Debt vs. Equity: Accounting for Claims Contingent on Firms’ Common Stock Performance

Determining accurate accounting methods for employee stock options and other stock-related claims has long been a headache for companies, investors, analysts, standard-setters and regulators.

Contradictory GAAP rulings that classify similar securities as both debt and equity have resulted in inconsistent company reporting over the years. In response to this issue, Columbia Business School’s Center for Excellence in Accounting and Security Analysis (CEASA) has released a white paper that details how Shareholder Value Accounting (SVA) can provide the most accurate, consistent and transparent means of accounting for the spectrum of contingent equity claims.

Debt vs. Equity: Accounting for Claims Contingent on Firms’ Common Stock Performance with Particular Attention to Employee Compensation Options is CEASA’s inaugural white paper. Co-authored by James Ohlson of Arizona State University and Stephen Penman of Columbia Business School, the white paper provides a critically needed guide that consistently and accurately accounts for a range of performance-related claims, including: employee stock options, stock appreciation rights, and put and call options, convertible debt and preferred stock, warrants and other hybrid securities.

SVA presents company executives, shareholders and the public at large with the most timely and accurate information about what a company is worth from the perspective of the shareholders. It eliminates the inconsistencies and confusion found in other methods of accounting for these claims.

The proposed accounting differs from current Generally Accepted Accounting Principles (GAAP) in that it revises the definition of a liability, recognizes gains and losses to shareholders from their claims, and resolves inconsistencies between similar claims that are currently classified as both debt and equity. Additionally, it provides shareholders with important, timely and transparent supplemental information that is currently not required in financial statements.

“This paper demonstrates the power of academia to provide tools for practitioners that improve the way we do business,” said R. Glenn Hubbard, dean of Columbia Business School. “CEASA’s strength is in bringing together faculty and end users to produce viable solutions for problems that businesses face today.”

Shareholder Value Accounting at Work

Example 1: Borrowing with warrants

A firm issues warrants to buy 20 of its shares at $30 per share, receiving $200 for the issue. The $200 is treated as a liability to repay the effective borrowing with an issue of shares -- in contrast to GAAP where it is treated as equity. Interest is recorded over the life of the warrant at the firm's borrowing rate, as with any borrowing. A further financing cost arises on exercise of the warrants in the form of a loss from issuing shares at less than market value. If the per-share value of the shares issued is $45 and the firm received only $30, the total loss from exercise is $300 ($15 x 20), less interest recognized over the life of the warrants. The loss is recognized progressively over the life of the warrant as the warrant moves into the money (and gains are recognized if the warrants fail to move into the money). Correspondingly, the liability is continually fair-valued to provide timely indication of the obligation of shareholders to issue shares at a price different from market value. A similar treatment applies to put options, convertible bonds and convertible preferred stock.

Example 2: Employee stock options

These are treated similarly to the warrants in Example 1, to which they are similar in substance. At grant date, a liability is recognized -- rather than equity in the accounting required in 2005 by the FASB -- to reflect the contingent obligation to issue shares. Like the FASB accounting, compensation expense is also recognized. However, in contrast to the FASB accounting, subsequent gains and losses are also recognized as the option moves away from or into the money, with a final settling up to the loss incurred, on exercise, from issuing shares at less than market price (or to the gain should the option lapse). Accordingly, the full cost, to shareholders, of issuing options is recorded.

PDF files of the paper can be accessed at www.gsb.columbia.edu

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