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The FASB discussed and expressed support for a set of draft principles that could be used to distinguish between equity and liabilities and a related set of decision rules to operationalize those principles.
The principles are as follows:
1) Equity instruments are always subordinated to all liability instruments but may be senior to other classes of equity.
2) An instrument is equity if the issuer cannot be required to settle it unless the issuer winds up its operations and distributes all of its remaining assets. (That is a sufficient but not necessary condition for equity classification.)
3) A settlement requirement that becomes effective when the holder has died, retired, resigned, or otherwise ceased to take an interest in the activities of the entity does not cause an instrument to be classified as a liability if the holder was required to hold the instrument in order to transact with the entity or otherwise engage in the activities of the entity.
4) Settlement requirements other than those described in item (3) indicate that an instrument is a liability or a liability-equity hybrid instrument (part equity and part liability).
5) An instrument should be separated into liability and equity components if the instrument has two separate or alternative outcomes, one of which would require equity classification if it were the only outcome and one of which would require liability classification if it were the only outcome.
6) Claims to percentages of remaining assets are neither necessary nor sufficient to identify an equity instrument. However, they may help to classify otherwise borderline instruments.
The decision rules to produce results consistent with the principles are as follows:
1) An entity must classify as equity retained earnings and capital contributed without the contributor receiving a claim against the entity in exchange even if that entity has issued no equity instruments.
2) An issuer must classify an instrument as a liability if the instrument has a fixed settlement date or must be settled on the occurrence of an event that is certain to occur, excluding those described in item 3(a) and 3(b) below.
3) An issuer must classify the following other instruments as equity:
o Instruments that the issuer cannot be required to settle before winding up its operations and distributing all of its assets (regardless of the amount of the claim).
o Instruments that the holder is required to own in order to do business with or otherwise actively engage in activities of the issuer and that are redeemable only if the holder dies, retires, resigns, or otherwise ceases to actively engage in the activities of the issuer. (This would include holdings, the amounts of which vary based on volume of business transacted by the holder.)
4) An instrument should be separated into liability and equity components if the instrument has two separate or alternative outcomes, one of which would require equity classification if it were the only outcome and one of which would require liability classification if it were the only outcome.
The Board will continue to refine the principles in future Board meetings.