Will FASB 150 Have A Chilling Effect On Entity Buy-Sell Plans?
On May 3, the Financial Accounting Standards Board (FASB) issued Statement 150–Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equities.
This statement represents the first phase of a larger FASB project. In this phase the board addressed the accounting for three particular financial instruments that, under previous guidance, issuing companies could account for as owners equity. (See sidebar.)
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Are stock redemption and other entity buy-out arrangements between businesses and their owners subject to this new accounting? In many, if not most cases, the answer is yes.
It is typical in entity buy-out arrangements to mandate the purchase of shares at certain triggering events (death, retirement, disability, etc.). In many cases, the mandatory redemption is an integral part of the agreement. It protects the surviving or remaining owners and helps support the sellers claim to the agreements stated valuation.
As a result of this new treatment, some private companies will have no shareholders equity and no net income. Also, companies need to be particularly careful regarding the covenants in their debt agreements with lenders and suppliers. These accounting changes may cause covenant violations based on revised debt to equity ratios.
What can companies do to react to these changes? The first step should be to avoid debt covenant violations. If possible, these covenants should be renegotiated with waivers or amendments added to take these changes into account. Future financial agreements should have clauses providing for covenants based on benchmarks that remain stable for the life of the agreement rather than subjecting them to the changes in GAAP.
The second step companies should take is to address mandatory buy-back agreements that may be in place. Removing the certainty of the redemption is one approach. A mandatory buy-back could be replaced with a put option given to the owners. This could be coupled with a company call option in the event that the shares are not offered for sale by an owner.
The owners should be careful to avoid side agreements that would assure that, one way or another, the sale would take place. The side agreement or understanding may make the shares mandatorily redeemable and subject to Statement 150.