At its June 28, 2000, meeting, the Financial Accounting Standards Board (FASB) reached tentative conclusions related to its longstanding project on distinguishing between liabilities and equity (the "project"). Those conclusions are still tentative and do not change current accounting. While the effective date of any final pronouncement may be years away, these tentative conclusions provide insight into the current thinking on accounting for compound and other debt/equity instruments subject to the project.

Many debt or equity instruments are fairly easy to classify. Examples include straight bonds and common stock. A straight bond entails a contractual agreement on the part of the issuer to repay the bondholder with an amount of the issuer's cash or other assets representing the original principle and interest. It does not convey any of the risks or rewards of ownership in the issuer. The straight bond imposes an obligation for performance upon the issuer. Accordingly, it is a debt instrument and the issuer records it as a liability on the issuer's financial statements. Common stock, on the other hand, conveys the risks and rewards of ownership but imposes no performance by the issuer until or unless the issuer declares the dividend. Common stock is an equity instrument and the issuer records it in stockholders' equity.

Other instruments are not so easily classified. Examples would include preferred stock that has a mandatory redemption option, a preferred stock that at the issuer's option can be exchanged for notes payable and convertible debt. These and other types of financial instruments may have components that raise questions about the liability or equity nature of the instrument.

History of the Liabilities and Equity Project

The FASB first added a project to consider issues related to classifying financial instruments with characteristics of liabilities, equity or both to its agenda in 1986. After considering the responses to its August 1990 Discussion Memorandum, "Distinguishing Between Liabilities and Equity Instruments and Accounting for Instruments with Characteristics of Both," in the early 1990s, the project was largely inactive until December 1996. The FASB's June 28 actions are the next step in the process of issuing new standards. Once the staff of the FASB prepares a ballot draft for its formal vote, an exposure draft of a new standard will be released for comment from industry, the accounting profession and other interested parties. The exposure draft is scheduled for release during the third quarter of this year.

Matters Considered by the FASB

The focus of the project has been largely on classification issues. The current path the FASB is taking would involve unbundling or bifurcating the accounting for instruments that have both debt and equity components. This would entail splitting out the components of the instrument that are like debt from those that are like equity, valuing those separate components, and separately classifying and accounting for each component. The concept of unbundling the separate components of an instrument is not new. Paragraphs 6-11 of Accounting Principles Board (APB), Opinion 14, "Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants" (issued March 1969), discuss the pros and cons of such an approach. However, the FASB's predecessor board opted not to require the unbundling of convertible debt in APB Opinion 14.

In addition to the "unbundling" question, the project dealt with how the instruments should be split up and how they should be classified. The FASB's "obligations-based" approach requires that:

• (i) components that require or allow the holder to require the issuer to settle the obligation by transferring assets would be classified as liabilities;
• (ii) components that require or allow the issuer to settle in the equity securities of the issuer would be classified as equity if the component is settleable with a fixed number of the issuer's shares. Components settleable with a variable number of shares to satisfy an obligation that is fixed would initially be classified as liabilities.

Other matters concluded by the FASB include the classification of minority interests, a new model for derivatives indexed to the issuer's own stock price, and how to determine when instruments should be combined and possibly split up again. Two topics on the agenda that are yet to be addressed are how and when components may change from being a liability to equity and vice versa, and the earnings per share and income tax accounting issues arising from the unbundling approach to classifying compound financial instruments.

Issues for Issuers of Financial Statements

Convertible Debt: Both issuers and holders would separate convertible debt into two components. One component, the warrant to issue the entity's own equity, would be classified as an equity instrument. The second component would be straight debt, issued at a discount. Because the debt discount resulting from the bifurcation will be accreted as interest expense over the term of the debt, issuers of convertible debt will report higher interest expense in their financial statements. For those issuers not already required to bifurcate their convertible debt under FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities," possible issues include compliance with interest coverage ratios in existing debt agreements.

Redeemable or Mezzanine Securities: Redeemable preferred stock and trust-preferred securities are currently classified in the "mezzanine" (not equity and not debt). The FASB's current thinking would eliminate this accounting and require issuers to classify most mezzanine securities as liabilities. This may have a significant impact on the debt-equity ratios of issuers of these types of securities.

Minority Interest: The FASB's conclusions include the requirement that minority interests be classified as equity in consolidated financial statements. This is a major and potentially troublesome change from current practice. Recognition of gains and losses (through the income statement, in many circumstances) on dispositions of partial interests in subsidiaries has been part of generally accepted accounting principles for many years. It may be very difficult and costly for some entities to compute amounts for restatement. Some entities also will experience covenant issues under current debt agreements as a result.

Equity Derivatives: Some derivative instruments indexed to the issuer's equity will no longer be considered equity instruments based on the FASB's tentative conclusions. The FASB concluded that a security that is net settleable in the issuer's equity is classified as an asset or liability if the holder's return does not move in the same direction as changes in the value of the underlying equity shares. Accordingly, contrary to current accounting, equity derivatives where the holder is short are assets or liabilities under the FASB's model. Reclassifying as assets or liabilities such instruments as forward purchase agreements and written options indexed to the issuer's equity, and marking them to fair value, will have a significant income statement and balance-sheet effect on companies that use these instruments.

Conclusion

With an exposure draft still to be issued and the required comment period and hearings, the effective date on any final pronouncement may be years away. Nevertheless, issuers of compound or other instruments subject to the project should begin anticipating the implications today. The FASB appears to have concluded that it will allow some sort of restatement upon transition, but it is unlikely that previously issued but still outstanding instruments will be grandfathered completely. Further information on the Liabilities and Equity project and the FASB's tentative conclusions may be found at http://www.rutgers.edu/Accounting/raw/fasb/tech/index.html. Click on Project Updates.

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