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

By Ryan, Stephen G.; Herz, Robert H. et al. | Accounting Horizons, December 2001 | Go to article overview
Save to active project

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


Ryan, Stephen G., Herz, Robert H., Iannaconi, Teresa E., Maines, Laureen A., Palepu, Krishna, Schrand, Catherine M., Skinner, Douglas J., Vincent, Linda, Accounting Horizons


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.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
Loading One moment ...
Project items
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited article

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

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

While we understand printed pages are helpful to our users, this limitation is necessary to help protect our publishers' copyrighted material and prevent its unlawful distribution. We are sorry for any inconvenience.
Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.

Are you sure you want to delete this highlight?