[Federal Register Volume 76, Number 59 (Monday, March 28, 2011)]
[Rules and Regulations]
[Pages 17192-17285]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-5584]
[[Page 17191]]
Vol. 76
Monday,
No. 59
March 28, 2011
Part II
Securities and Exchange Commission
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17 CFR Part 211
Staff Accounting Bulletin No. 114; Rule
Federal Register / Vol. 76 , No. 59 / Monday, March 28, 2011 / Rules
and Regulations
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 211
[Release No. SAB 114]
Staff Accounting Bulletin No. 114
AGENCY: Securities and Exchange Commission.
ACTION: Publication of Staff Accounting Bulletin.
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SUMMARY: This Staff Accounting Bulletin (SAB) revises or rescinds
portions of the interpretive guidance included in the codification of
the Staff Accounting Bulletin Series. This update is intended to make
the relevant interpretive guidance consistent with current
authoritative accounting guidance issued as part of the Financial
Accounting Standards Board's Accounting Standards Codification. The
principal changes involve revision or removal of accounting guidance
references and other conforming changes to ensure consistency of
referencing throughout the SAB Series.
DATES: Effective Date: March 28, 2011.
FOR FURTHER INFORMATION CONTACT: Lisa Tapley, Assistant Chief
Accountant, or Annemarie Ettinger, Senior Special Counsel, Office of
the Chief Accountant, at (202) 551-5300, or Craig Olinger, Deputy Chief
Accountant, Division of Corporation Finance, at (202) 551-3400,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549.
SUPPLEMENTARY INFORMATION: The statements in staff accounting bulletins
are not rules or interpretations of the Commission, nor are they
published as bearing the Commission's official approval. They represent
interpretations and practices followed by the Division of Corporation
Finance and the Office of the Chief Accountant in administering the
disclosure requirements of the Federal securities laws.
Dated: March 7, 2011.
Elizabeth M. Murphy,
Secretary.
PART 211--[AMENDED]
0
Accordingly, Part 211 of Title 17 of the Code of Federal Regulations is
amended by adding Staff Accounting Bulletin No. 114 to the table found
in Subpart B.
Staff Accounting Bulletin No. 114
This Staff Accounting Bulletin (SAB) revises or rescinds portions
of the interpretive guidance included in the codification of the Staff
Accounting Bulletin Series. This update is intended to make the
relevant interpretive guidance consistent with current authoritative
accounting guidance issued as part of the Financial Accounting
Standards Board's Accounting Standards Codification (FASB ASC). The
principal changes involve revision or removal of accounting guidance
references and other conforming changes to ensure consistency of
referencing throughout the SAB Series.
The following describes the changes made to the Staff Accounting
Bulletin Series and certain specific topics that are presented at the
end of this release:
a. The SAB Series is amended to update authoritative accounting
literature references to the FASB ASC throughout. In addition, several
conforming formatting changes were made for consistency across SAB
topics. Due to the number of these changes, the SAB Series is
represented in its entirety in this release. All of the changes are
technical in nature, and none of the changes are intended to change the
guidance provided in the SAB Series.
Topic 1: Financial Statements
a. Topic 1.D.1, the introductory facts are amended to conform to
changes made to Items 17 and 18 of Form 20-F to reflect that certain
disclosures are required only if a basis of accounting other than U.S.
generally accepted accounting principles (GAAP) or International
Financial Reporting Standards as issued by the International Accounting
Standards Board is used. The introductory facts are also amended to
remove the reference to Form F-2, as this form was eliminated effective
December 1, 2005. Finally, the introductory facts are amended to
reflect the foreign issuer reporting enhancements contained in SEC
Release No. 33-8959.
b. Topic 1.I, the footnote previously numbered 6 within the
interpretive response to question 1 is removed as the referenced
guidance is now within the FASB ASC, and thus a history of the prior
source is no longer relevant.
c. Topic 1.I, the footnote previously numbered 7 within the
interpretive response to question 2 is removed as the term ``ADC'' is
now defined within the body of SAB Topic 1.I.
d. Topic 1.K, the interpretive response to question 3 is amended to
conform to the accounting guidance contained in FASB ASC Topic 350,
Intangible Assets--Goodwill and Other. This conforming change reflects
the fact that goodwill is no longer subject to amortization. The
interpretive response to question 3 is also amended to replace the term
``carrying value'' with the term ``fair value'' to reflect the
measurement guidance for financial assets and liabilities as stated in
FASB ASC Topic 820, Fair Value Measurements and Disclosures.
e. Topic 1.K, the interpretive response to question 4, is amended
to replace Item 7 of Form 8-K with Item 9.01 of Form 8-K.
Topic 3: Senior Securities
a. Topic 3.A, the interpretive response is amended to replace Rule
11-02(a)(7) of Regulation S-X with Rule 11-02(b)(7) of Regulation S-X.
Topic 5: Miscellaneous Accounting
a. Topic 5.F, the introductory facts and interpretive response are
amended to replace the term ``restatement'' with the term
``retrospective adjustment,'' to replace the term ``restate(d)'' with
the term ``retrospectively adjust(ed)'' and to replace the term
``retroactively'' with the term ``retrospectively'' to conform to the
accounting guidance contained in FASB ASC Topic 250, Accounting Changes
and Error Corrections.
b. Topic 5.F, the interpretive response is amended to remove an
unnecessary reference to FASB Statement No. 5 and FASB Statement No.
13.
c. Topic 5.M, the footnote previously numbered 8 within the
interpretive response is removed to delete a reference which is not
included in the FASB ASC.
d. Topic 5.S, the interpretive responses to questions 2, 4
(including footnote 29) and 5 are amended to revise the quoted
accounting guidance to conform to the language as published in the FASB
ASC. The interpretive response to question 4 is amended to remove
guidance which is not included in the FASB ASC. The footnote previously
numbered 31 within the interpretive response to question 4 is removed
to delete a reference which is not included in the FASB ASC.
e. Topic 5.V, the interpretive response to question 1 is amended to
remove an unnecessary reference to SAB Topic 5.E, as the referenced
guidance in SAB Topic 5.E was removed with the issuance of SAB No. 112.
As a result, the related footnote previously numbered 38 is removed.
f. Topic 5.Y, the interpretive response to question 3 is amended to
remove the reference to Regulation S-B, as this Regulation was
eliminated effective February 4, 2008.
g. Topic 5.Z.4, footnote 51 is amended to remove an unnecessary
reference to SAB Topic 5.E.
h. Topic 5.BB, the introductory facts are amended to revise the
quoted
[[Page 17193]]
accounting guidance to conform to the language as published in the FASB
ASC.
Topic 6: Interpretations of Accounting Series Releases and Financial
Reporting Releases
a. Topic 6.K.3, the interpretive response is amended to conform to
the accounting guidance contained in FASB ASC Topic 350, Intangible
Assets--Goodwill and Other. This conforming change reflects the fact
that goodwill is not amortized, but rather only tested for impairment.
b. Topic 6.L is amended throughout to update the references to the
AICPA Audit and Accounting Guide, Depository and Lending Institutions
with Conforming Changes as of June 1, 2009 (Audit Guide). Quoted
guidance has been amended to conform to the language as published in
the Audit Guide.
Topic 8: Retail Companies
a. Topic 8.A, the interpretive response is amended to remove
unnecessary background information on the issuance of pre-FASB
Codification standards.
Topic 13: Revenue Recognition
a. Topic 13.A.4.c, the interpretive response is amended to revise
the quoted accounting guidance to conform to the language as published
in the FASB ASC.
b. Topic 13.B, questions 2, 3, 4 and 5 and the interpretive
responses and footnotes related to questions 2, 3, 4 and 5 are removed
to eliminate unnecessary references and guidance specifically related
to the original adoption of this SAB Topic.
Topic 14: Share-Based Payment
a. Topic 14.G is removed to eliminate unnecessary guidance on non-
GAAP financial measures. Staff guidance on non-GAAP financial measures
can be found in the Division of Corporation Finance's Compliance and
Disclosure Interpretations.
b. Topics 14.H, 14.J, 14.K and 14.M are removed to eliminate
unnecessary transition guidance specifically related to the first time
adoption of FASB Statement No. 123(R), Share-Based Payment. Companies
that had share-based payment arrangements prior to the adoption of FASB
Statement No. 123(R) were required to apply this transition guidance in
2006 and therefore for these companies the guidance in Topics 14.H,
14.J, 14.K and 14.M is no longer relevant. For companies now entering
into share-based payment arrangements for the first time, the guidance
in FASB ASC Topic 718, Compensation--Stock Compensation, should be
applied.
c. Topic 14.L is removed to conform to changes made to Items 17 and
18 of Form 20-F to reflect that reconciling items are required for
disclosure only if a basis of accounting other than U.S. generally
accepted accounting principles or International Financial Reporting
Standards as issued by the International Accounting Standards Board is
used.[
Note: The text of SAB 114 will not appear in the Code of
Federal Regulations.
]Table of Contents
TOPIC 1: FINANCIAL STATEMENTS
A. Target Companies
B. Allocation of Expenses and Related Disclosure in Financial
Statements of Subsidiaries, Divisions or Lesser Business Components
of Another Entity
1. Costs Reflected in Historical Financial Statements
2. Pro Forma Financial Statements and Earnings per Share
3. Other Matters
C. Unaudited Financial Statements for a Full Fiscal Year
D. Foreign Companies
1. Disclosures Required of Companies Complying With Item 17 of
Form 20-F
2. ``Free distributions'' by Japanese Companies
E. Requirements for Audited or Certified Financial Statements
1. Removed by SAB 103
2. Qualified Auditors' Opinions
F. Financial Statement Requirements in Filings Involving the
Formation of a One-Bank Holding Company
G. Removed by Financial Reporting Release (FRR) 55
H. Removed by FRR 55
I. Financial Statements of Properties Securing Mortgage Loans
J. Application of Rule 3-05 in Initial Public Offerings
K. Financial Statements of Acquired Troubled Financial Institutions
L. Removed by SAB 103
M. Materiality
1. Assessing Materiality
2. Immaterial Misstatements That Are Intentional
N. Considering the Effects of Prior Year Misstatements When
Quantifying Misstatements in Current Year Financial Statements
TOPIC 2: BUSINESS COMBINATIONS
A. Acquisition Method
1. Removed by SAB 103
2. Removed by SAB 103
3. Removed by SAB 103
4. Removed by SAB 103
5. Removed by SAB 112
6. Debt Issue Costs
7. Removed by SAB 112
8. Business Combinations Prior to an Initial Public Offering
9. Removed by SAB 112
B. Removed by SAB 103
C. Removed by SAB 103
D. Financial Statements of Oil and Gas Exchange Offers
E. Removed by SAB 103
F. Removed by SAB 103
TOPIC 3: SENIOR SECURITIES
A. Convertible Securities
B. Removed by ASR 307
C. Redeemable Preferred Stock
TOPIC 4: EQUITY ACCOUNTS
A. Subordinated Debt
B. S Corporations
C. Change in Capital Structure
D. Earnings per Share Computations in an Initial Public Offering
E. Receivables From Sale of Stock
F. Limited Partnerships
G. Notes and Other Receivables From Affiliates
TOPIC 5: MISCELLANEOUS ACCOUNTING
A. Expenses of Offering
B. Gain or Loss From Disposition of Equipment
C.1. Removed by SAB 103
C.2. Removed by SAB 103
D. Organization and Offering Expenses and Selling Commissions--
Limited Partnerships Trading in Commodity Futures
E. Accounting for Divestiture of a Subsidiary or Other Business
Operation
F. Accounting Changes Not Retroactively Applied Due to Immateriality
G. Transfers of Nonmonetary Assets by Promoters or Shareholders
H. Removed by SAB 112
I. Removed by SAB 70
J. New Basis of Accounting Required in Certain Circumstances
K. Removed by SAB 95
L. LIFO Inventory Practices
M. Other Than Temporary Impairment of Certain Investments in Equity
Securities
N. Discounting by Property-Casualty Insurance Companies
O. Research and Development Arrangements
P. Restructuring Charges
1. Removed by SAB 103
2. Removed by SAB 103
3. Income Statement Presentation of Restructuring Charges
4. Disclosures
Q. Increasing Rate Preferred Stock
R. Removed by SAB 103
S. Quasi-Reorganization
T. Accounting for Expenses or Liabilities Paid by Principal
Stockholder(s)
U. Removed by SAB 112
V. Certain Transfers of Nonperforming Assets
W. Contingency Disclosures Regarding Property-Casualty Insurance
Reserves for Unpaid Claim Costs
X. Removed by SAB 103
Y. Accounting and Disclosures Relating to Loss Contingencies
Z. Accounting and Disclosure Regarding Discontinued Operations
1. Removed by SAB 103
2. Removed by SAB 103
3. Removed by SAB 103
4. Disposal of Operation With Significant Interest Retained
6. Removed by SAB 103
7. Accounting for the Spin-Off of a Subsidiary
[[Page 17194]]
AA. Removed by SAB 103
BB. Inventory Valuation Allowances
CC. Impairments
DD. Written Loan Commitments Recorded at Fair Value Through Earnings
TOPIC 6: INTERPRETATIONS OF ACCOUNTING SERIES RELEASES AND FINANCIAL
REPORTING RELEASES
A.1. Removed by SAB 103
B. Accounting Series Release 280--General Revision of Regulation S-
X: Income or Loss Applicable to Common Stock
C. Accounting Series Release 180--Institution of Staff Accounting
Bulletins (SABs)--Applicability of Guidance Contained in SABs
D. Redesignated as Topic 12.A by SAB 47
E. Redesignated as Topic 12.B by SAB 47
F. Removed by SAB 103
G. Accounting Series Releases 177 and 286--Relating to Amendments to
Form 10-Q, Regulation S-K, and Regulations S-X Regarding Interim
Financial Reporting
1. Selected Quarterly Financial Data (Item 302(a) of Regulation S-K)
a. Disclosure of Selected Quarterly Financial Data
b. Financial Statements Presented on Other Than a Quarterly Basis
c. Removed by SAB 103
2. Amendments to Form 10-Q
a. Form of Condensed Financial Statements
b. Reporting Requirements for Accounting Changes
1. Preferability
2. Filing of a Letter From the Accountants
H. Accounting Series Release 148-Disclosure Of Compensating Balances
And Short-Term Borrowing Arrangements (Adopted November 13, 1973 As
Modified By ASR 172 Adopted On June 13, 1975 And ASR 280 Adopted On
September 2, 1980)
1. Applicability
a. Arrangements With Other Lending Institutions
b. Bank Holding Companies and Brokerage Firms
c. Financial Statements of Parent Company and Unconsolidated
Subsidiaries
d. Foreign Lenders
2. Classification of Short-Term Obligations-Debt Related to Long-
Term Projects
3. Compensating Balances
a. Compensating Balances for Future Credit Availability
b. Changes in Compensating Balances
c. Float
4. Miscellaneous
a. Periods Required
b. 10-Q Disclosures
I. Accounting Series Release 149-Improved Disclosure Of Income Tax
Expense (Adopted November 28, 1973 And Modified By ASR 280 Adopted
On September 2, 1980)
1. Tax Rate
2. Taxes of Investee Company
3. Net of Tax Presentation
4. Loss Years
5. Foreign Registrants
6. Securities Gains and Losses
7. Tax Expense Components v. ``Overall'' Presentation
J. Removed by SAB 47
K. Accounting Series Release 302--Separate Financial Statements
Required by Regulation S-X
1. Removed by SAB 103
2. Parent Company Financial Information
a. Computation of Restricted Net Assets of Subsidiaries
b. Application of Tests for Parent Company Disclosures
3. Undistributed Earnings of 50% or Less Owned Persons
4. Application of Significant Subsidiary Test to Investees and
Unconsolidated Subsidiaries
a. Separate Financial Statement Requirements
b. Summarized Financial Statement Requirements
L. Financial Reporting Release 28--Accounting for Loan Losses by
Registrants Engaged in Lending Activities
1. Accounting for loan losses
2. Developing and Documenting a Systematic Methodology
a. Developing a Systematic Methodology
b. Documenting a Systematic Methodology
3. Applying a Systematic Methodology--Measuring and Documenting Loan
Losses Under FASB ASC Subtopic 310-10
a. Measuring and Documenting Loan Losses Under FASB ASC Subtopic
310-10--General
b. Measuring and Documenting Loan Losses Under FASB ASC Subtopic
310-10 for a Collateral Dependent Loan
c. Measuring and Documenting Loan Losses Under FASB ASC Subtopic
310-10--Fully Collateralized Loans
4. Applying a Systematic Methodology--Measuring and Documenting Loan
Losses Under FASB ASC Subtopic 450-20
a. Measuring and Documenting Loan Losses Under FASB ASC Subtopic
450-20--General
b. Measuring and Documenting Loan Losses Under FASB ASC Subtopic
450-20--Adjusting Loss Rates
c. Measuring and Documenting Loan Losses Under FASB ASC Subtopic
450-20--Estimating Losses on Loans Individually Reviewed for
Impairment but not Considered Individually Impaired
5. Documenting the Results of a Systematic Methodology
a. Documenting the Results of a Systematic Methodology--General
b. Documenting the Results of a Systematic Methodology--Allowance
Adjustments
6. Validating a Systematic Methodology
TOPIC 7: REAL ESTATE COMPANIES
A. Removed by SAB 103
B. Removed by SAB 103
C. Schedules of Real Estate and Accumulated Depreciation, and of
Mortgage Loans on Real Estate
D. Income Before Depreciation
TOPIC 8: RETAIL COMPANIES
A. Sales Of Leased Or Licensed Departments
B. Finance Charges
TOPIC 9: FINANCE COMPANIES
A. Removed by SAB 103
B. Removed by ASR 307
TOPIC 10: UTILITY COMPANIES
A. Financing by Electric Utility Companies Through Use of
Construction Intermediaries
B. Removed by SAB 103
C. Jointly Owned Electric Utility Plants
D. Long-Term Contracts for Purchase of Electric Power
E. Classification of Charges for Abandonments and Disallowances
F. Presentation of Liabilities for Environmental Costs
TOPIC 11: MISCELLANEOUS DISCLOSURE
A. Operating-Differential Subsidies
B. Depreciation and Depletion Excluded From Cost of Sales
C. Tax Holidays
D. Removed by SAB 103
E. Chronological Ordering of Data
F. LIFO Liquidations
G. Tax Equivalent Adjustment in Financial Statements of Bank Holding
Companies
H. Disclosures by Bank Holding Companies Regarding Certain Foreign
Loans
1. Deposit/Relending Arrangements
2. Accounting and Disclosures by Bank Holding Companies for a
``Mexican Debt Exchange'' Transaction
I. Reporting of an Allocated Transfer Risk Reserve in Filings Under
the Federal Securities Laws
J. Removed by SAB 103
K. Application of Article 9 and Guide 3
L. Income Statement Presentation of Casino-Hotels
M. Disclosure of the Impact That Recently Issued Accounting
Standards Will Have on the Financial Statements of the Registrant
When Adopted in a Future Period
N. Disclosures of the Impact of Assistance From Federal Financial
Institution Regulatory Agencies
TOPIC 12: OIL AND GAS PRODUCING ACTIVITIES
A. Accounting Series Release 257--Requirements for Financial
Accounting and Reporting Practices for Oil and Gas Producing
Activities
1. Estimates of Reserve Quantities
2. Estimates of Future Net Revenues
3. Disclosure of Reserve Information
a. Removed by SAB 103
b. Removed by SAB 113
c. Limited Partnership 10-K Reports
d. Removed by SAB 113
e. Rate Regulated Companies
4. Removed by SAB 103
B. Removed by SAB 103
C. Methods of Accounting by Oil and Gas Producers
1. First-Time Registrants
2. Consistent Use of Accounting Methods Within a Consolidated Entity
D. Application of Full Cost Method of Accounting
1. Treatment of Income Tax Effects in the Computation of the
Limitation on Capitalized Costs
2. Exclusion of Costs From Amortization
3. Full Cost Ceiling Limitation
a. Exemptions for Purchased Properties
[[Page 17195]]
b. Use of Cash Flow Hedges in the Computation of the Limitation on
Capitalized Costs
c. Effect of Subsequent Events on the Computation of the Limitation
on Capitalized Costs
4. Interaction of FASB ASC Subtopic 410-20, Asset Retirement and
Environmental Obligations--Asset Retirement Obligations, and the
Full Cost Rules
a. Impact of FASB ASC Subtopic 410-20 on the Full Cost Ceiling Test
b. Impact of FASB ASC Subtopic 410-20 on the Calculation of
Depreciation, Depletion, and Amortization
c. Removed by SAB 113
E. Financial Statements of Royalty Trusts
F. Gross Revenue Method of Amortizing Capitalized Costs
G. Removed by SAB 113
TOPIC 13: REVENUE RECOGNITION
A. Selected Revenue Recognition Issues
1. Revenue Recognition--General
2. Persuasive Evidence of an Arrangement
3. Delivery and Performance
a. Bill and Hold Arrangements
b. Customer Acceptance
c. Inconsequential or Perfunctory Performance Obligations
d. License Fee Revenue
e. Layaway Sales Arrangements
f. Nonrefundable Up-Front Fees
g. Deliverables Within an Arrangement
4. Fixed or Determinable Sales Price
a. Refundable Fees for Services
b. Estimates and Changes in Estimates
d. Claims Processing and Billing Services
B. Disclosures
TOPIC 14: SHARE-BASED PAYMENT
A. Share-Based Payment Transactions with Nonemployees
B. Transition From Nonpublic to Public Entity Status
C. Valuation Methods
D. Certain Assumptions Used in Valuation Methods
E. FASB ASC Topic 718, Compensation--Stock Compensation, and Certain
Redeemable Financial Instruments
F. Classification of Compensation Expense Associated With Share-
Based Payment Arrangements
G. Removed by SAB 114
H. Removed by SAB 114
I. Capitalization of Compensation Cost Related to Share-Based
Payment Arrangements
J. Removed by SAB 114
K. Removed by SAB 114
L. Removed by SAB 114
M. Removed by SAB 114
TOPIC 1: FINANCIAL STATEMENTS
A. Target Companies
Facts: Company X proposes to file a registration statement covering
an exchange offer to stockholders of Company Y, a publicly held
company. Company X asks Company Y to furnish information about its
business, including current audited financial statements, for inclusion
in the prospectus. Company Y declines to furnish such information.
Question 1: In filing the registration statement without the
required information about Company Y, may Company X rely on Rule 409 in
that the information is ``unknown or not reasonably available?''
Interpretive Response: Yes, but to determine whether such reliance
is justified, the staff requests the registrant to submit as
supplemental information copies of correspondence between the
registrant and the target company evidencing the request for and the
refusal to furnish the financial statements. In addition, the
prospectus must include any financial statements which are relevant and
available from the Commission's public files and must contain a
statement adequately describing the situation and the sources of
information about the target company. Other reliable sources of
financial information should also be utilized.
Question 2: Would the response change if Company Y was a closely
held company?
Interpretive Response: Yes. The staff does not believe that Rule
409 is applicable to negotiated transactions of this type.
B. Allocation of Expenses and Related Disclosure in Financial
Statements of Subsidiaries, Divisions or Lesser Business Components of
Another Entity
Facts: A company (the registrant) operates as a subsidiary of
another company (parent). Certain expenses incurred by the parent on
behalf of the subsidiary have not been charged to the subsidiary in the
past. The subsidiary files a registration statement under the
Securities Act of 1933 in connection with an initial public offering.
1. Costs Reflected in Historical Financial Statements
Question 1: Should the subsidiary's historical income statements
reflect all of the expenses that the parent incurred on its behalf?
Interpretive Response: In general, the staff believes that the
historical income statements of a registrant should reflect all of its
costs of doing business. Therefore, in specific situations, the staff
has required the subsidiary to revise its financial statements to
include certain expenses incurred by the parent on its behalf. Examples
of such expenses may include, but are not necessarily limited to, the
following (income taxes and interest are discussed separately below):
1. Officer and employee salaries,
2. Rent or depreciation,
3. Advertising,
4. Accounting and legal services, and
5. Other selling, general and administrative expenses.
When the subsidiary's financial statements have been previously
reported on by independent accountants and have been used other than
for internal purposes, the staff has accepted a presentation that shows
income before tax as previously reported, followed by adjustments for
expenses not previously allocated, income taxes, and adjusted net
income.
Question 2: How should the amount of expenses incurred on the
subsidiary's behalf by its parent be determined, and what disclosure is
required in the financial statements?
Interpretive Response: The staff expects any expenses clearly
applicable to the subsidiary to be reflected in its income statements.
However, the staff understands that in some situations a reasonable
method of allocating common expenses to the subsidiary (e.g.,
incremental or proportional cost allocation) must be chosen because
specific identification of expenses is not practicable. In these
situations, the staff has required an explanation of the allocation
method used in the notes to the financial statements along with
management's assertion that the method used is reasonable.
In addition, since agreements with related parties are by
definition not at arms length and may be changed at any time, the staff
has required footnote disclosure, when practicable, of management's
estimate of what the expenses (other than income taxes and interest
discussed separately below) would have been on a stand alone basis,
that is, the cost that would have been incurred if the subsidiary had
operated as an unaffiliated entity. The disclosure has been presented
for each year for which an income statement was required when such
basis produced materially different results.
Question 3: What are the staff's views with respect to the
accounting for and disclosure of the subsidiary's income tax expense?
Interpretive Response: Recently, a number of parent companies have
sold interests in subsidiaries, but have retained sufficient ownership
interests to permit continued inclusion of the subsidiaries in their
consolidated tax returns. The staff believes that it is material to
investors to know what the effect on income would have been if the
registrant had not been eligible to be included in a consolidated
income tax return with its parent. Some of these subsidiaries have
calculated their tax provision on the separate return basis,
[[Page 17196]]
which the staff believes is the preferable method. Others, however,
have used different allocation methods. When the historical income
statements in the filing do not reflect the tax provision on the
separate return basis, the staff has required a pro forma income
statement for the most recent year and interim period reflecting a tax
provision calculated on the separate return basis.\1\
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\1\ FASB ASC paragraph 740-10-30-27 (Income Taxes Topic) states:
``The consolidated amount of current and deferred tax expense for a
group that files a consolidated tax return shall be allocated among
the members of the group when those members issue separate financial
statements. * * * The method adopted * * * shall be systematic,
rational, and consistent with the broad principles established by
this Subtopic. A method that allocates current and deferred taxes to
members of the group by applying this Topic to each member as if it
were a separate taxpayer meets those criteria.''
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Question 4: Should the historical income statements reflect a
charge for interest on intercompany debt if no such charge had been
previously provided?
Interpretive Response: The staff generally believes that financial
statements are more useful to investors if they reflect all costs of
doing business, including interest costs. Because of the inherent
difficulty in distinguishing the elements of a subsidiary's capital
structure, the staff has not insisted that the historical income
statements include an interest charge on intercompany debt if such a
charge was not provided in the past, except when debt specifically
related to the operations of the subsidiary and previously carried on
the parent's books will henceforth be recorded in the subsidiary's
books. In any case, financing arrangements with the parent must be
discussed in a note to the financial statements. In this connection,
the staff has taken the position that, where an interest charge on
intercompany debt has not been provided, appropriate disclosure would
include an analysis of the intercompany accounts as well as the average
balance due to or from related parties for each period for which an
income statement is required. The analysis of the intercompany accounts
has taken the form of a listing of transactions (e.g., the allocation
of costs to the subsidiary, intercompany purchases, and cash transfers
between entities) for each period for which an income statement was
required, reconciled to the intercompany accounts reflected in the
balance sheets.
2. Pro Forma Financial Statements and Earnings per Share
Question: What disclosure should be made if the registrant's
historical financial statements are not indicative of the ongoing
entity (e.g., tax or other cost sharing agreements will be terminated
or revised)?
Interpretive Response: The registration statement should include
pro forma financial information that is in accordance with Article 11
of Regulation S-X and reflects the impact of terminated or revised cost
sharing agreements and other significant changes.
3. Other matters
Question: What is the staff's position with respect to dividends
declared by the subsidiary subsequent to the balance sheet date?
Interpretive Response: The staff believes that such dividends
either be given retroactive effect in the balance sheet with
appropriate footnote disclosure, or reflected in a pro forma balance
sheet. In addition, when the dividends are to be paid from the proceeds
of the offering, the staff believes it is appropriate to include pro
forma per share data (for the latest year and interim period only)
giving effect to the number of shares whose proceeds were to be used to
pay the dividend. A similar presentation is appropriate when dividends
exceed earnings in the current year, even though the stated use of
proceeds is other than for the payment of dividends. In these
situations, pro forma per share data should give effect to the increase
in the number of shares which, when multiplied by the offering price,
would be sufficient to replace the capital in excess of earnings being
withdrawn.
C. Unaudited Financial Statements for a Full Fiscal Year
Facts: Company A, which is a reporting company under the Securities
Exchange Act of 1934, proposes to file a registration statement within
90 days of its fiscal year end but does not have audited year-end
financial statements available. The company meets the criteria under
Rule 3-01(c) of Regulation S-X and is therefore not required to include
year-end audited financial statements in its registration statement.
However, the Company does propose to include in the prospectus the
unaudited results of operations for its entire fiscal year.
Question: Would the staff find this objectionable?
Interpretive Response: The staff recognizes that many registrants
publish the results of their most recent year's operations prior to the
availability of year-end audited financial statements. The staff will
not object to the inclusion of unaudited results for a full fiscal year
and indeed would expect such data in the registration statement if the
registrant has published such information. When such data is included
in a prospectus, it must be covered by a management's representation
that all adjustments necessary for a fair statement of the results have
been made.
D. Foreign Companies
1. Disclosures Required of Companies Complying With Item 17 of Form 20-
F
Facts: A foreign private issuer may use Form 20-F as a registration
statement under section 12 or as an annual report under section 13(a)
or 15(d) of the Exchange Act. The registrant must furnish the financial
statements specified in Item 17 of that form (Effective for fiscal
years ending on or after December 15, 2011, compliance with Item 18
rather than Item 17 will be required for all issuer financial
statements in all Securities Act registration statements, Exchange Act
registration statements on Form 20-F, and annual reports on Form 20-F.
See SEC Release No. 33-8959). However, in certain circumstances, Form
F-3 requires that the annual report include financial statements
complying with Item 18 of the form. Also, financial statements
complying with Item 18 are required for registration of securities
under the Securities Act in most circumstances. Item 17 permits the
registrant to use its financial statements that are prepared on a
comprehensive basis other than U.S. GAAP, but requires quantification
of the material differences in the principles, practices and methods of
accounting for any basis other than International Financial Reporting
Standards (IFRS) as issued by the International Accounting Standards
Board (IASB). An issuer complying with Item 18, other than those using
IFRS as issued by the IASB, must satisfy the requirements of Item 17
and also must provide all other information required by U.S. GAAP and
Regulation S-X.
Question: Assuming that the registrant's financial statements
include a discussion of material variances from U.S. GAAP along with
quantitative reconciliations of net income and material balance sheet
items, does Item 17 of Form 20-F require other disclosures in addition
to those prescribed by the standards and practices which comprise the
comprehensive basis on which the registrant's primary financial
statements are prepared?
Interpretive Response: No. The distinction between Items 17 and 18
is premised on a classification of the requirements of U.S. GAAP and
[[Page 17197]]
Regulation S-X into those that specify the methods of measuring the
amounts shown on the face of the financial statements and those
prescribing disclosures that explain, modify or supplement the
accounting measurements. Disclosures required by U.S. GAAP but not
required under the foreign GAAP on which the financial statements are
prepared need not be furnished pursuant to Item 17.
Notwithstanding the absence of a requirement for certain
disclosures within the body of the financial statements, some matters
routinely disclosed pursuant to U.S. GAAP may rise to a level of
materiality such that their disclosure is required by Item 5
(Management's Discussion and Analysis) of Form 20-F. Among other
things, this item calls for a discussion of any known trends, demands,
commitments, events or uncertainties that are reasonably likely to
affect liquidity, capital resources or the results of operations in a
material way. Also, instruction 2 of this item requires ``a discussion
of any aspects of the differences between foreign and U.S. GAAP, not
discussed in the reconciliation, that the registrant believes is
necessary for an understanding of the financial statements as a
whole.'' Matters that may warrant discussion in response to Item 5
include the following:
Material undisclosed uncertainties (such as reasonably
possible loss contingencies), commitments (such as those arising from
leases), and credit risk exposures and concentrations;
Material unrecognized obligations (such as pension
obligations);
Material changes in estimates and accounting methods, and
other factors or events affecting comparability;
Defaults on debt and material restrictions on dividends or
other legal constraints on the registrant's use of its assets;
Material changes in the relative amounts of constituent
elements comprising line items presented on the face of the financial
statements;
Significant terms of financings which would reveal
material cash requirements or constraints;
Material subsequent events, such as events that affect the
recoverability of recorded assets;
Material related party transactions (as addressed by FASB
ASC Topic 850, Related Party Disclosures) that may affect the terms
under which material revenues or expenses are recorded; and
Significant accounting policies and measurement
assumptions not disclosed in the financial statements, including
methods of costing inventory, recognizing revenues, and recording and
amortizing assets, which may bear upon an understanding of operating
trends or financial condition.
2. ``Free Distributions'' by Japanese Companies
Facts: It is the general practice in Japan for corporations to
issue ``free distributions'' of common stock to existing shareholders
in conjunction with offerings of common stock so that such offerings
may be made at less than market. These free distributions usually are
from 5 to 10 percent of outstanding stock and are accounted for in
accordance with provisions of the Commercial Code of Japan by a
transfer of the par value of the stock distributed from paid-in capital
to the common stock account. Similar distributions are sometimes made
at times other than when offering new stock and are also designated
``free distributions.'' U.S. accounting practice would require that the
fair value of such shares, if issued by U.S. companies, be transferred
from retained earnings to the appropriate capital accounts.
Question: Should the financial statements of Japanese corporations
included in Commission filings which are stated to be prepared in
accordance with U.S. GAAP be adjusted to account for stock
distributions of less than 25 percent of outstanding stock by
transferring the fair value of such stock from retained earnings to
appropriate capital accounts?
Interpretive Response: If registrants and their independent
accountants believe that the institutional and economic environment in
Japan with respect to the registrant is sufficiently different that
U.S. accounting principles for stock dividends should not apply to free
distributions, the staff will not object to such distributions being
accounted for at par value in accordance with Japanese practice. If
such financial statements are identified as being prepared in
accordance with U.S. GAAP, then there should be footnote disclosure of
the method being used which indicates that U.S. companies issuing
shares in comparable amounts would be required to account for them as
stock dividends, and including in such disclosure the fair value of any
such shares issued during the year and the cumulative amount (either in
an aggregate figure or a listing of the amounts by year) of the fair
value of shares issued over time.
E. Requirements for Audited or Certified Financial Statements
1. Removed by SAB 103
2. Qualified Auditors' Opinions
Facts: The accountants' report is qualified as to scope of audit,
or the accounting principles used.
Question: Does the staff consider the requirements for audited or
certified financial statements met when the auditors' opinion is so
qualified?
Interpretive Response: No. The staff does not accept as consistent
with the requirements of Rule 2-02(b) of Regulation S-X financial
statements on which the auditors' opinions are qualified because of a
limitation on the scope of the audit, since in these situations the
auditor was unable to perform all the procedures required by
professional standards to support the expression of an opinion. This
position was discussed in Accounting Series Release (ASR) 90 in
connection with representations concerning the verification of prior
years' inventories in first audits.
Financial statements for which the auditors' opinions contain
qualifications relating to the acceptability of accounting principles
used or the completeness of disclosures made are also unacceptable.
(See ASR 4, and with respect to a ``going concern'' qualification, ASR
115.)
F. Financial Statement Requirements in Filings Involving the Formation
of a One-Bank Holding Company
Facts: Holding Company A is organized for the purpose of issuing
common stock to acquire all of the common stock of Bank A. Under the
plan of reorganization, each share of common stock of Bank A will be
exchanged for one share of common stock of the holding company. The
shares of the holding company to be issued in the transaction will be
registered on Form S-4. The holding company will not engage in any
operations prior to consummation of the reorganization, and its only
significant asset after the transaction will be its investment in the
bank. The bank has been furnishing its shareholders with an annual
report that includes financial statements that comply with GAAP. Item
14 of Schedule 14A of the proxy rules provides that financial
statements generally are not necessary in proxy material relating only
to changes in legal organization (such as reorganizations involving the
issuer and one or more of its totally held subsidiaries).
Question 1: Must the financial statements and the information
required
[[Page 17198]]
by Securities Act Industry Guide (``Guide 3'') \2\ for Bank A be
included in the initial registration statement on Form S-4?
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\2\ Item 801 of Regulation S-K.
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Interpretive Response: No, provided that certain conditions are
met. The staff will not take exception to the omission of financial
statements and Guide 3 information in the initial registration
statement on Form S-4 if all of the following conditions are met:
There are no anticipated changes in the shareholders'
relative equity ownership interest in the underlying bank assets,
except for redemption of no more than a nominal number of shares of
unaffiliated persons who dissent;
In the aggregate, only nominal borrowings are to be
incurred for such purposes as organizing the holding company, to pay
nonaffiliated persons who dissent, or to meet minimum capital
requirements;
There are no new classes of stock authorized other than
those corresponding to the stock of Bank A immediately prior to the
reorganization;
There are no plans or arrangements to issue any additional
shares to acquire any business other than Bank A; and,
There has been no material adverse change in the financial
condition of the bank since the latest fiscal year-end included in the
annual report to shareholders.
If at the time of filing the S-4, a letter is furnished to the staff
stating that all of these conditions are met, it will not be necessary
to request the Division of Corporation Finance to waive the financial
statement or Guide 3 requirements of Form S-4.
Although the financial statements may be omitted, the filing should
include a section captioned, ``Financial Statements,'' which states
either that an annual report containing financial statements for at
least the latest fiscal year prepared in conformity with GAAP was
previously furnished to shareholders or is being delivered with the
prospectus. If financial statements have been previously furnished, it
should be indicated that an additional copy of such report for the
latest fiscal year will be furnished promptly upon request without
charge to shareholders. The name and address of the person to whom the
request should be made should be provided. One copy of such annual
report should be furnished supplementally with the initial filing for
purposes of staff review.
If any nominal amounts are to be borrowed in connection with the
formation of the holding company, a statement of capitalization should
be included in the filing which shows Bank A on an historical basis,
the pro forma adjustments, and the holding company on a pro forma
basis. A note should also explain the pro forma effect, in total and
per share, which the borrowings would have had on net income for the
latest fiscal year if the transaction had occurred at the beginning of
the period.
Question 2: Are the financial statements of Bank A required to be
audited for purposes of the initial Form S-4 or the subsequent Form 10-
K report?
Interpretive Response: The staff will not insist that the financial
statements in the annual report to shareholders used to satisfy the
requirement of the initial Form S-4 be audited.
The consolidated financial statements of the holding company to be
included in the registrant's initial report on Form 10-K should comply
with the applicable financial statement requirements in Regulation S-X
at the time such annual report is filed. However, the regulations also
provide that the staff may allow one or more of the required statements
to be unaudited where it is consistent with the protection of
investors.\3\ Accordingly, the policy of the Division of Corporation
Finance is as follows:
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\3\ Rule 3-13 of Regulation S-X.
The registrant should file audited balance sheets as of the two
most recent fiscal years and audited statements of income and cash
flows for each of the three latest fiscal years, with appropriate
footnotes and schedules as required by Regulation S-X unless the
financial statements have not previously been audited for the
periods required to be filed. In such cases, the Division will not
object if the financial statements in the first annual report on
Form 10-K (or the special report filed pursuant to Rule 15d-2) \4\
are audited only for the two latest fiscal years.\5\ This policy
only applies to filings on Form 10-K, and not to any Securities Act
filings made after the initial S-4 filing.
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\4\ Rule 15d-2 would be applicable if the annual report
furnished with the Form S-4 was not for the registrant's most recent
fiscal year. In such a situation, Rule 15d-2 would require the
registrant to file a special report within 90 days after the
effective date of the Form S-4 furnishing audited financial
statements for the most recent fiscal year.
\5\ Unaudited statements of income and cash flows should be
furnished for the earliest period.
The above procedure may be followed without making a specific request
of the Division of Corporation Finance for a waiver of the financial
statement requirements of Form 10-K.
The information required by Guide 3 should also be provided in the
Form 10-K for at least the periods for which audited financial
statements are furnished. If some of the statistical information for
the two most recent fiscal years for which audited financial statements
are included (other than information on nonperforming loans and the
summary of loan loss experience) is unavailable and cannot be obtained
without unwarranted or undue burden or expense, such data may be
omitted provided a brief explanation in support of such representation
is included in the report on Form 10-K. In all cases, however,
information with respect to nonperforming loans and loan loss
experience, or reasonably comparable data, must be furnished for at
least the two latest fiscal years in the initial 10-K. Thereafter, for
subsequent years in reports on Form 10-K, all of the Guide 3
information is required; Guide 3 information which had been omitted in
the initial 10-K in accordance with the above procedure can be excluded
in any subsequent 10-Ks.
G. Removed by Financial Reporting Release (FRR) 55
H. Removed by FRR 55
I. Financial Statements of Properties Securing Mortgage Loans
Facts: A registrant files a Securities Act registration statement
covering a maximum of $100 million of securities. Proceeds of the
offering will be used to make mortgage loans on operating residential
or commercial property. Proceeds of the offering will be placed in
escrow until $1 million of securities are sold at which point escrow
may be broken, making the proceeds immediately available for lending,
while the selling of securities would continue.
Question 1: Under what circumstances are the financial statements
of a property on which the registrant makes or expects to make a loan
required to be included in a filing?
Interpretive Response: Rule 3-14 of Regulation S-X specifies the
requirements for financial statements when the registrant has acquired
one or more properties which in the aggregate are significant, or since
the date of the latest balance sheet required has acquired or proposes
to acquire one or more properties which in the aggregate are
significant.
Included in the category of properties acquired or to be acquired
under Rule 3-14 are operating properties underlying certain mortgage
loans, which in economic substance represent an investment in real
estate or a joint venture rather than a loan. Certain characteristics
of a lending arrangement indicate that the ``lender'' has the same
risks and potential rewards as an owner or joint venturer. Those
characteristics
[[Page 17199]]
are set forth in the Acquisition, Development, and Construction
Arrangements (ADC Arrangements) Subsection of FASB ASC Subtopic 310-10,
Receivables--Overall.6 7 In September 1986 the EITF \8\
reached a consensus on this issue \9\ to the effect that, although the
guidance in the ADC Arrangements Subsection of FASB ASC Subtopic 310-10
was issued to address the real estate ADC arrangements of financial
institutions, preparers and auditors should consider that guidance in
accounting for shared appreciation mortgages, loans on operating real
estate and real estate ADC arrangements entered into by enterprises
other than financial institutions.
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\6\ [Original footnote removed by SAB 114.]
\7\ [Original footnote removed by SAB 114.]
\8\ The Emerging Issues Task Force (``EITF'') was formed in 1984
to assist the Financial Accounting Standards Board in the early
identification and resolution of emerging accounting issues. Topics
to be discussed by the EITF are publicly announced prior to its
meetings and minutes of all EITF meetings are available to the
public.
\9\ FASB ASC paragraph 310-10-05-9.
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FASB ASC Subtopic 815-15, Derivatives and Hedging--Embedded
Derivatives, generally requires that embedded instruments meeting the
definition of a derivative and not clearly and closely related to the
host contract be accounted for separately from the host instrument. If
the embedded expected residual profit component of an ADC arrangement
need not be separately accounted for as a derivative under FASB ASC
Topic 815, then the disclosure requirements discussed below for ADC
loans and similar arrangements should be followed.\10\
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\10\ The equity kicker (the expected residual profit) would
typically not be separated from the host contract and accounted for
as a derivative because FASB ASC subparagraph 815-15-25-1(c) exempts
a hybrid contract from bifurcation if a separate instrument with the
same terms as the embedded equity kicker is not a derivative
instrument subject to the requirements of FASB ASC Topic 815.
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In certain cases the ``lender'' has virtually the same potential
rewards as those of an owner or a joint venturer by virtue of
participating in expected residual profit.\11\ In addition, the ADC
Arrangements Subsection of FASB ASC Subtopic 310-10 includes a number
of other characteristics which, when considered individually or in
combination, would suggest that the risks of an ADC arrangement are
similar to those associated with an investment in real estate or a
joint venture or, conversely, that they are similar to those associated
with a loan. Among those other characteristics is whether the lender
agrees to provide all or substantially all necessary funds to acquire
the property, resulting in the borrower having title to, but little or
no equity in, the underlying property. The staff believes that the
borrower's equity in the property is adequate to support accounting for
the transaction as a mortgage loan when the borrower's initial
investment meets the criteria in FASB ASC paragraph 360-20-40-18
(Property, Plant, and Equipment Topic) \12\ and the borrower's payments
of principal and interest on the loan are adequate to maintain a
continuing investment in the property which meets the criteria in FASB
ASC paragraph 360-20-40-19.\13\
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\11\ Expected residual profit is defined in the ADC Arrangements
Subsection of FASB ASC Subtopic 310-10 as the amount of profit,
whether called interest or another name, such as equity kicker,
above a reasonable amount of interest and fees expected to be earned
by the ``lender.''
\12\ FASB ASC Subtopic 360-20 establishes standards for the
recognition of profit on real estate sales transactions. FASB ASC
paragraph 360-20-40-18 states that the buyer's initial investment
shall be adequate to demonstrate the buyer's commitment to pay for
the property and shall indicate a reasonable likelihood that the
seller will collect the receivable. Guidance on minimum initial
investments in various types of real estate is provided in FASB ASC
paragraphs 360-20-40-55-1 and 360-20-40-55-2.
\13\ FASB ASC paragraph 360-20-40-19 states that the buyer's
continuing investment in a real estate transaction shall not qualify
unless the buyer is contractually required to pay each year on its
total debt for the purchase price of the property an amount at least
equal to the level annual payment that would be needed to pay that
debt and interest on the unpaid balance over not more than (a) 20
years for debt for land and (b) the customary amortization term of a
first mortgage loan by an independent established lending
institution for other real estate.
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The financial statements of properties which will secure mortgage
loans made or to be made from the proceeds of the offering which have
the characteristics of real estate investments or joint ventures should
be included as required by Rule 3-14 in the registration statement when
such properties secure loans previously made, or have been identified
as security for probable loans prior to effectiveness, and in filings
made pursuant to the undertaking in Item 20D of Securities Act Industry
Guide 5.
Rule 1-02(w) of Regulation S-X includes the conditions used in
determining whether an acquisition is significant. The separate
financial statements of an individual property should be provided when
a property would meet the requirements for a significant subsidiary
under this rule using the amount of the ``loan'' as a substitute for
the ``investment in the subsidiary'' in computing the specified
conditions. The combined financial statements of properties which are
not individually significant should also be provided. However, the
staff will not object if the combined financial statements of such
properties are not included if none of the conditions specified in Rule
1-02(w), with respect to all such properties combined, exceeds 20% in
the aggregate.
Under certain circumstances, information may also be required
regarding operating properties underlying mortgage loans where the
terms do not result in the lender having virtually the same risks and
potential rewards as those of owners or joint venturers. Generally, the
staff believes that, where investment risks exist due to substantial
asset concentration, financial and other information should be included
regarding operating properties underlying a mortgage loan that
represents a significant amount of the registrant's assets. Such
presentation is consistent with Rule 3-13 of Regulation S-X and Rule
408 under the Securities Act of 1933.
Where the amount of a loan exceeds 20% of the amount in good faith
expected to be raised in the offering, disclosures would be expected to
consist of financial statements for the underlying operating properties
for the periods contemplated by Rule 3-14. Further, where loans on
related properties are made to a single person or group of affiliated
persons which in the aggregate amount to more than 20% of the amount
expected to be raised, the staff believes that such lending
arrangements result in a sufficient concentration of assets so as to
warrant the inclusion of financial and other information regarding the
underlying properties.
Question 2: Will the financial statements of the mortgaged
properties be required in filings made under the 1934 Act?
Interpretive Response: Rule 3-09 of Regulation S-X specifies the
requirement for significant, as defined, investments in operating
entities, the operations of which are not included in the registrant's
consolidated financial statements.\14\ Accordingly, the staff believes
that the financial statements of properties securing significant loans
which have the characteristics of real
[[Page 17200]]
estate investments or joint ventures should be included in subsequent
filings as required by Rule 3-09. The materiality threshold for
determining whether such an investment is significant is the same as
set forth in paragraph (a) of that Rule.\15\
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\14\ Rule 3-14 states that the financial statements of an
acquired property should be furnished if the acquisition took place
during the period for which the registrant's income statements are
required. Paragraph (b) of the Rule states that the information
required by the Rule is not required to be included in a filing on
Form 10-K. That exception is consistent with Item 8 of Form 10-K
which excludes acquired company financial statements, which would
otherwise be required by Rule 3-05 of Regulation S-X, from inclusion
in filings on that Form. Those exceptions are based, in part, on the
fact that acquired properties and acquired companies will generally
be included in the registrant's consolidated financial statements
from the acquisition date.
\15\ Rule 3-09(a) states, in part, that ``[i]f any of the
conditions set forth in [Rule] 1-02(w), substituting 20 percent for
10 percent in the tests used therein to determine significant
subsidiary, are met * * * separate financial statements * * * shall
be filed.''
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Likewise, the staff believes that filings made under the 1934 Act
should include the same financial and other information relating to
properties underlying any loans which are significant as discussed in
the last paragraph of Question 1, except that in the determination of
significance the 20% disclosure threshold should be measured using
total assets. The staff believes that this presentation would be
consistent with Rule 12b-20 under the Securities Exchange Act of 1934.
Question 3: The interpretive response to question 1 indicates that
the staff believes that the borrower's equity in an operating property
is adequate to support accounting for the transaction as a mortgage
loan when the borrower's initial investment meets the criteria in FASB
ASC paragraph 360-20-40-18 and the borrower's payments of principal and
interest on the loan are adequate to maintain a continuing investment
in the property which meets the criteria in FASB ASC paragraph 360-20-
40-19. Is it the staff's view that meeting these criteria is the only
way the borrower's equity in the property is considered adequate to
support accounting for the transaction as a mortgage loan?
Interpretive Response: No. It is the staff's position that the
determination of whether loan accounting is appropriate for these
arrangements should be made by the registrant and its independent
accountants based on the facts and circumstances of the individual
arrangements, using the guidance provided in the ADC Arrangements
Subsection of FASB ASC Subtopic 310-10. As stated in that Subsection,
loan accounting may not be appropriate when the lender participates in
expected residual profit and has virtually the same risks as those of
an owner, or joint venturer. In assessing the question of whether the
lender has virtually the same risks as an owner, or joint venturer, the
essential test that needs to be addressed is whether the borrower has
and is expected to continue to have a substantial amount at risk in the
project.\16\ The criteria described in FASB ASC Subtopic 360-20,
Property, Plant, and Equipment--Real Estate Sales, provide a ``safe
harbor'' for determining whether the borrower has a substantial amount
at risk in the form of a substantial equity investment. The borrower
may have a substantial amount at risk without meeting the criteria
described in FASB ASC Subtopic 360-20.
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\16\ Regarding the composition of the borrower's investment,
FASB ASC paragraph 310-10-25-20 indicates that the borrower's
investment may include the value of land or other assets contributed
by the borrower, net of encumbrances. The staff emphasizes that such
paragraph indicates, ``* * * recently acquired property generally
should be valued at no higher than cost * * *'' Thus, for such
recently acquired property, appraisals will not be sufficient to
justify the use of a value in excess of cost.
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Question 4: What financial statements should be included in filings
made under the Securities Act regarding investment-type arrangements
that individually amount to 10% or more of total assets?
Interpretive Response: In the staff's view, separate audited
financial statements should be provided for any investment-type
arrangement that constitutes 10% or more of the greater of (i) the
amount of minimum proceeds or (ii) the total assets of the registrant,
including the amount of proceeds raised, as of the date the filing is
required to be made. Of course, the narrative information required by
items 14 and 15 of Form S-11 should also be included with respect to
these investment-type arrangements.
Question 5: What information must be provided under the Securities
Act for investment-type arrangements that individually amount to less
than 10%?
Interpretive Response: No specific financial information need be
presented for investment-type arrangements that amount to less than
10%. However, where such arrangements aggregate more than 20%, a
narrative description of the general character of the properties and
arrangements should be included that gives an investor an understanding
of the risks and rewards associated with these arrangements. Such
information may, for example, include a description of the terms of the
arrangements, participation by the registrant in expected residual
profits, and property types and locations.
Question 6: What financial statements should be included in annual
reports filed under the Exchange Act with respect to investment-type
arrangements that constitute 10% or more of the registrant's total
assets?
Interpretive Response: In annual reports filed with the Commission,
the staff has advised registrants that separate audited financial
statements should be provided for each nonconsolidated investment-type
arrangement that is 20% or more of the registrant's total assets. While
the distribution is on-going, however, the percentage may be calculated
using the greater of (i) the amount of the minimum proceeds or (ii) the
total assets of the registrant, including the amount of proceeds
raised, as of the date the filing is required to be made. In annual
reports to shareholders registrants may either include the separate
audited financial statements for 20% or more nonconsolidated
investment-type arrangements or, if those financial statements are not
included, present summarized financial information for those
arrangements in the notes to the registrant's financial statements.
The staff has also indicated that separate summarized financial
information (as defined in Rule 1-02(bb) of Regulation S-X) should be
provided in the footnotes to the registrant's financial statements for
each nonconsolidated investment-type arrangement that is 10% or more
but less than 20%. Of course, registrants should also make appropriate
textural disclosure with respect to material investment-type
arrangements in the ``business'' and ``property'' sections of their
annual reports to the Commission.\17\
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\17\ Registrants are reminded that in filings on Form 8-K that
are triggered in connection with an acquisition of an investment-
type arrangement, separate audited financial statements are required
for any such arrangement that individually constitutes 10% or more.
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Question 7: What information should be provided in annual reports
filed under the Exchange Act with respect to investment-type
arrangements that do not meet the 10% threshold?
Interpretive Response: The staff believes it will not be necessary
to provide any financial information (full or summarized) for
investment-type arrangements that do not meet the 10% threshold.
However, in the staff's view, where such arrangements aggregate more
than 20%, a narrative description of the general character of the
properties and arrangements would be necessary. The staff believes that
information should be included that would give an investor an
understanding of the risks and rewards associated with these
arrangements. Such information may, for example, include a description
of the terms of the arrangements, participation by the registrant in
expected residual profits, and property types and locations. Of course,
disclosure regarding the operations of such components should be
included as part
[[Page 17201]]
of the Management's Discussion and Analysis where there is a known
trend or uncertainty in the operations of such properties, either
individually or in the aggregate, which would be reasonably likely to
result in a material impact on the registrant's future operations,
liquidity or capital resources.
J. Application of Rule 3-05 in Initial Public Offerings
Facts: Rule 3-05 of Regulation S-X establishes the financial
statement requirements for businesses acquired or to be acquired. If
required, financial statements must be provided for one, two or three
years depending upon the relative significance of the acquired entity
as determined by the application of Rule 1-02(w) of Regulation S-X. The
calculations required for these tests are applied by comparison of the
financial data of the registrant and acquiree(s) for the fiscal years
most recently completed prior to the acquisition. The staff has
recognized that these tests literally applied in some initial public
offerings may require financial statements for an acquired entity which
may not be significant to investors because the registrant has had
substantial growth in assets and earnings in recent years.\18\
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\18\ An acquisition which was relatively significant in the
earliest year for which a registrant is required to file financial
statements may be insignificant to its latest fiscal year due to
internal growth and/or subsequent acquisitions. Literally applied,
Rules 3-05 and 1-02(w) might still require separate financial
statements for the now insignificant acquisition.
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Question: How should Rules 3-05 and 1-02(w) of Regulation S-X be
applied in determining the periods for which financial statements of
acquirees are required to be included in registration statements for
initial public offerings?
Interpretive Response: It is the staff's view that initial public
offerings involving businesses that have been built by the aggregation
of discrete businesses that remain substantially intact after
acquisition \19\ were not contemplated during the drafting of Rule 3-05
and that the significance of an acquired entity in such situations may
be better measured in relation to the size of the registrant at the
time the registration statement is filed, rather than its size at the
time the acquisition was made. Therefore, for a first time registrant,
the staff has indicated that in applying the significance tests in Rule
3-05, the three tests in Rule 1-02(w) generally can be measured against
the combined entities, including those to be acquired, which comprise
the registrant at the time the registration statement is filed. The
staff's policy is intended to ensure that the registration statement
will include not less than three, two and one year(s) of audited
financial statements for not less than 60%, 80% and 90%, respectively,
of the constituent businesses that will comprise the registrant on an
ongoing basis. In all circumstances, the audited financial statements
of the registrant are required for three years, or since its inception
if less than three years. The requirement to provide the audited
financial statements of a constituent business in the registration
statement is satisfied for the post-acquisition period by including the
entity's results in the audited consolidated financial statements of
the registrant. If additional periods are required, the entity's
separate audited financial statements for the immediate pre-acquisition
period(s) should be presented.\20\
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\19\ For example, nursing homes, hospitals or cable TV systems.
This interpretation would not apply to businesses for which the
relative significance of one portion of the business to the total
business may be altered by post-acquisition decisions as to the
allocation of incoming orders between plants or locations. This
bulletin does not address all possible cases in which similar relief
may be appropriate but, rather, attempts to describe a general
framework within which administrative policy has been established.
In other distinguishable situations, registrants may request relief
as appropriate to their individual facts and circumstances.
\20\ If audited pre-acquisition financial statements of a
business are necessary pursuant to the alternative tests described
here, the interim period following that entity's latest pre-
acquisition fiscal year end but prior to its acquisition by the
registrant generally would be required to be audited.
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In order for the pre-acquisition audited financial statements of an
acquiree to be omitted from the registration statement, the following
conditions must be met:
a. The combined significance of businesses acquired or to be
acquired for which audited financial statements cover a period of less
than 9 months \21\ may not exceed 10%;
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\21\ As a matter of policy the staff accepts financial
statements for periods of not less than 9, 21 and 33 consecutive
months (not more than 12 months may be included in any period
reported on) as substantial compliance with requirements for
financial statements for 1, 2 and 3 years, respectively.
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b. The combined significance of businesses acquired or to be
acquired for which audited financial statements cover a period of less
than 21 months may not exceed 20%; and
c. The combined significance of businesses acquired or to be
acquired for which audited financial statements cover a period of less
than 33 months may not exceed 40%.
Combined significance is the total, for all included companies, of
each individual company's highest level of significance computed under
the three tests of significance. The significance tests should be
applied to pro forma financial statements of the registrant, prepared
in a manner consistent with Article 11 of Regulation S-X. The pro forma
balance sheet should be as of the date of the registrant's latest
balance sheet included in the registration statement, and should give
effect to businesses acquired subsequent to the end of the latest year
or to be acquired as if they had been acquired on that date. The pro
forma statement of operations should be for the registrant's most
recent fiscal year included in the registration statement and should
give effect to all acquisitions consummated during and subsequent to
the end of the year and probable acquisitions as if they had been
consummated at the beginning of that fiscal year.
The three tests specified in Rule 1-02(w) should be made in
comparison to the registrant's pro forma consolidated assets and pretax
income from continuing operations. The assets and pretax income of the
acquired businesses which are being evaluated for significance should
reflect any new cost basis arising from purchase accounting.
Example: On February 20, 20X9 Registrant files Form S-1
containing its audited consolidated financial statements as of and
for the three years ended December 31, 20X8. Acquisitions since
inception have been:
----------------------------------------------------------------------------------------------------------------
Highest
significance at
Acquiree Fiscal year end Date of acquisition acquisition
(percent)
----------------------------------------------------------------------------------------------------------------
A...................................... 3/31 1/1/x7........................... 60
B...................................... 7/31 4/1/x7........................... 45
C...................................... 9/30 9/1/x7........................... 40
D...................................... 12/31 2/1/x8........................... 21
E...................................... 3/31 11/1/x8.......................... 11
[[Page 17202]]
F...................................... 12/31 To be acquired................... 11
----------------------------------------------------------------------------------------------------------------
The following table reflects the application of the significance
tests to the combined financial information at the time the
registration statement is filed.
----------------------------------------------------------------------------------------------------------------
Significance of
--------------------------------------------------------- Highest level of
Component entity Earnings Investment significance
Assets (percent) (percent) (percent)
----------------------------------------------------------------------------------------------------------------
A................................... 12 23 12 23
B................................... 10 21 10 21
C................................... 21 3 4 21
D................................... 10 5 13 13
E................................... 4 * 9 3 9
F................................... 2 11 6 11
----------------------------------------------------------------------------------------------------------------
* Loss.
Year 1 (most recent fiscal year)--Entity E is the only acquiree for
which pre-acquisition financial statements may be omitted for the
latest year since significance for each other entity exceeds 10% under
one or more test.
Year 2 (preceding fiscal year)--Financial statements for E and F
may be omitted since their combined significance is 20% and no other
combination can be formed with E which would not exceed 20%.
Year 3 (second preceding fiscal year)--Financial statements for D,
E and F may be omitted since the combined significance of these
entities is 33% \22\ and no other combination can be formed with E and
F which would not exceed 40%.
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\22\ Combined significance is the sum of the significance of D's
investment test (13%), E's earnings test (9%) and F's earnings test
(11%).
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The financial statement requirements must be satisfied by filing
separate pre-acquisition audited financial statements for each entity
that was not included in the consolidated financial statements for the
periods set forth above. The following table illustrates the
requirements for this example.
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\23\ The audited pre-acquisition period need not correspond to
the acquiree's pre-acquisition fiscal year. However, audited periods
must not be for periods in excess of 12 months.
----------------------------------------------------------------------------------------------------------------
Period in
Minimum financial consolidated Separate pre-
Component entity Date of statement financial acquisition
acquisition requirement statements audited financial
(months) statement
----------------------------------------------------------------------------------------------------------------
Registrant.......................... N/A 33 36 .................
A................................... 1/1/x7 33 24 9
B................................... 4/1/x7 33 21 \23\ 12
C................................... 9/1/x7 33 16 17
D................................... 2/1/x8 21 11 10
E................................... 11/1/x8 ................. 2 .................
F................................... To be acquired. 9 ................. 9
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K. Financial Statements of Acquired Troubled Financial Institutions
Facts: Federally insured depository institutions are subject to
regulatory oversight by various Federal agencies including the Federal
Reserve, Office of the Comptroller of the Currency, Federal Deposit
Insurance Corporation and Office of Thrift Supervision. During the
1980s, certain of these institutions experienced significant financial
difficulties resulting in their inability to meet necessary capital and
other regulatory requirements. The Financial Institutions Reform,
Recovery and Enforcement Act of 1989 was adopted to address various
issues affecting this industry.
Many troubled institutions have merged into stronger institutions
or reduced the scale of their operations through the sale of branches
and other assets pursuant to recommendation or directives of the
regulatory agencies. In other situations, institutions that were taken
over by or operated under the management of a Federal regulator have
been reorganized, sold or transferred by that Federal agency to
financial and nonfinancial companies.
A number of registrants have acquired, or are contemplating
acquisition of, these troubled financial institutions. Complete audited
financial statements of the institutions for the periods necessary to
comply fully with Rule 3-05 of Regulation S-X may not be reasonably
available in some cases. Some troubled institutions have never obtained
an audit while others have been operated under receivership by
regulators for a significant period without audit. Auditors' reports on
the financial statements of some of these acquirees may not satisfy the
requirements of Rule 2-02 of Regulation S-X because they contain
qualifications due to audit scope limitations or disclaim an opinion.
[[Page 17203]]
A registrant that acquires a troubled financial institution for
which complete audited financial statements are not reasonably
available may be precluded from raising capital through a public
offering of securities for up to three years following the acquisition
because of the inability to comply with Rule 3-05.
Question 1: Are there circumstances under which the staff would
conclude that financial statements of an acquired troubled financial
institution are not required by Rule 3-05?
Interpretive Response: Yes. In some case, financial statements will
not be required because there is not sufficient continuity of the
acquired entity's operations prior to and after the acquisition, so
that disclosure of prior financial information is material to an
understanding of future operations, as discussed in Rule 11-01 of
Regulation S-X. For example, such a circumstance may exist in the case
of an acquisition solely of the physical facilities of a banking branch
with assumption of the related deposits if neither income-producing
assets (other than treasury bills and similar low-risk investment) nor
the management responsible for its historical investment and lending
activities transfer with the branch to the registrant. In this and
other circumstances, where the registrant can persuasively demonstrate
that continuity of operations is substantially lacking and a
representation to this effect is included in the filing, the staff will
not object to the omission of financial statements. However, applicable
disclosures specified by Industry Guide 3, Article 11 of Regulation S-X
(pro forma information), and other information which is descriptive of
the transaction and of the assets acquired and liabilities assumed
should be furnished to the extent reasonably available.
Question 2: If the acquired financial institution is found to
constitute a business having material continuity of operations after
the transaction, are there circumstances in which the staff will waive
the requirements of Rule 3-05?
Interpretive Response: Yes. The staff believes the circumstances
surrounding the present restructuring of U.S. depository institutions
are unique. Accordingly, the staff has identified situations in which
it will grant a waiver of the requirements of Rule 3-05 of Regulation
S-X to the extent that audited financial statements are not reasonably
available.
For purposes of this waiver a ``troubled financial institution'' is
one which either:
1. Is in receivership, conservatorship or is otherwise operating
under a similar supervisory agreement with a Federal financial
regulatory agency; or
2. Is controlled by a Federal regulatory agency; or
3. Is acquired in a Federally assisted transaction.
A registrant that acquires a troubled financial institution that is
deemed significant pursuant to Rule 3-05 may omit audited financial
statements of the acquired entity, if such statements are not
reasonably available and the total acquired assets of the troubled
institution do not exceed 20% of the registrant's assets before giving
effect to the acquisition. The staff will consider requests for waivers
in situations involving more significant acquisitions, where Federal
financial assistance or guarantees are an essential part of the
transaction, or where the nature and magnitude of Federal assistance is
so pervasive as to substantially reduce the relevance of such
information to an assessment of future operations. Where financial
statements are waived, disclosure concerning the acquired business as
outlined in response to Question 3 must be furnished.
Question 3: Where historical financial statements meeting the
requirements of Rule 3-05 of Regulation S-X are waived, what financial
statements and other disclosures would the staff expect to be provided
in filings with the Commission?
Interpretive Response: Where complete audited historical financial
statements of a significant acquiree that is a troubled financial
institution are not provided, the staff would expect filings to include
an audited statement of assets acquired and liabilities assumed if the
acquisition is not already reflected in the registrant's most recent
audited balance sheet at the time the filing is made. Where reasonably
available, unaudited statement of operations and cash flows that are
prepared in accordance with GAAP and otherwise comply with Regulation
S-X should be filed in lieu of any audited financial statements which
are not provided if historical information may be relevant.
In all cases where a registrant succeeds to assets and/or
liabilities of a troubled financial institution which are significant
to the registrant pursuant to the tests in Rule 1-02(w) of Regulation
S-X, narrative description should be required, quantified to the extent
practicable, of the anticipated effects of the acquisition on the
registrant's financial condition, liquidity, capital resources and
operating results. If Federal financial assistance (including any
commitments, agreements or understandings made with respect to capital,
accounting or other forbearances) may be material, the limits,
conditions and other variables affecting its availability should be
disclosed, along with an analysis of its likely short term and long
term effects on cash flows and reported results.
If the transaction will result in the recognition of any
significant intangibles that cannot be separately sold, such as
goodwill or a core deposit intangible, the discussion of the
transaction should describe the amount of such intangibles, the
necessarily subjective nature of the estimation of the life (in the
case of intangibles subject to amortization) and value of such
intangibles, and the effects upon future results of operations,
liquidity and capital resources, including any consequences if a
recognized intangible will be excluded from the calculation of capital
for regulatory purposes. The discussion of the impact on future
operations should specifically address the period over which
intangibles subject to amortization will be amortized and the period
over which any discounts on acquired assets will be taken into income.
If amortization of intangibles subject to amortization will be over a
period which differs from the period over which income from discounts
on acquired assets will be recognized (whether from amortization of
discounts or sale of discounted assets), disclosure should be provided
concerning the disparate effects of the amortization and income
recognition on operating results for all affected periods.
Information specified by Industry Guide 3 should be furnished to
the extent applicable and reasonably available. For the categories
identified in the Industry Guide, the registrant should disclose the
fair value of loans and investments acquired, as well as their
principal amount and average contractual yield and term. Amounts of
acquired investments, loans, or other assets that are nonaccrual, past
due or restructured, or for which other collectibility problems are
indicated should be disclosed. Where historical financial statements of
the acquired entity are furnished, pro forma information presented
pursuant to Rule 11-02 should be supplemented as necessary with a
discussion of the likely effects of any Federal assistance and changes
in operations subsequent to the acquisition. To the extent historical
financial statements meeting all the requirements of Rule 3-05 are not
furnished, the filing should include an explanation of the basis for
their omission.
[[Page 17204]]
Question 4: If an audited statement of assets acquired and
liabilities assumed is required, but certain of the assets conveyed in
the transaction are subject to rights allowing the registrant to put
the assets back to the seller upon completion of a due diligence
review, will the staff grant an extension of time for filing the
required financial statement until the put period lapses?
Interpretive Response: If it is impracticable to provide an audited
statement at the time the Form 8-K reporting the transaction is filed,
an extension of time is available under certain circumstances.
Specifically, if more than 25% of the acquired assets may be put and
the put period does not exceed 120 days, the registrant should timely
file a statement of assets acquired and liabilities assumed on an
unaudited basis with full disclosure of the terms and amounts of the
put arrangement. Within 21 days after the put period lapses, the
registrant should furnish an audited statement of assets acquired and
liabilities assumed unless the effects of the transaction are already
reflected in an audited balance sheet which has been filed with the
Commission. However, until the audited financial statement has been
filed, certain offerings under the Securities Act of 1933 would be
prevented, as described in the instructions to Item 9.01 of Form 8-K.
L. Removed by SAB 103
M. Materiality
1. Assessing Materiality
Facts: During the course of preparing or auditing year-end
financial statements, financial management or the registrant's
independent auditor becomes aware of misstatements in a registrant's
financial statements. When combined, the misstatements result in a 4%
overstatement of net income and a $.02 (4%) overstatement of earnings
per share. Because no item in the registrant's consolidated financial
statements is misstated by more than 5%, management and the independent
auditor conclude that the deviation from GAAP is immaterial and that
the accounting is permissible.\24\
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\24\ AU 312 states that the auditor should consider audit risk
and materiality both in (a) planning and setting the scope for the
audit and (b) evaluating whether the financial statements taken as a
whole are fairly presented in all material respects in conformity
with GAAP. The purpose of this SAB is to provide guidance to
financial management and independent auditors with respect to the
evaluation of the materiality of misstatements that are identified
in the audit process or preparation of the financial statements
(i.e., (b) above). This SAB is not intended to provide definitive
guidance for assessing ``materiality'' in other contexts, such as
evaluations of auditor independence, as other factors may apply.
There may be other rules that address financial presentation. See,
e.g., Rule 2a-4, 17 CFR 270.2a-4, under the Investment Company Act
of 1940.
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Question: FASB ASC paragraph 105-10-05-6 (Generally Accepted
Accounting Principles Topic) states, ``The provisions of the
Codification need not be applied to immaterial items.'' In the staff's
view, may a registrant or the auditor of its financial statements
assume the immateriality of items that fall below a percentage
threshold set by management or the auditor to determine whether amounts
and items are material to the financial statements?
Interpretive Response: No. The staff is aware that certain
registrants, over time, have developed quantitative thresholds as
``rules of thumb'' to assist in the preparation of their financial
statements, and that auditors also have used these thresholds in their
evaluation of whether items might be considered material to users of a
registrant's financial statements. One rule of thumb in particular
suggests that the misstatement or omission \25\ of an item that falls
under a 5% threshold is not material in the absence of particularly
egregious circumstances, such as self-dealing or misappropriation by
senior management. The staff reminds registrants and the auditors of
their financial statements that exclusive reliance on this or any
percentage or numerical threshold has no basis in the accounting
literature or the law.
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\25\ As used in this SAB, ``misstatement'' or ``omission''
refers to a financial statement assertion that would not be in
conformity with GAAP.
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The use of a percentage as a numerical threshold, such as 5%, may
provide the basis for a preliminary assumption that--without
considering all relevant circumstances--a deviation of less than the
specified percentage with respect to a particular item on the
registrant's financial statements is unlikely to be material. The staff
has no objection to such a ``rule of thumb'' as an initial step in
assessing materiality. But quantifying, in percentage terms, the
magnitude of a misstatement is only the beginning of an analysis of
materiality; it cannot appropriately be used as a substitute for a full
analysis of all relevant considerations. Materiality concerns the
significance of an item to users of a registrant's financial
statements. A matter is ``material'' if there is a substantial
likelihood that a reasonable person would consider it important. In its
Concepts Statement 2, Qualitative Characteristics of Accounting
Information, the FASB stated the essence of the concept of materiality
as follows:
The omission or misstatement of an item in a financial report is
material if, in the light of surrounding circumstances, the
magnitude of the item is such that it is probable that the judgment
of a reasonable person relying upon the report would have been
changed or influenced by the inclusion or correction of the
item.\26\
\26\ Concepts Statement 2, paragraph 132. See also Concepts
Statement 2, Glossary of Terms--Materiality.
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This formulation in the accounting literature is in substance
identical to the formulation used by the courts in interpreting the
Federal securities laws. The Supreme Court has held that a fact is
material if there is--
a substantial likelihood that the * * * fact would have been
viewed by the reasonable investor as having significantly altered
the ``total mix'' of information made available.\27\
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\27\ TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976).
See also Basic, Inc. v. Levinson, 485 U.S. 224 (1988). As the
Supreme Court has noted, determinations of materiality require
``delicate assessments of the inferences a `reasonable shareholder'
would draw from a given set of facts and the significance of those
inferences to him.* * *'' TSC Industries, 426 U.S. at 450.
Under the governing principles, an assessment of materiality
requires that one views the facts in the context of the ``surrounding
circumstances,'' as the accounting literature puts it, or the ``total
mix'' of information, in the words of the Supreme Court. In the context
of a misstatement of a financial statement item, while the ``total
mix'' includes the size in numerical or percentage terms of the
misstatement, it also includes the factual context in which the user of
financial statements would view the financial statement item. The
shorthand in the accounting and auditing literature for this analysis
is that financial management and the auditor must consider both
``quantitative'' and ``qualitative'' factors in assessing an item's
materiality.\28\ Court decisions, Commission rules and enforcement
actions, and accounting and auditing literature \29\ have all
considered ``qualitative'' factors in various contexts.
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\28\ See, e.g., Concepts Statement 2, paragraphs 123-124; AU
312A.10 (materiality judgments are made in light of surrounding
circumstances and necessarily involve both quantitative and
qualitative considerations); AU 312A.34 (``Qualitative
considerations also influence the auditor in reaching a conclusion
as to whether misstatements are material.''). As used in the
accounting literature and in this SAB, ``qualitative'' materiality
refers to the surrounding circumstances that inform an investor's
evaluation of financial statement entries. Whether events may be
material to investors for non-financial reasons is a matter not
addressed by this SAB.
\29\ See, e.g., Rule 1-02(o) of Regulation S-X, 17 CFR 210.1-
02(o), Rule 405 of Regulation C, 17 CFR 230.405, and Rule 12b-2, 17
CFR 240.12b-2; AU 312A.10-.11, 317.13, 411.04 n. 1, and 508.36; In
re Kidder Peabody Securities Litigation, 10 F. Supp. 2d 398
(S.D.N.Y. 1998); Parnes v. Gateway 2000, Inc., 122 F.3d 539 (8th
Cir. 1997); In re Westinghouse Securities Litigation, 90 F.3d 696
(3d Cir. 1996); In the Matter of W.R. Grace & Co., Accounting and
Auditing Enforcement Release (``AAER'') 1140 (June 30, 1999); In the
Matter of Eugene Gaughan, AAER 1141 (June 30, 1999); In the Matter
of Thomas Scanlon, AAER 1142 (June 30, 1999); and In re Sensormatic
Electronics Corporation, Sec. Act Rel. No. 7518 (March 25, 1998).
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[[Page 17205]]
The FASB has long emphasized that materiality cannot be reduced to
a numerical formula. In its Concepts Statement 2, the FASB noted that
some had urged it to promulgate quantitative materiality guides for use
in a variety of situations. The FASB rejected such an approach as
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representing only a ``minority view, stating--
The predominant view is that materiality judgments can properly
be made only by those who have all the facts. The Board's present
position is that no general standards of materiality could be
formulated to take into account all the considerations that enter
into an experienced human judgment.\30\
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\30\ Concepts Statement 2, paragraph 131.
The FASB noted that, in certain limited circumstances, the
Commission and other authoritative bodies had issued quantitative
materiality guidance, citing as examples guidelines ranging from one to
ten percent with respect to a variety of disclosures.\31\ And it took
account of contradictory studies, one showing a lack of uniformity
among auditors on materiality judgments, and another suggesting
widespread use of a ``rule of thumb'' of five to ten percent of net
income.\32\ The FASB also considered whether an evaluation of
materiality could be based solely on anticipating the market's reaction
to accounting information.\33\
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\31\ Concepts Statement 2, paragraphs 131 and 166.
\32\ Concepts Statement 2, paragraph 167.
\33\ Concepts Statement 2, paragraphs 168-169.
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The FASB rejected a formulaic approach to discharging ``the onerous
duty of making materiality decisions'' \34\ in favor of an approach
that takes into account all the relevant considerations. In so doing,
it made clear that--
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\34\ Concepts Statement 2, paragraph 170.
[M]agnitude by itself, without regard to the nature of the item
and the circumstances in which the judgment has to be made, will not
generally be a sufficient basis for a materiality judgment.\35\
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\35\ Concepts Statement 2, paragraph 125.
Evaluation of materiality requires a registrant and its auditor to
consider all the relevant circumstances, and the staff believes that
there are numerous circumstances in which misstatements below 5% could
well be material. Qualitative factors may cause misstatements of
quantitatively small amounts to be material; as stated in the auditing
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literature:
As a result of the interaction of quantitative and qualitative
considerations in materiality judgments, misstatements of relatively
small amounts that come to the auditor's attention could have a
material effect on the financial statements.\36\
\36\ AU 312.11.
Among the considerations that may well render material a
quantitatively small misstatement of a financial statement item are--
Whether the misstatement arises from an item capable of
precise measurement or whether it arises from an estimate and, if so,
the degree of imprecision inherent in the estimate.\37\
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\37\ As stated in Concepts Statement 2, paragraph 130:
Another factor in materiality judgments is the degree of
precision that is attainable in estimating the judgment item. The
amount of deviation that is considered immaterial may increase as
the attainable degree of precision decreases. For example, accounts
payable usually can be estimated more accurately than can contingent
liabilities arising from litigation or threats of it, and a
deviation considered to be material in the first case may be quite
trivial in the second.
This SAB is not intended to change current law or guidance in
the accounting literature regarding accounting estimates. See, e.g.,
FASB ASC Topic 250, Accounting Changes and Error Corrections.
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Whether the misstatement masks a change in earnings or
other trends.
Whether the misstatement hides a failure to meet analysts'
consensus expectations for the enterprise.
Whether the misstatement changes a loss into income or
vice versa.
Whether the misstatement concerns a segment or other
portion of the registrant's business that has been identified as
playing a significant role in the registrant's operations or
profitability.
Whether the misstatement affects the registrant's
compliance with regulatory requirements.
Whether the misstatement affects the registrant's
compliance with loan covenants or other contractual requirements.
Whether the misstatement has the effect of increasing
management's compensation--for example, by satisfying requirements for
the award of bonuses or other forms of incentive compensation.
Whether the misstatement involves concealment of an
unlawful transaction.
This is not an exhaustive list of the circumstances that may affect
the materiality of a quantitatively small misstatement.\38\ Among other
factors, the demonstrated volatility of the price of a registrant's
securities in response to certain types of disclosures may provide
guidance as to whether investors regard quantitatively small
misstatements as material. Consideration of potential market reaction
to disclosure of a misstatement is by itself ``too blunt an instrument
to be depended on'' in considering whether a fact is material.\39\
When, however, management or the independent auditor expects (based,
for example, on a pattern of market performance) that a known
misstatement may result in a significant positive or negative market
reaction, that expected reaction should be taken into account when
considering whether a misstatement is material.\40\
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\38\ The staff understands that the Big Five Audit Materiality
Task Force (``Task Force'') was convened in March of 1998 and has
made recommendations to the Auditing Standards Board including
suggestions regarding communications with audit committees about
unadjusted misstatements. See generally Big Five Audit Materiality
Task Force. ``Materiality in a Financial Statement Audit--
Considering Qualitative Factors When Evaluating Audit Findings''
(August 1998).
\39\ See Concepts Statement 2, paragraph 169.
\40\ If management does not expect a significant market
reaction, a misstatement still may be material and should be
evaluated under the criteria discussed in this SAB.
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For the reasons noted above, the staff believes that a registrant
and the auditors of its financial statements should not assume that
even small intentional misstatements in financial statements, for
example those pursuant to actions to ``manage'' earnings, are
immaterial.\41\ While the intent of management does not render a
misstatement material, it may provide significant evidence of
materiality. The evidence may be particularly compelling where
management has intentionally misstated items in the financial
statements to ``manage'' reported earnings. In that instance, it
presumably has done so believing that the resulting amounts and trends
would be significant to users of the registrant's financial
statements.\42\ The staff believes that investors generally would
regard as significant a management practice to over- or under-state
earnings up to an amount just short of a percentage threshold in order
to ``manage'' earnings. Investors presumably also would regard as
significant an accounting practice that, in essence, rendered all
earnings figures subject to a management-directed margin of
misstatement.
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\41\ Intentional management of earnings and intentional
misstatements, as used in this SAB, do not include insignificant
errors and omissions that may occur in systems and recurring
processes in the normal course of business. See notes 37 and 49
infra.
\42\ Assessments of materiality should occur not only at year-
end, but also during the preparation of each quarterly or interim
financial statement. See, e.g., In the Matter of Venator Group,
Inc., AAER 1049 (June 29, 1998).
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The materiality of a misstatement may turn on where it appears in
the financial statements. For example, a misstatement may involve a
segment of the
[[Page 17206]]
registrant's operations. In that instance, in assessing materiality of
a misstatement to the financial statements taken as a whole,
registrants and their auditors should consider not only the size of the
misstatement but also the significance of the segment information to
the financial statements taken as a whole.\43\ ``A misstatement of the
revenue and operating profit of a relatively small segment that is
represented by management to be important to the future profitability
of the entity'' \44\ is more likely to be material to investors than a
misstatement in a segment that management has not identified as
especially important. In assessing the materiality of misstatements in
segment information--as with materiality generally--
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\43\ See, e.g., In the Matter of W.R. Grace & Co., AAER 1140
(June 30, 1999).
\44\ AU 9326.33.
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situations may arise in practice where the auditor will conclude
that a matter relating to segment information is qualitatively
material even though, in his or her judgment, it is quantitatively
immaterial to the financial statements taken as a whole.\45\
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\45\ Id.
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Aggregating and Netting Misstatements
In determining whether multiple misstatements cause the financial
statements to be materially misstated, registrants and the auditors of
their financial statements should consider each misstatement separately
and the aggregate effect of all misstatements.\46\ A registrant and its
auditor should evaluate misstatements in light of quantitative and
qualitative factors and ``consider whether, in relation to individual
amounts, subtotals, or totals in the financial statements, they
materially misstate the financial statements taken as a whole.'' \47\
This requires consideration of--
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\46\ The auditing literature notes that the ``concept of
materiality recognizes that some matters, either individually or in
the aggregate, are important for fair presentation of financial
statements in conformity with generally accepted accounting
principles.'' AU 312.03. See also AU 312.04.
\47\ AU 312.34. Quantitative materiality assessments often are
made by comparing adjustments to revenues, gross profit, pretax and
net income, total assets, stockholders' equity, or individual line
items in the financial statements. The particular items in the
financial statements to be considered as a basis for the materiality
determination depend on the proposed adjustment to be made and other
factors, such as those identified in this SAB. For example, an
adjustment to inventory that is immaterial to pretax income or net
income may be material to the financial statements because it may
affect a working capital ratio or cause the registrant to be in
default of loan covenants.
the significance of an item to a particular entity (for example,
inventories to a manufacturing company), the pervasiveness of the
misstatement (such as whether it affects the presentation of
numerous financial statement items), and the effect of the
misstatement on the financial statements taken as a whole.* * * \48\
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\48\ AU 508.36.
Registrants and their auditors first should consider whether each
misstatement is material, irrespective of its effect when combined with
other misstatements. The literature notes that the analysis should
consider whether the misstatement of ``individual amounts'' causes a
material misstatement of the financial statements taken as a whole. As
with materiality generally, this analysis requires consideration of
both quantitative and qualitative factors.
If the misstatement of an individual amount causes the financial
statements as a whole to be materially misstated, that effect cannot be
eliminated by other misstatements whose effect may be to diminish the
impact of the misstatement on other financial statement items. To take
an obvious example, if a registrant's revenues are a material financial
statement item and if they are materially overstated, the financial
statements taken as a whole will be materially misleading even if the
effect on earnings is completely offset by an equivalent overstatement
of expenses.
Even though a misstatement of an individual amount may not cause
the financial statements taken as a whole to be materially misstated,
it may nonetheless, when aggregated with other misstatements, render
the financial statements taken as a whole to be materially misleading.
Registrants and the auditors of their financial statements accordingly
should consider the effect of the misstatement on subtotals or totals.
The auditor should aggregate all misstatements that affect each
subtotal or total and consider whether the misstatements in the
aggregate affect the subtotal or total in a way that causes the
registrant's financial statements taken as a whole to be materially
misleading.\49\
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\49\ AU 312.34.
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The staff believes that, in considering the aggregate effect of
multiple misstatements on a subtotal or total, registrants and the
auditors of their financial statements should exercise particular care
when considering whether to offset (or the appropriateness of
offsetting) a misstatement of an estimated amount with a misstatement
of an item capable of precise measurement. As noted above, assessments
of materiality should never be purely mechanical; given the imprecision
inherent in estimates, there is by definition a corresponding
imprecision in the aggregation of misstatements involving estimates
with those that do not involve an estimate.
Registrants and auditors also should consider the effect of
misstatements from prior periods on the current financial statements.
For example, the auditing literature states,
Matters underlying adjustments proposed by the auditor but not
recorded by the entity could potentially cause future financial
statements to be materially misstated, even though the auditor has
concluded that the adjustments are not material to the current
financial statements.\50\
\50\ AU 380.09.
This may be particularly the case where immaterial misstatements recur
in several years and the cumulative effect becomes material in the
current year.
2. Immaterial Misstatements That Are Intentional
Facts: A registrant's management intentionally has made adjustments
to various financial statement items in a manner inconsistent with
GAAP. In each accounting period in which such actions were taken, none
of the individual adjustments is by itself material, nor is the
aggregate effect on the financial statements taken as a whole material
for the period. The registrant's earnings ``management'' has been
effected at the direction or acquiescence of management in the belief
that any deviations from GAAP have been immaterial and that accordingly
the accounting is permissible.
Question: In the staff's view, may a registrant make intentional
immaterial misstatements in its financial statements?
Interpretive Response: No. In certain circumstances, intentional
immaterial misstatements are unlawful.
Considerations of the Books and Records Provisions Under the Exchange
Act
Even if misstatements are immaterial,\51\ registrants must comply
with Sections 13(b)(2)--(7) of the Securities Exchange Act of 1934 (the
``Exchange Act'').\52\ Under these provisions, each registrant with
[[Page 17207]]
securities registered pursuant to Section 12 of the Exchange Act,\53\
or required to file reports pursuant to Section 15(d),\54\ must make
and keep books, records, and accounts, which, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of
assets of the registrant and must maintain internal accounting controls
that are sufficient to provide reasonable assurances that, among other
things, transactions are recorded as necessary to permit the
preparation of financial statements in conformity with GAAP.\55\ In
this context, determinations of what constitutes ``reasonable
assurance'' and ``reasonable detail'' are based not on a
``materiality'' analysis but on the level of detail and degree of
assurance that would satisfy prudent officials in the conduct of their
own affairs.\56\ Accordingly, failure to record accurately immaterial
items, in some instances, may result in violations of the securities
laws.
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\51\ FASB ASC paragraph 105-10-05-6 states that ``[t]he
provisions of the Codification need not be applied to immaterial
items.'' This SAB is consistent with that provision of the
Codification. In theory, this language is subject to the
interpretation that the registrant is free intentionally to set
forth immaterial items in financial statements in a manner that
plainly would be contrary to GAAP if the misstatement were material.
The staff believes that the FASB did not intend this result.
\52\ 15 U.S.C. 78m(b)(2)-(7).
\53\ 15 U.S.C. 78l.
\54\ 15 U.S.C. 78o(d).
\55\ Criminal liability may be imposed if a person knowingly
circumvents or knowingly fails to implement a system of internal
accounting controls or knowingly falsifies books, records or
accounts. 15 U.S.C. 78m(4) and (5). See also Rule 13b2-1 under the
Exchange Act, 17 CFR 240.13b2-1, which states, ``No person shall,
directly or indirectly, falsify or cause to be falsified, any book,
record or account subject to Section 13(b)(2)(A) of the Securities
Exchange Act.''
\56\ 15 U.S.C. 78m(b)(7). The books and records provisions of
section 13(b) of the Exchange Act originally were passed as part of
the Foreign Corrupt Practices Act (``FCPA''). In the conference
committee report regarding the 1988 amendments to the FCPA, the
committee stated:
The conference committee adopted the prudent man qualification
in order to clarify that the current standard does not connote an
unrealistic degree of exactitude or precision. The concept of
reasonableness of necessity contemplates the weighing of a number of
relevant factors, including the costs of compliance.
Cong. Rec. H2116 (daily ed. April 20, 1988).
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The staff recognizes that there is limited authoritative guidance
\57\ regarding the ``reasonableness'' standard in Section 13(b)(2) of
the Exchange Act. A principal statement of the Commission's policy in
this area is set forth in an address given in 1981 by then Chairman
Harold M. Williams.\58\ In his address, Chairman Williams noted that,
like materiality, ``reasonableness'' is not an ``absolute standard of
exactitude for corporate records.'' \59\ Unlike materiality, however,
``reasonableness'' is not solely a measure of the significance of a
financial statement item to investors. ``Reasonableness,'' in this
context, reflects a judgment as to whether an issuer's failure to
correct a known misstatement implicates the purposes underlying the
accounting provisions of Sections 13(b)(2)--(7) of the Exchange
Act.\60\
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\57\ So far as the staff is aware, there is only one judicial
decision that discusses Section 13(b)(2) of the Exchange Act in any
detail, SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724
(N.D. Ga. 1983), and the courts generally have found that no private
right of action exists under the accounting and books and records
provisions of the Exchange Act. See e.g., Lamb v. Phillip Morris
Inc., 915 F.2d 1024 (6th Cir. 1990) and JS Service Center
Corporation v. General Electric Technical Services Company, 937 F.
Supp. 216 (S.D.N.Y. 1996).
\58\ The Commission adopted the address as a formal statement of
policy in Securities Exchange Act Release No. 17500 (January 29,
1981), 46 FR 11544 (February 9, 1981), 21 SEC Docket 1466 (February
10, 1981).
\59\ Id. at 46 FR 11546.
\60\ Id.
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In assessing whether a misstatement results in a violation of a
registrant's obligation to keep books and records that are accurate
``in reasonable detail,'' registrants and their auditors should
consider, in addition to the factors discussed above concerning an
evaluation of a misstatement's potential materiality, the factors set
forth below.
The significance of the misstatement. Though the staff
does not believe that registrants need to make finely calibrated
determinations of significance with respect to immaterial items,
plainly it is ``reasonable'' to treat misstatements whose effects are
clearly inconsequential differently than more significant ones.
How the misstatement arose. It is unlikely that it is ever
``reasonable'' for registrants to record misstatements or not to
correct known misstatements--even immaterial ones--as part of an
ongoing effort directed by or known to senior management for the
purposes of ``managing'' earnings. On the other hand, insignificant
misstatements that arise from the operation of systems or recurring
processes in the normal course of business generally will not cause a
registrant's books to be inaccurate ``in reasonable detail.'' \61\
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\61\ For example, the conference report regarding the 1988
amendments to the FCPA stated:
The Conferees intend to codify current Securities and Exchange
Commission (SEC) enforcement policy that penalties not be imposed
for insignificant or technical infractions or inadvertent conduct.
The amendment adopted by the Conferees [Section 13(b)(4)]
accomplishes this by providing that criminal penalties shall not be
imposed for failing to comply with the FCPA's books and records or
accounting provisions. This provision [Section 13(b)(5)] is meant to
ensure that criminal penalties would be imposed where acts of
commission or omission in keeping books or records or administering
accounting controls have the purpose of falsifying books, records or
accounts, or of circumventing the accounting controls set forth in
the Act. This would include the deliberate falsification of books
and records and other conduct calculated to evade the internal
accounting controls requirement.
Cong. Rec. H2115 (daily ed. April 20, 1988).
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The cost of correcting the misstatement. The books and
records provisions of the Exchange Act do not require registrants to
make major expenditures to correct small misstatements.\62\ Conversely,
where there is little cost or delay involved in correcting a
misstatement, failing to do so is unlikely to be ``reasonable.''
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\62\ As Chairman Williams noted with respect to the internal
control provisions of the FCPA, ``[t]housands of dollars ordinarily
should not be spent conserving hundreds.'' 46 FR 11546.
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The clarity of authoritative accounting guidance with
respect to the misstatement. Where reasonable minds may differ about
the appropriate accounting treatment of a financial statement item, a
failure to correct it may not render the registrant's financial
statements inaccurate ``in reasonable detail.'' Where, however, there
is little ground for reasonable disagreement, the case for leaving a
misstatement uncorrected is correspondingly weaker.
There may be other indicators of ``reasonableness'' that registrants
and their auditors may ordinarily consider. Because the judgment is not
mechanical, the staff will be inclined to continue to defer to
judgments that ``allow a business, acting in good faith, to comply with
the Act's accounting provisions in an innovative and cost-effective
way.'' \63\
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\63\ Id., at 11547.
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The Auditor's Response to Intentional Misstatements
Section 10A(b) of the Exchange Act requires auditors to take
certain actions upon discovery of an ``illegal act.'' \64\ The statute
specifies that these obligations are triggered ``whether or not [the
illegal acts are] perceived to have a material effect on the financial
statements of the issuer. * * *'' Among other things, Section 10A(b)(1)
requires the auditor to inform the appropriate level of management of
an illegal act (unless clearly inconsequential) and assure that the
registrant's audit committee is ``adequately informed'' with respect to
the illegal act.
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\64\ Section 10A(f) defines, for purposes of Section 10A, an
``illegal act'' as ``an act or omission that violates any law, or
any rule or regulation having the force of law.'' This is broader
than the definition of an ``illegal act'' in AU 317.02, which
states, ``Illegal acts by clients do not include personal misconduct
by the entity's personnel unrelated to their business activities.''
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As noted, an intentional misstatement of immaterial items in a
registrant's financial statements may violate Section 13(b)(2) of the
Exchange Act and thus be an illegal act. When such a violation occurs,
an auditor must take steps to see that the registrant's audit committee
is ``adequately informed'' about the illegal act. Because Section
10A(b)(1) is triggered regardless of whether an illegal
[[Page 17208]]
act has a material effect on the registrant's financial statements,
where the illegal act consists of a misstatement in the registrant's
financial statements, the auditor will be required to report that
illegal act to the audit committee irrespective of any ``netting'' of
the misstatements with other financial statement items.
The requirements of Section 10A echo the auditing literature. See,
e.g., Statement on Auditing Standards (SAS) Nos. 54 and 99. Pursuant to
paragraph 77 of SAS 99, if the auditor determines there is evidence
that fraud may exist, the auditor must discuss the matter with the
appropriate level of management that is at least one level above those
involved, and with senior management and the audit committee. The
auditor must report directly to the audit committee fraud involving
senior management and fraud that causes a material misstatement of the
financial statements. Paragraph 6 of SAS 99 states that ``misstatements
arising from fraudulent financial reporting are intentional
misstatements or omissions of amounts or disclosures in financial
statements designed to deceive financial statement users * * *'' \65\
SAS 99 further states that fraudulent financial reporting may involve
falsification or alteration of accounting records; misrepresenting or
omitting events, transactions or other information in the financial
statements; and the intentional misapplication of accounting principles
relating to amounts, classifications, the manner of presentation, or
disclosures in the financial statements.\66\ The clear implication of
SAS 99 is that immaterial misstatements may be fraudulent financial
reporting.\67\
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\65\ An unintentional illegal act triggers the same procedures
and considerations by the auditor as a fraudulent misstatement if
the illegal act has a direct and material effect on the financial
statements. See AU 110 n. 1, 317.05 and 317.07. Although
distinguishing between intentional and unintentional misstatements
is often difficult, the auditor must plan and perform the audit to
obtain reasonable assurance that the financial statements are free
of material misstatements in either case.
\66\ Although the auditor is not required to plan or perform the
audit to detect misstatements that are immaterial to the financial
statements, SAS 99 requires the auditor to evaluate several fraud
``risk factors'' that may bring such misstatements to his or her
attention. For example, an analysis of fraud risk factors under SAS
99 must include, among other things, consideration of management's
interest in maintaining or increasing the registrant's stock price
or earnings trend through the use of unusually aggressive accounting
practices, whether management has a practice of committing to
analysts or others that it will achieve unduly aggressive or clearly
unrealistic forecasts, and the existence of assets, liabilities,
revenues, or expenses based on significant estimates that involve
unusually subjective judgments or uncertainties.
\67\ In requiring the auditor to consider whether fraudulent
misstatements are material, and in requiring differing responses
depending on whether the misstatement is material, SAS 99 makes
clear that fraud can involve immaterial misstatements. Indeed, a
misstatement can be ``inconsequential'' and still involve fraud.
Under SAS 99, assessing whether misstatements due to fraud are
material to the financial statements is a ``cumulative process''
that should occur both during and at the completion of the audit.
SAS 99 further states that this accumulation is primarily a
``qualitative matter'' based on the auditor's judgment. The staff
believes that in making these assessments, management and auditors
should refer to the discussion in Part 1 of this SAB.
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Auditors that learn of intentional misstatements may also be
required to (1) re-evaluate the degree of audit risk involved in the
audit engagement, (2) determine whether to revise the nature, timing,
and extent of audit procedures accordingly, and (3) consider whether to
resign.\68\
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\68\ Auditors should document their determinations in accordance
with SAS 96, SAS 99, and other appropriate sections of the audit
literature.
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Intentional misstatements also may signal the existence of
reportable conditions or material weaknesses in the registrant's system
of internal accounting control designed to detect and deter improper
accounting and financial reporting.\69\ As stated by the National
Commission on Fraudulent Financial Reporting, also known as the
Treadway Commission, in its 1987 report,
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\69\ See, e.g., SAS 99.
The tone set by top management--the corporate environment or
culture within which financial reporting occurs--is the most
important factor contributing to the integrity of the financial
reporting process. Notwithstanding an impressive set of written
rules and procedures, if the tone set by management is lax,
fraudulent financial reporting is more likely to occur.\70\
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\70\ Report of the National Commission on Fraudulent Financial
Reporting at 32 (October 1987). See also Report and Recommendations
of the Blue Ribbon Committee on Improving the Effectiveness of
Corporate Audit Committees (February 8, 1999).
An auditor is required to report to a registrant's audit committee
any reportable conditions or material weaknesses in a registrant's
system of internal accounting control that the auditor discovers in the
course of the examination of the registrant's financial statements.\71\
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\71\ AU 325.02. See also AU 380.09, which, in discussing matters
to be communicated by the auditor to the audit committee, states:
The auditor should inform the audit committee about adjustments
arising from the audit that could, in his judgment, either
individually or in the aggregate, have a significant effect on the
entity's financial reporting process. For purposes of this section,
an audit adjustment, whether or not recorded by the entity, is a
proposed correction of the financial statements. * * *
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GAAP Precedence Over Industry Practice
Some have argued to the staff that registrants should be permitted
to follow an industry accounting practice even though that practice is
inconsistent with authoritative accounting literature. This situation
might occur if a practice is developed when there are few transactions
and the accounting results are clearly inconsequential, and that
practice never changes despite a subsequent growth in the number or
materiality of such transactions. The staff disagrees with this
argument. Authoritative literature takes precedence over industry
practice that is contrary to GAAP.\72\
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\72\ See AU 411.05.
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General Comments
This SAB is not intended to change current law or guidance in the
accounting or auditing literature.\73\ This SAB and the authoritative
accounting literature cannot specifically address all of the novel and
complex business transactions and events that may occur. Accordingly,
registrants may account for, and make disclosures about, these
transactions and events based on analogies to similar situations or
other factors. The staff may not, however, always be persuaded that a
registrant's determination is the most appropriate under the
circumstances. When disagreements occur after a transaction or an event
has been reported, the consequences may be severe for registrants,
auditors, and, most importantly, the users of financial statements who
have a right to expect consistent accounting and reporting for, and
disclosure of, similar transactions and events. The staff, therefore,
[[Page 17209]]
encourages registrants and auditors to discuss on a timely basis with
the staff proposed accounting treatments for, or disclosures about,
transactions or events that are not specifically covered by the
existing accounting literature.
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\73\ The FASB Discussion Memorandum, ``Criteria for Determining
Materiality,'' states that the financial accounting and reporting
process considers that ``a great deal of the time might be spent
during the accounting process considering insignificant matters. * *
* If presentations of financial information are to be prepared
economically on a timely basis and presented in a concise
intelligible form, the concept of materiality is crucial.'' This SAB
is not intended to require that misstatements arising from
insignificant errors and omissions (individually and in the
aggregate) arising from the normal recurring accounting close
processes, such as a clerical error or an adjustment for a missed
accounts payable invoice, always be corrected, even if the error is
identified in the audit process and known to management. Management
and the auditor would need to consider the various factors described
elsewhere in this SAB in assessing whether such misstatements are
material, need to be corrected to comply with the FCPA, or trigger
procedures under Section 10A of the Exchange Act. Because this SAB
does not change current law or guidance in the accounting or
auditing literature, adherence to the principles described in this
SAB should not raise the costs associated with recordkeeping or with
audits of financial statements.
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N. Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements
(Added by SAB 108)
Facts: During the course of preparing annual financial statements,
a registrant is evaluating the materiality of an improper expense
accrual (e.g., overstated liability) in the amount of $100, which has
built up over 5 years, at $20 per year.\74\ The registrant previously
evaluated the misstatement as being immaterial to each of the prior
year financial statements (i.e., years 1-4). For the purpose of
evaluating materiality in the current year (i.e., year 5), the
registrant quantifies the error as a $20 overstatement of expenses.
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\74\ For purposes of these facts, assume the registrant properly
determined that the overstatement of the liability resulted from an
error rather than a change in accounting estimate. See the FASB ASC
Master Glossary for the distinction between an error in previously
issued financial statements and a change in accounting estimate.
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Question 1: Has the registrant appropriately quantified the amount
of this error for the purpose of evaluating materiality for the current
year?
Interpretive Response: No. In this example, the registrant has only
quantified the effects of the identified unadjusted error that arose in
the current year income statement. The staff believes a registrant's
materiality evaluation of an identified unadjusted error should
quantify the effects of the identified unadjusted error on each
financial statement and related financial statement disclosure.
Topic 1M notes that a materiality evaluation must be based on all
relevant quantitative and qualitative factors.\75\ This analysis
generally begins with quantifying potential misstatements to be
evaluated. There has been diversity in practice with respect to this
initial step of a materiality analysis.
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\75\ Topic 1N addresses certain of these quantitative issues,
but does not alter the analysis required by Topic 1M.
---------------------------------------------------------------------------
The diversity in approaches for quantifying the amount of
misstatements primarily stems from the effects of misstatements that
were not corrected at the end of the prior year (``prior year
misstatements''). These prior year misstatements should be considered
in quantifying misstatements in current year financial statements.
The techniques most commonly used in practice to accumulate and
quantify misstatements are generally referred to as the ``rollover''
and ``iron curtain'' approaches.
The rollover approach, which is the approach used by the registrant
in this example, quantifies a misstatement based on the amount of the
error originating in the current year income statement. Thus, this
approach ignores the effects of correcting the portion of the current
year balance sheet misstatement that originated in prior years (i.e.,
it ignores the ``carryover effects'' of prior year misstatements).
The iron curtain approach quantifies a misstatement based on the
effects of correcting the misstatement existing in the balance sheet at
the end of the current year, irrespective of the misstatement's year(s)
of origination. Had the registrant in this fact pattern applied the
iron curtain approach, the misstatement would have been quantified as a
$100 misstatement based on the end of year balance sheet misstatement.
Thus, the adjustment needed to correct the financial statements for the
end of year error would be to reduce the liability by $100 with a
corresponding decrease in current year expense.
As demonstrated in this example, the primary weakness of the
rollover approach is that it can result in the accumulation of
significant misstatements on the balance sheet that are deemed
immaterial in part because the amount that originates in each year is
quantitatively small. The staff is aware of situations in which a
registrant, relying on the rollover approach, has allowed an erroneous
item to accumulate on the balance sheet to the point where eliminating
the improper asset or liability would itself result in a material error
in the income statement if adjusted in the current year. Such
registrants have sometimes concluded that the improper asset or
liability should remain on the balance sheet into perpetuity.
In contrast, the primary weakness of the iron curtain approach is
that it does not consider the correction of prior year misstatements in
the current year (i.e., the reversal of the carryover effects) to be
errors. Therefore, in this example, if the misstatement was corrected
during the current year such that no error existed in the balance sheet
at the end of the current year, the reversal of the $80 prior year
misstatement would not be considered an error in the current year
financial statements under the iron curtain approach. Implicitly, the
iron curtain approach assumes that because the prior year financial
statements were not materially misstated, correcting any immaterial
errors that existed in those statements in the current year is the
``correct'' accounting, and is therefore not considered an error in the
current year. Thus, utilization of the iron curtain approach can result
in a misstatement in the current year income statement not being
evaluated as an error at all.
The staff does not believe the exclusive reliance on either the
rollover or iron curtain approach appropriately quantifies all
misstatements that could be material to users of financial statements.
In describing the concept of materiality, Concepts Statement 2,
Qualitative Characteristics of Accounting Information, indicates that
materiality determinations are based on whether ``it is probable that
the judgment of a reasonable person relying upon the report would have
been changed or influenced by the inclusion or correction of the item''
(emphasis added).\76\ The staff believes registrants must quantify the
impact of correcting all misstatements, including both the carryover
and reversing effects of prior year misstatements, on the current year
financial statements. The staff believes that this can be accomplished
by quantifying an error under both the rollover and iron curtain
approaches as described above and by evaluating the error measured
under each approach. Thus, a registrant's financial statements would
require adjustment when either approach results in quantifying a
misstatement that is material, after considering all relevant
quantitative and qualitative factors.
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\76\ Concepts Statement 2, paragraph 132. See also Concepts
Statement 2, Glossary of Terms--Materiality.
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As a reminder, a change from an accounting principle that is not
generally accepted to one that is generally accepted is a correction of
an error.\77\
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\77\ See definition of ``error in previously issued financial
statements'' in the FASB ASC Master Glossary.
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The staff believes that the registrant should quantify the current
year misstatement in this example using both the iron curtain approach
(i.e., $100) and the rollover approach (i.e., $20). Therefore, if the
$100 misstatement is considered material to the financial statements,
after all of the relevant quantitative and qualitative factors are
considered, the registrant's financial statements would need to be
adjusted.
It is possible that correcting an error in the current year could
materially misstate the current year's income statement. For example,
correcting the
[[Page 17210]]
$100 misstatement in the current year will:
Correct the $20 error originating in the current year;
Correct the $80 balance sheet carryover error that
originated in Years 1 through 4; but also
Misstate the current year income statement by $80.
If the $80 understatement of current year expense is material to
the current year, after all of the relevant quantitative and
qualitative factors are considered, the prior year financial statements
should be corrected, even though such revision previously was and
continues to be immaterial to the prior year financial statements.
Correcting prior year financial statements for immaterial errors would
not require previously filed reports to be amended. Such correction may
be made the next time the registrant files the prior year financial
statements.
The following example further illustrates the staff's views on
quantifying misstatements, including the consideration of the effects
of prior year misstatements:
Facts: During the course of preparing annual financial statements,
a registrant is evaluating the materiality of a sales cut-off error in
which $50 of revenue from the following year was recorded in the
current year, thereby overstating accounts receivable by $50 at the end
of the current year. In addition, a similar sales cut-off error existed
at the end of the prior year in which $110 of revenue from the current
year was recorded in the prior year. As a result of the combination of
the current year and prior year cut-off errors, revenues in the current
year are understated by $60 ($110 understatement of revenues at the
beginning of the current year partially offset by a $50 overstatement
of revenues at the end of the current year). The prior year error was
evaluated in the prior year as being immaterial to those financial
statements.
Question 2: How should the registrant quantify the misstatement in
the current year financial statements?
Interpretive Response: The staff believes the registrant should
quantify the current year misstatement in this example using both the
iron curtain approach (i.e., $50) and the rollover approach (i.e.,
$60). Therefore, assuming a $60 misstatement is considered material to
the financial statements, after all relevant quantitative and
qualitative factors are considered, the registrant's financial
statements would need to be adjusted.
Further, in this example, recording an adjustment in the current
year could alter the amount of the error affecting the current year
financial statements. For instance:
If only the $60 understatement of revenues were to be
corrected in the current year, then the overstatement of current year
end accounts receivable would increase to $110; or,
If only the $50 overstatement of accounts receivable were
to be corrected in the current year, then the understatement of current
year revenues would increase to $110.
If the misstatement that exists after recording the adjustment in
the current year financial statements is material (considering all
relevant quantitative and qualitative factors), the prior year
financial statements should be corrected, even though such revision
previously was and continues to be immaterial to the prior year
financial statements. Correcting prior year financial statements for
immaterial errors would not require previously filed reports to be
amended. Such correction may be made the next time the registrant files
the prior year financial statements.
If the cut-off error that existed in the prior year was not
discovered until the current year, a separate analysis of the financial
statements of the prior year (and any other prior year in which
previously undiscovered errors existed) would need to be performed to
determine whether such prior year financial statements were materially
misstated. If that analysis indicates that the prior year financial
statements are materially misstated, they would need to be restated in
accordance with FASB ASC Topic 250, Accounting Changes and Error
Corrections.\78\
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\78\ FASB ASC paragraph 250-10-45-23.
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Facts: When preparing its financial statements for years ending on
or before November 15, 2006, a registrant quantified errors by using
either the iron curtain approach or the rollover approach, but not
both. Based on consideration of the guidance in this Staff Accounting
Bulletin, the registrant concludes that errors existing in previously
issued financial statements are material.
Question 3: Will the staff expect the registrant to restate prior
period financial statements when first applying this guidance?
Interpretive Response: The staff will not object if a registrant
\79\ does not restate financial statements for fiscal years ending on
or before November 15, 2006, if management properly applied its
previous approach, either iron curtain or rollover, so long as all
relevant qualitative factors were considered.
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\79\ If a registrant's initial registration statement is not
effective on or before November 15, 2006, and the registrant's prior
year(s) financial statements are materially misstated based on
consideration of the guidance in this Staff Accounting Bulletin, the
prior year financial statements should be restated in accordance
with FASB ASC paragraph 250-10-45-23. If a registrant's initial
registration statement is effective on or before November 15, 2006,
the guidance in the interpretive response to Question 3 is
applicable.
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To provide full disclosure, registrants electing not to restate
prior periods should reflect the effects of initially applying the
guidance in Topic 1N in their annual financial statements covering the
first fiscal year ending after November 15, 2006. The cumulative effect
of the initial application should be reported in the carrying amounts
of assets and liabilities as of the beginning of that fiscal year, and
the offsetting adjustment should be made to the opening balance of
retained earnings for that year. Registrants should disclose the nature
and amount of each individual error being corrected in the cumulative
adjustment. The disclosure should also include when and how each error
being corrected arose and the fact that the errors had previously been
considered immaterial.
Early application of the guidance in Topic 1N is encouraged in any
report for an interim period of the first fiscal year ending after
November 15, 2006, filed after the publication of this Staff Accounting
Bulletin. In the event that the cumulative effect of application of the
guidance in Topic 1N is first reported in an interim period other than
the first interim period of the first fiscal year ending after November
15, 2006, previously filed interim reports need not be amended.
However, comparative information presented in reports for interim
periods of the first year subsequent to initial application should be
adjusted to reflect the cumulative effect adjustment as of the
beginning of the year of initial application. In addition, the
disclosures of selected quarterly information required by Item 302 of
Regulation S-K should reflect the adjusted results.
TOPIC 2: BUSINESS COMBINATIONS
A. Acquisition Method
1. Removed by SAB 103
2. Removed by SAB 103
3. Removed by SAB 103
4. Removed by SAB 103
5. Removed by SAB 112
6. Debt Issue Costs
Facts: Company A is to acquire the net assets of Company B in a
transaction
[[Page 17211]]
to be accounted for as a business combination. In connection with the
transaction, Company A has retained an investment banker to provide
advisory services in structuring the acquisition and to provide the
necessary financing. It is expected that the acquisition will be
financed on an interim basis using ``bridge financing'' provided by the
investment banker. Permanent financing will be arranged at a later date
through a debt offering, which will be underwritten by the investment
banker. Fees will be paid to the investment banker for the advisory
services, the bridge financing, and the underwriting of the permanent
financing. These services may be billed separately or as a single
amount.
Question 1: Should total fees paid to the investment banker for
acquisition-related services and the issuance of debt securities be
allocated between the services received?
Interpretive Response: Yes. Fees paid to an investment banker in
connection with a business combination or asset acquisition, when the
investment banker is also providing interim financing or underwriting
services, must be allocated between acquisition related services and
debt issue costs.
When an investment banker provides services in connection with a
business combination or asset acquisition and also provides
underwriting services associated with the issuance of debt or equity
securities, the total fees incurred by an entity should be allocated
between the services received on a relative fair value basis. The
objective of the allocation is to ascribe the total fees incurred to
the actual services provided by the investment banker.
FASB ASC Topic 805, Business Combinations, provides guidance for
the portion of the costs that represent acquisition-related services.
The portion of the costs pertaining to the issuance of debt or equity
securities should be accounted for in accordance with other applicable
GAAP.
Question 2: May the debt issue costs of the interim ``bridge
financing'' be amortized over the anticipated combined life of the
bridge and permanent financings?
1. Interpretive Response: No. Debt issue costs should be amortized
by the interest method over the life of the debt to which they relate.
Debt issue costs related to the bridge financing should be recognized
as interest cost during the estimated interim period preceding the
placement of the permanent financing with any unamortized amounts
charged to expense if the bridge loan is repaid prior to the expiration
of the estimated period. Where the bridged financing consists of
increasing rate debt, the guidance issued in FASB ASC Topic 470, Debt,
should be followed.\1\
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\1\ As noted in FASB ASC paragraph 470-10-35-2, the term-
extending provisions of the debt instrument should be analyzed to
determine whether they constitute an embedded derivative requiring
separate accounting in accordance with FASB ASC Topic 815,
Derivatives and Hedging.
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7. Removed by SAB 112
8. Business Combinations Prior to an Initial Public Offering
Facts: Two or more businesses combine in a single combination just
prior to or contemporaneously with an initial public offering.
Question: Does the guidance in SAB Topic 5.G apply to business
combinations entered into just prior to or contemporaneously with an
initial public offering?
Interpretive Response: No. The guidance in SAB Topic 5.G is
intended to address the transfer, just prior to or contemporaneously
with an initial public offering, of nonmonetary assets in exchange for
a company's stock. The guidance in SAB Topic 5.G is not intended to
modify the requirements of FASB ASC Topic 805. Accordingly, the staff
believes that the combination of two or more businesses should be
accounted for in accordance with FASB ASC Topic 805.
9. Removed by SAB 112
B. Removed by SAB 103
C. Removed by SAB 103
D. Financial Statements of Oil And Gas Exchange Offers
Facts: The oil and gas industry has experienced periods of time
where there have been a significant number of ``exchange offers'' (also
referred to as ``roll-ups'' or ``put-togethers'') to form a publicly
held company, take an existing private company public, or increase the
size of an existing publicly held company. An exchange offer
transaction involves a swap of shares in a corporation for interests in
properties, typically limited partnership interests. Such interests
could include direct interests such as working interests and royalties
related to developed or undeveloped properties and indirect interests
such as limited partnership interests or shares of existing oil and gas
companies. Generally, such transactions are structured to be tax-free
to the individual or entity trading the property interest for shares of
the corporation. Under certain circumstances, however, part or all of
the transaction may be taxable. For purposes of the discussion in this
Topic, in each of these situations, the entity (or entities) or
property (or properties) are deemed to constitute a business.
One financial reporting issue in exchange transactions involves
deciding which prior financial results of the entities should be
reported.
Question 1: In Form 10-K filings with the Commission, the staff has
permitted limited partnerships to omit certain of the oil and gas
reserve value information and the supplemental summary of oil and gas
activities disclosures required by FASB ASC Subtopic 932-235,
Extractive Activities--Oil and Gas--Notes to Financial Statements, in
some circumstances. Is it permissible to omit these disclosures from
the financial statements included in an exchange offering?
Interpretive Response: No. Normally full disclosures of reserve
data and related information are required. The exemptions previously
allowed relate only to partnerships where value-oriented data are
otherwise available to the limited partners pursuant to the partnership
agreement. The staff has previously stated that it will require all of
the required disclosures for partnerships which are the subject of
exchange offers.\2\ These disclosures may, however, be presented on a
combined basis if the entities are under common control.
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\2\ See SAB 40, Topic 12.A.3.c.
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The staff believes that the financial statements in an exchange
offer registration statement should provide sufficient historical
reserve quantity and value-based disclosures to enable offerees and
secondary market public investors to evaluate the effect of the
exchange proposal. Accordingly, in all cases, it will be necessary to
present information as of the latest year-end on reserve quantities and
the future net revenues associated with such quantities. In certain
circumstances, where the exchange is accounted for using the
acquisition method of accounting, the staff will consider, on a case-
by-case basis, granting exemptions from (i) the disclosure requirements
for year-to-year reconciliations of reserve quantities, and (ii) the
requirements for a summary of oil and gas producing activities and a
summary of changes in the net present value of reserves. For instance,
the staff may consider requests for exemptions in cases where the
properties acquired in the exchange transaction are fully explored and
developed, particularly if the management of the emerging company has
not been involved in the exploration and development of such
properties.
[[Page 17212]]
Question 2: If the exchange company will use the full cost method
of accounting, does the full cost ceiling limitation apply as of the
date of the financial statements reflecting the exchange?
Interpretive Response: Yes. The full cost ceiling limitation on
costs capitalized does apply. However, as discussed under Topic 12.D.3,
the Commission has stated that in unusual circumstances, registrants
may request an exemption if as a result of a major purchase, a write-
down would be required even though it can be demonstrated that the fair
value of the properties clearly exceeds the unamortized costs.
Question 3: How should ``common control accounting'' be applied to
the specific assets and liabilities of the new exchange company?
Interpretive Response: Consistent with SAB Topic 12.C.2, under
``common control accounting'' the various accounting methods followed
by the offeree entities should be conformed to the methods adopted by
the new exchange company. It is not appropriate to combine assets and
liabilities accounted for on different bases. Accordingly, all of the
oil and gas properties of the new entity must be accounted for on the
same basis (either full cost or successful efforts) applied
retrospectively.
Question 4: What pro forma financial information is required in an
exchange offer filing?
Interpretive Response: The requirements for pro forma financial
information in exchange offer filings are the same as in any other
filings with the Commission and are detailed in Article 11 of
Regulation S-X.\3\ Rule 11-02(b) specifies the presentation
requirements, including periods presented and types of adjustments to
be made. The general criteria of Rule 11-02(b)(6) are that pro forma
adjustments should give effect to events that are (i) directly
attributable to the transaction, (ii) expected to have a continuing
impact on the registrant, and (iii) factually supportable. In the case
of an exchange offer, such adjustments typically are made to:
---------------------------------------------------------------------------
\3\ As announced in Financial Reporting Release No. 2 (July 9,
1982).
---------------------------------------------------------------------------
(1) Show varying levels of acceptance of the offer.
(2) Conform the accounting methods used in the historical financial
statements to those to be applied by the new entity.
(3) Recompute the depreciation, depletion and amortization charges,
in cases where the new entity will use full-cost accounting, on a
combined basis. If this computation is not practicable, and the
exchange offer is accounted for as a transaction among entities under
common control, historical depreciation, depletion and amortization
provisions may be aggregated, with appropriate disclosure.
(4) Reflect the acquisition in the pro forma statements where the
exchange offer is accounted for using the acquisition method of
accounting, including depreciation, depletion and amortization based on
the measurement guidance in FASB ASC Topic 805, Business Combinations.
(5) Provide pro forma reserve information comparable to the
disclosures required by FASB ASC paragraphs 932-235-50-3 through 932-
235-50-11B and FASB ASC paragraphs 932-235-50-29 through 932-235-50-36.
(6) Reflect significant changes, if any, in levels of operations
(revenues or costs), or in income tax status and to reflect debt
incurred in connection with the transaction.
In addition, the depreciation, depletion and amortization rate which
will apply for the initial period subsequent to consummation of the
exchange offer should be disclosed.
Question 5: Are there conditions under which the presentation of
other than full historical financial statements would be acceptable?
Interpretive Response: Generally, full historical financial
statements as specified in Rules 3-01 and 3-02 of Regulation S-X are
considered necessary to enable offerees and secondary market investors
to evaluate the transaction. Where securities are being registered to
offer to the security holders (including limited partners and other
ownership interests) of the businesses to be acquired, such financial
statements are normally required pursuant to Rule 3-05 of Regulation S-
X, either individually for each entity or, where appropriate,
separately for the offeror and on a combined basis for other entities,
generally excluding corporations. However, certain exceptions may apply
as explained in the outline below:
A. Acquisition Method Accounting
1. If the registrant can demonstrate that full historical financial
statements of the offeree businesses are not reasonably available, the
staff may permit presentation of audited Statements of Combined Gross
Revenues and Direct Lease Operating Expenses for all years for which an
income statement would otherwise be required. In these circumstances,
the registrant should also disclose in an unaudited footnote the
amounts of total exploration and development costs, and general and
administrative expenses along with the reasons why presentation of full
historical financial statements is not practicable.
2. The staff will consider requests to waive the requirement for
prior year financial statements of the offerees and instead allow
presentation of only the latest fiscal year and interim period, if the
registrant can demonstrate that the prior years' data would not be
meaningful because the offerees had no material quantity of production.
B. Common Control Accounting
The staff would expect that the full historical financial
statements as specified in Rules 3-01 and 3-02 of Regulation S-X would
be included in the registration statement for exchange offers accounted
for as transactions among entities under common control, including all
required supplemental reserve information. The presentation of
individual or combined financial statements would depend on the
circumstances of the particular exchange offer.
Registrants are also reminded that wherever historical results are
presented, it may be appropriate to explain the reasons why historical
costs are not necessarily indicative of future expenditures.
E. Removed by SAB 103
F. Removed by SAB 103
TOPIC 3: SENIOR SECURITIES
A. Convertible Securities
Facts: Company B proposes to file a registration statement covering
convertible securities.
Question: In registration, what consideration should be given to
the dilutive effects of convertible securities?
Interpretive Response: In a registration statement of convertible
preferred stock or debentures, the staff believes that disclosure of
pro forma earnings per share (EPS) is important to investors when the
proceeds will be used to extinguish existing preferred stock or debt
and such extinguishments will have a material effect on EPS. That
disclosure is required by Article 11, Rule 11-01(a)(8) and Rule 11-
02(b)(7) of Regulation S-X, if material.
B. Removed by ASR 307
C. Redeemable Preferred Stock
Facts: Rule 5-02.27 of Regulation S-X states that redeemable
preferred stocks are not to be included in amounts reported as
stockholders' equity, and that their redemption amounts are to be
[[Page 17213]]
shown on the face of the balance sheet. However, the Commission's rules
and regulations do not address the carrying amount at which redeemable
preferred stock should be reported, or how changes in its carrying
amount should be treated in calculations of earnings per share and the
ratio of earnings to combined fixed charges and preferred stock
dividends.
Question 1: How should the carrying amount of redeemable preferred
stock be determined?
Interpretive Response: The initial carrying amount of redeemable
preferred stock should be its fair value at date of issue. Where fair
value at date of issue is less than the mandatory redemption amount,
the carrying amount shall be increased by periodic accretions, using
the interest method, so that the carrying amount will equal the
mandatory redemption amount at the mandatory redemption date. The
carrying amount shall be further periodically increased by amounts
representing dividends not currently declared or paid, but which will
be payable under the mandatory redemption features, or for which
ultimate payment is not solely within the control of the registrant
(e.g., dividends that will be payable out of future earnings). Each
type of increase in carrying amount shall be effected by charges
against retained earnings or, in the absence of retained earnings, by
charges against paid-in capital.
The accounting described in the preceding paragraph would apply
irrespective of whether the redeemable preferred stock may be
voluntarily redeemed by the issuer prior to the mandatory redemption
date, or whether it may be converted into another class of securities
by the holder. Companies also should consider the guidance in FASB ASC
paragraph 480-10-S99-3A (Distinguishing Liabilities from Equity Topic).
Question 2: How should periodic increases in the carrying amount of
redeemable preferred stock be treated in calculations of earnings per
share and ratios of earnings to combined fixed charges and preferred
stock dividends?
Interpretive Response: Each type of increase in carrying amount
described in the Interpretive Response to Question 1 should be treated
in the same manner as dividends on nonredeemable preferred stock.
TOPIC 4: EQUITY ACCOUNTS
A. Subordinated Debt
Facts: Company E proposes to include in its registration statement
a balance sheet showing its subordinate debt as a portion of
stockholders' equity.
Question: Is this presentation appropriate?
Interpretive Response: Subordinated debt may not be included in the
stockholders' equity section of the balance sheet. Any presentation
describing such debt as a component of stockholders' equity must be
eliminated. Furthermore, any caption representing the combination of
stockholders' equity and only subordinated debts must be deleted.
B. S Corporations
Facts: An S corporation has undistributed earnings on the date its
S election is terminated.
Question: How should such earnings be reflected in the financial
statements?
Interpretive Response: Such earnings must be included in the
financial statements as additional paid-in capital. This assumes a
constructive distribution to the owners followed by a contribution to
the capital of the corporation.
C. Change in Capital Structure
Facts: A capital structure change to a stock dividend, stock split
or reverse split occurs after the date of the latest reported balance
sheet but before the release of the financial statements or the
effective date of the registration statement, whichever is later.
Question: What effect must be given to such a change?
Interpretive Response: Such changes in the capital structure must
be given retroactive effect in the balance sheet. An appropriately
cross-referenced note should disclose the retroactive treatment,
explain the change made and state the date the change became effective.
D. Earnings per Share Computations in an Initial Public Offering
Facts: A registration statement is filed in connection with an
initial public offering (IPO) of common stock. During the periods
covered by income statements that are included in the registration
statement or in the subsequent period prior to the effective date of
the IPO, the registrant issued for nominal consideration \1\ common
stock, options or warrants to purchase common stock or other
potentially dilutive instruments (collectively, referred to hereafter
as ``nominal issuances'').
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\1\ Whether a security was issued for nominal consideration
should be determined based on facts and circumstances. The
consideration the entity receives for the issuance should be
compared to the security's fair value to determine whether the
consideration is nominal.
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Prior to the effective date of FASB ASC Topic 260, Earnings Per
Share, the staff believed that certain stock and warrants \2\ should be
treated as outstanding for all reporting periods in the same manner as
shares issued in a stock split or a recapitalization effected
contemporaneously with the IPO. The dilutive effect of such stock and
warrants could be measured using the treasury stock method.
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\2\ The stock and warrants encompasses by the prior guidance
were those issuances of common stock at prices below the IPO price
and options or warrants with exercise prices below the IPO price
that were issued within a one-year period prior to the initial
filing of the registration statement relating to the IPO through the
registration statement's effective date.
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Question 1: Does the staff continue to believe that such treatment
for stock and warrants would be appropriate upon adoption of FASB ASC
Topic 260?
Interpretive Response: Generally, no. Historical EPS should be
prepared and presented in conformity with FASB ASC Topic 260.
In applying the requirements of FASB ASC Topic 260, the staff
believes that nominal issuances are recapitalizations in substance. In
computing basic EPS for the periods covered by income statements
included in the registration statement and in subsequent filings with
the SEC, nominal issuances of common stock should be reflected in a
manner similar to a stock split or stock dividend for which retroactive
treatment is required by FASB ASC paragraph 260-10-55-12. In computing
diluted EPS for such periods, nominal issuances of common stock and
potential common stock \3\ should be reflected in a manner similar to a
stock split or stock dividend.
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\3\ The FASB ASC Master Glossary defines potential common stock
as ``a security or other contract that may entitle its holder to
obtain common stock during the reporting period or after the end of
the reporting period.''
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Registrants are reminded that disclosure about materially dilutive
issuances is required outside the financial statements. Item 506 of
Regulation S-K requires presentation of the dilutive effects of those
issuances on net tangible book value. The effects of dilutive issuances
on the registrant's liquidity, capital resources and results of
operations should be addressed in Management's Discussion and Analysis.
Question 2: Does reflecting nominal issuances as outstanding for
all historical periods in the computation of earnings per share alter
the registrant's responsibility to determine whether compensation
expense must be
[[Page 17214]]
recognized for such issuances to employees?
Interpretive Response: No. Registrants must follow GAAP in
determining whether the recognition of compensation expense for any
issuances of equity instruments to employees is necessary.\4\
Reflecting nominal issuances as outstanding for all historical periods
in the computation of earnings per share does not alter that existing
responsibility under GAAP.
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\4\ As prescribed by FASB ASC Topic 718, Compensation--Stock
Compensation.
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E. Receivables From Sale of Stock
Facts: Capital stock is sometimes issued to officers or other
employees before the cash payment is received.
Question: How should the receivables from the officers or other
employees be presented in the balance sheet?
Interpretive Response: The amount recorded as a receivable should
be presented in the balance sheet as a deduction from stockholders'
equity. This is generally consistent with Rule 5-02.30 of Regulation S-
X which states that accounts or notes receivable arising from
transactions involving the registrant's capital stock should be
presented as deductions from stockholders' equity and not as assets.
It should be noted generally that all amounts receivable from
officers and directors resulting from sales of stock or from other
transactions (other than expense advances or sales on normal trade
terms) should be separately stated in the balance sheet irrespective of
whether such amounts may be shown as assets or are required to be
reported as deductions from stockholders' equity.
The staff will not suggest that a receivable from an officer or
director be deducted from stockholders' equity if the receivable was
paid in cash prior to the publication of the financial statements and
the payment date is stated in a note to the financial statements.
However, the staff would consider the subsequent return of such cash
payment to the officer or director to be part of a scheme or plan to
evade the registration or reporting requirements of the securities
laws.
F. Limited Partnerships
Facts: There exist a number of publicly held partnerships having
one or more corporate or individual general partners and a relatively
larger number of limited partners. There are no specific requirements
or guidelines relating to the presentation of the partnership equity
accounts in the financial statements. In addition, there are many
approaches to the parallel problem of relating the results of
operations to the two classes of partnership equity interests.
Question: How should the financial statements of limited
partnerships be presented so that the two ownership classes can readily
determine their relative participations in both the net assets of the
partnership and in the results of its operations?
Interpretive Response: The equity section of a partnership balance
sheet should distinguish between amounts ascribed to each ownership
class. The equity attributed to the general partners should be stated
separately from the equity of the limited partners, and changes in the
number of equity units authorized and outstanding should be shown for
each ownership class. A statement of changes in partnership equity for
each ownership class should be furnished for each period for which an
income statement is included.
The income statements of partnerships should be presented in a
manner which clearly shows the aggregate amount of net income (loss)
allocated to the general partners and the aggregate amount allocated to
the limited partners. The statement of income should also state the
results of operations on a per unit basis.
G. Notes and Other Receivables From Affiliates
Facts: The balance sheet of a corporate general partner is often
presented in a registration statement. Frequently, the balance sheet of
the general partner discloses that it holds notes or other receivables
from a parent or another affiliate. Often the notes or other
receivables were created in order to meet the ``substantial assets''
test which the Internal Revenue Service utilizes in applying its ``Safe
Harbor'' doctrine in the classification of organizations for income tax
purposes.
Question: How should such notes and other receivables be reported
in the balance sheet of the general partner?
Interpretive Response: While these notes and other receivables
evidencing a promise to contribute capital are often legally
enforceable, they seldom are actually paid. In substance, these
receivables are equivalent to unpaid subscriptions receivable for
capital shares which Rule 5-02.30 of Regulation S-X requires to be
deducted from the dollar amount of capital shares subscribed.
The balance sheet display of these or similar items is not
determined by the quality or actual value of the receivable or other
asset ``contributed'' to the capital of the affiliated general partner,
but rather by the relationship of the parties and the control inherent
in that relationship. Accordingly, in these situations, the receivable
must be treated as a deduction from stockholders' equity in the balance
sheet of the corporate general partner.
TOPIC 5: MISCELLANEOUS ACCOUNTING
A. Expenses of Offering
Facts: Prior to the effective date of an offering of equity
securities, Company Y incurs certain expenses related to the offering.
Question: Should such costs be deferred?
Interpretive Response: Specific incremental costs directly
attributable to a proposed or actual offering of securities may
properly be deferred and charged against the gross proceeds of the
offering. However, management salaries or other general and
administrative expenses may not be allocated as costs of the offering
and deferred costs of an aborted offering may not be deferred and
charged against proceeds of a subsequent offering. A short postponement
(up to 90 days) does not represent an aborted offering.
B. Gain or Loss From Disposition of Equipment
Facts: Company A has adopted the policy of treating gains and
losses from disposition of revenue producing equipment as adjustments
to the current year's provision for depreciation. Company B reflects
such gains and losses as a separate item in the statement of income.
Question: Does the staff have any views as to which method is
preferable?
Interpretive Response: Gains and losses resulting from the
disposition of revenue producing equipment should not be treated as
adjustments to the provision for depreciation in the year of
disposition, but should be shown as a separate item in the statement of
income.
If such equipment is depreciated on the basis of group of composite
accounts for fleets of like vehicles, gains (or losses) may be charged
(or credited) to accumulated depreciation with the result that
depreciation is adjusted over a period of years on an average basis. It
should be noted that the latter treatment would not be appropriate for
(1) an enterprise (such as an airline) which replaces its fleet on an
episodic rather than a continuing basis or (2) an enterprise (such as a
car leasing company) where equipment is sold after limited use so that
the equipment on hand is both fairly new and carried at amounts closely
related to current acquisition cost.
[[Page 17215]]
C.1. Removed by SAB 103
C.2. Removed by SAB 103
D. Organization and Offering Expenses and Selling Commissions--Limited
Partnerships Trading in Commodity Futures
Facts: Partnerships formed for the purpose of engaging in
speculative trading in commodity futures contracts sell limited
partnership interests to the public and frequently have a general
partner who is an affiliate of the partnership's commodity broker or
the principal underwriter selling the limited partnership interests.
The commodity broker or a subsidiary typically assumes the liability
for all or part of the organization and offering expenses and selling
commissions in connection with the sale of limited partnership
interests. Funds raised from the sale of partnership interests are
deposited in a margin account with the commodity broker and are
invested in Treasury Bills or similar securities. The arrangement
further provides that interest earned on the investments for an initial
period is to be retained by the broker until it has been reimbursed for
all or a specified portion of the aforementioned expenses and
commissions and that thereafter interest earned accrues to the
partnership.
In some instances, there may be no reference to reimbursement of
the broker for expenses and commissions to be assumed. The arrangements
may provide that all interest earned on investments accrues to the
partnership but that commissions on commodity transactions paid to the
broker are at higher rates for a specified initial period and at lower
rates subsequently.
Question 1: Should the partnership recognize a commitment to
reimburse the commodity broker for the organization and offering
expenses and selling commissions?
Interpretive Response: Yes. A commitment should be recognized by
reducing partnership capital and establishing a liability for the
estimated amount of expenses and commissions for which the broker is to
be reimbursed.
Question 2: Should the interest income retained by the broker for
reimbursement of expenses be recognized as income by the partnership?
Interpretive Response: Yes. All the interest income on the margin
account investments should be recognized as accruing to the partnership
as earned. The portion of income retained by the broker and not
actually realized by the partnership in cash should be applied to
reduce the liability for the estimated amount of reimbursable expenses
and commissions.
Question 3: If the broker retains all of the interest income for a
specified period and thereafter it accrues to the partnership, should
an equivalent amount of interest income be reflected on the
partnership's financial statements during the specified period?
Interpretive Response: Yes. If it appears from the terms of the
arrangement that it was the intent of the parties to provide for full
or partial reimbursement for the expenses and commissions paid by the
broker, then a commitment to reimbursement should be recognized by the
partnership and an equivalent amount of interest income should be
recognized on the partnership's financial statements as earned.
Question 4: Under the arrangements where commissions on commodity
transactions are at a lower rate after a specified period and there is
no reference to reimbursement of the broker for expenses and
commissions, should recognition be given on the partnership's financial
statements to a commitment to reimburse the broker for all or part of
the expenses and commissions?
Interpretive Response: If it appears from the terms of the
arrangement that the intent of the parties was to provide for full or
partial reimbursement of the broker's expenses and commissions, then
the estimated commitment should be recognized on the partnership's
financial statements. During the specified initial period commissions
on commodity transactions should be charged to operations at the lower
commission rate with the difference applied to reduce the
aforementioned commitment.
E. Accounting for Divestiture of a Subsidiary or Other Business
Operation
Facts: Company X transferred certain operations (including several
subsidiaries) to a group of former employees who had been responsible
for managing those operations. Assets and liabilities with a net book
value of approximately $8 million were transferred to a newly formed
entity--Company Y--wholly owned by the former employees. The
consideration received consisted of $1,000 in cash and interest bearing
promissory notes for $10 million, payable in equal annual installments
of $1 million each, plus interest, beginning two years from the date of
the transaction. The former employees possessed insufficient assets to
pay the notes and Company X expected the funds for payments to come
exclusively from future operations of the transferred business. Company
X remained contingently liable for performance on existing contracts
transferred and agreed to guarantee, at its discretion, performance on
future contracts entered into by the newly formed entity. Company X
also acted as guarantor under a line of credit established by Company
Y.
The nature of Company Y's business was such that Company X's
guarantees were considered a necessary predicate to obtaining future
contracts until such time as Company Y achieved profitable operations
and substantial financial independence from Company X.
Question: If deconsolidation of the subsidiaries and business
operations is appropriate, can Company X recognize a gain?
Interpretive Response: Before recognizing any gain, Company X
should identify all of the elements of the divesture arrangement and
allocate the consideration exchanged to each of those elements. In this
regard, we believe that Company X would recognize the guarantees at
fair value in accordance with FASB ASC Topic 460, Guarantees; the
contingent liability for performance on existing contracts in
accordance with FASB ASC Topic 450, Contingencies; and the promissory
notes in accordance with FASB ASC Topic 310, Receivables, and FASB ASC
Topic 835, Interest.
F. Accounting Changes Not Retroactively Applied Due to Immateriality
Facts: A registrant is required to adopt an accounting principle by
means of retrospective adjustment of prior periods' financial
statements. However, the registrant determines that the accounting
change does not have a material effect on prior periods' financial
statements and, accordingly, decides not to retrospectively adjust such
financial statements.
Question: In these circumstances, is it acceptable to adjust the
beginning balance of retained earnings of the period in which the
change is made for the cumulative effect of the change on the financial
statements of prior periods?
Interpretive Response: No. If prior periods are not retrospectively
adjusted, the cumulative effect of the change should be included in the
statement of income for the period in which the change is made. Even in
cases where the total cumulative effect is not significant, the staff
believes that the amount should be reflected in the results of
operations for the period in which the change is made. However, if the
cumulative effect
[[Page 17216]]
is material to current operations or to the trend of the reported
results of operations, then the individual income statements of the
earlier years should be retrospectively adjusted.
G. Transfers of Nonmonetary Assets by Promoters or Shareholders
Facts: Nonmonetary assets are exchanged by promoters or
shareholders for all or part of a company's common stock just prior to
or contemporaneously with a first-time public offering.
Question: Since FASB ASC paragraph 845-10-15-4 (Nonmonetary
Transactions Topic) states that the guidance in this topic is not
applicable to transactions involving the acquisition of nonmonetary
assets or services on issuance of the capital stock of an enterprise,
what value should be ascribed to the acquired assets by the company?
Interpretive Response: The staff believes that transfers of
nonmonetary assets to a company by its promoters or shareholders in
exchange for stock prior to or at the time of the company's initial
public offering normally should be recorded at the transferors'
historical cost basis determined under GAAP.
The staff will not always require that predecessor cost be used to
value nonmonetary assets received from an enterprise's promoters or
shareholders. However, deviations from this policy have been rare
applying generally to situations where the fair value of either the
stock issued \1\ or assets acquired is objectively measurable and the
transferor's stock ownership following the transaction was not so
significant that the transferor had retained a substantial indirect
interest in the assets as a result of stock ownership in the company.
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\1\ Estimating the fair value of the common stock issued,
however, is not appropriate when the stock is closely held and/or
seldom or ever traded.
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H. Removed by SAB 112
I. Removed by SAB 70
J. New Basis of Accounting Required in Certain Circumstances
Facts: Company A (or Company A and related persons) acquired
substantially all of the common stock of Company B in one or a series
of purchase transactions.
Question 1: Must Company B's financial statements presented in
either its own or Company A's subsequent filings with the Commission
reflect the new basis of accounting arising from Company A's
acquisition of Company B when Company B's separate corporate entity is
retained?
Interpretive Response: Yes. The staff believes that purchase
transactions that result in an entity becoming substantially wholly
owned (as defined in Rule 1-02(aa) of Regulation S-X) establish a new
basis of accounting for the purchased assets and liabilities.
When the form of ownership is within the control of the parent, the
basis of accounting for purchased assets and liabilities should be the
same regardless of whether the entity continues to exist or is merged
into the parent's operations. Therefore, Company B's separate financial
statements should reflect the new basis of accounting recorded by
Company A upon acquisition (i.e., ``pushed down'' basis).
Question 2: What is the staff's position if Company A acquired less
than substantially all of the common stock of Company B or Company B
had publicly held debt or preferred stock at the time Company B became
wholly owned?
Interpretive Response: The staff recognizes that the existence of
outstanding public debt, preferred stock or a significant
noncontrolling interest in a subsidiary might impact the parent's
ability to control the form of ownership. Although encouraging its use,
the staff generally does not insist on the application of push down
accounting in these circumstances.
Question 3: Company A borrows funds to acquire substantially all of
the common stock of Company B. Company B subsequently files a
registration statement in connection with a public offering of its
stock or debt.\2\ Should Company B's new basis (``push down'')
financial statements include Company A's debt related to its purchase
of Company B?
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\2\ The guidance in this SAB should also be considered for
Company B's separate financial statements included in its public
offering following Company B's spin-off or carve-out from Company A.
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Interpretive Response: The staff believes that Company A's debt,\3\
related interest expense, and allocable debt issue costs should be
reflected in Company B's financial statements included in the public
offering (or an initial registration under the Exchange Act) if: (1)
Company B is to assume the debt of Company A, either presently or in a
planned transaction in the future; (2) the proceeds of a debt or equity
offering of Company B will be used to retire all or a part of Company
A's debt; or (3) Company B guarantees or pledges its assets as
collateral for Company A's debt. Other relationships may exist between
Company A and Company B, such as the pledge of Company B's stock as
collateral for Company A's debt.\4\ While in this latter situation, it
may be clear that Company B's cash flows will service all or part of
Company A's debt, the staff does not insist that the debt be reflected
in Company B's financial statements providing there is full and
prominent disclosure of the relationship between Companies A and B and
the actual or potential cash flow commitment. In this regard, the staff
believes that FASB ASC Topic 450, Contingencies, FASB ASC Topic 850,
Related Party Disclosures, and FASB ASC Topic 460, Guarantees, require
sufficient disclosure to allow users of Company B's financial
statements to fully understand the impact of the relationship on
Company B's present and future cash flows. Rule 4-08(e) of Regulation
S-X also requires disclosure of restrictions which limit the payment of
dividends.
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\3\ The guidance in this SAB should also be considered where
Company A has financed the acquisition of Company B through the
issuance of mandatory redeemable preferred stock.
\4\ The staff does not believe Company B's financial statements
must reflect the debt in this situation because in the event of
default on the debt by Company A, the debt holder(s) would only be
entitled to Company B's stock held by Company A. Other equity or
debt holders of Company B would retain their priority with respect
to the net assets of Company B.
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Therefore, the staff believes that the equity section of Company
B's balance sheet and any pro forma financial information and
capitalization tables should clearly disclose that this arrangement
exists.\5\ Regardless of whether the debt is reflected in Company B's
financial statements, the notes to Company B's financial statements
should generally disclose, at a minimum: (1) The relationship between
Company A and Company B; (2) a description of any arrangements that
result in Company B's guarantee, pledge of assets \6\ or stock, etc.
that provides security for Company A's debt; (3) the extent (in the
aggregate and for each of the five years subsequent to the date of the
latest balance sheet presented) to which Company A is dependent on
Company B's cash flows to service its debt and the method by
[[Page 17217]]
which this will occur; and (4) the impact of such cash flows on Company
B's ability to pay dividends or other amounts to holders of its
securities. Additionally, the staff believes Company B's Management's
Discussion and Analysis of Financial Condition and Results of
Operations should discuss any material impact of its servicing of
Company A's debt on its own liquidity pursuant to Item 303(a)(1) of
Regulation S-K.
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\5\ For example, the staff has noted that certain registrants
have indicated on the face of such financial statements (as part of
the stockholder's equity section) the actual or potential financing
arrangement and the registrant's intent to pay dividends to satisfy
its parent's debt service requirements. The staff believes such
disclosures are useful to highlight the existence of arrangements
that could result in the use of Company B's cash to service Company
A's debt.
\6\ A material asset pledge should be clearly indicated on the
face of the balance sheet. For example, if all or substantially all
of the assets are pledged, the ``assets'' and ``total assets''
captions should include parenthetically: ``pledged for parent
company debt--See Note X.''
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K. Removed by SAB 95
L. LIFO Inventory Practices
Facts: On November 30, 1984, AcSEC and its Task Force on LIFO
Inventory Problems (task force) issued a paper, ``Identification and
Discussion of Certain Financial Accounting and Reporting Issues
Concerning LIFO Inventories.'' This paper identifies and discusses
certain financial accounting and reporting issues related to the last-
in, first-out (LIFO) inventory method for which authoritative
accounting literature presently provides no definitive guidance. For
some issues, the task force's advisory conclusions recommend changes in
current practice to narrow the diversity which the task force believes
exists. For other issues, the task force's advisory conclusions
recommend that current practice should be continued for financial
reporting purposes and that additional accounting guidance is
unnecessary. Except as otherwise noted in the paper, AcSEC generally
supports the task force's advisory conclusions. As stated in the issues
paper, ``Issues papers of the AICPA's accounting standards division are
developed primarily to identify financial accounting and reporting
issues the division believes need to be addressed or clarified by the
Financial Accounting Standards Board.'' On February 6, 1985, the FASB
decided not to add to its agenda a narrow project on the subject of
LIFO inventory practices.
Question 1: What is the SEC staff's position on the issues paper?
Interpretive Response: In the absence of existing authoritative
literature on LIFO accounting, the staff believes that registrants and
their independent accountants should look to the paper for guidance in
determining what constitutes acceptable LIFO accounting practice.\7\ In
this connection, the staff considers the paper to be an accumulation of
existing acceptable LIFO accounting practices which does not establish
any new standards and does not diverge from GAAP.
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\7\ In ASR 293 (July 2, 1981) see Financial Reporting
Codification Sec. 205, the Commission expressed its concerns about
the inappropriate use of Internal Revenue Service (IRS) LIFO
practices for financial statement preparation. Because the IRS
amended its regulations concerning the LIFO conformity rule on
January 13, 1981, allowing companies to apply LIFO differently for
financial reporting purposes than for tax purposes, the Commission
strongly encouraged registrants and their independent accountants to
examine their financial reporting LIFO practices. In that release,
the Commission acknowledged the ``task force which has been
established by AcSEC to accumulate information about [LIFO]
application problems'' and noted that ``This type of effort, in
addition to self-examination [of LIFO practices] by individual
registrants, is appropriate * * *''
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The staff also believes that the advisory conclusions recommended
in the issues paper are generally consistent with conclusions
previously expressed by the Commission, such as:
1. Pooling-paragraph 4-6 of the paper discusses LIFO inventory
pooling and concludes ``establishing separate pools with the principal
objective of facilitating inventory liquidations is unacceptable.'' In
Accounting and Auditing Enforcement Release 35, August 13, 1984, the
Commission stated that it believes that the Company improperly
realigned its LIFO pools in such a way as to maximize the likelihood
and magnitude of LIFO liquidations and thus, overstated net income.
2. New Items-paragraph 4-27 of the paper discusses determination of
the cost of new items and concludes ``if the double extension or an
index technique is used, the objective of LIFO is achieved by
reconstructing the base year cost of new items added to existing
pools.'' In ASR 293, the Commission stated that when the effects of
inflation on the cost of new products are measured by making a
comparison with current cost as the base-year cost, rather than a
reconstructed base-year cost, income is improperly increased.
Question 2: If a registrant utilizes a LIFO practice other than one
recommended by an advisory conclusion in the issues paper, must the
registrant change its practice to one specified in the paper?
Interpretive Response: Now that the issues paper is available, the
staff believes that a registrant and its independent accountants should
re-examine previously adopted LIFO practices and compare them to the
recommendations in the paper. In the event that the registrant and its
independent accountants conclude that the registrant's LIFO practices
are preferable in the circumstances, they should be prepared to justify
their position in the event that a question is raised by the staff.
Question 3: If a registrant elects to change its LIFO practices to
be consistent with the guidance in the issues paper and discloses such
changes in accordance with FASB ASC Topic 250, Accounting Changes and
Error Corrections, will the registrant be requested by the staff to
explain its past practices and its justification for those practices?
Interpretive Response: The staff does not expect to routinely raise
questions about changes in LIFO practices which are made to make a
company's accounting consistent with the recommendations in the issues
paper.
M. Other Than Temporary Impairment of Certain Investments in Equity
Securities
Facts: FASB ASC paragraph 320-10-35-33 (Investments--Debt and
Equity Securities Topic) does not define the phrase ``other than
temporary'' for available-for-sale equity securities. For its
available-for-sale equity securities, Company A has interpreted ``other
than temporary'' to mean permanent impairment. Therefore, because
Company A's management has not been able to determine that its
investment in Company B's equity securities is permanently impaired, no
realized loss has been recognized even though the market price of
Company B's equity securities is currently less than one-third of
Company A's average acquisition price.
Question: For equity securities classified as available-for-sale,
does the staff believe that the phrase ``other than temporary'' should
be interpreted to mean ``permanent''?
Interpretive Response: No. The staff believes that the FASB
consciously chose the phrase ``other than temporary'' because it did
not intend that the test be ``permanent impairment,'' as has been used
elsewhere in accounting practice.\8\
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\8\ [Original footnote removed by SAB 114.]
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The value of investments in equity securities classified as
available-for-sale may decline for various reasons. The market price
may be affected by general market conditions which reflect prospects
for the economy as a whole or by specific information pertaining to an
industry or an individual company. Such declines require further
investigation by management. Acting upon the premise that a write-down
may be required, management should consider all available evidence to
evaluate the realizable value of its investment in equity securities
classified as available-for-sale.
There are numerous factors to be considered in such an evaluation
and their relative significance will vary from case to case. The staff
believes that the
[[Page 17218]]
following are only a few examples of the factors which, individually or
in combination, indicate that a decline in value of an equity security
classified as available-for-sale is other than temporary and that a
write-down of the carrying value is required:
a. The length of the time and the extent to which the market value
has been less than cost;
b. The financial condition and near-term prospects of the issuer,
including any specific events which may influence the operations of the
issuer such as changes in technology that may impair the earnings
potential of the investment or the discontinuance of a segment of the
business that may affect the future earnings potential; or
c. The intent and ability of the holder to retain its investment in
the issuer for a period of time sufficient to allow for any anticipated
recovery in market value.
Unless evidence exists to support a realizable value equal to or
greater than the carrying value of the investment in equity securities
classified as available-for-sale, a write-down to fair value accounted
for as a realized loss should be recorded. Such loss should be
recognized in the determination of net income of the period in which it
occurs and the written down value of the investment in the company
becomes the new cost basis of the investment.
N. Discounting by Property-Casualty Insurance Companies
Facts: A registrant which is an insurance company discounts certain
unpaid claims liabilities related to short-duration \9\ insurance
contracts for purposes of reporting to state regulatory authorities,
using discount rates permitted or prescribed by those authorities
(``statutory rates'') which approximate 3\1/2\ percent. The registrant
follows the same practice in preparing its financial statements in
accordance with GAAP. It proposes to change for GAAP purposes, to using
a discount rate related to the historical yield on its investment
portfolio (``investment related rate'') which is represented to
approximate 7 percent, and to account for the change as a change in
accounting estimate, applying the investment related rate to claims
settled in the current and subsequent years while the statutory rate
would continue to be applied to claims settled in all prior years.
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\9\ The term ``short-duration'' refers to the period of coverage
(see FASB ASC paragraph 944-20-15-7 (Financial Services--Insurance
Topic)), not the period that the liabilities are expected to be
outstanding.
---------------------------------------------------------------------------
Question 1: What is the staff's position with respect to
discounting claims liabilities related to short-duration insurance
contracts?
Interpretive Response: The staff is aware of efforts by the
accounting profession to assess the circumstances under which
discounting may be appropriate in financial statements. Pending
authoritative guidance resulting from those efforts however, the staff
will raise no objection if a registrant follows a policy for GAAP
reporting purposes of:
Discounting liabilities for unpaid claims and claim
adjustment expenses at the same rates that it uses for reporting to
state regulatory authorities with respect to the same claims
liabilities, or
Discounting liabilities with respect to settled claims
under the following circumstances:
(1) The payment pattern and ultimate cost are fixed and
determinable on an individual claim basis, and
(2) The discount rate used is reasonable on the facts and
circumstances applicable to the registrant at the time the claims are
settled.
Question 2: Does the staff agree with the registrant's proposal
that the change from a statutory rate to an investment related rate be
accounted for as a change in accounting estimate?
Interpretive Response: No. The staff believes that such a change
involves a change in the method of applying an accounting principle,
i.e., the method of selecting the discount rate was changed. The staff
therefore believes that the registrant should reflect the cumulative
effect of the change in accounting by applying the new selection method
retroactively to liabilities for claims settled in all prior years, in
accordance with the requirements of FASB ASC Topic 250, Accounting
Changes and Error Corrections. Initial adoption of discounting for GAAP
purposes would be treated similarly. In either case, in addition to the
disclosures required by FASB ASC Topic 250 concerning the change in
accounting principle, a preferability letter from the registrant's
independent accountant is required.
O. Research and Development Arrangements
Facts: FASB ASC paragraph 730-20-25-5 (Research and Development
Topic) states that conditions other than a written agreement may exist
which create a presumption that the enterprise will repay the funds
provided by other parties under a research and development arrangement.
FASB ASC subparagraph 730-20-25-6(c) lists as one of those conditions
the existence of a ``significant related party relationship'' between
the enterprise and the parties funding the research and development.
Question 1: What does the staff consider a ``significant related
party relationship'' as that term is used in FASB ASC subparagraph 730-
20-25-6(c)?
Interpretive Response: The staff believes that a significant
related party relationship exists when 10 percent or more of the entity
providing the funds is owned by related parties.\10\ In unusual
circumstances, the staff may also question the appropriateness of
treating a research and development arrangement as a contract to
perform service for others at the less than 10 percent level. In
reviewing these matters the staff will consider, among other factors,
the percentage of the funding entity owned by the related parties in
relationship to their ownership in and degree of influence or control
over the enterprise receiving the funds.
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\10\ Related parties as used herein are as defined in the FASB
ASC Master Glossary.
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Question 2: FASB ASC paragraph 730-20-25-5 states that the
presumption of repayment ``can be overcome only by substantial evidence
to the contrary.'' Can the presumption be overcome by evidence that the
funding parties were assuming the risk of the research and development
activities since they could not reasonably expect the enterprise to
have resources to repay the funds based on its current and projected
future financial condition?
Interpretive Response: No. FASB ASC paragraph 730-20-25-3
specifically indicates that the enterprise ``may settle the liability
by paying cash, by issuing securities, or by some other means.'' While
the enterprise may not be in a position to pay cash or issue debt,
repayment could be accomplished through the issuance of stock or
various other means. Therefore, an apparent or projected inability to
repay the funds with cash (or debt which would later be paid with cash)
does not necessarily demonstrate that the funding parties were
accepting the entire risks of the activities.
P. Restructuring Charges
1. Removed by SAB 103
2. Removed by SAB 103
3. Income Statement Presentation of Restructuring Charges
Facts: Restructuring charges often do not relate to a separate
component of the entity, and, as such, they would not qualify for
presentation as losses on the disposal of a discontinued operation.
[[Page 17219]]
Additionally, since the charges are not both unusual and infrequent\11\
they are not presented in the income statement as extraordinary items.
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\11\ See FASB ASC paragraph 225-20-45-2.
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Question 1: May such restructuring charges be presented in the
income statement as a separate caption after income from continuing
operations before income taxes (i.e., preceding income taxes and/or
discontinued operations)?
Interpretive Response: No. FASB ASC paragraph 225-20-45-16 (Income
Statement Topic) states that items that do not meet the criteria for
classification as an extraordinary item should be reported as a
component of income from continuing operations.\12\ Neither FASB ASC
Subtopic 225-20, Income Statement--Extraordinary and Unusual Items, nor
Rule 5-03 of Regulation S-X contemplate a category in between
continuing and discontinued operations. Accordingly, the staff believes
that restructuring charges should be presented as a component of income
from continuing operations, separately disclosed if material.
Furthermore, the staff believes that a separately presented
restructuring charge should not be preceded by a sub-total representing
``income from continuing operations before restructuring charge''
(whether or not it is so captioned). Such a presentation would be
inconsistent with the intent of FASB ASC Subtopic 225-20.
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\12\ FASB ASC paragraph 225-20-45-16 further provides that such
items should not be reported on the income statement net of income
taxes or in any manner that implies that they are similar to
extraordinary items.
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Question 2: Some registrants utilize a classified or ``two-step''
income statement format (i.e., one which presents operating revenues,
expenses and income followed by other income and expense items). May a
charge which relates to assets or activities for which the associated
revenues and expenses have historically been included in operating
income be presented as an item of ``other expense'' in such an income
statement?
Interpretive Response: No. The staff believes that the proper
classification of a restructuring charge depends on the nature of the
charge and the assets and operations to which it relates. Therefore,
charges which relate to activities for which the revenues and expenses
have historically been included in operating income should generally be
classified as an operating expense, separately disclosed if material.
Furthermore, when a restructuring charge is classified as an operating
expense, the staff believes that it is generally inappropriate to
present a preceding subtotal captioned or representing operating income
before restructuring charges. Such an amount does not represent a
measurement of operating results under GAAP.
Conversely, charges relating to activities previously included
under ``other income and expenses'' should be similarly classified,
also separately disclosed if material.
Question 3: Is it permissible to disclose the effect on net income
and earnings per share of such a restructuring charge?
Interpretive Response: Discussions in MD&A and elsewhere which
quantify the effects of unusual or infrequent items on net income and
earnings per share are beneficial to a reader's understanding of the
financial statements and are therefore acceptable.
MD&A also should discuss the events and decisions which gave rise
to the restructuring, the nature of the charge and the expected impact
of the restructuring on future results of operations, liquidity and
sources and uses of capital resources.
4. Disclosures
Beginning with the period in which the exit plan is initiated, FASB
ASC Topic 420, Exit or Disposal Cost Obligations, requires disclosure,
in all periods, including interim periods, until the exit plan is
completed, of the following:
a. A description of the exit or disposal activity, including the
facts and circumstances leading to the expected activity and the
expected completion date
b. For each major type of cost associated with the activity (for
example, one-time termination benefits, contract termination costs, and
other associated costs):
(1) The total amount expected to be incurred in connection with the
activity, the amount incurred in the period, and the cumulative amount
incurred to date
(2) A reconciliation of the beginning and ending liability balances
showing separately the changes during the period attributable to costs
incurred and charged to expense, costs paid or otherwise settled, and
any adjustments to the liability with an explanation of the reason(s)
therefor
c. The line item(s) in the income statement or the statement of
activities in which the costs in (b) above are aggregated
d. For each reportable segment, the total amount of costs expected
to be incurred in connection with the activity, the amount incurred in
the period, and the cumulative amount incurred to date, net of any
adjustments to the liability with an explanation of the reason(s)
therefor
e. If a liability for a cost associated with the activity is not
recognized because fair value cannot be reasonably estimated, that fact
and the reasons therefor
Question: What specific disclosures about restructuring charges has
the staff requested to fulfill the disclosure requirements of FASB ASC
Topic 420 and MD&A?
Interpretive Response: The staff often has requested greater
disaggregation and more precise labeling when exit and involuntary
termination costs are grouped in a note or income statement line item
with items unrelated to the exit plan. For the reader's understanding,
the staff has requested that discretionary, or decision-dependent,
costs of a period, such as exit costs, be disclosed and explained in
MD&A separately. Also to improve transparency, the staff has requested
disclosure of the nature and amounts of additional types of exit costs
and other types of restructuring charges \13\ that appear
quantitatively or qualitatively material, and requested that losses
relating to asset impairments be identified separately from charges
based on estimates of future cash expenditures.
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\13\ Examples of common components of exit costs and other types
of restructuring charges which should be considered for separate
disclosure include, but are not limited to, involuntary employee
terminations and related costs, changes in valuation of current
assets such as inventory writedowns, long term asset disposals,
adjustments for warranties and product returns, leasehold
termination payments, and other facility exit costs, among others.
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The staff frequently reminds registrants that in periods subsequent
to the initiation date that material changes and activity in the
liability balances of each significant type of exit cost and
involuntary employee termination benefits \14\ (either as a result of
expenditures or changes in/reversals of estimates or the fair value of
the liability) should be disclosed in the footnotes to the interim and
annual financial statements and discussed in MD&A. In the event a
company recognized liabilities for exit costs and involuntary employee
termination benefits relating to multiple exit plans, the staff
believes presentation of separate information for each individual exit
plan that has a material effect on
[[Page 17220]]
the balance sheet, results of operations or cash flows generally is
appropriate.
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\14\ The staff would expect similar disclosures for employee
termination benefits whether those costs have been recognized
pursuant to FASB ASC Topic 420, FASB ASC Topic 712, Compensation--
Nonretirement Postemployment Benefits, or FASB ASC Topic 715,
Compensation--Retirement Benefits.
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For material exit or involuntary employee termination costs related
to an acquired business, the staff has requested disclosure in either
MD&A or the financial statements of:
1. When the registrant began formulating exit plans for which
accrual may be necessary,
2. The types and amounts of liabilities recognized for exit costs
and involuntary employee termination benefits and included in the
acquisition cost allocation, and
3. Any unresolved contingencies or purchase price allocation issues
and the types of additional liabilities that may result in an
adjustment of the acquisition cost allocation.
The staff has noted that the economic or other events that cause a
registrant to consider and/or adopt an exit plan or that impair the
carrying amount of assets, generally occur over time. Accordingly, the
staff believes that as those events and the resulting trends and
uncertainties evolve, they often will meet the requirement for
disclosure pursuant to the Commission's MD&A rules prior to the period
in which the exit costs and liabilities are recorded pursuant to GAAP.
Whether or not currently recognizable in the financial statements,
material exit or involuntary termination costs that affect a known
trend, demand, commitment, event, or uncertainty to management, should
be disclosed in MD&A. The staff believes that MD&A should include
discussion of the events and decisions which gave rise to the exit
costs and exit plan, and the likely effects of management's plans on
financial position, future operating results and liquidity unless it is
determined that a material effect is not reasonably likely to occur.
Registrants should identify the periods in which material cash outlays
are anticipated and the expected source of their funding. Registrants
should also discuss material revisions to exit plans, exit costs, or
the timing of the plan's execution, including the nature and reasons
for the revisions.
The staff believes that the expected effects on future earnings and
cash flows resulting from the exit plan (for example, reduced
depreciation, reduced employee expense, etc.) should be quantified and
disclosed, along with the initial period in which those effects are
expected to be realized. This includes whether the cost savings are
expected to be offset by anticipated increases in other expenses or
reduced revenues. This discussion should clearly identify the income
statement line items to be impacted (for example, cost of sales;
marketing; selling, general and administrative expenses; etc.). In
later periods if actual savings anticipated by the exit plan are not
achieved as expected or are achieved in periods other than as expected,
MD&A should discuss that outcome, its reasons, and its likely effects
on future operating results and liquidity.
The staff often finds that, because of the discretionary nature of
exit plans and the components thereof, presenting and analyzing
material exit and involuntary termination charges in tabular form, with
the related liability balances and activity (e.g., beginning balance,
new charges, cash payments, other adjustments with explanations, and
ending balances) from balance sheet date to balance sheet date, is
necessary to explain fully the components and effects of significant
restructuring charges. The staff believes that such a tabular analysis
aids a financial statement user's ability to disaggregate the
restructuring charge by income statement line item in which the costs
would have otherwise been recognized, absent the restructuring plan,
(for example, cost of sales; selling, general, and administrative;
etc.).
Q. Increasing Rate Preferred Stock
Facts: A registrant issues Class A and Class B nonredeemable
preferred stock \15\ on 1/1/X1. Class A, by its terms, will pay no
dividends during the years 20X1 through 20X3. Class B, by its terms,
will pay dividends at annual rates of $2, $4 and $6 per share in the
years 20X1, 20X2 and 20X3, respectively. Beginning in the year 20X4 and
thereafter as long as they remain outstanding, each instrument will pay
dividends at an annual rate of $8 per share. In all periods, the
scheduled dividends are cumulative.
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\15\ ``Nonredeemable'' preferred stock, as used in this SAB,
refers to preferred stocks which are not redeemable or are
redeemable only at the option of the issuer.
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At the time of issuance, eight percent per annum was considered to
be a market rate for dividend yield on Class A, given its
characteristics other than scheduled cash dividend entitlements (voting
rights, liquidation preference, etc.), as well as the registrant's
financial condition and future economic prospects. Thus, the registrant
could have expected to receive proceeds of approximately $100 per share
for Class A if the dividend rate of $8 per share (the ``perpetual
dividend'') had been in effect at date of issuance. In consideration of
the dividend payment terms, however, Class A was issued for proceeds of
$79\3/8\ per share. The difference, $20\5/8\, approximated the value of
the absence of $8 per share dividends annually for three years,
discounted at 8%.
The issuance price of Class B shares was determined by a similar
approach, based on the terms and characteristics of the Class B shares.
Question 1: How should preferred stocks of this general type
(referred to as ``increasing rate preferred stocks'') be reported in
the balance sheet?
Interpretive Response: As is normally the case with other types of
securities, increasing rate preferred stock should be recorded
initially at its fair value on date of issuance. Thereafter, the
carrying amount should be increased periodically as discussed in the
Interpretive Response to Question 2.
Question 2: Is it acceptable to recognize the dividend costs of
increasing rate preferred stocks according to their stated dividend
schedules?
Interpretive Response: No. The staff believes that when
consideration received for preferred stocks reflects expectations of
future dividend streams, as is normally the case with cumulative
preferred stocks, any discount due to an absence of dividends (as with
Class A) or gradually increasing dividends (as with Class B) for an
initial period represents prepaid, unstated dividend cost.\16\
Recognizing the dividend cost of these instruments according to their
stated dividend schedules would report Class A as being cost-free, and
would report the cost of Class B at less than its effective cost, from
the standpoint of common stock interests (i.e., for purposes of
computing income applicable to common stock and earnings per common
share) during the years 20X1 through 20X3.
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\16\ As described in the ``Facts'' section of this issue, a
registrant would receive less in proceeds for a preferred stock, if
the stock were to pay less than its perpetual dividend for some
initial period(s), than if it were to pay the perpetual dividend
from date of issuance. The staff views the discount on increasing
rate preferred stock as equivalent to a prepayment of dividends by
the issuer, as though the issuer had concurrently (a) issued the
stock with the perpetual dividend being payable from date of
issuance, and (b) returned to the investor a portion of the proceeds
representing the present value of certain future dividend
entitlements which the investor agreed to forgo.
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Accordingly, the staff believes that discounts on increasing rate
preferred stock should be amortized over the period(s) preceding
commencement of the perpetual dividend, by charging imputed dividend
cost against retained earnings and increasing the carrying amount of
the preferred stock by a corresponding amount. The discount at time of
issuance should be computed as
[[Page 17221]]
the present value of the difference between (a) dividends that will be
payable, if any, in the period(s) preceding commencement of the
perpetual dividend; and (b) the perpetual dividend amount for a
corresponding number of periods; discounted at a market rate for
dividend yield on preferred stocks that are comparable (other than with
respect to dividend payment schedules) from an investment standpoint.
The amortization in each period should be the amount which, together
with any stated dividend for the period (ignoring fluctuations in
stated dividend amounts that might result from variable rates,\17\
results in a constant rate of effective cost vis-a-vis the carrying
amount of the preferred stock (the market rate that was used to compute
the discount).
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\17\ See Question 3 regarding variable increasing rate preferred
stocks.
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Simplified (ignoring quarterly calculations) application of this
accounting to the Class A preferred stock described in the ``Facts''
section of this bulletin would produce the following results on a per
share basis:
Carrying Amount of Preferred Stock
----------------------------------------------------------------------------------------------------------------
Imputed dividend
Beginning of year (8% of carrying End of year
(BOY) amount at BOY)
----------------------------------------------------------------------------------------------------------------
Year 20x1.............................................. $79.38 6.35 85.73
Year 20x2.............................................. 85.73 6.86 92.59
Year 20x3.............................................. 92.59 7.41 100.00
----------------------------------------------------------------------------------------------------------------
During 20X4 and thereafter, the stated dividend of $8 measured
against the carrying amount of $100\18\ would reflect dividend cost of
8%, the market rate at time of issuance.
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\18\ It should be noted that the $100 per share amount used in
this issue is for illustrative purposes, and is not intended to
imply that application of this issue will necessarily result in the
carrying amount of a nonredeemable preferred stock being accreted to
its par value, stated value, voluntary redemption value or
involuntary liquidation value.
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The staff believes that existing authoritative literature, while
not explicitly addressing increasing rate preferred stocks, implicitly
calls for the accounting described in this bulletin.
The pervasive, fundamental principle of accrual accounting would,
in the staff's view, preclude registrants from recognizing the dividend
cost on the basis of whatever cash payment schedule might be arranged.
Furthermore, recognition of the effective cost of unstated rights and
privileges is well-established in accounting, and is specifically
called for by FASB ASC Subtopic 835-30, Interest--Imputation of
Interest, and Topic 3.C of this codification for unstated interest
costs of debt capital and unstated dividend costs of redeemable
preferred stock capital, respectively. The staff believes that the
requirement to recognize the effective periodic cost of capital applies
also to nonredeemable preferred stocks because, for that purpose, the
distinction between debt capital and preferred equity capital (whether
redeemable \19\ or nonredeemable) is irrelevant from the standpoint of
common stock interests.
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\19\ Application of the interest method with respect to
redeemable preferred stocks pursuant to Topic 3.C results in
accounting consistent with the provisions of this bulletin
irrespective of whether the redeemable preferred stocks have
constant or increasing stated dividend rates. The interest method,
as described in FASB ASC Subtopic 835-30, produces a constant
effective periodic rate of cost that is comprised of amortization of
discount as well as the stated cost in each period.
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Question 3: Would the accounting for discounts on increasing rate
preferred stock be affected by variable stated dividend rates?
Interpretive Response: No. If stated dividends on an increasing
rate preferred stock are variable, computations of initial discount and
subsequent amortization should be based on the value of the applicable
index at date of issuance and should not be affected by subsequent
changes in the index.
For example, assume that a preferred stock issued 1/1/X1 is
scheduled to pay dividends at annual rates, applied to the stock's par
value, equal to 20% of the actual (fluctuating) market yield on a
particular Treasury security in 20X1 and 20X2, and 90% of the
fluctuating market yield in 20X3 and thereafter. The discount would be
computed as the present value of a two-year dividend stream equal to
70% (90% less 20%) of the 1/1/X1 Treasury security yield, annually, on
the stock's par value. The discount would be amortized in years 20X1
and 20X2 so that, together with 20% of the 1/1/X1 Treasury yield on the
stock's par value, a constant rate of cost vis-a-vis the stock's
carrying amount would result. Changes in the Treasury security yield
during 20X1 and 20X2 would, of course, cause the rate of total reported
preferred dividend cost (amortization of discount plus cash dividends)
in those years to be more or less than the rate indicated by discount
amortization plus 20% of the 1/1/X1 Treasury security yield. However,
the fluctuations would be due solely to the impact of changes in the
index on the stated dividends for those periods.
Question 4: Will the staff expect retroactive changes by
registrants to comply with the accounting described in this bulletin?
Interpretive Response: All registrants will be expected to follow
the accounting described in this bulletin for increasing rate preferred
stocks issued after December 4, 1986.\20\ Registrants that have not
followed this accounting for increasing rate preferred stocks issued
before that date were encouraged to retroactively change their
accounting for those preferred stocks in the financial statements next
filed with the Commission. The staff did not object if registrants did
not make retroactive changes for those preferred stocks, provided that
all presentations of and discussions regarding income applicable to
common stock and earnings per share in future filings and shareholders'
reports are accompanied by equally prominent supplemental disclosures
(on the face of the income statement, in presentations of selected
financial data, in MD&A, etc.) of the impact of not changing their
accounting and an explanation of such impact (e.g., that dividend cost
has been recognized on a cash basis).
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\20\ The staff first publicly expressed its view as to the
appropriate accounting at the December 3-4, 1986 meeting of the
EITF.
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R. Removed by SAB 103
S. Quasi-Reorganization
Facts: As a consequence of significant operating losses and/or
recent write-downs of property, plant and equipment, a company's
financial statements reflect an accumulated deficit. The company
desires to eliminate the deficit by reclassifying amounts from paid-in-
capital. In addition, the company anticipates adopting a discretionary
change in
[[Page 17222]]
accounting principles \21\ that will be recorded as a cumulative-effect
type of accounting change. The recording of the cumulative effect will
have the result of increasing the company's retained earnings.
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\21\ Discretionary accounting changes require the filing of a
preferability letter by the registrant's independent accountant
pursuant to Item 601 of Regulation S-K and Rule 10-01(b)(6) of
Regulation S-X, respectively.
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Question 1: May the company reclassify its capital accounts to
eliminate the accumulated deficit without satisfying all of the
conditions enumerated in Section 210 \22\ of the Codification of
Financial Reporting Policies for a quasi-reorganization?
---------------------------------------------------------------------------
\22\ ASR 25.
---------------------------------------------------------------------------
Interpretive Response: No. The staff believes a deficit
reclassification of any nature is considered to be a quasi-
reorganization. As such, a company may not reclassify or eliminate a
deficit in retained earnings unless all requisite conditions set forth
in Section 210 \23\ for a quasi-reorganization are satisfied. \24\
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\23\ Section 210 (ASR 25) indicates the following conditions
under which a quasi-reorganization can be effected without the
creation of a new corporate entity and without the intervention of
formal court proceedings:
1. Earned surplus, as of the date selected, is exhausted;
2. Upon consummation of the quasi-reorganization, no deficit
exists in any surplus account;
3. The entire procedure is made known to all persons entitled to
vote on matters of general corporate policy and the appropriate
consents to the particular transactions are obtained in advance in
accordance with the applicable laws and charter provisions;
The procedure accomplishes, with respect to the accounts,
substantially what might be accomplished in a reorganization by
legal proceedings--namely, the restatement of assets in terms of
present considerations as well as appropriate modifications of
capital and capital surplus, in order to obviate, so far as
possible, the necessity of future reorganization of like nature.
\24\ In addition, FASB ASC Subtopic 852-20, Reorganizations--
Quasi-Reorganizations, outlines procedures that must be followed in
connection with and after a quasi-reorganization.
---------------------------------------------------------------------------
Question 2: Must the company implement the discretionary change in
accounting principle simultaneously with the quasi-reorganization or
may it adopt the change after the quasi-reorganization has been
effected?
Interpretive Response: The staff has taken the position that the
company should adopt the anticipated accounting change prior to or as
an integral part of the quasi-reorganization. Any such accounting
change should be effected by following GAAP with respect to the change.
\25\
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\25\ FASB ASC Topic 250 provides accounting principles to be
followed when adopting accounting changes. In addition, many newly-
issued accounting pronouncements provide specific guidance to be
followed when adopting the accounting specified in such
pronouncements.
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FASB ASC paragraph 852-20-25-5 (Reorganizations Topic) indicates
that, following a quasi-reorganization, an ``entity's accounting shall
be substantially similar to that appropriate for a new entity.'' The
staff believes that implicit in this ``fresh-start'' concept is the
need for the company's accounting principles in place at the time of
the quasi-reorganization to be those planned to be used following the
reorganization to avoid a misstatement of earnings and retained
earnings after the reorganization.\26\ FASB ASC paragraph 852-20-30-2
states, in part, ``* * * in general, assets should be carried forward
as of the date of the readjustment at fair and not unduly conservative
amounts, determined with due regard for the accounting to be
subsequently employed by the entity.'' (emphasis added)
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\26\ Certain newly-issued accounting standards do not require
adoption until some future date. The staff believes, however, that
if the registrant intends or is required to adopt those standards
within 12 months following the quasi-reorganization, the registrant
should adopt those standards prior to or as an integral part of the
quasi-reorganization. Further, registrants should consider early
adoption of standards with effective dates more than 12 months
subsequent to a quasi-reorganization.
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In addition, the staff believes that adopting a discretionary
change in accounting principle that will be reflected in the financial
statements within 12 months following the consummation of a quasi-
reorganization leads to a presumption that the accounting change was
contemplated at the time of the quasi-reorganization.\27\
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\27\ Certain accounting changes require restatement of prior
financial statements. The staff believes that if a quasi-
reorganization had been recorded in a restated period, the effects
of the accounting change on quasi-reorganization adjustments should
also be restated to properly reflect the quasi-reorganization in the
restated financial statements.
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Question 3: In connection with a quasi-reorganization, may there be
a write-up of net assets?
Interpretive Response: No. The staff believes that increases in the
recorded values of specific assets (or reductions in liabilities) to
fair value are appropriate providing such adjustments are factually
supportable; however, the amount of such increases is limited to
offsetting adjustments to reflect decreases in other assets (or
increases in liabilities) to reflect their new fair value. In other
words, a quasi-reorganization should not result in a write-up of net
assets of the registrant.
Question 4: The interpretive response to question 1 indicates that
the staff believes that a deficit reclassification of any nature is
considered to be a quasi-reorganization, and accordingly, must satisfy
all the conditions of Section 210.\28\ Assume a company has satisfied
all the requisite conditions of Section 210, and has eliminated a
deficit in retained earnings by a concurrent reduction in paid-in
capital, but did not need to restate assets and liabilities by a charge
to capital because assets and liabilities were already stated at fair
values. How should the company reflect the tax benefits of operating
loss or tax credit carryforwards for financial reporting purposes that
existed as of the date of the quasi-reorganization when such tax
benefits are subsequently recognized for financial reporting purposes?
---------------------------------------------------------------------------
\28\ See footnote 27.
---------------------------------------------------------------------------
Interpretive Response: The staff believes FASB ASC Subtopic 852-
740, Reorganizations--Income Taxes, requires that any subsequently
recognized tax benefits of operating loss or tax credit carryforwards
that existed as of the date of a quasi-reorganization be reported as a
direct addition to paid-in capital. The staff believes that this
position is consistent with the ``new company'' or ``fresh-start''
concept embodied in Section 210,\29\ and in existing accounting
literature regarding quasi-reorganizations, and with the FASB staff's
justification for such a position when they stated that a ``new
enterprise would not have tax benefits attributable to operating losses
or tax credits that arose prior to its organization date. \30\
---------------------------------------------------------------------------
\29\ Section 210 (ASR 25) discusses the ``conditions under which
a quasi-reorganization has come to be applied in accounting to the
corporate procedures in the course of which a company, without
creation of new corporate entity and without intervention of formal
court proceedings, is enabled to eliminate a deficit whether
resulting from operations or recognition of other losses or both and
to establish a new earned surplus account for the accumulation of
earnings subsequent to the date selected as the effective date of
the quasi-reorganization.'' It further indicates that ``it is
implicit in a procedure of this kind that it is not to be employed
recurrently, but only under circumstances which would justify an
actual reorganization or formation of a new corporation,
particularly if the sole purpose of the quasi-reorganization is the
elimination of a deficit in earned surplus resulting from operating
losses.'' (emphasis added)
\30\ FASB ASC paragraph 852-740-55-4 states in part: ``As
indicated in paragraph 852-20-25-5, after a quasi-reorganization,
the entity's accounting shall be substantially similar to that
appropriate for a new entity. As such, any subsequently recognized
tax benefit of an operating loss or tax credit carryforward that
existed at the date of a quasi-reorganization shall not be included
in the determination of income of the ``new'' entity, regardless of
whether losses that gave rise to an operating loss carryforward were
charged to income before the quasi-reorganization or directly to
contributed capital as part of the quasi-reorganization. A new
entity would not have tax benefits attributable to operating losses
or tax credits that arose before its organization date.''
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The staff believes that all registrants that comply with the
requirements of Section 210 in effecting a quasi-
[[Page 17223]]
reorganization should apply the accounting required by FASB ASC
paragraph 852-740-45-3 for the tax benefits of tax carryforward
items.31, 32 Therefore, even though the only effect of a
quasi-reorganization is the elimination of a deficit in retained
earnings because assets and liabilities are already stated at fair
values and the revaluation of assets and liabilities is unnecessary (or
a write-up of net assets is prohibited as indicated in the interpretive
response to question 3 above), subsequently recognized tax benefits of
operating loss or tax credit carryforward items should be recorded as a
direct addition to paid-in capital.
---------------------------------------------------------------------------
\31\ [Original footnote removed by SAB 114.]
\32\ FASB ASC paragraph 852-740-45-3 states: ``[t]he tax benefit
of deductible temporary differences and carryforwards as of the date
of a quasi reorganization as defined and contemplated in FASB ASC
Subtopic 852-20, ordinarily are reported as a direct addition to
contributed capital if the tax benefits are recognized in subsequent
years.''
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Question 5: If a company had previously recorded a quasi-
reorganization that only resulted in the elimination of a deficit in
retained earnings, may the company reverse such entry and ``undo'' its
quasi-reorganization?
Interpretive Response: No. The staff believes FASB ASC Topic 250,
Accounting Changes and Error Corrections, would preclude such a change
in accounting. It states: ``a method of accounting that was previously
adopted for a type of transaction or event that is being terminated or
that was a single, nonrecurring event in the past shall not be
changed.'' (emphasis added.) \33\
---------------------------------------------------------------------------
\33\ FASB ASC paragraph 250-10-45-12.
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T. Accounting for Expenses or Liabilities Paid by Principal
Stockholder(s)
(Replaced by SAB 107)
Facts: Company X was a defendant in litigation for which the
company had not recorded a liability in accordance with FASB ASC Topic
450, Contingencies. A principal stockholder \34\ of the company
transfers a portion of his shares to the plaintiff to settle such
litigation. If the company had settled the litigation directly, the
company would have recorded the settlement as an expense.
---------------------------------------------------------------------------
\34\ The FASB ASC Master Glossary defines principal owners as
``owners of record or known beneficial owners of more than 10
percent of the voting interests of the enterprise.''
---------------------------------------------------------------------------
Question: Must the settlement be reflected as an expense in the
company's financial statements, and if so, how?
Interpretive Response: Yes. The value of the shares transferred
should be reflected as an expense in the company's financial statements
with a corresponding credit to contributed (paid-in) capital.
The staff believes that such a transaction is similar to those
described in FASB ASC paragraph 718-10-15-4 (Compensation--Stock
Compensation Topic), which states that ``share-based payments awarded
to an employee of the reporting entity by a related party or other
holder of an economic interest \35\ in the entity as compensation for
services provided to the entity are share-based payment transactions to
be accounted for under this Topic unless the transfer is clearly for a
purpose other than compensation for services to the reporting entity.''
As explained in this paragraph, the substance of such a transaction is
that the economic interest holder makes a capital contribution to the
reporting entity, and the reporting entity makes a share-based payment
to its employee in exchange for services rendered.
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\35\ The FASB ASC Master Glossary defines an economic interest
in an entity as ``any type or form of pecuniary interest or
arrangement that an entity could issue or be a party to, including
equity securities; financial instruments with characteristics of
equity, liabilities or both; long-term debt and other debt-financing
arrangements; leases; and contractual arrangements such as
management contracts, service contracts, or intellectual property
licenses.'' Accordingly, a principal stockholder would be considered
a holder of an economic interest in an entity.
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The staff believes that the problem of separating the benefit to
the principal stockholder from the benefit to the company cited in FASB
ASC Topic 718 is not limited to transactions involving stock
compensation. Therefore, similar accounting is required in this and
other \36\ transactions where a principal stockholder pays an expense
for the company, unless the stockholder's action is caused by a
relationship or obligation completely unrelated to his position as a
stockholder or such action clearly does not benefit the company.
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\36\ For example, SAB Topic 1.B indicates that the separate
financial statements of a subsidiary should reflect any costs of its
operations which are incurred by the parent on its behalf.
Additionally, the staff notes that AICPA Technical Practice Aids
Sec. 4160 also indicates that the payment by principal stockholders
of a company's debt should be accounted for as a capital
contribution.
---------------------------------------------------------------------------
Some registrants and their accountants have taken the position that
since FASB ASC Topic 850, Related Party Disclosures, applies to these
transactions and requires only the disclosure of material related party
transactions, the staff should not analogize to the accounting called
for by FASB ASC paragraph 718-10-15-4 for transactions other than those
specifically covered by it. The staff notes, however, that FASB ASC
Topic 850 does not address the measurement of related party
transactions and that, as a result, such transactions are generally
recorded at the amounts indicated by their terms.\37\ However, the
staff believes that transactions of the type described above differ
from the typical related party transactions.
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\37\ However, in some circumstances it is necessary to reflect,
either in the historical financial statements or a pro forma
presentation (depending on the circumstances), related party
transactions at amounts other than those indicated by their terms.
Two such circumstances are addressed in Staff Accounting Bulletin
Topic 1.B.1, Questions 3 and 4. Another example is where the terms
of a material contract with a related party are expected to change
upon the completion of an offering (i.e., the principal shareholder
requires payment for services which had previously been contributed
by the shareholder to the company).
---------------------------------------------------------------------------
The transactions for which FASB ASC Topic 850 requires disclosure
generally are those in which a company receives goods or services
directly from, or provides goods or services directly to, a related
party, and the form and terms of such transactions may be structured to
produce either a direct or indirect benefit to the related party. The
participation of a related party in such a transaction negates the
presumption that transactions reflected in the financial statements
have been consummated at arm's length. Disclosure is therefore required
to compensate for the fact that, due to the related party's
involvement, the terms of the transaction may produce an accounting
measurement for which a more faithful measurement may not be
determinable.
However, transactions of the type discussed in the facts given do
not have such problems of measurement and appear to be transacted to
provide a benefit to the stockholder through the enhancement or
maintenance of the value of the stockholder's investment. The staff
believes that the substance of such transactions is the payment of an
expense of the company through contributions by the stockholder.
Therefore, the staff believes it would be inappropriate to account for
such transactions according to the form of the transaction.
U. Removed by SAB 112
V. Certain Transfers of Nonperforming Assets
Facts: A financial institution desires to reduce its nonaccrual or
reduced rate loans and other nonearning assets, including foreclosed
real estate (collectively, ``nonperforming assets''). Some or all of
such nonperforming assets are transferred to a newly-formed entity (the
``new entity''). The financial
[[Page 17224]]
institution, as consideration for transferring the nonperforming
assets, may receive (a) the cash proceeds of debt issued by the new
entity to third parties, (b) a note or other redeemable instrument
issued by the new entity, or (c) a combination of (a) and (b). The
residual equity interests in the new entity, which carry voting rights,
initially owned by the financial institution, are transferred to
outsiders (for example, via distribution to the financial institution's
shareholders or sale or contribution to an unrelated third party).
The financial institution typically will manage the assets for a
fee, providing necessary services to liquidate the assets, but
otherwise does not have the right to appoint directors or legally
control the operations of the new entity.
FASB ASC Topic 860, Transfers and Servicing, provides guidance for
determining when a transfer of financial assets can be recognized as a
sale. The interpretive guidance provided in response to Questions 1 and
2 of this SAB does not apply to transfers of financial assets falling
within the scope of FASB ASC Topic 860. Because FASB ASC Topic 860 does
not apply to distributions of financial assets to shareholders or a
contribution of such assets to unrelated third parties, the
interpretive guidance provided in response to Questions 1 and 2 of this
SAB would apply to such conveyances.
Further, registrants should consider the guidance contained in FASB
ASC Topic 810, Consolidation, in determining whether it should
consolidate the newly-formed entity.
Question 1: What factors should be considered in determining
whether such transfer of nonperforming assets can be accounted for as a
disposition by the financial institution?
Interpretive Response: The staff believes that determining whether
nonperforming assets have been disposed of in substance requires an
assessment as to whether the risks and rewards of ownership have been
transferred.\38\ The staff believes that the transfer described should
not be accounted for as a sale or disposition if (a) the transfer of
nonperforming assets to the new entity provides for recourse by the new
entity to the transferor financial institution, (b) the financial
institution directly or indirectly guarantees debt of the new entity in
whole or in part, (c) the financial institution retains a participation
in the rewards of ownership of the transferred assets, for example
through a higher than normal incentive or other management fee
arrangement,\39\ or (d) the fair value of any material non-cash
consideration received by the financial institution (for example, a
note or other redeemable instrument) cannot be reasonably estimated.
Additionally, the staff believes that the accounting for the transfer
as a sale or disposition generally is not appropriate where the
financial institution retains rewards of ownership through the holding
of significant residual equity interests or where third party holders
of such interests do not have a significant amount of capital at risk.
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\38\ [Original footnote removed by SAB 114.]
\39\ The staff recognizes that the determination of whether the
financial institution retains a participation in the rewards of
ownership will require an analysis of the facts and circumstances of
each individual transaction. Generally, the staff believes that, in
order to conclude that the financial institution has disposed of the
assets in substance, the management fee arrangement should not
enable the financial institution to participate to any significant
extent in the potential increases in cash flows or value of the
assets, and the terms of the arrangement, including provisions for
discontinuance of services, must be substantially similar to
management arrangements with third parties.
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Where accounting for the transfer as a sale or disposition is not
appropriate, the nonperforming assets should remain on the financial
institution's balance sheet and should continue to be disclosed as
nonaccrual, past due, restructured or foreclosed, as appropriate, and
the debt of the new entity should be recorded by the financial
institution.
Question 2: If the transaction is accounted for as a sale to an
unconsolidated party, at what value should the transfer be recorded by
the financial institution?
Interpretive Response: The staff believes that the transfer should
be recorded by the financial institution at the fair value of assets
transferred (or, if more clearly evident, the fair value of assets
received) and a loss recognized by the financial institution for any
excess of the net carrying value \40\ over the fair value.\41\ Fair
value is the amount that would be realizable in an outright sale to an
unrelated third party for cash.\42\ The same concepts should be applied
in determining fair value of the transferred assets, i.e., if an active
market exists for the assets transferred, then fair value is equal to
the market value. If no active market exists, but one exists for
similar assets, the selling prices in that market may be helpful in
estimating the fair value. If no such market price is available, a
forecast of expected cash flows, discounted at a rate commensurate with
the risks involved, may be used to aid in estimating the fair value. In
situations where discounted cash flows are used to estimate fair value
of nonperforming assets, the staff would expect that the interest rate
used in such computations will be substantially higher than the cost of
funds of the financial institution and appropriately reflect the risk
of holding these nonperforming assets. Therefore, the fair value
determined in such a way will be lower than the amount at which the
assets would have been carried by the financial institution had the
transfer not occurred, unless the financial institution had been
required under GAAP to carry such assets at market value or the lower
of cost or market value.
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\40\ The carrying value should be reduced by any allocable
allowance for credit losses or other valuation allowances. The staff
believes that the loss recognized for the excess of the net carrying
value over the fair value should be considered a credit loss and
this should not be included by the financial institution as loss on
disposition.
\41\ The staff notes that FASB ASC paragraph 942-810-45-2
(Financial Services--Depository and Lending Topic) provides guidance
that the newly created ``liquidating bank'' should continue to
report its assets and liabilities at fair values at the date of the
financial statements.
\42\ FASB ASC paragraph 845-10-30-14 (Nonmonetary Transactions
Topic) provides guidance that an enterprise that distributes loans
to its owners should report such distribution at fair value.
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Question 3: Where the transaction may appropriately be accounted
for as a sale to an unconsolidated party and the financial institution
receives a note receivable or other redeemable instrument from the new
entity, how should such asset be disclosed pursuant to Item III C,
``Risk Elements,'' of Industry Guide 3? What factors should be
considered related to the subsequent accounting for such instruments
received?
Interpretive Response: The staff believes that the financial
institution may exclude the note receivable or other asset from its
Risk Elements disclosures under Guide 3 provided that: (a) The
receivable itself does not constitute a nonaccrual, past due,
restructured, or potential problem loan that would require disclosure
under Guide 3, and (b) the underlying collateral is described in
sufficient detail to enable investors to understand the nature of the
note receivable or other asset, if material, including the extent of
any over-collateralization. The description of the collateral normally
would include material information similar to that which would be
provided if such assets were owned by the financial institution,
including pertinent Risk Element disclosures.
The staff notes that, in situations in which the transaction is
accounted for as a sale to an unconsolidated party and a portion of the
consideration received by the registrant is debt or another
[[Page 17225]]
redeemable instrument, careful consideration must be given to the
appropriateness of recording profits on the management fee arrangement,
or interest or dividends on the instrument received, including
consideration of whether it is necessary to defer such amounts or to
treat such payments on a cost recovery basis. Further, if the new
entity incurs losses to the point that its permanent equity based on
GAAP is eliminated, it would ordinarily be necessary for the financial
institution, at a minimum, to record further operating losses as its
best estimate of the loss in realizable value of its investment.\43\
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\43\ Typically, the financial institution's claim on the new
entity is subordinate to other debt instruments and thus the
financial institution will incur any losses beyond those incurred by
the permanent equity holders.
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W. Contingency Disclosures Regarding Property-Casualty Insurance
Reserves for Unpaid Claim Costs
Facts: A property-casualty insurance company (the ``Company'') has
established reserves, in accordance with FASB ASC Topic 944, Financial
Services--Insurance, for unpaid claim costs, including estimates of
costs relating to claims incurred but not reported (``IBNR'').\44\ The
reserve estimate for IBNR claims was based on past loss experience and
current trends except that the estimate has been adjusted for recent
significant unfavorable claims experience that the Company considers to
be nonrecurring and abnormal. The Company attributes the abnormal
claims experience to a recent acquisition and accelerated claims
processing; however, actuarial studies have been inconclusive and
subject to varying interpretations. Although the reserve is deemed
adequate to cover all probable claims, there is a reasonable
possibility that the abnormal claims experience could continue,
resulting in a material understatement of claim reserves.
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\44\ FASB ASC paragraph 944-40-30-1 prescribes that ``[t]he
liability for unpaid claims shall be based on the estimated ultimate
cost of settling the claims (including the effects of inflation and
other societal and economic factors), using past experience adjusted
for current trends, and any other factors that would modify past
experience.'' [Footnote reference omitted]
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FASB ASC Topic 450, Contingencies, requires, among other things,
disclosure of loss contingencies.\45\ However, FASB ASC paragraph 450-
10-05-6 notes that ``[n]ot all uncertainties inherent in the accounting
process give rise to contingencies.''
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\45\ FASB ASC paragraphs 450-20-50-3 through 450-20-50-4 provide
guidance that if no accrual is made for a loss contingency because
one or both of the conditions in FASB ASC paragraph 450-20-25-2 are
not met, or if an exposure to loss exists in excess of the amount
accrued pursuant to the provisions of FASB ASC paragraph 450-20-25-
2, disclosure of the contingency shall be made when there is at
least a reasonable possibility that a loss or an additional loss may
have been incurred. The disclosure shall indicate the nature of the
contingency and shall give an estimate of the possible loss or range
of loss or state that such an estimate cannot be made.'' [Footnote
reference omitted and emphasis added.]
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FASB ASC Topic 275, Risks and Uncertainties,\46\ also provides
disclosure guidance regarding certain significant estimates.
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\46\ FASB ASC Topic 275 provides that disclosures regarding
certain significant estimates should be made when certain criteria
are met. The guidance provides that the disclosure shall indicate
the nature of the uncertainty and include an indication that it is
at least reasonably possible that a change in the estimate will
occur in the near term. If the estimate involves a loss contingency
covered by FASB ASC Topic 450, the disclosure also should include an
estimate of the possible loss or range of loss, or state that such
an estimate cannot be made. Disclosure of the factors that cause the
estimate to be sensitive to change is encouraged but not required.
FASB ASC Topic 275 requires disclosures regarding current
vulnerability due to certain concentrations which may be applicable
as well.
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Question 1: In the staff's view, do FASB ASC Topics 450 and 275
disclosure requirements apply to property-casualty insurance reserves
for unpaid claim costs? If so, how?
Interpretive Response: Yes. The staff believes that specific
uncertainties (conditions, situations and/or sets of circumstances) not
considered to be normal and recurring because of their significance
and/or nature can result in loss contingencies \47\ for purposes of
applying FASB ASC Topics 450 and 275 disclosure requirements. General
uncertainties, such as the amount and timing of claims, that are
normal, recurring, and inherent to estimations of property-casualty
insurance reserves are not considered subject to the disclosure
requirements of FASB ASC Topic 450. Some specific uncertainties that
may result in loss contingencies pursuant to FASB ASC Topic 450,
depending on significance and/or nature, include insufficiently
understood trends in claims activity; judgmental adjustments to
historical experience for purposes of estimating future claim costs
(other than for normal recurring general uncertainties); significant
risks to an individual claim or group of related claims; or catastrophe
losses. The requirements of FASB ASC Topic 275 apply when ``[i]t is at
least reasonably possible that the estimate of the effect on the
financial statements of a condition, situation, or set of circumstances
that existed at the date of the financial statements will change in the
near term due to one or more future confirming events * * * [and] the
effect of the change would be material to the financial statements.''
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\47\ The loss contingency referred to in this document is the
potential for a material understatement of reserves for unpaid
claims.
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Question 2: Do the facts presented above describe an uncertainty
that requires disclosures under FASB ASC Topics 450 and 275?
Interpretive Response: Yes. The staff believes the judgmental
adjustments to historical experience for insufficiently understood
claims activity noted above results in a loss contingency within the
scope of FASB ASC Topics 450 and 275. Based on the facts presented
above, at a minimum the Company's financial statements should disclose
that for purposes of estimating IBNR claim reserves, past experience
was adjusted for what management believes to be abnormal claims
experience related to the recent acquisition of Company A and
accelerated claims processing. It should also be disclosed that there
is a reasonable possibility that the claims experience could be the
indication of an unfavorable trend which would require additional IBNR
claim reserves in the approximate range of $XX-$XX million
(alternatively, if Company management is unable to estimate the
possible loss or range of loss, a statement to that effect should be
disclosed).
Additionally, the staff also expects companies to disclose the
nature of the loss contingency and the potential impact on trends in
their loss reserve development discussions provided pursuant to
Property-Casualty Industry Guides 4 and 6. Consideration should also be
given to the need to provide disclosure in MD&A.
Question 3: Does the staff have an example in which specific
uncertainties involving an individual claim or group of related claims
result in a loss contingency the staff believes requires disclosure?
Interpretive Response: Yes. A property-casualty insurance company
(the ``Company'') underwrites product liability insurance for an
insured manufacturer which has produced and sold millions of units of a
particular product which has been used effectively and without problems
for many years. Users of the product have recently begun to report
serious health problems that they attribute to long term use of the
product and have asserted claims under the insurance policy
underwritten and retained by the Company. To date, the number of users
reporting such problems is relatively small, and there is presently no
conclusive evidence that demonstrates a causal link between long term
use of the product and the health problems experienced by the
claimants. However,
[[Page 17226]]
the evidence generated to date indicates that there is at least a
reasonable possibility that the product is responsible for the problems
and the assertion of additional claims is considered probable, and
therefore the potential exposure of the Company is material. While an
accrual may not be warranted since the loss exposure may not be both
probable and estimable, in view of the reasonable possibility of
material future claim payments, the staff believes that disclosures
made in accordance with FASB ASC Topics 450 and 275 would be required
under these circumstances.
The disclosure concepts expressed in this example would also apply
to an individual claim or group of claims that are related to a single
catastrophic event or multiple events having a similar effect.
X. Removed by SAB 103
Y. Accounting and Disclosures Relating to Loss Contingencies
Facts: A registrant believes it may be obligated to pay material
amounts as a result of product or environmental remediation liability.
These amounts may relate to, for example, damages attributed to the
registrant's products or processes, clean-up of hazardous wastes,
reclamation costs, fines, and litigation costs. The registrant may seek
to recover a portion or all of these amounts by filing a claim against
an insurance carrier or other third parties.
Question 1: Assuming that the registrant's estimate of an
environmental remediation or product liability meets the conditions set
forth in FASB ASC paragraph 410-30-35-12 (Asset Retirement and
Environmental Obligations Topic) for recognition on a discounted basis,
what discount rate should be applied and what, if any, special
disclosures are required in the notes to the financial statements?
Interpretive Response: The rate used to discount the cash payments
should be the rate that will produce an amount at which the
environmental or product liability could be settled in an arm's-length
transaction with a third party. Further, the discount rate used to
discount the cash payments should not exceed the interest rate on
monetary assets that are essentially risk free \48\ and have maturities
comparable to that of the environmental or product liability.
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\48\ As described in Concepts Statement 7, Using Cash Flow
Information and Present Value in Accounting Measurements.
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If the liability is recognized on a discounted basis to reflect the
time value of money, the notes to the financial statements should, at a
minimum, include disclosures of the discount rate used, the expected
aggregate undiscounted amount, expected payments for each of the five
succeeding years and the aggregate amount thereafter, and a
reconciliation of the expected aggregate undiscounted amount to amounts
recognized in the statements of financial position. Material changes in
the expected aggregate amount since the prior balance sheet date, other
than those resulting from pay-down of the obligation, should be
explained.
Question 2: What financial statement disclosures should be
furnished with respect to recorded and unrecorded product or
environmental remediation liabilities?
Interpretive Response: FASB ASC Section 450-20-50, Contingencies--
Loss Contingencies--Disclosure, identify disclosures regarding loss
contingencies that generally are furnished in notes to financial
statements. FASB ASC Section 410-30-50, Asset Retirement and
Environmental Obligations--Environmental Obligations--Disclosure,
identifies disclosures that are required and recommended regarding both
recorded and unrecorded environmental remediation liabilities. The
staff believes that product and environmental remediation liabilities
typically are of such significance that detailed disclosures regarding
the judgments and assumptions underlying the recognition and
measurement of the liabilities are necessary to prevent the financial
statements from being misleading and to inform readers fully regarding
the range of reasonably possible outcomes that could have a material
effect on the registrant's financial condition, results of operations,
or liquidity. In addition to the disclosures required by FASB ASC
Section 450-20-50 and FASB ASC Section 410-30-50, examples of
disclosures that may be necessary include:
Circumstances affecting the reliability and precision of
loss estimates.
The extent to which unasserted claims are reflected in any
accrual or may affect the magnitude of the contingency.
Uncertainties with respect to joint and several liability
that may affect the magnitude of the contingency, including disclosure
of the aggregate expected cost to remediate particular sites that are
individually material if the likelihood of contribution by the other
significant parties has not been established.
Disclosure of the nature and terms of cost-sharing
arrangements with other potentially responsible parties.
The extent to which disclosed but unrecognized contingent
losses are expected to be recoverable through insurance,
indemnification arrangements, or other sources, with disclosure of any
material limitations of that recovery.
Uncertainties regarding the legal sufficiency of insurance
claims or solvency of insurance carriers.\49\
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\49\ The staff believes there is a rebuttable presumption that
no asset should be recognized for a claim for recovery from a party
that is asserting that it is not liable to indemnify the registrant.
Registrants that overcome that presumption should disclose the
amount of recorded recoveries that are being contested and discuss
the reasons for concluding that the amounts are probable of
recovery.
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The time frame over which the accrued or presently
unrecognized amounts may be paid out.
Material components of the accruals and significant
assumptions underlying estimates.
Registrants are cautioned that a statement that the contingency is
not expected to be material does not satisfy the requirements of FASB
ASC Topic 450 if there is at least a reasonable possibility that a loss
exceeding amounts already recognized may have been incurred and the
amount of that additional loss would be material to a decision to buy
or sell the registrant's securities. In that case, the registrant must
either (a) disclose the estimated additional loss, or range of loss,
that is reasonably possible, or (b) state that such an estimate cannot
be made.
Question 3: What disclosures regarding loss contingencies may be
necessary outside the financial statements?
Interpretive Response: Registrants should consider the requirements
of Items 101 (Description of Business), 103 (Legal Proceedings), and
303 (MD&A) of Regulation S-K. The Commission has issued interpretive
releases that provide additional guidance with respect to these
items.\50\ In a 1989 interpretive release, the Commission noted that
the availability of insurance, indemnification, or contribution may be
relevant in determining whether the criteria for disclosure have been
met with respect to a contingency.\51\ The registrant's assessment in
this regard should include consideration of facts such as the periods
in which claims for recovery may be realized, the likelihood that the
claims may be contested, and
[[Page 17227]]
the financial condition of third parties from which recovery is
expected.
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\50\ See Securities Act Release No. 6130, FR 36, Securities Act
Release No. 33-8040, Securities Act Release No. 33-8039, and
Securities Act Release 33-8176.
\51\ See, e.g., footnote 30 of FR 36 (footnote 17 of Section
501.02 of the Codification of Financial Reporting Policies).
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Disclosures made pursuant to the guidance identified in the
preceding paragraph should be sufficiently specific to enable a reader
to understand the scope of the contingencies affecting the registrant.
For example, a registrant's discussion of historical and anticipated
environmental expenditures should, to the extent material, describe
separately (a) recurring costs associated with managing hazardous
substances and pollution in on-going operations, (b) capital
expenditures to limit or monitor hazardous substances or pollutants,
(c) mandated expenditures to remediate previously contaminated sites,
and (d) other infrequent or non-recurring clean-up expenditures that
can be anticipated but which are not required in the present
circumstances. Disaggregated disclosure that describes accrued and
reasonably likely losses with respect to particular environmental sites
that are individually material may be necessary for a full
understanding of these contingencies. Also, if management's
investigation of potential liability and remediation cost is at
different stages with respect to individual sites, the consequences of
this with respect to amounts accrued and disclosed should be discussed.
Examples of specific disclosures typically relevant to an
understanding of historical and anticipated product liability costs
include the nature of personal injury or property damages alleged by
claimants, aggregate settlement costs by type of claim, and related
costs of administering and litigating claims. Disaggregated disclosure
that describes accrued and reasonably likely losses with respect to
particular claims may be necessary if they are individually material.
If the contingency involves a large number of relatively small
individual claims of a similar type, such as personal injury from
exposure to asbestos, disclosure of the number of claims pending at
each balance sheet date, the number of claims filed for each period
presented, the number of claims dismissed, settled, or otherwise
resolved for each period, and the average settlement amount per claim
may be necessary. Disclosures should address historical and expected
trends in these amounts and their reasonably likely effects on
operating results and liquidity.
Question 4: What disclosures should be furnished with respect to
site restoration costs or other environmental remediation costs? \52\
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\52\ Registrants are reminded that FASB ASC Subtopic 410-20,
Asset Retirement and Environmental Obligations--Asset Retirement
Obligations, provides guidance for accounting and reporting for
costs associated with asset retirement obligations.
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Interpretive Response: The staff believes that material liabilities
for site restoration, post-closure, and monitoring commitments, or
other exit costs that may occur on the sale, disposal, or abandonment
of a property as a result of unanticipated contamination of the asset
should be disclosed in the notes to the financial statements.
Appropriate disclosures generally would include the nature of the costs
involved, the total anticipated cost, the total costs accrued to date,
the balance sheet classification of accrued amounts, and the range or
amount of reasonably possible additional losses. If an asset held for
sale or development will require remediation to be performed by the
registrant prior to development, sale, or as a condition of sale, a
note to the financial statements should describe how the necessary
expenditures are considered in the assessment of the asset's value and
the possible need to reflect an impairment loss. Additionally, if the
registrant may be liable for remediation of environmental damage
relating to assets or businesses previously disposed, disclosure should
be made in the financial statements unless the likelihood of a material
unfavorable outcome of that contingency is remote.\53\ The registrant's
accounting policy with respect to such costs should be disclosed in
accordance with FASB ASC Topic 235, Notes to Financial Statements.
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\53\ If the company has a guarantee as defined by FASB ASC Topic
460, Guarantees, the entity is required to provide the disclosures
and recognize the fair value of the guarantee in the company's
financial statements even if the ``contingent'' aspect of the
guarantee is deemed to be remote.
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Z. Accounting and Disclosure Regarding Discontinued Operations
1. Removed by SAB 103
2. Removed by SAB 103
3. Removed by SAB 103
4. Disposal of Operation With Significant Interest Retained
Facts: A Company disposes of its controlling interest in a
component of an entity as defined by the FASB ASC Master Glossary. The
Company retains a minority voting interest directly in the component or
it holds a minority voting interest in the buyer of the component.
Controlling interest includes those controlling interests established
through other means, such as variable interests. Because the Company's
voting interest enables it to exert significant influence over the
operating and financial policies of the investee, the Company is
required by FASB ASC Subtopic 323-10, Investments--Equity Method and
Joint Ventures--Overall, to account for its residual investment using
the equity method.\54\
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\54\ In some circumstances, the seller's continuing interest may
be so great that divestiture accounting is inappropriate.
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Question: May the historical operating results of the component and
the gain or loss on the sale of the majority interest in the component
be classified in the Company's statement of operations as
``discontinued operations'' pursuant to FASB ASC Subtopic 205-20,
Presentation of Financial Statements--Discontinued Operations?
Interpretive Response: No. A condition necessary for discontinued
operations reporting, as indicated in FASB ASC paragraph 205-20-45-1 is
that an entity ``not have any significant continuing involvement in the
operations of the component after the disposal transaction.'' In these
circumstances, the transaction should be accounted for as the disposal
of a group of assets that is not a component of an entity and
classified within continuing operations pursuant to FASB ASC paragraph
360-10-45-5 (Property, Plant, and Equipment Topic).\55\
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\55\ However, a plan of disposal that contemplates the transfer
of assets to a limited-life entity created for the single purpose of
liquidating the assets of a component of an entity would not
necessitate classification within continuing operations solely
because the registrant retains control or significant influence over
the liquidating entity.
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5. Classification and Disclosure of Contingencies Relating to
Discontinued Operations
Facts: A company disposed of a component of an entity in a previous
accounting period. The Company received debt and/or equity securities
of the buyer of the component or of the disposed component as
consideration in the sale, but this financial interest is not
sufficient to enable the Company to apply the equity method with
respect to its investment in the buyer. The Company made certain
warranties to the buyer with respect to the discontinued business, or
remains liable under environmental or other laws with respect to
certain facilities or operations transferred to the buyer. The
disposition satisfied the criteria of FASB ASC Subtopic 205-20 for
presentation as ``discontinued operations.'' The Company estimated the
fair value of the securities received in the transaction for purposes
of calculating the gain or loss on disposal that was recognized in its
financial statements. The results of discontinued operations prior to
the
[[Page 17228]]
date of disposal or classification as held for sale included provisions
for the Company's existing obligations under environmental laws,
product warranties, or other contingencies. The calculation of gain or
loss on disposal included estimates of the Company's obligations
arising as a direct result of its decision to dispose of the component,
under its warranties to the buyer, and under environmental or other
laws. In a period subsequent to the disposal date, the Company records
a charge to income with respect to the securities because their fair
value declined materially and the Company determined that the decline
was other than temporary. The Company also records adjustments of its
previously estimated liabilities arising under the warranties and under
environmental or other laws.
Question 1: Should the writedown of the carrying value of the
securities and the adjustments of the contingent liabilities be
classified in the current period's statement of operations within
continuing operations or as an element of discontinued operations?
Interpretive Response: Adjustments of estimates of contingent
liabilities or contingent assets that remain after disposal of a
component of an entity or that arose pursuant to the terms of the
disposal generally should be classified within discontinued
operations.\56\ However, the staff believes that changes in the
carrying value of assets received as consideration in the disposal or
of residual interests in the business should be classified within
continuing operations.
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\56\ Registrants are reminded that FASB ASC Topic 460,
Guarantees, requires recognition and disclosure of certain
guarantees which may impose accounting and disclosure requirements
in addition to those discussed in this SAB Topic.
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FASB ASC paragraph 205-20-45-4 requires that ``adjustments to
amounts previously reported in discontinued operations that are
directly related to the disposal of a component of an entity in a prior
period shall be classified separately in the current period in
discontinued operations.'' The staff believes that the provisions of
FASB ASC paragraph 205-20-45-4 apply only to adjustments that are
necessary to reflect new information about events that have occurred
that becomes available prior to disposal of the component of the
entity, to reflect the actual timing and terms of the disposal when it
is consummated, and to reflect the resolution of contingencies
associated with that component, such as warranties and environmental
liabilities retained by the seller.
Developments subsequent to the disposal date that are not directly
related to the disposal of the component or the operations of the
component prior to disposal are not ``directly related to the
disposal'' as contemplated by FASB ASC paragraph 205-20-45-4.
Subsequent changes in the carrying value of assets received upon
disposition of a component do not affect the determination of gain or
loss at the disposal date, but represent the consequences of
management's subsequent decisions to hold or sell those assets. Gains
and losses, dividend and interest income, and portfolio management
expenses associated with assets received as consideration for
discontinued operations should be reported within continuing
operations.
Question 2: What disclosures would the staff expect regarding
discontinued operations prior to the disposal date and with respect to
risks retained subsequent to the disposal date?
Interpretive Response: MD&A \57\ should include disclosure of known
trends, events, and uncertainties involving discontinued operations
that may materially affect the Company's liquidity, financial
condition, and results of operations (including net income) between the
date when a component of an entity is classified as discontinued and
the date when the risks of those operations will be transferred or
otherwise terminated. Disclosure should include discussion of the
impact on the Company's liquidity, financial condition, and results of
operations of changes in the plan of disposal or changes in
circumstances related to the plan. Material contingent liabilities,\58\
such as product or environmental liabilities or litigation, that may
remain with the Company notwithstanding disposal of the underlying
business should be identified in notes to the financial statements and
any reasonably likely range of possible loss should be disclosed
pursuant to FASB ASC Topic 450, Contingencies. MD&A should include
discussion of the reasonably likely effects of these contingencies on
reported results and liquidity. If the Company retains a financial
interest in the discontinued component or in the buyer of that
component that is material to the Company, MD&A should include
discussion of known trends, events, and uncertainties, such as the
financial condition and operating results of the issuer of the
security, that may be reasonably expected to affect the amounts
ultimately realized on the investments.
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\57\ Item 303 of Regulation S-K.
\58\ Registrants also should consider the disclosure
requirements of FASB ASC Topic 460.
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6. Removed by SAB 103
7. Accounting for the Spin-Off of a Subsidiary
Facts: A Company disposes of a business through the distribution of
a subsidiary's stock to the Company's shareholders on a pro rata basis
in a transaction that is referred to as a spin-off.
Question: May the Company elect to characterize the spin-off
transaction as resulting in a change in the reporting entity and
restate its historical financial statements as if the Company never had
an investment in the subsidiary, in the manner specified by FASB ASC
Topic 250, Accounting Changes and Error Corrections?
Interpretive Response: Not ordinarily. If the Company was required
to file periodic reports under the Exchange Act within one year prior
to the spin-off, the staff believes the Company should reflect the
disposition in conformity with FASB ASC Topic 360. This presentation
most fairly and completely depicts for investors the effects of the
previous and current organization of the Company. However, in limited
circumstances involving the initial registration of a company under the
Exchange Act or Securities Act, the staff has not objected to financial
statements that retroactively reflect the reorganization of the
business as a change in the reporting entity if the spin-off
transaction occurs prior to effectiveness of the registration
statement. This presentation may be acceptable in an initial
registration if the Company and the subsidiary are in dissimilar
businesses, have been managed and financed historically as if they were
autonomous, have no more than incidental common facilities and costs,
will be operated and financed autonomously after the spin-off, and will
not have material financial commitments, guarantees, or contingent
liabilities to each other after the spin-off. This exception to the
prohibition against retroactive omission of the subsidiary is intended
for companies that have not distributed widely financial statements
that include the spun-off subsidiary. Also, dissimilarity contemplates
substantially greater differences in the nature of the businesses than
those that would ordinarily distinguish reportable segments as defined
by FASB ASC paragraph 280-10-50-10 (Segment Reporting Topic).
[[Page 17229]]
AA. Removed by SAB 103
BB. Inventory Valuation Allowances
Facts: FASB ASC paragraph 330-10-35-1 (Inventory Topic), specifies
that: ``[a] departure from the cost basis of pricing the inventory is
required when the utility of the goods is no longer as great as its
cost. Where there is evidence that the utility of goods, in their
disposal in the ordinary course of business, will be less than cost,
whether due to physical deterioration, obsolescence, changes in price
levels, or other causes, the difference shall be recognized as a loss
of the current period. This is generally accomplished by stating such
goods at a lower level commonly designated as market.''
FASB ASC paragraph 330-10-35-14 indicates that ``[i]n the case of
goods which have been written down below cost at the close of a fiscal
year, such reduced amount is to be considered the cost for subsequent
accounting purposes.''
Lastly, the FASB ASC Master Glossary provides ``inventory
obsolescence'' as one of the items subject to a change in accounting
estimate.
Question: Does the write-down of inventory to the lower of cost or
market, as required by FASB ASC Topic 330, create a new cost basis for
the inventory or may a subsequent change in facts and circumstances
allow for restoration of inventory value, not to exceed original
historical cost?
Interpretive Response: Based on FASB ASC paragraph 330-10-35-14,
the staff believes that a write-down of inventory to the lower of cost
or market at the close of a fiscal period creates a new cost basis that
subsequently cannot be marked up based on changes in underlying facts
and circumstances.\59\
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\59\ See also disclosure requirement for inventory balances in
Rule 5-02(6) of Regulation S-X.
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CC. Impairments
Standards for recognizing and measuring impairment of the carrying
amount of long-lived assets including certain identifiable intangibles
to be held and used in operations are found in FASB ASC Topic 360,
Property, Plant, and Equipment. Standards for recognizing and measuring
impairment of the carrying amount of goodwill and identifiable
intangible assets that are not currently being amortized are found in
FASB ASC Topic 350, Intangibles--Goodwill and Other.
Facts: Company X has mainframe computers that are to be abandoned
in six to nine months as replacement computers are put in place. The
mainframe computers were placed in service in January 20X0 and were
being depreciated on a straight-line basis over seven years. No salvage
value had been projected at the end of seven years and the original
cost of the computers was $8,400. The board of directors, with the
appropriate authority, approved the abandonment of the computers in
March 20X3 when the computers had a remaining carrying value of $4,600.
No proceeds are expected upon abandonment. Abandonment cannot occur
prior to the receipt and installation of replacement computers, which
is expected prior to the end of 20X3. Management had begun reevaluating
its mainframe computer capabilities in January 20X2 and had included in
its 20X3 capital expenditures budget an estimated amount for new
mainframe computers. The 20X3 capital expenditures budget had been
prepared by management in August 20X2, had been discussed with the
company's board of directors in September 20X2 and was formally
approved by the board of directors in March 20X3. Management had also
begun soliciting bids for new mainframe computers beginning in the fall
of 20X2. The mainframe computers, when grouped with assets at the
lowest level of identifiable cash flows, were not impaired on a ``held
and used'' basis throughout this time period. Management had not
adjusted the original estimated useful life of the computers (seven
years) since 20X0.
Question 1: Company X proposes to recognize an impairment charge
under FASB ASC Topic 360 for the carrying value of the mainframe
computers of $4,600 in March 20X3. Does Company X meet the requirements
in FASB ASC Topic 360 to classify the mainframe computer assets as ``to
be abandoned?''
Interpretive Response: No. FASB ASC paragraph 360-10-35-47 provides
that ``a long-lived asset to be abandoned is disposed of when it ceases
to be used. If an entity commits to a plan to abandon a long-lived
asset before the end of its previously estimated useful life,
depreciation estimates shall be revised in accordance with FASB ASC
Topic 250, Accounting Changes and Error Corrections, to reflect the use
of the asset over its shortened useful life.''
Question 2: Would the staff accept an adjustment to write down the
carrying value of the computers to reflect a ``normalized
depreciation'' rate for the period from March 20X3 through actual
abandonment (e.g., December 20X3)? Normalized depreciation would
represent the amount of depreciation otherwise expected to be
recognized during that period without adjustment of the asset's useful
life, or $1,000 ($100/month for ten months) in the example fact
pattern.
Interpretive Response: No. The mainframe computers would be viewed
as ``held and used'' at March 20X3 under the fact pattern described.
There is no basis under FASB ASC Topic 360 to write down an asset to an
amount that would subsequently result in a ``normalized depreciation''
charge through the disposal date, whether disposal is to be by sale,
abandonment, or other means. FASB ASC paragraph 360-10-35-43 requires
the asset to be valued at the lower of carrying amount or fair value
less cost to sell in order to be classified as ``held for sale.'' For
assets that are classified as ``held and used'' under FASB ASC Topic
360, an assessment must first be made as to whether the asset (asset
group) is impaired. FASB ASC paragraph 360-10-35-17 indicates that an
impairment loss shall be recognized only if the carrying amount of a
long-lived asset (asset group) is not recoverable and exceeds its fair
value. The carrying amount of a long-lived asset (asset group) is not
recoverable if it exceeds the sum of the undiscounted cash flows
expected to result from the use and eventual disposition of the asset
(asset group). The staff would object to a write down of long-lived
assets to a ``normalized depreciation'' value as representing an
acceptable alternative to the approaches required in FASB ASC Topic
360.
The staff also believes that registrants must continually evaluate
the appropriateness of useful lives assigned to long-lived assets,
including identifiable intangible assets and goodwill. In the above
fact pattern, management had contemplated removal of the mainframe
computers beginning in January 20X2 and, more formally, in August 20X2
as part of compiling the 20X3 capital expenditures budget. At those
times, at a minimum, management should have reevaluated the original
useful life assigned to the computers to determine whether a seven year
amortization period remained appropriate given the company's current
facts and circumstances, including ongoing technological changes in the
market place. This reevaluation process should have continued at the
time of the September 20X2 board of directors' meeting to discuss
capital expenditure plans and, further, as the company pursued
mainframe computer bids. Given the contemporaneous evidence that
management's best estimate during much of 20X2 was that the current
mainframe computers would be removed from service in 20X3, the
depreciable life of the computers should
[[Page 17230]]
have been adjusted prior to 20X3 to reflect this new estimate. The
staff does not view the recognition of an impairment charge to be an
acceptable substitute for choosing the appropriate initial amortization
or depreciation period or subsequently adjusting this period as company
or industry conditions change. The staff's view applies also to
selection of, and changes to, estimated residual values. Consequently,
the staff may challenge impairment charges for which the timely
evaluation of useful life and residual value cannot be demonstrated.
Question 3: Has the staff expressed any views with respect to
company-determined estimates of cash flows used for assessing and
measuring impairment of assets under FASB ASC Topic 360?
Interpretive Response: In providing guidance on the development of
cash flows for purposes of applying the provisions of that Topic, FASB
ASC paragraph 360-10-35-30 indicates that ``estimates of future cash
flows used to test the recoverability of a long-lived asset (asset
group) shall incorporate the entity's own assumptions about its use of
the asset (asset group) and shall consider all available evidence. The
assumptions used in developing those estimates shall be reasonable in
relation to the assumptions used in developing other information used
by the entity for comparable periods, such as internal budgets and
projections, accruals related to incentive compensation plans, or
information communicated to others.''
The staff recognizes that various factors, including management's
judgments and assumptions about the business plans and strategies,
affect the development of future cash flow projections for purposes of
applying FASB ASC Topic 360. The staff, however, cautions registrants
that the judgments and assumptions made for purposes of applying FASB
ASC Topic 360 must be consistent with other financial statement
calculations and disclosures and disclosures in MD&A. The staff also
expects that forecasts made for purposes of applying FASB ASC Topic 360
be consistent with other forward-looking information prepared by the
company, such as that used for internal budgets, incentive compensation
plans, discussions with lenders or third parties, and/or reporting to
management or the board of directors.
For example, the staff has reviewed a fact pattern where a
registrant developed cash flow projections for purposes of applying the
provisions of FASB ASC Topic 360 using one set of assumptions and
utilized a second, more conservative set of assumptions for purposes of
determining whether deferred tax valuation allowances were necessary
when applying the provisions of FASB ASC Topic 740, Income Taxes. In
this case, the staff objected to the use of inconsistent assumptions.
In addition to disclosure of key assumptions used in the
development of cash flow projections, the staff also has required
discussion in MD&A of the implications of assumptions. For example, do
the projections indicate that a company is likely to violate debt
covenants in the future? What are the ramifications to the cash flow
projections used in the impairment analysis? If growth rates used in
the impairment analysis are lower than those used by outside analysts,
has the company had discussions with the analysts regarding their
overly optimistic projections? Has the company appropriately informed
the market and its shareholders of its reduced expectations for the
future that are sufficient to cause an impairment charge? The staff
believes that cash flow projections used in the impairment analysis
must be both internally consistent with the company's other projections
and externally consistent with financial statement and other public
disclosures.
DD. Written Loan Commitments Recorded at Fair Value Through Earnings
Facts: Bank A enters into a loan commitment with a customer to
originate a mortgage loan at a specified rate. As part of this written
loan commitment, Bank A expects to receive future net cash flows
related to servicing rights from servicing fees (included in the loan's
interest rate or otherwise), late charges, and other ancillary sources,
or from selling the servicing rights to a third party. If Bank A
intends to sell the mortgage loan after it is funded, pursuant to FASB
ASC paragraph 815-10-15-83 (Derivatives and Hedging Topic), the written
loan commitment is accounted for as a derivative instrument and
recorded at fair value through earnings (referred to hereafter as a
``derivative loan commitment''). If Bank A does not intend to sell the
mortgage loan after it is funded, the written loan commitment is not
accounted for as a derivative under FASB ASC Subtopic 815-10,
Derivatives and Hedging--Overall. However, FASB ASC subparagraph 825-
10-15-4(c) (Financial Instruments Topic) permits Bank A to record the
written loan commitment at fair value through earnings (referred to
hereafter as a ``written loan commitment''). Pursuant to FASB ASC
Subtopic 825-10, Financial Instruments--Overall, the fair value
measurement for a written loan commitment would include the expected
net future cash flows related to the associated servicing of the loan.
Question 1: In measuring the fair value of a derivative loan
commitment accounted for under FASB ASC Subtopic 815-10, should Bank A
include the expected net future cash flows related to the associated
servicing of the loan?
Interpretive Response: Yes. The staff believes that, consistent
with the guidance in FASB ASC Subtopic 860-50, Transfers and
Servicing--Servicing Assets and Liabilities,\60\ and FASB ASC Subtopic
825-10, the expected net future cash flows related to the associated
servicing of the loan should be included in the fair value measurement
of a derivative loan commitment. The expected net future cash flows
related to the associated servicing of the loan that are included in
the fair value measurement of a derivative loan commitment or a written
loan commitment should be determined in the same manner that the fair
value of a recognized servicing asset or liability is measured under
FASB ASC Subtopic 860-50. However, as discussed in FASB ASC paragraph
860-50-25-1, a separate and distinct servicing asset or liability is
not recognized for accounting purposes until the servicing rights have
been contractually separated from the underlying loan by sale or
securitization of the loan with servicing retained.
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\60\ FASB ASC Subtopic 860-50 permits an entity to subsequently
measure recognized servicing assets and servicing liabilities (which
are nonfinancial instruments) at fair value through earnings.
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The views in Question 1 apply to all loan commitments that are
accounted for at fair value through earnings. However, for purposes of
electing fair value accounting pursuant to FASB ASC Subtopic 825-10,
the views in Question 1 are not intended to be applied by analogy to
any other instrument that contains a nonfinancial element.
Question 2: In measuring the fair value of a derivative loan
commitment accounted for under FASB ASC Subtopic 815-10 or a written
loan commitment accounted for under FASB ASC Subtopic 825-10, should
Bank A include the expected net future cash flows related to
internally-developed intangible assets?
Interpretive Response: No. The staff does not believe that
internally-developed intangible assets (such as customer relationship
intangible assets) should be recorded as part of the fair value of a
derivative loan commitment or a written loan commitment. Such
[[Page 17231]]
nonfinancial elements of value should not be considered a component of
the related instrument. Recognition of such assets would only be
appropriate in a third-party transaction. For example, in the purchase
of a portfolio of derivative loan commitments in a business
combination, a customer relationship intangible asset is recorded
separately from the fair value of such loan commitments. Similarly,
when an entity purchases a credit card portfolio, FASB ASC paragraph
310-10-25-7 (Receivables Topic) requires an allocation of the purchase
price to a separately recorded cardholder relationship intangible
asset.
The view in Question 2 applies to all loan commitments that are
accounted for at fair value through earnings.
TOPIC 6: INTERPRETATIONS OF ACCOUNTING SERIES RELEASES AND FINANCIAL
REPORTING RELEASES
A.1. Removed by SAB 103
B. Accounting Series Release 280--General Revision of Regulation S-X:
Income or Loss Applicable to Common Stock
Facts: A registrant has various classes of preferred stock.
Dividends on those preferred stocks and accretions of their carrying
amounts cause income applicable to common stock to be less than
reported net income.
Question: In ASR 280, the Commission stated that although it had
determined not to mandate presentation of income or loss applicable to
common stock in all cases, it believes that disclosure of that amount
is of value in certain situations. In what situations should the amount
be reported, where should it be reported, and how should it be
computed?
Interpretive Response: Income or loss applicable to common stock
should be reported on the face of the income statement \1\ when it is
materially different in quantitative terms from reported net income or
loss \2\ or when it is indicative of significant trends or other
qualitative considerations. The amount to be reported should be
computed for each period as net income or loss less: (a) Dividends on
preferred stock, including undeclared or unpaid dividends if
cumulative; and (b) periodic increases in the carrying amounts of
instruments reported as redeemable preferred stock (as discussed in
Topic 3.C) or increasing rate preferred stock (as discussed in Topic
5.Q).
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\1\ When a registrant reports net income and total comprehensive
income in one continuous financial statement, the registrant must
continue to follow the guidance set forth in the SAB Topic. One
approach may be to provide a separate reconciliation of net income
to income available to common stock below comprehensive income
reported on a statement of income and comprehensive income.
\2\ The assessment of materiality is the responsibility of each
registrant. However, absent concerns about trends or other
qualitative considerations, the staff generally will not insist on
the reporting of income or loss applicable to common stock if the
amount differs from net income or loss by less than ten percent.
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C. Accounting Series Release 180--Institution of Staff Accounting
Bulletins (SABs)--Applicability of Guidance Contained in SABs
Facts: The series of SABs was instituted to achieve wide
dissemination of administrative interpretations and practices of the
Commission's staff. In illustration of certain interpretations and
practices, SABs may be written narrowly to describe the circumstances
of particular matters which resulted in expression of the staff's views
on those particular matters.
Question: How does the staff intend SABs to be applied in
circumstances analogous to those addressed in SABs?
Interpretive Response: The staff's purpose in issuing SABs is to
disseminate guidance for application not only in the narrowly described
circumstances, but also, unless authoritative accounting literature
calls for different treatment, in other circumstances where events and
transactions have similar accounting and/or disclosure implications.
Registrants and independent accountants are encouraged to consult
with the staff if they believe that particular circumstances call for
accounting and/or disclosure different from that which would result
from application of a SAB addressing those same or analogous
circumstances.
D. Redesignated as Topic 12.A by SAB 47
E. Redesignated as Topic 12.B by SAB 47
F. Removed by SAB 103
G. Accounting Series Releases 177 and 286--Relating to Amendments to
Form 10-Q, Regulation S-K, and Regulations S-X Regarding Interim
Financial Reporting
General Facts: Disclosure requirements for quarterly data on Form
10-Q were amended in ASR 177 and 286 to include condensed interim
financial statements, a narrative analysis of financial condition and
results of operations, a letter from the registrant's independent
public accountant commenting on any accounting change, and a signature
by the registrant's chief financial officer or chief accounting
officer.\3\ In addition, certain selected quarterly data is required to
be disclosed by virtually all registrants (see Item 302(a)(5) of
Regulation S-K).
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\3\ These requirements have been further revised to require the
company's CEO and CFO to certify to the information contained in the
company's periodic filing.
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1. Selected Quarterly Financial Data (Item 302(a) of Regulation S-K)
a. Disclosure of Selected Quarterly Financial Data
Facts: Item 302(a)(1) of Regulation S-K requires disclosure of net
sales, gross profit, income before extraordinary items and cumulative
effect of a change in accounting, per share data based upon such income
(loss), net income (loss), and net income (loss) attributable to the
registrant for each full quarter within the two most recent fiscal
years and any subsequent interim period for which financial statements
are included. Item 302(a)(3) requires the registrant to describe the
effect of any disposals of components of an entity \4\ and
extraordinary, unusual or infrequently occurring items recognized in
each quarter, as well as the aggregate effect and the nature of year-
end or other adjustments which are material to the results of that
quarter. Furthermore, Item 302(a)(2) requires a reconciliation of
amounts previously reported on Form 10-Q to the quarterly data
presented if the amounts differ.
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\4\ See question 5 for a discussion of the meaning of components
of an entity as used in Item 302(a)(2).
---------------------------------------------------------------------------
Question 1: Are these disclosure requirements applicable to
supplemental financial statements included in a filing with the SEC for
unconsolidated subsidiaries and 50% or less owned persons?
Interpretive Response: The summarized quarterly financial data
required by Item 302(a)(1) need not be included in supplemental
financial statements for unconsolidated subsidiaries and 50% or less
owned persons unless the financial statements are for a subsidiary or
affiliate that is itself a registrant which meets the criteria set
forth in Item 302(a)(5).
Question 2: If a company is in a specialized industry where ``gross
profit'' generally is not computed (e.g., banks, insurance companies
and finance companies), what disclosure should be made to comply with
the requirements of Item 302(a)(1)?
Interpretive Response: Companies in specialized industries should
present summarized quarterly financial data which are most meaningful
in their
[[Page 17232]]
particular circumstances. For example, a bank might present interest
income, interest expense, provision for loan losses, security gains or
losses and net income. Similarly, an insurance company might present
net premiums earned, underwriting costs and expenses, investment
income, security gains or losses and net income.
Question 3: If a company wishes to make its quarterly and annual
disclosures on the same basis, would disclosure of costs and expenses
associated directly with or allocated to products sold or services
rendered, or other appropriate data to enable users to compute ``gross
profit,'' satisfy the requirements of Item 302(a)(1)?
Interpretive Response: Yes.
Question 4: What is meant by ``per-share data based upon such
income'' as used in Item 302(a)(1)?
Interpretive Response: Item 302(a)(1) only requires disclosure of
per share amounts for income before extraordinary items and cumulative
effect of a change in accounting. It is expected that when per share
data is calculated for each full quarter based upon such income, the
per share amounts would be both basic and diluted. Although it is not
required by the rule, there are many instances where it would be
desirable to disclose other per share figures such as net earnings per
share and the per share effect of extraordinary items also. Where such
disclosure is made, per share data should be both basic and diluted.
Question 5: What is intended by the requirement set forth in Item
302(a)(3) that registrants ``describe the effect of'' disposals of
segments of a business, etc.?
Interpretive Response: The rule uses the language of segments of a
business that was previously found in the authoritative literature.
Consistent with the terminology used in FASB ASC Subtopic 205-20,
Presentation of Financial Statements--Discontinued Operations, as used
here, segments of a business is intended to mean components of an
entity. The rule is intended to require registrants to ``disclose the
amount'' of such unusual transactions and events included in the
results reported for each quarter. Such disclosure would be made in
narrative form. However, it would not require that matters covered by
MD&A be repeated. In this situation, registrants should disclose the
nature and amount of the unusual transaction or event and refer to MD&A
for further discussion of the matter.
Question 6: What is intended by the requirement of Item 302(a)(3)
to disclose ``the aggregate effect and the nature of year-end or other
adjustments which are material to the results of that quarter''?
Interpretive Response: This language is taken directly from FASB
ASC paragraph 270-10-50-2 (Interim Reporting Topic) which relates to
disclosures required for the fourth quarter of the year. FASB ASC Topic
270 indicates that earlier quarters should not be restated to reflect a
change in accounting estimate recorded at year end. However, changes in
an accounting estimate made in an interim period that materially affect
the quarter in which the change occurred are required to be disclosed
in order to avoid misleading comparisons. In making such disclosure,
registrants may wish to identify (but not restate) the prior periods in
which transactions were recorded which relate to the change in the
quarter.
Question 7: If company has filed a Form 10-Q/A amending a
previously filed Form 10-Q, is a reconciliation of quarterly data in
annual financial statements with the amounts originally reported on
Form 10-Q required?
Interpretive Response: Yes. However, if the company publishes
quarterly reports to shareholders and has previously made detailed
disclosure to shareholders in such reports of the change reported on
the Form 10-Q/A, no reconciliation would be required.
b. Financial Statements Presented on Other Than a Quarterly Basis
Facts: Item 302(a)(1) requires disclosure of quarterly financial
data for each full quarter of the last two fiscal years and in any
subsequent interim period for which an income statement is presented.
Question: If a company reports at interim dates on other than a
calendar-quarter basis (e.g., 12-12-16-12 week basis), will it be
precluded from reporting on such basis in the future?
Interpretive Response: No, as long as it discloses the basis of
interim fiscal period reporting and the interim fiscal periods on which
it reports are consistently determined from year to year (or, if not,
the lack of comparability is disclosed).
c. Removed by SAB 103
2. Amendments to Form 10-Q
a. Form of Condensed Financial Statements
Facts: Rules 10-01(a)(2) and (3) of Regulation S-X provide that
interim balance sheets and statements of income shall include only
major captions (i.e., numbered captions) set forth in Regulation S-X,
with the exception of inventories where data as to raw materials, work
in process and finished goods shall be included, if applicable, either
on the face of the balance sheet or in notes thereto. Where any major
balance sheet caption is less than 10% of total assets and the amount
in the caption has not increased or decreased by more than 25% since
the end of the preceding fiscal year, the caption may be combined with
others. When any major income statement caption is less than 15% of
average net income attributable to the registrant for the most recent
three fiscal years and the amount in the caption has not increased or
decreased by more than 20% as compared to the corresponding interim
period of the preceding fiscal year, the caption may be combined with
others. Similarly, the statement of cash flows may be abbreviated,
starting with a single figure of cash flows provided by operations and
showing other changes individually only when they exceed 10% of the
average of cash flows provided by operations for the most recent three
years.
Question 1: If a company previously combined captions in a Form 10-
Q but is required to present such captions separately in the Form 10-Q
for the current quarter, must it retroactively reclassify amounts
included in the prior-year financial statements presented for
comparative purposes to conform with the captions presented for the
current-year quarter?
Interpretive Response: Yes.
Question 2: If a company uses the gross profit method or some other
method to determine cost of goods sold for interim periods, will it be
acceptable to state only that it is not practicable to determine
components of inventory at interim periods?
Interpretive Response: The staff believes disclosure of inventory
components is important to investors. In reaching this decision, the
staff recognizes that registrants may not take inventories during
interim periods and that managements, therefore, will have to estimate
the inventory components. However, the staff believes that management
will be able to make reasonable estimates of inventory components based
upon their knowledge of the company's production cycle, the costs
(labor and overhead) associated with this cycle as well as the relative
sales and purchasing volume of the company.
Question 3: If a company has years during which operations resulted
in a net outflow of cash and cash equivalents, should it exclude such
years from the computation of cash and cash equivalents provided by
operations for the three most recent years in
[[Page 17233]]
determining what sources and applications must be shown separately?
Interpretive Response: Yes. Similar to the determination of average
net income, if operations resulted in a net outflow of cash and cash
equivalents during any year, such amount should be excluded in making
the computation of cash flow provided by operations for the three most
recent years unless operations resulted in a net outflow of cash and
cash equivalents in all three years, in which case the average of the
net outflow of cash and cash equivalents should be used for the test.
b. Reporting Requirements for Accounting Changes
1. Preferability
Facts: Rule 10-01(b)(6) of Regulation S-X requires that a
registrant who makes a material change in its method of accounting
shall indicate the date of and the reason for the change. The
registrant also must include as an exhibit in the first Form 10-Q filed
subsequent to the date of an accounting change, a letter from the
registrant's independent accountants indicating whether or not the
change is to an alternative principle which in his judgment is
preferable under the circumstances. A letter from the independent
accountant is not required when the change is made in response to a
standard adopted by the Financial Accounting Standards Board which
requires such a change.
Question 1: For some alternative accounting principles,
authoritative bodies have specified when one alternative is preferable
to another. However, for other alternative accounting principles, no
authoritative body has specified criteria for determining the
preferability of one alternative over another. In such situations, how
should preferability be determined?
Interpretive Response: In such cases, where objective criteria for
determining the preferability among alternative accounting principles
have not been established by authoritative bodies, the determination of
preferability should be based on the particular circumstances described
by and discussed with the registrant. In addition, the independent
accountant should consider other significant information of which he is
aware.\5\
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\5\ Registrants also are reminded that FASB ASC paragraph 250-
10-50-1 (Accounting Changes and Error Corrections Topic) requires
that companies disclose the nature of and justification for the
change as well as the effects of the change on net income for the
period in which the change is made. Furthermore, the justification
for the change should explain clearly why the newly adopted
principle is preferable to the previously-applied principle.
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Question 2: Management may offer, as justification for a change in
accounting principle, circumstances such as: their expectation as to
the effect of general economic trends on their business (e.g., the
impact of inflation), their expectation regarding expanding consumer
demand for the company's products, or plans for change in marketing
methods. Are these circumstances which enter into the determination of
preferability?
Interpretive Response: Yes. Those circumstances are examples of
business judgment and planning and should be evaluated in determining
preferability. In the case of changes for which objective criteria for
determining preferability have not been established by authoritative
bodies, business judgment and business planning often are major
considerations in determining that the change is to a preferable method
because the change results in improved financial reporting.
Question 3: What responsibility does the independent accountant
have for evaluating the business judgment and business planning of the
registrant?
Interpretive Response: Business judgment and business planning are
within the province of the registrant. Thus, the independent accountant
may accept the registrant's business judgment and business planning and
express reliance thereon in his letter. However, if either the plans or
judgment appear to be unreasonable to the independent accountant, he
should not accept them as justification. For example, an independent
accountant should not accept a registrant's plans for a major expansion
if he believes the registrant does not have the means of obtaining the
funds necessary for the expansion program.
Question 4: If a registrant, who has changed to an accounting
method which was preferable under the circumstances, later finds that
it must abandon its business plans or change its business judgment
because of economic or other factors, is the registrant's justification
nullified?
Interpretive Response: No. A registrant must in good faith justify
a change in its method of accounting under the circumstances which
exist at the time of the change. The existence of different
circumstances at a later time does not nullify the previous
justification for the change.
Question 5: If a registrant justified a change in accounting method
as preferable under the circumstances, and the circumstances change,
may the registrant revert to the method of accounting used before the
change?
Interpretive Response: Any time a registrant makes a change in
accounting method, the change must be justified as preferable under the
circumstances. Thus, a registrant may not change back to a principle
previously used unless it can justify that the previously used
principle is preferable in the circumstances as they currently exist.
Question 6: If one client of an independent accounting firm changes
its method of accounting and the accountant submits the required letter
stating his view of the preferability of the principle in the
circumstances, does this mean that all clients of that firm are
constrained from making the converse change in accounting (e.g., if one
client changes from FIFO to LIFO, can no other client change from LIFO
to FIFO)?
Interpretive Response: No. Each registrant must justify a change in
accounting method on the basis that the method is preferable under the
circumstances of that registrant. In addition, a registrant must
furnish a letter from its independent accountant stating that in the
judgment of the independent accountant the change in method is
preferable under the circumstances of that registrant. If registrants
in apparently similar circumstances make changes in opposite
directions, the staff has a responsibility to inquire as to the factors
which were considered in arriving at the determination by each
registrant and its independent accountant that the change was
preferable under the circumstances because it resulted in improved
financial reporting. The staff recognizes the importance, in many
circumstances, of the judgments and plans of management and recognizes
that such management judgments may, in good faith, differ. As indicated
above, the concern relates to registrants in apparently similar
circumstances, no matter who their independent accountants may be.
Question 7: If a registrant changes its accounting to one of two
methods specifically approved by the FASB in the Accounting Standards
Codification, need the independent accountant express his view as to
the preferability of the method selected?
Interpretive Response: If a registrant was formerly using a method
of accounting no longer deemed acceptable, a change to either method
approved by the FASB may be presumed to be a change to a preferable
method and no letter will be required from the independent accountant.
If, however, the registrant was formerly using one of the methods
approved by
[[Page 17234]]
the FASB for current use and wishes to change to an alternative
approved method, then the registrant must justify its change as being
one to a preferable method in the circumstances and the independent
accountant must submit a letter stating that in his view the change is
to a principle that is preferable in the circumstances.
2. Filing of a Letter From the Accountants
Facts: The registrant makes an accounting change in the fourth
quarter of its fiscal year. Rule 10-01(b)(6) of Regulation S-X requires
that the registrant file a letter from its independent accountants
stating whether or not the change is preferable in the circumstances in
the next Form 10-Q. Item 601(b)(18) of Regulation S-K provides that the
independent accountant's preferability letter be filed as an exhibit to
reports on Forms 10-K or 10-Q.
Question: When the independent accountant's letter is filed with
the Form 10-K, must another letter also be filed with the first
quarter's Form 10-Q in the following year?
Interpretive Response: No. A letter is not required to be filed
with Form 10-Q if it has been previously filed as an exhibit to the
Form 10-K.
H. Accounting Series Release 148--Disclosure of Compensating Balances
and Short-Term Borrowing Arrangements (Adopted November 13, 1973 as
Modified by ASR 172 Adopted on June 13, 1975 and ASR 280 Adopted on
September 2, 1980)
Facts: ASR 148 (as modified) amends Regulation S-X to include:
1. Disclosure of compensating balance arrangements.
2. Segregation of cash for compensating balance arrangements that
are legal restrictions on the availability of cash.
1. Applicability
a. Arrangements With Other Lending Institutions
Question: In addition to banks, is ASR 148 applicable to
arrangements with factors, commercial finance companies or other
lending entities?
Interpretive Response: Yes.
b. Bank Holding Companies and Brokerage Firms
Question: Do the provisions of ASR 148 apply to bank holding
companies and to brokerage firms filing under Rule 17a-5?
Interpretive Response: Yes; however, brokerage firms are not
expected to meet these requirements when filing Form X-17a-5.
c. Financial Statements of Parent Company and Unconsolidated
Subsidiaries
Question: Are the provisions of ASR 148 applicable to parent
company financial statements in addition to consolidated financial
statements? To financial statements of unconsolidated subsidiaries?
Interpretive Response: ASR 148 data for consolidated financial
statements only will generally be sufficient when a filing includes
consolidated and parent company financial statements. Such data are
required for each unconsolidated subsidiary or other entity when a
filing is required to include complete financial statements of those
entities. When the filing includes summarized financial data in a
footnote about such entities, the disclosures under ASR 148 relating to
the consolidated financial statements will be sufficient.
d. Foreign Lenders
Question: Are ASR 148 disclosure requirements applicable to
arrangements with foreign lenders?
Interpretive Response: Yes.
2. Classification of Short-Term Obligations--Debt Related to Long-Term
Projects
Facts: Companies engaging in significant long-term construction
programs frequently arrange for revolving cover loans which extend
until the completion of long-term construction projects. Such revolving
cover loans are typically arranged with substantial financial
institutions and typically have the following characteristics:
1. A firm long-term mortgage commitment is obtained for each
project.
2. Interest rates and terms are in line with the company's normal
borrowing arrangements.
3. Amounts are equal to the expected full mortgage amount of all
projects.
4. The company may draw down funds at its option up to the maximum
amount of the agreement.
5. The company uses short-term interim construction financing
(commercial paper, bank loans, etc.) against the revolving cover loan.
Such indebtedness is rolled over or drawn down on the revolving cover
loan at the company's option. The company typically has regular bank
lines of credit, but these generally are not legally enforceable.
Question: Under FASB ASC Subtopic 470-10, Debt--Overall, will the
classification of loans such as described above as long-term be
acceptable?
Interpretive Response: Where such conditions exist providing for a
firm commitment throughout the construction program as well as a firm
commitment for permanent mortgage financing, and where there are no
contingencies other than the completion of construction, the guideline
criteria are met and the borrowing under such a program should be
classified as long-term with appropriate disclosure.
3. Compensating Balances
a. Compensating Balances for Future Credit Availability
Facts: Rule 5-02.1 of Regulation S-X requires disclosure of
compensating balances in order to avoid undisclosed commingling of such
balances with other funds having different liquidity characteristics
and bearing no determinable relationship to borrowing arrangements. It
also requires footnote disclosure distinguishing the amounts of such
balances maintained under a formal agreement to assure future credit
availability.
Question: In disclosing compensating balances maintained to assure
future credit availability, is it necessary to segregate compensating
balances for an unused portion of a regular line of credit when a total
compensating balance amount covering both used and unused amounts of a
line of credit is disclosed?
Interpretive Response: No.
b. Changes in Compensating Balances
Facts: ASR 148 guidelines indicate the need for additional
disclosures where compensating balances were materially greater during
the period than at the end of the period.
Question: Does this disclosure relate to changes in the arrangement
(e.g., the required compensating balance percentage) or changes in
borrowing levels?
Interpretive Response: Both.
c. Float
Facts: ASR 148 states that ``compensating balance arrangements * *
* are normally expressed in terms of collected bank ledger balances but
the financial statements are presented on the basis of the company's
books. In order to make the disclosure of compensating balance amounts
* * * consistent with the cash amounts reflected in the financial
statements, the balance figure agreed upon by the bank and the company
should be adjusted if possible by the estimated float.''
[[Page 17235]]
Question: In determining the amount of ``float'' as suggested by
ASR 148 guidelines, frequently an adjustment to the bank balance is
required for ``uncollected funds.'' On what basis should this
adjustment be estimated?
Interpretive Response: The adjustment should be estimated based
upon the method used by the bank or a reasonable approximation of that
method. The following is a sample computation of the amount of
compensating balances to be disclosed where uncollected funds are
involved.
Assumptions: The company has agreed to maintain compensating
balances equal to 20% of short-term borrowings.
Short-term borrowings................................... $10,000,000
Compensating balances per bank balances................. 2,000,000
Estimated float (approximates the excess of outstanding 480,000
checks over deposits in transit).......................
Estimated uncollected funds............................. 320,000
Computation:
Compensating balances per bank balances............... 2,000,000
Estimated uncollected funds........................... 320,000
Estimated float....................................... (480,000)
Compensating balances stated in terms of a book cash 1,840,000
balance and to be disclosed............................
4. Miscellaneous
a. Periods required
Question: For what periods are ASR 148 disclosures required?
Interpretive Response: Disclosure of compensating balance
arrangements and other disclosures called for in ASR 148 are required
for the latest fiscal year but are generally not required for any later
interim period unless a material change has occurred since year end.
b. 10-Q Disclosures
Question: Are ASR 148 disclosures required in 10-Q's?
Interpretive Response: In general, ASR 148 disclosures are not
required in Form 10-Q. However, in some instances material changes in
borrowing arrangements or borrowing levels may give rise to the need
for disclosure either in Form 10-Q or Form 8-K.
I. Accounting Series Release 149--Improved Disclosure of Income Tax
Expense (Adopted November 28, 1973 and Modified by ASR 280 Adopted on
September 2, 1980)
Facts: ASR 149 and 280 amend Regulation S-X to include:
1. Disclosure of tax effect of timing differences comprising
deferred income tax expense.
2. Disclosure of the components of income tax expense, including
currently payable and the net tax effects of timing differences.
3. Disclosure of the components of income [loss] before income tax
expense [benefit] as either domestic or foreign.
4. Reconciliation between the statutory Federal income tax rate and
the effective tax rate.
1. Tax rate
Question 1: In reconciling to the effective tax rate should the
rate used be a combination of state and Federal income tax rates?
Interpretive Response: No, the reconciliation should be made to the
Federal income tax rate only.
Question 2: What is the ``applicable statutory Federal income tax
rate''?
Interpretive Response: The applicable statutory Federal income tax
rate is the normal rate applicable to the reporting entity. Hence, the
statutory rate for a U.S. partnership is zero. If, for example, the
statutory rate for U.S. corporations is 22% on the first $25,000 of
taxable income and 46% on the excess over $25,000, the ``normalized
rate'' for corporations would fluctuate in the range between 22% and
46% depending on the amount of pretax accounting income a corporation
has.
2. Taxes of Investee Company
Question: If a registrant records its share of earnings or losses
of a 50% or less owned person on the equity basis and such person has
an effective tax rate which differs by more than 5% from the applicable
statutory Federal income tax rate, is a reconciliation as required by
Rule 4-08(g) necessary?
Interpretive Response: Whenever the tax components are known and
material to the investor's (registrant's) financial position or results
of operations, appropriate disclosure should be made. In some instances
where 50% or less owned persons are accounted for by the equity method
of accounting in the financial statements of the registrant, the
registrant may not know the rate at which the various components of
income are taxed and it may not be practicable to provide disclosure
concerning such components.
It should also be noted that it is generally necessary to disclose
the aggregate dollar and per-share effect of situations where temporary
tax exemptions or ``tax holidays'' exist, and that such disclosures are
also applicable to 50% or less owned persons. Such disclosures should
include a brief description of the factual circumstances and give the
date on which the special tax status will terminate. See Topic 11.C.
3. Net of Tax Presentation
Question: What disclosure is required when an item is reported on a
net of tax basis (e.g., extraordinary items, discontinued operations,
or cumulative adjustment related to accounting change)?
Interpretive Response: When an item is reported on a net of tax
basis, additional disclosure of the nature of the tax component should
be provided by reconciling the tax component associated with the item
to the applicable statutory Federal income tax rate or rates.
4. Loss Years
Question: Is a reconciliation of a tax recovery in a loss year
required?
Interpretive Response: Yes, in loss years the actual book tax
benefit of the loss should be reconciled to expected normal book tax
benefit based on the applicable statutory Federal income tax rate.
5. Foreign Registrants
Question 1: Occasionally, reporting foreign persons may not operate
under a normal income tax base rate such as the current U.S. Federal
corporate income tax rate. What form of disclosure is acceptable in
these circumstances?
Interpretive Response: In such instances, reconciliations between
year-to-year effective rates or between a weighted average effective
rate and the current effective rate of total tax expense may be
appropriate in meeting the requirements of Rule 4-08(h)(2). A brief
description of how such a rate was determined would be required in
addition to other required disclosures. Such an approach would not be
acceptable for a U.S. registrant with foreign operations. Foreign
registrants with unusual tax situations may find that these guidelines
are not fully responsive to their needs. In such instances, registrants
should discuss the matter with the staff.
Question 2: Where there are significant reconciling items that
relate in significant part to foreign operations as well as domestic
operations, is it necessary to disclose the separate amounts of the tax
component by geographical area, e.g., statutory depletion allowances
provided for by U.S. and by other foreign jurisdictions?
Interpretive Response: It is not practicable to give an all-
encompassing answer to this question. However, in many cases such
disclosure would seem appropriate.
[[Page 17236]]
6. Securities Gains and Losses
Question: If the tax on the securities gains and losses of banks
and insurance companies varies by more than 5% from the applicable
statutory Federal income tax rate, should a reconciliation to the
statutory rate be provided?
Interpretive Response: Yes.
Tax Expense Components v. ``Overall'' Presentation
Facts: Rule 4-08(h) requires that the various components of income
tax expense be disclosed, e.g., currently payable domestic taxes,
deferred foreign taxes, etc. Frequently income tax expense will be
included in more than one caption in the financial statements. For
example, income taxes may be allocated to continuing operations,
discontinued operations, extraordinary items, cumulative effects of an
accounting change and direct charges and credits to shareholders'
equity.
Question: In instances where income tax expense is allocated to
more than one caption in the financial statements, must the components
of income tax expense included in each caption be disclosed or will an
``overall'' presentation such as the following be acceptable?
The components of income tax expense are:
Currently payable (per tax return):
Federal................................................. $350,000
Foreign................................................. 150,000
State................................................... 50,000
Deferred:
Federal............................................... 125,000
Foreign............................................... 75,000
---------------
State................................................. 50,000
800,000
Income tax expense is included in the financial statements as
follows:
Continuing operations................................... $600,000
Discontinued operations................................. (200,000)
Extraordinary income.................................... 300,000
---------------
Cumulative effect of change in accounting principle..... 100,000
800,000
Interpretive Response: An overall presentation of the nature
described will be acceptable.
J. Removed by SAB 47
K. Accounting Series Release 302--Separate Financial Statements
Required By Regulation S-X
1. Removed by SAB 103
2. Parent Company Financial Information
a. Computation of Restricted Net Assets of Subsidiaries
Facts: The revised rules for parent company disclosures adopted in
ASR 302 require, in certain circumstances, (1) footnote disclosure in
the consolidated financial statements about the nature and amount of
significant restrictions on the ability of subsidiaries to transfer
funds to the parent through intercompany loans, advances or cash
dividends [Rule 4-08(e)(3)], and (2) the presentation of condensed
parent company financial information and other data in a schedule (Rule
12-04). To determine which disclosures, if any, are required, a
registrant must compute its proportionate share of the net assets of
its consolidated and unconsolidated subsidiary companies as of the end
of the most recent fiscal year which are restricted as to transfer to
the parent company because the consent of a third party (a lender,
regulatory agency, foreign government, etc.) is required. If the
registrant's proportionate share of the restricted net assets of
consolidated subsidiaries exceeds 25% of the registrant's consolidated
net assets, both the footnote and schedule information are required. If
the amount of such restrictions is less than 25%, but the sum of these
restrictions plus the amount of the registrant's proportionate share of
restricted net assets of unconsolidated subsidiaries plus the
registrant's equity in the undistributed earnings of 50% or less owned
persons (investees) accounted for by the equity method exceed 25% of
consolidated net assets, the footnote disclosure is required.
Question 1: How are restricted net assets of subsidiaries computed?
Interpretative Response: The calculation of restricted net assets
requires an evaluation of each subsidiary to identify any circumstances
where third parties may limit the subsidiary's ability to loan, advance
or dividend funds to the parent. This evaluation normally comprises a
review of loan agreements, statutory and regulatory requirements, etc.,
to determine the dollar amount of each subsidiary's restrictions. The
related amount of the subsidiary's net assets designated as restricted,
however, should not exceed the amount of the subsidiary's net assets
included in consolidated net assets, since parent company disclosures
are triggered when a significant amount of consolidated net assets are
restricted. The amount of each subsidiary's net assets included in
consolidated net assets is determined by allocating (pushing down) to
each subsidiary any related consolidation adjustments such as
intercompany balances, intercompany profits, and differences between
fair value and historical cost arising from a business combination
accounted for as a purchase. This amount is referred to as the
subsidiary's adjusted net assets. If the subsidiary's adjusted net
assets are less than the amount of its restrictions because the push
down of consolidating adjustments reduced its net assets, the
subsidiary's adjusted net assets is the amount of the subsidiary's
restricted net assets used in the tests.
Registrants with numerous subsidiaries and investees may wish to
develop approaches to facilitate the determination of its parent
company disclosure requirements. For example, if the parent company's
adjusted net assets (excluding any interest in its subsidiaries) exceed
75% of consolidated net assets, or if the total of all of the
registrant's consolidated and unconsolidated subsidiaries' restrictions
and its equity in investees' earnings is less than 25% of consolidated
net assets, then the allocation of consolidating adjustments to the
subsidiaries to determine the amount of their adjusted net assets would
not be necessary since no parent company disclosures would be required.
Question 2: If a registrant makes a decision that it will
permanently reinvest the undistributed earnings of a subsidiary, and
thus does not provide for income taxes thereon because it meets the
criteria set forth in FASB ASC Subtopic 740-30, Income Taxes--Other
Considerations or Special Areas, is there considered to be a
restriction for purposes of the test?
Interpretive Response: No. The rules require that only third party
restrictions be considered. Restrictions on subsidiary net assets
imposed by management are not included.
b. Application of Tests for Parent Company Disclosures
Facts: The balance sheet of the registrant's 100%-owned subsidiary
at the most recent fiscal year-end is summarized as follows:
[[Page 17237]]
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Current assets............................. $120 Current liabilities........... $30
Noncurrent assets.......................... 45 Long-term debt................ 60
................. 90
................. Common stock.................. 25
................. Retained earnings............. 50
................. 75
165 165
----------------------------------------------------------------------------------------------------------------
Net assets of the subsidiary are $75. Assume there are no
consolidating adjustments to be allocated to the subsidiary.
Restrictive covenants of the subsidiary's debt agreements provide that:
Net assets, excluding intercompany loans, cannot be less than $35
60% of accumulated earnings must be maintained
Question 1: What is the amount of the subsidiary's restricted net
assets?
Interpretive Response:
------------------------------------------------------------------------
Computed
Restriction restrictions
------------------------------------------------------------------------
Net assets: Currently $75, cannot be less than $35; $35
therefore..............................................
Dividends: 60% of accumulated earnings ($50) cannot be 30
paid out; therefore....................................
------------------------------------------------------------------------
Restricted net assets for purposes of the test are $35. The maximum
amount that can be loaned or advanced to the parent without violating
the net asset covenant is $40 ($75 - 35). Alternatively, the subsidiary
could pay a dividend of up to $20 ($50 - 30) without violating the
dividend covenant, and loan or advance up to $20, without violating the
net asset provision.
Facts: The registrant has one 100%-owned subsidiary. The balance
sheet of the subsidiary at the latest fiscal year-end is summarized as
follows:
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Current assets............................. $75 Current liabilities........... $23
Noncurrent assets.......................... 90 Long-term debt................ 57
................. Redeemable preferred stock.... 10
................. Common stock.................. 30
-----------------
................. Retained earnings............. 45
------------------- -----------------
................. 75
165 165
----------------------------------------------------------------------------------------------------------------
Assume that the registrant's consolidated net assets are $130 and
there are no consolidating adjustments to be allocated to the
subsidiary. The subsidiary's net assets are $75. The subsidiary's
noncurrent assets are comprised of $40 in operating plant and equipment
used in the subsidiary's business and a $50 investment in a 30%
investee. The subsidiary's equity in this investee's undistributed
earnings is $18. Restrictive covenants of the subsidiary's debt
agreements are as follows:
1. Net assets, excluding intercompany balances, cannot be less than
$20.
2. 80% of accumulated earnings must be reinvested in the
subsidiary.
3. Current ratio of 2:1 must be maintained.
Question 2: Are parent company footnote or schedule disclosures
required?
Interpretive Response: Only the parent company footnote disclosures
are required. The subsidiary's restricted net assets are computed as
follows:
------------------------------------------------------------------------
Computed
Restriction restriction
------------------------------------------------------------------------
Net assets: Currently $75, cannot be less than $20; $20
therefore..............................................
Dividends: 80% of accumulated earnings ($45) cannot be 36
paid; therefore........................................
Current ratio: Must be at least 2:1 ($46 current assets 46
must be maintained since current liabilities are $23 at
fiscal year-end); therefore............................
------------------------------------------------------------------------
Restricted net assets for purposes of the test are $20. The amount
computed from the dividend restriction ($36) and the current ratio
requirement ($46) are not used because net assets may be transferred by
the subsidiary up to the limitation imposed by the requirement to
maintain net assets of at least $20, without violating the other
restrictions. For example, a transfer to the parent of up to $55 of net
assets could be accomplished by a combination of dividends of current
assets of $9 ($45 - 36), and loans or advances of current assets of up
to $20 and noncurrent assets of up to $26.
Parent company footnote disclosures are required in this example
since the restricted net assets of the subsidiary and the registrant's
equity in the earnings of its 100%-owned subsidiary's investee exceed
25% of consolidated net assets [($20 + 18)/$130 = 29%]. The parent
company schedule information is not required since the restricted net
assets of the subsidiary are only 15% of consolidated net assets ($20/
$130 = 15%).
Although the subsidiary's noncurrent assets are not in a form which
is readily transferable to the parent company, the illiquid nature of
the assets is not relevant for purposes of the parent company tests.
The objective of the tests is to require parent company disclosures
when the parent company does not have control of its subsidiaries'
funds because it does not have unrestricted access to their net assets.
The tests trigger parent company disclosures only when there are
significant third party restrictions on transfers by subsidiaries of
net assets and the subsidiaries' net assets comprise a significant
portion of consolidated net assets. Practical limitations, other than
third party restrictions on transferability at the measurement date
(most recent fiscal year-end), such as subsidiary illiquidity, are not
considered in computing restricted net assets. However, the potential
effect of any limitations other than those imposed by third parties
should be considered for inclusion in Management's Discussion and
Analysis of liquidity.
Facts:
------------------------------------------------------------------------
Net assets
------------------------------------------------------------------------
Subsidiary A............................................ $(500)
Subsidiary B............................................ 2,000
[[Page 17238]]
Consolidated............................................ 3,700
------------------------------------------------------------------------
Subsidiaries A and B are 100% owned by the registrant. Assume there
are no consolidating adjustments to be allocated to the subsidiaries.
Subsidiary A has restrictions amounting to $200. Subsidiary B's
restrictions are $1,000.
Question 3: What parent company disclosures are required for the
registrant?
Interpretive Response: Since subsidiary A has an excess of
liabilities over assets, it has no restricted net assets for purposes
of the test. However, both parent company footnote and schedule
disclosures are required, since the restricted net assets of subsidiary
B exceed 25% of consolidated net assets ($1,000/3,700 = 27%).
Facts:
------------------------------------------------------------------------
Net assets
------------------------------------------------------------------------
Subsidiary A........................................ $850
Subsidiary B........................................ 300
Consolidated........................................ 3,700
------------------------------------------------------------------------
The registrant owns 80% of subsidiary A. Subsidiary A owns 100% of
subsidiary B. Assume there are no consolidating adjustments to be
allocated to the subsidiaries. A may not pay any dividends or make any
affiliate loans or advances. B has no restrictions. A's net assets of
$850 do not include its investment in B.
Question 4: Are parent company footnote or schedule disclosures
required for this registrant?
Interpretive Response: No. All of the registrant's share of
subsidiary A's net assets ($680) are restricted. Although B may pay
dividends and loan or advance funds to A, the parent's access to B's
funds through A is restricted. However, since there are no limitations
on B's ability to loan or advance funds to the parent, none of the
parent's share of B's net assets are restricted. Since A's restricted
net assets are less than 25% of consolidated net assets ($680/3700 =
18%), no parent company disclosures are required.
Facts: The consolidating balance sheet of the registrant at the
latest fiscal year-end is summarized as follows:
----------------------------------------------------------------------------------------------------------------
Consolidating
Registrant Subsidiary adjustments Consolidated
----------------------------------------------------------------------------------------------------------------
Current assets.................................. $800 $700 $0 $1,500
30% investment in affiliate..................... 175 0 0 175
Investment in subsidiary........................ 350 0 (350) 0
Other noncurrent assets......................... 625 300 (100) 825
---------------------------------------------------------------
1,950 1,000 (450) 2,500
----------------------------------------------------------------------------------------------------------------
Current liabilities............................. 600 400 0 1,000
Concurrent liabilities.......................... 375 150 0 525
Redeemable preferred stock...................... 275 0 0 275
Common stock.................................... 110 1 (1) 110
Paid-in capital................................. 290 49 (49) 290
Retained earnings............................... 300 400 (400) 300
---------------------------------------------------------------
700 450 (450) 700
---------------------------------------------------------------
1,950 1,000 (450) 2,500
----------------------------------------------------------------------------------------------------------------
The acquisition of the 100%-owned subsidiary was consummated on the
last day of the most recent fiscal year. Immediately preceding the
acquisition, the registrant had net assets of $700, which included its
equity in the undistributed earnings of its 30% investee of $75.
Immediately after acquiring the subsidiary's net assets, which had an
historical cost of $450 and a fair value of $350, the registrant's net
assets were still $700 since debt and preferred stock totaling $350
were issued in the purchase. The subsidiary has debt covenants which
permit dividends, loans or advances, to the extent, if any, that net
assets exceed an amount which is determined by the sum of $100 plus 75%
of the subsidiary's accumulated earnings.
Question 5: What is the amount of the subsidiary's restricted net
assets? Are parent company footnote or schedule disclosures required?
Interpretive Response: Restricted net assets for purposes of the
test are $350, and both the parent company footnote and schedule
disclosures are required.
The amount of the subsidiary's restrictions at year-end is $400
[$100 + (75% x $400)]. The subsidiary's adjusted net assets after the
push down of the consolidation entry to the subsidiary to record the
noncurrent assets acquired at their fair value is $350 ($450 - $100).
Since the subsidiary's adjusted net assets ($350) are less than the
amount of its restrictions ($400), restricted net assets are $350. The
computed percentages applicable to each of the disclosure tests is in
excess of 25%. Therefore, both parent company footnote and schedule
information are required. The percentage applicable to the footnote
disclosure test is 61% [($75 + 350)/$700]. The computed percentage for
the schedule disclosure is 50% ($350/$700).
3. Undistributed Earnings of 50% or Less Owned Persons
Facts: Rule 4-08(e)(2) of Regulation SX requires footnote
disclosures of the amount of consolidated retained earnings which
represents undistributed earnings of 50% or less owned persons
(investee) accounted for by the equity method. The test adopted in ASR
302 to trigger disclosures about the registrant's restricted net assets
(Rule 4-08(e)(3)) includes the parent's equity in the undistributed
earnings of investees.
Question: Is the amount required for footnote disclosure the same
as the amount included in the test to determine disclosures about
restrictions?
Interpretive Response: Yes. The amount used in the test in Rule 4-
08(e)(3) should be the same as the amount required to be disclosed by
Rule 4-08(e)(2). This is the portion of the registrant's consolidated
retained earnings which represents the undistributed earnings of an
investee since the date(s) of acquisition. It is computed by
determining the registrant's cumulative equity in the investee's
earnings, adjusted by any dividends received, related goodwill
[[Page 17239]]
write-downs, and any related income taxes provided.
4. Application of Significant Subsidiary Test to Investees and
Unconsolidated Subsidiaries
a. Separate Financial Statement Requirements
Facts: Rule 3-09 of Regulation SX requires the presentation of
separate financial statements of unconsolidated subsidiaries and of 50%
or less owned persons (investee) accounted for by the equity method
either by the registrant or by a subsidiary of the registrant in
filings with the Commission if any of the tests of a significant
subsidiary are met at a 20% level.
Question 1: Are the requirements for separate financial statements
also applicable to an investee accounted for by the equity method by an
investee of the registrant?
Interpretive Response: Yes. Rule 3-09 is intended to apply to all
investees which are material to the financial position or results of
operations of the registrant, regardless of whether the investee is
held by the registrant, a subsidiary or another investee. Separate
financial statements should be provided for any lower tier investee
where such an entity is significant to the registrant's consolidated
financial statements.
Question 2: How is the significant subsidiary test applied to the
lower tier investee in the situation described in Question 1?
Interpretive Response: Since the disclosures provided by separate
financial statements of an investee are considered necessary to
evaluate the overall financial condition of the registrant, the
significant subsidiary test is computed based on the materiality of the
lower tier investee to the registrant consolidated. An example of the
application of the assets test of the significant subsidiary rules to
such an investee situation will illustrate the materiality measurement.
A registrant with total consolidated assets of $5,000 owns 50% of
Investee A, whose total assets are $3,800. Investee A has a 45%
investment in Investee B, whose total assets are $4,800. There are no
intercompany eliminations. Separate financial statements are required
for Investee A, and they are required for Investee B because the
registrant's share of B's total assets exceeds 20% of consolidated
assets [(50% x 45% x $4800)/$5000 = 22%].
b. Summarized Financial Statement Requirements
Facts: Rule 4-08(g) of Regulation S-X requires summarized financial
information about unconsolidated subsidiaries and 50% or less owned
persons (investee) to be included in the footnotes to the financial
statements if, in the aggregate, they meet the tests of a significant
subsidiary set forth in Rule 1-02(w).
Question 1: Must a registrant which includes separate financial
statements or condensed financial statements for unconsolidated
subsidiaries or investees in its annual report to shareholders also
include in such report the summarized financial information for these
entities pursuant to Rule 4-08(g)?
Interpretive Response: No. The purpose of the summarized
information is to provide minimum standards of disclosure when the
impact of such entities on the consolidated financial statements is
significant. If the registrant furnishes more information in the annual
report than is required by these minimum disclosure standards, such as
condensed financial information or separate audited financial
statements, the summarized data can be excluded. The Commission's rules
are not intended to conflict with the provisions of FASB ASC
subparagraph 323-10-50-3(c) (Investments--Equity Method and Joint
Ventures Topic), which provide that either separate financial
statements of investees be presented with the financial statements of
the reporting entity or that summarized information be included in the
reporting entity's financial statement footnotes.
Question 2: Can summarized information be omitted for individual
entities as long as the aggregate information for the omitted entity(s)
does not exceed 10% under any of the significance tests of Rule 1-
02(w)?
Interpretive Response: The 10% measurement level of the significant
subsidiary rule was not intended to establish a materiality criteria
for omission, and the arbitrary exclusion of summarized information for
selected entities up to a 10% level is not appropriate. Rule 4-08(g)
requires that the summarized information be included for all
unconsolidated subsidiaries and investees. However, the staff
recognizes that exclusion of the summarized information for certain
entities is appropriate in some circumstances where it is impracticable
to accumulate such information and the summarized information to be
excluded is de minimis.
L. Financial Reporting Release 28--Accounting for Loan Losses by
Registrants Engaged in Lending Activities
1. Accounting for Loan Losses
General: GAAP for recognition of loan losses is provided by FASB
ASC Subtopic 450-20, Contingencies--Loss Contingencies, and FASB ASC
Subtopic 310-10, Receivables--Overall.\6\ An estimated loss from a loss
contingency, such as the collectibility of receivables, should be
accrued when, based on information available prior to the issuance of
the financial statements, it is probable that an asset has been
impaired or a liability has been incurred at the date of the financial
statements and the amount of the loss can be reasonably estimated.\7\
FASB ASC Subtopic 310-10 provides more specific guidance on measurement
of loan impairment and related disclosures but does not change the
fundamental recognition criteria for loan losses provided by FASB ASC
Subtopic 450-20.
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\6\ [Original footnote removed by SAB 114.]
\7\ FASB ASC paragraph 450-20-25-2.
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Further guidance for SEC registrants is provided by FRR 28, which
added subsection (b), Procedural Discipline in Determining the
Allowance and Provision for Loan Losses to be Reported, of Section
401.09, Accounting for Loan Losses by Registrants Engaged in Lending
Activities, to the Codification of Financial Reporting Policies
(hereafter referred to as FRR 28). Additionally, public companies are
required to comply with the books and records provisions of the
Securities Exchange Act of 1934 (Exchange Act). Under Sections
13(b)(2)--(7) of the Exchange Act, registrants must make and keep
books, records, and accounts, which, in reasonable detail, accurately
and fairly reflect the transactions and dispositions of assets of the
registrant. Registrants also must maintain internal accounting controls
that are sufficient to provide reasonable assurances that, among other
things, transactions are recorded as necessary to permit the
preparation of financial statements in conformity with GAAP.
This staff interpretation applies to all registrants that are
creditors in loan transactions that, individually or in the aggregate,
have a material effect on the registrant's financial statements.\8\
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\8\ For purposes of this interpretation, a loan is defined
(consistent with the FASB ASC Master Glossary) as a contractual
right to receive money on demand or on fixed or determinable dates
that is recognized as an asset in the creditor's statement of
financial position. For purposes of this interpretation, loans do
not include trade accounts receivable or notes receivable with terms
less than one year or debt securities subject to the provisions of
FASB ASC Topic 320, Investments--Debt and Equity Securities.
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[[Page 17240]]
2. Developing and Documenting a Systematic Methodology
a. Developing a Systematic Methodology
Facts: Registrant A, or one of its consolidated subsidiaries,
engages in lending activities and is developing or performing a review
of its loan loss allowance methodology.
Question: What are some of the factors or elements that the staff
normally would expect Registrant A to consider when developing (or
subsequently performing an assessment of) its methodology for
determining its loan loss allowance under GAAP?
Interpretive Response: The staff normally would expect a registrant
that engages in lending activities to develop and document a systematic
methodology \9\ to determine its provision for loan losses and
allowance for loan losses as of each financial reporting date. It is
critical that loan loss allowance methodologies incorporate
management's current judgments about the credit quality of the loan
portfolio through a disciplined and consistently applied process. A
registrant's loan loss allowance methodology is influenced by entity-
specific factors, such as an entity's size, organizational structure,
business environment and strategy, management style, loan portfolio
characteristics, loan administration procedures, and management
information systems.
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\9\ FRR 28 states that ``the Commission's staff normally would
expect to find that the books and records of registrants engaged in
lending activities include documentation of [the]: (a) Systematic
methodology to be employed each period in determining the amount of
the loan losses to be reported, and (b) rationale supporting each
period's determination that the amounts reported were adequate.''
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However, as indicated in the AICPA Audit and Accounting Guide,
Depository and Lending Institutions with Conforming Changes as of June
1, 2009 (Audit Guide), while different institutions may use different
methods, there are certain common elements that should be included in
any [loan loss allowance] methodology for it to be effective.\10\ A
registrant's loan loss allowance methodology generally should: \11\
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\10\ See paragraph 9.05 of the Audit Guide.
\11\ Ibid.
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Include a detailed analysis of the loan portfolio,
performed on a regular basis;
Consider all loans (whether on an individual or group
basis);
Identify loans to be evaluated for impairment on an
individual basis under FASB ASC Subtopic 310-10 and segment the
remainder of the portfolio into groups of loans with similar risk
characteristics for evaluation and analysis under FASB ASC Subtopic
450-20;
Consider all known relevant internal and external factors
that may affect loan collectibility;
Be applied consistently but, when appropriate, be modified
for new factors affecting collectibility;
Consider the particular risks inherent in different kinds
of lending;
Consider current collateral values (less costs to sell),
where applicable;
Require that analyses, estimates, reviews and other loan
loss allowance methodology functions be performed by competent and
well-trained personnel;
Be based on current and reliable data;
Be well documented, in writing, with clear explanations of
the supporting analyses and rationale (see Question 2 below for staff
views on documenting a loan loss allowance methodology); and
Include a systematic and logical method to consolidate the
loss estimates and ensure the loan loss allowance balance is recorded
in accordance with GAAP.
For many entities engaged in lending activities, the allowance and
provision for loan losses are significant elements of the financial
statements.
Therefore, the staff believes it is appropriate for an entity's
management to review, on a periodic basis, its methodology for
determining its allowance for loan losses.\12\ Additionally, for
registrants that have audit committees, the staff believes that
oversight of the financial reporting and auditing of the loan loss
allowance by the audit committee can strengthen the registrant's
control system and process for determining its allowance for loan
losses.\13\
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\12\ For Federally insured depository institutions, the December
21, 1993 ``Interagency Policy Statement on the Allowance for Loan
and Lease Losses (ALLL)'' (the 1993 Interagency Policy Statement)
indicates that boards of directors and management have certain
responsibilities for the ALLL process and amounts reported. For
example, as indicated on page 4 of that statement, ``the board of
directors and management are expected to: Ensure that the
institution has an effective loan review system and controls[;]
Ensure the prompt charge-off of loans, or portions of loans, that
available information confirms to be uncollectible[; and] Ensure
that the institution's process for determining an adequate level for
the ALLL is based on a comprehensive, adequately documented, and
consistently applied analysis of the institution's loan and lease
portfolio.''
\13\ SAS 61 (as amended by SAS 90) states, in part: ``In
connection with each SEC engagement the auditor should discuss with
the audit committee the auditor's judgments about the quality, not
just the acceptability, of the entity's accounting principles as
applied in its financial reporting. The discussion should include
items that have a significant impact on the representational
faithfulness, verifiability, and neutrality of the accounting
information included in the financial statements. [Footnote
omitted.] Examples of items that may have such an impact are the
following:
1. Selection of new or changes to accounting policies
2. Estimates, judgments, and uncertainties
3. Unusual transactions
Accounting policies relating to significant financial statement
items, including the timing or transactions and the period in which
they are recorded.''
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A systematic methodology that is properly designed and implemented
should result in a registrant's best estimate of its allowance for loan
losses.\14\ Accordingly, the staff normally would expect registrants to
adjust their loan loss allowance balance, either upward or downward, in
each period for differences between the results of the systematic
determination process and the unadjusted loan loss allowance balance in
the general ledger.\15\
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\14\ Registrants should also refer to FASB ASC Section 450-20-
30, Contingencies--Loss Contingencies--Initial Measurement, which
provides accounting and disclosure guidance for situations in which
a range of loss can be reasonably estimated but no single amount
within the range appears to be a better estimate than any other
amount within the range.
\15\ Registrants should refer to the guidance on materiality in
SAB Topic 1.M.
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b. Documenting a Systematic Methodology
Question 1: Assume the same facts as in Question 1. What would the
staff normally expect Registrant A to include in its documentation of
its loan loss allowance methodology?
Interpretive Response: In FRR 28, the Commission provided guidance
for documentation of loan loss provisions and allowances for
registrants engaged in lending activities. The staff believes that
appropriate written supporting documentation for the loan loss
provision and allowance facilitates review of the loan loss allowance
process and reported amounts, builds discipline and consistency into
the loan loss allowance determination process, and improves the process
for estimating loan losses by helping to ensure that all relevant
factors are appropriately considered in the allowance analysis.
The staff, therefore, normally would expect a registrant to
document the relationship between the findings of its detailed review
of the loan portfolio and the amount of the loan loss allowance and the
provision for loan losses reported in each period.\16\
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\16\ FRR 28 states: ``The specific rationale upon which the
[loan loss allowance and provision] amount actually reported is
based--i.e., the bridge between the findings of the detailed review
[of the loan portfolio] and the amount actually reported in each
period--would be documented to help ensure the adequacy of the
reported amount, to improve auditability, and to serve as a
benchmark for exercise of prudent judgment in future periods.''
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[[Page 17241]]
The staff normally would expect to find that registrants maintain
written supporting documentation for the following decisions,
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strategies, and processes:\17\
\17\ Paragraph 9.64 in the Audit Guide outlines specific aspects
of effective internal control related to the allowance for loan
losses. These specific aspects include the control environment
(``management communication of the need for proper reporting of the
allowance''); management reports that summarize loan activity and
the institution's procedures and controls (``accumulation of
relevant, sufficient, and reliable data on which to base
management's estimate of the allowance''); ``independent loan
review;'' review of information and assumptions (``adequate review
and approval of the allowance estimates by the individuals specified
in management's written policy''); and assessment of the process
(``comparison of prior estimates related to the allowance with
subsequent results to assess the reliability of the process used to
develop the allowance'').
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Policies and procedures:
[cir] Over the systems and controls that maintain an appropriate
loan loss allowance, and
[cir] Over the loan loss allowance methodology;
Loan grading system or process;
Summary or consolidation of the loan loss allowance balance;
Validation of the loan loss allowance methodology; and
Periodic adjustments to the loan loss allowance process.
Question 2: The Interpretive Response to Question 2 indicates that
the staff normally would expect to find that registrants maintain
written supporting documentation for their loan loss allowance policies
and procedures. In the staff's view, what aspects of a registrant's
loan loss allowance internal accounting control systems and processes
would appropriately be addressed in its written policies and
procedures?
Interpretive Response: The staff is aware that registrants utilize
a wide range of policies, procedures, and control systems in their loan
loss allowance processes, and these policies, procedures, and systems
are tailored to the size and complexity of the registrant and its loan
portfolio. However, the staff believes that, in order for a
registrant's loan loss allowance methodology to be effective, the
registrant's written policies and procedures for the systems and
controls that maintain an appropriate loan loss allowance would likely
address the following:
The roles and responsibilities of the registrant's
departments and personnel (including the lending function, credit
review, financial reporting, internal audit, senior management, audit
committee, board of directors, and others, as applicable) who determine
or review, as applicable, the loan loss allowance to be reported in the
financial statements; \18\
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\18\ Paragraph 9.64 of the Audit Guide discusses ``management
communication of the need for proper reporting of the allowance.''
As indicated in that paragraph, the ``control environment strongly
influences the effectiveness of the system of controls and reflects
the overall attitude, awareness, and action of the board of
directors and management concerning the importance of control.''
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The registrant's accounting policies for loans and loan
losses, including the policies for charge-offs and recoveries and for
estimating the fair value of collateral, where applicable; \19\
---------------------------------------------------------------------------
\19\ Paragraph 9.56 of the Audit Guide refers to the
documentation, for disclosure purposes, that an entity should
include in the notes to the financial statements describing the
accounting policies the entity used to estimate its allowance and
related provision for loan losses.
---------------------------------------------------------------------------
The description of the registrant's systematic
methodology, which should be consistent with the registrant's
accounting policies for determining its loan loss allowance (see
Question 4 below for further discussion); \20\ and
---------------------------------------------------------------------------
\20\ Ibid. As indicated in paragraph 9.56, ``[s]uch a
description should identify the factors that influenced management's
judgment (for example, historical losses and existing economic
conditions) and may also include discussion of risk elements
relevant to particular categories of financial instruments.''
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The system of internal controls used to ensure that the
loan loss allowance process is maintained in accordance with GAAP.\21\
---------------------------------------------------------------------------
\21\ See also paragraph 9.64 in the Audit Guide which provides
information about specific aspects of effective internal control
related to the allowance for loan losses.q2
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The staff normally would expect an internal control system \22\ for the
loan loss allowance estimation process to:
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\22\ Ibid. Public companies are required to comply with the
books and records provisions of the Exchange Act. Under Sections
13(b)(2)--(7) of the Exchange Act, registrants must make and keep
books, records, and accounts, which, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of
assets of the registrant. Registrants also must maintain internal
accounting controls that are sufficient to provide reasonable
assurances that, among other things, transactions are recorded as
necessary to permit the preparation of financial statements in
conformity with GAAP.
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Include measures to provide assurance regarding the
reliability \23\ and integrity of information and compliance with laws,
regulations, and internal policies and procedures; \24\
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\23\ Concepts Statement 2, Qualitative Characteristics of
Accounting Information, provides guidance on ``reliability'' as a
primary quality of accounting information.
\24\ Section 13(b)(2)-(7) of the Exchange Act.
---------------------------------------------------------------------------
Reasonably assure that the registrant's financial
statements are prepared in accordance with GAAP; and
Include a well-defined loan review process.\25\
---------------------------------------------------------------------------
\25\ As indicated in paragraph 9.05, item a, in the Audit Guide,
a loan loss allowance methodology should ``include a detailed and
regular analysis of the loan portfolio.'' Paragraphs 9.06 to 9.13
provide additional information on how creditors traditionally
identify and review loans on an individual basis and review or
analyze loans on a group or pool basis.
---------------------------------------------------------------------------
A well-defined loan review process \26\ typically contains:
---------------------------------------------------------------------------
\26\ Ibid. Additionally, paragraph 9.64 in the Audit Guide
provides guidance on the loan review process. As stated in that
paragraph, ``[m]anagement reports summarizing loan activity,
renewals, and delinquencies are vital to the timely identification
of problem loans.'' The paragraph further states: ``Loan reviews
should be conducted by competent institution personnel who are
independent of the underwriting, supervision, and collections
functions. The specific lines of reporting depend on the complexity
of the institution's organizational structure, but the loan
reviewers should report to a high level of management that is
independent from the lending process in the institution.''
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An effective loan grading system that is consistently
applied, identifies differing risk characteristics and loan quality
problems accurately and in a timely manner, and prompts appropriate
administrative actions; \27\
---------------------------------------------------------------------------
\27\ Ibid.
---------------------------------------------------------------------------
Sufficient internal controls to ensure that all relevant
loan review information is appropriately considered in estimating
losses. This includes maintaining appropriate reports, details of
reviews performed, and identification of personnel involved; \28\ and
---------------------------------------------------------------------------
\28\ Ibid.
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Clear formal communication and coordination between a
registrant's credit administration function, financial reporting group,
management, board of directors, and others who are involved in the loan
loss allowance determination or review process, as applicable (e.g.,
written policies and procedures, management reports, audit programs,
and committee minutes).\29\
---------------------------------------------------------------------------
\29\ Ibid.
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Question 3: The Interpretive Response to Question 3 indicates that
the staff normally would expect a registrant's written loan loss
allowance policies and procedures to include a description of the
registrant's systematic allowance methodology, which should be
consistent with its accounting policies for determining its loan loss
allowance. What elements of a registrant's loan loss allowance
methodology would the staff normally expect to be described in the
registrant's written policies and procedures?
Interpretive Response: The staff normally would expect a
registrant's written policies and procedures to describe the primary
elements of its loan loss allowance methodology, including portfolio
segmentation and
[[Page 17242]]
impairment measurement. The staff normally would expect that, in order
for a registrant's loan loss allowance methodology to be effective, the
registrant's written policies and procedures would describe the
methodology:
For segmenting the portfolio:
[cir] How the segmentation process is performed (i.e., by loan
type, industry, risk rates, etc.); \30\
---------------------------------------------------------------------------
\30\ Paragraph 9.07 in the Audit Guide states that ``creditors
have traditionally identified loans that are to be evaluated for
collectibility by dividing the loan portfolio into different
segments. Loans with similar risk characteristics, such as risk
classification, past-due status, and type of loan should be grouped
together.'' Paragraph 9.08 provides additional guidance on
classifying individual loans and paragraph 9.13 indicates
considerations for groups or pools of loans.
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[cir] When a loan grading system is used to segment the portfolio:
The definitions of each loan grade;
A reconciliation of the internal loan grades to
supervisory loan grades, if applicable; and
The delineation of responsibilities for the loan grading
system.
For determining and measuring impairment under FASB ASC
Subtopic 310-10: \31\
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\31\ See FASB ASC paragraphs 310-10-35-16 through 310-10-35-19
on recognition of impairment and FASB ASC paragraphs 310-10-35-20
through 310-10-35-37 on measurement of impairment.
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[cir] The methods used to identify loans to be analyzed
individually;
[cir] For individually reviewed loans that are impaired, how the
amount of any impairment is determined and measured, including:
Procedures describing the impairment measurement
techniques available; and
Steps performed to determine which technique is most
appropriate in a given situation.
[cir] The methods used to determine whether and how loans
individually evaluated under FASB Subtopic 310-10, but not considered
to be individually impaired, should be grouped with other loans that
share common characteristics for impairment evaluation under FASB ASC
Subtopic 450-20.\32\
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\32\ See FASB ASC paragraph 310-10-35-36.
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For determining and measuring impairment under FASB ASC
Subtopic 450-20: \33\
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\33\ See FASB ASC paragraph 450-20-25-2 on accrual of loss
contingencies and FASB ASC paragraphs 310-10-35-5 through 310-10-35-
11 on collectibility of receivables.
---------------------------------------------------------------------------
[cir] How loans with similar characteristics are grouped to be
evaluated for loan collectibility (such as loan type, past-due status,
and risk);
[cir] How loss rates are determined (e.g., historical loss rates
adjusted for environmental factors or migration analysis) and what
factors are considered when establishing appropriate time frames over
which to evaluate loss experience; and
[cir] Descriptions of qualitative factors (e.g., industry,
geographical, economic, and political factors) that may affect loss
rates or other loss measurements.
3. Applying a Systematic Methodology--Measuring and Documenting Loan
Losses Under FASB ASC Subtopic 310-10
a. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 310-
10--General
Facts: Approximately one-third of Registrant B's commercial loan
portfolio consists of large balance, non-homogeneous loans. Due to
their large individual balances, these loans meet the criteria under
Registrant B's policies and procedures for individual review for
impairment under FASB ASC Subtopic 310-10.
Upon review of the large balance loans, Registrant B determines
that certain of the loans are impaired as defined by FASB ASC Subtopic
310-10.\34\
---------------------------------------------------------------------------
\34\ FASB ASC paragraph 310-10-35-8 provides that a loan is
impaired when, based on current information and events, it is
probable that all amounts due will not be collected pursuant to the
terms of the loan agreement.
---------------------------------------------------------------------------
Question: For the commercial loans reviewed under FASB ASC Subtopic
310-10 that are individually impaired, how would the staff normally
expect Registrant B to measure and document the impairment on those
loans? Can it use an impairment measurement method other than the
methods allowed by FASB ASC Subtopic 310-10?
Interpretive Response: For those loans that are reviewed
individually under FASB ASC Subtopic 310-10 and considered individually
impaired, Registrant B must use one of the methods for measuring
impairment that is specified by FASB ASC Subtopic 310-10 (that is, the
present value of expected future cash flows, the loan's observable
market price, or the fair value of collateral).\35\ Accordingly, in the
circumstances described above, for the loans considered individually
impaired under FASB ASC Subtopic 310-10, it would not be appropriate
for Registrant B to choose a measurement method not prescribed by FASB
ASC Subtopic 310-10. For example, it would not be appropriate to
measure loan impairment by applying a loss rate to each loan based on
the average historical loss percentage for all of its commercial loans
for the past five years.
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\35\ See FASB ASC paragraph 310-10-35-22.
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The staff normally would expect Registrant B to maintain as
sufficient, objective evidence \36\ written documentation to support
its measurement of loan impairment under FASB ASC Subtopic 310-10.\37\
If Registrant B uses the present value of expected future cash flows to
measure impairment of a loan, it should document the amount and timing
of cash flows, the effective interest rate used to discount the cash
flows, and the basis for the determination of cash flows, including
consideration of current environmental factors \38\ and other
information reflecting past events and current conditions. If
Registrant B uses the fair value of collateral to measure impairment,
the staff normally would expect to find that Registrant B had
documented how it determined the fair value, including the use of
appraisals, valuation assumptions and calculations, the supporting
rationale for adjustments to appraised values, if any, and the
determination of costs to sell, if applicable, appraisal quality, and
the expertise and independence of the appraiser.\39\ Similarly, the
staff normally would expect to find that Registrant B had documented
the amount, source, and date of the observable market price of a loan,
if that method of measuring loan impairment is used.
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\36\ Under GAAS, auditors should obtain ``sufficient competent
evidential matter'' to support its audit opinion. See AU Section
326. The staff normally would expect registrants to maintain such
evidential matter for its allowances for loan losses for use by the
auditors in conducting their annual audit.
\37\ Paragraph 9.74 in the Audit Guide outlines sources of
information, available from management, that the independent
accountant should consider in identifying loans that contain high
credit risk or other significant exposures and concentrations. These
sources of information would also likely include documentation of
loan impairment under FASB ASC Subtopic 310-10 or FASB ASC Subtopic
450-20. Additionally, as indicated in paragraphs 9.85 to 9.97 of the
Audit Guide, the independent accountant, in conducting an audit, may
perform a detailed loan file review for selected loans. A
registrant's loan files may contain documentation about borrowers'
financial resources and cash flows (see paragraph 9.92) or about the
collateral securing the loans, if applicable (see paragraphs 9.94
and 9.95).
\38\ FASB ASC paragraph 310-10-35-27 indicates that
environmental factors include existing industry, geographical,
economic, and political factors.
\39\ See paragraphs 9.94 and 9.95 in the Audit Guide for
additional information about documentation of loan collateral.
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[[Page 17243]]
b. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 310-10
for a Collateral Dependent Loan
Facts: Registrant C has a $10 million loan outstanding to Company X
that is secured by real estate, which Registrant C individually
evaluates under FASB ASC Subtopic 310-10 due to the loan's size.
Company X is delinquent in its loan payments under the terms of the
loan agreement. Accordingly, Registrant C determines that its loan to
Company X is impaired, as defined by FASB ASC Subtopic 310-10. Because
the loan is collateral dependent, Registrant C measures impairment of
the loan based on the fair value of the collateral. Registrant C
determines that the most recent valuation of the collateral was
performed by an appraiser eighteen months ago and, at that time, the
estimated value of the collateral (fair value less costs to sell) was
$12 million.
Registrant C believes that certain of the assumptions that were
used to value the collateral eighteen months ago do not reflect current
market conditions and, therefore, the appraiser's valuation does not
approximate current fair value of the collateral.
Several buildings, which are comparable to the real estate
collateral, were recently completed in the area, increasing vacancy
rates, decreasing lease rates, and attracting several tenants away from
the borrower. Accordingly, credit review personnel at Registrant C
adjust certain of the valuation assumptions to better reflect the
current market conditions as they relate to the loan's collateral.\40\
After adjusting the collateral valuation assumptions, the credit review
department determines that the current estimated fair value of the
collateral, less costs to sell, is $8 million.\41\ Given that the
recorded investment in the loan is $10 million, Registrant C concludes
that the loan is impaired by $2 million and records an allowance for
loan losses of $2 million.
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\40\ When reviewing collateral dependent loans, Registrant C may
often find it more appropriate to obtain an updated appraisal to
estimate the effect of current market conditions on the appraised
value instead of internally estimating an adjustment.
\41\ An auditor who uses the work of a specialist, such as an
appraiser, in performing an audit in accordance with GAAS should
refer to the guidance in SAS 73 (AU Section 336).
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Question: What documentation would the staff normally expect
Registrant C to maintain to support its determination of the allowance
for loan losses of $2 million for the loan to Company X?
Interpretive Response: The staff normally would expect Registrant C
to document that it measured impairment of the loan to Company X by
using the fair value of the loan's collateral, less costs to sell,
which it estimated to be $8 million.\42\ This documentation \43\ should
include the registrant's rationale and basis for the $8 million
valuation, including the revised valuation assumptions it used, the
valuation calculation, and the determination of costs to sell, if
applicable.
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\42\ See paragraphs 9.94 to 9.95 in the Audit Guide for further
information about documentation of loan collateral and associated
audit procedures that may be performed by the independent
accountant.
\43\ As stated in paragraph 9.14 of the Audit Guide, ``[t]he
approach for determination of the allowance should be well
documented.''
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Because Registrant C arrived at the valuation of $8 million by
modifying an earlier appraisal, it should document its rationale and
basis for the changes it made to the valuation assumptions that
resulted in the collateral value declining from $12 million eighteen
months ago to $8 million in the current period.
c. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 310-
10--Fully Collateralized Loans
Question: In the staff's view, what is an example of an acceptable
documentation practice for a registrant to adequately support its
determination that no allowance for loan losses should be recorded for
a group of loans because the loans are fully collateralized?
Interpretive Response: Consider the following fact pattern:
Registrant D has $10 million in loans that are fully collateralized by
highly rated debt securities with readily determinable market values.
The loan agreement for each of these loans requires the borrower to
provide qualifying collateral sufficient to maintain a loan-to-value
ratio with sufficient margin to absorb volatility in the securities'
market prices. Registrant D's collateral department has physical
control of the debt securities through safekeeping arrangements. In
addition, Registrant D perfected its security interest in the
collateral when the funds were originally distributed. On a quarterly
basis, Registrant D's credit administration function determines the
market value of the collateral for each loan using two independent
market quotes and compares the collateral value to the loan carrying
value. If there are any collateral deficiencies, Registrant D notifies
the borrower and requests that the borrower immediately remedy the
deficiency. Due in part to its efficient operation, Registrant D has
historically not incurred any material losses on these loans.
Registrant D believes these loans are fully-collateralized and
therefore does not maintain any loan loss allowance balance for these
loans.
Registrant D's management summary of the loan loss allowance
includes documentation indicating that, in accordance with its loan
loss allowance policy, the collateral protection on these loans has
been verified by the registrant, no probable loss has been incurred,
and no loan loss allowance is necessary.
Documentation in Registrant D's loan files includes the two
independent market quotes obtained each quarter for each loan's
collateral amount, the documents evidencing the perfection of the
security interest in the collateral, and other relevant supporting
documents. Additionally, Registrant D's loan loss allowance policy
includes a discussion of how to determine when a loan is considered
``fully collateralized'' and does not require a loan loss allowance.
Registrant D's policy requires the following factors to be considered
and its findings concerning these factors to be fully documented:
Volatility of the market value of the collateral;
Recency and reliability of the appraisal or other
valuation;
Recency of the registrant's or third party's inspection of
the collateral;
Historical losses on similar loans;
Confidence in the registrant's lien or security position
including appropriate:
[cir] Type of security perfection (e.g., physical possession of
collateral or secured filing);
[cir] Filing of security perfection (i.e., correct documents and
with the appropriate officials); and
[cir] Relationship to other liens; and
Other factors as appropriate for the loan type.
In the staff's view, Registrant D's documentation supporting its
determination that certain of its loans are fully collateralized, and
no loan loss allowance should be recorded for those loans, is
acceptable under FRR 28.
4. Applying a Systematic Methodology--Measuring and Documenting Loan
Losses Under FASB ASC Subtopic 450-20
a. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 450-
20--General
Question 1: In the staff's view, what are some general
considerations for a registrant in applying its systematic methodology
to measure and document loan losses under FASB ASC Subtopic 450-20?
Interpretive Response: For loans evaluated on a group basis under
FASB ASC Subtopic 450-20, the staff believes
[[Page 17244]]
that a registrant should segment the loan portfolio by identifying risk
characteristics that are common to groups of loans.\44\ Registrants
typically decide how to segment their loan portfolios based on many
factors, which vary with their business strategies as well as their
information system capabilities. Regardless of the segmentation method
used, the staff normally would expect a registrant to maintain
documentation to support its conclusion that the loans in each segment
have similar attributes or characteristics. As economic and other
business conditions change, registrants often modify their business
strategies, which may result in adjustments to the way in which they
segment their loan portfolio for purposes of estimating loan losses.
The staff normally would expect registrants to maintain documentation
to support these segmentation adjustments.\45\
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\44\ Paragraph 9.07 of the Audit Guide indicates that ``loans
with similar risk characteristics, such as risk classification,
past-due status, and type of loan, should be grouped together.''
\45\ Segmentation of the loan portfolio is a standard element in
a loan loss allowance methodology. As indicated in paragraph 9.05 of
the Audit Guide, the loan loss allowance methodology ``should be
well documented, with clear explanations of the supporting analyses
and rationale.''
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Based on the segmentation of the loan portfolio, a registrant
should estimate the FASB ASC Subtopic 450-20 portion of its loan loss
allowance. For those segments that require an allowance for loan
losses,\46\ the registrant should estimate the loan losses, on at least
a quarterly basis, based upon its ongoing loan review process and
analysis of loan performance.\47\ The registrant should follow a
systematic and consistently applied approach to select the most
appropriate loss measurement methods and support its conclusions and
rationale with written documentation.\48\
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\46\ An example of a loan segment that does not generally
require an allowance for loan losses is a group of loans that are
fully secured by deposits maintained at the lending institution.
\47\ FRR 28 refers to a ``systematic methodology to be employed
each period'' in determining provisions and allowances for loan
losses. As indicated in FRR 28, the staff normally would expect that
the systematic methodology would be documented ``to help ensure that
all matters affecting loan collectibility will consistently be
identified in the detailed [loan] review process.''
\48\ Ibid. Also, as indicated in paragraph 9.05 of the Audit
Guide, the loan loss allowance methodology ``should be well
documented, with clear explanations of the supporting analyses and
rationale.'' Further, as indicated in paragraph 9.14 of the Audit
Guide, ``[t]he approach for determination of the allowance should be
well documented.''
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Facts: After identifying certain loans for evaluation under FASB
ASC Subtopic 310-10, Registrant E segments its remaining loan portfolio
into five pools of loans. For three of the pools, it measures loan
impairment under FASB ASC Subtopic 450-20 by applying historical loss
rates, adjusted for relevant environmental factors, to the pools'
aggregate loan balances. For the remaining two pools of loans,
Registrant E uses a loss estimation model that is consistent with GAAP
to measure loan impairment under FASB ASC Subtopic 450-20.
Question 2: What documentation would the staff normally expect
Registrant E to prepare to support its loan loss allowance for its
pools of loans under FASB ASC Subtopic 450-20?
Interpretive Response: Regardless of the method used to determine
loan loss measurements under FASB ASC Subtopic 450-20, Registrant E
should demonstrate and document that the loss measurement methods used
to estimate the loan loss allowance for each segment of its loan
portfolio are determined in accordance with GAAP as of the financial
statement date.\49\
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\49\ Refer to FASB ASC subparagraph 450-20-25-2(b). Also, as
indicated in FASB ASC subparagraph 310-10-35-4(c), ``[t]he approach
for determination of the allowance shall be well documented and
applied consistently from period to period.''
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As indicated for Registrant E, one method of estimating loan losses
for groups of loans is through the application of loss rates to the
groups' aggregate loan balances. Such loss rates typically reflect the
registrant's historical loan loss experience for each group of loans,
adjusted for relevant environmental factors (e.g., industry,
geographical, economic, and political factors) over a defined period of
time. If a registrant does not have loss experience of its own, it may
be appropriate to reference the loss experience of other companies in
the same business, provided that the registrant demonstrates that the
attributes of the loans in its portfolio segment are similar to those
of the loans included in the portfolio of the registrant providing the
loss experience.\50\ Registrants should maintain supporting
documentation for the technique used to develop their loss rates,
including the period of time over which the losses were incurred. If a
range of loss is determined, registrants should maintain documentation
to support the identified range and the rationale used for determining
which estimate is the best estimate within the range of loan
losses.\51\
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\50\ Refer to FASB ASC paragraphs 310-10-35-10 through 310-10-
35-11.
\51\ Registrants should also refer to FASB ASC Subtopic 450-20,
which provides guidance for situations in which a range of loss can
be reasonably estimated but no single amount within the range
appears to be a better estimate than any other amount within the
range. Also, paragraph 9.14 of the Audit Guide notes the use of ``a
method that results in a range of estimates for the allowance,''
except for impairment measurement under FASB ASC Subtopic 310-10,
which is based on a single best estimate and not a range of
estimates. Paragraph 9.14 also states that ``[t]he approach for
determination of the allowance should be well documented.''
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The staff normally would expect that, before employing a loss
estimation model, a registrant would evaluate and modify, as needed,
the model's assumptions to ensure that the resulting loss estimate is
consistent with GAAP. In order to demonstrate consistency with GAAP,
registrants that use loss estimation models should typically document
the evaluation, the conclusions regarding the appropriateness of
estimating loan losses with a model or other loss estimation tool, and
the objective support for adjustments to the model or its results.\52\
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\52\ The systematic methodology (including, if applicable, loss
estimation models) used to determine loan loss provisions and
allowances should be documented in accordance with FRR 28, paragraph
9.05 of the Audit Guide, and FASB ASC Subtopic 310-10.
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In developing loss measurements, registrants should consider the
impact of current environmental factors and then document which factors
were used in the analysis and how those factors affected the loss
measurements. Factors that should be considered in developing loss
measurements include the following: \53\
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\53\ Refer to paragraph 9.13 in the Audit Guide.
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Levels of and trends in delinquencies and impaired loans;
Levels of and trends in charge-offs and recoveries;
Trends in volume and terms of loans;
Effects of any changes in risk selection and underwriting
standards, and other changes in lending policies, procedures, and
practices;
Experience, ability, and depth of lending management and
other relevant staff;
National and local economic trends and conditions;
Industry conditions; and
Effects of changes in credit concentrations.
For any adjustment of loss measurements for environmental factors,
a registrant should maintain sufficient, objective evidence \54\ (a) to
support the amount of the adjustment and (b) to explain why the
adjustment is necessary to reflect current
[[Page 17245]]
information, events, circumstances, and conditions in the loss
measurements.
---------------------------------------------------------------------------
\54\ AU 326 describes the ``sufficient competent evidential
matter'' that auditors must consider in accordance with GAAS.
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b. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 450-
20--Adjusting Loss Rates
Facts: Registrant F's lending area includes a metropolitan area
that is financially dependent upon the profitability of a number of
manufacturing businesses. These businesses use highly specialized
equipment and significant quantities of rare metals in the
manufacturing process. Due to increased low-cost foreign competition,
several of the parts suppliers servicing these manufacturing firms
declared bankruptcy. The foreign suppliers have subsequently increased
prices and the manufacturing firms have suffered from increased
equipment maintenance costs and smaller profit margins.
Additionally, the cost of the rare metals used in the manufacturing
process increased and has now stabilized at double last year's price.
Due to these events, the manufacturing businesses are experiencing
financial difficulties and have recently announced downsizing plans.
Although Registrant F has yet to confirm an increase in its loss
experience as a result of these events, management knows that it lends
to a significant number of businesses and individuals whose repayment
ability depends upon the long-term viability of the manufacturing
businesses. Registrant F's management has identified particular
segments of its commercial and consumer customer bases that include
borrowers highly dependent upon sales or salary from the manufacturing
businesses. Registrant F's management performs an analysis of the
affected portfolio segments to adjust its historical loss rates used to
determine the loan loss allowance. In this particular case, Registrant
F has experienced similar business and lending conditions in the past
that it can compare to current conditions.
Question: How would the staff normally expect Registrant F to
document its support for the loss rate adjustments that result from
considering these manufacturing firms' financial downturns? \55\
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\55\ This question and response would also apply to other
registrant fact patterns in which the registrant adjusts loss rates
for environmental factors.
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Interpretive Response: The staff normally would expect Registrant F
to document its identification of the particular segments of its
commercial and consumer loan portfolio for which it is probable that
the manufacturing business' financial downturn has resulted in loan
losses. In addition, the staff normally would expect Registrant F to
document its analysis that resulted in the adjustments to the loss
rates for the affected portfolio segments.\56\ The staff normally would
expect that, as part of its documentation, Registrant F would maintain
copies of the documents supporting the analysis, which may include
relevant economic reports, economic data, and information from
individual borrowers.
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\56\ Paragraph 9.56 of the Audit Guide refers to the
documentation, for disclosure purposes, that an entity should
include in the notes to the financial statements describing the
accounting policies and methodology the entity used to estimate its
allowance and related provision for loan losses. As indicated in
paragraph 9.56, ``[s]uch a description should identify the factors
that influenced management's judgment (for example, historical
losses and existing economic conditions) and may also include
discussion of risk elements relevant to particular categories of
financial instruments.''
---------------------------------------------------------------------------
Because in this case Registrant F has experienced similar business
and lending conditions in the past, it should consider including in its
supporting documentation an analysis of how the current conditions
compare to its previous loss experiences in similar circumstances. The
staff normally would expect that, as part of Registrant F's effective
loan loss allowance methodology, it would create a summary of the
amount and rationale for the adjustment factor for review by management
prior to the issuance of the financial statements.\57\
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\57\ Paragraph 9.64 in the Audit Guide indicates that effective
internal control related to the allowance for loan losses should
include ``accumulation of relevant, sufficient, and reliable data on
which to base management's estimate of the allowance.''
---------------------------------------------------------------------------
c. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 450-
20--Estimating Losses on Loans Individually Reviewed for Impairment But
Not Considered Individually Impaired
Facts: Registrant G has outstanding loans of $2 million to Company
Y and $1 million to Company Z, both of which are paying as agreed upon
in the loan documents. The registrant's loan loss allowance policy
specifies that all loans greater than $750,000 must be individually
reviewed for impairment under FASB ASC Subtopic 310-10. Company Y's
financial statements reflect a strong net worth, good profits, and
ongoing ability to meet debt service requirements. In contrast, recent
information indicates Company Z's profitability is declining and its
cash flow is tight. Accordingly, this loan is rated substandard under
the registrant's loan grading system. Despite its concern, management
believes Company Z will resolve its problems and determines that
neither loan is individually impaired as defined by FASB ASC Subtopic
310-10.
Registrant G segments its loan portfolio to estimate loan losses
under FASB ASC Subtopic 450-20. Two of its loan portfolio segments are
Segment 1 and Segment 2. The loan to Company Y has risk characteristics
similar to the loans included in Segment 1 and the loan to Company Z
has risk characteristics similar to the loans included in Segment
2.\58\
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\58\ These groups of loans do not include any loans that have
been individually reviewed for impairment under FASB ASC Section
310-10-35, Receivables--Overall--Subsequent Measurement, and
determined to be impaired as defined by FASB ASC Section 310-10-35.
---------------------------------------------------------------------------
In its determination of its loan loss allowance under FASB ASC
Subtopic 450-20, Registrant G includes its loans to Company Y and
Company Z in the groups of loans with similar characteristics (i.e.,
Segment 1 for Company Y's loan and Segment 2 for Company Z's loan).\59\
Management's analyses of Segment 1 and Segment 2 indicate that it is
probable that each segment includes some losses, even though the losses
cannot be identified to one or more specific loans. Management
estimates that the use of its historical loss rates for these two
segments, with adjustments for changes in environmental factors,
provides a reasonable estimate of the registrant's probable loan losses
in these segments.
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\59\ FASB ASC paragraph 310-10-35-36 states that if a creditor
concludes that an individual loan specifically identified for
evaluation is not impaired under FASB ASC Subtopic 310-10, that loan
may be included in the assessment of the allowance for loan losses
under FASB ASC Subtopic 450-20, but only if specific characteristics
of the loan indicate that it is probable that there would be an
incurred loss in a group of loans with those characteristics.
---------------------------------------------------------------------------
Question: How would the staff normally expect Registrant G to
adequately document a loan loss allowance under FASB ASC Subtopic 450-
20 for these loans that were individually reviewed for impairment but
are not considered individually impaired?
Interpretive Response: The staff normally would expect that, as
part of Registrant G's effective loan loss allowance methodology, it
would document its decision to include its loans to Company Y and
Company Z in its determination of its loan loss allowance under FASB
ASC Subtopic 450-20.\60\ The staff also normally would
[[Page 17246]]
expect that Registrant G would document the specific characteristics of
the loans that were the basis for grouping these loans with other loans
in Segment 1 and Segment 2, respectively.\61\ Additionally, the staff
normally would expect Registrant G to maintain documentation to support
its method of estimating loan losses for Segment 1 and Segment 2, which
typically would include the average loss rate used, the analysis of
historical losses by loan type and by internal risk rating, and support
for any adjustments to its historical loss rates.\62\ The registrant
would typically maintain copies of the economic and other reports that
provided source data.
---------------------------------------------------------------------------
\60\ Paragraph 9.05 in the Audit Guide indicates that an
entity's method of estimating credit losses should ``include a
detailed and regular analysis of the loan portfolio,'' ``consider
all loans (whether on an individual or pool-of-loans basis),'' ``be
based on current and reliable data,'' and ``be well documented, with
clear explanations of the supporting analyses and rationale.'' FASB
ASC paragraph 310-10-35-36 provides guidance as to the analysis to
be performed when determining whether a loan that is not
individually impaired under FASB ASC Subtopic 310-10 should be
included in the assessment of the loan loss allowance under FASB ASC
Subtopic 450-20.
\61\ Ibid.
\62\ Ibid.
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When measuring and documenting loan losses, Registrant G should
take steps to prevent layering loan loss allowances. Layering is the
inappropriate practice of recording in the allowance more than one
amount for the same probable loan loss. Layering can happen when a
registrant includes a loan in one segment, determines its best estimate
of loss for that loan either individually or on a group basis (after
taking into account all appropriate environmental factors, conditions,
and events), and then includes the loan in another group, which
receives an additional loan loss allowance amount.
5. Documenting the Results of a Systematic Methodology
a. Documenting the Results of a Systematic Methodology--General
Facts: Registrant H has completed its estimation of its loan loss
allowance for the current reporting period, in accordance with GAAP,
using its established systematic methodology.
Question: What summary documentation would the staff normally
expect Registrant H to prepare to support the amount of its loan loss
allowance to be reported in its financial statements?
Interpretive Response: The staff normally would expect that, to
verify that loan loss allowance balances are presented fairly in
accordance with GAAP and are auditable, management would prepare a
document that summarizes the amount to be reported in the financial
statements for the loan loss allowance.\63\ Common elements that the
staff normally would expect to find documented in loan loss allowance
summaries include: \64\
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\63\ FRR 28 states: ``[t]he specific rationale upon which the
[loan loss allowance and provision] amount actually reported is
based--i.e., the bridge between the findings of the detailed review
[of the loan portfolio] and the amount actually reported in each
period--would be documented to help ensure the adequacy of the
reported amount, to improve auditability, and to serve as a
benchmark for exercise of prudent judgment in future periods.''
\64\ See also paragraph 9.14 of the Audit Guide.
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The estimate of the probable loss or range of loss
incurred for each category evaluated (e.g., individually evaluated
impaired loans, homogeneous pools, and other groups of loans that are
collectively evaluated for impairment);
The aggregate probable loss estimated using the
registrant's methodology;
A summary of the current loan loss allowance balance;
The amount, if any, by which the loan loss allowance
balance is to be adjusted; \65\ and
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\65\ Subsequent to adjustments, the staff normally would expect
that there would be no material differences between the consolidated
loss estimate, as determined by the methodology, and the final loan
loss allowance balance reported in the financial statements.
Registrants should refer to SAB 99 and SAS 89 and its amendments to
AU Section 310.
---------------------------------------------------------------------------
Depending on the level of detail that supports the loan
loss allowance analysis, detailed subschedules of loss estimates that
reconcile to the summary schedule.
Generally, a registrant's review and approval process for the loan
loss allowance relies upon the data provided in these consolidated
summaries. There may be instances in which individuals or committees
that review the loan loss allowance methodology and resulting allowance
balance identify adjustments that need to be made to the loss estimates
to provide a better estimate of loan losses. These changes may be due
to information not known at the time of the initial loss estimate
(e.g., information that surfaces after determining and adjusting, as
necessary, historical loss rates, or a recent decline in the
marketability of property after conducting a FASB ASC Subtopic 310-10
valuation based upon the fair value of collateral). It is important
that these adjustments are consistent with GAAP and are reviewed and
approved by appropriate personnel.\66\ Additionally, it would typically
be appropriate for the summary to provide each subsequent reviewer with
an understanding of the support behind these adjustments. Therefore,
the staff normally would expect management to document the nature of
any adjustments and the underlying rationale for making the
changes.\67\
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\66\ Paragraph 9.64 in the Audit Guide indicates that effective
internal control related to the allowance for loan losses should
include ``adequate review and approval of the allowance estimates by
the individuals specified in management's written policy.''
\67\ See the guidance in paragraph 9.14 of the Audit Guide
(``[t]he approach for determination of the allowance should be well
documented'') and in FRR 28 (``the specific rationale upon which the
amount actually reported in each individual period is based would be
documented'').
---------------------------------------------------------------------------
The staff also normally would expect this documentation to be
provided to those among management making the final determination of
the loan loss allowance amount.\68\
---------------------------------------------------------------------------
\68\ Ibid.
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b. Documenting the Results of a Systematic Methodology--Allowance
Adjustments
Facts: Registrant I determines its loan loss allowance using an
established systematic process. At the end of each reporting period,
the accounting department prepares a summary schedule that includes the
amount of each of the components of the loan loss allowance, as well as
the total loan loss allowance amount, for review by senior management,
including the Credit Committee. Members of senior management meet to
discuss the loan loss allowance. During these discussions, they
identify changes that are required by GAAP to be made to certain of the
loan loss allowance estimates. As a result of the adjustments made by
senior management, the total amount of the loan loss allowance changes.
However, senior management (or its designee) does not update the loan
loss allowance summary schedule to reflect the adjustments or reasons
for the adjustments. When performing their audit of the financial
statements, the independent accountants are provided with the original
loan loss allowance summary schedule reviewed by senior management, as
well as a verbal explanation of the changes made by senior management
when they met to discuss the loan loss allowance.
Question: In the staff's view, are Registrant I's documentation
practices related to the balance of its loan loss allowance in
compliance with existing documentation guidance in this area?
Interpretive Response: No. A registrant should maintain supporting
documentation for the loan loss allowance amount reported in its
financial statements.\69\ As illustrated above, there may be instances
in which loan loss allowance reviewers identify
[[Page 17247]]
adjustments that need to be made to the loan loss estimates. The staff
normally would expect the nature of the adjustments, how they were
measured or determined, and the underlying rationale for making the
changes to the loan loss allowance balance to be documented.\70\ The
staff also normally would expect appropriate documentation of the
adjustments to be provided to management for review of the final loan
loss allowance amount to be reported in the financial statements. This
documentation should also be made available to the independent
accountants. If changes frequently occur during management or credit
committee reviews of the loan loss allowance, management may find it
appropriate to analyze the reasons for the frequent changes and to
reassess the methodology the registrant uses.\71\
---------------------------------------------------------------------------
\69\ Ibid.
\70\ Ibid.
\71\ As outlined in paragraph 9.64 of the Audit Guide, effective
internal controls related to the allowance for loan losses should
include adequate review and approval of allowance estimates,
including review of sources of relevant information, review of
development of assumptions, review of reasonableness of assumptions
and resulting estimates, and consideration of changes in previously
established methods to arrive at the allowance.
---------------------------------------------------------------------------
6. Validating a Systematic Methodology
Question: What is the staff's guidance to a registrant on
validating, and documenting the validation of, its systematic
methodology used to estimate loan loss allowances?
Interpretive Response: The staff believes that a registrant's loan
loss allowance methodology is considered valid when it accurately
estimates the amount of loss contained in the portfolio. Thus, the
staff normally would expect the registrant's methodology to include
procedures that adjust loan loss estimation methods to reduce
differences between estimated losses and actual subsequent charge-offs,
as necessary. To verify that the loan loss allowance methodology is
valid and conforms to GAAP, the staff believes it is appropriate for
management to establish internal control policies,\72\ appropriate for
the size of the registrant and the type and complexity of its loan
products. These policies may include procedures for a review, by a
party who is independent of the allowance for loan losses estimation
process, of the allowance for loan losses methodology and its
application in order to confirm its effectiveness.
---------------------------------------------------------------------------
\72\ Ibid.
---------------------------------------------------------------------------
In practice, registrants employ numerous procedures when validating
the reasonableness of their loan loss allowance methodology and
determining whether there may be deficiencies in their overall
methodology or loan grading process. Examples are:
A review of trends in loan volume, delinquencies,
restructurings, and concentrations.
A review of previous charge-off and recovery history,
including an evaluation of the timeliness of the entries to record both
the charge-offs and the recoveries.
A review by a party that is independent of the loan loss
allowance estimation process. This often involves the independent party
reviewing, on a test basis, source documents and underlying assumptions
to determine that the established methodology develops reasonable loss
estimates.
An evaluation of the appraisal process of the underlying
collateral. This may be accomplished by periodically comparing the
appraised value to the actual sales price on selected properties sold.
It is the staff's understanding that, in practice, management
usually supports the validation process with the workpapers from the
loan loss allowance review function. Additional documentation often
includes the summary findings of the independent reviewer. The staff
normally would expect that, if the methodology is changed based upon
the findings of the validation process, documentation that describes
and supports the changes would be maintained.\73\
---------------------------------------------------------------------------
\73\ See paragraph 9.64 of the Audit Guide.
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TOPIC 7: REAL ESTATE COMPANIES
A. Removed by SAB 103
B. Removed by SAB 103
C. Schedules of Real Estate and Accumulated Depreciation, and of
Mortgage Loans on Real Estate
Facts: Whenever investments in real estate or mortgage loans on
real estate are significant, the schedules of such items (see Rules 12-
28 and 12-29 of Regulation S-X) are required in a prospectus.
Question: Is such information also required in annual reports to
shareholders?
Interpretive Response: Although Rules 14a-3 and 14c-3 permit the
omission of financial statement schedules from annual reports to
shareholders, the staff is of the view that the information required by
these schedules is of such significance within the real estate industry
that the information should be included in the financial statements in
the annual report to shareholders.
D. Income Before Depreciation
Facts: Occasionally an income statement format will contain a
subtitle or caption titled ``Income before depreciation and
depletion.''
Question: Is this caption appropriate?
Interpretive Response: The staff objects to this presentation
because in the staff's view the presentation may suggest to the reader
that the amount so captioned represents cash flow for the period, which
is rarely the case (see ASR 142).
TOPIC 8: RETAIL COMPANIES
A. Sales of Leased or Licensed Departments
Facts: At times, department stores and other retailers have
included the sales of leased or licensed departments in the amount
reported as ``total revenues.''
Question: Does the staff have any objection to this practice?
Interpretive Response: The staff believes that FASB ASC Topic 840,
Leases, requires department stores and other retailers that lease or
license store space to account for rental income from leased
departments in accordance with FASB ASC Topic 840. Accordingly, it
would be inappropriate for a department store or other retailer to
include in its revenue the sales of the leased or licensed departments.
Rather, the department store or other retailer should include the
rental income as part of its gross revenue. The staff would not object
to disclosure in the footnotes to the financial statements of the
amount of the lessee's sales from leased departments. If the
arrangement is not a lease \1\ but rather a service arrangement that
provides for payment of a fee or commission, the retailer should
recognize the fee or commission as revenue when earned. If the retailer
assumes the risk of bad debts associated with the lessee's merchandise
sales, the retailer generally should present bad debt expense in
accordance with Rule 5-03 of Regulation S-X.
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\1\ The FASB ASC Master Glossary defines a lease as ``an
agreement conveying the right to use property, plant, or equipment
(land and/or depreciable assets) usually for a stated period of
time.''
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B. Finance Charges
Facts: Department stores and other retailers impose finance charges
on credit sales.
Question: How should such charges be disclosed?
Interpretive Response: As a minimum, the staff requests that the
amount of gross revenue from such charges be stated in a footnote and
that the income statement classification which includes
[[Page 17248]]
such revenue be identified. The following are examples of acceptable
disclosure:
Example 1
Consumer Credit Operations:
The results of the Consumer Credit Operations which are included in
the Statement of Earnings as a separate line item are as follows for
the fiscal year ended January 31, 20x0:
------------------------------------------------------------------------
------------------------------------------------------------------------
Service charges........................................ $167,000,000
Operating expenses:
Interest........................................... 60,000,000
Payroll............................................ 35,000,000
Provision for uncollected accounts................. 29,000,000
All other credit and collection expenses........... 32,000,000
Provision for Federal income taxes................. 5,000,000
----------------
Total operating expenses....................... 161,000,000
Consumer credit operations earnings.................... 6,000,000
------------------------------------------------------------------------
Example 2
Service charges on retail credit accounts are netted against
selling, general and administrative expense. The cost of administering
retail credit program continued to exceed service charges on customer
receivables as follows:
----------------------------------------------------------------------------------------------------------------
In millions
------------------------------------------------
Percent
20x2 20x1 increase
(decrease)
----------------------------------------------------------------------------------------------------------------
Costs:
Regional office operations................................. $45 $42 9
Interest................................................... 51 44 13
Provision for doubtful accounts............................ 21 15 34
------------------------------------------------
Total.................................................. 117 102 15
Less service charge income................................. 96 79 22
Net cost of credit......................................... 21 23 (10)
Net cost as percent of credit sales........................ 1.4% 1.6% ...............
----------------------------------------------------------------------------------------------------------------
The above results do not reflect either ``in store'' costs related
to credit operations or any allocation of corporate overhead expenses.
This SAB is not intended to change current guidance in the
accounting literature. For this reason, adherence to the principles
described in this SAB should not raise the costs associated with
record-keeping or with audits of financial statements.
TOPIC 9: FINANCE COMPANIES
A. Removed by SAB 103
B. Removed by ASR 307
TOPIC 10: UTILITY COMPANIES
A. Financing by Electric Utility Companies Through Use of Construction
Intermediaries
Facts: Some electric utility companies finance construction of a
generating plant or their share of a jointly owned plant through the
use of a ``construction intermediary'' which may be organized as a
trust or a corporation. Typically the utility assigns its interest in
property and other contract rights to the construction intermediary
with the latter authorized to obtain funds to finance construction with
term loans, bank loans, commercial paper and other sources of funds and
that may be available. The intermediary's borrowings are guaranteed in
part of the work in progress but more significantly, although
indirectly, by the obligation of the utility to purchase the project
upon completion and assume or otherwise settle the borrowings. The
utility may be committed to provide any deficiency of funds which the
intermediary cannot obtain and excess funds may be loaned to the
utility by the intermediary. (In one case involving construction of an
entire generating plant, the intermediary appointed the utility as its
agent to complete construction.) On the occurrence of an event such as
commencement of the testing period for the plant or placing the plant
in commercial service (but not later than a specified date) the
interest in the plant reverts to the utility and concurrently the
utility must either assume the obligations issued by the intermediary
or purchase them from the holders. The intermediary also may be
authorized to borrow amounts for accrued interest when due and those
amounts are added to the balance of the outstanding indebtedness.
Interest is thus capitalized during the construction period at rates
being charged by the lenders; however, it is deductible by the utility
for tax purposes in the year of accrual.
Question: How should construction work in progress and related
liabilities and interest expense being financed through a construction
intermediary be reflected in an electric utility's financial
statements?
Interpretive Response: The balance sheet of an electric utility
company using a construction intermediary to finance construction
should include the intermediary's work in progress in the appropriate
caption under utility plant. The related debt should be included in
long-term liabilities and disclosed either on the balance sheet or in a
note.
The amount of interest cost incurred and the respective amounts
expensed or capitalized shall be disclosed for each period for which an
income statement is presented. Consequently, capitalized interest
included as part of an intermediary's construction work in progress on
the balance sheet should be recognized on the current income statement
as interest expense with a corresponding offset to allowance for
borrowed funds used during construction. Income statements for
[[Page 17249]]
prior periods should also be restated. The amounts may be shown
separately on the statement or included with interest expense and
allowance for borrowed funds used during construction.
A note to the financial statements should describe briefly the
organization and purpose of the intermediary and the nature of its
authorization to incur debt to finance construction. The note should
disclose the rate at which interest on this debt has been capitalized
and the dollar amount for each period for which an income statement is
presented.
B. Removed by SAB 103
C. Jointly Owned Electric Utility Plants
Facts: Groups of electric utility companies have been building and
operating utility plants under joint ownership agreements or
arrangements which do not create legal entities for which separate
financial statements are presented.\1\ Under these arrangements, a
participating utility has an undivided interest in a utility plant and
is responsible for its proportionate share of the costs of construction
and operation and its entitled to its proportionate share of the energy
produced.
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\1\ Before considering the guidance in this SAB Topic,
registrants are reminded that the arrangement should be evaluated in
accordance with the provisions of FASB ASC Topic 810, Consolidation.
---------------------------------------------------------------------------
During the construction period a participating utility finances its
own share of a utility plant using its own financial resources and not
the combined resources of the group. Allowance for funds used during
construction is provided in the same manner and at the same rates as
for plants constructed to be used entirely by the participant utility.
When a joint-owned plant becomes operational, one of the
participant utilities acts as operator and bills the other participants
for their proportionate share of the direct expenses incurred. Each
individual participant incurs other expenses related to transmission,
distribution, supervision and control which cannot be related to the
energy generated or received from any particular source. Many companies
maintain depreciation records on a composite basis for each class of
property so that neither the accumulated allowance for depreciation nor
the periodic expense can be allocated to specific generating units
whether jointly or wholly owned.
Question: What disclosure should be made on the financial
statements or in the notes concerning interests in jointly owned
utility plants?
Interpretive Response: A participating utility should include
information concerning the extent of its interests in jointly owned
plants in a note to its financial statements. The note should include a
table showing separately for each interest in a jointly owned plant the
amount of utility plant in service, the accumulated provision for
depreciation (if available), the amount of plant under construction,
and the proportionate share. The amounts presented for plant in service
or plant under construction may be further subdivided to show amounts
applicable to plant subcategories such as production, transmission, and
distribution. The note should include statements that the dollar
amounts represent the participating utility's share in each joint plant
and that each participant must provide its own financing. Information
concerning two or more generating plants on the same site may be
combined if appropriate.
The note should state that the participating utility's share of
direct expenses of the joint plants is included in the corresponding
operating expenses on its income statement (e.g., fuel, maintenance of
plant, other operating expense). If the share of direct expenses is
charged to purchased power then the note should disclose the amount so
charged and the proportionate amounts charged to specific operating
expenses on the records maintained for the joint plants.
D. Long-Term Contracts for Purchase of Electric Power
Facts: Under long-term contracts with public utility districts,
cooperatives or other organizations, a utility company receives a
portion of the output of a production plant constructed and financed by
the district or cooperative. The utility has only a nominal or no
investment at all in the plant but pays a proportionate part of the
plant's costs, including debt service. The contract may be in the form
of a sale of a generating plant and its immediate lease back. The
utility is obligated to pay certain minimum amounts which cover debt
service requirements whether or not the plant is operating. At the
option of other parties to the contract and in accordance with a
predetermined schedule, the utility's proportionate share of the output
may be reduced. Separate agreements may exist for the transmission of
power to the utility's system.\2\
---------------------------------------------------------------------------
\2\ Registrants are reminded that the arrangement may contain a
guarantee that is within the scope of FASB ASC Topic 460,
Guarantees. Further, registrants should consider the guidance of
FASB ASC Topic 810, Consolidation. Also, registrants would need to
consider whether the arrangement contains a derivative that should
be accounted for according to FASB ASC Topic 815, Derivatives and
Hedging.
---------------------------------------------------------------------------
Question: How should the cost of power obtained under long-term
purchase contracts be reflected on the financial statements and what
supplemental disclosures should be made in notes to the statements?
Interpretive Response: The cost of power obtained under long-term
purchase contracts, including payments required to be made when a
production plant is not operating, should be included in the operating
expenses section of the income statement. A note to the financial
statements should present information concerning the terms and
significance of such contracts to the utility company including date of
contract expiration, share of plant output being purchased, estimated
annual cost, annual minimum debt service payment required and amount of
related long-term debt or lease obligations outstanding.
Additional disclosure should be given if the contract provides, or
is expected to provide, in excess of five percent of current or
estimated future system capability. This additional disclosure may be
in the form of separate financial statements of the vendor entity or
inclusion of the amount of the obligation under the contract as a
liability on the balance sheet with a corresponding amount as an asset
representing the right to purchase power under the contract.
The note to the financial statements should disclose the allocable
portion of interest included in charges under such contracts.
E. Classification of Charges for Abandonments and Disallowances
Facts: A public utility company abandons the construction of a
plant and, under the provisions of FASB ASC Subtopic 980-360, Regulated
Operations--Property, Plant, and Equipment, must charge a portion of
the costs of the abandoned plant to expense.\3\ Also, the utility
determines that it is probable that certain costs of a recently
completed plant will be disallowed, and charges those costs to
[[Page 17250]]
expense as required by FASB ASC Subtopic 980-360.
---------------------------------------------------------------------------
\3\ FASB ASC paragraphs 980-360-35-1 through 980-360-35-3
requires that costs of abandoned plants in excess of the present
value of the future revenues expected to be provided to recover any
allowable costs be charged to expense in the period that the
abandonment becomes probable. Also, FASB ASC paragraph 980-360-35-12
requires that disallowed costs for recently completed plants be
charged to expense when the disallowance becomes probable and can be
reasonably estimated.
---------------------------------------------------------------------------
Question: May such charges for abandonments and disallowances be
reported as extraordinary items in the statement of income?
Interpretive Response: No. The staff does not believe that such
charges meet the requirements of FASB ASC Subtopic 225-20, Income
Statement--Extraordinary and Unusual Items, that an item be both
unusual and infrequent to be classified as an extraordinary item.
Accordingly, the public utility was advised by the staff that such
charges should be reported as a component of income from continuing
operations, separately presented, if material.\4\
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\4\ Additionally, the registrant was reminded that FASB ASC
paragraph 225-20-45-16 provides that items which are not reported as
extraordinary should not be reported on the income statement net of
income taxes or in any manner that implies that they are similar to
extraordinary items.
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FASB ASC paragraph 225-20-45-2 indicates that to be unusual, an
item must ``possess a high degree of abnormality and be of a type
clearly unrelated to, or only incidentally related to, the ordinary and
typical activities of the entity, taking into account the environment
in which the entity operates.'' Similarly, that paragraph indicates
that, to be infrequent, an event should ``not reasonably be expected to
recur in the foreseeable future.''
Electric utilities operate under a franchise that requires them to
furnish adequate supplies of electricity for their service area. That
undertaking requires utilities to continually forecast the future
demand for electricity, and the costs to be incurred in constructing
the plants necessary to meet that demand. Abandonments and
disallowances result from the failure of demand to reach projected
levels and/or plant construction costs that exceed anticipated amounts.
Neither event qualifies as being both unusual and infrequent in the
environment in which electric utilities operate.
Accordingly, the staff believes that charges for abandonments and
disallowances under FASB ASC Subtopic 980-360 should not be presented
as extraordinary items.\5\
---------------------------------------------------------------------------
\5\ The staff also notes that FASB ASC paragraphs 980-360-35-1
through 980-360-35-3 and 980-360-35-12, in requiring that such costs
be ``recognized as a loss,'' do not specify extraordinary item
treatment. The staff believes that it generally has been the FASB's
practice to affirmatively require extraordinary item treatment when
it believes that it is appropriate for charges or credits to income
specifically required by a provision of a statement.
---------------------------------------------------------------------------
F. Presentation of Liabilities for Environmental Costs
Facts: A public utility company determines that it is obligated to
pay material amounts as a result of an environmental liability. These
amounts may relate to, for example, damages attributed to clean-up of
hazardous wastes, reclamation costs, fines, and litigation costs.
Question 1: May a rate-regulated enterprise present on its balance
sheet the amount of its estimated liability for environmental costs net
of probable future revenue resulting from the inclusion of such costs
in allowable costs for rate-making purposes?
Interpretive Response: No. FASB ASC Subtopic 980-340, Regulated
Operations--Other Assets and Deferred Costs, specifies the conditions
under which rate actions of a regulator can provide reasonable
assurance of the existence of an asset. The staff believes that
environmental costs meeting the criteria of FASB ASC paragraph 980-340-
25-1 \6\ should be presented on the balance sheet as an asset and
should not be offset against the liability. Contingent recoveries
through rates that do not meet the criteria of FASB ASC paragraph 980-
340-25-1 should not be recognized either as an asset or as a reduction
of the probable liability.
---------------------------------------------------------------------------
\6\ FASB ASC paragraph 980-340-25-16 requires a rate-regulated
enterprise to capitalize all or part of an incurred cost that would
otherwise be charged to expense if it is probable that future
revenue will be provided to recover the previously incurred cost
from inclusion of the costs in allowable costs for rate-making
purposes.
---------------------------------------------------------------------------
Question 2: May a rate-regulated enterprise delay recognition of a
probable and estimable liability for environmental costs which it has
incurred at the date of the latest balance sheet until the regulator's
deliberations have proceeded to a point enabling management to
determine whether this cost is likely to be included in allowable costs
for rate-making purposes?
Interpretive Response: No. FASB ASC Subtopic 450-20,
Contingencies--Loss Contingencies, states that an estimated loss from a
loss contingency shall be accrued by a charge to income if it is
probable that a liability has been incurred and the amount of the loss
can be reasonably estimated.\7\ The staff believes that actions of a
regulator can affect whether an incurred cost is capitalized or
expensed pursuant to FASB ASC Subtopic 980-340, but the regulator's
actions cannot affect the timing of the recognition of the liability.
---------------------------------------------------------------------------
\7\ Registrants also should apply the guidance of FASB ASC
Subtopic 410-30, Asset Retirement and Environmental Obligations--
Environmental Obligations, in determining the appropriate
recognition of environmental remediation costs.
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TOPIC 11: MISCELLANEOUS DISCLOSURE
A. Operating-Differential Subsidies
Facts: Company A has received an operating-differential subsidy
pursuant to the Merchant Marine Act of 1936, as amended.
Question: How should such subsidies be displayed in the income
statement?
Interpretive Response: Revenue representing an operating-
differential subsidy under the Merchant Marine Act of 1936, as amended,
must be set forth as a separate line item in the income statement
either under a revenue caption or as credit in the costs and expenses
section.
B. Depreciation and Depletion Excluded From Cost of Sales
Facts: Company B excludes depreciation and depletion from cost of
sales in its income statement.
Question: How should this exclusion be disclosed?
Interpretive Response: If cost of sales or operating expenses
exclude charges for depreciation, depletion and amortization of
property, plant and equipment, the description of the line item should
read somewhat as follows: ``Cost of goods sold (exclusive of items
shown separately below)'' or ``Cost of goods sold (exclusive of
depreciation shown separately below).'' To avoid placing undue emphasis
on ``cash flow,'' depreciation, depletion and amortization should not
be positioned in the income statement in a manner which results in
reporting a figure for income before depreciation.
C. Tax Holidays
Facts: Company C conducts business in a foreign jurisdiction which
attracts industry by granting a ``holiday'' from income taxes for a
specified period.
Question: Does the staff generally request disclosure of this fact?
Interpretive Response: Yes. In such event, a note must (1) disclose
the aggregate dollar and per share effects of the tax holiday and (2)
briefly describe the factual circumstances including the date on which
the special tax status will terminate.
D. Removed by SAB 103
E. Chronological Ordering of Data
Question: Does the staff have any preference in what order data are
presented (e.g., the most current data displayed first, etc.)?
Interpretive Response: The staff has no preference as to order;
however,
[[Page 17251]]
financial statements and other data presented in tabular form should
read consistently from left to right in the same chronological order
throughout the filing. Similarly, numerical data included in narrative
sections should be consistently ordered.
F. LIFO Liquidations
Facts: Registrant on LIFO basis of accounting liquidates a
substantial portion of its LIFO inventory and as a result includes a
material amount of income in its income statement which would not have
been recorded had the inventory liquidation not taken place.
Question: Is disclosure required of the amount of income realized
as a result of the inventory liquidation?
Interpretive Response: Yes. Such disclosure would be required in
order to make the financial statements not misleading. Disclosure may
be made either in a footnote or parenthetically on the face of the
income statement.
G. Tax Equivalent Adjustment in Financial Statements of Bank Holding
Companies
Facts: Bank subsidiaries of bank holding companies frequently hold
substantial amounts of state and municipal bonds, interest income from
which is exempt from Federal income taxes. Because of the tax exemption
the stated yield on these securities is lower than the yield on
securities with similar risk and maturity characteristics whose
interest is subject to Federal tax. In order to make the interest
income and resultant yields on tax exempt obligations comparable to
those on taxable investments and loans, a ``tax equivalent adjustment''
is often added to interest income when presented in analytical tables
or charts. When the data presented also includes income taxes, a
corresponding amount is added to income tax expense so that there is no
effect on net income. Adjustment may also be made for the tax
equivalent effect of exemption from state and local taxes.
Question 1: Is the concept of the tax equivalent adjustment
appropriate for inclusion in financial statements and related notes?
Interpretive Response: No. The tax equivalent adjustment represents
a credit to interest income which is not actually earned and realized
and a corresponding charge to taxes (or other expense) which will never
be paid. Consequently, it should not be reflected on the income
statement or in notes to financial statements included in reports to
shareholders or in a report or registration statement filed with the
Commission.
Question 2: May amounts representing tax equivalent adjustments be
included in the body of a statement of income provided they are
designated as not being included in the totals and balances on the
statement?
Interpretive Response: No. The tabular format of a statement
develops information in an orderly manner which becomes confusing when
additional numbers not an integral part of the statement are inserted
into it.
Question 3: May revenues on a tax equivalent adjusted basis be
included in selected financial data?
Interpretive Response: Revenues may be included in selected
financial data on a tax equivalent basis if the respective captions
state which amounts are tax equivalent adjusted and if the
corresponding unadjusted amounts are also reported in the selected
financial data.
Because of differences among registrants in making the tax
equivalency computation, a brief note should describe the extent of
recognition of exemption from Federal, state and local taxes and the
combined marginal or incremental rate used. Where net operating losses
exist, the note should indicate the nature of the tax equivalency
adjustment made.
Question 4: May information adjusted to a tax equivalent basis be
included in management's discussion and analysis of financial condition
and results of operations?
Interpretive Response: One of the purposes of MD&A is to enable
investors to appraise the extent that earnings have been affected by
changes in business activity and accounting principles or methods.
Material changes in items of revenue or expense should be analyzed and
explained in textual discussion and statistical tables. It may be
appropriate to use amounts or to present yields on a tax equivalent
basis. If appropriate, the discussion should include a comment on
material changes in investment securities positions that affect tax
exempt interest income. For example, there might be a comment on a
change from investments in tax exempt securities because of the
availability of net operating losses to offset taxable income of
current and future periods, or a comment on a change in the quality
level of the tax exempt investments resulting in increased interest
income and risk and a corresponding increase in the tax equivalent
adjustment.
Tax equivalent adjusted amounts should be clearly identified and
related to the corresponding unadjusted amounts in the financial
statements. A descriptive note similar to that suggested to accompany
adjusted amounts included in selected financial data should be
provided.
H. Disclosures by Bank Holding Companies Regarding Certain Foreign
Loans
1. Deposit/Relending Arrangements
Facts: Certain foreign countries experiencing liquidity problems,
by agreement with U.S. banks, have instituted arrangements whereby
borrowers in the foreign country may remit local currency to the
foreign country's central bank, in return for the central bank's
assumption of the borrowers' non-local currency obligations to the U.S.
banks. The local currency is held on deposit at the central bank, for
the account of the U.S. banks, and may be subject to relending to other
borrowers in the country. Ultimate repayment of the obligations to the
U.S. banks, in the requisite non-local currency, may not be due until a
number of years hence.
Question: What disclosures are appropriate regarding deposit/
relending arrangements of this general type?
Interpretive Response: The staff emphasizes that it is the
responsibility of each registrant to determine the appropriate
financial statement treatment and classification of foreign
outstandings. The facts and circumstances surrounding deposit/relending
arrangements should be carefully analyzed to determine whether the
local currency payments to the foreign central bank represent
collections of outstandings for financial reporting purposes, and
whether such outstandings should be classified as nonaccrual, past due
or restructured loans pursuant to Item III.C.1. of Industry Guide 3,
Statistical Disclosure by Bank Holding Companies (``Guide 3'').
The staff believes, however, that the impact of deposit/relending
arrangements covering significant amounts of outstandings to a foreign
country should be disclosed pursuant to Guide 3, Item III.C.3.,
Instruction (6)(a).\1\ The disclosures should include a general
description of the arrangements and, if significant, the amounts of
interest income recognized for financial reporting purposes which has
not been
[[Page 17252]]
remitted in the requisite non-local currency to the U.S. bank.
---------------------------------------------------------------------------
\1\ Instruction (6)(a) calls for description of the nature and
impact of developments in countries experiencing liquidity problems
which are expected to have a material impact on timely repayment of
principal or interest. Additionally, Instruction (6)(d)(ii) to Item
III.C.3. calls for disclosure of commitments to relend, or to
maintain on deposit, arising in connection with certain
restructurings of foreign outstanding.
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2. Accounting and Disclosures by Bank Holding Companies for a ``Mexican
Debt Exchange'' Transaction
Facts: Inquiries have been made of the staff regarding certain
accounting and disclosure issues raised by a proposed ``Mexican Debt
Exchange'' transaction which could involve numerous bank holding
companies with existing obligations of the United Mexican States
(``Mexico'') or other Mexican public sector entities (collectively,
``Existing Obligations''). The key elements of the Mexican Debt
Exchange are as follows:
Mexico will offer for sale bonds (``Bonds''), denominated in U.S.
dollars, which will pay interest at a LIBOR-based floating rate and
mature in twenty years. Mexico will undertake to list the Bonds on the
Luxembourg Stock Exchange. The Bonds will be secured, as to their
ultimate principal value only, by non-interest bearing securities of
the U.S. Treasury (``Zero Coupon Treasury Securities'') which will be
purchased by Mexico. The Zero Coupon Treasury Securities will be
pledged to holders of the Bonds and held in custody at the Federal
Reserve Bank of New York and will have a maturity date and ultimate
principal value which match the maturity date and principal value of
the Bonds. While the Bonds will have default and acceleration
provisions, the holder of a Bond will not be permitted to have access
to the collateral prior to the final scheduled maturity date, at which
time the proceeds of the collateral will be available to pay the full
principal amount of the Bonds. As such, the holder of a Bond ultimately
will be secured as to principal at maturity; however, the interest
payments will not be secured. The Bonds will not be subject to future
restructurings of Mexico's Existing Obligations, and Mexico has
indicated that neither the Bonds nor the Existing Obligations exchanged
therefore will be considered part of a base amount with respect to any
future requests by Mexico for new money.
The Mexican Debt Exchange will be structured in such a way that
potential purchasers of the Bonds will submit bids on a voluntary basis
to the auction agent. These bids will specify the face dollar amount of
existing restructured commercial bank obligations of Mexico or of other
Mexican public sector entities that the potential purchaser is willing
to tender and the face dollar amount of Bonds that the purchaser is
willing to accept in exchange for the Existing Obligations. Following
the auction date, Mexico will determine the face dollar amount of Bonds
to be issued and will exchange the Bonds for Existing Obligations
taking first the offer of the largest face dollar amount of Existing
Obligations per face dollar amount of Bonds, and so on, until all Bonds
which Mexico is willing to issue have been subscribed. It is therefore
possible that a greater amount of Existing Obligations could be
tendered than Mexico is willing to accept.
The lender has appropriately accounted for the transaction as a
troubled debt restructuring in accordance with the provisions of FASB
ASC Subtopic 310-40, Receivables--Troubled Debt Restructurings by
Creditors.
Question 1: What financial statement and other disclosure issues
regarding the Mexican Debt Exchange and the Bonds received should be
considered by registrants?
Interpretive Response: The staff believes that disclosure of the
nature of the transaction would be necessary, including:
Carrying value and terms of Existing Obligations
exchanged;
Face value, carrying value, market value and terms of
Bonds received;
The effect of the transaction on the allowance for loan
losses and the provision for losses in the current period; and
Annual interest income on Existing Obligations exchanged
and annual interest income on Bonds received.
On an ongoing basis, the staff believes that the terms, carrying value
and market value of the Bonds should be disclosed, if material, due to
their unique features.\2\
\2\ Registrants also are reminded that if the security received
in the exchange constitutes a debt security within the scope of FASB
ASC Topic 320, Investments--Debt and Equity Securities, the
disclosures required by FASB ASC Topic 320 also would need to be
provided.
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Question 2: What disclosure with respect to the Bonds received
would be acceptable under Industry Guide 3?
Interpretive Response: Instruction (4) to Item III.C.3. of Industry
Guide 3 states: ``The value of any tangible, liquid collateral may also
be netted against cross-border outstandings of a country if it is held
and realizable by the lender outside of the borrower's country.'' Given
the unique features of the Bonds in that the ultimate repayment of the
principal amount (but not interest) at maturity is assured, the staff
will not object to either of two presentations. Under the first
presentation, the carrying value of the Bonds, including any accrued
but unpaid interest, would be included as a ``cross-border
outstanding'' to the extent it exceeds the current fair value of the
Zero Coupon Treasury Securities which collateralize the bonds.
Alternatively, under the second presentation, the carrying value of the
Bond principal would be excluded from Mexican cross-border outstandings
provided (a) disclosure is made of the exclusion, (b) for purposes of
determining the 1% and .75% of total assets disclosure thresholds of
Item III.C.3. of Industry Guide 3, such carrying values are not
excluded, and (c) all the Guide 3 disclosures relating to cross-border
outstandings continue to be made, as discussed further below.
For registrants that adopt the alternative disclosure approach and
whose Mexican cross-border outstandings (excluding the carrying value
of the Bond principal) exceed 1% of total assets, appropriate footnote
disclosure of the exclusions should be made. Such footnote should
indicate the face amount and carrying value of the Bonds excluded, the
market value of such Bonds, and the face amount and current fair value
of the Zero Coupon Treasury Securities which secure the Bonds.
If the Mexican cross-border outstandings (excluding the carrying
value of the Bond principal) are less than 1% of total assets but with
the addition of the carrying value of the Bond principal would exceed
1%, the carrying value of the Mexican cross-border outstandings may be
excluded from the list of countries whose cross-border outstandings
exceed 1% of total assets provided that a footnote discloses the amount
of Mexican cross-border outstandings (excluding the carrying value of
the Bond principal) along with the footnote-type disclosure concerning
the Bonds discussed in the previous paragraph. This disclosure and any
other material disclosure specified by Item III.C.3. of Industry Guide
3 would continue to be made as long as Mexican exposure, including the
carrying value of the Bond principal, exceeded 1%.
If the Mexican cross-border outstandings (excluding the carrying
value of the Bond principal) are less than .75% of total assets but
with the addition of the carrying value of the Mexican Bond principal
would exceed .75% but be less than 1%, cross-border outstandings
disclosed pursuant to Instruction (7) to Item III.C.3. of Industry
Guide 3 may exclude Mexico provided a footnote is added to the
aggregate disclosure which discloses the amount of Mexican cross-border
outstandings and the fact that they have not been included. The
carrying value of the Bond principal may be excluded from the amount of
Mexican cross-border outstandings disclosed in the
[[Page 17253]]
footnote provided the footnote-type disclosure discussed in the second
preceding paragraph is also made.
In essence, the alternative discussed herein results in a change
only in the method of presenting information, not in the total
information required.\3\
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\3\ The following represents proposed disclosure using the
alternative method discussed above. Of course, it would be necessary
to supplement this disclosure with the additional disclosures
regarding foreign outstandings that are called for by Guide 3 (e.g.,
an analysis of the changes in aggregate outstandings), and the
disclosures called for by the Interpretive Responses to Question 1.
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The appropriate disclosure would depend on the level of Mexican
cross-border outstandings as follows:
A. Assuming that the remaining Mexican cross-border outstandings
are in excess of 1% of total assets:
Mexican cross-border outstandings (which excludes the
total amount of the carrying value of Bond principal) would be
disclosed in the table presenting all such outstandings in excess of
1%.
Proposed footnote disclosure--
Not included in this amount is $---- million of Mexican
Government Bonds maturing in 2008, with a carrying value of $----
million [if different from face value]. These Mexican Government
Bonds had a market value of $---- million on [reporting date]. The
principal amount of these bonds is fully secured, at maturity, by
$---- million face value of U.S. zero coupon treasury securities
that mature on the same date. The current fair value of these U.S.
Government securities is $---- million at [reporting date]. This
collateral is pledged to holders of the bonds and held in custody at
the Federal Reserve Bank of New York. The details of the transaction
in which these bonds were acquired was reported in the Corporation's
Form (8-K, 10-Q or 10-K) for (date). Accrued interest on the bonds,
which is not secured, is included in the outstandings reported
[amount to be disclosed if material]. Future interest on the bonds
remains a cross-border risk.
B. Assuming that remaining Mexican cross-border outstandings are
less than 1% of total assets but with the addition of the carrying
value of the Mexican Bond principal would exceed 1%:
There would not be any disclosure included in any cross-
border table.
The total amount of remaining cross-border Mexican
outstandings would be disclosed in a footnote to the table. Such
footnote would also explain that the Mexican outstandings are excluded
from the table.
Additional footnote disclosure--(same disclosure in A
above)
The disclosure required under this paragraph (plus any
other disclosure required by Item III.C.3. of Guide 3) would continue
so long as Mexican exposure, including the carrying value of the
Mexican Bond principal, exceeded 1%.
C. Assuming that the remaining Mexican cross-border outstandings is
less than .75% of total assets but with the addition of the carrying
value of the Mexican Bond principal is greater than .75% but less than
1%:
Mexico would not be included in the list of names of
countries required by Instruction 7 to Item III.C.3. of Industry Guide
3 and the amount of Mexican cross-border outstandings would not be
included in the aggregate amount of outstandings attributable to all
such countries.
A footnote would be added to this disclosure of aggregate
outstandings which discusses the Mexican outstandings and the Mexican
Bonds. An example follows:
Not included in the above aggregate outstandings are the
Corporation's cross-border outstandings to Mexico which totaled $--
-- million at (reporting date). This amount is less than .75% of
total assets. (The remaining portion of this footnote is the same
disclosure in A above.)
D. Assuming that the total of the Mexican cross-border outstanding
plus the carrying value of the Bond principal is less than the .75% of
total assets:
No disclosure would be required.
However, same disclosure as in A above would be provided
if any other aspects of the financial statements are materially
affected by this transaction (such as the allowance for loan losses).
Changes in aggregate outstandings to certain countries experiencing
liquidity problems are required to be presented in tabular form in
compliance with Instruction (6)(b) to Item III.C.3. In this table,
Existing Obligations exchanged for the Bonds would generally be
included in the aggregate cross-border outstandings at the beginning of
the period during which the exchange occurred. For registrants using
the alternative method, the amount of Existing Obligations which were
exchanged would be included as a deduction in the ``other changes''
caption in the table. In addition, a footnote will be provided to the
table as follows:
Relates primarily to the exchange of unsecured Mexican
outstandings for Mexican bonds. The principal amount of these bonds
is secured at maturity by $------ face U.S. Zero Coupon Treasury
Securities which mature on the same date and have a current fair
value of $------. Future interest on the bonds remains a cross-
border risk.]
I. Reporting of an Allocated Transfer Risk Reserve in Filings Under the
Federal Securities Laws
Facts: The Comptroller of the Currency, Board of Governors of the
Federal Reserve System and Federal Deposit Insurance Corporation
jointly issued final rules, pursuant to the International Lending
Supervision Act of 1983, requiring banking institutions to establish
special reserves (Allocated Transfer Risk Reserve ``ATRR'') against the
risks presented in certain international assets when the Federal
banking agencies determine that such reserves are necessary. The rules
provide that the ATRR is to be accounted for separately from the
General Allowances for Possible Loan Losses, and shall not be included
in the banking institution's capital or surplus. The rules also provide
that no ATRR provisions are required if the banking institution writes
down the assets in the requisite amount.
Question: How should the ATRR be reported in filings under the
Federal Securities Laws?
Interpretive Response: It is the staff's understanding that the
three banking agencies believe that those bank holding companies that
have not written down the designated assets by the requisite amount
and, therefore, are required to establish an ATRR should disclose the
amount of the ATRR. The staff believes that such disclosure should be
part of the discussion of Loan Loss Experience, Item IV of Guide 3.
Part A under Item IV calls for an analysis of loss experience in the
form of a reconciliation of the allowance for loan losses, and the
staff believes that it would be appropriate to show and discuss
separately the ATRR in the context of that reconciliation.
Registrants should recognize that the amount provided as an ATRR,
or the write off of the requisite amount, represents the identification
of an amount which those regulatory agencies have determined should not
be included as a part of the institution's capital or surplus for
purposes of administration of the regulatory and supervisory functions
of those agencies. In this context, the staff believes that disclosure
of the ATRR, as part of the footnote required to be presented in a
registrant's financial statements by Item 7(d) of Rule 9-03 of
Regulation S-X, may provide a more complete explanation of charge offs
and provisions for loan losses. It should be noted, however, that the
ATRR amount to be excluded from the institution's capital and surplus
does not address the more general issue of the adequacy of allowances
for any particular bank holding company's loans. It is still the
responsibility of each registrant to determine whether GAAP require an
additional provision for losses in excess of the amount required to be
included in an ATRR (or the requisite amount written off).
[[Page 17254]]
J. Removed by SAB 103
K. Application of Article 9 and Guide 3
Facts: Article 9 of Regulation S-X specifies the form and content
of and requirements for financial statements for bank holding companies
filing with the Commission. Similarly, bank holding companies disclose
supplemental statistical disclosures in filings, pursuant to Industry
Guide 3. No specific guidance as to the form and content of financial
statements or supplemental disclosures has been promulgated for
registrants which are not bank holding companies but which are engaged
in similar lending and deposit activities.\4\
---------------------------------------------------------------------------
\4\ The Commission staff has been considering the need for more
specific guidance in the area but believes that the FASB project on
financial instruments may make Commission action in this area
unnecessary. In the interim, this bulletin provides the staff's
views with respect to filings by similar entities such as saving and
loan holding companies.
---------------------------------------------------------------------------
Question: Should non-bank holding company registrants with material
amounts of lending and deposit activities file financial statements and
make disclosures called for by Article 9 of Regulation S-X and Industry
Guide 3?
Interpretive Response: In the staff's view, Article 9 and Guide 3,
while applying literally only to bank holding companies, provide useful
guidance to certain other registrants, including savings and loan
holding companies, on certain disclosures relevant to an understanding
of the registrant's operations. Thus, to the extent particular guidance
is relevant and material to the operations of an entity, the staff
believes the specified information, or comparable data, should be
provided.
For example, in accordance with Guide 3, bank holding companies
disclose information about yields and costs of various assets and
liabilities. Further, bank holding companies provide certain
information about maturities and repricing characteristics of various
assets and liabilities. Such companies also disclose risk elements,
such as nonaccrual and past due items in the lending portfolio. The
staff believes that this information and other relevant data would be
material to a description of business of other registrants with
material lending and deposit activities and accordingly, the specified
information and/or comparable data (such as scheduled item disclosure
for risk elements) should be provided.
In contrast, other requirements of Article 9 and Guide 3 may not be
material or relevant to an understanding of the financial statements of
some financial institutions. For example, bank holding companies
present average balance sheet information, because period-end
statements might not be representative of bank activity throughout the
year. Some financial institutions other than bank holding companies may
determine that average balance sheet disclosure does not provide
significant additional information. Others may determine that assets
and liabilities are subject to sufficient volatility that average
balance information should be presented.
Pursuant to Article 9, the income statements of bank holding
companies use a ``net interest income'' presentation. Similarly, bank
holding companies present the aggregate market value, at the balance
sheet date, of investment securities, on the face of the balance sheet.
The staff believes that such disclosures and other relevant information
should also be provided by other registrants with material lending and
deposit activities.
L. Income Statement Presentation of Casino-Hotels
Facts: Registrants having casino-hotel operations present
separately within the income statement amounts of revenue attributable
to casino, hotel and restaurant operations, respectively.
Question: What is the appropriate income statement presentation of
expenses attributable to casino-hotel activities?
Interpretive Response: The staff believes that the expenses
attributable to each of the separate revenue producing activities of
casino, hotel and restaurant operations should be separately presented
on the face of the income statement. Such a presentation is consistent
with the general reporting format for income statement presentation
under Regulation S-X (Rules 5-03.1 and 5-03.2) which requires
presentation of amounts of revenues and related costs and expenses
applicable to major revenue providing activities. This detailed
presentation affords an analysis of the relative contribution to
operating profits of each of the revenue producing activities of a
typical casino-hotel operation.
M. Disclosure of The Impact That Recently Issued Accounting Standards
Will Have on the Financial Statements of the Registrant When Adopted in
a Future Period
Facts: An accounting standard has been issued \5\ that does not
require adoption until some future date. A registrant is required to
include financial statements in filings with the Commission after the
issuance of the standard but before it is adopted by the registrant.
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\5\ Some registrants may want to disclose the potential effects
of proposed accounting standards not yet issued, (e.g., exposure
drafts). Such disclosures, which generally are not required because
the final standard may differ from the exposure draft, are not
addressed by this SAB. See also FRR 26.
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Question 1: Does the staff believe that these filings should
include disclosure of the impact that the recently issued accounting
standard will have on the financial position and results of operations
of the registrant when such standard is adopted in a future period?
Interpretive Response: Yes. The Commission addressed a similar
issue and concluded that registrants should discuss the potential
effects of adoption of recently issued accounting standards in
registration statements and reports filed with the Commission.\6\ The
staff believes that this disclosure guidance applies to all accounting
standards which have been issued but not yet adopted by the registrant
unless the impact on its financial position and results of operations
is not expected to be material.\7\ MD&A \8\ requires registrants to
provide information with respect to liquidity, capital resources and
results of operations and such other information that the registrant
believes to be necessary to understand its financial condition and
results of operations. In addition, MD&A requires disclosure of
presently known material changes, trends and uncertainties that have
had or that the registrant reasonably expects will have a material
impact on future sales, revenues or income from continuing operations.
The staff believes that disclosure of impending accounting changes is
necessary to inform the reader about expected impacts on financial
information to be reported in the future and, therefore, should be
disclosed in accordance with the existing MD&A
[[Page 17255]]
requirements. With respect to financial statement disclosure, GAAS \9\
specifically address the need for the auditor to consider the adequacy
of the disclosure of impending changes in accounting principles if (a)
the financial statements have been prepared on the basis of accounting
principles that were acceptable at the financial statement date but
that will not be acceptable in the future and (b) the financial
statements will be retrospectively adjusted in the future as a result
of the change. The staff believes that recently issued accounting
standards may constitute material matters and, therefore, disclosure in
the financial statements should also be considered in situations where
the change to the new accounting standard will be accounted for in
financial statements of future periods, prospectively or with a
cumulative catch-up adjustment.
---------------------------------------------------------------------------
\6\ FRR 6, Section 2.
\7\ In those instances where a recently issued standard will
impact the preparation of, but not materially affect, the financial
statements, the registrant is encouraged to disclose that a standard
has been issued and that its adoption will not have a material
effect on its financial position or results of operations.
\8\ Item 303 of Regulation S-K.
\9\ See AU 9410.13-18.
---------------------------------------------------------------------------
Question 2: Does the staff have a view on the types of disclosure
that would be meaningful and appropriate when a new accounting standard
has been issued but not yet adopted by the registrant?
Interpretive Response: The staff believes that the registrant
should evaluate each new accounting standard to determine the
appropriate disclosure and recognizes that the level of information
available to the registrant will differ with respect to various
standards and from one registrant to another. The objectives of the
disclosure should be to (1) notify the reader of the disclosure
documents that a standard has been issued which the registrant will be
required to adopt in the future and (2) assist the reader in assessing
the significance of the impact that the standard will have on the
financial statements of the registrant when adopted. The staff
understands that the registrant will only be able to disclose
information that is known.
The following disclosures should generally be considered by the
registrant:
A brief description of the new standard, the date that
adoption is required and the date that the registrant plans to adopt,
if earlier.
A discussion of the methods of adoption allowed by the
standard and the method expected to be utilized by the registrant, if
determined.
A discussion of the impact that adoption of the standard
is expected to have on the financial statements of the registrant,
unless not known or reasonably estimable. In that case, a statement to
that effect may be made.
Disclosure of the potential impact of other significant
matters that the registrant believes might result from the adoption of
the standard (such as technical violations of debt covenant agreements,
planned or intended changes in business practices, etc.) is encouraged.
N. Disclosures of The Impact of Assistance From Federal Financial
Institution Regulatory Agencies
Facts: An entity receives financial assistance from a Federal
regulatory agency in conjunction with either an acquisition of a
troubled financial institution, transfer of nonperforming assets to a
newly-formed entity, or other reorganization.
Question: What are the disclosure implications of the existence of
regulatory assistance?
Interpretive Response: The staff believes that users of financial
statements must be able to assess the impact of credit and other risks
on a company following a regulatory assisted acquisition, transfer or
other reorganization on a basis comparable to that disclosed by other
institutions, i.e., as if the assistance did not exist. In this regard,
the staff believes that the amount of regulatory assistance should be
disclosed separately and should be separately identified in the
statistical information furnished pursuant to Industry Guide 3, to the
extent it impacts such information.10, 11 Further, the
nature, extent and impact of such assistance needs to be fully
discussed in Management's Discussion and Analysis.\12\
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\10\ The staff has previously expressed its views regarding
acceptable methods of compliance with this principle in FASB ASC
paragraph 942-10-S99-6 (Financial Services--Depository and Lending
Topic).
\11\ See FASB ASC paragraph 942-10-S99-6 for guidance on the
appropriate period in which to record certain types of regulatory
assistance.
\12\ See Section 501.06.c. of the Financial Reporting
Codification for further discussion of the MD&A disclosures of the
effects of regulatory assistance.
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TOPIC 12: OIL AND GAS PRODUCING ACTIVITIES
A. Accounting Series Release 257--Requirements for Financial Accounting
and Reporting Practices for Oil and Gas Producing Activities
1. Estimates of Reserve Quantities
Facts: Rule 4-10 of Regulation S-X contains definitions of possible
reserves, probable reserves, and proved and developed oil and gas
reserves to be used in determining quantities of oil and gas reserves
to be reported in filings with the Commission.
Question: What pressure base should be used for reporting gas and
production, 14.73 psia or the pressure base specified by the state?
Interpretive Response: The reporting instructions to the Department
of Energy's Form EIA-28 specify that natural gas reserves are to be
reported at 14.73 psia and 60 degrees F. There is no pressure base
specified in Regulation S-X or S-K. At the present time staff will not
object to natural gas reserves and production data calculated at other
pressure bases, if such pressure bases are identified in the filing.
2. Estimates of Future Net Revenues
Facts: U.S. GAAP requires the disclosure of the standardized
measure of discounted future net cash flows from production of proved
oil and gas reserves.
Question: F or purposes of determining reserves and estimated
future net revenues, what price should be used for oil and gas which
will be produced after an existing contract expires or after the
redetermination date in a contract?
Interpretive Response: The price to be used for oil and gas which
will be produced after a contract expires or has a redetermination is
the average price during the 12-month period prior to the ending date
of the period covered by the balance sheet, determined as an unweighted
arithmetic average of the first-day-of-the-month price for each month
within such period for that oil and gas. This average price, which
should be based on the first-day-of-the-month market prices, may be
increased thereafter only for additional fixed and determinable
escalations, as appropriate. A fixed and determinable escalation is one
which is specified in amount and is not based on future events such as
rates of inflation.
3. Disclosure of Reserve Information
a. Removed by SAB 103
b. Removed by SAB 113
c. Limited Partnership 10-K Reports
Facts: Item 1201(a) of Regulation S-K contains an exemption from
the requirements to disclose certain information relating to oil and
gas operations for ``limited partnerships or joint ventures that
conduct, operate, manage, or report upon oil and gas drilling income
programs that acquire properties either for drilling and production, or
for production of oil, gas, or geothermal steam. * * *''
Limited partnership agreements often contain buy-out provisions
under which the general partner agrees to purchase limited partnership
interests that are offered for sale, based upon a specified valuation
formula. Because of these arrangements, the requirements for
[[Page 17256]]
disclosure of reserve value information may be of little significance
to the limited partners.
Question: Must the financial statements of limited partnerships
included in reports on Form 10-K contain the disclosures of estimated
future net revenues, present values and changes therein, and
supplemental summary of oil and gas activities specified in FASB ASC
paragraphs 932-235-50-23 through 932-235-50-36 (Extractive Activities--
Oil and Gas Topic)?
Interpretive Response: The staff will not take exception to the
omission of these disclosures in a limited partnership Form 10-K if
reserve value information is available to the limited partners pursuant
to the partnership agreement (even though the valuations may be
computed differently and may be as of a date other than year end).
However, the staff will require all of the information listed in FASB
ASC paragraphs 932-235-50-23 through 932-235-50-36 for partnerships
which are the subject of a business combination or exchange offer under
which various limited partnerships are to be consolidated or combined
into a single entity.
d. Removed by SAB 113
e. Rate Regulated Companies
Question: If a company has cost-of-service oil and gas producing
properties, how should they be treated in the supplemental disclosures
of reserve quantities and related future net revenues provided pursuant
to FASB ASC paragraphs 932-235-50-29 through 932-235-50-36?
Interpretive Response: Rule 4-10 provides that registrants may give
effect to differences arising from the ratemaking process for cost-of-
service oil and gas properties. Accordingly, in these circumstances,
the staff believes that the company's supplemental reserve quantity
disclosures should indicate separately the quantities associated with
properties subject to cost-of-service ratemaking, and that it is
appropriate to exclude those quantities from the future net revenue
disclosures. The company should also disclose the nature and impact of
its cost-of-service ratemaking, including the unamortized cost included
in the balance sheet.
4. Removed by SAB 103
B. Removed by SAB 103
C. Methods of Accounting by Oil and Gas Producers
1. First-Time Registrants
Facts: In ASR 300, the Commission announced that it would allow
registrants to change methods of accounting for oil and gas producing
activities so long as such changes were in accordance with GAAP.
Accordingly, the Commission stated that changes from the full cost
method to the successful efforts method would not require a
preferability letter. Changes to full cost, however, would require
justification by the company making the change and filing of a
preferability letter from the company's independent accountants.
Question: How does this policy apply to a nonpublic company which
changes its accounting method in connection with a forthcoming public
offering or initial registration under either the 1933 Act or 1934 Act?
Interpretive Response: The Commission's policy that first-time
registrants may change their previous accounting methods without filing
a preferability letter is applicable. Therefore, such a company may
change to the full cost method without filing a preferability letter.
2. Consistent Use of Accounting Methods Within a Consolidated Entity
Facts: Rule 4-10(c) of Regulation S-X states in part that ``[a]
reporting entity that follows the full cost method shall apply that
method to all of its operations and to the operations of its
subsidiaries * * *''
Question 1: May a subsidiary of the parent use the full cost method
if the parent company uses the successful efforts method of accounting
for oil and gas producing activities?
Interpretive Response: No. The use of different methods of
accounting in the consolidated financial statements by a parent company
and its subsidiary would be inconsistent with the full cost requirement
that a parent and its subsidiaries all use the same method of
accounting.
The staff's general policy is that an enterprise should account for
all its like operations in the same manner. However, Rule 4-10 of
Regulation S-X provides that oil and gas companies with cost-of-service
oil and gas properties may give effect to any differences resulting
from the ratemaking process, including regulatory requirements that a
certain accounting method be used for the cost-of-service properties.
Question 2: Must the method of accounting (full cost or successful
efforts) followed by a registrant for its oil and gas producing
activities also be followed by any fifty percent or less owned
companies in which the registrant carries its investment on the equity
method (equity investees)?
Interpretive Response: No. Conformity of accounting methods between
a registrant and its equity investees, although desirable, may not be
practicable and thus is not required. However, if a registrant
proportionately consolidates its equity investees, it will be necessary
to present them all on the same basis of accounting.
D. Application of Full Cost Method of Accounting
1. Treatment of Income Tax Effects in the Computation of the Limitation
on Capitalized Costs
Facts: Item (D) in Rule 4-10(c)(4)(i) of Regulation S-X provides
that the income tax effects related to the properties involved should
be deducted in computing the full cost ceiling.
Question 1: What specific types of income tax effects should be
considered in computing the income tax effects to be deducted from
estimated future net revenues?
Interpretive Response: The rule refers to income tax effects
generally. Thus, the computation should take into account (i) the tax
basis of oil and gas properties, (ii) net operating loss carryforwards,
(iii) foreign tax credit carryforwards, (iv) investment tax credits,
(v) alternative minimum taxes on tax preference items, and (vi) the
impact of statutory (percentage) depletion.
It may often be difficult to allocate a net operating loss (NOL)
carryforward between oil and gas assets and other assets. However, to
the extent that the NOL is clearly attributable to oil and gas
operations and is expected to be realized within the carryforward
period, it should be added to tax basis.
Similarly, to the extent that investment tax credit (ITC)
carryforwards and foreign tax credit carryforwards are attributable to
oil and gas operations and are expected to be realized within the
carryforward period, they should be considered as a deduction from the
tax effect otherwise computed. Consideration of NOL and ITC or foreign
tax credit carryforwards should not, of course, reduce the total tax
effect below zero.
Question 2: How should the tax effect be computed considering the
various factors discussed above?
[[Page 17257]]
Interpretive Response: Theoretically, taxable income and tax could
be determined on a year-by-year basis and the present value of the
related tax computed. However, the ``shortcut'' method illustrated
below is also acceptable.
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
ASSUMPTIONS:
Cost of proved properties being amortized............................ ........... $396,000 ...........
Lower of cost or estimated fair value of unproved properties to be ........... 49,000 ...........
amortized...........................................................
Cost of properties not being amortized............................... ........... 55,000 ...........
Capitalized costs of oil and gas assets.............................. ........... 500,000 ...........
Accumulated DD&A..................................................... ........... (100,000) ...........
Book basis of oil and gas assets..................................... ........... ........... $400,000
Excess of book basis over tax basis ($270,000) of oil and gas assets. ........... $(130,000) ...........
NOL carryforward*.................................................... ........... 20,000
(110,000)
Statutory tax rate (percent)......................................... ........... x 46% ...........
(50,600)
Foreign tax credit carryforward *.................................... ........... 1,000 ...........
ITC carryforward*.................................................... ........... 2,000 ...........
Related net deferred income tax liability............................ ........... ........... (47,600)
Net book basis to be recovered....................................... ........... ........... $352,400
Other Assumptions: ........... ........... ...........
Present value of ITC relating to future development costs............ ........... $1,500 ...........
Present value of statutory depletion attributable to future ........... $10,000 ...........
deductions..........................................................
Estimated preference (minimum) tax on percentage depletion in excess ........... $500 ...........
of cost depletion...................................................
Present value of future net revenue from proved oil and gas reserves. ........... $272,000 ...........
CALCULATION:
Present value of future net revenue.................................. ........... $272,000 ...........
Cost of properties not being amortized............................... ........... 55,000 ...........
Lower of cost or estimated fair value of unproved properties included ........... 49,000 ...........
in costs being amortized............................................
Total ceiling limitation before tax effects.......................... ........... ........... $376,000
Tax Effects: ........... ........... ...........
Total ceiling limitation before tax effects.......................... ........... $376,000 ...........
Less: Tax basis of properties........................................ $(270,000) ........... ...........
Statutory depletion.................................................. (10,000) ........... ...........
NOL carryforward..................................................... (20,000) ........... ...........
........... (300,000) ...........
Future taxable income................................................ ........... 76,000 ...........
Tax rate (percent)................................................... ........... x 46% ...........
Tax at statutory rate................................................ ........... (34,960) ...........
ITC (future development costs and carryforward)...................... ........... 3,500 ...........
Foreign tax credit carryforward...................................... ........... 1,000 ...........
Estimated preference tax............................................. ........... (500) ...........
Net tax effects...................................................... ........... ........... (30,960)
Cost Center Ceiling.................................................. ........... ........... $345,040
Less: Net book basis to be recovered................................. ........... ........... 352,400
REQUIRED WRITE-OFF, net of tax **.................................... ........... ........... $(7,360)
----------------------------------------------------------------------------------------------------------------
* All carryforward amounts in this example represent amounts which are available for tax purposes and which
relate to oil and gas operations.
** For accounting purposes, the gross write-off should be recorded to adjust both the oil and gas properties
account and the related deferred income taxes.
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
CALCULATION OF GROSS PRE-TAX WRITE-OFF:
----------------------------------------------------------------------------------------------------------------
Required write-off, net of tax....................................... ........... ........... $(7,360)
Divided by (100% minus the statutory rate of 46%).................... ........... ........... 54%
Gross pre-tax write-off.............................................. ........... ........... $(13,630)
----------------------------------------------------------------------------------------------------------------
Related Journal Entries DR CR ...........
----------------------------------------------------------------------------------------------------------------
Full cost ceiling impairment............................................. $13,630 ........... ...........
Oil and gas assets....................................................... ........... $13,630 ...........
Deferred income tax liability............................................ $6,270 ........... ...........
Deferred income tax benefit.............................................. ........... $6,270 ...........
----------------------------------------------------------------------------------------------------------------
2. Exclusion of Costs From Amortization
Facts: Rule 4-10(c)(3)(ii) indicates that the costs of acquiring
and evaluating unproved properties may be excluded from capitalized
costs to be amortized if the costs are unusually significant in
relation to aggregate costs to be amortized. Costs of major development
projects may also be incurred prior to ascertaining the quantities of
proved reserves attributable to such properties.
Question: At what point should amortization of previously excluded
costs commence--when proved reserves have been established or when
those reserves become marketable? For instance, a determination of
proved reserves may be made before completion of an extraction plant
necessary to process sour crude or a pipeline necessary to market the
reserves. May the costs continue to be excluded from amortization until
the plant or pipeline is in service?
[[Page 17258]]
Interpretive Response: No. The proved reserves and the costs
allocable to such reserves should be transferred into the amortization
base on an ongoing (well-by-well or property-by-property) basis as the
project is evaluated and proved reserves are established.
Once the determination of proved reserves has been made, there is
no justification for continued exclusion from the full cost pool,
regardless of whether other factors prevent immediate marketing.
Moreover, at the same time that the costs are transferred into the
amortization base, it is also necessary in accordance with FASB ASC
Subtopic 932-835, Extractive Activities--Oil and Gas--Interest, and
FASB ASC Subtopic 835-20, Interest--Capitalization of Interest, to
terminate capitalization of interest on such properties.
In this regard, registrants are reminded of their responsibilities
not to delay recognizing reserves as proved once they have met the
engineering standards.
3. Full Cost Ceiling Limitation
a. Exemptions for Purchased Properties
Facts: During 20x1, a registrant purchases proved oil and gas
reserves in place (``the purchased reserves'') in an arm's-length
transaction for the sum of $9.8 million. Primarily because the
registrant expects oil and gas prices to escalate, it paid $1.2 million
more for the purchased reserves than the ``Present Value of Estimated
Future Net Revenues'' computed as defined in Rule 4-10(c)(4)(i)(A) of
Regulation S-X. An analysis of the registrant's full cost center in
which the purchased reserves are located at December 31, 20x1 is as
follows:
----------------------------------------------------------------------------------------------------------------
Other
Total Purchased proved Unproved
reserves properties properties
----------------------------------------------------------------------------------------------------------------
(Amounts in thousands)
----------------------------------------------------------------------------------------------------------------
Present value of estimated future net revenues.............. $14,100 8,600 5,500 ...........
Cost, net of amortization................................... 16,300 9,800 5,500 1,000
Related deferred taxes...................................... 2,300 ........... 2,000 300
Income tax effects related to properties.................... 2,500 ........... 2,500 ...........
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Including Excluding
Comparison of capitalized costs with limitation on purchased purchased
capitalized costs at December 31, 20x1: reserves reserves
----------------------------------------------------------------------------------------------------------------
Capitalized costs, net of amortization...................... ........... $16,300 $6,500 ...........
Related deferred taxes...................................... ........... (2,300) (2,300) ...........
Net book cost............................................... ........... 14,000 4,200 ...........
Present value of estimated future net revenues.............. ........... 14,100 5,500 ...........
Lower of cost or market of unproved properties.............. ........... 1,000 1,000 ...........
Income tax effects related to properties.................... ........... (2,500) (2,500) ...........
Limitation on capitalized costs............................. ........... 12,600 4,000 ...........
Excess of capitalized costs over limitation on Capitalized ........... 1,400 200 ...........
costs, net of tax *........................................
----------------------------------------------------------------------------------------------------------------
* For accounting purposes, the gross write-off should be recorded to adjust both the oil and gas properties
account and the related deferred income taxes.
Question: Is it necessary for the registrant to write down the
carrying value of its full cost center at December 31, 20x1 by
$1,400,000?
Interpretive Response: Although the net carrying value of the full
cost center exceeds the cost center's limitation on capitalized costs,
the text of ASR 258 provides that a registrant may request an exemption
from the rule if as a result of a major purchase of proved properties,
a write down would be required even though the registrant believes the
fair value of the properties in a cost center clearly exceeds the
unamortized costs.
Therefore, to the extent that the excess carrying value relates to
the purchased reserves, the registrant may seek a temporary waiver of
the full-cost ceiling limitation from the staff of the Commission.
Registrants requesting a waiver should be prepared to demonstrate that
the additional value exists beyond reasonable doubt.
To the extent that the excess costs relate to properties other than
the purchased reserves, however, a write-off should be recorded in the
current period. In order to determine the portion of the total excess
carrying value which is attributable to properties other than the
purchased reserves, it is necessary to perform the ceiling computation
on a ``with and without'' basis as shown in the example above. Thus in
this case, the registrant must record a write-down of $200,000
applicable to other reserves. An additional $1,200,000 write-down would
be necessary unless a waiver was obtained.
b. Use of Cash Flow Hedges in the Computation of the Limitation on
Capitalized Costs
Facts: Rule 4-10(c)(4) of Regulation S-X provides, in pertinent
part, that capitalized costs, net of accumulated depreciation and
amortization, and deferred income taxes, should not exceed an amount
equal to the sum of components that include the present value of
estimated future net revenues computed by applying current prices of
oil and gas reserves (with consideration of price changes only to the
extent provided by contractual arrangements) to estimated future
production of proved oil and gas reserves as of the date of the latest
balance sheet presented.
As of the reported balance sheet date, capitalized costs of an oil
and gas producing company exceed the full cost limitation calculated
under the above-described rule based on current prices, as defined in
Rule 4-10(c)(8) of Regulation S-X, for oil and natural gas. However,
prior to the balance sheet date, the company entered into certain
hedging arrangements for a portion of its future natural gas and oil
production, thereby enabling the company to receive future cash flows
that are higher or lower than the estimated future cash flows indicated
by use of the average price during the 12-month period prior to the
balance sheet date, determined as
[[Page 17259]]
an unweighted arithmetic average of the first-day-of-the-month price
for each month within such period. These arrangements qualify as cash
flow hedges under the provisions of FASB ASC Topic 815, Derivatives and
Hedging, and are documented, designated, and accounted for as such
under the criteria of that standard.
Question: Under these circumstances, must the company use the
higher or lower prices to be received after taking into account the
hedging arrangements (``hedge-adjusted prices'') in calculating the
estimated cash flows from future production of oil and gas reserves
covered by the hedges as of the reported balance sheet date?
Interpretive Response: Yes. Derivative contracts that qualify as a
hedging instrument in a cash flow hedge and are accounted for as such
pursuant to FASB ASC Topic 815 represent the type of contractual
arrangements for which consideration of price changes should be given
under the existing rule. While the SEC staff has objected to previous
proposals to consider various hedging techniques as being equivalent to
the contractual arrangements permitted under the existing rules, the
staff's objection was based on concerns that the lack of clear,
consistent guidance in the accounting literature would lead to
inconsistent application in practice. However, the staff believes that
FASB ASC Topic 815 and related guidance (including a more systematic
approach to documentation) provides sufficient guidance so that
comparable financial reporting in comparable factual circumstances
should result.
This interpretive response reflects the SEC staff's view that,
assuming compliance with the prerequisite accounting requirements,
hedge-adjusted prices represent the best measure of estimated cash
flows from future production of the affected oil and gas reserves to
use in calculating the ceiling limitation. Nonetheless, the staff
expects that oil and gas producing companies subject to the full cost
rules will clearly indicate the effects of using cash flow hedges in
calculating ceiling limitations within their financial statement
footnotes. The staff further expects that disclosures will indicate the
portion of future oil and gas production being hedged. The dollar
amount that would have been charged to income had the effects of the
cash flow hedges not been considered in calculating the ceiling
limitation also should be disclosed.
The use of hedge-adjusted prices should be consistently applied in
all reporting periods, including periods in which the hedge-adjusted
price is more or less than the average price during the 12-month period
prior to the balance sheet date, determined as an unweighted arithmetic
average of the first-day-of-the-month price for each month within such
period. Oil and gas producers whose computation of the ceiling
limitation includes hedge-adjusted prices because of the use of cash
flow hedges also should consider the disclosure requirements under FASB
ASC Section 275-10-50, Risks and Uncertainties--Overall--Disclosure.
FASB ASC paragraph 275-10-50-9 calls for disclosure when it is at least
reasonably possible that the effects of cash flow hedges on capitalized
costs on the reported balance sheet date will change in the near term
due to one or more confirming events, such as potential future changes
in commodity prices.
In addition, the use of cash flow hedges in calculating the ceiling
limitation may represent a type of critical accounting policy that oil
and gas producers should consider disclosing consistent with the
cautionary advice provided in Financial Reporting Release No. 60
(Release Nos. 33-8040; 34-45149), Cautionary Advice Regarding
Disclosure about Critical Accounting Policies (December 12, 2001), and
Financial Reporting Release No. 72 (Release Nos. 33-8350; 34-48960),
Commission Guidance Regarding Management's Discussion and Analysis of
Financial Condition and Results of Operations (December 29, 2003).
Through these releases, the Commission has encouraged companies to
include, within their MD&A disclosures, full explanations, in plain
English, of the judgments and uncertainties affecting the application
of critical accounting policies, and the likelihood that materially
different amounts would be reported under different conditions or using
different assumptions.
The staff's guidance on this issue would apply to calculations of
ceiling limitations both in interim and annual reporting periods.
c. Effect of Subsequent Events on the Computation of the Limitation on
Capitalized Costs
Facts: Rule 4-10(c)(4)(ii) of Regulation S-X provides that an
excess of unamortized capitalized costs within a cost center over the
related cost ceiling shall be charged to expense in the period the
excess occurs.
Question: Assume that at the date of the company's fiscal year-end,
its capitalized costs of oil and gas producing properties exceed the
limitation prescribed by Rule 4-10(c)(4) of Regulation S-X. Thus, a
write-down is indicated. Subsequent to year-end but before the date of
the auditor's report on the company's financial statements, assume that
additional reserves are proved up (excluding the effect of increased
oil and gas prices subsequent to year-end) on properties owned at year-
end. The present value of future net revenues from the additional
reserves is sufficiently large that if the full cost ceiling limitation
were recomputed giving effect to those factors as of year-end, the
ceiling would more than cover the costs. Is it necessary to record a
write-down?
Interpretive Response: No. In this case, the proving up of
additional reserves on properties owned at year-end indicates that the
capitalized costs were not in fact impaired at year-end. However, for
purposes of the revised computation of the ``ceiling,'' the net book
costs capitalized as of year-end should be increased by the amount of
any additional costs incurred subsequent to year-end to prove the
additional reserves or by any related costs previously excluded from
amortization.
While the fact pattern described herein relates to annual periods,
the guidance on the effects of subsequent events applies equally to
interim period calculations of the ceiling limitation.
The registrant's financial statements should disclose that
capitalized costs exceeded the limitation thereon at year-end and
should explain why the excess was not charged against earnings. In
addition, the registrant's supplemental disclosures of estimated proved
reserve quantities and related future net revenues and costs should not
give effect to the reserves proved up or the cost incurred after year-
end. However, such quantities may be disclosed separately, with
appropriate explanations.
Registrants should be aware that oil and gas reserves related to
properties acquired after year-end would not justify avoiding a write-
off indicated as of year-end. Similarly, the effects of cash flow
hedging arrangements entered into after year-end cannot be factored
into the calculation of the ceiling limitation at year-end. Such
acquisitions and financial arrangements do not confirm situations
existing at year-end.
[[Page 17260]]
4. Interaction of FASB ASC Subtopic 410-20, Asset Retirement and
Environmental Obligations--Asset Retirement Obligations, and the Full
Cost Rules
a. Impact of FASB ASC Subtopic 410-20 on the Full Cost Ceiling Test
Facts: A company following the full cost method of accounting under
Rule 4-10(c) of Regulation S-X must periodically calculate a limitation
on capitalized costs, i.e., the full cost ceiling. Under FASB ASC
Subtopic 410-20, a company must recognize a liability for an asset
retirement obligation (ARO) at fair value in the period in which the
obligation is incurred, if a reasonable estimate of fair value can be
made. The company also must initially capitalize the associated asset
retirement costs by increasing long-lived oil and gas assets by the
same amount as the liability. Any asset retirement costs capitalized
pursuant to FASB ASC Subtopic 410-20 are subject to the full cost
ceiling limitation under Rule 4-10(c)(4) of Regulation S-X. If a
company were to calculate the full cost ceiling by reducing expected
future net revenues by the cash flows required to settle the ARO, then
the effect would be to ``double-count'' such costs in the ceiling test.
The assets that must be recovered would be increased while the future
net revenues available to recover the assets continue to be reduced by
the amount of the ARO settlement cash flows.
Question: How should a company compute the full cost ceiling to
avoid double-counting the expected future cash outflows associated with
asset retirement costs?
Interpretive Response: The future cash outflows associated with
settling AROs that have been accrued on the balance sheet should be
excluded from the computation of the present value of estimated future
net revenues for purposes of the full cost ceiling calculation.\1,2\
---------------------------------------------------------------------------
\1\ If an obligation for expected asset retirement costs has not
been accrued under FASB ASC Subtopic 410-20 for certain asset
retirement costs required to be included in the full cost ceiling
calculation under Rule 4-10(c)(4) of Regulation S-X, such costs
should continue to be included in the full cost ceiling calculation.
\2\ This approach is consistent with the guidance in FASB ASC
Subtopic 410-20 on testing for impairment under FASB ASC Section
360-10-35, Property, Plant, and Equipment--Overall--Subsequent
Measurement. Under that guidance, the asset tested should include
capitalized asset retirement costs. The estimated cash flows related
to the associated ARO that has been recognized in the financial
statements are to be excluded from both the undiscounted cash flows
used to test for recoverability and the discounted cash flows used
to measure the asset's fair value.
---------------------------------------------------------------------------
b. Impact of FASB ASC Subtopic 410-20 on the Calculation of
Depreciation, Depletion, and Amortization
Facts: Regarding the base for depreciation, depletion, and
amortization (DD&A) of proved reserves, Rule 4-10(c)(3)(i) of
Regulation S-X states that ``[c]osts to be amortized shall include (A)
all capitalized costs, less accumulated amortization, other than the
cost of properties described in paragraph (ii) below; \3\ (B) the
estimated future expenditures (based on current costs) to be incurred
in developing proved reserves; and (C) estimated dismantlement and
abandonment costs, net of estimated salvage values.'' FASB ASC Subtopic
410-20 requires that upon initial recognition of an ARO, the associated
asset retirement costs be included in the capitalized costs of the
company. Therefore, the estimated dismantlement and abandonment costs
described in (C) above may be included in the capitalized costs
described in (A) above, at least to the extent that an ARO has been
incurred as a result of acquisition, exploration and development
activities to date. Future development activities on proved reserves
may result in additional asset retirement obligations when such
activities are performed and the associated asset retirement costs will
be capitalized at that time.
---------------------------------------------------------------------------
\3\ The reference to ``cost of properties described in paragraph
(ii) below'' relates to the costs of investments in unproved
properties and major development projects, as defined.
---------------------------------------------------------------------------
Question: Should the costs to be amortized under Rule 4-10(c)(3) of
Regulation S-X include an amount for estimated dismantlement and
abandonment costs, net of estimated salvage values, that are expected
to result from future development activities?
Interpretive Response: Yes. Companies should estimate the amount of
dismantlement and abandonment costs that will be incurred as a result
of future development activities on proved reserves and include those
amounts in the costs to be amortized.
c. Removed by SAB 113
E. Financial Statements of Royalty Trusts
Facts: Several oil and gas exploration and production companies
have created ``royalty trusts.'' Typically, the creating company
conveys a net profits interest in certain of its oil and gas properties
to the newly created trust and then distributes units in the trust to
its shareholders. The trust is a passive entity which is prohibited
from entering into or engaging in any business or commercial activity
of any kind and from acquiring any oil and gas lease, royalty or other
mineral interest. The function of the trust is to serve as an agent to
distribute the income from the net profits interest. The amount to be
periodically distributed to the unitholders is defined in the trust
agreement and is typically determined based on the cash received from
the net profits interest less expenses of the trustee. Royalty trusts
have typically reported their earnings on the basis of cash
distributions to unitholders. The net profits interest paid to the
trust for any month is based on production from a preceding month;
therefore, the method of accounting followed by the trust for the net
profits interest income is different from the creating company's method
of accounting for the related revenue.
Question: Will the staff accept a statement of distributable income
which reflects the amounts to be distributed for the period in question
under the terms of the trust agreement in lieu of a statement of income
prepared under GAAP?
Interpretive Response: Yes. Although financial statements filed
with the Commission are normally required to be prepared in accordance
with GAAP, the Commission's rules provide that other presentations may
be acceptable in unusual situations. Since the operations of a royalty
trust are limited to the distribution of income from the net profits
interests contributed to it, the staff believes that the item of
primary importance to the reader of the financial statements of the
royalty trust is the amount of the cash distributions to the
unitholders for the period reported. Should there be any change in the
nature of the trust's operations due to revisions in the tax laws or
other factors,
[[Page 17261]]
the staff's interpretation would be reexamined.
A note to the financial statements should disclose the method used
in determining distributable income and should also describe how
distributable income as reported differs from income determined on the
basis of GAAP.
F. Gross Revenue Method of Amortizing Capitalized Costs
Facts: Rule 4-10(c)(3)(iii) of Regulation S-X states in part:
``Amortization shall be computed on the basis of physical units,
with oil and gas converted to a common unit of measure on the basis
of their approximate relative energy content, unless economic
circumstances (related to the effects of regulated prices) indicate
that use of units of revenue is a more appropriate basis of
computing amortization. In the latter case, amortization shall be
computed on the basis of current gross revenues (excluding royalty
payments and net profits disbursements) from production in relation
to future gross revenues based on current prices (including
consideration of changes in existing prices provided only by
contractual arrangements), from estimated production of proved oil
and gas reserves.'' \4\
\4\ Rule 4-10(c)(8) of Regulation S-X defines current price as
the average price during the 12-month period prior to the ending
date of the period covered by the report, determined as an
unweighted arithmetic average of the first-day-of-the-month price
for each month within such period, unless prices are defined by
contractual arrangements, excluding escalations based upon future
conditions.
---------------------------------------------------------------------------
Question: May entities using the full cost method of accounting for
oil and gas producing activities compute amortization based on the
gross revenue method described in the above rule when substantial
production is not subject to pricing regulation?
Interpretive Response: Yes. Under the existing rules for cost
amortization adopted in ASR 258, the use of the gross revenue method of
amortization was permitted in those circumstances where, because of the
effect of existing pricing regulations, the use of the units of
production method would result in an amortization provision that would
be inconsistent with the current sales prices being received. While the
effect of regulation on gas prices has lessened, factors other than
price regulation (such as changes in typical contract lengths and
methods of marketing natural gas) have caused oil and gas prices to be
disproportionate to their relative energy content. The staff therefore
believes that it may be more appropriate for registrants to compute
amortization based on the gross revenue method whenever oil and gas
sales prices are disproportionate to their relative energy content to
the extent that the use of the units of production method would result
in an improper matching of the costs of oil and gas production against
the related revenue received. The method should be consistently applied
and appropriately disclosed within the financial statements.
G. Removed by SAB 113
TOPIC 13: REVENUE RECOGNITION
A. Selected Revenue Recognition Issues
1. Revenue Recognition--General
The accounting literature on revenue recognition includes both
broad conceptual discussions as well as certain industry-specific
guidance.\1\ If a transaction is within the scope of specific
authoritative literature that provides revenue recognition guidance,
that literature should be applied. However, in the absence of
authoritative literature addressing a specific arrangement or a
specific industry, the staff will consider the existing authoritative
accounting standards as well as the broad revenue recognition criteria
specified in the FASB's conceptual framework that contain basic
guidelines for revenue recognition.
---------------------------------------------------------------------------
\1\ The February 1999 AICPA publication ``Audit Issues in
Revenue Recognition'' provides an overview of the authoritative
accounting literature and auditing procedures for revenue
recognition and identifies indicators of improper revenue
recognition.
---------------------------------------------------------------------------
Based on these guidelines, revenue should not be recognized until
it is realized or realizable and earned.\2\ Concepts Statement 5,
Recognition and Measurement in Financial Statements of Business
Enterprises, paragraph 83(b) states that ``an entity's revenue-earning
activities involve delivering or producing goods, rendering services,
or other activities that constitute its ongoing major or central
operations, and revenues are considered to have been earned when the
entity has substantially accomplished what it must do to be entitled to
the benefits represented by the revenues'' [footnote reference
omitted]. Paragraph 84(a) continues ``the two conditions (being
realized or realizable and being earned) are usually met by the time
product or merchandise is delivered or services are rendered to
customers, and revenues from manufacturing and selling activities and
gains and losses from sales of other assets are commonly recognized at
time of sale (usually meaning delivery)'' [footnote reference omitted].
In addition, paragraph 84(d) states that ``If services are rendered or
rights to use assets extend continuously over time (for example,
interest or rent), reliable measures based on contractual prices
established in advance are commonly available, and revenues may be
recognized as earned as time passes.''
---------------------------------------------------------------------------
\2\ Concepts Statement 5, paragraphs 83-84; FASB ASC paragraph
605-10-25-1 (Revenue Recognition Topic); FASB ASC paragraph 605-10-
25-3; FASB ASC paragraph 605-10-25-5. The citations provided herein
are not intended to present the complete population of citations
where a particular criterion is relevant. Rather, the citations are
intended to provide the reader with additional reference material.
---------------------------------------------------------------------------
The staff believes that revenue generally is realized or realizable
and earned when all of the following criteria are met:
Persuasive evidence of an arrangement exists,\3\
---------------------------------------------------------------------------
\3\ Concepts Statement 2, paragraph 63 states ``Representational
faithfulness is correspondence or agreement between a measure or
description and the phenomenon it purports to represent.'' The staff
believes that evidence of an exchange arrangement must exist to
determine if the accounting treatment represents faithfully the
transaction. See also FASB ASC paragraph 985-605-25-3 (Software
Topic). The use of the term ``arrangement'' in this SAB Topic is
meant to identify the final understanding between the parties as to
the specific nature and terms of the agreed-upon transaction.
---------------------------------------------------------------------------
Delivery has occurred or services have been rendered,\4\
---------------------------------------------------------------------------
\4\ Concepts Statement 5, paragraph 84(a), (b), and (d). Revenue
should not be recognized until the seller has substantially
accomplished what it must do pursuant to the terms of the
arrangement, which usually occurs upon delivery or performance of
the services.
---------------------------------------------------------------------------
The seller's price to the buyer is fixed or
determinable,\5\ and
---------------------------------------------------------------------------
\5\ Concepts Statement 5, paragraph 83(a); FASB ASC subparagraph
605-15-25-1(a); FASB ASC paragraph 985-605-25-3. The FASB ASC Master
Glossary defines a ``fixed fee'' as a ``fee required to be paid at a
set amount that is not subject to refund or adjustment. A fixed fee
includes amounts designated as minimum royalties.'' FASB ASC
paragraphs 985-605-25-30 through 985-605-25-40 discuss how to apply
the fixed or determinable fee criterion in software transactions.
The staff believes that the guidance in FASB ASC paragraphs 985-605-
25-30 through 985-605-25-31 and 985-605-25-36 through 985-605-25-40
is appropriate for other sales transactions where authoritative
guidance does not otherwise exist. The staff notes that FASB ASC
paragraphs 985-605-25-33 through 985-605-25-35 specifically consider
software transactions, however, the staff believes that guidance
should be considered in other sales transactions in which the risk
of technological obsolescence is high.
---------------------------------------------------------------------------
Collectibility is reasonably assured.\6\
---------------------------------------------------------------------------
\6\ FASB ASC paragraph 605-10-25-3 through 605-10-25-5. See also
Concepts Statement 5, paragraph 84(g) and FASB ASC paragraph 985-
605-25-3.
---------------------------------------------------------------------------
Some revenue arrangements contain multiple revenue-generating
activities. The staff believes that the determination of the units of
accounting within an arrangement should be made prior to the
application of the guidance in this SAB Topic by reference to the
applicable accounting literature.\7\
---------------------------------------------------------------------------
\7\ See FASB ASC paragraph 605-25-15-2 through 605-25-15-3 for
additional discussion.
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[[Page 17262]]
2. Persuasive Evidence of an Arrangement
Question 1
Facts: Company A has product available to ship to customers prior
to the end of its current fiscal quarter. Customer Beta places an order
for the product, and Company A delivers the product prior to the end of
its current fiscal quarter. Company A's normal and customary business
practice for this class of customer is to enter into a written sales
agreement that requires the signatures of the authorized
representatives of the Company and its customer to be binding. Company
A prepares a written sales agreement, and its authorized representative
signs the agreement before the end of the quarter. However, Customer
Beta does not sign the agreement because Customer Beta is awaiting the
requisite approval by its legal department. Customer Beta's purchasing
department has orally agreed to the sale and stated that it is highly
likely that the contract will be approved the first week of Company A's
next fiscal quarter.
Question: May Company A recognize the revenue in the current fiscal
quarter for the sale of the product to Customer Beta when (1) the
product is delivered by the end of its current fiscal quarter and (2)
the final written sales agreement is executed by Customer Beta's
authorized representative within a few days after the end of the
current fiscal quarter?
Interpretive Response: No. Generally the staff believes that, in
view of Company A's business practice of requiring a written sales
agreement for this class of customer, persuasive evidence of an
arrangement would require a final agreement that has been executed by
the properly authorized personnel of the customer. In the staff's view,
Customer Beta's execution of the sales agreement after the end of the
quarter causes the transaction to be considered a transaction of the
subsequent period.\8\ Further, if an arrangement is subject to
subsequent approval (e.g., by the management committee or board of
directors) or execution of another agreement, revenue recognition would
be inappropriate until that subsequent approval or agreement is
complete.
---------------------------------------------------------------------------
\8\ AU Section 560.05.
---------------------------------------------------------------------------
Customary business practices and processes for documenting sales
transactions vary among companies and industries. Business practices
and processes may also vary within individual companies (e.g., based on
the class of customer, nature of product or service, or other
distinguishable factors). If a company does not have a standard or
customary business practice of relying on written contracts to document
a sales arrangement, it usually would be expected to have other forms
of written or electronic evidence to document the transaction. For
example, a company may not use written contracts but instead may rely
on binding purchase orders from third parties or on-line authorizations
that include the terms of the sale and that are binding on the
customer. In that situation, that documentation could represent
persuasive evidence of an arrangement.
The staff is aware that sometimes a customer and seller enter into
``side'' agreements to a master contract that effectively amend the
master contract. Registrants should ensure that appropriate policies,
procedures, and internal controls exist and are properly documented so
as to provide reasonable assurances that sales transactions, including
those affected by side agreements, are properly accounted for in
accordance with GAAP and to ensure compliance with Section 13 of the
Securities Exchange Act of 1934 (i.e., the Foreign Corrupt Practices
Act). Side agreements could include cancellation, termination, or other
provisions that affect revenue recognition. The existence of a
subsequently executed side agreement may be an indicator that the
original agreement was not final and revenue recognition was not
appropriate.
Question 2
Facts: Company Z enters into an arrangement with Customer A to
deliver Company Z's products to Customer A on a consignment basis.
Pursuant to the terms of the arrangement, Customer A is a consignee,
and title to the products does not pass from Company Z to Customer A
until Customer A consumes the products in its operations. Company Z
delivers product to Customer A under the terms of their arrangement.
Question: May Company Z recognize revenue upon delivery of its
product to Customer A?
Interpretive Response: No. Products delivered to a consignee
pursuant to a consignment arrangement are not sales and do not qualify
for revenue recognition until a sale occurs. The staff believes that
revenue recognition is not appropriate because the seller retains the
risks and rewards of ownership of the product and title usually does
not pass to the consignee.
Other situations may exist where title to delivered products passes
to a buyer, but the substance of the transaction is that of a
consignment or a financing. Such arrangements require a careful
analysis of the facts and circumstances of the transaction, as well as
an understanding of the rights and obligations of the parties, and the
seller's customary business practices in such arrangements. The staff
believes that the presence of one or more of the following
characteristics in a transaction precludes revenue recognition even if
title to the product has passed to the buyer:
1. The buyer has the right to return the product and:
(a) The buyer does not pay the seller at the time of sale, and the
buyer is not obligated to pay the seller at a specified date or
dates,\9\
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\9\ FASB ASC subparagraph 605-15-25-1(b).
---------------------------------------------------------------------------
(b) The buyer does not pay the seller at the time of sale but
rather is obligated to pay at a specified date or dates, and the
buyer's obligation to pay is contractually or implicitly excused until
the buyer resells the product or subsequently consumes or uses the
product,\10\
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\10\ FASB ASC subparagraph 605-15-25-1(b). The arrangement may
not specify that payment is contingent upon subsequent resale or
consumption. However, if the seller has an established business
practice permitting customers to defer payment beyond the specified
due date(s) until the products are resold or consumed, then the
staff believes that the seller's right to receive cash representing
the sales price is contingent.
---------------------------------------------------------------------------
(c) The buyer's obligation to the seller would be changed (e.g.,
the seller would forgive the obligation or grant a refund) in the event
of theft or physical destruction or damage of the product,\11\
---------------------------------------------------------------------------
\11\ FASB ASC subparagraph 605-15-25-1(c).
---------------------------------------------------------------------------
(d) The buyer acquiring the product for resale does not have
economic substance apart from that provided by the seller,\12\ or
---------------------------------------------------------------------------
\12\ FASB ASC subparagraph 605-15-25-1(d).
---------------------------------------------------------------------------
(e) The seller has significant obligations for future performance
to directly bring about resale of the product by the buyer.\13\
---------------------------------------------------------------------------
\13\ FASB ASC subparagraph 605-15-25-1(e).
---------------------------------------------------------------------------
2. The seller is required to repurchase the product (or a
substantially identical product or processed goods of which the product
is a component) at specified prices that are not subject to change
except for fluctuations due to finance and holding costs,\14\ and the
amounts to be paid by the seller will be adjusted, as necessary, to
cover substantially all
[[Page 17263]]
fluctuations in costs incurred by the buyer in purchasing and holding
the product (including interest).\15\ The staff believes that
indicators of the latter condition include:
---------------------------------------------------------------------------
\14\ FASB ASC subparagraph 470-40-15-2(a) (Debt Topic). This
paragraph provides examples of circumstances that meet this
requirement. As discussed further therein, this condition is present
if (a) a resale price guarantee exists, (b) the seller has an option
to purchase the product, the economic effect of which compels the
seller to purchase the product, or (c) the buyer has an option
whereby it can require the seller to purchase the product.
\15\ FASB ASC subparagraph 470-40-15-2(b).
---------------------------------------------------------------------------
(a) The seller provides interest-free or significantly below market
financing to the buyer beyond the seller's customary sales terms and
until the products are resold,
(b) The seller pays interest costs on behalf of the buyer under a
third-party financing arrangement, or
(c) The seller has a practice of refunding (or intends to refund) a
portion of the original sales price representative of interest expense
for the period from when the buyer paid the seller until the buyer
resells the product.
3. The transaction possesses the characteristics set forth in FASB
ASC paragraphs 840-10-55-12 through 840-10-55-21 (Leases Topic) and
does not qualify for sales-type lease accounting.
4. The product is delivered for demonstration purposes.\16\
---------------------------------------------------------------------------
\16\ See FASB ASC paragraphs 985-605-25-28 through 985-605-25-
29.
---------------------------------------------------------------------------
This list is not meant to be a checklist of all characteristics of
a consignment or financing arrangement, and other characteristics may
exist. Accordingly, the staff believes that judgment is necessary in
assessing whether the substance of a transaction is a consignment, a
financing, or other arrangement for which revenue recognition is not
appropriate. If title to the goods has passed but the substance of the
arrangement is not a sale, the consigned inventory should be reported
separately from other inventory in the consignor's financial statements
as ``inventory consigned to others'' or another appropriate caption.
Question 3
Facts: The laws of some countries do not provide for a seller's
retention of a security interest in goods in the same manner as
established in the U.S. Uniform Commercial Code (UCC). In these
countries, it is common for a seller to retain a form of title to goods
delivered to customers until the customer makes payment so that the
seller can recover the goods in the event of customer default on
payment.
Question: Is it acceptable to recognize revenue in these
transactions before payment is made and title has transferred?
Interpretive Response: Presuming all other revenue recognition
criteria have been met, the staff would not object to revenue
recognition at delivery if the only rights that a seller retains with
the title are those enabling recovery of the goods in the event of
customer default on payment. This limited form of ownership may exist
in some foreign jurisdictions where, despite technically holding title,
the seller is not entitled to direct the disposition of the goods,
cannot rescind the transaction, cannot prohibit its customer from
moving, selling, or otherwise using the goods in the ordinary course of
business, and has no other rights that rest with a titleholder of
property that is subject to a lien under the U.S. UCC. On the other
hand, if retaining title results in the seller retaining rights
normally held by an owner of goods, the situation is not sufficiently
different from a delivery of goods on consignment. In this particular
case, revenue should not be recognized until payment is received.
Registrants and their auditors may wish to consult legal counsel
knowledgeable of the local law and customs outside the U.S. to
determine the seller's rights.
3. Delivery and Performance
a. Bill and Hold Arrangements
Facts: Company A receives purchase orders for products it
manufactures. At the end of its fiscal quarters, customers may not yet
be ready to take delivery of the products for various reasons. These
reasons may include, but are not limited to, a lack of available space
for inventory, having more than sufficient inventory in their
distribution channel, or delays in customers' production schedules.
Question: May Company A recognize revenue for the sale of its
products once it has completed manufacturing if it segregates the
inventory of the products in its own warehouse from its own products?
May Company A recognize revenue for the sale if it ships the
products to a third-party warehouse but (1) Company A retains title to
the product and (2) payment by the customer is dependent upon ultimate
delivery to a customer-specified site?
Interpretative Response: Generally, no. The staff believes that
delivery generally is not considered to have occurred unless the
customer has taken title and assumed the risks and rewards of ownership
of the products specified in the customer's purchase order or sales
agreement. Typically this occurs when a product is delivered to the
customer's delivery site (if the terms of the sale are ``FOB
destination'') or when a product is shipped to the customer (if the
terms are ``FOB shipping point'').
The Commission has set forth criteria to be met in order to
recognize revenue when delivery has not occurred.\17\ These include:
---------------------------------------------------------------------------
\17\ See In the Matter of Stewart Parness, AAER 108 (August 5,
1986); SEC v. Bollinger Industries, Inc., et al., LR 15093
(September 30, 1996); In the Matter of Laser Photonics, Inc., AAER
971 (September 30, 1997); In the Matter of Cypress Bioscience Inc.,
AAER 817 (September 19, 1996). See also Concepts Statement 5,
paragraph 84(a) and FASB ASC paragraph 985-605-25-25.
---------------------------------------------------------------------------
1. The risks of ownership must have passed to the buyer;
2. The customer must have made a fixed commitment to purchase the
goods, preferably in written documentation;
3. The buyer, not the seller, must request that the transaction be
on a bill and hold basis.\18\ The buyer must have a substantial
business purpose for ordering the goods on a bill and hold basis;
---------------------------------------------------------------------------
\18\ Such requests typically should be set forth in writing by
the buyer.
---------------------------------------------------------------------------
4. There must be a fixed schedule for delivery of the goods. The
date for delivery must be reasonable and must be consistent with the
buyer's business purpose (e.g., storage periods are customary in the
industry);
5. The seller must not have retained any specific performance
obligations such that the earning process is not complete;
6. The ordered goods must have been segregated from the seller's
inventory and not be subject to being used to fill other orders; and
7. The equipment [product] must be complete and ready for shipment.
The above listed conditions are the important conceptual criteria
that should be used in evaluating any purported bill and hold sale.
This listing is not intended as a checklist. In some circumstances, a
transaction may meet all factors listed above but not meet the
requirements for revenue recognition. The Commission also has noted
that in applying the above criteria to a purported bill and hold sale,
the individuals responsible for the preparation and filing of financial
statements also should consider the following factors: \19\
---------------------------------------------------------------------------
\19\ See Note 17, supra.
---------------------------------------------------------------------------
1. The date by which the seller expects payment, and whether the
seller has modified its normal billing and credit terms for this buyer;
\20\
---------------------------------------------------------------------------
\20\ Such individuals should consider whether FASB ASC Subtopic
835-30, Interest--Imputation of Interest, pertaining to the need for
discounting the related receivable, is applicable. FASB ASC
subparagraph 835-30-15-3(a) indicates that the requirements of that
Subtopic to record receivables at a discounted value are not
intended to apply to ``receivables and payables arising from
transactions with customers or suppliers in the normal course of
business which are due in customary trade terms not exceeding
approximately one year'' (emphasis added).
---------------------------------------------------------------------------
[[Page 17264]]
2. The seller's past experiences with and pattern of bill and hold
transactions;
3. Whether the buyer has the expected risk of loss in the event of
a decline in the market value of goods;
4. Whether the seller's custodial risks are insurable and insured;
5. Whether extended procedures are necessary in order to assure
that there are no exceptions to the buyer's commitment to accept and
pay for the goods sold (i.e., that the business reasons for the bill
and hold have not introduced a contingency to the buyer's commitment).
Delivery generally is not considered to have occurred unless the
product has been delivered to the customer's place of business or
another site specified by the customer. If the customer specifies an
intermediate site but a substantial portion of the sales price is not
payable until delivery is made to a final site, then revenue should not
be recognized until final delivery has occurred.\21\
---------------------------------------------------------------------------
\21\ FASB ASC paragraph 985-605-25-25.
---------------------------------------------------------------------------
b. Customer Acceptance
After delivery of a product or performance of a service, if
uncertainty exists about customer acceptance, revenue should not be
recognized until acceptance occurs.\22\ Customer acceptance provisions
may be included in a contract, among other reasons, to enforce a
customer's rights to (1) test the delivered product, (2) require the
seller to perform additional services subsequent to delivery of an
initial product or performance of an initial service (e.g., a seller is
required to install or activate delivered equipment), or (3) identify
other work necessary to be done before accepting the product. The staff
presumes that such contractual customer acceptance provisions are
substantive, bargained-for terms of an arrangement. Accordingly, when
such contractual customer acceptance provisions exist, the staff
generally believes that the seller should not recognize revenue until
customer acceptance occurs or the acceptance provisions lapse.
---------------------------------------------------------------------------
\22\ FASB ASC paragraph 985-605-25-21. Also, Concepts Statement
5, paragraph 83(b) states ``revenues are considered to have been
earned when the entity has substantially accomplished what it must
do to be entitled to the benefits represented by the revenues.'' If
an arrangement expressly requires customer acceptance, the staff
generally believes that customer acceptance should occur before the
entity has substantially accomplished what it must do to be entitled
to the benefits represented by the revenues, especially when the
seller is obligated to perform additional steps.
---------------------------------------------------------------------------
Question 1
Question: Do circumstances exist in which formal customer sign-off
(that a contractual customer acceptance provision is met) is
unnecessary to meet the requirements to recognize revenue?
Interpretive Response: Yes. Formal customer sign-off is not always
necessary to recognize revenue provided that the seller objectively
demonstrates that the criteria specified in the acceptance provisions
are satisfied. Customer acceptance provisions generally allow the
customer to cancel the arrangement when a seller delivers a product
that the customer has not yet agreed to purchase or delivers a product
that does not meet the specifications of the customer's order. In those
cases, revenue should not be recognized because a sale has not
occurred. In applying this concept, the staff observes that customer
acceptance provisions normally take one of four general forms. Those
forms, and how the staff generally assesses whether customer acceptance
provisions should result in revenue deferral, are described below:
(a) Acceptance provisions in arrangements that purport to be for
trial or evaluation purposes.\23\ In these arrangements, the seller
delivers a product to a customer, and the customer agrees to receive
the product, solely to give the customer the ability to evaluate the
delivered product prior to acceptance. The customer does not agree to
purchase the delivered product until it accepts the product. In some
cases, the acceptance provisions lapse by the passage of time without
the customer rejecting the delivered product, and in other cases
affirmative acceptance from the customer is necessary to trigger a
sales transaction. Frequently, the title to the product does not
transfer and payment terms are not established prior to customer
acceptance. These arrangements are, in substance, consignment
arrangements until the customer accepts the product as set forth in the
contract with the seller. Accordingly, in arrangements where products
are delivered for trial or evaluation purposes, revenue should not be
recognized until the earlier of when acceptance occurs or the
acceptance provisions lapse.
---------------------------------------------------------------------------
\23\ See, for example, FASB ASC paragraphs 985-605-25-28 through
985-605-25-29.
---------------------------------------------------------------------------
In contrast, other arrangements do not purport to be for trial or
evaluation purposes. In these instances, the seller delivers a
specified product pursuant to a customer's order, establishes payment
terms, and transfers title to the delivered product to the customer.
However, customer acceptance provisions may be included in the
arrangement to give the purchaser the ability to ensure the delivered
product meets the criteria set forth in its order. The staff evaluates
these provisions as follows:
(b) Acceptance provisions that grant a right of return or exchange
on the basis of subjective matters. An example of such a provision is
one that allows the customer to return a product if the customer is
dissatisfied with the product.\24\ The staff believes these provisions
are not different from general rights of return and should be accounted
for in accordance with FASB ASC Subtopic 605-15, Revenue Recognition--
Products. This Subtopic requires that the amount of future returns must
be reasonably estimable in order for revenue to be recognized prior to
the expiration of return rights.\25\ That estimate may not be made in
the absence of a large volume of homogeneous transactions or if
customer acceptance is likely to depend on conditions for which
sufficient historical experience is absent.\26\ Satisfaction of these
requirements may vary from product-to-product, location-to-location,
customer-to-customer, and vendor-to-vendor.
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\24\ FASB ASC paragraph 605-15-05-3.
\25\ FASB ASC subparagraph 605-15-25-1(f).
\26\ FASB ASC subparagraphs 605-15-25-3(c) and 605-15-25-3(d).
---------------------------------------------------------------------------
(c) Acceptance provisions based on seller-specified objective
criteria. An example of such a provision is one that gives the customer
a right of return or replacement if the delivered product is defective
or fails to meet the vendor's published specifications for the
product.\27\ Such rights are generally identical to those granted to
all others within the same class of customer and for which satisfaction
can be generally assured without consideration of conditions specific
to the customer. Provided the seller has previously demonstrated that
the product meets the specified criteria, the staff believes that these
provisions are not different from general or specific warranties and
should be accounted for as warranties in accordance with FASB ASC
Subtopic 450-20, Contingencies--Loss Contingencies. In this case, the
cost of potentially defective goods must be reliably estimable based on
a demonstrated history of substantially similar transactions.\28\
However, if the seller has not previously demonstrated that the
delivered product meets the seller's specifications, the staff believes
that revenue should be deferred until the specifications have been
objectively achieved.
---------------------------------------------------------------------------
\27\ FASB ASC paragraph 460-10-25-5 (Guarantees Topic) and FASB
ASC subparagraph 605-15-15-3(c).
\28\ FASB ASC paragraph 460-10-25-6.
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[[Page 17265]]
(d) Acceptance provisions based on customer-specified objective
criteria. These provisions are referred to in this document as
``customer-specific acceptance provisions'' against which substantial
completion and contract fulfillment must be evaluated. While formal
customer sign-off provides the best evidence that these acceptance
criteria have been met, revenue recognition also would be appropriate,
presuming all other revenue recognition criteria have been met, if the
seller reliably demonstrates that the delivered products or services
meet all of the specified criteria prior to customer acceptance. For
example, if a seller reliably demonstrates that a delivered product
meets the customer-specified objective criteria set forth in the
arrangement, the delivery criterion would generally be satisfied when
title and the risks and rewards of ownership transfers unless product
performance may reasonably be different under the customer's testing
conditions specified by the acceptance provisions. Further, the seller
should consider whether it would be successful in enforcing a claim for
payment even in the absence of formal sign-off. Whether the vendor has
fulfilled the terms of the contract before customer acceptance is a
matter of contract law, and depending on the facts and circumstances,
an opinion of counsel may be necessary to reach a conclusion.
Question 2
Facts: Consider an arrangement that calls for the transfer of title
to equipment upon delivery to a customer's site. However, customer-
specific acceptance provisions permit the customer to return the
equipment unless the equipment satisfies certain performance tests. The
arrangement calls for the vendor to perform the installation. Assume
the equipment and the installation are separate units of accounting
under FASB ASC Subtopic 605-25, Revenue Recognition--Multiple-Element
Arrangements.\29\
---------------------------------------------------------------------------
\29\ This fact is provided as an assumption to facilitate an
analysis of revenue recognition in this fact pattern. No
interpretation of FASB ASC Subtopic 605-25 is intended.
---------------------------------------------------------------------------
Question: Must revenue allocated to the equipment always be
deferred until installation and on-site testing are successfully
completed?
Interpretive Response: No. The staff would not object to revenue
recognition for the equipment upon delivery (presuming all other
revenue recognition criteria have been met for the equipment) if the
seller demonstrates that, at the time of delivery, the equipment
already meets all of the criteria and specifications in the customer-
specific acceptance provisions. This may be demonstrated if conditions
under which the customer intends to operate the equipment are
replicated in pre-shipment testing, unless the performance of the
equipment, once installed and operated at the customer's facility, may
reasonably be different from that tested prior to shipment.
Determining whether the delivered equipment meets all of a
product's criteria and specifications is a matter of judgment that must
be evaluated in light of the facts and circumstances of a particular
transaction. Consultation with knowledgeable project managers or
engineers may be necessary in such circumstances.
For example, if the customer acceptance provisions were based on
meeting certain size and weight characteristics, it should be possible
to determine whether those criteria have been met before shipment.
Historical experience with the same specifications and functionality of
a particular machine that demonstrates that the equipment meets the
customer's specifications also may provide sufficient evidence that the
currently shipped equipment satisfies the customer-specific acceptance
provisions.
If an arrangement includes customer acceptance criteria or
specifications that cannot be effectively tested before delivery or
installation at the customer's site, the staff believes that revenue
recognition should be deferred until it can be demonstrated that the
criteria are met. This situation usually will exist when equipment
performance can vary based on how the equipment works in combination
with the customer's other equipment, software, or environmental
conditions. In these situations, testing to determine whether the
criteria are met cannot be reasonably performed until the products are
installed or integrated at the customer's facility.
Although the following questions provide several examples
illustrating how the staff evaluates customer acceptance, the
determination of when customer-specific acceptance provisions of an
arrangement are met in the absence of the customer's formal
notification of acceptance depends on the weight of the evidence in the
particular circumstances. Different conclusions could be reached in
similar circumstances that vary only with respect to a single variable,
such as complexity of the equipment, nature of the interface with the
customer's environment, extent of the seller's experience with the same
type of transactions, or a particular clause in the agreement. The
staff believes management and auditors are uniquely positioned to
evaluate the facts and arrive at a reasoned conclusion. The staff will
not object to a determination that is well reasoned on the basis of
this guidance.
Question 3
Facts: Company E is an equipment manufacturer whose main product is
generally sold in a standard model. The contracts for sale of that
model provide for customer acceptance to occur after the equipment is
received and tested by the customer. The acceptance provisions state
that if the equipment does not perform to Company E's published
specifications, the customer may return the equipment for a full refund
or a replacement unit, or may require Company E to repair the equipment
so that it performs up to published specifications. Customer acceptance
is indicated by either a formal sign-off by the customer or by the
passage of 90 days without a claim under the acceptance provisions.
Title to the equipment passes upon delivery to the customer. Company E
does not perform any installation or other services on the equipment it
sells and tests each piece of equipment against its specifications
before shipment. Payment is due under Company E's normal payment terms
for that product 30 days after customer acceptance.
Company E receives an order from a new customer for a standard
model of its main product. Based on the customer's intended use of the
product, location and other factors, there is no reason that the
equipment would operate differently in the customer's environment than
it does in Company E's facility.
Question: Assuming all other revenue recognition criteria are met
(other than the issue raised with respect to the acceptance provision),
when should Company E recognize revenue from the sale of this piece of
equipment?
Interpretive Response: While the staff presumes that customer
acceptance provisions are substantive provisions that generally result
in revenue deferral, that presumption can be overcome as discussed
above. Although the contract includes a customer acceptance clause,
acceptance is based on meeting Company E's published specifications for
a standard model. Company E demonstrates that the equipment shipped
meets the specifications before shipment, and the equipment is expected
to operate the same in the customer's environment as it does in
[[Page 17266]]
Company E's. In this situation, Company E should evaluate the customer
acceptance provision as a warranty under FASB ASC Subtopic 450-20. If
Company E can reasonably and reliably estimate the amount of warranty
obligations, the staff believes that it should recognize revenue upon
delivery of the equipment, with an appropriate liability for probable
warranty obligations.
Question 4
Facts: Assume the same facts about Company E's equipment, contract
terms and customary practices as in Question 3 above. Company E enters
into an arrangement with a new customer to deliver a version of its
standard product modified as necessary to fit into a space of specific
dimensions while still meeting all of the published vendor
specifications with regard to performance. In addition to the customer
acceptance provisions relating to the standard performance
specifications, the customer may reject the equipment if it does not
conform to the specified dimensions. Company E creates a testing
chamber of the exact same dimensions as specified by the customer and
makes simple design changes to the product so that it fits into the
testing chamber. The equipment still meets all of the standard
performance specifications.
Question: Assuming all other revenue recognition criteria are met
(other than the issue raised with respect to the acceptance provision),
when should Company E recognize revenue from the sale of this piece of
equipment?
Interpretive Response: Although the contract includes a customer
acceptance clause that is based, in part, on a customer specific
criterion, Company E demonstrates that the equipment shipped meets that
objective criterion, as well as the published specifications, before
shipment. The staff believes that the customer acceptance provisions
related to the standard performance specifications should be evaluated
as a warranty under FASB ASC Subtopic 450-20. If Company E can
reasonably and reliably estimate the amount of warranty obligations, it
should recognize revenue upon delivery of the equipment, with an
appropriate liability for probable warranty obligations.
Question 5
Facts: Assume the same facts about Company E's equipment, contract
terms and customary practices as in Question 3 above. Company E enters
into an arrangement with a new customer to deliver a version of its
standard product modified as necessary to be integrated into the
customer's new assembly line while still meeting all of the standard
published vendor specifications with regard to performance. The
customer may reject the equipment if it fails to meet the standard
published performance specifications or cannot be satisfactorily
integrated into the new line. Company E has never modified its
equipment to work on an integrated basis in the type of assembly line
the customer has proposed. In response to the request, Company E
designs a version of its standard equipment that is modified as
believed necessary to operate in the new assembly line. The modified
equipment still meets all of the standard published performance
specifications, and Company E believes the equipment will meet the
requested specifications when integrated into the new assembly line.
However, Company E is unable to replicate the new assembly line
conditions in its testing.
Question: Assuming all other revenue recognition criteria are met
(other than the issue raised with respect to the acceptance provision),
when should Company E recognize revenue from the sale of this piece of
equipment?
Interpretive Response: This contract includes a customer acceptance
clause that is based, in part, on a customer specific criterion, and
Company E cannot demonstrate that the equipment shipped meets that
criterion before shipment. Accordingly, the staff believes that the
contractual customer acceptance provision has not been met at shipment.
Therefore, the staff believes that Company E should wait until the
product is successfully integrated at its customer's location and meets
the customer-specific criteria before recognizing revenue. While this
is best evidenced by formal customer acceptance, other objective
evidence that the equipment has met the customer-specific criteria may
also exist (e.g., confirmation from the customer that the
specifications were met).
c. Inconsequential or Perfunctory Performance Obligations
Question 1
Question: Does the failure to complete all activities related to a
unit of accounting preclude recognition of revenue for that unit of
accounting?
Interpretive Response: No. Assuming all other recognition criteria
are met, revenue for the unit of accounting may be recognized in its
entirety if the seller's remaining obligation is inconsequential or
perfunctory.
A seller should substantially complete or fulfill the terms
specified in the arrangement related to the unit of accounting at issue
in order for delivery or performance to have occurred.\30\ When
applying the substantially complete notion, the staff believes that
only inconsequential or perfunctory actions may remain incomplete such
that the failure to complete the actions would not result in the
customer receiving a refund or rejecting the delivered products or
services performed to date. In addition, the seller should have a
demonstrated history of completing the remaining tasks in a timely
manner and reliably estimating the remaining costs. If revenue is
recognized upon substantial completion of the terms specified in the
arrangement related to the unit of accounting at issue, all related
costs of performance or delivery should be accrued.
---------------------------------------------------------------------------
\30\ Concepts Statement 5, paragraph 83(b) states ``revenues are
considered to have been earned when the entity has substantially
accomplished what it must do to be entitled the benefits represented
by the revenues.''
---------------------------------------------------------------------------
Question 2
Question: What factors should be considered in the evaluation of
whether a remaining obligation related to a unit of accounting is
inconsequential or perfunctory?
Interpretive Response: A remaining performance obligation is not
inconsequential or perfunctory if it is essential to the functionality
of the delivered products or services. In addition, remaining
activities are not inconsequential or perfunctory if failure to
complete the activities would result in the customer receiving a full
or partial refund or rejecting (or a right to a refund or to reject)
the products delivered or services performed to date. The terms of the
sales contract regarding both the right to a full or partial refund and
the right of return or rejection should be considered when evaluating
whether a portion of the purchase price would be refundable. If the
company has a historical pattern of granting such rights, that
historical pattern should also be considered even if the current
contract expressly precludes such rights. Further, other factors should
be considered in assessing whether remaining obligations are
inconsequential or perfunctory. For example, the staff also considers
the following factors, which are not all-inclusive, to be indicators
that a remaining performance obligation is substantive rather than
inconsequential or perfunctory:
The seller does not have a demonstrated history of
completing the remaining tasks in a timely manner and reliably
estimating their costs.
[[Page 17267]]
The cost or time to perform the remaining obligations for
similar contracts historically has varied significantly from one
instance to another.
The skills or equipment required to complete the remaining
activity are specialized or are not readily available in the
marketplace.
The cost of completing the obligation, or the fair value
of that obligation, is more than insignificant in relation to such
items as the contract fee, gross profit, and operating income allocable
to the unit of accounting.
The period before the remaining obligation will be
extinguished is lengthy. Registrants should consider whether reasonably
possible variations in the period to complete performance affect the
certainty that the remaining obligations will be completed successfully
and on budget.
The timing of payment of a portion of the sales price is
coincident with completing performance of the remaining activity.
Registrants' determinations of whether remaining obligations are
inconsequential or perfunctory should be consistently applied.
Question 3
Facts: Consider a unit of accounting that includes both equipment
and installation because the two deliverables do not meet the
separation criteria under FASB ASC Subtopic 605-25. This may be because
the equipment does not have value to the customer on a standalone
basis, there is no objective and reliable evidence of fair value for
the installation or there is a general right of return when the
installation is not considered probable and in control of the vendor.
Question: In this situation, must all revenue be deferred until
installation is performed?
Interpretive Response: Yes, if installation is essential to the
functionality of the equipment.\31\ Examples of indicators that
installation is essential to the functionality of equipment include:
---------------------------------------------------------------------------
\31\ FASB ASC paragraph 985-605-25-12.
---------------------------------------------------------------------------
The installation involves significant changes to the
features or capabilities of the equipment or building complex
interfaces or connections;
The installation services are unavailable from other
vendors.\32\
---------------------------------------------------------------------------
\32\ See FASB ASC paragraphs 985-605-25-81 through 985-605-25-85
for analogous guidance.
---------------------------------------------------------------------------
Conversely, examples of indicators that installation is not
essential to the functionality of the equipment include:
The equipment is a standard product;
Installation does not significantly alter the equipment's
capabilities;
Other companies are available to perform the
installation.\33\
---------------------------------------------------------------------------
\33\ Ibid.
---------------------------------------------------------------------------
If it is determined that the undelivered service is not essential
to the functionality of the delivered product but a portion of the
contract fee is not payable until the undelivered service is delivered,
the staff would not consider that obligation to be inconsequential or
perfunctory. Generally, the portion of the contract price that is
withheld or refundable should be deferred until the outstanding service
is delivered because that portion would not be realized or
realizable.\34\
---------------------------------------------------------------------------
\34\ Concepts Statement 5, paragraph 83(a) and FASB ASC
subparagraph 605-15-25-1(b).
---------------------------------------------------------------------------
d. License Fee Revenue
Facts: Assume that intellectual property is physically delivered
and payment is received on December 20, upon the registrant's
consummation of an agreement granting its customer a license to use the
intellectual property for a term beginning on the following January 1.
Question: Should the license fee be recognized in the period ending
December 31?
Interpretive Response: No. In licensing and similar arrangements
(e.g., licenses of motion pictures, software, technology, and other
intangibles), the staff believes that delivery does not occur for
revenue recognition purposes until the license term begins.\35\
Accordingly, if a licensed product or technology is physically
delivered to the customer, but the license term has not yet begun,
revenue should not be recognized prior to inception of the license
term. Upon inception of the license term, revenue should be recognized
in a manner consistent with the nature of the transaction and the
earnings process.
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\35\ FASB ASC paragraph 926-605-25-1 (Entertainment--Films
Topic).
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e. Layaway Sales Arrangements
Facts: Company R is a retailer that offers ``layaway'' sales to its
customers. Company R retains the merchandise, sets it aside in its
inventory, and collects a cash deposit from the customer. Although
Company R may set a time period within which the customer must finalize
the purchase, Company R does not require the customer to enter into an
installment note or other fixed payment commitment or agreement when
the initial deposit is received. The merchandise generally is not
released to the customer until the customer pays the full purchase
price. In the event that the customer fails to pay the remaining
purchase price, the customer forfeits its cash deposit. In the event
the merchandise is lost, damaged, or destroyed, Company R either must
refund the cash deposit to the customer or provide replacement
merchandise.
Question: In the staff's view, when may Company R recognize revenue
for merchandise sold under its layaway program?
Interpretive Response: Provided that the other criteria for revenue
recognition are met, the staff believes that Company R should recognize
revenue from sales made under its layaway program upon delivery of the
merchandise to the customer. Until then, the amount of cash received
should be recognized as a liability entitled such as ``deposits
received from customers for layaway sales'' or a similarly descriptive
caption. Because Company R retains the risks of ownership of the
merchandise, receives only a deposit from the customer, and does not
have an enforceable right to the remainder of the purchase price, the
staff would object to Company R recognizing any revenue upon receipt of
the cash deposit. This is consistent with item two (2) in the
Commission's criteria for bill-and-hold transactions which states ``the
customer must have made a fixed commitment to purchase the goods.''
f. Nonrefundable Up-front Fees
Question 1
Facts: Registrants may negotiate arrangements pursuant to which
they may receive nonrefundable fees upon entering into arrangements or
on certain specified dates. The fees may ostensibly be received for
conveyance of a license or other intangible right or for delivery of
particular products or services. Various business factors may influence
how the registrant and customer structure the payment terms. For
example, in exchange for a greater up-front fee for an intangible
right, the registrant may be willing to receive lower unit prices for
related products to be delivered in the future. In some circumstances,
the right, product, or service conveyed in conjunction with the
nonrefundable fee has no utility to the purchaser separate and
independent of the registrant's performance of the other elements of
the arrangement. Therefore, in the absence of the registrant's
continuing involvement under the arrangement, the customer would not
have paid the fee. Examples of this type of arrangement include the
following:
[[Page 17268]]
A registrant sells a lifetime membership in a health club.
After paying a nonrefundable ``initiation fee,'' the customer is
permitted to use the health club indefinitely, so long as the customer
also pays an additional usage fee each month. The monthly usage fees
collected from all customers are adequate to cover the operating costs
of the health club.
A registrant in the biotechnology industry agrees to
provide research and development activities for a customer for a
specified term. The customer needs to use certain technology owned by
the registrant for use in the research and development activities. The
technology is not sold or licensed separately without the research and
development activities. Under the terms of the arrangement, the
customer is required to pay a nonrefundable ``technology access fee''
in addition to periodic payments for research and development
activities over the term of the contract.
A registrant requires a customer to pay a nonrefundable
``activation fee'' when entering into an arrangement to provide
telecommunications services. The terms of the arrangement require the
customer to pay a monthly usage fee that is adequate to recover the
registrant's operating costs. The costs incurred to activate the
telecommunications service are nominal.
A registrant charges users a fee for non-exclusive access
to its Web site that contains proprietary databases. The fee allows
access to the Web site for a one-year period. After the customer is
provided with an identification number and trained in the use of the
database, there are no incremental costs that will be incurred in
serving this customer.
A registrant charges a fee to users for advertising a
product for sale or auction on certain pages of its Web site. The
company agrees to maintain the listing for a period of time. The cost
of maintaining the advertisement on the Web site for the stated period
is minimal.
A registrant charges a fee for hosting another company's
Web site for one year. The arrangement does not involve exclusive use
of any of the hosting company's servers or other equipment. Almost all
of the projected costs to be incurred will be incurred in the initial
loading of information on the host company's Internet server and
setting up appropriate links and network connections.
Question: Assuming these arrangements qualify as single units of
accounting under FASB ASC Subtopic 605-25,\36\ when should the revenue
relating to nonrefundable, up-front fees in these types of arrangements
be recognized?
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\36\ The staff believes that the vendor activities associated
with the up-front fee, even if considered a deliverable to be
evaluated under FASB ASC Subtopic 605-25, will rarely provide value
to the customer on a standalone basis.
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Interpretive Response: The staff believes that registrants should
consider the specific facts and circumstances to determine the
appropriate accounting for nonrefundable, up-front fees. Unless the up-
front fee is in exchange for products delivered or services performed
that represent the culmination of a separate earnings process,\37\ the
deferral of revenue is appropriate.
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\37\ See Concepts Statement 5, footnote 51, for a description of
the ``earning process.''
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In the situations described above, the staff does not view the
activities completed by the registrants (i.e., selling the membership,
signing the contract, enrolling the customer, activating
telecommunications services or providing initial set-up services) as
discrete earnings events.\38\ The terms, conditions, and amounts of
these fees typically are negotiated in conjunction with the pricing of
all the elements of the arrangement, and the customer would ascribe a
significantly lower, and perhaps no, value to elements ostensibly
associated with the up-front fee in the absence of the registrant's
performance of other contract elements. The fact that the registrants
do not sell the initial rights, products, or services separately (i.e.,
without the registrants' continuing involvement) supports the staff's
view. The staff believes that the customers are purchasing the on-going
rights, products, or services being provided through the registrants'
continuing involvement. Further, the staff believes that the earnings
process is completed by performing under the terms of the arrangements,
not simply by originating a revenue-generating arrangement.
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\38\ In a similar situation, lenders may collect nonrefundable
loan origination fees in connection with lending activities. The
FASB concluded in FASB ASC Subtopic 310-20, Receivables--
Nonrefundable Fees and Other Costs, that loan origination is not a
separate revenue-producing activity of a lender, and therefore,
those nonrefundable fees collected at the outset of the loan
arrangement are not recognized as revenue upon receipt but are
deferred and recognized over the life of the loan (FASB ASC
paragraph 310-20-35-2).
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While the incurrence of nominal up-front costs helps make it clear
that there is not a separate earnings event in the telecommunications
example above, incurrence of substantive costs, such as in the Web
hosting example above, does not necessarily indicate that there is a
separate earnings event. Whether there is a separate earnings event
should be evaluated on a case-by-case basis. Some have questioned
whether revenue may be recognized in these transactions to the extent
of the incremental direct costs incurred in the activation. Because
there is no separable deliverable or earnings event, the staff would
generally object to that approach, except where it is provided for in
the authoritative literature (e.g., FASB ASC Subtopic 922-605,
Entertainment--Cable Television--Revenue Recognition).
Supply or service transactions may involve the charge of a
nonrefundable initial fee with subsequent periodic payments for future
products or services. The initial fees may, in substance, be wholly or
partly an advance payment for future products or services. In the
examples above, the on-going rights or services being provided or
products being delivered are essential to the customers receiving the
expected benefit of the up-front payment. Therefore, the up-front fee
and the continuing performance obligation related to the services to be
provided or products to be delivered are assessed as an integrated
package. In such circumstances, the staff believes that up-front fees,
even if nonrefundable, are earned as the products and/or services are
delivered and/or performed over the term of the arrangement or the
expected period of performance \39\ and generally should be deferred
and recognized systematically over the periods that the fees are
earned.\40\
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\39\ The revenue recognition period should extend beyond the
initial contractual period if the relationship with the customer is
expected to extend beyond the initial term and the customer
continues to benefit from the payment of the up-front fee (e.g., if
subsequent renewals are priced at a bargain to the initial up-front
fee).
\40\ A systematic method would be on a straight-line basis,
unless evidence suggests that revenue is earned or obligations are
fulfilled in a different pattern, in which case that pattern should
be followed.
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Some propose that revenue should be recognized when the initial
set-up is completed in cases where the on-going obligation involves
minimal or no cost or effort and should, therefore, be considered
perfunctory or inconsequential. However, the staff believes that the
substance of each of these transactions indicates that the purchaser is
paying for a service that is delivered over time. Therefore, revenue
recognition should occur over time, reflecting the provision of
service.\41\
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\41\ Concepts Statement 5, paragraph 84(d).
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Question 2
Facts: Company A provides its customers with activity tracking or
[[Page 17269]]
similar services (e.g., tracking of property tax payment activity,
sending delinquency letters on overdue accounts, etc.) for a ten-year
period. Company A requires customers to prepay for all the services for
the term specified in the arrangement. The on-going services to be
provided are generally automated after the initial customer set-up. At
the outset of the arrangement, Company A performs set-up procedures to
facilitate delivery of its on-going services to the customers. Such
procedures consist primarily of establishing the necessary records and
files in Company A's pre-existing computer systems in order to provide
the services. Once the initial customer set-up activities are complete,
Company A provides its services in accordance with the arrangement.
Company A is not required to refund any portion of the fee if the
customer terminates the services or does not utilize all of the
services to which it is entitled. However, Company A is required to
provide a refund if Company A terminates the arrangement early. Assume
Company A's activities are not within the scope of FASB ASC Subtopic
310-20, Receivables--Nonrefundable Fees and Other Costs, and that this
arrangement qualifies as a single unit of accounting under FASB ASC
Subtopic 605-25.\42\
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\42\ See Note 36, supra.
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Question: When should Company A recognize the service revenue?
Interpretive Response: The staff believes that, provided all other
revenue recognition criteria are met, service revenue should be
recognized on a straight-line basis, unless evidence suggests that the
revenue is earned or obligations are fulfilled in a different pattern,
over the contractual term of the arrangement or the expected period
during which those specified services will be performed,\43\ whichever
is longer. In this case, the customer contracted for the on-going
activity tracking service, not for the set-up activities. The staff
notes that the customer could not, and would not, separately purchase
the set-up services without the on-going services. The services
specified in the arrangement are performed continuously over the
contractual term of the arrangement (and any subsequent renewals).
Therefore, the staff believes that Company A should recognize revenue
on a straight-line basis, unless evidence suggests that the revenue is
earned or obligations are fulfilled in a different pattern, over the
contractual term of the arrangement or the expected period during which
those specified services will be performed, whichever is longer.
---------------------------------------------------------------------------
\43\ See Note 39, supra.
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In this situation, the staff would object to Company A recognizing
revenue in proportion to the costs incurred because the set-up costs
incurred bear no direct relationship to the performance of services
specified in the arrangement. The staff also believes that it is
inappropriate to recognize the entire amount of the prepayment as
revenue at the outset of the arrangement by accruing the remaining
costs because the services required by the contract have not been
performed.
Question 3
Facts: Assume the same facts as in Question 2 above.
Question: Are the initial customer set-up costs incurred by Company
A within the scope of FASB ASC Subtopic 720-15, Other Expenses--Start-
Up Costs?
Interpretive Response: FASB ASC paragraph 720-15-15-4 states that
the guidance does not address the financial reporting of costs incurred
related to ``ongoing customer acquisition costs, such as policy
acquisition costs'' addressed in FASB ASC Subtopic 944-30, Financial
Services--Insurance--Acquisition Costs, and ``loan origination costs''
addressed in FASB ASC Subtopic 310-20. This guidance addresses the more
substantive one-time efforts to establish business with an entirely new
class of customers (for example, a manufacturer who does all of its
business with retailers attempts to sell merchandise directly to the
public). As such, the set-up costs incurred in this example are not
within the scope of FASB ASC Subtopic 720-15.
The staff believes that the incremental direct costs (the FASB ASC
Master Glossary provides a definition) incurred related to the
acquisition or origination of a customer contract in a transaction that
results in the deferral of revenue, unless specifically provided for in
the authoritative literature, may be either expensed as incurred or
accounted for in accordance with FASB ASC paragraph 605-20-25-4 or FASB
ASC paragraph 310-20-25-2. The staff believes the accounting policy
chosen for these costs should be disclosed and applied consistently.
Question 4
Facts: Assume the same facts as in Question 2 above.
Question: What is the staff's view of the pool of contract
acquisition and origination costs that are eligible for capitalization?
Interpretive Response: As noted in Question 3 above, the FASB ASC
Master Glossary includes a definition of incremental direct costs. FASB
ASC Subtopic 310-10, Receivables--Overall, provides further guidance on
the types of costs eligible for capitalization as customer acquisition
costs indicating that only costs that result from successful loan
origination efforts are capitalized. Further, FASB ASC Subtopic 605-20,
Revenue Recognition--Services, also requires capitalization of
incremental direct customer acquisition costs. Although the facts of a
particular situation should be analyzed closely to capture those costs
that are truly direct and incremental, the staff generally would not
object to an accounting policy that results in the capitalization of
costs in accordance with FASB ASC Subtopic 310-20, Receivables--
Nonrefundable Fees and Other Costs, or FASB ASC Subtopic 605-20.
Registrants should disclose their policies for determining which costs
to capitalize as contract acquisition and origination costs.
Question 5
Facts: Assume the same facts as in Question 2 above. Based on the
guidance in Questions 2, 3 and 4 above, Company A has capitalized
certain direct and incremental customer set-up costs associated with
the deferred revenue.
Question: Over what period should Company A amortize these costs?
Interpretive Response: When both costs and revenue (in an amount
equal to or greater than the costs) are deferred, the staff believes
that the capitalized costs should be charged to expense proportionally
and over the same period that deferred revenue is recognized as
revenue.\44\
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\44\ FASB ASC paragraph 605-20-25-4.
---------------------------------------------------------------------------
g. Deliverables Within an Arrangement
Question: If a company (the seller) has a patent to its
intellectual property which it licenses to customers, the seller may
represent and warrant to its licensees that it has a valid patent, and
will defend and maintain that patent. Does that obligation to maintain
and defend patent rights, in and of itself, constitute a deliverable to
be evaluated under FASB ASC Subtopic 605-25?
Interpretive Response: No. Provided the seller has legal and valid
patents upon entering the license arrangement, existing GAAP on
licenses of intellectual property (e.g., FASB ASC Subtopic 985-605,
Software--Revenue Recognition, FASB ASC Subtopic 926-605,
Entertainment--Films--Revenue Recognition, and FASB ASC Subtopic 928-
605, Entertainment--Music--Revenue Recognition) does not indicate
[[Page 17270]]
that an obligation to defend valid patents represents an additional
deliverable to which a portion of an arrangement fee should be
allocated in an arrangement that otherwise qualifies for sales-type
accounting. While this clause may obligate the licenser to incur costs
in the defense and maintenance of the patent, that obligation does not
involve an additional deliverable to the customer. Defending the patent
is generally consistent with the seller's representation in the license
that such patent is legal and valid. Therefore, the staff would not
consider a clause like this to represent an additional deliverable in
the arrangement.\45\
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\45\ Note, however, the staff believes that this obligation
qualifies as a guarantee within the scope of FASB ASC Topic 460,
subject to a scope exception from the initial recognition and
measurement provisions.
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4. Fixed or Determinable Sales Price
a. Refundable Fees for Services
A company's contracts may include customer cancellation or
termination clauses. Cancellation or termination provisions may be
indicative of a demonstration period or an otherwise incomplete
transaction. Examples of transactions that financial management and
auditors should be aware of and where such provisions may exist include
``side'' agreements and significant transactions with unusual terms and
conditions. These contractual provisions raise questions as to whether
the sales price is fixed or determinable. The sales price in
arrangements that are cancelable by the customer is neither fixed nor
determinable until the cancellation privileges lapse.\46\ If the
cancellation privileges expire ratably over a stated contractual term,
the sales price is considered to become determinable ratably over the
stated term.\47\ Short-term rights of return, such as thirty-day money-
back guarantees, and other customary rights to return products are not
considered to be cancellation privileges, but should be accounted for
in accordance with FASB ASC Subtopic 605-15, Revenue Recognition--
Products.\48\
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\46\ FASB ASC paragraph 985-605-25-37.
\47\ Ibid.
\48\ Ibid.
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Question 1
Facts: Company M is a discount retailer. It generates revenue from
annual membership fees it charges customers to shop at its stores and
from the sale of products at a discount price to those customers. The
membership arrangements with retail customers require the customer to
pay the entire membership fee (e.g., $35) at the outset of the
arrangement. However, the customer has the unilateral right to cancel
the arrangement at any time during its term and receive a full refund
of the initial fee. Based on historical data collected over time for a
large number of homogeneous transactions, Company M estimates that
approximately 40% of the customers will request a refund before the end
of the membership contract term. Company M's data for the past five
years indicates that significant variations between actual and
estimated cancellations have not occurred, and Company M does not
expect significant variations to occur in the foreseeable future.
Question: May Company M recognize in earnings the revenue for the
membership fees and accrue the costs to provide membership services at
the outset of the arrangement?
Interpretive Response: No. In the staff's view, it would be
inappropriate for Company M to recognize the membership fees as earned
revenue upon billing or receipt of the initial fee with a corresponding
accrual for estimated costs to provide the membership services. This
conclusion is based on Company M's remaining and unfulfilled
contractual obligation to perform services (i.e., make available and
offer products for sale at a discounted price) throughout the
membership period. Therefore, the earnings process, irrespective of
whether a cancellation clause exists, is not complete.
In addition, the ability of the member to receive a full refund of
the membership fee up to the last day of the membership term raises an
uncertainty as to whether the fee is fixed or determinable at any point
before the end of the term. Generally, the staff believes that a sales
price is not fixed or determinable when a customer has the unilateral
right to terminate or cancel the contract and receive a cash refund. A
sales price or fee that is variable until the occurrence of future
events (other than product returns that are within the scope of FASB
ASC Subtopic 605-15) generally is not fixed or determinable until the
future event occurs. The revenue from such transactions should not be
recognized in earnings until the sales price or fee becomes fixed or
determinable. Moreover, revenue should not be recognized in earnings by
assessing the probability that significant, but unfulfilled, terms of a
contract will be fulfilled at some point in the future. Accordingly,
the revenue from such transactions should not be recognized in earnings
prior to the refund privileges expiring. The amounts received from
customers or subscribers (i.e., the $35 fee mentioned above) should be
credited to a monetary liability account such as ``customers'
refundable fees.''
The staff believes that if a customer has the unilateral right to
receive both (1) the seller's substantial performance under an
arrangement (e.g., providing services or delivering product) and (2) a
cash refund of prepaid fees, then the prepaid fees should be accounted
for as a monetary liability. In consideration of whether the monetary
liability can be derecognized, FASB ASC Topic 860, Transfers and
Servicing, provides that liabilities may be derecognized only if (1)
the debtor pays the creditor and is relieved of its obligation for the
liability (paying the creditor includes delivery of cash, other
financial assets, goods, or services or reacquisition by the debtor of
its outstanding debt securities) or (2) the debtor is legally released
from being the primary obligor under the liability.\49\ If a customer
has the unilateral right to receive both (1) the seller's substantial
performance under the arrangement and (2) a cash refund of prepaid
fees, then the refund obligation is not relieved upon performance of
the service or delivery of the products. Rather, the seller's refund
obligation is relieved only upon refunding the cash or expiration of
the refund privilege.
---------------------------------------------------------------------------
\49\ FASB ASC paragraph 405-20-40-1 (Liabilities Topic).
---------------------------------------------------------------------------
Some have argued that there may be a limited exception to the
general rule that revenue from membership or other service transaction
fees should not be recognized in earnings prior to the refund
privileges expiring. Despite the fact that FASB ASC Subtopic 605-15
expressly does not apply to the accounting for service revenue if part
or all of the service fee is refundable under cancellation privileges
granted to the buyer,\50\ they believe that in certain circumstances a
potential refund of a membership fee may be seen as being similar to a
right of return of products under FASB ASC Subtopic 605-15. They argue
that revenue from membership fees, net of estimated refunds, may be
recognized ratably over the period the services are performed whenever
pertinent conditions of FASB ASC Subtopic 605-15 are met, namely, there
is a large population of transactions that grant customers the same
unilateral termination or cancellation rights and reasonable estimates
can be made of how many customers likely will exercise those rights.
---------------------------------------------------------------------------
\50\ FASB ASC paragraph 605-15-15-3.
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[[Page 17271]]
The staff believes that, because service arrangements are
specifically excluded from the scope of FASB ASC Subtopic 605-15, the
most direct authoritative literature to be applied to the
extinguishment of obligations under such contracts is FASB ASC Topic
860. As noted above, because the refund privilege extends to the end of
the contract term irrespective of the amount of the service performed,
FASB ASC Topic 860 indicates that the liability would not be
extinguished (and therefore no revenue would be recognized in earnings)
until the cancellation or termination and related refund privileges
expire. Nonetheless, the staff recognizes that over the years the
accounting for membership refunds evolved based on analogy to FASB ASC
Subtopic 605-15 and that practice did not change when FASB ASC Topic
860 became effective. Reasonable people held, and continue to hold,
different views about the application of the accounting literature.
Pending further action in this area by the FASB, the staff will not
object to the recognition of refundable membership fees, net of
estimated refunds, as earned revenue over the membership term in the
limited circumstances where all of the following criteria have been
met: \51\
---------------------------------------------------------------------------
\51\ The staff will question further analogies to the guidance
in FASB ASC Subtopic 605-15 for transactions expressly excluded from
its scope.
---------------------------------------------------------------------------
The estimates of terminations or cancellations and refunded
revenues are being made for a large pool of homogeneous items (e.g.,
membership or other service transactions with the same characteristics
such as terms, periods, class of customers, nature of service, etc.).
Reliable estimates of the expected refunds can be made on
a timely basis.\52\ Either of the following two items would be
considered indicative of an inability to make reliable estimates: (1)
recurring, significant differences between actual experience and
estimated cancellation or termination rates (e.g., an actual
cancellation rate of 40% versus an estimated rate of 25%) even if the
impact of the difference on the amount of estimated refunds is not
material to the consolidated financial statements \53\ or (2) recurring
variances between the actual and estimated amount of refunds that are
material to either revenue or net income in quarterly or annual
financial statements. In addition, the staff believes that an estimate,
for purposes of meeting this criterion, would not be reliable unless it
is remote \54\ that material adjustments (both individually and in the
aggregate) to previously recognized revenue would be required. The
staff presumes that reliable estimates cannot be made if the customer's
termination or cancellation and refund privileges exceed one year.
---------------------------------------------------------------------------
\52\ Reliability is defined in Concepts Statement 2 as ``the
quality of information that assures that information is reasonably
free from error and bias and faithfully represents what it purports
to represent.'' Paragraph 63 of Concepts Statement 5 reiterates the
definition of reliability, requiring that ``the information is
representationally faithful, verifiable, and neutral.''
\53\ For example, if an estimate of the expected cancellation
rate varies from the actual cancellation rate by 100% but the dollar
amount of the error is immaterial to the consolidated financial
statements, some would argue that the estimate could still be viewed
as reliable. The staff disagrees with that argument.
\54\ The term ``remote'' is used here with the same definition
as used in the FASB ASC Master Glossary.
---------------------------------------------------------------------------
There is a sufficient company-specific historical basis
upon which to estimate the refunds,\55\ and the company believes that
such historical experience is predictive of future events. In assessing
these items, the staff believes that estimates of future refunds should
take into consideration, among other things, such factors as historical
experience by service type and class of customer, changing trends in
historical experience and the basis thereof (e.g., economic
conditions), the impact or introduction of competing services or
products, and changes in the customer's ``accessibility'' to the refund
(i.e., how easy it is for customers to obtain the refund).
---------------------------------------------------------------------------
\55\ FASB ASC paragraph 605-15-25-3 notes various factors that
may impair the ability to make a reasonable estimate of returns,
including the lack of sufficient historical experience. The staff
typically expects that the historical experience be based on the
particular registrant's historical experience for a service and/or
class of customer. In general, the staff typically expects a start-
up company, a company introducing new services, or a company
introducing services to a new class of customer to have at least two
years of experience to be able to make reasonable and reliable
estimates.
---------------------------------------------------------------------------
The amount of the membership fee specified in the
agreement at the outset of the arrangement is fixed, other than the
customer's right to request a refund.
If Company M does not meet all of the foregoing criteria, the staff
believes that Company M should not recognize in earnings any revenue
for the membership fee until the cancellation privileges and refund
rights expire.
If revenue is recognized in earnings over the membership period
pursuant to the above criteria, the initial amounts received from
customer or subscribers (i.e., the $35 fee mentioned above) should be
allocated to two liability accounts. The amount of the fee representing
estimated refunds should be credited to a monetary liability account,
such as ``customers' refundable fees,'' and the remaining amount of the
fee representing unearned revenue should be credited to a nonmonetary
liability account, such as ``unearned revenues.'' For each income
statement presented, registrants should disclose in the footnotes to
the financial statements the amounts of (1) the unearned revenue and
(2) refund obligations as of the beginning of each period, the amount
of cash received from customers, the amount of revenue recognized in
earnings, the amount of refunds paid, other adjustments (with an
explanation thereof), and the ending balance of (1) unearned revenue
and (2) refund obligations.
If revenue is recognized in earnings over the membership period
pursuant to the above criteria, the staff believes that adjustments for
changes in estimated refunds should be recorded using a retrospective
approach whereby the unearned revenue and refund obligations are
remeasured and adjusted at each balance sheet date with the offset
being recorded as earned revenue.\56\
---------------------------------------------------------------------------
\56\ The staff believes deferred costs being amortized on a
basis consistent with the deferred revenue should be similarly
adjusted. Such an approach is generally consistent with the
amortization methodology in FASB ASC paragraph 310-20-35-26.
---------------------------------------------------------------------------
Companies offering memberships often distribute membership packets
describing and discussing the terms, conditions, and benefits of
membership. Packets may include vouchers, for example, that provide new
members with discounts or other benefits from third parties. The costs
associated with the vouchers should be expensed when distributed.
Advertising costs to solicit members should be accounted for in
accordance with FASB ASC Subtopic 720-35, Other Expenses--Advertising
Costs. Incremental direct costs incurred in connection with enrolling
customers (e.g., commissions paid to agents) should be accounted for as
follows: (1) If revenue is deferred until the cancellation or
termination privileges expire, incremental direct costs should be
either (a) charged to expense when incurred if the costs are not
refundable to the company in the event the customer obtains a refund of
the membership fee, or (b) if the costs are refundable to the company
in the event the customer obtains a refund of the membership fee,
recorded as an asset until the earlier of termination or cancellation
or refund; or (2) if revenue, net of estimated refunds, is recognized
in earnings over the membership period, a like percentage of
incremental direct costs should be deferred and recognized in earnings
in the same pattern as revenue is recognized, and the
[[Page 17272]]
remaining portion should be either (a) charged to expense when incurred
if the costs are not refundable to the company in the event the
customer obtains a refund of the membership fee, or (b) if the costs
are refundable to the company in the event the customer obtains a
refund of the membership fee, recorded as an asset until the refund
occurs.\57\ All costs other than incremental direct costs (e.g.,
indirect costs) should be expensed as incurred.
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\57\ FASB ASC paragraphs 310-20-25-2 and 605-20-25-4 both
provide for the deferral of incremental direct costs associated with
acquiring a revenue-producing contract. Even though the revenue
discussed in this example is refundable, if a registrant meets the
aforementioned criteria for revenue recognition over the membership
period, the staff would analogize to this guidance. However, if
neither a nonrefundable contract nor a reliable basis for estimating
net cash inflows under refundable contracts exists to provide a
basis for recovery of incremental direct costs, the staff believes
that such costs should be expensed as incurred. See SAB Topic
13.A.3.f. Question 3.
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Question 2
Question: Will the staff accept an analogy to FASB ASC Subtopic
605-15 for service transactions subject to customer cancellation
privileges other than those specifically addressed in the previous
question?
Interpretive Response: The staff has accepted the analogy in
limited circumstances due to the existence of a large pool of
homogeneous transactions and satisfaction of the criteria in the
previous question. Examples of other arrangements involving customer
cancellation privileges and refundable service fees that the staff has
addressed include the following:
A leasing broker whose commission from the lessor upon a
commercial tenant's signing of a lease agreement is refundable (or in
some cases, is not due) under lessor cancellation privileges if the
tenant fails to move into the leased premises by a specified date.
A talent agent whose fee receivable from its principal
(i.e., a celebrity) for arranging a celebrity endorsement for a five-
year term is cancelable by the celebrity if the celebrity breaches the
endorsement contract with its customer.
An insurance agent whose commission received from the
insurer upon selling an insurance policy is refundable in whole for the
30-day period that state law permits the consumer to repudiate the
contract and then refundable on a declining pro rata basis until the
consumer has made six monthly payments.
In the first two of these cases, the staff advised the registrants
that the portion of revenue subject to customer cancellation and refund
must be deferred until no longer subject to that contingency because
the registrants did not have an ability to make reliable estimates of
customer cancellations due to the lack of a large pool of homogeneous
transactions. In the case of the insurance agent, however, the
particular registrant demonstrated that it had a sufficient history of
homogeneous transactions with the same characteristics from which to
reliably estimate contract cancellations and satisfy all the criteria
specified in the previous question. Accordingly, the staff did not
object to that registrant's policy of recognizing its sales commission
as revenue when its performance was complete, with an appropriate
allowance for estimated cancellations.
Question 3
Question: Must a registrant analogize to FASB ASC Subtopic 605-15,
or may it choose to defer all revenue until the refund period lapses as
suggested by FASB ASC Topic 860 even if the criteria above for analogy
to FASB ASC Subtopic 605-15 are met?
Interpretive Response: The analogy to FASB ASC Subtopic 605-15 is
presented as an alternative that would be acceptable to the staff when
the listed conditions are met. However, a registrant may choose to
defer all revenue until the refund period lapses. The policy chosen
should be disclosed and applied consistently.
Question 4
Question: May a registrant that meets the above criteria for
reliable estimates of cancellations choose at some point in the future
to change from the FASB ASC Subtopic 605-15 method to the FASB ASC
Topic 860 method of accounting for these refundable fees? May a
registrant change from the FASB ASC Topic 860 method to the FASB ASC
Subtopic 605-15 method?
Interpretive Response: The staff believes that FASB ASC Topic 860
provides a preferable accounting model for service transactions subject
to potential refunds. Therefore, the staff would not object to a change
from the FASB ASC Subtopic 605-15 method to the FASB ASC Topic 860
method. However, if a registrant had previously chosen the FASB ASC
Topic 860 method, the staff would object to a change to the FASB ASC
Subtopic 605-15 method.
Question 5
Question: Is there a minimum level of customers that must be
projected not to cancel before use of FASB ASC Subtopic 605-15 type
accounting is appropriate?
Interpretive Response: FASB ASC Subtopic 605-15 does not include
any such minimum. Therefore, the staff does not believe that a minimum
must apply in service transactions either. However, as the refund rate
increases, it may be increasingly difficult to make reasonable and
reliable estimates of cancellation rates.
Question 6
Question: When a registrant first determines that reliable
estimates of cancellations of service contracts can be made (e.g., two
years of historical evidence becomes available), how should the change
from the complete deferral method to the method of recognizing revenue,
net of estimated cancellations, over time be reflected?
Interpretive Response: Changes in the ability to meet the criteria
set forth above should be accounted for in the manner described in FASB
ASC paragraph 605-15-25-1, which addresses the accounting when a
company experiences a change in the ability to make reasonable
estimates of future product returns.
b. Estimates and Changes in Estimates
Accounting for revenues and costs of revenues requires estimates in
many cases; those estimates sometimes change. Registrants should ensure
that they have appropriate internal controls and adequate books and
records that will result in timely identification of necessary changes
in estimates that should be reflected in the financial statements and
notes thereto.
Question 1
Facts: FASB ASC paragraph 605-15-25-3 lists a number of factors
that may impair the ability to make a reasonable estimate of product
returns in sales transactions when a right of return exists.\58\ The
paragraph concludes by stating ``other factors may preclude a
reasonable estimate.''
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\58\ These factors include ``(a) the susceptibility of the
product to significant external factors, such as technological
obsolescence or changes in demand, (b) relatively long periods in
which a particular product may be returned, (c) absence of
historical experience with similar types of sales of similar
products, or inability to apply such experience because of changing
circumstances, for example, changes in the selling enterprise's
marketing policies and relationships with its customers, and (d)
absence of a large volume of relatively homogeneous transactions.''
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Question: What ``other factors,'' in addition to those listed in
FASB ASC paragraph 605-15-25-3, has the staff identified that may
preclude a registrant from making a reasonable and reliable estimate of
product returns?
Interpretive Response: The staff believes that the following
additional
[[Page 17273]]
factors, among others, may affect or preclude the ability to make
reasonable and reliable estimates of product returns: (1) Significant
increases in or excess levels of inventory in a distribution channel
(sometimes referred to as ``channel stuffing''), (2) lack of
``visibility'' into or the inability to determine or observe the levels
of inventory in a distribution channel and the current level of sales
to end users, (3) expected introductions of new products that may
result in the technological obsolescence of and larger than expected
returns of current products, (4) the significance of a particular
distributor to the registrant's (or a reporting segment's) business,
sales and marketing, (5) the newness of a product, (6) the introduction
of competitors' products with superior technology or greater expected
market acceptance, and (7) other factors that affect market demand and
changing trends in that demand for the registrant's products.
Registrants and their auditors should carefully analyze all factors,
including trends in historical data, which may affect registrants'
ability to make reasonable and reliable estimates of product returns.
The staff reminds registrants that if a transaction fails to meet
all of the conditions of FASB ASC paragraphs 605-15-25-1 and 605-15-25-
3, no revenue may be recognized until those conditions are subsequently
met or the return privilege has substantially expired, whichever occurs
first.\59\ Simply deferring recognition of the gross margin on the
transaction is not appropriate.
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\59\ FASB ASC paragraph 605-15-25-1.
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Question 2
Question: Is the requirement cited in the previous question for
``reliable'' estimates meant to imply a new, higher requirement than
the ``reasonable'' estimates discussed in FASB ASC Subtopic 605-15?
Interpretive Response: No. ``Reliability'' of financial information
is one of the qualities of accounting information discussed in Concepts
Statement 2, Qualitative Characteristics of Accounting Information. The
staff's expectation that estimates be reliable does not change the
existing requirement of FASB ASC Subtopic 605-15. If management cannot
develop an estimate that is sufficiently reliable for use by investors,
the staff believes it cannot make a reasonable estimate meeting the
requirements of that standard.
Question 3
Question: Does the staff expect registrants to apply the guidance
in Question 1 of Topic 13.A.4(a) above to sales of tangible goods and
other transactions specifically within the scope of FASB ASC Subtopic
605-15?
Interpretive Response: The specific guidance above does not apply
to transactions within the scope of FASB ASC Subtopic 605-15. The views
set forth in Question 1 of Topic 13.A.4(a) are applicable to the
service transactions discussed in that Question. Service transactions
are explicitly outside the scope of FASB ASC Subtopic 605-15.
Question 4
Question: Question 1 of Topic 13.A.4(a) above states that the staff
would expect a two-year history of selling a new service in order to be
able to make reliable estimates of cancellations. How long a history
does the staff believe is necessary to estimate returns in a product
sale transaction that is within the scope of FASB ASC Subtopic 605-15?
Interpretive Response: The staff does not believe there is any
specific length of time necessary in a product transaction. However,
FASB ASC Subtopic 605-15 states that returns must be subject to
reasonable estimation. Preparers and auditors should be skeptical of
estimates of product returns when little history with a particular
product line exists, when there is inadequate verifiable evidence of
historical experience, or when there are inadequate internal controls
that ensure the reliability and timeliness of the reporting of the
appropriate historical information. Start-up companies and companies
selling new or significantly modified products are frequently unable to
develop the requisite historical data on which to base estimates of
returns.
Question 5
Question: If a company selling products subject to a right of
return concludes that it cannot reasonably estimate the actual return
rate due to its limited history, but it can conservatively estimate the
maximum possible returns, does the staff believe that the company may
recognize revenue for the portion of the sales that exceeds the maximum
estimated return rate?
Interpretive Response: No. If a reasonable estimate of future
returns cannot be made, FASB ASC Subtopic 605-15 requires that revenue
not be recognized until the return period lapses or a reasonable
estimate can be made.\60\ Deferring revenue recognition based on the
upper end of a wide range of potential return rates is inconsistent
with the provisions of FASB ASC Subtopic 605-15.
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\60\ FASB ASC subparagraph 605-15-25-1(f).
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c. Contingent Rental Income
Facts: Company A owns and leases retail space to retailers. Company
A (lessor) renews a lease with a customer (lessee) that is classified
as an operating lease. The lease term is one year and provides that the
lease payments are $1.2 million, payable in equal monthly installments
on the first day of each month, plus one percent of the lessee's net
sales in excess of $25 million if the net sales exceed $25 million
during the lease term (i.e., contingent rental). The lessee has
historically experienced annual net sales in excess of $25 million in
the particular space being leased, and it is probable that the lessee
will generate in excess of $25 million net sales during the term of the
lease.
Question: In the staff's view, should the lessor recognize any
rental income attributable to the one percent of the lessee's net sales
exceeding $25 million before the lessee actually achieves the $25
million net sales threshold?
Interpretive Response: No. The staff believes that contingent
rental income ``accrues'' (i.e., it should be recognized as revenue)
when the changes in the factor(s) on which the contingent lease
payments is (are) based actually occur.\61\
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\61\ Lessees should follow the guidance established in FASB ASC
Subtopic 840-10.
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FASB ASC paragraph 840-20-25-1 states that ``[r]ent shall be
charged to expense by lessees (reported as income by lessors) over the
lease term as it becomes payable (receivable). If rental payments are
not made on a straight-line basis, rental expense nevertheless shall be
recognized on a straight-line basis unless another systematic and
rational basis is more representative of the time pattern in which use
benefit is derived from the leased property, in which case that basis
shall be used.''
FASB ASC paragraph 840-10-25-4 clarifies that ``lease payments that
depend on a factor that does not exist or is not measurable at the
inception of the lease, such as future sales volume, would be
contingent rentals in their entirety and, accordingly, would be
excluded from minimum lease payments and included in the determination
of income as they accrue.'' FASB ASC paragraph 840-10-55-38 provides
the following example of determining contingent rentals:
Assume that a lease agreement for retail store space stipulates a
monthly base rental of
[[Page 17274]]
$200 and a monthly supplemental rental of one-fourth of one percent
of monthly sales volume during the lease term. Even if the lease
agreement is a renewal for store space that had averaged monthly
sales of $25,000 for the past 2 years, minimum lease payments would
include only the $200 monthly base rental; the supplemental rental
is a contingent rental that is excluded from minimum lease payments.
The future sales for the lease term do not exist at the inception of
the lease, and future rentals would be limited to $200 per month if
the store were subsequently closed and no sales were made
thereafter.
FASB ASC Section 840-20-25 addresses whether it is appropriate for
lessors in operating leases to recognize scheduled rent increases on a
basis other than as required in FASB ASC paragraph 840-20-25-1. FASB
ASC subparagraph 840-20-25-2(a) states ``using factors such as the time
value of money, anticipated inflation, or expected future revenues
[emphasis added] to allocate scheduled rent increases is inappropriate
because these factors do not relate to the time pattern of the physical
usage of the leased property. However, such factors may affect the
periodic reported rental income or expense if the lease agreement
involves contingent rentals, which are excluded from minimum lease
payments and accounted for separately.'' In developing the basis for
why scheduled rent increases should be recognized on a straight-line
basis, the FASB distinguishes the accounting for scheduled rent
increases from contingent rentals. FASB ASC subparagraph 840-20-25-2(b)
states ``[i]f the lessee and lessor eliminate the risk of variable
payments inherent in contingent rentals by agreeing to scheduled rent
increases, the accounting shall reflect those different
circumstances.''
The example provided in FASB ASC paragraph 840-10-55-39 implies
that contingent rental income in leases classified as sales-type or
direct-financing leases becomes ``accruable'' when the changes in the
factors on which the contingent lease payments are based actually
occur. FASB ASC paragraph 840-20-25-2 indicates that contingent rental
income in operating leases should not be recognized in a manner
consistent with scheduled rent increases (i.e., on a straight-line
basis over the lease term or another systematic and rational allocation
basis if it is more representative of the time pattern in which the
leased property is physically employed) because the risk of variable
payments inherent in contingent rentals is substantively different than
scheduled rent increases. The staff believes that the reasoning in FASB
ASC Section 840-20-25 supports the conclusion that the risks inherent
in variable payments associated with contingent rentals should be
reflected in financial statements on a basis different than rental
payments that adjust on a scheduled basis and, therefore, operating
lease income associated with contingent rents would not be recognized
as time passes or as the leased property is physically employed.
Furthermore, prior to the lessee's achievement of the target upon which
contingent rentals are based, the lessor has no legal claims on the
contingent amounts. Consequently, the staff believes that it is
inappropriate to anticipate changes in the factors on which contingent
rental income in operating leases is based and recognize rental income
prior to the resolution of the lease contingencies.
Because Company A's contingent rental income is based upon whether
the customer achieves net sales of $25 million, the contingent rentals,
which may not materialize, should not be recognized until the
customer's net sales actually exceed $25 million. Once the $25 million
threshold is met, Company A would recognize the contingent rental
income as it becomes accruable, in this case, as the customer
recognizes net sales. The staff does not believe that it is appropriate
to recognize revenue based upon the probability of a factor being
achieved. The contingent revenue should be recorded in the period in
which the contingency is resolved.
d. Claims Processing and Billing Services
Facts: Company M performs claims processing and medical billing
services for healthcare providers. In this role, Company M is
responsible for preparing and submitting claims to third-party payers,
tracking outstanding billings, and collecting amounts billed. Company
M's fee is a fixed percentage (e.g., five percent) of the amount
collected. If no collections are made, no fee is due to Company M.
Company M has historical evidence indicating that the third-party
payers pay 85 percent of the billings submitted with no further effort
by Company M. Company M has determined that the services performed
under the arrangement are a single unit of accounting.
Question: May Company M recognize as revenue its five percent fee
on 85 percent of the gross billings at the time it prepares and submits
billings, or should it wait until collections occur to recognize any
revenue?
Interpretive Response: The staff believes that Company M must wait
until collections occur before recognizing revenue. Before the third-
party payer has remitted payment to Company M's customers for the
services billed, Company M is not entitled to any revenue. That is, its
revenue is not yet realized or realizable.\62\ Until Company M's
customers collect on the billings, Company M has not performed the
requisite activity under its contract to be entitled to a fee.\63\
Further, no amount of the fee is fixed or determinable or collectible
until Company M's customers collect on the billings.
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\62\ Concepts Statement 5, paragraph 83(a).
\63\ Concepts Statement 5, paragraph 83(b).
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B. Disclosures
Question: What disclosures are required with respect to the
recognition of revenue?
Interpretive Response: A registrant should disclose its accounting
policy for the recognition of revenue pursuant to FASB ASC Topic 235,
Notes to Financial Statements. FASB ASC paragraph 235-10-50-3 thereof
states that ``the disclosure should encompass important judgments as to
appropriateness of principles relating to recognition of revenue * * *
.'' Because revenue recognition generally involves some level of
judgment, the staff believes that a registrant should always disclose
its revenue recognition policy. If a company has different policies for
different types of revenue transactions, including barter sales, the
policy for each material type of transaction should be disclosed. If
sales transactions have multiple units of accounting, such as a product
and service, the accounting policy should clearly state the accounting
policy for each unit of accounting as well as how units of accounting
are determined and valued. In addition, the staff believes that changes
in estimated returns recognized in accordance with FASB ASC Subtopic
605-15 should be disclosed, if material (e.g., a change in estimate
from two percent of sales to one percent of sales).
Regulation S-X requires that revenue from the sales of products,
services, and other products each be separately disclosed on the face
of the income statement.\64\ The staff believes that costs relating to
each type of revenue similarly should be reported separately on the
face of the income statement.
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\64\ See Regulation S-X, Article 5-03(1) and (2).
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MD&A requires a discussion of liquidity, capital resources, results
of operations and other information necessary to an understanding of a
registrant's financial condition, changes in financial condition and
results of operations.\65\ This includes unusual or
[[Page 17275]]
infrequent transactions, known trends or uncertainties that have had,
or might reasonably be expected to have, a favorable or unfavorable
material effect on revenue, operating income or net income and the
relationship between revenue and the costs of the revenue. Changes in
revenue should not be evaluated solely in terms of volume and price
changes, but should also include an analysis of the reasons and factors
contributing to the increase or decrease. The Commission stated in FRR
36 that MD&A should ``give investors an opportunity to look at the
registrant through the eyes of management by providing a historical and
prospective analysis of the registrant's financial condition and
results of operations, with a particular emphasis on the registrant's
prospects for the future.'' \66\ Examples of such revenue transactions
or events that the staff has asked to be disclosed and discussed in
accordance with FRR 36 are:
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\65\ See Regulation S-K, Item 303 and FRR 36.
\66\ FRR 36; See also In the Matter of Caterpillar Inc., AAER
363 (March 31, 1992).
---------------------------------------------------------------------------
Shipments of product at the end of a reporting period that
significantly reduce customer backlog and that reasonably might be
expected to result in lower shipments and revenue in the next period.
Granting of extended payment terms that will result in a
longer collection period for accounts receivable (regardless of whether
revenue has been recognized) and slower cash inflows from operations,
and the effect on liquidity and capital resources. (The fair value of
trade receivables should be disclosed in the footnotes to the financial
statements when the fair value does not approximate the carrying
amount.)\67\
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\67\ FASB ASC Subtopic 825-10, Financial Instruments--Overall.
---------------------------------------------------------------------------
Changing trends in shipments into, and sales from, a sales
channel or separate class of customer that could be expected to have a
significant effect on future sales or sales returns.
An increasing trend toward sales to a different class of
customer, such as a reseller distribution channel that has a lower
gross profit margin than existing sales that are principally made to
end users. Also, increasing service revenue that has a higher profit
margin than product sales.
Seasonal trends or variations in sales.
A gain or loss from the sale of an asset(s).\68\
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\68\ Gains or losses from the sale of assets should be reported
as ``other general expenses'' pursuant to Regulation S-X, Article 5-
03(6). Any material item should be stated separately.
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TOPIC 14: SHARE-BASED PAYMENT
The interpretations in this SAB express views of the staff
regarding the interaction between FASB ASC Topic 718, Compensation--
Stock Compensation, and certain SEC rules and regulations and provide
the staff's views regarding the valuation of share-based payment
arrangements for public companies. FASB ASC Topic 718 is based on the
underlying accounting principle that compensation cost resulting from
share-based payment transactions be recognized in financial statements
at fair value.\1\ Recognition of compensation cost at fair value will
provide investors and other users of financial statements with more
complete and comparable financial information.\2\
---------------------------------------------------------------------------
\1\ FASB ASC paragraphs 718-10-30-2 through 718-10-30-4.
\2\ [Original footnote removed by SAB 114.]
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FASB ASC Topic 718 addresses a wide range of share-based
compensation arrangements including share options, restricted share
plans, performance-based awards, share appreciation rights, and
employee share purchase plans.
FASB ASC Topic 718 replaces guidance as originally issued in 1995,
that established as preferable, but did not require, a fair-value-based
method of accounting for share-based payment transactions with
employees.
The staff believes the guidance in this SAB will assist issuers in
their initial implementation of FASB ASC Topic 718 and enhance the
information received by investors and other users of financial
statements, thereby assisting them in making investment and other
decisions. This SAB includes interpretive guidance related to share-
based payment transactions with nonemployees, the transition from
nonpublic to public entity \3\ status, valuation methods (including
assumptions such as expected volatility and expected term), the
accounting for certain redeemable financial instruments issued under
share-based payment arrangements, the classification of compensation
expense, non-GAAP financial measures, first-time adoption of FASB ASC
Topic 718 in an interim period, capitalization of compensation cost
related to share-based payment arrangements, the accounting for income
tax effects of share-based payment arrangements upon adoption of FASB
ASC Topic 718, the modification of employee share options prior to
adoption of FASB ASC Topic 718 and disclosures in MD&A subsequent to
adoption of FASB ASC Topic 718.
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\3\ Defined in the FASB ASC Master Glossary.
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The staff recognizes that there is a range of conduct that a
reasonable issuer might use to make estimates and valuations and
otherwise implement FASB ASC Topic 718, and the interpretive guidance
provided by this SAB, particularly during the period of the Topic's
initial implementation. Thus, throughout this SAB the use of the terms
``reasonable'' and ``reasonably'' is not meant to imply a single
conclusion or methodology, but to encompass the full range of potential
conduct, conclusions or methodologies upon which an issuer may
reasonably base its valuation decisions. Different conduct, conclusions
or methodologies by different issuers in a given situation does not of
itself raise an inference that any of those issuers is acting
unreasonably. While the zone of reasonable conduct is not unlimited,
the staff expects that it will be rare when there is only one
acceptable choice in estimating the fair value of share-based payment
arrangements under the provisions of FASB ASC Topic 718 and the
interpretive guidance provided by this SAB in any given situation. In
addition, as discussed in the Interpretive Response to Question 1 of
Section C, Valuation Methods, estimates of fair value are not intended
to predict actual future events, and subsequent events are not
indicative of the reasonableness of the original estimates of fair
value made under FASB ASC Topic 718. Over time, as issuers and
accountants gain more experience in applying FASB ASC Topic 718 and the
guidance provided in this SAB, the staff anticipates that particular
approaches may begin to emerge as best practices and that the range of
reasonable conduct, conclusions and methodologies will likely narrow.
* * * * *
A. Share-Based Payment Transactions with Nonemployees
Question: Are share-based payment transactions with nonemployees
included in the scope of FASB ASC Topic 718?
Interpretive Response: Only certain aspects of the accounting for
share-based payment transactions with nonemployees are explicitly
addressed by FASB ASC Topic 718. This Topic explicitly:
Establishes fair value as the measurement objective in
accounting for all share-based payments; \4\ and
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\4\ FASB ASC paragraph 718-10-30-2.
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Requires that an entity record the value of a transaction
with a
[[Page 17276]]
nonemployee based on the more reliably measurable fair value of either
the good or service received or the equity instrument issued.\5\
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\5\ Ibid.
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FASB ASC Topic 718 does not supersede any of the authoritative
literature that specifically addresses accounting for share-based
payments with nonemployees. For example, FASB ASC Topic 718 does not
specify the measurement date for share-based payment transactions with
nonemployees when the measurement of the transaction is based on the
fair value of the equity instruments issued.\6\ For determining the
measurement date of equity instruments issued in share-based
transactions with nonemployees, a company should refer to FASB ASC
Subtopic 505-50, Equity--Equity Based Payments to Non-Employees.
---------------------------------------------------------------------------
\6\ [Original footnote removed by SAB 114.]
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With respect to questions regarding nonemployee arrangements that
are not specifically addressed in other authoritative literature, the
staff believes that the application of guidance in FASB ASC Topic 718
would generally result in relevant and reliable financial statement
information. As such, the staff believes it would generally be
appropriate for entities to apply the guidance in FASB ASC Topic 718 by
analogy to share-based payment transactions with nonemployees unless
other authoritative accounting literature more clearly addresses the
appropriate accounting, or the application of the guidance in FASB ASC
Topic 718 would be inconsistent with the terms of the instrument issued
to a nonemployee in a share-based payment arrangement.\7\ For example,
the staff believes the guidance in FASB ASC Topic 718 on certain
transactions with related parties or other holders of an economic
interest in the entity would generally be applicable to share-based
payment transactions with nonemployees. The staff encourages
registrants that have additional questions related to accounting for
share-based payment transactions with nonemployees to discuss those
questions with the staff.
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\7\ For example, due to the nature of specific terms in employee
share options, including nontransferability, nonhedgability and the
truncation of the contractual term due to post-vesting service
termination, FASB ASC Topic 718 requires that when valuing an
employee share option under the Black-Scholes-Merton framework, the
fair value of an employee share option be based on the option's
expected term rather than the contractual term. If these features
(i.e., nontransferability, nonhedgability and the truncation of the
contractual term) were not present in a nonemployee share option
arrangement, the use of an expected term assumption shorter than the
contractual term would generally not be appropriate in estimating
the fair value of the nonemployee share options.
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B. Transition From Nonpublic to Public Entity Status
Facts: Company A is a nonpublic entity \8\ that first files a
registration statement with the SEC to register its equity securities
for sale in a public market on January 2, 20X8.\9\ As a nonpublic
entity, Company A had been assigning value to its share options \10\
under the calculated value method prescribed by FASB ASC Topic 718,
Compensation--Stock Compensation,\11\ and had elected to measure its
liability awards based on intrinsic value. Company A is considered a
public entity on January 2, 20X8 when it makes its initial filing with
the SEC in preparation for the sale of its shares in a public market.
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\8\ Defined in the FASB ASC Master Glossary.
\9\ For the purposes of these illustrations, assume all of
Company A's equity-based awards granted to its employees were
granted after the adoption of FASB ASC Topic 718.
\10\ For purposes of this staff accounting bulletin, the phrase
``share options'' is used to refer to ``share options or similar
instruments.''
\11\ FASB ASC paragraph 718-10-30-20 requires a nonpublic entity
to use the calculated value method when it is not able to reasonably
estimate the fair value of its equity share options and similar
instruments because it is not practicable for it to estimate the
expected volatility of its share price. FASB ASC paragraph 718-10-
55-51 indicates that a nonpublic entity may be able to identify
similar public entities for which share or option price information
is available and may consider the historical, expected, or implied
volatility of those entities' share prices in estimating expected
volatility. The staff would expect an entity that becomes a public
entity and had previously measured its share options under the
calculated value method to be able to support its previous decision
to use calculated value and to provide the disclosures required by
FASB ASC subparagraph 718-10-50-2(f)(2)(ii).
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Question 1: How should Company A account for the share options that
were granted to its employees prior to January 2, 20X8 for which the
requisite service has not been rendered by January 2, 20X8?
Interpretive Response: Prior to becoming a public entity, Company A
had been assigning value to its share options under the calculated
value method. The staff believes that Company A should continue to
follow that approach for those share options that were granted prior to
January 2, 20X8, unless those share options are subsequently modified,
repurchased or cancelled.\12\ If the share options are subsequently
modified, repurchased or cancelled, Company A would assess the event
under the public company provisions of FASB ASC Topic 718. For example,
if Company A modified the share options on February 1, 20X8, any
incremental compensation cost would be measured under FASB ASC
subparagraph 718-20-35-3(a), as the fair value of the modified share
options over the fair value of the original share options measured
immediately before the terms were modified.\13\
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\12\ This view is consistent with the FASB's basis for rejecting
full retrospective application of FASB ASC Topic 718 as described in
the basis for conclusions of Statement 123R, paragraph B251.
\13\ FASB ASC paragraph 718-20-55-94. The staff believes that
because Company A is a public entity as of the date of the
modification, it would be inappropriate to use the calculated value
method to measure the original share options immediately before the
terms were modified.
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Question 2: How should Company A account for its liability awards
granted to its employees prior to January 2, 20X8 which are fully
vested but have not been settled by January 2, 20X8?
Interpretive Response: As a nonpublic entity, Company A had elected
to measure its liability awards subject to FASB ASC Topic 718 at
intrinsic value.\14\ When Company A becomes a public entity, it should
measure the liability awards at their fair value determined in
accordance with FASB ASC Topic 718.\15\ In that reporting period there
will be an incremental amount of measured cost for the difference
between fair value as determined under FASB ASC Topic 718 and intrinsic
value. For example, assume the intrinsic value in the period ended
December 31, 20X7 was $10 per award. At the end of the first reporting
period ending after January 2, 20X8 (when Company A becomes a public
entity), assume the intrinsic value of the award is $12 and the fair
value as determined in accordance with FASB ASC Topic 718 is $15. The
measured cost in the first reporting period after December 31, 20X7
would be $5.\16\
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\14\ FASB ASC paragraph 718-30-30-2.
\15\ FASB ASC paragraph 718-30-35-3.
\16\ $15 fair value less $10 intrinsic value equals $5 of
incremental cost.
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Question 3: After becoming a public entity, may Company A
retrospectively apply the fair-value-based method to its awards that
were granted prior to the date Company A became a public entity?
Interpretive Response: No. Before becoming a public entity, Company
A did not use the fair-value-based method for either its share options
or its liability awards granted to the Company's employees. The staff
does not believe it is appropriate for Company A to apply the fair-
value-based method on a retrospective basis, because it would require
the entity to make estimates of a prior period, which, due to
hindsight, may vary significantly from estimates
[[Page 17277]]
that would have been made contemporaneously in prior periods.\17\
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\17\ This view is consistent with the FASB's basis for rejecting
full retrospective application of FASB ASC Topic 718 as described in
the basis for conclusions of Statement 123R, paragraph B251.
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Question 4: Upon becoming a public entity, what disclosures should
Company A consider in addition to those prescribed by FASB ASC Topic
718? \18\
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\18\ FASB ASC Section 718-10-50.
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Interpretive Response: In the registration statement filed on
January 2, 20X8, Company A should clearly describe in MD&A the change
in accounting policy that will be required by FASB ASC Topic 718 in
subsequent periods and the reasonably likely material future
effects.\19\ In subsequent filings, Company A should provide financial
statement disclosure of the effects of the changes in accounting
policy. In addition, Company A should consider the applicability of SEC
Release No. FR-60 \20\ and Section V, ``Critical Accounting
Estimates,'' in SEC Release No. FR-72 \21\ regarding critical
accounting policies and estimates in MD&A.
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\19\ See generally SEC Release No. FR-72, ``Commission Guidance
Regarding Management's Discussion and Analysis of Financial
Condition and Results of Operations.''
\20\ SEC Release No. FR-60, ``Cautionary Advice Regarding
Disclosure About Critical Accounting Policies.''
\21\ SEC Release No. FR-72, ``Commission Guidance Regarding
Management's Discussion and Analysis of Financial Condition and
Results of Operations.''
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C. Valuation Methods
FASB ASC paragraph 718-10-30-6 (Compensation--Stock Compensation
Topic) indicates that the measurement objective for equity instruments
awarded to employees is to estimate at the grant date the fair value of
the equity instruments the entity is obligated to issue when employees
have rendered the requisite service and satisfied any other conditions
necessary to earn the right to benefit from the instruments. The Topic
also states that observable market prices of identical or similar
equity or liability instruments in active markets are the best evidence
of fair value and, if available, should be used as the basis for the
measurement for equity and liability instruments awarded in a share-
based payment transaction with employees.\22\ However, if observable
market prices of identical or similar equity or liability instruments
are not available, the fair value shall be estimated by using a
valuation technique or model that complies with the measurement
objective, as described in FASB ASC Topic 718.\23\
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\22\ FASB ASC paragraph 718-10-55-10.
\23\ FASB ASC paragraph 718-10-55-11.
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Question 1: If a valuation technique or model is used to estimate
fair value, to what extent will the staff consider a company's
estimates of fair value to be materially misleading because the
estimates of fair value do not correspond to the value ultimately
realized by the employees who received the share options?
Interpretive Response: The staff understands that estimates of fair
value of employee share options, while derived from expected value
calculations, cannot predict actual future events.\24\ The estimate of
fair value represents the measurement of the cost of the employee
services to the company. The estimate of fair value should reflect the
assumptions marketplace participants would use in determining how much
to pay for an instrument on the date of the measurement (generally the
grant date for equity awards). For example, valuation techniques used
in estimating the fair value of employee share options may consider
information about a large number of possible share price paths, while,
of course, only one share price path will ultimately emerge. If a
company makes a good faith fair value estimate in accordance with the
provisions of FASB ASC Topic 718 in a way that is designed to take into
account the assumptions that underlie the instrument's value that
marketplace participants would reasonably make, then subsequent future
events that affect the instrument's value do not provide meaningful
information about the quality of the original fair value estimate. As
long as the share options were originally so measured, changes in an
employee share option's value, no matter how significant, subsequent to
its grant date do not call into question the reasonableness of the
grant date fair value estimate.
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\24\ FASB ASC paragraph 718-10-55-15 states ``The fair value of
those instruments at a single point in time is not a forecast of
what the estimated fair value of those instruments may be in the
future.''
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Question 2: In order to meet the fair value measurement objective
in FASB ASC Topic 718, are certain valuation techniques preferred over
others?
Interpretive Response: FASB ASC paragraph 718-10-55-17 clarifies
that the Topic does not specify a preference for a particular valuation
technique or model. As stated in FASB ASC paragraph 718-10-55-11 in
order to meet the fair value measurement objective, a company should
select a valuation technique or model that (a) is applied in a manner
consistent with the fair value measurement objective and other
requirements of FASB ASC Topic 718, (b) is based on established
principles of financial economic theory and generally applied in that
field and (c) reflects all substantive characteristics of the
instrument.
The chosen valuation technique or model must meet all three of the
requirements stated above. In valuing a particular instrument, certain
techniques or models may meet the first and second criteria but may not
meet the third criterion because the techniques or models are not
designed to reflect certain characteristics contained in the
instrument. For example, for a share option in which the exercisability
is conditional on a specified increase in the price of the underlying
shares, the Black-Scholes-Merton closed-form model would not generally
be an appropriate valuation model because, while it meets both the
first and second criteria, it is not designed to take into account that
type of market condition.\25\
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\25\ See FASB ASC paragraphs 718-10-55-16 and 718-10-55-20.
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Further, the staff understands that a company may consider multiple
techniques or models that meet the fair value measurement objective
before making its selection as to the appropriate technique or model.
The staff would not object to a company's choice of a technique or
model as long as the technique or model meets the fair value
measurement objective. For example, a company is not required to use a
lattice model simply because that model was the most complex of the
models the company considered.
Question 3: In subsequent periods, may a company change the
valuation technique or model chosen to value instruments with similar
characteristics? \26\
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\26\ FASB ASC paragraph 718-10-55-17 indicates that an entity
may use different valuation techniques or models for instruments
with different characteristics.
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Interpretive Response: As long as the new technique or model meets
the fair value measurement objective as described in Question 2 above,
the staff would not object to a company changing its valuation
technique or model.\27\ A change in the valuation technique or model
used to meet the fair value
[[Page 17278]]
measurement objective would not be considered a change in accounting
principle. As such, a company would not be required to file a
preferability letter from its independent accountants as described in
Rule 10-01(b)(6) of Regulation S-X when it changes valuation techniques
or models.\28\ However, the staff would not expect that a company would
frequently switch between valuation techniques or models, particularly
in circumstances where there was no significant variation in the form
of share-based payments being valued. Disclosure in the footnotes of
the basis for any change in technique or model would be
appropriate.\29\
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\27\ The staff believes that a company should take into account
the reason for the change in technique or model in determining
whether the new technique or model meets the fair value measurement
objective. For example, changing a technique or model from period to
period for the sole purpose of lowering the fair value estimate of a
share option would not meet the fair value measurement objective of
the Topic.
\28\ FASB ASC paragraph 718-10-55-27.
\29\ See generally FASB ASC paragraph 718-10-50-1.
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Question 4: Must every company that issues share options or similar
instruments hire an outside third party to assist in determining the
fair value of the share options?
Interpretive Response: No. However, the valuation of a company's
share options or similar instruments should be performed by a person
with the requisite expertise.
D. Certain Assumptions Used in Valuation Methods
FASB ASC Topic 718's (Compensation--Stock Compensation Topic) fair
value measurement objective for equity instruments awarded to employees
is to estimate the grant-date fair value of the equity instruments that
the entity is obligated to issue when employees have rendered the
requisite service and satisfied any other conditions necessary to earn
the right to benefit from the instruments.\30\ In order to meet this
fair value measurement objective, management will be required to
develop estimates regarding the expected volatility of its company's
share price and the exercise behavior of its employees. The staff is
providing guidance in the following sections related to the expected
volatility and expected term assumptions to assist public entities in
applying those requirements.
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\30\ FASB ASC paragraph 718-10-55-4.
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The staff understands that companies may refine their estimates of
expected volatility and expected term as a result of the guidance
provided in FASB ASC Topic 718 and in sections (1) and (2) below.
Changes in assumptions during the periods presented in the financial
statements should be disclosed in the footnotes.\31\
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\31\ FASB ASC paragraph 718-10-50-2.
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1. Expected Volatility
FASB ASC paragraph 718-10-55-36 states, ``Volatility is a measure
of the amount by which a financial variable, such as share price, has
fluctuated (historical volatility) or is expected to fluctuate
(expected volatility) during a period. Option-pricing models require an
estimate of expected volatility as an assumption because an option's
value is dependent on potential share returns over the option's term.
The higher the volatility, the more the returns on the share can be
expected to vary--up or down. Because an option's value is unaffected
by expected negative returns on the shares, other things [being] equal,
an option on a share with higher volatility is worth more than an
option on a share with lower volatility.''
Facts: Company B is a public entity whose common shares have been
publicly traded for over twenty years. Company B also has multiple
options on its shares outstanding that are traded on an exchange
(``traded options''). Company B grants share options on January 2,
20X6.
Question 1: What should Company B consider when estimating expected
volatility for purposes of measuring the fair value of its share
options?
Interpretive Response: FASB ASC Topic 718 does not specify a
particular method of estimating expected volatility. However, the Topic
does clarify that the objective in estimating expected volatility is to
ascertain the assumption about expected volatility that marketplace
participants would likely use in determining an exchange price for an
option.\32\ FASB ASC Topic 718 provides a list of factors entities
should consider in estimating expected volatility.\33\ Company B may
begin its process of estimating expected volatility by considering its
historical volatility.\34\ However, Company B should also then
consider, based on available information, how the expected volatility
of its share price may differ from historical volatility.\35\ Implied
volatility \36\ can be useful in estimating expected volatility because
it is generally reflective of both historical volatility and
expectations of how future volatility will differ from historical
volatility.
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\32\ FASB ASC paragraph 718-10-55-35.
\33\ FASB ASC paragraph 718-10-55-37.
\34\ FASB ASC paragraph 718-10-55-40.
\35\ Ibid.
\36\ Implied volatility is the volatility assumption inherent in
the market prices of a company's traded options or other financial
instruments that have option-like features. Implied volatility is
derived by entering the market price of the traded financial
instrument, along with assumptions specific to the financial options
being valued, into a model based on a constant volatility estimate
(e.g., the Black-Scholes-Merton closed-form model) and solving for
the unknown assumption of volatility.
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The staff believes that companies should make good faith efforts to
identify and use sufficient information in determining whether taking
historical volatility, implied volatility or a combination of both into
account will result in the best estimate of expected volatility. The
staff believes companies that have appropriate traded financial
instruments from which they can derive an implied volatility should
generally consider this measure. The extent of the ultimate reliance on
implied volatility will depend on a company's facts and circumstances;
however, the staff believes that a company with actively traded options
or other financial instruments with embedded options \37\ generally
could place greater (or even exclusive) reliance on implied volatility.
(See the Interpretive Responses to Questions 3 and 4 below.)
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\37\ The staff believes implied volatility derived from embedded
options can be utilized in determining expected volatility if, in
deriving the implied volatility, the company considers all relevant
features of the instruments (e.g., value of the host instrument,
value of the option, etc.). The staff believes the derivation of
implied volatility from other than simple instruments (e.g., a
simple convertible bond) can, in some cases, be impracticable due to
the complexity of multiple features.
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The process used to gather and review available information to
estimate expected volatility should be applied consistently from period
to period. When circumstances indicate the availability of new or
different information that would be useful in estimating expected
volatility, a company should incorporate that information.
Question 2: What should Company B consider if computing historical
volatility? \38\
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\38\ See FASB ASC paragraph 718-10-55-37.
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Interpretive Response: The following should be considered in the
computation of historical volatility:
1. Method of Computing Historical Volatility--
The staff believes the method selected by Company B to compute its
historical volatility should produce an estimate that is representative
of Company B's expectations about its future volatility over the
expected (if using a Black-Scholes-Merton closed-form model) or
contractual (if using a lattice model) term \39\ of its employee share
options. Certain methods may not be appropriate
[[Page 17279]]
for longer term employee share options if they weight the most recent
periods of Company B's historical volatility much more heavily than
earlier periods.\40\ For example, a method that applies a factor to
certain historical price intervals to reflect a decay or loss of
relevance of that historical information emphasizes the most recent
historical periods and thus would likely bias the estimate to this
recent history.\41\
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\39\ For purposes of this staff accounting bulletin, the phrase
``expected or contractual term, as applicable'' has the same meaning
as the phrase ``expected (if using a Black-Scholes-Merton closed-
form model) or contractual (if using a lattice model) term of an
employee share option.''
\40\ FASB ASC subparagraph 718-10-55-37(a) states that entities
should consider historical volatility over a period generally
commensurate with the expected or contractual term, as applicable,
of the share option. Accordingly, the staff believes methods that
place extreme emphasis on the most recent periods may be
inconsistent with this guidance.
\41\ Generalized Autoregressive Conditional Heteroskedasticity
(``GARCH'') is an example of a method that demonstrates this
characteristic.
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2. Amount of Historical Data--
FASB ASC subparagraph 718-10-55-37(a) indicates entities should
consider historical volatility over a period generally commensurate
with the expected or contractual term, as applicable, of the share
option. The staff believes Company B could utilize a period of
historical data longer than the expected or contractual term, as
applicable, if it reasonably believes the additional historical
information will improve the estimate. For example, assume Company B
decided to utilize a Black-Scholes-Merton closed-form model to estimate
the value of the share options granted on January 2, 20X6 and
determined that the expected term was six years. Company B would not be
precluded from using historical data longer than six years if it
concludes that data would be relevant.
3. Frequency of Price Observations--
FASB ASC subparagraph 718-10-55-37(d) indicates an entity should
use appropriate and regular intervals for price observations based on
facts and circumstances that provide the basis for a reasonable fair
value estimate. Accordingly, the staff believes Company B should
consider the frequency of the trading of its shares and the length of
its trading history in determining the appropriate frequency of price
observations. The staff believes using daily, weekly or monthly price
observations may provide a sufficient basis to estimate expected
volatility if the history provides enough data points on which to base
the estimate.\42\ Company B should select a consistent point in time
within each interval when selecting data points.\43\
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\42\ Further, if shares of a company are thinly traded the staff
believes the use of weekly or monthly price observations would
generally be more appropriate than the use of daily price
observations. The volatility calculation using daily observations
for such shares could be artificially inflated due to a larger
spread between the bid and asked quotes and lack of consistent
trading in the market.
\43\ FASB ASC paragraph 718-10-55-40 states that a company
should establish a process for estimating expected volatility and
apply that process consistently from period to period. In addition,
FASB ASC paragraph 718-10-55-27 indicates that assumptions used to
estimate the fair value of instruments granted to employees should
be determined in a consistent manner from period to period.
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4. Consideration of Future Events--
The objective in estimating expected volatility is to ascertain the
assumptions that marketplace participants would likely use in
determining an exchange price for an option.\44\ Accordingly, the staff
believes that Company B should consider those future events that it
reasonably concludes a marketplace participant would also consider in
making the estimation. For example, if Company B has recently announced
a merger with a company that would change its business risk in the
future, then it should consider the impact of the merger in estimating
the expected volatility if it reasonably believes a marketplace
participant would also consider this event.
---------------------------------------------------------------------------
\44\ FASB ASC paragraph 718-10-55-35.
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5. Exclusion of Periods of Historical Data--
In some instances, due to a company's particular business
situations, a period of historical volatility data may not be relevant
in evaluating expected volatility.\45\ In these instances, that period
should be disregarded. The staff believes that if Company B disregards
a period of historical volatility, it should be prepared to support its
conclusion that its historical share price during that previous period
is not relevant to estimating expected volatility due to one or more
discrete and specific historical events and that similar events are not
expected to occur during the expected term of the share option. The
staff believes these situations would be rare.
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\45\ FASB ASC paragraph 718-10-55-37.
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Question 3: What should Company B consider when evaluating the
extent of its reliance on the implied volatility derived from its
traded options?
Interpretive Response: To achieve the objective of estimating
expected volatility as stated in FASB ASC paragraphs 718-10-55-35
through 718-10-55-41, the staff believes Company B generally should
consider the following in its evaluation: 1) the volume of market
activity of the underlying shares and traded options; 2) the ability to
synchronize the variables used to derive implied volatility; 3) the
similarity of the exercise prices of the traded options to the exercise
price of the employee share options; and 4) the similarity of the
length of the term of the traded and employee share options.\46\
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\46\ See generally Options, Futures, and Other Derivatives by
John C. Hull (Prentice Hall, 5th Edition, 2003).
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1. Volume of Market Activity--
The staff believes Company B should consider the volume of trading
in its underlying shares as well as the traded options. For example,
prices for instruments in actively traded markets are more likely to
reflect a marketplace participant's expectations regarding expected
volatility.
2. Synchronization of the Variables--
Company B should synchronize the variables used to derive implied
volatility. For example, to the extent reasonably practicable, Company
B should use market prices (either traded prices or the average of bid
and asked quotes) of the traded options and its shares measured at the
same point in time. This measurement should also be synchronized with
the grant of the employee share options; however, when this is not
reasonably practicable, the staff believes Company B should derive
implied volatility as of a point in time as close to the grant of the
employee share options as reasonably practicable.
3. Similarity of the Exercise Prices--
The staff believes that when valuing an at-the-money employee share
option, the implied volatility derived from at- or near-the-money
traded options generally would be most relevant.\47\ If, however, it is
not possible to find at- or near-the-money traded options, Company B
should select multiple traded options with an average exercise price
close to the exercise price of the employee share option.\48\
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\47\ Implied volatilities of options differ systematically over
the ``moneyness'' of the option. This pattern of implied
volatilities across exercise prices is known as the ``volatility
smile'' or ``volatility skew.'' Studies such as ``Implied
Volatility'' by Stewart Mayhew, Financial Analysts Journal, July-
August 1995, have found that implied volatilities based on near-the-
money options do as well as sophisticated weighted implied
volatilities in estimating expected volatility. In addition, the
staff believes that because near-the-money options are generally
more actively traded, they may provide a better basis for deriving
implied volatility.
\48\ The staff believes a company could use a weighted-average
implied volatility based on traded options that are either in-the-
money or out-of-the-money. For example, if the employee share option
has an exercise price of $52, but the only traded options available
have exercise prices of $50 and $55, then the staff believes that it
is appropriate to use a weighted average based on the implied
volatilities from the two traded options; for this example, a 40%
weight on the implied volatility calculated from the option with an
exercise price of $55 and a 60% weight on the option with an
exercise price of $50.
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[[Page 17280]]
4. Similarity of Length of Terms--
The staff believes that when valuing an employee share option with
a given expected or contractual term, as applicable, the implied
volatility derived from a traded option with a similar term would be
the most relevant. However, if there are no traded options with
maturities that are similar to the share option's contractual or
expected term, as applicable, then the staff believes Company B could
consider traded options with a remaining maturity of six months or
greater.\49\ However, when using traded options with a term of less
than one year,\50\ the staff would expect the company to also consider
other relevant information in estimating expected volatility. In
general, the staff believes more reliance on the implied volatility
derived from a traded option would be expected the closer the remaining
term of the traded option is to the expected or contractual term, as
applicable, of the employee share option.
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\49\ The staff believes it may also be appropriate to consider
the entire term structure of volatility provided by traded options
with a variety of remaining maturities. If a company considers the
entire term structure in deriving implied volatility, the staff
would expect a company to include some options in the term structure
with a remaining maturity of six months or greater.
\50\ The staff believes the implied volatility derived from a
traded option with a term of one year or greater would typically not
be significantly different from the implied volatility that would be
derived from a traded option with a significantly longer term.
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The staff believes Company B's evaluation of the factors above
should assist in determining whether the implied volatility
appropriately reflects the market's expectations of future volatility
and thus the extent of reliance that Company B reasonably places on the
implied volatility.
Question 4: Are there situations in which it is acceptable for
Company B to rely exclusively on either implied volatility or
historical volatility in its estimate of expected volatility?
Interpretive Response: As stated above, FASB ASC Topic 718 does not
specify a method of estimating expected volatility; rather, it provides
a list of factors that should be considered and requires that an
entity's estimate of expected volatility be reasonable and
supportable.\51\ Many of the factors listed in FASB ASC Topic 718 are
discussed in Questions 2 and 3 above. The objective of estimating
volatility, as stated in FASB ASC Topic 718, is to ascertain the
assumption about expected volatility that marketplace participants
would likely use in determining a price for an option.\52\ The staff
believes that a company, after considering the factors listed in FASB
ASC Topic 718, could, in certain situations, reasonably conclude that
exclusive reliance on either historical or implied volatility would
provide an estimate of expected volatility that meets this stated
objective.
---------------------------------------------------------------------------
\51\ FASB ASC paragraphs 718-10-55-36 through 718-10-55-37.
\52\ FASB ASC paragraph 718-10-55-35.
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The staff would not object to Company B placing exclusive reliance
on implied volatility when the following factors are present, as long
as the methodology is consistently applied:
Company B utilizes a valuation model that is based upon a
constant volatility assumption to value its employee share options;\53\
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\53\ FASB ASC paragraphs 718-10-55-18 and 718-10-55-39 discuss
the incorporation of a range of expected volatilities into option
pricing models. The staff believes that a company that utilizes an
option pricing model that incorporates a range of expected
volatilities over the option's contractual term should consider the
factors listed in FASB ASC Topic 718, and those discussed in the
Interpretive Responses to Questions 2 and 3 above, to determine the
extent of its reliance (including exclusive reliance) on the derived
implied volatility.
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The implied volatility is derived from options that are
actively traded;
The market prices (trades or quotes) of both the traded
options and underlying shares are measured at a similar point in time
to each other and on a date reasonably close to the grant date of the
employee share options;
The traded options have exercise prices that are both (a)
near-the-money and (b) close to the exercise price of the employee
share options; \54\ and
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\54\ When near-the-money options are not available, the staff
believes the use of a weighted-average approach, as noted in a
previous footnote, may be appropriate.
---------------------------------------------------------------------------
The remaining maturities of the traded options on which
the estimate is based are at least one year.
The staff would not object to Company B placing exclusive reliance
on historical volatility when the following factors are present, so
long as the methodology is consistently applied:
Company B has no reason to believe that its future
volatility over the expected or contractual term, as applicable, is
likely to differ from its past; \55\
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\55\ See FASB ASC paragraph 718-10-55-38. A change in a
company's business model that results in a material alteration to
the company's risk profile is an example of a circumstance in which
the company's future volatility would be expected to differ from its
past volatility. Other examples may include, but are not limited to,
the introduction of a new product that is central to a company's
business model or the receipt of U.S. Food and Drug Administration
approval for the sale of a new prescription drug.
---------------------------------------------------------------------------
The computation of historical volatility uses a simple
average calculation method;
A sequential period of historical data at least equal to
the expected or contractual term of the share option, as applicable, is
used; and
A reasonably sufficient number of price observations are
used, measured at a consistent point throughout the applicable
historical period.\56\
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\56\ If the expected or contractual term, as applicable, of the
employee share option is less than three years, the staff believes
monthly price observations would not provide a sufficient amount of
data.
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Question 5: What disclosures would the staff expect Company B to
include in its financial statements and MD&A regarding its assumption
of expected volatility?
Interpretive Response: FASB ASC paragraph 718-10-50-2 prescribes
the minimum information needed to achieve the Topic's disclosure
objectives.\57\ Under that guidance, Company B is required to disclose
the expected volatility and the method used to estimate it.\58\
Accordingly, the staff expects that at a minimum Company B would
disclose in a footnote to its financial statements how it determined
the expected volatility assumption for purposes of determining the fair
value of its share options in accordance with FASB ASC Topic 718. For
example, at a minimum, the staff would expect Company B to disclose
whether it used only implied volatility, historical volatility, or a
combination of both.
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\57\ FASB ASC Section 718-10-50.
\58\ FASB ASC subparagraph 718-10-50-2(f) (2) (ii).
---------------------------------------------------------------------------
In addition, Company B should consider the applicability of SEC
Release No. FR-60 and Section V, ``Critical Accounting Estimates,'' in
SEC Release No. FR-72 regarding critical accounting policies and
estimates in MD&A. The staff would expect such disclosures to include
an explanation of the method used to estimate the expected volatility
of its share price. This explanation generally should include a
discussion of the basis for the company's conclusions regarding the
extent to which it used historical volatility, implied volatility or a
combination of both. A company could consider summarizing its
evaluation of the factors listed in Questions 2 and 3 of this section
as part of these disclosures in MD&A.
Facts: Company C is a newly public entity with limited historical
data on the
[[Page 17281]]
price of its publicly traded shares and no other traded financial
instruments. Company C believes that it does not have sufficient
company specific information regarding the volatility of its share
price on which to base an estimate of expected volatility.
Question 6: What other sources of information should Company C
consider in order to estimate the expected volatility of its share
price?
Interpretive Response: FASB ASC Topic 718 provides guidance on
estimating expected volatility for newly public and nonpublic entities
that do not have company specific historical or implied volatility
information available.\59\ Company C may base its estimate of expected
volatility on the historical, expected or implied volatility of similar
entities whose share or option prices are publicly available. In making
its determination as to similarity, Company C would likely consider the
industry, stage of life cycle, size and financial leverage of such
other entities.\60\
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\59\ FASB ASC paragraphs 718-10-55-25 and 718-10-55-51.
\60\ FASB ASC paragraph 718-1055-25.
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The staff would not object to Company C looking to an industry
sector index (e.g., NASDAQ Computer Index) that is representative of
Company C's industry, and possibly its size, to identify one or more
similar entities.\61\ Once Company C has identified similar entities,
it would substitute a measure of the individual volatilities of the
similar entities for the expected volatility of its share price as an
assumption in its valuation model.\62\ Because of the effects of
diversification that are present in an industry sector index, Company C
should not substitute the volatility of an index for the expected
volatility of its share price as an assumption in its valuation
model.\63\
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\61\ If a company operates in a number of different industries,
it could look to several industry indices. However, when considering
the volatilities of multiple companies, each operating only in a
single industry, the staff believes a company should take into
account its own leverage, the leverages of each of the entities, and
the correlation of the entities' stock returns.
\62\ FASB ASC paragraph 718-10-55-51.
\63\ FASB ASC paragraph 718-10-55-25.
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After similar entities have been identified, Company C should
continue to consider the volatilities of those entities unless
circumstances change such that the identified entities are no longer
similar to Company C. Until Company C has sufficient information
available, the staff would not object to Company C basing its estimate
of expected volatility on the volatility of similar entities for those
periods for which it does not have sufficient information
available.\64\ Until Company C has either a sufficient amount of
historical information regarding the volatility of its share price or
other traded financial instruments are available to derive an implied
volatility to support an estimate of expected volatility, it should
consistently apply a process as described above to estimate expected
volatility based on the volatilities of similar entities.\65\
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\64\ FASB ASC paragraph 718-10-55-37. The staff believes that at
least two years of daily or weekly historical data could provide a
reasonable basis on which to base an estimate of expected volatility
if a company has no reason to believe that its future volatility
will differ materially during the expected or contractual term, as
applicable, from the volatility calculated from this past
information. If the expected or contractual term, as applicable, of
a share option is shorter than two years, the staff believes a
company should use daily or weekly historical data for at least the
length of that applicable term.
\65\ FASB ASC paragraph 718-10-55-40.
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2. Expected Term
FASB ASC paragraph 718-10-55-29 states ``The fair value of a traded
(or transferable) share option is based on its contractual term because
rarely is it economically advantageous to exercise, rather than sell, a
transferable share option before the end of its contractual term.
Employee share options generally differ from transferable [or tradable]
share options in that employees cannot sell (or hedge) their share
options--they can only exercise them; because of this, employees
generally exercise their options before the end of the options'
contractual term. Thus, the inability to sell or hedge an employee
share option effectively reduces the option's value [compared to a
transferable option] because exercise prior to the option's expiration
terminates its remaining life and thus its remaining time value.''
Accordingly, FASB ASC Topic 718 requires that when valuing an employee
share option under the Black-Scholes-Merton framework the fair value of
employee share options be based on the share options' expected term
rather than the contractual term.
The staff believes the estimate of expected term should be based on
the facts and circumstances available in each particular case.
Consistent with our guidance regarding reasonableness immediately
preceding Topic 14.A, the fact that other possible estimates are later
determined to have more accurately reflected the term does not
necessarily mean that the particular choice was unreasonable. The staff
reminds registrants of the expected term disclosure requirements
described in FASB ASC subparagraph 718-10-50-2(f)(2)(i).
Facts: Company D utilizes the Black-Scholes-Merton closed-form
model to value its share options for the purposes of determining the
fair value of the options under FASB ASC Topic 718. Company D recently
granted share options to its employees. Based on its review of various
factors, Company D determines that the expected term of the options is
six years, which is less than the contractual term of ten years.
Question 1: When determining the fair value of the share options in
accordance with FASB ASC Topic 718, should Company D consider an
additional discount for nonhedgability and nontransferability?
Interpretive Response: No. FASB ASC paragraph 718-10-55-29
indicates that nonhedgability and nontransferability have the effect of
increasing the likelihood that an employee share option will be
exercised before the end of its contractual term. Nonhedgability and
nontransferability therefore factor into the expected term assumption
(in this case reducing the term assumption from ten years to six
years), and the expected term reasonably adjusts for the effect of
these factors. Accordingly, the staff believes that no additional
reduction in the term assumption or other discount to the estimated
fair value is appropriate for these particular factors.\66\
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\66\ The staff notes the existence of academic literature that
supports the assertion that the Black-Scholes-Merton closed-form
model, with expected term as an input, can produce reasonable
estimates of fair value. Such literature includes J. Carpenter,
``The exercise and valuation of executive stock options,'' Journal
of Financial Economics, May 1998, pp.127-158; C. Marquardt, ``The
Cost of Employee Stock Option Grants: An Empirical Analysis,''
Journal of Accounting Research, September 2002, p. 1191-1217); and
J. Bettis, J. Bizjak and M. Lemmon, ``Exercise behavior, valuation,
and the incentive effect of employee stock options,'' Journal of
Financial Economics, forthcoming, 2005.
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Question 2: Should forfeitures or terms that stem from
forfeitability be factored into the determination of expected term?
Interpretive Response: No. FASB ASC Topic 718 indicates that the
expected term that is utilized as an assumption in a closed-form
option-pricing model or a resulting output of a lattice option pricing
model when determining the fair value of the share options should not
incorporate restrictions or other terms that stem from the pre-vesting
forfeitability of the instruments. Under FASB ASC Topic 718, these pre-
vesting restrictions or other terms are taken into account by
ultimately recognizing compensation cost only for awards for
[[Page 17282]]
which employees render the requisite service.\67\
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\67\ FASB ASC paragraph 718-10-30-11.
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Question 3: Can a company's estimate of expected term ever be
shorter than the vesting period?
Interpretive Response: No. The vesting period forms the lower bound
of the estimate of expected term.\68\
---------------------------------------------------------------------------
\68\ FASB ASC paragraph 718-10-55-31.
---------------------------------------------------------------------------
Question 4: FASB ASC paragraph 718-10-55-34 indicates that an
entity shall aggregate individual awards into relatively homogenous
groups with respect to exercise and post-vesting employment termination
behaviors for the purpose of determining expected term, regardless of
the valuation technique or model used to estimate the fair value. How
many groupings are typically considered sufficient?
Interpretive Response: As it relates to employee groupings, the
staff believes that an entity may generally make a reasonable fair
value estimate with as few as one or two groupings.\69\
---------------------------------------------------------------------------
\69\ The staff believes the focus should be on groups of
employees with significantly different expected exercise behavior.
Academic research suggests two such groups might be executives and
non-executives. A study by S. Huddart found executives and other
senior managers to be significantly more patient in their exercise
behavior than more junior employees. (Employee rank was proxied for
by the number of options issued to that employee.) See S. Huddart,
``Patterns of stock option exercise in the United States,'' in: J.
Carpenter and D. Yermack, eds., Executive Compensation and
Shareholder Value: Theory and Evidence (Kluwer, Boston, MA, 1999),
pp. 115-142. See also S. Huddart and M. Lang, ``Employee stock
option exercises: An empirical analysis,'' Journal of Accounting and
Economics, 1996, pp. 5-43.
---------------------------------------------------------------------------
Question 5: What approaches could a company use to estimate the
expected term of its employee share options?
Interpretive Response: A company should use an approach that is
reasonable and supportable under FASB ASC Topic 718's fair value
measurement objective, which establishes that assumptions and
measurement techniques should be consistent with those that marketplace
participants would be likely to use in determining an exchange price
for the share options.\70\ If, in developing its estimate of expected
term, a company determines that its historical share option exercise
experience is the best estimate of future exercise patterns, the staff
will not object to the use of the historical share option exercise
experience to estimate expected term.\71\
---------------------------------------------------------------------------
\70\ FASB ASC paragraph 718-10-55-13.
\71\ Historical share option exercise experience encompasses
data related to share option exercise, post-vesting termination, and
share option contractual term expiration.
---------------------------------------------------------------------------
A company may also conclude that its historical share option
exercise experience does not provide a reasonable basis upon which to
estimate expected term. This may be the case for a variety of reasons,
including, but not limited to, the life of the company and its relative
stage of development, past or expected structural changes in the
business, differences in terms of past equity-based share option
grants,\72\ or a lack of variety of price paths that the company may
have experienced.\73\
---------------------------------------------------------------------------
\72\ For example, if a company had historically granted share
options that were always in-the-money, and will grant at-the-money
options prospectively, the exercise behavior related to the in-the-
money options may not be sufficient as the sole basis to form the
estimate of expected term for the at-the-money grants.
\73\ For example, if a company had a history of previous equity-
based share option grants and exercises only in periods in which the
company's share price was rising, the exercise behavior related to
those options may not be sufficient as the sole basis to form the
estimate of expected term for current option grants.
---------------------------------------------------------------------------
FASB ASC Topic 718 describes other alternative sources of
information that might be used in those cases when a company determines
that its historical share option exercise experience does not provide a
reasonable basis upon which to estimate expected term. For example, a
lattice model (which by definition incorporates multiple price paths)
can be used to estimate expected term as an input into a Black-Scholes-
Merton closed-form model.\74\ In addition, FASB ASC paragraph 718-10-
55-32 states ``* * * expected term might be estimated in some other
manner, taking into account whatever relevant and supportable
information is available, including industry averages and other
pertinent evidence such as published academic research.'' For example,
data about exercise patterns of employees in similar industries and/or
situations as the company's might be used. While such comparative
information may not be widely available at present, the staff
understands that various parties, including actuaries, valuation
professionals and others are gathering such data.
---------------------------------------------------------------------------
\74\ FASB ASC paragraph 718-10-55-30.
---------------------------------------------------------------------------
Facts: Company E grants equity share options to its employees that
have the following basic characteristics:\75\
---------------------------------------------------------------------------
\75\ Employee share options with these features are sometimes
referred to as ``plain vanilla'' options.
---------------------------------------------------------------------------
The share options are granted at-the-money;
Exercisability is conditional only on performing service
through the vesting date;\76\
---------------------------------------------------------------------------
\76\ In this fact pattern the requisite service period equals
the vesting period.
---------------------------------------------------------------------------
If an employee terminates service prior to vesting, the
employee would forfeit the share options;
If an employee terminates service after vesting, the
employee would have a limited time to exercise the share options
(typically 30-90 days); and
The share options are nontransferable and nonhedgeable.
Company E utilizes the Black-Scholes-Merton closed-form model for
valuing its employee share options.
Question 6: As share options with these ``plain vanilla''
characteristics have been granted in significant quantities by many
companies in the past, is the staff aware of any ``simple''
methodologies that can be used to estimate expected term?
Interpretive Response: As noted above, the staff understands that
an entity that is unable to rely on its historical exercise data may
find that certain alternative information, such as exercise data
relating to employees of other companies, is not easily obtainable. As
such, some companies may encounter difficulties in making a refined
estimate of expected term. Accordingly, if a company concludes that its
historical share option exercise experience does not provide a
reasonable basis upon which to estimate expected term, the staff will
accept the following ``simplified'' method for ``plain vanilla''
options consistent with those in the fact set above: expected term =
((vesting term + original contractual term)/2). Assuming a ten year
original contractual term and graded vesting over four years (25% of
the options in each grant vest annually) for the share options in the
fact set described above, the resultant expected term would be 6.25
years.\77\ Academic research on the exercise of options issued to
executives provides some general support for outcomes that would be
produced by the application of this method.\78\
---------------------------------------------------------------------------
\77\ Calculated as [[[1 year vesting term (for the first 25%
vested) plus 2 year vesting term (for the second 25% vested) plus 3
year vesting term (for the third 25% vested) plus 4 year vesting
term (for the last 25% vested)] divided by 4 total years of vesting]
plus 10 year contractual life] divided by 2; that is, (((1+2+3+4)/4)
+ 10)/2 = 6.25 years.
\78\ J.N. Carpenter, ``The exercise and valuation of executive
stock options,'' Journal of Financial Economics, 1998, pp.127-158
studies a sample of 40 NYSE and AMEX firms over the period 1979-1994
with share option terms reasonably consistent to the terms presented
in the fact set and example. The mean time to exercise after grant
was 5.83 years and the median was 6.08 years. The ``mean time to
exercise'' is shorter than expected term since the study's sample
included only exercised options. Other research on executive options
includes (but is not limited to) J. Carr Bettis; John M. Bizjak; and
Michael L. Lemmon, ``Exercise behavior, valuation, and the incentive
effects of employee stock options,'' forthcoming in the Journal of
Financial Economics. One of the few studies on nonexecutive employee
options the staff is aware of is S. Huddart, ``Patterns of stock
option exercise in the United States,'' in: J. Carpenter and D.
Yermack, eds., Executive Compensation and Shareholder Value: Theory
and Evidence (Kluwer, Boston, MA, 1999), pp. 115-142.
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[[Page 17283]]
Examples of situations in which the staff believes that it may be
appropriate to use this simplified method include the following:
A company does not have sufficient historical exercise
data to provide a reasonable basis upon which to estimate expected term
due to the limited period of time its equity shares have been publicly
traded.
A company significantly changes the terms of its share
option grants or the types of employees that receive share option
grants such that its historical exercise data may no longer provide a
reasonable basis upon which to estimate expected term.
A company has or expects to have significant structural
changes in its business such that its historical exercise data may no
longer provide a reasonable basis upon which to estimate expected term.
The staff understands that a company may have sufficient historical
exercise data for some of its share option grants but not for others.
In such cases, the staff will accept the use of the simplified method
for only some but not all share option grants. The staff also does not
believe that it is necessary for a company to consider using a lattice
model before it decides that it is eligible to use this simplified
method. Further, the staff will not object to the use of this
simplified method in periods prior to the time a company's equity
shares are traded in a public market.
If a company uses this simplified method, the company should
disclose in the notes to its financial statements the use of the
method, the reason why the method was used, the types of share option
grants for which the method was used if the method was not used for all
share option grants, and the periods for which the method was used if
the method was not used in all periods. Companies that have sufficient
historical share option exercise experience upon which to estimate
expected term may not apply this simplified method. In addition, this
simplified method is not intended to be applied as a benchmark in
evaluating the appropriateness of more refined estimates of expected
term.
Also, as noted above in Question 5, the staff believes that more
detailed external information about exercise behavior will, over time,
become readily available to companies. As such, the staff does not
expect that such a simplified method would be used for share option
grants when more relevant detailed information becomes widely
available.
E. FASB ASC Topic 718, Compensation--Stock Compensation, and Certain
Redeemable Financial Instruments
Certain financial instruments awarded in conjunction with share-
based payment arrangements have redemption features that require
settlement by cash or other assets upon the occurrence of events that
are outside the control of the issuer.\79\ FASB ASC Topic 718 provides
guidance for determining whether instruments granted in conjunction
with share-based payment arrangements should be classified as liability
or equity instruments. Under that guidance, most instruments with
redemption features that are outside the control of the issuer are
required to be classified as liabilities; however, some redeemable
instruments will qualify for equity classification.\80\ SEC Accounting
Series Release No. 268, Presentation in Financial Statements of
``Redeemable Preferred Stocks,'' \81\ (``ASR 268'') and related
guidance \82\ address the classification and measurement of certain
redeemable equity instruments.
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\79\ The terminology ``outside the control of the issuer'' is
used to refer to any of the three redemption conditions described in
Rule 5-02.28 of Regulation S-X that would require classification
outside permanent equity. That rule requires preferred securities
that are redeemable for cash or other assets to be classified
outside of permanent equity if they are redeemable (1) at a fixed or
determinable price on a fixed or determinable date, (2) at the
option of the holder, or (3) upon the occurrence of an event that is
not solely within the control of the issuer.
\80\ FASB ASC paragraphs 718-10-25-6 through 718-10-25-19.
\81\ ASR 268, July 27, 1979, Rule 5-02.28 of Regulation S-X.
\82\ Related guidance includes FASB ASC paragraph 480-10-S99-3
(Distinguishing Liabilities from Equity Topic).
---------------------------------------------------------------------------
Facts: Under a share-based payment arrangement, Company F grants to
an employee shares (or share options) that all vest at the end of four
years (cliff vest). The shares (or shares underlying the share options)
are redeemable for cash at fair value at the holder's option, but only
after six months from the date of share issuance (as defined in FASB
ASC Topic 718). Company F has determined that the shares (or share
options) would be classified as equity instruments under the guidance
of FASB ASC Topic 718. However, under ASR 268 and related guidance, the
instruments would be considered to be redeemable for cash or other
assets upon the occurrence of events (e.g., redemption at the option of
the holder) that are outside the control of the issuer.
Question 1: While the instruments are subject to FASB ASC Topic
718,\83\ is ASR 268 and related guidance applicable to instruments
issued under share-based payment arrangements that are classified as
equity instruments under FASB ASC Topic 718?
---------------------------------------------------------------------------
\83\ FASB ASC paragraph 718-10-35-13 states that an instrument
ceases to be subject to this Topic when ``the rights conveyed by the
instrument to the holder are no longer dependent on the holder being
an employee of the entity (that is, no longer dependent on providing
service).''
---------------------------------------------------------------------------
Interpretive Response: Yes. The staff believes that registrants
must evaluate whether the terms of instruments granted in conjunction
with share-based payment arrangements with employees that are not
classified as liabilities under FASB ASC Topic 718 result in the need
to present certain amounts outside of permanent equity (also referred
to as being presented in ``temporary equity'') in accordance with ASR
268 and related guidance.\84\
---------------------------------------------------------------------------
\84\ Instruments granted in conjunction with share-based payment
arrangements with employees that do not by their terms require
redemption for cash or other assets (at a fixed or determinable
price on a fixed or determinable date, at the option of the holder,
or upon the occurrence of an event that is not solely within the
control of the issuer) would not be assumed by the staff to require
net cash settlement for purposes of applying ASR 268 in
circumstances in which FASB ASC Section 815-40-25, Derivatives and
Hedging--Contracts in Entity's Own Equity--Recognition, would
otherwise require the assumption of net cash settlement. See FASB
ASC paragraph 815-40-25-11, which states, in part: ``* * *the events
or actions necessary to deliver registered shares are not controlled
by an entity and, therefore, except under the circumstances
described in FASB ASC paragraph 815-40-25-16, if the contract
permits the entity to net share or physically settle the contract
only by delivering registered shares, it is assumed that the entity
will be required to net cash settle the contract.'' See also FASB
ASC subparagraph 718-10-25-15(a).
---------------------------------------------------------------------------
When an instrument ceases to be subject to FASB ASC Topic 718 and
becomes subject to the recognition and measurement requirements of
other applicable GAAP, the staff believes that the company should
reassess the classification of the instrument as a liability or equity
at that time and consequently may need to reconsider the applicability
of ASR 268.
Question 2: How should Company F apply ASR 268 and related guidance
to the shares (or share options) granted under the share-based payment
arrangements with employees that may be unvested at the date of grant?
Interpretive Response: Under FASB ASC Topic 718, when compensation
cost is recognized for instruments classified as equity instruments,
additional paid-in-capital \85\ is increased. If the award is not fully
vested at the grant date, compensation cost is recognized and
additional paid-in-capital is increased over time as services are
rendered over the requisite
[[Page 17284]]
service period. A similar pattern of recognition should be used to
reflect the amount presented as temporary equity for share-based
payment awards that have redemption features that are outside the
issuer's control but are classified as equity instruments under FASB
ASC Topic 718. The staff believes Company F should present as temporary
equity at each balance sheet date an amount that is based on the
redemption amount of the instrument, but takes into account the
proportion of consideration received in the form of employee services.
Thus, for example, if a nonvested share that qualifies for equity
classification under FASB ASC Topic 718 is redeemable at fair value
more than six months after vesting, and that nonvested share is 75%
vested at the balance sheet date, an amount equal to 75% of the fair
value of the share should be presented as temporary equity at that
date. Similarly, if an option on a share of redeemable stock that
qualifies for equity classification under FASB ASC Topic 718 is 75%
vested at the balance sheet date, an amount equal to 75% of the
intrinsic \86\ value of the option should be presented as temporary
equity at that date.
---------------------------------------------------------------------------
\85\ Depending on the fact pattern, this may be recorded as
common stock and additional paid in capital.
\86\ The potential redemption amount of the share option in this
illustration is its intrinsic value because the holder would pay the
exercise price upon exercise of the option and then, upon redemption
of the underlying shares, the company would pay the holder the fair
value of those shares. Thus, the net cash outflow from the
arrangement would be equal to the intrinsic value of the share
option. In situations where there would be no cash inflows from the
share option holder, the cash required to be paid to redeem the
underlying shares upon the exercise of the put option would be the
redemption value.
---------------------------------------------------------------------------
Question 3: Would the methodology described for employee awards in
the Interpretive Response to Question 2 above apply to nonemployee
awards to be issued in exchange for goods or services with similar
terms to those described above?
Interpretive Response: See Topic 14.A for a discussion of the
application of the principles in FASB ASC Topic 718 to nonemployee
awards. The staff believes it would generally be appropriate to apply
the methodology described in the Interpretive Response to Question 2
above to nonemployee awards.
F. Classification of Compensation Expense Associated with Share-Based
Payment Arrangements
Facts: Company G utilizes both cash and share-based payment
arrangements to compensate its employees and nonemployee service
providers. Company G would like to emphasize in its income statement
the amount of its compensation that did not involve a cash outlay.
Question: How should Company G present in its income statement the
non-cash nature of its expense related to share-based payment
arrangements?
Interpretive Response: The staff believes Company G should present
the expense related to share-based payment arrangements in the same
line or lines as cash compensation paid to the same employees.\87\ The
staff believes a company could consider disclosing the amount of
expense related to share-based payment arrangements included in
specific line items in the financial statements. Disclosure of this
information 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.
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\87\ FASB ASC Topic 718 does not identify a specific line item
in the income statement for presentation of the expense related to
share-based payment arrangements.
---------------------------------------------------------------------------
G. Removed by SAB 114 \88,89\
---------------------------------------------------------------------------
\88\ [Original footnote removed by SAB 114.]
\89\ [Original footnote removed by SAB 114.]
---------------------------------------------------------------------------
H. Removed by SAB 114 \90,91,92,93\
---------------------------------------------------------------------------
\90\ [Original footnote removed by SAB 114.]
\91\ [Original footnote removed by SAB 114.]
\92\ [Original footnote removed by SAB 114.]
\93\ [Original footnote removed by SAB 114.]
---------------------------------------------------------------------------
I. Capitalization of Compensation Cost Related to Share-Based Payment
Arrangements
Facts: Company K is a manufacturing company that grants share
options to its production employees. Company K has determined that the
cost of the production employees' service is an inventoriable cost. As
such, Company K is required to initially capitalize the cost of the
share option grants to these production employees as inventory and
later recognize the cost in the income statement when the inventory is
consumed.\94\
---------------------------------------------------------------------------
\94\ FASB ASC paragraph 718-10-25-2.
---------------------------------------------------------------------------
Question: If Company K elects to adjust its period end inventory
balance for the allocable amount of share-option cost through a period
end adjustment to its financial statements, instead of incorporating
the share-option cost through its inventory costing system, would this
be considered a deficiency in internal controls?
[[Page 17285]]
Interpretive Response: No. FASB ASC Topic 718, Compensation--Stock
Compensation, does not prescribe the mechanism a company should use to
incorporate a portion of share-option costs in an inventory-costing
system. The staff believes Company K may accomplish this through a
period end adjustment to its financial statements. Company K should
establish appropriate controls surrounding the calculation and
recording of this period end adjustment, as it would any other period
end adjustment. The fact that the entry is recorded as a period end
adjustment, by itself, should not impact management's ability to
determine that the internal control over financial reporting, as
defined by the SEC's rules implementing Section 404 of the Sarbanes-
Oxley Act of 2002,\95\ is effective.
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\95\ Release No. 34-47986, June 5, 2003, Management's Report on
Internal Control Over Financial Reporting and Certification of
Disclosure in Exchange Act Period Reports.
---------------------------------------------------------------------------
J. Removed by SAB 114 96 97 98
---------------------------------------------------------------------------
\96\ [Original footnote removed by SAB 114.]
\97\ [Original footnote removed by SAB 114.]
\98\ [Original footnote removed by SAB 114.]
---------------------------------------------------------------------------
K. Removed by SAB 114 99 100 101 102 103
---------------------------------------------------------------------------
\99\ [Original footnote removed by SAB 114.]
\100\ [Original footnote removed by SAB 114.]
\101\ [Original footnote removed by SAB 114.]
\102\ [Original footnote removed by SAB 114.]
\103\ [Original footnote removed by SAB 114.]
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L. Removed by SAB 114 104 105 106
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\104\ [Original footnote removed by SAB 114.]
\105\ [Original footnote removed by SAB 114.]
\106\ [Original footnote removed by SAB 114.]
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M. Removed by SAB 114
[FR Doc. 2011-5584 Filed 3-25-11; 8:45 am]
BILLING CODE 8011-01-P