Peeling away financial reporting issues one layer at a time

Accounting Convergence Dysfunction: The Case of the Liability/Equity Project

A recurring theme of my blogging is that financial accounting standards could (and should) be much simpler, and also much better if they were simpler. I have also placed some of the blame for the recent lack of progress, especially in the wake of the debt crisis, on the SEC's misguided and politically motivated emphasis on convergence with International Financial Reporting Standards. Just one case in point is the FASB/IASB convergence project on determining when a financial instrument that belongs on the right-hand side of the balance sheet should be classified as a liability or as equity.

As I described in a post from late 2007 (and here we are 2½ years later!) this project is a big deal. For any given company, liability classification could mean that a financial instrument would have to be fair valued (through net income, no less), but for a financial services company, the effect on  its debt/equity ratio could put it in the dog house of its prudential regulator.

Also, as I wrote in 2007, the FASB had finally, after 30(!) years, given up on trying to craft a revised definition for liabilities that would result in a sensible partitioning of the right side of the balance sheet. I took it as a sign of better things to come when the FASB finally declared, in its Preliminary Views document, that henceforth, the only items that would be admitted as equity were common stock and retained earnings. At long last, there was the distinct prospect of a simple, sensible and abuse-proof standard to put an end to the vicious cycle of rules-based standards and financially engineered evasive actions.

As it turns out, the putatively principled-based IASB blew off the FASB's principles-based approach and supplanted it with a potpourri of complex criteria for equity classification (the holy grail), replete with ambiguities that I am quite confident will be preserved in the final standard.  I'm certainly no financial engineer, but even I have espied obvious opportunities for window dressing. What follows is just one that came to mind without even having to think very hard.

The EPS Machine

According to the FASB's revised views, "instruments that require an entity to issue a specified number of its own perpetual equity instruments for no further compensation should be classified as equity (for example, prepaid forward contracts to issue shares)." Here's a recipe for making an EPS machine out of a prepaid forward contract classified as equity:

  • As of January 1, 20×1, Company A has 1000 common shares outstanding, and its current share price is $100. On that date the company enters into a prepaid forward contract to issue an additional 100 shares on December 31, 20×1. The January 1st prepayment amount is set at $100 per share (total of $10,000).
  • Net income for the year, before interest revenue on the $10,000 prepayment was $250.
  • Interest revenue from investing the $10,000 proceeds for one year at the risk-free rate of 10% was $1,000.
  • EPS before consideration of the forward sale of common shares was $.25 (=$250/1000 shares).
  • EPS including the effect of the forward sale and investment of the cash was $1.14 (=$1250/1100).
  • If the share issuance had taken place on December 31st, the issue price would have been $120 per share.

Thus, the effect of equity classification of the prepaid forward contract is to increase EPS by approximately 350%. This is in spite of the fact that the original shareholders (i.e., the only ones holding voting shares throughout the year) lost big time; they suffered a $2,000 loss from management's decision to sell forward at $100 per share, which was only partially offset by the $1,000 of interest revenue from investing the prepaid cash. From their point of view, therefore, net income for the year ended December 31, 20×1 was overstated by $2,000.

Would management have sold shares forward if the obligation to deliver shares had been classified as a liability and accounted for at fair value through net income? NO WAY! That's because the opportunity for (virtually) riskless accounting arbitrage would not have existed; and management might have spent more time, effort and resources on figuring out ways to create real value for its shareholders instead of the fictitious earnings from this bogus transaction.

I can think of at least two lessons from this example. First, standard setters and their staffs, having thought about this much longer than I have, must surely know that, as sure as the sun will set on the day you read my post, these particular complex and judgmental rules will create perverse incentives for managers that inevitably destroy shareholder value. Even if the FASB/IASB don't know exactly how it's going to happen, the fact that it will happen should be self-evident from history repeated 100-fold over at least the past 80 years.

Standard setters have a moral obligation to embrace a principles-based standard whenever they can. For no other "convergence" project is this moral obligation more evident. Instead, we must confront the irony that the accounting board associated with "principles" wants a rules-based standard, and the board associated with rules had admirably proposed a principle.

The second lesson comes from a question someone asked me yesterday: is it feasible for accounting to be principles-based in a world of complex contractual arrangements? I say yes, in part because rules-based accounting is itself responsible for the plethora of complex contractual arrangements to be accounted for. Unfortunately, however, those who navigate accounting standards loopholes for a living will have the IASB and "convergence" to thank for preserving their job security. As dysfunction abounds in the name of convergence, the inexorable destruction of shareholder value by the managers for whom window dressing trumps efficiency will continue unabated.

1 Comment

  1. Reply US Taxes May 8, 2010

    Good information about the case of liability

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