruments which grant the holder a right to “put it”, that is, to give it back to the entity. The
entity usually has the obligation to deliver cash or other assets to the holder. This put option
may also affect the classification of instruments commonly regarded as “equity” like
membership shares.
The IASB has identified a number of problems arising as a result of this approach and
concluded that IAS 32 leads to ‘anomalies’:
(a)
(b)
a requirement to recognise, on an ongoing basis, the liability at the amount that
can be demanded, that is, the fair value. This results in the entire market
capitalisation of the entity being recognised as a liability;
the recognition of changes in the fair value of the liability in profit or loss. When
the entity performs well and the fair value of the liabilities increases, a loss is
recognised. When the entity performs poorly and the fair value of the liability
decreases, a gain is recognised;
EFRAG Working Group on „Equity & Liabilities“
Pro-active Accounting Activities in Europe
(c)
(d)
(e)
the entity is likely to have negative net assets, because of unrecognised intangible
assets and goodwill, and because the measurement of recognised assets and
liabilities is not at fair value;
circumstances in which an entity’s balance sheet appears to be wholly, or mostly,
debt funded;
distributions of profits to shareholders are recognised as expenses. So net
income is a function of the distribution policy, not performance.
(5)
Due to the nature of these anomalies, the IASB thinks that a short term solution is needed.
The IASB currently is discussing a proposal to amend IAS 32 so that member shares
puttable at fair value are to be classified as equity. In the September Meeting the IASB also
discussed two additional proposals also dealing with the equity & liabilities distinction (crosscurrency convertible bonds and the recognition of a separate put option in connection with
the puttable member shares). These three proposals all indicate that the current definitions of
equity and liabilities in IAS 32 based solely on the ‘obligation’-criterion probably warrant a
more conceptual approach, i.e. the IASB should perhaps reconsider the whole distinction.
(6)
Currently, the IASB’s short-term ‘puttables’-project is managed by staff members of the New
Zealand standard-setter. Therefore, it may be concluded that the IASB’s project’s primary
aim is to fix the problem from a New Zealand perspective.
(7)
(8)
The IASB’s view and the long-term project
In addition to these proposals, which the IASB itself refers to as a kind of short-term-problemfixing, the IASB is involved in a joint project with the FASB. FASB is taking the lead in a
‘modified joint approach’. However, this project is a long-term one and a first discussion
paper is not due before 2006.
In July 2005, the FASB published a ‘Milestone One Draft’, dealing with single component
instruments only.1 This draft standard was already discussed at EFRAG TEG’s meeting in
early September.2 This draft proposes two different kinds of instruments to be classified as
equity: perpetual instruments, i.e. instruments without an obligation or a fixed maturity and
direct ownership instruments.
1
2
Please see the FASB project site for details, http://www.fasb.org/project/liabeq.shtml.
The EFRAG Update says about this discussion: „EFRAG TEG members welcomed the project,
but expressed some concerns about aspects of the Milestone Draft, including the extent to
which it appeared to rely on rule rather than principles. It was seen as particularly important that
FASB’s thinking is allowed to develop to address the settlement obligation underlying interest
and dividends before judging its merits. It was thought a pity that the Draft did not contain an
explanation of the reasoning behind the tentative conclusions reached, which made it difficult to
judge what FASB considered the objective of the classification to be.”
EFRAG Working Group on „Equity & Liabilities“
Pro-active Accounting Activities in Europe
(9)
Current Problems with the distinction between equity & liabilities of IAS 32 – European
dimension
Apart from the problems identified by the IASB, the classification of member shares seems to
be a major problem in Europe in general, which is the reason for EFRAG to initiate an own
European project as well. To evaluate which countries are affected by what particular kind of
problems, GASC mailed all European standard setters in early September. Until now, GASC
received only a few replies. Therefore, we describe the problem from a German perspective.
Of course, we expect this project to be a European project with a clear European
perspective. We will define the scope accordingly as we receive information on these issues
from other European standard setters. Currently, we can only suspect that Germany is not
the only country facing these problems.
(10) The problems in Germany are the result of certain aspects of the German legal framework
and the various legal forms in which businesses might be established. Apart from the public
limited liability companies German law grants the member (that is, the shareholder or
partner) the right to cancel his membership. This applies to private partnerships, private
limited companies, private limited partnerships and cooperative societies (mutual entities). All
contracts without a fixed maturity may be cancelled under certain conditions, and this right
may not be waived even on a contractual basis, since German law does not permit this kind
of waiver. As a result, classification as liabilities of all member shares or partnership interests
is unavoidable.
(11) The results of the classification for the presentation within the financial statements are
already outlined in the IASB analysis in par. 3 of this paper. In addition, we believe that a
measurement problem has to be considered: Since all these entities’ shares are not traded,
the whole company would have to be valued in order to measure the liability on each
reporting date. However, to conclude that these problems are not urgent would be forgone.
Although private partnerships, private limited partnerships and private limited companies do
not have to apply IFRS in their separate financial statements, many of them are subsidiaries
of entities reporting under IFRS. Thus, all problems lined out above will emerge when
consolidating the subsidiary.
In addition, about a third of all German commercial banks are operated in the legal form of a
cooperative society, some of them having issued a kind of bond (thus, IFRS application will
be mandatory from 2007 on).
(12) Possible approaches and scopes of this project
A)
The objective of EFRAG’s project should be that the long-term project of the IASB will
produce definitions of equity and liabilities that will lead to a classification that is
- sound from a conceptual point of view and
- applicable to different kinds of instruments in different European countries
both of a non-derivative and derivative nature.
EFRAG Working Group on „Equity & Liabilities“
Pro-active Accounting Activities in Europe
B)
C)
D)
GASC believes that both a short-term fix and a more broad-based reconsideration of
the whole issue are desirable.
GASC suggests, that as a first step EFRAG should form an opinion on both the current
IASB (shares puttable at fair value) and the FASB (Milestone One Draft) proposals.
Based on these opinions EFRAG may choose to officially comment on both proposals.
The output at this stage is likely to be comment letters or a paper in the form of a
critique or a discussion paper (this will depend on the working groups’ and EFRAG’s
opinion). This approach alone will probably not assure that the long-term solution
sufficiently considers the European view. The FASB has been working on this subject
for quite a long time. Consequently, it might be difficult to propose solutions which are
fundamentally different from the conclusions reached by the FASB. In addition, with the
IASB’s project being led by New Zealand, both projects lack European participation.
Based on the reaction of the IASB and the FASB the working group should consider its
second step. EFRAG may continue to (just) comment on further output relating to the
two projects (both the short-term and the long-term projects as they go along) or
EFRAG may choose to develop an own proposal on the matter. The output is then
likely to be a kind of position paper or even a draft standard. This will consume
considerably more resources and it is unsure whether such a proposal is likely to
influence either the IASB or FASB project.
GASC suggests setting up a PAN-European working group. As mentioned in par. (9),
GASC already mailed all European standard setters and asked for participation. So far,
the other standard setters did not nominate any potential members for the working
group. GASC stands ready to organize the first meeting of the working group as soon
as EFRAG finishes its process of nominations. GASC may recommend some members
from Germany, however, to ensure a clear European perspective, EFRAG should seek
other nominations as quickly as possible.