Is it equity? Is it debt? Or is it both?

• Author: Clarke, Carol M.
• Position: Distinguishing between debt and equity instruments

Mandatorily redeemable preferred stock, employee stock options, and convertible bonds may not seem to have much in common. But those three financial instruments, along with a variety of others, raise questions about how to distinguish between debt and equity instruments. That distinction is the main topic of a discussion memorandum, or DM, published by the Financial Accounting Standards Board (FASB) in August of 1990: "Distinguishing Between Liability and Equity Instruments and Accounting for instruments with Characteristics of Both."

An FASB DM is a neutral document prepared with the advice of a task force-in this case, the Task Force on Financial Instruments and Off-Balance-SheetFinancing. A DM does not contain tentative conclusions of the Board; rather, it raises issues and discusses alternative solutions to them. it is the basis for a public hearing on the issues, which is followed by an exposure draft of a proposed statement of financial accounting standards.

Although the FASB's financial instruments project has received a great deal of attention in the financial press, most of it has focused on such issues as when to measure financial instruments at their market values and how to treat hedges of one financial instrument with another. The part of the project that considers liability/equity issues has had a relatively low profile until now. But the DM, which considers only accounting by issuers of financial instruments, should be of interest to CFOs and other financial executives.

Why the distinction is important

Whether an instrument like mandatorily redeemable preferred stock is classified as a liability or as equity obviously affects reported amounts of liabilities and equity and related summary indicators, such as the debt/equity ratio and the asset/equity ratio. The line between liabilities and equity also is critical in measuring income. In present accounting, neither transactions between a company and its owners nor changes in the values of a company's outstanding equity instruments affect reported income, while payments of interest and at least some changes in the values of liabilities do affect reported income.

Some effects on net income of the distinction between liabilities and equity are obvious. If mandatorily redeemable preferred stock is treated as an equity instrument, the dividends are not deducted in determining the issuer's net income, although, like all preferred dividends, they are deducted to determine income available for common-stock holders. However, if the "stock" is considered to be a liability, the "dividends" would be reported as an expense and deducted in determining net income.

Other effects may not be quite so obvious. For example, if a stock purchase warrant or an employee stock option is recognized as equity at the date it is issued or granted, subsequent changes in its value do not affect the issuer's net income. If such instruments were recognized as liabilities, however, changes in their values before they either expire worthless or are exercised would affect net income. More on this later.

What's the urgency?

Both liabilities and equity are defined in FASB Concepts Statement 6, "Elements of Financial Statements." Liabilities are "probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events." Equity is the residual...