I. Guidance About Accounting Rules

A. Redeemable Equity Securities

Commission releases and staff accounting bulletins (Rule 5-02 of Regulation S-X, Financial Reporting Codification Section 211, SAB 3C, and SAB 6B(1)) describe the accounting and reporting that is applicable to mandatorily redeemable preferred stock. The staff considers that guidance to be applicable to all equity securities (not only preferred stock) the cash redemption of which is outside the control of the issuer, including stock subject to rescission rights.

Redeemable equity securities should be presented separately from "stockholders' equity" if they are redeemable at the option of the holder, or at a fixed date, or redemption is otherwise beyond the control of registrant. (See also EITF 96-13 concerning the need to classify certain puttable securities as liabilities.) This presentation is required even if the likelihood of the redemption event is considered remote. Where material, disclosures should include title of security, carrying amount, and redemption amount on the face of balance sheet. In notes, disclose general terms, redemption requirements in each of the succeeding five years, and number of shares authorized, issued and outstanding.

Redeemable securities are recorded initially at their fair value. If redeemable currently, the security should be adjusted to its redemption amount at each balance sheet date. If the security will become redeemable at a future determinable date, the security should be accreted in each period to the ultimate contractual redemption amount using an appropriate methodology, usually the interest method. The resulting increases or decreases in the carrying amount of the redeemable security reduce or increase income applicable to common shareholders in the calculation of EPS [SAB 3C]. Any extinguishment of redeemable securities for consideration that exceeds the carrying amount of the securities at that time should be treated as a reduction of income applicable to common shareholders. If charges or credits are material to income, separate disclosure of income applicable to common shareholders on the face of the income statement is required [SAB 6B(1)].

In some cases, the feature of the equity security that makes it redeemable is characterized as a "liquidation event." Ordinary liquidation events, which involve the redemption and liquidation of all equity securities, do not result in a security being classified as redeemable equity. However, "deemed" liquidation events that would require one or more particular classes or types of equity security to be redeemed cause those securities to be classified outside of permanent equity. Examples of deemed liquidation events that we have seen as requiring the redemption of preferred stock and such redemption is beyond the control of the registrant include the following:

a change in control
delisting from a stock exchange
inability to deliver common shares under a conversion provision
violation of a debt or other covenant
failure to have an IPO declared effective by a particular date.

These events are commonly characterized as "deemed liquidation" events, and the clauses describing the events are commonly included in the "Liquidation" section of the preferred stock indentures. By characterization of the provisions as liquidation provisions, registrants have sought to avoid ASR 268 treatment. However, the staff believes that these types of provisions are equivalent to ordinary redemption clauses that would cause the securities to be classified outside of permanent equity.

Canadian registrants must classify redeemable equity securities as debt pursuant to requirements of Canadian GAAP. The staff has not required that such classification be discussed in the footnote that reconciles Canadian GAAP to US GAAP. Further, the staff would not object if a US registrant classified and accounted for redeemable equity securities as debt.

B. Accounting for Advertising Costs

The AICPA provided guidance regarding the accounting for advertising costs in Statement of Position 93-7. The scope of that guidance applies to any promotional activity intended to stimulate, directly or indirectly, a customer's purchase of goods or services. It includes the use of commercial media, mailings, directory listings, catalogues, brochures, billboards and other means of attracting customers. However, other accounting literature is applicable to premiums, prizes, rebates, discounts and similar promotional devices.

The SOP provides that, with the limited exception of qualifying "direct response advertising," all advertising costs must be either expensed as incurred or deferred until first use of the advertising. For example, costs of producing material to be used in an advertising program may be expensed as incurred, or deferred until the advertising program commences. Costs of "communicating" an advertisement (for example, broadcast fees) are expensed as the communication occurs. Brochures, catalogues and similar material under the possession of the company may be accounted for as prepaid supplies — that is, expensed in relation to use, with write-off when superseded or otherwise diminished in utility. Advertising costs required to be expensed pursuant to the SOP may not be deferred as "pre-opening costs," "contract acquisition costs," or other similar characterization. However, the SOP does not amend SFAS 53 (film industry), SFAS 60 (insurance industry), or SFAS 67 (real estate industry).

Certain direct response advertising costs may be deferred under the SOP. Qualifying costs relating to a specific advertising activity must meet all of the following criteria:

A direct relationship between a sale and the specific advertising activity for which cost is deferred must be demonstrated clearly. More than trivial marketing effort after customer response to the advertising and before the sale is consummated (such as customer contact with a sales person or furnishing of additional product or financing information) will disqualify the sale as being deemed a direct result of the advertising. A significant lapse of time between the advertising activity and the ultimate sale in an environment of broad general advertising may disqualify the sale as being deemed a direct result of the advertising.
The advertisement's purpose must be one of eliciting a direct response in the form of a sale. For example, if the primary purpose (based on either intent or most frequent actual outcome) is identification of customers to which additional marketing efforts will be targeted, the advertising costs do not qualify.
Deferrable costs do not include administrative costs, occupancy costs, or depreciation of assets other than those used directly in advertising activities. Payroll related costs that are deferrable include only that portion of employees' total compensation and payroll-related fringe benefits that can be shown to directly relate to time spent performing the qualifying activities. Costs of prizes, gifts, membership kits and similar items are not deferrable under the SOP, but are accounted for as inventory in most circumstances.
The costs must be probable of recovery from future benefits. Objective historical evidence directly relevant to the particular advertising activity is necessary to demonstrate probability of recoverability. Ancillary income from sources other than the responding customer may not be included in the calculation of future benefits for the test. Future benefits to be included in the calculation are limited to revenues derived from the customer which are the direct result of the advertising activity alone, without significant additional marketing effort. Revenues from subsequent sales and renewals may be included only if insignificant market effort is required to obtain those revenues.
Qualifying deferred direct advertising costs must be amortized in proportion to the expected future benefits, based on historical evidence and verified by current results. Costs for each advertising activity should be accumulated and amortized separately. Costs of an advertising program extending beyond one quarter should be accumulated in separate cost pools on a quarterly basis. If the period over which a deferred advertising costs will be amortized exceeds twelve months, no portion of the deferred costs should be classified as current assets. Cash expenditures for advertising should be classified as operating, rather than investing, cash flows in the cash flows statement.
Registrants that incur material advertising costs should disclose whether costs are expensed as incurred or deferred until initial use. Registrants that defer direct response advertising costs should provide additional explanation of that accounting policy, including a description of the qualifying activity and the types of costs deferred. Total advertising expense recognized in each period should be disclosed, along with any amounts deferred at the latest balance sheet date. Material write-offs of deferred advertising costs should be disclosed separately.

On May 15, 2000, America Online, Inc. consented to the entry of a Order by the Commission making findings about the company's accounting for certain advertising costs, and directing AOL to cease and desist from causing any violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and rules thereunder. (See Accounting and Auditing Enforcement Release No. 1257). In addition, AOL agreed to pay a $3.5 million civil penalty.

During the two fiscal years ending June 30, 1996, AOL capitalized certain direct response advertising costs — primarily the costs associated with sending disks to potential customers. AOL based its capitalization of the advertising costs on a model that assumed stability of customer retention rates over an extended period, as well as the maintenance of the company's gross profit margin percentage. The Commission found that AOL did not meet the essential requirements of SOP 93-7 because its unstable business environment precluded reliable forecasts of future net revenues. Moreover, AOL did not assess recoverability of the capitalized cost on a cost-pool-by-cost-pool basis.

C. Selection of Discount Rates under SFAS 87 and 106

Registrants are reminded that discount rates selected to measure obligations for pension benefits and post retirement benefits other than pensions are expected to reflect the current level of interest rates at the measurement date. The guidance in paragraph 186 of SFAS 106, which is applicable to discount rates selected under both SFAS 106 and 87, states that "[t]he objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the benefit obligation when due." That paragraph further states that, to the extent that a company must consider expected reinvestment rates available in the future to estimate a discount rate applicable to expected cash flows, "[t]hose rates should be extrapolated from the existing yield curve at the measurement date." Companies must reevaluate the discount rate at each measurement date (at least annually). "If the general level of interest rates rises or declines, the assumed discount rate should change in a similar manner." FASB's guidance refers to high-quality, fixed-rate debt instruments. The staff believes a "high-quality" security is generally considered to be one receiving a rating no lower than the second highest rating given by a recognized rating agency (e.g., "AA").

D. Changes in Functional Currency

FASB Statement No. 52, Foreign Currency Translation, requires the assets, liabilities, and operations of a foreign operation to be measured using the functional currency of that foreign operation. The functional currency is the currency of the primary economic environment in which the entity operates, normally the currency in which the operation generates and expends cash. Appendix A to SFAS 52 provides guidance for determination of the functional currency. Once the functional currency has been determined, SFAS 52 requires that determination to be used consistently unless significant changes in economic facts and circumstances indicate clearly that the functional currency has changed.

Registrants with foreign operations in economies that have recently experienced economic turmoil should evaluate whether significant changes in economic facts and circumstances have occurred that warrant reconsideration of their functional currencies. Registrants with foreign operations in economies that have adopted the Euro currency should make similar evaluations. Determination of the functional currency is also required when the economy in which a foreign operation is located ceases to be highly inflationary.

The staff would expect a registrant's analysis to focus on factors that affect the specific foreign operation's cash flows. For example, problems in an Asian economy could cause local currency cash flow sources to severely diminish for a self-contained foreign operation and clearly indicate a different primary currency. Conversely, these problems generally would not indicate a change in functional currency for a foreign operation that is an integral component or extension of the parent company's operations. The staff generally will be skeptical that currency exchange rate fluctuations alone would cause a self-contained foreign operation to become an extension of the parent company. Remeasurement of assets and results using the registrant's reporting currency in lieu of determining the functional currency is appropriate only when the foreign operations are in a highly inflationary economy as defined by SFAS 52.

SFAS 52 does not prescribe specific disclosures about a change in functional currency. However, the staff believes that disclosures in the financial statements and MD&A may be necessary to permit an investor to understand the foreign operations and their impact on the registrant's results of operations, liquidity, and cash flows. Registrants should consider the need to disclose the nature and timing of the change, the actual and reasonably likely effects of the change, and economic facts and circumstances that led management to conclude that the change was appropriate. The effects of those underlying economic facts and circumstances on the registrant's business should also be discussed in MD&A.

E. Accounting for Investment Securities

The accounting for investment securities by banks, thrifts, insurance companies and other financial institutions continues to be monitored by the staff. Any sales or transfers out of the held-to-maturity investment portfolio or disclosures that such sales may occur may be indicative that the prior classifications were not appropriate. Sale or transfer of held-to-maturity debt securities for circumstances other than those permitted by paragraphs 8 and 11 SFAS No. 115 (or pursuant to the transition guidance in SFAS 133) creates a rebuttable presumption that the remaining held-to-maturity debt securities should be carried at market value. An explanation of such sales should be included in MD&A. Transfers to the trading portfolio should be rare.

If held-to-maturity debt securities are sold for reasons other than those listed in paragraph 8 of SFAS 115, the staff may challenge: (i) management's previous assertion regarding the classification of those securities; (ii) management's assertions regarding the classification of other held-to-maturity securities; and (iii) management's future assertions regarding the classification of subsequent security purchases as held to maturity. In addition, the staff has indicated that they also may consider whether previously filed financial statements should be restated to correct the apparent error in management's assertions regarding its ability to hold securities to maturity.

In connection with the review of the filings made by financial institutions (banks and thrifts, finance and insurance companies), the staff expects the following disclosures regarding the investment portfolio:

The accounting policy note to the financial statements should identify clearly the characteristics that must be present for the institution to carry a debt security at amortized cost, as specified in SFAS No. 115, rather than at market or lower of cost or market.
Market value of the portfolio should be disclosed on the face of the balance sheet. If the portfolio's fair value is less than its cost, MD&A should assess the significance of the unrealized loss relative to net worth and regulatory capital requirements.
Proceeds from the sales of debt securities should be distinguished from the proceeds from maturities in the cash flow statement or in a note thereto. Sales proceeds generated from the held-to-maturity portfolio should be distinguishable from those from the available-for-sale portfolio.
MD&A should analyze and, to the extent practicable, quantify the likely effects on current and future earnings and investment yields and on liquidity and capital resources of: material unrealized losses in the portfolio; material sales of securities at gains; and material shifts in average maturity. A similar analysis should be provided if a material portion of fixed rate mortgages maturing beyond one year carries rates below current market.
If a material proportion of the portfolio consists of securities that are not traded actively in a liquid market, MD&A should disclose that proportion, describe the nature of the securities and the source of market value information, and discuss any material risks associated with the investment relative to earnings and liquidity. Similar disclosure should be furnished if the portfolio includes instruments the market values of which are highly volatile relative to small changes in interest rates and this volatility may materially affect operating results or liquidity.
Trading securities and available-for-sale securities (categorized by types of investments) should be presented separately from the balance of the investment portfolio in Table II, "Investment Portfolio" of Industry Guide 3 data. Contractual maturities of investments held for sale need not be presented. The average yields on investments held for sale should be based on amortized cost and a footnote should so indicate.

F. Reverse Acquisitions — Accounting Issues

APB No. 16, paragraph 70 states that "presumptive evidence of the acquiring corporation in combinations effected by an exchange of stock is obtained by identifying the former common stockholder interests of a combining company which either retain or receive the larger portion of the voting rights in the combined corporation. That corporation should be treated as the acquirer unless other evidence clearly indicates that another corporation is the acquirer..." SAB Topic 2A affirms the above principle and discusses some of the factors which may rebut the normal presumption.

In December 1989, the Emerging Issues Committee of the Canadian Institute of Chartered Accountants reached a consensus concerning Reverse Takeover Accounting, which is compatible with the guidance included in Topic 2A. The EIC consensus indicates that the post reverse-acquisition comparative historical financial statements furnished for the "legal acquirer" should be those of the "legal acquiree" (i.e., the "accounting acquirer"), with appropriate footnote disclosure concerning the change in the capital structure effected at the acquisition date. Ordinarily, the guidance of APB 16 is applied in the allocation of the purchase price to all of the assets and liabilities of the accounting acquiree. (The staff believes the "partial step-up" methodology of EITF 90-13 applies only in the particular facts and circumstances specified in that consensus.)

The merger of a private operating company into a non-operating public shell corporation with nominal net assets typically results in the owners and management of the private company having actual or effective operating control of the combined company after the transaction, with shareholders of the former public shell continuing only as passive investors. These transactions are considered by the staff to be capital transactions in substance, rather than business combinations. That is, the transaction is equivalent to the issuance of stock by the private company for the net monetary assets of the shell corporation, accompanied by a recapitalization. The accounting is identical to that resulting from a reverse acquisition, except that no goodwill or other intangible should be recorded.

Transaction costs (e.g., legal and investment banking fees, stock issuance fees, etc.) may be incurred in a reverse acquisition. In the merger of two operating companies, those costs will be, depending on their nature, either part of the purchase consideration that is allocated to the net assets of the acquired business, charged directly to equity as a reduction from the fair value assigned to shares issued, or expenses of the period. In contrast, an operating company's reverse acquisition with a nonoperating company having some cash has been viewed by the staff as the issuance of equity by the accounting acquirer for the cash of the shell company. Accordingly, we believe transaction costs may be charged directly to equity only to the extent of the cash received, while all costs in excess of cash received should be charged to expense.

G. Revenue and Cost Recognition in Co-Marketing Arrangements

Co-marketing agreements allow sharing of risks and rewards of long-term marketing programs. An advertiser, broadcaster or internet service or content provider may charge less for marketing a retailer's products in exchange for a participation in the sales proceeds. In some cases, the retailer or the advertiser will guarantee the other party a minimum sales level. Also, in some cases, the retailer will advance funds for start-up costs. For example, funds advanced for internet marketing may be for hardware and software of the network server, product data-base interfaces, customer interfaces, and special interfaces between the retailer and the internet service. The terms of the co-marketing arrangement may be contained in a single contract, or in several contracts entered into at the same time.

A company advancing funds must recognize the use of the advance as an expense, purchase of a fixed asset, or, in limited cases, as a deferred cost in accordance with the substantive terms and deliverables specified in the co-marketing agreement. In one recent case, a retailer that was deferring recognition of any marketing expense until the advertising program commenced was required to revise its financial statements to expense the advance as certain start-up goods and services for which the retailer contracted were delivered by the advertiser.

Guarantees or make-wells by one co-marketing partner to the other typically necessitate deferral of revenue recognition by the guarantor to the extent of its guarantee because realization of its share of revenues under the co-marketing agreement is not reasonably assured unless the likelihood of having to perform under the guarantee is remote. A make-well agreement by the advertiser to furnish additional advertising services to the extent that income to the retailer did not meet specified minimum levels also creates a contingency necessitating the advertiser's deferral of its marketing program income to the extent of the value of the additional advertising contingently offered.

H. Write-Offs of Prepayments for Services, Occupancy or Usage

Some registrants that make significant prepayments for advertising and promotional services do not expect revenues directly attributable to the advertising during the period of its broadcast to be sufficient to recover its cost. Some have proposed that some or all of the prepayment be written off upon its disbursement, rather than recognized as the services are received. The staff believes that the assessment of recoverability of this prepayment is not different from other amounts prepaid or contractually committed for future services, occupancy or rights to use. While the registrant may believe that losses are likely during the "start-up," "build-out" or "expansionary" phase of its business, general accounting practices do not provide for the write-off of prepaid amounts, or accrual of firmly committed amounts, as a loss upon inception of the service, lease and similar agreement. Instead, GAAP requires that the amounts be amortized or recognized systematically over the period that the service, occupancy or usage occurs. See, for example, paragraph 44 of SOP 93-7. Results of operations for periods in which the services are received would not be accurately presented if the registrant reduced the cost of service to an amount less than both its historical cost to the Company and its fair value.

I. Internal Costs Associated with an Acquisition

Paragraph 76 of APB 16 specifies that indirect and general expenses related to business acquisitions are deducted as incurred, rather than capitalized as costs of the acquisition. Interpretation No. 33 of APB 16 further specifies that all "internal costs" associated with the business acquisition must be expensed, while "out of pocket" or "incremental" costs, such as finder's fees or fees paid to outside consultants may be capitalized. The staff believes that amounts paid to employees, even if characterized as finder's fees or payable only upon consummation of an acquisition, are internal costs which must be expensed as incurred, rather than capitalized.

J. Accounting for Extended Warranty Plans

FASB Technical Bulletin 90-1 provides accounting guidance for separately priced extended warranty and product maintenance contracts. Companies that enter into warranty contracts with customers must recognize the contract revenue over the contract period on a straight-line basis, unless sufficient, company-specific, historical evidence indicates that the costs of performing services under the contracts are incurred on other than a straight-line basis.

The staff recently became aware that some registrants have recognized substantially all of the warranty contract revenue upon sale of the contract to the customer if the registrant simultaneously reinsured its risk under the contract through an insurance company. Restatement of the financial statements to amortize revenue over the warranty contract term was necessary in these cases in accordance with TB 90-1. The amounts paid for insurance must be accounted for in accordance with paragraph 44 of FASB Statement No. 5. Generally, registrants should account for reinsurance contracts with third party insurers by analogy to FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. The registrant's obligation to the holder of the warranty contract and the re-insurance premiums paid to the insurance companies must be reflected on a gross basis in accordance with FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts.

In some cases, the registrant is not the primary obligor under the warranty contract. Instead, a third party is the primarily liable to the customer and the registrant acts solely as a broker that sells that party's warranty contracts to the customer. TB 90-1 is not applicable to the registrant in this circumstance. However, presentation of gross contract revenues and expenses by the broker is inappropriate. Instead, the registrant should present only its net fee as broker. If the registrant has continuing obligations after sale of the warranty contract as an administrative agent or in another capacity, amortization of the fee over the contract term is usually necessary.

K. SFAS 45 Guidance Limited to Franchise Agreements

Registrants should not analogize guidance in FASB Statement No. 45, Accounting for Franchise Fee Revenue, to agreements that do not satisfy all the criteria of a franchise agreement specified in paragraph 26 of that statement. The Board extracted from the AICPA Industry Accounting Guide the specialized accounting and reporting principles for franchise agreements without comprehensive reconsideration of that guidance in the context of broader principles of revenue recognition which are generally acceptable for other arrangements. Service contracts and agreements authorizing sales representatives and distributorships generally are not within the scope of SFAS 45.