Convertibles: Get Ready to Leverage Up

FASB prefers an accounting method for hybrids that could add a whole lot more liability to corporate balance sheets.
David KatzMay 23, 2007

Taking a page from Ebert and Roeper, the Financial Accounting Standards Board wants the door to the mezzanine permanently closed.

That’s not the mezzanine section of an old movie theater or opera house. Rather, it’s the vague middle ground where issuers of hybrid financial instruments—those that have characteristics of both stocks and bonds—avoid permanent balance-sheet classification. Instead of being tagged as either liabilities or equities on corporate balance sheets, convertibles currently can be booked as “temporary” equity.

While mezzanine financing would fall into this accounting netherworld, that’s not what FASB is bothered by these days. Indeed, there are many other kinds of financial instruments—puttable stock, stock options, and convertible equity and debt, for instance—that have found their way into accounting limbo. Half-jokingly alluding to the growing complexity of such instruments, FASB chairman Robert Herz has referred to the difficulty of classifying such things as “callable convertible puttable preferred stock.”

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Speaking at a recent financial reporting conference at Baruch College in New York City, Herz called the question of how to book such debt-equity mongrels one of the more troubling issues in corporate accounting. Whether there can and must be a bright line between equity and liability have been subjects for debate, he pointed out. Rather than draw sharp distinctions, some accountants would prefer to change the traditional accounting equation (assets – liabilities = equity, in one version) to assets = claims, thereby shedding the need to draw a bright line, the FASB chief noted.

For his part, Herz seems to like the bright line. Earlier this month, he was one of six FASB members who expressed a preference for a new accounting method that could be used to shut down the mezzanine. (Only one member, Ed Trott, who will retire from the board in June, preferred another method.) Called the “ownership method,” it could produce key changes in financial statements—changes that could add liabilities to corporate balance sheets and reduce net income. If it goes into effect, “the mezzanine would disappear,” says Ronald Lott, FASB’s senior technical advisor on the project. “Everything would be liability or equity.”

For instance, if the change went into effect, companies would be able to switch the classification of puttable shares and other borderline securities from equity to liability. And that, says Charles Mulford, a professor of accounting at Georgia Tech, “would make leverage appear higher.” In some cases, a burgeoning liability line might put corporations in violation of their debt covenants, he adds.

Under the ownership method favored by FASB, there would be an extremely narrow definition of equity. Only two types of instruments would fall on the equity side of the balance sheet. One would be “perpetual” instruments, which provide holders with the right to be paid interest at fixed dates indefinitely into the future, but supply them with no right to get their principal back. The other type would be “direct ownership” instruments—including common but not preferred stock–in which the holders are the last ones paid if there’s a bankruptcy. All other instruments would be classified as either a liability or an asset.

The only case in which an instrument would be reported as both equity and liability would be when there’s the possibility of a distinct non-equity payment and, after the payout, an equity share would remain outstanding (for example, a stock with required dividend payments).

While the difficulty in classifying instruments with mixed features is nothing new, their growing prevalence and complexity has moved FASB to consider changing the current system, according to Lott. “A lot of people are combining a lot of bells and whistles in the same instrument, whereas they wouldn’t be in the same instrument before,” he says, noting that many more convertible issues have call and put options than in the past.

Further, the current system is “a kind of hodgepodge,” with “no necessary underlying theme or consistency,” the FASB expert says, suggesting that the hybrid issue has opened up some considerable gaps in GAAP. For example, the opportunity cost a company assumes when holders of convertible debt switch their investment to stock doesn’t show up as an expense on the income statement.

Because previous accounting standard setters considered the sale of convertible stock an investor-to-investor transaction with no effect on the issuer, they failed to take into account the cost to existing shareholders. “The penalty for issuing those shares at less than market price just doesn’t show up anywhere,” says Lott.

Overall, the FASB official says, the board would like to have issuers record hybrid instruments as “either fish or fowl, debt or equity.” What it wants to avoid is having them classified as both.