Equity and Liability Securities

History of Equity and Liability Securities

There is currently debate over the classification of securities being distinguished as equity or liability. With basic investments such as bonds, certificates of deposit, and common or preferred stock, the distinction can be easily made. However, as financial instruments become more complex, distinguishing between equity and liabilities becomes more of a challenge. There are many ongoing debates over approach, definition, and application of equity and liability instruments between the IASB and the FASB, and with increasing influence from other countries such as Japan the debates over how to classify investments as either liabilities or equity is sure to continue for some time.

Financial investments occur when one entity provides services or assets to another in exchange for a certificate known as a security (Edmonds et al. 2006, 283-284). The investor of a financial investment is the party that provides the assets or services and in turn receives the security certificate, while the investee is the party receiving assets or services and issuing the security certificate. There are two primary types of investment securities, debt and equity.

Equity securities are obtained when an investor obtains an ownership interest in the investee. Equity securities primarily describe the rights of ownership, including the right to influence operations of the investee and to share in the profits or losses that result from the operations of the investee (Edmonds et al. 2006, 283-284). The two forms of equity securities that are most commonly found are common stock and preferred stock.

On the other hand, an investor receives a debt security when funds are loaned to the investee. In short, a debt security represents the investee's obligation to return assets to the investor and to pay interest for the use of the assets (Edmonds et al. 2006, 283-284). Some basic forms of debt securities include bonds, notes, certificates of deposit, municipal bonds, and commercial paper. In their most basic form, investment securities are certificates that describe the rights that investors receive when they loan or give assets or services to investees (Edmonds et al. 2006, 283-284).

While debt and equity securities in their basic form are quite distinguishable from one another, as financial investments become more complex, the ability to distinguish the two becomes a more difficult task in the complex securities market. GAAP currently requires that securities held as assets be classified into one of three categories; held-to-maturity, trading securities, or available-for-sale securities. Held-to-maturity securities include debt securities only, since equity securities representing ownership interests have no maturity date (Edmonds et al. 2006, 283-284). Held-to-maturity securities are reported on the balance sheet at their amortized historical cost. Trading securities can include both debt and equity securities which are bought and sold for the purpose of creating profits on the short-term appreciation of stock and bond prices, and are reported on the balance sheet at fair value (Edmonds et al. 2006, 283-284). Finally, available-for-sale securities include all marketable securities, whether debt or equity, that are not classified as held-to-maturity or trading securities. Available-for-sale securities, like trading securities, are presented on the balance sheet at their fair value (Edmonds et al. 2006, 283-284).

When considering different forward and option contracts, as well as various other bonds such as zero coupon bonds and derivatives, the ability to distinguish between debt securities or liabilities and equity securities become more challenging. According to the FASB, a new standard on how to distinguish liabilities and equities is necessary, because current accounting literature on the issue is inconsistent, and difficult to understand and apply to complex instruments (Deloitte 2007). The FASB's basic ownership approach will improve and simplify current accounting by narrowing what is to be considered an equity security. Under this approach, only common stock would qualify as equity, and other contracts that have previously been classified as equity, for example preferred stock and select other forward and option contracts, would instead be classified as liabilities (Deloitte 2007). The FASB's narrower definition of equity would simplify the definition and application of equity for distinction between interests of different classes of stakeholders. Additional benefits of the approach would be fewer opportunities to structure instruments in a way to achieve certain desired accounting treatment (Deloitte 2007).

Under the basic ownership approach, an entity would classify preferred stock and other perpetual instruments as liabilities (Deloitte 2007). This new way of classifying securities would be a major change from current GAAP, which currently requires equity classification of such contracts (Deloitte 2007). Also, under the basic ownership approach, indirect ownership interests such as options or forwards on an entity's equity would be classified as liabilities or assets (Deloitte 2007). The goal of the FASB with this basic ownership approach is to increase the distinction of what qualifies as equity securities and what qualifies as debt securities or liabilities.

IAS 32: Financial Instruments Presentation

IAS 32 is the standard that provides clarification on the differences between liabilities and equities currently. The objective of IAS 32 is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and liabilities. IAS 32 clarifies the classification of financial instruments as a liability or as equity, prescribes the accounting for treasury shares, and applies strict conditions under which assets and liabilities may be offset in the balance sheet.

The fundamental principle of IAS 32 is that a financial instrument is classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form. There are two exceptions; certain puttable instruments meeting specific criteria and certain obligations arising on liquidation (PWC 2009, 128-9). Entities must make the decision on the type of classification at the time they initially recognize the instrument. Classification is not subject to change based on circumstances that may change (Deloitte 2010a).

A financial instrument is to be classified as equity only if the instrument includes no contractual obligation to give cash or other assets to another entity and if the instrument will or may be settled in the issuer's own equity. Equity is either a non-derivative that includes no contractual obligation for the issuer to deliver its own equity; or a derivative that will be settled only by the issuer exchanging cash or other assets for its own equity (Deloitte 2010a).

One example of how liabilities and equity are distinguished under IAS 32 would be when an entity issues preferred shares that pay a fixed rate of dividends and that have a mandatory redemption feature at a future date. In this case since there is a contractual obligation to deliver cash, the instrument to be recognized as a liability. However, if it were preferred shares that do not have a fixed maturity and don't have a contractual obligation to make any payment, the instrument would be classified as equity. In this example even though both instruments are preferred shares they have different contractual terms making one a liability and the other equity. If a derivative financial instrument gives one party a choice over how it is settled; the issuer or the holder can choose settlement in cash or by exchanging shares for cash, it is an asset or liability unless all of the settlement alternatives would result in it being equity (Deloitte 2010a).

Financial instruments that have both a liability and an equity component are required by IAS 32 to be accounted for and presented separately. The split is made at issuance and is not changed with fluctuations in interest rates, or share prices. A convertible bond is an example of this type of instrument (PWC 2009, 121). The liability is the issuer's contractual obligation to pay cash, and the holder's option to convert into common shares is equity. The initial amount of the compound instrument is allocated into its equity and liability components, and the equity component is assigned the residual amount that results from deducting the amount determined for the liability component from the fair value of the instrument (PWC 2009, 121).

The IASB amended IAS 32 and IAS 1 Presentation of Financial Statements with respects to the balance sheet classification of puttable financial instruments and obligations arising only on liquidations in February of 2008. The result was that some instruments that were classified as liabilities would now be classified as equity because they represent the residual interest in the net assets of the entity (Deloitte 2010a). Another amendment was made to IAS 32 in October 2009 that has to do with the classification of rights. Before the amendment rights issues that offered a fixed amount of foreign currency were required to be accounted for as derivative liabilities. With this amendment to IAS 32 the rights are now to be issued pro rate to all of an entities shareholders, and they are classified as equity regardless of the currency of the exercise price (Deloitte 2010a).

Some other things IAS 32 states about liabilities and equity include: any transaction costs that are incurred on a compound instrument are allocated to the liability and equity components (PWC 2009, 131). Gains, losses, dividends, and interest related to the liability flow to the income statement, dividend payments on preferred shares that are liabilities are expenses, and distributions to holders of an equity instruments are charged directly against equity, not earnings. Also, treasury shares costs are deducted from equity and gain or loss is not recognized on treasury shares (Deloitte 2010a).

FASB

In the Statement of Financial Accounting Concepts No. 6, FASB defines both liabilities and equity. “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” (FASB 1985, 13). Concept Statement 6 also states that “equity is the residual interest in the assets of an entity that remains after deducting its liabilities” (FASB 1985, 16). Liabilities and equity both have characteristics that help individuals decide which one it is.

Liabilities have three main characteristics; the first is that it represents a current responsibility to one or more other entities that requires settlement by probable future transfer or use of assets at a pre-determined date (FASB 1985, 13). The second main characteristic of a liability is the responsibility obligates a particular entity leaving it no choice on avoiding the future repayment. The third main characteristic of a liability, according to Concept Statement No. 6, is that the transaction or event obligating the particular entity has already occurred. Liabilities have other important features that help identify them but are not required. One instance is that most liabilities have a legally binding contract which states the terms of the liability and when it is to be repaid.

Equity, on the other hand, has one main characteristic. This is that equity can be increased through contributions or investments by owners and the owners may receive distributions of assets from the entity (FASB 1985, 16). Equity ranges from common and preferred stock to retained earnings. Equity also depends significantly on the profitability of the entity. In not-for-profit organizations, they use the term net assets instead of equity. The main difference between the equity section of business enterprises and the net assets section of not-for-profit organizations is that not-for-profit organizations do not have an ownership interest in the same sense as a business enterprise. Calculating net assets in a not-for-profit firm is still the same as calculating equity for a business enterprise, but net assets are not identified as ownership interests.

Trying to distinguish between liabilities and equity is not always cut and dry. Sometimes problems arise in trying to decide if a particular situation is a liability or equity due to the fact that some situations have the characteristics of both liabilities and equity. Some equity transactions, like preferred stock, can potentially have a maturity date where the entity has to pay back the amount of the stock to the party that owns the stock. In that example, the transaction looks like it could potentially be a liability, but it is reported as equity. Another example would be convertible debt. In convertible debt there is an equity component and a liability component. The US GAAP requires the convertible debt to be treated wholly as a liability (Doupnik 2008, 153).

The nature of the entity can also cause problems to arise in trying to determine if the event is a liability or equity. This can be a problem in a not-for-profit organization mainly because of the nature of net assets. Net assets in a not-for-profit organization often have stipulations imposed by the donor(s) of the money or asset and can be tough to identify liability or net assets depending on the type of restrictions imposed. The different types of restrictions are permanent, temporary and unrestricted. Permanent restrictions of net assets do not expire through passage of time and cannot be fulfilled or removed from other assets with the same type of condition or reclassification from other types of net assets (FASB 1985, 25). Temporary restrictions of net assets can expire through passage of time and can be fulfilled or removed through actions of the entity towards the conditions from other assets with the same type of condition or reclassification from other types of net assets (FASB 1985, 25). Lastly, unrestricted net assets are the part of net assets that are not permanently or temporarily restricted by conditions. Concept Statement No. 6 says that the only limits on unrestricted net assets are broad limits from the nature of the organization and the organizations purposes detailed in the articles of incorporation or something similar and perhaps limits from contracts entered into with outside parties.

Comparison and Convergence

The differences in treatment for instruments with equity characteristics are wide in scope. The project for convergence is nearing its fifth year of discussion. Treatment under US GAAP is generally narrower in view for inclusion in equity, with the liabilities section acting as a catch all for those instrument not fitting the definition of equity (PWC 2009, 119). Liabilities, traditionally viewed as requiring a transfer of cash or other assets, do not fully fit economic substance of instruments.

Under US GAAP a hybrid section, mezzanine equity is permissible. Namely, convertible instruments and those instruments with optional outcomes do not fit the GAAP definition of equity. Under IAS 32 and proposed committee framework, these mezzanine equity instruments would be classified as liabilities. Current approaches by the Board and Staff of the reconciliation project have been committed to keeping the definition of a liability as it is under the current framework and previously mentioned (Deloitte 2010b). Application and use of stock, for instance, in transactions could be the framework behind distinction.

With the ongoing projects for convergence, and even a recent push for influence by Japan, the resulting standards will require reconciliation by those affected companies. New treatment of financial instruments with equity characteristics may require reclassification of the instruments from equity to liability or vice versa. The current proposed approach would classify a greater number of instruments as equity, including those that are own-share settled (Deloitte 2010b).

The opposing views on classification stem from the protracted argument of the solvency view of the IASB and the dilution view of the FASB. Under dilution, those instruments that would affect the earnings per share calculation are considered to be equity. Conversely, an instrument that would give a third party claim to company assets upon liquidation would be considered equity.

A discussed treatment of convertible instruments for reclassification is bifurcation of the instrument into equity and liability portions. While this would work towards alleviated the dilution and solvency debate, there are fundamentally different approaches between US GAAP and IFRS to value embedded equity instruments (PWC 2009, 124). A current valuation of the divided instrument would be a fair value estimate of the liability portion with the remainder of the purchase price being allocated to equity component of the compound instrument (Deloitte 2010b). This treatment would reflect the selling price of the instrument as for the future fulfillment of the liability and the potential for paid in capital on the instrument.

Reclassification of instruments under a new international standard could have sweeping effects. As mention previously, a new standard could require an instrument to be reclassified under a new equity framework or even allocated to bifurcated portions. These new treatments could have an impact on both the financial position and performance of a company. For instance, US GAAP would classify convertible bond as mezzanine equity, whereas bifurcation would split the equity and liability sections of the bond. Now the split instrument is in two sections of the balance sheet, which has implications on the leverage of the company. Ratio calculation involving equity would no longer incorporate the bifurcated liability and vice versa. This could alter the performance measures to reflect negatively on the company if the equity leverage is not at an acceptable level of return.

In addition to possible alteration of financial ratios and leverage, treatment of reclassified instruments could affect gains/losses and expenses on the income statement. Traditional liabilities such as bonds payable, are accounted for with the effective interest method over the life of the instrument. A callable or puttable convertible instrument accounted for as equity would then have interest expense when classified or bifurcated as a liability (PWC 2009, 121). Revaluation to market value of liabilities, permitted under IFRS, could also lead to gains or losses during a transition period having an impact the financial performance. A study of the impact from reclassification is due to be discussed at the February 2010 Project Meeting (Deloitte 2010b).

Having rigid rules for the framework of defining equity also leads to the possibility of usurping said rules. Part of the reason behind hybrid financial instruments was to blend in equity elements to make the sale of debt more attractive. Writing instruments in the future for structuring opportunities, namely classifying a liability as equity by having an uncertainty about its satisfaction, is of particular concern (Deloitte 2010b). The debate over approach, definition, and application of equity and liability instruments between the IASB, FASB, and increasing pressure from Japan will be ongoing for quite some time (Sano and Noriyuki 2010).

As one might surmise, the decision to classify a hybrid security as liability or equity is not a simple one under the current accounting framework. The FASB and IASB both need to clarify both liabilities and equity a little better to help entities report their transactions more accurately. With ongoing meetings and discussions on how to classify securities as liabilities or equity, in time, the distinction between the two will eventually become more universal, and easier to determine.

References

Deloitte. 2007. Heads Up: FASB Proposes to Narrow Definition of Equity. http://www.deloitte.com/view/en_US/us/article/21e6f721.

Deloitte. 2010a. IAS 32 Financial Instruments: Presentation.

http://www.iasplus.com/standard/ias32.htm.

Deloitte. 2010b. "IASB Agenda - Distinction Between Liabilities and Equity." http://www.iasplus.com/agenda/liabequity.htm (17 February 2010).

Doupnik, T., Perera, H. "International Financial Reporting Standards." International Accounting. 2 ed. New York: McGraw-Hill/Irwin, 2008. 153.

Edmonds, T. et al. “Accounting for Merchandising Businesses- Advanced Topics.” Fundamental Financial Accounting Concepts. 5 ed. Boston: McGraw-Hill/Irwin, 2006. 283-284.

FASB. Statement of Financial Accounting Concepts No. 6. Dec 1985. 13-17, 25.

PriceWaterhouseCoopers. September 2009. IFRS and US GAAP Similarities and Differences: 119-134.

Sano, Hideyuki, and Noriyuki Hirata. "Japan seeks bigger say on global accounting rules." Reuters. http://www.iasplus.com/agenda/liabequity.htm (18 February 2010).

Please be aware that the free essay that you were just reading was not written by us. This essay, and all of the others available to view on the website, were provided to us by students in exchange for services that we offer. This relationship helps our students to get an even better deal while also contributing to the biggest free essay resource in the UK!