Stocking Stuffers from the SEC Staff

Transcription

1 December 19, 2000; Volume 7; Issue 11 Stocking Stuffers from the SEC Staff I t s that time of year again. While others dream of snowmen and sugarplums, our thoughts turn to Washington. It is there that the American Institute of Certified Public Accountants hosts its annual National Conference on SEC Developments. The conference gives the SEC staff an opportunity to provide registrants with financial reporting guidance, just in time for the upcoming annual report season. The topics span a broad range of accounting and auditing issues. In Attachment I, we review the speeches focusing on financial instruments. Here s the rundown on what you ll find: Speaker/Topic Specific Areas (See Attachment I) David Kane, FAS Guidance on sensitivity disclosures 140 (Heads Up, Written financial guarantee not a October 19, 2000) permitted position for a QSPE Demonstrably distinct requirement Dominick Ragone III, Identifying an SPE Sponsor David Kane, Evaluating Substantive Residual Equity E. Michael Pierce, FAS 133 Issues Classification of a retained interest Qualitative factors Quantitative factors Factors akin to debt Factors akin to equity SEC staff conclusion Income statement classification Inappropriate netting of hedge assets/liabilities against hedged item Appropriate netting of hedge assets/liabilities against hedged item Netting of hedge assets and liabilities Forecasted transactions in cash flow hedging relationships As developments warrant, Heads Up is edited by Jim Johnson and published by Deloitte & Touche s Capital Markets Group (New York). Heads Up contains general information only; it is not a substitute for consultation with a professional. To receive copies, contact Robert Canaan at rcanaan@deloitte.com or visit our website at (Publications).

2 Speaker/Topic Specific Areas (See Attachment I) Dominick Ragone III Hedging foreign currency risk in a Various business combination Forward purchase company s own equity Securitizers and their bankers be particularly aware of the topics shown in bold. The SEC staff indicated that an issuer that writes a financial guarantee cannot be a QSPE (precluding a transferor from relying on this status for nonconsolidation). Thus, the presence of real third party equity or identifying who else might be the parent (e.g. the issuer s sponsor) becomes critical. Examples of the deals potentially affected? Synthetic bonds and other transactions incorporating a written option (all three topics) and collateralized bond and loan obligations (because they don t typically qualify as QSPEs) by the second and third topics. Want more meat on the bones? The actual speech transcripts are available on the SEC s website, Attachment II lists other topics covered by all of the staff speakers. Also, D&T publishes a nifty summary of the proceedings (expected mid-january) contact rcanaan@deloitte.com and we ll put one under your tree. Sleighbells Ring, Children Sing, Equity Derivatives Ding! I f adopted as a new Standard, a FASB proposal, Accounting for Financial Instruments with Characteristics of Liabilities, Equity or Both, will profoundly affect the accounting for certain equity derivatives linked to an issuer s own stock: namely, forward stock purchases, written puts, and the written call option embedded in convertible debt (a wide variety of other instruments are potentially affected but these are of particular interest to Heads Up readers). The table below compares key points of today s accounting with the Exposure Draft s recommendations: Convertible Debt (Issuer) Separate Accounting for Debt and Option Interest Expense Gain/loss on Conversion Earnings per Share Today s Accounting Typically, no. The instrument is accounted for as debt until conversion. Relatively low due to the embedded investor option Typically, no If converted method ED Recommendations The issuer has issued debt at a discount (equal to the relative fair value of the equity component). The embedded option is accounted for as equity. Higher compared to today s accounting. Discount is amortized as additional interest expense. Yes Not discussed December 19, 2000 Page 2

3 Written Puts and Forward Purchase Contracts Indexed to a Company s Stock Can These Instruments Ever Qualify as Equity or Temporary Equity? Earnings Impact when Conditions of EITF (for equity treatment) are met. Accounting when EITF Conditions (for equity treatment) Are Not Met Earnings per Share Today s Accounting Yes, if the conditions of EITF (for equity treatment) are met. None. The instruments are not adjusted to current fair value. Generally, as a derivative under FAS 133. Marked to current fair value with changes included in income. Yes, reverse treasury stock method (see EITF Appendix Topic D- 72) ED Recommendations No. Generally, these instruments would be derivatives under FAS 133 (assuming they meet the definition as such) and would be marked to current fair value with changes included in income. See above See above Not discussed Here s FASB s rationale. It starts with the meaning of the term obligation; defined in the ED as a duty or responsibility to transfer assets or issue equity shares. An obligation that requires a transfer of assets (typically cash) is a liability. An obligation that requires or permits a transfer of equity shares may turn out to be a liability or equity, depending on the obligation s profile. Complicating the mix: an instrument that has both liability and equity characteristics (a compound instrument) must be bifurcated into its proper components, each accounted for separately. See Attachment III for the profile characteristics necessary for equity treatment and several examples illustrating the ED s provisions: convertible debt, a written call option and a forward stock purchase. December 19, 2000 Page 3

4 There s much, much more in the proposal. Here are a few highlights: Mandatorily redeemable preferred stock (including those issued by a wholly-owned trust) are accounted for as liabilities. Perpetual preferred is equity, even if the instrument calls for cumulative dividends (assuming no enforceable obligation to pay the dividend exists). Equity treatment includes increasing rate preferred stock even if the increasing rate makes it highly probable that the issuer will redeem it. The ED has a dramatic impact on many private companies. Often, the stockholder s have an obligation to resell their investment upon death or retirement. The upshot all the equity is actually debt! We presume, although this isn t covered by the proposed standard, that returns to the investors are some form of above the line interest. Today minority interest is in accounting limbo hovering between debt and equity. Under the ED, an item must be one or the other. Minority interest (in the parlance of the ED, a noncontrolling interest in a consolidated subsidiary) will be included in the parent s equity accounts. Why? It does not represent an obligation. The sale of subsidiary shares to entities outside of the control group (either via issuance by the subsidiary or sale by the parent) produces neither gain nor loss unless the transaction results in the subsidiary no longer being consolidated. FASB s proposal represents a paradigm shift in the accounting notion of a liability. As a result, FASB has issued a companion exposure draft proposing to amend Concepts Statement No. 6, Elements of Financial Statements. The FASB proposes to make the standard effective for years beginning after June 15, It calls for retroactive restatement unless a position was closed before the initial year of adoption. For these contracts, the company has a choice to include none of them or all of them in the restatement. As usual, nothing substitutes for a slow read of the actual document. Your personal copy awaits you on FASB s website, If you re so motivated, FASB wants comments by March 31, And to All a Good Night! T he Global Capital Markets Team and the people of Deloitte & Touche wish all of our readers a happy and healthy holiday season followed by a prosperous and deal-filled New Year. December 19, 2000 Page 4

5 Attachment I Financial Instrument Topics 28 th Annual National Conference on SEC Developments [Editor s note: FAS 140 securitization and collateral disclosures are required in 12/31/00 year-end financial statements. FAS 140 transfer provisions apply on or after 4/1/01.] Topic: FAS 140 [Heads Up, October 19, 2000] Speaker: David Kane, Professional Accounting Fellow, Office of the Chief Accountant Area Sensitivity Analysis Disclosures Limits on What a QSPE May Hold Demonstrably Distinct Requirement to be a QSPE Classification of Securitized Financial Assets Synopsis Sensitivity or stress test disclosures require two or more pessimistic variations for each key assumption (e.g. interest rates, prepayment rates, credit losses, etc.) that would indicate whether the quantified variation has a linear relationship to the changes in the assumption. Regardless of the pessimistic variations selected, the staff believes that the sensitivity disclosures should provide investors with transparent information to determine the pro forma effects of a change in market conditions on retained interests. The staff has not objected to the selection of a hypothetical change that (1) is expected to reflect reasonably possible near-term changes and (2) reflects significant deviations that are possible but are not expected to occur ( outlier assumptions). Staff concluded that an SPE that that holds US treasury securities and also writes a financial guarantee (accounted for as a FAS 133 derivative and unrelated to the SPE s financial assets) cannot be a QSPE under FAS 140. The written guarantee is not consistent with the types of derivatives a QSPE can hold. Staff rejects the argument that the financial guarantee counterparty is a beneficial interest holder. 10 percent or more of the fair value of the interests in transferred assets must be held by third parties at all times. Staff will presume that transferor has regained control of the transferred assets if 10 percent level not maintained. Also applies to series in master trusts (10 percent or more of the fair value of all of the interests in the series must be held by third parties). Example given of mortgage loan transferred to a qualifying SPE (and accounted for a sale of a portion of the loan) in exchange for certificated debt instruments representing beneficial interests in those loans. [Editor s note, transferor presumably also receives cash or other proceeds.] The beneficial interests should be accounted for as debt securities under FAS 115. If SPE loses its qualifying status, the transferor should consolidate the SPE (eliminating the beneficial interests in consolidation) and rerecord the previously transferred assets and the SPE s other liabilities at fair value (FAS 140, para. 55).

6 [Editor s note: Two speakers covered topics affecting non-qualifying SPEs. Potentially, a sponsor (or a transferor, if there is one) may have to consolidate the SPE if there is not substantive residual equity capital, controlled by unrelated parties. The speeches dealt with determining who might be a sponsor and the characteristics of a substantive residual equity capital investment.] Topic: Special-Purpose Entities (Identifying a Sponsor) Dominick Ragone, Professional Accounting Fellow, Office of the Chief Accountant Area Synopsis General Registrants should not apply one specific factor to determine the sponsor; all of the facts and Qualitative Factors to Determine a Sponsor Quantitative Factors to Determine a Sponsor circumstances should be considered carefully. What is the SPE s business purpose? What is the SPE s name? What operations are being performed (e.g. lending or financing operations, asset management, and insurance or reinsurance). Who has, and what is the nature of relationships with third parties that transfer assets to or from the SPE (referral rights)? Who controls whether or not asset acquisitions are from the open market or from specific entities? Who provides the services necessary for the entity to perform the nature of its operations (asset management, liquidity facilities, trust services, financing arrangements). Who has the ability to change the service provider? Who is the primary arranger of debt placement? Who performs supporting roles associated with debt placement? Who receives the residual economics of the SPE including all fee arrangements? Who receives fees for asset management, debt placement, trustee services, referral services, liquidity/credit enhancement services? How are the fee arrangements structured? Who holds the subordinated interest in the SPE?. Topic: Substantive Residual Equity Capital Speaker: David Kane, Professional Accounting Fellow, Office of the Chief Accountant Area Background (Part 1) Background (Part II) Background (Part III) SEC staff conclusion Synopsis A company proposes to sponsor an SPE to which the sponsor pays an upfront premium. In return, the SPE pays the sponsor a calculable amount upon the occurrence of a defined risk event (e.g an earthquake). Investors in the SPE assume the risk (i.e. they receive a return of and on their investment unless the risk event occurs). The securities issued by the SPE had characteristics that suggested they were akin to debt: They are issued as notes. They have a principal amount, fixed final maturity date and periodic cash payments (albeit contingent on the event). They have no potential for capital appreciation or growth in principal. No legal opinion was obtainable concluding that the securities were equity under the law. The securities are marketed as debt securitie s and investors view them in a manner similar to other high risk fixed income investments. The securities issued by the SPE had characteristics that suggested they were akin to equity: They are equity instruments for tax and ERISA purposes. There is minimal capital subordinate to the risk-linked securities. The holders of the securities have very limited creditor rights. The staff does not believe the securities represent an equity interest in legal form and in substance (as required by Question 8 of EITF 96-21). Key reasons are shown in bold above. Attachment 1 Page 2

7 [Editor s note: FAS 133 takes effect for companies with fiscal years beginning after June 15, For companies with calendar year-ends, the effective date is January 1, Despite the fast approaching deadline, only one speech tackled the new standard.] Topic: FAS 133 Issues Speaker: E. Michael Pierce, Professional Accounting Fellow, Office of the Chief Accountant Area Income Statement Classification Inappropriate Balance Sheet Netting of Derivative Assets and Liabilities against Hedged Item Appropriate Balance Sheet Netting of Derivative Assets and Liabilities against Hedged Item Inappropriate Balance Sheet Netting of Derivative Assets and Liabilities Forecasted Transactions in Cash Flow Hedging Relationships Synopsis FAS 133 does not specify income statement classification requirements of hedging transactions. Prior to FAS 133, registrants generally presented the results of hedging relationships on a net basis on the income statement line item associated with the hedged item (e.g. interest expense for a swap hedging debt or cost of goods sold for a hedge of inventory). The staff expects this current practice to continue upon adoption of FAS 133. The staff expects specific footnote disclosure of the registrant s policy of how and where the impact of hedge effectiveness is recorded in the income statement. The staff has requested registrants to clearly disclose their accounting policy as to where in the income statement is reflected (1) hedge ineffectiveness and (2) the component of hedge gain or loss excluded from the assessment of effectiveness [e.g. option time value]. FAS 133 requires the disclosure of the amount and location of the net gain or loss representing these two items. The staff believes that these policies for hedge effectiveness and ineffectiveness should be applied on a consistent basis for similar hedging relationships. The fact pattern involves a fair value hedge of a $1 million debt. The derivative produced a $50 thousand loss and the debt adjustment resulted in a $50 thousand gain. Can the derivative liability and the debt be netted (presentation of a $1 million obligation) or must the debt be presented at $950 thousand and the derivative liability presented elsewhere? The debt must be presented at $950,000. The derivative liability is not associated with future cash obligations to the debt holders. The fact pattern involves a debt obligation that embeds a derivative that must be separately accounted for under FAS 133 (the interest rate on the debt is indexed to the S&P 500). The staff believes netting the embedded derivative and the host contract is an appropriate presentation of the company s overall future obligation on the debt instrument and the requirements in GAAP for a legal right of offset would be met. The embedded derivative is accounted for at fair value under FAS 133 and the host debt is accounted for under GAAP applicable to debt instruments. A company has derivatives with multiple counterparties, some are assets and others are liabilities [based on their current fair value]. Could all derivatives be netted? No. Among its provisions permitting offset, FIN 39 requires that two parties owe each other determinable amounts. Thus, only assets and liabilities arising from derivatives with a single counterparty could be netted if the other conditions of FIN 39 are met. Management should include in its formal documentation of the hedging relationship those factors considered in concluding that the forecasted transaction is probable. Auditors must gather sufficient, competent, verifiable evidence regarding management s assertion concerning the forecasted transaction. The staff believes the registrant should disclose in MD&A the events or circumstances that may determine whether a forecasted transaction is no longer probable of occurring which may result in a material gain or loss. Questions that might be raised by the staff in evaluating whether a registrant has a pattern of determining that forecasted transactions are no longer probable include: (1) what were the business or operating circumstances that led to the conclusion, (2) have their been other instances with similar forecasted transactions, (3) if yes, what were the business or operating circumstances and do the current circumstances differ, (4) were the events or circumstances within the control of the company and (5) is the registrant anticipating a similar forecasted transaction in the near future? (Table continued on next page) Attachment 1 Page 3

8 Area Forecasted Transactions in Cash Flow Hedging Relationships (Con t) Synopsis One instance (the determination that a forecasted transaction is no longer probable) is not a pattern but a recurrence will quickly raise a red flag. The staff will challenge past and future assertions regarding forecasted transactions due to a lack of credibility when registrants display a pattern. [Editor s note: The next speech covered an existing hedge accounting issue, classification (as temporary equity) of various preferred stock issues and a structured transaction involving the sale and a forward purchase of a Company s own stock from the company s investment banker.] Topic: Various Dominick Ragone III, Professional Accounting Fellow, Office of the Chief Accountant Area Hedging Foreign Currency Risk in a Business Combination Classification of Preferred Stock Redeemable in Common Stock (Case 1) Classification of Preferred Stock (Case II) Classification of Preferred Stock (Case III) Forward Equity Transaction Synopsis A foreign currency forward contract cannot be designated as a hedge [for accounting purposes] of a firm commitment (to purchase a business ) that is denominated in a currency other than the acquirer s functional currency. Thus, it is a speculative position that should be marked to fair value via earnings. APB 16 permits only direct costs to be included in the purchase price, hedging the purchase price is essentially the same as hedging changes in the fair value of goodwill (making an evaluation of effectiveness difficult to determine objectively) and it is inappropriate to defer hedging gains and losses over the useful life of goodwill. Consistent with 1995 staff position as communicated at the same conference. [Editor s note: this guidance is consistent with FAS 133.] [Note: This case and the two that follow deal with the application of Rule 5-02 of Regulation S-X (ASR 268)] Company issues preferred stock that is redeemable in common shares. The legal agreement states that if the company is unable to fully convert the preferred shares to common, it is required to redeem the preferred shares in cash. As of the preferred issuance date, there are insufficient authorized common shares for the conversion and a stockholder meeting would be required for the additional authorization. The preferred securities would be classified outside of permanent equity because the requirement to obtain shareholder approval is outside of the control of the company. Company issues non-redeemable preferred stock. It contains a liquidation preference triggered by a change in control (giving the holders a right to demand cash). Deemed liquidation events that require one or more particular classes or types of equity securities (versus redemption and liquidation of all equity securities) to be redeemed cause those securities to be classified outside of permanent equity. Same as Case II except that the holder would receive cash or other securities issued by the acquirer (the consideration used by the third party in effecting the change in control). The securities should be classified outside of permanent equity because the possibility of cash redemption is outside of the issuers control. Company A purchases a specific number of its own shares over a short period of time. Company A sells the shares to an investment bank at its own cost. Company A enters into a forward purchase contract (compensating the investment bank for its funding costs (net of dividends received by the investment bank)). At Company A s option, the contract may be settled physically (cash for shares), net share [shares equal to the investment banker s gain (loss) are received (paid)], or net cash [cash equal to the investment banker s gain (loss) is received (paid)]. The staff believes that Company A should apply EITF and record the stock issued and the forward together as an equity instrument similar to preferred stock with a cumulative dividend (which reduces EPS). The staff rejected accounting for the forward as an equity-linked derivative under EITF Attachment 1 Page 4

9 Attachment II Other Topics 28 th Annual National Conference on SEC Developments Speaker/Title* Lynn Turner, Chief Accountant Craig C. Olinger, Deputy Chief Accountant (Corp Fin) J. Travis Gilmer, Professional Accounting Fellow Richard Walker, Director (Division of Enforcement) Charles Niemeier, Chief Accountant (Division of Enforcement) Lynn Turner, Chief Accountant John Morrissey, Deputy Chief Accountant Jackson Day, Deputy Chief Accountant R. Scott Blackley, Professional Accounting Fellow Scott Taub, Professional Accounting Fellow Topics Covered New Auditor Independence Rules, including: Legal Services Accounting Firm Affiliate and Business Relationships Contingent Fees Fairness Opinions Significant Influence Quality Controls Proxy Disclosures Bright Lines Audit Committees Conceptual Framework (Independence Standards Board) International Reporting Issues: Publication of International Financial Reporting and Disclosure Issues in the Division of Corporate Finance New 20-F Implementation Issues Processing Matters Business Combinations Miscellaneous International Reporting Issues: Consolidation, including SPEs under IASC Standards, German Special Funds, and Policy Disclosures, Derecognition (IAS vs. US GAAP) Equity Method Accounting Newly Effective IAS Standards Look Back Program (national auditing firms) Panel on Audit Effectiveness Enforcement Access to Foreign Workpapers Reporting Illegal Acts SAB 99 Materiality (Heads Up, August 16, 1999) SAB 100 Restructuring Charges and One-time Events SAB 101 Revenue Recognition Panel on Audit Effectiveness AICPA Vision Project SEC Concept Release on International Accounting Standards Expectations for Future International Standard Setting Global Financial Reporting Infrastructure Fair Value Accounting Circumstances When Inventory May Be Above Cost Reverse Spin-off Accounting Application of EITF Issue 95-8 to Forfeitable Shares Pooling Criteria Stock Sales by Insiders Common Revenue Recognition Matter (shipping terms) FAS 48, Revenue Recognition when Right of Return Exists Income Statement Display: Cost of Sales, Investment Income, Gains on Security Sales, Cost of Equity Instruments Issued to Non-employees Income Statement Captions

10 Speaker/Title* Eric Jacobsen, Professional Accounting Fellow David Kane, Professional Accounting Fellow E. Michael Pierce, Professional Accounting Fellow Topics Covered Revenue Recognition Stock Compensation Liabilities Assumed in a Business Combination Valuation of Equity Instruments Audit Related Matters Accounting Changes (Separate financial statements of a subsidiary in a spin-off or other capital raising transaction) Accounting for Venture Capital Investment Portfolios Other than Temporary Declines in Marketable Securities *Unless otherwise indicated, all speakers are from the Office of the Chief Accountant Attachment 2 Page 2

11 Attachment III Illustrative Examples FASB ED, Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both To qualify as equity, an obligation that requires or permits a transfer of equity shares must meet the following profile: Profile Characteristics: 1 The obligation requires or permits settlement by the issuance of equity shares 2 The number of equity shares is fixed or, if variable, both 3 and 4 must be satisfied. 3 Any change in the obligation s monetary value is attributable to and equal to the change in fair value of a fixed number of the issuer s equity shares, and 4 The monetary value changes in the same direction as the change in the fair value of the underlying equity shares Explanation If settlement is permitted, it must be at the issuer s option. Monetary value is the gross amount of value measured in units of currency that must be conveyed to the holder of a financial instrument upon settlement of an obligation at its maturity absent a change in current market conditions. See Example 2. This positive correlation between monetary value and stock price demonstrates the existence of an owner relationship (i.e. a long position by the holder). Example 1 Convertible Bond. Three Kings Inc. issues a callable convertible bond. Each $1,000 bond is convertible into 10 shares of the Company s common stock. The bond consists of three obligations: to pay principal, to pay interest, to issue a fixed number of equity shares. The first two obligations are liabilities (can be combined for accounting purposes). The third obligation is equity (1 and 2 in the above table are satisfied; the convertible requires settlement in a fixed number of equity shares). Note the call option is not separately accounted for under the provisions of the ED because, if separated, it would be an asset. Example 2 Written Call Option. Eight-Day Lamps issues call options as partial payment for consulting services it received. Each call covers 1 share of stock and bears a strike price of $45. The call options permit Eight-Day to select either net cash settlement (the excess of the value of 1 share above the option s strike price) or net share settlement (same as net cash except that the payment is in shares or fractional shares with a fair value equal to the excess). The call options embed an obligation to issue cash or shares at Eight-Days option (condition 1 is met). The potential number of shares is variable (as the stock price increases, Eight-Day will have to increase the number of shares issued under the net share settlement option). Accordingly, conditions 3 and 4 must be met if the options are to be accounted for as equity. Assume the following stock prices prevail: When calls are issued - $45 per share 3 months later - $100 per share 6 months later - $75 per share The table below illustrates the monetary value tests: Change in Monetary Value Equals Change in Value of fixed number (1) of Shares? Monetary Value Issue Date $45-45=$0 3 months after issuance $100-45=$55 $ 55 Yes Yes 6 months after issuance $75-45=$30 $(25) Yes Yes Is Change in Same Direction?

12 Profile characteristics 3 and 4 are satisfied. Eight-Day Lamps accounts for the options as equity. Example 3 Forward Purchase of Shares. Songs for Holidays.com enters into a forward contract to purchase its own shares. It agrees that in 6 months it will pay $50 per share for one share of its own stock. Songs for Holidays.com must physically settle the contract. The forward is not an equity instrument. It fails profile characteristic 1 because settlement involves receipt of, rather than issuance of, shares of its own stock. Example 4 Forward Purchase of Shares. Same as Example 3, except that the contract must be net settled in shares (fractional shares). The contract involves an obligation to issue shares when Songs for Holidays.com stock price is above $50. Although profile characteristic 3 is met (changes in the monetary value of the contract equal the change in the price of a fixed number of shares) the movement is in the opposite direction. Thus, the counterparty benefits from a decrease in the price of Songs share price. Because profile characteristic number 4 is not met, Songs cannot account for the forward as equity. Attachment 3 Page 2