Introduction
In 2021, the FASB and IFRS, the institutions that formulate the standards and framework for financial reporting in the United States and globally, released several significant updates. Notably, the FASB is the central US regulatory body responsible for setting financial reporting standards for all types of businesses in the country, while IFRS develops standards for companies worldwide. This paper aims to highlight two of the most important financial reporting standards updates that FASB and IFRS released in 2021, Distinguishing Liabilities from Equity and COVID-19-Related Rent Concessions.
Notably, the FASB focused in 2021 on several topics for which reporting standards have changed. Topics include Distinguishing Liabilities from Equity, Insurance Long-Duration Contracts, Reference Rate Reform, Non-for-Profit financial Reporting, Tax Cuts, and Jobs Act, and other standards. Distinguishing Liabilities from Equity is one of the most critical issues on this list. The changes, released in April 2021, affected commercial entities that are SEC applicants. Early adoption of the standard was permitted from December 15, 2020, and the standard officially comes into force on December 15, 2021, and from December 15, 2023, for other companies. Companies should study the amendments within the allotted time and begin submitting financial statements following the revised standards from the beginning of the financial year. The update includes amendments to the updated accounting standards Separation of Liabilities and Equity (Topic 480).
The roadmap, which provides an overview and interpretation of the ASC 480-10 guidance, presents guidance on applying the update in practice. The most important aspect of the updates requires “(1) issuers to classify certain types of shares and certain share-settled contracts as liabilities or, in some circumstances, assets” (Carpenter & Barta, 2021, par.2). The guidance also requires that “(2) persons registered with the SEC must classify certain types of redeemable equity instruments as variable equity instruments” (Carpenter & Barta, 2021, par.2). The following will briefly discuss the main potential problems and options for making decisions on reporting in connection with other accounting topics.
Understanding the US GAAP ASC 480 Rules
First, you need to define what the new requirements for distinguishing between liabilities from equity mean. It is about defining and classifying the financial instruments used as a liability or not. Carpenter and Bartha (2021) note that the classification options are spelled out in US GAAP imply the ability to designate the liabilities issued by the enterprise as liabilities, constant capital, or variable capital. Definition and classification can be made following certain accounting characteristics. The following factors need to be considered: “Which unit of account is appropriate? Does the instrument contain any obligation of the company to pay cash, other assets, or a variable number of equity shares? If a commitment exists, is it conditional or unconditional?” (Carpenter & Barta, 2021, par. 4). Answering these questions will help financiers and accountants to distinguish between different types of capitalization clearly.
Carpenter and Bartha (2021) explain that, as a rule, businesses are capitalized either with equity capital or using borrowed funds. The stage of a company’s life cycle, debt and regulatory capital requirements, the cost of capital, and the implications for financial reporting can influence which components are included in a company’s capital structure. The company usually independently decides on the type of liabilities that are issued to raise capital. These factors also affect the combination of debt and equity liabilities that make up the capital structure. More mature and larger companies with well-established ways of doing business and stable capital inflows tend to use a mix of debt and equity liabilities and simpler equity capitalization. At the same time, companies at an early stage can receive financing using options with complex and unusual characteristics and preferred shares.
US GAAP has determined that liabilities as a part of an entity’s capital structure fall into three classification categories on the entity’s balance sheet. These are the liabilities, constant capital, and variable capital (Carpenter & Barta, 2021). The balance sheet of the financial statements includes such a classification since it affects how the profitability of the selected instrument is reflected in the company’s profit and loss. In particular, the profitability of instruments classified as liabilities is reflected in net income. Then, the performance of instruments designated as equity instruments is recognized in equity and does not affect net income. Finally, returns on variable capital, such as dividends and equity pricing adjustments, can cause a decrease in reported earnings per share.
Therefore, companies are more inclined to use a constant capital instrument, or in other words, equity capital, since it does not affect net income. At the same time, organizations are likely to be reluctant to classify capital liabilities as liabilities or variable capital for mentioned reasons and the ones set out below. In particular, the prevalence of capital liabilities classified as variable capital or liabilities affects the credit rating and the price of the company’s shares. Then, the reason to avoid these two categories could be regulatory capital requirements or debt covenant requirements, for example, concerning the leverage ratio.
Therefore, companies need to understand that ASC 480 updates define the classification of equity instruments or equity liabilities. In particular, the updates determine whether the instrument should be classified as a liability or not. This accounting guide was developed several years ago, and during this time, the FASB did not make significant changes beyond this update. The guidance applies to all SEC registrants and those who choose to apply the SEC guidance for financial reporting of covered equity liabilities.
As noted above, answering three key questions will help companies assess whether an equity instrument should be classified as a liability under ASC 480 guidelines. The first question is which unit of account is appropriate for the selected stand-alone financial instrument or equity instrument. Carpenter and Bartha (2021) note that sometimes liabilities are issued separately, and then there is only one unit of account for them. There are also financial transactions using two or more components, for each of which there are separate accounting units. For example, preferred shares can be issued with detachable warrants for the convenience of financiers and accountants and providing more room for maneuver in reporting. Further, if a company conducts a financial transaction with separately executable and legally separate items, they are treated as separate stand-alone financial instruments. In such a case, ASC 480 applies individually to each article.
Next, the answer to the question, “Does the instrument contain any obligation that might require the issuer to transfer cash, other assets, or a variable number of equity instruments?” also has a detailed interpretation (Carpenter & Barta, 2021, par. 4). Under ASC 480, an equity instrument is defined and classified as a liability if the instrument contains a liability that requires the issuer to transfer cash, equity instruments, such as a commitment to repurchase the instrument, or other assets.
As such, the ASC 480 management views the liability in its broadest sense, which includes all possible contingent and unconditional obligations or responsibilities to transfer assets or issue equity shares (Carpenter & Barta, 2021, par. 8). Therefore, the answer to this question clarifies what counts as a liability and what is not among equity instruments. Another explanation that helps determine whether an equity instrument is a liability relates to the question, “If a liability exists, is it contingent or unconditional?” (Carpenter & Barta, 2021, par. 4). The ASC 480 guidance specifies that a capital instrument such as a legal share is a liability only if it contains an unconditional commitment by the issuer to repurchase it. The reimbursement can be carried out through cash, several equity instruments, or other assets. According to ASC 480 guidelines, certain other liabilities can be designated as liabilities, regardless of whether the liability to repurchase is contingent or unconditional. These are liabilities such as the commitment to repurchase the issuer’s equity instruments.
Another important factor in the classification under the ASC 480 guidelines is the definition of the capital instrument as constant or variable capital. ASC 480 applies to SEC registrants who must apply the guidance to redeemable equity liabilities. Companies awaiting an IPO may also choose to apply the ASC 480 guidelines. According to the guidelines, variable capital includes liabilities (equity instruments) that contain liabilities outside the issuer’s control, which may require the issuer to repurchase the liabilities.
Therefore, equity liabilities determined as variable capital are subject to valuation and management at earnings per share under ASC 480-10-S99-3A (Carpenter & Barta, 2021). Often, the application of ASC 480-10-S99-3A is complex; the guide creates problems for the company’s financial statements, as it negatively affects the reported earnings per share of the company. In particular, adjustments to the repayment amount are usually treated as dividends; in this case, the numerator decreases when calculating earnings per share, which is a negative trend that companies will avoid. Therefore, some companies criticize this part of the guidance and propose further in-depth discussion of the classification and presentation according to ASC 480 and ASC 480-10-S99-3A.
IASB Updates on COVID-19-Related Rent Concessions
In 2021, IFRS addressed several changes to financial reporting standards, including rental benefits related to COVID-19, dynamic risk management, and other topics. Additional IASB Update The issue of COVID-19 related rental concessions was discussed in February and March 2021 during public meetings. The updates are subject to implementation starting from June 30, 2021, by all companies that have chosen to harmonize their financial statements with international standards developed by IFRS. Earlier, IFRS has already made decisions on granting a lease concession due to a lockdown caused by the COVID-19 pandemic. In particular, such concessions as deferred payments and deferred lease payments with subsequent repayment were proposed.
In February and March, the IFRS Board made some changes to the requirements for rental concessions during public meetings. In particular, the amendment to IFRS 16 Leases granted lessees an exemption in the form of an optional exemption from the measurement and determination of the COVID-19 related lease concession. This amendment implies that from June 30, 2021, enterprises will account for the concession as a variable rent, while the tax exemption has been extended for another year until June 30, 2022. In other words, for one more year, the rental objects will pay reduced rent payments taking into account the concession as a lease variable.
The official title of the amendment is Covid-19 Lease Benefits after June 30, 2021 (Amendment to IFRS 16). This amendment is an extension of a similar amendment to IFRS 16 Leases adopted in 2020; applications are pending until June 30, 2022. An additional practical tool was introduced in 2020 to assess renters when determining specific COVID-19 rental benefits and whether those benefits can be considered lease modifications. The goal of the new amendment, which extends the previous one by one more year, is to ease concessions on COVID-19 and to maintain the reduction in rental payments due to the reduction of global business activity as a result of the lockdown. The essence of the amendment is to consider lease benefits not as lease modifications but precisely as benefits. The amendment applies to annual financial statements for periods beginning April 1, 2021, and later.
The amendment received a lot of positive feedback, as the extension of the benefits for another year is consistent with the challenges and obstacles posed by the pandemic around the world. Business representatives consider it prudent to provide renters with lease concessions so that they can reduce lease payments for another year until June 30, 2022 (“IFRS/IASB extends rent concessions,” 2021). This solution helps many small and medium entrepreneurs to keep their business, and for large companies, this solution ensures them against excessive losses.
The decision came after IFRS received feedback from companies that lessees continue to experience operational difficulties applying the amendment to IFRS 16. Where concessions or concessions are defined as lease modifications, this requires lessees to reassess the obligation under lease, review of remuneration, and discount rate. This requirement is difficult to apply to renters with hundreds or thousands of leases and may simultaneously experience other disruptions caused by the pandemic (“IASB issues amendments to IFRS 16,” 2021). The need to determine whether a concession or concession met the definition of a lease modification was another unnecessary difficulty in preparing the financial statements.
The amendments that were extended by one year included some particular requirements. These were the demands to “provide renters with an exemption from the requirement to determine if the COVID-19-compliant lease concession is a modification of the lease; and require renters applying the exemption to treat COVID-19-related rental benefits as if they were not rental modifications” (“IASB issues amendments to IFRS 16,” 2021). For the amendment to be applied in practice, the lease concession must meet criteria such as the direct impact of COVID-19, the revised review, the impact on lease payments due before June 30, 2021, and no significant change in other conditions.
The amendments did not affect the lessor’s accounting, which did not undergo significant changes. In particular, most lessee concessions relate to leases reported as operating leases, which require less complex reporting than lessee accounting. The change in lease payments under IFSR 16 does not include accounting requirements for lessors and is not considered a modification. The FASB has adopted these changes as an amendment and extended benefits and concessions to US renters and owners.
The criteria by which the concessions are determined should be considered in more detail. The first criterion determines that the rent concession should be a direct consequence of the COVID-19 pandemic. The amendment does not provide additional guidance on applying this criterion, so companies must decide on whether the criterion is met at their discretion. Notably, some concessions cannot be granted for reasons that are not a direct consequence of the pandemic but related to it. For example, the application of rental incentives to underlying assets used in oil production since oil prices remain below the average level is not consistent with the amendment. The direct consequence of the pandemic is most often considered the closure of offices and retail outlets due to orders of distancing and social isolation or as part of a state lockdown.
The second criterion is called revision and means that the exemption must be a revised rental refund that will be less or remain the same as the refund before the revision, but not greater. It is noteworthy that benefits may include a reduction in the size of payments and a deferral of payments, in which case a slight increase in the nominal amount of the payment is possible, for example, within 5% of the original amount. This decision can be made to compensate the landlord for the time value of the money. Such a decision can be vital in states (jurisdictions) with high inflation rates when the time value of money can be of great importance and in the case of longer payment delays. Therefore, under the amendment, in the event of an increase in nominal payments, companies must indicate that this increase is related to the recovery of the time value of money. At the same time, the introduction of fines will not meet this second criterion.
The third criterion implies that the benefits are applicable to rent payments paid before June 30, 2021; the reduction in payments must initially relate to payments payable no later than June 30, 2021. In other words, the amendment does not make it possible to concession rent payments payable after the designated date; payments also cannot be split into parts that meet and do not meet the criterion. The fourth criterion requires that the lease concession or benefits do not include material changes to any other lease terms other than those that meet the criteria listed above.
In other words, it is impossible to apply two types of benefits simultaneously; only the benefits associated with a pandemic can be applied to concede rent payments under the amendment. Other lease modifications will not be considered under this amendment. They will not be subject to simplified reporting related to the recognition of the modification as an incentive. Examples of other modifications would be lease concessions such as lease extensions, additional options for lessees and lessors, and other concessions. In such a case, the lessee will apply the general requirements applicable to determine the lease.
Conclusion
Thus, the updates to the standards or amendments to the financial reporting standards proposed by the FASB and IFRS in 2021 – Distinguishing Liabilities from Equity and COVID-19-Related Rent Concessions were considered. The business community approved of both updates; the first amendment simplifies the maintenance of financial statements for enterprises that use various capital instruments, including liabilities, constant capital, or variable capital, avoiding consequences such as a decrease in the determining profitability of shares. At the same time, the second amendment supports businesses in the realities associated with the pandemic, when many enterprises were forced to stop working due to social distancing and lockdown and could not pay rent.
References
Carpenter, A. & Barta, S. (2021). Accounting brief: Distinguishing liabilities from equity. The Wall Street Journal.
IASB issues amendments to IFRS 16: COVID-19 related rent concessions. (2021).
IFRS, IASB extends rent concessions related to COVID-19. (2021).