RESEARCH PAPER PROPOSAL



STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 150

Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity

Research Paper Proposal

Accounting 576

Winter 2004

March 12, 2004

RESEARCH PAPER PROPOSAL

Statement of Financial Accounting Standards No. 150

I. INTRODUCTION

In May 2003, the Financial Accounting Standards Board (the FASB or the Board) issued a standard identified as the Statement of Financial Accounting Standards No. 150 (SFAS 150 or the Statement). SFAS 150 addresses how both public and non-public companies should now account for certain financial instruments with characteristics of both liabilities and equity.

A. Thesis Statement

Are all of the implications of implementation of SFAS 150 positive, or did the FASB issue a standard that could harm American companies, and potentially drive them out of business?

B. Why SFAS 150 Is Worth Pursuing

SFAS 150 is a new standard; therefore, by addressing it in my research paper, it will allow me to learn the basics of SFAS 150 and, therefore, be ahead of my fellow first year co-workers when we start full-time work in September. Additionally, by gaining an understanding of SFAS 150, I will be able to educate my father’s company on how the Standard will affect the company. Furthermore, I will be able to help my father’s company prepare to implement SFAS 150 in the near future.

C. Methods of Investigation

To date, it appears that approximately ninety-five percent of my research will be based on the studies and research efforts of other individuals. It will consist of searching through various resources available to me on the Internet. Additionally, a large majority of my research will be obtained from research tools that Deloitte & Touche provides for its employees.

My main research tools over winter quarter have been the SFAS 150 statement, various literature pieces published by the AICPA and the FASB, comment letters and articles written by individuals in small, privately held companies, public companies, and public accounting firms, and interpretations of SFAS 150 that were found on Deloitte & Touche’s research tool called Folio Views.

Since SFAS 150 is so new, I will also be coming to some of my own conclusions regarding whether or not the FASB made a good decision in implementing the Standard. These conclusions will comprise the other five percent of my research paper. To come to these conclusions I will use two methods. First, I will rely on my own understanding of SFAS 150 and analyze the information I obtain to make any conclusions I might have. Second, I will interview individuals in small, privately held companies, public companies and public accounting firms to gain their perspectives on the Standard and learn more about the impact SFAS 150 has on their respective business party.

D. Key Studies

Since SFAS 150 is so new, there have been limited studies conducted by the business, accounting, and financial environment. The list that follows identifies the few key studies found that outline the current understandings of SFAS 150’s implications on small, privately held companies, public companies, and public accounting firms.

(1) “CPC Scores Win As FASB Indefinitely Delays SFAS 150 for Private

Companies,” written by Robert A. Orben for the Committee on Private Companies of Financial Executives International (October 2003).

In Robert Orben’s letter, addressed to Chairmen Herz of the FASB, he addresses how several unintended consequences will occur if small, privately held companies have to implement the Standard as it is currently written. Specifically, this letter notes “the unintended consequences that will result from the application of SFAS 150, address the characteristics common to small, privately held companies that may form the basis for distinctions in accounting treatment, and propose changes that could eliminate the unintended consequences of SFAS 150” (Orben).

(2) “Issuance of SFAS 150 Impacts Private Companies,” written by Alfred King,

Valuation Researcher Alert (August 2003).

Alfred King’s article takes an opposite stance and claims that “the new accounting requirement should have no impact on a company” (King). In fact, this article strongly claims that the adoption of SFAS 150 will not adversely affect a company regardless of its size and business nature.

(3) “Deloitte & Touche’s SFAS 150 Interpretation and Firm Guidance,” written by

Deloitte & Touche’s National Office

This article is Deloitte’s interpretation of SFAS 150. It provides, to Deloitte’s employees, a brief summary of what Deloitte believes SFAS 150 requires its clients to implement. Additionally, this article provides guidance to Deloitte’s employees on how they are to use SFAS 150 while conducting an audit engagement. It explains how SFAS 150 changes the auditors approach to auditing the types of financial instruments with characteristics of both liabilities and equity that are addressed in the Standard.

II. KEY ISSUES SURROUNDING SFAS 150

A. The History of SFAS 150 and Its Current Status

In the wake of numerous accounting scandals and a turbulent United States’ market, the FASB decided it needed to take various actions to improve the reliability, relevance, and transparency of financial reporting. One action that was finally taken by the FASB was the May 2003 implementation of SFAS 150.

The consideration of establishing SFAS 150 was not new to the FASB. The FASB’s original work on SFAS 150 began approximately fifteen years ago, in 1988. For two years, the FASB considered the issues identified surrounding financial instruments with characteristics of both liabilities and equity, and then moved forward by issuing a discussion memorandum in August 1990, when the FASB received over one hundred and four comment letters. The FASB also held two public hearings in March 1991.

In spite of these steps, as other matters were deemed more important to the FASB, such as the FASB’s SFAS 133 –Accounting for Derivative Instruments and Hedging Activities and SFAS 140 –Accounting for Transfers and Servicing of Financial Assets, SFAS 150 was postponed. In December 1996, SFAS 150 was brought up again during one of the FASB’s meetings. At that meeting, the Board decided to begin deliberating SFAS 150 once again, and on October 27, 2000, the FASB released an exposure draft (Howard, slide 2). After the comments period ended for SFAS 150’s exposure draft, the Statements original effective date was set for June 15, 2002.

Despite issuing the effective date, the FASB incurred further complications with SFAS 150, so the statement was withdrawn and put on hold once again. Finally, however, with the uncovering of accounting scandals and the demand for more reliable, relevant, and transparent financial reporting, the FASB decided, in a six to one vote, that it was time to make one of its many contributions towards the improvement of financial reporting by officially implementing SFAS 150 (FASB Project Updates).

The new effective dates for SFAS 150 were set as follows: the first interim period beginning after June 15, 2003 for calendar year end public companies and companies with financial instruments entered into or modified after May 31, 2003; and the first fiscal period beginning after December 15, 2003 for non-public companies.

Since the May 2003 adoption, one component of SFAS 150 has now been indefinitely delayed. Non-public companies with financial instruments in the form of mandatorily redeemable financial shares were originally supposed to implement SFAS 150 by the first fiscal period beginning after December 15, 2003; however, now these companies temporarily do not have to implement the Standard and, thereby, reclassify these previously considered equity instruments as liabilities. The Boards postponement of this portion of SFAS 150 was the result of some unintended consequences that came to light when small, privately held companies attempted to implement SFAS 150. As it stands right now, the FASB is unable to comment on whether or not non-public companies will ever have to implement the postponed portions of SFAS 150. The Boards only comments are that it plans to readdress the issue sometime during 2004.

B. What are the FASB’s Reasons for Finally Issuing SFAS 150?

After fifteen years of contemplating the issuance of SFAS 150, the FASB finally issued the Standard for three reasons. First, as mentioned before, SFAS 150 was one of the Boards responses to the uncovering of several financial accounting scandals. Right after the fraudulent actions were uncovered, several regulatory bodies felt that they needed to take strict actions towards improving accounting regulations.

Second, SFAS 150 was issued by the FASB as a response to the concerns expressed by the preparers, auditors, regulators, investors, and other users of financial statements over the past decade. These parties had been expressing their concerns about how companies classified certain financial instruments with characteristics of both liabilities and equity, but that had previously presented these financial instruments either entirely as liabilities or equity, or as line items in the mezzanine section (items that fall between liabilities and equity) of the Balance Sheet (SFAS 150, Summary).

Third, the FASB undertook the final stages of drafting SFAS 150 as a way of accelerating the United States’ convergence with International Accounting Standards (SFAS 150, Appendix B2). Many other countries such, as the Canadian Institute of Chartered Accountants, the Australian Accounting Standards Board, and the International Accounting Standards Board, have already “addressed the issues of accounting for financial instruments with characteristics of liabilities, equity, or both” (SFAS 150, Appendix B2) and adopted standards comparable to SFAS 150.

C. Will SFAS 150 Improve Financial Reporting?

By issuing SFAS 150, the FASB believes that two specific areas of financial reporting reliability, relevance and transparency are, therefore, improved. The first area is the FASB’s Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises. The FASB believes that SFAS 150 will “result in a more complete depiction of an entity’s liabilities and equity and will, thereby, assist investors and creditors in assessing the amount, timing, and likelihood of potential future cash outflows and equity share issuances” (SFAS 150, Summary).

The second area is the FASB’s Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. The FASB believes that SFAS 150 will improve two areas of Concept Statement No. 2. First, it will “enhance the relevance of accounting information by providing more information about a company’s obligations to transfer assets or issue shares, thus improving its predictive value to users” (SFAS 150, Summary). Second, SFAS 150 will improve the reliability “by providing a portrayal of an entity’s capital structure that is unbiased, verifiable, and more representationally faithful than information reported prior to issuance of this Statement” (DNAACG, 1).

D. SFAF 150, Its Content and What It Establishes

As previously discussed, the FASB implemented SFAS 150 in order to establish official and uniform guidelines for companies on how to classify and measure, in the Balance Sheets, certain financial instruments that have characteristics of liabilities, equity or both. Therefore, through the standard the Board specifically “requires a company to classify a financial instrument that is within the scope as a liability because that financial instrument embodies an obligation to the company” (SFAS 150, 1).

There are three specific classes of financial instruments identified by the FASB that embody obligations for companies that the FASB felt should be classified as liabilities instead of as equity, or as a line item in the mezzanine section of the Balance Sheet. These three financial instruments include mandatorily redeemable financial shares, obligations to repurchase equity shares by transferring assets, and certain obligations to issue a variable number of shares.

E. Outcomes for the FASB As A Result of Issuing SFAS 150

After implementing SFAS 150, the FASB realized that its job was not thoroughly complete. In fact, the Board has since announced that there are two additional items that it will address, through either a new standard or an amendment, relating to the requirements of SFAS 150.

During the deliberation phase of writing SFAS 150, the FASB decided that several types of financial instruments with characteristics of both liabilities and equity should be excluded. The FASB felt that it should postpone the discussion of including these financial instruments in SFAS 150 until a later date because of the complexity of these instruments. Therefore, when the FASB came to this conclusion, it announced that SFAS 150 was only going to be Phase I of its overall project regarding financial instruments with characteristics of both liabilities and equity. Consequently, the FASB announced that at some point in the future, it would begin Phase II, where the Board would address the other financial instruments and make the decisions as to whether or not these instruments should be classified as liabilities or as equity. Examples of the financial instruments to be addressed during Phase II include: obligations relating to stock compensation, puttable shares, convertible bonds, and dual-indexed financial instruments.

Although the FASB has begun the deliberation period of Phase II, it has not come to a definite decision on how to approach Phase II. So far, the Board “plans to develop a new statement that addresses the remaining financial instruments that were not addressed in Statement 150 by utilizing a “fresh start” approach” (FASB Project Updates). Additionally, the FASB has also decided to expand the projects scope to include financial instruments with characteristics of both assets and equity.

Since implementing SFAS 150, the FASB has also come to another conclusion. The Board has announced that it feels that the current definition of liabilities, in FASB Concept Statement No. 6, should be amended. The Board, however, has decided to defer “issuing that amendment until it has concluded its deliberations on the next phase of this project” (FASB Project Update).

During the FASB’s deliberations on Phase I of SFAS 150, many discussions occurred between the members of the Board regarding financial instruments that if truly considered appeared to be more like liabilities rather than equity. The area that caused the Board discussed to make the proposed amendment was the accounting for financial instruments that “embody obligations that require (or permit at the issuer’s discretion) settlement by issuance of the issuer’s equity shares” (SFAS 150, Appendix A, pg 36).

Under the current definition of liabilities, in Concepts Statement No. 6, the financial instruments mentioned should not be classified as liabilities; however, the FASB believes that these financial instruments truly represent liabilities and, therefore, should instead be classified as liabilities. The Boards rational for this particular issue was the following example: “A financial instrument that requires settlement by issuance of $100,000 worth of equity shares establishes something more akin to a debtor-creditor relationship than to an ownership relationship, because it requires that the issuer convey a fixed amount of value to the holder that does not vary with the issuer’s equity shares” (SFAS 150, Appendix A, pg 36). Using this rational, the Board agreed that these financial instruments should not be considered equity, therefore, giving rise to an amendment to Concept Statement No. 6.

Although the Board considered and rejected the alternative of keeping the classification of these financial instruments as liabilities, it decided that it would be preferable to reconsider the distinction between liabilities and equity. Therefore, as it stands right now, the Boards proposal is to revise the definition of liabilities so that it “encompasses certain obligations that a reporting entity can or must settle by issuing its own equity shares, depending on the nature of the relationship established between the holder and the issuer” (SFAS 150, Summary).

F. Does SFAS 150 Take Substance Versus Form to an Extreme?

Since issuing SFAS 150, announcing that work on Phase II of SFAS 150 has started, and proposing an amendment to Concept Statement No. 6, the FASB has received several comment letters from small, privately held companies, public companies and public accounting firms expressing the companies’ concerns about the Standard. Many of the concerns expressed in the companies’ comment letters have one thing in common; these parties are concerned that Phases I and II of SFAS 150 and the proposed amendments to Concept Statement No. 6 are taking the concept of substance versus form to an extreme.

Deloitte states, in its comment letter to the FASB, that, as a whole, the company generally agrees with Phases I and II of SFAS 150 and the proposed amendments to Concept Statement No. 6; however, it believes “that the approach proposed by the Board puts too much emphasis on the form of the transactions, while ignoring the true economic substance of the transactions,” (Deloitte & Touch, Comment Letter) addressed in SFAS 150.

Below, is one example provided in the comment letters illustrating how the FASB has placed too much of an emphasis on the form of transactions through the requirements in SFAS 150:

Under SFAS 150, mandatorily redeemable preferred stock is considered to be a liability because it embodies a “nondiscretionary obligation to transfer assets to the holder to redeem the shares at a specified price and time.” However, increasing-rate preferred stock, which is essentially the same, is not considered to be a liability because it is not mandatorily redeemable in form. Overall, the substance of these two instruments is essentially the same; however, under the guidance of SFAS 150 these two financial instruments are classified differently.

- Deloitte & Touche Comment Letter

IV. PRELIMINARY EXPECTATIONS

As it is the case with almost every single one of the FASB’s Statements of Financial Accounting Standards, not all of the parties impacted by the Standard can be pleased. As history has proven, it will always be the case that one of the parties impacted, in the business environment, will not be happy and, therefore, the party will raise the conflicting issues that argue against what the FASB feels is in the best interest of the business environment and the public. After collecting my research and writing the research paper, I expect to find that SFAS 150 is another example of this continuing problem that arises from trying to have unified accounting standards for both public and private companies to follow and public accounting firms to enforce.

Despite this predicted finding, I believe my research will also show me that despite the positive improvements identified by the FASB, there are also definitely a lot of negative issues arising because of SFAS 150. Consequently, the FASB will end up spending a substantial amount of time considering these issues. To date, the FASB has already postponed many portions of SFAS 150, and as I continue with my research and get further into writing the research paper, I believe that I will find and then communicate in my paper that SFAS 150, as a whole, is in major need of revisions.

With all the uncertainties surrounding SFAS 150, I expect to see several private companies refusing to implement the Standard as the actual implementation dates come near. Even though the FASB and other regulatory bodies are attempting to get both public and private companies to use uniform accounting standards, most private companies feel that the requirements of SFAS 150 do not reflect the true financial positions of private companies. Therefore, it can be expected that these companies will refuse to follow and implement SFAS 150. As I have already learned from my research, several of the creditors, investors, and analysts of private companies are encouraging them to boycott the implementation of SFAS 150. These parties understand that the unintended consequences could potentially ruin private companies in the future. Consequently, as a result of these potential actions, the FASB will be hindered in accomplishing one of its goals, which is to have all companies operating in the United States by reporting their financial results using one unified set of accounting standards.

REFERENCES

RSM McGladrey. “New Accounting Standard Addresses Debt Vs. Equity Issues” Bank

Notes (August 2003).

Deloitte’s National Accounting Services Communications Group. “FASB Issues Final

FSPs.” Accounting Roundup. Deloitte & Touche. (December 16, 2003)

The Financial Accounting Standards Board. “Statement of Financial Accounting

Standards No. 150 –Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Financial Accounting Series. No. 244-A (May 2003).

Deloitte’s National Accounting Services Communications Group. “Effective Dates of

SFAS 150 for Financial Instruments that are Mandatorily Redeemable.”

Ollsson, Fredrik. “SFAS 150 Flow Chart.” September 2003.

Forrestel, Richard Jr. “Testimony of Richard Forrestel, Jr. on behalf of The Associated

General Contractors of America.” 12 November 2003.

The Financial Accounting Standards Board. “FASB Exposure Drafts –Summary of

Comment Letters.” Deloitte & Touche Folio Views. (October 2003).

Deloitte’s National Accounting Services Communication Group (DNASCG). “FASB

Statement No. 150 –Summary.” Deloitte & Touche Folio Views. (October 2003).

Smith, John T. “Proposed Amendments to FASB Concepts Statement No. 6 to Revise

the Definition of Liabilities.” Deloitte & Touche Folio Views. (October 2003).

Howard, Jon. “Accounting For Financial Instruments with Characteristics of Liabilities,

Equity or Both.” Deloitte’s Continuing Professional Education Presentation. Deloitte & Touch National Office, Wilton. 23 February, 2001.

Orben, Robert A. “CPC Scores Win as FASB Indefinitely Delays SFAS 150 for Private

Companies.” 30 October 2003.

King, Alfred. “Issuance of SFAS 150 Impacts Private Companies” Valuation Researcher

Alert. (August 2003). 20 January 2004.

Associated General Contractors News & Bulletins –Press Releases. Associated General

Contractors of America. 21 November 2003.

The Financial Accounting Standards Board. “Project Updates –Liabilities and Equity.”

(March 5, 2004). 5 March 2004.

Deloitte & Touche. “Comment Letter -Accounting for Financial Instruments with

Characteristics of Liabilities, Equity, or Both and Proposed Amendment to FASB Concepts Statement No. 6 to Revise the Definition of Liabilities.” (May 25, 2001).

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