[Federal Register Volume 68, Number 95 (Friday, May 16, 2003)]
[Rules and Regulations]
[Pages 26840-26925]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-12063]



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Part V





Securities and Exchange Commission





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17 CFR Part 211



Staff Accounting Bulletin No. 103, ``Update of Codification of Staff 
Accounting Bulletins''; Rules and Regulations

  Federal Register / Vol. 68 , No. 95 / Friday, May 16, 2003 / Rules 
and Regulations  

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 211

[Release No. SAB 103]


Staff Accounting Bulletin No. 103, ``Update of Codification of 
Staff Accounting Bulletins''

AGENCY: Securities and Exchange Commission.

ACTION: Publication of staff accounting bulletin.

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SUMMARY: This staff accounting bulletin revises or rescinds portions of 
the interpretive guidance included in the codification of staff 
accounting bulletins in order to make this interpretive guidance 
consistent with current authoritative accounting and auditing guidance 
and SEC rules and regulations. The principal revisions relate to the 
rescission of material no longer necessary because of private sector 
developments in U.S. generally accepted accounting principles, as well 
as Commission rulemaking.

DATES: Effective May 9, 2003.

FOR FURTHER INFORMATION CONTACT: Paul Munter or Jack Albert, Office of 
the Chief Accountant (202-942-4400), or Craig Olinger, Division of 
Corporation Finance (202-942-2960), Securities and Exhange Commission, 
450 Fifth Street, NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

Background

    The last comprehensive review of the staff accounting bulletins was 
completed by the staff in 1981, which culminated in issuance of Staff 
Accounting Bulletin No. 40. At that time, the staff completed a 
comprehensive review of the material included in staff accounting 
bulletin numbers 1 through 38 to revise and update such materials, and 
to codify those staff accounting bulletins in order to make the 
interpretive guidance contained therein more useful to registrants, 
accountants and others (Staff Accounting Bulletin No. 39 was separately 
considered by the staff).
    Since that time, the staff has issued 62 additional staff 
accounting bulletins (through number 102) and occasional amendments 
(e.g., SAB No. 71A), and has, on a sporadic basis, revised or rescinded 
the guidance in individual staff accounting bulletins based on 
subsequent Commission rulemaking activities or developments by private 
sector accounting and auditing standards-setters. However, a 
comprehensive review of the guidance contained in the staff accounting 
bulletin codification has not been undertaken since 1981.
    Recent guidance issued by the Financial Accounting Standards Board 
(FASB), specifically Statements of Financial Accounting Standards 
(Statements) 141, Business Combinations, 142, Goodwill and Other 
Intangible Assets, 143, Accounting for Asset Retirement Obligations, 
144, Accounting for the Impairment or Disposal of Long-Lived Assets, 
146, Accounting for Costs Associated with Exit or Disposal Activities, 
147, Acquisitions of Certain Financial Institutions--an Amendment of 
FASB Statements No. 72 and 144 and FASB Interpretation No. 9, and 
Interpretations 45, Guarantor's Accounting and Disclosure Requirements 
for Guarantees, Including Indirect Guarantees of Indebtedness of 
Others--an Interpretation of FASB Statements No. 5, 57, and 107 and 
Rescission of FASB Interpretation No. 34 and 46, Consolidation of 
Variable Interest Entities, revise or supersede certain guidance 
contained in Accounting Principles Board (APB) Opinions 16, Business 
Combinations, 17, Intangible Assets, and 30, Reporting the Results of 
Operations-- Reporting the Effects of Disposal of a Segment of a 
Business, and Extraordinary, Unusual and Infrequently Occurring Events 
and Transactions, Statements 5, Accounting for Contingencies, and 121, 
Accounting for the Impairment of Long-Lived Assets and for Long-Lived 
Assets to Be Disposed Of, as well as several issues addressed by the 
FASB's Emerging Issues Task Force (EITF) and other authoritative 
guidance. Provisions of the accounting standards identified above that 
have been revised or superseded were the subject of several staff 
interpretations included in the staff accounting bulletins. 
Furthermore, certain guidance contained in many of the staff accounting 
bulletins either is no longer useful or relevant due to the passage of 
time, or has been made obsolete by subsequent Commission rulemaking 
activities.
    Therefore, the purpose of this staff accounting bulletin is to 
comprehensively update the existing codification to enhance the 
integrity and usefulness of this guidance.
    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: May 9, 2003.
Margaret H. McFarland,
Deputy Secretary.

PART 211--[AMENDED]

    Accordingly, Part 211 of Title 17 of the Code of Federal 
Regulations is amended by adding Staff Accounting Bulletin No. 103 to 
the table found in Subpart B.

Staff Accounting Bulletin No. 103

    The staff hereby revises the Staff Accounting Bulletin Series as 
follows:

1. Topic 1: Financial Statements

    a. Topic 1.A is modified to delete the reference to previously-
deleted Rules 3-07 and 3-08 of Regulation S-X.
    b. Topic 1.B.1 is modified to reflect the provisions of FASB 
Statement 109, Accounting for Income Taxes.
    c. Topic 1.D.1 is modified to conform such guidance with the 
revised disclosure requirements for foreign private issuers required 
under Form 20-F as a result of the Commission's International 
Disclosure Standards rule (Exchange Act Release No. 34-41936) which 
became effective September 30, 2000. The modifications primarily relate 
to changes in the former reference in this guidance to Item 9 
(Management's Discussion and Analysis) of Form 20-F to make the 
reference consistent with the new non-financial disclosure requirements 
of this Form.
    d. Topic 1.E.1 is deleted. A definition of the term ``audit (or 
examination),'' which was the subject of this interpretive guidance, is 
now provided in Rule 1-02 of Regulation S-X, thus making the guidance 
contained in this staff accounting bulletin unnecessary.
    e. Topic 1.F is modified to change the references in this guidance 
from Form S-14 to Form S-4, since Form S-4 subsequently replaced Form 
S-14. This topic is also modified to delete question 3 and the related 
interpretive response. The guidance contained in this interpretive 
response, related to the appropriate accounting treatment for costs 
incurred to register securities issued for the formation of one-bank 
holding companies, has been superseded by American Institute of 
Certified Public Accountants' (AICPA) Statement of Position (SOP) 98-5, 
Reporting on the Costs of Start-Up Activities.
    f. Topic 1.I is modified to update the former reference in this 
guidance to the American Institute of Certified Public Accountants' 
February 1986 Notice to Practitioners, ADC Arrangements. ADC

[[Page 26841]]

Arrangements was originally issued as a notice to practitioners, 
published in the April 1986 issue of The Journal of Accountancy. This 
notice was subsequently reprinted without modification as Exhibit I to 
the AICPA's Practice Bulletin 1 dated November 1987. Furthermore, 
question 8 of this topic is deleted because the guidance contained in 
this question and interpretive response, which related to transition to 
the guidance in Topic 1.I, is no longer relevant due to the passage of 
time. Furthermore, the reference in the interpretive response to 
question 1 to Rule 1-02(v) of Regulation S-X has been changed to Rule 
1-02(w) of Regulation S-X, since this Rule was redesignated in Exchange 
Act Release No. 34-35094.
    g. Topic 1.J, the first paragraph of the interpretative response is 
modified to remove the reference to specific percentages and refer to 
the significance tests in Rule 3-05.
    h. Topic 1.L is deleted since it refers to the bankruptcy of a 
specific accounting firm (Laventhol & Horwath) which occurred in 1990.
    i. Topic 1.M is modified to update references to authoritative 
literature such as SAS 99, Consideration of Fraud in a Financial 
Statement Audit, which superseded SAS 82, Consideration of Fraud in a 
Financial Statement Audit.
    2. Topic 2: Business Combinations--Note: In June 2001, the FASB 
issued Statement 141, which superseded APB Opinion 16, and Statement 
142 which superseded APB Opinion 17. Paragraph 13 of Statement 141 
requires all business combinations within the scope of that statement 
to be accounted for using the purchase method as described in that 
statement. The provisions of Statement 141 are applicable to all 
business combinations initiated after June 30, 2001. The pooling-of-
interests method of accounting for business combinations, as provided 
for in APB Opinion 16, is no longer permitted for business combinations 
initiated after June 30, 2001. Several of the interpretive questions in 
this topic relate to the conditions that must be met in order for a 
business combination to be appropriately accounted for under the 
pooling-of-interests method. Accordingly, these interpretive questions 
are no longer needed.
    a. Topic 2.A.1 is deleted. This topic addresses the impact of cash 
contingencies on classifying a combination as a pooling-of-interests. 
Since business combinations cannot be accounted for using the pooling-
of-interests method, the guidance is no longer relevant.
    b. Topic 2.A.2 is deleted. This topic contained two interpretive 
questions regarding how the acquiring corporation should be determined 
in a purchase business combination, following the guidance in APB 
Opinion 16. These interpretations were premised on the language 
contained in paragraph 70 of APB Opinion 16, which indicated that ``* * 
* presumptive evidence of the acquiring corporation in combinations 
effected by an exchange of stock is obtained by identifying the former 
common stockholder interests of a combining company which either retain 
or receive the larger portion of the voting rights in the combined 
corporation. That corporation should be treated as the acquirer unless 
other evidence clearly indicates that another corporation is the 
acquirer.'' Guidance on identifying the acquiring entity is now 
provided in paragraphs 15 through 19 of Statement 141. This guidance 
provides several factors to be considered in determining the acquiring 
entity, one of which is the relative voting rights in the combined 
entity after the combination. The presumptive language contained in APB 
Opinion 16 was not retained in Statement 141. Therefore, the guidance 
in Topic 2.A.2 is no longer relevant.
    c. Topic 2.A.3 is deleted. This topic provided interpretive 
guidance regarding the application of the purchase method of accounting 
for business combinations to acquisitions of financial institutions 
during a period of unusual economic conditions (i.e., a period of 
abnormally high interest rates). This guidance focused on: (1) Unique 
considerations in the allocation of purchase price to acquired tangible 
and intangible assets in financial institution acquisitions (such as 
the determination of the fair values of assets acquired, and the 
identification and valuation of identifiable intangible assets), (2) 
the appropriate measure of the fair value of deposit liabilities 
assumed in acquisitions of financial institutions, and (3) the 
appropriate amortization periods and methods for intangible assets 
acquired and goodwill arising from financial institution acquisitions. 
Statements 141 and 147 provide new guidance as to the criteria for 
recognizing an intangible asset apart from goodwill in a purchase 
business combination. Statement 142 provides new guidance on the 
initial recognition and measurement of intangible assets, and the 
determination of the useful lives and amortization methods for 
intangible assets subject to amortization. Statement 142 also provides 
new guidance on accounting for goodwill. Consequently, the guidance 
contained in this topic is no longer relevant.
    d. Topic 2.A.4 is deleted. This topic provided guidance on the 
determination of the appropriate amortization period for goodwill 
arising from financial institution acquisitions which occurred after 
December 23, 1981 at the time an entity participating in such an 
acquisition became an SEC registrant. Under the provisions of Statement 
142, goodwill is not amortized, but instead must be tested for 
impairment at least annually following the methodology provided in that 
statement. Therefore, the guidance in this topic is no longer relevant.
    e. Topic 2.A.5 is modified to update the former references to APB 
Opinion 16 contained therein to the relevant portions of Statement 141, 
and to otherwise make the language in this guidance consistent with the 
provisions of Statement 141.
    f. Topic 2.A.6 is modified to update the former references to APB 
Opinion 16 contained therein to the relevant portions of Statement 141, 
and to otherwise make the language in this guidance consistent with the 
provisions of Statement 141.
    g. Topic 2.A.7 is modified to update the former references to APB 
Opinion 16 contained therein to the relevant portions of Statement 141, 
and to otherwise make the language in this guidance consistent with the 
provisions of Statement 141.
    h. Topic 2.A.8 is modified to update the former references to APB 
Opinion 16 contained therein to the relevant portions of Statement 141, 
and to otherwise make the language in this guidance consistent with the 
provisions of Statement 141. Furthermore, footnote 2 is deleted, since 
this footnote provided transition guidance which is no longer necessary 
due to the passage of time.
    i. Topic 2.A.9 is modified to update the former references to APB 
Opinion 16 contained therein to the relevant portions of Statement 141, 
and to otherwise make the language in this guidance consistent with the 
provisions of Statement 141.
    j. Topic 2.B is deleted. It addressed the treatment of merger 
expenses in a pooling-of-interests combination. Since, under Statement 
141, all combinations are treated as purchases, this guidance is no 
longer necessary.
    k. Topic 2.C is deleted. It addressed certain pro forma disclosures 
required for a pooling-of-interests combination. Since, under Statement 
141, all combinations are treated as purchases, this guidance is no 
longer necessary.

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    l. Topic 2.D is modified to update the former references to APB 
Opinion 16 contained therein to the relevant portions of Statement 141, 
and to otherwise make the language in this guidance consistent with the 
provisions of Statement 141 and to delete portions of the guidance 
related to pooling-of-interests accounting.
    m. Topic 2.E is deleted. The topic addressed the implications of 
risk sharing provisions on the classification of a combination as a 
pooling-of-interests. Since, under Statement 141, all combinations are 
treated as purchases, this guidance is no longer necessary.
    n. Topic 2.F is deleted. This topic addressed the implications of 
treasury stock transactions following the consummation of a business 
combination on the classification of a combination as a pooling-of-
interest. Since, under Statement 141, all combinations are treated as 
purchases, this guidance is no longer necessary.

3. Topic 3: Senior Securities

    a. Topic 3.C is modified to include a reference to EIT Topic D-98 
in the interpretive response to Question 1.

4. Topic 4: Equity Accounts

    a. Topic 4.B is retitled. It previously referred to Subchapter S 
Corporations. Such entities are now referred to as S Corporations.
    b. Topic 4.E is modified to revise the interpretive response to be 
consistent with revisions subsequently made in Rule 5-02.30 of 
Regulation S-X.

5. Topic 5: Miscellaneous Accounting

    a. Topics 5.C.1 and 5.C.2 are deleted. These topics provided 
interpretive guidance related to the current recognition of tax loss 
carryforwards under APB Opinion 11, Accounting for Income Taxes. APB 
Opinion 11 has since been superseded by Statement 109 and the guidance 
contained in these topics is no longer relevant.
    b. Topic 5.E, question 1 is modified to add an appropriate 
reference to FASB Interpretation 46.
    c. Topic 5.E, question 2 is modified to remove, in the interpretive 
response, the reference to APB Opinion 30, since the relevant 
authoritative guidance that this response was referring to (accounting 
for the disposal of a segment of a business) has been superseded by 
Statement 144. Additionally, that interpretive response is modified to 
remove the reference to ASR 95, Accounting for Real Estate Transactions 
Where Circumstances Indicate that Profits Were Not Earned at the Time 
the Transactions Were Recorded, which previously was rescinded.
    d. Topic 5.F is modified to delete the reference in the 
interpretive response to Statement 8, Accounting for the Translation of 
Foreign Currency Transactions and Foreign Currency Financial 
Statements, which has since been superseded.
    e. Topic 5.J, footnote 1 has been modified to reflect the fact that 
the FASB has not determined when or whether it will address push down 
accounting. Additionally, the interpretive response to question 3 has 
been modified to include reference to the guidance provided in 
Interpretation 45.
    f. Topic 5.M is modified in order to conform this guidance with the 
provisions of Statement 115, Accounting for Certain Investments in Debt 
and Equity Securities, which superseded Statement 12, Accounting for 
Certain Marketable Securities. The guidance contained in question 1 of 
this interpretation continues to be relevant, because Statement 115, 
like Statement 12, requires a determination of whether a decline in the 
fair value of debt or equity securities is other than temporary. 
References to the applicable authoritative literature in the 
interpretive response to this question are changed, and the language in 
the interpretive response to question 1 is modified, to be consistent 
with the new authoritative guidance. Question 2 and the related 
interpretive response are deleted since Statement 115, paragraph 16 now 
provides relevant guidance on determining the amount of the write down 
when a decline in fair value is judged to be other than temporary.
    g. Topics 5.P.1 and 5.P.2 are deleted. These topics provided 
interpretive guidance related to APB Opinion 30 and EITF Issues 94-3, 
Liability Recognition for Certain Employee Termination Benefits and 
Other Costs to Exit an Activity (Including Certain Costs Incurred in a 
Restructuring), and 95-3, Recognition of Liabilities in Connection with 
a Purchase Business Combination, as they applied to restructuring 
provisions. Statement 146 establishes standards for accruing 
liabilities related to exiting activities and requires that the 
liability be recorded when it has been incurred and that it be recorded 
at its fair value. Accordingly, the previous guidance provided in these 
topics is no longer needed.
    h. Topic 5.P.3 is modified to delete the language that referred to 
the requirements of APB Opinion 30 regarding the reporting of 
discontinued operations, which has since been superseded by Statement 
144. Footnote 13 of this guidance also has been modified and renumbered 
to make reference to Statement 131, Disclosures about Segments of an 
Enterprise and Related Information, which superseded Statement 14, 
Financial Reporting for Segments of a Business Enterprise. The guidance 
in this footnote continues to be relevant, considering the revisions 
hereby made, under Statement 131.
    i. Topic 5.P.4 is modified to change the reference in former 
footnote 16 from Statement 38, Accounting for Preacquisition 
Contingencies of Purchased Enterprises, to Statement 141. Statement 141 
superseded Statement 38, although the guidance in Statement 38 was 
carried forward into the new standard without reconsideration. 
Therefore, the guidance in this footnote remains relevant. 
Additionally, the topic is modified to reflect the disclosure 
requirements of Statement 146.
    j. Topic 5.R is deleted. With the issuance of Statement 140, 
Accounting for Transfers and Servicing of Financial Assets and 
Extinguishments of Liabilities, and Interpretation 39, Offsetting of 
Amounts Related to Certain Contracts, this guidance is no longer 
needed.
    k. Topic 5.S, question 4 is modified to change the references in 
the interpretive response from Statement 96, Accounting for Income 
Taxes, to the relevant provisions in Statement 109. Although Statement 
109 superseded Statement 96, the guidance in this interpretive response 
remains relevant, considering the revisions hereby made, because 
Statement 109 carried forward the same guidance contained in Statement 
96 with respect to quasi-reorganizations.
    l. Topic 5.T, footnote 2 is modified to remove reference to APB 
Opinion 16, which was superseded, and Topic 2.B, which is being 
deleted.
    m. Topic 5.U is modified to add new footnotes 4 and 5 to clarify 
the guidance applicable to gain deferral situations.
    n. Topic 5.V is modified to note that the interpretive guidance 
therein does not apply to sales of the residual equity in an entity 
holding nonperforming loans to an unrelated party. Instead, the 
provisions of Statement 140 apply to such transactions. Also, it is 
modified to add an appropriate reference to FASB Interpretation 46 and 
to delete the reference to EITF Topic D-14, Transactions involving 
Special-Purpose Entities. In addition, footnote 5 has been modified to 
note that EITF Issue 87-17, Spinoffs or Other Distributions of Loans 
Receivable to Shareholders, was subsequently codified as issue 11 of 
EITF Issue 01-02, Interpretations of APB Opinion No. 29.

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    o. Topic 5.W is modified to incorporate the guidance of SOP 94-6, 
Disclosure of Certain Significant Risks and Uncertainties.
    p. Topic 5.X is deleted. This interpretive guidance expressed the 
staff's views regarding the accounting for income tax benefits of 
thrift bad-debt losses. This guidance was intended to serve as interim 
guidance until a new standard on accounting for income taxes was 
adopted. The FASB subsequently issued Statement 109 which provides 
guidance on this issue.
    q. Topic 5.Y is modified as follows:
    i. The Facts section, questions 1, 2, and 3 are deleted. The 
remaining questions are renumbered. This information is no longer 
needed because the issues are addressed in SOP 96-1, Environmental 
Remediation Liabilities.
    ii. Previously-numbered question 4 is modified to replace the 
reference to EITF Issue No. 93-5, Accounting For Environmental 
Liabilities, with SOP 96-1 (SOP 96-1 carried forward the guidance 
previously contained in EITF Issue 93-5). In addition, previously-
numbered footnote 3, included in the interpretive response to question 
4, is modified to provide the relevant language from Concepts Statement 
7, Using Cash Flow Information and Present Value in Accounting 
Measurements.
    iii. Previously-numbered question 5 is modified to incorporate 
guidance from and reference to SOP 96-1.
    iv. The interpretive response to previously-numbered question 7 is 
modified to refer registrants to the disclosure requirements of 
Statement 143 for legal obligations associated with the retirement of 
tangible long-lived assets within the scope of that statement and to 
Interpretation 45 for guarantees.
    v. Previously-numbered question 8 and the related interpretive 
response are deleted. This guidance, related to the appropriate 
accounting for site restoration costs, post-closure and monitoring 
costs, or other environmental costs incurred at the end of the useful 
life of an asset, is no longer relevant due to the issuance of 
Statement 143, which establishes accounting standards for recognition 
and measurement of liabilities for asset retirement obligations and 
associated asset retirement costs.
    r. Topic 5.Z.1 is deleted. The guidance in this interpretive 
response provided the staff's views as to whether the criteria under 
APB Opinion 30 for presentation as discontinued operations had been met 
under certain facts and circumstances. Statement 144 provides new 
guidance on reporting discontinued operations that supersedes the 
portions of APB Opinion 30 that addressed this issue. Therefore, this 
interpretative guidance is no longer relevant.
    s. Topic 5.Z.2 is deleted. The guidance in these interpretive 
responses provided the staff's views as to whether the criteria under 
APB Opinion 30 for presentation as discontinued operations had been met 
under certain facts and circumstances. Statement 144 provides new 
guidance on reporting discontinued operations that supersedes the 
portions of APB Opinion 30 that addressed this issue. Therefore, this 
interpretative guidance is no longer relevant.
    t. Topic 5.Z.3 is deleted. The guidance in these interpretive 
responses provided the staff's views as to whether the criteria under 
APB Opinion 30 for presentation as discontinued operations had been met 
under certain facts and circumstances. Statement 144 provides new 
guidance on reporting discontinued operations that supersedes the 
portions of APB Opinion 30 that addressed this issue. Therefore, this 
interpretative guidance is no longer relevant.
    u. Topic 5.Z.4 is modified to be consistent with the guidance of 
Statement 144, which superseded the previous guidance of APB Opinion 
30.
    v. Topic 5.Z.5 is modified to reflect the appropriate terminology 
from Statement 144 (separate component) rather than that previously 
provided by APB Opinion 30 (segment of a business), to make other 
changes related to the accounting provisions of Statement 144, and to 
remind registrants of the disclosure requirements of Interpretation 45.
    w. Topic 5.Z.6 is deleted. This topic provided the staff's views as 
to whether subsidiaries that a company intends to sell, which cannot be 
reported as discontinued operations under APB Opinion 30, must be 
consolidated in the company's financial statements. This interpretive 
question arose as a result of the ``temporary control'' exception to 
consolidation in ARB 51, Consolidated Financial Statements, as amended 
by Statement 94, Consolidation of all Majority-Owned Subsidiaries. 
Statement 144 provides guidance which supersedes the guidance in APB 
Opinion 30 related to the reporting of discontinued operations. 
Statement 144 also amended ARB 51 to eliminate the exception to 
consolidation for a subsidiary for which control is likely to be 
temporary. Therefore, the interpretive guidance in this topic is no 
longer relevant.
    x. Topic 5.Z.7 is modified to change the reference therein from APB 
Opinion 30 to Statement 144. Furthermore, the interpretive response is 
also amended to add language clarifying the staff's interpretation of 
the term ``dissimilar'' based on long-standing staff practice.
    y. Topic 5.AA is deleted. Statement 140 superseded the previous 
guidance on extinguishments of debt. Accordingly, the guidance is no 
longer needed.
    z. Topic 5.CC is modified. Topic 5.CC provides interpretive 
guidance on certain questions related to the recognition and 
measurement of impairment of the carrying amount of long-lived assets, 
certain identifiable intangible assets, and goodwill pursuant to the 
provisions of Statement 121 and APB Opinion 17. A portion of this 
guidance has since been superseded by Statements 142 and 144 and is now 
deleted. The remaining relevant guidance is rewritten so that it is 
consistent with the requirements of Statements 142 and 144.

6. Topic 6: Interpretations of Accounting Series Releases

    a. Topic 6.A.1 is deleted. ASR 166, Disclosure of Unusual Risks and 
Uncertainties in Financial Reporting, has been rescinded. Therefore, 
the guidance contained in this topic is no longer relevant.
    b. Topic 6.F.1 is deleted. This interpretation provided 
interpretive guidance on the requirements of Rule 12-03 of Regulation 
S-X. The schedule previously required under Rule 12-03 was eliminated 
by Exchange Act Release No. 34-35094. Therefore, the guidance contained 
in this topic is no longer necessary.
    c. Topic 6.G.1 is modified as follows:
    i. The interpretive response to Question 5 is modified to 
incorporate the terminology used in Statement 144.
    ii. Question 7 and the related interpretive response under sub-
section a. to this topic are modified to remove the reference to Form 
8, which was rescinded by Exchange Act Release No. 34-31905.
    iii. Sub-section c. and the related questions and interpretive 
responses thereunder are deleted. Item 302(a)(5) of Regulation S-K was 
amended by Exchange Act Release No. 34-42266 which made the 
requirements of Item 302(a) of Regulation S-K applicable to any 
registrant, except a foreign private issuer, that has securities 
registered pursuant to sections 12(b) or 12(g) of the Exchange Act. 
Therefore, the guidance contained in these questions and interpretive 
responses, which related to the former requirements of Item 302(a) of 
Regulation S-K, no longer applies.
    d. Topic 6.G.2.a is modified as follows:
    i. Question 4 is modified to refer to cash and cash equivalents 
rather than to

[[Page 26844]]

funds. APB Opinion 19, Reporting Changes in Financial Position, 
referred to flow of funds. Statement 95, Statement of Cash Flows, 
superseded APB Opinion 19 and refers to flow of cash and cash 
equivalents.
    ii. Question 5 is deleted. Question 5 refers to an analysis of 
changes in each element of working capital, which is consistent with a 
``funds'' model. However, with the provisions of Statement 95, which 
uses ``cash and cash equivalents,'' this guidance is no longer 
relevant.
    e. Topic 6.G.2.b.1 is modified to add a footnote reference to APB 
Opinion 20, Accounting Changes, which requires disclosure of the nature 
and justification of a change in accounting principle.
    f. Topic 6.H is modified as follows:
    i. The Facts section is modified to delete item (3), since the 
related supplemental schedule that this item was referring to (Rule 12-
10 of Regulation S-X) was eliminated by Exchange Act Release No. 34-
35094.
    ii. Topic 6.H.1.b is modified to refer to Rule 17a-5 as currently 
numbered.
    iii. Topic 6.H.2.a is modified to remove the reference to ASR 172, 
Notice of Rescission of Guidelines Set Forth in Accounting Series 
Release No. 148 Pertaining to Classification of Short-Term Obligations 
Expected to be Refinanced.
    iv. Topic 6.H.4.c and the related question and interpretive 
response thereunder are deleted. The schedule formerly required 
pursuant to Rule 12-10 of Regulation S-X was eliminated by Exchange Act 
Release No. 34-35094. Therefore, this guidance, which related to the 
disclosures previously required under Rule 12-10, is no longer 
relevant.
    g. Topic 6.I.3 is modified to refer to discontinued operations 
rather than discontinuance or disposals of business segments so that it 
is consistent with Statement 144.
    h. Topic 6.I.7 is modified to refer to Rule 4-08(h) rather than 
Rule 4-08(g) to reflect current numbering.
    i. Topic 6.K.1 is deleted. This topic provided interpretive 
guidance related to the early adoption of ASR 302, Separate Financial 
Statements Required by Regulation S-X. This guidance is no longer 
necessary due to the passage of time.
    j. Topic 6.4.b is modified to refer to Rule 1-02(w). The rules for 
determining significant subsidiaries were previously renumbered and 
moved to subsection (w).

7. Topic 7: Real Estate Companies

    a. Topic 7.A is deleted. This topic provided guidance on the 
presentation of funds data in quarterly reports on Form 10-Q for real 
estate companies. This guidance is no longer relevant due to the 
issuance Statement 95.
    b. Topic 7.B is deleted. This topic provided guidance on the 
appropriate format for the statement of changes in financial position 
for registrants engaged in retail land development and sale activities. 
This guidance is no longer relevant due to the issuance of Statement 
95.

8. Topic 8: Retail Companies

    a. The Facts to Topic 8.A are rewritten to make them more 
generically applicable to retail companies.

9. Topic 9: Finance Companies

    a. Topic 9.A is deleted. This topic provided interpretive guidance 
on the appropriate accounting for nonrefundable ``points'' charged by 
finance companies at the time a loan transaction is closed. Related 
guidance is now provided in Statement 91, Accounting for Nonrefundable 
Fees and Costs Associated with Originating or Acquiring Loans and 
Initial Direct Costs of Leases, making the continued need for the 
guidance in this topic unnecessary.

10. Topic 10: Utility Companies

    a. In the interpretive response to Topic 10.A, reference to Rule 4-
08(j) is deleted since that rule no longer exists.
    b. Topic 10.B is deleted. This topic provided interpretive guidance 
on disclosures that should be made concerning the estimated future 
costs of storing spent nuclear fuel and decommissioning nuclear 
generating plants. Statement 143 establishes accounting standards for 
recognition and measurement of a liability for an asset retirement 
obligation and the associated asset retirement cost, including required 
disclosures. Therefore, the guidance in this topic is no longer 
relevant.
    c. Topic 10.C is modified to add a footnote reminding registrants 
to consider the guidance provided in Interpretation 46.
    d. In the interpretive response to Topic 10.D, the second, third 
and fourth sentences of the final paragraph are deleted. These 
sentences referred to ASR 122, Coverage of Fixed Charges, which has 
been rescinded. Additionally, a footnote is added to remind registrants 
of the need to consider the guidance provided in Interpretations 45 and 
46 and Statement 133, Accounting for Derivative Instruments and Hedging 
Activities and related literature.
    e. Topic 10.E, question 2 and related interpretive response dealing 
with transition to the requirements of Statement 90, Regulated 
Enterprises--Accounting for Abandonments and Disallowances of Plant 
Costs is deleted as no longer necessary due to the passage of time.
    f. Topic 10.F is modified to incorporate a footnote to the 
interpretive response to relate the response to the requirements of SOP 
96-1.

11. Topic 11: Miscellaneous Disclosure

    a. Topic 11.D is deleted. This topic provided interpretive guidance 
on the offsetting of related assets and liabilities. This guidance is 
no longer necessary due to the issuance of Interpretation 39.
    b. Question 1 of Topic 11.H.2 is deleted with Questions 2 and 3 
being renumbered as Questions 1 and 2. Question 1 and the Interpretive 
Response are no longer needed in light of the provisions of Statements 
15 and 114.
    c. Topic 11.J is deleted. This topic provided interpretive guidance 
on reporting information related to financial guarantees. This guidance 
is no longer necessary due to the issuance of Interpretation 45.
    d. Topic 11.K, footnote one is modified to remove reference to 
activities of the FASB's financial instruments project which 
subsequently have been completed.
    e. Topic 11.N, footnote 2 is modified to remove reference to 
Statement 72, Accounting for Certain Acquisitions of Banking or Thrift 
Institutions (an Amendment of APB Opinion No. 17, an Interpretation of 
APB Opinions 16 and 17, and an Amendment of FASB Interpretation No. 9). 
With the issuance of Statement 147, the provisions of Statement 72 are 
no longer relevant to the accounting for such transactions.

12. Topic 12: Oil and Gas Producing Activities

    a. Topic 12.A.1 is revised to delete, in the interpretive response 
to question 3, the reference to Item 2(b)(3) of Regulation S-K, which 
has been redesignated within Industry Guide 2.
    b. Topic 12.A.2 is revised to update the references to the required 
disclosures of the standardized measure of discounted future net cash 
flows to the provisions of Statement 69, Disclosures about Oil and Gas 
Producing Activities. Consistent with this change, reference to 
``standardized measure of discounted future net cash flows'' is 
substituted for ``estimated future net revenues'' and ``year end 
prices'' substituted for ``current prices'' for consistency with the 
terminology used in Statement 69. Furthermore, questions 4-11, and the 
related

[[Page 26845]]

interpretive responses to those questions which deal with the reporting 
implications of the Windfall Profits Tax and the 1985 natural gas price 
decontrol and disclosure of reserve information are deleted as no 
longer being relevant.
    c. Topic 12 A.3.a is deleted. The required disclosures of the 
standardized measure of discounted future net cash flows is provided by 
Statement 69 and the guidance is no longer necessary.
    d. Topic 12.A.3.c is revised to update the references to the 
required disclosures of the standardized measure of discounted future 
net cash flows to the provisions of Statement 69.
    e. Topic 12.A.3.d is revised to update the references to the 
required disclosures of the standardized measure of discounted future 
net cash flows to the provisions of Statement 69.
    f. Topic 12.A.4, regarding filings by Canadian registrants, is 
deleted as no longer being relevant.
    g. Topic 12.B regarding supplemental disclosures on the basis of 
reserve recognition accounting is deleted as no longer being relevant.
    h. Topic 12.C.2 is revised to update the references currently 
included in Regulation S-X.
    i. Topic 12.D.1 is revised to update the references currently 
included in Regulation S-X.
    j. Topic 12.D.2 is revised to update the references to the required 
disclosures of the standardized measure of discounted future net cash 
flows to the provisions of Statement 69.
    k. Topic 12.D.3.a is revised to update the references currently 
included in Regulation S-X.
    l. Topic 12.D.3.b is redesignated as Topic 12.D.3.c and revised to 
provide updated guidance consistent with Statement 133.
    m. Topic 12.D.3.b is rewritten to reflect the changes in the 
computation as a result of changes in the authoritative literature 
related to derivatives accounted for in accordance with Statement 133.
    n. Topic 12.F is revised to substitute the reference to Rule 4-
10(c)(3)(iii) of Regulation S-X for outdated Rule 4-10(i)(3)(iii) of 
Regulation S-X.
    o. Topic 12.G is revised to update the references to the required 
disclosures of the standardized measure of discounted future net cash 
flows to the provisions of Statement 69 and to substitute the reference 
to Rule 4-10(c)(4) of Regulation S-X for Rule 4-10(k)(4) of Regulation 
S-X.

13. Topic 13: Revenue Recognition

    a. Topic 13.A.3, the following changes are made:
    i. The interpretive response to question 3 is modified to 
incorporate the guidance on separate elements of an arrangement from 
EITF Issue 00-21. Additionally, footnote 24 is modified to remove the 
reference to Statement 53, Financial Reporting by Producers and 
Distributors of Motion Picture Films, which has been superseded and to 
add a reference to SOP 00-2, Accounting by Producers or Distributors of 
Films.
    ii. The interpretive response to question 7 is modified to refer to 
Statement 140 which replaced Statement 125, Accounting for Transfers 
and Servicing of Financial Assets and Extinguishments of Liabilities.
    b. Topic 13.B, footnote 6 is modified to refer to SAS 99 which 
superseded SAS 82.

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. Deleted by SAB 103
    2. Qualified auditors' opinions
F. Financial Statement Requirements In Filings Involving The 
Formation of a One-Bank Holding Company
G. Deleted by FRR 55
H. Deleted 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. Deleted by SAB 103
M. Materiality
    1. Assessing materiality
    2. Immaterial misstatements that are intentional

Topic 2: Business Combinations

A. Purchase Method
    1. Deleted by SAB 103
    2. Deleted by SAB 103
    3. Deleted by SAB 103
    4. Deleted by SAB 103
    5. Adjustments to allowances for loan losses in connection with 
business combinations
    6. Debt issue costs
    7. Loss contingencies assumed in a business combination
    8. Business combinations prior to an initial public offering
    9. Liabilities assumed in a business combination
B. Deleted by SAB 103
C. Deleted by SAB 103
D. Financial Statements of Oil and Gas Exchange Offers
E. Deleted by SAB 103
F. Deleted by SAB 103

Topic 3: Senior Securities

A. Convertible Securities
B. Deleted 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. Deleted by SAB 103
C.2. Deleted 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. Accounting For Sales Of Stock By A Subsidiary
I. Deleted by SAB 70
J. Push Down Basis of Accounting Required in Certain Limited 
Circumstances
K. Deleted by SAB 95
L. LIFO Inventory Practices
M. Other Than Temporary Impairment of Certain Investments in Debt 
and Equity Securities
N. Discounting by Property-Casualty Insurance Companies
O. Research and Development Arrangements
P. Restructuring Charges
    1. Deleted by SAB 103
    2. Deleted by SAB 103
    3. Income statement presentation of restructuring charges
    4. Disclosures
Q. Increasing Rate Preferred Stock
R. Deleted by SAB 103
S. Quasi-Reorganization
T. Accounting for Expenses or Liabilities Paid by Principal 
Stockholder(s)
U. Gain Recognition on the Sale of a Business or Operating Assets to 
A Highly Leveraged Entity
V. Certain Transfers of Nonperforming Assets
W. Contingency Disclosures Regarding Property-Casualty Insurance 
Reserves for Unpaid Claim Costs
X. Deleted by SAB 103
Y. Accounting and Disclosures Relating to Loss Contingencies
Z. Accounting and Disclosure Regarding Discontinued Operations
    1. Deleted by SAB 103
    2. Deleted by SAB 103

[[Page 26846]]

    3. Deleted by SAB 103
    4. Disposal of operation with significant interest retained
    5. Classification and disclosure of contingencies relating to 
discontinued operations
    6. Deleted by SAB 103
    7. Accounting for the spin-off of a subsidiary
AA. Deleted by SAB 103
BB. Inventory Valuation Allowances
CC. Impairments

Topic 6: Interpretations of Accounting Series Releases and Financial 
Reporting Releases

A.1. Deleted 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. Deleted by SAB 103
G. Accounting Series Releases 177 and 286--Relating to Amendments to 
Form 10-Q, Regulation S-K, and Regulation 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. Deleted 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. Deleted by SAB 47
K. Accounting Series Release 302--Separate Financial Statements 
Required by Regulation S-X
    1. Deleted 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 Statement 114
    a. Measuring and documenting loan losses under Statement 114--
general
    b. Measuring and documenting loan losses under Statement 114 for 
a collateral dependent loan
    c. Measuring and documenting loan losses under Statement 114--
fully collateralized loans
    4. Applying a systematic methodology--measuring and documenting 
loan losses under Statement 5
    a. Measuring and documenting loan losses under Statement 5--
general
    b. Measuring and documenting loan losses under Statement 5--
adjusting loss rates
    c. Measuring and documenting loan losses under Statement 5--
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. Deleted by SAB 103
B. Deleted 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. Deleted by SAB 103
B. Deleted by ASR 307

Topic 10: Utility Companies

A. Financing by Electric Utility Companies Through Use of 
Construction Intermediaries
B. Deleted 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. Deleted 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. Deleted 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 quantities of proved reserves
    2. Estimates of future net revenues
    3. Disclosure of reserve information
    a. Deleted by SAB 103
    b. Unproved properties
    c. Limited partnership 10-K reports
    d. Limited partnership registration statements
    e. Rate regulated companies
    4. Deleted by SAB 103
B. Deleted 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

[[Page 26847]]

    2. Exclusion of costs from amortization
    3. Full cost ceiling limitation
    a. Exemptions for purchased properties
    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
E. Financial Statements of Royalty Trusts
F. Gross Revenue Method of Amortizing Capitalized Costs
G. Inclusion of Methane Gas in Proved Reserves

Topic 13: Revenue Recognition

A. Selected Revenue Recognition Issues
    1. Revenue recognition--general
    2. Persuasive evidence of an arrangement
    3. Delivery and performance
    4. Fixed or determinable sales price
    5. Income statement presentation
B. Disclosures 2

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, 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\
---------------------------------------------------------------------------

    \1\ Paragraph 40 of Statement 109 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 [Statement 
109{time} . A method that allocates current and deferred taxes to 
members of the group by applying [Statement 109] to each member as 
if it were a separate taxpayer meets those criteria.
---------------------------------------------------------------------------

    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

[[Page 26848]]

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. However, in certain 
circumstances, Forms F-3 and F-2 require 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. An issuer complying 
with Item 18 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 
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:
    [sbull] Material undisclosed uncertainties (such as reasonably 
possible loss contingencies), commitments (such as those arising from 
leases), and credit risk exposures and concentrations;
    [sbull] Material unrecognized obligations (such as pension 
obligations);
    [sbull] Material changes in estimates and accounting methods, and 
other factors or events affecting comparability;

[[Page 26849]]

    [sbull] Defaults on debt and material restrictions on dividends or 
other legal constraints on the registrant's use of its assets;
    [sbull] Material changes in the relative amounts of constituent 
elements comprising line items presented on the face of the financial 
statements;
    [sbull] Significant terms of financings which would reveal material 
cash requirements or constraints;
    [sbull] Material subsequent events, such as events that affect the 
recoverability of recorded assets;
    [sbull] Material related party transactions (as addressed by 
Statement 57) that may affect the terms under which material revenues 
or expenses are recorded; and
    [sbull] 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. Deleted 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 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 by Securities Act Industry Guide (``Guide 3'') \1\ for Bank A 
be included in the initial registration statement on Form S-4?
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    \1\ 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:
    [sbull] 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;
    [sbull] 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;
    [sbull] There are no new classes of stock authorized other than 
those corresponding to the stock of Bank A immediately prior to the 
reorganization;
    [sbull] There are no plans or arrangements to issue any additional 
shares to acquire any business other than Bank A; and
    [sbull] 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

[[Page 26850]]

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.\2\ Accordingly, the policy of the Division of Corporation 
Finance is as follows:
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    \2\ Rule 3-13 of Regulation S-X.
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    [sbull] 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) \3\ are audited only 
for the two latest fiscal years.\4\ 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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    \3\ 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.
    \4\ Unaudited statements of income and cash flows should be 
furnished for the earliest period.
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    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. Deleted by FRR 55

H. Deleted 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 are set forth in Exhibit I to the Appendix of the 
American Institute of Certified Public Accountants' Practice Bulletin 1 
\1\ ``ADC \2\ Arrangements'' (``Exhibit I to PB1''). In September 1986 
the EITF \3\ reached a consensus on this issue \4\ to the effect that, 
although Exhibit I to PB1 was issued to address the real estate ADC 
arrangements of financial institutions, preparers and auditors should 
consider the guidance contained in Exhibit I to PB1 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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    \1\ ``ADC Arrangements'' was originally issued as a notice to 
practitioners (February 1986, as published in the April 1986 issue 
of the Journal of Accountancy). The notice to practitioners was 
reprinted without change as Exhibit I to the Appendix of the 
American Institute of Certified Public Accountants' Practice 
Bulletin 1 (November 1987).
    \2\ Acquisition, development and construction.
    \3\ 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.
    \4\ See Issue 86-21.
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    Statement 133 as amended by Statements 137 and 138, 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 the 
expected residual profit component of an ADC arrangement need not be 
separately accounted for as a derivative under Statement 133, then the 
disclosure requirements discussed below for ADC loans and similar 
arrangements should be followed.\5\
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    \5\ The equity kicker (the expected residual profit) would 
typically not be separated from the host contract and accounted for 
as a derivative because paragraph 12(c) of Statement 133 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 Statement 133.

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[[Page 26851]]

    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.\6\ In addition, Exhibit I to 
PB1 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 paragraph 11 of 
Statement 66 \7\ 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 paragraph 12 of Statement 66.\8\
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    \6\ Expected residual profit is defined in Exhibit I to PB1 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.''
    \7\ Statement 66 establishes standards for the recognition of 
profit on real estate sales transactions. Paragraph 11 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 paragraphs 53 and 54 of Statement 66.
    \8\ Paragraph 12 of Statement 66 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.\9\ Accordingly, the staff believes 
that the financial statements of properties securing significant loans 
which have the characteristics of real 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.\10\
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    \9\ 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.
    \10\ 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.''
---------------------------------------------------------------------------

    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 
paragraph 11 of Statement 66 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 paragraph 12 of 
Statement 66. 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

[[Page 26852]]

provided in the Exhibit I to the Appendix of the American Institute of 
Certified Public Accountants Practice Bulletin 1 (November, 1987) 
(``Exhibit I to PB1''). As stated in Exhibit I to PB1, 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.\11\ The criteria described in Statement 66 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 Statement 66.
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    \11\ Regarding the composition of the borrower's investment, 
paragraph 9b of Exhibit I to PB1 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.\12\
---------------------------------------------------------------------------

    \12\ 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 constitues 10% or more.
---------------------------------------------------------------------------

    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 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.\1\
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    \1\ 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 \2\ were not

[[Page 26853]]

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.\3\ 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:
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    \2\ 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.
    \3\ 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.
---------------------------------------------------------------------------

    a. The combined significance of businesses acquired or to be 
acquired for which audited financial statements cover a period of less 
than 9 months \4\ may not exceed 10%;
---------------------------------------------------------------------------

    \4\ 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
                                                  Fiscal year                                      significance
                   Acquiree                           end              Date of acquisition        at 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
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                    Highest level
                Component entity                      Assets        of earnings     Investment    of signficance
                                                     (percent)       (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            \1\9               3               9
F...............................................               2              11               6             11
----------------------------------------------------------------------------------------------------------------
\1\ Loss


[[Page 26854]]

    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% \5\ and no other combination can be formed with E and F 
which would not exceed 40%.
---------------------------------------------------------------------------

    \5\ 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%).
---------------------------------------------------------------------------

    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.

----------------------------------------------------------------------------------------------------------------
                                                                                                   Separate pre-
                                                                      Minimum        Period in      acquisition
                                                                     financial     consolidated       audited
           Component entity                Date of acquisition       statement       financial       financial
                                                                    requirement     statements       statement
                                                                     (months)        (months)        (months)
----------------------------------------------------------------------------------------------------------------
 
Registrant............................  N/A.....................              33              36  ..............
A.....................................  1/1/x7..................              33              24               9
B.....................................  4/1/x7..................              33              21           \6\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
----------------------------------------------------------------------------------------------------------------
\6\ 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.

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.
    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

[[Page 26855]]

audited financial statements are not reasonably available.
    For purposes of this waiver a ``troubled financial institution'' is 
one which either:
    a. Is in receivership, conservatorship or is otherwise operating 
under a similar supervisory agreement with a federal financial 
regulatory agency; or
    b. Is controlled by a federal regulatory agency; or
    c. 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 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 will be amortized and the period over which any discounts 
on acquired assets will be taken into income. If amortization of 
intangibles 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 
carrying 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.
    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 Instruction 1 to Item 7 of Form 8-K.

L. Deleted 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.\1\
---------------------------------------------------------------------------

    \1\ 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.

---------------------------------------------------------------------------

[[Page 26856]]

    Question: Each Statement of Financial Accounting Standards adopted 
by the FASB states, ``The provisions of this Statement 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 \2\ 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.
---------------------------------------------------------------------------

    \2\ See, e.g., Rule 2a-4, 17 CFR 270.2a-4, under the Investment 
Company Act of 1940. As used in this SAB, ``misstatement'' or 
``omission'' refers to a financial statement assertion that would 
not be in conformity with GAAP.
---------------------------------------------------------------------------

    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, 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.\3\
---------------------------------------------------------------------------

    \3\ Concepts Statement 2, paragraph 132. See also Concepts 
Statement 2, Glossary of Terms--Materiality.

    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.\4\
---------------------------------------------------------------------------

    \4\ 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.\5\ Court decisions, Commission rules and enforcement 
actions, and accounting and auditing literature \6\ have all considered 
``qualitative'' factors in various contexts.
---------------------------------------------------------------------------

    \5\ 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.
    \6\ 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).
---------------------------------------------------------------------------

    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 
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.\7\
---------------------------------------------------------------------------

    \7\ 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.\8\ 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.\9\ The FASB also considered whether an evaluation of 
materiality could be based solely on anticipating the market's reaction 
to accounting information.\10\
---------------------------------------------------------------------------

    \8\ Concepts Statement 2, paragraphs 131 and 166.
    \9\ Concepts Statement 2, paragraph 167.
    \10\ Concepts Statement 2, paragraphs 168-169.
---------------------------------------------------------------------------

    The FASB rejected a formulaic approach to discharging ``the onerous 
duty of making materiality decisions'' \11\ in favor of an approach 
that takes into account all the relevant considerations. In so doing, 
it made clear that--
---------------------------------------------------------------------------

    \11\ 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.\12\
---------------------------------------------------------------------------

    \12\ 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

[[Page 26857]]

misstatements of quantitatively small amounts to be material; as stated 
---------------------------------------------------------------------------
in the auditing 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.\13\
---------------------------------------------------------------------------

    \13\ AU 312.11.

    Among the considerations that may well render material a 
quantitatively small misstatement of a financial statement item are--
    [sbull] 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.\14\
---------------------------------------------------------------------------

    \14\ 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., 
Accounting Principles Board Opinion 20, Accounting Changes 10, 11, 
31-33 (July 1971).
---------------------------------------------------------------------------

    [sbull] Whether the misstatement masks a change in earnings or 
other trends.
    [sbull] Whether the misstatement hides a failure to meet analysts' 
consensus expectations for the enterprise.
    [sbull] Whether the misstatement changes a loss into income or vice 
versa.
    [sbull] 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.
    [sbull] Whether the misstatement affects the registrant's 
compliance with regulatory requirements.
    [sbull] Whether the misstatement affects the registrant's 
compliance with loan covenants or other contractual requirements.
    [sbull] 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.
    [sbull] 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.\15\ 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.\16\ 
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.\17\
---------------------------------------------------------------------------

    \15\ 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).
    \16\ See Concepts Statement 2, paragraph 169.
    \17\ 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.
---------------------------------------------------------------------------

    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.\18\ 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.\19\ 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.
---------------------------------------------------------------------------

    \18\ 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.
    \19\ 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).
---------------------------------------------------------------------------

    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 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.\20\ ``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.''\21\ 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--

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.\22\
---------------------------------------------------------------------------

    \20\ See, e.g., In the Matter of W.R. Grace & Co., AAER 1140 
(June 30, 1999).
    \21\ AU 9326.33.
    \22\ Id.
---------------------------------------------------------------------------

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.\23\ 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.'' \24\ 
This requires consideration of--
---------------------------------------------------------------------------

    \23\ 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.
    \24\ 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.


[[Page 26858]]


---------------------------------------------------------------------------

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. * * * 
\25\
---------------------------------------------------------------------------

    \25\ 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.\26\
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    \26\ 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.\27\
---------------------------------------------------------------------------

    \27\ 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,\1\ registrants must comply 
with Sections 13(b)(2)-(7) of the Securities Exchange Act of 1934 (the 
``Exchange Act'').\2\ Under these provisions, each registrant with 
securities registered pursuant to Section 12 of the Exchange Act,\3\ or 
required to file reports pursuant to Section 15(d),\4\ 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.\5\ 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.\6\ Accordingly, 
failure to record accurately immaterial items, in some instances, may 
result in violations of the securities laws.
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    \1\ FASB Statements generally provide that ``[t]he provisions of 
this Statement need not be applied to immaterial items.'' This SAB 
is consistent with that provision of the Statements. 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.
    \2\ 15 U.S.C. 78m(b)(2)-(7).
    \3\ 15 U.S.C. 78l.
    \4\ 15 U.S.C. 78o(d).
    \5\ 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.''
    \6\ 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 
\7\ regarding the ``reasonableness'' standard in Section 13(b)(2) of 
the Exchange Act.

[[Page 26859]]

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.\8\ In his address, Chairman Williams noted that, like 
materiality, ``reasonableness'' is not an ``absolute standard of 
exactitude for corporate records.'' \9\ 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.\10\
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    \7\ 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).
    \8\ 8 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).
    \9\ 9 Id. at 46 FR 11546.
    \10\ 10 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.
    [sbull] 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.
    [sbull] 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.'' \11\
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    \11\ 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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    [sbull] 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.\12\ Conversely, 
where there is little cost or delay involved in correcting a 
misstatement, failing to do so is unlikely to be ``reasonable.''
---------------------------------------------------------------------------

    \12\ 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.
---------------------------------------------------------------------------

    [sbull] 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.'' \13\
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    \13\ 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.'' \14\ 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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    \14\ 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 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, 
for example, 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 * * *.'' \15\ 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.\16\ The clear

[[Page 26860]]

implication of SAS 99 is that immaterial misstatements may be 
fraudulent financial reporting.\17\
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    \15\ 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.
    \16\ 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.
    \17\ 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.\18\
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    \18\ 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.\19\ As stated by the National 
Commission on Fraudulent Financial Reporting, also known as the 
Treadway Commission, in its 1987 report,
---------------------------------------------------------------------------

    \19\ 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.\20\
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    \20\ 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.\21\
---------------------------------------------------------------------------

    \21\ 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.\22\
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    \22\ 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.\23\ 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, 
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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    \23\ 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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Topic 2: Business Combinations

A. Purchase Method

1. Deleted by SAB 103
2. Deleted by SAB 103
3. Deleted by SAB 103
4. Deleted by SAB 103
5. Adjustments to Allowances for Loan Losses in Connection With 
Business Combinations
    Facts: Bank A acquires Bank B in a business combination.
    Question: Are there circumstances in which it is appropriate for 
Bank A, in assigning acquisition cost to the loan receivables acquired 
from Bank B, to adjust Bank B's carrying value for those loans not only 
to reflect appropriate current interest rates, but also to reflect a 
different estimate of uncollectibility? \1\
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    \1\ Under Statement 141, the guidelines for allocating 
acquisition cost to receivable is ``at present values of amounts to 
be received determined at appropriate current interest rates, less 
allowances for uncollectibility and collection cost, if necessary.''
---------------------------------------------------------------------------

    Interpretive Response: Needed changes in allowances for loan losses 
are ordinarily to be made through provisions for loan losses rather 
than through purchase accounting adjustments. Except in the limited 
circumstances discussed below, where Bank A has plans for ultimate 
recovery of loans acquired from Bank B that are demonstrably different 
from plans that had served as the basis for Bank B's estimate of loan 
losses, purchase accounting adjustments reflecting different estimates 
of uncollectibility may raise questions from the staff as to: (a) The 
reasonableness of the preacquisition allowance for loan losses recorded 
by Bank B, or (b) whether the adjustments will have a distortive effect 
on current or future period financial statements of Bank A. Similar 
questions may be raised by the staff regarding significant changes in 
allowances for loan losses that are recorded by a bank shortly before 
it is acquired.
    Estimation of probable loan losses involves judgment, and Banks A 
and B

[[Page 26861]]

may differ in their systematic approaches to such estimation. 
Nevertheless, assuming that appropriate methodology (i.e., giving due 
consideration to all relevant facts and circumstances affecting 
collectibility) is followed by each bank, the staff believes that each 
bank's estimate of the uncollectible portion of Bank B's loan portfolio 
should fall within a range of acceptability. That is, the staff 
believes that the uncollectible portion of Bank B's loans as estimated 
separately by the two banks ordinarily should not be different by an 
amount that is material to the financial statements of Bank B and, 
therefore, an adjustment to the net carrying value of Bank B's loan 
portfolio at the acquisition date to reflect a different estimate of 
uncollectibility ordinarily would be unnecessary and inappropriate.
    However, a purchase accounting adjustment to reflect a different 
estimate of uncollectibility may be appropriate where Bank A has plans 
regarding ultimate recovery of certain acquired loans demonstrably 
different from the plans that had served as the basis for Bank B's 
estimation of losses on those loans.\2\ In such circumstances, Bank B's 
estimate of uncollectibility for those certain loans may be largely or 
entirely irrelevant for purposes of determining the net carrying value 
at which those loans should be recorded by Bank A. For example, if Bank 
B had intended to hold certain loans to maturity but Bank A plans to 
sell them, the acquisition cost allocated to those loans should equal 
the value that currently could be obtained for them in a sale.\3\ In 
that case, Bank A would report those loans as assets held for sale 
rather than as part of its loan portfolio, and would report them in 
postacquisition periods at the lower of cost or market value until 
sold.
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    \2\ A bank's plans for recovering the net carrying value of 
certain individual loans or groups of loans may differ from its 
plans regarding other loans. The plan for recovering the net 
carrying value of a loan might be, for example, (a) holding the loan 
to maturity, (b) selling it, or (c) foreclosing on the collateral 
underlying the loan. The assigned value of loans should be based on 
the plan for recovery.
    \3\ It is not acceptable to recognize losses on loans that are 
due to concerns as to ultimate collectibility through a purchase 
accounting adjustment, nor is it acceptable to report such losses as 
``loss on sale.'' An excess of carrying value of Bank B's loans over 
their market value at the acquisition date that is due to concerns 
as to ultimate collectibility should have been recognized by Bank B 
through its provision for loan losses.
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    The staff does not intend to suggest that an acquiring bank should 
record acquired loans at an amount that reflects an unreasonable 
estimate of uncollectibility. If Bank B's financial statements as of 
the acquisition date are not fairly stated in accordance with generally 
accepted accounting principles because of an unreasonable allowance for 
loan losses, that allowance for loan losses should not serve as a basis 
for recording the acquired loans. Rather, Bank B's preacquisition 
financial statements should be restated to reflect an appropriate 
allowance, with the resultant adjustment being applied to the restated 
preacquisition income statement of Bank B for the period(s) in which 
the events or changes in conditions that gave rise to the needed change 
in the allowance occurred.
6. Debt Issue Costs
    Facts: Company A is to acquire the net assets of Company B in a 
transaction 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: Are all fees paid to the investment banker a direct 
cost of the acquisition and, as such, accounted for as an element of 
the purchase price of the business acquired?
    Interpretive Response: No. Fees paid to an investment banker in 
connection with a business combination, when the investment banker is 
also providing interim financing or underwriting services, must be 
allocated between direct costs of the acquisition and debt issue costs.
    Statement 141 provides that direct costs such as finder's fees and 
fees paid to outside consultants should be treated as components of the 
cost of the acquisition, while the costs of registering and issuing any 
equity securities are treated as a reduction of the otherwise 
determined fair value of the equity securities. However, debt issue 
costs are an element of the effective interest cost of the debt, and 
neither the source of the debt financing nor the use of the debt 
proceeds changes the nature of such costs. Accordingly, they should not 
be considered a direct cost of the acquisition.
    The portions of the fees allocated to direct costs and to debt 
issue costs should be representative of the actual services provided. 
Thus, in making a reasonable allocation (or in determining that an 
allocation made by the investment banker is reasonable \1\ factors such 
as (i) the fees charged by investment bankers in connection with other 
recent bridge financings and (ii) fees charged for advisory services 
when obtained separately, should normally be considered to determine 
the relative fair values of the two services. Whether these or other 
factors are considered, the allocation should normally result in an 
effective debt service cost (interest and amortization of debt issue 
costs \2\ which is comparable to the effective cost of other recent 
debt issues of similar investment risk and maturity. The amount 
accounted for as debt issue costs should be separately disclosed, if 
material.\1\
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    \1\ This would apply irrespective of whether the fees for the 
services were billed as a single amount or separately, since the 
separate billing of the services implicitly involves an allocation 
by the investment banker.
    \2\ See Question 2 regarding the period over which the debt 
issue costs related to bridge financings should be amortized.
    \3\ See Rule 5-02(17) of Regulations S-X.
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    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?
    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 consensus reached in EITF Issue 86-15 should 
be followed.\4\
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    \4\ As noted in the ``Status'' section of the Abstract to Issue 
86-15, 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 
Statement 133 (as amended).
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7. Loss Contingencies Assumed in a Business Combination
    Facts: A registrant acquires a business enterprise in a business 
combination. In connection with the acquisition, the acquiring company 
assumes certain contingent liabilities of the acquired company.
    Question: How should the acquiring company account for and disclose 
contingent liabilities that have been assumed in a business 
combination?

[[Page 26862]]

    Interpretive Response: In accordance with Statement 141, the 
acquiring company should allocate the cost of an acquired company to 
the assets acquired and liabilities assumed based on their fair values 
at the date of acquisition. With respect to contingencies for which a 
fair value is not determinable at the date of acquisition, the guidance 
of Statement 5 and Interpretation 14 should be applied. If the 
registrant is awaiting additional information that it has arranged to 
obtain for the measurement of a contingency during the allocation 
period specified by Statement 141, the staff believes that the 
registrant should disclose that the purchase price allocation is 
preliminary. In that circumstance, the registrant should describe the 
nature of the contingency and furnish other available information that 
will enable a reader to understand its potential effects on the final 
allocation and on post-acquisition operating results. Management's 
Discussion and Analysis should include appropriate disclosure regarding 
any unrecognized preacquisition contingency and its reasonably likely 
effects on operating results, liquidity, and financial condition.
    The staff believes that the allocation period should not extend 
beyond the minimum reasonable period necessary to gather the 
information that the registrant has arranged to obtain for purposes of 
the estimate. Since an allocation period usually should not exceed one 
year, registrants believing that they will require a longer period are 
encouraged to discuss their circumstances with the staff. If it is 
unlikely that the liability can be estimated on the basis of 
information known to be obtainable at the time of the initial purchase 
price allocation, the allocation period should not be extended with 
respect to that liability. An adjustment to the contingent liability 
after the expiration of the allocation period would be recognized as an 
element of net income.
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 Statement 141.\1\ Accordingly, the staff 
believes that the combination of two or more businesses should be 
accounted for in accordance with Statement 141.
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    \1\ The provisions of Statement 141 apply to transactions 
involving the transfer of net assets as well as the acquisition of 
stock of a corporation. This guidance does not address the 
accounting for joint ventures or leverage buy-out transactions as 
discussed in EITF Issue 88-16.
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9. Liabilities Assumed in a Business Combination
    Facts: Company A acquires Company Z in a business combination. 
Company Z has recorded liabilities for contingencies such as product 
warranties and environmental costs.
    Question: Are there circumstances in which it is appropriate for 
Company A to adjust Company Z's carrying value for these liabilities in 
the purchase price allocation?
    Interpretive Response: Yes. Statement 141 requires that 
receivables, liabilities, and accruals be recorded in the purchase 
price allocation at their fair value, typically the present value of 
amounts to be received or paid, determined using appropriate current 
market interest rates. In some cases, fair value is readily 
determinable from contemporaneous arms-length transactions involving 
substantially identical assets or liabilities, or from amounts quoted 
by a third party to purchase the assets or assume the liabilities. More 
frequently, fair values are based on estimations of the underlying cash 
flows to be received or paid, discounted to their present value using 
appropriate current market interest rates.
    The historical accounting by Company Z for receivables or 
liabilities may often be premised on estimates of the amounts to be 
received or paid. Amounts recorded by Company A in its purchase price 
allocation may be expected to differ from Company Z's historical 
carrying values due, at least, to the effects of the acquirer's 
discounting, including differences in interest rates. Estimation of 
probable losses and future cash flows involves judgment, and companies 
A and Z may differ in their systematic approaches to such estimation. 
Nevertheless, assuming that both companies employ a methodology that 
appropriately considers all relevant facts and circumstances affecting 
cash flows, the staff believes that the two estimates of undiscounted 
cash inflows and outflows should not differ by an amount that is 
material to the financial statements of Company Z, unless Company A 
will settle the liability in a manner demonstrably different from the 
manner in which Company Z had planned to do so (for example, settlement 
of the warranty obligation through outsourcing versus an internal 
service department). But the source of other differences in the 
estimates of the undiscounted cash flows to be received or paid should 
be investigated and reconciled. If those estimates of undiscounted cash 
flows are materially different, an accounting error in Company Z's 
historical financial statements may be present, or Company A may be 
unaware of important information underlying Company Z's estimates that 
also is relevant to an estimate of fair value.
    The staff is not suggesting that an acquiring company should record 
assumed liabilities at amounts that reflect an unreasonable estimate. 
If Company Z's financial statements as of the acquisition date are not 
fairly stated in accordance with GAAP because of an improperly recorded 
liability, that liability should not serve as a basis for recording 
assumed amounts. That is, the correction of a seller's erroneous 
application of GAAP should not occur through the purchase price 
allocation. Rather, Company Z's financial statements should be restated 
to reflect an appropriate amount, with the resultant adjustment being 
applied to the historical income statement of Company Z for the 
period(s) in which the trends, events, or changes in operations and 
conditions that gave rise to the needed change in the liability 
occurred. It would also be inappropriate for Company Z to report the 
amount of any necessary adjustment in the period just prior to the 
acquisition, unless that is the period in which the trends, events, or 
changes in operations and conditions occurred. The staff would expect 
that such trends, events, and changes would be disclosed in 
Management's Discussion and Analysis in the appropriate period(s) if 
their effect was material to a company's financial position, results of 
operations or cash flows.
    In summary, the staff believes that purchase price adjustments 
necessary to record liabilities and loss accruals at fair value 
typically are required, while merely adding an additional ``cushion'' 
of 10 or 20 or 30 percent to such account balances is not appropriate. 
To arrive at those fair values, the undiscounted cash flows must be 
projected, period by period, based on historical experience and 
discounted at the appropriate current market discount rate.

[[Page 26863]]

B. Deleted by SAB 103

C. Deleted 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(ies) or property(ies) 
are deemed to constitute a business.
    The fundamental accounting issues in exchange transactions involve 
determining the basis at which the properties exchanged should be 
recorded and deciding what prior financial results of the entities 
should be reported. In this regard, Statement 141 specifies that a 
business combination be accounted for using the purchase method. 
Statement 141 speaks specifically to business combinations between 
nonaffiliated enterprises. When affiliated enterprises (under common 
control) are involved, the guidance in paragraphs D11-D13 of Statement 
141 should be followed. In particular, paragraph D12 states:

    When accounting for a transfer of assets or exchange of shares 
between entities under common control, the entity that receives the 
net assets or the equity interest shall initially recognize the 
assets and liabilities transferred at their carrying amounts in the 
accounts of the transferring entity at the date of transfer.

    Paragraph D13 states:

    The purchase method of accounting shall be applied if the effect 
of the transfer or exchange * * * is the acquisition of all or a 
part of the noncontrolling equity interests in a subsidiary.

    The staff has developed administrative policies which it has 
followed with respect only to the financial statements of oil and gas 
exchange offers included in filings with the Commission and the 
conclusions expressed in this Topic should not be analogized to other 
circumstances.
    Question 1: What are the staff's general guidelines in determining 
the appropriate basis of accounting in an exchange transaction?
    Interpretive Response: The staff believes the basis of accounting 
should be determined pursuant to the provisions of Statement 141, if it 
is applicable. Accordingly, where unrelated parties are involved, it is 
appropriate to apply purchase accounting based on the fair value of 
either the stock issued or the properties involved.
    The following chart shows the method of accounting to be used under 
some relatively simple sets of circumstances.

              Accounting--Based on Status of Issuing Entity
------------------------------------------------------------------------
                                                      Non-public company
            Condition             Public company \1\          \2\
------------------------------------------------------------------------
High degree of common ownership   Purchase            Entities under
 or common control between         accounting based    common control--
 issuing corporation and           on fair value of    carry-over basis
 offerees \3\.                     stock \4\.
All other, i.e., without common   Purchase            Purchase
 ownership or control.             accounting based    accounting based
                                   on fair value of    on fair value of
                                   stock.              properties.
------------------------------------------------------------------------
\1\ Issuing corporation is an existing public company before the
  exchange offer with an established market for its stock (includes
  situations involving use of a shell company established by a public
  company).
\2\ Issuing corporation is not public prior to the exchange offer and
  thus has no established market for its stock.
\3\ Common control ordinarily exists where the issuing corporation acts
  as general partner for the offeree partnership(s). Where all the
  following conditions apply, common control will be considered to exist
  between the issuing corporation and the offerees even though the
  issuer does not exercise the same legal powers as a general partner:
a. The issuer or its survivor initially acquired the property for
  exploration and development and
b. Other investors were of a passive nature, solicited to provide
  financing with the hope of a return on their investment, and
c. The issuer or its survivor has continued to exercise day-to-day
  managerial control.
\4\ In rare instances, such as when the property interest owners
  accepting the exchange offer acquire a majority of the voting shares
  of the company emerging from the exchange transaction, reorganization
  accounting may be considered appropriate. In such cases, the
  particular facts and circumstances should be reviewed with the
  Commission staff.

    This chart reflects the staff's view that purchase accounting is 
generally appropriate except in situations where the principles for 
transactions involving common control apply. When a non-public entity 
acts as offeror to a group of related entities, the transaction is 
essentially a reorganization, and thus there is no basis for a change 
in the cost basis of the properties involved. If an existing public 
company (with an established market for its stock) has common ownership 
or control with the offerees, and the offerees acquire a majority 
interest in the emerging company, a question may arise as to whether 
the transaction is a reorganization.
    Question 2: In some situations, a non-public issuer may be 
affiliated with some but not all of the offerees. Assuming the 
nonaffiliated offerees are not deemed ``co-promoters'' of the new 
entity, how should such a transaction be accounted for?
    Interpretive Response: The property interests acquired from 
affiliated and nonaffiliated parties should each be accounted for as 
though acquired in separate exchange offer transactions. Thus in some 
circumstances, it may be necessary to record the interests owned by 
affiliated persons at predecessor cost while recording the interests of 
nonaffiliated persons as a purchase.
    Example: Facts--D Company (a non-public company) forms a shell, E 
Company, to become its successor and to sponsor an exchange offer. E 
makes the exchange offer to four entities: A, B, C and D. A and B are 
unaffiliated; C is a limited partnership sponsored by D. The 
shareholders of D will become the principal or controlling shareholders 
of E.
    Basis of Accounting--Since there is no market for E's stock, it 
should record the properties received from C and from D at their 
predecessor cost. The properties received from A and B

[[Page 26864]]

should be recorded at their fair market value.
    Question 3: How should ``common control accounting'' be applied to 
the specific assets and liabilities of the new exchange company?
    Interpretive Response: 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, as in the case of any merger between oil 
and gas companies, 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 retroactively.
    Question 4: In Form 10-K filings with the Commission, the staff has 
permitted limited partnerships to omit certain of the oil and gas 
reserve data disclosures required by Statement 69 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 
merger or exchange offers.\5\ These disclosures may, however, be 
presented on a combined basis.
---------------------------------------------------------------------------

    \5\ See SAB 40, Topic 12.A.3.c.
---------------------------------------------------------------------------

    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 as a purchase, 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.
    Question 5: Assume an exchange transaction is to be accounted for 
as a purchase and recorded at the fair value of the properties. 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 6: 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.\6\ 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:
---------------------------------------------------------------------------

    \6\ As announced in FRR 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 reorganization, historical 
depreciation, depletion and amortization provisions may be aggregated, 
with appropriate disclosure.
    (4) Reflect purchase cost in the pro forma statements (where the 
exchange offer is accounted for on the purchase basis), including 
depreciation, depletion and amortization based on the purchase cost.
    (5) Provide pro forma reserve information.
    (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 7: 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 Regulations 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. Purchase Accounting
    1. If the registrant can demonstrate that full historical financial 
statements of the offeree partnerships 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 offeree partnerships 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 offeree partnerships had no material quantity 
of production.

[[Page 26865]]

B. Common Control Accounting
    The staff would expect 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 
reorganizations, 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. Deleted by SAB 103

F. Deleted 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(a)(7) of Regulation S-X, if material.

B. Deleted by ASR 307

C. Redeemable Preferred Stock

    Facts: Rule 5-02.28 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 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 EITF 
Topic D-98.
    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'').
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    Prior to the effective date of Statement 128, 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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    Question 1: Does the staff continue to believe that such treatment 
for stock and warrants would be appropriate upon adoption of Statement 
128?

[[Page 26866]]

    Interpretive Response: Generally, no. Historical EPS should be 
prepared and presented in conformity with Statement 128.
    In applying the requirements of Statement 128, 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 paragraph 54 of Statement 128. 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.
---------------------------------------------------------------------------

    \3\ Statement 128 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.''
---------------------------------------------------------------------------

    Registrants are reminded that disclosure about materially dilutive 
issuances is required outside the financial statements. Item 506 of 
Regulation S-K requires tabular 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 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.
---------------------------------------------------------------------------

    \4\ As prescribed by APB Opinion 25, Statement 123, and related 
interpretations.
---------------------------------------------------------------------------

E. Receivables From Sale of Stock

    Facts: Compensation often arises when capital stock is issued or is 
to be issued to officers or other employees at prices below market.
    Question: How should the deferred compensation be presented in the 
balance sheet?
    Interpretive Response: The amounts recorded as deferred 
compensation 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

[[Page 26867]]

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.

C.1. Deleted by SAB 103

C.2. Deleted 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 1: Company X proposes to account for the transaction as a 
divestiture, but to defer recognition of gain until the owners of 
Company Y begin making payments on the promissory notes. Does this 
proposed accounting treatment reflect the economic substance of the 
transaction?

[[Page 26868]]

    Interpretive Response: No. The circumstances are such that the 
risks of the business have not, in substance, been transferred to 
Company Y or its owners. In assessing whether the legal transfer of 
ownership of one or more business operations has resulted in a 
divestiture for accounting purposes, the principal consideration must 
be an assessment of whether the risks and other incidents of ownership 
have been transferred to the buyer with sufficient certainty.
    When the facts and circumstances are such that there is a 
continuing involvement by the seller in the business, recognition of 
the transaction as a divestiture for accounting purposes is 
questionable. Such continuing involvement may take the form of 
effective veto power over major contracts or customers, significant 
voting power on the board of directors, or other involvement in the 
continuing operations of the business entailing risks or managerial 
authority similar to that of ownership.
    Other circumstances may also raise questions concerning whether the 
incidents of ownership have, in substance, been transferred to the 
buyer. These include:
    [sbull] Absence of significant financial investment in the business 
by the buyer, as evidenced, for instance, by a token down payment;
    [sbull] Repayment of debt which constitutes the principal 
consideration in the transaction is dependent on future successful 
operations of the business; or
    [sbull] The continued necessity for debt or contract performance 
guarantees on behalf of the business by the seller.
    In the above transaction, the seller's continuing involvement in 
the business and the presence of certain of the other factors cited 
evidence the fact that the seller has not been divorced from the risks 
of ownership. Accounting for this proposed transaction as a 
divestiture--even with deferral of the ``gain''--does not reflect its 
economic substance and therefore is not appropriate.
    Further, Company X may need to consider whether it should 
consolidate Company Y by way of its variable interests pursuant to the 
provisions of FASB Interpretation 46.
    Question 2: If the transaction is not to be treated as a 
divestiture for accounting purposes, what is the proper accounting 
treatment?
    Interpretive Response: If, in the circumstances surrounding a 
particular transaction, a determination is made that a legal transfer 
of business ownership should not be recognized as a divestiture for 
accounting purposes, an accounting treatment consistent with that 
determination is required. In this instance, if Company Y is not 
consolidated by Company X, the assets and liabilities of the business 
which were the subject of the transaction should be segregated in the 
balance sheet of the selling entity under captions such as: ``Assets of 
business transferred under contractual arrangements (notes 
receivable),'' and ``Liabilities of business transferred'' or similar 
captions which appropriately convey the distinction between the legal 
form of the transaction and its accounting treatment.
    A note to the financial statements should describe the nature of 
the legal arrangements, relevant financing and other details and the 
accounting treatment.
    Where, as in this instance, realization of the sale price is wholly 
or principally dependent on the operating results of the business 
operations which were the subject of the transaction, the uncertainty 
associated with such realization should be reflected in the financial 
statements of the seller. Thus, absent a deterioration in the business, 
any operating losses of the divested business should be considered the 
best evidence of a change in valuation of the business in a manner 
somewhat analogous to equity accounting for an investment in common 
stock.\1\ If the business suffered a loss during its initial period of 
operations after the transaction, that loss should be reflected in the 
financial statements of the seller by recording a valuation allowance 
and a corresponding charge to income. The amount of the valuation 
allowance (absent unusual circumstances) would be at least the amount 
of the loss attributable to the business. Other evidence, however (such 
as a question as to the ability of the business to continue as a going 
concern), might require that a higher valuation allowance be 
established.
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    \1\ The staff recognizes that APB Opinion 18 is specifically 
applicable only to the use of the equity method of accounting for 
investments in common stock. The principles enunicated in Opinion 18 
are also relevant in these particular circumstances, however, 
notably paragraph 12, which states, in pertinent part: ``The equity 
method tends to be most appropriate if an investment enables the 
investor to influence the operating of financial decisions of the 
investee. The investor then has a degree of responsibility for the 
return on its investment, and it is appropriate to include in the 
results of operations of the investor its share of the earnings or 
losses of the investee.''
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    This accounting treatment should be continued for each period until 
either:
    1. The net assets of the business have been written down to zero 
(or a net liability recognized in accordance with GAAP); or
    2. Circumstances have changed sufficiently that it has become 
appropriate to recognize the transaction as a divestiture.
    In the latter instance, it would normally also be appropriate to 
recaption any asset balance remaining on the balance sheet of the 
seller in keeping with the changed circumstances, e.g., ``Notes 
receivable.''
    In the case where the business reports net income, such net income 
should not be recorded by the former owner, because the rewards of 
ownership (but not the risks) have been passed to Company Y. Any 
payments received on obligations of the buyer arising out of the 
transaction should be treated as a reduction of the carrying value of 
the segregated assets of the business.
    Question 3: Should Company X recognize interim (quarterly) losses 
of the business even if it is projected that it will have a profit for 
the full year?
    Interpretive Response: Yes. However, for quarters for which the 
business has net income, such net income may be recognized by Company X 
to the extent of any cumulative quarterly losses within the same fiscal 
year. Similarly, quarterly losses of the business need not be 
recognized by Company X except to the extent that they exceed any 
cumulative quarterly net income within the same fiscal year. Disclosure 
of this accounting treatment should be made in the notes to Company X's 
interim financial statements.
    Question 4: If the accounting treatment described above is applied 
to the transaction, when should a gain or loss on the transaction be 
recognized?
    Interpretive Response: Whether or not the transaction is treated as 
a divestiture for accounting purposes, GAAP require that losses on such 
transactions be recognized. When it is determined that no divestiture 
should be recognized for accounting purposes, it follows that gain 
should not be recognized until:
    1. The circumstances precluding treatment of the transaction as a 
divestiture have changed sufficiently to permit such recognition; and,
    2. Any major uncertainties as to ultimate realization of profit 
have been removed, that is, the consideration received in the 
transaction can be reasonably evaluated.
    The authoritative literature indicates that:

    Profit is deemed to be realized when a sale in the ordinary 
course of business is effected, unless the circumstances are such 
that the collection of the sale price is not reasonably assured.\2\

    \2\ ARB 43, Chapter 1, Section A. This passage is also quoted in 
paragraph 12 of APB Opinion 10, footnote 8, which states, in 
pertinent part: ``The Board recognizes that there are exceptional 
cases where receivables are collectible over an extended period of 
time and, because of the terms of the transactions or other 
conditions, there is no reasonable basis for estimating the degree 
of collectibility. When such circumstances exist, and as long as 
they exist, either the installment method or the cost recovery 
method of accounting may be used.''

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[[Page 26869]]

    The considerations discussed above regarding recognition of a 
divestiture for accounting purposes are also of importance in reaching 
a determination as to whether or not collection of the sale price is 
reasonably assured and profit recognition is therefore appropriate. In 
addition, circumstances such as the following tend to raise questions 
as to the propriety of profit recognition at any given time subsequent 
to the transaction:
    1. Evidence of financial weakness of the buyer.
    2. Substantial uncertainty as to the amount of future costs and 
expenses to be incurred by the seller.
    3. Substantial uncertainty as to the amount of proceeds to be 
realized because of the form of consideration received; e.g., 
nonrecourse debt, notes with optional settlement provisions, 
purchaser's stock, or other nonmonetary consideration which may be of 
indeterminable value.
    (Where satisfaction of the buyer's obligations to the seller 
remains dependent on earnings of the business divested, it will 
frequently be appropriate for the seller to continue to measure the 
uncertainty of ultimate collection by the operating losses of the 
business.)
    The degree of uncertainty surrounding ultimate realization of the 
consideration is a matter which must be evaluated in the light of the 
attendant circumstances each time realization is evaluated. The degree 
of uncertainty is enhanced, however, by the presence of any of the 
factors referred to above, and such factors must be considered in 
reaching a determination with respect to recognition of gain.

F. Accounting Changes Not Retroactively Applied Due to Immateriality

    Facts: A registrant is required to adopt an accounting principle by 
means of restatement 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 restate 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 restated, the 
cumulative effect of the change should be included in the statement of 
income for the period in which the change is made (not to be reported 
as a cumulative effect adjustment in the manner of APB Opinion 20). 
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 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 retroactively adjusted.
    This position is consistent with the requirements of Statement 5 
and Statement 13, which indicate that ``the cumulative effect [of the 
change] on retained earnings at the beginning of the earliest period 
restated shall be included in determining net income of that period.''

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 paragraph 4 of APB Opinion 29 states that Opinion 
29 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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

H. Accounting for Sales of Stock by a Subsidiary

    Facts: The registrant owns 95% of its subsidiary's stock. The 
subsidiary sells its unissued shares in a public offering, which 
decreases the registrant's ownership of the subsidiary from 95% to 90%. 
The offering price per share exceeds the registrant's carrying amount 
per share of subsidiary stock.
    Question 1: When an offering takes the form of a subsidiary's 
direct sale of its unissued shares, will the staff permit the amount in 
excess of the parent's carrying value to be reflected as a gain in the 
consolidated income statement of the parent?
    Interpretive Response: Yes, in some circumstances. Although the 
staff at one time insisted that such transactions be accounted for as 
capital transactions in the consolidated financial statements, it has 
reconsidered its views on this matter with respect to certain of these 
transactions where the sale of such shares by a subsidiary is not a 
part of a broader corporate reorganization contemplated or planned by 
the registrant. In situations where no other such capital transactions 
are contemplated, the staff has determined that it will accept 
accounting treatment for such transactions that is in accordance with 
the Advisory Conclusions in paragraph 30 of the June 3, 1980 Issues 
Paper, ``Accounting in Consolidation for Issuances of a Subsidiary's 
Stock.'' The staff believes that this issues paper should provide 
appropriate guidance on this matter until the FASB addresses this issue 
as a part of its project on Accounting for the Reporting Entity, 
including Consolidations, the Equity Method, and Related Matters.
    Question 2: What is meant by the phrase ``broader corporate 
reorganization contemplated or planned by the registrant'' and are 
there other situations where the staff has objected to gain 
recognition?
    Interpretive Response: The staff believes that gain recognition is 
not appropriate in situations where subsequent capital transactions are 
contemplated that raise concerns about the likelihood of the registrant 
realizing that gain, such as where the registrant intends to spin-off 
its subsidiary to shareholders or where reacquisition of shares is 
contemplated at the time of issuance. The staff will presume that 
repurchases were contemplated at the date of issuance in those 
situations

[[Page 26870]]

where shares are repurchased within one year of issuance or where a 
specific plan existed to repurchase shares at the time shares were 
issued. In addition, the staff believes that realization is not assured 
where the subsidiary is a newly-formed, non-operating entity; a 
research and development, start-up or development stage company; an 
entity whose ability to continue in existence is in question; or other 
similar circumstances. In those situations, the staff believes that the 
change in the parent company's proportionate share of subsidiary equity 
resulting from the additional equity raised by the subsidiary should be 
accounted for as an equity transaction in consolidation. Gain deferral 
is not appropriate.
    Question 3: In the staff's opinion, may gain be recognized for 
issuances of subsidiary stock in situations other than sales of 
unissued shares in a public offering?
    Interpretive Response: Yes. The staff believes that gain 
recognition is acceptable in situations other than sales of unissued 
shares in a public offering as long as the value of the proceeds can be 
objectively determined. With respect to issuances of stock options, 
warrants, and convertible and other similar securities, gain should not 
be recognized before exercise or conversion into common stock, and then 
only provided that realization of the gain is reasonably assured (see 
Question 2 above) at the time of such exercise or conversion.
    Question 4: Will repurchasing shares of a subsidiary's stock affect 
the potential for gain recognition by the registrant in consolidation 
for subsequent issuances of that subsidiary's stock? \1\
---------------------------------------------------------------------------

    \1\ This question and interpretive response assume that the 
repurchases were not contemplated at the time of earlier gain 
recognition. See Question 2.
---------------------------------------------------------------------------

    Interpretive Response: Yes. Where previous gains have been 
recognized in consolidation on issuances of a subsidiary's stock and 
shares of the subsidiary are subsequently repurchased by the 
subsidiary, its parent or any member of the consolidated group, gain 
recognition should not occur on issuances subsequent to the date of a 
repurchase until such time as shares have been issued in an amount 
equivalent to the number of repurchased shares. The staff views such 
transactions as analogous to treasury stock transactions from the 
standpoint of the consolidated entity that should not result in 
recognition of gains or losses.
    Question 5: May registrants selectively apply the guidance in the 
SAB by recognizing the impact of certain issuances by a subsidiary in 
the income statement and other issuances as equity transactions?
    Interpretive Response: No. The staff believes that income statement 
treatment in consolidation for issuances of stock by a subsidiary 
represents a choice among alternative accounting methods and, 
therefore, must be applied consistently to all stock transactions that 
meet the conditions for income statement treatment set forth herein for 
any subsidiary. If a registrant recognizes gains on issuances of stock 
by a subsidiary, thus adopting income statement recognition as its 
accounting policy, then it must also recognize losses for stock 
issuances by that or any other subsidiary that result in decreases in 
its proportionate share of the dollar amount of the subsidiary's 
equity. Regardless of the method of accounting selected, when a 
subsidiary issues securities at prices less than the parent's carrying 
value per share, the registrant must assess whether the investment has 
been impaired, in which case a provision should be reflected in the 
income statement.
    Question 6: How should the registrant disclose the accounting for 
issuances of a subsidiary's stock in the consolidated financial 
statements?
    Interpretive Response: The staff believes that gains (or losses) 
arising from issuances by a subsidiary of its own stock, if recorded in 
income by the parent, should be presented as a separate line item in 
the consolidated income statement without regard to materiality and 
clearly be designated as non-operating income. An appropriate 
description of the transaction should be included in the notes to the 
financial statements, as further described below.
    The accounting method adopted by the registrant for issuances of a 
subsidiary's stock should be disclosed in its accounting policy 
footnote and consistently applied (See Question 5). The staff believes 
that the registrant also should include a separate footnote that 
describes issuances of subsidiary stock that have occurred during all 
periods presented. This footnote should clearly describe the 
transaction, the identification of the subsidiary and nature of its 
operations, the number of shares issued, the price per share and the 
total dollar amount and nature of consideration received, and the 
percentage ownership of the parent both before and after the 
transaction. Additionally, the registrant should clearly state whether 
deferred income taxes have been provided on gains recognized and, if no 
provision has been recorded, a clear explanation of the reasons. 
Finally, the staff expects registrants to include disclosure in their 
Management Discussion and Analysis of the impact of specific 
transactions that have occurred and the likelihood of similar 
transactions occurring in future years.

I. Deleted by SAB 70

J. Push Down Basis of Accounting Required in Certain Limited 
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 A's cost of acquiring 
Company B should be ``pushed down,'' i.e., used to establish a new 
accounting basis in Company B's separate financial statements.\1\
---------------------------------------------------------------------------

    \1\ The Task Force on Consolidation Problems, Accounting 
Standards Division of the American Institute of Certified Public 
Accountants issued a paper entitled ``Push Down'' Accounting, 
October 30, 1979. This paper addresses the issues relating to ``push 
down'' accounting, cities authoritative literature and indicates 
that a substantial change in ownership justifies a new basis of 
accounting.
---------------------------------------------------------------------------

    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?
    Interpretative Response: The staff recognizes that the existence of 
outstanding public debt, preferred stock or a significant minority 
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.

[[Page 26871]]

    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?
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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 Statements 5 
and 57 as well as Interpretation 45 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. 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\
---------------------------------------------------------------------------

    \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 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.
    \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.
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \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.''
---------------------------------------------------------------------------

    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.

K. Deleted 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.\1\ 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.
---------------------------------------------------------------------------

    \1\ 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 * * * ''
---------------------------------------------------------------------------

    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

[[Page 26872]]

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 APB Opinion 20 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 Debt and 
Equity Securities

    Facts: Paragraph 16 of Statement 115 specifies that ``[f]or 
individual securities classified as either available-for-sale or held-
to-maturity, an enterprise shall determine whether a decline in fair 
value below the amortized cost basis is other than temporary * * * If 
the decline in fair value is judged to be other than temporary, the 
cost basis of the individual security shall be written down to fair 
value as a new cost basis and the amount of the write-down shall be 
included in earnings (that is, accounted for as a realized loss).''
    Statement 115 does not define the phrase ``other than temporary.'' 
In applying this guidance to its own situation, 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 is permanently impaired, no 
realized loss has been recognized even though the market price of B's 
shares is currently less than one-third of A's average acquisition 
price.
    Question: 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.\1\
---------------------------------------------------------------------------

    \1\ Footnote 4 to Statement 115 refers to this SAB for a 
discussion of considerations applicable to a determination as to 
whether a decline in market value below cost, at a particular point 
in time, is other than temporary. FASB's implementation guide ``A 
Guide to Implementation of Statement 115 on Accounting for Certain 
Investments in Debt and Equity Securities,'' SAS 92, ``Auditing 
Derivative Instruments, Hedging Activities, and Investments in 
Securities,'' AICPA Audit Guide, ``Auditing Derivative Instruments, 
Hedging Activities, and Investments in Securities,'' and EITF Topic 
D-44 also address issues related to the determination of whether a 
decline in fair value of an investment security is other than 
temporary.
---------------------------------------------------------------------------

    The value of investments in marketable securities classified as 
either available-for-sale or held-to-maturity 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.
    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 following are only a few examples of the factors 
which, individually or in combination, indicate that a decline 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 exits to support a realizable value equal to or 
greater than the carrying value of the investment, a write-down to fair 
value accounted for as a realized loss should be recorded. In 
accordance with the guidance of paragraph 16 of Statement 115, 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 \1\ 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.
---------------------------------------------------------------------------

    \1\ The term ``short-duration'' refers to the period of coverage 
(see statement 60, paragraph 7), 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:
    [sbull] 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

[[Page 26873]]

    [sbull] Discounting liabilities with respect to settled claims 
under the following circumstances:
    [sbull] The payment pattern and ultimate cost are fixed and 
determinable on an individual claim basis, and
    [sbull] 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 APB Opinion 20. Initial adoption of 
discounting for GAAP purposes would be treated similarly. In either 
case, in addition to the disclosures required by APB Opinion 20 
concerning the change in accounting principle, a preferability letter 
from the registrant's independent accountant is required.

O. Research and Development Arrangements

    Facts: Statement 68 paragraph 7 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. Paragraph 8(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 paragraph 8(c) of 
Statement 68?
    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.\1\ 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.
---------------------------------------------------------------------------

    \1\ Related parties as used herein are as defined in paragraph 
24 of Statement 57.
---------------------------------------------------------------------------

    Question 2: Paragraph 7 of Statement 68 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. Paragraph 5 of Statement 68 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. Deleted by SAB 103
2. Deleted 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. 
Additionally, since the charges are not both unusual and infrequent \1\ 
they are not presented in the income statement as extraordinary items.
---------------------------------------------------------------------------

    \1\ See APB Opinion 30, paragraph 20.
---------------------------------------------------------------------------

    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. Paragraph 26 of APB Opinion 30 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.\2\ Neither Opinion 30 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 Opinion 30.
---------------------------------------------------------------------------

    \2\ Paragraph 26 of APB Opinion 30 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.
---------------------------------------------------------------------------

    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

[[Page 26874]]

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, 
Statement 146 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 Statement 
146 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 \1\ 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.
---------------------------------------------------------------------------

    \1\ 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.
---------------------------------------------------------------------------

    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 \2\ (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 the balance sheet, results of 
operations or cash flows generally is appropriate.
---------------------------------------------------------------------------

    \2\ The staff would expect similar disclosures for employee 
termination benefits whether those costs have been recognized 
pursuant to Statement 88, 112, or 146.
---------------------------------------------------------------------------

    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:
    a. When the registrant began formulating exit plans for which 
accrual may be necessary,
    b. The types and amounts of liabilities recognized for exit costs 
and involuntary employee termination benefits and included in the 
acquisition cost allocation, and
    c. 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

[[Page 26875]]

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 \1\ 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.
---------------------------------------------------------------------------

    \1\ ``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.
---------------------------------------------------------------------------

    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.\2\ 
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.
---------------------------------------------------------------------------

    \2\ As described in the ``Facts'' section of the 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 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 dividened 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.
---------------------------------------------------------------------------

    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 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,\3\ 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).
---------------------------------------------------------------------------

    \3\ See Question 3 regarding variable increasing rate preferred 
stocks.
---------------------------------------------------------------------------

    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 (8%
                                                        Beginning of Year    of Carrying Amount     End of year
                                                              (BOY)                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 \4\ would reflect dividend cost of 
8%, the market rate at time of issuance.
---------------------------------------------------------------------------

    \4\ 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 nonredeemable preferred stock being accreted to 
its par value, stated value, voluntary redemption value or 
involuntary liquidation value.
---------------------------------------------------------------------------

    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 APB Opinion 21 and Topic 3.C of this codification for 
unstated interest costs of debt capital and unstated dividend costs of 
redeemable preferred stock capital,

[[Page 26876]]

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 \5\ or 
nonredeemable) is irrelevant from the standpoint of common stock 
interests.
---------------------------------------------------------------------------

    \5\ 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 APB Opinion 21, producers a constant effective 
periodic rate of cost that is comprised of amortization of discount 
as well as the stated cost of each period.
---------------------------------------------------------------------------

    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.\6\ 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).
---------------------------------------------------------------------------

    \6\ The staff first publicly expressed its view as to the 
appropriate accounting at the December 3-4, 1986 meeting of the 
EITF.
---------------------------------------------------------------------------

R. Deleted 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 accounting principles \1\ 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.
---------------------------------------------------------------------------

    \1\ 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.
---------------------------------------------------------------------------

    Question 1: May the company reclassify its capital accounts to 
eliminate the accumulated deficit without satisfying all of the 
conditions enumerated in Section 210 \2\ of the Codification of 
Financial Reporting Policies for a quasi-reorganization?
---------------------------------------------------------------------------

    \2\ 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 \3\ for a quasi-reorganization are satisfied.\4\
---------------------------------------------------------------------------

    \3\ 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;
    4. 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.
    \4\ In addition, ARB 43, Chapter 7A, 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.\5\
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    \5\ Opinion 20 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.
---------------------------------------------------------------------------

    Chapter 7A of ARB 43 indicates that, following a quasi-
reorganization, a ``company's accounting should be substantially 
similar to that appropriate for a new company.'' 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.\6\ Chapter 7A of ARB 43 states, in 
part, ``* * * in general, assets should be carried forward as of the 
date of the readjustment at fair and

[[Page 26877]]

not unduly conservative amounts, determined with due regard for the 
accounting to be employed by the Company thereafter.'' (emphasis added)
---------------------------------------------------------------------------

    \6\ 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.\7\
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    \7\ 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 are 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.\8\ 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?
---------------------------------------------------------------------------

    \8\ See footnote 3.
---------------------------------------------------------------------------

    Interpretive Response: The staff believes Statement 109 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,\9\ 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.\10\
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    \9\ 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)
    \10\ FASB Special Report: A Guide to Implementation of Statement 
109 on Accounting for Income Taxes: Questions and Answers answer 9 
states in part: ``ARB 43, Chapter 7, `Capital Accounts,' states that 
after a quasi-reorganization, the enterprise's accounting should be 
substantially similar to that appropriate for a new enterprise. As 
such, any subsequently recognized tax benefit of an operating loss 
or tax credit carryforward that existed at the date of a quasi-
reorganization should not be included in the determination of income 
of the ``new'' enterprise, regardless of whether losses that gave 
rise to an operating loss carryforward were charged to income prior 
to the quasi-reorganization or directly to contributed capital as 
part of the quasi-reorganization. A new enterprise would not have 
tax benefits attributable to operating losses or tax credits that 
arose prior to its organization date.''
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    The FASB recognized that a practice existed of recording deficit 
elimination type quasi-reorganizations without evaluating the 
concurrent need to restate assets and liabilities to fair values, and 
provided guidance on accounting for the tax benefits of carryforward 
items subsequent to such an event.\11\ This practice and accounting is 
not permitted by Section 210, and accordingly, is not appropriate for 
registrants. The staff believes that all registrants that comply with 
the requirements of Section 210 in effecting a quasi-reorganization 
should apply the accounting required by the first sentence of paragraph 
39 of Statement 109 for the tax benefits of tax carryforward items.\12\ 
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.
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    \11\ Statement 109, paragraph 39, states, in part: ``The only 
exception is for enterprises that have previously both adopted 
Statement 96 and effected a quasi reorganization that involves only 
the elimination of a deficit in retained earnings by a concurrent 
reduction in contributed capital prior to adopting this Statement. 
For those enterprises, subsequent recognition of the tax benefit of 
prior deductible temporary differences and carryforwards is included 
in income and reported as required by paragraph 37 * * * and then 
reclassified from retained earnings to contributed capital.'' Also, 
see Footnote 10.
    \12\ The first sentence of paragraph 39 of Statement 109 states: 
``[t]he tax benefit of deductible temporary differences and 
carryforwards as of the date of a quasi reorganization as defined 
and contemplated in ARB 43, Chapter 7, 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 Opinion 20 would 
preclude such a change in accounting. It states: ``a method of 
accounting that was previously adopted for a type of transaction or 
event which is being terminated or which was a single, nonrecurring 
event in the past should not be changed.'' (emphasis added)\13\
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    \13\ Opinion 20, paragraph 16.
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T. Accounting for Expenses or Liabilities Paid by Principal 
Stockholder(s)

    Facts: Company X was a defendant in litigation for which the 
company had not recorded a liability in accordance with Statement 5. A 
principal stockholder 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.
    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 AICPA Interpretation 1 to Opinion 25 in which a principal 
stockholder\1\

[[Page 26878]]

establishes or finances a stock option, purchase or award plan for one 
or more employees of the company. Interpretation 1 states that ``if a 
principal stockholder's intention is to enhance or maintain the value 
of his investment by entering into such an arrangement, the corporation 
is implicitly benefiting from the plan by retention of, and possibly 
improved performance by, the employee. In this case, the benefits to a 
principal stockholder and to the corporation are generally impossible 
to separate. Similarly, it is virtually impossible to separate a 
principal stockholder's personal satisfaction from the benefit to the 
corporation.'' As a result, Interpretation 1 requires the company to 
account for such a transaction as if it were a compensatory plan 
adopted by the company, with an offsetting contribution to capital, 
unless: (1) The stockholder's relationship to the employee would 
normally result in generosity, (2) the stockholder has an obligation to 
the employee which is unrelated to employment, or (3) the company 
clearly does not benefit from the transaction.
---------------------------------------------------------------------------

    \1\ Statement 57, paragraph 24e, defines principal owners as 
``owners of record or known beneficial owners of more than 10 
percent of the voting interests of the enterprise.''
---------------------------------------------------------------------------

    The staff believes that the problem of separating the benefit to 
the principal stockholder from the benefit to the company cited in 
Interpretation 1 is not limited to transactions involving stock 
compensation. Therefore, similar accounting is required in this and 
other\2\ 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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    \2\ 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 Statement 57 applies to these transactions and requires only the 
disclosure of material related party transactions, the staff should not 
require the accounting called for by Interpretation 1 for transactions 
other than those specifically covered by it. The staff notes, however, 
that Statement 57 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.\3\ However, the staff 
believes that transactions of the type described above differ from the 
typical related party transactions.
---------------------------------------------------------------------------

    \3\ 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 Statement 57 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 determined that it was inappropriate to permit 
accounting according to the form of the transaction.

U. Gain Recognition on the Sale of A Business or Operating Assets to A 
Highly Leveraged Entity

    Facts: A registrant has sold a subsidiary, division or operating 
assets to a newly formed, thinly capitalized, highly leveraged entity 
(NEWCO) for cash or a combination of cash and securities, which may 
include subordinated debt, preferred stock, warrants, options or other 
instruments issued by NEWCO. In some of these transactions, registrants 
may guarantee debt or enter into other agreements (sometimes referred 
to as make-well agreements) that may require the registrant to infuse 
cash into NEWCO under certain circumstances. Securities received in the 
transaction are not actively traded and are subordinate to 
substantially all of NEWCO's other debt. The value of the consideration 
received appears to exceed the cost basis of the net assets sold.
    Question 1: Assuming the transaction may be properly accounted for 
as a divestiture,\1\ does the staff believe it is appropriate for the 
registrant to recognize a gain?
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    \1\ Transactions such as these require careful evaluation to 
determine whether, in substance, a divestiture has occurred. SAB 
Topic 5.E provides the staff's views on circumstances that may exist 
that would lead the staff to conclude that the risks of the business 
have not been transferred to the new owners and that a divestiture 
has not occurred. Topic 5.E indicates that factors to consider in 
determining whether a transaction should be accounted for as a 
divestiture include:
    [sbull] Continuing involvement by the seller in the business;
    [sbull] Absence of a significant financial investment in the 
business by the buyer;
    [sbull] Repayment of debt, which constitutes the principal 
consideration in the transaction, is dependent on future successful 
operations; or
    [sbull] The continued necessity for debt or contract performance 
guarantees on behalf of the business by the seller.
    Further, the seller should consider whether it is required to 
consolidate the entity by way of its variable interests held in the 
NEWCO pursuant to the provisions of FASB Interpretation 46.
---------------------------------------------------------------------------

    Interpretive Response: The staff believes there often exist 
significant uncertainties about the seller's ability to realize non-
cash proceeds received in transactions in which the purchaser is a 
thinly capitalized, highly leveraged entity, particularly when its 
assets consist principally of those purchased from the seller. The 
staff believes that such uncertainties raise doubt as to whether 
immediate gain recognition is appropriate. Factors that may lead the 
staff to question gain recognition in such transactions include:
    1. Situations in which the assets or operations sold have 
historically not produced cash flows from operations \2\ that will be 
sufficient to fund future debt service and full dividend requirements 
on a current basis.\3\ Often the servicing of debt and preferred 
dividend requirements is dependent upon future events that cannot be 
assured, such as sales of assets or improvements in earnings.
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    \2\ As defined in paragraphs 21-24 of Statement 95.
    \3\ The ability of NEWCO to fund the debt service and the 
dividend requirement(s) should be evaluated on a full accrual 
basis--i.e., irrespective of the purchaser's ability to satisfy 
those requirements through deferral (contractually or otherwise) of 
any required cash payments or the issuance of additional securities 
to satisfy such requirements.
---------------------------------------------------------------------------

    2. The lack of any substantial amount of equity capital in NEWCO 
other than that provided by the registrant; and/or
    3. The existence of contingent liabilities of the registrant, such 
as debt guarantees or agreements that require

[[Page 26879]]

the registrant to infuse cash into NEWCO under certain circumstances.
    The staff also believes that even where the registrant receives 
solely cash proceeds, the recognition of any gain would be impacted by 
the existence of any guarantees or other agreements that may require 
the registrant to infuse cash into NEWCO, particularly when the first 
two factors listed above exist.
    Question 2: If immediate recognition of all or a portion of the 
apparent gain is not appropriate due to the existence of facts and 
circumstances similar to the above, at what future date should the gain 
be recognized and how should the deferred gain be disclosed in the 
financial statements?
    Interpretive Response: Generally, the staff believes that the 
deferred gain\4\ should not be recognized until such time as cash flows 
from operating activities are sufficient to fund debt service and 
dividend requirements (on a full accrual basis)\5\ or the registrant's 
investment in NEWCO has been or could be readily converted to cash 
(e.g., active trading market develops in NEWCO securities and the 
registrant is not restricted from selling such securities, the 
registrant sells the securities received on a nonrecourse basis, etc.) 
and the registrant has no further obligations under any debt guarantees 
or other agreements that would require it to make additional 
investments in NEWCO.
---------------------------------------------------------------------------

    \4\ In situations in which the gain is deferred following the 
guidance in this SAB, the staff believes that the seller generally 
should not recognize any income from the securities received in such 
transactions (including accretion of securities to their face or 
redemption value) until realization is more fully assured.
    \5\ See note 4.
---------------------------------------------------------------------------

    The staff believes that the amount of any deferred gain (including 
deferral of interest or dividend income on securities received) should 
be disclosed on the face of the balance sheet as a deduction from the 
related asset account (i.e., investment in NEWCO). The footnotes to the 
financial statements should include a complete description of the 
transaction, including the existence of any commitments and 
contingencies, the terms of the securities received, and the accounting 
treatment of amounts due thereon.

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 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.
    Statement 140 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 Statement 
140. Because Statement 140 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 
Interpretation 46 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. SAB Topic 5.E \1\ discusses some factors that the staff 
believes should be considered in determining whether the risks of a 
business have been transferred. Consistent with the factors discussed 
in SAB Topic 5.E, 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,\2\ 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.
---------------------------------------------------------------------------

    \1\ SAB Topic 5.E addresses the accounting for the transfer of 
certain operations whereby there is a continuing involvement by the 
seller or other evidence that incidents of ownership remain with the 
seller.
    \2\ 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.
---------------------------------------------------------------------------

    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\3\ over the fair value.\4\ Fair value 
is the amount that

[[Page 26880]]

would be realizable in an outright sale to an unrelated third party for 
cash.\5\ 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.
---------------------------------------------------------------------------

    \3\ 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.
    \4\ The staff notes that the EITF reached a consensus at its 
November 17, 1988 meeting on Issue 88-25 that the newly created 
``liquidating bank'' should continue to report its assets and 
liabilities at fair values at the date of the financial statements.
    \5\ The EITF reached a consensus on issue 11 of Issue 01-02 that 
an enterprise that distributes loans to its owners should report 
such distribution at fair value.
---------------------------------------------------------------------------

    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 redeemable 
instrument, careful consideration must be given to the appropriateness 
of recording profits on the management fee arrangements 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.\6\
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    \6\ 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.
---------------------------------------------------------------------------

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 Statement 60 for unpaid claim 
costs, including estimates of costs relating to claims incurred but not 
reported (``IBNR'').\1\ 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.
---------------------------------------------------------------------------

    \1\ Paragraph 18 of Statement 60 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]
---------------------------------------------------------------------------

    Statement 5 requires, among other things, disclosure of loss 
contingencies.\2\ However, paragraph 2 of that Statement notes that 
``[n]ot all uncertainties inherent in the accounting process give rise 
to contingencies as that term is used in [Statement 5].''
---------------------------------------------------------------------------

    \2\ Paragraph 10 of Statement 5 specified that ``[i]f no accrual 
is made for a loss contingency because one or both of the conditions 
in paragraph 8 are not met, or if an exposure to loss exists in 
excess of the amount accrued pursuant to the provisions of paragraph 
8, 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.]
---------------------------------------------------------------------------

    SOP-94-6 \3\ also provides disclosure guidance regarding certain 
significant estimates.
---------------------------------------------------------------------------

    \3\ SOP 94-6 provides that disclosures regarding certain 
significant estimates should be made when the following criteria are 
met. The SOP provides that:
    The disclosure should 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 [Statement]. 5, 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. (footnote references omitted)
    SOP 94-6 requires disclosures regarding current vulnerability 
due to certain concentrations which my be applicable as well.
---------------------------------------------------------------------------

    Question 1: In the staff's view, do Statement 5 and SOP 94-6 
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 \4\ for purposes of 
applying Statement 5 and SOP 94-6 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 Statements 5. Some specific uncertainties that may 
result in loss contingencies pursuant to Statement 5, 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 SOP 94-6 apply when ``[i]t is at least reasonably 
possible that the estimate of

[[Page 26881]]

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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    \4\ The loss contingency referred to in this document is the 
potential for a material understatement of reserves for unpaid 
claims.
---------------------------------------------------------------------------

    Question 2: Do the facts presented above describe an uncertainty 
that requires disclosures under Statement 5 and SOP 94-6?
    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 Statement 5 and SOP 94-6. 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, 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 Statement 5 and SOP 94-6 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. Deleted 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 paragraph 132 of SOP 96-1 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. SOP 96-1 further states that the 
discount rate used to discount the cash payments should not exceed the 
interest rate on monetary assets that are essentially risk free \1\ and 
have maturities comparable to that of the environmental or product 
liability.
---------------------------------------------------------------------------

    \1\ As described in Concepts Statement 7.
---------------------------------------------------------------------------

    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: Paragraphs 9 and 10 of Statement 5 identify 
disclosures regarding loss contingencies that generally are furnished 
in notes to financial statements. SOP 96-1 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 Statement 5 and SOP 96-1, 
examples of disclosures that may be necessary include:
    [sbull] Circumstances affecting the reliability and precision of 
loss estimates.
    [sbull] The extent to which unasserted claims are reflected in any 
accrual or may affect the magnitude of the contingency.
    [sbull] 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.
    [sbull] Disclosure of the nature and terms of cost-sharing 
arrangements with other potentially responsible parties.
    [sbull] The extent to which disclosed but unrecognized contingent 
losses are expected to be recoverable through insurance, 
indemnification arrangements, or other sources, with

[[Page 26882]]

disclosure of any material limitations of that recovery.
    [sbull] Uncertainties regarding the legal sufficiency of insurance 
claims or solvency of insurance carriers.\2\
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    \2\ The staff believes there is a rebuttable presumpiton 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 presumpiton 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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    [sbull] The time frame over which the accrued or presently 
unrecognized amounts may be paid out.
    [sbull] 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 
Statement 5 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 Regulations S-K and S-B. The Commission has issued 
interpretive releases that provide additional guidance with respect to 
these items.\3\ 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.\4\ 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 the financial condition of third 
parties from which recovery is expected.
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    \3\ 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.
    \4\ See, for example, footnote 30 of FR 36 (footnote 17 of 
Section 501.02 of the Codification of Financial Reporting Policies).
---------------------------------------------------------------------------

    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?\5\
---------------------------------------------------------------------------

    \5\ Registrants are reminded that Statement 143 provides 
guidance for accounting and reporting for costs associated with 
asset retirement obligations.
---------------------------------------------------------------------------

    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.\6\ The registrant's 
accounting policy with respect to such costs should be disclosed in 
accordance with Opinion 22.
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    \6\ If the company has a guarantee as defined by Interpretation 
45, 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.
---------------------------------------------------------------------------

Z. Accounting and Disclosure Regarding Discontinued Operations

1. Deleted by SAB 103
2. Deleted by SAB 103
3. Deleted 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 Statement 144. 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 
Opinion 18 to account for its residual investment using the equity 
method.\1\
---------------------------------------------------------------------------

    \1\ In some circumstances, the seller's continuing interest may 
be so great that divestiture accounting is inappropriate. See SAB 
Topic 5.E.
---------------------------------------------------------------------------

    Question: May the historical operating results of the component and 
the gain or

[[Page 26883]]

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 Statement 144?
    Interpretive Response: No. A condition necessary for discontinued 
operations reporting, as indicated in paragraph 42 of Statement 144 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 Statement 144.\2\
---------------------------------------------------------------------------

    \2\ 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.
---------------------------------------------------------------------------

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 Statement 144 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 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.\1\ 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.
---------------------------------------------------------------------------

    \1\ Registrants are reminded that Interpretation 45 requires 
recognition and disclosure of certain guarantees which may impose 
accounting and disclosure requirements in addition to those 
discussed in this SAB Topic.
---------------------------------------------------------------------------

    Paragraph 44 of Statement 144 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 
paragraph 44 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 paragraph 44 of Statement 144. 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\12\ 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,\3\ 
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 Statement 5. 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.
---------------------------------------------------------------------------

    \12\ Item 303 of Regulation S-K.
    \3\ Registrants also should consider the disclosure requirements 
of Interpretation 45.
---------------------------------------------------------------------------

6. Deleted 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

[[Page 26884]]

an investment in the subsidiary, in the manner specified by paragraph 
34 of APB Opinion 20?
    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 Statement 144. 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 Statement 131.

AA. Deleted by SAB 103

BB. Inventory Valuation Allowances

    Facts: ARB 43, Chapter 4, Statement 5, 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 obsolescence, changes in price levels, or other causes, the 
difference should 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.''
    Footnote 2 to that same chapter indicates that ``[i]n the case of 
goods which have been written down below cost at the close of a fiscal 
period, such reduced amount is to be considered the cost for subsequent 
accounting purposes.''
    Lastly, Opinion 20 provides ``inventory obsolescence'' as one of 
the items subject to estimation and changes in estimates under the 
guidance in paragraphs 10-11 and 31-33 of that Opinion.
    Question: Does the write-down of inventory to the lower of cost or 
market, as required by ARB 43, 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 ARB 43, footnote 2, 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.\1\
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    \1\ See also disclosure requirement for inventory balances in 
Rule 5-02(6) of Regulation S-X.
---------------------------------------------------------------------------

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 Statement 144. 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 Statement 142.
    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 Statement 144 for the carrying value of the mainframe computers 
of $4,600 in March 20X3. Does Company X meet the requirements in 
Statement 144 to classify the mainframe computer assets as ``to be 
abandoned?''
    Interpretive Response: No. Statement 144, paragraph 28, 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 Opinion 20 
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 Statement 144 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. For an asset that meets the requirements 
to be classified as ``held for sale'' under Statement 144, paragraph 34 
of that standard requires the asset to be valued at the lower of 
carrying amount or fair value less cost to sell. For assets that are 
classified as ``held and used'' under Statement 144, an assessment must 
first be made as to whether the asset (asset group) is impaired. 
Paragraph 7 of Statement 144 indicates that an impairment loss shall be 
recognized only if the carrying amount of a long-

[[Page 26885]]

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 Statement 144.
    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 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 Statement 144?
    Interpretive Response: In providing guidance on the development of 
cash flows for purposes of applying the provisions of Statement 144, 
paragraph 17 of that Statement 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 Statement 144. The staff, however, cautions registrants that 
the judgments and assumptions made for purposes of applying Statement 
144 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 Statement 144 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 Statement 144 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 Statement 109. 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.

Topic 6: Interpretations of Accounting Series Releases and Financial 
Reporting Releases

A.1. Deleted 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\ If a registrant elects to follow the encouraged disclosure 
discussed in paragraph 23 of Statement 130, and displays the 
components of other comprehensive income and the total for 
comprehensive income using a one-statement approach, 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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[[Page 26886]]

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. Deleted by SAB 103

G. Accounting Series Releases 177 and 286--Relating to Amendments To 
Form 10-Q, Regulation S-K, and Regulation 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.\1\ In addition, certain selected quarterly data is required to 
be disclosed by virtually all registrants (see Item 302(a)(5) of 
Regulation S-K).
---------------------------------------------------------------------------

    \1\ 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, and net income 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 \1\ 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.
---------------------------------------------------------------------------

    \1\ 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 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 Statement 144, 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 
paragraph 31 of APB Opinion 28 which relates to disclosures required 
for the fourth quarter of the year. The Opinion 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

[[Page 26887]]

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. Deleted 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 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: In determining whether or not major income statement 
captions may be combined, does average ``net income'' for the last 
three years (using the company's last year end as the starting point) 
mean ``net income'' or income before extraordinary items and changes in 
accounting principles?
    Interpretive Response: It means ``net income.''
    Question 3: 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 4: 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 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.

A. 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.\1\
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    \1\ Registrants also are reminded that paragraph 17 of APB 
Opinion 20 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.
---------------------------------------------------------------------------

    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

[[Page 26888]]

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 a Statement of Financial 
Accounting Standards, 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 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

[[Page 26889]]

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 Statement 6, 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.''
    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        1,840,000
         cash 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.

[[Page 26890]]

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.
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.
7. 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. Deleted by SAB 47

K. Accounting Series Release 302--Separate Financial Statements 
Required By Regulation S-X

1. Deleted 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

[[Page 26891]]

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 APB Opinion 23, 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:

----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
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:
    [sbull] Net assets, excluding intercompany loans, cannot be less 
than $35
    [sbull] 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)                          30
 cannot be 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:

[[Page 26892]]



----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
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
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:

[[Page 26893]]



----------------------------------------------------------------------------------------------------------------
                                                                                   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 undisputed 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 
amortized, 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,

[[Page 26894]]

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 APB Opinion 18, par 
20(c) and (d), 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 
Statements 5 and 114.\1\ 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.\2\ Statement 114 
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 Statement 5. Additional guidance 
on the recognition, measurement, and disclosure of loan losses is 
provided by EITF Topic D-80, Interpretation 14, and the AICPA Audit and 
Accounting Guide, Banks and Savings Institutions.
---------------------------------------------------------------------------

    \1\ As amended by Statement 118.
    \2\ Paragraph 8 of Statement 5.
---------------------------------------------------------------------------

    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.\3\
---------------------------------------------------------------------------

    \3\ For purposes of this interpretation, a loan is defined 
(consistent with paragraph 4 of Statement 114) 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 on year or debt securities subject to the provisions of 
Statement 115
---------------------------------------------------------------------------

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 \1\ 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.
---------------------------------------------------------------------------

    \1\ 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.''
---------------------------------------------------------------------------

    However, as indicated in the AICPA Audit and Accounting Guide, 
Banks and Savings Institutions (Audit Guide), ``[w]hile 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.'' \2\ A registrant's loan loss 
allowance methodology generally should: \3\
---------------------------------------------------------------------------

    \2\ See paragraph 7.05 of the Audit Guide.
    \3\ Ibid.
---------------------------------------------------------------------------

    [sbull] Include a detailed analysis of the loan portfolio, 
performed on a regular basis;
    [sbull] Consider all loans (whether on an individual or group 
basis);
    [sbull] Identify loans to be evaluated for impairment on an 
individual basis under Statement 114 and segment the remainder of the 
portfolio into groups of loans with similar risk characteristics

[[Page 26895]]

for evaluation and analysis under Statement 5;
    [sbull] Consider all known relevant internal and external factors 
that may affect loan collectibility;
    [sbull] Be applied consistently but, when appropriate, be modified 
for new factors affecting collectibility;
    [sbull] Consider the particular risks inherent in different kinds 
of lending;
    [sbull] Consider current collateral values (less costs to sell), 
where applicable;
    [sbull] Require that analyses, estimates, reviews and other loan 
loss allowance methodology functions be performed by competent and 
well-trained personnel;
    [sbull] Be based on current and reliable data;
    [sbull] 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
    [sbull] 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.\4\ 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.\5\
---------------------------------------------------------------------------

    \4\ 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.''
    \5\ 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:
    [sbull] Selection of new or changes to accounting policies
    [sbull] Estimates, judgments, and uncertainties
    [sbull] Unusual transactions
    [sbull] Accounting policies relating to significant financial 
statement items, including the timing or transactions and the period 
in which they are recorded.''
---------------------------------------------------------------------------

    A systematic methodology that is properly designed and implemented 
should result in a registrant's best estimate of its allowance for loan 
losses.\6\ 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.\7\
---------------------------------------------------------------------------

    \6\ Registrants should also refer to Interpretation 14, 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.
    \7\ Registrants should refer to the guidance on materiality in 
SAB 99 (SAB Topic 1.M).
---------------------------------------------------------------------------

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.\8\
---------------------------------------------------------------------------

    \8\ 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.''
---------------------------------------------------------------------------

    The staff normally would expect to find that registrants maintain 
written supporting documentation for the following decisions, 
strategies, and processes: \9\
---------------------------------------------------------------------------

    \9\ Paragraph 7.39 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''); 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''); and ``consideration by management of 
whether the allowance is consistent with the operational plans of 
the institution.''
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    [sbull] Policies and procedures:
    [sbull] Over the systems and controls that maintain an appropriate 
loan loss allowance, and
    [sbull] Over the loan loss allowance methodology;
    [sbull] Loan grading system or process;
    [sbull] Summary or consolidation of the loan loss allowance 
balance;
    [sbull] Validation of the loan loss allowance methodology; and
    [sbull] 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:
    [sbull] 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

[[Page 26896]]

allowance to be reported in the financial statements; \10\
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    \10\ Paragraph 7.39 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.''
---------------------------------------------------------------------------

    [sbull] 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; \11\
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    \11\ Paragraph 7.33 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.
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    [sbull] 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); \12\ and
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    \12\ Ibid. As indicated in paragraph 7.33, ``[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.''
---------------------------------------------------------------------------

    [sbull] The system of internal controls used to ensure that the 
loan loss allowance process is maintained in accordance with GAAP.\13\
---------------------------------------------------------------------------

    \13\ See also paragraph 7.39 in the Audit Guide which provides 
information about specific aspects of effective internal control 
related to the allowance for loan losses.
---------------------------------------------------------------------------

    The staff normally would expect an internal control system \14\ for 
the loan loss allowance estimation process to:
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    \14\ 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.
---------------------------------------------------------------------------

    [sbull] Include measures to provide assurance regarding the 
reliability \15\ and integrity of information and compliance with laws, 
regulations, and internal policies and procedures; \16\
---------------------------------------------------------------------------

    \15\ Concepts Statement 2 provides guidance on ``reliability'' 
as a primary quality of accounting information.
    \16\ Section 13(b)(2)-(7) of the Exchange Act.
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    [sbull] Reasonably assure that the registrant's financial 
statements are prepared in accordance with GAAP; and
    [sbull] Include a well-defined loan review process.\17\
---------------------------------------------------------------------------

    \17\ As indicated in paragraph 7.05, item a, in the Audit Guide, 
a loan loss allowance methodology should ``include a detailed and 
regular analysis of the loan portfolio.'' Paragraphs 7.06 to 7.13 
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 \18\ typically contains:
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    \18\ Ibid. Additionally, paragraph 7.39 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 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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    [sbull] 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; \19\
---------------------------------------------------------------------------

    \19\ Ibid.
---------------------------------------------------------------------------

    [sbull] 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; \20\ and
---------------------------------------------------------------------------

    \20\ Ibid.
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    [sbull] 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).\21\
---------------------------------------------------------------------------

    \21\ 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 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:
    [sbull] For segmenting the portfolio:
    [sbull] How the segmentation process is performed (i.e., by loan 
type, industry, risk rates, etc.); \22\
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    \22\ Paragraph 7.07 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. Each segment should contain loans with similar 
characteristics, such as risk classification, past-due status, and 
type of loan.'' Paragraph 7.08 provides additional guidance on 
classifying individual loans and paragraph 7.13 indicates 
considerations for groups or pools of loans.
---------------------------------------------------------------------------

    [sbull] When a loan grading system is used to segment the 
portfolio:
    [sbull] The definitions of each loan grade;
    [sbull] A reconciliation of the internal loan grades to supervisory 
loan grades, if applicable; and
    [sbull] The delineation of responsibilities for the loan grading 
system.
    [sbull] For determining and measuring impairment under Statement 
114: \23\
---------------------------------------------------------------------------

    \23\ See Statement 114, paragraphs 8 through 10 on recognition 
of impairment and paragraphs 11 through 16 on measurement of 
impairment. See also the guidance in EITF Topic D-80.
---------------------------------------------------------------------------

    [sbull] The methods used to identify loans to be analyzed 
individually;
    [sbull] For individually reviewed loans that are impaired, how the 
amount of any impairment is determined and measured, including:
    [sbull] Procedures describing the impairment measurement techniques 
available; and
    [sbull] Steps performed to determine which technique is most 
appropriate in a given situation.
    [sbull] The methods used to determine whether and how loans 
individually evaluated under Statement 114, but not considered to be 
individually impaired, should be grouped with other loans that share 
common characteristics for impairment evaluation under Statement 5.\24\
---------------------------------------------------------------------------

    \24\ See EITF Topic D-80, Exhibit D-80A, Question 10.
---------------------------------------------------------------------------

    [sbull] For determining and measuring impairment under Statement 5: 
\25\
---------------------------------------------------------------------------

    \25\ See Statement 5, paragraphs 8(a) and 8(b) on accrual of 
loss contingencies and paragraphs 22 and 23 on collectibility of 
receivables. See also the guidance in EITF Topic D-80.
---------------------------------------------------------------------------

    [sbull] How loans with similar characteristics are grouped to be 
evaluated for loan collectibility (such as loan type, past-due status, 
and risk);
    [sbull] 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
    [sbull] Descriptions of qualitative factors (e.g., industry, 
geographical, economic,

[[Page 26897]]

and political factors) that may affect loss rates or other loss 
measurements.
3. Applying a Systematic Methodology--Measuring and Documenting Loan 
Losses Under Statement 114

a. Measuring and Documenting Loan Losses Under Statement 114--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 Statement 114.
    Upon review of the large balance loans, Registrant B determines 
that certain of the loans are impaired as defined by Statement 114.\1\
    Question: of the commercial loans reviewed under Statement 114 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 Statement 114?
---------------------------------------------------------------------------

    \1\ Paragraph 8 of Statement 114 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.
---------------------------------------------------------------------------

    Interpretive Response: For those loans that are reviewed 
individually under Statement 114 and considered individually impaired, 
Registrant B must use one of the methods for measuring impairment that 
is specified by Statement 114 (that is, the present value of expected 
future cash flows, the loan's observable market price, or the fair 
value of collateral).\2\ Accordingly, in the circumstances described 
above, for the loans considered individually impaired under Statement 
114, it would not be appropriate for Registrant B to choose a 
measurement method not prescribed by Statement 114. 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.
---------------------------------------------------------------------------

    \2\ See paragraph 13 of Statement 114.
---------------------------------------------------------------------------

    The staff normally would expect Registrant B to maintain as 
sufficient, objective evidence \3\ written documentation to support its 
measurement of loan impairment under Statement 114.\4\ 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 \5\ 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.\6\ 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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    \3\ 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.
    \4\ Paragraph 7.45 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 Statement 114 or Statement 5. Additionally, as 
indicated in paragraphs 7.56 to 7.68 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 7.63) or about the collateral securing 
the loans, if applicable (see paragraph 7.65 and 7.66).
    \5\ Question 16 in Exhibit D-80A of EITF Topic D-80 
indicates that environmental factors include existing industry, 
geographical, economic, and political factors.
    \6\ See paragraphs 7.65 and 7.66 in the Audit Guide for 
additional information about documentation of loan collateral.
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b. Measuring and Documenting Loan Losses Under Statement 114 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 Statement 114 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 Statement 114. 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.\7\ 
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.\8\ 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.
---------------------------------------------------------------------------

    \7\ 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.
    \8\ 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).
---------------------------------------------------------------------------

    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.\9\ This documentation \10\ 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.
---------------------------------------------------------------------------

    \9\ See paragraphs 7.65 to 7.66 in the Audit Guide for further 
information about documentation of loan collateral and associated 
audit procedures that may be performed by the independent 
accountant.
    \10\ As stated in paragraph 7.14 of the Audit Guide, ``[t]he 
institution's conclusions about the appropriate amount [of loan 
impairment and the allowance for loan losses] should be well 
documented.''
---------------------------------------------------------------------------

    Because Registrant C arrived at the valuation of $8 million by 
modifying an earlier appraisal, it should document its

[[Page 26898]]

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 Statement 114--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:
    [sbull] Volatility of the market value of the collateral;
    [sbull] Recency and reliability of the appraisal or other 
valuation;
    [sbull] Recency of the registrant's or third party's inspection of 
the collateral;
    [sbull] Historical losses on similar loans;
    [sbull] Confidence in the registrant's lien or security position 
including appropriate:
    [sbull] Type of security perfection (e.g., physical possession of 
collateral or secured filing);
    [sbull] Filing of security perfection (i.e., correct documents and 
with the appropriate officials); and
    [sbull] Relationship to other liens; and
    [sbull] 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 Statement 5

a. Measuring and Documenting Loan Losses Under Statement 5--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 Statement 5?
    Interpretive Response: For loans evaluated on a group basis under 
Statement 5, the staff believes that a registrant should segment the 
loan portfolio by identifying risk characteristics that are common to 
groups of loans.\1\ 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.\2\
---------------------------------------------------------------------------

    \1\ Paragraph 7.07 of the Audit Guide indicates that ``[e]ach 
segment [of the loan portfolio] should contain loans with similar 
characteristics, such as risk classification, past-due status, and 
type of loan.''
    \2\ Segmentation of the loan portfolio is a standard element in 
a loan loss allowance methodology. As indicated in paragraph 7.05 of 
the Audit Guide, the loan loss allowance methodology ``should be 
well documented, with clear explanations of the supporting analyses 
and rationale.''
---------------------------------------------------------------------------

    Based on the segmentation of the loan portfolio, a registrant 
should estimate the Statement 5 portion of its loan loss allowance. For 
those segments that require an allowance for loan losses,\3\ 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.\4\ 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.\5\
---------------------------------------------------------------------------

    \3\ 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.
    \4\ 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.''
    \5\ Ibid. Also, as indicated in paragraph 7.05 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 7.14 of the Audit 
Guide, ``[t]he institution's conclusions about the appropriate 
amount [of the allowance] should be well documented.''
---------------------------------------------------------------------------

    Facts: After identifying certain loans for evaluation under 
Statement 114, Registrant E segments its remaining loan portfolio into 
five pools of loans. For three of the pools, it measures loan 
impairment under Statement 5 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 Statement 5.
    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 Statement 5?
    Interpretive Response: Regardless of the method used to determine 
loan loss measurements under Statement 5, Registrant E should 
demonstrate and document that the loss measurement

[[Page 26899]]

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.\6\
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    \6\ Refer to paragraph 8(b) of Statement 5. Also, as indicated 
in Exhibit D-80A of EITF Topic D-80, ``[t]he approach for 
determination of the allowance should be well documented and applied 
consistently from period to period.'' (See the overview section of 
Exhibit D-80A and Question 18.)
---------------------------------------------------------------------------

    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.\7\ 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.\8\
---------------------------------------------------------------------------

    \7\ Refer to paragraph 23 of Statement 5.
    \8\ Registrants should also refer to Interpretation 14, 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 7.14 of the Audit Guide notes that the use of ``a 
method that results in a range of estimates for the allowance,'' 
except for impairment measurement under Statement 114, which is 
based on ``a single best estimate and not a range of estimates.'' 
Paragraph 7.14 also states that ``[t]he institution's conclusions 
about the appropriate amount should be well documented.''
---------------------------------------------------------------------------

    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.\9\
---------------------------------------------------------------------------

    \9\ 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 
7.05 of the Audit Guide, and EITF Topic D-80.
---------------------------------------------------------------------------

    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: \10\
---------------------------------------------------------------------------

    \10\ Refer to paragraph 7.13 in the Audit Guide.
---------------------------------------------------------------------------

    [sbull] Levels of and trends in delinquencies and impaired loans;
    [sbull] Levels of and trends in charge-offs and recoveries;
    [sbull] Trends in volume and terms of loans;
    [sbull] Effects of any changes in risk selection and underwriting 
standards, and other changes in lending policies, procedures, and 
practices;
    [sbull] Experience, ability, and depth of lending management and 
other relevant staff;
    [sbull] National and local economic trends and conditions;
    [sbull] Industry conditions; and
    [sbull] Effects of changes in credit concentrations.
    For any adjustment of loss measurements for environmental factors, 
a registrant should maintain sufficient, objective evidence \11\ (a) to 
support the amount of the adjustment and (b) to explain why the 
adjustment is necessary to reflect current information, events, 
circumstances, and conditions in the loss measurements.
---------------------------------------------------------------------------

    \11\ AU 326 describes the ``sufficient competent evidential 
matter'' that auditors must consider in accordance with GAAS.
---------------------------------------------------------------------------

b. Measuring and Documenting Loan Losses Under Statement 5--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? \12\
---------------------------------------------------------------------------

    \12\ This question and response would also apply to other 
registrant fact patterns in which the registrant adjusts loss rates 
for environmental factors.
---------------------------------------------------------------------------

    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.\13\ 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,

[[Page 26900]]

economic data, and information from individual borrowers.
---------------------------------------------------------------------------

    \13\ Paragraph 7.33 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 7.33, ``[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.\14\
---------------------------------------------------------------------------

    \14\ Paragraph 7.39 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 Statement 5--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 Statement 114. 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 Statement 114.
    Registrant G segments its loan portfolio to estimate loan losses 
under Statement 5. 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.\15\
---------------------------------------------------------------------------

    \15\ These groups of loans do not include any loans that have 
been individually reviewed for impairment under Statement 114 and 
determined to be impaired as defined by Statement 114.
---------------------------------------------------------------------------

    In its determination of its loan loss allowance under Statement 5, 
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).\16\ 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.
---------------------------------------------------------------------------

    \16\ Question 10 in Exhibit D-80A of EITF Topic D-80 
states that if a creditor concludes that an individual loan 
specifically identified for evaluation is not impaired under 
Statement 114, that loan may be included in the assessment of the 
allowance for loan losses under Statement 5, 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 Statement 5 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 
Statement 5.\17\ The staff also normally would 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.\18\ 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.\19\ The registrant would 
typically maintain copies of the economic and other reports that 
provided source data.
---------------------------------------------------------------------------

    \17\ Paragraph 7.05 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.'' 
Question 10 in Exhibit D-80A of EITF Topic D-80 provides 
guidance as to the analysis to be performed when determining whether 
a loan that is not individually impaired under Statement 114 should 
be included in the assessment of the loan loss allowance under 
Statement 5.
    \18\ Ibid.
    \19\ Ibid.
---------------------------------------------------------------------------

    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.\1\ Common elements that the 
staff normally would expect to find documented in loan loss allowance 
summaries include:\2\
---------------------------------------------------------------------------

    \1\ 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 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.''
    \2\ See also paragraph 7.14 of the Audit guide.
---------------------------------------------------------------------------

    [sbull] 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);
    [sbull] The aggregate probable loss estimated using the 
registrant's methodology;
    [sbull] A summary of the current loan loss allowance balance;
    [sbull] The amount, if any, by which the loan loss allowance 
balance is to be adjusted; \3\ and
---------------------------------------------------------------------------

    \3\ 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 refeer to SAB 99 and SAS 89 and its amendments to 
AU Section 310.

---------------------------------------------------------------------------

[[Page 26901]]

    [sbull] 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 Statement 114 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.\4\ 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.\5\
---------------------------------------------------------------------------

    \4\ Paragraph 7.39 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.''
    \5\ See the guidance in paragraph 7.14 of the Audit Guide (``the 
institution's conclusions about the appropriate amount shoudl 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.\6\
---------------------------------------------------------------------------

    \6\ Ibid.
---------------------------------------------------------------------------

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.\7\ As illustrated above, there may be instances 
in which loan loss allowance reviewers identify 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.\8\ 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.\9\
---------------------------------------------------------------------------

    \7\ Ibid.
    \8\ Ibid.
    \9\ As outlined in paragraph 7.39 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 soruces 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,\1\ appropriate for 
the size of the registrant and the type and complexity of its loan 
products.
---------------------------------------------------------------------------

    \1\ Ibid.
---------------------------------------------------------------------------

    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.
    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:
    [sbull] A review of trends in loan volume, delinquencies, 
restructurings, and concentrations.
    [sbull] 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.
    [sbull] 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.
    [sbull] 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

[[Page 26902]]

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.\2\
---------------------------------------------------------------------------

    \2\ See paragraph 7.39 of the Audit Guide.
---------------------------------------------------------------------------

Topic 7: Real Estate Companies

A. Deleted by SAB 103

B. Deleted 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: In November 1975 the staff issued SAB 1 that 
addressed this issue. In that SAB the staff did not object to retailers 
presenting sales of leased or licensed departments in the amount 
reported as ``total revenues'' because of industry practice. 
Subsequently, in November 1976 the FASB issued Statement 13. In June 
1995, the AICPA staff amended its Technical Practice Aid (TPA) section 
5100.16 based upon an interpretation of Statement 13 that leases of 
departments within a retail establishment are leases of tangible assets 
within the scope of Statement 13.\1\ Consistent with the interpretation 
in TPA section 5100.16, the staff believes that Statement 13 requires 
department stores and other retailers that lease or license store space 
to account for rental income from leased departments in accordance with 
Statement 13. 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 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(b)(5) of Regulation S-X.
---------------------------------------------------------------------------

    \1\ Statement 13, paragraph 1 defines a lease as ``the right to 
use property, plant, or equipment (land or depreciable assets or 
both) usually for a stated period of time.''
---------------------------------------------------------------------------

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 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:

----------------------------------------------------------------------------------------------------------------
                                                                                                      Percent
                          (in millions)                                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)
                                                                 =================

[[Page 26903]]

 
        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. Deleted by SAB 103

B. Deleted 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 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. Deleted 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.
---------------------------------------------------------------------------

    \1\ Before considering the guidance in this SAB Topic, 
registrants are reminded that the arrangement should be evaluated in 
accordance with the provisions of Interpretation 46.
---------------------------------------------------------------------------

    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

[[Page 26904]]

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.\1\
---------------------------------------------------------------------------

    \1\ Registrants are reminded that the arrangement may contain a 
guarantee that is within the scope of Interpretation 45. Further, 
registrants should consider the guidance of Interpretation 46. Also, 
registrants would need to consider whether the arrangement contains 
a derivative that should be accounted for according to Statement 
133.
---------------------------------------------------------------------------

    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 Statement 90, must charge a portion 
of the costs of the abandoned plant to expense.\1\ Also, the utility 
determines that it is probable that certain costs of a recently 
completed plant will be disallowed, and charges those costs to expense 
as required by Statement 90.
---------------------------------------------------------------------------

    \1\ Paragraph 3 of Statement 90 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, 
paragraph 7 of Statement 90 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 APB Opinion 30 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.\2\
---------------------------------------------------------------------------

    \2\ Additionally, the registrant was reminded that paragraph 26 
of APB Opinion 30 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.
---------------------------------------------------------------------------

    Paragraph 20 of APB Opinion 30 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 Statement 90 should not be presented as 
extraordinary items.\3\
---------------------------------------------------------------------------

    \3\ The staff also notes that paragraphs 3 and 7 of Statement 
90, 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. Statement 71 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 paragraph 9 \1\ of 
Statement 71 should be presented on the balance sheet as an asset and 
should not be offset against the liability. Contingent recoveries

[[Page 26905]]

through rates that do not meet the criteria of paragraph 9 should not 
be recognized either as an asset or as a reduction of the probable 
liability.
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    \1\ Paragraph 9 of Statement 71 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. Statement 5 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.\2\ The staff believes that actions of 
a regulator can affect whether an incurred cost is capitalized or 
expensed pursuant to Statement 71, but the regulator's actions cannot 
affect the timing of the recognition of the liability.
---------------------------------------------------------------------------

    \2\ Registrants also should apply the guidance of SOP 96-1 in 
determining the appropriate recognition of environmental remediation 
costs.
---------------------------------------------------------------------------

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. Deleted 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, 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

[[Page 26906]]

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 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 
therefor 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 
Statement 15 as amended by Statement 114.
    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:
    [sbull] Carrying value and terms of Existing Obligations exchanged;
    [sbull] Face value, carrying value, market value and terms of Bonds 
received;
    [sbull] The effect of the transaction on the allowance for loan 
losses and the provision for losses in the current period; and
    [sbull] 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

[[Page 26907]]

disclosed, if material, due to their unique features.\1\
---------------------------------------------------------------------------

    \1\ Registrants also are reminded that if the security received 
in the exchange constitutes a debt security within the scope of 
Statement 115, the disclosures required by Statement 115 also would 
need to be provided.
---------------------------------------------------------------------------

    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 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.\12\
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    \12\ 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.
---------------------------------------------------------------------------

    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:
    [sbull] 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%.
    [sbull] 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%:
    [sbull] There would not be any disclosure included in any cross-
border table.
    [sbull] 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.
    [sbull] Additional footnote disclosure--(same disclosure in A 
above).
    [sbull] 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%:
    [sbull] 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.
    [sbull] 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:
    [sbull] No disclosure would be required.
    [sbull] However, same disclosure as in A above would be provided if 
any other aspects of the financial statements are

[[Page 26908]]

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:
    [sbull] 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).

J. Deleted 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.\1\
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    \1\ 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

[[Page 26909]]

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 \1\ 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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    \1\ 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.
---------------------------------------------------------------------------

    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 with respect to Statement 52 and concluded that ``The Commission 
also believes that registrants that have not yet adopted Statement 52 
should discuss the potential effects of adoption in registration 
statements and reports filed with the Commission.'' \2\ 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.\3\ MD&A \4\ 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 requirements. With 
respect to financial statement disclosure, GAAS \5\ 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 restated 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.
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    \2\ FRR 6, Section 2.
    \3\ 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.
    \4\ Item 303 of Regulation S-K.
    \5\ See AU 9410.13-18.
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    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:
    [sbull] A brief description of the new standard, the date that 
adoption is required and the date that the registrant plans to adopt, 
if earlier.
    [sbull] A discussion of the methods of adoption allowed by the 
standard and the method expected to be utilized by the registrant, if 
determined.
    [sbull] 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.
    [sbull] 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.\1,2\ Further,

[[Page 26910]]

the nature, extent and impact of such assistance needs to be fully 
discussed in Management's Discussion and Analysis.\3\
---------------------------------------------------------------------------

    \1\ The staff has previously expressed its views regarding 
acceptable methods of compliance with this principle in the minutes 
of EITF Issue 88-19, and an announcement by the SEC Observer to the 
EITF at the February 23, 1989 meeting.
    \2\ See EITF Issue 88-19 for guidance on the appropriate period 
in which to record certain types of regulatory assistance.
    \3\ See Section 501.06.c. of the Financial Reporting 
Codification for further discussion of the MD&A disclosures of the 
effects of regulatory assistance.
---------------------------------------------------------------------------

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 Quantities of Proved Reserves
    Facts: Rule 4-10 contains definitions of proved reserves, proved 
developed reserves, and proved undeveloped reserves to be used in 
determining quantities of oil and gas reserves to be reported in 
filings with the Commission.
    Question 1: The definition of proved reserves states that 
reservoirs are considered proved if ``economic producibility is 
supported by either actual production or conclusive formation test.'' 
May oil and gas reserves be considered proved if economic producibility 
is supported only by core analyses and/or electric or other log 
interpretations?
    Interpretive Response: Economic producibility of estimated proved 
reserves can be supported to the satisfaction of the Office of 
Engineering if geological and engineering data demonstrate with 
reasonable certainty that those reserves can be recovered in future 
years under existing economic and operating conditions. The relative 
importance of the many pieces of geological and engineering data which 
should be evaluated when classifying reserves cannot be identified in 
advance. In certain instances, proved reserves may be assigned to 
reservoirs on the basis of a combination of electrical and other type 
logs and core analyses which indicate the reservoirs are analogous to 
similar reservoirs in the same field which are producing or have 
demonstrated the ability to produce on a formation test.
    Question 2: In determining whether ``proved undeveloped reserves'' 
encompass acreage on which fluid injection (or other improved recovery 
technique) is contemplated, is it appropriate to distinguish between 
(i) fluid injection used for pressure maintenance during the early life 
of a field and (ii) fluid injection used to effect secondary recovery 
when a field is in the late stages of depletion? The definition in Rule 
4-10(a)(4) does not make this distinction between pressure maintenance 
activity and fluid injection undertaken for purposes of secondary 
recovery.
    Interpretive Response: The Office of Engineering believes that the 
distinction identified in the above question may be appropriate in a 
few limited circumstances, such as in the case of certain fields in the 
North Sea. The staff will review estimates of proved reserves 
attributable to fluid injection in the light of the strength of the 
evidence presented by the registrant in support of a contention that 
enhanced recovery will be achieved.
    Question 3: What volumes of natural gas liquids should be reported 
as net reserves, that portion recovered in a gas processing plant and 
allocated to the leasehold interest or the total recovered by a plant 
from net interest gas?
    Interpretive Response: Companies should report reserves of natural 
gas liquids which are net to their leasehold interests, i.e., that 
portion recovered in a processing plant and allocated to the leasehold 
interest. It may be appropriate in the case of natural gas liquids not 
clearly attributable to leasehold interests ownership to follow 
instructions to Item 3 of Securities Act Industry Guide 2 and report 
such reserves separately and describe the nature of the ownership.
    Question 4: 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 the staff will 
not object to natural gas reserves and production data calculated at 
other pressure bases, if such other pressure bases are identified in 
the filing.
2. Estimates of Future Net Revenues
    Facts: Paragraphs 30-34 of Statement 69 require the disclosure of 
the standardized measure of discounted future net cash flows from 
production of proved oil and gas reserves, computed by applying year-
end prices of oil and gas (with consideration of price changes only to 
the extent provided by contractual arrangements) to estimated future 
production as of the latest balance sheet date, less estimated future 
expenditures (based on current costs) of developing and producing the 
proved reserves, and assuming continuation of existing economic 
conditions.
    Question 1: For purposes of determining reserves and estimated 
future net revenues, what price should be used for 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 gas which will be 
produced after a contract expires or has a redetermination is the 
current market price at the end of the fiscal year for that category of 
gas. This price may be increased thereafter only for additional fixed 
and determinable escalations, as appropriate, for that category of gas. 
A fixed and determinable escalation is one which is specified in amount 
and is not based on future events such as rates of inflation.
    Question 2: What price should be applied to gas which at the end of 
a fiscal year is not yet subject to a gas sales contract?
    Interpretive Response: The price to be used is the current market 
price for similarly situated gas at the end of the fiscal year provided 
the company can reasonably expect to sell the gas at the prevailing 
market price.
    Question 3: To what extent should price increases announced by OPEC 
or by certain government agencies not yet effective at the date of the 
reserve report be considered in determining current prices?
    Interpretive Response: Current prices should not reflect price 
increases announced but not yet effective at the date of the reserve 
valuation, i.e., the end of the fiscal year.
3. Disclosure of Reserve Information
    a. Deleted by SAB 103
    b. Unproved properties
    Facts: Disclosures of reserve information are based on estimated 
quantities of proved reserves of oil and gas. Regulation S-K prohibits 
disclosure of estimated quantities of probable or possible reserves of 
oil and gas and any estimated value thereof in any document publicly 
filed with the Commission.
    Question: What types of disclosures will be permitted by 
registrants who wish to indicate that some of their properties have 
value other than that attributable to proved reserves?
    Interpretive Response: The Office of Engineering has, for the past 
several years, suggested to registrants the following form of 
disclosure for undeveloped lease acreage:

    In addition to proved reserves, the estimated (or appraised) 
value of leases or parts of leases to which proved reserves cannot 
be attributable is $xxx.


[[Page 26911]]


    The registrant should describe the basis on which the estimate was 
made. For example, such estimated values are often based on the market 
demand for leasehold acreage which, in turn, is based on a number of 
qualitative factors such as proximity to production. If the disclosed 
amount is based on an appraisal, the person making the appraisal should 
be named.
    c. Limited partnership 10-K reports
    Facts: Securities Act Industry Guide 2 contains an exemption from 
the requirements of the Guide 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 which acquire properties either for drilling and 
production, or for production of oil, gas, or geothermal steam.'' 
Regulation S-X does not contain a similar exemption from the 
supplemental disclosure requirements of Statement 69.
    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 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 by paragraphs 
24-34 of Statement 69?
    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 specified by 
these paragraphs of Statement 69 for partnerships which are the subject 
of a merger or exchange offer under which various limited partnerships 
are to be combined into a single entity.
    d. Limited partnership registration statements
    Facts: The staff requires that a registration statement relating to 
an offering of limited partnership interests include the most recent 
year-end balance sheet of the general partner. This is considered 
necessary for purposes of assessing the financial responsibility of the 
general partner.
    Question: What disclosures of oil and gas reserve information must 
accompany the balance sheet of the general partner?
    Interpretive Response: Disclosures should include oil and gas 
reserve information that pertains to the balance sheet, i.e., the 
estimated year-end quantities of proved oil and gas reserves and the 
estimated future net revenues and present values thereof specified by 
paragraphs 10-17 and 30-34, respectively, of Statement 69.
    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 paragraphs 30-34 of Statement 69?
    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. Deleted by SAB 103

B. Deleted 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 because of the position expressed in Statement 25 
that successful efforts is considered preferable by the FASB for 
accounting changes. 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 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: If a parent company uses the successful efforts method 
of accounting for oil and gas producing activities, may a subsidiary of 
the parent use the full cost method?
    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) of Rule 4-10(c)(4)(i) of Regulation S-X states that 
the income

[[Page 26912]]

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) minimum taxes on tax preference items, and (vi) the impact of 
statutory (percentage) depletion.
    It may often be difficult to allocate net operating loss 
carryforwards (NOLs) between oil and gas assets and other assets. 
However, to the extent that the NOLs are clearly attributable to oil 
and gas operations and are expected to be realized within the 
carryforward period, they 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 NOLs 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?
    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:
  Capitalized Costs of Oil and                                 $500,000
   Gas Assets.................
  Accumulated DD&A............                                 (100,000)
                                                           -------------
    Book basis of oil and gas                                   400,000
     assets...................
  Related deferred income                                        35,000
   taxes......................
                                                           -------------
Net book basis to be recovered                                 $365,000
                                                           =============
NOL carryforward *............                                 $ 20,000
  Foreign tax credit                                            $ 1,000
   carryforward *.............
  ITC--Carryforward *.........                     $2,000
      Present value of ITC                          1,500       $ 3,500
       relating to future
       development costs......
                                             --------------
Estimated preference (minimum)                                    $ 500
 tax on percentage depletion
 in excess of cost depletion..
  Tax basis of oil and gas                                     $270,000
   assets.....................
  Present value of statutory                                   $ 10,000
   depletion attributable to
   future deductions..........
  Statutory tax rate (percent)                                      46%
  Present value of future net                                  $272,000
   revenues from proved oil
   and gas reserves...........
  Cost of properties not being                                 $ 55,000
   amortized..................
  Lower of cost or estimated                                   $ 49,000
   fair value of unproved
   properties included in
   costs being amortized......
CALCULATION
  Present value of future net                                  $272,000
   revenue....................
  Cost of properties not being                                   55,000
   amortized..................
  Lower of cost or estimated                                     49,000
   fair value of unproved
   properties included in
   costs being amortized......
Tax Effects:
    Total of above items......                                 $376,000
    Less: Tax basis of             (270,000)
     properties...............
        Statutory depletion...      (10,000)
        NOL carryforward......      (20,000)     (300,000)
                               ----------------------------
    Future taxable income.....                     76,000
    Tax rate (percent)........                      x 46%
                                             --------------
    Tax payable at statutory                      (34,960)
     rate.....................
    ITC.......................                      3,500
    Foreign tax credit                              1,000
     carryforward.............
    Estimated preference tax..                       (500)
                                             --------------
Total tax effects.............                                  (30,960)
                                                           -------------
Cost Center Ceiling...........                                 $345,040
  Less: Net book basis........                                  365,000
                                                           -------------
REQUIRED WRITE-OFF, net of tax                                ($ 19,960)
 **...........................
                                                           =============
------------------------------------------------------------------------
* All carryforward amounts in this example represent amounts which are
  available for tax purposes and which related 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.

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

[[Page 26913]]

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?
    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 
Interpretation 33 and Statement 34 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:

                                               [Amounts in 1,000]
----------------------------------------------------------------------------------------------------------------
                                                                     Purchased     Other  proved     Unproved
                                                       Total         reserves       properties      properties
----------------------------------------------------------------------------------------------------------------
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
                                                                     purchased       purchased
                                                                     reserves        reserves
----------------------------------------------------------------------------------------------------------------
Comparison of capitalized costs with limitation
 on capitalized costs at December 31, 20x1......
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                            $1,400            $200
 Capitalized 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 were 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

[[Page 26914]]

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 spot market prices for 
oil and natural gas. However, prior to the balance sheet date, the 
company enters 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 than the estimated future 
cash flows indicated by use of the spot market price as of the reported 
balance sheet date. These arrangements qualify as cash flow hedges 
under the provisions of Statement 133 as amended and interpreted, 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 prices to be received after taking into account the hedging 
arrangements (``hedge-adjusted prices'') in calculating the current 
price of the quantities of its 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 
hedging instruments in a cash flow hedge and are accounted for as such 
pursuant to Statement 133 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. For example, prior to the 
adoption of Statement 133, hedging activities related to foreign 
exchange rates were addressed in Statement 52. The use of futures 
contracts as hedging arrangements was previously addressed in Statement 
80. The guidance provided in these Statements differed from Statement 
133 in the criteria used to qualify for hedge accounting. However, the 
staff believes that Statement 133 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 less than the current spot market price. 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 the SOP 94-6. Paragraph 14 of SOP 94-6 
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 FR 60. Through this release, 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 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 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 auditors' report on the company's financial statements, assume that 
one of two events occurs: (1) additional reserves are proved up on 
properties owned at year-end, or (2) price increases become known which 
were not fixed and determinable at year-end. The present value of 
future net revenues from the additional reserves or from the increased 
prices 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. It is necessary to record a 
write down?
    Interpretive Response: No. In these cases, the proving up of 
additional reserves on properties owned at year-end or the increase in 
prices 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. However, the 
staff cautions registrants that the process of considering subsequent 
price changes in the determination of whether a ceiling write-down is 
called for should be similar to the consideration given to other 
subsequent events under the auditing literature. The staff expects that 
the date selected for the ceiling recomputation will be consistent from 
period to period, and bear a logical relationship to the filing date of 
the affected financial statements. For example, it would seem logical 
that an oil and gas producing company would

[[Page 26915]]

consistently make whatever recalculations are necessary at the date the 
auditors are completing their interim reviews.
    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 or to the price increases occurring after year-end. However, such 
quantities and amounts 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.

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, 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.

    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 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. Inclusion of Methane Gas in Proved Reserves

    Facts: Because of a concern over worldwide oil and gas supplies, 
Congress, in 1980, provided for tax incentives (credits) for the 
production of oil and gas from other than conventional sources. As a 
consequence, significant amounts of gas are now recovered from seams of 
coal beds. This gas is referred to as coalbed methane. It is produced 
using conventional drilling methods, but for various reasons, it may be 
more costly to produce than oil and gas recovered from customary 
sources and some reserves may not be economical without the tax 
credits.
    Rule 4-10(a)(1)(i)(A) of Regulation S-X indicates that oil and gas 
producing activities include the search for crude oil, including 
condensate and natural gas liquids, or natural gas in their natural 
states and original locations. Rule 4-10(a)(2)(iii)(D) of Regulation S-
X states that estimates of proved reserves do not include (among other 
things) natural gas that can be recovered from coal.\1\ In addition, 
the definition of proved oil and gas reserves includes a provision that 
the quantities of natural gas be recovered from existing reservoirs. 
Under these definitions, ``coalbed methane'' gas has generally not been 
included in the disclosures in Commission filings required by Statement 
69. Further, coalbed methane has generally not been counted in proved 
oil and gas reserves for purposes of the full cost ceiling test in Rule 
4-10(c)(4) since that test is based on the same definition of proved 
oil and gas reserves.
---------------------------------------------------------------------------

    \1\ Similar language appears in Statements 19 and 25.
---------------------------------------------------------------------------

    Question: Is it appropriate to consider coalbed methane gas within 
the definition of proved reserves for purposes of the disclosures 
relating to

[[Page 26916]]

oil and gas producing activities and the full cost ceiling test?
    Interpretive Response: Yes. The prohibition against the inclusion 
of gas derived from coal was meant to apply to the recovery of 
hydrocarbons from the processing of coal. The extraction of methane gas 
from coalbed seams using conventional methods was not contemplated at 
the time Rule 4-10(a) was developed. The staff believes that, since 
coalbed methane gas can be recovered from coal in its natural state and 
original location, it should be included in proved reserves, provided 
that it complies in all other respects with the definition of proved 
oil and gas reserves as specified in Rule 4-10(a)(2) including the 
requirement that methane production be economical at current prices, 
costs (net of the tax credit) and existing operating conditions.\2\ 
Methane gas from coalbeds (like any other hydrocarbon obtained from 
conventional reservoirs) that cannot be produced at a profit under 
current economic and operating conditions, or for which there is no 
market or any existing method of delivery to the market, cannot be 
included in the category of proved reserves.
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    \2\ Proved oil and gas reserves are the estimated quantities of 
crude oil, natural gas, and natural gas liquids which geological and 
engineering data demonstrate with reasonable certainty to be 
recoverable in future years from known reservoirs under existing 
economic and operating conditions. (Emphasis added.)
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    In instances where methane gas is deemed to be economically 
producible only as a consequence of existing Federal tax incentives, 
the staff believes that additional disclosure should be provided as to 
the specific quantities and values of reported proved reserves that are 
dependent on existing U.S. tax policy together with any other 
information necessary to inform readers of the risks attendant with any 
future change to existing Federal tax policy.

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. Examples of existing literature on revenue recognition 
include Statements 13, 45, 48, 49, 50, 51, and 66; Opinion 10; ARBs 43 
(Chapter 1a) and 45; SOPs 81-1 and 97-2; EITF Issues 88-18, 91-9, 95-1, 
and 95-4; and Concepts Statement 5.\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\ In February 1999, the AICPA published a booklet entitled 
``Audit Issues in Revenue Recognition.'' This booklet provides an 
overview of the current authoritative accounting literature and 
auditing procedures for revenue recognition and identifies 
indicators of improper revenue recognition.
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    Based on these guidelines, revenue should not be recognized until 
it is realized or realizable and earned.\2\ Concepts Statement 5, 
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.''
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    \2\ Concepts Statement 5, paragraphs 83-84; ARB 43, Chapter 1A, 
paragraph 1; Opinion 10, paragraph 12. 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:
    [sbull] Persuasive evidence of an arrangement exists,\3\
---------------------------------------------------------------------------

    \3\ Concepts Statement 3, Qualitative Characteristics of 
Accounting Information, 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 SOP 97-2, paragraph 8. The use of the term 
``arrangement'' in this SAB is meant to identify the final 
understanding between the parties as to the specific nature and 
terms of the agreed-upon transaction.
---------------------------------------------------------------------------

    [sbull] 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.
---------------------------------------------------------------------------

    [sbull] The seller's price to the buyer is fixed or 
determinable,\5\ and
---------------------------------------------------------------------------

    \5\ Concepts Statement 5, paragraph 83(a); Statement 48, 
paragraph 6(a); SOP 97-2, paragraph 8. SOP 97-2 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.'' Paragraphs 26-33 of SOP 97-2 
discuss how to apply the fixed or determinable fee criterion in 
software transactions. The staff believes that the guidance in 
paragraphs 26 and 30-33 is appropriate for other sales transactions 
where authoritative guidance does not otherwise exist. The staff 
notes that paragraphs 27 through 29 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.
---------------------------------------------------------------------------

    [sbull] Collectibility is reasonably assured.\6\
---------------------------------------------------------------------------

    \6\ ARB 43, Chapter 1A, paragraph 1 and Opinion 10, paragraph 
12. See also Concepts Statement 5, paragraph 84(g) and SOP 97-2, 
paragraph 8.
---------------------------------------------------------------------------

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

[[Page 26917]]

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.\1\ 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.
---------------------------------------------------------------------------

    \1\ 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.\2\
---------------------------------------------------------------------------

    \2\ Statement 48, paragraphs 6(b)) and 22.
---------------------------------------------------------------------------

    (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, \3\
---------------------------------------------------------------------------

    \3\ Statement 48, paragraphs 6(b) and 22. 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,\4\
---------------------------------------------------------------------------

    \4\ Statement 48, paragraph 6(c).
---------------------------------------------------------------------------

    (d) the buyer acquiring the product for resale does not have 
economic substance apart from that provided by the seller,\5\ or
---------------------------------------------------------------------------

    \5\ Statement 48, paragraph 6(d).
---------------------------------------------------------------------------

    (e) the seller has significant obligations for future performance 
to directly bring about resale of the product by the buyer.\6\
---------------------------------------------------------------------------

    \6\ Statement 48, paragraph 6(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,\7\ and the 
amounts to be paid by the seller will be adjusted, as necessary, to 
cover substantially all fluctuations in costs incurred by the buyer in 
purchasing and holding the product (including interest).\8\ The staff 
believes that indicators of the latter condition include:
---------------------------------------------------------------------------

    \7\ Statement 49, paragraph 5(a). Paragraph 5(a) 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.
    \8\ Statement 49, paragraph 5(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 EITF 
Issue 95-1 and does not qualify for sales-type lease accounting.
    4. The product is delivered for demonstration purposes.\9\
---------------------------------------------------------------------------

    \9\ See SOP 97-2, paragraph 25.
---------------------------------------------------------------------------

    This list is not meant to be a checklist of all characteristics of 
a consignment or a 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

[[Page 26918]]

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.
3. Delivery and Performance
    Question 3
    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.\1\ These include:
---------------------------------------------------------------------------

    \1\ See In the Matter of Stewart Parness, AAER Release 108 
(August 5, 1986); SEC v. Bollinger Industries, Inc., et al, Lit. Rel 
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). Also see Concepts Statement 5, 
paragraph 84(a) and SOP 97-2, paragraph 22.
---------------------------------------------------------------------------

    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.\2\ The buyer must have a substantial business 
purpose for ordering the goods on a bill and hold basis;
---------------------------------------------------------------------------

    \2\ 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 
which 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:\3\
---------------------------------------------------------------------------

    \3\ See Note 1, 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; 
\4\
---------------------------------------------------------------------------

    \4\ Such individuals should consider whether Opinoin 21 
pertaining to the need for discounting the related receivable, is 
applicable. Opinion 21, paragraph 3(a), indicates that the 
requirements of that Opinion 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).
---------------------------------------------------------------------------

    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.\5\
---------------------------------------------------------------------------

    \5\ SOP 97-2, paragraph 22.
---------------------------------------------------------------------------

    After delivery of a product or performance of a service, if 
uncertainty exists about customer acceptance, revenue should not be 
recognized until acceptance occurs.\6\ 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.
---------------------------------------------------------------------------

    \6\ SOP 97-2 paragraph 20. 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.
---------------------------------------------------------------------------

    A seller should substantially complete or fulfill the terms 
specified in the arrangement in order for delivery or performance to 
have occurred.\7\ 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 
arrangement, all remaining costs of performance or delivery should be 
accrued.
---------------------------------------------------------------------------

    \7\ Concepts Statement 5, paragraph 83(b) states that ``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.''

---------------------------------------------------------------------------

[[Page 26919]]

    If an arrangement (i.e., outside the scope of SOP 81-1) requires 
the delivery or performance of multiple deliverables, or ``elements,'' 
the existence of undelivered elements may affect the conclusion as to 
whether revenue for a delivered element may be recognized as discussed 
in EITF Issue 00-21.\8\
---------------------------------------------------------------------------

    \8\ Paragraph 4 of EITF Issue 00-21 describes the scope of that 
consensus. As of the January 23, 2003 of the EITF (the EITF 
subsequently established a working group to revisit the scope of the 
consensus; accordingly, registrants should consult the current EITF 
Abstract for the final resolution of the scope of the consensus), 
paragraph 4 states that ``This Issue applies to all deliverables 
(that is, products, services, or rights to use assets) within 
contractually binding arrangements (whether written, oral, or 
implied, and hereinafter referred to as ``arrangements;'') in all 
industries under which a vendor will perform multiple revenue-
generating activities, except as follows:
    a. To the extent that a deliverables(s) in an arrangement is 
within the scope of other existing higher-level authoritative 
literature that provides guidance on whether and/or how to separate 
multiple-deliverable arrangements and how to allocate value among 
those separate units of accounting (including, but not limited to, 
Statements 13, 45, and 66; Technical Bulletin 90-1; and SOPs 81-1, 
997-2, and 00-2), that deliverables(s) should be accounted for in 
accordance with that literature. However, if that arrangement also 
includes a deliverable(s) that is not within the scope of such 
higher-level literature, this Issue should be applied to determine 
(1) whether that deliverable(s) represents a separate unit of 
accounting from the deliverable(s) that is within the scope of other 
higher-level literature and, if so, (2) how to allocate the 
arrangement consideration to the separate units of accounting, 
unless the higher-level literature provides guidance with respect to 
(1) or (2), above, for the deliverable(s) that is not otherwise in 
the scope of the higher-level literature. The literature to be 
applied first is that which is applicable to the first delivered 
item(s).
    b. Arrangements that include vendor offers to a customer for 
either (1) free or discounted products or services that will be 
delivered (either by the vendor or by another unrelated entity) at a 
future date if the customer completes a specified cumulative level 
of revenue transactions with the vendor or remains a customer of the 
vendor for a specified time period or (2) a rebate or refund of a 
determinable cash amount if the customer completes a specified 
cumulative level of revenue transactions with the vendor or remains 
a customer of the vendor for a specified time period, are excluded 
from the scope of this Issue. Additionally, arrangements involving 
the sale of award credits by broad-based loyalty program operators 
are excluded from the scope of this Issue.''
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    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.\9\ 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.
---------------------------------------------------------------------------

    \9\ SOP 00-2, paragraph 7.
---------------------------------------------------------------------------

    Question 4
    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 that 
``the customer must have made a fixed commitment to purchase the 
goods.''
    Question 5
    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:
    [sbull] 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.
    [sbull] 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.
    [sbull] 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.
    Question: When should the revenue relating to nonrefundable, up-
front fees in these types of arrangements be recognized?
    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,\10\ the 
deferral of revenue is appropriate.
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    \10\ See Concepts Statement 5, footnote 51, for a description of 
the ``earning process.''

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[[Page 26920]]

    In the situations described above, the staff does not view the 
activities completed by the registrants (i.e., selling the membership, 
signing the contract, or enrolling the customer or activating 
telecommunications services) as discrete earnings events.\11\ 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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    \11\ In a similar situation, lenders may collect nonrefundable 
loan origination fees in connection with lending activities. The 
FASB concluded in Statement 91 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 (paragraphs 5 and 
37).
---------------------------------------------------------------------------

    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 \12\ and generally should be deferred 
and recognized systematically over the periods that the fees are 
earned.\13\
---------------------------------------------------------------------------

    \12\ 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).
    \13\ 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.
---------------------------------------------------------------------------

    Question 6
    Facts: Company A provides its customers with activity tracking or 
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.\14\ 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 Statement 91.
---------------------------------------------------------------------------

    \14\ Footnote 1 of SOP 98-5 states that ``this SOP does not 
address the financial reporting of costs incurred related to ongoing 
customer acquisition, such as policy acquisition costs in Statement 
60 * * * and loan origination costs in Statement 91 * * *. The SOP 
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 SOP 98-5. 
The staff believes that the incremental direct costs (Statement 91 
provides an analogous definition) incurred related to the 
acquisition or origination of a customer contract, unless 
specifically provided for in the authoritative literature, should be 
accounted for in accordance with paragraph 4 of Technical Bulletin 
90-1 or paragraph 5 of Statement 91.
---------------------------------------------------------------------------

    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,\15\ 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.
---------------------------------------------------------------------------

    \15\ See Note 12, supra.
---------------------------------------------------------------------------

    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.
4. Fixed or Determinable Sales Price
    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 are neither fixed nor 
determinable until the cancellation privileges lapse.\1\ If the 
cancellation privileges expire ratably over a stated contractual term, 
the sales price is considered to become determinable ratably over the 
stated term.\2\ 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

[[Page 26921]]

accounted for in accordance with Statement 48.\3\
---------------------------------------------------------------------------

    \1\ SOP 97-2, paragraph 31.
    \2\ Ibid.
    \3\ Ibid.
---------------------------------------------------------------------------

    Question 7
    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 
Statement 48) 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, Statement 140 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.\4\ 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.
---------------------------------------------------------------------------

    \4\ Statement 140, paragraph 16.
---------------------------------------------------------------------------

    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 Statement 48 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,\5\ 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 Statement 48. 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 
Statement 48 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.
---------------------------------------------------------------------------

    \5\ Statement 48, paragraph 4.
---------------------------------------------------------------------------

    The staff believes that, because service arrangements are 
specifically excluded from the scope of Statement 48, the most direct 
authoritative literature to be applied to the extinguishment of 
obligations under such contracts is Statement 140. As noted above, 
because the refund privilege extends to the end of the contract term 
irrespective of the amount of the service performed, Statement 140 
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 Statement 48 and that practice did 
not change when Statement 140 became effective. Reasonable people held, 
and continue to hold, different views about the application of the 
accounting literature. For the staff to prohibit such accounting in 
this SAB may result in significant change in practice that, in these 
particular circumstances, may be more appropriately addressed in a 
formal rulemaking or standards-setting project.
    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: \6\
---------------------------------------------------------------------------

    \6\ The staff will question further analogies to the guidance in 
Statement 48 for transactions expressly excluded from its scope.
---------------------------------------------------------------------------

    [sbull] 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.).
    [sbull] Reliable estimates of the expected refunds can be made on a 
timely basis.\7\ Either of the following two items would be considered 
indicative of an inability to make reliable estimates: (1) recurring,

[[Page 26922]]

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 \8\ 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 \9\ 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.
---------------------------------------------------------------------------

    \7\ 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.''
    \8\ 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.
    \9\ The term ``remote'' is used here with the same definition as 
used in Statement 5.
---------------------------------------------------------------------------

    [sbull] There is a sufficient company-specific historical basis 
upon which to estimate the refunds,\10\ 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).
---------------------------------------------------------------------------

    \10\ Paragraph 8 of Statement 48 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.
---------------------------------------------------------------------------

    [sbull] 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.
    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. The costs associated with the 
vouchers should be expensed when distributed. Advertising costs to 
solicit members should be accounted for in accordance with SOP 93-7. 
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 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.\11\ All costs other 
than incremental direct costs (e.g., indirect costs) should be expensed 
as incurred.
---------------------------------------------------------------------------

    \11\ Statement 91, paragraph 5 and Technical Bulletin 90-1, 
paragraph 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 Note 14 of SAB Topic 13.A.3.
---------------------------------------------------------------------------

    Question 8
    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.\12\
---------------------------------------------------------------------------

    \12\ Lessees should follow the guidance established in EITF 
Issue 98-9.
---------------------------------------------------------------------------

    Statement 13 paragraph 19(b) states that lessors should account for 
operating leases as follows: ``Rent shall be reported in income over 
the lease term as it becomes receivable according to the provisions of 
the lease. However, if the rentals vary from a straight-line basis, the 
income shall be recognized on a straight-line basis unless another 
systematic and rational basis is more

[[Page 26923]]

representative of the time pattern in which use benefit from the leased 
property is diminished, in which case that basis shall be used.''
    Statement 29 amended Statement 13 and 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.'' [Summary] Paragraph 17 of 
Statement 29 provides the following example of determining contingent 
rentals:

    A lease agreement for retail store space could stipulate a 
monthly base rental of $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.

    Technical Bulletin 85-3 addresses whether it is appropriate for 
lessors in operating leases to recognize scheduled rent increases on a 
basis other than as required in Statement 13, paragraph 19(b). 
Paragraph 2 of Technical Bulletin 85-3 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 under Statement 13, as 
amended by Statement 29.'' 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. Paragraph 13 states ``There is an important 
substantive difference between lease rentals that are contingent upon 
some specified future event and scheduled rent increases that are 
unaffected by future events; the accounting under Statement 13 reflects 
that difference. If the lessor and lessee eliminate the risk of 
variable payments by agreeing to scheduled rent increases, the 
accounting should reflect those different circumstances.''
    The example provided in Statement 29 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. Technical Bulletin 
85-3 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 Technical Bulletin 85-3 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.
    Question 9
    Facts: Paragraph 8 of Statement 48 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.\13\ The paragraph 
concludes by stating ``other factors may preclude a reasonable 
estimate.''
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    \13\ These factors include ``(a) the susceptibility of the 
product to significant external factors, such as technological 
obsolescence or changes in demand, (b) relative 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 
paragraph 8 of Statement 48, 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 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 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, that 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 paragraphs 6 and 8 in Statement 48, no revenue 
may be recognized until those conditions are subsequently met or the 
return privilege has substantially expired, whichever occurs first.\14\ 
Simply deferring recognition of the gross margin on the transaction is 
not appropriate.
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    \14\ Statement 48, paragraph 6.
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5. Income Statement Presentation
    Question 10

[[Page 26924]]

    Facts: Company A operates an internet site from which it will sell 
Company T's products. Customers place their orders for the product by 
making a product selection directly from the internet site and 
providing a credit card number for the payment. Company A receives the 
order and authorization from the credit card company, and passes the 
order on to Company T. Company T ships the product directly to the 
customer. Company A does not take title to the product and has no risk 
of loss or other responsibility for the product. Company T is 
responsible for all product returns, defects, and disputed credit card 
charges. The product is typically sold for $175 of which Company A 
receives $25. In the event a credit card transaction is rejected, 
Company A loses its margin on the sale (i.e., the $25).
    Question: In the staff's view, should Company A report revenue on a 
gross basis as $175 along with costs of sales of $150 or on a net basis 
as $25, similar to a commission?
    Interpretive Response: Company A should report the revenue from the 
product on a net basis. In assessing whether revenue should be reported 
gross with separate display of cost of sales to arrive at gross profit 
or on a net basis, the staff considers whether the registrant: \1\
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    \1\ Subsequent to the issuance of this SAB, the EITF provided 
additional guidance on gross vs. net presentation in Issue 99-19.
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    1. Acts as principal in the transaction,
    2. takes title to the products,
    3. has risks and rewards of ownership, such as the risk of loss for 
collection, delivery, or returns, and
    4. acts as an agent or broker (including performing services, in 
substance, as an agent or broker) with compensation on a commission or 
fee basis.\2\
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    \2\ See, for example, ARB 43, Chapter 11A, paragraph 20; SOP 81-
1, paragraphs 58-60; and Statement 45, paragraph 16.
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    If the company performs as an agent or broker without assuming the 
risks and rewards of ownership of the goods, sales should be reported 
on a net basis.

B. Disclosures

    Question 1
    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 Opinion 22. Paragraph 
12 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 elements, such as a 
product and service, the accounting policy should clearly state the 
accounting policy for each element as well as how multiple elements are 
determined and valued. In addition, the staff believes that changes in 
estimated returns recognized in accordance with Statement 48 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.\1\ 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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    \1\ See Regulation S-X, Article 5-03(b)(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.\2\ This includes unusual or 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.'' \3\ 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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    \2\ See Regulation S-K, Article 303 and FRR 36.
    \3\ FRR 36, also see In the Matter of Caterpillar Inc., AAER 363 
(March 31, 1992).
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    [sbull] 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.
    [sbull] 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.) \4\
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    \4\ Statement 107.
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    [sbull] 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.
    [sbull] 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.
    [sbull] Seasonal trends or variations in sales.
    [sbull] A gain or loss from the sale of an asset(s).\5\
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    \5\ Gains or losses from the sale of assets should be reported 
as ``other general expenses'' pursuant to Regulation S-X, Article 5-
03(b)(6). Any material item should be stated separately.
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    Question 2
    Question: Will the staff expect retroactive changes by registrants 
to comply with the accounting described in this bulletin?
    Interpretive Response: All registrants are expected to apply the 
accounting and disclosures described in this bulletin. The staff, 
however, will not object if registrants that have not applied this 
accounting do not restate prior financial statements provided they 
report a change in accounting principle in accordance with Opinion 20 
and Statement 3 no later than the fourth fiscal quarter of the fiscal 
year beginning after December 15, 1999. In periods subsequent to 
transition, registrants should disclose the amount of revenue (if 
material to income before income taxes) recognized in those periods 
that was included in the cumulative effect adjustment. If a registrant 
files financial statements with the Commission before applying the 
guidance in this bulletin, disclosures similar to those described in 
SAB Topic 11.M should be provided. With regard to question 10 of Topic 
13.A and Topic 8.A regarding income statement presentation, the staff 
would normally expect retroactive application

[[Page 26925]]

to all periods presented unless the effect of applying the guidance 
herein is immaterial.
    However, if registrants have not previously complied with GAAP, for 
example, by recording revenue for products prior to delivery that did 
not comply with the applicable bill-and-hold guidance, those 
registrants should apply the guidance in Opinion 20 for the correction 
of an error.\6\ In addition, registrants should be aware that the 
Commission may take enforcement action where a registrant in prior 
financial statements has violated the antifraud or disclosure 
provisions of the securities laws with respect to revenue recognition.
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    \6\ Opinion 20, paragraph 13 and paragraphs 36-37 describe and 
provide the accounting and disclosure requirements applicable to the 
correction of an error in previously issued financial statements. 
Because the term ``error'' as used in Opinion 20 includes 
``oversight or misuse of facts that existed at the time that the 
financial statements were prepared,'' that term includes both 
unintentional errors as well as intentional fraudulent financial 
reporting and misappropriation of assets as described in SAS 99.

[FR Doc. 03-12063 Filed 5-15-03; 8:45 am]
BILLING CODE 8010-01-P