This case encourages students to consider the larger question of the factors that differentiate whether financial instruments qualify for recognition as liabilities or part of equity. It also requires them to carefully consider the profession’s definitions of those elements. You may wish to suggest to your students that they consult FASB ASC 480: “Distinguishing Liabilities from Equity” (previously SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity), and the FASB’s Preliminary Views on phase two of that project, which set forth the most common arguments on the issues in this case. In IAS No. 32,
“Financial Instruments: Presentation,” the IFRS generally requires more preferred shares to be classified as debt than does U.S. GAAP. The standard provides additional perspective on the issue. Or, you may prefer that they think for themselves and approach the issue from scratch.
There is no right or wrong answer. Both views can and often are convincingly defended. The process of developing and synthesizing the arguments likely will be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process.
Domination by one or two individuals should be discouraged.
Arguments brought out in IAS 32 cited above include the following:
Classification as Liability or Equity
The fundamental principle of IAS 32 is that a financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form. The enterprise must make the decision at the time the instrument is initially recognised. The classification is not subsequently changed based on changed circumstances. [IAS 32.15]
contractual obligation to deliver cash or another financial asset to another entity and (b) if the instrument will or may be settled in the issuer's own equity instruments, it is either:
a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or
a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.
[IAS 32.16]
Illustration – preference shares
If an enterprise issues preference (preferred) shares that pay a fixed rate of dividend and that have a mandatory redemption feature at a future date, the substance is that they are a contractual obligation to deliver cash and, therefore, should be recognised as a liability. In contrast, normal preference shares do not have a fixed maturity, and the issuer does not have a contractual obligation to make any payment. Therefore, they are equity. [IAS 32.18]
Arguments brought out in FASB documents cited above include the following:
Basic Ownership Approach—The Board’s Preliminary View
The underlying principle of the basic ownership approach is that claims against the entity’s assets are liabilities (or assets) if they reduce (or enhance) the net assets available to the owners of the entity. Under the approach, an instrument would be classified as equity if it is a basic ownership instrument. A basic ownership instrument (1) is the most subordinated interest in an entity and (2) entitles the holder to a share of the entity’s net assets after all higher priority claims have been satisfied. All other instruments, for example, all forward contracts, options, and convertible debt, would
Case 18–3 (concluded)
Ownership-Settlement Approach
Under the ownership-settlement approach, an entity would classify instruments based on the nature of their return and their settlement requirements (or lack thereof). The following three types of instruments would be classified as equity:
1. Basic ownership instruments
2. Other perpetual instruments (for example, preferred shares)
3. Indirect ownership instruments settled by issuing related basic ownership instruments.
An indirect ownership instrument has the following characteristics:
1. It is not perpetual
2. Its terms link its value to the price of a basic ownership instrument and cause its fair value to change in the same direction as the fair value of that basic
ownership instrument.
3. It does not include a contingent exercise provision based on either of the following factors:
(a) A market price for anything other than the reporting entity’s basic ownership instruments; or
(b) A price index other than an index calculated or measured solely by
reference to the reporting entity’s own operations (for example, revenue of the reporting entity).
If an instrument has one or more equity outcomes and one or more nonequity outcomes, it would be separated into an equity component and a nonequity
component. Examples of instruments that would be separated are convertible debt and puttable stock. The nonequity component of a separated instrument would be initially measured at fair value and the difference between the fair value of the nonequity
component and the transaction price of the instrument would be allocated to the equity component. All other instruments that are not equity instruments or are not separated are classified as assets or liabilities. Instruments or components with varying payoffs at the settlement date are measured at fair value through income unless other generally accepted accounting principles apply. Instruments or components with fixed payoffs
Requirement 1
Cisco reports accumulated other comprehensive income (loss) in its balance sheet as a component of shareholders’ equity as follows:
($ in millions)
Shareholders' equity: 2011 2010
Preferred stock
Common stock and additional paid-in capital $38,648 $37,793 Retained earnings (accumulated deficit) 7,284 5,851 Accumulated other comprehensive income (loss) 1,294 623 Total shareholders' equity $47,226 $44,285 Requirement 2
Cisco relies on FASB ASC 220–10–45–8: “Comprehensive Income–Overall–Other Presentation Matters” when reporting comprehensive income. Cisco reports a separate statement of comprehensive income.
45–8 An entity shall display comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements that constitute a full set of financial statements. This Subtopic does not require a specific format for that financial statement but requires that an entity display net income as a component of comprehensive income in that financial statement. Examples 1 through 2 (paragraphs 220–10–55–4 through 55–27) provide illustrations of the components of other comprehensive income and total comprehensive income being reported below the total for net income in a statement that reports results of operations or in a separate statement of comprehensive income that begins with net income..
Case 18–4 (continued) Requirement 3
Comprehensive income is a more expansive view of the change in shareholders’
equity than traditional net income. It is the total nonowner change in equity for a reporting period. In fact, it encompasses all changes in equity other than from transactions with owners. Transactions between the corporation and its shareholders primarily include dividends and the sale or purchase of shares of the company’s stock.
Most nonowner changes are reported in the income statement. So, the changes other than those that are part of traditional net income are the ones reported as “other comprehensive income.” Two attributes of other comprehensive income are reported:
(1) components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods.
The first of these—components of comprehensive income created during the reporting period—can be reported either (a) as an extension of the income statement or (b) in a separate statement, immediately following the income statement.
Regardless of the placement a company chooses, the presentation is similar. It will report net income, other components of comprehensive income, and total comprehensive income, similar to the following:
($ in millions)
Net income $xxx
Other comprehensive income:
Net unrealized holding gains (losses) on investments (net of tax)† $ x Gains (losses) from and amendments to postretirement plans (net of tax)‡ (x) Deferred gains (losses) from derivatives (net of tax)§ x Gains (losses) from foreign currency translation (net of tax)* x xx
Comprehensive income $xxx
† Changes in the fair value of some equity securities.
‡ Gains and losses due to revising assumptions or market returns differing from expectations, and prior service cost from amending the plan (described in Chapter 17).
§ When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives
Appendix to the text).
* Gains or losses from changes in foreign currency exchange rates when translating financial statements of foreign subsidiaries. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in the accounting curriculum.)
This is the measure of comprehensive income Cisco reported in the disclosure note. Notice that each component is reported net of its related income tax expense or income tax benefit.
The second measure—the comprehensive income accumulated over the current and prior periods—is reported as a separate component of shareholders’ equity. This is what Cisco reported in its balance sheet as indicated in Requirement 1 ($1,294 million in 2011). Be sure to realize this amount represents the cumulative sum of the changes in each component created during each reporting period (the disclosure note) throughout all prior years.
Requirement 4.
One component of Other comprehensive Income for Cisco Is "Change in unrealized gains on investments.” For reporting purposes, investments in some marketable equity securities are reported at their fair values. The holding gains and losses from writing these securities up or down to fair value are not reported in the income statement, but instead are reported as a component of Other comprehensive income in the balance sheet. This makes up the greatest part of Cisco’s Other comprehensive income. From the information Cisco's financial statements provide, we can determine how the company calculated the $1,294 million accumulated other comprehensive income at the end of fiscal 2011:
($ in millions)
Accumulated other comprehensive income (loss), 2010 $623
Change in net unrealized gains on investments 169
Change in derivative instruments (21)
Change in cumulative translation adjustment and other 538
Change in minority interest (15)
Accumulated other comprehensive income (loss), 2011 $1,294