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 that it forces 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.
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
Case 18–10 (continued)
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
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 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
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
Many issues would have to be resolved if this approach were to be seriously pursued. For instance, would all present liabilities be treated as "equities"? If not, which would be treated differently? Today the distinction between short term and long term is not considered to be particularly relevant for at least some companies, so it might be questionable to distinguish on that basis. Another possibility would be to treat only liabilities incurred in exchange for cash proceeds as "equities." However, labor, inventory, and the like also are
"capital" in a broad sense, so it may be hard to justify treating obligations incurred to acquire them differently from obligations to pay cash.
The concept of income under this approach is another question. Would an attempt to eliminate the line between liabilities and equity make it inappropriate to attempt to measure income, or would it merely change the underlying