Peeling away financial reporting issues one layer at a time

Liabilities and Equity: FASB Turns Accounting on Its Ear

I am happy to report that the FASB’s recently issued Preliminary Views document entitled Financial Instruments with Characteristics of Equity fills me with cautious optimism that, at long last, the FASB may actually be able to create a principles-based accounting standard. 

The Games Companies Play on the Right-Hand Side of the Balance Sheet

In the halcyon days of the 1970s when accounting was purportedly more "principles-based", a popular scheme of companies was to create financial instruments that were owners’ equity in name only.  The objective was to report cash expenditures as dividends associated with a variant of preferred stock, instead of income-reducing interest expense associated with debt.

In recent years, particularly since FAS 133 has required fair value accounting for all derivatives within its scope, new games were invented. One of my favorite schemes exploited a loophole in EITF 00-19 involving written put options.  To qualify as owners’ equity (thereby avoiding fair valuation with gains and losses to earnings), a company issuing the put options on their own stock had to retain the ability to settle in cash or stock. Solely because of the favorable accounting treatment for this weird arrangement, companies rushed to make sizable bets that their stock price wouldn’t go down in exchange for a modest premium for writing the put option. (Would they make the same bet on the stock of another company?  Nope.  That’s because they wouldn’t get the same sweet accounting treatment.)  It so happens that this particular trick was ill-timed, as stock prices sank with the bursting of the dot-com bubble.  Many companies ended up losing hundreds of times the amount of the premium — with nary a blip on the income statement, or a whisper to shareholders about the evaporation of cash or share dilution until judgment day was nye upon them.

A Thirty Years Accounting War

The FASB’s project on distinguishing liabilities from equities may not have begun officially until 1986, but the SEC teed it up seven years earlier in Accounting Series Release No. 268.  Abuses of the supposedly fuzzy border between liabilities and equity had been rampant for years, and the SEC felt they couldn’t wait any longer for the FASB to take some kind of stand — any stand.

Out of admirably restrained deference to the FASB, whom they exhorted to do the heavily lifting via a project that would be concluded within a reasonable time, new SEC rules (Reg. S-X, Rule 5-02.28) addressed only one particular abuse, so-called "redeemable preferred stock."  But, I can’t help wondering what ASR 268 would have looked like if: (1) the SEC had even an inkling that after almost thirty years, the most fundamental principles would still be unresolved, and ASR 268, which was intended to be temporary, is still needed; and (2) the rules produced thus far would be an unintelligible and inconsistent hash of 60 separate pronouncements

At the risk of oversimplification (and to be charitable), the underlying problem that the FASB had been grappling with all this time boils down to, believe it or not, a constraint inherent in the Fundamental Accounting Equation.  If you have an equation with three variables (assets, liabilities, owners’ equity), only two of the variables can be defined independently and the third variable must be defined in terms of the other two.  Thus far, the FASB’s approach has been to attempt to establish independent definitions for assets and liabilities — and to define owners’ equity by default as assets minus liabilities. 

The asset/liability approach, which has been enshrined in the FASB’s Conceptual Framework, seems reasonable; but, they have failed to follow up with coherent rules, largely due to political forces that eroded the will to adhere to this simple constraint.  By defining some kinds of equity independent of assets and liabilities (certain derivatives in a company’s own stock, for example), the inevitable result is a soupy right-hand side of the balance sheet, ripe for creative engineering of financial instruments to achieve a desirable accounting result. 

Peace in Our Time?

I was a doctoral student at the time ASR 268 was issued, when one of my professors, the late John Shank, explained to us that enterprising managers will always be looking to create transactions (and value for themselves) by devising transactions that are consistent with accounting rules, while completely inconsistent with their intent and spirit.  John’s maxim goes a long way toward explaining how this sorry state I have been describing has come to pass.

But, as I started to tell you, I am now filled with hope — a rare and heady feeling for me when it comes to the future of financial reporting! The title of the preliminary views documents indicates right from the start that a fundamental shift in approach is contemplated.  Henceforth, assets and owners’ equity would be independently defined — and liabilities would be equal to assets minus owners’ equity.  The approach, if adopted, should work, if owners’ equity can be defined to be strictly limited to common stock plus retained earnings. 

Thus, everything else on the right-hand side will be reported as liabilities. Much of the fun and profit will be taken out of financial engineering for an illusory accounting result, and may actually focus managers on figuring out how to make real money.  Here are some examples of implementation issues that are likely to raise hackles:

  • Stock options granted to employees would be classified as liabilities.  Because they are derivatives, they would fall within the scope of FAS 133 and fair valued, with changes in value going to earnings.  In effect, we would be shifting from grant-date valuation to exercise-date valuation.
  • FASB clearly intends to value all financial instruments that are not owners’ equity at fair value, so shifting financial instruments like preferred stock from equity to liabilities will add even more volatility to earnings.
  • Minority interest has just recently been reclassified to owners’ equity and renamed non-controlling interests.  Will that position be reversed?

As always, regulated business will cry foul and insist that accounting standards must serve them, too. And now, for the sake of accounting convergence, we’re supposed to care about banks in Europe as well?  On the bright side, this may be the time and place where the FASB finally understands that the needs of regulators and even regulated companies should not hinder them from serving the needs of investors.  … Perhaps I’m getting too hopeful. 

Is this going to take another 30 years?  Should it take even more than one year?

 

1 Comment

  1. Reply David Harper December 25, 2007

    Thanks for the helpful context and this great blog!
    But I do not get how the “solved for” variable changes from equity to liabilities. My read is that under basic ownership, they have moved the line that separates liabilities from equity “down” as far as possible. Below it is only the residual; above it, some items that used to qualify as equity are now liabilities.
    But isn’t it true that the equity is still the residual (the book value that remains after assets – liabilities). I understand that formerly items like derivatives are now assets/liabilities, but I don’t get how liabilities are the plug variable – aren’t all of the liabilities valued independently such that (the smaller) equity is still the residual?

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