86 AAA Financial Reporting Policy Committee
Response to the FASB’s PreliminaryViews on Financial Instruments with the Characteristics of Equity 87
Source: https://eds-b-ebscohost-com.ezproxy.umgc.edu/eds/pdfviewer/pdfviewer?vid=5&sid=96c79cb4-4203-4771-8341-1dc85206983dsessionmgr101COMMENTARY
Response to the FASB’s PreliminaryViews on
Financial Instruments with the Characteristics of Equity
FinancialAccounting and Reporting Section of theAmericanAccounting Association—Financial Reporting Policy Committee
Patrick E. Hopkins (chair and principal co-author); Christine A. Botosan, Mark T. Bradshaw (principal co-author); Carolyn M. Callahan,
Jack Ciesielski, David B. Farber, Mark Kohlbeck, Leslie Hodder (principal co-author); Robert J. Laux, Thomas L. Stober,
Phillip C. Stocken, and Teri Lombardi Yohn
INTRODUCTION
The Financial Reporting Policy Committee Committee of the Financial Accounting and Reporting Section of the American Accounting Association AAA is charged with responding to discussion papers and exposure drafts related to financial accounting and reporting issues.1 The Committee is pleased to respond to the Financial Accounting Standards Board’s FASB Preliminary Views on Financial Instruments with the Characteristics of Equity PV.2
The FASB issued the PV in response to an “increase in classification issues” related to liabilities and equity para. 7. It is argued that these classification issues arose because of an increasing array of complex financial instruments, which have made the straightforward identification of “debt” versus “equity” more difficult. The FASB contends that the current accounting standards for classifying securities as debt or equity depend more on legal form than on economic characteristics. Accordingly, the FASB expresses concern over perceived abuses by managers
This comment letter was developed by the members of the Financial Reporting Policy Committee of the Financial Accounting and Reporting Section of the American Accounting Association and does not represent an official position of the American Accounting Association.
The Committee is independent of the Financial Accounting Standards Committee FASC of the American Accounting Association.
On February 28, 2008, the International Accounting Standards Board IASB issued a related Invitation to Comment, Financial Instruments with the Characteristics of Equity. The Committee also prepared and submitted to the IASB a version of this letter.
Submitted: June 2008
Accepted: November 2008
Published Online: February 2009
Corresponding author: Patrick E. Hopkins
Email: peh@indiana.edu
85
engaged in financial structuring to achieve favorable financial reporting treatment. Much of the FASB’s concern is over a wedge between debt versus equity classification of a particular security and the means by which the security is ultimately settled. For example, “stock issuance is a readily accepted substitute for cash payment because if the markets are deep and liquid the two are interchangeable for many entities.” Because an entity’s stock is not an asset of the entity, the obligation to deliver common stock is generally interpreted to not satisfy the definition of a liability contained in the FASB’s 1985 Statement of Financial Accounting Concepts SFAC No. 6, Elements of Financial Statements. Furthermore, given the perceived arbitrary nature of the actual physical form of settlement i.e., assets, such as cash, versus an entity’s stock and the complexity of the authoritative literature related to liabilities and equity e.g., the PV refers to more than 60 pieces of authoritative literature within its scope, the PV suggests that the existing accounting guidance causes an unacceptable level of nonsubstantive, financial-reporting-outcomefocused transaction structuring.
Although the FASB has considered numerous approaches for distinguishing debt and equity, the PV describes three possible equity-attribute-based approaches for distinguishing equity instruments from nonequity instruments these nonequity instruments are usually liabilities, but sometimes are assets: basic-ownership BO, ownership-settlement OS, and reassessed-expected outcomes REO. The BO approach restricts equity to include only the basic-ownership interest, defined as the most subordinated interest in the assets of an entity; all other securities are considered debt. Accordingly, securities such as preferred stock, certain mandatorily redeemable shares, employee stock options, and written call options would be classified as debt. The OS approach expands the classification of equity to include perpetual instruments such as preferred stock and instruments ultimately settled by issuance of the basic-ownership interest, such as employee stock options. The REO approach is the most expansive in the classification of instruments as equity, as it includes as equity instruments or components of instruments those for which the counterparty payoff is related to the price of the basic-ownership instruments; thus, hybrid instruments with convertible features would include both debt and equity components.
The PV explicitly indicates the FASB’s preliminary decision that the BO approach is the most appropriate for identifying the financial instruments that should comprise equity. The body of the text in the PV discusses the BO approach exclusively; the OS and REO approaches are discussed in Appendices A and B, respectively. Although all three approaches include instruments that satisfy the definition of a “basic-ownership instrument,” the BO approach limits reported equity to the residual claim embodied in the i.e., one basic-ownership instrument. The OS and REO approaches are not quite as restrictive in their definition of equity; for example, the OS approach includes in equity 1 the basic-ownership instrument; 2 other instruments that are ownership interests in legal form; and 3 other contracts settled in basic-ownership instruments or whose price is determined by prices of basic-ownership interests. The FASB rejects both the OS and REO approaches because of a presumed level of complexity embedded in the classifications under these approaches that exceeds that in the BO approach.
Appendix E of the PV summarizes the extensive history of the liabilities-and-equity portion of the financial-instruments project. During this time, the AAA FASC 1993, 1999, 2001 published three comment letters related to liability-and-equity classification issues, and members of the organizing committee for the 2004 AAA/FASB conference published an award-winning commentary related to accounting for liabilities Botosan et al. 2005. The conceptual and research-related analyses included in those four published papers are germane to the fundamental issues underlying the distinction between equity and liabilities. Although we refer to these published commentaries in the present letter, the Committee strongly recommends that the FASB and staff refer to AAA FASC 1999, 2001, and Botosan et al. 2005 as input for this PV.
Before addressing any of the method-specific issues in the PV, the Committee wishes to express its concern that the scope of the PV is much more expansive than the usual transaction, event, or instrument-specific accounting matters typically addressed in past standard setting releases. Instead, the PV proposes completely new attributes-based definitions for a heretofore residually defined, primary financial statement element i.e., equity. The Committee believes that the financial statement elements have a position of primacy in our accounting model and should be redefined only as part of a comprehensive reanalysis of the conceptual framework.
The Committee is aware that the FASB and IASB have undertaken a joint, comprehensive conceptual framework project; however, we are concerned that the definition of equity is being re-deliberated in an isolated, stopgap project that 1 is intended to correct specific perceived abuses by reporting entities and 2 appears to be largely independent of the preliminary, theoretical, elements-related work being conducted on the conceptual framework project. In some ways, the PV’s apparent de facto rejection of the current conceptual framework definition of the liabilities element, along with its primary focus on curtailing transaction structuring, is reminiscent of past concerns expressed about the Committee on Accounting Policy and the Accounting Principles Board Storey and Storey 1998, 46.
In general, the Committee is not convinced that proposed financial reporting alternatives and, in this case, a wholesale reclassification of instruments inconsistent with the definition of the elements should be evaluated primarily on the dimensions of relative simplicity or the ability to curtail transaction structuring. Although we concur that simplicity is desirable, ceteris paribus, we view transactional or reporting complexity as a financial reporting constraint, rather than an objective. The Committee also believes that a goal of reducing nonsubstantive, reporting-outcomefocused transaction structuring is likely better addressed by regulators e.g., the Securities and Exchange Commission, rather than by standard setters.
The PV solicits comments on 22 separate issues, 11 of which are related to the basicownership BO approach favored by the Board. The remaining 11 issues relate to the two preliminarily rejected approaches described in the PV i.e., the OS approach and the REO approach and other potentially unidentified approaches the Board should consider. Our letter will not individually address many of the detailed, method-specific questions presented in the PV. Instead, although we will address common elements of each of the proposed approaches, we will focus much of our commentary on the relatively new, narrow construction of equity operationalized under the BO approach. Specifically, we focus on just the first issue raised in the PV that solicits views on the preferred BO approach. The following questions raised by the FASB are examined in the sections that follow:
1 Are the principles underlying the BO approach clear?
2 Are the principles underlying the BO approach appropriate?
3 Would the BO approach significantly simplify the accounting for instruments within the scope of the PV?
Based on our analysis of these questions, the Committee concludes that the principles underlying the BO approach are not clearly defined, are not appropriate given the extant conceptual framework, and will not simplify accounting for instruments that are within the scope of the PV. Specifically, the principles are not clear because the articulated definition of priority is based either on subordination or liquidation, whereas the operational criteria appear to be based on dilutionrelated factors. Furthermore, the principles are not appropriate because they are inconsistent with the extant conceptual framework and would significantly increase the heterogeneity of financial instruments reported in liabilities. This increased heterogeneity will also likely lead to reduced decision usefulness of reported liabilities and equity information. Although such a mechanistic approach could simplify the process of balance sheet classification, any simplification gained via a single-instrument equity class is likely quite small in comparison with the significantly increased complexity in the definition, measurement, and interpretation of reported net income and comprehensive income. Finally, the Committee concludes that the suggested identification criteria for a basic-ownership interest i.e., the only financial instrument classified in equity under the BO approach fails to evaluate important characteristics of ownership interests; thus, the equityclassification simplicity derived from the BO approach appears to be illusory. We address the questions raised by the FASB in the following sections.
ARE THE PRINCIPLES UNDERLYING THE BO APPROACH CLEAR?
The PV defines a basic-ownership instrument as the lowest priority claim; thus, the definition of equity has the apparently desirable attribute that it does not depend on the definition of a liability. However, under the proposed accounting, the definition of equity now depends on the definition of the lowest priority claim, which the Committee concludes is ambiguously specified in the PV. For example, within the PV, the lowest priority claim is described variously as 1 legally subordinated to other ownership interests footnote 2; 2 having the lowest priority in liquidation footnote 10; and 3 conceptually subject to dilution of value by other ownership interests para. 68. As the Committee outlines in the following discussion, each of these notions of priority is distinct, and they are neither equivalent nor internally consistent. More importantly, the Committee’s analysis suggests that the basic-ownership-instrument definition is not operational for even the least-complex instruments.
Priority Based on Legal Subordination
By definition, legal subordination must derive from statutory, contractual, or equitable enforceability. Therefore, legal subordination is state, context, and jurisdiction dependent. For example, an instrument may be legally subordinated only with respect to bankruptcy-contingent distributions or with respect to certain contractually specified decision rights. Junior, or reducedvoting, common stock is an example of a common form of legal subordination with respect to decision rights in the United States. Legal subordination of decision rights may be combined with other types of legal subordination or legal preferences. In Germany, junior shares are often called preference shares because reduced-voting shares typically have a preference for current dividends. However, neither junior shares nor preference shares typically has legal priority in liquidation. The identification, evaluation, and weighting of important context-dependent combinations of contractual provisions i.e., establishing legal subordination and legal priority are not described in the PV.
Also unclear in the definition of lowest priority is whether the subordinated decision rights included in junior shares, ceteris paribus, are sufficient to result in equity classification of the junior shares because they meet the definition of basic-ownership interests, resulting in liability classification of the super-voting common shares i.e., those with increased voting rights relative to other classes of common shares. Just as the exercise of common stock warrants can dilute the proportionate claims of existing common stockholders, the exercise of decision rights can dilute the proportionate claims of shares with subordinated decision rights. For example, when Proctor & Gamble Co. acquired Wella AG, the subset of shares with subordinated decision rights were offered a 30 percent lower price than super-voting common shares despite their equal claim to distributions in involuntary liquidation. Scenarios such as these suggest that the financial claims of nonvoting instruments may be classified as equity because they can be legally subordinated by the exercise of decision rights held by another class of seemingly equity-like instruments.
The Committee’s uncertainty about the effect on classification of subordinated decision rights highlights a fundamental and significant conceptual impediment to consistent application of the BO approach: classifying equity based on the relative contractual or statutory priorities of financial claims effectively divorces the concept of equity from the concept of control. In our analysis, this could potentially result in equity comprising entirely nonvoting or minimally voting claims i.e., common stock that reflects residual claims but has no or low voting rights relative to other classes of common stock.
Priority Based on Liquidation Standing
A second type of priority described in the PV, priority in liquidation footnote 10, is another type of contractual or statutory subordination. As a practical matter, operational or experienced priority in liquidation settings often arises from economic compulsion or reputational concerns rather than legal enforceability. Thus, we do not view priority in liquidation as equivalent to legal subordination. However, as a working definition used to ascertain the lowest priority claim, priority in liquidation gives rise to many of the same ambiguities as legal subordination because it is state and context dependent.
Liquidation can encompass two broad types of business termination: voluntary and involuntary. Because either type of liquidation event is entirely hypothetical and quite rare at any given measurement date for a going concern, classifiers need to construct a hypothetical scenario. If an instrument has priority only in bankruptcy, can priority of that instrument be extrapolated to solvency, or must insolvency be assumed to prioritize the claims? If insolvency is assumed, and the value of a particular claim under an insolvency scenario is always zero, would that instrument’s priority in liquidation be considered the lowest? In practice, both voluntary and involuntary liquidations may involve negotiated settlements among the claimants that deviate from prenegotiation contractual or statutory claims. How should the potential for negotiated settlements be factored into the intended hypothetical liquidation scenario?
Involuntary liquidations may be governed by statute or subject to the discretion of a bankruptcy trustee. Should adjudication be factored into the hypothetical liquidation scenario taking into account the attributes of particular legal or political jurisdictions? In the absence of applicable contract, statutory, or case law, or outside the scope of contractually specified decision rights, how will subordination or priority in liquidation be determined? The Committee concludes that the concepts of legal subordination and priority in liquidation were not sufficiently described or made operational in the PV.
Priority Based on Dilution
Defining the lowest priority claim as a claim that is subject to dilution of value by other claims is independent from legal subordination and priority in bankruptcy. Common equity may be subject to dilution by many financial instruments that do not have priority in liquidation. Unvested options are one example. Hence, this definition and the ones based on legal subordination and priority in liquidation do not result in consistent classification of instruments.
As an independent construct, dilution of value is inadequate to distinguish liabilities from equity. Paragraph 68 describes a situation where the increase in the value of one claim reduces the value of another claim. Under the BO approach the transferee class of wealth would be classified as a liability and the transferor class would be classified as equity. We note that all claims are subject to “wealth transfers” among the claimants. If compensatory options expire out of the money, then option holders become the transferors of the fair value of the goods and services previously provided, and common stock holders become the transferees. Wealth transfers between and among debt holders and equity holders is a fundamental tenet in finance. Repurchase of one class of common stock will reduce the assets available for distribution to other classes of stock. Because the values of all claims are potentially dilutive or reduce assets available to satisfy the other claims, we do not believe that this attribute alone is sufficient to distinguish debt from equity.
For these reasons, the Committee observes that the underlying principles of the BO approach are unclear. The following exercise illustrates our concerns. Without consulting Table 2 in the PV, we attempt to classify claims related to the following two examples, using only the criteria provided in the BO approach.
Example 1
Note 16 of Berkshire Hathaway’s 2007 annual report states that “each share of Class B common stock has dividend and distribution rights equal to one-thirtieth 1/30 of such rights of a Class A share,” but that “each share of Class B common stock possesses voting rights equivalent to one-two-hundredth 1/200 of the voting rights of a share of Class A common stock.” Berkshire Hathaway’s Class A and Class B shares appear to have meaningful differences between them. Is Class B stock the lowest priority claim? If so, then Class B is considered equity, leaving the super-voting Class A stock to be classified as a liability.
Example 2
Company B has common stock and unvested or out-of-the-money compensatory stock options outstanding. Are the unexercised options the lowest priority claim?
Table 1 illustrates our analyses.
Table 1 in this letter summarizes our application of the BO approach to two specific examples. In each case, we arrive at an equity amount that comprises entirely noncontrolling and/or nonvoting claims and the classification as liabilities of controlling common shares. This occurs because the identification of a basic-ownership interest under the BO approach necessarily results in classification of all other claims as liabilities.
Table 2 in Appendix C of the PV contains examples of how the three proposed approaches would classify 25 different financial instruments. The instrument in Example 1 in this comment letter is not included in the set of examples included in Table 2 of the PV. The instrument in Example 2 in this comment letter is equivalent to item 8 in Table 2 of the PV; however, we obtain a different answer using the BO definitions of least priority claim. Specifically, we classify options as equity, rather than liabilities. The rationale for the PV’s classification of options is tied to the dilutive effect that options may have on equity. However, as we note above, dilution is a bidirectional concept that can also occur within the set of financial instruments included within liabilities and within equity. Moreover, our classification is more consistent with Paragraph 58 of the PV that states that nonequity claims are at least partially protected from risk by basicownership instruments, and their share of rewards is limited. Although the share of rewards i.e.,
Example Instrument
TABLE 1
Illustrative Examples of BOApproach
Lowest priority claim according to
Preliminary Views?
Legally subordinated?
Subordinated in liquidation?
Subject to wealth transfers or dilution by other claims?
Example 1:
Berkshire-
B shares
Yes—Decision rights are subordinated to A shares
No
Yes—Any
disproportionate
change in value of A shares e.g., because of clientele effects changes the proportionate value of B shares.a
Yes—Neither class has contractual priority in liquidation. Each class can dilute the value of the other, but only the B shares have inferior decision rights that could affect value in liquidation.
Example 2: Unvested or out-ofthe-money
ESOs
Yes—ESO holders have no legal claim on any assets or distributions.
Decision rights are also subordinated because shares under option are nonvoting.
Yes—Unvested ESO
holders typically have no statutory or contractual priority in involuntary
liquidation, but answer may differ for voluntary liquidation e.g., “golden parachute”.
Yes—The common owners can approve dividends, thereby reducing the value of outstanding options and increasing common claims. A negative asset outcome can render the options worthless.
Yes
a An analysis of price data reveals that between 1996 and 2008, the closing price of Berkshire B deviated from its theoretical value of 1/30 of the A share price by an average of 1.6 percent. However, the deviation was as large as 15 percent on some days, and the price deviation increased during periods of price volatility. The B shares were “underpriced” approximately 59 percent of the time and “overpriced” 35 percent of the time.
upside returns for options is unlimited, options are not protected from risk by basic-ownership interests because their value can become zero well before the value of common equity becomes worthless.
ARE THE PRINCIPLES UNDERLYING THE BO APPROACH APPROPRIATE?
We limit our evaluation of the appropriateness of the principles underlying the BO approach to an evaluation of two criteria. First, is the proposed approach consistent with the conceptual framework? Second, does the proposed approach increase decision usefulness of the financial statements?
We use these two criteria because we believe that consistency with the conceptual framework is the most important attribute of a financial accounting standard. Furthermore, internal consistency of accounting standards with the conceptual framework is important to their understandability and effectiveness. Although we recognize that the IASB and FASB have undertaken a joint revision of the conceptual frameworks, no consensus on modifications has been reached to date.
The Committee’s framework for evaluating the appropriateness of the BO approach is consistent with Chambers’ 1970, 82 observations about the design of complex systems:
A complex system is a contraption for doing complex things. Commonly, it consists of subsystems, each doing or designed to do its own thing, but each designed to fit into and be part of the complex system. No subsystem in a well-designed system is inconsistent with the whole system … if it were, we would not call such a system well designed, for inconsistencies will require additional subsystems to offset them.
First, we evaluate decision usefulness instead of complexity because decision usefulness is a pervasive qualitative characteristic of accounting information and because simple accounting may not adequately address complex transactions. Second, we believe that well-designed accounting standards are those most responsive to well-specified objectives. Third, we believe that the inconsistencies with the conceptual framework’s definition of liabilities inherent in each of the approaches described by the PV will ultimately require additional guidance to offset them, which will create greater complexity and demand for more guidance.
Is the BO Approach Consistent with the Conceptual Framework?
Currently the conceptual frameworks of the FASB and IASB define liabilities in terms of present obligations to transfer assets or perform services. Equity is unambiguously computed as a residual amount—assets minus liabilities. If, as proposed by the BO approach, equity is defined as the basic-ownership instrument, liabilities will become a new de facto residual classification category, encompassing all other credits not elsewhere defined as contra-assets. Consistent with this assessment, the proposed definition for liabilities reads:
A liability is a claim, the probability-weighted outcome of which would reduce the assets available for distribution to basic ownership interests para. D11.
Because a liability outcome is inferred from a reduction of assets available for distribution to basic-ownership interests rather than its reduction of assets available for distribution to nonbasicownership interests, an instrument cannot be classified as a liability without first unambiguously identifying the basic-ownership instrument.
Although some would say that the BO approach is more consistent with a proprietary view than current GAAP, we disagree because the BO approach omits from its classification criteria any consideration of current or incipient decision rights. Our position is consistent with Sprague 1907 1972, 53, who describes the proprietary view as one that recognizes essential differential rights of claimants rather than grouping them as a class:
Thus the right-hand side of the balance sheet is entirely composed of claims against or rights over the left-hand side. “Is it not then true,” it will be asked, “that the right-hand side is entirely composed of liabilities?” The answer to this is that the rights of others, or the liabilities, differ materially from the rights of the proprietor…
Although Sprague 1907 1972, 53 mentions differences in profit and loss participation as one attribute that distinguishes liabilities from equity, he describes as most fundamental the differences in decision rights:
the rights of the proprietor involve dominion over the assets and the power to use them as he pleases even to alienating them, while the creditor cannot interfere with him or them except in extraordinary circumstances.
Without dominion, the simple existence of a residuary interest is clearly inconsistent with the classical notion of proprietary ownership. Proprietary ownership is multidimensional, and each dimension must be present.
Paton 1922 1973, 73 disparages the proprietary approach because he believes that aspects of ownership including control, risk, and outcome-dependent returns are inseparably diffused across all claims. He notes that all instruments provide capital and assume risk for return, and that holders of all instruments have some measure of control or return that varies with the state of the enterprise. His views are frequently labeled the “entity perspective:”
To sum up, if all existing corporate stocks and bonds were to be arranged in a series according to the degree of risk attached to each … and if control or any other aspect of ownership were followed in making the arrangement, there would be no clear-cut line of cleavage.
Our view of the existing conceptual framework reflects aspects of both the entity and proprietary views. Specifically, all claims likely have present or incipient attributes associated with the notion of ownership. However, some claims also have attributes associated with liabilities, and this classification is useful. If all claims have some attributes in common with ownership, but only some claims have attributes associated with liabilities, then identifying the attributes associated with liabilities and leaving the other class as the residual category is the only way to meaningfully separate the claims into distinct categories.
Two attributes uniquely identified with liabilities are the existence of a present settlement obligation by the enterprise and the requirement to settle that obligation by sacrificing assets of the enterprise. Debt and preferred stock each possess to varying degrees attributes associated with ownership. For example, holders of these instruments may be endowed with current decision rights and incipient control rights, and the values are potentially residuary. However, only debt embodies a current obligation to sacrifice assets that would subject the firm to default; thus, debt claims are classified as liabilities. In our view, the relative merit of defining liabilities versus defining equity is a function of users’ perceptions of the relative uniqueness of ownership attributes versus liability attributes.
The PV envisages creating a new financial element definition for equity at the standards level. In conjunction with the existing definition of liabilities in the conceptual framework, the new definition results in conceptual vacuity. Equity is any claim that does not meet the definition of a liability CON 6 except for claims not meeting the definition of liabilities that are classified as liabilities PV. Liabilities are items meeting the definition of liabilities CON 6 as well as other items not meeting the definition of liabilities that are classified as liabilities PV. Thus, under the BO approach, liabilities could include items such as common stock, participating preferred stock, and warrants for which there is no present obligation to transfer assets or provide services.
We view the wholesale reclassification to liabilities of claims not meeting the conceptual definition of liabilities as inappropriate and as detrimental over current practice. Such a reclassification has potential to reduce classification inconsistencies among instruments within the scope of the PV, but would increase inconsistencies between these instruments and other liabilities that embody a current obligation to transfer assets. As discussed more fully below, we believe that the increased heterogeneity within the liability category would immediately decrease decision usefulness.
Does the BO Approach Increase Decision Usefulness?
In addition to concerns about the inconsistency of the BO approach with the conceptual framework, we are also concerned about how well a BO approach would serve external users of financial statements. In the PV, the FASB expresses concern over the complexity of the current literature, which presumably affects both preparers and users of financial statements i.e., more than 60 pieces of literature focused on narrow issues and were responsive in nature. Such extensive literature will inevitably increase information processing costs of external users. Information complexity can lead to at least two user outcomes—the adoption of simpler strategies for dealing with complexity or the impairment of their understanding e.g., Hirst and Hopkins 1998; Payne 1976. As an example, Plumlee 2003 found evidence consistent with both effects in the context of six tax law changes that were part of the Tax Reform Act of 1986. Because of the complexity of these changes, she found that analysts’ forecasts of effective tax rates incorporated the effects of the less complex law changes, but not those that were more complex.
To a certain extent, however, the narrow nature of much of this guidance suggests that many situations are idiosyncratic or not wide in scope, thus mitigating widespread user problems directly because of the complexity of the current literature. Moreover, which user group is primarily suffering from this complexity—sophisticated or unsophisticated? Concepts Statement No. 1 para. 34 states that “Financial statement information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.” However, several paragraphs later it is acknowledged that users’ understanding of financial information varies widely. Are sophisticated users currently misled by the reporting of debt and equity instruments? Will unsophisticated users be able to more clearly understand these instruments under the PV?
In addition to concerns over complexity, the FASB also expresses concerns that this literature is 1 inconsistent; 2 subject to financial structuring; and 3 difficult to understand and apply. The primary inconsistency with the current literature is the classification of certain instruments as liabilities when those instruments will be settled by delivery of a firm’s equity, which conflicts with the definition of liabilities under Concepts Statement No. 6. The concern over financial structuring can be exemplified by the recent rise in the popularity of numerous structured products, such as trust preferred securities TPS and contingently convertible debt COCOs. In piecemeal fashion, various regulatory pronouncements have curbed perceived abuses inherent in the financial reporting for these instruments e.g., SFAS No. 155 for TPS, EITF Issue No. 04–8 for COCOs. Users’ difficulty in understanding the complexity of accounting for hybrid financial instruments is alleged by the FASB, with little support in the PV.
It is imperative to have some structure on how the accounting partition of liabilities and equity affects users’ decisions before concluding that such instruments create difficulty for users. AAA FASC 1999 offers two alternative decision criteria the FASB could incorporate into its deliberations over the definitions of liabilities and equity—the insolvency risk approach or the common equity valuation approach. Both approaches are rooted in the perspective of external users of financial statements. The insolvency risk approach adopts the perspective that a firm may only be forced into insolvency by liabilities; other claims that are “nonobligatory” and cannot force insolvency are considered equity. The common equity valuation approach presumes that equity holders have all residual claims after nonresidual claims of other securities; thus common equity is the only equity. The majority of prior accounting rules align primarily with the insolvency risk approach, whereas the PV aligns more with the common equity valuation approach.
As described by the AAA FASC 1999, the two approaches differ in terms of how they would categorize obligations versus nonobligations and residual claims versus nonresidual claims. Securities that are clear obligations are considered liabilities under either approach, and securities that represent the residual claim on assets are equity under either approach. Securities that reflect either nonresidual claims or nonobligations are viewed differently by these two approaches e.g., preferred stock and minority interest. The AAA FASC 1999 acknowledges that neither approach is inherently preferable to the other, but consistent application of one or the other is a desirable outcome in terms of increasing the decision usefulness of resulting financial statements. Conditional on classification based on insolvency risk, the common equity valuation approach appears most useful for external users. However, in favoring the BO approach, the FASB has satisfied the charge to revise the classifications of debt and equity to be a consistent application of the common equity valuation criterion. The PV adopts a rigid common equity valuation approach, and restrictively identifies only one owner class. The question, then, becomes, how useful is the categorization of all securities other than common equity as liabilities?
A standard argument in the academic literature is that recognition versus disclosure and balance sheet or income statement classification rules do not matter, as long as relevant information is captured somewhere in the financial statements or the public domain. This argument relies on the efficiency of the market to collectively process all relevant information in financial statements. It is very difficult to prove or disprove this notion, because research design shortcomings almost always lead to two mutually exclusive interpretations Barth 2000. However, if one loosens the noose of an idealistic research design, the clear takeaway from most academic research on disclosure or presentation of financial information is that presentation matters. Thus, evidence from prior studies lends itself to a conclusion that the partition of debt and equity will matter to external users.
Botosan et al. 2005 provided a nice discussion of prior research on the importance of the distinction between liabilities and equity, and we touch only on parts of their discussion here. Hopkins 1996 performed the most directly applicable study, examining the effects on buy-side equity analysts of liability versus equity classification of mandatorily redeemable preferred stock. His predictions were based on psychology research documenting that individuals mentally access their own knowledge base of similar situations when faced with a problem. In this setting, seasoned analysts should know that issuances of equity securities are generally associated with stock price drops for the issuer, but that debt issuances are not. In the experiment, analysts were provided with pro forma prospectus information related to an offering of mandatorily redeemable preferred stock MRPS classified either as a liability or equity. Analysts’ stock price judgments were correlated with the location of the MRPS; analysts observing equity classification predicted lower prices than analysts observing liability classification. Findings similar to those of Hopkins 1996 have appeared in other studies e.g., Gramlich et al. 2006; thus, the evidence is fairly clear that classification of securities as liabilities versus equity can be an important factor in interpreting and using reported information related to financial instruments.
In addition to evidence that classification of securities clearly matters to users and affects decisions, other research has found that users do not naively rely on simple liabilities versus equity partitions when examining financial statements. Several studies have examined how various financial instruments are correlated with systematic risk or market prices. Cheng et al. 2003 and Linsmeier et al. 2007 present the most interesting evidence. They examined various financial instruments and concluded that investors treat securities such as preferred stock differently depending on the financial health of the firm. For example, when insolvency risk is high, investors treat preferred stock as equity, but when it is low, they treat preferred stock as a debt obligation.
How the BO approach would change the decision usefulness of financial statements depends on how we view users. If we believe financial statement users heuristically view the liabilitiesequity split, then the BO approach would mechanically lead to increased leverage ratios, which could undermine the effectiveness of extant models for liquidity and valuation analysis. However, if we presume that users process information about financial instruments with diligence similar to Cheng et al. 2003 and Linsmeier et al. 2007, then users may appropriately condition their interpretations based on disclosed instrument terms and not merely their classification as debt or equity.
However, either conclusion is difficult to draw based on current research, which operates in an environment where most sophisticated users presume that equity represents a number of residual claims, not just a single basic-ownership residual claim.
WOULD THE BO APPROACH SIGNIFICANTLY SIMPLIFY THE ACCOUNTING FOR INSTRUMENTS WITHIN THE SCOPE OF THE PV?
Simplicity in financial reporting is cited as an overriding consideration for some Board members in choosing the BO approach para. 51. The PV describes the BO approach as a relatively straightforward exercise:
Determining which instruments are equity is most simply described as drawing a line between different types of claims to an entity’s net assets … If all claims to an entity’s assets were listed in order of seniority, a line could be drawn below any item in that list, and all claims below it would be a residual because they are entitled to a share of anything left over after all senior claims are settled. Thus, the search for the appropriate line between equity and other claims is the search for the appropriate level of residual paras. 52 and 53.
However, the apparent relative simplicity of the BO approach is predicated on at least four underlying assumptions that:
1
subordination to all other claims is the singularly relevant characteristic of ownership;
2
the most residual financial claim can be determined based on objective criteria or criteria less subject to interpretation or manipulation;
3
comingling different classes of stakeholders within equity is inherently less transparent and less informative than comingling different classes of stakeholders within liabilities; and
4
income measurement will be less complex under the BO approach than under other approaches considered.
We address each of these points in turn.
Subordination is the Singularly Relevant Characteristic of Ownership
As discussed in the section titled: Are the Principles Underlying the BO Approach Clear?, we believe that exclusive reliance on subordination-related criteria to determine a single class of equity claims can logically result in equity comprising entirely nonvoting claims. The reason for this apparent misclassification is that the BO criteria capture only one relevant attribute of ownership. Focusing on a single attribute would not result in inconsistent classification if all relevant characteristics of ownership were perfectly correlated. However, modern financial markets make possible nearly complete separation of financial risk-bearing, decision rights, rights to current income, and other attributes traditionally associated with ownership.
This separation requires an equity definition to either identify a singularly relevant and unique attribute among those attributes associated with ownership, or to specify the conditions under which one or another of multiple relevant attributes should prevail for purposes of classification at any time. We do not believe that the BO approach sufficiently identifies a unique or singularly relevant ownership attribute. Dilution in value by other claims is not a discriminating characteristic because the values of all claims are jointly determined by claim structures and asset outcomes. Furthermore, subordination in liquidation is not a singularly relevant attribute of ownership. Hence, the BO approach and its contemplated classifications are difficult to describe logically and difficult to translate into an understandable concept of ownership.
One seemingly obvious solution is to incorporate “dominion over assets” into the definition of basic-ownership equity; however, a workable definition of dominion is elusive. Dominion in this context is arguably related to the concept of control, the operational definition of which is at the heart of the consolidations project that began in 1982 and remains unfinished to this day.
We do not intend to endorse either the proprietary perspective or the entity perspective for accounting in this discussion. We believe that the conceptual framework reflects elements of each. We refer to the traditional notion of proprietary ownership only to point out that any classification approach that does not explicitly consider relative decision rights will constitute a significant departure from existing proprietary accounting theory and business law. We refer to the entity perspective because we are sympathetic to Paton’s 1922 1973 suggestion that all claims likely reflect some attributes of ownership and that these ownership attributes are state and context dependent. Therefore, any attempt to categorize claims based on differential ownership criteria will be difficult.
However, in contrast to the pure entity perspective, our view is that a reported grouping of liabilities provides useful information because these claims embody identifiable and relevant attributes not associated with the other class of claims. The least complex way of distinguishing liabilities from equity and the one most consistent with the accepted elements of financial statements is to classify claims based on distinguishing characteristics associated with liabilities.
The Most Residual Financial Claim Can Be Determined Based on Objective Criteria— Financial Claims Can Be Reliably and Unambiguously Ranked in Order of Subordination
The argument that the BO approach is less complex and less subject to transaction structuring is based on the assumption that financial claims can be ranked unambiguously in order of subordination based on objective criteria and that criteria relevant for classification cannot be manipulated. As discussed in the section titled: Are the Principles Underlying the BO Approach Clear?, we believe that the BO criteria are highly ambiguous. For example, we could not reach a unanimous agreement among our Committee members on the appropriate classification of certain instruments using the BO criteria.
A major source of ambiguity about priority arises from the state-dependent nature of claims. For example, both the decision rights and the participation in residual value associated with debt depend on the firm’s proximity to insolvency. The claims available to option holders depend on whether the options are exercised or exercisable and whether asset values have increased or decreased subsequent to issuance. Contractual priorities may be effective only in some states of the world.
Another source of ambiguity arises from the need to evaluate instruments that provide priority in some states of the world and subordination in other states of the world. Classification is inherently subjective when hypothetical scenarios must be formulated or when competing priority and subordination clauses must be evaluated to determine a measure of overall priority or subordination. Because we do not believe that financial claims can be objectively or unambiguously ranked in order of subordination, we do not view the BO approach as materially less subjective than other considered approaches. Although we do not address the potential for intentional manipulation as a first-order concern, we suspect that the ingenuity of the capital markets will prevail whenever ambiguity creates opportunity for profit making and such opportunities are not constrained by regulation and enforcement.
Comingling Different Classes of Stakeholders within Equity is Inherently Less Transparent and Less Informative than Comingling Different Classes of Stakeholders within Liabilities
The PV asserts that the BO approach allows users to identify claims that would reduce residual basic owners’ share of the reporting entity’s net assets para. 59. Although we do not think that the BO approach will impair users’ ability to identify claims that would reduce residual basic owners’ claims, we do not think that this ability would necessarily be improved. First, instruments potentially classified as basic-ownership interests are already separately captioned within the equity section. Second, the values are jointly determined so that each claim has the potential to reduce the share of net assets available to other claims. The extent to which such potential reductions are recognized is an issue of measurement rather than classification.
The PV also asserts that the BO more clearly distinguishes the interests of different stakeholders para. 62. The basis for this assertion is unclear because any decrease of heterogeneity within equity is accompanied by increased heterogeneity within liabilities. We note at least three ways in which the nature of different stakeholder interests will become less clear under the BO approach. First, the increased heterogeneity of items within liabilities is accompanied by a loss of conceptual meaning of the liabilities class. Therefore, without explicit additional disclosure, users will not know which liabilities embody obligations. Second, comingling within liabilities of claims not having settlement obligations reduces the current information content of leverage ratios widely used for assessing solvency. For two otherwise equivalent firms, a given quantity of preferred stock results in the same leverage ratio as the same quantity of straight debt. Third, change in equity instrument values does not give rise to comprehensive income in the current accounting model. The BO approach’s remeasurement of redeemable basic-ownership interests at current redemption values comingles within equity instruments subject to remeasurement with those that are not paras. 32 and 33.
That Income Measurement will be Less Complex under the BO Approach than under Other Approaches Considered
Classification of all other claims as liabilities has potentially far-reaching implications for income recognition that are likely to increase the complexity of income measurement, presentation, and disclosure. For example, current accounting standards require recognition of a capital charge on debt capital. Recognition of periodic interest charges on perpetual, contingent claims classified as liabilities under the BO approach will be necessary to maintain internal consistency with this approach. Alternatively, another systematic approach to recognition of financing expense will need to be developed. The PV does not systematically address measurement or income recognition under any of the approaches. Given the current mix of measurement bases, difficulties associated with income measurement should not be ignored in evaluating whether a given approach will improve financial reporting, increase complexity, or reduce opportunities for manipulation.
CONCLUSION
In summary, the Committee concludes that the principles underlying the BO approach are not clearly defined, are not appropriate given the extant conceptual framework, and will not simplify accounting for instruments that are within the scope of the PV. Specifically, the principles are not clear because the stated definition of priority is based either on subordination or liquidation, whereas the operational criteria appear to be based on dilution-related factors. Furthermore, the principles are not appropriate because they are inconsistent with the extant conceptual framework and would significantly increase the heterogeneity of financial instruments reported in liabilities. This increased heterogeneity will also likely lead to reduced decision usefulness of reported liabilities and equity information. Although such a mechanistic approach could simplify the process of balance sheet classification, any simplification gained via a single-instrument equity class is likely quite small in comparison with the significantly increased complexity in the definition, measurement, and interpretation of reported net income and comprehensive income. Finally, the Committee concludes that the suggested identification criteria for a basic-ownership interest i.e., the only financial instrument classified in equity under the BO approach fail to evaluate important characteristics of ownership interests.
Clearly, identifying a solution to the problem is not easy, as evidenced by the many years FASB has already devoted to this project. The Committee does not intend to imply that a solution is simple and does not attempt to provide one here. However, we note that the majority of our documented concerns are based on perceived inconsistencies between the PV and the conceptual framework. Given the ongoing work on the conceptual framework, any wholesale redefinition of liabilities and equity might be addressed concurrently or subsequent to the conceptual framework project. Furthermore, the FASB’s preference for the basic-ownership approach seems to rest largely on the argument relative to the OS and REO approaches that it is simpler in its application. However, as we note previously, this notion of simplicity is illusory because it seems to transfer the complexity from the preparer’s classification algorithm to the financial statement users’ decision usefulness exercise. Given that complexity seems inherent in these instruments, one alternative to the BO approach as currently specified is to modify it to include an expanded array of instruments, which would likely avoid the objectionable classification of certain instruments with more characteristics of equity than debt.
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Accounting Horizons March 2009
American Accounting Association
Accounting Horizons March 2009
American Accounting Association
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