Statement of Financial Accounting Standards No. 150 Developments in the FASBs Project to Examine the Accounting for Financial Instruments with Characteristics of Liabilities Equity or Both

This past May, the Financial Accounting Standards Board (FASB) released the
Statement of Financial Accounting Standards No. 150 Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity (SFAS
150). As a result, the balance sheets for many companies will change. SFAS 150
is the culmination of significant effort by the FASB, but only concludes a
first phase of the FASB's redeliberation of its October 2000 Exposure Draft,
Accounting for Financial Instruments with Characteristics of Liabilities,
Equity or Both (the Exposure Draft).<small>^{<a href="#2" name="2a">2</a>}</small>

</p><p>The FASB considers SFAS
150 a limited-scope statement. It provides guidance on certain freestanding
financial instruments that should be classified as liabilities (although they
may not be in current practice): (1) mandatorily redeemable instruments, (2)
instruments embodying obligations (or indexed to obligations) to repurchase an
issuer's equity shares by transferring assets and (3) certain instruments
that the issuer must or can choose to settle with equity shares.

</p><p>The
FASB has not reached a determination on certain other issues embodied in the
Exposure Draft, including separation of instruments with characteristics of
both liabilities and equity into components, accounting for noncontrolling
interests in consolidated subsidiaries, and the inclusion of ownership interest
concepts in revised definitions of liabilities and equity.

</p><p>Until
now, issuers have classified certain financial instruments with characteristics
of both liabilities and equity either entirely as equity or in a section on the
balance sheet between the captions "total liabilities" and
"equity" sometimes referred to as the "mezzanine."
Under SFAS 150, the obligations affected will be accounted for as liabilities.

</p><h3>Financial Instruments Affected</h3>

<p>SFAS 150 requires issuers to classify as liabilities (or assets in some
circumstances<small>^{<a href="#3" name="3a">3</a>}</small>) three classes of freestanding financial instruments<small>^{<a href="#4" name="4a">4</a>}</small> that
embody obligations for the issuer.

</p><p><i>Mandatorily Redeemable Financial Instruments.</i> These
instruments are those issued in the form of shares that include an
unconditional obligation for the issuer to redeem the instrument by
transferring cash or other assets to the holder at a specified date or upon the
occurrence of an event. The most common of these is mandatorily redeemable
preferred stock. Current practice classifies these securities in the mezzanine.
SFAS 150 eliminates this accounting and requires issuers to classify these
securities as liabilities.

</p><p>Some of these securities may embody a conditional obligation to redeem. In those
cases, the securities would be classified as equity until such time as the
event that is conditional occurs or the event becomes certain to occur. When
the condition is resolved, the security would be reclassified from equity to
debt. (SFAS 150 notes that securities for which the obligation to redeem is
conditioned on the death of the holder are liabilities at issuance. This
follows the old rubric that the only certainties in life are death and taxes.)

</p><p><i>Obligations to Repurchase the Issuer's Equity Shares by Transferring Assets.</i> Financial instruments such as forward-purchase
contracts, or written put options on the issuer's equity shares that are
to be physically settled or net-cash settled, are to be classified as
liabilities if at inception the financial instrument contains an obligation to
repurchase the issuer's equity shares (or is indexed to such an
obligation) and requires the issuer to transfer cash or other assets to settle
the obligation.

</p><p><i>Certain Obligations to Issue a Variable Number of Shares.</i> Financial instruments where the issuer must or may settle the
unconditional obligation by issuing a variable number of the issuer's
equity shares (rather than cash or other assets) are to be classified as
liabilities if the monetary value of the obligation is predominantly based on
either (a) a fixed monetary amount known at inception, (b) variations in
something other than the fair value of the issuer's equity shares or (c)
variations inversely related to changes in the fair value of the issuer's
equity shares.

</p><h3>Implementation and Impact on Financial Reporting</h3>

<p>SFAS 150 is effective for financial instruments entered into or modified after May
31, 2003. The statement is otherwise effective at the beginning of the first
interim reporting period beginning after June 15, 2003.<small>^{<a href="#5" name="5a">5</a>}</small> Accordingly, users of
financial statements will begin to see changes with the issuance of
third-quarter statements in mid-October.

</p><p>As previously noted, the financial instruments affected by SFAS 150 will be
classified as liabilities. The provisions of SFAS 150 will be applied to those
financial instruments outstanding at the beginning of the interim period of
adoption by reporting the cumulative effect of a change in accounting
principle, initially measuring the financial instruments at fair value or other
measurement attributes required by SFAS 150. SFAS 150 prohibits restatement of
financial statements for earlier periods presented by an issuer.

</p><p>Among other areas affected by the implementation of SFAS 150 will be the reporting of
dividends, interest expense and earnings per share. Items previously reported
as dividends will be reported as interest expenses, as may certain changes in
fair value of the financial instruments subsequent to initial valuation.

</p><p>Already, in the "Recently Issued Accounting Standards" section of their most
recent quarterly reporting since the release of SFAS 150, many companies have
indicated the application of SFAS 150 to financial instruments on their balance
sheets. Some, such as Sara Lee Corp. in its May 29, 2003, Form 8K, have
provided detailed disclosure on how SFAS 150 will affect $295 million of
preferred equity securities issued by a foreign subsidiary and currently
classified as "minority interest in subsidiaries." First Tennessee
National Corp., in its July 7, 2003, press release, has signaled that the
implementation of SFAS 150 will impact its net interest margin because of the
new treatment the expense associated with its trust-preferred and
REIT-preferred securities will receive when the statement is adopted in the
third quarter. Previously these costs were considered non-interest expenses.
And others, such as EaglePicher Holdings Inc. and American Skiing Co., while
currently presenting financial instruments in the mezzanine, do not anticipate
that the implementation of SFAS 150 will have any material impact on their
financial condition or results of operations.

</p><h3>Disclosures</h3>

<p>SFAS 150 requires the following disclosures.

</p><ol>
<li>The nature and terms of the financial instruments within the scope of SFAS 150
including:

<ul>
<li>the rights and obligations embodied in those instruments;
</li><li>information about the settlement alternatives, if any; and
</li><li>identity of the entity that controls the settlement alternatives.
</li></ul>

</li><li>For all financial instruments within the scope of SFAS 150, and for each
settlement alternative:

<ul>

<li>the amount that would be paid or the number of shares that would be issued and
fair value if the settlement had occurred on the reporting date;
</li><li>how changes in the fair value of the issuer's equity securities would
affect those settlement amounts;
</li><li>the maximum amount the issuer would be required to pay to redeem the instrument
by physical settlement, if applicable;
</li><li>the maximum number of shares that could be issued, if applicable;
</li><li>if applicable, that the contract does not limit the amount that the issuer
would be required to pay or the number of shares the issuer could be required
to issue; and
</li><li>for a forward contract or an option indexed to the issuer's equity
shares, the forward price or option strike price, the number of shares to which
the contract is indexed and the settlement date or dates of the contract, as
applicable.
</li></ul>
</li></ol>

<h3>Conclusion</h3>

<p>SFAS 150 resolves certain questions of balance-sheet "geography" between
the classification of debt and equity providing a framework for determining the
status of the financial instruments within its scope. With companies
implementing SFAS 150 in the third quarter of 2003 and early 2004, financial
statement analysts and other financial statements users must be alert to
evaluate the statement of operations and balance-sheet impact of the
implementation on their analyses. Unless already considered, the changes
required by SFAS 150 may impact compliance with lending agreements and
covenants as financial instruments move from the mezzanine or equity to
liabilities.

</p><hr>
<h3>Footnotes</h3>

<p><small>^{<a name="1">1</a>}</small> James M. Lukenda is a managing director in Huron Consulting Group's Corporate Advisory Services practice. The current president of the Association of
Insolvency and Restructuring Advisors, he has wide experience in accounting, financial and operating matters related to corporate reorganizations. <a href="#1a">Return to article</a>

</p><p><small>^{<a name="2">2</a>}</small> See Lukenda, James M., "New Standards for Distinguishing Between Liabilities and Equity May Be Close at Hand," <i>ABI Journal,</i> Vol. XIX, No. 8, October 2000. <a href="#2a">Return to article</a>

</p><p><small>^{<a name="3">3</a>}</small> Some instruments that have characteristics of both debt and equity, in some circumstances, also have characteristics of assets. An example provided in SFAS 150 is a forward contract to purchase the issuer's equity securities that is to be net cash settled. <a href="#3a">Return to article</a>

</p><p><small>^{<a name="4">4</a>}</small> A freestanding obligation is "a financial instrument that is entered into separately and apart from the entity's other financial instruments or equity transactions, or that is entered into in conjunction with some other transaction and is legally detachable and separately exercisable (SFAS 150, Appendix D)." <a href="#4a">Return to article</a>

</p><p><small>^{<a name="5">5</a>}</small> The effective date for mandatorily redeemable financial instruments of nonpublic entities is the fiscal period beginning after Dec. 15, 2003. <a href="#5a">Return to article</a>