New Accounting Standards for Distinguishing Between Liabilities and Equity May Be Close at Hand

At its June 28, 2000, meeting, the Financial Accounting Standards Board (FASB) reached tentative
conclusions related to its longstanding project on distinguishing between liabilities and equity (the
"project"). Those conclusions are still tentative and do not change current accounting. While the effective
date of any final pronouncement may be years away, these tentative conclusions provide insight into the
current thinking on accounting for compound and other debt/equity instruments subject to the project.

Many debt or equity instruments are fairly easy to classify. Examples include straight bonds and common
stock. A straight bond entails a contractual agreement on the part of the issuer to repay the bondholder with
an amount of the issuer's cash or other assets representing the original principle and interest. It does not
convey any of the risks or rewards of ownership in the issuer. The straight bond imposes an obligation for
performance upon the issuer. Accordingly, it is a debt instrument and the issuer records it as a liability on
the issuer's financial statements. Common stock, on the other hand, conveys the risks and rewards of
ownership but imposes no performance by the issuer until or unless the issuer declares the dividend.
Common stock is an equity instrument and the issuer records it in stockholders' equity.

Other instruments are not so easily classified. Examples would include preferred stock that has a
mandatory redemption option, a preferred stock that at the issuer's option can be exchanged for notes
payable and convertible debt. These and other types of financial instruments may have components that
raise questions about the liability or equity nature of the instrument.

History of the Liabilities and Equity Project

The FASB first added a project to consider issues related to classifying financial instruments with
characteristics of liabilities, equity or both to its agenda in 1986. After considering the responses to its
August 1990 Discussion Memorandum, "Distinguishing Between Liabilities and Equity Instruments and
Accounting for Instruments with Characteristics of Both," in the early 1990s, the project was largely
inactive until December 1996. The FASB's June 28 actions are the next step in the process of issuing new
standards. Once the staff of the FASB prepares a ballot draft for its formal vote, an exposure draft of a new
standard will be released for comment from industry, the accounting profession and other interested parties.
The exposure draft is scheduled for release during the third quarter of this year.

Matters Considered by the FASB

The focus of the project has been largely on classification issues. The current path the FASB is taking
would involve unbundling or bifurcating the accounting for instruments that have both debt and equity
components. This would entail splitting out the components of the instrument that are like debt from those
that are like equity, valuing those separate components, and separately classifying and accounting for each
component. The concept of unbundling the separate components of an instrument is not new. Paragraphs
6-11 of Accounting Principles Board (APB), Opinion 14, "Accounting for Convertible Debt and Debt
Issued with Stock Purchase Warrants" (issued March 1969), discuss the pros and cons of such an approach.
However, the FASB's predecessor board opted not to require the unbundling of convertible debt in APB
Opinion 14.

In addition to the "unbundling" question, the project dealt with how the instruments should be split up
and how they should be classified. The FASB's "obligations-based" approach requires that:

• (i) components that require or allow the holder to require the issuer to settle the obligation by
  transferring assets would be classified as liabilities;
• (ii) components that require or allow the issuer to settle in the equity securities of the issuer would be
  classified as equity if the component is settleable with a fixed number of the issuer's shares.
  Components settleable with a variable number of shares to satisfy an obligation that is fixed would
  initially be classified as liabilities.

Other matters concluded by the FASB include the classification of minority interests, a new model for
derivatives indexed to the issuer's own stock price, and how to determine when instruments should be
combined and possibly split up again. Two topics on the agenda that are yet to be addressed are how and
when components may change from being a liability to equity and vice versa, and the earnings per share
and income tax accounting issues arising from the unbundling approach to classifying compound financial
instruments.

Issues for Issuers of Financial Statements

Convertible Debt: Both issuers and holders would separate convertible debt into two components. One
component, the warrant to issue the entity's own equity, would be classified as an equity instrument. The
second component would be straight debt, issued at a discount. Because the debt discount resulting from
the bifurcation will be accreted as interest expense over the term of the debt, issuers of convertible debt will
report higher interest expense in their financial statements. For those issuers not already required to
bifurcate their convertible debt under FASB Statement No. 133, "Accounting for Derivative Instruments
and Hedging Activities," possible issues include compliance with interest coverage ratios in existing debt
agreements.

Redeemable or Mezzanine Securities: Redeemable preferred stock and trust-preferred securities are
currently classified in the "mezzanine" (not equity and not debt). The FASB's current thinking would
eliminate this accounting and require issuers to classify most mezzanine securities as liabilities. This may
have a significant impact on the debt-equity ratios of issuers of these types of securities.

Minority Interest: The FASB's conclusions include the requirement that minority interests be classified
as equity in consolidated financial statements. This is a major and potentially troublesome change from
current practice. Recognition of gains and losses (through the income statement, in many circumstances)
on dispositions of partial interests in subsidiaries has been part of generally accepted accounting principles
for many years. It may be very difficult and costly for some entities to compute amounts for restatement.
Some entities also will experience covenant issues under current debt agreements as a result.

Equity Derivatives: Some derivative instruments indexed to the issuer's equity will no longer be
considered equity instruments based on the FASB's tentative conclusions. The FASB concluded that a
security that is net settleable in the issuer's equity is classified as an asset or liability if the holder's return
does not move in the same direction as changes in the value of the underlying equity shares. Accordingly,
contrary to current accounting, equity derivatives where the holder is short are assets or liabilities under the
FASB's model. Reclassifying as assets or liabilities such instruments as forward purchase agreements and
written options indexed to the issuer's equity, and marking them to fair value, will have a significant
income statement and balance-sheet effect on companies that use these instruments.

Conclusion

With an exposure draft still to be issued and the required comment period and hearings, the effective
date on any final pronouncement may be years away. Nevertheless, issuers of compound or other
instruments subject to the project should begin anticipating the implications today. The FASB appears to
have concluded that it will allow some sort of restatement upon transition, but it is unlikely that previously
issued but still outstanding instruments will be grandfathered completely. Further information on the
Liabilities and Equity project and the FASB's tentative conclusions may be found at http://www.rutgers.edu/Accounting/raw/fasb/tech/index.html. Click on Project Updates.