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 [email protected] Martin Schmidt, German Accounting Standards Committee, +49 (0) 30 206412-30, [email protected] 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.