Speech by SEC Staff:
Remarks at the 2003 Thirty-First AICPA National Conference on Current SEC Developments


Robert J. Comerford

Professional Accounting Fellow
Current Accounting Projects
Office of the Chief Accountant
U.S. Securities and Exchange Commission

December 11, 2003

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners or other members of the staff.


The SEC staff has dealt with a variety of registrant and standard-setting issues over the past year and I will be sharing our views on a number of these issues, including those on: (1) application of EITF Issue No. 96-19, Debtor's Accounting for a Modification or Exchange of Debt Instruments, to modified remarketable put bond transactions, (2) application of FAS 128, Earnings per Share, to certain structured convertible bond offerings and (3) classification and disclosure of certain trade accounts payable transactions involving an intermediary.

Application of EITF Issue No. 96-191 to Modified Remarketable Put Bond Transactions

Several years ago instruments called remarketable put bonds became a relatively popular source of financing. Many of these instruments are now approaching their remarketing date. As a result, I am going to spend the next few minutes discussing the proper application of EITF Issue No. 96-19 to these instruments. In order to do so, I would like to offer up a highly simplified remarketable put bond fact pattern.2

Assume that a company issues a 5-year bond for $1,000, which is also the bond's face value. Two years later, the issuer's investment bank may call the bond from its holder for $1,000, reset the interest rate on the bond according to a predetermined formula and then sell the bond bearing this new interest rate to new investors for the bond's then-current fair value. The predetermined formula has a fixed component plus a newly determined spread reflecting the credit risk of the issuer as of the reset date. If the investment bank does not call the bond the original investor must sell the bond back to the issuer for $1,000. The Issuer's participation on the reset date is limited to either of the following scenarios. If the investment bank exercises its call option and remarkets the bond the issuer must pay the bond's new interest rate until the bond's final maturity date. If the investment bank does not exercise its call, the issuer must repurchase the bond from the original investor.

Applying those "bond math" principals that we all learned back in the day, you will soon realize that the investment bank will exercise its call option only if the fixed portion of the reset interest rate exceeds the then current risk-free rate for three-year borrowings on the remarketing date. This allows the investment bank to sell the new bond at a premium, which becomes the investment bank's profit.

However, there is a slight added cost to the issuer when the bond is sold at a premium. Typically, when investors purchase bonds for prices in excess of face value, they demand a higher credit spread than they would for an instrument priced at its face value. This is because amounts paid in excess of face value typically do not carry creditor rights in the event of an issuer's bankruptcy; thus, the higher credit spread compensates investors for the incremental credit risk associated with the premium.

The first round of re-marketable put bonds have begun to hit their remarketing dates in a previously unforeseen and historically low interest rate environment. Consequently, issuers have found that premiums on their remarketed bonds are higher than had been anticipated on the bond's original issuance date, which in turn has been driving up the issuer's cost of funds. In order to match creditor rights with the purchase price expected to be paid by the new investors, some issuers have considered increasing the face value of their soon to be remarketed bonds to equal resale price that would have resulted had the bonds been remarketed pursuant to their original terms. Concurrent with this increase in face value, the issuer would reduce the interest rate on the bonds to a market-based rate appropriate to 3-year debt of the issuer. This matching of the remarketed bond's new face value with its expected issuance price has the potential to reduce the credit spread demanded by the new investors, thus reducing the issuer's overall cost of funds.

However, as is often the case with structured transactions, the little changes that I have mentioned may have unintended consequences for the issuer. Because increasing the remarketable put bond's face value and reducing its coupon to a market-based rate is not contemplated in the original terms of the bond, these modifications require evaluation under the guidance contained in EITF Issue No. 96-19. For those of you who may be wondering, Issue No. 96-19 provides guidance as to when a debt modification is merely a modification and when it is a modification that is accounted for as the extinguishment of one obligation and the issuance of another. Typically, Issue No. 96-19 requires extinguishment accounting only if the difference between the present value of the cash flows associated with the original instrument and those associated with the modified instrument exceeds 10 percent, which would not be expected in this instance. However, extinguishment accounting also results in instances in which debt is acquired from one party and then reissued to another party. For transactions involving an intermediary, an issuer must determine whether the intermediary is acting as a principal or as an agent of the issuer in order to determine whether the modification involves two or three parties. Issue No. 96-19 provides indicators to consider in making such a determination.

The Staff believes that a thorough analysis of the modified remarketing transaction that I have described causes the investment bank to be viewed as playing a dual role in the transaction. The investment bank may be viewed as that of a principal in the first component of the transaction involving the acquisition of the bond from the original investor, the resetting of the bond's interest rate pursuant to the bond's original terms and the subsequent tendering of these instruments back to the issuer at a price in excess of the instrument's face value. Once the issuer has increased the principal amount and decreased the coupon of the replacement bond, the investment bank's role is that of the issuer's agent conducting the placement of a modified bond to a new investor.

The Implementation Guidelines in EITF Issue No. 96-19 list four indicators to consider when evaluating whether an intermediary is acting as a principal or as the issuer's agent. In the interest of time, I am going to skip this analysis as it pertains to the investment bank's role as a principal in the first half of the transaction, as that analysis is fairly straightforward.3 However, I would like to walk through those indicators as they pertain to the investment bank's role in placing the modified bonds with new investors.

We believe that this analysis provides a firm basis for concluding that the investment bank acts as the issuer's agent in the debt placement component of these modified remarketing transactions. Because this amounts to the transaction being the issuer's acquisition of its own bonds from one investor coupled with the issuance of a modified bond to a new investor, Exhibit 96-19A requires that this transaction be accounted for as the extinguishment and de-recognition of the old bond and the recognition of the new bond at its fair value with the difference between these two amounts recognized in the income statement as an extinguishment loss.

Application of FAS 1284 to certain structured convertible bond offerings

Moving on to earnings per share issues associated with derivatives on an issuer's own stock, I am going to spend the next few minutes discussing the application of FAS 128 to a highly structured convertible bond. If you are a closet structurer, I am going to discuss the bond that results from tweaking Instrument C in EITF Issue No. 90-19.5 This tweaked instrument is not actually described in Issue No. 90-19 so for purposes of this discussion I will refer to this tweaked instrument as Instrument X. If you think that I am speaking Greek; I promise to translate into plain English in a moment. But first, I would like to point out that there are some parts of this discussion that are broadly applicable outside of the world of structured financial instruments. So if you find yourself dozing, I'll provide a wake up call when I get to that part of this discussion.

EITF Issue No. 90-19 describes Instrument C as a bond that is "convertible" into a fixed number of shares of the issuer's common stock. However, unlike a typical convertible bond, upon conversion, Instrument C's face value is repaid in cash. The bond's conversion spread, which represents the excess of the bond's conversion value over its face value, may be paid in either cash or stock at the issuer's option.

The Emerging Issues Task Force concluded in Issue No. 90-19 that the "if-converted" method of calculating diluted EPS is not applicable to Instrument C. Because the bond's principal and interest must be settled in cash, the Task Force concluded that no numerator or denominator adjustments arise from these components of the bond. Instead, issuers need only increase their diluted EPS denominator by the variable number of shares that would be issued upon conversion if the issuer chose to settle the conversion spread obligation with shares.6

Let's now illustrate, with numbers, the reason why some have grown to love EITF Issue No. 90-19. Assume that Instrument C has a principal amount of $100, pays $2 of interest per year and is convertible into 1 share of the issuer's stock. Assume also that the issuer's average share price over the reporting period is $150, its net income for the period is $100 and it had 20 shares outstanding. In this example, basic EPS equals $5.00 per share.7 Applying the "if-converted" method to Instrument C dilutes EPS to $4.86 per share, 8 while applying the treasury stock method to Instrument C only dilutes EPS to $4.92 per share.9 Thus, EITF Issue No. 90-19 results in instrument C being less dilutive than a traditional convertible bond. Of course, the downside of instrument C is that the principal and interest must be settled in cash.

To build upon Instrument C's favorable diluted EPS treatment, Instrument X provides the issuer with the ability to settle investor conversions in any combination of shares or cash. However, to achieve the same EPS treatment as Instrument C, those who issue Instrument X take advantage of the guidance in FAS 128 pertaining to share settleable obligations. This guidance indicates that if an issuer has a "stated policy" or a past practice of cash settling these obligations, the issuer may assume cash settlement for diluted EPS purposes provided that certain conditions are met. Specifically the "stated policy" or past practice must provide a reasonable basis for concluding that the issuer would in fact choose to cash settle its obligation.

Some have called Instrument X the golden goose of convertible bonds because they believe that by combining Instrument X's settlement flexibility with a "stated policy" of cash settling the bond's principal amount, they have preserved the favorable "treasury stock method" treatment afforded Instrument C and given themselves the flexibility to share-settle if it becomes prudent to do so.

For those of you who have dozed off, here is your wake up call. First and foremost, for those of you who may not be aware, the FASB will soon be issuing an exposure draft, as part of the short-term convergence project, that would eliminate an entity's ability to overcome share settlement presumptions via a "stated policy" or past practice. Second, we'd like to remind preparers and auditors that the mere assertion of a cash settlement policy is not necessarily sufficient to overcome FAS 128's share settlement presumption. Not surprisingly, we believe that a registrant's "stated policy" must have substance if it is to be relied upon as the basis for excluding share settleable obligations from a registrant's diluted EPS calculation. The following factors would seem to be useful in evaluating whether a "stated policy" has substance.

Settlement alternatives as a selling point — Registrants and auditors should examine the extent to which the flexibility associated with the ability to share settle factored into senior management's decision to approve the issuance of the instrument rather than an instrument that only allowed for cash settlement.

Intent and Ability — Registrants and auditors should consider the extent to which the registrant has the positive intent and ability to cash settle the face value and interest components of the instrument upon conversion. Both current and projected liquidity should be considered in determining whether positive intent and ability exists. The registrant's independent auditors should also ask for a management representation attesting to the registrant's positive intent and ability to cash settle.

Disclosure Commensurate with Intent — Auditors should consider the extent to which the disclosures included in a registrant's current period financial statements as well as those included in the instrument's offering documents acknowledge and support the registrant's positive intent and ability to adhere to its "stated policy."

Past Practice — Registrants and auditors should also examine whether the registrant has previously share settled contracts that provided a choice of settlement alternatives.

Principal executive officers and principal financial officers in particular should evaluate the substance of any accounting that depends upon management intent, such as the "stated policy" I've just discussed. The substance of such policies would seem to bear on the conclusions expressed in the certifications required by Sections 302 and 906 of the Sarbanes-Oxley Act.

Classification and Disclosure of Certain Trade Accounts Payable Transactions Involving an Intermediary

The last issue that I will discuss this morning draws upon certain transactions involving trade account payables that have recently come to the Staff's attention. It is our belief that these transactions have been structured to circumvent the balance sheet presentation and classification requirements of Regulation S-X, Article 5.10

Article 5 of Regulation S-X requires that an entity separately disclose on the face of its balance sheet amounts relating to borrowings from financial institutions and amounts payable to trade creditors. The arrangements we've recently become aware of involve the use of a structured arrangement in which an intermediary, typically a financial institution or one of its affiliates, pays trade payables on behalf of the purchaser in order to take advantage of discounts for early payment that the purchaser would not otherwise avail itself of. The purchaser then pays the lender either the full amount of the trade payable at a future date beyond the payable's normal terms, or an amount less than the full amount of the trade payable but on the trade payable's normal due date. Thus, the arrangement between the lender and the purchaser often results in the purchaser securing financing at lower cost of funds than is inherent in the vendor's invoice. In this transaction, the vendor is often not aware of the arrangement between the purchaser and the lender.

In another twist on the same transaction, the vendor may be a willing participant in a tri-party arrangement between the manufacturer, the vendor and the intermediary. Specifically, the intermediary accepts an IOU from the purchaser and presents a separate IOU to the vendor. The lender provides the purchaser with incentives similar to those provided in the first transaction and provides the vendor with the ability to present its IOU to the lender for accelerated payment at an appropriately discounted amount.

The Staff believes that the substance of both of these transactions equates to the purchaser obtaining financing from a lender in order to pay amounts due to its vendors. Thus, we believe that pursuant to the provisions of FAS 14011 the manufacturer's original liability to the vendor is extinguished on the date the lender remits cash or a lender IOU to the vendor. Pursuant to the provisions of Article 5, the purchaser should derecognize its trade account payable and record a new liability classified on its balance sheet as a borrowing from the lender. Consistent with this classification, the purchaser should then accrete the difference between the initial carrying amount of the borrowing (i.e. the discounted amount of the vendor invoice) and the repayment amount (i.e. the amount owed to the lender) through interest expense using the effective yield method.

The Staff believes that some manufacturers may have classified borrowings from the lender as an "interest-free" trade payable. As you can surmise from the analysis that I have just provided, the Staff disagrees with this balance sheet classification and the resulting lack of interest expense recognition. I would suggest that this is the type of transaction Scott referred to earlier as one that appears designed to frustrate transparent financial reporting. If you are a registrant or a preparer and your gut is telling you that the accounting for a transaction you are considering does not feel right, a pre-filing submission to the Office of the Chief Accountant may be a great way to de-mystify the black box that many perceive the SEC to be and provide an opportunity for us to work together so that we can provide investors with the right information from the start.


1 EITF Issue No. 96-19, Debtors Accounting for a Modification or Exchange of Debt Instruments

2 A more detailed discussion of these instruments may be found in Derivatives Implementation Group Issue B13.

3 Indicator 1 — Although the investment bank's funds do not appear to be at risk at the time that it exercises its call option (it has already received soft bids indicating the fair value of the instrument exceeds its face amount and will be selling the instrument back to the issuer at that fair value), the investment bank did originally place its funds at risk at the time that it purchased the call option from the original holder, thus pointing to the investment bank's role being that of a principal.

Indicator 2 — N/A

Indicator 3 - The issuer cannot compel the investment bank to exercise its call option. Being as the investment bank would be economically indifferent to selling to a new investor a bond that has been modified pursuant to the terms set forth in the original bond's documentation or a bond that has been modified pursuant to the fact pattern above, the issuer does not have a means to compel the investment bank to work through the issuer. This points to the investment bank's role being that of a principal.

Indicator 4 — In this leg of the transaction the investment bank's compensation is derived solely from the difference between the sale proceeds of the modified bond and the bond's original face value, once again pointing to the investment bank's role being that of a principal.

4 SFAS 128 — Earnings per share

5 EITF Issue No. 90-19 — Convertible bonds with Issuer Option to Settle for Cash Upon Conversion

6 EITF Issue No. 90-19 specifies that the Issuer must include the dilutive impact of the conversion spread in its diluted EPS calculation via the provisions of paragraph 29 of FAS 128 and EITF Topic D-72, Effect of Contracts That May Be Settled in Stock or Cash on the Computation of Diluted Earnings per Share which effectively results in the treatment described.

7 Basic EPS = [Income Available to Common Shareholders (IACS)] / [Shares Outstanding (SO)] = $100 / 20 shares = $5.00

8 Diluted EPS (Computed via "If-Converted" Method) = [IACS + Interest (net of tax)] / [SO + Potential Common Shrs] = ($100 + $2) / (20 + 1) shares = $4.86

9 Potential Common Shares = (Conversion Spread Value) / (Avg. Share Price) = $50 / $150 per share = 0.33 shares

Diluted EPS (Computed via "Treasury Stock" Method) = IACS / (SO + Potential Common Shrs) = ($100) / (20 + 0.33) shares = $4.92

10 Article 5, Commercial and Industrial Companies

11 SFAS 140 — Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a Replacement of FASB Statement No. 125 — (paragraph 16) states "A debtor shall derecognize a liability if and only if it has been extinguished. A liability has been extinguished if either of the following conditions is met...(b) The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor."