| Winter 2007 |
Construction Advisor
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Implementing SFAS No.
150
For a variety of legitimate business reasons, it is very common for
companies to have buy-sell agreements and buy-out agreements in place.
These agreements are very helpful related to continuity of the business
and, in many cases, lenders (and others) prefer that these type
arrangements exist so that they will know who they are "dealing with"
related to ownership within the business. In certain cases, these type
agreements must be reflected in financial statements as liabilities
because the agreements constitute an "obligating event" related to
transfer of assets of reporting entities. As an example, when companies
have a buy-out agreement that is "triggered" by an event that is certain
to occur (e.g., the death or retirement of the owners of the business),
there is no question that assets will have to be "transferred" in order
to settle the obligation. The only question relates to "when" the assets
must be transferred in order to settle the obligation.
In practice, reporting entities, including those within the construction
industry, have been reflecting ownership interests that were subject to
mandatory redemption (because of the buy-out agreement) within the equity
section of the balance sheet. When the Financial Standards Accounting Board
(FASB), the authoritative rule-making body that establishes accounting and
reporting standards, "took a look" at these type arrangements, the conclusion
was reached that a liability (rather than equity) should be recorded in the
financial statements because it is "certain" that assets must be transferred to
in order to settle the obligation.
In addressing this particular reporting issue, the FASB (in May 2003) issued
SFAS No. 150, entitled Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. While this document is
limited in its scope, it has the potential to have a "significant impact" on
financial statements of private companies (including those within the
construction industry). SFAS No. 150 provides new guidelines for reporting
financial instruments as either liabilities or equity, causing many instruments
previously classified as equity to be reclassified as liabilities. This
conclusion has the potential to "torpedo" the equity section of the balance
sheet for many construction contractors. The three classes of financial
instruments that must be reported in the liability section of the balance sheet
are as follows:
- Mandatorily-Redeemable Financial Instruments (MRFI) - MRFIs include
(for example) shares of stock that a company must buy-back in exchange for
cash or other assets at a specified date or upon an event that is certain to
occur (e.g., the death of the owner).
- Obligations to Repurchase Equity Shares of the Issuer by Transferring
Assets - These obligations include (for example) those that will be
settled by transferring assets of the company in order to settle the
obligations. Essentially, these obligations are "pretty much the same" as
obligations related to mandatory redemption of equity.
- Certain Obligations to Issue a Variable Number of Shares - These
obligations include (for example) those that can be settled by transferring
shares of the company's stock, the value of which is fixed or tied to a
variable that is determinable. So, again, the obligation must be settled but,
in this particular case, through transferring equity securities rather than
assets.
Practice Note: As used in SFAS No. 150, the reference to "shares"
includes various forms of ownership that may not take the legal form of
securities. For example, ownership interests in C corporations, S corporations,
partnerships, etc., all are included within the scope of this interpretation.
Shortly after the issuance of SFAS No. 150, a "firestorm" of protest erupted
from the private sector because of the potentially negative effect on private
businesses, especially construction contractors. Of particular concern was the
guidance within SFAS No. 150 requiring that mandatorily-redeemable equity to be
classified in the liability section of the balance sheet (rather than as
equity). As mentioned earlier, it is not uncommon (in fact, it is very common),
for construction contractors to have buy-sell agreements (mandatory redemption
agreements) and buy-out agreements related to ownership interests in the
company. These agreements are often partially or totally funded by life
insurance, but the FASB concluded that the existence of a "funding mechanism"
related to the liability (e.g., the life insurance policy) did not limit the
applicability of the guidance. So, even though these arrangements/agreements
were "put together" for the sake of business continuity, estate and gift
planning purposes, and other reasons (often at the request of banks and bonding
companies), these arrangements/agreements now have the real potential of "not
being positive" by "being negative" related to the financial reporting process.
Before the issuance of SFAS No. 150, generally accepted accounting principles
(GAAP) required only a disclosure buy-sell and buy-out arrangements in those
notes to the financial statements; however with the issuance of SFAS No. 150,
the FASB has reached "new conclusions" related to the financial reporting
ramifications of MRFIs. In those cases where the company (rather than the owners
of the company) have the obligation to retire equity at the death of an owner
(an event that is certain to occur), the equity section of the balance sheet
simply would "go away" with the implementation of this new accounting guidance.
Example Buy-Out Agreement Wording that Could "Trigger" SFAS No.
150
Very commonly for a variety of reasons, companies have buy-sell and buy-out
agreements in place. Using a "real" example (that has been sanitized) to
illustrate how the wording within these arrangements can be problematic,
consider the wording in the following two examples that has been "extracted"
from "boiler plate" stock purchase agreements.
Example #1. Whereas, the shareholders and the corporation wish to set
forth their agreement with reference to disposition of any stock in the
corporation either during the lifetime of any shareholder or after the death of
the shareholder…. In the event that a shareholder wishes to dispose of his/her
shares, or any portion thereof, the selling shareholder shall first notify (in
writing) the corporation, and the corporation shall in turn notify (in writing)
the other shareholders of the identity of the selling shareholder and the
proposed purchaser or purchasers, the number of offered shares, and the proposed
price and terms of sale. The corporation shall thereupon have a right of
first refusal to purchase the offered shares at the price and on the terms
offered by the proposed purchaser, whichever the corporation may select...
If the corporation does not exercise its right to purchase the offered shares,
the shareholders (other than the selling shareholder) shall have the right to
purchase any of the offered shares not purchased by the corporation at the same
optional prices and terms as were available to the corporation.
Practice Note: The "right of first refusal" wording is not problematic
related to implementing SFAS No. 150 because the company is not "obligated" to
redeem equity. Rather, there is a "choice" that the company has related to
redeeming the equity.
Example #2. Upon the death of any of the shareholders, the corporation
shall purchase all of the shares of stock held by such deceased shareholder in
the corporation by paying to the personal representative of the deceased
shareholder, or the person entitled thereto under the lawfully probated will of
the decedent, the agreed value per share, as hereinafter provided, of the
aggregate shares held by such deceased shareholder at the time of his/her death.
Practice Note: This buy-out agreement at the death of a shareholder
constitutes an unconditional obligation of the company in that the only
"uncertainty" related to the obligation is when (not if) the shareholder will
die. Essentially, using the provisions of SFAS No. 150, these type arrangements
result in liability recognition in the financial statements.
Example to Illustrate Financial Reporting Using SFAS No. 150
To illustrate the financial reporting impact of implementing the accounting
guidance in SFAS No. 150 on construction contractors, assume that the contractor
issues shares of stock that are required to be redeemed upon the death of the
holder for a proportionate share of the book value of the entity. The death of
the holder is an event that is certain to occur. Therefore, this type MRFI would
be classified within the liability section of the balance sheet where,
previously, this type financial instrument has been reflected in the equity
section of the balance sheet. No uncommonly, all of the equity of the
construction company might be subject to these mandatory redemption requirements
so that the entire equity section of the balance sheet would need to be
reclassified into the liability section of the balance sheet. If the stock
represents the only shares in the entity, the entity reports those instruments
in the liability section of the balance sheet, and describes these ownership
interests as shares subject to mandatory redemption (to distinguish these
instruments from other financial statement liabilities). In addition, in using
this accounting guidance, the entity would be required to present interest
costs/payments separately (apart from interest and payments to other creditors)
in statements of income and cash flows. The entity also must comply with
disclosure requirements where the note disclosures clearly must stipulate that
the instruments are mandatorily redeemable upon the death of the holders of
those instruments (i.e., the owners of the business).
The example below reveals the impact (consequences) of implementing SFAS No.
150 for contractors, including the potentially alarming effects of these
reporting issues on loan agreement covenants, bonding and federal, state, and
other governing bodies' qualifying requirements:
Example Balance Sheet
The negative impact of implementing SFAS No. 150 on the private sector,
especially contractors, brought several national organizations together in
protest. Associated General Contractors (AGC), the Construction Financial
Management Association (CFMA), and the Financial Executives Institute (FEI)
brought their concerns to the FASB. After hearing from AGC and others, the FASB
indefinitely deferred the effective date of SFAS No. 150 for private companies
pending further action from the FASB. While the deferral of the effective date
is not a "blanket" deferral (covering all scenarios that can be encountered by
construction contractors), in most cases involving mandatorily-redeemable equity
instruments, contractors will not need to implement this literature until the
FASB addresses the issue again.
However, this issue may not be a "dead" issue for contractors. SFAS No. 150
is the first phase of a larger FASB project on liabilities and equity and it is
difficult to anticipate the future impacts of this project on private businesses
(including contractors).
In the short term, it may be wise to take steps to restructure certain
business and financial affairs. Assuming private companies will not be exempt
from classifying MRFIs (e.g., buy-sell agreements) as liabilities in the future,
it may be wise to consider the following:
- " Modifying or amending existing mandatory buy-sell agreements so they
have a contingent obligation placing the agreements outside the scope of SFAS
No. 150.
- Making these agreements a "first right of refusal" for redemption. For
example, the redemption requirements could be placed on other stockholders,
employees, or family members, and life insurance could be transferred to those
parties to cover the mandatory redemption requirement. Very importantly,
"rights of first refusal" will not "trigger" liability treatment related to
the ownership interests.
- Modifying the mandatory redemption requirement by basing it on the
realization of proceeds from life insurance. With this type modification, when
there is no realization of the proceeds from the policy, there would not be a
redemption requirement that would "trigger" reclassification of ownership
interests. Very importantly, in efforts to "restructure" these arrangements,
an inordinate amount of care needs to be exercised to ensure that there is no
"skirt around" the substantive requirements within SFAS No. 150. As an
example, when transferring the insurance policy to those who will satisfy the
mandatory redemption requirement, the company does not need to pay the
premiums on the policy for those that will be collecting the proceeds from the
policy.
- Issuing financial statements using an other comprehensive basis of
accounting, referred to as OCBOA financial statements. Importantly, the
"classification and measurement" provisions within SFAS No. 150 are not
applicable in OCBOA financial statements (e.g., income tax basis statements),
but the note disclosure requirements still must be followed in these
statements. One of the "practical nightmares" that might be encountered with
even considering OCBOA financial statements in the construction industry
relates to the fact that is might be impractical (if not impossible) to
utilize an OCBOA for financial reporting purposes because of reporting
constraints mandated by bonding, lender, and regulatory requirements.
- Continuing to report MRFIs as equity under pre-SFAS No. 150 reporting
requirements and disclosing exceptions in the notes to the financial
statements. However, this approach likely will result in the company receiving
a report on the financial statements that includes a "modification" clearly
indicating that the requirements within SFAS No. 150 were not followed.
- Having loan agreements (covenants) rewritten to encompass ratios based on
modified-GAAP (pre-SFAS No. 150) or to encompass consideration of financial
information that includes the SFAS No. 150 requirements.
Finally, keep in mind that while these changes may address the issues caused
by implementing SFAS No. 150, future FASB guidance on this project may require
additional action to avoid unintended consequences. It also is important to
remember that, while private company construction contractors "caught a break"
with the deferral of the effective date associated with reclassifying and
remeasuring ownership interests into the liability section of the balance sheet,
the disclosure requirements in other FASB literature still must be followed. In
particular, the provisions with SFAS No. 129, entitled Disclosure of
Information about Capital Structure, still are applicable. In particular,
this accounting guidance requires disclosure of information related to rights
and privileges of the various securities that are utilized by reporting entities
(including mandatory redemption requirements associated with ownership
interests).
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