The Financial Accounting Standards Board has issued a proposed update to accounting standards meant to cut through complexity known to compromise reporting quality.
The board’s newest proposal is meant to improve guidance in GAAP for certain financial instruments that have characteristics of both liabilities and equities, including convertible instruments. FASB says it heard thorough an agenda consultation process a few years ago that the guidance was overly complex and inconsistent, causing uncertainty that fueled financial restatements.
The board zeroed in on two specific areas where improved guidance was warranted, FASB said. Convertible instruments, for example bonds that can be converted to shares at maturity, have been particularly problematic, along with contracts in an entity’s own equity that may qualify for an exception from derivative accounting.
With respect to convertible instruments, GAAP currently provides for five different accounting models, most of which require embedded conversion features to be separately recognized from the host contract. That has led to complexity in selecting the correct model to apply, while users of financial statements said they don’t get any benefit out of the separate recognition.
As a result, FASB simplified the model to eliminate the separation requirement. Under the proposal, FASB says, a convertible debt instrument would be accounted for as a single liability measured at its amortized cost while a convertible preferred stock would be accounted for as a single equity instrument measured at its historical cost.
“The board expects the amendments in this proposed update would provide financial statement users with a simpler and more consistent starting point to perform analyses across entities,” FASB says.
With respect to contracts in an entity’s own equity, current standards require entities to determine whether a contract meets some specific conditions that would qualify it for classification as equity, which preparers have said is difficult guidance to apply. The guidance sometimes leads to form-over-substance accounting conclusions, FASB said, where a remote feature in a contract may drive the accounting treatment.
The proposal would modify the language to permit more judgment and remove some of the settlement criteria, among others. That should reduce or eliminate situations where classification conclusions are driven by remote contingent events, FASB says. It also would make the guidance easier for everyone to understand, according to the board.
With those and additional changes to address earnings-per-share guidance, “we believe the proposed ASU would reduce complexity and improve understandability in this area while providing financial statement users with more relevant information,” said FASB Chairman Russ Golden in a statement.