Accounting for financial instruments with characteristics of liabilities and equities has never been easy, and the Financial Accounting Standards Board has had a hard time hammering out the difference.
Even as the board issued Statement 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, in 2003, it considered the standard only one phase of a broader project that would end with the determination of liability and equity classifications for all financial instruments.
And no sooner was the statement issued than unsolicited comment letters came pouring in - some 200 of them, mostly from companies in the building, architecture and real estate industries. And none of them were happy with the classification of certain instruments that could be construed as equities or as liabilities.
Especially troublesome was the classification of mandatorily redeemable shares as a liability. A comment letter from the Construction Financial Management Association summarized a common complaint: "Under FAS 150, current financial instruments classified as equity (such as 'mandatorily redeemable shares') will now be required to be classified as equity," the letter stated. "For many privately held construction companies that utilize even simple buy-sell agreements for share redemption (whether or not these agreements are funded by life insurance policies or by equity 'buy back' that can be paid over time), this new requirement will have disastrous and far-reaching consequences."
FASB reacted to the comments by deferring the effective date of FAS 150 indefinitely for mandatorily redeemable shares of nonpublic companies and for mandatorily redeemable noncontrolling interest.
The fundamental issue, however, went much deeper than such microeconomic specifics.
"One part of the milestone draft focuses on what is equity, what is ownership," said FASB project manager Brooke Richards.
Having two years of experience with Statement 150, the board has presented the first part of the second phase of the project, a so-called "milestone draft" that proposes a few changes in principle that will result in changes to the classification of certain instruments.
The roots of the problem in defining these instruments go back to Concepts Statement 6, Elements of Financial Statements. The requirements of Statement 150 are based on the current definition of a liability in that statement.
Upon completion of the project, however, the board intends to reconsider the treatment of liability and equity under Concepts Statement 6.
"In the liabilities and equity project, we are really trying to determine what equity is, so we are developing the concept of equity as we go," Richards said. "It's challenging, because this project addresses only financial instruments, and the concepts statement addresses more than that. The conceptual framework team has to determine how to change based on what the board decided on the concept of equity and liability in this project, and then on concepts relating to the project on revenue recognition."
Among the instruments that would be reclassified as equity under the principles of the milestone draft are: perpetual instruments, direct ownership instruments, and indirect ownership instruments indexed to and settled or ultimately settled with the same direct ownership instruments on which their counterparty payoffs are based.
Other instruments in the scope of the draft, including mandatorily redeemable shares, would be classified as liabilities or assets.
In hammering out the draft, the board decided that classifications should be based on both economic characteristics and ultimate settlement, instead of just one. The board concluded that two criteria should be considered in distinguishing liabilities and assets from equity: an ownership criterion and a settlement criterion.
The board believes that the "Ownership-Settlement Approach" for classification would result in more "representationally faithful" information than other approaches that it considered, and can be used as a basis for accounting for multiple-component instruments. Multi-component instruments will be dealt with in the second milestone of Phase 2.
If the changes proposed in the draft are implemented, ramifications will ripple through other FASB pronouncements, including Statement 123R, on share-based payments, Accounting Series Release 268 of the Securities and Exchange Commission, on the presentation in financial statements of redeemable preferred stocks, Emerging Issues Task Force Topic No. D-98, on classification and measurement of redeemable securities, and American Institute of CPAs Position 93-6, on employee stock ownership plans.
By the time that it finishes the project, the board intends to amend or replace Statement 150 and all related staff positions.
FASB is using this project to further converge with the international standards issued by the International Accounting Standards Board. Under a "modified joint approach," the two boards plan to issue a preliminary views document that will serve as the basis for joint redeliberations and development of a common final statement. That document may be issued early in 2006, with a final statement possible by the end of 2007.
The milestone draft is a new kind of FASB document. It does not address all matters that will eventually be addressed in a traditional pre-statement exposure draft. The current milestone does not deal with the definition and classification of multiple-component instruments, measurement, earnings per share, disclosure, transition, and effective date, all of which will be covered in the eventual preliminary views document.
"This is something new we're doing," Richards said. "Instead of waiting until the end of the project, we stop at what we call a milestone, so we can flesh out some of the issues ahead of time. It's supposed to speed up the process."
Comments are not formally solicited at the milestone stage, Richards said, but they would be welcome from any interested parties. A copy of the draft can be downloaded at www.fasb.org.
In that next milestone stage, the board also will consider whether certain instruments in the scope of this draft, such as equities with settlement requirements, should be separately displayed on the face of the balance sheet.
The next stage will also deal with multi-component instruments, such as puttable stock, put warrants, convertible debt, prepaid contracts and variable share forward contracts.
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