Peeling away financial reporting issues one layer at a time

Making Myself Clearer on the Topic of Liabilities and Equity

I made a conscious decision to eschew formulas in my recent post on the difficulty the FASB has had in creating a standard that results in a reasonable classification of liabilities and equity.  An exchange of emails with Accounting Onion reader David Harper now makes me think that my approach wasn’t as clear as it could have been — especially since David is the founder and principle contributor to www.bionicturtle.com, a popular financial training website.  He is also the author of the financial statements tutorial on investopedia.com.  So, if it ain’t clear to him, I’ve got some explainin’ to do.

Following David’s comments, I’m going to organize this supplement to my original analysis into two parts: classification and measurement.

Classification of Liabilities and Equities: Past versus Future

The accounting model, according to the FASB’s conceptual framework, looks like this:

Assets – Liabilities = Owners’ Equity

The variables on the left side are defined independently, so therefore, owners’ equity is supposed to be strictly defined as assets minus liabilities.  However, the reality that emerged over time through actual financial reporting standards looks like this:

Assets – Liabilities – Other Stuff = Owners’ Equity

Until recently, “other stuff” consisted of:

  • Deferred taxes (reclassified as a liabilities in FAS 109)
  • Minority interest in consolidated subsidiaries (relcassified as owners’ equity in FAS 141R
  • Equity financial instruments subject to mandatory redemption (only some reclassified as liabilities in FAS 150). 

This “other stuff” was part of the motivation to come up with better classification rules for liabilities and owners’ equity.  As I described in my earlier post, the attempt to base standards on an indepdent definition for liabilities ran into a lot of political resistance that did little but create high-paying jobs for financial engineers and super-specialized accountants in the national offices of the Big Four auditing firms.  That’s why the FASB is proposing to turn the model on its ear, if you will, so that it looks like this:

Assets – Owners’ Equity = Liabilities

At the same time, the definition of owners’ equity will admit initial recognition of only the most common of common stock, plus retained earnings.

What About Measurement of Liabilities and Equities

Now that owners’ equity has been moved to the left-hand side, will the approach to its measurement change?  No.  For measurement purposes, owners’ equity is still the residual, as in my first equation, above.  So, we’ll actually employ two formulations of the relationship among basic balance sheet elements: one for classification (i.e., initial recognition), and another for measurement. 

David realized that this dual approach might be a possibility, and I think it may have been a source of his confusion.  It certainly seems strange, but that is what is being proposed.  And, I support it.  That’s because the FASB has utterly and shamefully failed to reign in 30 years of chaos.  I generally am predisposed to support incremental changes, but in this case, the FASB has little choice but to throw everything out and start again from scratch.

David, thanks again for your comments, and I hope this clarifies some aspects of my earlier post for all.

2 Comments

  1. Reply David Harper December 30, 2007

    Tom
    Thank you, that’s helpful. I’ve had a chance to look at the source doc; I see now why “you are filled with hope.” The logic of classifying only equity, er, into equity is totally solid. On a technical level, I’d love to see this happen. It raises interesting questions, as you earlier suggested, about the treatment of derivatives (e.g., it is so frustrating to see consultants fob off SARs instead of options onto companies in pursuit of accounting games) and convertibles (where I suppose a lack of separation is the sometimes price you’d pay for simplicity of the basic ownership approach) and about the measurement of EPS. On a political level, I didn’t think FASB was this brave; does this have any hope? You mentioned the implication of options going to “exercise date valuation” under this approach. I was around for a lot of the FAS 123R debate, and gosh i can’t imagine some folks letting this happen…in my humble opinion, a core problem is the perception that bottom-line earnings/EPS matter. Why are tech companies so resistant to expensing options, for example? Because they perceive that (reported) earnings matter. They’ve been convinced of that. But under either system, the current (i.e., where the earnings is almost useless because so much is hidden) or the proposed (i.e., where it will fall underneath explicit charges that will nonetheless require deconstruction), the reported earnings is just the line item that happens to be at the bottom – a fine place to start but not the only place to start…but thanks for the updates, it is really great to see plain-English sensible interpretation of the latest accounting developments!

  2. Reply Independent Accountant January 7, 2008

    I don’t fault the FASB for 30 years of chaos. I fault the Big 87654. The problem is: they don’t get sued often enough! If the fear of multi-billion dollar lawsuits was really in these guys, they would say things like, “I don’t care what that mechanically looks like. It has no economic substance. Forget it”.

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