Debt vs' Equity

1
Debt vs. Equity

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

2
Debt vs Equity

• What do the following have in common?
• Mandatorily redeemable preferred stock
• TOPRS (trust originated preferred stock)
• Forward contracts on firms 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.

3
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.

4
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.

5
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.

6
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).

7
How TOPRs work
divs
interest
Firm
Trust
Investors
loan
Buy stk.
bonds
Pfd. Stk.
8
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.

9
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)

10
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.

11
SFAS 150

• Requires liability classification of
• Mandatorily redeemable shares
• Any obligations to repurchase the firms 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 SP 500)
• Varies inversely with FV of issuers equity shares

12
SFAS 150

• What do the following have in common?
• Mandatorily redeemable preferred stock
• TOPRS (trust originated preferred stock)
• Forward contracts on firms stock
• They are all liabilities according to SFAS 150.

13
But wait

• SFAS 150 says that an obligation that is settled
  by issuing a variable number of equity shares is
  a liability.
• That doesnt 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.

14
What is the effect of SFAS 150?

• Many of these securities have gone away
• On April 2, 2001, GM redeemed the series G
  Trusts sole assets causing the series G trust to
  redeem the approximate 5 million outstanding
  series G 9.87 trust originated preferred shares
  (TOPRs). from GMs 2001 10-K.
• Firearms Training Systems replaced mandatorily
  redeemable preferred stock with regular preferred
  stock in the wake of SFAS 150.

15
But the FASB isnt 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.