Cash-strapped companies that issue complex financial instruments to raise funds will be able to more easily evaluate how to report those instruments under rules the FASB is developing, according to February 3, 2021, board discussions.
The board provided more direction for its staff to research toward developing simpler rules to improve and align the two existing indexation models used to evaluate financial instruments with characteristics of equity. An indexation principle will be developed to reduce inconsistencies across GAAP.
The work, still in its early stages of phase two of the board’s efforts, tackles an area in U.S. GAAP companies say causes frequent financial statement restatements: distinguishing liabilities from equity.
“We have a bit of a Frankenstein’s monster approach here on the accounting model today,” FASB Chair Richard Jones said. “And trying to bring some consistency there – I think it not only increases the likelihood that people actually get the right answer, I certainly recognize that getting the right answer is probably the most important thing we can provide a user.”
For financial statement users, complexity is one of the worst things to have in financial reporting, Jones said. “And the ability to make it very clear how the model works and then people getting the right model to begin with I think is very helpful,” he said.
The project will utilize the indexation guidance in Topic 480, Distinguishing Liabilities from Equity, and Subtopic 815-40, Derivatives and Hedging—Contracts in Entity’s Own Equity, with a goal to reduce inconsistencies that currently exist between different sections of the guidance on evaluating financial instruments with characteristics of liabilities and equity.
The board did not vote on specific rules as the meeting was focused on giving staff members direction on angles to research.
Board members, for example, directed staff to research the scope of the indexation principle being applied to: freestanding financial instruments that have all the characteristics of a derivative instrument, freestanding instruments that potentially are settled in an entity’s own stock, regardless of whether the instrument has all the characteristics of a derivative instruments, and embedded features that have the characteristics of a derivative.
“I think the broad scope helps us then come up with an aligned model,” FASB Vice Chair James Kroeker said. Current rules “confuse users, prepares, and an awful lot of auditors as well as to why some instruments actually go through two tests and you can explain the mechanics of that but the logic of taking a freestanding instrument and say test it under one model and say ‘just kiddin’ there’s a more restrictive model you have to test it under again’ I think results in an awful lot of potential for foot faults and unintended errors, so I think having a single principle for the broad scope is the right answer,” he said.
The board also steered its staff to research:
- including guidance that is in Subtopic 815-40 which requires that an entity determine whether a contract is indexed to an entity’s own stock, using a two-step process: evaluate the feature for any contingent exercise provisions and evaluate the feature’s settlement provisions.
- developing indexation guidance based on a combination of both qualitative and quantitative guidance.
- addressing whether an instrument (or feature) is not indexed to an entity’s own stock.
At a future meeting, staff members will bring various alternatives back to the board for formalized vote on the topic, the discussions indicated. The next batch of discussions will take place during the summer.
This article originally appeared in the February 4, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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