FASB Views on Equity Instruments; More

The Financial Accounting Standards Board is offering a preview of how it wants to draw a sharper line between equity and liabilities, specifically to address complex financial instruments that have blurred the distinction between the two bedrock accounting concepts for years.

The Board issued its preliminary views in “Financial Instruments with Characteristics of Equity” to get feedback on how it plans to simplify and improve financial reporting for complicated financial instruments that have certain characteristics of equity. The document says the Board is leaning toward an “ownership approach” to defining equity, limiting instruments that can be classified as equity to the lowest residual interests in an entity.

That means the holders of the instruments would be viewed as the owners of the entity, which therefore represents equity. All other instruments would be classified as either liabilities or assets. FASB says an instrument that reduces the net assets available to the owners of the entity is a liability, while an instrument that enhances net assets available to the owners is an asset. Under this approach, forward contracts, options, and convertible debt would be classified as liabilities or assets.

Linsmeier

“The basic ownership approach would represent a major change to current accounting and reporting,” FASB member Tom Linsmeier said in a statement. “That change is needed to achieve two key objectives. The first is to provide investors with understandable information about the relative priority of claims on an entity’s net assets and income. The second is to develop a less complex approach, which also should reduce existing opportunities to structure arrangements to achieve a desired accounting result.”

FASB says the proposal is a significant step in its effort to develop a single standard that would replace more than 60 existing pieces of guidance that have been pieced together over a number of years. That patchwork of existing guidance constantly raises questions about how it should be applied and has been cited as a complicating factor in restatements.

The Board says it believes its proposal is generally in line with what investors are demanding: a narrow, principles-based view of what constitutes equity. The Board expects the International Accounting Standards Board to seek comments from its constituent audiences on FASB’s view as well.

Mulford

Chuck Mulford, head of the Financial Analysis Lab at Georgia Tech, says FASB has struggled to define “equity” for financial reporting purposes “for as long as I can remember.” In its purest form, equity represents the holdings of the ultimate residual shareholders of the company, he explains, with no guaranteed return, unlimited upside earning potential, and no guarantees in the event of liquidation of the company. Debt, by contrast, involves a required interest payment stream, a required maturity date, and guarantees in the event of liquidation.

The introduction of preferred stock, however, began a cascade of increasingly complex financial instruments that have features of both debt and equity, Mulford says. “Almost every day there’s some kind of new-fangled derivative,” he says. “When you start getting these instruments that have elements of both, it’s hard to classify them. And the more new-fangled instruments that get invented, the harder it is to know what it is.”

In Mulford’s opinion, FASB has taken a fairly restrictive view of what constitutes equity, which could result in far more liabilities being reported on balance sheets. Specifically, he says, FASB can expect grief over its preliminary view that “perpetual instruments” (instruments that do not mature) would be treated as liability. That means preferred stock would be classified as liability, he notes.

“This is a very conservative definition of what equity is,” Mulford says. “That will have some fairly significant implications. If preferred stock gets moved to a liability, companies are going to see their equity shrink and their debt grow.” Given that dividends would be treated as interest, it would also affect reported income, he said. “This is going to give readers and commentators a lot to think about,” he says.

The board is open to comments on the preliminary views through May 30, 2008.

Separately, FASB also issued proposed staff positions recently on revising the factors that would be considered in determining the useful life of an intangible asset and on excluding lease transactions from the scope of new fair value measurement rules.

In proposed FASB Staff Position No. FAS 142-f, the staff proposes to tweak accounting literature to improve the consistency between the useful life of an intangible asset as determined under Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, and the period of expected cash flows used to measure the value of the asset under other accounting literature. Under existing rules, companies are not allowed to use their own assumptions about renewal or extension of an arrangement, even if they can reasonably expect substantial cost or changes. The proposal would remove that restriction and allow companies to consider their own experience with renewals or extensions.

In proposed FSP FAS 157-a, the staff says it wants to remove lease transactions from the scope of FAS 157, Fair Value Measurement, because of implementation problems that have surfaced with FAS 157. The Board wants to take up those lease issues in the context of its long-term project to rewrite lease accounting rules under FAS 13, Accounting for Leases.

EU to End Reconciliation for GAAP

Now that the Securities and Exchange Commission has agreed to accept certain international accounting without reconciliation to U.S. accounting, the call is beginning for European regulators to reciprocate.

Charlie McCreevy, commissioner for Internal Market and Services at the European Union, said the EU should begin accepting financial statements prepared under U.S. Generally Accepted Accounting Principles without reconciliation to EU-required International Financial Reporting Standards. McCreevy said at a recent conference of the European Federation of Accountants he will propose action to that effect to the European Union.

“Now it will be Europe’s turn to accept accounts in U.S. GAAP,” he said. “This decision will have to be taken next year … This is the only sensible way forward.”

McCreevy

McCreevy said the EU showed backbone only a few years ago when it chose to adopt IFRS as part of a globalization strategy. He applauded the SEC for making a similarly significant move by recently eliminating the requirement for non-U.S. companies preparing reports under IFRS to reconcile their reports to U.S. GAAP. “So the strategy we have been pursuing with our U.S. counterparts is bearing fruit,” McCreevy said. “We are making strides toward one global accounting language.”

The influential European Union regulator said the SEC’s decision to eliminate the reconciliation requirement came earlier than expected. He also defended the SEC’s stance to accept only IFRS as written by the International Accounting Standards Board and not regional adaptations of IFRS, such as the European Union has developed.

“Let us not forget the facts here,” he said. “We in Europe have decided to go for IFRS because we rightly believed in the virtues of having a single accounting language … We have been preaching this gospel to our U.S. counterparts for the last five years, asking them with indefatigable stamina to accept IFRS … We have got what we have been asking for, 100 percent.”

PCAOB Proposes Criteria for Overseas Cooperation

The Public Company Accounting Oversight Board is ready to start relying more on foreign regulators to oversee U.S.-registered audit firms, but the Board is looking for public input on its criteria for doing so.

The PCAOB published a proposed policy statement that outlines what it considers important criteria when deciding whether to rely on an overseas regulator to police audit firms in other countries that want to do business in the U.S. capital markets. The policy statement defines what the Board envisions as “full reliance” on an overseas regulator to inspect such audit firms in accordance with Sarbanes-Oxley requirements.

Specifically, the proposed policy gives guidance on how to apply the Board’s Rule 4012, Inspections of Foreign Registered Public Accounting Firms. The PCAOB said it has already exercised some reliance on overseas regulators in accordance with Rule 4012 to complete audit firm inspections in the past three years.

The proposed policy would rely heavily on five broad principles, which are set forth in Rule 4012. Those principles include the adequacy and integrity of a given country’s oversight system, the independence of the oversight system, the independence of the regulator’s funding, the transparency of the system, and the system’s historical performance.

Olson

“The PCAOB will not take the determination to move to full reliance lightly,” PCAOB Chairman Mark Olson said at a recent Board meeting on the topic. “We take seriously the authority that Congress granted us, and before placing full reliance on a non-U.S. counterpart, we will take measures to carefully assess the adequacy of our counterpart’s program. We will also continue to be engaged with our counterparts when in a full reliance mode.”

Board member Kayla Gillian said roughly half of the 1,800 registered firms under PCAOB authority are located outside the United States, and roughly half of that number is subject to mandatory inspections. For legal and logistical reasons, she said, “it is impossible for us to meet our mandate all by ourselves.”

The Board is accepting comments through March 4, 2008.