Evaluation of the FASB's Proposed Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both: AAA Financial Accounting Standards Committee. (Commentary)

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INTRODUCTION

The October 27, 2000 FASB Exposure Draft, Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both, (hereafter the ED) provides criteria for classifying financing instruments--financial instruments used for financing purposes--or their components as either liabilities or equity on firms' balance sheets. It responds to the fact that financing instruments and firms' capital structures have become so complex that firms' balance sheet classifications of these instruments are conceptually problematic and cross-sectionally inconsistent. For example, some firms classify complex financing instruments, such as mandatorily redeemable preferred stock, in the "mezzanine" between the liability and equity sections of the balance sheet, while others classify the same instruments as liabilities or equity. Because the mezzanine is not acknowledged in current accounting concepts or standards, its meaning is vague and its use inconsistent. The Committee supports the FASB's development of standar ds to classify financing instruments in a consistent and conceptually sound fashion. However, we also recognize that this task involves various difficult conceptual and practical issues. This article discusses these issues and makes recommendations.

To highlight the distinct classification and valuation issues across different types of instruments, we distinguish and define below the following classes of financing instruments:

* Simple

* Compound, with:

* separable components

* inseparable components

* Hybrid

The most difficult issues arise with inseparable compound and hybrid financing instruments.

A simple financing instrument has a single component that is either straight debt or common equity. A compound financing instrument consists of multiple components; at least one is a liability and one is equity. The components of a compound financing instrument may be separable, meaning that the components can be independently valued through their lives. A bond with an attached warrant is a separable compound financing instrument. Alternatively, when the components of a compound financing instrument are inseparable, the instrument has liability and equity components that can be defined separately for valuation purposes, but the instrument's ultimate payoff is either as a liability or as equity, not both. Convertible debt is an inseparable compound financing instrument. A hybrid financing instrument has characteristics of a liability and equity but does not have distinct components that are straight debt or common equity. Preferred stock is a hybrid instrument.

This article summarizes the Committee's four main comments on the ED. (1)

1) The ED classifies most complex financing instruments as liabilities, yielding a very heterogeneous set of liabilities and an artificially narrow set of equities. This decreases the usefulness of the balance sheet both for assessing a firm's solvency and for valuing its residual claims.

2) The ED does not clearly link the classification of financing instruments on the balance sheet to the related costs on the income statement, rendering analysis of the two financial statements through ratios such as return on equity difficult.

3) The ED's classification of hybrid and inseparable compound financing instruments relies on contractual provisions such as mandatory redemption rather than economic substance.

4) The ED bases the valuation of inseparable compound instruments on the relative fair values of the components, with embedded options valued incrementally above the value of the host instrument. This approach does not properly reflect the following two factors:

a) the probabilities that these instruments will be settled as debt or equity, and

b) the joint values of multiple, interacting options.

Because reliable valuation is generally difficult for inseparable compound financing instruments, expanded measurement guidance is needed. …