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I'll close out the Corporation Finance session by highlighting our views and observations on four issues that we've focused on lately as a Division.
The statement of cash flow classification issue relates to whether the cash flow effects of customer receivables represent operating cash flows or investing cash flows. We've generally observed that registrants as a whole properly classify cash flows stemming from trade accounts receivable as operating cash flows. But when it comes to long-term customer receivables, which might be referred to as a note or loan receivable, we've recently observed that some registrants try to classify those receivables as investing cash flows. We believe that classification is incorrect.
In our view, Statement 95 is clear in its requirement to present cash flows from long-term customer receivables as operating cash flows.
Paragraph 22 of Statement 95 states that cash receipts from sales of goods or services are operating cash flows. That classification is required regardless of whether those cash flows stem from collection of the receivable from the customer or the sale of the customer receivable to others; regardless of whether those receivables are on account or stem from the issuance of a note; and regardless of whether they are collected in the short-term or the long-term.
In reaching this conclusion, we considered whether an inherent conflict exists between the paragraph 22 requirement I just referred to and that of paragraph 16, which states that receipts from collections or sales of loans are investing activities. We believe that no conflict exists.
In deliberating Statement 95, the FASB noted that the three categories of cash flows are not clearly mutually exclusive. For items, at the margin, that is cash receipts and payments that appear to have aspects of more than one class of cash flows, a reasonable case often may be made for alternative classification. However, there were two at the margin items that the FASB explicitly addressed: "interest paid and received" and "installment sales and purchases."
In considering installment sales, the FASB acknowledged that those cash flows posed "a somewhat difficult classification" issue. They noted that because the cash inflows might occur over several years after the date of sale, those cash flows might be viewed as having aspects of both operating and investing cash flows. In fact, the Exposure Draft for Statement 95 proposed classifying as operating cash flows only those cash flows that occurred "soon before or after" the time of sale. Subsequent receipts of principal would have been investing cash flows. After considering the views of respondents to the Exposure Draft, the FASB ultimately rejected this view and concluded that ALL receipts, principal and interest, on sales of inventory should be classified as operating cash flows.
It's important to note that Statement 102 did not change this requirement. The classification question addressed in Statement 102 related to purchases and sales of securities in a financial institution's trading account and items similar to their trading account securities, such as loans acquired for resale. Prior to Statement 102, Statement 95 treated these as investing activities in part because they did not represent cash flows from the purchase and sale of inventory. At the heart of the classification question in Statement 102 was whether a financial institution's trading account and items similar to the trading account, such as loans acquired for resale, were the equivalent of or similar to product inventory for a non-financial institution such that those cash flows should be presented as operating cash flows. In concluding that such amounts are operating cash flows, Statement 102 reaffirmed the position in Statement 95 that all cash flows from sales of inventory are operating cash flows.
We recently addressed a registrant fact pattern that illustrates these concepts. Within the manufacturing world, it is not unusual for a registrant to have a captive wholly-owned finance subsidiary that originates loans solely in connection with a customer's purchase of the registrant's inventory. Think of automobiles, motorcycles, RVs, pre-fab homes, heavy equipment, and similar big ticket items. I've simplified the transaction we evaluated for illustrative purposes, but it generally played out like this:
Registrant, which I'll refer to as Parent, manufactures Product A and sells it to customer, for $10. Customer pays no cash at the time of sale. Concurrent with the sale, Parent's wholly-owned finance subsidiary originates a long-term loan to the Parent's customer for the balance of $10 and remits cash to Parent of $10. The issue here is: how should the registrant's consolidated statement of cash flows reflect the transaction?
In this fact pattern, the registrant asserted that at the consolidated level there was an investing cash outflow of $10, resulting from the activities of the Finance Sub, and an operating cash inflow of $10, resulting from the cash collected by Parent from Finance Sub. We objected to this conclusion.
In doing so, we noted that from the standpoint of the consolidated entity there has been no cash inflow or outflow. At the consolidated level, Registrant simply sold Product A in exchange for a long-term note receivable. In reaching this conclusion, we considered the accounting at the Finance Sub level and whether that accounting should bear on the consolidated presentation.
It is not unusual for Finance Sub to be a public registrant and issue its own set of stand-alone financial statements. The Finance Sub's business is originating and selling loans. It has no manufactured product inventory. In evaluating how to classify the cash outflow related to its $10 loan to the Parent's customer, Finance Sub will look to Statement 102 to assess whether its loan is similar to inventory. If Finance Sub did not originate the customer loan for resale, it would appropriately classify that loan as an investing activity. In evaluating whether the Finance Subs accounting for the transaction in its standalone financial statements should be retained in the Parent's consolidated financial statements, we considered EITF Issue 85-12. This Issue addressed whether the consolidated financial statements should retain the specialized industry accounting principles applicable to an investment company subsidiary or whether the accounting principles applicable to the parent company should be applied to the investment company subsidiary's investments.
We do not believe it is appropriate to extend this issue by analogy to the cash flow classification of long-term customer receivables. In reaching this conclusion, we noted that there are no specialized industry accounting principles that apply to the cash flow transaction. We were guided by the substance of the transaction from the perspective of the consolidated entity. At the consolidated level, there are no cash inflows or outflows. The substance of the transaction is the sale of inventory in exchange for a long-term note receivable. In these circumstances, we think Statement 95 is clear. All cash flows related to the purchase or sale of inventory are operating cash flows.
Let me switch gears to a stock-based compensation measurement issue under existing GAAP that is specific to IPO registration statements - the valuation of privately held company equity securities issued as compensation. Some folks refer to this as the "cheap stock" issue. The objective of the valuation is to determine the fair value of a single share of the company's stock on the measurement date so that the company can determine what, if any, compensation expense they need to recognize.
The difficulty typically arises because quoted market prices don't exist, as the company is privately-held, and recent arm's length transactions of the same or a similar security of the company have not occurred. In these circumstances, the company's management should use valuation methodologies to try and determine the fair value of its equity securities. Consistent with the practices recommended in the AICPA's recently issued Practice Aid on this matter; most registrants employ a two-step methodology. They determine the value of the entity as a whole, commonly referred to as the company's enterprise value, and then they allocate that enterprise value to the outstanding equity in order to determine the fair value of a single share of common stock. We've noticed three recurring themes surrounding the determination of the enterprise value and the allocation of that value to the company's equity in our filing reviews.
Theme #1 - The approach used to determine enterprise valuation must be appropriate for the company's stage of development at the measurement date.
You can look to your slide to get a sense of the stages of development.
In terms of enterprise valuation approaches, they generally fall into one of three broad categories - the market approach, the income approach and the asset-based approach. The market approach uses direct comparisons to other enterprises and their equity securities to determine enterprise value - for example, it might use multiples of EBITDA for a comparable company. The income approach is based on expectations of future income and cash flows - the discounted cash flow method is the most common example. And the asset-based approach generally determines the fair value of the enterprise as the fair value of the company's assets less the fair value of its liabilities.
We believe that it is very unlikely that the use of an asset-based approach to determine enterprise value for any measurement date during the reporting periods included in an IPO registration statement would be appropriate, primarily for two reasons. One, the asset-based approach is generally only appropriate for the very early stages of development. Think of a company that has virtually no financial history, no developed product or a small amount of invested cash. In our experience, the IPO company and its predecessor are well beyond these very early stages of development at the time it files the IPO. Two, applying the asset-based approach to later stages of development, say a company with product revenues, tends to understate the value of the enterprise because the approach does not capture the value of internally generated goodwill.
Theme #2 - The enterprise value allocation method must also be appropriate for the company's stage of development.
Typically, companies issue senior equity securities, such as convertible preferred stock, in the pre-IPO period. When a company has more than one class of equity outstanding, they need to allocate the enterprise value to those different equity classes. Generally, there are three methods used to allocate enterprise value: a probability weighted-expected return method, an option-pricing method, and the current-value method. If you want to understand the mechanics of these methods, the AICPA Practice Aid might be a good starting point, but let me try to give you a perspective from 50,000 feet.
The probability method uses the probability of possible future outcomes, such as those listed on the slide, and the enterprise value expected to result from each of those possible outcomes to determine the fair value of a common share. The option pricing method views the common stock as a call option on the company's enterprise value. It assumes that the exercise price of that call option is equal to the difference between the company's enterprise value and the liquidation preference of the preferred stock. And the current value method determines the value of common stock assuming that dissolution or sale is imminent.
In evaluating the allocation methods used in certain IPO registration statements, we've noticed two trends. Companies are using the current value allocation method to determine compensation expense in one or more of the IPO reporting periods. And companies are averaging the results of different allocation methods despite the fact that those allocation methods yield materially different results.
We think it is very unlikely that the use of a current value allocation method would be appropriate in any IPO reporting period. Because the current value method assumes dissolution or sale, it should be limited to primarily two circumstances. (1) Companies in which the going concern assumption is virtually irrelevant because a liquidity event is imminent and (2) companies that are at such an early stage of development, think infancy, founder's capital and no revenues- that they simply have no basis to make a reasonable estimate. In our experience, it would be highly unusual for these circumstances to exist in the IPO reporting periods. Absent "in-the-money" conversion rights, the current value allocation method assumes that the fair value of the preferred stock equals its liquidation preference. Because the current value allocation method essentially assumes liquidation of the company at the measurement date, we believe it is inconsistent with the going concern assumption inherent in companies filing IPO registration statements.
We also question the appropriateness of averaging allocation methods that yield materially different results. In some cases the underlying conceptual differences between certain allocation methods would appear to render the results of averaging somewhat meaningless. For example, the probability-weighted allocation method is forward-looking and the current value method is not. Averaging a forward-looking allocation method that considers the value inherent in a going concern with an allocation method that does not is like trying to average apples and oranges. The result isn't meaningful.
Often one method is better than another for a particular set of circumstances. We believe management should select the allocation method that is most appropriate for its circumstances. While we understand that it is not unusual to use the results of a different allocation method to confirm the results of the selected method, we believe that material differences between allocation methods are red flags requiring investigation of both the assumptions used in the different methods and the appropriateness of the selected method itself. If management chooses to average or otherwise weight disparate results, they must provide objective and reliable evidence to support the relative weighting of those results. We are skeptical that such evidence exists.
The theme here is that discounts need to be supported by objective and reliable information. The issues we've raised on recent registrant fact patterns seem to fall into two general categories - (1) Situations where the type of discount does not appear to be appropriate and (2) Situations where the magnitude of the discount is unsupported.
I think one example of that first category is what some have referred to as the "lack of control discount" or the "minority interest discount." This discount was purported to relate to the difference in value between a share held by a minority shareholder and one held by a controlling shareholder. In one fact pattern we evaluated, the registrant asserted that a lack of control discount was relevant to the income approach it used to value the enterprise. In evaluating this assertion, we focused on whether management could demonstrate that the cash flows used in the income approach included disproportionate returns to certain shareholders. That is, could management support with objective and reliable information that the controlling shareholders received greater returns than the minority shareholders not through their rights as stockholders, but through their participation, perhaps as employees, in the ongoing operations of the business. In this case, management was unable to support such an assertion. And we also noted that pro rata dividends were paid by the company to shareholders which also demonstrated that the shareholders were not receiving disproportionate returns. The bottom line here is that if management cannot support with objective and reliable information that there is a disproportionate return to certain shareholders, either through the enterprise value cash flows or the equity rights, we do not believe that a lack of control discount is appropriate.
The second issue we address with frequency is the magnitude of discounts, particularly the magnitude of the discount for the lack of marketability. While there are no bright lines, management has the burden of supporting the amount of the discount they select. It's not enough to simply cite the average marketability discount used by your investment banker or to highlight that the amount of the discount used falls within a broad range you noted in an academic study. As a starting point in evaluating these discounts, we try to understand the duration of the restrictions and the volatility of the underlying stock. Generally, the longer the duration and the higher the volatility, the higher the discount. The AICPA Practice Aid lists other examples you might consider, but it too is not an all-inclusive list. It's important to note that if you are deriving a marketability discount from what you believe to be comparable companies, you need to ensure that the discount only gives effect to the lack of liquidity of the comparable companies' stock and not to other factors specific to the comparable companies such as the successful execution of a business plan or the reduction in risk associated with achieving projected results. In responding to staff comment in this area, management should be cognizant of the fact that while qualitative factors may have entered into their determination, they ultimately quantified a discount. At the end of the day, management must provide sufficient objective support for the amount of any discount taken.
As you may recall, in January 2003, the SEC issued its rules on the presentation and disclosure of Non-GAAP measures. And in June 2003, we issued an FAQ that provides additional guidance. Since issuing that guidance, we have periodically received inquiries about the appropriateness of presenting certain types of non-GAAP measures. One such measure is what folks generally refer to as a managed-basis measure. Generally, a managed-basis measure purports to depict what a registrant's revenue and net income would have been had certain activities that the registrant manages on behalf of others actually been activities of the registrant.
While there may be many variations of this theme, there appears to be two broad categories of such measures - those used by financial institutions and retailing companies to remove sale accounting for securitized loans and receivables and those used by non-financial institutions to give effect to the revenues of activities they manage on behalf of others.
For the non-financial institution population, the managed-basis measure is frequently called "system-wide revenues" or something comparable. It's typically used by registrants that earn revenues in two ways: (A) from operations of a business they own and (B) by managing similar businesses for others. For example, a franchisor that generates revenue from both restaurants it owns and from fees charged for franchised restaurants owned by others, or a registrant that generates revenue from hospitals they own and fees for managing hospitals owned by others.
In these circumstances the managed-basis performance measure or system-wide revenue is typically calculated by adding to a registrant's own revenue the revenue of the entities they manage. Some measures we've seen subtract the management fee revenue, but others do not. Where we've seen this measure, we've asked registrants to remove it. Here's why.
Item 10 defines a non-GAAP measure as a numerical measure of a registrant's historical or future performance. Because managed entity revenues are not revenues of the registrant, we believe presentations of system-wide revenues are prohibited under Item 10 and may be misleading. We have not objected, however, if registrants include a footnote to their selected financial data that quantifies the revenues of the business they manage for others and describes it in an appropriate context, if it is useful in understanding the registrant's own revenues. For example, it is not unusual for a registrant's management fee to be based on a percentage of the revenue earned by the managed franchise. In these circumstances, quantification of the managed franchise's revenues might be useful to understanding trends in the registrant's management fee revenue.
From the financial institution and retail company perspective, managed basis disclosures that purport to present what the registrant's performance would have been had a securitization not been accounted for as a sale are generally non-GAAP financial measures. For example, some registrants have presented interest revenues and expenses assuming a securitization that was accounted for under GAAP as a sale was instead accounted for as a collateralized borrowing. In evaluating whether this measure is a permitted non-GAAP measure, we focus on whether the measure is used by management to manage the business. For example, we consider whether the measure is consistent with the company's segment reporting under Statement 131. Since segment information presented in accordance with Statement 131 is not a non-GAAP measure, the measure would be permitted if it is disclosed as a measure of segment profitability and presented in an appropriate context. Absent this link to segment profitability, we are skeptical that such measures are appropriate.
Some have suggested that the reason for presenting this type of measure is that it facilitates comparability between companies. The premise seems to be that financial institutions sell loans and retailers sell receivables to varying degrees. And the sale of the loans introduces volatility into earnings that would not exist had the company opted to retain its loans and use them as collateral for borrowings. For example, in the sale transaction, the company might have a gain in the period that they sell the loans and market value adjustments in each subsequent period to record the retained interest at fair value. Thus, the reasoning seems to go that the measure is useful because it has the effect of normalizing the period-to-period volatility inherent in the sale transaction so that the company that entered into the sale transaction can be compared to the company that entered into the collateralized borrowing.
We have not yet found this reasoning persuasive. Here's why. We were cognizant at the time we wrote the non-GAAP rule that it was not possible to contemplate all possible types of measures and all of the reasons for their use. And for that reason, we were very careful in writing the rule and the FAQ to avoid saying that certain adjustments or certain measures could never be presented. But there was one exception: In Item 10(e) of Regulation S-K as well as in our response to FAQ Question 8, we explicitly state that companies should never use a non-GAAP financial measure in an attempt to smooth earnings. In evaluating this measure, we have been unable to discern how adjustments to normalize period-to-period volatility are any different than adjustments to smooth earnings. And, so based on our understanding to date, we do not believe that presentation of what the registrant's performance would have been had a securitization not been accounted for as a sale is appropriate.
But it's important to note two things.
First, we are not asserting that all managed-basis measures are prohibited. Some managed-basis disclosures are required by Statement 140. For example, when an entity has a retained interest in securitized loans and continues to service those loans after sale, Statement 140 requires disclosure of total financial assets managed by the entity, which includes both the sold loans and the loans that remain on balance sheet, as well as related credit and delinquency information. Because these disclosures are required by Statement 140, they are not considered non-GAAP financial measures.
Second, we are not asserting that information about the risks and benefits of a retained interest is not meaningful. On the contrary, if a registrant has a material exposure through its retained interest to assets or liabilities that are off balance sheet, we would expect the registrant to include the disclosures required by FR 67 for that retained interest as well as any additional information about those off balance sheet assets and liabilities, such as quantified credit quality and interest rate spread statistics, that is necessary to understand the sources of risks and benefits inherent in the retained interest.
Let me close by briefly highlighting disclosure requirements that can be triggered when management includes a statement of its intent to pay future dividends in a registration statement. In the last year, companies began registering a new-type of security in the U.S. - the income deposit security or what I'll refer to as an IDS. The IDS originated as a way for low-growth, mature companies with stable cash flows and little technology risk to access an IPO market heavily skewed towards high growth companies. It was modeled after an existing Canadian security and it's basically a unit that consists of a note, which typically has a fixed coupon, and a share of the company's common stock.
The marketing premise was that in a weak IPO market investors would find attractive the high yield that results from the combination of a fixed coupon on the debt and a promise to pay a regular dividend on the stock equal to cash in excess of operating needs. And recently, this premise has been extended beyond IDSs to straight IPO equity offerings. Some registrants are attempting to access the public equity market through an IPO of their common stock and a promise to pay regular dividends on that common stock equal to cash in excess of operating needs.
Three elements of this intended dividend policy caught our attention:
And so, it was in this context that we evaluated the dividend policy disclosures provided in these registration statements. Ultimately, we concluded that those disclosures ought to have four elements:
I'll let you peruse the slides that follow to get a flavor for the type of disclosure we've required. But let me close with two observations:
Thank you for your attention. I look forward to your questions.