Debt vs. Equity: Accounting for Claims Contingent on Firms' Common Stock Performance With Particular Attention to Employee Compensation Options

Project Output

White Paper Policy Brief 1 Policy Brief 2 Panel Discussion CEASA Comments: Recent FASB Staff Position CEASA Comments: Backdating Stock Options

Project Overview

This project lays out a comprehensive solution to the problem of accounting for claims based the performance of a firm's stock price. The accounting covers employee stock options, stock appreciation rights, put and call options, convertible debt and preferred stock, warrants, and other hybrid securities. This issue has vexed the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) who have approached the problem on a piece-meal basis, leading to inconsistent treatments of claims that in substance are very similar.

Settlement of contingent equity claims results in gains and losses to shareholders. The proposed accounting presumes that financial reports are prepared for reporting to common shareholders, the owners, and is organized around a feature that is common to all contingent equity claims: Issuing shares at less than their fair value - when an option or warrant is exercised, for example -- results in a loss to current shareholders, as does the repurchasing of shares at more than their fair value - when a put option on the shares is exercised. The proposed accounting recognizes these losses and also the gains to shareholders when contingent claim holders do not exercise their right to convert into common shares.

Contingent claims are liabilities to issue or repurchase shares at prices different from fair value.The accounting also recognizes that, prior to settlement of the claim, a contingent liability exists for the shareholders to surrender value to the claimants. Accordingly, a liability should be booked when the claim is initiated, measured at the fair value of the claim. So, for example, the cash received for the issue of a warrant or put option on the firm's stock - the fair value at initiation - is effectively a borrowing to be repaid by the issue of shares should the claim be exercised. Consequently the accounting also recognizes interest expense on the borrowing over the life of the outstanding claim.

Timely reporting requires liabilities to be continually updated to fair value. In order to provide timely information to shareholders about how their interest in the firm is affected, the accounting requires that the carrying value of the liability to be periodically adjusted to fair value. Accordingly, the financial statements report the gradual truing up to the final settlement of the claim.

Timely reporting requires that gains and losses on outstanding claims be continually updated. Adjusting outstanding liabilities to fair value results in unrealized gains and losses to shareholders. These gains and losses are reported as part of Comprehensive Income but outside Net Income -- in Other Comprehensive Income or similar income category that distinguishes them from normal income from business activities.

Particular attention to employee compensation options. Compensation options have features that differ from other contingent claims: They involve an exchange for services rather than cash. So, consistent with current FASB and IASB prescriptions, deferred compensation is recognized at the grant date of the option and amortized over a service life. However, inconsistent with FASB and IASB prescriptions, a liability is also recorded at grant date, but with a netting against the deferred compensation such that the net liability (and net asset) is zero. The accounting further reports the effect of the final settlement on equity value, along with a continual reporting of the likely settlement effect by a periodic updating of the net liability.

Debt vs. equity.The proposed accounting draws a clear distinction between debt and equity, an issue that has vexed the FASB for over a decade. In so doing, it revises the definition of a liability under generally accepted accounting principles (GAAP), and resolves the inconsistencies in GAAP that lead to similar claims being classified as both debt and equity. The GAAP definition requires the firm to distribute assets to settle the obligation. With a focus on reporting to shareholders, the paper takes a shareholder's view, and shareholders see a liability as an obligation for them to surrender share value. To the shareholder, cash settlement and a settlement in shares are economically equivalent; if management chooses to reduce their share value to settle claims, rather than paying cash, they lose. A clear equity concept emerges: Equity applies solely to the claim of the current common shareholders (and all other claims are debt).

Faithfully reporting to shareholders.The proposed accounting satisfies the demand for "faithfully" and transparently reporting to shareholders. Shareholders are notified, with continual updating, of the gains and losses they bear from issuing claims on their share value, and also of the liabilities they face for claims still outstanding. "Option overhang" - off-balance sheet under current GAAP - is booked as a liability.

Accounting principles are consistently applied to recognize substance over form. By providing a comprehensive and unified treatment for all contingent equity claims, the proposed accounting meets the standard of applying accounting principles on a consistent basis to instruments that are in substance the same. Accordingly, it finesses the structural engineering-to achieve a desired accounting outcome -- that is prompted by the inconsistent approaches currently available under GAAP; the accounting enforces substance over form. The accounting for warrants and options corresponds to that for convertible debt, for example, and the accounting for borrowing by issuing warrants accords with that for borrowing by writing put options (and indeed regular borrowing). Inconsistencies between the accounting prescribed for specific hybrid securities in the recent FASB Statement 150 and that for other hybrid securities (including employee options) are resolved, unambiguously. As to measurement, the proposed accounting presents no substantial difficulties over those presented by recent FASB pronouncements on contingent claims and share-based compensation, and the truing-up features of the accounting discourage earnings management.