Accounting & Tax

Accounting Change Could Curb Stock Buyback Derivatives

Companies protest, as proposal would force companies to account for derivatives as liabilities.
CFO.com StaffMay 31, 2001

According to Dow Jones Newswires, U.S. corporations and investment banks are protesting a proposed accounting change that could effectively curtail the use of equity derivatives to hedge stock buyback programs.

In a barrage of letters to the Financial Accounting Standards Board, says Dow Jones, companies ranging from J.P. Morgan Chase & Co. to Microsoft Corp. say the change, if adopted, would make some derivatives much less palatable because it would force companies to account for them as liabilities. Currently, corporations can account for those derivatives as equity as long as the contract is settled in stock; switching them to a liability classification could make quarterly earnings results more volatile.

Companies use derivatives such as forward share repurchases or writing put options on their own stock for a variety of tax and hedging purposes during stock buybacks or employee stock option programs. Dow Jones reports that besides Microsoft, Cigna Corp., Eli Lilly & Co. and Intel Corp. have written letters critical of the proposal to the FASB on the matter.

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Nor are investment banks, which do a brisk business creating such structures for their corporate clients, thrilled by the prospect of unattractive accounting treatment, says the news service. J.P. Morgan Chase, Goldman Sachs Group Inc., Credit Suisse First Boston Corp., Deutsche Banc AG (G.DBK), UBS AG (Z.UBS) and Bank of America Corp. (BAC) all criticized the proposal in letters to the FASB, urging the body to keep the accounting rules unchanged.

Derivatives are not the biggest profit-generating product of investment banks but are still a useful revenue generator. A downturn in corporate consumption of such products wouldn’t have a meaningful effect on most investment banks’ earnings, but it’s still a business that they wish to defend, according to Dow Jones.

Under FASB’s tentative timeline, the change wouldn’t take place until June 2002, and the final rule could be altered in response to corporate concerns. But as it stands now, the proposal requires corporations to label an instrument equity only if they can demonstrate an “ownership relationship.” If a derivative’s value moves in the opposite direction of a corporation’s stock price – as many do – it would be considered a liability, even if the contract is ultimately settled in stock.

Currently, a company can write call options or put options against its stock, and classify either as equity as long as the contract is settled in its own shares. Earnings per share are affected by the contracts only if they wind up in the money, requiring new shares to be issued that would dilute existing stockholders’ stake, explains Dow Jones.

Under the FASB proposal, those call options would still be treated as equity, but written put options settled in shares would be considered liability simply because they move in the opposite direction of share price. The fluctuation in their value would be much more likely to affect earnings from quarter to quarter than under present accounting rules.

The idea behind the FASB’s proposal is to provide shareholders with a clearer view of the value of derivatives that corporations hold, says Dow Jones. The Association for Investment Management and Research, an organization for analysts and portfolio managers, has written in support of most of the changes, though it noted that the board’s definition of equity might be too restrictive.

Critics of the proposal argue that current accounting is clear enough, and the changes won’t make much sense to investors anyway. Over the next six months, FASB will be evaluating comments, and is likely to revise the proposal before releasing a final rule sometime in the second quarter of 2002, says Dow Jones.

How much it is expected to retreat from its original plan is subject to some debate. Traditionally, the FASB has tried to accommodate corporate concerns about accounting treatments, but Dow Jones says the board may still be smarting from its attempt last year to toughen standards for merger accounting. In that instance, the board backed away from a plan to force merged companies to amortize goodwill under purchase accounting methods, although it did go through with the elimination of pooling accounting. Its decision – made after heavy pressure from corporations and Congress – was roundly criticized by accounting purists, who claimed the final rule ended up allowing corporations to pump up earnings and assets, making mergers seem more lucrative than reality.

As a result, says the news service, board members may be loathe to drop the entire derivatives accounting project, as many critics are urging them to do, though they’re likely to make some changes.