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Firm Overview More Liabilities Will Be Recorded Under Proposed Accounting Rules
December 2007
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The Financial Accounting Standards Board (FASB) proposed significant revisions to the classification of debt and equity in financial statements. The proposal would limit the transactions that could be classified as equity.
Absent modification of underlying loan agreements, the proposed rules will make it difficult for some companies to meet debt to equity restrictions. The new pronouncements will also reduce income for those companies that must reclassify instruments as equity. This occurs because transactions and costs associated with equity do not affect the income statement, while all other transactions (like debt and related interest) do. The cost associated with the restated transactions will now be included in the income statement, instead of being shown as direct changes in stockholders’ equity.
The most obvious change will be for preferred stock. The FASB dropped its previous view that “perpetual” instruments could join “basic ownership instruments” (i.e., common stock) in the equity category. Perpetual instruments give holders a claim to fixed amounts indefinitely (even though called dividends), and do not have a repayment or settlement requirement.
Common stock and other derivatives must also be classified as liabilities or assets.
The debate on these topics has gone on for years. There are currently 60-plus piecemeal guidelines on this subject currently. As evidence of how complicated certain financial instruments and the related rules have become, the FASB’s simplification still takes 72 pages to explain. According to the proposal:
“The current literature is inconsistent, subject to structuring, or difficult to understand and apply. … The complexity has caused many questions and numerous restatements over the past few years.”The pronouncement is a move to a more principles-based approach to accounting. In the FASB’s words, the more narrow definition of equity “provides fewer opportunities than the other approaches to structure instruments and arrangements to achieve a desired accounting treatment”. If the proposal is implemented, these more creative transactions that previously recorded equity will no longer be attractive to their issuers.
The FASB will accept written comments on their proposal until May 30, 2008. The International Accounting Standards Board (IASB) intends to release the same requirements in early 2008 for a simultaneous comment period. Both accounting boards will then review comments and issue a joint statement as part of the ongoing accounting convergence efforts.
Fulcrum Inquiry is a licensed CPA firm. We perform financial investigations, forensic accounting and business valuations.