Narrowing the Equity GAAP

FASB proposes limiting which financial instruments can be considered equity, opening the door to more liabilities on corporate balance sheets.
Sarah JohnsonDecember 3, 2007

The Financial Accounting Standards Board has proposed a new way of classifying financial instruments that could have characteristics of both liability and equity.

FASB’s new approach would draw the line between these financial instruments, constricting the scope of those that could be classified as equity. For example, companies would have to record forward contracts, options, and convertible debt as either liabilities or assets.

In a “preliminary views” document released on Friday, the board said the changes would simplify financial reporting by creating a single standard meant to replace the 60-plus piecemeal guidelines have that caused confusion for accountants and auditors and led to many restatements. FASB member Tom Linsmeier has called the new approach “a major change to current accounting and reporting.”

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The 72-page document released for public comment is the result of a complex technical debate that has been going on at FASB for many years. And the effect is a seemingly simple directive: Any instrument that does not fall into FASB’s “basic ownership instrument” label should be classified as either an asset or liability. Simply put, “claims against the entity’s assets are liabilities (or assets) if they reduce (or enhance) the net assets available to the owners of the entity,” the board wrote in the document.

To be sure, the effect of this change will not be considered so simple for companies’ confidence. It will bring liabilities onto corporate balance sheets for some instruments that have been reported as equity, FASB project manager Jill Switter told It could also reduce net income, when you consider that those instruments that have traditionally been considered equity have had no effect on net income.

Moreover, Charles Mulford, a Georgia Tech accounting professor, theorized to earlier this year that FASB’s change “would make leverage appear higher,” raising the possibility that corporations would be in violation of their debt covenants as their liability threshold expands.

Basic ownership instruments include common stock whose owners are the last ones paid during a liquidation. Therefore, they do not include preferred stock.

There are some limited circumstances where financial instruments could still be separated into either the liability or equity category, Switter says. For instance, a share’s registration rights penalty could be recorded as a liability, whereas the share itself would be recorded as an equity. However, “the staff was only able to find very limited situations where that would happen,” Switter says.

At the same time, companies would have to split up the parts of financial instruments that have both a basic ownership component and a liability component. Those instruments would be reported as if they were two “separate freestanding” items, according to the FASB document.

FASB chose the basic ownership method over two other choices its board members had debated because the approach will provide more useful information for investors’ decision-making and for its simplicity. FASB notes that investor groups, such as the CFA Institute, have been calling for a more principles-based view of equity. Because it requires a narrow definition of equity, the board wrote, the concept “provides fewer opportunities than the other approaches to structure instruments and arrangements to achieve a desired accounting treatment.”

The board has dropped its previous view that “perpetual” instruments could join basic ownership instruments in the equity category. Perpetual instruments give holders claim to paid interest at fixed rates indefinitely but do not have a settlement requirement. FASB also says that derivatives of a company’s basic ownership instruments must be classified as liabilities or assets.

The Preliminary Views on Financial Instruments with Characteristics of Equity is available for comment until May 30. Next year, the International Accounting Standards Board will release the document to its own constituents for a simultaneous comment period. And then both boards will review the comments and begin deliberating on a joint standard as part of its ongoing convergence efforts.