Geraldine A. Sinatra
Philadelphia +1 215 994 2824
The Financial Accounting Standards Board (FASB) recently issued Statement of Financial Accounting Standards (FAS) No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” The Statement requires companies to reclassify as liabilities a number of financial instruments that were previously accounted for as equity. FAS 150 is part of the FASB’s ongoing liabilities and equity project. The next phase of the project is expected to address the accounting of various equity instruments not covered by FAS 150.
The application of the new accounting requirements is still unclear in some respects and detailed answers will depend on the evolution of accounting practices. It is clear, however, that FAS 150 may have major implications for portfolio companies of private equity funds. This Update highlights these implications.
Overview of FAS 150
The Statement requires an issuer to classify the following instruments as liabilities:
The Statement does not cover preferred stock that can be redeemed at the option of the issuer, the option of the holder, or upon some contingent event outside the control of the issuer and the holder. Accordingly, present practice still applies and preferred stock with these features may be classified as equity unless it also contains a mandatory redemption feature. The FASB announced that puttable and contingently redeemable stock will be addressed in the next phase of its liabilities and equity project.
The different treatment of freestanding put options seems to result in a strange dichotomy. It appears that a put right created by the terms of the equity security itself (e.g., a Certificate of Designation) is not within the scope of the Statement, while a put right contained in a separate written agreement would be within the scope.
In general, financial instruments covered by the Statement must initially be measured at fair value. Subsequent changes in fair value are recognized in earnings. Payments or accruals of dividends and similar amounts to holders of equity instruments classified as liabilities must be reported as interest cost.
The Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, with one exception. For mandatorily redeemable shares of a nonpublic entity, the Statement is effective for existing or new contracts for fiscal periods beginning after December 15, 2003. “Nonpublic entity” is defined to include privately held companies with registered high-yield debt.
Implications for Portfolio Companies of Private Equity Funds
The capital structure of many portfolio companies of private equity funds may include equity instruments within the scope of the Statement. Two basic categories need to be scrutinized:
If an instrument is classified as a liability, the implications go beyond financial statement presentation and may complicate compliance with debt covenants. Debt instruments typically define the core terms of their financial covenants, such as “Indebtedness” or “Interest Expense,” by reference to GAAP as “in effect from time to time.” Companies that are required to reclassify equity as debt, and dividends as interest, must analyze their financial covenants to assure continued compliance.
What should a company do if the reclassification of equity instruments results in covenant compliance issues?
We will update you on further developments affecting the accounting treatment of hybrid instruments frequently encountered in the capital structure of portfolio companies.
Should you have any questions or require any additional information, please contact any of the following Dechert partners or the Dechert attorney with whom you regularly work.