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Valuation and classification of company issued cash and share-puts

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Abstract

This paper examines whether investors’ valuations of cash and share-put warrants are influenced by their potential differential effect on firm solvency. It is motivated by the enactment of SFAS 150, which requires that all contingent put warrant obligations be classified as balance sheet liabilities regardless of put type. Consistent with the critics of SFAS150, we show that market participants differentially value cash and share-puts based on their solvency characteristics beyond the firm’s recorded assets and liabilities. Our results add to existing capital structure literature by suggesting that complex financial instruments (such as cash and share-puts) be reported separately from each other on a firm’s balance sheet.

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Notes

  1. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2004 and otherwise is effective at the beginning of the first interim period of any issuer after June 15, 2004.

  2. Cash-puts were first classified as liabilities by the FASB in Emerging Issues Task Force Number 88–9 (“EITF 88-9”) Put Warrants (FASB 1988). See also Accounting Series Release Number 268 (SEC 1979). The accounting treatment for share-puts was first addressed by the IASB in 1996 with the issuance of International Accounting Standard 32 (“IAS 32”): Financial Instruments: Disclosure and Presentation (IASB 1996). Consistent with IAS 32, the FASB classified share-puts as equity instruments through the issuance of Emerging Issues Task Force Number 96-13 (“EITF 96-13”): Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Company’s Own Stock (FASB 1996). Final consensus regarding the proper accounting treatment for cash and share puts was reached by the FASB in November, 2000 through the issuance of Emerging Issues Task Force Number 00-19 (“EITF 00-19”): Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled by a Company’s Own Stock) which confirmed the prior classification scheme of cash-puts as liabilities and share-puts as equity (FASB 2000).

  3. Most issuers recorded contingent cash-put obligations in the mezzanine section of their balance sheet. In contrast, share-put issuers disclosed their contingent put obligation in the footnotes to their financial statements. See Appendix A for a further discussion of put warrant footnote disclosures provided by pre-SFAS 150 cash and share-put issuers.

  4. Penman (2003) indicates that an expense arises when the firm’s stock price falls, giving rise to the “contingent liability.” SFAS 150 does not recommend booking this expense.

  5. The first milestone draft to SFAS 150 Summary and Background of Milestone Draft developed principles for classifying single-component instruments based on the Ownership-Settlement Approach (FASB 2003b). It was presented in a format similar to that of an Exposure Draft. However, it does not address all of the matters that would be expected to be addressed in an Exposure Draft, such as multiple-component instruments, earnings per share, disclosure, transition and effective date. These matters are to be addressed in the Second Milestone Draft.

  6. This favorable ruling is contained in an SEC No-Action Letter dated February 22, 1991 (SEC 1991).

  7. The tax treatment of puts is governed under IRC Section 1032 which requires firms to exclude put sale proceeds from gross income for income tax purposes.

  8. This assumes that −LOSSCASH is greater than +A. If the incremental loss amount is less, then the firm will experience a small increase to firm solvency. Assuming that the firm repurchases its common equity from a third party in accordance with a previously announced share repurchase program, the overall impact to firm solvency is the same as Case II (−LOSSCASH-FMV+A (Case III) = −S+A (Case II)).

  9. In addition, in 2003 the IASB amended IAS 32 to be consistent with SFAS 150 and currently requires issuers to account for share-puts as liabilities. See paragraphs 11(b)(ii), and 21 of IAS 32 (IASB 2003).

  10. See, for example, Myers (1977) and Warner (1977).

  11. The NAARS and MERGENT databases are used as the primary sources for our search for two reasons. First, they contain a large set of publicly traded companies including those traded on the New York, American, and OTC stock exchanges. Second, they include firms involved in cash and exchange offerings as well as public offerings and private placements. We use the NAARS database as a source since it includes public filings through 1994. We use the MERGENT database as our source to select post-1994 put issuances since it includes public filings from 1995 to the current date.

  12. Most put contracts had vesting periods ranging from 3 months to 1 year.

  13. Twenty-five of the thirty-seven put issuers had puts outstanding between two and four years. Twelve firms had puts outstanding for periods ranging from 5 to 9 years.

  14. These statistics are based on the information provided by 44 firms. Eight firms did not provide put proceed information in their financial statements.

  15. This benefit may come at a cost, however. Share-puts may carry an implicit cost either in the form of a lower sales price or higher common equity strike price in order to gain investor acceptance of the net-share settlement feature. This may partially explain why firms with less significant put programs issued cash rather than share-puts.

  16. Since cash puts are required to be valued as balance sheet liabilities in the pre-SFAS 150 period, our results provide the surprising finding that investors are able to “see through” the required liability accounting for these out of the money cash puts and not value them as liabilities when the puts do not affect company solvency.

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Authors and Affiliations

  1. Iowa State University, Ames, IA, USA

    William D. Terando

  2. Southern Methodist University, Dallas, TX, USA

    Wayne H. Shaw

  3. University of Nebraska at Lincoln, Lincoln, NE, USA

    David B. Smith

Authors
  1. William D. Terando
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  2. Wayne H. Shaw
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  3. David B. Smith
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Correspondence to William D. Terando.

Appendix A

Appendix A

Firms issuing puts also included discussions of their put programs in the footnotes to their financial statements. While the type of information disclosed varied greatly across firms, most put issuers disclosed the time period that they began selling puts and the put settlement terms. In addition, share-put issuers either disclosed their put obligation amount or the necessary information required to allow the reader to independently determine this item (since cash-put issuers were required to show their conditional put obligation as a balance sheet obligation they did not always disclose this item in their footnotes). In many cases both cash and share-put issuers also included the following additional information in their footnotes: number of put warrants issued and put proceeds received, put warrant vesting period, put warrant strike price (or average strike price if more than one set of put warrants had been issued), number of puts outstanding at year-end, whether the outstanding puts were “in” or “out-of-the money” at year-end, and the put warrant activity for the year (puts sold, exercised, net-cash settled, net-share settled, expired). These additional disclosures, however, were not uniform across firms. In all cases, however, share-put issuers either disclosed their put obligation amount or the necessary information required to allow the reader to independently determine this item (since cash-put issuers were required to show their conditional put obligation as a balance sheet obligation they did not always disclose this item in their footnotes).

In this Appendix, we include two sample put warrant footnote disclosures. The first is from the 1997 financial statements of Symbol Technologies (cash-put issuer). The second is from the 2000 financial statements of Pall Corporation (share-put issuer). Each is shown below:

1.1 Cash-put issuer-sample footnote disclosure no. 1

Symbol Technologies (1997 Financial Statements (for the years ending December 31, 1997, 1996 and 1995); Discussion included the “Common Stock” footnote and included in the sub-section entitled “Common Equity Put Options”):

During April 1997 the Company issued common equity put options on 150,000 shares of its common stock which are exercisable for a period of one year from the date of issuance and give independent parties the right to sell such shares to the Company at a strike price of $31.163 per share. Proceeds of $285,000 from the issuance of the April 1997, put options were credited to additional paid in capital.

The balance of the common equity put option account as of December 31, 1997 and December 31, 1996, represents the amount the Company would be obligated to pay if all unexpired put options were exercised relating to unexpired transactions outstanding as of the respective balance sheet dates. The decrease in the balance as of December 31, 1997 from December 31, 1996 is due to the expiration of obligations associated with 70,500 shares and 375,000 shares, respectively of the Company’s common stock at strike prices of $26.703 and $24.421, respectively, and corresponding reclassification to additional paid in capital, partially offset by the April issuance previously described.

1.2 Share-put issuer-sample footnote disclosure no. 2

Pall Corporation (2000 Financial Statements (for the fiscal years ending July 29, 2000, July 31, 1999 and August 1, 1998); Discussion included as a part of the “Common Stock” footnote and included in the sub-section entitled: “Share Repurchases”):

In connection with the Company’s stock repurchase program, approximately 1,360 put options with strike prices ranging from $21.40 to $22.75 were sold under three separate contracts with an independent third party during fiscal 2000. The contracts grant the purchaser the right to sell shares of Pall Corporation stock to the Company at specified future dates and prices. In the event the puts are exercised, the contracts allow the Company to determine whether to settle in cash or shares. As such, the contracts are considered equity instruments and changes in fair value are not recognized in the Company’s financial statements. The premiums received of $2,049 were recorded as additions to capital in excess of par value. Contracts related to approximately 920 put options expired in fiscal 2000 unexercised. At July 29, 2000, one contract for approximately 440 put options, with a strike price of $22.75 and expiration date of September 25, 2000, is outstanding.

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Terando, W.D., Shaw, W.H. & Smith, D.B. Valuation and classification of company issued cash and share-puts. Rev Quant Finan Acc 29, 223–240 (2007). https://doi.org/10.1007/s11156-007-0033-z

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