Distinguishing between Liabilities and Equity: Two Mini-Cases for Improving Students' Critical Thinking Skills in Intermediate Financial Accounting

CASE DESCRIPTIONThe instructional approach herein is designed for undergraduate intermediate financial accounting. With a minimum use of classroom time the following learning objectives can be met: (1) students gain an appreciation for the diversity of financial instruments as they vary along a continuum from pure debt, through hybrids to pure equity; (2) students gain an understanding of representational faithfulness and the limitation of a dichotomous classification scheme to faithfully represent the diversity of financial instruments that exist; and (3) students have an introductory experience with principles-based accounting rules and applied professional research. Minimal use of class time is achieved because, after an initial in-class activity, case assignments are completed outside of class. One follow-up class period, after students complete cases, is useful for summary, comparison of ideas, and feedback.The cases develop competencies considered important for entry into the accounting profession including critical thinking, writing, applied professional research, and working in groups [Big 8 Public Accounting Firms "White Paper" (1989), Accounting Education Change Commission (1990), American Institute of Certified Public Accountants' Core Competency Framework (1999)]. Student feedback data from two administrations of the cases is included.CASE SYNOPSISAn overview of the instructional strategy is as follows. An introductory in-class exercise has students rank a series of financial instruments from most debt-like to most equity-like, and decide where the line separating debt from equity should be. Case A requires students to evaluate the representational faithfulness of debt and equity categories of an example company balance sheet, an experience which demonstrates the limitation of a dichotomous classification scheme. Case B has students analyze characteristics of a financial instrument drawn from practice, making judgments about classification based alternatively on (1) application of existing authoritative literature, and (2) a conceptual analysis of essential features of the financial instrument.INTRODUCTION TO HYBRID SECURITY CLASSIFICATIONTraditionally, share instruments have been reported in the stockholders' equity section of the balance sheet. This led to some diversity in the stockholders' equity section, with both common shares and various types of preferred shares being classified as equity. Over time, this practice has changed. In 1979 the United States Securities and Exchange Commission (SEC) ruled that redeemable stock had to be excluded from the stockholders' equity section of the balance sheet (Accounting Series Release No. 268, 1979), which led to the practice of reporting redeemable stock in an unclassified area between liabilities and equity, commonly known as the mezzanine. Stocks covered by this ruling include shares redeemable at the option of the holder, as well as shares mandatorily redeemable on a specific date. The balance sheet below illustrates mezzanine reporting of redeemable preferred stock by Net Talk.com, Inc.The Financial Accounting Standards Board (FASB) in 2003 issued Statement No. 150 which required that mandatorily redeemable stocks be reported as liabilities, and related dividends be treated as interest or financing expense in the income statement. The FASB thereby removed one instrument from the mezzanine; however shares redeemable at the option of the holder are still reported in the mezzanine in the U.S., as illustrated above by Net Talk.com. The International Accounting Standards Board (IASB) in 2003 issued International Accounting Standard No. 32 (IAS No. 32). IAS No.32 requires liability classification for all redeemable shares, including those redeemable at the discretion of the holder. IAS No. 32 states that for equity classification, a firm must have an unconditional right to avoid repayment, otherwise a liability exists. …