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U.S. accounting rulemakers seek to cut the number of financial reporting restatements that tech start-ups and other companies have had to file because they misclassified convertible debt and other financial instruments that have traits of both debt and equity.
Start-ups and technology companies, together with their auditors, would be the most affected by the Financial Accounting Standards Board effort to clarify and simplify distinguishing debt from equity. Distinguishing debt from equity has vexed rulemakers, companies and auditors for years.
“Frankly, it’s a mess,” FASB member Christine Botosan , said Sept. 20 of current accounting for the instruments at issue.“We need to help the system by bringing some rationality to the accounting for liabilities and equity.”
In convertible debt deals, companies put sweeteners into loan payoff terms that allow a conversion of cash settlement to settlement in company shares.
If a company errs in the classification of the transactions, securities regulators may prescribe costly restatements. The financial reporting errors—typically treating an item as equity when it’s actually a liability—could cost many millions of dollars.
Mislabeling of instruments with debt and liability characteristics has been the number-one cause of financial reporting restatements since 2005, according to data gathered by Massachusetts financial reporting research firm Audit Analytics.
In the nascent effort, FASB plans to focus on improving convertible debt accounting guidance and on clarifying indexation and settlement provisions, which keep instruments out of the purview of derivatives accounting rules. The provisions act as a kind of initial “screen” in the accounting, say accountants at the board.
Under the indexation and settlement guidance, an instrument that might be part of a hybrid financial vehicle that isn’t deemed a derivative if it’s indexed to a company’s own shares and meets the definition of equity.
Under the planned standard-setting, items that are derivatives today mightn’t be derivatives tomorrow.
FASB rules on derivatives call for mark-to-market accounting of such instruments and for booking gains and losses in them through earnings, unless the derivatives’ use qualifies for hedge accounting treatment.
“They’re picking the right projects,” said Jack Ciesielski, president of investment firm R.G. Associates Inc., Baltimore, and publisher of Analyst’s Accounting Observer, referring to the liablities and equity project and other rulemaking FASB chose to start Sept. 20.
“Let’s hope they tackle them with enough vision and energy that they really make significant improvements,” he told Bloomberg BNA.
Financial Executives International, the organization led by Fortune 500 companies’ treasurers and controllers, welcomed FASB’s docket-setting decisions.
“We applaud the FASB’s efforts to address the areas with the most pressing needs for improvement in accounting and financial reporting, and we look forward to continuing to work with the FASB to provide perspectives” from the corporate community, said Sarah Ovuka, an FEI professional accounting fellow .
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