Question

The current conceptual distinction between liabilities and equity defines liabilities independently of assets and equity, with equity defined as a residual amount. The present proliferation of financial instruments that combine features of both debt and equity and the difficulty of drawing a distinction have led many to conclude that the present two-category distinction between liabilities and equity should be eliminated. Two opposing viewpoints are: View #1: The distinction should be maintained. View #2: The distinction should be eliminated, and financial instruments should instead be reported in accordance with the priority of their claims to enterprise assets. One type of security that often is mentioned in the debate is convertible bonds. Although stock in many ways, such a security also obligates the issuer to transfer assets at a specified price and redemption date. Thus, it also has features of debt. In considering this question, focus on conceptual issues regarding the practicable and theoretically appropriate treatment, unconstrained by GAAP.

Required:

Should the present two-category distinction between liabilities and equity be retained?

Which view do you favor?

Develop a list of arguments in support of your view. Make sure you explain.

Answer 1

Answer:

You may wish to suggest to your students that they consult the FASB 1990 Discussion Memorandum, “Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both,” which sets forth the most common arguments on the issues in this case.  Or, you may prefer that they think for themselves and approach the issue from scratch.

There is no right or wrong answer.  Both views can and often are convincingly defended.  The process of developing and synthesizing the arguments likely will be more beneficial than any single solution.  Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole.  It is important that each student actively participate in the process.  Domination by one or two individuals should be discouraged.

A significant benefit of this case is its forcing students' consideration and acceptance of the fact that both liabilities and equities are claims to an enterprise's assets.  It also requires them to carefully consider the profession's definitions of those elements.  Arguments brought out in the FASB DM include the following:

Arguments Supporting View 1:

Some students likely will argue that convertible bonds and other similar instruments can be appropriately classified in the two existing categories on the basis of existing distinctions and definitions.  For instance, they might focus on the characteristic of a liability that requires that the enterprise issuing it have little or no discretion to avoid the future sacrifice of economic benefits.

Concepts Statement 6 defines liabilities as:

      . . .  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.  [paragraph 35]

      Three essential characteristics of a liability are:

a.   It embodies a present duty or responsibility to one or more other entities for settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand.

b.   The duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice.

c.   The transaction or other event obligating the entity has already happened.

Equity of a business enterprise is defined simply as the residual interest: the difference between an enterprise's assets and its liabilities.  The essential characteristics of equity focus on the conditions for transferring assets to the holders of equity interests.  Usually, a company is not obligated to transfer assets to owners except in the event of liquidation unless it voluntarily acts to do so, such as by declaring a dividend.  A company's liabilities and equity are mutually exclusive claims to or interests in its assets by others, and liabilities take precedence over ownership interests.

A company may have two or more classes of equity, such as preferred stock and common stock; no class has an unconditional right to receive distributions of assets other than in liquidation and then only after all liabilities have been settled.  That is the essential distinction between liabilities and equity.  A liability entails an obligation to transfer assets or provide services in the future, while an equity instrument does not.

The distinction between liabilities and equity is important to reported financial position.  So, whether an issue of convertible bonds is classified as a liability or as equity affects both reported amounts of total liabilities and equity and summary amounts based on those amounts, such as ratios. The distinction also is critical in measuring income.  Comprehensive income is defined in Concepts Statement 6 to include all changes in equity during a period other than those resulting from transactions with owners.  Income includes only inflows in excess of the amount needed to maintain capital.  Without a distinction between the claims of creditors and those of owners, measurement of income is not possible.

Reported income also is affected.  Convertible bonds have features of both debt (fixed interest and principal payments) and equity (ability to participate in the benefits of stock ownership). If convertible bonds are treated as an equity instrument, the interest payments are not deducted in determining the issuer's net income.  However, if they are deemed to be liability, the interest would be reported as an expense and deducted in determining net income.

Arguments Supporting View 2:

Arguments here center on the “entity theory” of accounting first proposed by W. A. Paton in 1922 which views the accounting equation as:

Assets = Equities

With equities including both what are termed liabilities and equity in the current conceptual framework.  A central feature of this theory is that profits are determined with reference to all capital suppliers.  That is, profits are determined before deducting either interest or dividends.  Both interest and dividends, and income taxes as well, are treated as distributions of profits.

Examples of possible formats of a balance sheet and an income statement under this alternative suggested by the DM follow.

Balance sheet on the next page

Balance Sheet

Cash                                  $ 2,050                           Accounts payable   $1,200

Investments                          5,000                           Mortgage   4,000

Inventory                             7,000                           Bonds     5,000

Plant and                                                                  Preferred stock 5,000

  equipment   15,000 Common stock   4,800

                                                                                 Retained earnings     9,050

                                          ______                               Total equities   18,850

                                                                                     Total liabilities                             

Total assets                       $29,050                                   and equities                 $29,050

Income Statement

Sales $30,000

Cost of goods sold   10,000

Selling and other expenses                                             4,000

Excess of revenues over expenses                             $16,000

Interest on mortgage   300

Interest on bonds   400

Income taxes 5,000

Preferred dividends       450

Earnings attributable to common stock $9,850

Common dividends     800

Earnings retained $9,050           

                              or, alternatively:

Sales $30,000

Cost of goods sold                                                       10,000

Selling and other expenses      4,000

Enterprise net income   $16,000

Interest on mortgage                                                         300

Interest on bonds 400

Income taxes   5,000

Preferred dividends 450

Common dividends      800

Earnings retained $9,050