FASB and the Liability-Equity Split

Instruments that have characteristics of both liability and equity have long been a thorny issue for the board. Separately, the PCAOB outlined next...
Craig SchneiderOctober 11, 2005

Breaking up is hard to do in love — and in accounting. For the Financial Accounting Standards Board, one of its biggest technical challenges has been a project addressing the separate classification and measurement of a financial instrument that has characteristics of both liability and equity.

Last week FASB continued to discuss the issue, which over the years has become “much harder than I thought it would be,” according to board member Michael Crooch. The difficulty has been in devising a rule that consistently divides the instrument, he explains, while also yielding an answer that makes sense to all board members — and is not subject to being circumvented by “very smart people on Wall Street.” Convertible debt is the classic example, notes Crooch: The instrument could be paid off as a debt, or it could be exchanged for shares (that is, converted to equity).

During last week’s discussion, the board examined the use of an “obligation first approach” to measure the separate liability and equity components of a financial instrument. In this approach, a calculation would first be made of the largest liability amount; the total value of the instrument, minus that obligation, would be the equity portion.

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The FASB staff intends to present an alternative approach at a future meeting; so far, all suggestions for handling the tricky classification of such instruments have raised objections from board members. “It’s still a work in progress,” says Crooch, who would not speculate whether the issue would be resolved by year-end.

Separately, the board decided not to add a new project to its agenda that would revisit the definition of cash equivalents in Statement No. 95, Statement of Cash Flows, regarding the classification of auction-rate securities. According to Crooch, the majority of board members felt the agenda was “very full” and that the problem was not a priority.

As for the Public Company Accounting Oversight Board, last week the PCAOB held a meeting of its standing advisory group to obtain feedback on proposed 2006 standard-setting activities. They include:

Engagement quality review, particularly at smaller public accounting firms.
Fraud detection, in areas such as auditing related-party transactions and appropriate use of confirmations.
Communications with audit committees, including whether and how current practices should be reflected in the auditing standard.
Principles of reporting. The meaning of “present fairly in conformity with GAAP,” consistency, and adequacy of disclosure; and whether FASB Statement No. 154 needs revision.
Fair value (including use of specialists). The PCAOB is gathering information as it waits for FASB to finalize its own standard.
Risk assessment, including audit planning, procedures, and evaluations of audit findings.
Independence quality controls. The board is considering a separate standards project.
Codification of PCAOB standards and authority of PCAOB interim standards.

During his opening remarks at the PCAOB meeting, chief auditor Douglas Carmichael also mentioned some upcoming guidance that’s working its way through the board’s pipeline:

Reports on the implementation of SAS 99 are expected within a couple of months. These reports will identify what’s working (and what isn’t) in the implementation of SAS 99, which concerns auditor responsibility for fraud detection, and the implementation of Standard No. 2, which was written in response to the Section 404 internal-control provisions of Sarbanes-Oxley. No firms or public companies will be named in the reports, noted Carmichael.

Staff Q&As on auditing fair-value measurements related to stock-based compensation are also expected soon. These are pursuant to Statement 123R, which requires the expensing of employee stock options.

Next week, FASB is scheduled to discuss:

• Whether and how to proceed with final guidance for a practical exception to the application of grant date under 123R;

• Whether and how to issue a proposed staff position about the useful life and amortization of intangible assets;

• Clarifying the disclosures for proposed guidance on measuring the fair value of certain derivative contracts under Statement 133.

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