>Appendix: Summaries of Speeches and Other CommentsAICPA’s December 5–7, 2005 SEC & PCAOB Conference
>>SPEECH BY MARTIN P. DUNN, DEPUTY DIRECTOR, DIVISION OF CORPORATION FINANCE
Securities Offering Reform
Effective December 1, 2005, significant reforms were made to the rules that govern registered securities offerings under the Securities Act of 1933. Deputy Director Dunn spoke at length describing the changes and their expected impact.
The reforms can be summarized in five general categories: (1) communication prior to and during registration, (2) shelf offerings, (3) prospectus delivery, (4) changes to periodic reporting disclosures, and (5) liability.
One of the objectives of the reform is to provide registrants added flexibility in communication during the registration and offering process. The degree to which the rules have been relaxed varies with the size and reporting history of the company. Large, closely followed, and "seasoned" issuers are granted the greatest flexibility; initial public offerings are granted the least. The relaxed rules allow companies to:
Provide information to investors through "free writing prospectuses," allowing regulators to focus on the content of the communication, rather than the method (written or verbal) by which the information is delivered, and
Continue to provide the marketplace factual business and financial information during what was previously a quiet period prior to the filing of a registration statement.
The most notable of reforms to the shelf registration process is the creation of a new category of issuer, the "Well Known Seasoned Issuer." These are companies that are large, widely held, and have a public reporting history. This category of issuer can use a new automatic shelf registration; a short form filing that is immediately effective upon filing. This allows securities to be issued without the delay typically experienced between filing and effectiveness.
Physical delivery of the final prospectus is no longer required as long as it is readily accessible by investors.
Periodic Reporting Disclosures
Annual reports on Form 10-K now require:
Disclosure of risk factors (material changes in risk factors must be reported in the Form 10-Q);
The cover page of the Form 10-K to indicate whether the registrant is a well known seasoned issuer or a voluntary filer;
Well known seasoned issuers and accelerated filers to disclose unresolved material SEC comments that remain outstanding for more than 180 days as of fiscal year end.
The reforms also changed a number of the Securities Act liability provisions. These changes include the following:
Section 11 liability for underwriters and issuers in a shelf registration is now determined as of the date of the shelf takedown, rather than upon effectiveness of the registration statement. Section 11 liability for directors, officers who sign the registration statement, and "experts" continues to be determined at the registration statement effective date. If an expert provides a new report or opinion in an Exchange Act report or in connection with the takedown that would require a consent, however, there would be a new effective date for that expert.
The liability of security sellers for false and misleading statements (Section 12(a)(2)) is now based solely on information deemed to have been conveyed to the investor before or at the time of the security sale, rather than being based on information in the final prospectus.
Section 11 liability now applies to prospectus supplements.
These can be found on the SEC's Web site at www.sec.gov.
>>SPEECH BY JOEL K. LEVINE, ASSOCIATE CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE
Amendments to Accelerated Filer Definition and Filing Deadlines
Mr. Levine discussed proposed amendments to the accelerated filer definition and filing deadlines and indicated that the Commission would hold an open meeting to vote on these proposed amendments.
Editor’s Note: On December 14, 2005, the SEC held the open meeting to which Mr. Levine referred. the balance of this section will describe the results of the Commission's deliberations.
At its December 14, 2005, meeting, the SEC amended the definition of "accelerated filer" by creating a new category, "large accelerated filers," for companies that have an aggregate worldwide market value1 of $700 million or more and meet the other conditions in Exchange Act Rule 12b-2 that apply to accelerated filers (e.g., having previously filed at least one annual report). Accelerated filers other than large accelerated filers are those companies with an aggregate worldwide market value of at least $75 million but less than $700 million.
Also at the meeting, the SEC delayed by one additional year the final phase-in of Form 10-K filing deadlines for "large accelerated filers." Large accelerated filers will continue to be subject to the current 75-day deadline for Form 10-K for an additional year. Beginning with fiscal years ending on or after December 15, 2006, large accelerated filers will become subject to a 60-day deadline for Form 10-K.
Accelerated filers, other than large accelerated filers, will continue to be subject to the current 75-day deadline. The current Form 10-Q deadlines will be maintained for all filers. As such, the deadlines are as follows:
Form 10-K Deadline
Form 10-Q Deadline
Large accelerated filers:
Fiscal years ending prior to December 15, 2006
Fiscal years ending on or after December 15, 2006
75 days after year end
60 days after year end
40 days after quarter end
40 days after quarter end
75 days after year end
40 days after quarter en
90 days after year end
45 days after quarter end
Additionally, the amendments will ease some of the current restrictions on the exit of companies from accelerated filer status. The final rule is available on the SEC's Web site, www.sec.gov.
1 - Aggregate worldwide market value is the market value of outstanding voting and nonvoting common equity held by non-affiliates and, for purposes of applying these amendments, should be calculated as of the last business day of the issuer's most recently completed second fiscal quarter.
>>SPEECH BY RACHEL MINCIN, ASSOCIATE CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE
Disclosures About Off-Balance-Sheet Arrangements
In connection with the Sarbanes-Oxley Act, the Commission issued final rules in 2003 requiring disclosure about off-balance-sheet arrangements that management believes are reasonably likely to have a material effect on the registrant's financial position, results of operations, and cash flows. The rules include a definition of off-balance-sheet arrangements and require that the related disclosures be presented in a separately captioned section in MD&A.
The Sarbanes-Oxley Act also required the SEC to complete a study of filings by issuers to determine both (1) the extent of off-balance-sheet transactions, including assets, liabilities, leases, losses, and the use of special purpose entities; and (2) whether generally accepted accounting principles result in financial statements that reflect the economics of such off-balance-sheet transactions to investors in a transparent fashion.
The study was completed and submitted to the President of the United States and certain other components of the government in June 2005 (see Heads Up, June 23, 2005). For the study, the SEC staff analyzed data collected from the 2003 Form 10-K filings of a sample of 200 issuers, comprising the 100 largest issuers and 100 randomly selected issuers. At the Conference, Ms. Mincin presented a summary of the proportion of issuers that reported off-balance-sheet arrangements in MD&A:
Variable Interest Entities
Ms. Mincin observed that a significant portion of issuers did not have a separately captioned off-balance-sheet arrangement section in MD&A and, for those that did, the data was often incomplete. Specific examples of transactions that were included in other sections of Form 10-K filings but were omitted from the off-balance-sheet arrangement section in MD&A include:
Retained interests in securitized assets,
Interests in variable interest entities, and
Ms. Mincin emphasized that disclosures of off-balance-sheet arrangements need to include information necessary for an understanding of the arrangement and its material effects, including:
Nature and business purpose of the arrangement,
Importance of the arrangement,
Financial impact of the arrangement and exposure to risk as a result of the arrangement, and
Known events, demands, commitments, trends or uncertainties that affect availability or benefit of the arrangement.
Ms. Mincin also suggested the following best practices for disclosure of off-balance-sheet arrangements:
Include descriptions that specifically address the company's particular circumstances and operations,
Include cross references that clearly identify specific information in the footnotes and integrate the substance of the footnotes into MD&A, and
When there are no material transactions that meet the Regulation S-K definition of an off-balance-sheet arrangement, clearly disclose that fact.
>>SPEECH BY SONDRA L. STOKES, ASSOCIATE CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE
Disclosure Controls and Procedures and Internal Control Over Financial Reporting
Ms. Stokes reminded the audience that all registrants are required to evaluate the effectiveness of disclosure controls and procedures on a quarterly basis in accordance with Item 307 of Regulation S-K in connection with management's certification requirements under Section 302 of the Sarbanes-Oxley Act of 2002. Once a registrant has completed its first annual assessment of the effectiveness of its internal control over financial reporting (ICFR), it is also required to make disclosure on a quarterly basis of material changes in ICFR. The requirements related to management's annual assessment of ICFR are in Item 308 of Regulation S-K and apply to (1) accelerated filers with fiscal years ending on or after November 15, 2004; (2) foreign private issuers who are accelerated filers with fiscal years ending on or after July 15, 2006; and (3) non-accelerated filers (including small businesses) with fiscal years ending on or after July 15, 2007.
In each quarterly filing on Form 10-Q in Item 4, Controls and Procedures, management must clearly state its conclusion as to whether disclosure controls and procedures are either (1) "effective" or (2) "ineffective" as of the end of the respective quarter, without any qualifying or alternative language. The SEC will request that a company amend its filing if it includes qualifying or alternative language in its conclusion on the effectiveness of disclosure controls and procedures. Examples of unacceptable language include phrases such as "effective except for," "effective except as disclosed below," or "adequate."
If, during the quarter, a company has identified the existence of a material weakness in ICFR that is not remediated by the end of the quarter, the registrant should (1) disclose the existence of such material weakness and (2) describe the nature of the material weakness, the impact on financial reporting and the control environment, and management's remediation plan. Ms. Stokes indicated that, while highly unlikely, it is possible that a registrant could conclude that disclosure controls and procedures are effective if a material weakness exists in ICFR. This is due to the substantial overlap between disclosure controls and procedures and ICFR. Ms. Stokes reaffirmed that when a material weakness exists in ICFR, management has a high hurdle to overcome before being able to conclude that disclosure controls and procedures are effective.
However, if management does conclude that disclosure controls and procedures are effective, notwithstanding the existence of a material weakness in ICFR, it is critical that the company clearly disclose the factors that it considered and the basis for reaching this conclusion. Ms. Stokes stated the disclosure should not be "boilerplate"; rather, it should reflect in detail the specific facts considered by the registrant.
Ms. Stokes stated that a material weakness in ICFR does not always exist when previously issued financial statements are restated for the correction of an error(s). A registrant should consider why the restatement was necessary and whether the restatement resulted from a material weakness in underlying controls. However, she acknowledged that a restatement of previously issued financial statements to reflect the correction of an error(s) is indicative of at least a significant deficiency and a "strong indicator" that a material weakness exists, as described in PCAOB Auditing Standard No. 2, An Audit of Internal Control Performed in Conjunction With An Audit of Financial Statements.
In the case of a restatement of previously issued financial statements to reflect the correction of an error(s), Ms. Stokes commented that the SEC's rules do not require a registrant to make a full reassessment of its report on internal control over financial reporting; the rules require the registrant to make only one assessment at its year-end balance sheet date.
Ms. Stokes noted that the registrant would have to address disclosure of the material weakness(es) in its Form 10-K/A in conjunction with its Regulation S-K, Item 307 and 308(c) disclosures. Item 307 disclosures might need to be changed to state that disclosure controls and procedures were not effective and Item 308(c) disclosures might need to be changed to state that a material weakness in internal control over financial reporting was identified subsequent to year end. In accordance with AICPA Codification of Statements of Auditing Standards, AU Section 561, "Subsequent Discovery of Facts Existing at the Date of the Auditor's Report," an auditor would need to issue a revised report on the registrant's internal control over financial reporting for inclusion in the Form 10-K/A. Ms. Stokes observed that, although the registrant is not required to reassess its report on internal control over financial reporting, it may elect to do so since the registrant would likely want an unqualified opinion on management's assessment of internal control over financial reporting from its auditors upon reissuance of the auditor's opinion. This would prompt the registrant to issue a revised management report on internal control over financial reporting.
Ms. Stokes stated that, other than as permitted for certain specialized industries, available quoted market prices are evidence of the fair value of a financial instrument, and that using block discounts to determine fair value is not in accordance with GAAP. Taking a block discount refers to taking a discount from the quoted market price of a financial instrument when an entity's position in a traded security is so large that the entity believes it cannot be absorbed readily by the market (e.g., because the security is thinly traded).
Ms. Stokes referred to a registrant example involving company-issued preferred stock that was convertible into common. In estimating the fair value of its convertible preferred stock, the registrant took a block discount from the quoted market price of its common stock because the preferred stock was convertible into approximately 50 percent of the company's existing outstanding common stock and it believed its shares were thinly traded. The SEC staff objected to the use of the discount and believes that, other than as permitted for certain specialized industries, quoted market prices are generally the best evidence of fair value.
The use of quoted market prices versus block discounts is supported by paragraphs 5 and 58 of FASB Statement No. 107, Disclosures About Fair Value of Financial Instruments, and by paragraph 3(a) of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. The prohibition on using block discounts to estimate fair value is supported by paragraph 6 of Statement 107 and footnote 3 of EITF Issue No. 98-5, "Accounting for Convertible Securities With Beneficial Conversion Features or Contingently Adjustable Conversion Ratios."
Warrants Issued to Non-Employees
Ms. Stokes explained that warrants issued to nonemployees differ from employee share options in that they typically do not contain transfer restrictions and are normally subject to immediate exercise. These differences impact how the fair values of warrants granted to nonemployees and share options granted to employees should be estimated when using a Black-Scholes model. She then referred to footnote 7 of SEC Staff Accounting Bulletin No. 107, Share-Based Payment, which states the following, in part:
If these features (i.e. nontransferability, nonhedgability and the potential truncation of the contractual term) were not present in a nonemployee share option arrangement, the use of an expected term assumption shorter than the contractual term would generally not be appropriate in estimating the fair value of the nonemployee share option. [Emphasis added]
Accordingly, Ms. Stokes stated that if warrants issued to non-employees are valued using a Black-Scholes model, issuers should use the contractual term in the calculation, not the expected term if it is shorter.
>>SPEECHES BY JEFF NAUMANN, ENABLING TECHNOLOGY SPECIALIST, OFFICE OF THE CHIEF ACCOUNTANT; KEITH WILSON, ASSOCIATE CHIEF AUDITOR, PCAOB; JOHN STANTIAL, UNITED TECHNOLOGIES; JOHN PHILIP, INFOSYS TECHNOLOGIES LIMITED; AND WAYNE HARDING, XBRL US
XBRL and the SEC Voluntary Filing Program
In February, the SEC adopted final rules enabling registrants to voluntarily submit supplemental financial information using the eXtensible Business Reporting Language (XBRL) format in addition to filing its financial information in HTML or ASCII format, as currently required. XBRL is a data tagging language for enhancing financial reporting. Tagging provides greater context to data through standard definitions that turn text-based information, such as the filings currently contained in the Commission's EDGAR system, into documents that can be retrieved, searched, and analyzed through automated means. Data tags describe information such as items included in financial statements. This enables investors and other marketplace participants to analyze data from different sources and allows for the automatic exchange of financial information across various software platforms, including Web services. The SEC will use the tagged data to assist in its review of financial statements and disclosures and provide the ability to screen filings when submitted in order to manage the review process in a risk-based manner.
The SEC encourages, but does not require, registrants to participate in the program. The XBRL documents are furnished, rather than filed, as Exhibit 100 to Exchange Act and Investment Company Act filings. While there is no deadline for XBRL submission, the SEC encourages it either with the official filing or shortly thereafter. Registrants participating in the program are free to stop and start at any time.
Volunteers must provide disclosures about the XBRL documents that (1) include cautionary language that the submission should not be relied upon for investing decisions since the document is furnished to the SEC and not filed and (2) disclose that the information is "unaudited" or "unreviewed." XBRL documents must contain at least one of the following: (1) a complete set of financial statements (footnotes and schedules may be omitted); (2) earnings information from a Form 8-K or Form 6-K; or (3) financial highlights or condensed financial information. Optional content may include audit opinions, interim review reports, reports of management on the financial statements, certifications, and MD&A.
Editor’s Note: The final rule is available on the SEC's Web site. For more information on the XBRL program, including links to the final rule, the filer manual, and frequently asked questions about the XBRL program, see the SEC's Web site at www.sec.gov.
Assurance reporting is not a required part of the XBRL program; however, in May 2005, the PCAOB issued a list of frequently asked questions and answers regarding the application of attest standards, engagement procedures, and engagement reporting. These frequently asked questions can be viewed at the PCAOB's Web site, www.pcaobus.org.
>>SPEECH BY HERBERT S. WANDER, CO-CHAIR, SEC ADVISORY COMMITEE ON SMALLER PUBLIC COMPANIES
Smaller Public Company Issues
The SEC Advisory Committee on Smaller Public Companies was formed by SEC Chairman William H. Donaldson in December 2004 to examine the impact of the Sarbanes-Oxley Act on smaller public companies and make recommendations to the Commission. The Advisory Committee is composed of four subcommittees that deal with (1) accounting standards, (2) capital formation, (3) corporate governance and disclosure and, (4) internal controls .
Mr. Wander reported key activities of the four subcommittees and highlighted some of the recommendations that may come out of these subcommittees. Information regarding Advisory Committee activities can be found in the Small Business section of the SEC's Web site at www.sec.gov.
>>SPEECH BY CRAIG C. OLINGER, DEPUTY CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE AND SUSAN KOSKI-GRAFER, SENIOR ASSOCIATE CHIEF ACCOUNTANT, OFFICE OF THE CHIEF ACCOUNTANT
The presenters discussed new rules, issues related to the first-time application of IFRS, several reporting issues, and international regulatory developments.
Recent Rules Affecting Foreign Private Issuers
First-Time Application of IFRS Rule
A number of countries, led by those in Europe, have mandated the use of International Financial Reporting Standards (IFRS) beginning in 2005. As a result, several hundred foreign private issuers will be adopting IFRS for the first time in their 2005 financial statements to be filed with the SEC next year. The SEC staff has indicated that over the next several months it will be focused on the implementation of IFRS by these foreign private issuers.
Omission of Financial Statements for the Third Year
To eliminate certain inconsistencies between IFRS and SEC rules and regulations, and to address other issues related to the first-time application of IFRS for foreign private issuers, the Commission issued First-time Application of International Financial Reporting Standards (Release 33-8567, April 12, 2005) (the Rule).
The Rule permits eligible foreign private issuers, for their first year of reporting under IFRS, to file only two years of audited financial statements (versus three, as otherwise required under Regulation S-X) prepared in accordance with IFRS, with appropriate related disclosure. All years presented using IFRS must be reconciled to US GAAP.
This two-year accommodation is available to registrants that adopt IFRS by fiscal year 2007 and applies to all annual reports on Form 20-F and to 1933 and 1934 Act Registration Statements. The two-year accommodation is available for financial statements of the registrant and for the financial statements of other "foreign businesses" included in the registrant's filings (e.g., financial statements of (1) acquired businesses provided under Regulation S-X Rule 3-05, (2) equity method investees under Rule 3-09, (3) guarantors under Rule 3-10, (4) collateral entities under Rule 3-16, and (5) target companies in a business combination filed in a Form F-4, Form S-4, or proxy statement).
A registrant may include "previous" GAAP (i.e., the GAAP used by the issuer immediately prior to the adoption of IFRS) financial information, but is not required to do so. However, if previous GAAP information is included, there must be appropriate cautionary language about the lack of comparability with IFRS; side-by-side presentation with IFRS is prohibited.
The Rule contemplates full compliance with IFRS; it requires an unreserved and explicit statement of compliance and the auditors' report must be unqualified. An exception to full compliance exists for registrants that prepare financial statements in accordance with IFRS, as adopted by the European Union (referred to as "EU GAAP" in the Rule) as long as the financial statements include:
Audited reconciliations from EU GAAP to IFRS as published by IASB, including any additional required disclosures; and
Audited reconciliations to US GAAP.
All first-time adopters are required to disclose their transition elections under IFRS 1, First-time Adoption of International Financial Reporting Standards, as well as the initial reconciliation of previous GAAP to IFRS. The staff emphasized that their reviews during the 2005–2006 implementation period would focus on faithful and consistent application of IFRS, and the completeness of the US GAAP reconciliation. The staff emphasized the importance of transparent disclosure of reconciling items — especially in order to help investors understand those reconciling items arising from the transitional exemptions from IFRS allowed under IFRS 1 (e.g., elimination of any foreign currency cumulated translation adjustments) versus ongoing differences between IFRS and US GAAP.
The Rule addresses not only the financial statements, but other disclosures of Form 20-F and other foreign registration statements as well. Selected Financial Data, for example, should reflect data from the financial statements, and accordingly should include:
Two years of IFRS data (expanding to five years over future periods); and
Five years of US GAAP (unless a shorter period is already permitted
Selected Financial Data disclosures prepared on a basis of previous GAAP are permitted, but not required. Where issuers elect to include or incorporate previous GAAP financial information they must prominently disclose that the filing contains financial information based on the issuer's previous GAAP, which is not comparable to IFRS. The SEC did not specify particular language to be used as they believe it may vary depending on the use made of the previous GAAP information.
The Rule also allows other disclosures to be based on two years of IFRS data (with disclosure of US GAAP amounts, if material). These include (Item numbers refer to Form 20-F):
.· Description of the Business (Item 4),
Operating and Financial Review and MD&A (Item 5),
Market Risk Disclosures (Item 11), and
Industry Guide Data (previous GAAP or US GAAP for previous years).
Interim Financial Information in Registration Statements Effective Less Than Nine Months After Year End
Under existing rules, interim financial statements required to be included in Form 20-F registration statements only because they have been published in the home country (see Form 20-F, Item 8.A.5) do not need to be reconciled to US GAAP unless they are prepared on a different basis of accounting than those in the most recent annual financial statements. The Rule provides an accommodation when the change in the basis of accounting is to adopt IFRS. In these cases, a reconciliation from IFRS to US GAAP is not required. The staff noted that registrants need to include appropriate disclosures about the lack of comparability between the most recent annual financial statements prepared on a previous GAAP basis and the interim IFRS financial statements. The Rule also acknowledges that an issuer may be unable to comply fully with IFRS for interim financial information during the transition year and that the issuer should provide appropriate cautionary language in this regard.
Interim Financial Information in Registration Statements Effective More Than Nine Months After Year End
When interim financial statements are required in a Form 20-F registration statement effective more than nine months after year end, the rule provides the following four options during the transition year:
Previous GAAP option — include three years of audited annual previous GAAP and current comparative unaudited interim previous GAAP financial statements, all reconciled to US GAAP;
IFRS option — two years of audited annual IFRS and current comparative unaudited interim IFRS GAAP financial statements, all reconciled to US GAAP;
US GAAP condensed option — three years audited previous GAAP financial statements, current comparative unaudited interim IFRS GAAP financial statements, all reconciled to US GAAP and condensed US GAAP balance sheet and income statement for most recent fiscal year and current and comparative interim period;
Case-by-case option — the staff is open to consultation if registrants believe they are either unable to comply with the other three options and believe that alternative meaningful combinations of previous GAAP, IFRS, and US GAAP could be substituted.
Retroactive Application of Improved IFRS Standards in Registration Statements
Where a registrant adopted IFRS prior to January 1, 2005, and later adopts the Improvement Project standards, its financial statements for periods prior to adoption of the improved standards may require restatement if reissued. This arises because many of the Improvement Project standards require retrospective application, and Item 5(b)(1)(ii) of Form F-3, Material Changes, states, in part: "include restated financial statements if there has been a change in accounting principles…where such change…requires a material retroactive restatement of the financial statements." While this requirement is articulated in the instructions to Form F-3, the staff indicated that they will be applying it to all registration statements.
A number of IFRS implementation issues were discussed at the May 2005, AICPA International Practices Task Force meeting. Affected registrants and their auditors are advised by the SEC staff to read the highlights of that meeting. Items discussed include:
Registration statements in the transition year,
Exceptions mandated or permitted by IFRS No. 1,
EU GAAP matters,
Other disclosures, and
Non-GAAP Measures Rule and IFRS Financial Information
The staff clarified that rules regarding the use of non-GAAP financial measures is not intended to prohibit additional useful captions and subtotals that are consistent with IFRS reporting. The staff cited the presentation of operating results articulated in IAS 1, paragraph BC 13 as an example. The staff will evaluate compliance with IFRS and challenge the purpose and usefulness of unusual/additional measures and presentations that appear to be misleading or inconsistent with IFRS. Where the income statement presentation is considered acceptable under IFRS, additional disclosure under the non-GAAP measures rule generally would not be required.
New Rules on Shell Companies
The staff noted that the new shell company rules (Release No. 33-8587, Use of Form S-8, Form 8-K, and Form 20-F by Shell Companies), also apply to foreign private issuers. Upon completion of a merger or reorganization with an operating company, a foreign private issuer shell company must file a Form 20-F within four business days. This is a significant acceleration of the due date.
Securities Offering Reform Rule
The staff clarified that while a foreign private issuer meeting the necessary conditions can be considered a "well known seasoned issuer," a filer utilizing the Multi-Jurisdictional Disclosure System ("MJDS") may not be considered a "well known seasoned issuer."
Internal Controls Over Financial Reporting Under Section 404 of the Sarbanes-Oxley Act
Accelerated Filer Definition
Mr. Olinger noted that the accelerated filer definition impacts the revised compliance dates for foreign private issuers for internal control reporting under Section 404. Accelerated filers are required to comply with Section 404 for the first fiscal year ending after July 15, 2006. Non-accelerated filers must comply for the first fiscal year ending after July 15, 2007. Mr. Olinger indicated that for December 31 year-end companies, the market capitalization test should be completed as of June 30, with all other tests completed as of December 31.
Applicability of Sarbanes-Oxley 404 to Interim Information
The staff indicated that because a foreign private issuer is not required to file interim financial statements, management's report on internal control over financial reporting only needs to cover those periods that are filed with the SEC (thus, closing procedures over interim periods not filed with the SEC need not be reported on).
"Bifurcation" of Sarbanes-Oxley 404 Reporting
The SEC staff is still considering whether it would be appropriate for management to conclude, in its assertion on internal control over financial reporting, that the controls surrounding home-country GAAP financial statements were effective, but that the controls surrounding the reconciliation to US GAAP were not effective. The staff is also considering the effect of this situation on the auditor's attestation under PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements.
Disclosure Controls and Procedures
The staff noted that foreign private issuers currently are subject to the Disclosure Controls and Procedures reporting requirements of Regulation S-K Item 307 and must consider the impact of restatements on previous control effectiveness disclosures. In cases where material weaknesses are found, the staff expects that careful consideration be given to the need for disclosure under Item 15, Controls and Procedures, of Form 20-F.
Mr. Olinger indicated that regardless of whether a registrant applies home-country GAAP or IFRS, it must reconcile the condensed consolidating information required under Article 3-10 of Regulation S-X with US GAAP. He clarified that the reconciliation should be prepared with a level of detail consistent with Item 17 of Form 20-F to aid investors in evaluating the sufficiency of the guarantees.
The SEC staff also believes condensed consolidating cash flow statement data presented under Article 3-10 should not reflect "price-level adjusted" information. The staff will allow registrants to prospectively apply this guidance beginning with fiscal years ending December 31, 2005.
International Regulatory Developments
Ms. Koski-Grafer indicated that the International Organization of Securities Commissions (IOSCO) has a project underway to promote consistent application of IFRS across the globe. It involves the creation of a database to which regulators will contribute information on regulatory decisions relating to the interpretation of IFRS.
Participating regulators are expected to use their best efforts to refer to this database when making decisions and to contribute information. Contribution of information is not required, but it is encouraged. Conflicting decisions on the application of IFRS will be referred to the IASB and its interpretation committee. IOSCO anticipates that the database will be operational by the second half of 2006. At this stage it is not intended for the catalogue of decisions to be publicly accessible.
Ms. Koski-Grafer indicated that the Public Interest Oversight Board (PIOB), established in February 2005 by the International Auditing and Assurance Standards Board (IAASB), will oversee the work of the International Federation of Accountants' (IFAC) auditing, ethics, and education standards setting committees and its Member Body Compliance Program. The stated objective of the PIOB is to help ensure that IFAC's standard-setting activities reflect the public interest and are fully transparent to those affected by the standards.
>>SPEECHES BY CHARLES D. NIEMEIER, BOARD MEMBER, PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD AND DOUGLAS R. CARMICHAEL, CHIEF AUDITOR, PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
Mr. Niemeier emphasized that the accounting profession is currently in the spotlight and that many outside the profession who were previously unaware of the auditors' role now have awakened to the significance of the profession to the capital markets. He acknowledged that four years ago the profession was in crisis, but that the profession has responded by admitting mistakes and making the changes that the Sarbanes-Oxley Act required it to make. In his view, the increased focus on the profession makes it critical that the profession communicate to the public in a way that helps people to better understand what auditors do and why.
Mr. Niemeier commended the FASB and the SEC for their commitment to reducing the complexity of financial reporting. However, he expressed his view that effecting change will take a collaborative effort from all interested parties. He encouraged everyone involved to contribute.
Mr. Niemeier noted that while professional judgment is at the root of the profession, CPAs have a tendency instead to rely on rules. He stated that "there is a simple truth that there is no rule against doing the right thing," and continued by saying that "often we know what the right thing is" and that we have a professional responsibility to "do the right thing" regardless of what the rules will allow.
PCAOB Standard Setting Update
Mr. Carmichael focused on three areas: (1) standard setting, (2) internal control over financial reporting, and (3) fraud detection, which are discussed below.
Mr. Carmichael emphasized that the PCAOB has made significant progress, citing increased staffing of highly qualified professionals at the PCAOB and the establishment of solid working relations with the SEC and an effective process whereby the PCAOB can promulgate authoritative guidance through PCAOB Staff Questions and Answers.
Mr. Carmichael stated that the PCAOB is in the process of developing Staff Questions and Answers on the following topics:
Predecessor and successor auditor situations when an issuer is required to use the retrospective application method of reporting a change in accounting principle or is required to restate financial statements to correct an error and the predecessor auditor is no longer independent of the issuer. The answers will provide a means whereby the successor auditor will be able to report only on the adjustments, presuming the predecessor auditor is willing to reissue its original report.
Auditing of Statement 123(R) Assumptions — The answers will provide detailed guidance to auditors related to the application of AICPA Statement of Auditing Standards No. 101 (AU Section 328), Auditing Fair Value Measurements and Disclosures, when auditing the assumptions used in fair value measurements required by FASB Statement No. 123 (revised 2004), Share-Based Payment (e.g., volatility and expected term).
Internal Control Over Financial Reporting
Mr. Carmichael stated that the PCAOB, pursuant to Rule 4010, recently issued its "Report on the Initial Implementation of Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements." Under Rule 4010, the PCAOB may publish summaries, compilations, or general reports concerning the results of its various inspections, provided that no such published report may identify the firm or firms to which any quality control criticisms in the report relate. These reports also may include information that was not gathered during the inspection process.
Mr. Carmichael stated that the report includes the following observations in the areas of efficiency and effectiveness, as follows:
Due primarily to externally imposed time constraints, auditors were unable to fully integrate the financial statement and internal control components in their first-year audits under Auditing Standard 2.
Auditors, to varying degrees, approached the audit of internal control from the bottom up, rather than top down.
The nature, timing, and extent of the auditors' testing were not fully altered to reflect the level of risk assessed within a given area.
A significant number of engagement teams chose not to use a single transaction for their walkthroughs, but rather subjected multiple transactions from different parts of the process to their walkthrough procedures.
Auditors did not fully use the work of others to the extent that Auditing Standard 2 allows.
Auditors identified control deficiencies but did not sufficiently evaluate the adequacy of compensating controls on a timely basis.
In several instances, auditors had not adequately focused on the period-end financial reporting process and had not identified and tested sufficient controls over financial statement presentation and disclosure.
In some cases, the report noted that higher-risk areas should have received more attention than they did. Specifically, the PCAOB believes that, given the high degree of risk, the period-end financial reporting process is always a significant process and that significant attention to this process is necessary in virtually all audits.
In some walkthroughs, auditors did not ask sufficiently probing questions to be able to identify the points at which a necessary control was missing or inadequate.
After identifying control deficiencies, auditors did not always re-evaluate the original risk assessments used in planning the audit of internal control.
Auditors did not always determine the effect of control deficiencies on the nature, timing, and extent of substantive procedures to be performed as part of the financial statement audit.
In addition to these observations, the report clarifies that the objective of an audit of internal control over financial reporting is to obtain reasonable assurance that no material weaknesses exist. However, when planning the audit, the auditor must consider the fact that deficiencies, either individually or in the aggregate, may represent a material weakness. The standard does not require the auditor to design the audit to identify all deficiencies or significant deficiencies.
Mr. Carmichael stated that the PCAOB is in the process of developing its next 4010 report that will address implementation of AICPA Statement of Auditing Standards No. 99 (AU Section 316), Consideration of Fraud in a Financial Statement Audit. He is concerned that auditors are not taking fraud detection seriously enough in the performance of audits. Although the report is not finalized and therefore subject to change, he stated that the following issues might be addressed:
Fraud Brainstorming Session — Engagement teams should determine that the right people are involved in the brainstorming sessions.
Fraud Risk Factors — When risks are identified, it is the expectation of the PCAOB that an appropriate response will be identified and the audit documentation would reflect the fact that the approach has changed in response to the risk.
Extent of Testing — When the risk of fraud increases, the PCAOB expects that the work performed by the auditor in these areas will increase (e.g., increased sample sizes for confirmations).
Error Evaluation — Qualitative factors should be considered when evaluating all errors detected during the audit to determine whether the errors are intentional or the result of management bias, specifically when the errors are the result of departures from generally accepted accounting principles.
Journal Entry Testing — Auditors need to determine that selections are made from a complete population. In addition, journal entries should not be excluded from the sample based on quantitative thresholds alone (e.g., do not exclude all journal entries below an established threshold).
Senior Management Involvement — The PCAOB expects that senior members of the engagement team will be extensively involved in the fraud consideration process in an audit. He advised the avoidance of the "checklist approach," which results in senior members of the engagement team receiving less information upon which to evaluate decisions.
>Accounting Highlights of the AICPA'S December 5–7, 2005 SEC and PCAOB Conference
All preparers, auditors and users of financial statements. The leaders whose remarks are summarized in this section expressed their views on broad issues facing the financial reporting community. While the remarks do not directly affect current U.S. reporting requirements, they capture important themes and the direction of future developments.
Companies that have more than one business unit, division, product line, etc. (i.e., those that could potentially have more than one operating and reportable segment).
Companies that have goodwill and more than one operating segment.
>Appendix: Summaries of Speeches and Other Comments Financial Accounting and Reporting Matters AICPA’s December 5–7, 2005 SEC & PCAOB Conference
>>SYNTHESIS OF SPEECHES BY CHRISTOPHER COX, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION; ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD; PAUL S. ATKINS, COMMISSIONER, SECURITIES AND EXCHANGE COMMISSION; SCOTT A. TAUB, ACTING CHIEF ACCOUNTANT, SECURITIES AND EXCHANGE COMMISSION
All preparers, auditors and users of financial statements. The leaders whose remarks are summarized in this section expressed their views on broad issues facing the financial reporting community. While the remarks do not directly affect current U.S. reporting requirements, they capture important themes and the direction of future developments.
Accounting Complexity and Lack of Transparency
Christopher Cox, Chairman of the SEC, noted that the SEC has joined with the FASB and the PCAOB in a major effort to make accounting less complex. Mr. Cox, observing that many of the accounting scandals "were made possible in part by the sheer complexity of the rules," fears that "conformity to hundreds of technical rules became not a shield to protect investors, but a sword to be wielded against them."
Robert Herz, Chairman of the FASB, echoed this sentiment, stating that "the detail and volume of accounting, auditing, and reporting guidance now pose a major challenge to maintaining and enhancing the quality and transparency of financial reporting to investors and the capital markets." Mr. Herz also believes that complexity can lead to a "check-the-box, form over substance approach to accounting" that encourages some to structure transactions to achieve a desired accounting outcome contrary to economic substance. Mr. Herz, who views this issue as one of both national and international importance, noted that accounting complexity adds to the costs and effort involved in financial reporting, and reduces the transparency of financial statements to investors and analysts, making it more difficult to perform comprehensive financial analysis. Additionally, an increased number of restatements due to accounting errors have been an unwelcome byproduct of the many detailed rules that are a part of existing accounting literature.
What is the source of complexity? A number of contributing factors were cited by the speakers. Mr. Herz listed the following
Conflicting perspectives and agendas of participants in the reporting process
Demands from companies and industry groups for special exceptions and accounting treatments to address their specific business needs;
An evolutionary approach to standard-setting that can result in non-conceptually based compromises, exceptions, and inconsistencies in standards over time;
An emphasis on short-term earnings; and
Creation of anti-abuse rules to curb structured "form over substance transactions."
Scott Taub, Acting Chief Accountant of the SEC, observed that accounting complexity is an unintended consequence of constituent desires to reduce income statement volatility or simplify the accounting for specific types of transactions. To illustrate his point, Mr. Taub discussed the shortcut method of hedge accounting and the optional smoothing mechanisms that registrants choose to make in accounting for their benefit plans.
Some critics assert that fair value accounting adds to complexity. Mr. Taub does not agree. Although he acknowledges that fair value poses measurement challenges, he believes that increased use of fair value actually may reduce complexity in financial reporting, particularly with regard to financial instruments. For example, if all financial instruments were recorded at fair value, there would be no need to assess whether contracts contain embedded derivatives, nor any need for fair value hedge accounting for financial instruments, with its myriad of stringent requirements. He noted also that improvements have occurred within the valuation profession that should help alleviate some of the measurement challenges in the future.
SEC Chairman Cox, FASB Chairman Herz, and SEC Commissioner Atkins suggested that the existence of multiple standard-setters or rule makers adds complexity to accounting literature. Although Messrs. Cox and Herz referred to recognized, established standard-setting bodies, SEC Commissioner Atkins expressed a concern that accounting positions of the SEC staff, even if publicly disseminated (e.g., SAB 1011), inject additional detailed rules into accounting literature, adding to complexity. Mr. Atkins does not object to the SEC staff attempting to explain or apply existing literature to a given fact pattern; however, he believes that "if the SEC feels that everyone should follow a particular approach, the approach should be set forth in a rule or standard that has been subjected to due process of notice and comment."
Editor’s Note: In a later Q&A session, Mr. Taub clarified that the SEC staff does not intend to create new accounting rules when it states its views. However, registrants should remember that the SEC staff's views are based on the underlying authoritative literature cited in the staff guidance. Any registrant wishing ot account for a transaction in a manner contrary to the staff's views should be able to explain how its proposed accounting treatment complies with GAAP.
Finally, Messrs. Cox, Atkins, Herz, and Taub agreed that auditors' and other constituents' reluctance to exercise professional judgment generates additional complexity. How so? Mr. Herz explained that the FASB receives numerous requests from preparers and auditors for detailed rules, bright lines and safe harbors, many of which "stem from a fear of the potential consequences of second-guessing by regulators, enforcers, and the trial bar." Mr. Atkins, concurred, noting that "the possibility of a future challenge by someone exercising 20-20 hindsight makes people reluctant to use their professional judgment."
How can accounting be simplified? There is no easy way to reduce complexity. In Mr. Taub's view, some complexity could be reduced immediately if those involved in financial reporting focused on communication, transparency, and simply telling financial statement readers what is going on and why. To address other entrenched complexities, cooperation of numerous financial reporting stakeholders will be required. SEC Chairman Cox noted that the SEC, the PCAOB, the government, and the accounting profession will need to work together to meet the challenge. As summarized by Mr. Herz, "Principles-based standards…cannot succeed without more principles-based regulatory review and enforcement and without a more principles-based legal framework around financial reporting."
Mr. Herz also announced the FASB's three-pronged effort to reduce complexity:
Improve the understandability, consistency, and usability of the accounting literature through
Completing its current project to compile a comprehensive and integrated codification of all existing accounting literature organized by subject matter (i.e., a "one-stop-shopping" source of accounting literature);
Consolidating U.S. accounting standard-setting under the FASB to stem the proliferation of accounting guidance issued from multiple sources; and
Developing new standards more consistent with a "principles-based" or "objectives-oriented" system.
Strengthen the FASB's conceptual framework to provide a foundation for the future development of principles-based standards.
Although these are steps in the right direction, Mr. Herz does not believe they alone will achieve the goal of reducing complexity unless the "structural, institutional, cultural, and behavioral" drivers of complexity are addressed.
Role of Technology in Financial Reporting
Many speakers at the Conference expressed optimism that technological advances may help to reduce complexity in financial reporting. Such advances could result from implementation of XBRL.
XBRL is an acronym for eXtensible Business Reporting Language, a technology that provides an identifying electronic "tag" for each data item included in financial information. For example, the net income line item in an income statement would have its own identifying tag. These tags are easily read by computer applications, which can accurately and efficiently analyze that information, thus sparing analysts the effort of manually re-entering and comparing the financial information. Additional information about XBRL can be found at http://www.xbrl.org/home.
SEC Chairman Cox, an ardent proponent of this technology, believes it will do for business reporting what the bar code did for product distribution. In his view, "the interactive data that this initiative will create will lead to vast improvements in the quality, timeliness, and usefulness of information that investors get about the companies they're investing in." Additional XBRL benefits envisioned by Mr. Cox include providing SEC analysts with better fraud detection tools, making it easier and less expensive for preparers and their accountants to comply with SEC reporting requirements, and automating significant portions of the internal control documentation and testing required by the Sarbanes-Oxley Act of 2002. In his remarks, Mr. Taub noted that XBRL or similar interactive data technology could, to a great extent, simplify data analysis by streamlining collection and collation, and by confirming the accuracy of financial information. Messrs. Taub and Herz also can foresee this technology increasing the efficiency with which financial information is distributed to investors and other constituents. Mr. Cox noted that the improvements that will result from XBRL will free accountants to devote more time and energy to the questions of accounting judgment and materiality that are the ultimate determinants of quality.
The SEC has established an XBRL voluntary program that provides registrants with the option of furnishing XBRL information in their periodic filings. The SEC and its staff encourage registrants to participate in the trial and provide feedback to the SEC so it can continue to assess the usefulness of the technology.
Competition in the Accounting Profession
In addition to his comments regarding accounting complexity and XBRL, SEC Chairman Cox discussed another issue that he characterized as a "pressing matter" - the lack of competition in the market for audit services for large public companies. Mr. Cox discussed the market share of the four largest firms and stated his belief that such concentration indicates that significant barriers prevent other firms from competing for audits of large public companies. He noted that the SEC needs to review its rules to ensure that they do not discourage competition in this market.
1 - Titles of each Standard referenced in the Appendix appear in the Glossary of Standards.
>>SPEECH BY SHAN L. BENEDICT, PROFESSIONAL ACCOUNTING FELLOW; OFFICE OF THE CHIEF ACCOUNTANT
Impact of nonsubstantive vesting conditions
The effect of non-compete agreements on the requisite service period for share-based payment awards
All companies, especially those with significant grants to employees who are "retirement eligible."
Companies with non-compete provisions incorporated into share-based payment programs
All companies with share-based payment arrangements.
All companies with non- GAAP financial measures related to share-based payment arrangements.
Generally, companies that grant equity awards that contain liquidity features (e.g., puts on the underlying stock).
Impact of Nonsubstantive Vesting Conditions
The terms of many share-based compensation arrangements contain clauses providing for acceleration or continued "vesting" in awards after an employee has retired from active service. Statement 123(R) indicates that compensation cost for awards should be recorded over the "requisite service period" (the period over which an employee is required to provide service). Ms. Benedict highlighted that once the employee is eligible to leave employment without losing the award, by definition there is no longer a requisite service period. In other words, when employees are able to continue to vest without providing service (or acceleration of vesting is provided), the stated vesting term is nonsubstantive and should be ignored for purposes of recognizing compensation expense
Company A issues an award with a fair value of $100 to an employee. The award vests at the end of four years provided that the employee is still working for the company at the end of those four years. Assuming this basic fact pattern, the requisite service period would be four years and the $100 would be recognized ratably over that period.
How should the $100 fair value be recognized if the award is granted to employees currently eligible for retirement, and the terms allow for continued vesting in the award after retirement from the company? That is, the award will vest after four years even if the employee retires any time during the four-year period.
In this example, Ms. Benedict stated that the entire $100 should be recognized on the grant date for an employee who is retirement eligible. The rationale? Immediate expense is required because a retirement-eligible employee may retire from the company at any time and retain the award.
Editor’s Note: Reggie Oakley, FASB Practice Fellow, emphasized the same point at the Technical Accounting Issues session of the Conference and directed participants to paragraphs A56–A58 of Statement 123(R) for additional detailed guidance on this issue.
In practice many companies have adopted an accounting policy under Opinion 25 or Statement 123 (prior to the adoption of Statement 123(R)) of recognizing compensation cost (either in the income statement or in the required pro forma disclosures) over the "nominal" vesting period (four years, in the above example) with acceleration of unrecognized compensation cost, if, and when, an employee elects to retire. Ms. Benedict stated that companies that have followed this approach in the past need not consider their previous accounting conclusion to be an error. Rather, these companies should continue to follow their previous accounting policy for awards granted prior to the adoption of Statement 123(R) (even after the adoption of Statement 123(R)). The Statement 123(R) methodology, outlined by Ms. Benedict, should be applied to all new awards and to previously granted awards modified after adoption of Statement 123(R). Companies in this position should disclose the impact of this change in policy so that investors can compare results of operations pre- and post-adoption of Statement 123(R).
Editor’s Note: While Ms. Benedict did not elaborate on the disclosures the staff would expect, when a company's accounting policy includes recognizing compensation cost over the "normal" vesting period for awards granted prior to the adoption of Statement 123(R), our informal understanding is that the SEC staff would expect companies to include the following:
· Its accounting policy, and indicate that this policy differs from the policy required and applied for awards granted after the adoption of Statement 123(R)
· Prior to the adoption of Statement 123(R), a company should quantify and disclose the difference between the previously selected accounting method and the method required under Statement 123(R), pursuant to SAB Topic 11.M.
· Subsequent to adoption of Statement 123(R), a company should disclose the amount of compensation cost that continues to be recognized over the "nominal" vesting period for awards that were granted to retirement-eligible employees prior to adoption of Statement 123(R).
The Effect of Non-Compete Agreements on the Requisite Service Period for Share-Based Payment Awards
Ms. Benedict's discussions above focused on situations where a stated vesting condition should be ignored since it is considered to be nonsubstantive. In contrast, other provisions of a share-based payment award may create an "in-substance" service period over which compensation cost should be recognized. Illustrations 15 and 16 in Statement 123(R) are two examples where a non-compete agreement is included in the provisions of a share-based payment award. Ms. Benedict focused on Illustration 16 where the FASB concluded that the effect of the non-compete agreement, in concert with other factors, created an in-substance requisite service period over which compensation expense should be recognized.
However, as indicated in Statement 123(R), inclusion of a substantive non-compete agreement in the terms of a share based-payment award will not always lead to this conclusion. In fact, Ms. Benedict indicated that "the sole fact that substantive non-compete provisions are included in the terms of a share-based payment award would not lead to the determination that an in-substance requisite service period must exist." The concept is that compensation cost should be spread over the non-compete period, rather than immediately expensed, only in situations where "the employee was essentially in the same position as if a stated substantive vesting period existed." In that regard, the SEC staff does not believe that recognition of compensation over the period of a non-compete agreement will be "a common occurrence." In making this assessment, companies will need to consider their specific facts and circumstances in light of the guidance provided in Illustrations 15 and 16 (including footnote 112) of Statement 123(R). Companies were invited to discuss their circumstances with the staff.
Required Disclosures — Pre- and Post-Adoption of Statement 123(R)
Prior to the adoption of Statement 123(R), most companies elected to follow the intrinsic value model provided for in Opinion 25 (generally resulting in little or no compensation expense), and to provide Statement 123 fair value information in the pro forma footnote disclosures only. The adoption of Statement 123(R), therefore, may result in financial statements that are significantly different from periods before adoption. In these circumstances, companies should ensure that their disclosures are detailed enough for users of the financial statements to determine the financial impact of transitioning to Statement 123(R), including the impact in the past, present, and future.
Similarly, Ms. Benedict indicated that compensation cost recognized or disclosed in accordance with Statement 123 and the amount that will be recognized under Statement 123(R) could be different due to (1) refinements of estimates, and/or (2) companies modifying plans or individual outstanding awards. When making such changes, companies need to disclose the effects of these changes and explain the reasons for them. Additionally, she reminded companies of disclosure requirements in Statement 123 when they modify the terms of share-based payment awards before the adoption of Statement 123(R).
Editor’s Note: Ms. Benedict referred to remarks made by Mr. Chad Kokenge, Professional Accounting Fellow, Office of the Chief Accountant, during the 2004 AICPA National Conference on Current SEC and PCAOB Developments. Mr. Kokenge stated that the SEC staff would expect registrants to disclose their reasoning for accelerating share-based payment awards prior to adopting Statement 123(R).
Ms. Benedict also reiterated the staff's view (Section H of SAB 107, Opinion 28, and Article 10 of Regulation S-X) that all annual period disclosures of newly adopted accounting standards should be presented in the financial statements of the first interim period in which a new standard is adopted.
Disclosure of Non-GAAP Financial Measures in Relation to Share-Based Payment Expense Recognized
Measures that exclude the impact of share-based payment transactions such as "Net Income Before Share-Based Payment Charge" are non-GAAP financial measures as discussed in Regulation G and Item 10(e) of Regulation S-K. FAQ 8, in the related series of frequently asked questions prepared by the SEC staff, clarifies that in order to exclude an amount that is recurring (and to report the non-GAAP measure), a company needs to demonstrate the usefulness of the measure.
A company may only avail itself of FAQ 8 and disclose non-GAAP measures when this hurdle is overcome, and when the measure does not violate any of the other prohibitions. In order to overcome this burden, a company should be able to demonstrate that it utilizes the non-GAAP financial measure to internally evaluate performance.
Application of ASR 268 to Share-Based Payment Arrangements
Many awards with repurchase obligations (cash settlement obligations including put features) will be classified as liabilities under Statement 123(R). However, for some awards with redemption features, a proper analysis under Statement 123(R) might indicate that the award is not a liability. In the latter circumstance, Ms. Benedict reminded participants that the "mezzanine equity" requirements in ASR 268 (as further clarified in Topic D-98) apply to all share-based payment awards. ASR 268 requires classification outside of permanent equity for equity instruments that are redeemable at a fixed or determinable price (including redemption at fair value) on a fixed or determinable date (1) at the option of the holder, or (2) upon the occurrence of an event that is not solely within the control of the issuer. Note that the status section of Topic D-98 has been updated to provide transition guidance for non-liability share-based payment awards with redemption features upon the adoption of Statement 123(R).
>>SPEECH BY TODD E. HARDIMAN, ASSOCIATE CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE
Embedded conversion options and freestanding warrants
All companies with convertible debt and convertible preferred stock.
Embedded Conversion Options and Freestanding Warrants
Mr. Hardiman stated that the SEC staff frequently encounters mistakes in the accounting for convertible debt, convertible preferred stock, and freestanding warrants to buy the registrant's stock. Why? The complexity in accounting for these instruments lies in part in the difficulty of identifying the appropriate applicable guidance; companies need to consider a plethora of FASB pronouncements, EITF Issues, and SEC guidance and their interaction with one another.
Determining Whether Conversion Options and Freestanding Warrants Are Equity
Mr. Hardiman indicated that with respect to embedded conversion options, companies tend to focus on intrinsic value issues (whether embedded conversion options have beneficial conversion features under Issue 98-5 and Issue 00-27) and neglect to consider potential classification issues under Statement 133 and Issue 00-19. That is, companies fail to consider whether the embedded conversion option should be bifurcated and accounted for separately as a derivative liability instrument. The SEC staff suggested that before considering intrinsic value issues, registrants should first determine whether the embedded derivative should be separated from the host contract. This involves determining whether the embedded conversion option should be classified as a liability (e.g., derivative subject to Statement 133) or equity, if it were freestanding.
From the issuer's perspective, a freestanding instrument on an issuer's own stock or a similar option embedded in a debt host would not be considered a derivative under Statement 133 if the instrument is both (1) indexed to its own stock, and (2) classified in stockholders' equity. Issue 00-19 addresses whether an option on an issuer's own stock is considered a liability or equity. Mr. Hardiman indicated that the default classification of a freestanding option and an embedded conversion option is a liability unless the very restrictive and specific requirements for equity classification as stated in Issue 00-19 have been met.
Conventional Convertible Debt
In order to attain equity classification, paragraphs 12–32 of Issue 00-19 specify very stringent criteria (e.g., the issuer must have the ability to settle in unregistered shares) that must be met in addition to the general settlement provisions. Paragraph 4 of Issue 00-19 provides an exception to applying the stringent criteria for equity classification (paragraphs 12–32) only if the contract is a conventional convertible debt instrument in which the holder may realize the value of the conversion option only by exercising the option and receiving the entire proceeds in a fixed number of shares, or the equivalent amount of cash (at the discretion of the issuer). Mr. Hardiman observed that the reference to the discretion of the issuer refers to the form of settlement (i.e., cash or shares), not the number of shares to be issued upon conversion.
In Issue 05-2, the Emerging Issues Task Force further clarified the term "conventional convertible debt" as contemplated in paragraph 4 of Issue 00-19. The Task Force reached a consensus that a conventional convertible debt instrument is an instrument that provides the holder with an option to convert into a fixed number of shares, and the ability to exercise that option is based on the passage of time, or a contingent event.
The SEC staff has encountered numerous instances where the accounting for the conversion option is dependent on the convertible instrument being considered conventional (i.e., if the stringent criteria of paragraphs 12–32 of Issue 00-19 were to be applied, the embedded derivative would fail to attain equity classification) and companies have assumed incorrectly that they have issued conventional convertible debt as contemplated in paragraph 4 of Issue 00-19. What is the most common mistake companies make in this regard? Concluding that convertible debt is conventional when the number of shares the holder can convert into is not fixed. For example, the number of shares is not fixed if it can vary based on a contingent future event, even if the event is under the control of the issuer (see Editor's Note below for an exception provided under Issue 05-2 for standard anti-dilution provisions).
Another common mistake: In order to be considered conventional, the entire proceeds upon exercise of the conversion option should be settled either in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer). Convertible debt that can be settled in a combination of cash and shares is not considered to be conventional convertible debt.
Mr. Hardiman provided the following examples of features in convertible debt agreements that will cause convertible debt to be considered non-conventional:
Debt is convertible into a fixed number of shares based on a conversion ratio that resets under certain circumstances. (See Editor's Note.)
The number of shares issuable is not fixed. It is dependent on a contingent future event. Mr. Hardiman indicated that the SEC staff believes that this analysis would not change even if the contingent event is under the control of the issuer.
Debt is convertible into a fixed number of shares based on a conversion ratio that resets under certain circumstances. However, the maximum number of shares has been fixed at issuance.
The number of shares issuable is not fixed; even though a maximum number has been established, it may still vary (i.e., it could be less than the maximum).
Debt is convertible into a fixed number of shares at the option of the holder one year from issuance or after a secondary offering of the issuer's common shares. In the event of a secondary offering, the conversion ratio will adjust to 80 percent of the average trading price for a specified period of time after the secondary offering. The conversion ratio, in the absence of a secondary offering, is fixed at issuance of the debt.
Even though the issuer controls the conversion ratio and the holder does not have the ability to impact the conversion ratio, the debt will not be considered conventional since the number of shares issuable is not fixed.
The face amount of debt is only redeemable in cash. The conversion spread can be settled in cash or shares. (For example, see instrument C in Issue 90-19.)
The entire proceeds are not settled in either shares or cash. Also, in this example the number of shares issuable is not fixed if share settlement is elected.
Editor’s Note: The SEC staff did not intend to change the consensus the EITF reached under Issue 2 of Issue 05-2 regarding standard antidilution provisions. The consensus states that an instrument that contains "standard" antidilution provisions would not preclude a conclusion that the instrument is convertible into a fixed number of shares. Standard antidilution provisions are those that result in adjustments to the conversion ratio in the event of an equity restructuring transaction (as defined in the glossary of Statement 123(R) that are designed to maintain the value of the conversion option.
If a company has determined that its debt does not meet the definition of a conventional convertible debt, it must apply the provisions in paragraphs 12–32 of Issue 00-19 to determine the proper classification of the conversion option. The important point here is that the issuer should determine if there is any possible scenario under which the conversion option can be settled in cash. A low probability cannot alter the conclusion, even if it is remote that the issuer could be required to settle the conversion option in cash. Because the possibility of cash settlement exists, the conversion option should be classified as a liability and bifurcated from the debt host. Conversion options classified as liabilities must be measured at fair value each reporting period
Registration Rights and Liquidated Damages Clauses
In discussing some of the issues around equity classification under Issue 00-19, Mr. Hardiman also offered some thoughts on Issue 05-4 currently being discussed by the Task Force. The issuer, unless exempt from the provisions of paragraphs 14–18 of Issue 00-19, must be able to settle the instrument in unregistered shares. Because of this requirement, registration rights agreements that include a liquidated damages clause commonly accompany the issuance of equity instruments, stock purchase warrants, and financial instruments that are convertible into the issuer's own shares. Typically, the agreement requires the issuer to use its "best efforts" to register the underlying shares by the end of a specified grace period. If the issuer fails to have the registration declared effective within the grace period (or if effectiveness is not maintained), the issuer is required to pay liquidated damages to the investor each month until the registration is declared effective. The Task Force is discussing whether the registration right with a liquidated damages clause is separate from the related financial instrument (e.g., warrant or conversion option in convertible debt) or, if combined, affects whether the unit can be classified as equity. Currently there is diversity in practice on these issues.
Mr. Hardiman noted that while the Task Force has not reached a consensus, companies must consider carefully the terms of registration-rights agreements, specifically as it relates to the liquated damages penalty. For example, if the liquidated damages clause is not limited to the difference between the fair value of registered and unregistered shares, the SEC staff has concluded that the issuer is effectively compelled to settle in cash in an amount equal to the value of the registered shares. Why? Settlement in unregistered shares and payment of the penalty is an uneconomic alternative in that the combined value exceeds the value of the registered shares. Therefore, if the amount of liquidated damages is not appropriately limited, settlement in cash equal to the value of the registered shares is assumed. Thus, the unit would not be considered to meet the requirements of an equity instrument.
Sufficient Available Authorized and Unissued Shares
Mr. Hardiman stated that consideration of the paragraph 19 criteria of Issue 00-19 is another area where the SEC staff has noted errors. Registrants have failed to consider all other commitments that may require the issuance of stock during the maximum period of the contract. Paragraph 19 states that in order to assume settlement in shares, a company should have sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative could be outstanding. This analysis should take into account all instruments that can be settled in shares regardless of probability (e.g., employee stock options and other embedded and freestanding instruments).
Some instruments may require settlement in a variable number of shares, and the maximum number of shares is not capped. Because a company is not able to determine that it will have sufficient authorized shares to settle the instrument, share-settlement is not within the control of the company, and, therefore, cannot be classified within equity. In addition, this instrument could cause other instruments to fail the criteria to be considered equity. Why? A possibility exists that the company will have to settle the uncapped instrument first, resulting in a lack of authorized and available shares to settle other contracts in shares.
Editor’s Note: The fact that there is not a limit on the maximum number of shares issuable is not always evident. Consider the following example. Convertible debt of $20 million contains a conversion price based on the lower of $5 or 80 percent of the daily average stock price of the common stock. Therefore, if the conversion price is $5, the shares issuable are 4 million. On the other hand if the conversion price is $0.01, the share issuable are 2 billion shares. Because the number of shares that could be required to be issued is not capped, the company cannot conclude that it will always have enough authorized and unissued shares to settle the conversion of the debt. The conversion option would not be considered an equity instrument and should be bifurcated.
In his concluding remarks Mr. Hardiman stated that companies should explicitly state in their disclosures the features of alltheir instruments indexed to their own stock with specific disclosure of the accounting analysis of these features.
>>SPEECH BY JOEL K. LEVINE, ASSOCIATE CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE
According to Mr. Levine, the statement of cash flows is receiving increased focus by investors and greater scrutiny in SEC staff reviews. The Division of Corporation Finance continues to address a number of cash flow presentation issues, several of which are discussed below.
Statement 95 does not require separate disclosure of cash flows from discontinued operations; however, if a company chooses to separately disclose those amounts, it must do so consistently for all periods affected.2 In determining whether a company's presentation of cash flows pertaining to discontinued operations is appropriate, the SEC staff makes such assessment with the following basic principle of Statement 95 in mind:
All cash flows must be reported as operating, investing, or financing activities.
What are some examples of acceptable presentation methods? Cash flows pertaining to discontinued operations should be separately disclosed either (1) within each category of the statement of cash flows, or (2) near the bottom of the statement of cash flows, by category. Alternatively, companies choosing not to separately disclose cash flows pertaining to discontinued operations should present all cash flows (i.e., continuing and discontinued), within each category without differentiation. It would not be appropriate to present cash flows from discontinued operations as a single line item at the bottom of the statement of cash flows or all within operating activities (i.e., aggregating operating, investing, and financing cash flows). Doing so would violate the basic principle of Statement 95 stated above.
Mr. Levine also highlighted the importance of disclosure in the liquidity and capital resources section in the MD&A. Companies should describe how cash flows pertaining to discontinued operations are reported in the statement of cash flows, or if they are not separately disclosed in the statement of cash flows, the amounts should be quantified, by category, in MD&A. Companies also should discuss the impact on future liquidity and capital resources due to the absence of cash flows from discontinued operations.
Dealer Floor Plan Financing
In many dealer floor plan financing arrangements, the finance entity is a subsidiary of the supplier. In those situations, the dealer reports purchases as increases to inventory and trade loans (a non-cash transaction), with repayments of trade loans presented within operating activities in the statement of cash flows. The end result on the statement of cash flows? A net operating cash inflow in the amount of the dealer's gross profit.
Registrants have run into problems when the financing entity in such an arrangement is not affiliated with the supplier. The SEC staff's view under that circumstance is that the amounts financed are not trade loans; rather, they are third party loans. As such, cash flows related to the amounts borrowed and repaid should be presented as financing activities in the statement of cash flows.
Insurance Settlement Proceeds
Mr. Levine stated that cash received from insurance settlements should be presented in the statement of cash flows based on the nature of the insurance coverage (i.e., the nature of the loss). It would not be appropriate to classify such proceeds based on how a company plans to spend those proceeds (see paragraph 22(c) of Statement 95).
The following examples were provided by Mr. Levine:
Nature of Loss
Cash Flow Statement Classification of Insurance Proceeds
Property, plant, and equipment under operating lease
Property, plant, and equipment owned, or under capital lease
In addition to appropriate presentation in the statement of cash flows, Mr. Levine also reminded registrants to include a discussion of material insurance proceeds in MD&A, including:
What you received;
Why you received it;
What you plan to do with it;
Where it is classified in the statement of cash flows; and
The impact on reported earnings.
2 - See footnote 10 of Statement 95.
>>SPEECH BY G. ANTHONY LOPEZ, ASSOCIATE CHIEF ACCOUNTANT, OFFICE OF THE CHIEF ACCOUNTANT
Vendors that sell products to customers, including resellers of the vendors' products
Companies that sell software products
Income Statement Geography
There are many sources of authoritative literature, often analogized to, that address where items should be presented on the income statement. Mr. Lopez pointed out that Issue 99-19 is the primary authoritative literature that addresses whether revenue should be recognized on a gross or net basis. The guidance and related examples in Issue 99-19 focus on Internet-based companies; however, the scope of Issue 99-19 is not limited to companies that sell products or services over the Internet. Mr. Lopez believes that this frequently leads to an awkward application of Issue 99-19 to non-Internet-based companies, or in some cases, an incorrect conclusion by companies that the guidance does not apply. He also noted that the SEC staff finds it helpful generally to begin its Issue 99-19 analysis by identifying the ultimate customer in the arrangement.
As summarized below, Mr. Lopez discussed the SEC staff's views on how to account for various types of arrangements when the guidance in Issue 99-19 is not applied easily.
Research and Development Reimbursements
Mr. Lopez pointed out that companies often analogize to Issues 99-19, 00-10, 01-14, and/or the AICPA Audit and Accounting Guide, "Audit of Federal Government Contractors," when determining whether research and development costs (and the related reimbursements for those costs) should be presented on a gross or net basis. He did not indicate what the SEC staff believes is the appropriate presentation; however, he did note that the SEC staff has observed instances where companies may in fact be "cherry picking" their presentation depending on whether they are, or expect to be, in net gain or net loss positions. He also reminded companies to treat income statement classification issues consistently and to adequately disclose their classification policy. However, Mr. Lopez cautioned that companies within the scope of the Audit and Accounting Guide must follow its guidance to determine the appropriate income statement presentation.
Mr. Lopez discussed whether deferred revenue that is recognized as part of a business combination in accordance with Issue 01-3 should be presented on a gross or net basis when recognized in the income statement. He believes companies should focus on the nature of each arrangement and should look to the guidance outlined in Concepts Statement 6. For example, under Concepts Statement 6, in order for an item to be considered a component of revenue, it must represent an inflow "from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations." Mr. Lopez provided the following example:
A company entered into a business combination and recognized deferred revenue for an obligation of the target to deliver sold inventory. The SEC staff concluded, in this instance, that since delivery of inventory was part of the ongoing major operations of the company, the deferred revenue should be presented as revenue on a gross basis when recognized in the income statement of the combined company.
Companies that collect taxes from customers in connection with the sale of a product or service must determine whether those taxes should be presented on a gross or net basis. In making the gross versus net determination, Mr. Lopez believes that companies should consider the types of taxes involved (e.g., excise taxes, sales taxes, etc.) and whether the company is acting in a pass-through capacity or whether it has the primary obligation for remittance of the taxes. He believes that companies should look to the guidance in Issue 01-14. Mr. Lopez provided the following example:
A cable television operator collected taxes from its subscribers and remitted those taxes to the cable franchising authority. In this fact pattern, the operator was the primary obligor for those taxes. In such a situation, the SEC staff concluded that the operator should recognize the taxes collected and remitted on a gross basis (i.e., as revenue and expense).
Intangible Asset Amortization
Mr. Lopez discussed how companies should determine whether intangible asset amortization should be presented as part of (1) cost of sales or (2) selling, general, and administrative expense. He believes such a determination generally should be based on the function of the intangible asset. For example, if the intangible asset is a component of the activities that constitute the entity's ongoing major or central operations (that is, a revenue generating activity of the company), generally it should be classified as part of the cost of sales (e.g., amortization of a patent). Any presentation still must comply with the requirements of Rule 5-03 of Regulation S-X and SAB Topic 11.B.
Mr. Lopez emphasized that this issue is particularly important when the sale to the customer, including a reseller, occurs prior to the vendor's year end but the rebate is offered after year-end. He believes that a rebate should be considered "offered" at the date the related revenue is recognized (regardless of when the rebate actually is provided to the customer) if the vendor does not, in substance, control that rebate. Mr. Lopez believes that a vendor would not be in control of the rebate if it is economically compelled to provide that rebate. Judgment is involved in determining whether a vendor is economically compelled. He believes an important factor to consider is the relative size of the customer compared to the vendor that is offering the rebate (e.g., the manufacturer). If the vendor concludes that it is economically compelled to provide the rebate, then it must recognize the sales incentive when the related revenue is recognized.
Editor’s Note: While not addressed specifically by Mr. Lopez, issues 1 and 2 of Issue 01-9 also relate to the income statement geography of consideration given by a vendor to a customer — specifically, whether that consideration should be presented in the vendor's income statement as a reduction of revenue or as a cost or expense.
Software Revenue Recognition
According to Mr. Lopez, the SEC staff recently concluded that an upgrade would be considered "specified" if there is a promise to upgrade, regardless of whether that promise includes or refers to specific features and functionality of the upgrade. If the conclusion is reached that the upgrade right is "specified" and there is not vendor-specific objective evidence of the fair value of the upgrade, then the vendor would have to defer all revenue from the arrangement until the earlier of the point at which (1) such sufficient vendor-specific objective evidence does exist or (2) all elements of the arrangement have been delivered.
Additionally, Mr. Lopez reminded companies that they cannot default to recognizing revenue ratably over the term of the arrangement in situations where there is not vendor-specific objective evidence. The ratable method is appropriate only for those arrangements that are in substance a subscription or for post-contract customer support and services.
>>SPEECH BY RACHEL MINCIN, ASSOCIATE CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE
Loans and receivables
· Held for sale accounting
· Cash flow presentation
Retained interests in securitized loans — cash flow
Companies with loans or trade receivables held for sale, including those to be sold under securitization programs.
Companies that enter into securitization transactions.
Loans and Receivables
The scope of SOP 01-6 includes not only finance companies, but also non-finance companies that engage in transactions that involve lending to or financing the activities of others. Ms. Mincin indicated that these activities include selling goods or services in exchange for trade receivables. Under the guidance in paragraph 8, the SEC staff believes that loans and trade receivables should be accounted for as held for sale if (1) at origination, management intends to sell the loans or receivables or (2) management decides to sell loans or receivables that were not initially classified as held for sale.
What is the financial statement impact of classifying loans or receivables as held for sale? They should be reported separately on the balance sheet at the lower of cost or fair value (individually or in the aggregate). Disclosure should be made explaining how the company determines when to classify a loan or receivable as held for sale and the method used to determine the recorded amount. For the presentation of loans or trade receivables in the statement of cash flows, Ms. Mincin provided the following views:
Nature of Cash Flows
Cash Flow Statement Classification
For finance companies, cash flows resulting from the acquisition and sale of loans that are acquired specifically for resale and are carried at lower of cost or fair value3
For finance companies, cash flows resulting from the acquisition and sale of loans that are acquired with the intention of holding for the foreseeable future
For non-finance companies, cash flows from the sale of loans or trade receivables resulting from the sale of goods or services4
For non-finance companies, cash flows from the sale of loans that were not the result of sales of inventory or delivery of services to the company's customers that were acquired with the intention of holding for the foreseeable future
Retained Interests in Securitized Loans — Cash Flows
Ms. Mincin also shared her views on the classification in the statement of cash flows for retained interests in securitized loans. According to Ms. Mincin, the "receipt" of a retained interest in a securitization does not result in a cash flow to the company. However, the company should consider whether that transaction needs to be disclosed as a noncash investing activity in the statement of cash flows.
Ms. Mincin stated that paragraph 8 of Statement 102 requires principal payments received on retained interests to be recognized as operating cash inflows only when the retained interest is accounted for like a trading security under Statement 115. If the retained interest is not accounted for like a trading security, principal payments received should be presented as investing cash inflows. The result? It is possible to end up with negative operating cash flows from a securitization transaction. Ms. Mincin illustrated this point by way of the following example:
Company A acquires loans for sale for $100. The cash paid to acquire the loans is presented properly as an operating cash outflow. The company sells the loans and receives $98 in cash and a retained interest of $5 classified as available for sale. The cash received from the sale of the loans is presented properly as an operating cash inflow. Principal payments received on the retained interest are presented properly as an investing activity inflow. The end result is a $2 operating cash outflow and a $5 investing cash inflow.
- See paragraph 9 of Statement 102
- See paragraph 22 of Statement 95.
>>SPEECH BY MARK A. NORTHAN, PROFESSIONAL ACCOUNTING FELLOW, OFFICE OF THE CHIEF ACCOUNTANT
Companies using the shortcut method for hedging interest rate risk with an interest rate swap.
Companies that indirectly absorb or receive variability of an entity through arrangements with another enterprise.
Companies with convertible redeemable preferred stock.
Shortcut Method of Assessing Hedge Effectiveness
The SEC staff has seen instances where companies have applied the shortcut method without meeting all of the requisite criteria listed in paragraph 68 of Statement 133. Mr. Northan pointed to the guidance in Implementation Issue E4, which states that all shortcut conditions must be met — simply complying with the "spirit" or "principle" of the shortcut method is not acceptable. While a theme of this year's Conference was to look for the principle, he noted that as a practical exception provided in Statement 133, the SEC staff does not believe the shortcut method has an underlying spirit or principle.
One of the criteria for the shortcut method is that the fair value of an interest rate swap at the inception of the hedging relationship must be zero. The SEC staff has seen situations where financing elements have been included in interest rate swaps as adjustments to the "pay" or "receive" legs of the swap. For example, instead of directly paying a broker fee for a certain transaction, the fee may be added to the pay leg of an interest rate swap. Even though no cash may have been exchanged when the swap was entered into, the SEC staff holds the view that these "adjustments" result in the swap having a fair value other than zero at inception. As a result, the hedge would fail to meet the shortcut criteria.
Therefore, what are the consequences for a company that applied the shortcut method without meeting all of the criteria? The SEC staff generally would expect companies to remove the effects of hedge accounting for all periods during which the company relied on the shortcut method, as usually all other general hedge requirements would not have been met for prior periods, such as prospective and retrospective testing of hedge effectiveness. That is, the derivative should be marked to market in the income statement and, for fair value hedges, adjustments to the hedged item reversed.
Editor’s Note: On a related mater, a question was raised about the concept of concurrent designation and documentation of a hedge. The SEC staff member who responded stated that "concurrent" means occurring "at the same time."
Implicit Variable Interests
At last year's Conference, the SEC staff indicated that companies should be considering "activities around the entity" when analyzing the consolidation provisions in Interpretation 46(R).5 In March 2005, the FASB issued guidance6 on implicit variable interests indicating that variable interests may encompass implied or indirect interests in an entity. The objective of that guidance is to prevent companies from avoiding the requirements of Interpretation 46(R) simply by entering into arrangements with another holder (related or unrelated) of an interest in the entity, rather than with the entity directly. Mr. Northan stated that identification of implicit variable interests involves judgment based on specific facts and circumstances. In identifying implicit variable interests, preparers should consider the following questions:
Was the arrangement entered into in contemplation of the entity's formation?
Was the arrangement entered into contemporaneously with the issuance of a variable interest?
Why was the arrangement entered into with a variable interest holder instead of with the entity?
Did the arrangement reference specified assets of the variable interest entity?
Redeemable Equity Securities
EITF Topic D-98 requires redeemable shares to be classified outside of permanent equity and initially recognized at fair value. If redeemable in the current period, the shares should be adjusted to redemption amount at each balance sheet date. If the shares are not redeemable in the current period, but it is probable that they will become redeemable, then the shares should be adjusted to their redemption value using one of the two methods allowed in Topic D-98 (see example below). If it is not probable that the shares will become redeemable, then subsequent adjustment is not necessary until it becomes probable.
The SEC staff has received inquiries on the accounting for preferred securities that include multiple mutually exclusive options exercisable by the holder. For example, consider a security that contains both a conversion option, which is currently exercisable, and a redemption option, which is not currently exercisable but will become exercisable following the passage of a specified period of time. Questions have arisen about the probability of the security ever becoming redeemable because of the likelihood that the holder will exercise the conversion option first. Mr. Northan explained that the exercise of the conversion option is outside of the control of the issuer; therefore, absent any action by the holder, the security will become redeemable upon the passage of time. As a result, the instrument described above would be considered probable of becoming redeemable.
On January 1, 20X4, Company A issues 100,000 shares of redeemable convertible preferred stock for $1,000 per share, with the following terms:
Conversion option: The preferred shares are convertible by the holder, any time after issuance, into common shares of A at a conversion rate of 1:1.
Redemption option: If not previously converted, the preferred shares are redeemable by the holder any time after five years from issuance (i.e., on or after January 1, 20X9) for $1,100 per share.
Company A must make a policy decision — it may either (1) accrete the carrying amount of the preferred stock to its redemption value over the period from January 1, 20X4, through January 1, 20X9, using the interest method described in Opinion 21, or (2) immediately adjust the carrying amount of the preferred stock to its redemption value (i.e., $1,100). Company A should consistently apply the method selected and make appropriate disclosure in the financial statements of the selected policy. It cannot ignore the redemption provision even if it concludes that the preferred shares will be converted rather than redeemed.
5 - Pursuant to Interpretation 46(R), the holder of a variable interest in a variable interest entity that is considered the primary beneficiary should consolidate the variable interest entity. A variable interest is an interest in an entity that absorbs or receives changes in the value of the entity's net assets.
6 - FSP FIN 46(R)-5.
>>SPEECH BY REGGIE OAKLEY, PRACTICE FELLOW, FINANCIAL ACCOUNTING STANDARDS BOARD
Statement 123(R) implementation issues
All companies that issue share-based payment awards.
Statement 123(R) Implementation Issues
In a technical accounting issues breakout session, Mr. Oakley discussed the Statement 123(R) Resource Group, which the FASB staff is using to identify Statement 123(R) accounting issues. The Resource Group is a panel of experts (composed of preparers, auditors, and consultants) selected by the FASB staff with the objective of identifying and resolving potential issues. Discussions of this group do not establish GAAP; instead, the FASB staff has used FASB Staff Positions to resolve certain identified issues. Where members of the group reach agreement, the consensus of the group may indicate that the selected issue is addressed sufficiently in the existing Statement 123(R) framework. While the Resource Group's meetings are not public, representatives of the SEC and PCAOB are invited to observe. Mr. Oakley discussed a number of Statement 123(R) implementation issues identified by this group, including the following that resulted in FASB Staff Positions
FSP FAS 123(R)-1, which defers the requirement of Statement 123(R) to reassess the classification (equity or liability) of an award when the holder's rights are no longer contingent upon his or her being an employee of the entity;
FSP FAS 123(R)-2, which gives entities a practical accommodation to the application of "grant date" as defined in Statement 123(R); and
FSP FAS 123(R)-3, which gives entities a simplified method to computing their APIC Pool upon adoption of Statement 123(R).
In addition to the issues formally addressed in FSPs, Mr. Oakley highlighted the following issues considered by the Resource Group:
Pro Forma Balance Sheet Amounts
The pro forma disclosures required by Statement 123 did not require entities to report the impact, if any, that share-based payment transactions would have on the balance sheet (the "hypothetical balance sheet" impact). Some companies may have appropriately "capitalized" stock-based compensation cost as a pro forma component of the cost of an unrecorded pro forma asset in computing pro forma net income. At issue is how to treat the pro forma asset (the hypothetical balance sheet adjustment) upon and subsequent to the adoption of Statement 123(R).
Lender XYZ grants options to its loan origination personnel. Under Statement 123, Lender XYZ made a hypothetical adjustment to its loan portfolio, representing pro forma direct loan costs, and to net income for the pro forma compensation cost related to the options granted.
The Resource Group agreed that the following alternatives are acceptable methods for dealing with the hypothetical balance sheet adjustment under the modified prospective method of adoption:
Upon adoption, adjust the balance sheet, with a corresponding adjustment to APIC, for the impacts of the pro forma asset(s). As assets are realized or depreciated, the capitalized stock-based compensation expense would be relieved through the income statement.
Upon adoption, no entries are recorded on the balance sheet. Amounts capitalized in the pro forma balance sheet are recognized as additional expense in the income statement when the related asset is realized or depreciated (as if the opening balance sheet had been adjusted for the pro forma asset). How do you balance the books? A corresponding adjustment to APIC would be recorded when the additional expense is recorded.
If an entity failed to consider the impacts of capitalization in computing stock-based compensation cost in preparing its Statement 123 footnote disclosures, it need not account for any pro forma asset upon adoption of Statement 123(R). However, regardless of a company's policy selected prior to adoption, after adoption of Statement 123(R), a company must consider compensation under share-based payment awards in determining amounts capitalized to inventory and other internally developed assets (when such costs meet the appropriate capitalization criteria).
Interim Period Tax Effects
Under Statement 123(R), when the exercise of an award results in a tax deduction greater than the compensation cost recognized, the resulting "excess tax benefit" is recorded in APIC. The accumulation of excess tax benefits in APIC builds up what is commonly referred to as an entity's "APIC Pool." Likewise, when the tax deduction is less than the compensation cost recognized, the resulting "tax benefit deficiency" is recorded in APIC. However, recording a tax benefit deficiency directly to equity is only permitted when there is a sufficient APIC Pool to absorb the deficiency; otherwise, the deficiency is recorded in the income statement. The Resource Group discussed the issue of how "excess tax benefits" and "tax benefit deficiencies" should be treated for interim financial reporting purposes.
Resource Group members agreed that an acceptable approach for interim reporting purposes would be to consider the APIC Pool adjustment to be an annual calculation (versus a daily, weekly or quarterly adjustment). Under this approach, an excess "tax benefit deficiency" (and the related charge against income) occurring in one quarter can be offset and reversed in a subsequent quarter (within the same fiscal year) if, in that subsequent quarter, an excess tax benefit arises that is large enough to absorb the previous deficiency.
Assume a company's APIC Pool balance is zero as of January 1, 2006, the beginning of the fiscal year and the date of adoption of Statement 123(R). On March 15, 2006, a stock option is exercised and results in a tax benefit deficiency of $80, which is recorded as income tax expense (due to the absence of any APIC Pool credits).
On June 15, 2006, another stock option is exercised and results in an excess tax benefit of $100. In the six months ended June 30, 2006, the company would reflect a net increase in APIC of $20; the $80 of income tax expense recorded in the first quarter would be reversed in the second quarter.
Mr. Oakley explained that the Resource Group members also concluded that the impact of tax benefit excesses and deficiencies should be accounted for in the interim period in which they occur (that is, they should be treated as discrete items). The effects of expected future excesses and deficiencies should not be anticipated when preparing current period interim or annual financial statements.
>>SPEECH BY BRIAN K. ROBERSON, PROFESSIONAL ACCOUNTING FELLOW, OFFICE OF THE CHIEF ACCOUNTANT
All entities that file financial statements with the SEC.
Entities accounting for business combinations in which a preexisting relationship(s) exists between the parties.
Materiality and Quantification of Errors
During the 2004 Conference, a former Professional Accounting Fellow, Russell Hodge, discussed the two ways in which errors that span more than one period are quantified — the "rollover" approach and the "iron curtain" approach. Not everyone agrees which is the better of the two; both have their respective strengths and weaknesses.
To illustrate the difference between the approaches, Mr. Roberson gave the following example:
Assume a liability is overstated by $80 at the end of the prior year and is overstated by $100 at the end of the current year. The rollover approach (which is income statement focused) quantifies the current-year error as $20. The iron curtain approach (which is balance sheet focused) quantifies the current-year error as $100.
Assume that the error is corrected in the current year. In that case, the rollover approach would quantify the error at $80 (the period-to-period change); the iron curtain approach measures the error at zero because the end of period balance sheet is correct.
Mr. Roberson reiterated that the SEC staff does not believe diversity is appropriate in this area. Further, the staff continues to consider the issue and to evaluate whether and what type of guidance would be appropriate. In light of the perceived weaknesses of both approaches, the staff continues to believe that the better approach may be to quantify the error using both approaches.
As to any guidance to be issued, Mr. Roberson noted that the SEC is cognizant that registrants will need time to digest the new guidance and that some form of implementation guidance would be helpful. Until that time, registrants were encouraged to understand their current approach to quantifying errors. In a decentralized company, are units evaluating errors consistently? Are there errors, "immaterial" under the rollover approach, accumulating on the balance sheet? Ultimately, quantifying errors and evaluating materiality is a registrant's responsibility first (and an auditor responsibility second), as registrants are responsible for preparing the financial statements.
Editor’s Note: It has been widely expected that the SEC staff will release a Staff Accounting Bulletin dealing with the materiality topics discussed by Mr. Roberson. His remarks indicate that any SAB would not be effective for 2005 calendar year-end companies.
Mr. Roberson also reminded registrants to consider future periods in quantifying errors and in applying the materiality disclaimer found at the end of each FASB standard. Preparers were reminded that a decision to not apply a FASB standard must continually be updated as "the fact that not applying a particular provision in GAAP is immaterial in one period is not a lifetime pass to never apply the provision." He sounded a final word of caution regarding registrants who fail to apply GAAP to "immaterial" items in order to avoid negative financial statement consequences. Mr. Roberson concluded that "not applying the standard [because application] would cause users to view your financial statements differently…by definition, makes the difference material."
Matters Involving EITF Issue No. 04-1
An acquisition between parties with a preexisting relationship should be considered a multiple-element transaction, the business combination and the settlement of the preexisting relationship. The latter requires the determination of a gain or loss. The key take-away? A buyer of a target, with which it has a preexisting relationship, cannot "bury" the gain or loss resulting from the implicit settlement of the relationship in goodwill.
Buyer and target are parties to a supply contract, the terms of which are unfavorable from the buyer's perspective (i.e., price paid by buyer to target for product is above current market price). The contract does not include a settlement provision. As a result of the business combination, the contract is de facto settled. Buyer should measure and recognize a settlement loss calculated as the amount by which the value of the supply contract is unfavorable when compared to the value of a contract based on current market prices for the same or similar items.
Mr. Roberson also indicated that the SEC staff has concluded that this multiple element accounting also applies to less than 100 percent acquisitions. The speech contains an illustration of this situation
Next was the topic of reacquired rights. Issue 04-1 states that an intangible asset should be recorded apart from goodwill when previously granted rights to use the acquirer's intangible assets (e.g., trade names under franchise or rights to technology under a license) are reacquired in a business combination. Valuation and life were noted as the two most common issues addressed by the SEC staff.
Valuation — Registrants were reminded that the rights need to be valued as if the registrant was buying a right not previously owned. He illustrated the point by citing the acquisition of a previously granted restaurant franchise. Mr. Roberson indicated that the higher price paid for the franchise of a mature restaurant might include values attributable to factors independent of the value of the franchise right — for example customer relationship intangibles, workforce, real estate, etc.
Life — Mr. Roberson noted that one indication of the life of the right could be the life the acquirer uses for its existing intangible asset. There are differing views as to useful life if the original grant of the asset had been for a limited period of time: over the remainder of the contractual life originally granted or based on the useful life of the license to the acquirer. Mr. Roberson referred the audience to the FASB's exposure draft for the replacement of Statement 141, in which the FASB has proposed that such rights be amortized over the remaining contractual period of the pre-combination contract that granted the rights. He also mentioned the SEC staff's willingness to discuss this accounting issue with registrants.
>>SPEECH BY PAMELA R. SCHLOSSER, PROFESSIONAL ACCOUNTING FELLOW, OFFICE OF THE CHIEF ACCOUNTANT
"Breakage" - revenue recognition by a vendor when a customer makes a payment in advance of vendor performance and the customer does not demand full performance
Customer-related intangible assets acquired in a business combination
New basis of accounting
Companies that sell gift cards, phone cards, or enter into other arrangements in which the customer makes a payment in advance of vendor performance.
Companies that acquire other businesses.
Certain business combination transactions involving an OLDCO or NEWCO.
In a timely message to retailers and other vendors this holiday season, Ms. Schlosser addressed revenue recognition by a vendor on arrangements in which a customer makes a payment in advance of vendor performance (e.g., gift cards and phone cards.) In some cases, the customer does not demand full performance for various reasons. This is referred to frequently as "breakage." The issue is when the vendor can derecognize the deferred revenue liability and recognize revenue in the absence of performance.
Ms. Schlosser reminded the audience that the SEC staff has stated previously that it is appropriate for a vendor to apply the liability derecognition guidance of Statement 140 to these circumstances. However, breakage also can be recognized in earnings prior to being legally released if the vendor can demonstrate that it is remote that the customer will require performance.
The important point is that companies should not recognize breakage as revenue immediately upon the receipt of payment, even if there is historical evidence to suggest that for a certain percentage of transactions, performance will not be required. The SEC staff has objected to a registrant recognizing, based on historical redemption rates, 10 percent of the prepayment as revenue and 90 percent as deferred revenue upon the sale of a gift card, since performance had not yet occurred.
Ms. Schlosser described two acceptable approaches to revenue recognition:
Specific Identification — Vendors can recognize gift card breakage on a card-by-card basis as the vendor is legally released from its obligation, for example, at redemption or expiration; or at the point redemption becomes remote.
Homogeneous Pool — Vendors can recognize gift card breakage in proportion to actual redemptions if redemption of a certain amount of homogeneous transactions is remote. Under this approach, the estimated value of gift cards expected to go unused in a homogeneous pool sold over a certain period of time would be recognized as the remaining gift cards are redeemed. The company would need to reasonably and objectively determine both the estimated time period of actual gift card redemption, and the amount of breakage.
Assume a retailer issues $1,000 of gift cards and can objectively demonstrate that 10 percent of all gift cards sold are not redeemed, resulting in $100 of breakage, and that its gift cards will be redeemed on a pro-rata basis over the next twenty-four months. Under the homogeneous pool approach, the $100 in breakage would be recognized into income pro rata over the next twenty-four months.
Customer-Related Intangible Assets Acquired in a Business Combination
Ms. Schlosser addressed a difficult business combination question: How should the fair value of an acquired intangible asset be estimated when that intangible will not be used to its fullest extent by the acquirer? Consider the following example:
Company A is an apparel retailer and acquires Company B, which sells toys to Company A's existing customers. Under business combination accounting, Company B's customer relationships should be recognized separately as intangible assets in the purchase price allocation. If Company A already has customer relationships with those same customers, albeit for different product sales, at what amount should those customer relationships be recognized?
Some have argued that Company A should not assign any value to Company B's relationships with those customers since it already has relationships with them. The SEC staff has found such arguments difficult to accept. It believes that there is value in Company B's relationships as Company A now has the ability to sell new products to its retail customers that it was unable to sell prior to the acquisition. Even if the two companies sold competing products, the SEC staff believes the increased "shelf space" at each of its customer's retail locations would be indicative of value to those relationships. Accordingly, some amount should be assigned to Company B's customer relationships.
How should Company A estimate the fair value of the relationships? The SEC staff believes the income approach - based on the benefits of incremental sales to those customers - generally is the most appropriate approach. In addition, Ms. Schlosser pointed out that both Statement 1417 and Issue 02-178 state that fair value estimates should incorporate assumptions that marketplace participants would use in estimating fair value. She recommended consultation with the SEC staff in a situation in which a company thinks that an entity-specific valuation is appropriate.
Editor’s Note: In a separate Q&A session, another SEC staff member explained that the AICPA's Practice Aid, "Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries," provides some guidance on the use of marketplace assumptions in estimating fair value of intangible assets acquired in a business combination.
New Basis of Accounting
Ms. Schlosser explained that, with the recent uptick in M&A activity, the number of new basis issues, addressed by the staff, is on the rise. She discussed a few of the issues addressed recently.
Application of EITF Topic D-97
Topic D-97 explains that investors that come together to make an investment may be considered to constitute a "collaborative group" — that is, they have worked together to promote and collaborate on both the form and subsequent operations of that entity. The conclusion of whether a group of investors is considered a "collaborative group" could significantly impact whether push-down accounting is required (i.e., whether the company has become substantially wholly owned).
Ms. Schlosser stated that the staff has no "golden rules" in applying Topic D-97. Given that the application of Topic D-97 is highly dependent upon an entity's specific facts and circumstances, she stated that "the totality of all of the factors should be evaluated in concluding whether the investors represent a collaborative group." Some of the questions that the staff may ask in gaining a better understanding of the relationship among the investors, and thus whether a collaborative group exists, are:
How did the various investors come together to make this investment?
Hypothetically, if one of the investors would have backed out of the deal, would the deal still have been done?
How are board seats determined and can the number of seats change over time?
What is the nature of decisions that require unanimous or majority approval of the investors?
What evidence supports that sale restrictions are considered reasonable and customary?
Determining the Appropriate Accounting Models
SEC staff members also address many questions on when a new basis of accounting should be applied. First, it is important to understand whose accounting is being considered: the accounting for an OLDCO (an existing operating company that underwent a change in ownership) or a NEWCO (a newly formed entity that just acquired an operating company)? Ms. Schlosser explained that SAB 54 and Topic D-97 are applied from the perspective of an OLDCO and, therefore, should not be applied to NEWCOs. Consequently, in transactions that involve a NEWCO, registrants must look to the guidance in Statement 141 and Issue 88-16. Additionally, it is important to understand that the form of the transaction may impact the accounting result, especially in the application of Issue 88-16. Ms. Schlosser provided the following examples:
A business was acquired for cash by a NEWCO. NEWCO, which was infused with cash through issuance of stock and debt, is owned by a group of unrelated investors prior to the acquisition. The registrant concluded that NEWCO should not record a step up in fair value of the acquired business because it believed no one single shareholder or collaborative group controlled the entity. That is, the registrant analyzed the fact pattern by looking through NEWCO and applying the collaborative group guidance in Topic D-97 to the unrelated investors in NEWCO.
The staff's response? They did not consider Topic D-97 to be relevant. Because it was NEWCO's accounting that was at issue rather than OLDCO, the staff did not believe the issue was one of determining whether push-down accounting was applicable. The question then becomes what is the appropriate accounting?
Since this transaction was not "highly leveraged" and, therefore, not within the scope of Issue 88-16, the staff concluded that Statement 141 was relevant. In this fact pattern, NEWCO was considered the accounting acquirer since it was concluded to be substantive; it acquired a single operating company for cash and the entire ownership of the operating company had changed. As a result, NEWCO's acquisition of the operating company should result in a full step-up in basis.
A highly leveraged NEWCO is merged into an operating company in a series of related transactions. The registrant argued that Issue 88-16 was applicable. However, the form of the transaction differed from the leveraged buyout transaction described in that Issue abstract. Since NEWCO did not acquire the stock of the operating company, but rather merged into the operating company as part of a series of related transactions, the staff objected to the application of Issue 88-16.
The moral of the story? In both examples, the role of NEWCO, the amount of debt, and the form of the transactions are crucial in determining the appropriate accounting. Ms. Schlosser encouraged companies and their auditors to continue to consult with the staff in these areas of judgmental accounting.
7 - Statement 141, paragraph B174
8 - Issue 02-17, paragraph 6
>>SPEECH BY ALISON T. SPIVEY, ASSOCIATE CHIEF ACCOUNTANT, OFFICE OF THE CHIEF ACCOUNTANT
All companies with share-based option awards granted to employees
Companies using the "simplified method" as discussed in SAB 107 to estimate the expected term of share-based option awards.
All companies with share-based payment arrangements.
Expected Volatility Assumption
Statement 123(R) defines volatility as "a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period." However, Statement 123(R) does not specify a method of estimating expected volatility; rather, paragraph A32 of Statement 123(R) provides a list of factors that are required to be considered in estimating expected volatility. Factors to consider include historical volatility and implied volatility. SAB 107 includes the SEC staff's thoughts on determining expected volatility as well as when exclusive reliance on either historical volatility or current implied volatility is appropriate.
The SEC staff acknowledged that in many circumstances companies may conclude that sole reliance on either historical or implied volatility is inappropriate. In those circumstances, all information available to estimate expected volatility should be considered. Companies should keep in mind that the objective is to determine the volatility assumption that marketplace participants would be likely to use in determining an exchange price for an option. Ms. Spivey provided some additional thoughts on implied volatility and historical volatility as a result of questions received after release of the SAB.
Ms. Spivey reiterated that the SEC staff, as stated in SAB 107, will not object to a company exclusively relying on the implied volatility derived from a traded option with a remaining maturity of at least one year, assuming other criteria provided in the SAB are also met (even if the employee option has a longer term than the traded option). In addition, SAB 107 also notes that implied volatility based on a traded option with a remaining maturity of six months or more could be considered as long as a company also considers other relevant information in estimating expected volatility.
Ms. Spivey stated that the SEC staff has become aware of the following two methods of computing historical volatility that would not be considered to be a good faith effort in estimating expected volatility:
A method that weighs the most recent periods of historical volatility much more heavily than earlier periods; and
A method that relies solely on using the average value of the daily high and low share prices to compute volatility.
Editor’s Note: Shan Benedict, Professional Accounting Fellow, Office of the Chief Accountant, emphasized in her remarks that the SEC staff believes that subsequent changes in an award's value after its grant date do not call into question the reasonableness of the grant date fair value provided that the company utilized good faith estimates in the application of provisions of Statement 123(R) (which includes estimates of expected term and volatility).
Expected Term Assumption
SAB 107 provides a "simplified" method for estimating the expected term for "plain vanilla" options, as those options are described in the Staff Accounting Bulletin. This alternative is available for all public companies. However SAB 107 is silent on whether this guidance applies to nonpublic companies. Ms. Spivey clarified that the SEC staff would not object if a company applied the simplified method in the financial statements for the pre-IPO years included in the initial registration statement filed with the Commission.
Statement 123(R) states that the best evidence of fair value for employee share options is observable market prices of identical or similar instruments in active markets. Since the issuance of SAB 107, the SEC staff has become aware of efforts to design and sell a market instrument for the purpose of providing a value for employee share options. Ms. Spivey stated that they are not currently aware of any such instruments that have been sold in the market for the purpose of valuing employee share options. However, the SEC staff believes it should be possible to design instruments whose transaction prices would be a reasonable estimate of the fair value of underlying employee share options.
Ms. Spivey then discussed two possible approaches to market transactions that might meet the fair value measurement objective in Statement 123(R):
Design an instrument that would result in a payoff that tracked the payoff on an underlying pool of employee stock options, or
Structure an arrangement in which a company compensates a market participant to assume the role of the employer and its risks associated with future exercises of options.
Ms. Spivey contrasted the above alternatives to an approach where an instrument is structured to replicate the restrictive terms included in employee share options. In this case, the SEC staff does not believe that the value that a third party investor would assign to an instrument with the same restrictive terms would represent the fair value of the employee share option consistent with the measurement objective of Statement 123(R). That is, it does not seem possible to replicate an employer-employee relationship or the effects of that relationship in a transaction with a third party.
Ms. Spivey stated that the marketing plan for the instrument is an equally important consideration because marketplace participants will need information about the terms of the awards as well as other information that would be useful to appropriately determine a fair value estimate.
Editor’s Note: Former Chief Accountant, Don Nicolaisen, issued a statement expressing his views on the use of market instruments to estimate grant date fair value of employee share options. This statement is accompanied by a memo from the Office of Economic Analysis as well as comments from SEC Chairman Christopher Cox. For these statements and further information on market instruments visit the SEC's Web site at www.sec.gov.
>>SPEECH BY CAROL A. STACEY, CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE
Ensuring complete, accurate, and relevant financial statements
All entities that file financial statements with the SEC. Ms. Stacey suggests five ways preparers and auditors can ensure that financial statements are complete, accurate, and relevant.
Ensuring Complete, Accurate, and Relevant Financial Statements
"Full, fair, and accurate disclosure is the mantra that we live by," Ms. Stacey said as she challenged companies and their auditors to ensure that their financial statements provide the information that investors need to make informed business decisions. While management remains responsible for its company's financial statements, Ms. Stacey re-emphasized the role played by independent registered auditors in the financial reporting process. By reference to the May 16, 2005 SEC and PCAOB guidance, she reiterated that neither the internal control process nor the independence rules preclude dialogue between a company and its auditor pertaining to new or complex transactions or accounting standards.
Ms. Stacey articulated the following five ways companies and their auditors can ensure that financial statements are complete, accurate, and relevant to users:
1. Improving the Use of Technology
Ms. Stacey called for better use of technology in understanding a company and all its available information, including press releases and other periodic filings beyond financial statements. Once this understanding is achieved, the next step involves comparisons of the company with its competitors. Although XBRL is not currently required, Ms. Stacey believes XBRL has the potential to create benefits and cost savings through easier access and analysis of financial information, while concurrently assisting companies in their internal and external financial reporting. Ms. Stacey reminded registrants that they can voluntarily furnish, in an exhibit to an EDGAR filing, supplemental tagged information using XBRL
2. Increasing Accountant Education
Ms. Stacey challenged accountants to place a high priority on education. Citing Statement 133 as an example, she encouraged continued training on complex standards that frequently are applied by registrants, in lieu of extensive reliance on subject matter experts.
3. Reducing Financial Statement Complexity
Ms. Stacey asked preparers to consider how their accounting can be simplified. U.S. GAAP often establishes one clear accounting application, but it does allow certain other optional methods. The use of these optional methods tends to increase complexity. Possible areas that offer immediate opportunity to reduce complexity include:
Choosing the direct method of cash flow,
Choosing not to aggregate segments,
Presenting the income statement by function and nature, and
Adopting more rigorous other-than-temporary impairment policies.
In addition, Ms. Stacey noted that Statement 133's general preference is for derivative instruments to be reported at fair value, with changes in fair value being recorded though current income. As such, a company can reduce financial reporting complexity by foregoing use of fair value hedging.
4. Applying Judgment
Echoing one of the Conference themes, Ms. Stacey took the opportunity to emphasize the criticality of applying judgment by all of those involved in the financial reporting process. Financial statement preparation involves the use of estimates and assumptions, which will only increase if the trend toward fair value measures in financial statements continues to gain momentum. Management should describe to users how they arrived at estimates and assumptions, including events and circumstances that could cause changes in estimates and assumptions. Preparers were reminded to look to the SEC's 2003 MD&A interpretive release for additional guidance regarding disclosures related to management's use of estimates and assumptions.
In addition, she reminded auditors to engage experts and challenge management as deemed appropriate. Regulators and users were urged to be mindful of hindsight and second-guessing, and instead to focus on whether registrants (and auditors) had a reasonable basis for the estimates or assumptions.
5. Reducing "Disclosure Overload"
Ms. Stacey emphasized that financial reporting is a communication exercise, as opposed to one of compliance. While increased business complexity is a contributing factor, opportunities remain for preparers to reduce the size of their filings. Ms. Stacey, reiterating many of the items included in the 2003 MD&A interpretive release, mentioned prioritizing disclosures for investors, emphasizing in MD&A those issues that keep the CEO "up at night," eliminating redundancies, and communicating in plain English. Lastly, she urged registrants to push back if they receive disclosure requests from the Division of Corporation Finance that the registrants believe are not material or are redundant of other disclosures in the filings.
>>SPEECH BY SONDRA L. STOKES, ASSOCIATE CHIEF ACCOUNTANT, DIVISION OF CORPORATION FINANCE
Companies that have more than one business unit, division, product line, etc. (i.e., those that could potentially have more than one operating and reportable segment).
Companies that have goodwill and more than one operating segment.
Ms. Stokes explained that the SEC staff continues to scrutinize registrants' application of Statement 131 in (1) identifying all operating segments9 and (2) appropriate aggregation of those operating segments to arrive at reportable segments.10 She reminded participants that, in addition to meeting all five criteria outlined in paragraph 17 of Statement 131, operating segments must possess similar economic characteristics before they can be aggregated into reportable segments.
Editor’s Note: In a separate Q&A session, the SEC staff reminded participants that they generally do not accept the argument that a certain component is not an operating segment solely because the Chief Operating Decision Maker ("CODM") does not use the information provided. If the CODM receives certain information, generally the SEC staff presumes that the information is used to make decisions about resources to be allocated to the segment and to assess its performance.
Ms. Stokes gave an example of a registrant that aggregated its operating segments into one reportable segment, but the operating segments had gross margins ranging from minus 15 percent to positive 60 percent. While there is no clear guidance on the meaning of "similar economic characteristics," the SEC staff objected to the aggregation because the significantly different gross margins made it difficult to conclude that the segments possessed similar economic characteristics.
Goodwill Allocated to Reporting Units
Why are segment disclosures so important? In addition to providing investors with a management perspective, Ms. Stokes reminded participants that conclusions over operating segments impact other areas of accounting - for example, goodwill impairment under Statement 142. Remember that, at the date of a business combination, goodwill needs to be allocated to a reporting unit and that goodwill impairment is tested annually at the reporting unit level. Also remember that Statements 141 and 142 define a "reporting unit" as an operating segment or one level below an operating segment.
The consequence? If an enterprise makes an inappropriate conclusion regarding operating segments (e.g., one operating segment should have been two - one large profitable segment and one small unprofitable segment), it will likely inappropriately conclude on its reporting units as well. As a result, the enterprise might not record a goodwill impairment that is otherwise necessary (e.g., the deficiency of book value over fair value of an impaired reporting unit may have been inappropriately masked by the excess of fair value over book value of another reporting unit). Another potential consequence is that the enterprise could incorrectly calculate the amount of the goodwill impairment charge if the fair values of two reporting units are inappropriately combined in the impairment test.
When goodwill is material to an entity's financial position, Ms. Stokes reminded participants that registrants should consider discussing the following in their critical accounting estimates section of their MD&A: the nature of an entity's reporting units, how goodwill was allocated to those reporting units upon acquisition, how and when subsequent changes in the number of reporting units are identified, and the related accounting consequences.
9 - Paragraph 10 of Statement 131 provides the definition of an operating segment.
10 - Paragraph 17 of Statement 131 provides a list of criteria that must be met before two or more operating segments are aggregated to form a reportable segment.
>Glossary of Standards
FASB Statement No. 95, Statement of Cash Flows
FASB Statement No. 102, Statement of Cash Flows — Exemption of Certain Enterprises and Classification of Cash Flows From Certain Securities Acquired for Resale — an amendment of FASB Statement No. 95
FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities
FASB Statement No. 123, Accounting for Stock-Based Compensation
FASB Statement No. 131, Disclosures About Segments of an Enterprise and Related Information
FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities
FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
FASB Statement No. 141, Business Combinations
FASB Statement No. 142, Goodwill and Other Intangible Assets
FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities
FASB Staff Position No. FAS 123(R)-1, "Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services Under FASB Statement No. 123(R)"
FASB Staff Position No. FAS 123(R)-2, "Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R)"
FASB Staff Position No. FAS 123(R)-3, "Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards"
FASB Staff Position No. FIN 46(R)-5, "Implicit Variable Interests Under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities"
FASB Concepts Statement No. 6, Elements of Financial Statements
Statement 133 Implementation Issue No. E4, "Hedging — General: Application of the Shortcut Method"
FASB Exposure Draft of a Proposed Statement of Financial Accounting Standards, Business Combinations — a replacement of FASB Statement No. 141
EITF Issue No. 88-16, "Basis in Leveraged Buyout Transactions"
EITF Issue No. 90-19, "Convertible Bonds With Issuer Option to Settle for Cash Upon Conversion"
EITF Issue No. 98-5, "Accounting for Convertible Securities With Beneficial Conversion Features or Contingently Adjustable Conversion Ratios"
EITF Issue No. 99-19, "Reporting Revenue Gross as a Principal Versus Net as an Agent"
EITF Issue No. 00-10, "Accounting for Shipping and Handling Fees and Costs"
EITF Issue No. 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock"
EITF Issue No. 00-27, "Application of Issue No. 98-5 to Certain Convertible Instruments"
EITF Issue No. 01-3, "Accounting in a Business Combination for Deferred Revenue of an Acquiree"
EITF Issue No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products)"
EITF Issue No. 01-14, "Income Statement Characterization of Reimbursements Received for 'Out-of-Pocket' Expenses Incurred"
EITF Issue No. 02-17, "Recognition of Customer Relationship Intangible Assets Acquired in a Business Combination"
EITF Issue No. 04-1, "Accounting for Preexisting Relationships Between the Parties to a Business Combination"
EITF Issue No. 05-2, "The Meaning of 'Conventional Convertible Debt Instrument' in EITF Issue No. 00-19, 'Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock'"
EITF Issue No. 05-4, "The Effect of a Liquidated Damages Clause on a Freestanding Financial Instrument Subject to EITF Issue No. 00-19, 'Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock'"
EITF Topic No. D-97, "Push-Down Accounting"
EITF Topic No. D-98, "Classification and Measurement of Redeemable Securities"
APB Opinion No. 21, Interest on Receivables and Payables
APB Opinion No. 25, Accounting for Stock Issued to Employees
APB Opinion No. 28, Interim Financial Reporting
SEC Regulation S-K, Item 10, "General"
SEC Regulation S-X, Article 5, "Commercial and Industrial Companies"