Equity and Liabilities – A Discussion of IAS 32 and a Critique of the Classification

Abstract

It is a traditional convention in accounting to distinguish between two classes of claims, liabilities and equity. The International Accounting Standards Board and the Financial Accounting Standards Board have been using a dichotomous classification approach, adhering to this convention. However, over the recent years, this approach has been put under stress. First, there is an ever-growing variety of hybrid financial instruments, some of which designed to exploit this classification approach (accounting arbitrage). Second, the adoption of IFRS in Europe and elsewhere has brought scenarios to light in which the classification approach does not result in decision-useful information. These issues arise when IFRS are applied by entities in legal forms other than a private or public limited company. This essay discusses IAS 32 in the light of the historic origins of the dichotomous classification approach, the recent standard-setting activities and a review of the empirical research. This essay suggests that a reconsideration of the traditional dichotomous classification might be a way forward.

JEL Classification:

• M40
• M41

Acknowledgements

The author is pleased to acknowledge the valuable input gained from various discussions with individual members of the IASB (Prof. Sir D. Tweedie, J. Leisenring, J. Smith) and IASB staff, members of the German Accounting Standards Board (Dr L. Knorr, Prof. A. Barckow), members of the related EFRAG/GASB working groups, Prof. H. Kampmann and two anonymous referees. However, the content of the paper is the responsibility of the author.

Notes

1 See IAS 32.BC52.

2 The FASB began its project in 1986; the first document was a comprehensive Discussion Memorandum, An Analysis of Issues Related to Distinguishing Between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both, which was published in 1990.

3 See Paton (1922, p. 38), who referred to these claims as ‘equities’.

4 Note that, in the Discussion Paper DP/2013/1 A Review of the Conceptual Framework for Financial Reporting, the IASB proposes to introduce re-measurement of some equity claims (see par. 5.18 ff.).

5 The term ‘company’ is used in this essay with the meaning of ‘public and private limited companies’ (e.g. the société anonyme and société à responsabilité limitée in France, the Aktiengesellschaft and Gesellschaft mit beschränkter Haftung in Germany, the società per azioni and the società a responsabilità limitata in Italy, the sociedad anónima and the sociedad de responsabilidad limitada in Spain, and public and private companies limited by share or guarantee in the UK). This meaning is consistent with the UK/Commonwealth legal tradition. In this legal tradition, the term ‘company’ does not include every type of association. However, in the Roman–French (continental European) legal tradition, the closest equivalents to the English term ‘company’ comprise all types of associations (société, Gesellschaft, società, sociedad), including partnerships (e.g. the société en nom collectif and the société en commandite simple in France, the Offene Handelsgesellschaft and the Kommanditgesellschaft in Germany, the società in nome collettivo and the società in accomandita semplice in Italy, the sociedad colectiva and the sociedad en comandita simple in Spain) and cooperative entities.

6 See e.g. Kimmel and Warfield (1993), and the FASB Discussion Memorandum (see note 2 above).

7 One difference is that, unlike IAS 32, the framework (par. F.4.38) and the current IAS 37 require recognition of a liability only if the outflow of resources is probable (i.e. more likely than not), whereas under IAS 32, that probability is irrelevant. Another difference is discussed in Section 4.2 of this essay.

8 The relevant SFAC 6 containing the definitions of the elements was published in 1985.

9 The frameworks were also intended to serve as a deductive basis for future standards. However, many authors argue that the boards have often departed from their conceptual frameworks when developing standards on specific issues (Loftus, 2003). When they do use the framework, they often do so only to rationalise their choice motivated by other factors (e.g. Young, 2003, 2006).

10 The term ‘correct’ is used here with the meaning of ‘not feeling wrong in the standard-setters’ view’. IASB and FASB discussed alternative approaches based on a selection of ‘acid-test’ financial instruments and evaluated the approaches based on whether it yields the ‘desired’ classification (see note 14 below).

11 See note 2 above.

12 See e.g. the comments made by the AAA's Financial Accounting Standards Committee (1993, 1999) and the comments on the FASB's 2000 Exposure Draft ‘Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both’ (American Accounting Association, 2001).

13 See IASB, discussion paper ‘Financial Instruments with Characteristics of Equity’, www.iasb.org. In addition to IAS 32 and three FASB approaches, one approach was developed in a project under EFRAG's proactive accounting activities in Europe initiative (see Barckow et al., 2008).

14 See agenda papers 15, and 15a-15c.

15 See agenda paper 4 for the July 2010 IASB meeting.

16 See agenda papers 2/2A for the September 2010 IASB meeting.

17 See IASB Update October 2010, p. 8, reasoning that ‘they do not have the capacity currently to devote the time necessary to deliberate the project issues.’

18 See DP/2013/1, par. 2.6 ff.

19 E.g., the shares in a German private limited company (Gesellschaft mit beschränkter Haftung) are often made puttable by way of including a related put right in the company's articles of association.

20 General partners in a partnership usually bear unlimited personal liability, while the personal liability of the members in a cooperative entity can either be unlimited or limited (‘capped’).

21 For cooperative entities in Europe, the amount is usually ‘capped’ (see e.g. European Commission (2004), par. 1.1., 3.2.6). The claim is a residual claim, but is asymmetrically linked to the cooperative's performance. The owner participates in losses if reserves are depleted – the claim is reduced to the extent necessary to honour all liabilities, but the claim cannot increase over a threshold (cap), usually the amount originally paid in. In some jurisdictions, the members are not entitled to a pro-rata share in the reserves even on liquidation (see European Commission (2004), par. 3.2.5).

22 IAS 32.BC50 ff. contain a high-level discussion of the issue.

23 IAS 32.16A and .16B.

24 IAS 32.16C and .16D.

25 See e.g. paras. .AG14G, .AG14H and .AG14I of IAS 32.

26 See e.g. the definition in IFRS 3: ‘For the purposes of this IFRS, “owners” is used broadly to include holders of equity interests of investor-owned entities […]’.

27 KPMG International Financial Reporting Group (2012), par. 7.3.40.63-67; Ernst & Young Financial Reporting Group (2013), pp. 3044 f.; PricewaterhouseCoopers LLP (2011), par. 7.18.1.

28 See IFRIC Update March 2010, pp. 2 f.

29 Again, the question of whether decisions on dividends or distributions of retained earnings are made by management (the entity) or the shareholders (either a body of the entity, or holders of financial instruments outside the entity, depending on the view adopted), depends merely on jurisdiction. In many European countries, dividends are decided upon by the shareholders, whereas in the USA, dividends are declared by the board of directors. Therefore, switching from the currently prevailing view to the currently dissenting view would have no consequences in the USA, but severe consequences in many European countries. In these European countries, no legal form would be able to present shareholders' claims as equity based on this principle. Noteworthy, authoritative US literature is consistent with the (currently dissenting) view in that actions of the shareholders are not deemed ‘under the control of the shareholders’ (see e.g. US ASC 815-40-25-19 and US ASC 480-10-S993A).

30 See the IASB Update, June 2006, p. 4.

31 See the minutes of the FASB meeting on 27 July 2007, www.fasb.org.

32 See DP/2013/1, par. 3.103 ff.

33 Interestingly, at first glance, even Paton in 1922 appeared to pre-suppose a classification approach. In distinguishing two classes of claims (which he labelled ‘equities’): ‘The left-hand side of the conventional balance sheet is conceded to cover a single homogenous class, commonly called “assets” or “resources”. The right-hand side, however, is held to include fundamentally distinct classifications, “proprietorship” and “liabilities”’ (Paton, 1922, p. 50). However, when describing the various kinds of claims, such as different varieties of bonds, preference shares, callable or redeemable shares, he concluded that: ‘it would be impossible to draw any hard and fast line of division which […] corresponded to the proprietor-creditor grouping’ (p. 73), finally asking, ‘[u]nder these circumstances, who is the corporate “proprietor” and who is the “creditor”?’ (p. 75).

34 See e.g. Botosan et al. (2005), who provide an overview of related research and the standard-setting activities up to the issuance of the FASB Preliminary Views document.

35 However, Givoly and Palom (1981) find no evidence that firms manage the terms and conditions of convertible debt issues to achieve a balance sheet classification that is preferable for the purposes of the calculation of earnings per share under ABP 15.

36 Consistent with this finding, a certain degree of vagueness is intrinsic to standard-setting and makes consistent rules difficult within a dynamic setting (see Penno, 2008).

37 See e.g. Hirst and Hopkins (1998) and Maines and McDaniel (2000). There is also evidence that companies lobby standard-setters to require expenses to be disclosed rather than recognising them, e.g. in relation to stock options (see e.g. Koh, 2011).

38 Theoretically, the cost of equity increases with higher leverage (see e.g. Rubinstein, 1973), a relationship consistently documented by empirical evidence (see e.g. Beaver et al., 1970; Botosan and Plumlee, 2005). However, the link between the cost of capital and leverage hinges on the default risk that is associated with debt. If residual claims are classified as debt (e.g. because they are puttable), the implications of the finance literature are not valid: Unlike ‘true’ debt, a residual claim does not expose the entity to the risk of an excess of debt over assets (as a reason for default). Therefore, classifying financial instruments which represent the residual claim as debt increases only perceived leverage. However, the empirical finance literature draws on capital market data, and is thus limited to listed companies. The finance literature has not given much attention to other legal forms with puttable residual interests.

39 E.g., the standard-setters in France, Germany and the UK traditionally have all been using a dichotomous classification based on a positive definition of a liability using the ‘obligation’ criterion (consistent with IFRS). However, they combine this approach with a ‘by source’ approach (see Section 2). In addition to claims that meet the ‘functional’ definition, the legal (share) capital is always classified as equity despite its substance (i.e. even if it does meet the definition of a liability). E.g., the former FRS 4 in the UK stated that:

Certain kinds of shares have features that make them economically similar to debt. Nonetheless, the requirement to classify capital instruments as debt if they contain an obligation to transfer economic benefits does not apply to shares. The legal status of shares is well established and understood and there are specific condition in the UK and Irish legislation that have to be satisfied if any payment is made in respect of them.

In France and Germany, this classification approach is not easily reconcilable to the authoritative standards and guidance, which explicitly contain only the definition of a liability based on the ‘obligation’ criterion. In practice, however, legal capital is classified as equity even if it does meet this definition. Therefore, one may conclude that the classification approach in France and Germany as applied in practice contains inductive elements in addition to the approach set out in the standards.

40 See DP/2013/1, section 5.

41 See DP/2013/1, par. 5.37.

42 Prudential regulators also define equity based on its loss-absorbing capabilities (see e.g. Basel Committee on Banking Supervision, 2011, par. 9). Also under the loss absorption approach ‘economic compulsion’-type instruments would not be classified as equity. Similarly, prudential supervisors do not include instruments that have an ‘incentive to redeem’ in Tier 1 capital (see Committee on Banking Supervision, 2011, par. 55).

43 See note 13 above and Barckow et al. (2008).