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Is it equity? Is it debt? Or is it both?

Mandatorily redeemable preferred stock, employee stock options, and convertible bonds may not seem to have much in common. But those three financial instruments, along with a variety of others, raise questions about how to distinguish between debt and equity instruments. That distinction is the main topic of a discussion memorandum, or DM, published by the Financial Accounting Standards Board (FASB) in August of 1990: "Distinguishing Between Liability and Equity Instruments and Accounting for instruments with Characteristics of Both."

An FASB DM is a neutral document prepared with the advice of a task force-in this case, the Task Force on Financial Instruments and Off-Balance-SheetFinancing. A DM does not contain tentative conclusions of the Board; rather, it raises issues and discusses alternative solutions to them. it is the basis for a public hearing on the issues, which is followed by an exposure draft of a proposed statement of financial accounting standards.

Although the FASB's financial instruments project has received a great deal of attention in the financial press, most of it has focused on such issues as when to measure financial instruments at their market values and how to treat hedges of one financial instrument with another. The part of the project that considers liability/equity issues has had a relatively low profile until now. But the DM, which considers only accounting by issuers of financial instruments, should be of interest to CFOs and other financial executives.

Why the distinction is important

Whether an instrument like mandatorily redeemable preferred stock is classified as a liability or as equity obviously affects reported amounts of liabilities and equity and related summary indicators, such as the debt/equity ratio and the asset/equity ratio. The line between liabilities and equity also is critical in measuring income. In present accounting, neither transactions between a company and its owners nor changes in the values of a company's outstanding equity instruments affect reported income, while payments of interest and at least some changes in the values of liabilities do affect reported income.

Some effects on net income of the distinction between liabilities and equity are obvious. If mandatorily redeemable preferred stock is treated as an equity instrument, the dividends are not deducted in determining the issuer's net income, although, like all preferred dividends, they are deducted to determine income available for common-stock holders. However, if the "stock" is considered to be a liability, the "dividends" would be reported as an expense and deducted in determining net income.

Other effects may not be quite so obvious. For example, if a stock purchase warrant or an employee stock option is recognized as equity at the date it is issued or granted, subsequent changes in its value do not affect the issuer's net income. If such instruments were recognized as liabilities, however, changes in their values before they either expire worthless or are exercised would affect net income. More on this later.

What's the urgency?

Both liabilities and equity are defined in FASB Concepts Statement 6, "Elements of Financial Statements." Liabilities are "probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events." Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. The essential distinction between liabilities and equity in the current concepts is that a liability instrument embodies an obligation to transfer assets or provide services to the holder, while an equity instrument does not. With such an apparently sharp distinction, why is there a problem with determining whether a particular financial instrument is a liability or equity?

One problem is that innovation in the financial markets has resulted in numerous instruments that blur the line between debt and equity. For example, features such as mandatory redemption provisions and dividend rates that float with changes in interest rates, added to preferred stock to make it a more versatile financing vehicle, may cause some issues of preferred stock to look more like debt than equity. Even common stock occasionally has taken on features that raise questions about its nature. One example is a provision that requires the issuer to repurchase the stock at the election of the holder.

Most of the liability/equity practice problems fit into one of two categories-an enterprise is obligated either to repurchase or to issue its own equity instruments for a specified price. The question is whether those obligations qualify as liabilities or as equity instruments.

An obligation to repurchase stock-liability or equity?

The nature of an obligation to repurchase or redeem stock is the issue raised by mandatorily redeemable preferred stock and put options written on an enterprise's own stock. The former is the more familiar instrument, so we'll use that in our example.

A company that issues mandatorily redeemable preferred stock simultaneously incurs a contractual obligation to redeem the stock for a specified or determinable amount on a specified or determinable date. In other words, the issuer receives cash from investors that it is obligated to repay to them, in the meantime paying a fee for the use of the investors' funds. Sounds a lot like a liability, doesn't it? Yet, present practice does not treat such stock as a liability. The SEC does, however, require public companies to exclude mandatorily redeemable stock from stockholders' equity. Such stock, often referred to as temporary equity, usually is presented between liabilities and equity-"on the mezzanine." In the income statement, however, mandatorily redeemable stock is treated just like all other preferreds; the dividends are deducted from net income to determine earnings available for holders of common stock.

The FASB's conceptual framework does not include a "mezzanine" element. A financial instrument must be either a liability or equity. Whether mandatorily redeemable preferred stock qualifies as a liability turns mainly on the issuer's ability to avoid the future payment of cash to redeem the stock. For an obligation to qualify as a liability under the current definition, the issuer must have little or no discretion to avoid the future sacrifice of assets embodied in the obligation. Because mandatorily redeemable preferred stock is characterized as stock for legal purposes, an issuer must qualify under the applicable statutes to distribute assets to owners for redemption to be legally permissible. Generally, the issuer must be solvent and redemption of the stock must not endanger the rights of creditors whose rights are senior to those of the holders of the mandatorily redeemable stock.

Because the legal restrictions on distributing assets to owners permit an issuer of mandatorily redeemable preferred stock to avoid satisfying its obligation if it encounters severe financial difficulties, some contend that the stock does not qualify as a liability. Others take the view that an obligation to pay cash is not "easily avoidable" if the issuer can avoid it only by getting into such poor financial condition that it does not qualify to distribute assets to owners. While it may not be difficult to get into poor financial condition, the consequences are such that companies rarely do it intentionally.

Should there be a "mezzanine" element in which to classify instruments that are equity for legal purposes but that the issuer is contractually obligated to redeem? The DM considers that question also, but it points out that adding a third "capital" element to financial statements would greatly complicate the concept and measurement of income. Income is a return on equity. Adding an element that is neither equity nor a liability to be deducted in determining equity (net assets) would call for a new concept of income. Presumably a multilevel notion of income would be needed, with no single amount designated as net income of the enterprise.

An obligation to issue stockliability or equity?

Resolving the issue of whether a company's

Resolving to redeem its stock is a liability or equity requires applying the current conceptual definitions of liabilities and equity to specific instruments; it does not question the definitions themselves. Companies also frequently incur obligations to issue their own stock at a specified price. There is little question about how the current definitions apply to such obligations, but the result has led some to question certain aspects of the definitions.

This is the specific issue raised by employee stock options. The need to resolve the concerns of some Board members on this point led to a temporary suspension of work on the Board's stock compensation project to await progress on the liability/equity part of the financial instruments project. The Board expects to resume consideration of accounting for stock compensation after it has resolved the broader issue of whether an obligation to issue an enterprise's stock is a liability or an equity instrument.

Under the current definitions, employee stock options and similar instruments, such as stock purchase warrants, are equity instruments because they obligate a company only to issue its own stock. Since a company's own stock is not its asset-consistent with the familiar principle that treasury stock is not an asset-an obligation to issue stock does not require the company to transfer its assets to another entity, which is the distinguishing feature of a liability under the current definition.

Some disagree with that result.

They note that issuing stock for less than its current market value, as happens when an employee stock option is exercised, dilutes the value of the other stockholders' holdings.

They think that dilution should be recognized as an expense or loss in measuring the company's net income. Advocates of this view tend to equate the interests of a company with the interests of its existing holders of common stock before the options are granted or exercised.

Others argue that the current classification of obligations to issue stock as equity instruments is appropriate. They point out that exercise of an employee stock option or a stock purchase warrant only shifts value between groups of stockholders. In effect, the new stockholders benefit at the expense of the preexisting stockholders. The net effect on the entire group of stockholders is zero. Those who take this position do not focus on benefits or losses to a particular group of stockholders in measuring a company's net income.

How that disagreement is resolved could significantly affect the outcome of the stock compensation project. The Board has voted on several occasions to recognize compensation expense for all stock options granted to employees, but the Board members have not been able to agree on how to measure the expense. Recognizing employee stock options as equity instruments would preclude so-called exercise-date accounting, in which the final measure of compensation expense depends on the value of an option when it is exercised (or expires worthless) because changes in the values of a company's own equity instruments do not affect its income. Rather, compensation expense would be measured as the fair value of the option itself at the date it is considered to become an outstanding equity instrument. Recognizing an employee stock option as a liability, on the other hand, would point toward exercise-date accounting.

The difference can be significant. For example, under exercise-date accounting, the total effect on income of an option with a strike price of $100 that is exercised when the market price of the stock is $150 would be $50 per share. The fair value of the option at the date it vested, determined using an option pricing model, might be $10 per share.

What about instruments with both debt and equity components?

The DM also considers how issuers should account for instruments that have characteristics of both liabilities and equity. Examples are convertible bonds and puttable common stock. A convertible bond combines an obligation to pay cash-a liability-and an obligation to issue stock if the holder elects to convert the bond. The latter obligation is an equity instrument under the current definitions. The DM offers two alternatives: to account for the instrument as entirely a liability or entirely an equity instrument, depending on which component governs at issuance, or to account separately for the liability and equity components.

In present practice, only instruments that have physically separable components, such as bonds issued with detachable stock purchase warrants, are accounted for as part debt and part equity. The entire proceeds of issuing a convertible bond are accounted for as a liability because the debt and equity components cannot be traded separately. Some think that accounting misrepresents the amounts of the issuer's liabilities and effective interest cost. They contend that the accounting for instruments that have characteristics of both liabilities and equity should recognize their separate components.

For example, an enterprise might issue convertible bonds with a face amount of $50,000,000 and a coupon rate, payable semi-annually, of 7.8 percent when the market interest rate for otherwise comparable, nonconvertible bonds is 10 percent. Under present accounting, the entire proceeds of issuance would be recognized as a liability, and interest expense of $1,950,000 ($50,000,000 x 7.8% x.5) would be recognized each six months.

To recognize the debt and equity components of the bonds separately, a "withand-without" method might be used to allocate the proceeds to the components. The present value of the interest payments and the principal amount, calculated at the market interest rate of 10 percent for otherwise comparable nonconvertible bonds, would be recorded as a liability. The rest of the proceeds would be attributed to the conversion feature and credited to equity.

In the example, the resulting journal entry at issuance would be:

Cash $50,000,000

Convertible bonds $39,960,000

Paid-in capital-options

outstanding $10,040,000

The interest expense recognized each period would be based on the effective interest rate of 10 percent. The liability would be increased by the interest expense and reduced by interest paid to accrue the liability from the discounted value at issuance to its face amount at maturity.

in the example, the two alternatives would produce the following interest expense for the first year the bonds are outstanding: For the period january 1 to june 30, accounting for the governing characteristic would produce interest expense of $1,950,000. Likewise, for July 1 to December 31, it will produce $1,950,000. But, for the same periods, accounting separately for the components will produce $1,998,000 and $2,000,000, respectively.

Advocates of separate accounting for the components of a convertible bond argue that today's accounting impairs comparability between issuers of straight debt and issuers of convertible debt. An issuer of nonconvertible bonds with an investment grade credit rating may seem to incur the same effective interest rate as a lower-rated issuer of convertible bonds if the accounting does not recognize that purchasers of the convertible bonds receive both interest payments and a chance to obtain common stock at a favorable price as a return on their funds.

This could affect you

The issues in the DM on distinguishing between liability and equity instruments might eventually lead to significant changes in both balance sheets and income statements. The possible effects are not limited to companies that issue innovative financial instruments like "funny" preferreds or puttable common stock. Issuers of more traditional instruments like convertible bonds and employee stock options could be affected as well.

The deadline for submitting comment letters on the DM is December 31, 1990, and the FASB will hold a public hearing on the issues on March 25-27, 1991. We encourage you to participate in the FASB's due process on this important project. Read the DM. Share your views with the Board.
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Title Annotation:distinguishing between debt and equity instruments
Author:Kahn, Diana W.
Publication:Financial Executive
Date:Nov 1, 1990
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