Distinguishing Between Equity and Liabilities - A View on FASB's and IASB's Approaches and an Introduction of the Loss Absorption Approach

Abstract:     
The problem of distinguishing between equity and liabilities for accounting purposes has been under discussion for decades now. Different standardsetting institutions have published discussion papers on the topic recently.

The Financial Accounting Standards Board (FASB) introduces three possible approaches, namely the basic ownership approach, the ownership-settlement approach and the re-assessed expected outcomes approach. Working groups of the European Financial Reporting Advisory Group (EFRAG)'s Proactive Accounting Activities in Europe (PAAinE) Initiative and the German standardsetter, the Accounting Standards Committee of Germany (ASCG), developed the loss absorption approach. These four proposals and the concept of the amended IAS 32 will be described and evaluated in our paper.

All of the approaches maintain the classic twofold structure of capital claims on the balance sheet, though empirical capital claims are characterised by a bundle of features. Thus accepting the premise of a dichotomous capital classification, the different approaches are analysed with respect to their possible decision-usefulness, based on a set of criteria which are commonly understood as qualitative characteristics of decision-useful information.

At the current state none of the approaches is without open questions. As to the FASB approaches the reasoning behind the proposed principles and rules remains unclear. The three approaches lead to different cuts between equity and liabilities - despite the FASB's expressed preference for the basic ownership approach, the results seem somewhat arbitrary. IAS 32 amend leads to principally more relevant information, but lacks a basis of consistent principles. The principle behind the loss absorption approach is somewhat similar to IAS 32's obligation principle, but avoids its blurring of information in relation to redeemable residual claims.

Number of Pages in PDF File: 33

Keywords: Equity, Liabilities, IAS 32, LAA, BOA, OSA, REO

JEL Classification: M41, M44, G32

working papers series