4.6 Equity Transactions
As discussed in Section 4.3, equity-classified securities are nonmonetary accounts that must be measured at historical exchange rates (i.e., the rates that were in effect when the securities were issued).
ASC 480 provides guidance on determining whether a financial instrument with both debt- and equity-like characteristics must be classified as a liability (or, in certain circumstances, as an asset). ASC 480 applies to freestanding financial instruments only and therefore does not apply to embedded features in a hybrid instrument, such as a put option embedded in a preferred share. However, just because an entity concludes that it is not required to classify an instrument as a liability under ASC 480 does not mean that the instrument is automatically classified as equity. Rather, an entity must perform further analysis under other Codification subtopics (e.g., ASC 815-40, ASC 505) to determine whether the instrument should be classified as a liability or as equity.
4.6.1 Distinguishing Liabilities From Equity
Under ASC 480, certain financial instruments that embody an obligation of the
issuer should be accounted for as liabilities even if their legal form is that
of equity. ASC 480 requires that the following three classes of financial
instruments be accounted for as liabilities (or, in some circumstances, as
assets):
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Mandatorily redeemable financial instruments — The issuer of a financial instrument that is in the form of a share must classify the share as a liability if it embodies an unconditional obligation requiring the issuer to redeem the share by transferring assets, unless redemption would occur only upon the liquidation or termination of the reporting entity (e.g., mandatorily redeemable shares and mandatorily redeemable NCIs that do not contain any substantive conversion features). This guidance does not, however, apply to certain mandatorily redeemable financial instruments issued by nonpublic entities that are not SEC registrants (see ASC 480-10-15-7A).
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Obligations to repurchase the issuer’s equity shares by transferring assets — A financial instrument other than an equity share is classified as a liability if it both (1) embodies an obligation to repurchase the issuer’s equity shares (or is indexed to such an obligation) and (2) requires (or may require) the issuer to settle the obligation by transferring assets (e.g., physically settled or net-cash-settled forward purchase contracts or written put options on the entity’s own equity shares).
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Certain obligations to issue a variable number of shares — A financial instrument that embodies an unconditional obligation or a financial instrument other than an outstanding share that embodies a conditional obligation that the issuer must or may settle by issuing a variable number of its equity shares is classified as a liability if the obligation’s monetary value is based solely or predominantly on one of the following: (1) a fixed monetary amount, (2) variations on something other than the fair value of the issuer’s equity shares, or (3) variations inversely related to changes in the fair value of the entity’s equity shares (e.g., share-settled debt and net-share-settled forward purchase contracts or written put options on the entity’s own equity shares). See ASC 480-10-25-14 for more information.
In addition, ASC 480-10-S99 contains SEC guidance and SEC staff interpretations
on how to account for and present redeemable equity instruments (including
classification within equity) that are not classified as liabilities under ASC
480-10-25 in an entity’s financial statements. As summarized in the table below,
the foreign currency effects of financial instruments with characteristics of
both debt and equity depend on whether those instruments are classified as
liabilities, temporary equity, or permanent equity under ASC 480.
Classification | Foreign Currency Effects |
|---|---|
Liability | The instrument represents a monetary liability and therefore should be
remeasured, as of each reporting date, in the functional
currency at the current exchange rate. Any change in the
functional-currency-denominated value of the debt caused
by changes in exchange rates should be recognized as a
transaction gain or loss unless the liability is
subsequently measured at fair value, with changes in
fair value recognized in earnings. In those situations,
the entire change in fair value (including the exchange
rate change component) would be recognized in the same
line item.7 |
Temporary equity | Like other equity instruments, instruments classified in temporary equity on the
balance sheet are considered nonmonetary accounts under
ASC 830. Changes in exchange rates therefore will not
result in transaction gains or losses under ASC 830.
However, to the extent that the instrument must be
subsequently remeasured under ASC 480-10-S99-3A, the
measurement of the instrument’s redemption value must
incorporate the effect of exchange rates. That is, the
effect of exchange rates would be recorded through
retained earnings (or, in the absence of retained
earnings, APIC) and included as an adjustment to net
income available to common shareholders in the
calculation of earnings per share in accordance with ASC
480-10-S99-3A. Further, although ASC 480-10-S99-3A does
not address foreign currency, consideration of the
effects of changes in exchange rates when the “floor” is
applied would be most consistent with the intention of
the concept in that guidance. |
Permanent equity | The instrument represents a nonmonetary account that must be measured at the historical exchange rate. Changes in exchange rates therefore will not result in transaction gains or losses. |
For further discussion of the application of ASC 480-10-S99-3A,
see Chapter 9 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity.
4.6.2 Dividends
The declaration of a cash dividend, if the dividend is not paid on the declaration date, results in the recognition of a monetary liability (i.e., a dividend payable). If the dividend is payable in a currency other than the entity’s functional currency, it must be remeasured, as of each reporting date, in the functional currency at the current exchange rate. Any change in the functional-currency-denominated value of the dividend payable caused by changes in exchange rates is recognized as a transaction gain or loss. The FASB 52
Implementation Group addressed this issue in December 1981 when it decided that
“the transaction adjustment on a dividend payable or receivable account should
be charged or credited to income.” This accounting is required regardless of
whether the dividend is payable to the entity’s parent or other third-party
shareholders.
Example 4-6
Foreign-Currency-Denominated Dividend
Company A, whose functional currency is
the ZAR, declares a $60 million dividend to its equity
shareholders on November 12, 20X6. The spot exchange
rate on the declaration date is $1 = ZAR 10. Assume the
following additional facts:
-
The dividend will be paid in ZAR at the spot rate in effect on December 27, 20X6.
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The closing spot exchange rate on December 27, 20X6, is $1 = ZAR 12.
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The dividend of ZAR 720 million ($60 million × 12) is paid on January 14, 20X7.
Because the payable is denominated in a
foreign currency (USD), A is at risk for fluctuations in
the foreign currency exchange rate between the
declaration date and December 27, the date on which the
exchange rate is fixed so that the dividend can be paid.
Therefore, A should record a transaction loss related to
the liability for the devaluation of the ZAR to the USD
for the period from November 12 through December 27.
Since the dividend will be paid in ZAR (i.e., A’s
functional currency), foreign exchange risk is no longer
associated with this payable after December 27.
Footnotes
7
For liability instruments for which the fair
value option has been elected, changes in fair
value related to both instrument-specific credit
risk and exchange rates are recorded in OCI in
accordance with ASC 830.