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.