Distinguishing liabilities from equity - A first step

Point of view Feb 14, 2017

We support taking a holistic view of the model for distinguishing liabilities from equity, but interim improvements can be made.

Targeted improvements would help to simplify the liability versus equity decision

  • Companies often enter into financial instruments that straddle the line between liability and equity
    classification in the financial statements. These instruments are becoming increasingly common and
    complex as markets evolve.
  • Although based on sound fundamentals, the model for distinguishing liabilities from equity can be difficult to apply—making the determination of classification challenging. This is, in part, because the model can result in different classification for instruments with minor differences in contractual terms. And, classification is not solely a balance sheet matter. It also drives whether or not the income statement is impacted.
  • The FASB requested feedback on whether to add a project on distinguishing liabilities from equity to its agenda. Based on the challenges with applying the current model, we encourage such a project.
  • While we believe the FASB should ultimately take a holistic view of the model, our recommendation is to wait until completion of a project on performance reporting. It is important to know how a liability or equity would be represented in the performance statement before deciding on classification. Given the time it may take to address performance reporting and then reconsider the liability and equity model, we support targeted improvements to the guidance and enhanced transparency through disclosure as an interim step that will simplify the accounting evaluation and reduce costs to preparers.

 

Liability versus equity: The case for change 

Investments in private companies – balancing opportunity and risk
Investments in private companies – balancing opportunity and risk
Investments in private companies – balancing opportunity and risk
Investments in private companies – balancing opportunity and risk
Investments in private companies – balancing opportunity and risk
Investments in private companies – balancing opportunity and risk
Investments in private companies – balancing opportunity and risk

Background

The FASB first added a project related to distinguishing liabilities from equity to its technical agenda in 1986. Since that time, various aspects of this accounting have been revisited multiple times. Today, as financial markets evolve and become more complex, financial instruments are also becoming increasingly complex.

It has been challenging for the accounting standards to keep up with the pace of change. The current literature, although grounded in fundamental concepts, has been subject to multiple patches that addressed narrow issues as they arose, leading to guidance that is more dependent on legal form than economic substance. As a result, the model does not always result in classification that reflects the economics. Given the complexity, the FASB recently solicited feedback on whether it should add a project on distinguishing liabilities from equity to its agenda.

"The topic is a source of errors and significant confusion because of complexity and difficulties with interpretation and application."

Source: FASB Invitation for Comment

The current model

Today’s model is based on the idea that instruments with creditor rights are liabilities and instruments with ownership rights are equity. Equity-type instruments that include creditor-type rights from events outside the control of the company are mezzanine equity or a liability. While the model is conceptually sound, it is not simple to apply.

The complexity arises in deciding which features offer creditor rights and which offer ownership rights, that is, which features will result in the company surrendering assets and which will result in surrendering a residual interest. And, how should instruments that offer both be classified? Other challenges include how to measure, and when and how to premeasure, each instrument depending on how it’s classified. 

Interaction with performance reporting

In addition to a liabilities and equity project, the FASB sought feedback on whether to add a project on performance reporting. A performance reporting project could include categorizing the income statement into operating and nonoperating activities or separating earnings components with different characteristics to enhance users’ understanding of them.

Given the potential for a performance reporting project, there is a possibility that changes will be made to the income statement and other comprehensive income. Today, one reason the classification of liabilities versus equity matters is because changes in liabilities are recorded in the income statement while changes in equity are not. 

 

 

Limiting the models for convertible instruments

We recommended that remeasurements be separately presented, and that is one of the paths forward the FASB is considering. If that or a similar change is made, users could distinguish the impact of a liability’s remeasurement from the rest of the results of a company’s operations. This could alleviate some of the concern with the determination as to whether a financial instrument is classified as a liability or equity.

As such, we recommend that the FASB first tackle performance reporting before performing a comprehensive review of the model for distinguishing liabilities from equity. Because of the considerable amount of time such projects may take, we suggest two targeted improvements as an interim step: (1) limit the accounting models for convertible instruments and (2) disregard remote scenarios in the evaluation of classification.

Limiting the accounting models for convertible instruments

Currently, four models exist for convertible debt:

For convertible preferred stock, these four models apply, and the issuer also needs to consider presentation within mezzanine or permanent equity. The number of models makes accounting for convertible instruments unnecessarily complex. To simplify the analysis, we propose adopting one model for all convertible instruments. We believe development of a separation model that incorporates elements of the derivative model and the cash conversion model would better reflect the economic substance of convertible instruments and move US GAAP closer to the accounting for convertible debt under IFRS.

Under our approach, companies would separate the conversion feature from the debt or preferred stock, whether or not the conversion feature is accounted for as a derivative. If the separated feature needs to be accounted for as a derivative, it is a liability. If it is not accounted for as a derivative, it is included in equity. The FASB would have to research the method of allocating value to the host and conversion options, but we believe the goal should be to have the income statement reflect the “interest” cost. This could be done by measuring the separated feature at fair value at issuance, with the remainder going to the debt.


Removing remote scenarios may result in fewer liabilities

Consideration of remote scenarios

The current accounting model for distinguishing liabilities from equity requires an issuer to consider any possibility under which cash settlement of an instrument could occur no matter how remote. When a scenario exists under which cash settlement could be deemed outside the issuer’s control, the accounting presumes cash settlement and liability or mezzanine equity classification is required.

For example, to assess classification a company must consider whether it has sufficient authorized and unissued shares available to settle an equity instrument, such as a warrant. If there is even a remote scenario when there would not be sufficient authorized and unissued shares available to settle the instrument, the instrument would be classified as a liability. Liability classification would be required even if the company has a history of obtaining shareholder approval to increase its authorized shares.

Our recommendation is to create a model that disregards events that could require cash settlement if they have a remote chance of occurring. This would result in accounting that better reflects the economic substance of the transaction and would also more closely align with the accounting under IFRS in which contingent settlement provisions that are extremely rare, highly abnormal, and very unlikely to occur are not considered in the classification conclusion.

Disclosure

Because different users may view the various claims on the company in different lights, the Board should consider enhanced disclosure requirements that would describe the key features of these financial instruments, along with their classification and liquidation preference.

In conclusion

As financial instruments become more complex, the evaluation of whether to classify those instruments as liabilities or equity also becomes more challenging. The existing guidance is complex, even for seasoned professionals, and different accounting outcomes can arise from subtle differences in contractual terms that are often non-substantive.

We believe the FASB should take a comprehensive approach to revising the guidance for distinguishing liabilities from
equity after completion of a project on performance reporting. Until then, we recommend targeted improvements to the model. These include: (1) limiting the accounting models for convertible instruments to focus on a single model that more faithfully represents the economics of the instrument and (2) enabling preparers to disregard remote scenarios in evaluating equity versus liability classification. These improvements will simplify the classification determination as liability or equity until a holistic reconsideration of the model can be completed.

 

 

  

Video perspectives

Companies often finance operations with securities that have characteristics of both debt and equity.  PwC’s Jonathan Rhine discusses three frequently encountered pieces of guidance, in the order they’re often considered: 1) Liabilities valued through earnings, 2) Embedded derivatives and 3) Mezzanine classified instruments. The accounting outcome can vary significantly based on the type of instrument issued and the literature that's applicable.


 

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Beth Paul
US Strategic Thought Leader, National Professional Services Group
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