FASB: Criteria for Liability Extinguishment

Project Updates

Criteria for Liability Extinguishment

Last Updated: June 20, 2005 (Updated sections are indicated with an asterisk *)

The staff has prepared this summary of Board decisions for information purposes only. Those Board decisions are tentative and do not change current accounting. Official positions of the FASB are determined only after extensive due process and deliberations.

Objectives
*Decisions Reached at the Last Meeting
*Immediate Plans
*Summary of Tentative Decisions
*Board Meeting and Public Meeting Dates
Related FASB Articles
History and Background
Contact Information

Objectives

The main objective of the liability extinguishment project is to provide research related to the accounting for certain contracts. The project will:

  1. Support the Board’s projects on revenue recognition and conceptual framework by developing an asset/liability model, under which revenues are recognized when assets are created or liabilities are extinguished, for executory customer contracts. The liability extinguishment project will analyze contractual rights and obligations arising at inception of the arrangement to complete discharge to identify and evaluate rights and obligations that satisfy recognition criteria. (Recognition criteria, such as relevance, reliability, and measurability, are contained in FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, and assets and liabilities are defined in FASB Concepts Statement No. 6, Elements of Financial Statements.)

  2. Develop criteria for derecognizing performance obligations (both through partial and complete performance). The development of that criteria will include:

    1. Assessing whether the legal extinguishment model in FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, is appropriate for performance obligations, and, if that model is deemed not to be appropriate,

    2. Identifying alternative indicators of performance that could be used as criteria for derecognizing performance obligations.

  3. Re-evaluate existing guidance for derecognition of financial liabilities and, if necessary, clarify paragraph 16(b) of Statement 140 to address specific practice questions that have been raised by various constituent groups.

  4. Consider the implications of the Board’s decisions on other non-revenue-related executory contracts.

*Decisions Reached at the Last Meeting (June 8, 2005)

At its June 8, 2005 meeting, the Board decided that a unilateral firm offer (i.e. an offer to sell that is enforceable and irrevocable for the offeror) does not convey rights that meet the definition of an asset per FASB Statement of Concepts No. 6, Elements of Financial Statements, to the offeror.

In addition, the Board discussed, but did not conclude, as to whether a firm offer imposes on the offeror an obligation to stand ready to enter into a bilateral contract that meets the definition of a liability. Several Board members believe that a unilateral offer to sell is not a liability prior to acceptance of the offer. Those Board members believe that prior to acceptance of the offer, the offer represents a conditional obligation, with the conditional element being the acceptance of the offer by the offeree. Other Board members believe that a unilateral offer to sell that is legally enforceable and irrevocable is a liability to stand ready to enter into a bilateral contract. Those Board members believe that the offer is similar to an option contract and the nature of the liability is a commitment of supply and possibly price protection when the offer is quoted at other than prevailing market prices.

*Immediate Plans

The Revenue Recognition project team plans to address elements separation criteria and the definition of performance value (the measurement attribute that Board members selected at the May 11, 2005 Board meeting on Revenue Recognition) during the third quarter. The Liability Extinguishment project team will then apply the decisions reached regarding elements separation and the definition of performance value, as well as the decisions previously made (included as attachment to this summary) to its analysis bilateral contracts.

*Summary of Tentative Decisions

November 24, 2004

  • The Board decided not to pursue a derecognition model based solely on legal principles because of the perceived representational faithfulness and operationality issues.

  • To identify and describe indicators of performance that subsequently could be used to develop models for derecognition or measurement of performance obligations.

June 8, 2005

  • Firm offers do not convey rights to the offerer that meet the definition of assets.

  • The Board did not decide, whether (1) a firm offer imposes on the offeror a stand-ready obligation to enter into a bilateral contract that meets the definition of a liability and (2) fair value is conceptually the most relevant measurement attribute for the stand-ready obligation to enter into a bilateral contract.

Related Decisions Made in the Revenue Recognition Project

  • The accounting for assets and liabilities associated with revenue-generating transactions will focus on enforceable customer contracts. Agreements that are not enforceable do not give rise to rights and obligations that meet the definitions of assets and liabilities; that is, only enforceable agreements (contracts) give rise to rights and obligations that may meet the definitions of assets and liabilities.

  • A contract does not have to be worthy of enforcement in order to give rise to assets and liabilities.

  • A contract with cancellation provisions might give rise to assets and liabilities; however, executory contracts in which both parties have cancellation rights without penalty may not give rise to pre-performance rights and obligations that meet the definitions of assets and liabilities.

  • Firm offers may contain obligations that meet the definitions of liabilities.

  • Unconditional and mature rights and obligations might meet the definitions of assets and liabilities, but conditional rights and obligations do not. Unconditional rights and obligations associated with particular conditional rights and obligations may meet the definitions of assets and liabilities.

  • The terms conditional and contingent are synonymous.

  • The unit of account for the pre-performance period in which the subject is fungible is the contract as a whole; the unit of account for the pre-performance period in which the subject is unique is the individual assets and liabilities; and the unit of account for the post-performance period is the individual assets and liabilities arising from unconditional rights and obligations.

*Board Meeting and Public Meeting Dates

The Board meeting minutes are provided for the information and convenience of constituents who want to follow the Board’s deliberations. All of the conclusions reported are tentative and may be changed at future Board meetings. Decisions become final only after a formal written ballot to issue a final Statement or Interpretation.

The following are links to the minutes for each meeting.

June 8, 2005 Board Meeting—Discussion of the assets and liabilities that arise in a firm offer
November 24, 2004 Board Meeting—Discussion of the application of the liability derecognition criteria in paragraph 16 of Statement 140 to performance obligations
April 14, 2004 Board Meeting—Discussion of scope, direction, and priorities of project
December 4, 2003 FASAC Meeting—Discussion of criteria for liability extinguishment
June 25, 2003 Board Meeting—Discussion of input received from legal academics
February 26, 2003 Board Meeting—Addition of project to technical agenda

Related FASB Articles

None.

History and Background

In some transactions, a third party agrees to make payments to a lender in settlement of an obligation of an existing debtor. The lender agrees to look first to the third party for payment of the debt and to treat the original debtor as a guarantor, in substance releasing the debtor from its obligation on the condition that a third party assumes that obligation but the debtor remains secondarily liable. Although the three-party arrangement may be evidenced by valid contracts, economically releasing the debtor, paragraph 16(b) requires that the debtor must be legally released for liability extinguishment to be accomplished. The staff has recently been made aware that several constituents account for arrangements such as the one described above by removing the debt from the balance sheet, which some believe is inconsistent with the intent of Statement 140.

The distinction between economic release and legal release has become problematic in application of the criterion in paragraph 16(b) of Statement 140, which reads as follows:

    [A liability is derecognized when it is extinguished. Extinguishment is accomplished if] the debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. [Footnote reference omitted.]

The phrase “legally released from being the primary obligor” does not have a precise meaning under U.S. law. Therefore, while contracts evidencing the three-party arrangement described above, which supports an economic extinguishment for the original debtor, may exist, attorneys will not provide a legal opinion stating that legal extinguishment has been achieved unless a novation is obtained.

EITF Issue No. 02-10, “Determining Whether a Debtor Is Legally Released as Primary Obligor When the Debtor Becomes Secondarily Liable under the Original Obligation,” attempted to address this issue at the June 19–20, 2002 EITF meeting. No consensus was reached at that meeting, and the FASB staff was directed to further explore with the Board the meaning of the phrase “legally released from being the primary obligor” in the context of paragraph 16(b) of Statement 140.

Subsequent to the EITF meeting, the staff issued a memorandum entitled “Determining Whether a Debtor Is Legally Released as Primary Obligor When the Debtor Guarantees the Obligation of the Entity Undertaking Related Payments.” That memorandum was discussed by staff and Board members at a series of three small group meetings. As a result of those meetings, it was decided that the issue is beyond the authority and interpretive powers of the EITF and that the Board formally would consider whether to add a project to its technical agenda.

At its February 26, 2003 meeting, the Board added a limited-scope project to its agenda to evaluate the perceived ambiguities in the language of paragraph 16(b) and to develop proposed revised language to eliminate those ambiguities. The staff developed new language that would:

  1. Retain the notion of a legal release

  2. Replace the reference to primary obligor, which has no precise meaning in law, with wording that places emphasis on the party principally responsible for making future payments on the debt obligation

  3. Explicitly disallow derecognition where the original debtor remains jointly and severally liable.

At the June 25, 2003, Board meeting, the staff presented recommended changes to the wording in paragraph 16(b) to improve its clarity. Although the staff’s recommended language was an improvement, the Board believed that additional improvements could be made through a broad reconsideration of liability extinguishment. The Board believed that that broad reconsideration should consider use of a purely legal criterion for derecognition while also considering deleting “legally” from the criterion altogether and developing a replacement criterion that is not linked with legal notions of liability extinguishment.

The Board met with FASAC on December 4, 2003, to discuss current financial reporting issues that Council members were aware of relating to liability extinguishment. FASAC members were asked to comment on several issues that could potentially be addressed by the project. Refer to the FASAC materials for a more detailed discussion of those issues.

At its April 14, 2004 meeting, the Board set the following priorities for the liability extinguishment project:

  1. The first project priority is to support the revenue recognition project by considering how the liability derecognition criteria in paragraphs 16(a) and 16(b) of Statement 140 would be applied in the context of derecognizing performance obligations. If those criteria are determined not to be operational, the Board will explore other approaches for derecognition of performance obligations.

  2. The second project priority is to address whether and, if so, how to clarify paragraph 16(b) in Statement 140 to address specific practice questions.

  3. The third project priority is to consider whether the existing liability derecognition guidance in Statement 140 should also apply to liabilities that are explicitly excluded from the scope of that Statement (for example, accounting for leases and postretirement benefits) and, if so, whether or not to amend the requirements of those Statements. The Board also directed the staff to consider the applicability of that guidance to other circumstances, such as those encountered in Statement 15 and Issue 96-19.

Project Resource Group

A project resource group consisting primarily of preparers and auditors has been developed to assist the Board and staff in identifying practice issues associated with existing accounting criteria for liability extinguishment and issues related to the implementation and application of decisions reached in the liability extinguishment project.

Legal Advisory Group

A legal advisory group is being developed to assist the Board and staff in analyzing and evaluating the legal aspects of existing and proposed recognition and derecognition criteria.

If you are interested in providing input to the staff as part of either the Project Resource Group or the Legal Advisory Group please contact either the project manager or the assistant project manager on the project.

Contact Information

For additional information about this project, you may contact:

Peter Proestakes
Project Manager
pcproestakes@fasb.org

Tara L. McKenna
Assistant Project Manager
tlmckenna@fasb.org

Additional Details