SFAS 150's unintended Alchemy: turning positive into negative.

• Author: Sinnett, William M.
• Position: Private company - Statement of Financial Accounting Standards

Our company has always been profitable, and it has a solid balance sheet, but it may soon show a negative net worth," complains Alfred King, vice chairman of Valuation Research Corp. and a member of FEI's Committee on Private Companies (CPC), in reaction to SFAS 150.

To gain an understanding of why this can happen, it's good to look back to the 1970s, when financial engineering was just beginning to leverage the world of corporate finance. King says he remembers it well. "In the good old days, bonds were debt and preferred stock was equity," he reminisces. "But then, in the '70s, investment bankers invented mandatorily redeemable preferred stock--preferred stock that had to be redeemed by the issuing company in, say, 10 years. Now, what is the difference between a bond and preferred stock that has to be redeemed by the company on a certain date?"

The Securities and Exchange Commission (SEC) first addressed the question of mandatorily redeemable preferred stock in its Accounting Series Release 268, issued in 1979. At that time, the Commission amended Regulation S-X to modify the financial statement presentation of preferred stocks subject to mandatory redemption requirements or whose redemption is outside the control of the issuer.

However, the SEC left unanswered the question of whether such financial instruments were considered liabilities. "The Commission is cognizant of these conceptual problems in determining the appropriate accounting for and reporting of redeemable preferred stock and believes that these matters can best be addressed by the Financial Accounting Standards Board (FASB)," the release states. Thus, FASB has spent decades trying to define the difference between "debt" and "equity."

Its latest thinking, Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, was issued last May--and has drawn its share of criticism. In fact, the rule has now been put on indefinite hold (see box on page 42), though it hasn't gone away.

In a comment letter to FASB, FEI's Committee on Private Companies observes that SFAS 150 has a number of "unintended consequences for privately held companies." (The extensive October 30 comment letter and illustrations of issues can be found on the FEI Web site (www.fei.org) in the "FASB Comment Letters" section.)

Private companies affected by SFAS 150 are those that have shareholder buy-sell agreements...