Note: Some very helpful comments on my most recent post have led me to conclude that I made some factual and logical errors. Fortunately, though, my main message, that stock issuance costs should be recorded as an expense, is not affected; but the path to that conclusion has been altered enough for me to want to start with a clean slate. Hence, I have withdrawn my previous post, and offer this one as a substitute. To my readers who may have already read the earlier post, or receive enough stuff from me via email, I apologize.
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I haven’t written for a few weeks, mainly because traveling and teaching at SMU has taken up a lot of my time. Now that the semester is over (except for finals-related activities), I’m eager to get going my blog going again; and this post is about a long-festering peeve that came to a boil recently when discussing the topic of share issue costs with my students.
My larger peeve (which I hope is shared by many) is the failure of the FASB to provide a clear definition of an expense. According to Concepts Statement No. 6, expenses are “…outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, [footnote omitted] rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.” [¶ 81]
That definition is pretty good, and as I will describe later, the FASB has utilized it well when it promulgated FAS 123R; but it could be clearer in two respects. First, the phrase “ongoing major or central operations” is vague, and doesn’t fit in all cases. For example, interest on debt has long been reported as an expense (from APB 21, pre-dating the conceptual framework), yet most folks with just an undergraduate business degree know enough to distinguish financing activities from “central operations.” Debt issue costs, it seems, are similar enough to interest costs to have been counted as an expense as well.
In contrast to debt issue costs, though, the costs of issuing equity is not specifically addressed in GAAP, and practice has been to charge paid-in capital in lieu of expense recognition. The observation that debt usually (don’t forget perpetual bonds) has a maturity date, and that equity does not, is often cited as a justification for the disparity; but, as even the “conceptual” definition of an expense would indicate, that is merely a distinction without constituting a difference that should matter.
Unfortunately, the SEC staff effectively endorsed the wacky treatment of equity issue costs when it issued Staff Accounting Bulletin No. 1 (Topic 5.A of the Codification of SABs), which also pre-dated the conceptual framework. Among many other topics, it addressed whether costs incurred in contemplation of an equity issuance could be deferred until the offering actually occurs. That portion is brief enough to quote verbatim:
A. Expenses of Offering
Facts: Prior to the effective date of an offering of equity securities, Company Y incurs certain expenses related to the offering.
Question: Should such costs be deferred?
Interpretive Response: Specific incremental costs directly attributable to a proposed or actual offering of securities may properly be deferred and charged against the gross proceeds of the offering. However, management salaries or other general and administrative expenses may not be allocated as costs of the offering and deferred costs of an aborted offering may not be deferred and charged against proceeds of a subsequent offering. A short postponement (up to 90 days) does not represent an aborted offering.
[bold italics supplied]
The second part of the conceptual definition of an expense that lacks clarity is that phrase “outflows or using up of assets.” It doesn’t clearly distinguish between the resource that is being used up and the method of payment, which could be anything that reduces (or dilutes) the interests of a present common shareholder in the net assets of the entity.
To its everlasting credit, however, a later generation of FASB members finally had the gumption to call a halt to the stock option charade when it promulgated FAS 123R. Essentially, the Board clarified, despite withering pressure to state otherwise, that the resource being used up is employee services; and even though the method of payment (e.g., stock versus cash) could affect measurement, it does not affect recognition.
Surely, if you paid a consultant with stock options you would not ignore the cost of the consulting services. So, why should you ignore the stock issuance costs you paid to an investment banker?
If I were writing the concepts statements today, I would clarify that there are three fundamentally different types of expenses:
- Use (or using up) of productive resources — like inventory, equipment and employee services;
- Payments to stakeholders (e.g., debt holders) other than the present holders of common shares;
- Payments to government authorities as taxes, etc.;
and then I would clarify that the form of payment does not affect the determination of whether an expense has been incurred.
By the FASB’s definition of an expense, and as clarified in FAS 123R, stock issue costs are clearly an expense, but I wish that the definition were written in a way that makes this clearer. Among other things, I would want my students to be able to plainly see that when they are reducing paid-in capital for stock issue costs instead of recognizing an expense, they are following rules of GAAP that the FASB cannot justify on the basis of its conceptual framework.
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I suppose that when compared to the big issues the FASB is currently deep in the mucky muck, stock issue costs is small potatoes, but I hope this post will be regarded as more than a pedagogical cavil from an old professor. Stock issue costs in an IPO are always big bucks to the issuer; and they can be highly material if post-IPO growth profitability is inconsistent with the ‘story’ told by the prospectus. And with crowdfunding looming, the topic gains in significance for policymakers.
The SEC has essentially been twiddling its thumbs on everything except that misbegotten convergence project for the last ten years. It’s time the staff started earning their pay again. Rescinding SAB Topic 5.A would be an excellent place to start, but it should also ‘encourage’ the FASB to address the topic of stock issue costs, so as to make the accounting treatment consistent with both debt issue costs, stock-based compensation — and the conceptual definition of an expense.