SFAS No. 150: accounting for financial instruments with liabilities and equities characteristics: what will the AICPA come up with next—and what does it all mean to you! RMA's ongoing series looks at implications for bankers

RMA Journal, The, Feb, 2004 by Alan Reinstein

Except for instruments indexed to and potentially settled in the issuers' own shares, SFAS No. 150 will significantly change the accounting for many types of financial instruments and could even lead to certain firms now violating their debt covenants.

Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (SFAS No. 150, May 2003) forms the first stage of a major FASB project to clarify financial instruments that contain both debt and equity features. A response to concerns of preparers, auditors, regulators, investors, and other users of financial statements, SFAS No. 150 redefines many financial instruments previously classified as part of shareholder equity or "mezzanine" equity as liabilities, and the return paid to the holders as interest expense rather than dividends. This can cause major decreases in a firm's reported shareholder equity and net income, which may cause it to violate its debt covenant agreements or other contracts.

Applicability

SFAS No. 150 usually requires issuers to classify the following material instruments as liabilities:

* A financial instrument issued in the form of shares that is mandatorily redeemable--i.e., an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.

* A financial instrument that, at inception, embodies an obligation to repurchase the issuer's equity shares, or is indexed to such an obligation, and may require the issuer to settle the obligation by transferring assets (e.g., a forward purchase contract or written put option on the issuer's equity shares that is to be physically settled or net cash settled).

* A financial instrument that embodies an unconditional obligation; or a conditional obligation that the issuer can settle by issuing a variable number of its equity shares, if, at inception, the monetary value of the obligation is based predominantly on:

* A fixed monetary amount known at inception--for example, a payable settleable with a variable number of the issue"s equity shares;

* Variations in something other than the fair value of the issuer's equity shares--for example, indexed to the S&P 500 and settleable with a variable number of the issuer's equity shares; or

* Variations inversely related to changes in the fair value of the issuer's equity shares--for example, a written put option that could be net share settled.

SFAS No. 150 does not apply to embedded financial instrument features with conditional redemption features. It also does not reclassify or remeasure convertible bonds, puttable stock, or other conditionally redeemable outstanding shares; nor does it address financial instruments indexed partly to the issuer's equity shares and partly to other items. SFAS No. 150 excludes shares under most employee compensation arrangements, including most Employee Stock Ownership Plans (ESOPs). Future SFASs will address similar instruments not addressed in SFAS No. 150.

SFAS No. 150 focuses on three major categories of financial instruments. First, firms must redeem mandatorily redeemable shares for cash or other assets at a fixed or determinable date or upon the occurrence of an event that is certain to occur, such as a specific shareholder's death. However, put-table or convertible shares are not considered mandatorily redeemable, since the firm incurs an obligation only if the holders elect to use such options. Private companies whose shareholder agreements require all shareholders to sell their shares to the entity when they terminate employment or when they die should segregate such mandatorily redeemable shares as a separate liability and segregate the payments to shareholders as an expense separate from interest expense in the income statements and statements of cash flows. Such transactions will significantly reduce both net income and stockholders' equity.

Second, SFAS No. 150 addresses freestanding written puts or forward purchase contracts on a firm's own shares that are either physically settled or net cash settled. Such contracts obligate the firm to pay cash or other assets upon exercise in exchange for its shares, and the "losing party" must pay cash to the "winning" party for the value of the contract when no shares change hands. For example, assume that an entity writes a put option or enters into a forward purchase contract on 100 of its own shares with a strike price of $10. If the share price is $7 at the settlement date, under physical settlement the entity will pay $1,000 and receive 100 shares with a current value of $700. Under net cash settlement, the firm will pay $300 [i.e., $1,000 - $700] to the counterparty, and no shares will change hands. Freestanding contracts are legally detachable and separately exercisable. Such put options could be transferred to shareholders who could then exercise them, while an embedded put option (not covered under SFAS No. 150) cannot be transferred separately from the shares.