Distinguishing liabilities from equity has been saved
Distinguishing liabilities from equity
On the Radar: Financial reporting impacts of ASC 480
Distinguishing liabilities from equity has implications for how a financial instrument is reflected in your income statement. So it’s important that the classification of liabilities is done in a thorough, thoughtful way. Let’s break down ASC 480 and the three key questions you need to consider when identifying liabilities versus equity.
3 keys to distinguishing liabilities from equity
Entities raising capital must apply the highly complex, rules-based guidance in US GAAP to determine whether the securities they issue are classified as liabilities, permanent equity, or temporary equity. To reach the proper accounting conclusion, they must consider the following key questions:
All entities are capitalized with debt or equity. The mix of debt and equity securities that comprise an entity’s capital structure, and an entity’s decision about the type of security to issue when raising capital, may depend on the stage of the entity’s life cycle, the cost of capital, the need to comply with regulatory capital requirements or debt covenants (e.g., capital or leverage ratios), and the financial reporting implications. For example, early-stage and smaller growth companies are often financed with preferred stock and warrants with complex and unusual features, whereas larger, more mature entities often have a mix of debt and equity securities with more plain-vanilla common stock capitalization.
Under US GAAP, securities issued as part of an entity’s capital structure are classified within one of the following three categories on an entity’s balance sheet:
- Temporary equity*
- Permanent equity
*For SEC registrants and non-SEC registrants that choose to apply the SEC’s rules and guidance.
On the Radar: Distinguishing liabilities from equity
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Why classification of liabilities is so important
An instrument’s classification on the balance sheet will affect how returns on the instrument are reflected in an entity’s income statement. Returns on liability-classified instruments are reflected in net income (e.g., interest expense or mark-to-market adjustments), whereas returns on equity-classified instruments are generally reflected in equity, without affecting net income. However, dividends and remeasurement adjustments on equity securities that are classified as temporary equity may reduce an entity’s reported earnings per share (EPS).
In addition to the effect on net income and EPS, entities often seek to avoid classifying capital securities as liabilities or within temporary equity for other reasons, including:
- The effect of the classification on the security’s credit rating and stock price
- Regulatory capital requirements
- Debt covenant requirements (e.g., leverage or capital ratios)
ASC 480 is the starting point for determining whether an instrument must be classified as a liability. SEC registrants and non-SEC registrants that elect to apply the SEC’s guidance on redeemable equity securities must also consider the classification within equity. The relevant accounting guidance has existed for a number of years without substantial recent changes. In addition, we are not aware of any plans of the FASB or SEC to significantly change the guidance in the near future.
The SEC staff closely scrutinizes the appropriate balance sheet classification of capital securities. This is evident in comment letters on registrants’ filings and the number of restatements arising from inappropriate classification.
Classifying liabilities under ASC 480
Securities issued in the legal form of debt must be classified as liabilities. In addition, ASC 480 requires liability classification for three types of freestanding financial instruments that are not debt in legal form:
In evaluating whether an instrument must be classified as a liability under ASC 480, entities must consider these three key questions:
Permanent equity versus temporary equity
SEC registrants are required to apply the SEC’s guidance on redeemable equity securities. An entity that has filed a registration statement with the SEC is considered an SEC registrant. Other entities, such as companies that anticipate an initial public offering (IPO) in the future, may elect to apply this guidance.
Equity-classified securities that contain any obligation outside the issuer’s control (whether conditional or unconditional) that may require the issuer to redeem the security must be classified as temporary equity. Equity securities that are classified as temporary equity are subject to the recognition, measurement, and EPS guidance in ASC 480-10-S99-3A, which is often complex to apply. The remeasurement guidance in ASC 480-10-S99-3A may negatively affect an entity’s reported EPS because adjustments to the redemption amount are often treated as dividends that reduce the numerator in EPS calculations.
With the rise in the number of IPOs and transactions involving special purpose acquisition companies, many nonpublic entities are applying the SEC’s guidance on classification of redeemable equity securities before they file with the SEC.
Continue your liability classification learning
Deloitte’s Roadmap to distinguishing liabilities from equity (issued April 2021) provides a comprehensive discussion of the classification, recognition, measurement, presentation and disclosure, and EPS guidance in ASC 480 and ASC 480-10-S99-3A. Entities should also consider Deloitte’s Roadmap to Contracts on an Entity’s Own Equity for guidance on equity-linked instruments that are not outstanding shares.
This Roadmap provides Deloitte’s insights into and interpretations of the guidance in ASC 805 on business combinations, pushdown accounting, common-control transactions, and asset acquisitions, as well as an overview of related SEC reporting requirements. The Roadmap reflects guidance issued through April 2021 and discusses several active FASB projects that may result in changes to current requirements.
While the accounting frameworks for this guidance have been in place for many years, views on applying them continue to evolve. This publication is intended to help entities navigate the guidance and arrive at appropriate accounting conclusions.
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The Roadmap series contains comprehensive, easy-to-understand accounting guides on selected topics of broad interest to the financial reporting community.