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Company Debt and Equity by unp56200

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									                          Debt vs. Equity

                      SFAS 150: Accounting for Certain
                         Financial Instruments with
                     Characteristics of Both Liabilities and
                                     Equity




Understanding Accounting for Equity
 Debt vs Equity
   What do the following have in common?
        •   Mandatorily redeemable preferred stock
        •   TOPRS (trust originated preferred stock)
        •   Forward contracts on firm’s stock
        •   Convertible bonds
   They are securities that have some characteristics of
    debt and some characteristics of equity.
   Some firms used to put them between liabilities and
    equity on the balance sheet (mezzanine), others used to
    put them in equity.




Understanding accounting for equity                           2
 Liability vs Equity (CON6)
   Equity or net assets is the residual interest in the assets
    of an entity that remains after deducting the liabilities.
   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.




Understanding accounting for equity                               3
 Mandatorily Redeemable Preferred Stock
   Characteristics of both
        • Fixed cumulative dividend payments are similar to interest
          payments.
        • Fixed redemption date and price are similar to principal
          payments for debt.
   Is it debt or is it equity?
   The SEC ruled that redeemable preferred stock is not
    equity, but did not state that is debt.
   So, companies put the securities between liabilities and
    equity on the balance sheet – mezzanine.




Understanding accounting for equity                                    4
 Example: Firearms Training Systems, Inc.

   Had $27.6 million in mandatorily redeemable preferred
    stock on balance sheet at 2003 and $30.4 million at 2004.
   See separate Excel presentation here.




Understanding accounting for equity                             5
 Example: Trust Originated Preferred Stock
   Company issues debt to a wholly owned trust.
   The trust issues preferred stock to investors and uses the
    proceeds of the issuance of the securities to purchase the
    debt from the company having a stated maturity.
   When the company makes its payments of interest to
    the trust, the trust distributes the cash to the holders of
    the preferred stock.
   The preferred securities must be redeemed upon
    maturity of the debt.
   The company can record interest on debt (which is tax
    deductible) instead of dividends on stock (which is not).

Understanding accounting for equity                               6
 How TOPRs work




                             $interest           $divs

                               $loan             $Buy stk.
            Firm                         Trust               Investors

                              bonds              Pfd. Stk.




Understanding accounting for equity                                      7
 General Motors’ TOPrS

   Issued $220 million of TOPrS in July 1997.
   Because the preferred stock in the trust is mandatorily
    redeemable, it cannot be equity (according to the SEC).
   But not required to call it debt.
   So GM put it in mezzanine.
   See balance sheet here.




Understanding accounting for equity                           8
 Forward contracts on firm stock
   Firm sells a forward contract on its own stock.
   The firm receives cash and promises to buy its own
    stock at a specified date and specified price.
   Because it is a transaction with a current stockholder, it
    was required to be classified as equity (EITF 00-19)




Understanding accounting for equity                              9
 SFAS 150 (issued in 2003)
   Many investors were concerned (and confused) about
    the classification in the balance sheet of certain financial
    instruments that had characteristics of both liabilities
    and equity.
   Some firms classified these as equity and some as
    mezzanine.




Understanding accounting for equity                                10
 SFAS 150
   Requires liability classification of:
        • Mandatorily redeemable shares
        • Any obligations to repurchase the firm’s own shares
        • Unconditional obligations in which the issuer must
          or may settle by issuing a variable number of its
          equity shares if
           • Fixed monetary amount known
           • Varies in something other than the FV of the
             equity shares (e.g., indexed to S&P 500)
           • Varies inversely with FV of issuer’s equity shares



Understanding accounting for equity                               11
 SFAS 150
   What do the following have in common?
        • Mandatorily redeemable preferred stock
        • TOPRS (trust originated preferred stock)
        • Forward contracts on firm’s stock
   They are all liabilities according to SFAS 150.




Understanding accounting for equity                   12
 But wait…
     SFAS 150 says that an obligation that is settled by
      issuing a variable number of equity shares is a liability.
     That doesn’t meet the definition of a liability under
      CON6:
          • 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.
     SFAS 150 states that FASB will amend CON6 to
      include equity issuances in the definition of a liability.




Understanding accounting for equity                                           13
 What is the effect of SFAS 150?
   Many of these securities have gone away:
   “On April 2, 2001, GM redeemed the series G Trust’s
    sole assets causing the series G trust to redeem the
    approximate 5 million outstanding series G 9.87% trust
    originated preferred shares (TOPRs).”… from GM’s
    2001 10-K.
   Firearms Training Systems replaced mandatorily
    redeemable preferred stock with regular preferred stock
    in the wake of SFAS 150.




Understanding accounting for equity                           14
 But the FASB isn’t finished…..
   The FASB, in a joint project with the IASB, is working
    on a comprehensive standard of accounting for
    instruments with characteristics of liabilities and equity.
   Develop a conceptual framework for the accounting.
   In the meantime, financial institutions are developing
    contracts that do not meet the criteria in SFAS 150 so
    that they are not considered liabilities – structuring
    transactions around the new rules.




Understanding accounting for equity                               15

								
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