November 2006 — Current Accounting and Disclosure Issues in the Division of Corporation Finance

 In particular, SAB 107 provides guidance on the following:

• share-based payment transactions with nonemployees;
• transition from nonpublic to public entity status;
• valuation methods (including assumptions such as expected volatility and expected term);
• accounting for certain redeemable financial instruments issued under share-based payment arrangements;
• classification of compensation expense;
• non-GAAP financial measures;
• first-time adoption of SFAS 123R in an interim period;
• capitalization of compensation cost related to share-based payment arrangements;
• accounting for income tax effects of share-based payment arrangements upon adoption of SFAS 123R;
• modification of employee share options prior to adoption of SFAS 123R; and
• disclosures in Management’s Discussion and Analysis (MD&A) subsequent to adoption of SFAS 123R.

 The adoption of SFAS 123R may result in significant differences between the financial statements of periods before and after the adoption. Therefore, it is imperative that disclosure in MD&A and the financial statements assist investors in understanding the impact of the adoption of SFAS 123R, including the impact on the comparability of financial statements from period to period. As SAB 107 points out, this disclosure should be quantitative as well as qualitative. Section F of SAB 107 discusses ways that registrants could disclose the effect of share-based payment arrangements on individual line items in the financial statements. Disclosure of the amount of expense might be appropriate in a parenthetical note to the appropriate income statement line items, on the cash flow statement, in the footnotes to the financial statements, or within MD&A. Registrants should avoid presentations on the face of the financial statements that give the impression that the nature of the expense related to share-based compensation is different from cash compensation paid to the same employees (for example by creating one or more separate line items for share-based compensation or by adding a table totaling the amount of share-based compensation included in various line item).

 The statements are available at: http://www.sec.gov/news/press/2005-129.htm and http://www.sec.gov/news/speech/spch090905dtn.htm. The Commission's Office of Economic Analysis also provided their views in a memo which provides a fuller understanding of the issues, available at: http://www.sec.gov//news/extra/memo083105.htm.

 The Commission voted in November 2004 to postpone the final phase-in period for acceleration of periodic report filing dates (see Release No. 33-8507). As a result, for an additional year the deadline for accelerated filers remained at 75 days after year end for annual reports and at 40 days after quarter end for quarterly reports.

 The Commission voted in December 2005 to adopt amendments to the periodic report filing deadlines and the Exchange Act Rule 12b-2 definition of an "accelerated filer" (see Release No. 33-8644). The amendments create a new category of filers, "large accelerated filers," for companies that have a public float of $700 million or more and meet the same other conditions that apply to accelerated filers. The amendments also redefine "accelerated filers" as companies that have at least $75 million but less than $700 million in public float. Under the amendments, the deadlines large accelerated filers and accelerated filers are as follows:

 The amendments also modify the procedures by which accelerated filers can exit accelerated filer status by permitting an accelerated filer whose public float has dropped below $50 million to file an annual report on a non-accelerated basis for the same fiscal year that the determination of public float is made. The amendments similarly permit a large accelerated filer to promptly exit large accelerated filer status once its public float has dropped below $500 million.

 Foreign private issuers filing on Forms 20-F or 40-F are not subject to the new rules. However, a foreign private issuer electing to file on Forms 10-K and 10-Q in lieu of Form 20-F or 40-F will be subject to the large accelerated filing and accelerated filing rule if it meets the respective definition.

 Rule 12b-25 permits registrants an extension of time in which to file their Forms 10-K and 10-Q and still be considered to have filed those reports timely. The new rules do not change the 15 calendar day period (for Form 10-K) and 5 calendar day period (for Form 10-Q) provided for under Rule 12b-25.

 Large accelerated filers and accelerated filers can file their Article 12 financial statement schedules by amendment within 30 days following the due date of their Form 10-K.

 If an accelerated filer changes its fiscal year end, the transition report deadlines are phased in under the same schedule as quarterly and annual reports on Forms 10-Q and 10-K.

 A registrant becomes a large accelerated filer if it meets all of the following criteria at the end of its fiscal year:

• the registrant has been a reporting company under Section 13(a) or 15(d) of the Exchange Act for a period of at least 12 calendar months,
• the registrant has filed at least one annual report pursuant to Section 13(a) or 15(d) of the Exchange Act,
• the registrant had worldwide market value of outstanding voting and non-voting common equity held by non-affiliates of $700 million or more as of the last business day of its most recently completed second fiscal quarter, and
• the registrant is not eligible to use small business forms (10-KSB and 10-QSB) for its annual and quarterly reports.

 A large accelerated filer that has an aggregate worldwide market value of the voting and non-voting common equity held by non-affiliates less than $500 million, as of the last business day of the registrant’s most recently completed second quarter, may exit large accelerated filer status at the end of that fiscal year. The registrant would file its annual report for that year and subsequent periodic reports as an accelerated filer, or a non-accelerated filer, as appropriate. Thereafter, a registrant would again have to satisfy the large accelerated filer definition to become subject to the large accelerated filing requirements.

 Accelerated Filer Definition

 A registrant becomes an accelerated filer if it meets all of the following criteria at the end of its fiscal year:

• the registrant has been a reporting company under Section 13(a) or 15(d) of the Exchange Act for a period of at least 12 calendar months,
• the registrant has filed at least one annual report pursuant to Section 13(a) or 15(d) of the Exchange Act,
• the registrant had a non-affiliated common equity public float of $75 million or more, but less than $700 million, as of the last business day of its most recently completed second fiscal quarter, and
• the registrant is not eligible to use small business forms (10-KSB and 10-QSB) for its annual and quarterly reports.

 An accelerated filer that has an aggregate worldwide market value of the voting and non-voting common equity held by non-affiliates less than $50 million, as of the last business day of the registrant’s most recently completed second quarter, may exit accelerated filer status at the end of that fiscal year. The registrant would file its annual report for that year and subsequent periodic reports as a non-accelerated filer. Thereafter, a registrant would again have to satisfy the accelerated filer definition to become subject to the accelerated filing requirements.

 Forms 10-K and 10-Q Disclosures

 The rules require that all Exchange Act registrants filing on Form 10-K include cover page disclosures in their Forms 10-K. The amended cover page requires the registrant to indicate by check mark whether it is a large accelerated filer, an accelerated filer or a non-accelerated filer and to disclose its worldwide non-affiliated common equity public float as of the end of the last business day of the registrant’s most recently completed second fiscal quarter. The filing status disclosure is also required on Form 10-Q.

 If a registrant’s cover page to its Form 10-K incorrectly depicts its filing status or mistakenly discloses its non-affiliated common equity public float as of the date of filing, rather than as of the last business day of its most recently completed second fiscal quarter, it should file an amended Form 10-K. That amendment should include a corrected cover page, a new signature page, and Exhibit 31, a revised 302 certification required by Item 601 of Regulations S-K and S-B which includes the first 2 certifying statements. Note that both the share price and outstanding share amount must be as of the last business day of the most recently completed second fiscal quarter.

 For purposes of completing the cover page to their first Form 10-K, we have advised registrants who complete their IPO after their most recently completed second quarter to compute their worldwide common equity public float as of a date within 60 days of filing the report. This method was used prior to the adoption of the new rules. Note that this is only to fulfill the cover page disclosure requirement. It does not mean the issuer uses that common equity public float to determine whether it is a large accelerated filer or an accelerated filer. In this scenario, the registrant would not qualify as a large accelerated filer or an accelerated filer because it was not a public company for 12 months and it had not filed at least one annual report as of its fiscal year-end.

 Transactional Filings

 In addition to accelerating the Form 10-Q filing deadlines, the rules accelerated the updating requirements of interim financial statements required in registration statements at the time of effectiveness and in proxy statements at the time they are mailed to conform to the accelerated phase-in filing deadlines of Form 10-Q. Therefore, if the registrant meets the definition of a large accelerated filer or an accelerated filer, its interim financial statements cannot be older than 129 days.

 An accelerated filer that meets the three tests specified in S-X Rule 3-01(c) must update to include its audited year-end financial statements using the same phase-in schedule for its Form 10-K. Therefore, an accelerated filer meeting the tests must include its audited year-end financial statements by 75 days after year-end. For fiscal years ending on or after December 15, 2006, a large accelerated filer must include its audited year-end financial statements by 60 days after year-end (75 days for fiscal years ending before December 15, 2006).

 If the filer does not meet the Rule 3-01(c) tests, it will still be able to delay updating to include its year-end financial statements until 45 days after its year-end. The 45-day period has not changed. Note that, despite the stipulated timeframes, registrants are required to include their year-end audited financial statements in definitive proxy statements and registration statements at the time of effectiveness if they are available.

 Financial Statements under S-X Rules 3-05 and 3-09

 The requirement for updating interim and fiscal year-end financial statements of an acquired business included in an acquirer’s Form 8-K or in its proxy/registration statement under S-X Rule 3-05 has been accelerated only when the acquired company is itself a large accelerated filer or an accelerated filer. Therefore, an acquirer must include the financial statements of the acquired business at least as current as the financial statements required to be filed by the acquired company in its own periodic reports. Large accelerated filers and accelerated filers still have 75 days from consummation to file 3-05 financial statements on Form 8-K.

 Separate financial statements of unconsolidated subsidiaries and 50% or less owned persons required by S-X Rule 3-09 will not be accelerated for inclusion in the parent’s Form 10-K unless both the parent and the subsidiary/investee are accelerated filers.

 After May 22, 2006, the Commission's website began presenting a list of filings declared effective on the previous business day (see the link to the notifications of effectiveness on the Commission’s Web site at http://www.sec.gov/cgi-bin/browse-edgar?action=geteffect). The effectiveness notices will be distributed as an EDGAR form type called "EFFECT." Consequently, for the first time, an interested person can search for a company's filings and be able to see when the staff declared a particular Securities Act registration statement effective.

 McAfee consented, without admitting or denying the allegations of the complaint, to a Court order enjoining it from violating the antifraud, books and records, internal controls, and periodic reporting provisions of the federal securities laws. The order also requires that McAfee pay a $50 million civil penalty, which the Commission will seek to distribute to harmed investors pursuant to the Fair Funds provision of the Sarbanes-Oxley Act of 2002. In addition, McAfee agreed to appoint an Independent Consultant to examine and recommend improvements to McAfee’s internal accounting controls and revenue recognition and reserves practices to better ensure compliance with the federal securities laws.

 According to the complaint, McAfee defrauded investors into believing that it had legitimately met or exceeded its revenue projections and Wall Street earnings estimates during the 1998 through 2000 period. In reality, however, McAfee engaged in "channel stuffing" or the aggressive overselling of its products to distributors in amounts that far exceeded the demand for the products. While engaging in this "channel stuffing," McAfee improperly recorded the sales to distributors as revenue. McAfee offered its distributors lucrative sales incentives that included deep price discounts and rebates in an effort to persuade the distributors to continue to buy and stockpile McAfee products. McAfee also secretly paid distributors millions of dollars to hold the excess inventory, rather than return it for a refund and resulting reduction in McAfee’s revenues. In other instances, McAfee used an undisclosed, wholly-owned subsidiary, Net Tools, Inc., to repurchase inventory that McAfee had oversold to its distributors All of these actions were inconsistent with generally accepted accounting principles (GAAP) and led to McAfee’s October 2003 restatement of its financial results for 1997 through 2003.

 The complaint further alleged that McAfee took action to conceal the fraud from investors by, among other things, recording the payments and discounts that it offered to distributors in an inappropriate manner, and improperly manipulating reserve accounts to increase inadequate sales reserves and cover the costs of the distributor payments. The complaint alleged that McAfee defrauded investors by reporting false and materially misleading financial and other information in periodic reports, financial statements, and securities registration statements that McAfee filed with the Commission, in press releases, and in other public statements. See AAER No. 2360 for more information.

 The Commission’s complaint alleged that AIG’s reinsurance transactions with General Re Corporation (Gen Re) were designed to inflate falsely AIG’s loss reserves in order to end analyst criticism that AIG’s reserves had been declining. The complaint also identifies a number of other transactions in which AIG materially misstated its financial results through sham transactions and entities created to mislead the investing public. Specifically, the Commission’s complaint alleges that in December 2000 and March 2001, AIG entered into two sham reinsurance transactions with Gen Re that had no economic substance but were designed to allow AIG to improperly add $500 million in phony loss reserves to its balance sheet in the fourth quarter of 2000 and the first quarter of 2001. In addition, the complaint alleges that in 2000, AIG engaged in a transaction with Capco Reinsurance Company, Ltd. (Capco) to conceal approximately $200 million in underwriting losses in its general insurance business by improperly converting them to capital (or investment) losses to make those losses less embarrassing to AIG. The complaint further alleges that in 1991, AIG established Union Excess Reinsurance Company Ltd. (Union Excess), an offshore reinsurer, to which it ultimately ceded approximately 50 reinsurance contracts for its own benefit. Although AIG controlled Union Excess, it improperly failed to consolidate Union Excess’s financial results with its own, and in fact took steps to conceal its control over Union Excess from its auditors and regulators. As a result of these actions and other accounting improprieties, AIG fraudulently improved its financial results.

 Shortly after federal and state regulators contacted AIG about the Gen Re transaction, AIG commenced an internal investigation that eventually led to a restatement of its prior accounting for approximately 66 transactions or items. In its restatement, AIG admitted not only that its accounting for certain transactions had been improper, but also that the purpose behind some of those transactions was to improve financial results that AIG believed to be important to the market. AIG also conceded in its restatement that certain transactions may have "involved documentation that did not accurately reflect the true nature of the arrangements … [and] misrepresentations to members of management, regulators and AIG’s independent auditors." Furthermore, the restatement summarized several transactions that AIG accounted for improperly, including, among others, the two sham reinsurance transactions with Gen Re and certain transactions involving Capco and Union Excess. The restatement resulted in approximately $2.26 billion in charges for corrections of errors related to periods prior to fiscal 2004, reducing AIG’s shareholders’ equity at December 31, 2004 by approximately $2.26 billion (or 2.7%).

 See AAER No. 2371 for more information.

 The Commission's complaint alleged that Tyco overstated its reported financial results by at least $1 billion from 1996 through 2002 by, among other things, employing various improper accounting practices and a scheme involving transactions with no economic substance in violation of the federal securities law.

 The Commission's complaint alleged that Tyco inflated its operating income by at least $500 million as a result of improper accounting practices related to some of its many acquisitions that included undervaluing acquired assets, overvaluing acquired liabilities, and misusing accounting rules concerning the establishment and utilization of purchase accounting reserves. The complaint further alleged that Tyco also improperly established and used various kinds of reserves to make adjustments at the end of reporting periods to enhance and smooth its publicly reported results and to meet earnings forecasts.

 In addition, the complaint alleged that Tyco inflated its operating income by $567 million from its fiscal year 1998 through its fiscal quarter ended December 31, 2002, by recognizing revenue for connection fees that its ADT Security Services, Inc. subsidiary charged to dealers from whom it purchased security monitoring contracts. Because the connection fee was fully offset by an equal increase in the purchase price ADT allocated to the purchased dealers' security monitoring contracts, the connection fee transactions lacked economic substance and should not have been recorded in Tyco's income statement. In 2003, Tyco restated its operating income and cash flow relating to the connection fees.

 The complaint further alleged that, from September 1996 through early 2002, Tyco failed to disclose in its proxy statements and annual reports certain executive compensation, executive indebtedness, and related party transactions of its former senior management. Tyco also incorrectly accounted for certain executive bonuses paid in fiscal years 2000 and 2001, thereby failing to expense the costs of the bonuses in its financial statements. Finally, the complaint alleged that Tyco violated the antibribery provisions of the Foreign Corrupt Practices Act when employees or agents of its Brazilian subsidiary made payments to Brazilian officials to obtain or retain business for Tyco.

 Between 1996 and 2002, as a result of these various practices, Tyco made false and misleading statements or omitted information in its filings with the Commission and in its public statements to investors and analysts. See AAER No. 2414 for more details.

 Baker and Lefkof consented to pay civil penalties of $35,000 each, while Baker also consented to a bar from serving as an officer or director of a public company for five years, and an a bar from practicing before the Commission as an accountant for five years under SEC Rule of Practice 102(e).

 The complaint charged Baker and the former sales executives with securities fraud, and charged Lefkof with violating the antifraud provisions of the Securities Act. The complaint also charged all of the defendants with causing Netopia to report false financial information to the Commission. The complaint additionally charged all of the defendants with causing Netopia's failure to maintain accurate books and records, and charges Lefkof and Baker with causing the company's failure to maintain adequate internal controls. The complaint also charged Baker and the former sales executives with circumventing internal accounting controls and charged all of the defendants with falsifying the company's books and records. Baker, in the complaint, was further charged with lying to accountants and falsely certifying Netopia's financial statements.

 The Commission's complaint alleged that the two sales executives, Netopia’s former head of worldwide sales, Thomas A. Skoulis and the former head of software sales, Peter M. Frankel entered into two secret side deals in 2002 and 2003, each for approximately $750,000. Pursuant to the side deals, Netopia's customer, which had limited resources, would only have to pay Netopia if and when it successfully resold the software to an end-user. It was improper to record revenue for the transactions because payment was contingent on future events. Skoulis and Frankel concealed the deal terms from Netopia's finance department. In connection with the 2002 deal, Frankel directed that contingency language be physically "whited out" from the face of the customer's purchase order. For the 2003 deal, Skoulis directed Frankel to hide a copy of the customer's side letter that set forth the contingency. Their actions caused Netopia to report fraudulently inflated software revenue to the investing public, and for the fourth quarter ended September 30, 2003, allowed the company to report its first profitable quarter in three years.

 The complaint also alleged that in April 2004 Baker, and later Lefkof, learned of the payment contingency associated with the 2003 transaction but failed to take immediate corrective action. Rather than take corrective action, Baker concealed the side agreement from Netopia's Audit Committee, including requesting that the customer delete references to the deal in communications with Netopia. Later, on July 2, 2004, Lefkof obtained a copy of the side agreement containing the payment contingency for the 2003 deal. Notwithstanding their knowledge of the side agreement, Lefkof and Baker allowed Netopia to issue a misleading press release on July 6, 2004, that incorrectly treated the outstanding order as merely an uncollectible bad debt. In actuality, the Commission alleged, the sale should never have been recorded as revenue, and Netopia should have restated its 2003 financial statements.

 See AAER Nos. 2403 and 2404 for more information. Charges against the former sales executives are pending.

 In its complaint, the Commission charged Burr with insider trading, violating the antifraud, books and records and internal controls provisions of the federal securities laws and aiding and abetting the books and records, periodic reporting and internal controls provisions of the securities laws. In its complaint the Commission alleged that, in 1999 and 2000, Dollar General's accounting staff determined that Dollar General should have recognized $13.4 million in import freight expenses in fiscal 1999. Rather than restating prior periods, as required by GAAP, or recognizing all the expense in fiscal year 1999, Burr participated in discussions of possible ways to account for the $13.4 million in freight expenses to avoid recognizing all such expenses in fiscal year 1999. The complaint further alleged that on February 5, 2000, Dollar General's former controller sent a memorandum to Burr and others describing a $10 million "variance" in relation to freight expenses, and Dollar General's intention to charge the $10 million 1999 "shortfall" at a rate of $833,000 per month during Dollar General's fiscal year 2000. Ultimately, Dollar General recorded the shortfall in this manner. Burr knew that deferring the bulk of the expenses to fiscal year 2000 avoided the negative impact on already announced fiscal year 1999 earnings as well as year-end bonus payments to Dollar General employees, including Burr. The Commission's complaint alleges that, by deferring the freight expenses, Dollar General met certain targets, including an internal target for employee bonuses and analysts' expectations for the Company's earnings per share for fiscal year 1999. If Dollar General had recognized the freight expenses in 1999, it would have fallen short of the bonus target and analysts' expectations.

 The complaint further alleged that Burr engaged in insider trading. After Dollar General terminated Burr in February 2001, Burr and his counsel met with Dollar General senior management. At this meeting, on April 12, 2001, Burr's counsel told Dollar General management that Burr could not sign a separation agreement until he knew that certain accounting issues were addressed by Dollar General. Burr also wanted a release from the Company for any responsibility for certain accounting issues. In April 2001, Burr exercised Dollar General options on two occasions and sold 131,597 Dollar General shares at sales prices ranging from $22.50 – $24.02. After the Company's April 30, 2001 press release announcing accounting irregularities and the necessity for a restatement, Dollar General's stock price dropped from its Friday, April 27, 2001 closing price of $23.00 to a Tuesday, May 1, 2001 closing price of $15.76. The complaint alleged that Burr avoided losses by his sale of Dollar General securities.

 See AAER Nos. 2411 and 2226 for more details.

 Raytheon’s improper accounting and disclosures involved the practices of prematurely recognizing revenue and delaying significant losses for certain aircraft in hopes of eventually turning RAC around. From 1997 through 1999, Raytheon prematurely recognized revenue on RAC’s sale of unfinished aircraft through improper "bill and hold" transactions that did not comply with GAAP. These practices resulted in material overstatements of RAC’s reported annual net sales revenue by approximately $80 million at year-end 1997 and $110 million at year-end 1998, which led to 13 percent overstatements of the subsidiary’s annual operating income in both of these periods. These errors enabled both Raytheon and RAC to meet certain internal and external earnings targets. Although Raytheon did restate for these material errors at year-end 1999, the company misleadingly attributed the restatement to additional "clarification" purportedly provided by "new guidance" on revenue recognition issued by the Commission in Staff Accounting Bulletin No. 101 ("SAB 101"), instead of the improper accounting practices that had occurred at RAC prior to that time.

 In addition, between 1997 and 2001, Raytheon failed to fully and accurately disclose known risks, trends, uncertainties, and other information concerning the deteriorating state of RAC’s commuter aircraft business and the negative impact this decline was having on asset values associated with RAC’s line of nineteen-seat, turboprop aircraft (the commuters) and, thus, on Raytheon and RAC’s results of operations. Raytheon also engaged in several improper accounting practices that delayed and mischaracterized known losses associated with RAC’s commuter line during this time period.

 Had Raytheon properly accounted for its commuter assets, the Commission alleged the company would have reported material reductions in RAC’s reported operating income of at least $34 million, $22 million, and $21 million at year-end 1998, 1999, and 2000, respectively, which represented 13 percent of the subsidiary’s reported annual operating income in each of these periods. Moreover, RAC’s operating results would have been further reduced by at least $67 million (41 percent) at year-end 2000 had Burnham, Servello, and other senior Raytheon and RAC management timely and appropriately recognized losses inherent in a planned "soft landing" of the commuter aircraft line. In addition, at this time, internal company documents and other information indicate that these senior executives expected commuter losses of $240 million given the cash sales prices that had been approved in the "soft landing," and a charge of $67 million to $240 million would have reduced Raytheon’s 2000 profit before taxes by at least 8 to 27 percent. Burnham and other senior Raytheon officers, however, caused Raytheon to improperly take this charge in the third quarter of 2001, when the company wrote down its on- and off-balance sheet commuter assets by $693 million after the terrorist attacks of September 11th. Given the charge that should have been taken at year-end 2000, Raytheon’s third quarter 2001 commuter loss provision was overstated by 10 to 53 percent.

 Each respondent agreed to cease and desist from committing or causing the violations charged as well as any future violations of these provisions. Raytheon, Burnham, and Servello also consented to the entry of a final judgment in a related civil action filed in the U.S. District Court for the District of Columbia for the purposes of awarding civil monetary penalties and disgorgement. Raytheon consented to pay a penalty of $12 million and $1 in disgorgement. Burnham and Servello agreed to pay disgorgement of certain past bonus amounts, pre-judgment interest, and penalties in the total amounts of $1,238,344 and $34,628, respectively.

 The Commission’s investigation as to other individuals involved in this matter is continuing. See AAER 2449 for more details.

 The Commission found that, at or near the end of each reporting period between 1997–1999, Coca-Cola employed an undisclosed "channel stuffing" practice in Japan known as "gallon pushing" to record sales in a current period that would have occurred in future periods. Specifically, Coca-Cola offered Japanese bottlers extended credit terms to induce them to purchase quantities of beverage concentrate they otherwise would not have purchased until a later period.

 As a result of gallon pushing, from 1997 to 1999 Coca-Cola's Japanese bottlers' concentrate inventory levels increased at more than a five times greater rate than that of finished product sales to retailers. Gallon pushing resulted in Coca-Cola prematurely recording sales that would have occurred in later periods and made it likely that Coca-Cola's bottlers would purchase less concentrate in later periods. This practice contributed approximately $0.01 to $0.02 to Coca-Cola's quarterly EPS and resulted in Coca-Cola meeting as opposed to missing analysts' consensus or modified consensus earnings estimates in 8 out of the 12 quarters from 1997–1999. Despite the impact to current earnings and the likely impact to future earnings, Coca-Cola failed to disclose its gallon pushing practice in its periodic reports. Coca-Cola misled investors by failing to disclose in MD&A the period-end practices that impacted the company's current and future operating results.

 Also, Coca-Cola made misstatements in a January 2000 Form 8-K about a subsequent inventory reduction, which continued to conceal the impact of prior end-of-period practices and further misled investors. In that Form 8-K, Coca-Cola disclosed that a worldwide concentrate inventory reduction was planned to occur during the first half of the year 2000. The Form 8-K described the inventory reduction as a joint action between Coca-Cola and its bottlers and that certain bottlers throughout the world, specifically including those in Japan, had indicated that they intended to reduce their inventory levels during the first half of the year 2000, when in fact the bottlers were unaware of the inventory reduction.

 As set for the in the Form 8-K, the impact on Coca-Cola's earnings for the first and second quarter of 2000 was estimated to be between $0.11 and $0.13 per share. The Form 8-K, however, did not disclose that more than $0.05 of the estimated earnings impact would be attributable to an anticipated reduction of sales for Japan with a corresponding gross profit impact more than five times greater than that of any other operating division in the world.

 Although the Commission did not make findings about Coca-Cola's accounting treatment for its gallon pushing sales, it did find that Coca-Cola's failure to disclose the impact of gallon pushing on current and future earnings, as well as the false statements and omissions within the Form 8-K, violated certain antifraud and periodic reporting requirements of the federal securities laws. See AAER-2232 for more details.

 The Commission alleges that Conaway and McDonald failed to disclose in MD&A the reasons for a massive inventory overbuy in the summer of 2001 and its impact on the company's liquidity. The MD&A disclosure attributed increases in inventory to "seasonal inventory fluctuations and actions taken to improve our overall in-stock position" where, in reality, a significant portion of the inventory buildup was allegedly caused by the purchase of $850 million of excess inventory. The defendants allegedly dealt with Kmart's liquidity problems by delaying payments owed vendors, thereby effectively borrowing $570 million from them by the end of the third quarter. Kmart filed for bankruptcy on January 22, 2002.

 The Commission's complaint seeks as relief permanent injunctions, disgorgement with prejudgment interest, civil penalties and officer and director bars. See AAER-2295 for more details. The Commission’s Kmart investigation is continuing.

 While all of the criteria in paragraphs 7–32 should be analyzed, the most common reasons for a conclusion to account for warrants as liabilities are:

1. the warrants could be required to be settled in cash if certain events occurred, such as delisting from the registrant’s primary stock exchange or in the event of a change of control; and
2. the registrant elected an accounting policy for the registration rights agreement that considered the registration rights agreement and the warrant together as a unit and the registration rights agreement could require significant liquidated damages be paid to the holder of the instrument in the event the issuer fails to register the underlying shares under a preset timeframe, or in some cases, where the issuer fails to maintain an effective registration statement with a current prospectus for a preset time period. The liquidated damages usually are expressed as a percentage of the original amount invested by the holder and may or may not be capped at a certain maximum percentage.

 In June 2005, the EITF began deliberating the effect of a liquidated damages clause on a freestanding financial instruments, such as warrants. The preliminary deliberations resulted in 4 alternative views (see the deliberations of EITF Issue 05-4). In September 2005, the FASB staff postponed further deliberations by the EITF until the FASB could address whether a separate registration rights agreement is a derivative under FASB SFAS 133. On October 20, 2006, the FASB issued a proposed FSP, No. EITF 00-19-b, Accounting for Registration Payment Arrangements. The proposed FSP specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement No. 5, Accounting for Contingencies. The comment period on the proposed FSP ends December 4, 2006. Until the final FSP is issued and adopted, registrants should continue to use their existing accounting policy consistently among all of their contracts, along with clear disclosure regarding the policy selected. Upon the issuance of the anticipated FSP, which for calendar year companies is expected to go into effect beginning with the first quarter of 2007, registrants should apply the transition guidance in the FSP.

 As previously mentioned, in analyzing instruments under EITF 00-19, the probability of the event occurring is not a factor. For example, certain warrants can only be settled in cash if the registrant’s stock is delisted from its primary stock exchange. Even if delisting is not considered probable of ever occurring, the warrants would still be classified as a liability under the EITF 00-19 analysis. Similarly, the likelihood that a change in control could occur is not a factor.

 Embedded conversion features that meet the criteria for bifurcation under SFAS 133 may qualify for the paragraph 11(a) scope exception in SFAS 133. In analyzing whether the conversion feature meets the paragraph 11(a) scope exception, one of the things the registrant must determine is whether the conversion feature would be classified within stockholders’ equity. To determine classification, the conversion feature must be analyzed under EITF 00-19. The first step of the EITF 00-19 analysis for these features is to determine whether the host contract is a conventional convertible instrument (paragraph 4 of EITF 00-19 and EITF 05-2, The Meaning of "Conventional Convertible Debt Instrument" in EITF Issue 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock"). One of the common features that prevents the convertible instrument from qualifying as "conventional" is a reset provision in the instrument where, if a company issues an instrument in the future that has a price less than the conversion price in the convertible instrument, the conversion price in the convertible instrument is reset. If the instrument is a conventional convertible instrument, the embedded conversion option would qualify for equity classification under EITF 00-19, qualify for the scope exception in SFAS 133 and not be bifurcated from the host instrument. In that case, the convertible instrument should be accounted for in accordance with APB 14; ASR 268 and EITF Topic D-98 should be considered for the classification and measurement of the instrument; and EITFs 98-5 and 00-27 should be considered for any beneficial conversion feature.

 If the instrument does not qualify as conventional convertible, paragraphs 7–32 of EITF 00-19 must be analyzed to determine whether the conversion feature should be accounted for as a liability or equity. If the feature is classified as a liability under EITF 00-19, it would not qualify for the paragraph 11 scope exception in SFAS 133 and therefore the feature would be accounted for as a derivative at fair value, with changes in fair value recorded in earnings. If the feature is classified as equity under EITF 00-19 and meets the other criterion in the SFAS 133 paragraph 11 scope exception, the embedded conversion option is not bifurcated from the host instrument. The registrant should assess whether the convertible preferred stock instrument should be classified in permanent equity or temporary equity by reference to ASR 268 and EITF D-98. Additionally, registrants should assess whether there is a beneficial conversion feature that must be accounted for under EITFs 98-5 and 00-27.

 Registrants should ensure that they have properly considered SFAS 133 and EITF 00-19 in accounting for the conversion feature embedded within their convertible debt and convertible preferred stock instruments. The two most common causes of improper accounting stem from the following terms:

1. the number of shares issuable upon conversion of the convertible instrument is variable, and there is no cap on the number of shares which could be issued; and
2. the registrant elected an accounting policy for the registration rights agreement that considered the registration rights agreement and the convertible instrument together as a unit and the registration rights agreement could require significant liquidated damages be paid to the holder of the instrument in the event the issuer fails to register the underlying shares issuable upon conversion under a preset timeframe, or in some cases, where the issuer does not maintain an effective registration statement with a current prospectus for a preset time period.

 In the first case above, since there is no explicit limit on the number of shares that are to be delivered upon exercise of the conversion feature, the registrant is not able to assert that it will have sufficient authorized and unissued shares to settle the conversion option. As a result, the conversion feature would be accounted for as a derivative liability, with changes in fair value recorded in earnings each period. Additionally, registrants should note that a variable share settled instrument that results in liability classification may impact the classification of previously issued instruments, as well as instruments issued in the future.

 Registrants should ensure they have appropriately analyzed all terms contained in their convertible preferred stock and convertible debt agreements, including any other embedded features that could require bifurcation under SFAS 133, for example, puts, calls, contingent interest features, etc. Registrants should ensure all of these features have been appropriately identified, accounted for, valued, and disclosed.

 SFAS 95 requires that an entity report its cash inflows and outflows according to whether they relate to operating, investing, or financing activities. Footnote 10 of the statement specifically addresses discontinued operations and says that separate disclosure of cash flows pertaining to discontinued operations reflected in the operating, investing, and financing categories is not required. The footnote continues and states that an enterprise that nevertheless chooses to report separately operating cash flows of discontinued operations shall do so consistently for all periods affected.

 While there are variations in cash flow presentation for discontinued operations, the staff believes the key consideration is whether they conform to the basic disclosure requirement in FAS 95 that all cash flows be reported as relating to either operating, investing, or financing activities. Some of the variations that appear to be consistent with this disclosure requirement include:

• Combining the cash flows generated from discontinued operations with the cash flows from continuing operations within each of the 3 categories;
• Separately identifying the cash flows related to discontinued operations within each of the 3 categories, or just separately for operating cash flows; and,
• Displaying the cash flows related to discontinued operations separately for operating, investing and financing activities near the bottom of the statement, just before "net increase or decrease in cash and cash equivalents."

 SFAS 95 does not appear to support aggregating operating, investing, and financing cash flows from discontinued operations into a single line item, as some registrants have presented. Also, FAS 95 does not appear to support presenting cash flows from operating, investing, and financing activities of the discontinued operations all within the operating cash flow category.

 Registrants who have discontinued operations should carefully consider how to present disclosures about their cash flows within the Liquidity and Capital Resources section of MD&A. Management should pay particular attention to describing how cash flows from discontinued operations are reflected in their cash flows statements, and, if material, they should quantify those cash flows if they are not separately identified in those statements. In addition, management should describe how it expects the absence of cash flows, or absence of negative cash flows, related to the discontinued operations to impact the company's future liquidity and capital resources, and should discuss any significant past, present, or upcoming cash uses as a result of discontinuing the operation.

 Paragraph 22c of SFAS 95 states that proceeds of insurance settlements should be classified as operating cash inflows, except for proceeds that are directly related to investing or financing activities. It provides an example that proceeds received from the destruction of a building would be classified as an investing cash inflow.

 This guidance seems to suggest that proceeds from insurance settlements should be classified based on the nature of the insurance coverage which resulted in the right to receive payment. Said differently, classification of the cash inflow is based on the nature of the loss that is covered by the registrant’s insurance policy. Classification of the proceeds is not affected by how a registrant spends, or plans to spend, those proceeds. So, for example, proceeds received under a business interruption policy would be classified within operating activities. Classification of proceeds received under a policy that protects against damage to, or loss of, property depends on the nature of the covered property. Recovery on fixed assets owned or leased under capital leases would be an investing activity, and settlements related to inventory, for example, would be an operating activity.

 Material cash settlements should also be discussed in MD&A to inform investors of cash received and why it was received, what the company plans to do with the proceeds, how it is presented on the cash flows statement, and the impact, if any, on reported earnings.

 In September 2005, the EITF issued EITF No. 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty to provide guidance on whether some or all of these buy/sell arrangements should be accounted for as a single exchange transaction within the scope of Accounting Principles Board Opinion No. 29, Accounting for Nonmonetary Transactions. The EITF consensus also addressed whether there are any circumstances under which nonmonetary exchanges of inventory within the same line of business should be recognized at fair value.

 For example, in situations where a registrant cannot apply SOP 81-1 to their service contracts, a revenue recognition model that recognizes revenue as the service is performed using a proportional performance model, as contemplated by SAB Topic 13, is an often acceptable model. An output-based approach would generally be utilized. An input-based approach may be acceptable where the input measures are a reasonable surrogate for output measures. However, a cost-to-cost approach to revenue recognition is generally not appropriate outside the scope of SOP 81-1 since it rarely gives a good estimate of proportional performance.

 Disaggregate product and service information

• Report product and service revenues (and costs of revenues) separately on the face of the income statement
• Furnish separate revenues of each major product or service within segment data
• Describe the major revenue-generating products, services, or arrangements clearly
• For major contracts or groups of similar contracts, disclose essential terms, including payment terms and unusual provisions or conditions

 Disclose when revenue is recognized (examples)

• Upon delivery (indicate whether terms are customarily FOB shipping point or FOB destination)
• Upon completion of service
• After commencement of service, ratably over service period
• Upon satisfaction of a significant condition of sale — (identify the condition)

  • Only after customer acceptance?
  • Only after testing?
• Upon completion of all terms of contract
• Over performance period based on progress toward completion
• Upon delivery of separate elements in multi-element arrangement

 If revenue is recognized over the service period, based on progress toward completion, proportional performance, or based on separate contract elements or milestones, disclose how the period’s revenue is measured

• Disclose how progress is measured (cost to cost, time and materials, units of delivery, units of work performed)
• Identify types of contract payment milestones, and explain how they relate to substantive performance and revenue recognition events
• Disclose whether contracts with a single counterparty are combined or bifurcated
• Identify contract elements permitting separate revenue recognition, and describe how they are distinguished
• Explain how contract revenue is allocated among elements

  • Relative fair value or residual method?
  • Fair value based on vendor specific evidence or by other means?

 Disclose material assumptions, estimates and uncertainties

• Disclose contingencies such as rights of return, conditions of acceptance, warranties, price protection, etc.
• Describe the accounting treatments for the contingencies
• Describe significant assumptions, material changes, and reasonably likely uncertainties
• Special disclosures and conditions are specified by SAB Topic 13 for companies that recognize refundable revenues by analogy to FASB Statement No. 48, Sales With the Right of Return.

 Staff reviews have uncovered registrants that allocated the excess purchase price to an intangible asset rather than goodwill, under the premise that the intangible asset could not be separately valued because it is indistinguishable from goodwill. However, this method, called the residual method, does not comply with SFAS 141 which requires that intangible assets that meet the recognition criteria be recorded at fair value. As a result, the SEC staff made a Staff Announcement, No. D-108, Use of the Residual Method to Value Acquired Assets Other Than Goodwill, at the September 2004 EITF meeting. EITF D-108 states that the residual method should no longer be used to value intangible assets other than goodwill. Rather, intangible assets should be separately and directly valued and the resulting fair value recognized. Registrants that have applied the residual method to the valuation of intangible assets should refer to EITF D-108 for transition guidance.

 Any change to the date of the annual goodwill impairment test would constitute a change in the method of applying an accounting principle, as discussed in paragraph 4 of SFAS 154, and therefore would require justification of the change on the basis of preferability. The registrant is required by Rule 10-01(b)(6) of Regulation S-X to disclose the date of and reason for the change. The registrant is also required by Item 601 of Regulation S-K to file, as an exhibit to the first Form 10-Q or 10-QSB after the date of the change, a letter from the registrant’s independent registered public accounting firm indicating whether or not the change is to an alternative principle which in his judgment is preferable under the circumstances. See Staff Accounting Bulletin Topic 6.G.2.b. for additional guidance.

 Bright line or rule of thumb tests are not appropriate for evaluating other-than-temporary impairments. The determination of whether a decline is other than temporary must be made using all evidence that is available to the investor, and not just that related to the registrant such as its financial condition and near-term prospects, but also the severity and duration of the decline in fair value and the investor’s intent and ability to hold an investment for a reasonable period of time sufficient for a forecasted recovery. Guidance in evaluating whether a security’s recent decline in value is other than temporary has in the past only been found in SAB Topic 5:M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities.

 In November 2003, the EITF issued No. 03-01, Other-Than-Temporary Impairments, and in November 2005, the FASB issued FSP Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, which amends certain portions of EITF 03-01. EITF 03-01 and FSP Nos. FAS 115-1 and FAS 124-1 are similar to the staff’s historical analysis discussed above. The guidance requires disclosures addressing impairments in a qualitative and quantitative manner.

 Since the typical equity security does not have a contractual cash flow at maturity on which to rely, an investor’s intent and ability to hold an equity security for a reasonable period of time should be analyzed differently than a typical debt security. The ability to hold an equity security indefinitely would not, by itself, allow an investor to avoid an other-than-temporary impairment.

 As a practical matter there are limitations on the period of time that management can incorporate into its forecast of market price recoveries. As the forecasted market price recovery period lengthens, the uncertainties inherent in management’s estimate increase, which impact the reliability of that estimate. Market price recoveries that cannot reasonably be expected to occur within an acceptable forecast period should not be included in the assessment of recoverability.

 A recognized or potential other than temporary impairment may require discussion in MD&A, if material, if it is considered to be a known material event or uncertainty, an unusual or infrequent event or transaction, or necessary to an understanding of financial condition or results of operations. Some items to consider in an MD&A discussion, including discussion of critical accounting policies, include the amount of the charge, the underlying reasons for the charge and its timing, an identification of which segment the charge relates to, whether or not it is included in the segment’s profit or loss measure under FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, potential risk and uncertainties regarding future declines, and the estimated effects that material declines would have on the registrant’s liquidity.

 In several Accounting and Auditing Enforcement Releases, e.g., In the Matter of Fleet/Norstar, AAER No. 29557; In the Matter of Excel Bancorp, Inc., AAER No. 29675; In the of Matter Abington Bancorp, Inc., AAER No. 30614; and In the Matter of Presidential Life Corporation, AAER No. 31934, the Commission has taken action in instances when other than temporary declines in value were not reported in a timely and appropriate fashion. In these releases, the Commission observed that a registrant’s assessment of the realizable value of a marketable security should begin with its contemporaneous market price because that price reflects the market’s most recent evaluation of the total mix of available information. Objective evidence is required to support a realizable value in excess of a contemporaneous market price. That information may include the company’s financial performance (including such factors as earnings trends, dividend payments, asset quality, and specific events), the near term prospects of the company, the financial condition and prospects of the company’s region and industry, and the registrant’s investment intent.

 Additionally, the releases state that the Commission expects registrants to employ a systematic methodology that includes documentation of the factors considered. The methodology should ensure that all available evidence concerning declines in market values below cost are identified and evaluated in a disciplined manner by responsible personnel. Auditors are reminded of the need to closely examine the documentation concerning their client’s determinations of other than temporary declines in market values.

 Auction rate securities are considered highly liquid by market participants because of the auction process. However, because the auction rate securities have long-term maturity dates and there is no guarantee the holder will be able to liquidate its holdings, these securities do not meet the definition of cash equivalents in paragraphs 8 and 9 of SFAS 95. Registrants should refer to SFAS 115 to determine the proper accounting and SFAS 95 to determine the proper classification on the Statement of Cash Flows. To determine if the auction rate securities should be presented on the balance sheet as current or noncurrent assets, registrants should refer to ARB No. 43, Chapter 3A, Working Capital — Current Assets and Current Liabilities.

 Registrants, their auditors, and their advisors have a responsibility to critically assess the claims against the company in order to identify those for which losses should be accrued and those that are not accrued because the success of the claim is only reasonably possible. Disclosure should discuss the nature of the claim, the amount accrued, if any, and the possible range of loss for claims where any amount within the range of reasonably possible loss is material. Circumstances where a loss was accrued for a claim without disclosure in prior filings of the nature of the claim and the range of reasonably possible loss should be rare due to the nature of most contingencies. A registrant that accrues a significant loss for a contingency, but whose prior disclosure of the low end of the range of reasonably possible loss was zero with no loss accrued, should ensure that there is robust disclosure that explains what triggered the significant loss in the period in which it was recorded.

 While income tax contingencies no longer fall within the scope of SFAS 5, FIN 48 provides disclosure requirements related to uncertain tax positions. FASB Statement No. 109, Accounting for Income Taxes, also provides disclosure requirements for income tax items that arise as a result of temporary differences. As with other contingencies, such as litigation contingencies, registrants need to balance concerns regarding confidentiality with the need for the registrant’s investors, analysts, and regulators to gain a clear understanding of the registrant’s liquidity, as well as results of operations and financial position, through footnote disclosure and discussions in MD&A.

 Many individual loss contingencies can have particular characteristics and uncertainties that would make aggregated disclosure insufficient to provide material information necessary to an understanding of the loss contingency position. Companies should consider whether it is necessary to discuss loss contingencies on both an aggregated and disaggregated basis.

 Common loss contingencies involve product warranties and defects, guarantees of indebtedness, indemnification provisions, claims or assessments, environmental contamination, and other pending or threatened litigation. The discussion and analysis should include a quantification of the related accruals and adjustments, costs of legal defense, and reasonably likely exposure to additional loss, as well as the assumptions management has made concerning those amounts. If a registrant provides indemnification for matters associated with a discontinued operation, and management determines it is reasonably likely the company will incur a material liability, MD&A should discuss the relevant terms of the indemnification, including the duration of the agreement and the extent of coverage or exposure.

 A company should articulate the reasons the assumptions it used best reflect its exposure, and the extent to which the resulting estimates of loss are sensitive to changes in those assumptions. The need to address the underlying assumptions is especially important when there is a material difference between the range of reasonably possible loss and the amount accrued. Due to the extent of judgment involved in assessing probability and estimating loss, MD&A should also address the timing of the accounting effects to properly convey information about variability. The discussion should indicate when the underlying event associated with a loss contingency occurred and describe the developments during the intervening periods which resulted in the establishment or adjustment of accruals.

 The staff expects registrants with material defined benefit plans to include clear disclosure of how it determines its assumed discount rate, either in the financial statement footnotes or in the critical accounting policies section of MD&A. That disclosure should include the specific source data used to support the discount rate. If the registrant benchmarks its assumption off of published long-term bond indices, it should explain how it determined that the timing and amount of cash outflows related to the bonds included in the indices matches its estimated defined benefit payments. If there are differences between the terms of the bonds and the terms of the defined benefit obligations (for example if the bonds are callable), the registrant should explain how it adjusts for the difference. Increases to the benchmark rates should not be made unless the registrant has detailed analysis that supports the specific amount of the increase.

 The discussion and analysis of employee benefits should also provide readers with information regarding the following to the extent material:

• the effects of accounting for the registrant’s benefit plans and
• the funding of the accumulated and projected benefit obligations on the registrant’s financial condition and operating performance.

 Assumptions and Estimates

 The accounting for employee benefit plans typically involves numerous assumptions and estimates, and frequently the use of experts such as actuaries in determining asset allocations and quantifying benefit obligations, funding requirements, and compensation expense. The accounting standards for pension and post-retirement plans also involve mechanisms that serve to limit the volatility in earnings, which would otherwise result from recording changes in the value of plan assets and benefit obligations in the financial statements in the periods in which such changes occur.

 MD&A should identify the following:

• material assumptions underlying the accounting for benefit plans, and
• changes to those assumptions having a material effect on financial condition and operating performance.

 Registrants should ensure that the disclosure of their accounting policies and other footnote disclosure in the financial statements are comprehensive and minimize unnecessary repetition of information in MD&A.

 Changes to Assumptions and Estimates

 A registrant should consider the impact of its various assumptions, to determine the extent to which the assumptions or changes in the assumptions have a material effect, including those concerning:

• the long-term rates of return on plan assets,
• discount rates used for projecting benefit obligations,
• methods of deriving market-related value,
• average remaining service period,
• average remaining life expectancy, and
• any alternate methods of amortizing gains and losses selected.

 While some of these assumptions are subject to frequent revision, others may be relatively static. In describing material changes to the assumptions, it may be necessary to indicate how often revisions are made.

 Comparison of Actual and Expected Results

 Accounting for employee benefit plans is largely dependent on the assumptions concerning the periods of attribution (the process of assigning the cost of benefits to period of employee service) and the calculation and amortization of gains and losses. Therefore, MD&A should address the material trends or patterns of amounts reflected in the financial statements, significant assumptions and any material variations between the results based on those assumptions, and the registrant’s actual experience. For example, when results of operations are materially impacted by benefit plans, the registrant should disclose the material underlying assumptions and their effect to sufficiently address the quality of the registrant’s earnings. In addition, when material deviations between the actual and expected long-term rates of return on plan assets arise, those amounts should be disclosed, as should any material deferred gains or losses that result. Under these circumstances, a registrant should quantify the amounts, and indicate the periods in which these will be reflected in the results of operations.

 When addressing the expected and actual long-term rates of return on plan assets, registrants should disclose, where material:

• the various categories of investments held as plan assets,
• the relative asset allocations or holdings in each category, and
• any reasonably likely changes in the allocation of plan assets.

 A sensitivity analysis, demonstrating how a change in the assumed long-term rates of return would impact the results of operations, may also be necessary to sufficiently convey the quality of the registrant’s earnings and the degree of uncertainty. If deferred gains and losses are material, a registrant should discuss the amortization periods, while differentiating between gains and losses that are subject to amortization and those that are not.

 Other disclosures in MD&A related to benefit plans, including those related to exposure, recognition and funding obligations, should follow a similar approach. MD&A should build on and not unnecessarily repeat information disclosed in the notes to the financial statements. Registrants should disclose material assumptions and changes in assumptions, the resulting material effect on financial condition and operating performance, material deviations between results based on the assumptions used by registrants and actual plan performance, and the known material trends and uncertainties relating to plans, including those caused by these deviations. For example, registrants should consider whether disclosure of the historical pattern of expense recognition and the periods over which any amounts deferred in other comprehensive income will be recognized in results of operations is necessary.

 Funding Obligations

 If there are material funding obligations, a registrant should:

• quantify the amounts of the funding obligations,
• address the material known trends or uncertainties relating to paying such amounts (for example, if the registrant expects to pay them over a specified period of time, or if there are known material uncertainties concerning payment),
• address the material impact of future payments on future cash flows, and
• address any material uncertainty in the funding obligation itself (for example, uncertainty introduced by significant differences between the duration of debt instruments included in plan assets, or changing demographics in the workforce, and the expected timing of future benefit payments).

 The funding of pension obligations is influenced by several factors, among them, voluntary contributions and funding requirements determined by ERISA and the IRS. The required contribution is a calculated amount, which increases for certain underfunded plans in the form of a deficit reduction contribution and could be decreased if excess funding credits are available. Registrants who are experiencing financial difficulty may conclude that there is significant uncertainty surrounding future funding of pension obligations, primarily due to the possibility of bankruptcy which in turn could result in the termination of the pension plan. Registrants whose future funding is uncertain due to financial difficulty should disclose the nature of the uncertainty and a range of reasonably possible future funding, which may include disclosure of the statutory termination obligation.

 If the chief operating decision maker receives reports of a component’s operating results on a quarterly or more frequent basis, the staff may challenge a registrant’s determination that the component is not an operating segment for purposes of SFAS 131 unless reports of other overlapping sets of components are more clearly representative of the way the business is managed. On a few occasions, the staff has requested copies of all reports furnished to the chief operating decision maker if the reported segments did not appear realistic for management’s assessment of a registrant’s performance or conflicted with that officer’s public statements describing the registrant. The staff also has reviewed analyst’s reports, interviews by management with the press, and other public information to evaluate consistency with segment disclosures in the financial statements. Where that information revealed different or additional segments, amendment of the registrant’s filings to comply with SFAS 131 was required.

 The staff has also seen improper aggregation in situations involving a quantitatively immaterial segment. The staff has seen instances where a quantitatively immaterial segment is aggregated with a reportable segment because it does not meet the quantitative thresholds requiring separate presentation. If the quantitatively immaterial segment does not share a majority1 of the aggregation criteria with the reporting segment, aggregation is inappropriate. In this situation, the quantitatively immaterial operating segment would best be placed into the "other" category.

 Information about geographic areas is also required to be disclosed based on countries, both the country of domicile and for foreign countries. If a registrant manages its business by geographic regions and determines its reportable segments accordingly, it still must provide the separate geographic disclosures for each country in which revenues are material. Some registrants provide this disclosure by presenting material countries separately within the subtotals by region.

 The reconciliation of segment elements to the consolidated financial statements should quantify and clearly explain each material reconciling item. Effects of measurement differences should be identified, and asymmetrical allocations among segments should be highlighted.

 If annual financial statements are required in a registration statement or proxy statement that includes subsequent periods managed on the basis of the new organizational structure, the annual audited financial statements should include a revised segment footnote that reflects the new reportable segments. The registrant’s Description of Business and MD&A should be similarly revised. Prior filings that reported the old organizational structure should not be amended. The revised annual financial statements and related disclosures may be included in the registration or proxy statement or in a Form 8-K incorporated by reference. If a registrant files a Form S-3 or Form S-8 that incorporates its most recent Forms 10-K and 10-Q before the new organizational structure is required to be presented in the financial statements, management and their advisors should consider whether the change in reportable segments is a material change per Item 11 of Form S-3 or General Instruction G.2. of Form S-8, respectively. If the change in reportable segments is deemed to be a material change, the registrant should report recasted segment information prior to the effective date of the Form S-3 or Form S-8.

 A registrant must go to the component level if the following criteria are met: the component is a business, discrete financial information is available, and segment management regularly reviews the operating results of that component. Segment management will generally consist of different people than the chief operating decision maker. Additional guidance on components may be found in EITF Topic D-101, Clarification of Reporting Unit Guidance in Paragraph 30 of FASB Statement No. 142, including guidance on whether components may be aggregated.

 While the components of an operating segment may be aggregated for the purposes of goodwill impairment testing and considered a single reporting unit if the components have similar economic characteristics, it is not permissible to aggregate separate operating segments into one reporting unit. At a minimum, each operating segment is a reporting unit under SFAS 142 that should be tested separately. Additionally, registrants should not aggregate components from different operating segments that share similar economic characteristics into a single reporting unit.

 Given the impact the identification of reporting units can have on the determination of a goodwill impairment charge, registrants should consider providing disclosure in the critical accounting estimates section of MD&A. This disclosure may be particularly important when the amount of goodwill is material. The disclosure should address how the reporting units were identified, how goodwill is allocated to the reporting units, and whether there have been any changes to the number of reporting units, or the manner in which goodwill was allocated. If such changes have taken place, they should be explained.

 Contemporaneous designation and documentation of a hedging relationship are fundamental to the application of hedge accounting. If contemporaneous documentation can not be demonstrated, an auditor will be unable to determine whether the company has, after the fact, selected the hedged item or transaction, or the method of measuring effectiveness, to achieve a desired accounting result. Upon the adoption of SFAS 133, the staff believes that most registrants undertook efforts to adhere to the spirit and form of the standard and to satisfy all of its requirements. In the course of the filing review process, however, the staff has encountered instances where registrants have not been diligent in meeting those requirements. The staff has noted instances of shortcutting or minimizing the process, as well as instances of aggressive interpretation and attempts to achieve results inconsistent with the spirit of SFAS 133. The staff will continue to challenge the application of hedge accounting in instances where an entity has not contemporaneously complied with SFAS 133’s formal documentation requirements upon designation of a hedging relationship, or has otherwise shortcutted or circumvented the process. Two documentation requirements are emphasized below.

 The hedged forecasted transaction

 SFAS 133 stresses that the documentation of the hedged forecasted transaction must be sufficiently specific such that when a transaction occurs, it is clear whether or not that particular transaction is the hedged transaction. Thus, the documentation of the forecasted transaction should include reference to the timing (i.e., the estimated date), the nature, and amount (i.e., the hedged quantity or amount) of the forecasted transaction.

 Description of how the entity will assess and measure hedge effectiveness

 While SFAS 133 provides an entity with flexibility in determining the method for assessing hedge effectiveness, the methodology used must be reasonable, and must be documented at inception of the hedging relationship. Additionally, SFAS 133 requires that an entity use the chosen method consistently throughout the hedge period (a) to assess, at inception of the hedge and on an on-going basis, whether it expects the hedging relationship to be highly effective in achieving offset and (b) to determine the ineffective aspect of the hedge. The method used for assessing hedge effectiveness and measuring ineffectiveness must be documented with sufficient specificity so that a third party could perform the measurement based on the documentation and arrive at the same result as the registrant. When hedge accounting has a material impact on a registrant, we encourage registrants to include disclosures that clearly describe the specific methodology used to test hedge effectiveness for each type of SFAS 133 hedge, as well as how often those tests are performed. Disclosures of this type may be appropriately included within the critical accounting estimates section of MD&A.

 The shortcut method is an exception from the periodic assessment and measurement requirements of SFAS 133 and the circumstances in which it can be applied are limited. SFAS 133 limits its use to hedges of interest rate risk that involve interest-rate swaps and recognized interest-bearing assets or liabilities, hedges that are often referred to as "straightforward hedges of interest rate risk". It also requires that general hedge requirements such as contemporaneous formal documentation be met. It then adds additional criteria in paragraph 68 specifically for shortcut method hedges to be met.

 The staff has seen several instances in which the shortcut method has been inappropriately applied. Many of the hedges encountered did appear to provide economic offset, however, they failed to meet one or more of the criteria necessary to qualify for the shortcut method. In some instances registrants assumed that they did not need to assess or measure ineffectiveness because they had met the "spirit" of the shortcut method. The staff does not believe that the shortcut criteria have a "spirit" or a principle that can be met without strictly complying with the stated requirements. This view is consistent with SFAS 133 Implementation Issue No. E4 which indicates that each and every one of the shortcut criteria must be met and that "a hedging relationship cannot qualify for application of the shortcut method based on an assumption of no ineffectiveness justified by applying other criteria."

 One example of where the shortcut method has been inappropriately applied involves the requirement that interest rate swaps must have a fair value of zero at the inception of the hedging relationship. In some situations, registrants have incorporated a financing element in the interest rate swap that results in a fair value other than zero. The financing element is included as an adjustment to the "pay" or "receive" legs of the interest rate swap. These adjustments are often made in lieu of paying or receiving a dealer or broker fee or some other component of the transaction that was being exchanged. These hedging transactions involve multiple components and, since the financing element causes the swap to have a fair value other than zero at inception (even if no cash is exchanged at inception), the hedge does not qualify for the shortcut method.

 There is similarly no guidance in SFAS 133 related to classification of derivatives that do not qualify for hedge accounting. As a result, we encourage disclosure of the location in the income statement where the changes in the fair value of non-hedge accounting derivatives are reflected as well as the amount. However, we generally believe that a presentation that splits the components of a derivative into different line items on the income statement or that reclassifies realized gains and losses of a derivative out of the line item that included unrealized gains and losses of the same derivative is inappropriate. For example, if a registrant classifies changes in fair value of economic hedges (unrealized gains and losses) in a single line item such as "risk management activities", a registrant should not reclassify realized gains and losses (the periodic or final cash settlements from these economic hedges) in the period realized out of risk management activities and into revenue or expense lines associated with the related exposure. While SFAS 133 was essentially "silent on geography," it was the clear intention of the FASB to eliminate the practice of synthetic instrument accounting. The presentation described in the above example is essentially a form of synthetic instrument accounting from an income statement perspective.

 Registrants should focus on the clarity of their disclosures when they use hedges, both those that qualify for hedge accounting under SFAS 133 and those that don’t. Registrants should provide transparent, "plain English" disclosures related to derivatives, including reasons for their use, associated hedging strategies, and methods and assumptions used to estimate fair value, as required by SFAS 107 and SFAS 133, and Item 305 of Regulation S-K. Furthermore, when hedge accounting has a material impact on the registrant, registrants should ensure they have disclosures, for each type of fair value and cash flow hedge, that clearly describe the specific type of asset or liability (or identified portion thereof) being hedged and the derivative used for that type of hedge. Registrants should also consider providing disclosures regarding their use of SFAS 133 elections. We note that the FASB staff recently proposed adding a project to the FASB's agenda to increase the disclosure requirements of SFAS 133. The proposed project would consider existing disclosures and assess new requirements that would improve transparency and relevance to the financial statement readers. We encourage registrants to monitor the FASB's discussions in this area.

 Accounting Principles Board Opinion No. 22, Disclosure of Accounting Policies, sets forth the general requirements for accounting policy disclosures in the financial statements. Industry Guide 3 specifies additional detail that should be provided in explanation of loss allowances within the Description of Business. Viewed together, these disclosures should describe in a comprehensive and clear manner the registrant’s accounting policies for determining the amount of the allowance in a level of detail sufficient to explain and describe the systematic analysis and procedural discipline applied. Registrants commonly develop different elements in their allowances to estimate (1) losses based upon specific evaluations of known loss on individual loans, (2) estimated unidentified losses on various pools of loans and/or groups of graded loans, and (3) other elements of estimated probable losses based on other facts and circumstances. The disclosures should describe and quantify each element of the allowance, andexplain briefly how the registrant’s procedural discipline was applied in determining the amount, and not simply the "adequacy," of each specific element. If loans are grouped by pool or by grading within type to estimate unidentified probable losses, the basis for those groupings and the methods for determining loss factors to be applied to those groupings should be described. The basis for estimating the impact of environmental factors, such as local and national economic conditions and trends in delinquencies and losses, whether through modifying loss factors or through a separate allowance element, should be disclosed. Changes in methodology and their impact should be disclosed in accordance with Accounting Principles Board Opinion No. 20, Accounting Changes.

 MD&A should explain the period-to-period changes in specific elements of the allowance. It also should discuss the extent to which actual experience has differed from original estimates. The reasons for changes in management’s estimates should indicate what evidence management relied upon to determine that the revised estimates were more appropriate and how those revised estimates were determined. A registrant following a procedural discipline should be recording provisions for loan losses that reflect the changes in asset quality as measured in the registrant’s periodic loan reviews. MD&A should discuss the reasons for the changes in assets quality and explain how those changes have affected the allowance and provision. If historical loss experience appears low or high relative to the level of the allowance at the latest balance sheet date, a reconciling explanation should be provided. If a registrant changes its methodology, the basis for changing its methodology and the effects of the change should be explained.

 As noted in Section II.M.2., SFAS 133 does not provide specific guidance on geography, but at the same time the staff believes that some classifications may not make sense. As an example, a financial institution classifying in the provision for loan losses all changes in credit derivatives used as economic hedges would not seem appropriate given the importance of that line item to certain credit quality analyses.

 Financial institutions must present the provision for loan losses as a deduction in the determination of net interest income, pursuant to Article 9 of Regulation S-X. Credit loss provisions on other types of balance sheet and off-balance sheet items that do not affect net interest income should not be included in the provision for loan losses. Loss provisions not related to interest income should be recorded in other appropriate categories of income or expense. Direct transfers of amounts between the allowance for loan losses and other credit loss allowances are not appropriate, except for a circumstance in which an off-balance sheet loan commitment becomes an outstanding loan. Changes in the amount of the allowance for loan losses should be reflected in the provision for loan losses, while changes in other allowances should be reflected in other appropriate categories of income or expense.

 Paragraph 55 of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement No. 125, specifies the accounting in a circumstance where the seller regains control of assets previously accounted for appropriately as having been sold, such as in the case of a call option that becomes exercisable upon the event of borrower default. The assets should be accounted for in the same manner as a purchase of the assets from the former transferee in exchange for liabilities assumed. Specifically, the transferor recognizes in its financial statements those assets together with liabilities to the former transferees or beneficial interest holders in those assets at fair value on the date that the call becomes exercisable, regardless of whether it intends to exercise the call. EITF Issue 02-9 further clarifies the accounting for a transferor’s re-recognition of assets pursuant to paragraph 55 of SFAS 140.

 The original balance sheet classification of the asset when originally transferred should be maintained when control over that asset is re-recognized by the transferor. For instance, if the asset subject to the call or repurchased by the transferor is a loan, the balance sheet classification by the transferor upon re-recognition should be Loans, not Other Assets. No loan loss allowance should be recorded upon initial re-recognition of loans at fair value. Subsequent accounting for the re-recognized loan will depend on whether the loans are classified as held for investment or held for sale.

 In the event that loans re-recognized by the transferor have the risk elements contemplated by Item III.C.1.of Industry Guide 3 (i.e., nonaccrual, past due, restructured), the amount of such loans should be included in the disclosures required by that Item. Supplemental disclosures may be made to facilitate understanding of the aggregate amounts reported pursuant to Item III.C.1. These disclosures may include, for example, information as to the nature of the loans, any guarantees, the extent of collateral, or amounts in process of collection. For example, if a loan re-recognized by a transferor is accruing, but it is contractually past due 90 days or more as to principal or interest, that loan should be included in the disclosure required by Item III.C.1(b) even if the loan is guaranteed through a government program, such as the Veterans Administration (VA) or Federal Housing Authority (FHA).

 Disclosures about certain restructured loans also are required for certain registrants by Item III.C.1(c) of Industry Guide 3.

 Registrants should appropriately identify and account for loans and receivables that the registrant intends to sell, and consider the need for clarifying disclosure that:

• Identifies the amount of loans/receivables held for sale;
• Explains how it determines which loans/receivables are initially accounted for as held for sale or are later transferred to the held for sale classification;
• Describes the method it uses to determine the lower of cost or fair value for loans/receivables held for sale; and
• Reconciles the changes in loans/receivables held for sale balances to the amounts presented in the consolidated statement of cash flows.

 Registrants should ensure that they have appropriately classified the cash payments and receipts on loans that are held for sale in the statement of cash flows (loans that are unrelated to the sale of inventory; see Section II.C.1. above). Paragraph 9 of SFAS 102 states that cash flows related to loans that were originated or purchased specifically for resale and are held for short periods of time should be classified as operating. Cash flows related to loans that were not acquired specifically for resale and carried at the lower of cost or market value should be classified as investing.

 One such product is an option adjustable-rate mortgage (option ARM), which is being sold to home buyers who desire smaller monthly mortgage payments. This mortgage product gives borrowers the option to make monthly payments that are less than the interest actually owed on the loan. The result is that the deferred interest is added to the principal amount of the mortgage loan creating a rising loan balance, often referred to as a negative amortization loan. If the loan balance grows to the extent that the loan-to-value ratio exceeds an established threshold, the lender may restructure the loan, requiring the borrower to immediately begin making larger payments.

 The types of residential mortgage loans held and the underwriting standards used to originate these loans are important to an understanding of a registrant’s financial condition and results of operations. While the information required by Industry Guide 3 includes basic categorical statistics about a registrant’s loan portfolio, more detailed information about certain loan products may be needed in order to provide a complete picture of the portfolio’s credit risk. Some disclosure examples follow for use in Description of Business or MD&A, as appropriate.

 Provide disaggregated information about residential mortgage loans with features that may result in higher credit risk

• Describe the significant terms of each type of residential mortgage loan product offered, including underwriting standards used for each product, maximum loan-to-value ratios and how credit management monitors and analyzes key features, such as loan-to-value ratios and negative amortization, and changes from period to period.
• Disclose the approximate amount (or percentage) of loans originated during the period and loans as of the end of the reporting period that relate to each type of residential mortgage loan product.
• Disclose the approximate amount (or percentage) of off-balance sheet loans with retained credit risk which relate to each type of residential mortgage loan product.
• Disclose the amount of loans that experienced negative amortization during the period and the amount of increase in the loan balance during the period that resulted from negative amortization.
• Describe your policy for placing loans on non-accrual status when the loan’s terms allow for a minimum monthly payment less than interest accrued on the loan, and the impact of this policy on the nonperforming loan statistics disclosed.
• Disclose the approximate amount (or percentage) of residential mortgage loans as of the end of the reporting period with loan-to-value ratios above 100%.
• Disclose any geographic concentrations that exist as of period end in your portfolio of residential mortgage loans with high loan-to-value ratios.

 Describe risk mitigation activities used to reduce exposure to credit risk related to residential mortgage loans

• Describe risk mitigation transactions used to reduce credit risk exposure, such as insurance arrangements, credit default agreements or credit derivatives.
• Explain any limitations of your credit risk mitigation strategies.
• Disclose the impact that credit risk mitigation transactions have had on your financial statements.

 Disclose trends related to residential mortgage loans with features that may result in higher credit risk that are reasonably likely to have a material favorable or unfavorable impact on net interest income after the provision for loan loss

• Disclose any changes in the percentage of borrowers who have chosen a minimum payment option during the period instead of choosing a payment option that includes full payment of interest expense or payment of interest and principal.
• Describe any significant weakening in local housing markets in which you have a concentration of residential mortgage loans with high loan-to-value ratios.
• Disclose changes in credit losses and interest income recognized for higher risk loans.

 An Item 4.01 Form 8-K must be filed no later than 4 business days after the merger. In addition to disclosing the name of the new accounting firm, the Form 8-K disclosure should describe the merger and state whether the merged firm resigned as auditors or the registrant dismissed the old firm. Auditors and registrants should be aware of any independence issues that could arise from the merger and address them appropriately.

 If the old firm continues in business, even if as a shell, and is licensed to practice and in good standing as a public accounting firm, it would be able to continue to reissue prior opinions or provide consents to the use of prior opinions. Should the new firm be willing to assume liability for the old firm’s audits, it could issue a new opinion that covers the prior audited periods and provide consents to the use of that opinion.

 If neither firm is willing or able to reissue opinions on prior audited periods or provide a consent to the use of a prior opinion, the registrant would have to provide a formal request for waiver of consent under Securities Act Rule 437C or write to the staff of the Office of the Chief Accountant in the Division of Corporation Finance to request a waiver of the re-issuance of a prior opinion where no consent is needed. Generally, the staff limits granting waivers to hostile takeovers/tender offers.

 A firm does not have to be registered to reissue a prior report (or issue a consent to the use of a prior report) issued before October 22, 2003, or to issue a report or consent on financial statements of a material acquiree that is a private company (non-issuer) that are filed pursuant to Rule 3-05 of Regulation S-X or Rule 310(c) of Regulation S-B.

 An unregistered firm may be able to perform some audit services if the services represent less than 20% of the total engagement hours or fees provided by the principal accountant related to issuing all or part of its audit report. See PCAOB Rules 1001 and 2100 for more details.

 The Commission's rules require that all fees, including fees related to audits of employee benefit plans, paid to the principal auditor be included in the company’s fee disclosures, regardless of whether or not the audit committee of the company pre-approved those fees. As part of the exercise to gather the information for the required fee disclosures, the audit committee should be made aware of all fees paid to the principal auditor, including those related to audits of the employee benefit plans. The company may elect to separately indicate in their disclosures those fees paid to the principal auditor that were not subject to the pre-approval requirements.

 Registrants and their auditors are reminded that the financial statements included in a Form 11-K must be audited by an independent auditor that is registered with the PCAOB and the audit report must refer to the standards of the PCAOB rather than GAAS.

 Corporation Finance accountants:

• review financial statements and disclosures for a variety of complex transactions, as well as interesting and unusual accounting, auditing and factual issues.
• review filings to identify potential or actual material accounting, auditing, financial reporting or disclosure deficiencies resulting from deviations from GAAP, GAAS or the accounting rules and policies of the SEC.
• interact with top professionals in the accounting and securities industries.
• influence accounting standards and practices.
• propose new and amended disclosure rules.
• field questions from registrants, prospective registrants and the public.
• offer guidance and counseling, either informally orin writing.

 Accountants in the Division work directly with corporate officers, underwriters, outside accountants and counsel, as well as with division lawyers and financial analysts. Much of the work involves novel and unique accounting issues, financing and business structures. Accountants in the Division review a variety of disclosure documents including registration statements; initial public offerings; proxy materials; annual reports; documents concerning tender offers; and filings related to mergers and acquisitions.

 The Division’s fellowship, which originated about seven years ago, typically involves researching financial reporting issues in connection with Division policy or program initiatives, reviewing filings by public companies to identify significant accounting and disclosure problems, and developing and presenting training on emerging or controversial accounting issues for accountants and attorneys at the Commission. Requirements include a Master’s or Ph.D and teaching experience in upper-level/advanced financial accounting courses. Expertise in quantitative analysis and finance, the ability to discuss issues in plain English, and a background in international accounting are plus factors.

 While on sabbatical or leave of absence from the home university, an academic fellow maintains an employee relationship with the home institution, typically earning 12/9 of the usual 9-month academic salary (currently up to about $170,396), plus benefits and relocation expenses. [Note: The salary cap does not mean that an academic fellow’s maximum 12-month salary is $170,396. Rather, $170,396 is the maximum salary that the SEC will reimburse to the school (all normal university benefits will also be reimbursed). The employing university is permitted to pay the professor more than this amount.]

 Indicate your initial interest and request more information by sending an e-mail to one or more current academic fellows in Office of the Chief Accountant (David Plumlee plumleed@sec.gov; Marlene Plumlee plumleem@sec.gov; Tom Noland nolandt@sec.gov), the Division of Corporation Finance (Parveen Gupta guptap@sec.gov, or Office of Economic Analysis (Duane Seppi seppid@sec.gov; Yaniv Grinstein grinsteiny@sec.gov; Jennifer Marietta-Westberg westbergj@sec.gov). Feel free to contact the current academic fellows to discuss the nature of the position and the application process.

 Application reviews for the 2007 -2008 academic fellowships will begin in late 2006, and will continue until the positions are filled. Interviews will be conducted at the SEC headquarters in Washington, DC. Candidates’ travel expenses cannot be reimbursed. The SEC’s goal is to announce final selections by the Spring of 2007.

 To find out more about the experiences of three previous academic fellows, see Thomas J. Linsmeier’s article in Accounting Horizons (September 1996) and articles by Steve Kolenda and Patricia Fairfield in the Financial Reporting Journal (Summer 2000.)