SFAS 150's unintended Alchemy: turning positive into negative.

Our company has always been profitable, and it has a solid balance sheet, but it may soon show a negative net worth," complains Alfred King, vice chairman of Valuation Research Corp. and a member of FEI's Committee on Private Companies (CPC), in reaction to SFAS 150.

To gain an understanding of why this can happen, it's good to look back to the 1970s, when financial engineering was just beginning to leverage the world of corporate finance. King says he remembers it well. "In the good old days, bonds were debt and preferred stock was equity," he reminisces. "But then, in the '70s, investment bankers invented mandatorily redeemable preferred stock--preferred stock that had to be redeemed by the issuing company in, say, 10 years. Now, what is the difference between a bond and preferred stock that has to be redeemed by the company on a certain date?"

The Securities and Exchange Commission (SEC) first addressed the question of mandatorily redeemable preferred stock in its Accounting Series Release 268, issued in 1979. At that time, the Commission amended Regulation S-X to modify the financial statement presentation of preferred stocks subject to mandatory redemption requirements or whose redemption is outside the control of the issuer.

However, the SEC left unanswered the question of whether such financial instruments were considered liabilities. "The Commission is cognizant of these conceptual problems in determining the appropriate accounting for and reporting of redeemable preferred stock and believes that these matters can best be addressed by the Financial Accounting Standards Board (FASB)," the release states. Thus, FASB has spent decades trying to define the difference between "debt" and "equity."

Its latest thinking, Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, was issued last May--and has drawn its share of criticism. In fact, the rule has now been put on indefinite hold (see box on page 42), though it hasn't gone away.

In a comment letter to FASB, FEI's Committee on Private Companies observes that SFAS 150 has a number of "unintended consequences for privately held companies." (The extensive October 30 comment letter and illustrations of issues can be found on the FEI Web site (www.fei.org) in the "FASB Comment Letters" section.)

Private companies affected by SFAS 150 are those that have shareholder buy-sell agreements specifying that, upon the death or termination of a shareholder, the company is required to repurchase the ownership interest. In other words, these companies have mandatorily redeemable stock. However, to be consistent with public company accounting, SFAS 150 requires the fair market value of all mandatorily redeemable shares of private companies to be reflected as a liability, and not as equity.

King notes that his company, Valuation Research Corp., has a shareholder buy-sell agreement in place for the company's shareholders. But he points out that his company does not buy back any shares until it has identified other employees or shareholders who will then buy the stock from the company. Thus, the company will buy shares from one shareholder and sell to another, making the net effect zero.

At virtually no time is the company a net buyer or net seller of stock, and it certainly does not buy and hold. King cannot speak to the buy-sell arrangements for other organizations, but for his company, he questions how this buy-sell arrangement could constitute a liability. "This is a triumph of theory over economic reality," he argues.

Consequences, Albeit Unintended

A major consequence is negative book equity. As noted, SFAS 150 requires the fair market value of all mandatorily redeemable shares to be reflected as a liability. For a company that is 100 percent employee-owned, this could result in negative book equity, with a significant increase in recorded liabilities.

Additionally, the company may appear to be insolvent, because the liability is shown at fair market value, and, if the assets are not reported at fair market value, total liabilities will exceed total assets This raises the question of how to measure fair market value: What is the fair market value of the shares of a company that appears to be insolvent due only to an accounting rule?

This leads to a second unintended consequence: the unsolvable monetary value scenario. If a company's market value is equal to its pre-SFAS 150 book value, and 100 percent of its shares are subject to mandatory redemption, the recorded liability under SFAS 150 will reduce the book value of the company to zero, which reduces the monetary value under the redemption requirement to zero, which raises the book value back to its pre-SFAS 150 amount, which then becomes the redemption price, and so on. If you haven't guessed by now, this results in an unsolvable circular equation.

If readers are a bit lost at this point, don't worry. That is a normal reaction. But try to imagine the reaction of a bank officer lending money to an "insolvent" borrower--the concern raised by David Butler, vice president finance and administration for Millard Group Inc.

Millard Group, a firm in the list services industry with well-known clients such as L.L. Bean, Lands' End and Time Inc., has been consistently profitable over the years. "Millard Group holds life insurance policies to cover a fair market value redemption liability if any current owner should unexpectedly die," Butler explains, "and the existing redemption agreement provides for redemption payments to be made over time if there ever was any other voluntary transfer of ownership, so that no sale or liquidation will ever be required."

Nevertheless, SFAS 150, as presently written, will require the redemption value of the stock (at fair market value) to be shown as a liability, again resulting in a negative net worth.

How will that affect existing credit relationships? Butler has explained the implications of SFAS 150 to his bank, and even though his bankers understand the situation, they say they are not sure that the bank examiners will. The bankers question how examiners will react to credit lines being extended to a "technically insolvent" company.

Or, if Millard Group decides not to adopt SFAS 150, and then receives a qualified audit opinion (see adjacent sidebar), what will be the response of the bank examiners then?

"This is a degradation, not an improvement, in financial reporting, because SFAS 150 now portrays a consistently profitable company with a negative net worth," argues Butler. "We agree with the bank, that this issue must be resolved sooner rather than later." Alternatively, he says that Millard Group may rewrite its redemption agreement, an option he's uncomfortable with, because he sees it as a victory of "form over substance."

Jeffery Baker, a partner at McGladrey & Pullen LLP, is already telling his clients to have these discussions with their bankers now. "If you decide not to adopt SFAS 150, as currently written, you can expect either a qualified or adverse audit opinion," he cautions (see adjacent sidebar). "Most bank debt agreements require an unqualified opinion, and if you only work with one bank, SFAS 150 is relatively easy to explain. But if you have relationships with a number of banks, creditors, and vendors, the explanations become more difficult. The bigger your audience, the more complicated an adverse audit opinion becomes."

Baker adds that while it is not unreasonable to ask a banker to accept a qualified or adverse opinion, it's not a good long-term solution. Unqualified opinions are the accepted norm, and Baker expects bankers to encourage companies to move in that direction.

These are questions that Arthur Neis, vice president, treasurer and CFO of Life Care Services LLC (LCS), is wrestling with. LCS is a multitiered private company, with operating companies wholly owned by a non-operating holding company. The holding company is owned by the stockholders, and would therefore show the liability for the mandatorily redeemable stock. The operating companies are owned by the holding company, and would not have this type of ownership liability.

After extensive discussions with his accountants and lawyers, Neis is considering not adopting SFAS 150. He expects that this will result in an adverse opinion for the holding company, but the operating companies should continue to receive their traditional unqualified opinions.

"If we do adopt 150," he says, "Holdings would be insolvent, though certainly not illiquid." Having resolved this issue, he must still determine how to pay dividends to shareholders. "Because LCS is a Subchapter S Corporation, the stockholders receive pass-through income, on which they are responsible for paying income taxes. But the reclassification of equity as a mandatorily redeemable obligation could prevent the payment of dividends. Our stockholders would effectively owe taxes on Holdings' income, but not be able to receive dividends with which to pay the taxes," Neis explains.

He is certain that commercial law will resolve this problem, but opines, "It is unfortunate that the accounting standard-setters may have created a problem that may have to be resolved by commercial law."

In addition to working with creditors and auditors, the unintended consequences of SFAS 150 have to be explained to shareholders--a difficult task. Having discussed it with the audit committee and the board, Neis began his communique to all of his shareholders with this paragraph:

"Why would the CFO ever write to shareholders about a pronouncement of the Financial Accounting Standards Board (FASB) and describe in, detail SFAS 150? I am doing this because of its potential psychological impact on you. That's right--there is no monetary impact, but the psychological pain could be high. Permit me to explain ..."

Types of Audit Opinions

The independent auditor will typically issue an unqualified report stating that the financial statements are in accordance with generally accepted accounting principles (GAAP). If an entity does not follow GAAP (such as not adopting FAS 150), it is likely that the auditor would issue one of two types of audit opinions:

"Qualified" Opinion. This opinion will state that the financial statements are in accordance with GAAP, except for a specified GAAP departure.

"Adverse" Opinion. This opinion states that the financial statements are not in accordance with GAAP and the reasons therefore are described.

In both the qualified and adverse opinions, the auditor will include in the opinion the departure from GAAP and will quantify the amounts involved, if determinable. Whether a qualified or adverse opinion is rendered is subject to the judgment of the auditor, who will consider matters such as the nature of the GAAP departure and the magnitude of the amounts involved.

On Nov. 7, 2003, FASB staff issued FASB Staff Position (FSP) 150-3. This FSP would delay indefinitely the implementation of SFAS 150 by non-public entities for mandatorily redeemable shares, other than those shares subject to mandatory redemption at a fixed time or amount. FASB plans to re-examine this issue during phase II of its liabilities and equity project or in phase II of its business combinations project.

William M. Sinnett is Manager of Research for Financial Executives Research Foundation, Inc. (FERF) and is moderator for FELIX (www.fei.org/rf/felix/). He can be reached at [e-mail].