by Glenn Cheney
Norwalk, Conn. - When is equity a liability? More often than it used to be, thanks to a new statement issued by the Financial Accounting Standards Board.
FASB Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, requires certain types of freestanding instruments to be reported as liabilities in financial statements.
“For quite a while, we’ve been looking at instruments that seem like equities when you look at them one way but liabilities when you look at them another way,” said FASB senior project manager Halsey Bullen. “We weren’t able to resolve all the issues - at least not yet - but the board wanted to take some action now on three categories of instruments that can be accounted for entirely as liabilities.”
The statement calls for mandatorily redeemable shares to be treated as liabilities rather than as temporary or “mezzanine” equities, as they have been treated in accordance with the rules of the Securities and Exchange Commission. Many private companies have constructed agreements with employee stockholders to buy back such shares upon retirement. This obligation, the board said, constitutes a clear liability and should be accounted for as such.
Instruments that may require the issuer to buy back some of its shares, including put options and forward purchases, have also been categorized as liabilities. The statement redefines such instruments to make them subject to the accounting specified for derivatives.
Also reclassified as liabilities are obligations that can be settled with shares whose price is fixed or tied to a market index, or which varies with the value of the issuers’ shares.
Enron and other companies used this device to raise capital without reporting liabilities. Bullen said that the legal accounting practice “really bugged some people because [the companies] had the alternative of reporting the obligations as liabilities but chose not to.”
He noted that, in developing the standard, the board considered whether the receivers of these three categories of equities were the same as stockholders. “The answer,” said Bullen, “is clearly that they are not.”
The statement does not apply to features embedded in a financial instrument that is not a derivative in its entirety. FASB expects to deal with these in a subsequent financial instruments project. That second stage will revise the definition of liabilities to encompass certain obligations that a reporting entity can or must settle by issuing its own equities.
FASB will begin work on the second stage of the project in July, after a new member joins the board. It will address convertible bonds, puttable stock, and other instruments with embedded features that blur the line between equity and liability. The board may adopt a bifurcated standard that determines one set of accounting rules for the equity part of an instrument, and another set for the embedded liability part.
Statement 150 will most affect companies with complex financial structures. Investors are expected to appreciate the greater transparency of financial reports. Kevin Stoklosa, an accounting specialist at Moody Investors Services, said that it will give investors a better picture of the potential for future cash outflows.
“I think this statement is good to the extent that it addresses some very narrow issues that were causing problems,” Stoklosa said. “It has the weakness that it requires liability classification for certain instruments only when they are free-standing but not when those same instruments are embedded in other instruments. I think they should have taken that extra step.”
The statement went into effect just two weeks after being issued. It applies to almost all relevant financial instruments entered into or modified after May 31, 2003. Privately owned companies, which may find the shift in accounting for mandatorily redeemable financial instruments to be problematic, will not need to meet the new requirements until the first fiscal period beginning after Dec. 15, 2003.
With exceptional swiftness, FASB posted the new statement almost as soon as it was approved, and the written version was printed within a week. Bullen noted that the board had informed the public that the statement was likely to be issued soon and with little time before the effective date. The statement is available at the FASB Web site, www.fasb.org.
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