The Fine Line: Debt vs. Equity
by Bennett Strickland
Distinguishing between debt and equity has long been debated in the accounting world and is one of the most complex issues in practice today. Take an instrument like mandatorily redeemable preferred stock for example. Is it classified as a liability or as equity? This clearly affects reported amounts of liabilities and equity, and also things such as the debt-to-equity ratio and the asset-to-equity ratio.
The line between liabilities and equity is also critical in measuring income. So companies began to take advantage of manipulating their debt and equity and therefore manipulating their net income. Neither changes in the values of a company’s outstanding equity instruments or transactions between a company and its owners, affect reported income. Whereas, interest payments and at least some changes in the values of liabilities actually do affect reported income.
A lot of companies will try and classify their equity as debt and some may get away with it. However, the consequences can be substantial if the IRS deems that the company needs to reclassify. In Laidlow Transportation Inc. v. commissioner (TC Memo 1998-332), the taxpayer’s tax liability was increased by more than $55 million after the IRS made the company reclassify their debt as equity. So when companies are walking the fine line of debt versus equity they must ask themselves, is it worth it?
The staff at Langdon & Company LLP are all too familiar with such an issue and would be happy to help your company decide which classification is proper. Please contact our office for more information.
Bennett ([email protected]) is an auditor at Langdon & Company LLP. He primarily focuses on healthcare and nonprofit organizations.