Loss Absorption Approach to Defining Equity - PAAinE

The attached discussion paper was developed by the German standards setter and published on Monday (28th Jan) by the European Financial Reporting Advisory Group (EFRAG) on behalf of Pro-active Accounting Activities in Europe (PAAinE).

This paper sets out an alternate approach which defines financial instruments as equity (or not) based on whether they absorb losses. This approach would define co-operative member shares (potentially including those that do not have a claim on the residual net assets) as equity. The following co-op example is taken from the paper:

IE10 Share puttable, exercise limited to par (cooperative bank)

Fact pattern:

· Entity J issues puttable shares, repayable at par at the holder’s request.
· Entity J has reserves of 100m CU.
· Accounting losses are deducted from reserves, but if losses are sufficient to deplete the reserves, further losses are allocated pro-rata amongst shares then in issue, so a member’s claim after depletion of the reserves is reduced.
· The claim of the shareholder is then for the par value less her/her share of further losses after reserves are depleted.

Analysis

The entity is able to absorb losses of 100m plus the shares in issue before a shortfall arises

Result: Equity


This discussion paper is well worth a read and sets out a good case for abandoning the current IAS 32 and proposed FASB approaches and instead adopting the Loss Absorption Approach. It is a comprehensive, coherent, well made case and the best response I’ve seen so far to the prevailing view.