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Good morning. Today I'd like to share some recent experiences we've had related to accounting for financial instruments. I'll start with the scope of the FASB literature on transfers of financial assets, then provide some observations on redeemable equity shares and contracts on own stock, and wrap up with a few tips on derivatives and hedging issues.
Beginning with transfers, we've recently heard of efforts to structure certain sales of beneficial interests in a manner that some believe falls outside the scope of Codification Topic 860 on transfers of financial assets. Those efforts involved selling preferred interests in a subsidiary that holds only financial assets rather than selling senior interests in the financial assets themselves. The idea seems to be that by describing the beneficial interests sold as equity in a consolidated subsidiary it may be possible to classify the proceeds received as noncontrolling equity interests rather than collateralized debt in the financial statements of the parent sponsor.
For some companies this may be appealing as a kind of "back up" plan. That is, if derecognition is not possible for whatever reason, presentation of the proceeds received on a failed sale within shareholders' equity rather than as debt may be the next best thing, or perhaps even better if those proceeds increase third party measures of capital for a distressed institution. Such strategies may raise concerns if they become more common under new FASB standards that make derecognition more difficult, so now seems like a good time to share information about how to grapple with the issues they raise.
In a typical example, a bank transfers loans to a consolidated special purpose entity in exchange for all senior and subordinated interests in the newly formed entity. The senior interests, which pay a prescribed rate of return each period, are then sold to outside investors, while the junior interests are retained by the bank. The activities of the SPE are significantly limited, primarily relating to servicing and, in some cases, rolling over assets as they mature. In this and other ways, these structures may be similar to QSPE's and other asset-backed financing structures that will more often be consolidated by their sponsors under the revised model of control in FASB Statements 166 and 167.
While these structures contain only financial assets and do not have the breadth and scope of activities of a business, some believe that by describing the beneficial interests sold as legal form equity and not including an explicit maturity date they can classify securitization proceeds received as noncontrolling equity interests in the consolidated financial statements of the parent sponsor. We have reached a different view in these circumstances. Beneficial interests in such entities are essentially transfers of interests in financial asset cash flows dressed up in legal entity form, and we believe the proceeds received on such transfers should be presented as collateralized borrowings pursuant to transfer accounting requirements to the extent the underlying financial assets themselves do not qualify for derecognition.
To say it again in another way, when a subsidiary is created simply to issue beneficial interests backed by financial assets rather than to engage in substantive business activities, we've concluded that sales of interests in the subsidiary should be viewed as transfers of interests in the financial assets themselves.1 The objective of an asset-backed financing is to provide the beneficial interest holders with rights to a portion of financial asset cash flows and the guiding literature is contained in Codification Topic 860 on transfers of financial assets. That literature requires a transfer to be reflected either as a sale or collateralized borrowing, depending on its specific characteristics-presentation as an equity interest in the reporting entity is not a possible outcome.
I'd like to turn now to the evaluation of contracts on own stock and redeemable shares. A key question in accounting for both types of instruments is whether the company can avoid settling the instrument in cash or other assets even in contingent scenarios that may be improbable. With a few defined exceptions, a share-based derivative, such as a warrant or option on common stock, is accounted for by its issuer as an asset or liability (rather than as equity) if there is any circumstance in which the issuer could be required to settle it in cash. Similarly, an equity share is generally presented as mezzanine temporary equity if it could require cash settlement for reasons beyond the company's control.
In some cases determining whether a company can avoid paying out cash in all possible circumstances can be a difficult question, requiring a detailed analysis of both the instrument's terms and various debt versus equity accounting requirements. One question that has come up several times recently is-specifically who needs to have the power to decide how an instrument is settled to conclude that the company is in control of a settlement alternative? For instance, if a company had the right but not the obligation to settle a warrant in cash upon exercise, but could also choose to settle the warrant in shares, classification of that warrant in equity would still be appropriate, assuming all other requirements are met.
So who does need to have the power? In a typical corporate structure, the power to control the form of settlement might be expected to reside with the Board of Directors or executive management. However, there are a variety of governance structures in practice. For a limited partnership, the governance structure of the entity would often consist of the general partner, and one would usually expect cash versus share settlement decisions to reside with that partner in order for a decision to be within the company's control. In any case, in order for a settlement option to be under company control, one would generally expect that control would rest with the party or parties tasked with management or governance by the owners of the entity.
Throwing in an additional twist, the SEC staff guidance on redeemable shares also notes that there may be situations in which control by the governance structure of an entity, such as the Board of Directors, may be insufficient to demonstrate that a settlement option is within the company's control. These are often situations in which specific shareholders have the ability to seize control of the governance structure and require redemption of their interests in a preferential manner using another feature of the instrument. A typical example is a provision whereby a class of preferred shareholders can take control of the Board upon failure to pay dividends and thereby exercise a preexisting embedded call option on their preferred stock. Unless there were a third provision that makes the call inoperable when the preferred shareholders are in control, the shares would be classified in temporary equity because the combination of the contingent control right and the call could be used in the same manner as a put option by the preferred shareholder. Of course, whenever the analysis becomes this involved a healthy attention to appropriate disclosure is probably in order.
Before leaving this topic, I would like to stress that many protective rights that provide powers to specific shareholders in contingent scenarios would not result in a conclusion that the related shares should be classified in temporary equity. Similarly, company call features are not usually considered third party redemption rights. Nevertheless, in evaluating whether a cash settlement feature is under company control it is important to consider possible interactions whereby a combination of rights creates a security that is puttable or contingently puttable at the option of the holder.
Finally, I'll share a couple of quick tips on derivatives and hedging issues.
In my time on the staff, I've spent a fair amount of time dealing with questions about embedded derivatives, and I've noticed some recurring themes. In particular, I've noticed that a common source of error comes at the very beginning of the analysis in defining the terms of the embedded feature to be evaluated. While there may be more than one way to approach this task, I just want to stress that when evaluating a feature, half the battle is making sure the embedded feature and host contract identified add up to the actual hybrid instrument that you are ultimately accounting for. Whether you are analyzing embedded features in a debt instrument, a share of stock, a supply arrangement, or something else, double checking that the numbers add up will help ensure that you have properly identified the embedded feature for analysis and that it is valued in a manner that captures its primary economic characteristics. In other words, significant economic characteristics of a hybrid instrument should not be lost or double-counted in the process of bifurcating an embedded derivative.
I'd specifically highlight that the process of identifying the terms of the host and embedded feature can affect:
So again, taking the time to specifically identify the terms of the embedded feature in a well articulated manner at the beginning of the process can make a big difference in ensuring that the embedded derivative analysis is performed appropriately.
Turning to hedge accounting, we've heard rumblings that some may be looking to expand the number of hedging relationships subject to the shortcut or critical terms match methods. While I do not intend to spend time today on specific hedging relationships I do want to caution again that hedging methods that do not require a full evaluation of effectiveness are intended for straightforward hedging relationships involving conventional instruments. To the extent a hedging relationship involves unusual terms that raise questions about the level of effectiveness of the hedge a more complete analysis of ineffectiveness would likely be necessary.
Thank you for your time today. That concludes my prepared remarks and I look forward to answering questions.
1 Relevant technical references include FASB ASC subparagraph 860-10-15-4(f), which notes that investments by owners in a business are not in scope of Topic 860, and paragraph 860-10-55-13, which notes that the guidance in Subtopic 860-10 "does not apply to a transfer of an ownership interest in a consolidated subsidiary by its parent if that consolidated subsidiary holds nonfinancial assets."