[Federal Register Volume 76, Number 59 (Monday, March 28, 2011)]
[Rules and Regulations]
[Pages 17192-17285]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-5584]



[[Page 17191]]

Vol. 76

Monday,

No. 59

March 28, 2011

Part II





Securities and Exchange Commission





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17 CFR Part 211



Staff Accounting Bulletin No. 114; Rule

  Federal Register / Vol. 76 , No. 59 / Monday, March 28, 2011 / Rules 
and Regulations  

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 211

[Release No. SAB 114]


Staff Accounting Bulletin No. 114

AGENCY: Securities and Exchange Commission.

ACTION: Publication of Staff Accounting Bulletin.

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SUMMARY: This Staff Accounting Bulletin (SAB) revises or rescinds 
portions of the interpretive guidance included in the codification of 
the Staff Accounting Bulletin Series. This update is intended to make 
the relevant interpretive guidance consistent with current 
authoritative accounting guidance issued as part of the Financial 
Accounting Standards Board's Accounting Standards Codification. The 
principal changes involve revision or removal of accounting guidance 
references and other conforming changes to ensure consistency of 
referencing throughout the SAB Series.

DATES: Effective Date: March 28, 2011.

FOR FURTHER INFORMATION CONTACT: Lisa Tapley, Assistant Chief 
Accountant, or Annemarie Ettinger, Senior Special Counsel, Office of 
the Chief Accountant, at (202) 551-5300, or Craig Olinger, Deputy Chief 
Accountant, Division of Corporation Finance, at (202) 551-3400, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549.

SUPPLEMENTARY INFORMATION: The statements in staff accounting bulletins 
are not rules or interpretations of the Commission, nor are they 
published as bearing the Commission's official approval. They represent 
interpretations and practices followed by the Division of Corporation 
Finance and the Office of the Chief Accountant in administering the 
disclosure requirements of the Federal securities laws.

    Dated: March 7, 2011.
Elizabeth M. Murphy,
Secretary.

PART 211--[AMENDED]

0
Accordingly, Part 211 of Title 17 of the Code of Federal Regulations is 
amended by adding Staff Accounting Bulletin No. 114 to the table found 
in Subpart B.

Staff Accounting Bulletin No. 114

    This Staff Accounting Bulletin (SAB) revises or rescinds portions 
of the interpretive guidance included in the codification of the Staff 
Accounting Bulletin Series. This update is intended to make the 
relevant interpretive guidance consistent with current authoritative 
accounting guidance issued as part of the Financial Accounting 
Standards Board's Accounting Standards Codification (FASB ASC). The 
principal changes involve revision or removal of accounting guidance 
references and other conforming changes to ensure consistency of 
referencing throughout the SAB Series.
    The following describes the changes made to the Staff Accounting 
Bulletin Series and certain specific topics that are presented at the 
end of this release:
    a. The SAB Series is amended to update authoritative accounting 
literature references to the FASB ASC throughout. In addition, several 
conforming formatting changes were made for consistency across SAB 
topics. Due to the number of these changes, the SAB Series is 
represented in its entirety in this release. All of the changes are 
technical in nature, and none of the changes are intended to change the 
guidance provided in the SAB Series.

Topic 1: Financial Statements

    a. Topic 1.D.1, the introductory facts are amended to conform to 
changes made to Items 17 and 18 of Form 20-F to reflect that certain 
disclosures are required only if a basis of accounting other than U.S. 
generally accepted accounting principles (GAAP) or International 
Financial Reporting Standards as issued by the International Accounting 
Standards Board is used. The introductory facts are also amended to 
remove the reference to Form F-2, as this form was eliminated effective 
December 1, 2005. Finally, the introductory facts are amended to 
reflect the foreign issuer reporting enhancements contained in SEC 
Release No. 33-8959.
    b. Topic 1.I, the footnote previously numbered 6 within the 
interpretive response to question 1 is removed as the referenced 
guidance is now within the FASB ASC, and thus a history of the prior 
source is no longer relevant.
    c. Topic 1.I, the footnote previously numbered 7 within the 
interpretive response to question 2 is removed as the term ``ADC'' is 
now defined within the body of SAB Topic 1.I.
    d. Topic 1.K, the interpretive response to question 3 is amended to 
conform to the accounting guidance contained in FASB ASC Topic 350, 
Intangible Assets--Goodwill and Other. This conforming change reflects 
the fact that goodwill is no longer subject to amortization. The 
interpretive response to question 3 is also amended to replace the term 
``carrying value'' with the term ``fair value'' to reflect the 
measurement guidance for financial assets and liabilities as stated in 
FASB ASC Topic 820, Fair Value Measurements and Disclosures.
    e. Topic 1.K, the interpretive response to question 4, is amended 
to replace Item 7 of Form 8-K with Item 9.01 of Form 8-K.

Topic 3: Senior Securities

    a. Topic 3.A, the interpretive response is amended to replace Rule 
11-02(a)(7) of Regulation S-X with Rule 11-02(b)(7) of Regulation S-X.

Topic 5: Miscellaneous Accounting

    a. Topic 5.F, the introductory facts and interpretive response are 
amended to replace the term ``restatement'' with the term 
``retrospective adjustment,'' to replace the term ``restate(d)'' with 
the term ``retrospectively adjust(ed)'' and to replace the term 
``retroactively'' with the term ``retrospectively'' to conform to the 
accounting guidance contained in FASB ASC Topic 250, Accounting Changes 
and Error Corrections.
    b. Topic 5.F, the interpretive response is amended to remove an 
unnecessary reference to FASB Statement No. 5 and FASB Statement No. 
13.
    c. Topic 5.M, the footnote previously numbered 8 within the 
interpretive response is removed to delete a reference which is not 
included in the FASB ASC.
    d. Topic 5.S, the interpretive responses to questions 2, 4 
(including footnote 29) and 5 are amended to revise the quoted 
accounting guidance to conform to the language as published in the FASB 
ASC. The interpretive response to question 4 is amended to remove 
guidance which is not included in the FASB ASC. The footnote previously 
numbered 31 within the interpretive response to question 4 is removed 
to delete a reference which is not included in the FASB ASC.
    e. Topic 5.V, the interpretive response to question 1 is amended to 
remove an unnecessary reference to SAB Topic 5.E, as the referenced 
guidance in SAB Topic 5.E was removed with the issuance of SAB No. 112. 
As a result, the related footnote previously numbered 38 is removed.
    f. Topic 5.Y, the interpretive response to question 3 is amended to 
remove the reference to Regulation S-B, as this Regulation was 
eliminated effective February 4, 2008.
    g. Topic 5.Z.4, footnote 51 is amended to remove an unnecessary 
reference to SAB Topic 5.E.
    h. Topic 5.BB, the introductory facts are amended to revise the 
quoted

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accounting guidance to conform to the language as published in the FASB 
ASC.

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

    a. Topic 6.K.3, the interpretive response is amended to conform to 
the accounting guidance contained in FASB ASC Topic 350, Intangible 
Assets--Goodwill and Other. This conforming change reflects the fact 
that goodwill is not amortized, but rather only tested for impairment.
    b. Topic 6.L is amended throughout to update the references to the 
AICPA Audit and Accounting Guide, Depository and Lending Institutions 
with Conforming Changes as of June 1, 2009 (Audit Guide). Quoted 
guidance has been amended to conform to the language as published in 
the Audit Guide.

Topic 8: Retail Companies

    a. Topic 8.A, the interpretive response is amended to remove 
unnecessary background information on the issuance of pre-FASB 
Codification standards.

Topic 13: Revenue Recognition

    a. Topic 13.A.4.c, the interpretive response is amended to revise 
the quoted accounting guidance to conform to the language as published 
in the FASB ASC.
    b. Topic 13.B, questions 2, 3, 4 and 5 and the interpretive 
responses and footnotes related to questions 2, 3, 4 and 5 are removed 
to eliminate unnecessary references and guidance specifically related 
to the original adoption of this SAB Topic.

Topic 14: Share-Based Payment

    a. Topic 14.G is removed to eliminate unnecessary guidance on non-
GAAP financial measures. Staff guidance on non-GAAP financial measures 
can be found in the Division of Corporation Finance's Compliance and 
Disclosure Interpretations.
    b. Topics 14.H, 14.J, 14.K and 14.M are removed to eliminate 
unnecessary transition guidance specifically related to the first time 
adoption of FASB Statement No. 123(R), Share-Based Payment. Companies 
that had share-based payment arrangements prior to the adoption of FASB 
Statement No. 123(R) were required to apply this transition guidance in 
2006 and therefore for these companies the guidance in Topics 14.H, 
14.J, 14.K and 14.M is no longer relevant. For companies now entering 
into share-based payment arrangements for the first time, the guidance 
in FASB ASC Topic 718, Compensation--Stock Compensation, should be 
applied.
    c. Topic 14.L is removed to conform to changes made to Items 17 and 
18 of Form 20-F to reflect that reconciling items are required for 
disclosure only if a basis of accounting other than U.S. generally 
accepted accounting principles or International Financial Reporting 
Standards as issued by the International Accounting Standards Board is 
used.[

    Note:  The text of SAB 114 will not appear in the Code of 
Federal Regulations.

]Table of Contents

TOPIC 1: FINANCIAL STATEMENTS

A. Target Companies
B. Allocation of Expenses and Related Disclosure in Financial 
Statements of Subsidiaries, Divisions or Lesser Business Components 
of Another Entity
    1. Costs Reflected in Historical Financial Statements
    2. Pro Forma Financial Statements and Earnings per Share
    3. Other Matters
C. Unaudited Financial Statements for a Full Fiscal Year
D. Foreign Companies
    1. Disclosures Required of Companies Complying With Item 17 of 
Form 20-F
    2. ``Free distributions'' by Japanese Companies
E. Requirements for Audited or Certified Financial Statements
    1. Removed by SAB 103
    2. Qualified Auditors' Opinions
F. Financial Statement Requirements in Filings Involving the 
Formation of a One-Bank Holding Company
G. Removed by Financial Reporting Release (FRR) 55
H. Removed by FRR 55
I. Financial Statements of Properties Securing Mortgage Loans
J. Application of Rule 3-05 in Initial Public Offerings
K. Financial Statements of Acquired Troubled Financial Institutions
L. Removed by SAB 103
M. Materiality
    1. Assessing Materiality
    2. Immaterial Misstatements That Are Intentional
N. Considering the Effects of Prior Year Misstatements When 
Quantifying Misstatements in Current Year Financial Statements

TOPIC 2: BUSINESS COMBINATIONS

A. Acquisition Method
    1. Removed by SAB 103
    2. Removed by SAB 103
    3. Removed by SAB 103
    4. Removed by SAB 103
    5. Removed by SAB 112
    6. Debt Issue Costs
    7. Removed by SAB 112
    8. Business Combinations Prior to an Initial Public Offering
    9. Removed by SAB 112
B. Removed by SAB 103
C. Removed by SAB 103
D. Financial Statements of Oil and Gas Exchange Offers
E. Removed by SAB 103
F. Removed by SAB 103

TOPIC 3: SENIOR SECURITIES

A. Convertible Securities
B. Removed by ASR 307
C. Redeemable Preferred Stock

TOPIC 4: EQUITY ACCOUNTS

A. Subordinated Debt
B. S Corporations
C. Change in Capital Structure
D. Earnings per Share Computations in an Initial Public Offering
E. Receivables From Sale of Stock
F. Limited Partnerships
G. Notes and Other Receivables From Affiliates

TOPIC 5: MISCELLANEOUS ACCOUNTING

A. Expenses of Offering
B. Gain or Loss From Disposition of Equipment
C.1. Removed by SAB 103
C.2. Removed by SAB 103
D. Organization and Offering Expenses and Selling Commissions--
Limited Partnerships Trading in Commodity Futures
E. Accounting for Divestiture of a Subsidiary or Other Business 
Operation
F. Accounting Changes Not Retroactively Applied Due to Immateriality
G. Transfers of Nonmonetary Assets by Promoters or Shareholders
H. Removed by SAB 112
I. Removed by SAB 70
J. New Basis of Accounting Required in Certain Circumstances
K. Removed by SAB 95
L. LIFO Inventory Practices
M. Other Than Temporary Impairment of Certain Investments in Equity 
Securities
N. Discounting by Property-Casualty Insurance Companies
O. Research and Development Arrangements
P. Restructuring Charges
    1. Removed by SAB 103
    2. Removed by SAB 103
    3. Income Statement Presentation of Restructuring Charges
    4. Disclosures
Q. Increasing Rate Preferred Stock
R. Removed by SAB 103
S. Quasi-Reorganization
T. Accounting for Expenses or Liabilities Paid by Principal 
Stockholder(s)
U. Removed by SAB 112
V. Certain Transfers of Nonperforming Assets
W. Contingency Disclosures Regarding Property-Casualty Insurance 
Reserves for Unpaid Claim Costs
X. Removed by SAB 103
Y. Accounting and Disclosures Relating to Loss Contingencies
Z. Accounting and Disclosure Regarding Discontinued Operations
    1. Removed by SAB 103
    2. Removed by SAB 103
    3. Removed by SAB 103
    4. Disposal of Operation With Significant Interest Retained
    6. Removed by SAB 103
    7. Accounting for the Spin-Off of a Subsidiary

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AA. Removed by SAB 103
BB. Inventory Valuation Allowances
CC. Impairments
DD. Written Loan Commitments Recorded at Fair Value Through Earnings

TOPIC 6: INTERPRETATIONS OF ACCOUNTING SERIES RELEASES AND FINANCIAL 
REPORTING RELEASES

A.1. Removed by SAB 103
B. Accounting Series Release 280--General Revision of Regulation S-
X: Income or Loss Applicable to Common Stock
C. Accounting Series Release 180--Institution of Staff Accounting 
Bulletins (SABs)--Applicability of Guidance Contained in SABs
D. Redesignated as Topic 12.A by SAB 47
E. Redesignated as Topic 12.B by SAB 47
F. Removed by SAB 103
G. Accounting Series Releases 177 and 286--Relating to Amendments to 
Form 10-Q, Regulation S-K, and Regulations S-X Regarding Interim 
Financial Reporting
1. Selected Quarterly Financial Data (Item 302(a) of Regulation S-K)
a. Disclosure of Selected Quarterly Financial Data
b. Financial Statements Presented on Other Than a Quarterly Basis
c. Removed by SAB 103
2. Amendments to Form 10-Q
a. Form of Condensed Financial Statements
b. Reporting Requirements for Accounting Changes
1. Preferability
2. Filing of a Letter From the Accountants
H. Accounting Series Release 148-Disclosure Of Compensating Balances 
And Short-Term Borrowing Arrangements (Adopted November 13, 1973 As 
Modified By ASR 172 Adopted On June 13, 1975 And ASR 280 Adopted On 
September 2, 1980)
1. Applicability
a. Arrangements With Other Lending Institutions
b. Bank Holding Companies and Brokerage Firms
c. Financial Statements of Parent Company and Unconsolidated 
Subsidiaries
d. Foreign Lenders
2. Classification of Short-Term Obligations-Debt Related to Long-
Term Projects
3. Compensating Balances
a. Compensating Balances for Future Credit Availability
b. Changes in Compensating Balances
c. Float
4. Miscellaneous
a. Periods Required
b. 10-Q Disclosures
I. Accounting Series Release 149-Improved Disclosure Of Income Tax 
Expense (Adopted November 28, 1973 And Modified By ASR 280 Adopted 
On September 2, 1980)
1. Tax Rate
2. Taxes of Investee Company
3. Net of Tax Presentation
4. Loss Years
5. Foreign Registrants
6. Securities Gains and Losses
7. Tax Expense Components v. ``Overall'' Presentation
J. Removed by SAB 47
K. Accounting Series Release 302--Separate Financial Statements 
Required by Regulation S-X
1. Removed by SAB 103
2. Parent Company Financial Information
a. Computation of Restricted Net Assets of Subsidiaries
b. Application of Tests for Parent Company Disclosures
3. Undistributed Earnings of 50% or Less Owned Persons
4. Application of Significant Subsidiary Test to Investees and 
Unconsolidated Subsidiaries
a. Separate Financial Statement Requirements
b. Summarized Financial Statement Requirements
L. Financial Reporting Release 28--Accounting for Loan Losses by 
Registrants Engaged in Lending Activities
1. Accounting for loan losses
2. Developing and Documenting a Systematic Methodology
a. Developing a Systematic Methodology
b. Documenting a Systematic Methodology
3. Applying a Systematic Methodology--Measuring and Documenting Loan 
Losses Under FASB ASC Subtopic 310-10
a. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 
310-10--General
b. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 
310-10 for a Collateral Dependent Loan
c. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 
310-10--Fully Collateralized Loans
4. Applying a Systematic Methodology--Measuring and Documenting Loan 
Losses Under FASB ASC Subtopic 450-20
a. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 
450-20--General
b. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 
450-20--Adjusting Loss Rates
c. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 
450-20--Estimating Losses on Loans Individually Reviewed for 
Impairment but not Considered Individually Impaired
5. Documenting the Results of a Systematic Methodology
a. Documenting the Results of a Systematic Methodology--General
b. Documenting the Results of a Systematic Methodology--Allowance 
Adjustments
6. Validating a Systematic Methodology

TOPIC 7: REAL ESTATE COMPANIES

A. Removed by SAB 103
B. Removed by SAB 103
C. Schedules of Real Estate and Accumulated Depreciation, and of 
Mortgage Loans on Real Estate
D. Income Before Depreciation

TOPIC 8: RETAIL COMPANIES

A. Sales Of Leased Or Licensed Departments
B. Finance Charges

TOPIC 9: FINANCE COMPANIES

A. Removed by SAB 103
B. Removed by ASR 307

TOPIC 10: UTILITY COMPANIES

A. Financing by Electric Utility Companies Through Use of 
Construction Intermediaries
B. Removed by SAB 103
C. Jointly Owned Electric Utility Plants
D. Long-Term Contracts for Purchase of Electric Power
E. Classification of Charges for Abandonments and Disallowances
F. Presentation of Liabilities for Environmental Costs

TOPIC 11: MISCELLANEOUS DISCLOSURE

A. Operating-Differential Subsidies
B. Depreciation and Depletion Excluded From Cost of Sales
C. Tax Holidays
D. Removed by SAB 103
E. Chronological Ordering of Data
F. LIFO Liquidations
G. Tax Equivalent Adjustment in Financial Statements of Bank Holding 
Companies
H. Disclosures by Bank Holding Companies Regarding Certain Foreign 
Loans
1. Deposit/Relending Arrangements
2. Accounting and Disclosures by Bank Holding Companies for a 
``Mexican Debt Exchange'' Transaction
I. Reporting of an Allocated Transfer Risk Reserve in Filings Under 
the Federal Securities Laws
J. Removed by SAB 103
K. Application of Article 9 and Guide 3
L. Income Statement Presentation of Casino-Hotels
M. Disclosure of the Impact That Recently Issued Accounting 
Standards Will Have on the Financial Statements of the Registrant 
When Adopted in a Future Period
N. Disclosures of the Impact of Assistance From Federal Financial 
Institution Regulatory Agencies

TOPIC 12: OIL AND GAS PRODUCING ACTIVITIES

A. Accounting Series Release 257--Requirements for Financial 
Accounting and Reporting Practices for Oil and Gas Producing 
Activities
1. Estimates of Reserve Quantities
2. Estimates of Future Net Revenues
3. Disclosure of Reserve Information
a. Removed by SAB 103
b. Removed by SAB 113
c. Limited Partnership 10-K Reports
d. Removed by SAB 113
e. Rate Regulated Companies
4. Removed by SAB 103
B. Removed by SAB 103
C. Methods of Accounting by Oil and Gas Producers
1. First-Time Registrants
2. Consistent Use of Accounting Methods Within a Consolidated Entity
D. Application of Full Cost Method of Accounting
1. Treatment of Income Tax Effects in the Computation of the 
Limitation on Capitalized Costs
2. Exclusion of Costs From Amortization
3. Full Cost Ceiling Limitation
a. Exemptions for Purchased Properties

[[Page 17195]]

b. Use of Cash Flow Hedges in the Computation of the Limitation on 
Capitalized Costs
c. Effect of Subsequent Events on the Computation of the Limitation 
on Capitalized Costs
4. Interaction of FASB ASC Subtopic 410-20, Asset Retirement and 
Environmental Obligations--Asset Retirement Obligations, and the 
Full Cost Rules
a. Impact of FASB ASC Subtopic 410-20 on the Full Cost Ceiling Test
b. Impact of FASB ASC Subtopic 410-20 on the Calculation of 
Depreciation, Depletion, and Amortization
c. Removed by SAB 113
E. Financial Statements of Royalty Trusts
F. Gross Revenue Method of Amortizing Capitalized Costs
G. Removed by SAB 113

TOPIC 13: REVENUE RECOGNITION

A. Selected Revenue Recognition Issues
1. Revenue Recognition--General
2. Persuasive Evidence of an Arrangement
3. Delivery and Performance
a. Bill and Hold Arrangements
b. Customer Acceptance
c. Inconsequential or Perfunctory Performance Obligations
d. License Fee Revenue
e. Layaway Sales Arrangements
f. Nonrefundable Up-Front Fees
g. Deliverables Within an Arrangement
4. Fixed or Determinable Sales Price
a. Refundable Fees for Services
b. Estimates and Changes in Estimates
d. Claims Processing and Billing Services
B. Disclosures

TOPIC 14: SHARE-BASED PAYMENT

A. Share-Based Payment Transactions with Nonemployees
B. Transition From Nonpublic to Public Entity Status
C. Valuation Methods
D. Certain Assumptions Used in Valuation Methods
E. FASB ASC Topic 718, Compensation--Stock Compensation, and Certain 
Redeemable Financial Instruments
F. Classification of Compensation Expense Associated With Share-
Based Payment Arrangements
G. Removed by SAB 114
H. Removed by SAB 114
I. Capitalization of Compensation Cost Related to Share-Based 
Payment Arrangements
J. Removed by SAB 114
K. Removed by SAB 114
L. Removed by SAB 114
M. Removed by SAB 114

TOPIC 1: FINANCIAL STATEMENTS

A. Target Companies

    Facts: Company X proposes to file a registration statement covering 
an exchange offer to stockholders of Company Y, a publicly held 
company. Company X asks Company Y to furnish information about its 
business, including current audited financial statements, for inclusion 
in the prospectus. Company Y declines to furnish such information.
    Question 1: In filing the registration statement without the 
required information about Company Y, may Company X rely on Rule 409 in 
that the information is ``unknown or not reasonably available?''
    Interpretive Response: Yes, but to determine whether such reliance 
is justified, the staff requests the registrant to submit as 
supplemental information copies of correspondence between the 
registrant and the target company evidencing the request for and the 
refusal to furnish the financial statements. In addition, the 
prospectus must include any financial statements which are relevant and 
available from the Commission's public files and must contain a 
statement adequately describing the situation and the sources of 
information about the target company. Other reliable sources of 
financial information should also be utilized.
    Question 2: Would the response change if Company Y was a closely 
held company?
    Interpretive Response: Yes. The staff does not believe that Rule 
409 is applicable to negotiated transactions of this type.

B. Allocation of Expenses and Related Disclosure in Financial 
Statements of Subsidiaries, Divisions or Lesser Business Components of 
Another Entity

    Facts: A company (the registrant) operates as a subsidiary of 
another company (parent). Certain expenses incurred by the parent on 
behalf of the subsidiary have not been charged to the subsidiary in the 
past. The subsidiary files a registration statement under the 
Securities Act of 1933 in connection with an initial public offering.
1. Costs Reflected in Historical Financial Statements
    Question 1: Should the subsidiary's historical income statements 
reflect all of the expenses that the parent incurred on its behalf?
    Interpretive Response: In general, the staff believes that the 
historical income statements of a registrant should reflect all of its 
costs of doing business. Therefore, in specific situations, the staff 
has required the subsidiary to revise its financial statements to 
include certain expenses incurred by the parent on its behalf. Examples 
of such expenses may include, but are not necessarily limited to, the 
following (income taxes and interest are discussed separately below):
    1. Officer and employee salaries,
    2. Rent or depreciation,
    3. Advertising,
    4. Accounting and legal services, and
    5. Other selling, general and administrative expenses.
    When the subsidiary's financial statements have been previously 
reported on by independent accountants and have been used other than 
for internal purposes, the staff has accepted a presentation that shows 
income before tax as previously reported, followed by adjustments for 
expenses not previously allocated, income taxes, and adjusted net 
income.
    Question 2: How should the amount of expenses incurred on the 
subsidiary's behalf by its parent be determined, and what disclosure is 
required in the financial statements?
    Interpretive Response: The staff expects any expenses clearly 
applicable to the subsidiary to be reflected in its income statements. 
However, the staff understands that in some situations a reasonable 
method of allocating common expenses to the subsidiary (e.g., 
incremental or proportional cost allocation) must be chosen because 
specific identification of expenses is not practicable. In these 
situations, the staff has required an explanation of the allocation 
method used in the notes to the financial statements along with 
management's assertion that the method used is reasonable.
    In addition, since agreements with related parties are by 
definition not at arms length and may be changed at any time, the staff 
has required footnote disclosure, when practicable, of management's 
estimate of what the expenses (other than income taxes and interest 
discussed separately below) would have been on a stand alone basis, 
that is, the cost that would have been incurred if the subsidiary had 
operated as an unaffiliated entity. The disclosure has been presented 
for each year for which an income statement was required when such 
basis produced materially different results.
    Question 3: What are the staff's views with respect to the 
accounting for and disclosure of the subsidiary's income tax expense?
    Interpretive Response: Recently, a number of parent companies have 
sold interests in subsidiaries, but have retained sufficient ownership 
interests to permit continued inclusion of the subsidiaries in their 
consolidated tax returns. The staff believes that it is material to 
investors to know what the effect on income would have been if the 
registrant had not been eligible to be included in a consolidated 
income tax return with its parent. Some of these subsidiaries have 
calculated their tax provision on the separate return basis,

[[Page 17196]]

which the staff believes is the preferable method. Others, however, 
have used different allocation methods. When the historical income 
statements in the filing do not reflect the tax provision on the 
separate return basis, the staff has required a pro forma income 
statement for the most recent year and interim period reflecting a tax 
provision calculated on the separate return basis.\1\
---------------------------------------------------------------------------

    \1\ FASB ASC paragraph 740-10-30-27 (Income Taxes Topic) states: 
``The consolidated amount of current and deferred tax expense for a 
group that files a consolidated tax return shall be allocated among 
the members of the group when those members issue separate financial 
statements. * * * The method adopted * * * shall be systematic, 
rational, and consistent with the broad principles established by 
this Subtopic. A method that allocates current and deferred taxes to 
members of the group by applying this Topic to each member as if it 
were a separate taxpayer meets those criteria.''
---------------------------------------------------------------------------

    Question 4: Should the historical income statements reflect a 
charge for interest on intercompany debt if no such charge had been 
previously provided?
    Interpretive Response: The staff generally believes that financial 
statements are more useful to investors if they reflect all costs of 
doing business, including interest costs. Because of the inherent 
difficulty in distinguishing the elements of a subsidiary's capital 
structure, the staff has not insisted that the historical income 
statements include an interest charge on intercompany debt if such a 
charge was not provided in the past, except when debt specifically 
related to the operations of the subsidiary and previously carried on 
the parent's books will henceforth be recorded in the subsidiary's 
books. In any case, financing arrangements with the parent must be 
discussed in a note to the financial statements. In this connection, 
the staff has taken the position that, where an interest charge on 
intercompany debt has not been provided, appropriate disclosure would 
include an analysis of the intercompany accounts as well as the average 
balance due to or from related parties for each period for which an 
income statement is required. The analysis of the intercompany accounts 
has taken the form of a listing of transactions (e.g., the allocation 
of costs to the subsidiary, intercompany purchases, and cash transfers 
between entities) for each period for which an income statement was 
required, reconciled to the intercompany accounts reflected in the 
balance sheets.
2. Pro Forma Financial Statements and Earnings per Share
    Question: What disclosure should be made if the registrant's 
historical financial statements are not indicative of the ongoing 
entity (e.g., tax or other cost sharing agreements will be terminated 
or revised)?
    Interpretive Response: The registration statement should include 
pro forma financial information that is in accordance with Article 11 
of Regulation S-X and reflects the impact of terminated or revised cost 
sharing agreements and other significant changes.
3. Other matters
    Question: What is the staff's position with respect to dividends 
declared by the subsidiary subsequent to the balance sheet date?
    Interpretive Response: The staff believes that such dividends 
either be given retroactive effect in the balance sheet with 
appropriate footnote disclosure, or reflected in a pro forma balance 
sheet. In addition, when the dividends are to be paid from the proceeds 
of the offering, the staff believes it is appropriate to include pro 
forma per share data (for the latest year and interim period only) 
giving effect to the number of shares whose proceeds were to be used to 
pay the dividend. A similar presentation is appropriate when dividends 
exceed earnings in the current year, even though the stated use of 
proceeds is other than for the payment of dividends. In these 
situations, pro forma per share data should give effect to the increase 
in the number of shares which, when multiplied by the offering price, 
would be sufficient to replace the capital in excess of earnings being 
withdrawn.

C. Unaudited Financial Statements for a Full Fiscal Year

    Facts: Company A, which is a reporting company under the Securities 
Exchange Act of 1934, proposes to file a registration statement within 
90 days of its fiscal year end but does not have audited year-end 
financial statements available. The company meets the criteria under 
Rule 3-01(c) of Regulation S-X and is therefore not required to include 
year-end audited financial statements in its registration statement. 
However, the Company does propose to include in the prospectus the 
unaudited results of operations for its entire fiscal year.
    Question: Would the staff find this objectionable?
    Interpretive Response: The staff recognizes that many registrants 
publish the results of their most recent year's operations prior to the 
availability of year-end audited financial statements. The staff will 
not object to the inclusion of unaudited results for a full fiscal year 
and indeed would expect such data in the registration statement if the 
registrant has published such information. When such data is included 
in a prospectus, it must be covered by a management's representation 
that all adjustments necessary for a fair statement of the results have 
been made.

D. Foreign Companies

1. Disclosures Required of Companies Complying With Item 17 of Form 20-
F
    Facts: A foreign private issuer may use Form 20-F as a registration 
statement under section 12 or as an annual report under section 13(a) 
or 15(d) of the Exchange Act. The registrant must furnish the financial 
statements specified in Item 17 of that form (Effective for fiscal 
years ending on or after December 15, 2011, compliance with Item 18 
rather than Item 17 will be required for all issuer financial 
statements in all Securities Act registration statements, Exchange Act 
registration statements on Form 20-F, and annual reports on Form 20-F. 
See SEC Release No. 33-8959). However, in certain circumstances, Form 
F-3 requires that the annual report include financial statements 
complying with Item 18 of the form. Also, financial statements 
complying with Item 18 are required for registration of securities 
under the Securities Act in most circumstances. Item 17 permits the 
registrant to use its financial statements that are prepared on a 
comprehensive basis other than U.S. GAAP, but requires quantification 
of the material differences in the principles, practices and methods of 
accounting for any basis other than International Financial Reporting 
Standards (IFRS) as issued by the International Accounting Standards 
Board (IASB). An issuer complying with Item 18, other than those using 
IFRS as issued by the IASB, must satisfy the requirements of Item 17 
and also must provide all other information required by U.S. GAAP and 
Regulation S-X.
    Question: Assuming that the registrant's financial statements 
include a discussion of material variances from U.S. GAAP along with 
quantitative reconciliations of net income and material balance sheet 
items, does Item 17 of Form 20-F require other disclosures in addition 
to those prescribed by the standards and practices which comprise the 
comprehensive basis on which the registrant's primary financial 
statements are prepared?
    Interpretive Response: No. The distinction between Items 17 and 18 
is premised on a classification of the requirements of U.S. GAAP and

[[Page 17197]]

Regulation S-X into those that specify the methods of measuring the 
amounts shown on the face of the financial statements and those 
prescribing disclosures that explain, modify or supplement the 
accounting measurements. Disclosures required by U.S. GAAP but not 
required under the foreign GAAP on which the financial statements are 
prepared need not be furnished pursuant to Item 17.
    Notwithstanding the absence of a requirement for certain 
disclosures within the body of the financial statements, some matters 
routinely disclosed pursuant to U.S. GAAP may rise to a level of 
materiality such that their disclosure is required by Item 5 
(Management's Discussion and Analysis) of Form 20-F. Among other 
things, this item calls for a discussion of any known trends, demands, 
commitments, events or uncertainties that are reasonably likely to 
affect liquidity, capital resources or the results of operations in a 
material way. Also, instruction 2 of this item requires ``a discussion 
of any aspects of the differences between foreign and U.S. GAAP, not 
discussed in the reconciliation, that the registrant believes is 
necessary for an understanding of the financial statements as a 
whole.'' Matters that may warrant discussion in response to Item 5 
include the following:
     Material undisclosed uncertainties (such as reasonably 
possible loss contingencies), commitments (such as those arising from 
leases), and credit risk exposures and concentrations;
     Material unrecognized obligations (such as pension 
obligations);
     Material changes in estimates and accounting methods, and 
other factors or events affecting comparability;
     Defaults on debt and material restrictions on dividends or 
other legal constraints on the registrant's use of its assets;
     Material changes in the relative amounts of constituent 
elements comprising line items presented on the face of the financial 
statements;
     Significant terms of financings which would reveal 
material cash requirements or constraints;
     Material subsequent events, such as events that affect the 
recoverability of recorded assets;
     Material related party transactions (as addressed by FASB 
ASC Topic 850, Related Party Disclosures) that may affect the terms 
under which material revenues or expenses are recorded; and
     Significant accounting policies and measurement 
assumptions not disclosed in the financial statements, including 
methods of costing inventory, recognizing revenues, and recording and 
amortizing assets, which may bear upon an understanding of operating 
trends or financial condition.
2. ``Free Distributions'' by Japanese Companies
    Facts: It is the general practice in Japan for corporations to 
issue ``free distributions'' of common stock to existing shareholders 
in conjunction with offerings of common stock so that such offerings 
may be made at less than market. These free distributions usually are 
from 5 to 10 percent of outstanding stock and are accounted for in 
accordance with provisions of the Commercial Code of Japan by a 
transfer of the par value of the stock distributed from paid-in capital 
to the common stock account. Similar distributions are sometimes made 
at times other than when offering new stock and are also designated 
``free distributions.'' U.S. accounting practice would require that the 
fair value of such shares, if issued by U.S. companies, be transferred 
from retained earnings to the appropriate capital accounts.
    Question: Should the financial statements of Japanese corporations 
included in Commission filings which are stated to be prepared in 
accordance with U.S. GAAP be adjusted to account for stock 
distributions of less than 25 percent of outstanding stock by 
transferring the fair value of such stock from retained earnings to 
appropriate capital accounts?
    Interpretive Response: If registrants and their independent 
accountants believe that the institutional and economic environment in 
Japan with respect to the registrant is sufficiently different that 
U.S. accounting principles for stock dividends should not apply to free 
distributions, the staff will not object to such distributions being 
accounted for at par value in accordance with Japanese practice. If 
such financial statements are identified as being prepared in 
accordance with U.S. GAAP, then there should be footnote disclosure of 
the method being used which indicates that U.S. companies issuing 
shares in comparable amounts would be required to account for them as 
stock dividends, and including in such disclosure the fair value of any 
such shares issued during the year and the cumulative amount (either in 
an aggregate figure or a listing of the amounts by year) of the fair 
value of shares issued over time.

E. Requirements for Audited or Certified Financial Statements

1. Removed by SAB 103
2. Qualified Auditors' Opinions
    Facts: The accountants' report is qualified as to scope of audit, 
or the accounting principles used.
    Question: Does the staff consider the requirements for audited or 
certified financial statements met when the auditors' opinion is so 
qualified?
    Interpretive Response: No. The staff does not accept as consistent 
with the requirements of Rule 2-02(b) of Regulation S-X financial 
statements on which the auditors' opinions are qualified because of a 
limitation on the scope of the audit, since in these situations the 
auditor was unable to perform all the procedures required by 
professional standards to support the expression of an opinion. This 
position was discussed in Accounting Series Release (ASR) 90 in 
connection with representations concerning the verification of prior 
years' inventories in first audits.
    Financial statements for which the auditors' opinions contain 
qualifications relating to the acceptability of accounting principles 
used or the completeness of disclosures made are also unacceptable. 
(See ASR 4, and with respect to a ``going concern'' qualification, ASR 
115.)

F. Financial Statement Requirements in Filings Involving the Formation 
of a One-Bank Holding Company

    Facts: Holding Company A is organized for the purpose of issuing 
common stock to acquire all of the common stock of Bank A. Under the 
plan of reorganization, each share of common stock of Bank A will be 
exchanged for one share of common stock of the holding company. The 
shares of the holding company to be issued in the transaction will be 
registered on Form S-4. The holding company will not engage in any 
operations prior to consummation of the reorganization, and its only 
significant asset after the transaction will be its investment in the 
bank. The bank has been furnishing its shareholders with an annual 
report that includes financial statements that comply with GAAP. Item 
14 of Schedule 14A of the proxy rules provides that financial 
statements generally are not necessary in proxy material relating only 
to changes in legal organization (such as reorganizations involving the 
issuer and one or more of its totally held subsidiaries).
    Question 1: Must the financial statements and the information 
required

[[Page 17198]]

by Securities Act Industry Guide (``Guide 3'') \2\ for Bank A be 
included in the initial registration statement on Form S-4?
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    \2\ Item 801 of Regulation S-K.
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    Interpretive Response: No, provided that certain conditions are 
met. The staff will not take exception to the omission of financial 
statements and Guide 3 information in the initial registration 
statement on Form S-4 if all of the following conditions are met:
     There are no anticipated changes in the shareholders' 
relative equity ownership interest in the underlying bank assets, 
except for redemption of no more than a nominal number of shares of 
unaffiliated persons who dissent;
     In the aggregate, only nominal borrowings are to be 
incurred for such purposes as organizing the holding company, to pay 
nonaffiliated persons who dissent, or to meet minimum capital 
requirements;
     There are no new classes of stock authorized other than 
those corresponding to the stock of Bank A immediately prior to the 
reorganization;
     There are no plans or arrangements to issue any additional 
shares to acquire any business other than Bank A; and,
     There has been no material adverse change in the financial 
condition of the bank since the latest fiscal year-end included in the 
annual report to shareholders.

If at the time of filing the S-4, a letter is furnished to the staff 
stating that all of these conditions are met, it will not be necessary 
to request the Division of Corporation Finance to waive the financial 
statement or Guide 3 requirements of Form S-4.
    Although the financial statements may be omitted, the filing should 
include a section captioned, ``Financial Statements,'' which states 
either that an annual report containing financial statements for at 
least the latest fiscal year prepared in conformity with GAAP was 
previously furnished to shareholders or is being delivered with the 
prospectus. If financial statements have been previously furnished, it 
should be indicated that an additional copy of such report for the 
latest fiscal year will be furnished promptly upon request without 
charge to shareholders. The name and address of the person to whom the 
request should be made should be provided. One copy of such annual 
report should be furnished supplementally with the initial filing for 
purposes of staff review.
    If any nominal amounts are to be borrowed in connection with the 
formation of the holding company, a statement of capitalization should 
be included in the filing which shows Bank A on an historical basis, 
the pro forma adjustments, and the holding company on a pro forma 
basis. A note should also explain the pro forma effect, in total and 
per share, which the borrowings would have had on net income for the 
latest fiscal year if the transaction had occurred at the beginning of 
the period.
    Question 2: Are the financial statements of Bank A required to be 
audited for purposes of the initial Form S-4 or the subsequent Form 10-
K report?
    Interpretive Response: The staff will not insist that the financial 
statements in the annual report to shareholders used to satisfy the 
requirement of the initial Form S-4 be audited.
    The consolidated financial statements of the holding company to be 
included in the registrant's initial report on Form 10-K should comply 
with the applicable financial statement requirements in Regulation S-X 
at the time such annual report is filed. However, the regulations also 
provide that the staff may allow one or more of the required statements 
to be unaudited where it is consistent with the protection of 
investors.\3\ Accordingly, the policy of the Division of Corporation 
Finance is as follows:
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    \3\ Rule 3-13 of Regulation S-X.

    The registrant should file audited balance sheets as of the two 
most recent fiscal years and audited statements of income and cash 
flows for each of the three latest fiscal years, with appropriate 
footnotes and schedules as required by Regulation S-X unless the 
financial statements have not previously been audited for the 
periods required to be filed. In such cases, the Division will not 
object if the financial statements in the first annual report on 
Form 10-K (or the special report filed pursuant to Rule 15d-2) \4\ 
are audited only for the two latest fiscal years.\5\ This policy 
only applies to filings on Form 10-K, and not to any Securities Act 
filings made after the initial S-4 filing.
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    \4\ Rule 15d-2 would be applicable if the annual report 
furnished with the Form S-4 was not for the registrant's most recent 
fiscal year. In such a situation, Rule 15d-2 would require the 
registrant to file a special report within 90 days after the 
effective date of the Form S-4 furnishing audited financial 
statements for the most recent fiscal year.
    \5\ Unaudited statements of income and cash flows should be 
furnished for the earliest period.

The above procedure may be followed without making a specific request 
of the Division of Corporation Finance for a waiver of the financial 
statement requirements of Form 10-K.
    The information required by Guide 3 should also be provided in the 
Form 10-K for at least the periods for which audited financial 
statements are furnished. If some of the statistical information for 
the two most recent fiscal years for which audited financial statements 
are included (other than information on nonperforming loans and the 
summary of loan loss experience) is unavailable and cannot be obtained 
without unwarranted or undue burden or expense, such data may be 
omitted provided a brief explanation in support of such representation 
is included in the report on Form 10-K. In all cases, however, 
information with respect to nonperforming loans and loan loss 
experience, or reasonably comparable data, must be furnished for at 
least the two latest fiscal years in the initial 10-K. Thereafter, for 
subsequent years in reports on Form 10-K, all of the Guide 3 
information is required; Guide 3 information which had been omitted in 
the initial 10-K in accordance with the above procedure can be excluded 
in any subsequent 10-Ks.

G. Removed by Financial Reporting Release (FRR) 55

H. Removed by FRR 55

I. Financial Statements of Properties Securing Mortgage Loans

    Facts: A registrant files a Securities Act registration statement 
covering a maximum of $100 million of securities. Proceeds of the 
offering will be used to make mortgage loans on operating residential 
or commercial property. Proceeds of the offering will be placed in 
escrow until $1 million of securities are sold at which point escrow 
may be broken, making the proceeds immediately available for lending, 
while the selling of securities would continue.
    Question 1: Under what circumstances are the financial statements 
of a property on which the registrant makes or expects to make a loan 
required to be included in a filing?
    Interpretive Response: Rule 3-14 of Regulation S-X specifies the 
requirements for financial statements when the registrant has acquired 
one or more properties which in the aggregate are significant, or since 
the date of the latest balance sheet required has acquired or proposes 
to acquire one or more properties which in the aggregate are 
significant.
    Included in the category of properties acquired or to be acquired 
under Rule 3-14 are operating properties underlying certain mortgage 
loans, which in economic substance represent an investment in real 
estate or a joint venture rather than a loan. Certain characteristics 
of a lending arrangement indicate that the ``lender'' has the same 
risks and potential rewards as an owner or joint venturer. Those 
characteristics

[[Page 17199]]

are set forth in the Acquisition, Development, and Construction 
Arrangements (ADC Arrangements) Subsection of FASB ASC Subtopic 310-10, 
Receivables--Overall.6 7 In September 1986 the EITF \8\ 
reached a consensus on this issue \9\ to the effect that, although the 
guidance in the ADC Arrangements Subsection of FASB ASC Subtopic 310-10 
was issued to address the real estate ADC arrangements of financial 
institutions, preparers and auditors should consider that guidance in 
accounting for shared appreciation mortgages, loans on operating real 
estate and real estate ADC arrangements entered into by enterprises 
other than financial institutions.
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    \6\ [Original footnote removed by SAB 114.]
    \7\ [Original footnote removed by SAB 114.]
    \8\ The Emerging Issues Task Force (``EITF'') was formed in 1984 
to assist the Financial Accounting Standards Board in the early 
identification and resolution of emerging accounting issues. Topics 
to be discussed by the EITF are publicly announced prior to its 
meetings and minutes of all EITF meetings are available to the 
public.
    \9\ FASB ASC paragraph 310-10-05-9.
---------------------------------------------------------------------------

    FASB ASC Subtopic 815-15, Derivatives and Hedging--Embedded 
Derivatives, generally requires that embedded instruments meeting the 
definition of a derivative and not clearly and closely related to the 
host contract be accounted for separately from the host instrument. If 
the embedded expected residual profit component of an ADC arrangement 
need not be separately accounted for as a derivative under FASB ASC 
Topic 815, then the disclosure requirements discussed below for ADC 
loans and similar arrangements should be followed.\10\
---------------------------------------------------------------------------

    \10\ The equity kicker (the expected residual profit) would 
typically not be separated from the host contract and accounted for 
as a derivative because FASB ASC subparagraph 815-15-25-1(c) exempts 
a hybrid contract from bifurcation if a separate instrument with the 
same terms as the embedded equity kicker is not a derivative 
instrument subject to the requirements of FASB ASC Topic 815.
---------------------------------------------------------------------------

    In certain cases the ``lender'' has virtually the same potential 
rewards as those of an owner or a joint venturer by virtue of 
participating in expected residual profit.\11\ In addition, the ADC 
Arrangements Subsection of FASB ASC Subtopic 310-10 includes a number 
of other characteristics which, when considered individually or in 
combination, would suggest that the risks of an ADC arrangement are 
similar to those associated with an investment in real estate or a 
joint venture or, conversely, that they are similar to those associated 
with a loan. Among those other characteristics is whether the lender 
agrees to provide all or substantially all necessary funds to acquire 
the property, resulting in the borrower having title to, but little or 
no equity in, the underlying property. The staff believes that the 
borrower's equity in the property is adequate to support accounting for 
the transaction as a mortgage loan when the borrower's initial 
investment meets the criteria in FASB ASC paragraph 360-20-40-18 
(Property, Plant, and Equipment Topic) \12\ and the borrower's payments 
of principal and interest on the loan are adequate to maintain a 
continuing investment in the property which meets the criteria in FASB 
ASC paragraph 360-20-40-19.\13\
---------------------------------------------------------------------------

    \11\ Expected residual profit is defined in the ADC Arrangements 
Subsection of FASB ASC Subtopic 310-10 as the amount of profit, 
whether called interest or another name, such as equity kicker, 
above a reasonable amount of interest and fees expected to be earned 
by the ``lender.''
    \12\ FASB ASC Subtopic 360-20 establishes standards for the 
recognition of profit on real estate sales transactions. FASB ASC 
paragraph 360-20-40-18 states that the buyer's initial investment 
shall be adequate to demonstrate the buyer's commitment to pay for 
the property and shall indicate a reasonable likelihood that the 
seller will collect the receivable. Guidance on minimum initial 
investments in various types of real estate is provided in FASB ASC 
paragraphs 360-20-40-55-1 and 360-20-40-55-2.
    \13\ FASB ASC paragraph 360-20-40-19 states that the buyer's 
continuing investment in a real estate transaction shall not qualify 
unless the buyer is contractually required to pay each year on its 
total debt for the purchase price of the property an amount at least 
equal to the level annual payment that would be needed to pay that 
debt and interest on the unpaid balance over not more than (a) 20 
years for debt for land and (b) the customary amortization term of a 
first mortgage loan by an independent established lending 
institution for other real estate.
---------------------------------------------------------------------------

    The financial statements of properties which will secure mortgage 
loans made or to be made from the proceeds of the offering which have 
the characteristics of real estate investments or joint ventures should 
be included as required by Rule 3-14 in the registration statement when 
such properties secure loans previously made, or have been identified 
as security for probable loans prior to effectiveness, and in filings 
made pursuant to the undertaking in Item 20D of Securities Act Industry 
Guide 5.
    Rule 1-02(w) of Regulation S-X includes the conditions used in 
determining whether an acquisition is significant. The separate 
financial statements of an individual property should be provided when 
a property would meet the requirements for a significant subsidiary 
under this rule using the amount of the ``loan'' as a substitute for 
the ``investment in the subsidiary'' in computing the specified 
conditions. The combined financial statements of properties which are 
not individually significant should also be provided. However, the 
staff will not object if the combined financial statements of such 
properties are not included if none of the conditions specified in Rule 
1-02(w), with respect to all such properties combined, exceeds 20% in 
the aggregate.
    Under certain circumstances, information may also be required 
regarding operating properties underlying mortgage loans where the 
terms do not result in the lender having virtually the same risks and 
potential rewards as those of owners or joint venturers. Generally, the 
staff believes that, where investment risks exist due to substantial 
asset concentration, financial and other information should be included 
regarding operating properties underlying a mortgage loan that 
represents a significant amount of the registrant's assets. Such 
presentation is consistent with Rule 3-13 of Regulation S-X and Rule 
408 under the Securities Act of 1933.
    Where the amount of a loan exceeds 20% of the amount in good faith 
expected to be raised in the offering, disclosures would be expected to 
consist of financial statements for the underlying operating properties 
for the periods contemplated by Rule 3-14. Further, where loans on 
related properties are made to a single person or group of affiliated 
persons which in the aggregate amount to more than 20% of the amount 
expected to be raised, the staff believes that such lending 
arrangements result in a sufficient concentration of assets so as to 
warrant the inclusion of financial and other information regarding the 
underlying properties.
    Question 2: Will the financial statements of the mortgaged 
properties be required in filings made under the 1934 Act?
    Interpretive Response: Rule 3-09 of Regulation S-X specifies the 
requirement for significant, as defined, investments in operating 
entities, the operations of which are not included in the registrant's 
consolidated financial statements.\14\ Accordingly, the staff believes 
that the financial statements of properties securing significant loans 
which have the characteristics of real

[[Page 17200]]

estate investments or joint ventures should be included in subsequent 
filings as required by Rule 3-09. The materiality threshold for 
determining whether such an investment is significant is the same as 
set forth in paragraph (a) of that Rule.\15\
---------------------------------------------------------------------------

    \14\ Rule 3-14 states that the financial statements of an 
acquired property should be furnished if the acquisition took place 
during the period for which the registrant's income statements are 
required. Paragraph (b) of the Rule states that the information 
required by the Rule is not required to be included in a filing on 
Form 10-K. That exception is consistent with Item 8 of Form 10-K 
which excludes acquired company financial statements, which would 
otherwise be required by Rule 3-05 of Regulation S-X, from inclusion 
in filings on that Form. Those exceptions are based, in part, on the 
fact that acquired properties and acquired companies will generally 
be included in the registrant's consolidated financial statements 
from the acquisition date.
    \15\ Rule 3-09(a) states, in part, that ``[i]f any of the 
conditions set forth in [Rule] 1-02(w), substituting 20 percent for 
10 percent in the tests used therein to determine significant 
subsidiary, are met * * * separate financial statements * * * shall 
be filed.''
---------------------------------------------------------------------------

    Likewise, the staff believes that filings made under the 1934 Act 
should include the same financial and other information relating to 
properties underlying any loans which are significant as discussed in 
the last paragraph of Question 1, except that in the determination of 
significance the 20% disclosure threshold should be measured using 
total assets. The staff believes that this presentation would be 
consistent with Rule 12b-20 under the Securities Exchange Act of 1934.
    Question 3: The interpretive response to question 1 indicates that 
the staff believes that the borrower's equity in an operating property 
is adequate to support accounting for the transaction as a mortgage 
loan when the borrower's initial investment meets the criteria in FASB 
ASC paragraph 360-20-40-18 and the borrower's payments of principal and 
interest on the loan are adequate to maintain a continuing investment 
in the property which meets the criteria in FASB ASC paragraph 360-20-
40-19. Is it the staff's view that meeting these criteria is the only 
way the borrower's equity in the property is considered adequate to 
support accounting for the transaction as a mortgage loan?
    Interpretive Response: No. It is the staff's position that the 
determination of whether loan accounting is appropriate for these 
arrangements should be made by the registrant and its independent 
accountants based on the facts and circumstances of the individual 
arrangements, using the guidance provided in the ADC Arrangements 
Subsection of FASB ASC Subtopic 310-10. As stated in that Subsection, 
loan accounting may not be appropriate when the lender participates in 
expected residual profit and has virtually the same risks as those of 
an owner, or joint venturer. In assessing the question of whether the 
lender has virtually the same risks as an owner, or joint venturer, the 
essential test that needs to be addressed is whether the borrower has 
and is expected to continue to have a substantial amount at risk in the 
project.\16\ The criteria described in FASB ASC Subtopic 360-20, 
Property, Plant, and Equipment--Real Estate Sales, provide a ``safe 
harbor'' for determining whether the borrower has a substantial amount 
at risk in the form of a substantial equity investment. The borrower 
may have a substantial amount at risk without meeting the criteria 
described in FASB ASC Subtopic 360-20.
---------------------------------------------------------------------------

    \16\ Regarding the composition of the borrower's investment, 
FASB ASC paragraph 310-10-25-20 indicates that the borrower's 
investment may include the value of land or other assets contributed 
by the borrower, net of encumbrances. The staff emphasizes that such 
paragraph indicates, ``* * * recently acquired property generally 
should be valued at no higher than cost * * *'' Thus, for such 
recently acquired property, appraisals will not be sufficient to 
justify the use of a value in excess of cost.
---------------------------------------------------------------------------

    Question 4: What financial statements should be included in filings 
made under the Securities Act regarding investment-type arrangements 
that individually amount to 10% or more of total assets?
    Interpretive Response: In the staff's view, separate audited 
financial statements should be provided for any investment-type 
arrangement that constitutes 10% or more of the greater of (i) the 
amount of minimum proceeds or (ii) the total assets of the registrant, 
including the amount of proceeds raised, as of the date the filing is 
required to be made. Of course, the narrative information required by 
items 14 and 15 of Form S-11 should also be included with respect to 
these investment-type arrangements.
    Question 5: What information must be provided under the Securities 
Act for investment-type arrangements that individually amount to less 
than 10%?
    Interpretive Response: No specific financial information need be 
presented for investment-type arrangements that amount to less than 
10%. However, where such arrangements aggregate more than 20%, a 
narrative description of the general character of the properties and 
arrangements should be included that gives an investor an understanding 
of the risks and rewards associated with these arrangements. Such 
information may, for example, include a description of the terms of the 
arrangements, participation by the registrant in expected residual 
profits, and property types and locations.
    Question 6: What financial statements should be included in annual 
reports filed under the Exchange Act with respect to investment-type 
arrangements that constitute 10% or more of the registrant's total 
assets?
    Interpretive Response: In annual reports filed with the Commission, 
the staff has advised registrants that separate audited financial 
statements should be provided for each nonconsolidated investment-type 
arrangement that is 20% or more of the registrant's total assets. While 
the distribution is on-going, however, the percentage may be calculated 
using the greater of (i) the amount of the minimum proceeds or (ii) the 
total assets of the registrant, including the amount of proceeds 
raised, as of the date the filing is required to be made. In annual 
reports to shareholders registrants may either include the separate 
audited financial statements for 20% or more nonconsolidated 
investment-type arrangements or, if those financial statements are not 
included, present summarized financial information for those 
arrangements in the notes to the registrant's financial statements.
    The staff has also indicated that separate summarized financial 
information (as defined in Rule 1-02(bb) of Regulation S-X) should be 
provided in the footnotes to the registrant's financial statements for 
each nonconsolidated investment-type arrangement that is 10% or more 
but less than 20%. Of course, registrants should also make appropriate 
textural disclosure with respect to material investment-type 
arrangements in the ``business'' and ``property'' sections of their 
annual reports to the Commission.\17\
---------------------------------------------------------------------------

    \17\ Registrants are reminded that in filings on Form 8-K that 
are triggered in connection with an acquisition of an investment-
type arrangement, separate audited financial statements are required 
for any such arrangement that individually constitutes 10% or more.
---------------------------------------------------------------------------

    Question 7: What information should be provided in annual reports 
filed under the Exchange Act with respect to investment-type 
arrangements that do not meet the 10% threshold?
    Interpretive Response: The staff believes it will not be necessary 
to provide any financial information (full or summarized) for 
investment-type arrangements that do not meet the 10% threshold. 
However, in the staff's view, where such arrangements aggregate more 
than 20%, a narrative description of the general character of the 
properties and arrangements would be necessary. The staff believes that 
information should be included that would give an investor an 
understanding of the risks and rewards associated with these 
arrangements. Such information may, for example, include a description 
of the terms of the arrangements, participation by the registrant in 
expected residual profits, and property types and locations. Of course, 
disclosure regarding the operations of such components should be 
included as part

[[Page 17201]]

of the Management's Discussion and Analysis where there is a known 
trend or uncertainty in the operations of such properties, either 
individually or in the aggregate, which would be reasonably likely to 
result in a material impact on the registrant's future operations, 
liquidity or capital resources.

J. Application of Rule 3-05 in Initial Public Offerings

    Facts: Rule 3-05 of Regulation S-X establishes the financial 
statement requirements for businesses acquired or to be acquired. If 
required, financial statements must be provided for one, two or three 
years depending upon the relative significance of the acquired entity 
as determined by the application of Rule 1-02(w) of Regulation S-X. The 
calculations required for these tests are applied by comparison of the 
financial data of the registrant and acquiree(s) for the fiscal years 
most recently completed prior to the acquisition. The staff has 
recognized that these tests literally applied in some initial public 
offerings may require financial statements for an acquired entity which 
may not be significant to investors because the registrant has had 
substantial growth in assets and earnings in recent years.\18\
---------------------------------------------------------------------------

    \18\ An acquisition which was relatively significant in the 
earliest year for which a registrant is required to file financial 
statements may be insignificant to its latest fiscal year due to 
internal growth and/or subsequent acquisitions. Literally applied, 
Rules 3-05 and 1-02(w) might still require separate financial 
statements for the now insignificant acquisition.
---------------------------------------------------------------------------

    Question: How should Rules 3-05 and 1-02(w) of Regulation S-X be 
applied in determining the periods for which financial statements of 
acquirees are required to be included in registration statements for 
initial public offerings?
    Interpretive Response: It is the staff's view that initial public 
offerings involving businesses that have been built by the aggregation 
of discrete businesses that remain substantially intact after 
acquisition \19\ were not contemplated during the drafting of Rule 3-05 
and that the significance of an acquired entity in such situations may 
be better measured in relation to the size of the registrant at the 
time the registration statement is filed, rather than its size at the 
time the acquisition was made. Therefore, for a first time registrant, 
the staff has indicated that in applying the significance tests in Rule 
3-05, the three tests in Rule 1-02(w) generally can be measured against 
the combined entities, including those to be acquired, which comprise 
the registrant at the time the registration statement is filed. The 
staff's policy is intended to ensure that the registration statement 
will include not less than three, two and one year(s) of audited 
financial statements for not less than 60%, 80% and 90%, respectively, 
of the constituent businesses that will comprise the registrant on an 
ongoing basis. In all circumstances, the audited financial statements 
of the registrant are required for three years, or since its inception 
if less than three years. The requirement to provide the audited 
financial statements of a constituent business in the registration 
statement is satisfied for the post-acquisition period by including the 
entity's results in the audited consolidated financial statements of 
the registrant. If additional periods are required, the entity's 
separate audited financial statements for the immediate pre-acquisition 
period(s) should be presented.\20\
---------------------------------------------------------------------------

    \19\ For example, nursing homes, hospitals or cable TV systems. 
This interpretation would not apply to businesses for which the 
relative significance of one portion of the business to the total 
business may be altered by post-acquisition decisions as to the 
allocation of incoming orders between plants or locations. This 
bulletin does not address all possible cases in which similar relief 
may be appropriate but, rather, attempts to describe a general 
framework within which administrative policy has been established. 
In other distinguishable situations, registrants may request relief 
as appropriate to their individual facts and circumstances.
    \20\ If audited pre-acquisition financial statements of a 
business are necessary pursuant to the alternative tests described 
here, the interim period following that entity's latest pre-
acquisition fiscal year end but prior to its acquisition by the 
registrant generally would be required to be audited.
---------------------------------------------------------------------------

    In order for the pre-acquisition audited financial statements of an 
acquiree to be omitted from the registration statement, the following 
conditions must be met:
    a. The combined significance of businesses acquired or to be 
acquired for which audited financial statements cover a period of less 
than 9 months \21\ may not exceed 10%;
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    \21\ As a matter of policy the staff accepts financial 
statements for periods of not less than 9, 21 and 33 consecutive 
months (not more than 12 months may be included in any period 
reported on) as substantial compliance with requirements for 
financial statements for 1, 2 and 3 years, respectively.
---------------------------------------------------------------------------

    b. The combined significance of businesses acquired or to be 
acquired for which audited financial statements cover a period of less 
than 21 months may not exceed 20%; and
    c. The combined significance of businesses acquired or to be 
acquired for which audited financial statements cover a period of less 
than 33 months may not exceed 40%.
    Combined significance is the total, for all included companies, of 
each individual company's highest level of significance computed under 
the three tests of significance. The significance tests should be 
applied to pro forma financial statements of the registrant, prepared 
in a manner consistent with Article 11 of Regulation S-X. The pro forma 
balance sheet should be as of the date of the registrant's latest 
balance sheet included in the registration statement, and should give 
effect to businesses acquired subsequent to the end of the latest year 
or to be acquired as if they had been acquired on that date. The pro 
forma statement of operations should be for the registrant's most 
recent fiscal year included in the registration statement and should 
give effect to all acquisitions consummated during and subsequent to 
the end of the year and probable acquisitions as if they had been 
consummated at the beginning of that fiscal year.
    The three tests specified in Rule 1-02(w) should be made in 
comparison to the registrant's pro forma consolidated assets and pretax 
income from continuing operations. The assets and pretax income of the 
acquired businesses which are being evaluated for significance should 
reflect any new cost basis arising from purchase accounting.

    Example: On February 20, 20X9 Registrant files Form S-1 
containing its audited consolidated financial statements as of and 
for the three years ended December 31, 20X8. Acquisitions since 
inception have been:

----------------------------------------------------------------------------------------------------------------
                                                                                                    Highest
                                                                                                significance at
                Acquiree                  Fiscal year end          Date of  acquisition           acquisition
                                                                                                   (percent)
----------------------------------------------------------------------------------------------------------------
A......................................               3/31  1/1/x7...........................                 60
B......................................               7/31  4/1/x7...........................                 45
C......................................               9/30  9/1/x7...........................                 40
D......................................              12/31  2/1/x8...........................                 21
E......................................               3/31  11/1/x8..........................                 11

[[Page 17202]]

 
F......................................              12/31  To be acquired...................                 11
----------------------------------------------------------------------------------------------------------------

    The following table reflects the application of the significance 
tests to the combined financial information at the time the 
registration statement is filed.

----------------------------------------------------------------------------------------------------------------
                                                          Significance of
                                     ---------------------------------------------------------  Highest level of
          Component entity                                    Earnings          Investment        significance
                                      Assets  (percent)      (percent)          (percent)
----------------------------------------------------------------------------------------------------------------
A...................................                 12                 23                 12                 23
B...................................                 10                 21                 10                 21
C...................................                 21                  3                  4                 21
D...................................                 10                  5                 13                 13
E...................................                  4                * 9                  3                  9
F...................................                  2                 11                  6                 11
----------------------------------------------------------------------------------------------------------------
* Loss.

    Year 1 (most recent fiscal year)--Entity E is the only acquiree for 
which pre-acquisition financial statements may be omitted for the 
latest year since significance for each other entity exceeds 10% under 
one or more test.
    Year 2 (preceding fiscal year)--Financial statements for E and F 
may be omitted since their combined significance is 20% and no other 
combination can be formed with E which would not exceed 20%.
    Year 3 (second preceding fiscal year)--Financial statements for D, 
E and F may be omitted since the combined significance of these 
entities is 33% \22\ and no other combination can be formed with E and 
F which would not exceed 40%.
---------------------------------------------------------------------------

    \22\ Combined significance is the sum of the significance of D's 
investment test (13%), E's earnings test (9%) and F's earnings test 
(11%).
---------------------------------------------------------------------------

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

    \23\ The audited pre-acquisition period need not correspond to 
the acquiree's pre-acquisition fiscal year. However, audited periods 
must not be for periods in excess of 12 months.

----------------------------------------------------------------------------------------------------------------
                                                                                Period in
                                                         Minimum financial     consolidated      Separate pre-
          Component entity                 Date of           statement          financial         acquisition
                                         acquisition        requirement         statements     audited financial
                                                                                 (months)          statement
----------------------------------------------------------------------------------------------------------------
Registrant..........................                N/A                 33                 36  .................
A...................................             1/1/x7                 33                 24                  9
B...................................             4/1/x7                 33                 21            \23\ 12
C...................................             9/1/x7                 33                 16                 17
D...................................             2/1/x8                 21                 11                 10
E...................................            11/1/x8  .................                  2  .................
F...................................    To be acquired.                  9  .................                  9
----------------------------------------------------------------------------------------------------------------

K. Financial Statements of Acquired Troubled Financial Institutions

    Facts: Federally insured depository institutions are subject to 
regulatory oversight by various Federal agencies including the Federal 
Reserve, Office of the Comptroller of the Currency, Federal Deposit 
Insurance Corporation and Office of Thrift Supervision. During the 
1980s, certain of these institutions experienced significant financial 
difficulties resulting in their inability to meet necessary capital and 
other regulatory requirements. The Financial Institutions Reform, 
Recovery and Enforcement Act of 1989 was adopted to address various 
issues affecting this industry.
    Many troubled institutions have merged into stronger institutions 
or reduced the scale of their operations through the sale of branches 
and other assets pursuant to recommendation or directives of the 
regulatory agencies. In other situations, institutions that were taken 
over by or operated under the management of a Federal regulator have 
been reorganized, sold or transferred by that Federal agency to 
financial and nonfinancial companies.
    A number of registrants have acquired, or are contemplating 
acquisition of, these troubled financial institutions. Complete audited 
financial statements of the institutions for the periods necessary to 
comply fully with Rule 3-05 of Regulation S-X may not be reasonably 
available in some cases. Some troubled institutions have never obtained 
an audit while others have been operated under receivership by 
regulators for a significant period without audit. Auditors' reports on 
the financial statements of some of these acquirees may not satisfy the 
requirements of Rule 2-02 of Regulation S-X because they contain 
qualifications due to audit scope limitations or disclaim an opinion.

[[Page 17203]]

    A registrant that acquires a troubled financial institution for 
which complete audited financial statements are not reasonably 
available may be precluded from raising capital through a public 
offering of securities for up to three years following the acquisition 
because of the inability to comply with Rule 3-05.
    Question 1: Are there circumstances under which the staff would 
conclude that financial statements of an acquired troubled financial 
institution are not required by Rule 3-05?
    Interpretive Response: Yes. In some case, financial statements will 
not be required because there is not sufficient continuity of the 
acquired entity's operations prior to and after the acquisition, so 
that disclosure of prior financial information is material to an 
understanding of future operations, as discussed in Rule 11-01 of 
Regulation S-X. For example, such a circumstance may exist in the case 
of an acquisition solely of the physical facilities of a banking branch 
with assumption of the related deposits if neither income-producing 
assets (other than treasury bills and similar low-risk investment) nor 
the management responsible for its historical investment and lending 
activities transfer with the branch to the registrant. In this and 
other circumstances, where the registrant can persuasively demonstrate 
that continuity of operations is substantially lacking and a 
representation to this effect is included in the filing, the staff will 
not object to the omission of financial statements. However, applicable 
disclosures specified by Industry Guide 3, Article 11 of Regulation S-X 
(pro forma information), and other information which is descriptive of 
the transaction and of the assets acquired and liabilities assumed 
should be furnished to the extent reasonably available.
    Question 2: If the acquired financial institution is found to 
constitute a business having material continuity of operations after 
the transaction, are there circumstances in which the staff will waive 
the requirements of Rule 3-05?
    Interpretive Response: Yes. The staff believes the circumstances 
surrounding the present restructuring of U.S. depository institutions 
are unique. Accordingly, the staff has identified situations in which 
it will grant a waiver of the requirements of Rule 3-05 of Regulation 
S-X to the extent that audited financial statements are not reasonably 
available.
    For purposes of this waiver a ``troubled financial institution'' is 
one which either:
    1. Is in receivership, conservatorship or is otherwise operating 
under a similar supervisory agreement with a Federal financial 
regulatory agency; or
    2. Is controlled by a Federal regulatory agency; or
    3. Is acquired in a Federally assisted transaction.

A registrant that acquires a troubled financial institution that is 
deemed significant pursuant to Rule 3-05 may omit audited financial 
statements of the acquired entity, if such statements are not 
reasonably available and the total acquired assets of the troubled 
institution do not exceed 20% of the registrant's assets before giving 
effect to the acquisition. The staff will consider requests for waivers 
in situations involving more significant acquisitions, where Federal 
financial assistance or guarantees are an essential part of the 
transaction, or where the nature and magnitude of Federal assistance is 
so pervasive as to substantially reduce the relevance of such 
information to an assessment of future operations. Where financial 
statements are waived, disclosure concerning the acquired business as 
outlined in response to Question 3 must be furnished.

    Question 3: Where historical financial statements meeting the 
requirements of Rule 3-05 of Regulation S-X are waived, what financial 
statements and other disclosures would the staff expect to be provided 
in filings with the Commission?
    Interpretive Response: Where complete audited historical financial 
statements of a significant acquiree that is a troubled financial 
institution are not provided, the staff would expect filings to include 
an audited statement of assets acquired and liabilities assumed if the 
acquisition is not already reflected in the registrant's most recent 
audited balance sheet at the time the filing is made. Where reasonably 
available, unaudited statement of operations and cash flows that are 
prepared in accordance with GAAP and otherwise comply with Regulation 
S-X should be filed in lieu of any audited financial statements which 
are not provided if historical information may be relevant.
    In all cases where a registrant succeeds to assets and/or 
liabilities of a troubled financial institution which are significant 
to the registrant pursuant to the tests in Rule 1-02(w) of Regulation 
S-X, narrative description should be required, quantified to the extent 
practicable, of the anticipated effects of the acquisition on the 
registrant's financial condition, liquidity, capital resources and 
operating results. If Federal financial assistance (including any 
commitments, agreements or understandings made with respect to capital, 
accounting or other forbearances) may be material, the limits, 
conditions and other variables affecting its availability should be 
disclosed, along with an analysis of its likely short term and long 
term effects on cash flows and reported results.
    If the transaction will result in the recognition of any 
significant intangibles that cannot be separately sold, such as 
goodwill or a core deposit intangible, the discussion of the 
transaction should describe the amount of such intangibles, the 
necessarily subjective nature of the estimation of the life (in the 
case of intangibles subject to amortization) and value of such 
intangibles, and the effects upon future results of operations, 
liquidity and capital resources, including any consequences if a 
recognized intangible will be excluded from the calculation of capital 
for regulatory purposes. The discussion of the impact on future 
operations should specifically address the period over which 
intangibles subject to amortization will be amortized and the period 
over which any discounts on acquired assets will be taken into income. 
If amortization of intangibles subject to amortization will be over a 
period which differs from the period over which income from discounts 
on acquired assets will be recognized (whether from amortization of 
discounts or sale of discounted assets), disclosure should be provided 
concerning the disparate effects of the amortization and income 
recognition on operating results for all affected periods.
    Information specified by Industry Guide 3 should be furnished to 
the extent applicable and reasonably available. For the categories 
identified in the Industry Guide, the registrant should disclose the 
fair value of loans and investments acquired, as well as their 
principal amount and average contractual yield and term. Amounts of 
acquired investments, loans, or other assets that are nonaccrual, past 
due or restructured, or for which other collectibility problems are 
indicated should be disclosed. Where historical financial statements of 
the acquired entity are furnished, pro forma information presented 
pursuant to Rule 11-02 should be supplemented as necessary with a 
discussion of the likely effects of any Federal assistance and changes 
in operations subsequent to the acquisition. To the extent historical 
financial statements meeting all the requirements of Rule 3-05 are not 
furnished, the filing should include an explanation of the basis for 
their omission.

[[Page 17204]]

    Question 4: If an audited statement of assets acquired and 
liabilities assumed is required, but certain of the assets conveyed in 
the transaction are subject to rights allowing the registrant to put 
the assets back to the seller upon completion of a due diligence 
review, will the staff grant an extension of time for filing the 
required financial statement until the put period lapses?
    Interpretive Response: If it is impracticable to provide an audited 
statement at the time the Form 8-K reporting the transaction is filed, 
an extension of time is available under certain circumstances. 
Specifically, if more than 25% of the acquired assets may be put and 
the put period does not exceed 120 days, the registrant should timely 
file a statement of assets acquired and liabilities assumed on an 
unaudited basis with full disclosure of the terms and amounts of the 
put arrangement. Within 21 days after the put period lapses, the 
registrant should furnish an audited statement of assets acquired and 
liabilities assumed unless the effects of the transaction are already 
reflected in an audited balance sheet which has been filed with the 
Commission. However, until the audited financial statement has been 
filed, certain offerings under the Securities Act of 1933 would be 
prevented, as described in the instructions to Item 9.01 of Form 8-K.

L. Removed by SAB 103

M. Materiality

1. Assessing Materiality
    Facts: During the course of preparing or auditing year-end 
financial statements, financial management or the registrant's 
independent auditor becomes aware of misstatements in a registrant's 
financial statements. When combined, the misstatements result in a 4% 
overstatement of net income and a $.02 (4%) overstatement of earnings 
per share. Because no item in the registrant's consolidated financial 
statements is misstated by more than 5%, management and the independent 
auditor conclude that the deviation from GAAP is immaterial and that 
the accounting is permissible.\24\
---------------------------------------------------------------------------

    \24\ AU 312 states that the auditor should consider audit risk 
and materiality both in (a) planning and setting the scope for the 
audit and (b) evaluating whether the financial statements taken as a 
whole are fairly presented in all material respects in conformity 
with GAAP. The purpose of this SAB is to provide guidance to 
financial management and independent auditors with respect to the 
evaluation of the materiality of misstatements that are identified 
in the audit process or preparation of the financial statements 
(i.e., (b) above). This SAB is not intended to provide definitive 
guidance for assessing ``materiality'' in other contexts, such as 
evaluations of auditor independence, as other factors may apply. 
There may be other rules that address financial presentation. See, 
e.g., Rule 2a-4, 17 CFR 270.2a-4, under the Investment Company Act 
of 1940.
---------------------------------------------------------------------------

    Question: FASB ASC paragraph 105-10-05-6 (Generally Accepted 
Accounting Principles Topic) states, ``The provisions of the 
Codification need not be applied to immaterial items.'' In the staff's 
view, may a registrant or the auditor of its financial statements 
assume the immateriality of items that fall below a percentage 
threshold set by management or the auditor to determine whether amounts 
and items are material to the financial statements?
    Interpretive Response: No. The staff is aware that certain 
registrants, over time, have developed quantitative thresholds as 
``rules of thumb'' to assist in the preparation of their financial 
statements, and that auditors also have used these thresholds in their 
evaluation of whether items might be considered material to users of a 
registrant's financial statements. One rule of thumb in particular 
suggests that the misstatement or omission \25\ of an item that falls 
under a 5% threshold is not material in the absence of particularly 
egregious circumstances, such as self-dealing or misappropriation by 
senior management. The staff reminds registrants and the auditors of 
their financial statements that exclusive reliance on this or any 
percentage or numerical threshold has no basis in the accounting 
literature or the law.
---------------------------------------------------------------------------

    \25\ 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, Qualitative Characteristics of Accounting 
Information, the FASB stated the essence of the concept of materiality 
as follows:

    The omission or misstatement of an item in a financial report is 
material if, in the light of surrounding circumstances, the 
magnitude of the item is such that it is probable that the judgment 
of a reasonable person relying upon the report would have been 
changed or influenced by the inclusion or correction of the 
item.\26\

    \26\ Concepts Statement 2, paragraph 132. See also Concepts 
Statement 2, Glossary of Terms--Materiality.
---------------------------------------------------------------------------

    This formulation in the accounting literature is in substance 
identical to the formulation used by the courts in interpreting the 
Federal securities laws. The Supreme Court has held that a fact is 
material if there is--

    a substantial likelihood that the * * * fact would have been 
viewed by the reasonable investor as having significantly altered 
the ``total mix'' of information made available.\27\
---------------------------------------------------------------------------

    \27\ TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). 
See also Basic, Inc. v. Levinson, 485 U.S. 224 (1988). As the 
Supreme Court has noted, determinations of materiality require 
``delicate assessments of the inferences a `reasonable shareholder' 
would draw from a given set of facts and the significance of those 
inferences to him.* * *'' TSC Industries, 426 U.S. at 450.

    Under the governing principles, an assessment of materiality 
requires that one views the facts in the context of the ``surrounding 
circumstances,'' as the accounting literature puts it, or the ``total 
mix'' of information, in the words of the Supreme Court. In the context 
of a misstatement of a financial statement item, while the ``total 
mix'' includes the size in numerical or percentage terms of the 
misstatement, it also includes the factual context in which the user of 
financial statements would view the financial statement item. The 
shorthand in the accounting and auditing literature for this analysis 
is that financial management and the auditor must consider both 
``quantitative'' and ``qualitative'' factors in assessing an item's 
materiality.\28\ Court decisions, Commission rules and enforcement 
actions, and accounting and auditing literature \29\ have all 
considered ``qualitative'' factors in various contexts.
---------------------------------------------------------------------------

    \28\ See, e.g., Concepts Statement 2, paragraphs 123-124; AU 
312A.10 (materiality judgments are made in light of surrounding 
circumstances and necessarily involve both quantitative and 
qualitative considerations); AU 312A.34 (``Qualitative 
considerations also influence the auditor in reaching a conclusion 
as to whether misstatements are material.''). As used in the 
accounting literature and in this SAB, ``qualitative'' materiality 
refers to the surrounding circumstances that inform an investor's 
evaluation of financial statement entries. Whether events may be 
material to investors for non-financial reasons is a matter not 
addressed by this SAB.
    \29\ See, e.g., Rule 1-02(o) of Regulation S-X, 17 CFR 210.1-
02(o), Rule 405 of Regulation C, 17 CFR 230.405, and Rule 12b-2, 17 
CFR 240.12b-2; AU 312A.10-.11, 317.13, 411.04 n. 1, and 508.36; In 
re Kidder Peabody Securities Litigation, 10 F. Supp. 2d 398 
(S.D.N.Y. 1998); Parnes v. Gateway 2000, Inc., 122 F.3d 539 (8th 
Cir. 1997); In re Westinghouse Securities Litigation, 90 F.3d 696 
(3d Cir. 1996); In the Matter of W.R. Grace & Co., Accounting and 
Auditing Enforcement Release (``AAER'') 1140 (June 30, 1999); In the 
Matter of Eugene Gaughan, AAER 1141 (June 30, 1999); In the Matter 
of Thomas Scanlon, AAER 1142 (June 30, 1999); and In re Sensormatic 
Electronics Corporation, Sec. Act Rel. No. 7518 (March 25, 1998).

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[[Page 17205]]

    The FASB has long emphasized that materiality cannot be reduced to 
a numerical formula. In its Concepts Statement 2, the FASB noted that 
some had urged it to promulgate quantitative materiality guides for use 
in a variety of situations. The FASB rejected such an approach as 
---------------------------------------------------------------------------
representing only a ``minority view, stating--

    The predominant view is that materiality judgments can properly 
be made only by those who have all the facts. The Board's present 
position is that no general standards of materiality could be 
formulated to take into account all the considerations that enter 
into an experienced human judgment.\30\
---------------------------------------------------------------------------

    \30\ Concepts Statement 2, paragraph 131.

    The FASB noted that, in certain limited circumstances, the 
Commission and other authoritative bodies had issued quantitative 
materiality guidance, citing as examples guidelines ranging from one to 
ten percent with respect to a variety of disclosures.\31\ And it took 
account of contradictory studies, one showing a lack of uniformity 
among auditors on materiality judgments, and another suggesting 
widespread use of a ``rule of thumb'' of five to ten percent of net 
income.\32\ The FASB also considered whether an evaluation of 
materiality could be based solely on anticipating the market's reaction 
to accounting information.\33\
---------------------------------------------------------------------------

    \31\ Concepts Statement 2, paragraphs 131 and 166.
    \32\ Concepts Statement 2, paragraph 167.
    \33\ Concepts Statement 2, paragraphs 168-169.
---------------------------------------------------------------------------

    The FASB rejected a formulaic approach to discharging ``the onerous 
duty of making materiality decisions'' \34\ in favor of an approach 
that takes into account all the relevant considerations. In so doing, 
it made clear that--
---------------------------------------------------------------------------

    \34\ Concepts Statement 2, paragraph 170.

    [M]agnitude by itself, without regard to the nature of the item 
and the circumstances in which the judgment has to be made, will not 
generally be a sufficient basis for a materiality judgment.\35\
---------------------------------------------------------------------------

    \35\ Concepts Statement 2, paragraph 125.

    Evaluation of materiality requires a registrant and its auditor to 
consider all the relevant circumstances, and the staff believes that 
there are numerous circumstances in which misstatements below 5% could 
well be material. Qualitative factors may cause misstatements of 
quantitatively small amounts to be material; as stated in the auditing 
---------------------------------------------------------------------------
literature:

    As a result of the interaction of quantitative and qualitative 
considerations in materiality judgments, misstatements of relatively 
small amounts that come to the auditor's attention could have a 
material effect on the financial statements.\36\

    \36\ AU 312.11.

    Among the considerations that may well render material a 
quantitatively small misstatement of a financial statement item are--
     Whether the misstatement arises from an item capable of 
precise measurement or whether it arises from an estimate and, if so, 
the degree of imprecision inherent in the estimate.\37\
---------------------------------------------------------------------------

    \37\ As stated in Concepts Statement 2, paragraph 130:
    Another factor in materiality judgments is the degree of 
precision that is attainable in estimating the judgment item. The 
amount of deviation that is considered immaterial may increase as 
the attainable degree of precision decreases. For example, accounts 
payable usually can be estimated more accurately than can contingent 
liabilities arising from litigation or threats of it, and a 
deviation considered to be material in the first case may be quite 
trivial in the second.
    This SAB is not intended to change current law or guidance in 
the accounting literature regarding accounting estimates. See, e.g., 
FASB ASC Topic 250, Accounting Changes and Error Corrections.
---------------------------------------------------------------------------

     Whether the misstatement masks a change in earnings or 
other trends.
     Whether the misstatement hides a failure to meet analysts' 
consensus expectations for the enterprise.
     Whether the misstatement changes a loss into income or 
vice versa.
     Whether the misstatement concerns a segment or other 
portion of the registrant's business that has been identified as 
playing a significant role in the registrant's operations or 
profitability.
     Whether the misstatement affects the registrant's 
compliance with regulatory requirements.
     Whether the misstatement affects the registrant's 
compliance with loan covenants or other contractual requirements.
     Whether the misstatement has the effect of increasing 
management's compensation--for example, by satisfying requirements for 
the award of bonuses or other forms of incentive compensation.
     Whether the misstatement involves concealment of an 
unlawful transaction.
    This is not an exhaustive list of the circumstances that may affect 
the materiality of a quantitatively small misstatement.\38\ Among other 
factors, the demonstrated volatility of the price of a registrant's 
securities in response to certain types of disclosures may provide 
guidance as to whether investors regard quantitatively small 
misstatements as material. Consideration of potential market reaction 
to disclosure of a misstatement is by itself ``too blunt an instrument 
to be depended on'' in considering whether a fact is material.\39\ 
When, however, management or the independent auditor expects (based, 
for example, on a pattern of market performance) that a known 
misstatement may result in a significant positive or negative market 
reaction, that expected reaction should be taken into account when 
considering whether a misstatement is material.\40\
---------------------------------------------------------------------------

    \38\ The staff understands that the Big Five Audit Materiality 
Task Force (``Task Force'') was convened in March of 1998 and has 
made recommendations to the Auditing Standards Board including 
suggestions regarding communications with audit committees about 
unadjusted misstatements. See generally Big Five Audit Materiality 
Task Force. ``Materiality in a Financial Statement Audit--
Considering Qualitative Factors When Evaluating Audit Findings'' 
(August 1998).
    \39\ See Concepts Statement 2, paragraph 169.
    \40\ If management does not expect a significant market 
reaction, a misstatement still may be material and should be 
evaluated under the criteria discussed in this SAB.
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    For the reasons noted above, the staff believes that a registrant 
and the auditors of its financial statements should not assume that 
even small intentional misstatements in financial statements, for 
example those pursuant to actions to ``manage'' earnings, are 
immaterial.\41\ While the intent of management does not render a 
misstatement material, it may provide significant evidence of 
materiality. The evidence may be particularly compelling where 
management has intentionally misstated items in the financial 
statements to ``manage'' reported earnings. In that instance, it 
presumably has done so believing that the resulting amounts and trends 
would be significant to users of the registrant's financial 
statements.\42\ The staff believes that investors generally would 
regard as significant a management practice to over- or under-state 
earnings up to an amount just short of a percentage threshold in order 
to ``manage'' earnings. Investors presumably also would regard as 
significant an accounting practice that, in essence, rendered all 
earnings figures subject to a management-directed margin of 
misstatement.
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    \41\ Intentional management of earnings and intentional 
misstatements, as used in this SAB, do not include insignificant 
errors and omissions that may occur in systems and recurring 
processes in the normal course of business. See notes 37 and 49 
infra.
    \42\ Assessments of materiality should occur not only at year-
end, but also during the preparation of each quarterly or interim 
financial statement. See, e.g., In the Matter of Venator Group, 
Inc., AAER 1049 (June 29, 1998).
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    The materiality of a misstatement may turn on where it appears in 
the financial statements. For example, a misstatement may involve a 
segment of the

[[Page 17206]]

registrant's operations. In that instance, in assessing materiality of 
a misstatement to the financial statements taken as a whole, 
registrants and their auditors should consider not only the size of the 
misstatement but also the significance of the segment information to 
the financial statements taken as a whole.\43\ ``A misstatement of the 
revenue and operating profit of a relatively small segment that is 
represented by management to be important to the future profitability 
of the entity'' \44\ is more likely to be material to investors than a 
misstatement in a segment that management has not identified as 
especially important. In assessing the materiality of misstatements in 
segment information--as with materiality generally--
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    \43\ See, e.g., In the Matter of W.R. Grace & Co., AAER 1140 
(June 30, 1999).
    \44\ AU 9326.33.
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    situations may arise in practice where the auditor will conclude 
that a matter relating to segment information is qualitatively 
material even though, in his or her judgment, it is quantitatively 
immaterial to the financial statements taken as a whole.\45\
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    \45\ Id.
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Aggregating and Netting Misstatements
    In determining whether multiple misstatements cause the financial 
statements to be materially misstated, registrants and the auditors of 
their financial statements should consider each misstatement separately 
and the aggregate effect of all misstatements.\46\ A registrant and its 
auditor should evaluate misstatements in light of quantitative and 
qualitative factors and ``consider whether, in relation to individual 
amounts, subtotals, or totals in the financial statements, they 
materially misstate the financial statements taken as a whole.'' \47\ 
This requires consideration of--
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    \46\ The auditing literature notes that the ``concept of 
materiality recognizes that some matters, either individually or in 
the aggregate, are important for fair presentation of financial 
statements in conformity with generally accepted accounting 
principles.'' AU 312.03. See also AU 312.04.
    \47\ AU 312.34. Quantitative materiality assessments often are 
made by comparing adjustments to revenues, gross profit, pretax and 
net income, total assets, stockholders' equity, or individual line 
items in the financial statements. The particular items in the 
financial statements to be considered as a basis for the materiality 
determination depend on the proposed adjustment to be made and other 
factors, such as those identified in this SAB. For example, an 
adjustment to inventory that is immaterial to pretax income or net 
income may be material to the financial statements because it may 
affect a working capital ratio or cause the registrant to be in 
default of loan covenants.

    the significance of an item to a particular entity (for example, 
inventories to a manufacturing company), the pervasiveness of the 
misstatement (such as whether it affects the presentation of 
numerous financial statement items), and the effect of the 
misstatement on the financial statements taken as a whole.* * * \48\
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    \48\ AU 508.36.

    Registrants and their auditors first should consider whether each 
misstatement is material, irrespective of its effect when combined with 
other misstatements. The literature notes that the analysis should 
consider whether the misstatement of ``individual amounts'' causes a 
material misstatement of the financial statements taken as a whole. As 
with materiality generally, this analysis requires consideration of 
both quantitative and qualitative factors.
    If the misstatement of an individual amount causes the financial 
statements as a whole to be materially misstated, that effect cannot be 
eliminated by other misstatements whose effect may be to diminish the 
impact of the misstatement on other financial statement items. To take 
an obvious example, if a registrant's revenues are a material financial 
statement item and if they are materially overstated, the financial 
statements taken as a whole will be materially misleading even if the 
effect on earnings is completely offset by an equivalent overstatement 
of expenses.
    Even though a misstatement of an individual amount may not cause 
the financial statements taken as a whole to be materially misstated, 
it may nonetheless, when aggregated with other misstatements, render 
the financial statements taken as a whole to be materially misleading. 
Registrants and the auditors of their financial statements accordingly 
should consider the effect of the misstatement on subtotals or totals. 
The auditor should aggregate all misstatements that affect each 
subtotal or total and consider whether the misstatements in the 
aggregate affect the subtotal or total in a way that causes the 
registrant's financial statements taken as a whole to be materially 
misleading.\49\
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    \49\ AU 312.34.
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    The staff believes that, in considering the aggregate effect of 
multiple misstatements on a subtotal or total, registrants and the 
auditors of their financial statements should exercise particular care 
when considering whether to offset (or the appropriateness of 
offsetting) a misstatement of an estimated amount with a misstatement 
of an item capable of precise measurement. As noted above, assessments 
of materiality should never be purely mechanical; given the imprecision 
inherent in estimates, there is by definition a corresponding 
imprecision in the aggregation of misstatements involving estimates 
with those that do not involve an estimate.
    Registrants and auditors also should consider the effect of 
misstatements from prior periods on the current financial statements. 
For example, the auditing literature states,

    Matters underlying adjustments proposed by the auditor but not 
recorded by the entity could potentially cause future financial 
statements to be materially misstated, even though the auditor has 
concluded that the adjustments are not material to the current 
financial statements.\50\

    \50\ AU 380.09.

This may be particularly the case where immaterial misstatements recur 
in several years and the cumulative effect becomes material in the 
current year.
2. Immaterial Misstatements That Are Intentional
    Facts: A registrant's management intentionally has made adjustments 
to various financial statement items in a manner inconsistent with 
GAAP. In each accounting period in which such actions were taken, none 
of the individual adjustments is by itself material, nor is the 
aggregate effect on the financial statements taken as a whole material 
for the period. The registrant's earnings ``management'' has been 
effected at the direction or acquiescence of management in the belief 
that any deviations from GAAP have been immaterial and that accordingly 
the accounting is permissible.
    Question: In the staff's view, may a registrant make intentional 
immaterial misstatements in its financial statements?
    Interpretive Response: No. In certain circumstances, intentional 
immaterial misstatements are unlawful.
Considerations of the Books and Records Provisions Under the Exchange 
Act
    Even if misstatements are immaterial,\51\ registrants must comply 
with Sections 13(b)(2)--(7) of the Securities Exchange Act of 1934 (the 
``Exchange Act'').\52\ Under these provisions, each registrant with

[[Page 17207]]

securities registered pursuant to Section 12 of the Exchange Act,\53\ 
or required to file reports pursuant to Section 15(d),\54\ must make 
and keep books, records, and accounts, which, in reasonable detail, 
accurately and fairly reflect the transactions and dispositions of 
assets of the registrant and must maintain internal accounting controls 
that are sufficient to provide reasonable assurances that, among other 
things, transactions are recorded as necessary to permit the 
preparation of financial statements in conformity with GAAP.\55\ In 
this context, determinations of what constitutes ``reasonable 
assurance'' and ``reasonable detail'' are based not on a 
``materiality'' analysis but on the level of detail and degree of 
assurance that would satisfy prudent officials in the conduct of their 
own affairs.\56\ Accordingly, failure to record accurately immaterial 
items, in some instances, may result in violations of the securities 
laws.
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    \51\ FASB ASC paragraph 105-10-05-6 states that ``[t]he 
provisions of the Codification need not be applied to immaterial 
items.'' This SAB is consistent with that provision of the 
Codification. In theory, this language is subject to the 
interpretation that the registrant is free intentionally to set 
forth immaterial items in financial statements in a manner that 
plainly would be contrary to GAAP if the misstatement were material. 
The staff believes that the FASB did not intend this result.
    \52\ 15 U.S.C. 78m(b)(2)-(7).
    \53\ 15 U.S.C. 78l.
    \54\ 15 U.S.C. 78o(d).
    \55\ Criminal liability may be imposed if a person knowingly 
circumvents or knowingly fails to implement a system of internal 
accounting controls or knowingly falsifies books, records or 
accounts. 15 U.S.C. 78m(4) and (5). See also Rule 13b2-1 under the 
Exchange Act, 17 CFR 240.13b2-1, which states, ``No person shall, 
directly or indirectly, falsify or cause to be falsified, any book, 
record or account subject to Section 13(b)(2)(A) of the Securities 
Exchange Act.''
    \56\ 15 U.S.C. 78m(b)(7). The books and records provisions of 
section 13(b) of the Exchange Act originally were passed as part of 
the Foreign Corrupt Practices Act (``FCPA''). In the conference 
committee report regarding the 1988 amendments to the FCPA, the 
committee stated:
    The conference committee adopted the prudent man qualification 
in order to clarify that the current standard does not connote an 
unrealistic degree of exactitude or precision. The concept of 
reasonableness of necessity contemplates the weighing of a number of 
relevant factors, including the costs of compliance.
    Cong. Rec. H2116 (daily ed. April 20, 1988).
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    The staff recognizes that there is limited authoritative guidance 
\57\ regarding the ``reasonableness'' standard in Section 13(b)(2) of 
the Exchange Act. A principal statement of the Commission's policy in 
this area is set forth in an address given in 1981 by then Chairman 
Harold M. Williams.\58\ In his address, Chairman Williams noted that, 
like materiality, ``reasonableness'' is not an ``absolute standard of 
exactitude for corporate records.'' \59\ Unlike materiality, however, 
``reasonableness'' is not solely a measure of the significance of a 
financial statement item to investors. ``Reasonableness,'' in this 
context, reflects a judgment as to whether an issuer's failure to 
correct a known misstatement implicates the purposes underlying the 
accounting provisions of Sections 13(b)(2)--(7) of the Exchange 
Act.\60\
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    \57\ So far as the staff is aware, there is only one judicial 
decision that discusses Section 13(b)(2) of the Exchange Act in any 
detail, SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724 
(N.D. Ga. 1983), and the courts generally have found that no private 
right of action exists under the accounting and books and records 
provisions of the Exchange Act. See e.g., Lamb v. Phillip Morris 
Inc., 915 F.2d 1024 (6th Cir. 1990) and JS Service Center 
Corporation v. General Electric Technical Services Company, 937 F. 
Supp. 216 (S.D.N.Y. 1996).
    \58\ The Commission adopted the address as a formal statement of 
policy in Securities Exchange Act Release No. 17500 (January 29, 
1981), 46 FR 11544 (February 9, 1981), 21 SEC Docket 1466 (February 
10, 1981).
    \59\ Id. at 46 FR 11546.
    \60\ Id.
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    In assessing whether a misstatement results in a violation of a 
registrant's obligation to keep books and records that are accurate 
``in reasonable detail,'' registrants and their auditors should 
consider, in addition to the factors discussed above concerning an 
evaluation of a misstatement's potential materiality, the factors set 
forth below.
     The significance of the misstatement. Though the staff 
does not believe that registrants need to make finely calibrated 
determinations of significance with respect to immaterial items, 
plainly it is ``reasonable'' to treat misstatements whose effects are 
clearly inconsequential differently than more significant ones.
     How the misstatement arose. It is unlikely that it is ever 
``reasonable'' for registrants to record misstatements or not to 
correct known misstatements--even immaterial ones--as part of an 
ongoing effort directed by or known to senior management for the 
purposes of ``managing'' earnings. On the other hand, insignificant 
misstatements that arise from the operation of systems or recurring 
processes in the normal course of business generally will not cause a 
registrant's books to be inaccurate ``in reasonable detail.'' \61\
---------------------------------------------------------------------------

    \61\ For example, the conference report regarding the 1988 
amendments to the FCPA stated:
    The Conferees intend to codify current Securities and Exchange 
Commission (SEC) enforcement policy that penalties not be imposed 
for insignificant or technical infractions or inadvertent conduct. 
The amendment adopted by the Conferees [Section 13(b)(4)] 
accomplishes this by providing that criminal penalties shall not be 
imposed for failing to comply with the FCPA's books and records or 
accounting provisions. This provision [Section 13(b)(5)] is meant to 
ensure that criminal penalties would be imposed where acts of 
commission or omission in keeping books or records or administering 
accounting controls have the purpose of falsifying books, records or 
accounts, or of circumventing the accounting controls set forth in 
the Act. This would include the deliberate falsification of books 
and records and other conduct calculated to evade the internal 
accounting controls requirement.
    Cong. Rec. H2115 (daily ed. April 20, 1988).
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     The cost of correcting the misstatement. The books and 
records provisions of the Exchange Act do not require registrants to 
make major expenditures to correct small misstatements.\62\ Conversely, 
where there is little cost or delay involved in correcting a 
misstatement, failing to do so is unlikely to be ``reasonable.''
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    \62\ As Chairman Williams noted with respect to the internal 
control provisions of the FCPA, ``[t]housands of dollars ordinarily 
should not be spent conserving hundreds.'' 46 FR 11546.
---------------------------------------------------------------------------

     The clarity of authoritative accounting guidance with 
respect to the misstatement. Where reasonable minds may differ about 
the appropriate accounting treatment of a financial statement item, a 
failure to correct it may not render the registrant's financial 
statements inaccurate ``in reasonable detail.'' Where, however, there 
is little ground for reasonable disagreement, the case for leaving a 
misstatement uncorrected is correspondingly weaker.

There may be other indicators of ``reasonableness'' that registrants 
and their auditors may ordinarily consider. Because the judgment is not 
mechanical, the staff will be inclined to continue to defer to 
judgments that ``allow a business, acting in good faith, to comply with 
the Act's accounting provisions in an innovative and cost-effective 
way.'' \63\
---------------------------------------------------------------------------

    \63\ Id., at 11547.
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The Auditor's Response to Intentional Misstatements
    Section 10A(b) of the Exchange Act requires auditors to take 
certain actions upon discovery of an ``illegal act.'' \64\ The statute 
specifies that these obligations are triggered ``whether or not [the 
illegal acts are] perceived to have a material effect on the financial 
statements of the issuer. * * *'' Among other things, Section 10A(b)(1) 
requires the auditor to inform the appropriate level of management of 
an illegal act (unless clearly inconsequential) and assure that the 
registrant's audit committee is ``adequately informed'' with respect to 
the illegal act.
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    \64\ Section 10A(f) defines, for purposes of Section 10A, an 
``illegal act'' as ``an act or omission that violates any law, or 
any rule or regulation having the force of law.'' This is broader 
than the definition of an ``illegal act'' in AU 317.02, which 
states, ``Illegal acts by clients do not include personal misconduct 
by the entity's personnel unrelated to their business activities.''
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    As noted, an intentional misstatement of immaterial items in a 
registrant's financial statements may violate Section 13(b)(2) of the 
Exchange Act and thus be an illegal act. When such a violation occurs, 
an auditor must take steps to see that the registrant's audit committee 
is ``adequately informed'' about the illegal act. Because Section 
10A(b)(1) is triggered regardless of whether an illegal

[[Page 17208]]

act has a material effect on the registrant's financial statements, 
where the illegal act consists of a misstatement in the registrant's 
financial statements, the auditor will be required to report that 
illegal act to the audit committee irrespective of any ``netting'' of 
the misstatements with other financial statement items.
    The requirements of Section 10A echo the auditing literature. See, 
e.g., Statement on Auditing Standards (SAS) Nos. 54 and 99. Pursuant to 
paragraph 77 of SAS 99, if the auditor determines there is evidence 
that fraud may exist, the auditor must discuss the matter with the 
appropriate level of management that is at least one level above those 
involved, and with senior management and the audit committee. The 
auditor must report directly to the audit committee fraud involving 
senior management and fraud that causes a material misstatement of the 
financial statements. Paragraph 6 of SAS 99 states that ``misstatements 
arising from fraudulent financial reporting are intentional 
misstatements or omissions of amounts or disclosures in financial 
statements designed to deceive financial statement users * * *'' \65\ 
SAS 99 further states that fraudulent financial reporting may involve 
falsification or alteration of accounting records; misrepresenting or 
omitting events, transactions or other information in the financial 
statements; and the intentional misapplication of accounting principles 
relating to amounts, classifications, the manner of presentation, or 
disclosures in the financial statements.\66\ The clear implication of 
SAS 99 is that immaterial misstatements may be fraudulent financial 
reporting.\67\
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    \65\ An unintentional illegal act triggers the same procedures 
and considerations by the auditor as a fraudulent misstatement if 
the illegal act has a direct and material effect on the financial 
statements. See AU 110 n. 1, 317.05 and 317.07. Although 
distinguishing between intentional and unintentional misstatements 
is often difficult, the auditor must plan and perform the audit to 
obtain reasonable assurance that the financial statements are free 
of material misstatements in either case.
    \66\ Although the auditor is not required to plan or perform the 
audit to detect misstatements that are immaterial to the financial 
statements, SAS 99 requires the auditor to evaluate several fraud 
``risk factors'' that may bring such misstatements to his or her 
attention. For example, an analysis of fraud risk factors under SAS 
99 must include, among other things, consideration of management's 
interest in maintaining or increasing the registrant's stock price 
or earnings trend through the use of unusually aggressive accounting 
practices, whether management has a practice of committing to 
analysts or others that it will achieve unduly aggressive or clearly 
unrealistic forecasts, and the existence of assets, liabilities, 
revenues, or expenses based on significant estimates that involve 
unusually subjective judgments or uncertainties.
    \67\ In requiring the auditor to consider whether fraudulent 
misstatements are material, and in requiring differing responses 
depending on whether the misstatement is material, SAS 99 makes 
clear that fraud can involve immaterial misstatements. Indeed, a 
misstatement can be ``inconsequential'' and still involve fraud. 
Under SAS 99, assessing whether misstatements due to fraud are 
material to the financial statements is a ``cumulative process'' 
that should occur both during and at the completion of the audit. 
SAS 99 further states that this accumulation is primarily a 
``qualitative matter'' based on the auditor's judgment. The staff 
believes that in making these assessments, management and auditors 
should refer to the discussion in Part 1 of this SAB.
---------------------------------------------------------------------------

    Auditors that learn of intentional misstatements may also be 
required to (1) re-evaluate the degree of audit risk involved in the 
audit engagement, (2) determine whether to revise the nature, timing, 
and extent of audit procedures accordingly, and (3) consider whether to 
resign.\68\
---------------------------------------------------------------------------

    \68\ Auditors should document their determinations in accordance 
with SAS 96, SAS 99, and other appropriate sections of the audit 
literature.
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    Intentional misstatements also may signal the existence of 
reportable conditions or material weaknesses in the registrant's system 
of internal accounting control designed to detect and deter improper 
accounting and financial reporting.\69\ As stated by the National 
Commission on Fraudulent Financial Reporting, also known as the 
Treadway Commission, in its 1987 report,
---------------------------------------------------------------------------

    \69\ See, e.g., SAS 99.

    The tone set by top management--the corporate environment or 
culture within which financial reporting occurs--is the most 
important factor contributing to the integrity of the financial 
reporting process. Notwithstanding an impressive set of written 
rules and procedures, if the tone set by management is lax, 
fraudulent financial reporting is more likely to occur.\70\
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    \70\ Report of the National Commission on Fraudulent Financial 
Reporting at 32 (October 1987). See also Report and Recommendations 
of the Blue Ribbon Committee on Improving the Effectiveness of 
Corporate Audit Committees (February 8, 1999).

    An auditor is required to report to a registrant's audit committee 
any reportable conditions or material weaknesses in a registrant's 
system of internal accounting control that the auditor discovers in the 
course of the examination of the registrant's financial statements.\71\
---------------------------------------------------------------------------

    \71\ AU 325.02. See also AU 380.09, which, in discussing matters 
to be communicated by the auditor to the audit committee, states:
    The auditor should inform the audit committee about adjustments 
arising from the audit that could, in his judgment, either 
individually or in the aggregate, have a significant effect on the 
entity's financial reporting process. For purposes of this section, 
an audit adjustment, whether or not recorded by the entity, is a 
proposed correction of the financial statements. * * *
---------------------------------------------------------------------------

GAAP Precedence Over Industry Practice
    Some have argued to the staff that registrants should be permitted 
to follow an industry accounting practice even though that practice is 
inconsistent with authoritative accounting literature. This situation 
might occur if a practice is developed when there are few transactions 
and the accounting results are clearly inconsequential, and that 
practice never changes despite a subsequent growth in the number or 
materiality of such transactions. The staff disagrees with this 
argument. Authoritative literature takes precedence over industry 
practice that is contrary to GAAP.\72\
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    \72\ See AU 411.05.
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General Comments
    This SAB is not intended to change current law or guidance in the 
accounting or auditing literature.\73\ This SAB and the authoritative 
accounting literature cannot specifically address all of the novel and 
complex business transactions and events that may occur. Accordingly, 
registrants may account for, and make disclosures about, these 
transactions and events based on analogies to similar situations or 
other factors. The staff may not, however, always be persuaded that a 
registrant's determination is the most appropriate under the 
circumstances. When disagreements occur after a transaction or an event 
has been reported, the consequences may be severe for registrants, 
auditors, and, most importantly, the users of financial statements who 
have a right to expect consistent accounting and reporting for, and 
disclosure of, similar transactions and events. The staff, therefore,

[[Page 17209]]

encourages registrants and auditors to discuss on a timely basis with 
the staff proposed accounting treatments for, or disclosures about, 
transactions or events that are not specifically covered by the 
existing accounting literature.
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    \73\ The FASB Discussion Memorandum, ``Criteria for Determining 
Materiality,'' states that the financial accounting and reporting 
process considers that ``a great deal of the time might be spent 
during the accounting process considering insignificant matters. * * 
* If presentations of financial information are to be prepared 
economically on a timely basis and presented in a concise 
intelligible form, the concept of materiality is crucial.'' This SAB 
is not intended to require that misstatements arising from 
insignificant errors and omissions (individually and in the 
aggregate) arising from the normal recurring accounting close 
processes, such as a clerical error or an adjustment for a missed 
accounts payable invoice, always be corrected, even if the error is 
identified in the audit process and known to management. Management 
and the auditor would need to consider the various factors described 
elsewhere in this SAB in assessing whether such misstatements are 
material, need to be corrected to comply with the FCPA, or trigger 
procedures under Section 10A of the Exchange Act. Because this SAB 
does not change current law or guidance in the accounting or 
auditing literature, adherence to the principles described in this 
SAB should not raise the costs associated with recordkeeping or with 
audits of financial statements.
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N. Considering the Effects of Prior Year Misstatements When Quantifying 
Misstatements in Current Year Financial Statements

(Added by SAB 108)
    Facts: During the course of preparing annual financial statements, 
a registrant is evaluating the materiality of an improper expense 
accrual (e.g., overstated liability) in the amount of $100, which has 
built up over 5 years, at $20 per year.\74\ The registrant previously 
evaluated the misstatement as being immaterial to each of the prior 
year financial statements (i.e., years 1-4). For the purpose of 
evaluating materiality in the current year (i.e., year 5), the 
registrant quantifies the error as a $20 overstatement of expenses.
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    \74\ For purposes of these facts, assume the registrant properly 
determined that the overstatement of the liability resulted from an 
error rather than a change in accounting estimate. See the FASB ASC 
Master Glossary for the distinction between an error in previously 
issued financial statements and a change in accounting estimate.
---------------------------------------------------------------------------

    Question 1: Has the registrant appropriately quantified the amount 
of this error for the purpose of evaluating materiality for the current 
year?
    Interpretive Response: No. In this example, the registrant has only 
quantified the effects of the identified unadjusted error that arose in 
the current year income statement. The staff believes a registrant's 
materiality evaluation of an identified unadjusted error should 
quantify the effects of the identified unadjusted error on each 
financial statement and related financial statement disclosure.
    Topic 1M notes that a materiality evaluation must be based on all 
relevant quantitative and qualitative factors.\75\ This analysis 
generally begins with quantifying potential misstatements to be 
evaluated. There has been diversity in practice with respect to this 
initial step of a materiality analysis.
---------------------------------------------------------------------------

    \75\ Topic 1N addresses certain of these quantitative issues, 
but does not alter the analysis required by Topic 1M.
---------------------------------------------------------------------------

    The diversity in approaches for quantifying the amount of 
misstatements primarily stems from the effects of misstatements that 
were not corrected at the end of the prior year (``prior year 
misstatements''). These prior year misstatements should be considered 
in quantifying misstatements in current year financial statements.
    The techniques most commonly used in practice to accumulate and 
quantify misstatements are generally referred to as the ``rollover'' 
and ``iron curtain'' approaches.
    The rollover approach, which is the approach used by the registrant 
in this example, quantifies a misstatement based on the amount of the 
error originating in the current year income statement. Thus, this 
approach ignores the effects of correcting the portion of the current 
year balance sheet misstatement that originated in prior years (i.e., 
it ignores the ``carryover effects'' of prior year misstatements).
    The iron curtain approach quantifies a misstatement based on the 
effects of correcting the misstatement existing in the balance sheet at 
the end of the current year, irrespective of the misstatement's year(s) 
of origination. Had the registrant in this fact pattern applied the 
iron curtain approach, the misstatement would have been quantified as a 
$100 misstatement based on the end of year balance sheet misstatement. 
Thus, the adjustment needed to correct the financial statements for the 
end of year error would be to reduce the liability by $100 with a 
corresponding decrease in current year expense.
    As demonstrated in this example, the primary weakness of the 
rollover approach is that it can result in the accumulation of 
significant misstatements on the balance sheet that are deemed 
immaterial in part because the amount that originates in each year is 
quantitatively small. The staff is aware of situations in which a 
registrant, relying on the rollover approach, has allowed an erroneous 
item to accumulate on the balance sheet to the point where eliminating 
the improper asset or liability would itself result in a material error 
in the income statement if adjusted in the current year. Such 
registrants have sometimes concluded that the improper asset or 
liability should remain on the balance sheet into perpetuity.
    In contrast, the primary weakness of the iron curtain approach is 
that it does not consider the correction of prior year misstatements in 
the current year (i.e., the reversal of the carryover effects) to be 
errors. Therefore, in this example, if the misstatement was corrected 
during the current year such that no error existed in the balance sheet 
at the end of the current year, the reversal of the $80 prior year 
misstatement would not be considered an error in the current year 
financial statements under the iron curtain approach. Implicitly, the 
iron curtain approach assumes that because the prior year financial 
statements were not materially misstated, correcting any immaterial 
errors that existed in those statements in the current year is the 
``correct'' accounting, and is therefore not considered an error in the 
current year. Thus, utilization of the iron curtain approach can result 
in a misstatement in the current year income statement not being 
evaluated as an error at all.
    The staff does not believe the exclusive reliance on either the 
rollover or iron curtain approach appropriately quantifies all 
misstatements that could be material to users of financial statements.
    In describing the concept of materiality, Concepts Statement 2, 
Qualitative Characteristics of Accounting Information, indicates that 
materiality determinations are based on whether ``it is probable that 
the judgment of a reasonable person relying upon the report would have 
been changed or influenced by the inclusion or correction of the item'' 
(emphasis added).\76\ The staff believes registrants must quantify the 
impact of correcting all misstatements, including both the carryover 
and reversing effects of prior year misstatements, on the current year 
financial statements. The staff believes that this can be accomplished 
by quantifying an error under both the rollover and iron curtain 
approaches as described above and by evaluating the error measured 
under each approach. Thus, a registrant's financial statements would 
require adjustment when either approach results in quantifying a 
misstatement that is material, after considering all relevant 
quantitative and qualitative factors.
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    \76\ Concepts Statement 2, paragraph 132. See also Concepts 
Statement 2, Glossary of Terms--Materiality.
---------------------------------------------------------------------------

    As a reminder, a change from an accounting principle that is not 
generally accepted to one that is generally accepted is a correction of 
an error.\77\
---------------------------------------------------------------------------

    \77\ See definition of ``error in previously issued financial 
statements'' in the FASB ASC Master Glossary.
---------------------------------------------------------------------------

    The staff believes that the registrant should quantify the current 
year misstatement in this example using both the iron curtain approach 
(i.e., $100) and the rollover approach (i.e., $20). Therefore, if the 
$100 misstatement is considered material to the financial statements, 
after all of the relevant quantitative and qualitative factors are 
considered, the registrant's financial statements would need to be 
adjusted.
    It is possible that correcting an error in the current year could 
materially misstate the current year's income statement. For example, 
correcting the

[[Page 17210]]

$100 misstatement in the current year will:
     Correct the $20 error originating in the current year;
     Correct the $80 balance sheet carryover error that 
originated in Years 1 through 4; but also
     Misstate the current year income statement by $80.
    If the $80 understatement of current year expense is material to 
the current year, after all of the relevant quantitative and 
qualitative factors are considered, the prior year financial statements 
should be corrected, even though such revision previously was and 
continues to be immaterial to the prior year financial statements. 
Correcting prior year financial statements for immaterial errors would 
not require previously filed reports to be amended. Such correction may 
be made the next time the registrant files the prior year financial 
statements.
    The following example further illustrates the staff's views on 
quantifying misstatements, including the consideration of the effects 
of prior year misstatements:
    Facts: During the course of preparing annual financial statements, 
a registrant is evaluating the materiality of a sales cut-off error in 
which $50 of revenue from the following year was recorded in the 
current year, thereby overstating accounts receivable by $50 at the end 
of the current year. In addition, a similar sales cut-off error existed 
at the end of the prior year in which $110 of revenue from the current 
year was recorded in the prior year. As a result of the combination of 
the current year and prior year cut-off errors, revenues in the current 
year are understated by $60 ($110 understatement of revenues at the 
beginning of the current year partially offset by a $50 overstatement 
of revenues at the end of the current year). The prior year error was 
evaluated in the prior year as being immaterial to those financial 
statements.
    Question 2: How should the registrant quantify the misstatement in 
the current year financial statements?
    Interpretive Response: The staff believes the registrant should 
quantify the current year misstatement in this example using both the 
iron curtain approach (i.e., $50) and the rollover approach (i.e., 
$60). Therefore, assuming a $60 misstatement is considered material to 
the financial statements, after all relevant quantitative and 
qualitative factors are considered, the registrant's financial 
statements would need to be adjusted.
    Further, in this example, recording an adjustment in the current 
year could alter the amount of the error affecting the current year 
financial statements. For instance:
     If only the $60 understatement of revenues were to be 
corrected in the current year, then the overstatement of current year 
end accounts receivable would increase to $110; or,
     If only the $50 overstatement of accounts receivable were 
to be corrected in the current year, then the understatement of current 
year revenues would increase to $110.
    If the misstatement that exists after recording the adjustment in 
the current year financial statements is material (considering all 
relevant quantitative and qualitative factors), the prior year 
financial statements should be corrected, even though such revision 
previously was and continues to be immaterial to the prior year 
financial statements. Correcting prior year financial statements for 
immaterial errors would not require previously filed reports to be 
amended. Such correction may be made the next time the registrant files 
the prior year financial statements.
    If the cut-off error that existed in the prior year was not 
discovered until the current year, a separate analysis of the financial 
statements of the prior year (and any other prior year in which 
previously undiscovered errors existed) would need to be performed to 
determine whether such prior year financial statements were materially 
misstated. If that analysis indicates that the prior year financial 
statements are materially misstated, they would need to be restated in 
accordance with FASB ASC Topic 250, Accounting Changes and Error 
Corrections.\78\
---------------------------------------------------------------------------

    \78\ FASB ASC paragraph 250-10-45-23.
---------------------------------------------------------------------------

    Facts: When preparing its financial statements for years ending on 
or before November 15, 2006, a registrant quantified errors by using 
either the iron curtain approach or the rollover approach, but not 
both. Based on consideration of the guidance in this Staff Accounting 
Bulletin, the registrant concludes that errors existing in previously 
issued financial statements are material.
    Question 3: Will the staff expect the registrant to restate prior 
period financial statements when first applying this guidance?
    Interpretive Response: The staff will not object if a registrant 
\79\ does not restate financial statements for fiscal years ending on 
or before November 15, 2006, if management properly applied its 
previous approach, either iron curtain or rollover, so long as all 
relevant qualitative factors were considered.
---------------------------------------------------------------------------

    \79\ If a registrant's initial registration statement is not 
effective on or before November 15, 2006, and the registrant's prior 
year(s) financial statements are materially misstated based on 
consideration of the guidance in this Staff Accounting Bulletin, the 
prior year financial statements should be restated in accordance 
with FASB ASC paragraph 250-10-45-23. If a registrant's initial 
registration statement is effective on or before November 15, 2006, 
the guidance in the interpretive response to Question 3 is 
applicable.
---------------------------------------------------------------------------

    To provide full disclosure, registrants electing not to restate 
prior periods should reflect the effects of initially applying the 
guidance in Topic 1N in their annual financial statements covering the 
first fiscal year ending after November 15, 2006. The cumulative effect 
of the initial application should be reported in the carrying amounts 
of assets and liabilities as of the beginning of that fiscal year, and 
the offsetting adjustment should be made to the opening balance of 
retained earnings for that year. Registrants should disclose the nature 
and amount of each individual error being corrected in the cumulative 
adjustment. The disclosure should also include when and how each error 
being corrected arose and the fact that the errors had previously been 
considered immaterial.
    Early application of the guidance in Topic 1N is encouraged in any 
report for an interim period of the first fiscal year ending after 
November 15, 2006, filed after the publication of this Staff Accounting 
Bulletin. In the event that the cumulative effect of application of the 
guidance in Topic 1N is first reported in an interim period other than 
the first interim period of the first fiscal year ending after November 
15, 2006, previously filed interim reports need not be amended. 
However, comparative information presented in reports for interim 
periods of the first year subsequent to initial application should be 
adjusted to reflect the cumulative effect adjustment as of the 
beginning of the year of initial application. In addition, the 
disclosures of selected quarterly information required by Item 302 of 
Regulation S-K should reflect the adjusted results.

TOPIC 2: BUSINESS COMBINATIONS

A. Acquisition Method

1. Removed by SAB 103
2. Removed by SAB 103
3. Removed by SAB 103
4. Removed by SAB 103
5. Removed by SAB 112
6. Debt Issue Costs
    Facts: Company A is to acquire the net assets of Company B in a 
transaction

[[Page 17211]]

to be accounted for as a business combination. In connection with the 
transaction, Company A has retained an investment banker to provide 
advisory services in structuring the acquisition and to provide the 
necessary financing. It is expected that the acquisition will be 
financed on an interim basis using ``bridge financing'' provided by the 
investment banker. Permanent financing will be arranged at a later date 
through a debt offering, which will be underwritten by the investment 
banker. Fees will be paid to the investment banker for the advisory 
services, the bridge financing, and the underwriting of the permanent 
financing. These services may be billed separately or as a single 
amount.
    Question 1: Should total fees paid to the investment banker for 
acquisition-related services and the issuance of debt securities be 
allocated between the services received?
    Interpretive Response: Yes. Fees paid to an investment banker in 
connection with a business combination or asset acquisition, when the 
investment banker is also providing interim financing or underwriting 
services, must be allocated between acquisition related services and 
debt issue costs.
    When an investment banker provides services in connection with a 
business combination or asset acquisition and also provides 
underwriting services associated with the issuance of debt or equity 
securities, the total fees incurred by an entity should be allocated 
between the services received on a relative fair value basis. The 
objective of the allocation is to ascribe the total fees incurred to 
the actual services provided by the investment banker.
    FASB ASC Topic 805, Business Combinations, provides guidance for 
the portion of the costs that represent acquisition-related services. 
The portion of the costs pertaining to the issuance of debt or equity 
securities should be accounted for in accordance with other applicable 
GAAP.
    Question 2: May the debt issue costs of the interim ``bridge 
financing'' be amortized over the anticipated combined life of the 
bridge and permanent financings?
    1. Interpretive Response: No. Debt issue costs should be amortized 
by the interest method over the life of the debt to which they relate. 
Debt issue costs related to the bridge financing should be recognized 
as interest cost during the estimated interim period preceding the 
placement of the permanent financing with any unamortized amounts 
charged to expense if the bridge loan is repaid prior to the expiration 
of the estimated period. Where the bridged financing consists of 
increasing rate debt, the guidance issued in FASB ASC Topic 470, Debt, 
should be followed.\1\
---------------------------------------------------------------------------

    \1\ As noted in FASB ASC paragraph 470-10-35-2, the term-
extending provisions of the debt instrument should be analyzed to 
determine whether they constitute an embedded derivative requiring 
separate accounting in accordance with FASB ASC Topic 815, 
Derivatives and Hedging.
---------------------------------------------------------------------------

7. Removed by SAB 112
8. Business Combinations Prior to an Initial Public Offering
    Facts: Two or more businesses combine in a single combination just 
prior to or contemporaneously with an initial public offering.
    Question: Does the guidance in SAB Topic 5.G apply to business 
combinations entered into just prior to or contemporaneously with an 
initial public offering?
    Interpretive Response: No. The guidance in SAB Topic 5.G is 
intended to address the transfer, just prior to or contemporaneously 
with an initial public offering, of nonmonetary assets in exchange for 
a company's stock. The guidance in SAB Topic 5.G is not intended to 
modify the requirements of FASB ASC Topic 805. Accordingly, the staff 
believes that the combination of two or more businesses should be 
accounted for in accordance with FASB ASC Topic 805.
9. Removed by SAB 112

B. Removed by SAB 103

C. Removed by SAB 103

D. Financial Statements of Oil And Gas Exchange Offers

    Facts: The oil and gas industry has experienced periods of time 
where there have been a significant number of ``exchange offers'' (also 
referred to as ``roll-ups'' or ``put-togethers'') to form a publicly 
held company, take an existing private company public, or increase the 
size of an existing publicly held company. An exchange offer 
transaction involves a swap of shares in a corporation for interests in 
properties, typically limited partnership interests. Such interests 
could include direct interests such as working interests and royalties 
related to developed or undeveloped properties and indirect interests 
such as limited partnership interests or shares of existing oil and gas 
companies. Generally, such transactions are structured to be tax-free 
to the individual or entity trading the property interest for shares of 
the corporation. Under certain circumstances, however, part or all of 
the transaction may be taxable. For purposes of the discussion in this 
Topic, in each of these situations, the entity (or entities) or 
property (or properties) are deemed to constitute a business.
    One financial reporting issue in exchange transactions involves 
deciding which prior financial results of the entities should be 
reported.
    Question 1: In Form 10-K filings with the Commission, the staff has 
permitted limited partnerships to omit certain of the oil and gas 
reserve value information and the supplemental summary of oil and gas 
activities disclosures required by FASB ASC Subtopic 932-235, 
Extractive Activities--Oil and Gas--Notes to Financial Statements, in 
some circumstances. Is it permissible to omit these disclosures from 
the financial statements included in an exchange offering?
    Interpretive Response: No. Normally full disclosures of reserve 
data and related information are required. The exemptions previously 
allowed relate only to partnerships where value-oriented data are 
otherwise available to the limited partners pursuant to the partnership 
agreement. The staff has previously stated that it will require all of 
the required disclosures for partnerships which are the subject of 
exchange offers.\2\ These disclosures may, however, be presented on a 
combined basis if the entities are under common control.
---------------------------------------------------------------------------

    \2\ 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 using the 
acquisition method of accounting, the staff will consider, on a case-
by-case basis, granting exemptions from (i) the disclosure requirements 
for year-to-year reconciliations of reserve quantities, and (ii) the 
requirements for a summary of oil and gas producing activities and a 
summary of changes in the net present value of reserves. For instance, 
the staff may consider requests for exemptions in cases where the 
properties acquired in the exchange transaction are fully explored and 
developed, particularly if the management of the emerging company has 
not been involved in the exploration and development of such 
properties.

[[Page 17212]]

    Question 2: If the exchange company will use the full cost method 
of accounting, does the full cost ceiling limitation apply as of the 
date of the financial statements reflecting the exchange?
    Interpretive Response: Yes. The full cost ceiling limitation on 
costs capitalized does apply. However, as discussed under Topic 12.D.3, 
the Commission has stated that in unusual circumstances, registrants 
may request an exemption if as a result of a major purchase, a write-
down would be required even though it can be demonstrated that the fair 
value of the properties clearly exceeds the unamortized costs.
    Question 3: How should ``common control accounting'' be applied to 
the specific assets and liabilities of the new exchange company?
    Interpretive Response: Consistent with SAB Topic 12.C.2, under 
``common control accounting'' the various accounting methods followed 
by the offeree entities should be conformed to the methods adopted by 
the new exchange company. It is not appropriate to combine assets and 
liabilities accounted for on different bases. Accordingly, all of the 
oil and gas properties of the new entity must be accounted for on the 
same basis (either full cost or successful efforts) applied 
retrospectively.
    Question 4: What pro forma financial information is required in an 
exchange offer filing?
    Interpretive Response: The requirements for pro forma financial 
information in exchange offer filings are the same as in any other 
filings with the Commission and are detailed in Article 11 of 
Regulation S-X.\3\ Rule 11-02(b) specifies the presentation 
requirements, including periods presented and types of adjustments to 
be made. The general criteria of Rule 11-02(b)(6) are that pro forma 
adjustments should give effect to events that are (i) directly 
attributable to the transaction, (ii) expected to have a continuing 
impact on the registrant, and (iii) factually supportable. In the case 
of an exchange offer, such adjustments typically are made to:
---------------------------------------------------------------------------

    \3\ As announced in Financial Reporting Release No. 2 (July 9, 
1982).
---------------------------------------------------------------------------

    (1) Show varying levels of acceptance of the offer.
    (2) Conform the accounting methods used in the historical financial 
statements to those to be applied by the new entity.
    (3) Recompute the depreciation, depletion and amortization charges, 
in cases where the new entity will use full-cost accounting, on a 
combined basis. If this computation is not practicable, and the 
exchange offer is accounted for as a transaction among entities under 
common control, historical depreciation, depletion and amortization 
provisions may be aggregated, with appropriate disclosure.
    (4) Reflect the acquisition in the pro forma statements where the 
exchange offer is accounted for using the acquisition method of 
accounting, including depreciation, depletion and amortization based on 
the measurement guidance in FASB ASC Topic 805, Business Combinations.
    (5) Provide pro forma reserve information comparable to the 
disclosures required by FASB ASC paragraphs 932-235-50-3 through 932-
235-50-11B and FASB ASC paragraphs 932-235-50-29 through 932-235-50-36.
    (6) Reflect significant changes, if any, in levels of operations 
(revenues or costs), or in income tax status and to reflect debt 
incurred in connection with the transaction.

In addition, the depreciation, depletion and amortization rate which 
will apply for the initial period subsequent to consummation of the 
exchange offer should be disclosed.
    Question 5: Are there conditions under which the presentation of 
other than full historical financial statements would be acceptable?
    Interpretive Response: Generally, full historical financial 
statements as specified in Rules 3-01 and 3-02 of Regulation S-X are 
considered necessary to enable offerees and secondary market investors 
to evaluate the transaction. Where securities are being registered to 
offer to the security holders (including limited partners and other 
ownership interests) of the businesses to be acquired, such financial 
statements are normally required pursuant to Rule 3-05 of Regulation S-
X, either individually for each entity or, where appropriate, 
separately for the offeror and on a combined basis for other entities, 
generally excluding corporations. However, certain exceptions may apply 
as explained in the outline below:
A. Acquisition Method Accounting
    1. If the registrant can demonstrate that full historical financial 
statements of the offeree businesses are not reasonably available, the 
staff may permit presentation of audited Statements of Combined Gross 
Revenues and Direct Lease Operating Expenses for all years for which an 
income statement would otherwise be required. In these circumstances, 
the registrant should also disclose in an unaudited footnote the 
amounts of total exploration and development costs, and general and 
administrative expenses along with the reasons why presentation of full 
historical financial statements is not practicable.
    2. The staff will consider requests to waive the requirement for 
prior year financial statements of the offerees and instead allow 
presentation of only the latest fiscal year and interim period, if the 
registrant can demonstrate that the prior years' data would not be 
meaningful because the offerees had no material quantity of production.
B. Common Control Accounting
    The staff would expect that the full historical financial 
statements as specified in Rules 3-01 and 3-02 of Regulation S-X would 
be included in the registration statement for exchange offers accounted 
for as transactions among entities under common control, including all 
required supplemental reserve information. The presentation of 
individual or combined financial statements would depend on the 
circumstances of the particular exchange offer.
    Registrants are also reminded that wherever historical results are 
presented, it may be appropriate to explain the reasons why historical 
costs are not necessarily indicative of future expenditures.

E. Removed by SAB 103

F. Removed by SAB 103

TOPIC 3: SENIOR SECURITIES

A. Convertible Securities

    Facts: Company B proposes to file a registration statement covering 
convertible securities.
    Question: In registration, what consideration should be given to 
the dilutive effects of convertible securities?
    Interpretive Response: In a registration statement of convertible 
preferred stock or debentures, the staff believes that disclosure of 
pro forma earnings per share (EPS) is important to investors when the 
proceeds will be used to extinguish existing preferred stock or debt 
and such extinguishments will have a material effect on EPS. That 
disclosure is required by Article 11, Rule 11-01(a)(8) and Rule 11-
02(b)(7) of Regulation S-X, if material.

B. Removed by ASR 307

C. Redeemable Preferred Stock

    Facts: Rule 5-02.27 of Regulation S-X states that redeemable 
preferred stocks are not to be included in amounts reported as 
stockholders' equity, and that their redemption amounts are to be

[[Page 17213]]

shown on the face of the balance sheet. However, the Commission's rules 
and regulations do not address the carrying amount at which redeemable 
preferred stock should be reported, or how changes in its carrying 
amount should be treated in calculations of earnings per share and the 
ratio of earnings to combined fixed charges and preferred stock 
dividends.
    Question 1: How should the carrying amount of redeemable preferred 
stock be determined?
    Interpretive Response: The initial carrying amount of redeemable 
preferred stock should be its fair value at date of issue. Where fair 
value at date of issue is less than the mandatory redemption amount, 
the carrying amount shall be increased by periodic accretions, using 
the interest method, so that the carrying amount will equal the 
mandatory redemption amount at the mandatory redemption date. The 
carrying amount shall be further periodically increased by amounts 
representing dividends not currently declared or paid, but which will 
be payable under the mandatory redemption features, or for which 
ultimate payment is not solely within the control of the registrant 
(e.g., dividends that will be payable out of future earnings). Each 
type of increase in carrying amount shall be effected by charges 
against retained earnings or, in the absence of retained earnings, by 
charges against paid-in capital.
    The accounting described in the preceding paragraph would apply 
irrespective of whether the redeemable preferred stock may be 
voluntarily redeemed by the issuer prior to the mandatory redemption 
date, or whether it may be converted into another class of securities 
by the holder. Companies also should consider the guidance in FASB ASC 
paragraph 480-10-S99-3A (Distinguishing Liabilities from Equity Topic).
    Question 2: How should periodic increases in the carrying amount of 
redeemable preferred stock be treated in calculations of earnings per 
share and ratios of earnings to combined fixed charges and preferred 
stock dividends?
    Interpretive Response: Each type of increase in carrying amount 
described in the Interpretive Response to Question 1 should be treated 
in the same manner as dividends on nonredeemable preferred stock.

TOPIC 4: EQUITY ACCOUNTS

A. Subordinated Debt

    Facts: Company E proposes to include in its registration statement 
a balance sheet showing its subordinate debt as a portion of 
stockholders' equity.
    Question: Is this presentation appropriate?
    Interpretive Response: Subordinated debt may not be included in the 
stockholders' equity section of the balance sheet. Any presentation 
describing such debt as a component of stockholders' equity must be 
eliminated. Furthermore, any caption representing the combination of 
stockholders' equity and only subordinated debts must be deleted.

B. S Corporations

    Facts: An S corporation has undistributed earnings on the date its 
S election is terminated.
    Question: How should such earnings be reflected in the financial 
statements?
    Interpretive Response: Such earnings must be included in the 
financial statements as additional paid-in capital. This assumes a 
constructive distribution to the owners followed by a contribution to 
the capital of the corporation.

C. Change in Capital Structure

    Facts: A capital structure change to a stock dividend, stock split 
or reverse split occurs after the date of the latest reported balance 
sheet but before the release of the financial statements or the 
effective date of the registration statement, whichever is later.
    Question: What effect must be given to such a change?
    Interpretive Response: Such changes in the capital structure must 
be given retroactive effect in the balance sheet. An appropriately 
cross-referenced note should disclose the retroactive treatment, 
explain the change made and state the date the change became effective.

D. Earnings per Share Computations in an Initial Public Offering

    Facts: A registration statement is filed in connection with an 
initial public offering (IPO) of common stock. During the periods 
covered by income statements that are included in the registration 
statement or in the subsequent period prior to the effective date of 
the IPO, the registrant issued for nominal consideration \1\ common 
stock, options or warrants to purchase common stock or other 
potentially dilutive instruments (collectively, referred to hereafter 
as ``nominal issuances'').
---------------------------------------------------------------------------

    \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 FASB ASC Topic 260, Earnings Per 
Share, the staff believed that certain stock and warrants \2\ should be 
treated as outstanding for all reporting periods in the same manner as 
shares issued in a stock split or a recapitalization effected 
contemporaneously with the IPO. The dilutive effect of such stock and 
warrants could be measured using the treasury stock method.
---------------------------------------------------------------------------

    \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 FASB ASC 
Topic 260?
    Interpretive Response: Generally, no. Historical EPS should be 
prepared and presented in conformity with FASB ASC Topic 260.
    In applying the requirements of FASB ASC Topic 260, the staff 
believes that nominal issuances are recapitalizations in substance. In 
computing basic EPS for the periods covered by income statements 
included in the registration statement and in subsequent filings with 
the SEC, nominal issuances of common stock should be reflected in a 
manner similar to a stock split or stock dividend for which retroactive 
treatment is required by FASB ASC paragraph 260-10-55-12. In computing 
diluted EPS for such periods, nominal issuances of common stock and 
potential common stock \3\ should be reflected in a manner similar to a 
stock split or stock dividend.
---------------------------------------------------------------------------

    \3\ The FASB ASC Master Glossary defines potential common stock 
as ``a security or other contract that may entitle its holder to 
obtain common stock during the reporting period or after the end of 
the reporting period.''
---------------------------------------------------------------------------

    Registrants are reminded that disclosure about materially dilutive 
issuances is required outside the financial statements. Item 506 of 
Regulation S-K requires presentation of the dilutive effects of those 
issuances on net tangible book value. The effects of dilutive issuances 
on the registrant's liquidity, capital resources and results of 
operations should be addressed in Management's Discussion and Analysis.
    Question 2: Does reflecting nominal issuances as outstanding for 
all historical periods in the computation of earnings per share alter 
the registrant's responsibility to determine whether compensation 
expense must be

[[Page 17214]]

recognized for such issuances to employees?
    Interpretive Response: No. Registrants must follow GAAP in 
determining whether the recognition of compensation expense for any 
issuances of equity instruments to employees is necessary.\4\ 
Reflecting nominal issuances as outstanding for all historical periods 
in the computation of earnings per share does not alter that existing 
responsibility under GAAP.
---------------------------------------------------------------------------

    \4\ As prescribed by FASB ASC Topic 718, Compensation--Stock 
Compensation.
---------------------------------------------------------------------------

E. Receivables From Sale of Stock

    Facts: Capital stock is sometimes issued to officers or other 
employees before the cash payment is received.
    Question: How should the receivables from the officers or other 
employees be presented in the balance sheet?
    Interpretive Response: The amount recorded as a receivable should 
be presented in the balance sheet as a deduction from stockholders' 
equity. This is generally consistent with Rule 5-02.30 of Regulation S-
X which states that accounts or notes receivable arising from 
transactions involving the registrant's capital stock should be 
presented as deductions from stockholders' equity and not as assets.
    It should be noted generally that all amounts receivable from 
officers and directors resulting from sales of stock or from other 
transactions (other than expense advances or sales on normal trade 
terms) should be separately stated in the balance sheet irrespective of 
whether such amounts may be shown as assets or are required to be 
reported as deductions from stockholders' equity.
    The staff will not suggest that a receivable from an officer or 
director be deducted from stockholders' equity if the receivable was 
paid in cash prior to the publication of the financial statements and 
the payment date is stated in a note to the financial statements. 
However, the staff would consider the subsequent return of such cash 
payment to the officer or director to be part of a scheme or plan to 
evade the registration or reporting requirements of the securities 
laws.

F. Limited Partnerships

    Facts: There exist a number of publicly held partnerships having 
one or more corporate or individual general partners and a relatively 
larger number of limited partners. There are no specific requirements 
or guidelines relating to the presentation of the partnership equity 
accounts in the financial statements. In addition, there are many 
approaches to the parallel problem of relating the results of 
operations to the two classes of partnership equity interests.
    Question: How should the financial statements of limited 
partnerships be presented so that the two ownership classes can readily 
determine their relative participations in both the net assets of the 
partnership and in the results of its operations?
    Interpretive Response: The equity section of a partnership balance 
sheet should distinguish between amounts ascribed to each ownership 
class. The equity attributed to the general partners should be stated 
separately from the equity of the limited partners, and changes in the 
number of equity units authorized and outstanding should be shown for 
each ownership class. A statement of changes in partnership equity for 
each ownership class should be furnished for each period for which an 
income statement is included.
    The income statements of partnerships should be presented in a 
manner which clearly shows the aggregate amount of net income (loss) 
allocated to the general partners and the aggregate amount allocated to 
the limited partners. The statement of income should also state the 
results of operations on a per unit basis.

G. Notes and Other Receivables From Affiliates

    Facts: The balance sheet of a corporate general partner is often 
presented in a registration statement. Frequently, the balance sheet of 
the general partner discloses that it holds notes or other receivables 
from a parent or another affiliate. Often the notes or other 
receivables were created in order to meet the ``substantial assets'' 
test which the Internal Revenue Service utilizes in applying its ``Safe 
Harbor'' doctrine in the classification of organizations for income tax 
purposes.
    Question: How should such notes and other receivables be reported 
in the balance sheet of the general partner?
    Interpretive Response: While these notes and other receivables 
evidencing a promise to contribute capital are often legally 
enforceable, they seldom are actually paid. In substance, these 
receivables are equivalent to unpaid subscriptions receivable for 
capital shares which Rule 5-02.30 of Regulation S-X requires to be 
deducted from the dollar amount of capital shares subscribed.
    The balance sheet display of these or similar items is not 
determined by the quality or actual value of the receivable or other 
asset ``contributed'' to the capital of the affiliated general partner, 
but rather by the relationship of the parties and the control inherent 
in that relationship. Accordingly, in these situations, the receivable 
must be treated as a deduction from stockholders' equity in the balance 
sheet of the corporate general partner.

TOPIC 5: MISCELLANEOUS ACCOUNTING

A. Expenses of Offering

    Facts: Prior to the effective date of an offering of equity 
securities, Company Y incurs certain expenses related to the offering.
    Question: Should such costs be deferred?
    Interpretive Response: Specific incremental costs directly 
attributable to a proposed or actual offering of securities may 
properly be deferred and charged against the gross proceeds of the 
offering. However, management salaries or other general and 
administrative expenses may not be allocated as costs of the offering 
and deferred costs of an aborted offering may not be deferred and 
charged against proceeds of a subsequent offering. A short postponement 
(up to 90 days) does not represent an aborted offering.

B. Gain or Loss From Disposition of Equipment

    Facts: Company A has adopted the policy of treating gains and 
losses from disposition of revenue producing equipment as adjustments 
to the current year's provision for depreciation. Company B reflects 
such gains and losses as a separate item in the statement of income.
    Question: Does the staff have any views as to which method is 
preferable?
    Interpretive Response: Gains and losses resulting from the 
disposition of revenue producing equipment should not be treated as 
adjustments to the provision for depreciation in the year of 
disposition, but should be shown as a separate item in the statement of 
income.
    If such equipment is depreciated on the basis of group of composite 
accounts for fleets of like vehicles, gains (or losses) may be charged 
(or credited) to accumulated depreciation with the result that 
depreciation is adjusted over a period of years on an average basis. It 
should be noted that the latter treatment would not be appropriate for 
(1) an enterprise (such as an airline) which replaces its fleet on an 
episodic rather than a continuing basis or (2) an enterprise (such as a 
car leasing company) where equipment is sold after limited use so that 
the equipment on hand is both fairly new and carried at amounts closely 
related to current acquisition cost.

[[Page 17215]]

C.1. Removed by SAB 103

C.2. Removed by SAB 103

D. Organization and Offering Expenses and Selling Commissions--Limited 
Partnerships Trading in Commodity Futures

    Facts: Partnerships formed for the purpose of engaging in 
speculative trading in commodity futures contracts sell limited 
partnership interests to the public and frequently have a general 
partner who is an affiliate of the partnership's commodity broker or 
the principal underwriter selling the limited partnership interests. 
The commodity broker or a subsidiary typically assumes the liability 
for all or part of the organization and offering expenses and selling 
commissions in connection with the sale of limited partnership 
interests. Funds raised from the sale of partnership interests are 
deposited in a margin account with the commodity broker and are 
invested in Treasury Bills or similar securities. The arrangement 
further provides that interest earned on the investments for an initial 
period is to be retained by the broker until it has been reimbursed for 
all or a specified portion of the aforementioned expenses and 
commissions and that thereafter interest earned accrues to the 
partnership.
    In some instances, there may be no reference to reimbursement of 
the broker for expenses and commissions to be assumed. The arrangements 
may provide that all interest earned on investments accrues to the 
partnership but that commissions on commodity transactions paid to the 
broker are at higher rates for a specified initial period and at lower 
rates subsequently.
    Question 1: Should the partnership recognize a commitment to 
reimburse the commodity broker for the organization and offering 
expenses and selling commissions?
    Interpretive Response: Yes. A commitment should be recognized by 
reducing partnership capital and establishing a liability for the 
estimated amount of expenses and commissions for which the broker is to 
be reimbursed.
    Question 2: Should the interest income retained by the broker for 
reimbursement of expenses be recognized as income by the partnership?
    Interpretive Response: Yes. All the interest income on the margin 
account investments should be recognized as accruing to the partnership 
as earned. The portion of income retained by the broker and not 
actually realized by the partnership in cash should be applied to 
reduce the liability for the estimated amount of reimbursable expenses 
and commissions.
    Question 3: If the broker retains all of the interest income for a 
specified period and thereafter it accrues to the partnership, should 
an equivalent amount of interest income be reflected on the 
partnership's financial statements during the specified period?
    Interpretive Response: Yes. If it appears from the terms of the 
arrangement that it was the intent of the parties to provide for full 
or partial reimbursement for the expenses and commissions paid by the 
broker, then a commitment to reimbursement should be recognized by the 
partnership and an equivalent amount of interest income should be 
recognized on the partnership's financial statements as earned.
    Question 4: Under the arrangements where commissions on commodity 
transactions are at a lower rate after a specified period and there is 
no reference to reimbursement of the broker for expenses and 
commissions, should recognition be given on the partnership's financial 
statements to a commitment to reimburse the broker for all or part of 
the expenses and commissions?
    Interpretive Response: If it appears from the terms of the 
arrangement that the intent of the parties was to provide for full or 
partial reimbursement of the broker's expenses and commissions, then 
the estimated commitment should be recognized on the partnership's 
financial statements. During the specified initial period commissions 
on commodity transactions should be charged to operations at the lower 
commission rate with the difference applied to reduce the 
aforementioned commitment.

E. Accounting for Divestiture of a Subsidiary or Other Business 
Operation

    Facts: Company X transferred certain operations (including several 
subsidiaries) to a group of former employees who had been responsible 
for managing those operations. Assets and liabilities with a net book 
value of approximately $8 million were transferred to a newly formed 
entity--Company Y--wholly owned by the former employees. The 
consideration received consisted of $1,000 in cash and interest bearing 
promissory notes for $10 million, payable in equal annual installments 
of $1 million each, plus interest, beginning two years from the date of 
the transaction. The former employees possessed insufficient assets to 
pay the notes and Company X expected the funds for payments to come 
exclusively from future operations of the transferred business. Company 
X remained contingently liable for performance on existing contracts 
transferred and agreed to guarantee, at its discretion, performance on 
future contracts entered into by the newly formed entity. Company X 
also acted as guarantor under a line of credit established by Company 
Y.
    The nature of Company Y's business was such that Company X's 
guarantees were considered a necessary predicate to obtaining future 
contracts until such time as Company Y achieved profitable operations 
and substantial financial independence from Company X.
    Question: If deconsolidation of the subsidiaries and business 
operations is appropriate, can Company X recognize a gain?
    Interpretive Response: Before recognizing any gain, Company X 
should identify all of the elements of the divesture arrangement and 
allocate the consideration exchanged to each of those elements. In this 
regard, we believe that Company X would recognize the guarantees at 
fair value in accordance with FASB ASC Topic 460, Guarantees; the 
contingent liability for performance on existing contracts in 
accordance with FASB ASC Topic 450, Contingencies; and the promissory 
notes in accordance with FASB ASC Topic 310, Receivables, and FASB ASC 
Topic 835, Interest.

F. Accounting Changes Not Retroactively Applied Due to Immateriality

    Facts: A registrant is required to adopt an accounting principle by 
means of retrospective adjustment of prior periods' financial 
statements. However, the registrant determines that the accounting 
change does not have a material effect on prior periods' financial 
statements and, accordingly, decides not to retrospectively adjust such 
financial statements.
    Question: In these circumstances, is it acceptable to adjust the 
beginning balance of retained earnings of the period in which the 
change is made for the cumulative effect of the change on the financial 
statements of prior periods?
    Interpretive Response: No. If prior periods are not retrospectively 
adjusted, the cumulative effect of the change should be included in the 
statement of income for the period in which the change is made. Even in 
cases where the total cumulative effect is not significant, the staff 
believes that the amount should be reflected in the results of 
operations for the period in which the change is made. However, if the 
cumulative effect

[[Page 17216]]

is material to current operations or to the trend of the reported 
results of operations, then the individual income statements of the 
earlier years should be retrospectively adjusted.

G. Transfers of Nonmonetary Assets by Promoters or Shareholders

    Facts: Nonmonetary assets are exchanged by promoters or 
shareholders for all or part of a company's common stock just prior to 
or contemporaneously with a first-time public offering.
    Question: Since FASB ASC paragraph 845-10-15-4 (Nonmonetary 
Transactions Topic) states that the guidance in this topic is not 
applicable to transactions involving the acquisition of nonmonetary 
assets or services on issuance of the capital stock of an enterprise, 
what value should be ascribed to the acquired assets by the company?
    Interpretive Response: The staff believes that transfers of 
nonmonetary assets to a company by its promoters or shareholders in 
exchange for stock prior to or at the time of the company's initial 
public offering normally should be recorded at the transferors' 
historical cost basis determined under GAAP.
    The staff will not always require that predecessor cost be used to 
value nonmonetary assets received from an enterprise's promoters or 
shareholders. However, deviations from this policy have been rare 
applying generally to situations where the fair value of either the 
stock issued \1\ or assets acquired is objectively measurable and the 
transferor's stock ownership following the transaction was not so 
significant that the transferor had retained a substantial indirect 
interest in the assets as a result of stock ownership in the company.
---------------------------------------------------------------------------

    \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. Removed by SAB 112

I. Removed by SAB 70

J. New Basis of Accounting Required in Certain Circumstances

    Facts: Company A (or Company A and related persons) acquired 
substantially all of the common stock of Company B in one or a series 
of purchase transactions.
    Question 1: Must Company B's financial statements presented in 
either its own or Company A's subsequent filings with the Commission 
reflect the new basis of accounting arising from Company A's 
acquisition of Company B when Company B's separate corporate entity is 
retained?
    Interpretive Response: Yes. The staff believes that purchase 
transactions that result in an entity becoming substantially wholly 
owned (as defined in Rule 1-02(aa) of Regulation S-X) establish a new 
basis of accounting for the purchased assets and liabilities.
    When the form of ownership is within the control of the parent, the 
basis of accounting for purchased assets and liabilities should be the 
same regardless of whether the entity continues to exist or is merged 
into the parent's operations. Therefore, Company B's separate financial 
statements should reflect the new basis of accounting recorded by 
Company A upon acquisition (i.e., ``pushed down'' basis).
    Question 2: What is the staff's position if Company A acquired less 
than substantially all of the common stock of Company B or Company B 
had publicly held debt or preferred stock at the time Company B became 
wholly owned?
    Interpretive Response: The staff recognizes that the existence of 
outstanding public debt, preferred stock or a significant 
noncontrolling interest in a subsidiary might impact the parent's 
ability to control the form of ownership. Although encouraging its use, 
the staff generally does not insist on the application of push down 
accounting in these circumstances.
    Question 3: Company A borrows funds to acquire substantially all of 
the common stock of Company B. Company B subsequently files a 
registration statement in connection with a public offering of its 
stock or debt.\2\ Should Company B's new basis (``push down'') 
financial statements include Company A's debt related to its purchase 
of Company B?
---------------------------------------------------------------------------

    \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. Other relationships may exist between 
Company A and Company B, such as the pledge of Company B's stock as 
collateral for Company A's debt.\4\ While in this latter situation, it 
may be clear that Company B's cash flows will service all or part of 
Company A's debt, the staff does not insist that the debt be reflected 
in Company B's financial statements providing there is full and 
prominent disclosure of the relationship between Companies A and B and 
the actual or potential cash flow commitment. In this regard, the staff 
believes that FASB ASC Topic 450, Contingencies, FASB ASC Topic 850, 
Related Party Disclosures, and FASB ASC Topic 460, Guarantees, require 
sufficient disclosure to allow users of Company B's financial 
statements to fully understand the impact of the relationship on 
Company B's present and future cash flows. Rule 4-08(e) of Regulation 
S-X also requires disclosure of restrictions which limit the payment of 
dividends.
---------------------------------------------------------------------------

    \3\ The guidance in this SAB should also be considered where 
Company A has financed the acquisition of Company B through the 
issuance of mandatory redeemable preferred stock.
    \4\ The staff does not believe Company B's financial statements 
must reflect the debt in this situation because in the event of 
default on the debt by Company A, the debt holder(s) would only be 
entitled to Company B's stock held by Company A. Other equity or 
debt holders of Company B would retain their priority with respect 
to the net assets of Company B.
---------------------------------------------------------------------------

    Therefore, the staff believes that the equity section of Company 
B's balance sheet and any pro forma financial information and 
capitalization tables should clearly disclose that this arrangement 
exists.\5\ Regardless of whether the debt is reflected in Company B's 
financial statements, the notes to Company B's financial statements 
should generally disclose, at a minimum: (1) The relationship between 
Company A and Company B; (2) a description of any arrangements that 
result in Company B's guarantee, pledge of assets \6\ or stock, etc. 
that provides security for Company A's debt; (3) the extent (in the 
aggregate and for each of the five years subsequent to the date of the 
latest balance sheet presented) to which Company A is dependent on 
Company B's cash flows to service its debt and the method by

[[Page 17217]]

which this will occur; and (4) the impact of such cash flows on Company 
B's ability to pay dividends or other amounts to holders of its 
securities. Additionally, the staff believes Company B's Management's 
Discussion and Analysis of Financial Condition and Results of 
Operations should discuss any material impact of its servicing of 
Company A's debt on its own liquidity pursuant to Item 303(a)(1) of 
Regulation S-K.
---------------------------------------------------------------------------

    \5\ For example, the staff has noted that certain registrants 
have indicated on the face of such financial statements (as part of 
the stockholder's equity section) the actual or potential financing 
arrangement and the registrant's intent to pay dividends to satisfy 
its parent's debt service requirements. The staff believes such 
disclosures are useful to highlight the existence of arrangements 
that could result in the use of Company B's cash to service Company 
A's debt.
    \6\ A material asset pledge should be clearly indicated on the 
face of the balance sheet. For example, if all or substantially all 
of the assets are pledged, the ``assets'' and ``total assets'' 
captions should include parenthetically: ``pledged for parent 
company debt--See Note X.''
---------------------------------------------------------------------------

K. Removed by SAB 95

L. LIFO Inventory Practices

    Facts: On November 30, 1984, AcSEC and its Task Force on LIFO 
Inventory Problems (task force) issued a paper, ``Identification and 
Discussion of Certain Financial Accounting and Reporting Issues 
Concerning LIFO Inventories.'' This paper identifies and discusses 
certain financial accounting and reporting issues related to the last-
in, first-out (LIFO) inventory method for which authoritative 
accounting literature presently provides no definitive guidance. For 
some issues, the task force's advisory conclusions recommend changes in 
current practice to narrow the diversity which the task force believes 
exists. For other issues, the task force's advisory conclusions 
recommend that current practice should be continued for financial 
reporting purposes and that additional accounting guidance is 
unnecessary. Except as otherwise noted in the paper, AcSEC generally 
supports the task force's advisory conclusions. As stated in the issues 
paper, ``Issues papers of the AICPA's accounting standards division are 
developed primarily to identify financial accounting and reporting 
issues the division believes need to be addressed or clarified by the 
Financial Accounting Standards Board.'' On February 6, 1985, the FASB 
decided not to add to its agenda a narrow project on the subject of 
LIFO inventory practices.
    Question 1: What is the SEC staff's position on the issues paper?
    Interpretive Response: In the absence of existing authoritative 
literature on LIFO accounting, the staff believes that registrants and 
their independent accountants should look to the paper for guidance in 
determining what constitutes acceptable LIFO accounting practice.\7\ In 
this connection, the staff considers the paper to be an accumulation of 
existing acceptable LIFO accounting practices which does not establish 
any new standards and does not diverge from GAAP.
---------------------------------------------------------------------------

    \7\ In ASR 293 (July 2, 1981) see Financial Reporting 
Codification Sec.  205, the Commission expressed its concerns about 
the inappropriate use of Internal Revenue Service (IRS) LIFO 
practices for financial statement preparation. Because the IRS 
amended its regulations concerning the LIFO conformity rule on 
January 13, 1981, allowing companies to apply LIFO differently for 
financial reporting purposes than for tax purposes, the Commission 
strongly encouraged registrants and their independent accountants to 
examine their financial reporting LIFO practices. In that release, 
the Commission acknowledged the ``task force which has been 
established by AcSEC to accumulate information about [LIFO] 
application problems'' and noted that ``This type of effort, in 
addition to self-examination [of LIFO practices] by individual 
registrants, is appropriate * * *''
---------------------------------------------------------------------------

    The staff also believes that the advisory conclusions recommended 
in the issues paper are generally consistent with conclusions 
previously expressed by the Commission, such as:
    1. Pooling-paragraph 4-6 of the paper discusses LIFO inventory 
pooling and concludes ``establishing separate pools with the principal 
objective of facilitating inventory liquidations is unacceptable.'' In 
Accounting and Auditing Enforcement Release 35, August 13, 1984, the 
Commission stated that it believes that the Company improperly 
realigned its LIFO pools in such a way as to maximize the likelihood 
and magnitude of LIFO liquidations and thus, overstated net income.
    2. New Items-paragraph 4-27 of the paper discusses determination of 
the cost of new items and concludes ``if the double extension or an 
index technique is used, the objective of LIFO is achieved by 
reconstructing the base year cost of new items added to existing 
pools.'' In ASR 293, the Commission stated that when the effects of 
inflation on the cost of new products are measured by making a 
comparison with current cost as the base-year cost, rather than a 
reconstructed base-year cost, income is improperly increased.
    Question 2: If a registrant utilizes a LIFO practice other than one 
recommended by an advisory conclusion in the issues paper, must the 
registrant change its practice to one specified in the paper?
    Interpretive Response: Now that the issues paper is available, the 
staff believes that a registrant and its independent accountants should 
re-examine previously adopted LIFO practices and compare them to the 
recommendations in the paper. In the event that the registrant and its 
independent accountants conclude that the registrant's LIFO practices 
are preferable in the circumstances, they should be prepared to justify 
their position in the event that a question is raised by the staff.
    Question 3: If a registrant elects to change its LIFO practices to 
be consistent with the guidance in the issues paper and discloses such 
changes in accordance with FASB ASC Topic 250, Accounting Changes and 
Error Corrections, will the registrant be requested by the staff to 
explain its past practices and its justification for those practices?
    Interpretive Response: The staff does not expect to routinely raise 
questions about changes in LIFO practices which are made to make a 
company's accounting consistent with the recommendations in the issues 
paper.

M. Other Than Temporary Impairment of Certain Investments in Equity 
Securities

    Facts: FASB ASC paragraph 320-10-35-33 (Investments--Debt and 
Equity Securities Topic) does not define the phrase ``other than 
temporary'' for available-for-sale equity securities. For its 
available-for-sale equity securities, Company A has interpreted ``other 
than temporary'' to mean permanent impairment. Therefore, because 
Company A's management has not been able to determine that its 
investment in Company B's equity securities is permanently impaired, no 
realized loss has been recognized even though the market price of 
Company B's equity securities is currently less than one-third of 
Company A's average acquisition price.
    Question: For equity securities classified as available-for-sale, 
does the staff believe that the phrase ``other than temporary'' should 
be interpreted to mean ``permanent''?
    Interpretive Response: No. The staff believes that the FASB 
consciously chose the phrase ``other than temporary'' because it did 
not intend that the test be ``permanent impairment,'' as has been used 
elsewhere in accounting practice.\8\
---------------------------------------------------------------------------

    \8\ [Original footnote removed by SAB 114.]
---------------------------------------------------------------------------

    The value of investments in equity securities classified as 
available-for-sale may decline for various reasons. The market price 
may be affected by general market conditions which reflect prospects 
for the economy as a whole or by specific information pertaining to an 
industry or an individual company. Such declines require further 
investigation by management. Acting upon the premise that a write-down 
may be required, management should consider all available evidence to 
evaluate the realizable value of its investment in equity securities 
classified as available-for-sale.
    There are numerous factors to be considered in such an evaluation 
and their relative significance will vary from case to case. The staff 
believes that the

[[Page 17218]]

following are only a few examples of the factors which, individually or 
in combination, indicate that a decline in value of an equity security 
classified as available-for-sale is other than temporary and that a 
write-down of the carrying value is required:
    a. The length of the time and the extent to which the market value 
has been less than cost;
    b. The financial condition and near-term prospects of the issuer, 
including any specific events which may influence the operations of the 
issuer such as changes in technology that may impair the earnings 
potential of the investment or the discontinuance of a segment of the 
business that may affect the future earnings potential; or
    c. The intent and ability of the holder to retain its investment in 
the issuer for a period of time sufficient to allow for any anticipated 
recovery in market value.
    Unless evidence exists to support a realizable value equal to or 
greater than the carrying value of the investment in equity securities 
classified as available-for-sale, a write-down to fair value accounted 
for as a realized loss should be recorded. Such loss should be 
recognized in the determination of net income of the period in which it 
occurs and the written down value of the investment in the company 
becomes the new cost basis of the investment.

N. Discounting by Property-Casualty Insurance Companies

    Facts: A registrant which is an insurance company discounts certain 
unpaid claims liabilities related to short-duration \9\ insurance 
contracts for purposes of reporting to state regulatory authorities, 
using discount rates permitted or prescribed by those authorities 
(``statutory rates'') which approximate 3\1/2\ percent. The registrant 
follows the same practice in preparing its financial statements in 
accordance with GAAP. It proposes to change for GAAP purposes, to using 
a discount rate related to the historical yield on its investment 
portfolio (``investment related rate'') which is represented to 
approximate 7 percent, and to account for the change as a change in 
accounting estimate, applying the investment related rate to claims 
settled in the current and subsequent years while the statutory rate 
would continue to be applied to claims settled in all prior years.
---------------------------------------------------------------------------

    \9\ The term ``short-duration'' refers to the period of coverage 
(see FASB ASC paragraph 944-20-15-7 (Financial Services--Insurance 
Topic)), not the period that the liabilities are expected to be 
outstanding.
---------------------------------------------------------------------------

    Question 1: What is the staff's position with respect to 
discounting claims liabilities related to short-duration insurance 
contracts?
    Interpretive Response: The staff is aware of efforts by the 
accounting profession to assess the circumstances under which 
discounting may be appropriate in financial statements. Pending 
authoritative guidance resulting from those efforts however, the staff 
will raise no objection if a registrant follows a policy for GAAP 
reporting purposes of:
     Discounting liabilities for unpaid claims and claim 
adjustment expenses at the same rates that it uses for reporting to 
state regulatory authorities with respect to the same claims 
liabilities, or
     Discounting liabilities with respect to settled claims 
under the following circumstances:
    (1) The payment pattern and ultimate cost are fixed and 
determinable on an individual claim basis, and
    (2) The discount rate used is reasonable on the facts and 
circumstances applicable to the registrant at the time the claims are 
settled.
    Question 2: Does the staff agree with the registrant's proposal 
that the change from a statutory rate to an investment related rate be 
accounted for as a change in accounting estimate?
    Interpretive Response: No. The staff believes that such a change 
involves a change in the method of applying an accounting principle, 
i.e., the method of selecting the discount rate was changed. The staff 
therefore believes that the registrant should reflect the cumulative 
effect of the change in accounting by applying the new selection method 
retroactively to liabilities for claims settled in all prior years, in 
accordance with the requirements of FASB ASC Topic 250, Accounting 
Changes and Error Corrections. Initial adoption of discounting for GAAP 
purposes would be treated similarly. In either case, in addition to the 
disclosures required by FASB ASC Topic 250 concerning the change in 
accounting principle, a preferability letter from the registrant's 
independent accountant is required.

O. Research and Development Arrangements

    Facts: FASB ASC paragraph 730-20-25-5 (Research and Development 
Topic) states that conditions other than a written agreement may exist 
which create a presumption that the enterprise will repay the funds 
provided by other parties under a research and development arrangement. 
FASB ASC subparagraph 730-20-25-6(c) lists as one of those conditions 
the existence of a ``significant related party relationship'' between 
the enterprise and the parties funding the research and development.
    Question 1: What does the staff consider a ``significant related 
party relationship'' as that term is used in FASB ASC subparagraph 730-
20-25-6(c)?
    Interpretive Response: The staff believes that a significant 
related party relationship exists when 10 percent or more of the entity 
providing the funds is owned by related parties.\10\ In unusual 
circumstances, the staff may also question the appropriateness of 
treating a research and development arrangement as a contract to 
perform service for others at the less than 10 percent level. In 
reviewing these matters the staff will consider, among other factors, 
the percentage of the funding entity owned by the related parties in 
relationship to their ownership in and degree of influence or control 
over the enterprise receiving the funds.
---------------------------------------------------------------------------

    \10\ Related parties as used herein are as defined in the FASB 
ASC Master Glossary.
---------------------------------------------------------------------------

    Question 2: FASB ASC paragraph 730-20-25-5 states that the 
presumption of repayment ``can be overcome only by substantial evidence 
to the contrary.'' Can the presumption be overcome by evidence that the 
funding parties were assuming the risk of the research and development 
activities since they could not reasonably expect the enterprise to 
have resources to repay the funds based on its current and projected 
future financial condition?
    Interpretive Response: No. FASB ASC paragraph 730-20-25-3 
specifically indicates that the enterprise ``may settle the liability 
by paying cash, by issuing securities, or by some other means.'' While 
the enterprise may not be in a position to pay cash or issue debt, 
repayment could be accomplished through the issuance of stock or 
various other means. Therefore, an apparent or projected inability to 
repay the funds with cash (or debt which would later be paid with cash) 
does not necessarily demonstrate that the funding parties were 
accepting the entire risks of the activities.

P. Restructuring Charges

1. Removed by SAB 103
2. Removed by SAB 103
3. Income Statement Presentation of Restructuring Charges
    Facts: Restructuring charges often do not relate to a separate 
component of the entity, and, as such, they would not qualify for 
presentation as losses on the disposal of a discontinued operation.

[[Page 17219]]

Additionally, since the charges are not both unusual and infrequent\11\ 
they are not presented in the income statement as extraordinary items.
---------------------------------------------------------------------------

    \11\ See FASB ASC paragraph 225-20-45-2.
---------------------------------------------------------------------------

    Question 1: May such restructuring charges be presented in the 
income statement as a separate caption after income from continuing 
operations before income taxes (i.e., preceding income taxes and/or 
discontinued operations)?
    Interpretive Response: No. FASB ASC paragraph 225-20-45-16 (Income 
Statement Topic) states that items that do not meet the criteria for 
classification as an extraordinary item should be reported as a 
component of income from continuing operations.\12\ Neither FASB ASC 
Subtopic 225-20, Income Statement--Extraordinary and Unusual Items, nor 
Rule 5-03 of Regulation S-X contemplate a category in between 
continuing and discontinued operations. Accordingly, the staff believes 
that restructuring charges should be presented as a component of income 
from continuing operations, separately disclosed if material. 
Furthermore, the staff believes that a separately presented 
restructuring charge should not be preceded by a sub-total representing 
``income from continuing operations before restructuring charge'' 
(whether or not it is so captioned). Such a presentation would be 
inconsistent with the intent of FASB ASC Subtopic 225-20.
---------------------------------------------------------------------------

    \12\ FASB ASC paragraph 225-20-45-16 further provides that such 
items should not be reported on the income statement net of income 
taxes or in any manner that implies that they are similar to 
extraordinary items.
---------------------------------------------------------------------------

    Question 2: Some registrants utilize a classified or ``two-step'' 
income statement format (i.e., one which presents operating revenues, 
expenses and income followed by other income and expense items). May a 
charge which relates to assets or activities for which the associated 
revenues and expenses have historically been included in operating 
income be presented as an item of ``other expense'' in such an income 
statement?
    Interpretive Response: No. The staff believes that the proper 
classification of a restructuring charge depends on the nature of the 
charge and the assets and operations to which it relates. Therefore, 
charges which relate to activities for which the revenues and expenses 
have historically been included in operating income should generally be 
classified as an operating expense, separately disclosed if material. 
Furthermore, when a restructuring charge is classified as an operating 
expense, the staff believes that it is generally inappropriate to 
present a preceding subtotal captioned or representing operating income 
before restructuring charges. Such an amount does not represent a 
measurement of operating results under GAAP.
    Conversely, charges relating to activities previously included 
under ``other income and expenses'' should be similarly classified, 
also separately disclosed if material.
    Question 3: Is it permissible to disclose the effect on net income 
and earnings per share of such a restructuring charge?
    Interpretive Response: Discussions in MD&A and elsewhere which 
quantify the effects of unusual or infrequent items on net income and 
earnings per share are beneficial to a reader's understanding of the 
financial statements and are therefore acceptable.
    MD&A also should discuss the events and decisions which gave rise 
to the restructuring, the nature of the charge and the expected impact 
of the restructuring on future results of operations, liquidity and 
sources and uses of capital resources.
4. Disclosures
    Beginning with the period in which the exit plan is initiated, FASB 
ASC Topic 420, Exit or Disposal Cost Obligations, requires disclosure, 
in all periods, including interim periods, until the exit plan is 
completed, of the following:
    a. A description of the exit or disposal activity, including the 
facts and circumstances leading to the expected activity and the 
expected completion date
    b. For each major type of cost associated with the activity (for 
example, one-time termination benefits, contract termination costs, and 
other associated costs):
    (1) The total amount expected to be incurred in connection with the 
activity, the amount incurred in the period, and the cumulative amount 
incurred to date
    (2) A reconciliation of the beginning and ending liability balances 
showing separately the changes during the period attributable to costs 
incurred and charged to expense, costs paid or otherwise settled, and 
any adjustments to the liability with an explanation of the reason(s) 
therefor
    c. The line item(s) in the income statement or the statement of 
activities in which the costs in (b) above are aggregated
    d. For each reportable segment, the total amount of costs expected 
to be incurred in connection with the activity, the amount incurred in 
the period, and the cumulative amount incurred to date, net of any 
adjustments to the liability with an explanation of the reason(s) 
therefor
    e. If a liability for a cost associated with the activity is not 
recognized because fair value cannot be reasonably estimated, that fact 
and the reasons therefor
    Question: What specific disclosures about restructuring charges has 
the staff requested to fulfill the disclosure requirements of FASB ASC 
Topic 420 and MD&A?
    Interpretive Response: The staff often has requested greater 
disaggregation and more precise labeling when exit and involuntary 
termination costs are grouped in a note or income statement line item 
with items unrelated to the exit plan. For the reader's understanding, 
the staff has requested that discretionary, or decision-dependent, 
costs of a period, such as exit costs, be disclosed and explained in 
MD&A separately. Also to improve transparency, the staff has requested 
disclosure of the nature and amounts of additional types of exit costs 
and other types of restructuring charges \13\ that appear 
quantitatively or qualitatively material, and requested that losses 
relating to asset impairments be identified separately from charges 
based on estimates of future cash expenditures.
---------------------------------------------------------------------------

    \13\ Examples of common components of exit costs and other types 
of restructuring charges which should be considered for separate 
disclosure include, but are not limited to, involuntary employee 
terminations and related costs, changes in valuation of current 
assets such as inventory writedowns, long term asset disposals, 
adjustments for warranties and product returns, leasehold 
termination payments, and other facility exit costs, among others.
---------------------------------------------------------------------------

    The staff frequently reminds registrants that in periods subsequent 
to the initiation date that material changes and activity in the 
liability balances of each significant type of exit cost and 
involuntary employee termination benefits \14\ (either as a result of 
expenditures or changes in/reversals of estimates or the fair value of 
the liability) should be disclosed in the footnotes to the interim and 
annual financial statements and discussed in MD&A. In the event a 
company recognized liabilities for exit costs and involuntary employee 
termination benefits relating to multiple exit plans, the staff 
believes presentation of separate information for each individual exit 
plan that has a material effect on

[[Page 17220]]

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

    \14\ The staff would expect similar disclosures for employee 
termination benefits whether those costs have been recognized 
pursuant to FASB ASC Topic 420, FASB ASC Topic 712, Compensation--
Nonretirement Postemployment Benefits, or FASB ASC Topic 715, 
Compensation--Retirement Benefits.
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    For material exit or involuntary employee termination costs related 
to an acquired business, the staff has requested disclosure in either 
MD&A or the financial statements of:
    1. When the registrant began formulating exit plans for which 
accrual may be necessary,
    2. The types and amounts of liabilities recognized for exit costs 
and involuntary employee termination benefits and included in the 
acquisition cost allocation, and
    3. Any unresolved contingencies or purchase price allocation issues 
and the types of additional liabilities that may result in an 
adjustment of the acquisition cost allocation.
    The staff has noted that the economic or other events that cause a 
registrant to consider and/or adopt an exit plan or that impair the 
carrying amount of assets, generally occur over time. Accordingly, the 
staff believes that as those events and the resulting trends and 
uncertainties evolve, they often will meet the requirement for 
disclosure pursuant to the Commission's MD&A rules prior to the period 
in which the exit costs and liabilities are recorded pursuant to GAAP. 
Whether or not currently recognizable in the financial statements, 
material exit or involuntary termination costs that affect a known 
trend, demand, commitment, event, or uncertainty to management, should 
be disclosed in MD&A. The staff believes that MD&A should include 
discussion of the events and decisions which gave rise to the exit 
costs and exit plan, and the likely effects of management's plans on 
financial position, future operating results and liquidity unless it is 
determined that a material effect is not reasonably likely to occur. 
Registrants should identify the periods in which material cash outlays 
are anticipated and the expected source of their funding. Registrants 
should also discuss material revisions to exit plans, exit costs, or 
the timing of the plan's execution, including the nature and reasons 
for the revisions.
    The staff believes that the expected effects on future earnings and 
cash flows resulting from the exit plan (for example, reduced 
depreciation, reduced employee expense, etc.) should be quantified and 
disclosed, along with the initial period in which those effects are 
expected to be realized. This includes whether the cost savings are 
expected to be offset by anticipated increases in other expenses or 
reduced revenues. This discussion should clearly identify the income 
statement line items to be impacted (for example, cost of sales; 
marketing; selling, general and administrative expenses; etc.). In 
later periods if actual savings anticipated by the exit plan are not 
achieved as expected or are achieved in periods other than as expected, 
MD&A should discuss that outcome, its reasons, and its likely effects 
on future operating results and liquidity.
    The staff often finds that, because of the discretionary nature of 
exit plans and the components thereof, presenting and analyzing 
material exit and involuntary termination charges in tabular form, with 
the related liability balances and activity (e.g., beginning balance, 
new charges, cash payments, other adjustments with explanations, and 
ending balances) from balance sheet date to balance sheet date, is 
necessary to explain fully the components and effects of significant 
restructuring charges. The staff believes that such a tabular analysis 
aids a financial statement user's ability to disaggregate the 
restructuring charge by income statement line item in which the costs 
would have otherwise been recognized, absent the restructuring plan, 
(for example, cost of sales; selling, general, and administrative; 
etc.).

Q. Increasing Rate Preferred Stock

    Facts: A registrant issues Class A and Class B nonredeemable 
preferred stock \15\ on 1/1/X1. Class A, by its terms, will pay no 
dividends during the years 20X1 through 20X3. Class B, by its terms, 
will pay dividends at annual rates of $2, $4 and $6 per share in the 
years 20X1, 20X2 and 20X3, respectively. Beginning in the year 20X4 and 
thereafter as long as they remain outstanding, each instrument will pay 
dividends at an annual rate of $8 per share. In all periods, the 
scheduled dividends are cumulative.
---------------------------------------------------------------------------

    \15\ ``Nonredeemable'' preferred stock, as used in this SAB, 
refers to preferred stocks which are not redeemable or are 
redeemable only at the option of the issuer.
---------------------------------------------------------------------------

    At the time of issuance, eight percent per annum was considered to 
be a market rate for dividend yield on Class A, given its 
characteristics other than scheduled cash dividend entitlements (voting 
rights, liquidation preference, etc.), as well as the registrant's 
financial condition and future economic prospects. Thus, the registrant 
could have expected to receive proceeds of approximately $100 per share 
for Class A if the dividend rate of $8 per share (the ``perpetual 
dividend'') had been in effect at date of issuance. In consideration of 
the dividend payment terms, however, Class A was issued for proceeds of 
$79\3/8\ per share. The difference, $20\5/8\, approximated the value of 
the absence of $8 per share dividends annually for three years, 
discounted at 8%.
    The issuance price of Class B shares was determined by a similar 
approach, based on the terms and characteristics of the Class B shares.
    Question 1: How should preferred stocks of this general type 
(referred to as ``increasing rate preferred stocks'') be reported in 
the balance sheet?
    Interpretive Response: As is normally the case with other types of 
securities, increasing rate preferred stock should be recorded 
initially at its fair value on date of issuance. Thereafter, the 
carrying amount should be increased periodically as discussed in the 
Interpretive Response to Question 2.
    Question 2: Is it acceptable to recognize the dividend costs of 
increasing rate preferred stocks according to their stated dividend 
schedules?
    Interpretive Response: No. The staff believes that when 
consideration received for preferred stocks reflects expectations of 
future dividend streams, as is normally the case with cumulative 
preferred stocks, any discount due to an absence of dividends (as with 
Class A) or gradually increasing dividends (as with Class B) for an 
initial period represents prepaid, unstated dividend cost.\16\ 
Recognizing the dividend cost of these instruments according to their 
stated dividend schedules would report Class A as being cost-free, and 
would report the cost of Class B at less than its effective cost, from 
the standpoint of common stock interests (i.e., for purposes of 
computing income applicable to common stock and earnings per common 
share) during the years 20X1 through 20X3.
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    \16\ As described in the ``Facts'' section of this issue, a 
registrant would receive less in proceeds for a preferred stock, if 
the stock were to pay less than its perpetual dividend for some 
initial period(s), than if it were to pay the perpetual dividend 
from date of issuance. The staff views the discount on increasing 
rate preferred stock as equivalent to a prepayment of dividends by 
the issuer, as though the issuer had concurrently (a) issued the 
stock with the perpetual dividend being payable from date of 
issuance, and (b) returned to the investor a portion of the proceeds 
representing the present value of certain future dividend 
entitlements which the investor agreed to forgo.
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    Accordingly, the staff believes that discounts on increasing rate 
preferred stock should be amortized over the period(s) preceding 
commencement of the perpetual dividend, by charging imputed dividend 
cost against retained earnings and increasing the carrying amount of 
the preferred stock by a corresponding amount. The discount at time of 
issuance should be computed as

[[Page 17221]]

the present value of the difference between (a) dividends that will be 
payable, if any, in the period(s) preceding commencement of the 
perpetual dividend; and (b) the perpetual dividend amount for a 
corresponding number of periods; discounted at a market rate for 
dividend yield on preferred stocks that are comparable (other than with 
respect to dividend payment schedules) from an investment standpoint. 
The amortization in each period should be the amount which, together 
with any stated dividend for the period (ignoring fluctuations in 
stated dividend amounts that might result from variable rates,\17\ 
results in a constant rate of effective cost vis-a-vis the carrying 
amount of the preferred stock (the market rate that was used to compute 
the discount).
---------------------------------------------------------------------------

    \17\ 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
                                                         Beginning of year   (8% of carrying      End of year
                                                                (BOY)         amount at BOY)
----------------------------------------------------------------------------------------------------------------
Year 20x1..............................................             $79.38               6.35              85.73
Year 20x2..............................................              85.73               6.86              92.59
Year 20x3..............................................              92.59               7.41             100.00
----------------------------------------------------------------------------------------------------------------

    During 20X4 and thereafter, the stated dividend of $8 measured 
against the carrying amount of $100\18\ would reflect dividend cost of 
8%, the market rate at time of issuance.
---------------------------------------------------------------------------

    \18\ It should be noted that the $100 per share amount used in 
this issue is for illustrative purposes, and is not intended to 
imply that application of this issue will necessarily result in the 
carrying amount of a nonredeemable preferred stock being accreted to 
its par value, stated value, voluntary redemption value or 
involuntary liquidation value.
---------------------------------------------------------------------------

    The staff believes that existing authoritative literature, while 
not explicitly addressing increasing rate preferred stocks, implicitly 
calls for the accounting described in this bulletin.
    The pervasive, fundamental principle of accrual accounting would, 
in the staff's view, preclude registrants from recognizing the dividend 
cost on the basis of whatever cash payment schedule might be arranged. 
Furthermore, recognition of the effective cost of unstated rights and 
privileges is well-established in accounting, and is specifically 
called for by FASB ASC Subtopic 835-30, Interest--Imputation of 
Interest, and Topic 3.C of this codification for unstated interest 
costs of debt capital and unstated dividend costs of redeemable 
preferred stock capital, respectively. The staff believes that the 
requirement to recognize the effective periodic cost of capital applies 
also to nonredeemable preferred stocks because, for that purpose, the 
distinction between debt capital and preferred equity capital (whether 
redeemable \19\ or nonredeemable) is irrelevant from the standpoint of 
common stock interests.
---------------------------------------------------------------------------

    \19\ Application of the interest method with respect to 
redeemable preferred stocks pursuant to Topic 3.C results in 
accounting consistent with the provisions of this bulletin 
irrespective of whether the redeemable preferred stocks have 
constant or increasing stated dividend rates. The interest method, 
as described in FASB ASC Subtopic 835-30, produces a constant 
effective periodic rate of cost that is comprised of amortization of 
discount as well as the stated cost in each period.
---------------------------------------------------------------------------

    Question 3: Would the accounting for discounts on increasing rate 
preferred stock be affected by variable stated dividend rates?
    Interpretive Response: No. If stated dividends on an increasing 
rate preferred stock are variable, computations of initial discount and 
subsequent amortization should be based on the value of the applicable 
index at date of issuance and should not be affected by subsequent 
changes in the index.
    For example, assume that a preferred stock issued 1/1/X1 is 
scheduled to pay dividends at annual rates, applied to the stock's par 
value, equal to 20% of the actual (fluctuating) market yield on a 
particular Treasury security in 20X1 and 20X2, and 90% of the 
fluctuating market yield in 20X3 and thereafter. The discount would be 
computed as the present value of a two-year dividend stream equal to 
70% (90% less 20%) of the 1/1/X1 Treasury security yield, annually, on 
the stock's par value. The discount would be amortized in years 20X1 
and 20X2 so that, together with 20% of the 1/1/X1 Treasury yield on the 
stock's par value, a constant rate of cost vis-a-vis the stock's 
carrying amount would result. Changes in the Treasury security yield 
during 20X1 and 20X2 would, of course, cause the rate of total reported 
preferred dividend cost (amortization of discount plus cash dividends) 
in those years to be more or less than the rate indicated by discount 
amortization plus 20% of the 1/1/X1 Treasury security yield. However, 
the fluctuations would be due solely to the impact of changes in the 
index on the stated dividends for those periods.
    Question 4: Will the staff expect retroactive changes by 
registrants to comply with the accounting described in this bulletin?
    Interpretive Response: All registrants will be expected to follow 
the accounting described in this bulletin for increasing rate preferred 
stocks issued after December 4, 1986.\20\ Registrants that have not 
followed this accounting for increasing rate preferred stocks issued 
before that date were encouraged to retroactively change their 
accounting for those preferred stocks in the financial statements next 
filed with the Commission. The staff did not object if registrants did 
not make retroactive changes for those preferred stocks, provided that 
all presentations of and discussions regarding income applicable to 
common stock and earnings per share in future filings and shareholders' 
reports are accompanied by equally prominent supplemental disclosures 
(on the face of the income statement, in presentations of selected 
financial data, in MD&A, etc.) of the impact of not changing their 
accounting and an explanation of such impact (e.g., that dividend cost 
has been recognized on a cash basis).
---------------------------------------------------------------------------

    \20\ The staff first publicly expressed its view as to the 
appropriate accounting at the December 3-4, 1986 meeting of the 
EITF.
---------------------------------------------------------------------------

R. Removed by SAB 103

S. Quasi-Reorganization

    Facts: As a consequence of significant operating losses and/or 
recent write-downs of property, plant and equipment, a company's 
financial statements reflect an accumulated deficit. The company 
desires to eliminate the deficit by reclassifying amounts from paid-in-
capital. In addition, the company anticipates adopting a discretionary 
change in

[[Page 17222]]

accounting principles \21\ that will be recorded as a cumulative-effect 
type of accounting change. The recording of the cumulative effect will 
have the result of increasing the company's retained earnings.
---------------------------------------------------------------------------

    \21\ Discretionary accounting changes require the filing of a 
preferability letter by the registrant's independent accountant 
pursuant to Item 601 of Regulation S-K and Rule 10-01(b)(6) of 
Regulation S-X, respectively.
---------------------------------------------------------------------------

    Question 1: May the company reclassify its capital accounts to 
eliminate the accumulated deficit without satisfying all of the 
conditions enumerated in Section 210 \22\ of the Codification of 
Financial Reporting Policies for a quasi-reorganization?
---------------------------------------------------------------------------

    \22\ ASR 25.
---------------------------------------------------------------------------

    Interpretive Response: No. The staff believes a deficit 
reclassification of any nature is considered to be a quasi-
reorganization. As such, a company may not reclassify or eliminate a 
deficit in retained earnings unless all requisite conditions set forth 
in Section 210 \23\ for a quasi-reorganization are satisfied. \24\
---------------------------------------------------------------------------

    \23\ Section 210 (ASR 25) indicates the following conditions 
under which a quasi-reorganization can be effected without the 
creation of a new corporate entity and without the intervention of 
formal court proceedings:
    1. Earned surplus, as of the date selected, is exhausted;
    2. Upon consummation of the quasi-reorganization, no deficit 
exists in any surplus account;
    3. The entire procedure is made known to all persons entitled to 
vote on matters of general corporate policy and the appropriate 
consents to the particular transactions are obtained in advance in 
accordance with the applicable laws and charter provisions;
    The procedure accomplishes, with respect to the accounts, 
substantially what might be accomplished in a reorganization by 
legal proceedings--namely, the restatement of assets in terms of 
present considerations as well as appropriate modifications of 
capital and capital surplus, in order to obviate, so far as 
possible, the necessity of future reorganization of like nature.
    \24\ In addition, FASB ASC Subtopic 852-20, Reorganizations--
Quasi-Reorganizations, outlines procedures that must be followed in 
connection with and after a quasi-reorganization.
---------------------------------------------------------------------------

    Question 2: Must the company implement the discretionary change in 
accounting principle simultaneously with the quasi-reorganization or 
may it adopt the change after the quasi-reorganization has been 
effected?
    Interpretive Response: The staff has taken the position that the 
company should adopt the anticipated accounting change prior to or as 
an integral part of the quasi-reorganization. Any such accounting 
change should be effected by following GAAP with respect to the change. 
\25\
---------------------------------------------------------------------------

    \25\ FASB ASC Topic 250 provides accounting principles to be 
followed when adopting accounting changes. In addition, many newly-
issued accounting pronouncements provide specific guidance to be 
followed when adopting the accounting specified in such 
pronouncements.
---------------------------------------------------------------------------

    FASB ASC paragraph 852-20-25-5 (Reorganizations Topic) indicates 
that, following a quasi-reorganization, an ``entity's accounting shall 
be substantially similar to that appropriate for a new entity.'' The 
staff believes that implicit in this ``fresh-start'' concept is the 
need for the company's accounting principles in place at the time of 
the quasi-reorganization to be those planned to be used following the 
reorganization to avoid a misstatement of earnings and retained 
earnings after the reorganization.\26\ FASB ASC paragraph 852-20-30-2 
states, in part, ``* * * in general, assets should be carried forward 
as of the date of the readjustment at fair and not unduly conservative 
amounts, determined with due regard for the accounting to be 
subsequently employed by the entity.'' (emphasis added)
---------------------------------------------------------------------------

    \26\ Certain newly-issued accounting standards do not require 
adoption until some future date. The staff believes, however, that 
if the registrant intends or is required to adopt those standards 
within 12 months following the quasi-reorganization, the registrant 
should adopt those standards prior to or as an integral part of the 
quasi-reorganization. Further, registrants should consider early 
adoption of standards with effective dates more than 12 months 
subsequent to a quasi-reorganization.
---------------------------------------------------------------------------

    In addition, the staff believes that adopting a discretionary 
change in accounting principle that will be reflected in the financial 
statements within 12 months following the consummation of a quasi-
reorganization leads to a presumption that the accounting change was 
contemplated at the time of the quasi-reorganization.\27\
---------------------------------------------------------------------------

    \27\ Certain accounting changes require restatement of prior 
financial statements. The staff believes that if a quasi-
reorganization had been recorded in a restated period, the effects 
of the accounting change on quasi-reorganization adjustments should 
also be restated to properly reflect the quasi-reorganization in the 
restated financial statements.
---------------------------------------------------------------------------

    Question 3: In connection with a quasi-reorganization, may there be 
a write-up of net assets?
    Interpretive Response: No. The staff believes that increases in the 
recorded values of specific assets (or reductions in liabilities) to 
fair value are appropriate providing such adjustments are factually 
supportable; however, the amount of such increases is limited to 
offsetting adjustments to reflect decreases in other assets (or 
increases in liabilities) to reflect their new fair value. In other 
words, a quasi-reorganization should not result in a write-up of net 
assets of the registrant.
    Question 4: The interpretive response to question 1 indicates that 
the staff believes that a deficit reclassification of any nature is 
considered to be a quasi-reorganization, and accordingly, must satisfy 
all the conditions of Section 210.\28\ Assume a company has satisfied 
all the requisite conditions of Section 210, and has eliminated a 
deficit in retained earnings by a concurrent reduction in paid-in 
capital, but did not need to restate assets and liabilities by a charge 
to capital because assets and liabilities were already stated at fair 
values. How should the company reflect the tax benefits of operating 
loss or tax credit carryforwards for financial reporting purposes that 
existed as of the date of the quasi-reorganization when such tax 
benefits are subsequently recognized for financial reporting purposes?
---------------------------------------------------------------------------

    \28\ See footnote 27.
---------------------------------------------------------------------------

    Interpretive Response: The staff believes FASB ASC Subtopic 852-
740, Reorganizations--Income Taxes, requires that any subsequently 
recognized tax benefits of operating loss or tax credit carryforwards 
that existed as of the date of a quasi-reorganization be reported as a 
direct addition to paid-in capital. The staff believes that this 
position is consistent with the ``new company'' or ``fresh-start'' 
concept embodied in Section 210,\29\ and in existing accounting 
literature regarding quasi-reorganizations, and with the FASB staff's 
justification for such a position when they stated that a ``new 
enterprise would not have tax benefits attributable to operating losses 
or tax credits that arose prior to its organization date. \30\
---------------------------------------------------------------------------

    \29\ Section 210 (ASR 25) discusses the ``conditions under which 
a quasi-reorganization has come to be applied in accounting to the 
corporate procedures in the course of which a company, without 
creation of new corporate entity and without intervention of formal 
court proceedings, is enabled to eliminate a deficit whether 
resulting from operations or recognition of other losses or both and 
to establish a new earned surplus account for the accumulation of 
earnings subsequent to the date selected as the effective date of 
the quasi-reorganization.'' It further indicates that ``it is 
implicit in a procedure of this kind that it is not to be employed 
recurrently, but only under circumstances which would justify an 
actual reorganization or formation of a new corporation, 
particularly if the sole purpose of the quasi-reorganization is the 
elimination of a deficit in earned surplus resulting from operating 
losses.'' (emphasis added)
    \30\ FASB ASC paragraph 852-740-55-4 states in part: ``As 
indicated in paragraph 852-20-25-5, after a quasi-reorganization, 
the entity's accounting shall be substantially similar to that 
appropriate for a new entity. As such, any subsequently recognized 
tax benefit of an operating loss or tax credit carryforward that 
existed at the date of a quasi-reorganization shall not be included 
in the determination of income of the ``new'' entity, regardless of 
whether losses that gave rise to an operating loss carryforward were 
charged to income before the quasi-reorganization or directly to 
contributed capital as part of the quasi-reorganization. A new 
entity would not have tax benefits attributable to operating losses 
or tax credits that arose before its organization date.''
---------------------------------------------------------------------------

    The staff believes that all registrants that comply with the 
requirements of Section 210 in effecting a quasi-

[[Page 17223]]

reorganization should apply the accounting required by FASB ASC 
paragraph 852-740-45-3 for the tax benefits of tax carryforward 
items.31, 32 Therefore, even though the only effect of a 
quasi-reorganization is the elimination of a deficit in retained 
earnings because assets and liabilities are already stated at fair 
values and the revaluation of assets and liabilities is unnecessary (or 
a write-up of net assets is prohibited as indicated in the interpretive 
response to question 3 above), subsequently recognized tax benefits of 
operating loss or tax credit carryforward items should be recorded as a 
direct addition to paid-in capital.
---------------------------------------------------------------------------

    \31\ [Original footnote removed by SAB 114.]
    \32\ FASB ASC paragraph 852-740-45-3 states: ``[t]he tax benefit 
of deductible temporary differences and carryforwards as of the date 
of a quasi reorganization as defined and contemplated in FASB ASC 
Subtopic 852-20, ordinarily are reported as a direct addition to 
contributed capital if the tax benefits are recognized in subsequent 
years.''
---------------------------------------------------------------------------

    Question 5: If a company had previously recorded a quasi-
reorganization that only resulted in the elimination of a deficit in 
retained earnings, may the company reverse such entry and ``undo'' its 
quasi-reorganization?
    Interpretive Response: No. The staff believes FASB ASC Topic 250, 
Accounting Changes and Error Corrections, would preclude such a change 
in accounting. It states: ``a method of accounting that was previously 
adopted for a type of transaction or event that is being terminated or 
that was a single, nonrecurring event in the past shall not be 
changed.'' (emphasis added.) \33\
---------------------------------------------------------------------------

    \33\ FASB ASC paragraph 250-10-45-12.
---------------------------------------------------------------------------

T. Accounting for Expenses or Liabilities Paid by Principal 
Stockholder(s)

(Replaced by SAB 107)
    Facts: Company X was a defendant in litigation for which the 
company had not recorded a liability in accordance with FASB ASC Topic 
450, Contingencies. A principal stockholder \34\ of the company 
transfers a portion of his shares to the plaintiff to settle such 
litigation. If the company had settled the litigation directly, the 
company would have recorded the settlement as an expense.
---------------------------------------------------------------------------

    \34\ The FASB ASC Master Glossary defines principal owners as 
``owners of record or known beneficial owners of more than 10 
percent of the voting interests of the enterprise.''
---------------------------------------------------------------------------

    Question: Must the settlement be reflected as an expense in the 
company's financial statements, and if so, how?
    Interpretive Response: Yes. The value of the shares transferred 
should be reflected as an expense in the company's financial statements 
with a corresponding credit to contributed (paid-in) capital.
    The staff believes that such a transaction is similar to those 
described in FASB ASC paragraph 718-10-15-4 (Compensation--Stock 
Compensation Topic), which states that ``share-based payments awarded 
to an employee of the reporting entity by a related party or other 
holder of an economic interest \35\ in the entity as compensation for 
services provided to the entity are share-based payment transactions to 
be accounted for under this Topic unless the transfer is clearly for a 
purpose other than compensation for services to the reporting entity.'' 
As explained in this paragraph, the substance of such a transaction is 
that the economic interest holder makes a capital contribution to the 
reporting entity, and the reporting entity makes a share-based payment 
to its employee in exchange for services rendered.
---------------------------------------------------------------------------

    \35\ The FASB ASC Master Glossary defines an economic interest 
in an entity as ``any type or form of pecuniary interest or 
arrangement that an entity could issue or be a party to, including 
equity securities; financial instruments with characteristics of 
equity, liabilities or both; long-term debt and other debt-financing 
arrangements; leases; and contractual arrangements such as 
management contracts, service contracts, or intellectual property 
licenses.'' Accordingly, a principal stockholder would be considered 
a holder of an economic interest in an entity.
---------------------------------------------------------------------------

    The staff believes that the problem of separating the benefit to 
the principal stockholder from the benefit to the company cited in FASB 
ASC Topic 718 is not limited to transactions involving stock 
compensation. Therefore, similar accounting is required in this and 
other \36\ transactions where a principal stockholder pays an expense 
for the company, unless the stockholder's action is caused by a 
relationship or obligation completely unrelated to his position as a 
stockholder or such action clearly does not benefit the company.
---------------------------------------------------------------------------

    \36\ For example, SAB Topic 1.B indicates that the separate 
financial statements of a subsidiary should reflect any costs of its 
operations which are incurred by the parent on its behalf. 
Additionally, the staff notes that AICPA Technical Practice Aids 
Sec.  4160 also indicates that the payment by principal stockholders 
of a company's debt should be accounted for as a capital 
contribution.
---------------------------------------------------------------------------

    Some registrants and their accountants have taken the position that 
since FASB ASC Topic 850, Related Party Disclosures, applies to these 
transactions and requires only the disclosure of material related party 
transactions, the staff should not analogize to the accounting called 
for by FASB ASC paragraph 718-10-15-4 for transactions other than those 
specifically covered by it. The staff notes, however, that FASB ASC 
Topic 850 does not address the measurement of related party 
transactions and that, as a result, such transactions are generally 
recorded at the amounts indicated by their terms.\37\ However, the 
staff believes that transactions of the type described above differ 
from the typical related party transactions.
---------------------------------------------------------------------------

    \37\ However, in some circumstances it is necessary to reflect, 
either in the historical financial statements or a pro forma 
presentation (depending on the circumstances), related party 
transactions at amounts other than those indicated by their terms. 
Two such circumstances are addressed in Staff Accounting Bulletin 
Topic 1.B.1, Questions 3 and 4. Another example is where the terms 
of a material contract with a related party are expected to change 
upon the completion of an offering (i.e., the principal shareholder 
requires payment for services which had previously been contributed 
by the shareholder to the company).
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    The transactions for which FASB ASC Topic 850 requires disclosure 
generally are those in which a company receives goods or services 
directly from, or provides goods or services directly to, a related 
party, and the form and terms of such transactions may be structured to 
produce either a direct or indirect benefit to the related party. The 
participation of a related party in such a transaction negates the 
presumption that transactions reflected in the financial statements 
have been consummated at arm's length. Disclosure is therefore required 
to compensate for the fact that, due to the related party's 
involvement, the terms of the transaction may produce an accounting 
measurement for which a more faithful measurement may not be 
determinable.
    However, transactions of the type discussed in the facts given do 
not have such problems of measurement and appear to be transacted to 
provide a benefit to the stockholder through the enhancement or 
maintenance of the value of the stockholder's investment. The staff 
believes that the substance of such transactions is the payment of an 
expense of the company through contributions by the stockholder. 
Therefore, the staff believes it would be inappropriate to account for 
such transactions according to the form of the transaction.

U. Removed by SAB 112

V. Certain Transfers of Nonperforming Assets

    Facts: A financial institution desires to reduce its nonaccrual or 
reduced rate loans and other nonearning assets, including foreclosed 
real estate (collectively, ``nonperforming assets''). Some or all of 
such nonperforming assets are transferred to a newly-formed entity (the 
``new entity''). The financial

[[Page 17224]]

institution, as consideration for transferring the nonperforming 
assets, may receive (a) the cash proceeds of debt issued by the new 
entity to third parties, (b) a note or other redeemable instrument 
issued by the new entity, or (c) a combination of (a) and (b). The 
residual equity interests in the new entity, which carry voting rights, 
initially owned by the financial institution, are transferred to 
outsiders (for example, via distribution to the financial institution's 
shareholders or sale or contribution to an unrelated third party).
    The financial institution typically will manage the assets for a 
fee, providing necessary services to liquidate the assets, but 
otherwise does not have the right to appoint directors or legally 
control the operations of the new entity.
    FASB ASC Topic 860, Transfers and Servicing, provides guidance for 
determining when a transfer of financial assets can be recognized as a 
sale. The interpretive guidance provided in response to Questions 1 and 
2 of this SAB does not apply to transfers of financial assets falling 
within the scope of FASB ASC Topic 860. Because FASB ASC Topic 860 does 
not apply to distributions of financial assets to shareholders or a 
contribution of such assets to unrelated third parties, the 
interpretive guidance provided in response to Questions 1 and 2 of this 
SAB would apply to such conveyances.
    Further, registrants should consider the guidance contained in FASB 
ASC Topic 810, Consolidation, in determining whether it should 
consolidate the newly-formed entity.
    Question 1: What factors should be considered in determining 
whether such transfer of nonperforming assets can be accounted for as a 
disposition by the financial institution?
    Interpretive Response: The staff believes that determining whether 
nonperforming assets have been disposed of in substance requires an 
assessment as to whether the risks and rewards of ownership have been 
transferred.\38\ The staff believes that the transfer described should 
not be accounted for as a sale or disposition if (a) the transfer of 
nonperforming assets to the new entity provides for recourse by the new 
entity to the transferor financial institution, (b) the financial 
institution directly or indirectly guarantees debt of the new entity in 
whole or in part, (c) the financial institution retains a participation 
in the rewards of ownership of the transferred assets, for example 
through a higher than normal incentive or other management fee 
arrangement,\39\ or (d) the fair value of any material non-cash 
consideration received by the financial institution (for example, a 
note or other redeemable instrument) cannot be reasonably estimated. 
Additionally, the staff believes that the accounting for the transfer 
as a sale or disposition generally is not appropriate where the 
financial institution retains rewards of ownership through the holding 
of significant residual equity interests or where third party holders 
of such interests do not have a significant amount of capital at risk.
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    \38\ [Original footnote removed by SAB 114.]
    \39\ The staff recognizes that the determination of whether the 
financial institution retains a participation in the rewards of 
ownership will require an analysis of the facts and circumstances of 
each individual transaction. Generally, the staff believes that, in 
order to conclude that the financial institution has disposed of the 
assets in substance, the management fee arrangement should not 
enable the financial institution to participate to any significant 
extent in the potential increases in cash flows or value of the 
assets, and the terms of the arrangement, including provisions for 
discontinuance of services, must be substantially similar to 
management arrangements with third parties.
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    Where accounting for the transfer as a sale or disposition is not 
appropriate, the nonperforming assets should remain on the financial 
institution's balance sheet and should continue to be disclosed as 
nonaccrual, past due, restructured or foreclosed, as appropriate, and 
the debt of the new entity should be recorded by the financial 
institution.
    Question 2: If the transaction is accounted for as a sale to an 
unconsolidated party, at what value should the transfer be recorded by 
the financial institution?
    Interpretive Response: The staff believes that the transfer should 
be recorded by the financial institution at the fair value of assets 
transferred (or, if more clearly evident, the fair value of assets 
received) and a loss recognized by the financial institution for any 
excess of the net carrying value \40\ over the fair value.\41\ Fair 
value is the amount that would be realizable in an outright sale to an 
unrelated third party for cash.\42\ The same concepts should be applied 
in determining fair value of the transferred assets, i.e., if an active 
market exists for the assets transferred, then fair value is equal to 
the market value. If no active market exists, but one exists for 
similar assets, the selling prices in that market may be helpful in 
estimating the fair value. If no such market price is available, a 
forecast of expected cash flows, discounted at a rate commensurate with 
the risks involved, may be used to aid in estimating the fair value. In 
situations where discounted cash flows are used to estimate fair value 
of nonperforming assets, the staff would expect that the interest rate 
used in such computations will be substantially higher than the cost of 
funds of the financial institution and appropriately reflect the risk 
of holding these nonperforming assets. Therefore, the fair value 
determined in such a way will be lower than the amount at which the 
assets would have been carried by the financial institution had the 
transfer not occurred, unless the financial institution had been 
required under GAAP to carry such assets at market value or the lower 
of cost or market value.
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    \40\ The carrying value should be reduced by any allocable 
allowance for credit losses or other valuation allowances. The staff 
believes that the loss recognized for the excess of the net carrying 
value over the fair value should be considered a credit loss and 
this should not be included by the financial institution as loss on 
disposition.
    \41\ The staff notes that FASB ASC paragraph 942-810-45-2 
(Financial Services--Depository and Lending Topic) provides guidance 
that the newly created ``liquidating bank'' should continue to 
report its assets and liabilities at fair values at the date of the 
financial statements.
    \42\ FASB ASC paragraph 845-10-30-14 (Nonmonetary Transactions 
Topic) provides guidance that an enterprise that distributes loans 
to its owners should report such distribution at fair value.
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    Question 3: Where the transaction may appropriately be accounted 
for as a sale to an unconsolidated party and the financial institution 
receives a note receivable or other redeemable instrument from the new 
entity, how should such asset be disclosed pursuant to Item III C, 
``Risk Elements,'' of Industry Guide 3? What factors should be 
considered related to the subsequent accounting for such instruments 
received?
    Interpretive Response: The staff believes that the financial 
institution may exclude the note receivable or other asset from its 
Risk Elements disclosures under Guide 3 provided that: (a) The 
receivable itself does not constitute a nonaccrual, past due, 
restructured, or potential problem loan that would require disclosure 
under Guide 3, and (b) the underlying collateral is described in 
sufficient detail to enable investors to understand the nature of the 
note receivable or other asset, if material, including the extent of 
any over-collateralization. The description of the collateral normally 
would include material information similar to that which would be 
provided if such assets were owned by the financial institution, 
including pertinent Risk Element disclosures.
    The staff notes that, in situations in which the transaction is 
accounted for as a sale to an unconsolidated party and a portion of the 
consideration received by the registrant is debt or another

[[Page 17225]]

redeemable instrument, careful consideration must be given to the 
appropriateness of recording profits on the management fee arrangement, 
or interest or dividends on the instrument received, including 
consideration of whether it is necessary to defer such amounts or to 
treat such payments on a cost recovery basis. Further, if the new 
entity incurs losses to the point that its permanent equity based on 
GAAP is eliminated, it would ordinarily be necessary for the financial 
institution, at a minimum, to record further operating losses as its 
best estimate of the loss in realizable value of its investment.\43\
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    \43\ Typically, the financial institution's claim on the new 
entity is subordinate to other debt instruments and thus the 
financial institution will incur any losses beyond those incurred by 
the permanent equity holders.
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W. Contingency Disclosures Regarding Property-Casualty Insurance 
Reserves for Unpaid Claim Costs

    Facts: A property-casualty insurance company (the ``Company'') has 
established reserves, in accordance with FASB ASC Topic 944, Financial 
Services--Insurance, for unpaid claim costs, including estimates of 
costs relating to claims incurred but not reported (``IBNR'').\44\ The 
reserve estimate for IBNR claims was based on past loss experience and 
current trends except that the estimate has been adjusted for recent 
significant unfavorable claims experience that the Company considers to 
be nonrecurring and abnormal. The Company attributes the abnormal 
claims experience to a recent acquisition and accelerated claims 
processing; however, actuarial studies have been inconclusive and 
subject to varying interpretations. Although the reserve is deemed 
adequate to cover all probable claims, there is a reasonable 
possibility that the abnormal claims experience could continue, 
resulting in a material understatement of claim reserves.
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    \44\ FASB ASC paragraph 944-40-30-1 prescribes that ``[t]he 
liability for unpaid claims shall be based on the estimated ultimate 
cost of settling the claims (including the effects of inflation and 
other societal and economic factors), using past experience adjusted 
for current trends, and any other factors that would modify past 
experience.'' [Footnote reference omitted]
---------------------------------------------------------------------------

    FASB ASC Topic 450, Contingencies, requires, among other things, 
disclosure of loss contingencies.\45\ However, FASB ASC paragraph 450-
10-05-6 notes that ``[n]ot all uncertainties inherent in the accounting 
process give rise to contingencies.''
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    \45\ FASB ASC paragraphs 450-20-50-3 through 450-20-50-4 provide 
guidance that if no accrual is made for a loss contingency because 
one or both of the conditions in FASB ASC paragraph 450-20-25-2 are 
not met, or if an exposure to loss exists in excess of the amount 
accrued pursuant to the provisions of FASB ASC paragraph 450-20-25-
2, disclosure of the contingency shall be made when there is at 
least a reasonable possibility that a loss or an additional loss may 
have been incurred. The disclosure shall indicate the nature of the 
contingency and shall give an estimate of the possible loss or range 
of loss or state that such an estimate cannot be made.'' [Footnote 
reference omitted and emphasis added.]
---------------------------------------------------------------------------

    FASB ASC Topic 275, Risks and Uncertainties,\46\ also provides 
disclosure guidance regarding certain significant estimates.
---------------------------------------------------------------------------

    \46\ FASB ASC Topic 275 provides that disclosures regarding 
certain significant estimates should be made when certain criteria 
are met. The guidance provides that the disclosure shall indicate 
the nature of the uncertainty and include an indication that it is 
at least reasonably possible that a change in the estimate will 
occur in the near term. If the estimate involves a loss contingency 
covered by FASB ASC Topic 450, the disclosure also should include an 
estimate of the possible loss or range of loss, or state that such 
an estimate cannot be made. Disclosure of the factors that cause the 
estimate to be sensitive to change is encouraged but not required.
    FASB ASC Topic 275 requires disclosures regarding current 
vulnerability due to certain concentrations which may be applicable 
as well.
---------------------------------------------------------------------------

    Question 1: In the staff's view, do FASB ASC Topics 450 and 275 
disclosure requirements apply to property-casualty insurance reserves 
for unpaid claim costs? If so, how?
    Interpretive Response: Yes. The staff believes that specific 
uncertainties (conditions, situations and/or sets of circumstances) not 
considered to be normal and recurring because of their significance 
and/or nature can result in loss contingencies \47\ for purposes of 
applying FASB ASC Topics 450 and 275 disclosure requirements. General 
uncertainties, such as the amount and timing of claims, that are 
normal, recurring, and inherent to estimations of property-casualty 
insurance reserves are not considered subject to the disclosure 
requirements of FASB ASC Topic 450. Some specific uncertainties that 
may result in loss contingencies pursuant to FASB ASC Topic 450, 
depending on significance and/or nature, include insufficiently 
understood trends in claims activity; judgmental adjustments to 
historical experience for purposes of estimating future claim costs 
(other than for normal recurring general uncertainties); significant 
risks to an individual claim or group of related claims; or catastrophe 
losses. The requirements of FASB ASC Topic 275 apply when ``[i]t is at 
least reasonably possible that the estimate of the effect on the 
financial statements of a condition, situation, or set of circumstances 
that existed at the date of the financial statements will change in the 
near term due to one or more future confirming events * * * [and] the 
effect of the change would be material to the financial statements.''
---------------------------------------------------------------------------

    \47\ 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 FASB ASC Topics 450 and 275?
    Interpretive Response: Yes. The staff believes the judgmental 
adjustments to historical experience for insufficiently understood 
claims activity noted above results in a loss contingency within the 
scope of FASB ASC Topics 450 and 275. Based on the facts presented 
above, at a minimum the Company's financial statements should disclose 
that for purposes of estimating IBNR claim reserves, past experience 
was adjusted for what management believes to be abnormal claims 
experience related to the recent acquisition of Company A and 
accelerated claims processing. It should also be disclosed that there 
is a reasonable possibility that the claims experience could be the 
indication of an unfavorable trend which would require additional IBNR 
claim reserves in the approximate range of $XX-$XX million 
(alternatively, if Company management is unable to estimate the 
possible loss or range of loss, a statement to that effect should be 
disclosed).
    Additionally, the staff also expects companies to disclose the 
nature of the loss contingency and the potential impact on trends in 
their loss reserve development discussions provided pursuant to 
Property-Casualty Industry Guides 4 and 6. Consideration should also be 
given to the need to provide disclosure in MD&A.
    Question 3: Does the staff have an example in which specific 
uncertainties involving an individual claim or group of related claims 
result in a loss contingency the staff believes requires disclosure?
    Interpretive Response: Yes. A property-casualty insurance company 
(the ``Company'') underwrites product liability insurance for an 
insured manufacturer which has produced and sold millions of units of a 
particular product which has been used effectively and without problems 
for many years. Users of the product have recently begun to report 
serious health problems that they attribute to long term use of the 
product and have asserted claims under the insurance policy 
underwritten and retained by the Company. To date, the number of users 
reporting such problems is relatively small, and there is presently no 
conclusive evidence that demonstrates a causal link between long term 
use of the product and the health problems experienced by the 
claimants. However,

[[Page 17226]]

the evidence generated to date indicates that there is at least a 
reasonable possibility that the product is responsible for the problems 
and the assertion of additional claims is considered probable, and 
therefore the potential exposure of the Company is material. While an 
accrual may not be warranted since the loss exposure may not be both 
probable and estimable, in view of the reasonable possibility of 
material future claim payments, the staff believes that disclosures 
made in accordance with FASB ASC Topics 450 and 275 would be required 
under these circumstances.
    The disclosure concepts expressed in this example would also apply 
to an individual claim or group of claims that are related to a single 
catastrophic event or multiple events having a similar effect.

X. Removed by SAB 103

Y. Accounting and Disclosures Relating to Loss Contingencies

    Facts: A registrant believes it may be obligated to pay material 
amounts as a result of product or environmental remediation liability. 
These amounts may relate to, for example, damages attributed to the 
registrant's products or processes, clean-up of hazardous wastes, 
reclamation costs, fines, and litigation costs. The registrant may seek 
to recover a portion or all of these amounts by filing a claim against 
an insurance carrier or other third parties.
    Question 1: Assuming that the registrant's estimate of an 
environmental remediation or product liability meets the conditions set 
forth in FASB ASC paragraph 410-30-35-12 (Asset Retirement and 
Environmental Obligations Topic) for recognition on a discounted basis, 
what discount rate should be applied and what, if any, special 
disclosures are required in the notes to the financial statements?
    Interpretive Response: The rate used to discount the cash payments 
should be the rate that will produce an amount at which the 
environmental or product liability could be settled in an arm's-length 
transaction with a third party. Further, the discount rate used to 
discount the cash payments should not exceed the interest rate on 
monetary assets that are essentially risk free \48\ and have maturities 
comparable to that of the environmental or product liability.
---------------------------------------------------------------------------

    \48\ As described in Concepts Statement 7, Using Cash Flow 
Information and Present Value in Accounting Measurements.
---------------------------------------------------------------------------

    If the liability is recognized on a discounted basis to reflect the 
time value of money, the notes to the financial statements should, at a 
minimum, include disclosures of the discount rate used, the expected 
aggregate undiscounted amount, expected payments for each of the five 
succeeding years and the aggregate amount thereafter, and a 
reconciliation of the expected aggregate undiscounted amount to amounts 
recognized in the statements of financial position. Material changes in 
the expected aggregate amount since the prior balance sheet date, other 
than those resulting from pay-down of the obligation, should be 
explained.
    Question 2: What financial statement disclosures should be 
furnished with respect to recorded and unrecorded product or 
environmental remediation liabilities?
    Interpretive Response: FASB ASC Section 450-20-50, Contingencies--
Loss Contingencies--Disclosure, identify disclosures regarding loss 
contingencies that generally are furnished in notes to financial 
statements. FASB ASC Section 410-30-50, Asset Retirement and 
Environmental Obligations--Environmental Obligations--Disclosure, 
identifies disclosures that are required and recommended regarding both 
recorded and unrecorded environmental remediation liabilities. The 
staff believes that product and environmental remediation liabilities 
typically are of such significance that detailed disclosures regarding 
the judgments and assumptions underlying the recognition and 
measurement of the liabilities are necessary to prevent the financial 
statements from being misleading and to inform readers fully regarding 
the range of reasonably possible outcomes that could have a material 
effect on the registrant's financial condition, results of operations, 
or liquidity. In addition to the disclosures required by FASB ASC 
Section 450-20-50 and FASB ASC Section 410-30-50, examples of 
disclosures that may be necessary include:
     Circumstances affecting the reliability and precision of 
loss estimates.
     The extent to which unasserted claims are reflected in any 
accrual or may affect the magnitude of the contingency.
     Uncertainties with respect to joint and several liability 
that may affect the magnitude of the contingency, including disclosure 
of the aggregate expected cost to remediate particular sites that are 
individually material if the likelihood of contribution by the other 
significant parties has not been established.
     Disclosure of the nature and terms of cost-sharing 
arrangements with other potentially responsible parties.
     The extent to which disclosed but unrecognized contingent 
losses are expected to be recoverable through insurance, 
indemnification arrangements, or other sources, with disclosure of any 
material limitations of that recovery.
     Uncertainties regarding the legal sufficiency of insurance 
claims or solvency of insurance carriers.\49\
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    \49\ The staff believes there is a rebuttable presumption that 
no asset should be recognized for a claim for recovery from a party 
that is asserting that it is not liable to indemnify the registrant. 
Registrants that overcome that presumption should disclose the 
amount of recorded recoveries that are being contested and discuss 
the reasons for concluding that the amounts are probable of 
recovery.
---------------------------------------------------------------------------

     The time frame over which the accrued or presently 
unrecognized amounts may be paid out.
     Material components of the accruals and significant 
assumptions underlying estimates.
    Registrants are cautioned that a statement that the contingency is 
not expected to be material does not satisfy the requirements of FASB 
ASC Topic 450 if there is at least a reasonable possibility that a loss 
exceeding amounts already recognized may have been incurred and the 
amount of that additional loss would be material to a decision to buy 
or sell the registrant's securities. In that case, the registrant must 
either (a) disclose the estimated additional loss, or range of loss, 
that is reasonably possible, or (b) state that such an estimate cannot 
be made.
    Question 3: What disclosures regarding loss contingencies may be 
necessary outside the financial statements?
    Interpretive Response: Registrants should consider the requirements 
of Items 101 (Description of Business), 103 (Legal Proceedings), and 
303 (MD&A) of Regulation S-K. The Commission has issued interpretive 
releases that provide additional guidance with respect to these 
items.\50\ In a 1989 interpretive release, the Commission noted that 
the availability of insurance, indemnification, or contribution may be 
relevant in determining whether the criteria for disclosure have been 
met with respect to a contingency.\51\ The registrant's assessment in 
this regard should include consideration of facts such as the periods 
in which claims for recovery may be realized, the likelihood that the 
claims may be contested, and

[[Page 17227]]

the financial condition of third parties from which recovery is 
expected.
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    \50\ See Securities Act Release No. 6130, FR 36, Securities Act 
Release No. 33-8040, Securities Act Release No. 33-8039, and 
Securities Act Release 33-8176.
    \51\ See, e.g., footnote 30 of FR 36 (footnote 17 of Section 
501.02 of the Codification of Financial Reporting Policies).
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    Disclosures made pursuant to the guidance identified in the 
preceding paragraph should be sufficiently specific to enable a reader 
to understand the scope of the contingencies affecting the registrant. 
For example, a registrant's discussion of historical and anticipated 
environmental expenditures should, to the extent material, describe 
separately (a) recurring costs associated with managing hazardous 
substances and pollution in on-going operations, (b) capital 
expenditures to limit or monitor hazardous substances or pollutants, 
(c) mandated expenditures to remediate previously contaminated sites, 
and (d) other infrequent or non-recurring clean-up expenditures that 
can be anticipated but which are not required in the present 
circumstances. Disaggregated disclosure that describes accrued and 
reasonably likely losses with respect to particular environmental sites 
that are individually material may be necessary for a full 
understanding of these contingencies. Also, if management's 
investigation of potential liability and remediation cost is at 
different stages with respect to individual sites, the consequences of 
this with respect to amounts accrued and disclosed should be discussed.
    Examples of specific disclosures typically relevant to an 
understanding of historical and anticipated product liability costs 
include the nature of personal injury or property damages alleged by 
claimants, aggregate settlement costs by type of claim, and related 
costs of administering and litigating claims. Disaggregated disclosure 
that describes accrued and reasonably likely losses with respect to 
particular claims may be necessary if they are individually material. 
If the contingency involves a large number of relatively small 
individual claims of a similar type, such as personal injury from 
exposure to asbestos, disclosure of the number of claims pending at 
each balance sheet date, the number of claims filed for each period 
presented, the number of claims dismissed, settled, or otherwise 
resolved for each period, and the average settlement amount per claim 
may be necessary. Disclosures should address historical and expected 
trends in these amounts and their reasonably likely effects on 
operating results and liquidity.
    Question 4: What disclosures should be furnished with respect to 
site restoration costs or other environmental remediation costs? \52\
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    \52\ Registrants are reminded that FASB ASC Subtopic 410-20, 
Asset Retirement and Environmental Obligations--Asset Retirement 
Obligations, provides guidance for accounting and reporting for 
costs associated with asset retirement obligations.
---------------------------------------------------------------------------

    Interpretive Response: The staff believes that material liabilities 
for site restoration, post-closure, and monitoring commitments, or 
other exit costs that may occur on the sale, disposal, or abandonment 
of a property as a result of unanticipated contamination of the asset 
should be disclosed in the notes to the financial statements. 
Appropriate disclosures generally would include the nature of the costs 
involved, the total anticipated cost, the total costs accrued to date, 
the balance sheet classification of accrued amounts, and the range or 
amount of reasonably possible additional losses. If an asset held for 
sale or development will require remediation to be performed by the 
registrant prior to development, sale, or as a condition of sale, a 
note to the financial statements should describe how the necessary 
expenditures are considered in the assessment of the asset's value and 
the possible need to reflect an impairment loss. Additionally, if the 
registrant may be liable for remediation of environmental damage 
relating to assets or businesses previously disposed, disclosure should 
be made in the financial statements unless the likelihood of a material 
unfavorable outcome of that contingency is remote.\53\ The registrant's 
accounting policy with respect to such costs should be disclosed in 
accordance with FASB ASC Topic 235, Notes to Financial Statements.
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    \53\ If the company has a guarantee as defined by FASB ASC Topic 
460, Guarantees, the entity is required to provide the disclosures 
and recognize the fair value of the guarantee in the company's 
financial statements even if the ``contingent'' aspect of the 
guarantee is deemed to be remote.
---------------------------------------------------------------------------

Z. Accounting and Disclosure Regarding Discontinued Operations

1. Removed by SAB 103
2. Removed by SAB 103
3. Removed by SAB 103
4. Disposal of Operation With Significant Interest Retained
    Facts: A Company disposes of its controlling interest in a 
component of an entity as defined by the FASB ASC Master Glossary. The 
Company retains a minority voting interest directly in the component or 
it holds a minority voting interest in the buyer of the component. 
Controlling interest includes those controlling interests established 
through other means, such as variable interests. Because the Company's 
voting interest enables it to exert significant influence over the 
operating and financial policies of the investee, the Company is 
required by FASB ASC Subtopic 323-10, Investments--Equity Method and 
Joint Ventures--Overall, to account for its residual investment using 
the equity method.\54\
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    \54\ In some circumstances, the seller's continuing interest may 
be so great that divestiture accounting is inappropriate.
---------------------------------------------------------------------------

    Question: May the historical operating results of the component and 
the gain or loss on the sale of the majority interest in the component 
be classified in the Company's statement of operations as 
``discontinued operations'' pursuant to FASB ASC Subtopic 205-20, 
Presentation of Financial Statements--Discontinued Operations?
    Interpretive Response: No. A condition necessary for discontinued 
operations reporting, as indicated in FASB ASC paragraph 205-20-45-1 is 
that an entity ``not have any significant continuing involvement in the 
operations of the component after the disposal transaction.'' In these 
circumstances, the transaction should be accounted for as the disposal 
of a group of assets that is not a component of an entity and 
classified within continuing operations pursuant to FASB ASC paragraph 
360-10-45-5 (Property, Plant, and Equipment Topic).\55\
---------------------------------------------------------------------------

    \55\ However, a plan of disposal that contemplates the transfer 
of assets to a limited-life entity created for the single purpose of 
liquidating the assets of a component of an entity would not 
necessitate classification within continuing operations solely 
because the registrant retains control or significant influence over 
the liquidating entity.
---------------------------------------------------------------------------

5. Classification and Disclosure of Contingencies Relating to 
Discontinued Operations
    Facts: A company disposed of a component of an entity in a previous 
accounting period. The Company received debt and/or equity securities 
of the buyer of the component or of the disposed component as 
consideration in the sale, but this financial interest is not 
sufficient to enable the Company to apply the equity method with 
respect to its investment in the buyer. The Company made certain 
warranties to the buyer with respect to the discontinued business, or 
remains liable under environmental or other laws with respect to 
certain facilities or operations transferred to the buyer. The 
disposition satisfied the criteria of FASB ASC Subtopic 205-20 for 
presentation as ``discontinued operations.'' The Company estimated the 
fair value of the securities received in the transaction for purposes 
of calculating the gain or loss on disposal that was recognized in its 
financial statements. The results of discontinued operations prior to 
the

[[Page 17228]]

date of disposal or classification as held for sale included provisions 
for the Company's existing obligations under environmental laws, 
product warranties, or other contingencies. The calculation of gain or 
loss on disposal included estimates of the Company's obligations 
arising as a direct result of its decision to dispose of the component, 
under its warranties to the buyer, and under environmental or other 
laws. In a period subsequent to the disposal date, the Company records 
a charge to income with respect to the securities because their fair 
value declined materially and the Company determined that the decline 
was other than temporary. The Company also records adjustments of its 
previously estimated liabilities arising under the warranties and under 
environmental or other laws.
    Question 1: Should the writedown of the carrying value of the 
securities and the adjustments of the contingent liabilities be 
classified in the current period's statement of operations within 
continuing operations or as an element of discontinued operations?
    Interpretive Response: Adjustments of estimates of contingent 
liabilities or contingent assets that remain after disposal of a 
component of an entity or that arose pursuant to the terms of the 
disposal generally should be classified within discontinued 
operations.\56\ However, the staff believes that changes in the 
carrying value of assets received as consideration in the disposal or 
of residual interests in the business should be classified within 
continuing operations.
---------------------------------------------------------------------------

    \56\ Registrants are reminded that FASB ASC Topic 460, 
Guarantees, requires recognition and disclosure of certain 
guarantees which may impose accounting and disclosure requirements 
in addition to those discussed in this SAB Topic.
---------------------------------------------------------------------------

    FASB ASC paragraph 205-20-45-4 requires that ``adjustments to 
amounts previously reported in discontinued operations that are 
directly related to the disposal of a component of an entity in a prior 
period shall be classified separately in the current period in 
discontinued operations.'' The staff believes that the provisions of 
FASB ASC paragraph 205-20-45-4 apply only to adjustments that are 
necessary to reflect new information about events that have occurred 
that becomes available prior to disposal of the component of the 
entity, to reflect the actual timing and terms of the disposal when it 
is consummated, and to reflect the resolution of contingencies 
associated with that component, such as warranties and environmental 
liabilities retained by the seller.
    Developments subsequent to the disposal date that are not directly 
related to the disposal of the component or the operations of the 
component prior to disposal are not ``directly related to the 
disposal'' as contemplated by FASB ASC paragraph 205-20-45-4. 
Subsequent changes in the carrying value of assets received upon 
disposition of a component do not affect the determination of gain or 
loss at the disposal date, but represent the consequences of 
management's subsequent decisions to hold or sell those assets. Gains 
and losses, dividend and interest income, and portfolio management 
expenses associated with assets received as consideration for 
discontinued operations should be reported within continuing 
operations.
    Question 2: What disclosures would the staff expect regarding 
discontinued operations prior to the disposal date and with respect to 
risks retained subsequent to the disposal date?
    Interpretive Response: MD&A \57\ should include disclosure of known 
trends, events, and uncertainties involving discontinued operations 
that may materially affect the Company's liquidity, financial 
condition, and results of operations (including net income) between the 
date when a component of an entity is classified as discontinued and 
the date when the risks of those operations will be transferred or 
otherwise terminated. Disclosure should include discussion of the 
impact on the Company's liquidity, financial condition, and results of 
operations of changes in the plan of disposal or changes in 
circumstances related to the plan. Material contingent liabilities,\58\ 
such as product or environmental liabilities or litigation, that may 
remain with the Company notwithstanding disposal of the underlying 
business should be identified in notes to the financial statements and 
any reasonably likely range of possible loss should be disclosed 
pursuant to FASB ASC Topic 450, Contingencies. MD&A should include 
discussion of the reasonably likely effects of these contingencies on 
reported results and liquidity. If the Company retains a financial 
interest in the discontinued component or in the buyer of that 
component that is material to the Company, MD&A should include 
discussion of known trends, events, and uncertainties, such as the 
financial condition and operating results of the issuer of the 
security, that may be reasonably expected to affect the amounts 
ultimately realized on the investments.
---------------------------------------------------------------------------

    \57\ Item 303 of Regulation S-K.
    \58\ Registrants also should consider the disclosure 
requirements of FASB ASC Topic 460.
---------------------------------------------------------------------------

6. Removed by SAB 103
7. Accounting for the Spin-Off of a Subsidiary
    Facts: A Company disposes of a business through the distribution of 
a subsidiary's stock to the Company's shareholders on a pro rata basis 
in a transaction that is referred to as a spin-off.
    Question: May the Company elect to characterize the spin-off 
transaction as resulting in a change in the reporting entity and 
restate its historical financial statements as if the Company never had 
an investment in the subsidiary, in the manner specified by FASB ASC 
Topic 250, Accounting Changes and Error Corrections?
    Interpretive Response: Not ordinarily. If the Company was required 
to file periodic reports under the Exchange Act within one year prior 
to the spin-off, the staff believes the Company should reflect the 
disposition in conformity with FASB ASC Topic 360. This presentation 
most fairly and completely depicts for investors the effects of the 
previous and current organization of the Company. However, in limited 
circumstances involving the initial registration of a company under the 
Exchange Act or Securities Act, the staff has not objected to financial 
statements that retroactively reflect the reorganization of the 
business as a change in the reporting entity if the spin-off 
transaction occurs prior to effectiveness of the registration 
statement. This presentation may be acceptable in an initial 
registration if the Company and the subsidiary are in dissimilar 
businesses, have been managed and financed historically as if they were 
autonomous, have no more than incidental common facilities and costs, 
will be operated and financed autonomously after the spin-off, and will 
not have material financial commitments, guarantees, or contingent 
liabilities to each other after the spin-off. This exception to the 
prohibition against retroactive omission of the subsidiary is intended 
for companies that have not distributed widely financial statements 
that include the spun-off subsidiary. Also, dissimilarity contemplates 
substantially greater differences in the nature of the businesses than 
those that would ordinarily distinguish reportable segments as defined 
by FASB ASC paragraph 280-10-50-10 (Segment Reporting Topic).

[[Page 17229]]

AA. Removed by SAB 103

BB. Inventory Valuation Allowances

    Facts: FASB ASC paragraph 330-10-35-1 (Inventory Topic), specifies 
that: ``[a] departure from the cost basis of pricing the inventory is 
required when the utility of the goods is no longer as great as its 
cost. Where there is evidence that the utility of goods, in their 
disposal in the ordinary course of business, will be less than cost, 
whether due to physical deterioration, obsolescence, changes in price 
levels, or other causes, the difference shall be recognized as a loss 
of the current period. This is generally accomplished by stating such 
goods at a lower level commonly designated as market.''
    FASB ASC paragraph 330-10-35-14 indicates that ``[i]n the case of 
goods which have been written down below cost at the close of a fiscal 
year, such reduced amount is to be considered the cost for subsequent 
accounting purposes.''
    Lastly, the FASB ASC Master Glossary provides ``inventory 
obsolescence'' as one of the items subject to a change in accounting 
estimate.
    Question: Does the write-down of inventory to the lower of cost or 
market, as required by FASB ASC Topic 330, create a new cost basis for 
the inventory or may a subsequent change in facts and circumstances 
allow for restoration of inventory value, not to exceed original 
historical cost?
    Interpretive Response: Based on FASB ASC paragraph 330-10-35-14, 
the staff believes that a write-down of inventory to the lower of cost 
or market at the close of a fiscal period creates a new cost basis that 
subsequently cannot be marked up based on changes in underlying facts 
and circumstances.\59\
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    \59\ See also disclosure requirement for inventory balances in 
Rule 5-02(6) of Regulation S-X.
---------------------------------------------------------------------------

CC. Impairments

    Standards for recognizing and measuring impairment of the carrying 
amount of long-lived assets including certain identifiable intangibles 
to be held and used in operations are found in FASB ASC Topic 360, 
Property, Plant, and Equipment. Standards for recognizing and measuring 
impairment of the carrying amount of goodwill and identifiable 
intangible assets that are not currently being amortized are found in 
FASB ASC Topic 350, Intangibles--Goodwill and Other.
    Facts: Company X has mainframe computers that are to be abandoned 
in six to nine months as replacement computers are put in place. The 
mainframe computers were placed in service in January 20X0 and were 
being depreciated on a straight-line basis over seven years. No salvage 
value had been projected at the end of seven years and the original 
cost of the computers was $8,400. The board of directors, with the 
appropriate authority, approved the abandonment of the computers in 
March 20X3 when the computers had a remaining carrying value of $4,600. 
No proceeds are expected upon abandonment. Abandonment cannot occur 
prior to the receipt and installation of replacement computers, which 
is expected prior to the end of 20X3. Management had begun reevaluating 
its mainframe computer capabilities in January 20X2 and had included in 
its 20X3 capital expenditures budget an estimated amount for new 
mainframe computers. The 20X3 capital expenditures budget had been 
prepared by management in August 20X2, had been discussed with the 
company's board of directors in September 20X2 and was formally 
approved by the board of directors in March 20X3. Management had also 
begun soliciting bids for new mainframe computers beginning in the fall 
of 20X2. The mainframe computers, when grouped with assets at the 
lowest level of identifiable cash flows, were not impaired on a ``held 
and used'' basis throughout this time period. Management had not 
adjusted the original estimated useful life of the computers (seven 
years) since 20X0.
    Question 1: Company X proposes to recognize an impairment charge 
under FASB ASC Topic 360 for the carrying value of the mainframe 
computers of $4,600 in March 20X3. Does Company X meet the requirements 
in FASB ASC Topic 360 to classify the mainframe computer assets as ``to 
be abandoned?''
    Interpretive Response: No. FASB ASC paragraph 360-10-35-47 provides 
that ``a long-lived asset to be abandoned is disposed of when it ceases 
to be used. If an entity commits to a plan to abandon a long-lived 
asset before the end of its previously estimated useful life, 
depreciation estimates shall be revised in accordance with FASB ASC 
Topic 250, Accounting Changes and Error Corrections, to reflect the use 
of the asset over its shortened useful life.''
    Question 2: Would the staff accept an adjustment to write down the 
carrying value of the computers to reflect a ``normalized 
depreciation'' rate for the period from March 20X3 through actual 
abandonment (e.g., December 20X3)? Normalized depreciation would 
represent the amount of depreciation otherwise expected to be 
recognized during that period without adjustment of the asset's useful 
life, or $1,000 ($100/month for ten months) in the example fact 
pattern.
    Interpretive Response: No. The mainframe computers would be viewed 
as ``held and used'' at March 20X3 under the fact pattern described. 
There is no basis under FASB ASC Topic 360 to write down an asset to an 
amount that would subsequently result in a ``normalized depreciation'' 
charge through the disposal date, whether disposal is to be by sale, 
abandonment, or other means. FASB ASC paragraph 360-10-35-43 requires 
the asset to be valued at the lower of carrying amount or fair value 
less cost to sell in order to be classified as ``held for sale.'' For 
assets that are classified as ``held and used'' under FASB ASC Topic 
360, an assessment must first be made as to whether the asset (asset 
group) is impaired. FASB ASC paragraph 360-10-35-17 indicates that an 
impairment loss shall be recognized only if the carrying amount of a 
long-lived asset (asset group) is not recoverable and exceeds its fair 
value. The carrying amount of a long-lived asset (asset group) is not 
recoverable if it exceeds the sum of the undiscounted cash flows 
expected to result from the use and eventual disposition of the asset 
(asset group). The staff would object to a write down of long-lived 
assets to a ``normalized depreciation'' value as representing an 
acceptable alternative to the approaches required in FASB ASC Topic 
360.
    The staff also believes that registrants must continually evaluate 
the appropriateness of useful lives assigned to long-lived assets, 
including identifiable intangible assets and goodwill. In the above 
fact pattern, management had contemplated removal of the mainframe 
computers beginning in January 20X2 and, more formally, in August 20X2 
as part of compiling the 20X3 capital expenditures budget. At those 
times, at a minimum, management should have reevaluated the original 
useful life assigned to the computers to determine whether a seven year 
amortization period remained appropriate given the company's current 
facts and circumstances, including ongoing technological changes in the 
market place. This reevaluation process should have continued at the 
time of the September 20X2 board of directors' meeting to discuss 
capital expenditure plans and, further, as the company pursued 
mainframe computer bids. Given the contemporaneous evidence that 
management's best estimate during much of 20X2 was that the current 
mainframe computers would be removed from service in 20X3, the 
depreciable life of the computers should

[[Page 17230]]

have been adjusted prior to 20X3 to reflect this new estimate. The 
staff does not view the recognition of an impairment charge to be an 
acceptable substitute for choosing the appropriate initial amortization 
or depreciation period or subsequently adjusting this period as company 
or industry conditions change. The staff's view applies also to 
selection of, and changes to, estimated residual values. Consequently, 
the staff may challenge impairment charges for which the timely 
evaluation of useful life and residual value cannot be demonstrated.
    Question 3: Has the staff expressed any views with respect to 
company-determined estimates of cash flows used for assessing and 
measuring impairment of assets under FASB ASC Topic 360?
    Interpretive Response: In providing guidance on the development of 
cash flows for purposes of applying the provisions of that Topic, FASB 
ASC paragraph 360-10-35-30 indicates that ``estimates of future cash 
flows used to test the recoverability of a long-lived asset (asset 
group) shall incorporate the entity's own assumptions about its use of 
the asset (asset group) and shall consider all available evidence. The 
assumptions used in developing those estimates shall be reasonable in 
relation to the assumptions used in developing other information used 
by the entity for comparable periods, such as internal budgets and 
projections, accruals related to incentive compensation plans, or 
information communicated to others.''
    The staff recognizes that various factors, including management's 
judgments and assumptions about the business plans and strategies, 
affect the development of future cash flow projections for purposes of 
applying FASB ASC Topic 360. The staff, however, cautions registrants 
that the judgments and assumptions made for purposes of applying FASB 
ASC Topic 360 must be consistent with other financial statement 
calculations and disclosures and disclosures in MD&A. The staff also 
expects that forecasts made for purposes of applying FASB ASC Topic 360 
be consistent with other forward-looking information prepared by the 
company, such as that used for internal budgets, incentive compensation 
plans, discussions with lenders or third parties, and/or reporting to 
management or the board of directors.
    For example, the staff has reviewed a fact pattern where a 
registrant developed cash flow projections for purposes of applying the 
provisions of FASB ASC Topic 360 using one set of assumptions and 
utilized a second, more conservative set of assumptions for purposes of 
determining whether deferred tax valuation allowances were necessary 
when applying the provisions of FASB ASC Topic 740, Income Taxes. In 
this case, the staff objected to the use of inconsistent assumptions.
    In addition to disclosure of key assumptions used in the 
development of cash flow projections, the staff also has required 
discussion in MD&A of the implications of assumptions. For example, do 
the projections indicate that a company is likely to violate debt 
covenants in the future? What are the ramifications to the cash flow 
projections used in the impairment analysis? If growth rates used in 
the impairment analysis are lower than those used by outside analysts, 
has the company had discussions with the analysts regarding their 
overly optimistic projections? Has the company appropriately informed 
the market and its shareholders of its reduced expectations for the 
future that are sufficient to cause an impairment charge? The staff 
believes that cash flow projections used in the impairment analysis 
must be both internally consistent with the company's other projections 
and externally consistent with financial statement and other public 
disclosures.

DD. Written Loan Commitments Recorded at Fair Value Through Earnings

    Facts: Bank A enters into a loan commitment with a customer to 
originate a mortgage loan at a specified rate. As part of this written 
loan commitment, Bank A expects to receive future net cash flows 
related to servicing rights from servicing fees (included in the loan's 
interest rate or otherwise), late charges, and other ancillary sources, 
or from selling the servicing rights to a third party. If Bank A 
intends to sell the mortgage loan after it is funded, pursuant to FASB 
ASC paragraph 815-10-15-83 (Derivatives and Hedging Topic), the written 
loan commitment is accounted for as a derivative instrument and 
recorded at fair value through earnings (referred to hereafter as a 
``derivative loan commitment''). If Bank A does not intend to sell the 
mortgage loan after it is funded, the written loan commitment is not 
accounted for as a derivative under FASB ASC Subtopic 815-10, 
Derivatives and Hedging--Overall. However, FASB ASC subparagraph 825-
10-15-4(c) (Financial Instruments Topic) permits Bank A to record the 
written loan commitment at fair value through earnings (referred to 
hereafter as a ``written loan commitment''). Pursuant to FASB ASC 
Subtopic 825-10, Financial Instruments--Overall, the fair value 
measurement for a written loan commitment would include the expected 
net future cash flows related to the associated servicing of the loan.
    Question 1: In measuring the fair value of a derivative loan 
commitment accounted for under FASB ASC Subtopic 815-10, should Bank A 
include the expected net future cash flows related to the associated 
servicing of the loan?
    Interpretive Response: Yes. The staff believes that, consistent 
with the guidance in FASB ASC Subtopic 860-50, Transfers and 
Servicing--Servicing Assets and Liabilities,\60\ and FASB ASC Subtopic 
825-10, the expected net future cash flows related to the associated 
servicing of the loan should be included in the fair value measurement 
of a derivative loan commitment. The expected net future cash flows 
related to the associated servicing of the loan that are included in 
the fair value measurement of a derivative loan commitment or a written 
loan commitment should be determined in the same manner that the fair 
value of a recognized servicing asset or liability is measured under 
FASB ASC Subtopic 860-50. However, as discussed in FASB ASC paragraph 
860-50-25-1, a separate and distinct servicing asset or liability is 
not recognized for accounting purposes until the servicing rights have 
been contractually separated from the underlying loan by sale or 
securitization of the loan with servicing retained.
---------------------------------------------------------------------------

    \60\ FASB ASC Subtopic 860-50 permits an entity to subsequently 
measure recognized servicing assets and servicing liabilities (which 
are nonfinancial instruments) at fair value through earnings.
---------------------------------------------------------------------------

    The views in Question 1 apply to all loan commitments that are 
accounted for at fair value through earnings. However, for purposes of 
electing fair value accounting pursuant to FASB ASC Subtopic 825-10, 
the views in Question 1 are not intended to be applied by analogy to 
any other instrument that contains a nonfinancial element.
    Question 2: In measuring the fair value of a derivative loan 
commitment accounted for under FASB ASC Subtopic 815-10 or a written 
loan commitment accounted for under FASB ASC Subtopic 825-10, should 
Bank A include the expected net future cash flows related to 
internally-developed intangible assets?
    Interpretive Response: No. The staff does not believe that 
internally-developed intangible assets (such as customer relationship 
intangible assets) should be recorded as part of the fair value of a 
derivative loan commitment or a written loan commitment. Such

[[Page 17231]]

nonfinancial elements of value should not be considered a component of 
the related instrument. Recognition of such assets would only be 
appropriate in a third-party transaction. For example, in the purchase 
of a portfolio of derivative loan commitments in a business 
combination, a customer relationship intangible asset is recorded 
separately from the fair value of such loan commitments. Similarly, 
when an entity purchases a credit card portfolio, FASB ASC paragraph 
310-10-25-7 (Receivables Topic) requires an allocation of the purchase 
price to a separately recorded cardholder relationship intangible 
asset.
    The view in Question 2 applies to all loan commitments that are 
accounted for at fair value through earnings.

TOPIC 6: INTERPRETATIONS OF ACCOUNTING SERIES RELEASES AND FINANCIAL 
REPORTING RELEASES

A.1. Removed by SAB 103

B. Accounting Series Release 280--General Revision of Regulation S-X: 
Income or Loss Applicable to Common Stock

    Facts: A registrant has various classes of preferred stock. 
Dividends on those preferred stocks and accretions of their carrying 
amounts cause income applicable to common stock to be less than 
reported net income.
    Question: In ASR 280, the Commission stated that although it had 
determined not to mandate presentation of income or loss applicable to 
common stock in all cases, it believes that disclosure of that amount 
is of value in certain situations. In what situations should the amount 
be reported, where should it be reported, and how should it be 
computed?
    Interpretive Response: Income or loss applicable to common stock 
should be reported on the face of the income statement \1\ when it is 
materially different in quantitative terms from reported net income or 
loss \2\ or when it is indicative of significant trends or other 
qualitative considerations. The amount to be reported should be 
computed for each period as net income or loss less: (a) Dividends on 
preferred stock, including undeclared or unpaid dividends if 
cumulative; and (b) periodic increases in the carrying amounts of 
instruments reported as redeemable preferred stock (as discussed in 
Topic 3.C) or increasing rate preferred stock (as discussed in Topic 
5.Q).
---------------------------------------------------------------------------

    \1\ When a registrant reports net income and total comprehensive 
income in one continuous financial statement, the registrant must 
continue to follow the guidance set forth in the SAB Topic. One 
approach may be to provide a separate reconciliation of net income 
to income available to common stock below comprehensive income 
reported on a statement of income and comprehensive income.
    \2\ The assessment of materiality is the responsibility of each 
registrant. However, absent concerns about trends or other 
qualitative considerations, the staff generally will not insist on 
the reporting of income or loss applicable to common stock if the 
amount differs from net income or loss by less than ten percent.
---------------------------------------------------------------------------

C. Accounting Series Release 180--Institution of Staff Accounting 
Bulletins (SABs)--Applicability of Guidance Contained in SABs

    Facts: The series of SABs was instituted to achieve wide 
dissemination of administrative interpretations and practices of the 
Commission's staff. In illustration of certain interpretations and 
practices, SABs may be written narrowly to describe the circumstances 
of particular matters which resulted in expression of the staff's views 
on those particular matters.
    Question: How does the staff intend SABs to be applied in 
circumstances analogous to those addressed in SABs?
    Interpretive Response: The staff's purpose in issuing SABs is to 
disseminate guidance for application not only in the narrowly described 
circumstances, but also, unless authoritative accounting literature 
calls for different treatment, in other circumstances where events and 
transactions have similar accounting and/or disclosure implications.
    Registrants and independent accountants are encouraged to consult 
with the staff if they believe that particular circumstances call for 
accounting and/or disclosure different from that which would result 
from application of a SAB addressing those same or analogous 
circumstances.

D. Redesignated as Topic 12.A by SAB 47

E. Redesignated as Topic 12.B by SAB 47

F. Removed by SAB 103

G. Accounting Series Releases 177 and 286--Relating to Amendments to 
Form 10-Q, Regulation S-K, and Regulations S-X Regarding Interim 
Financial Reporting

    General Facts: Disclosure requirements for quarterly data on Form 
10-Q were amended in ASR 177 and 286 to include condensed interim 
financial statements, a narrative analysis of financial condition and 
results of operations, a letter from the registrant's independent 
public accountant commenting on any accounting change, and a signature 
by the registrant's chief financial officer or chief accounting 
officer.\3\ In addition, certain selected quarterly data is required to 
be disclosed by virtually all registrants (see Item 302(a)(5) of 
Regulation S-K).
---------------------------------------------------------------------------

    \3\ These requirements have been further revised to require the 
company's CEO and CFO to certify to the information contained in the 
company's periodic filing.
---------------------------------------------------------------------------

1. Selected Quarterly Financial Data (Item 302(a) of Regulation S-K)
a. Disclosure of Selected Quarterly Financial Data
    Facts: Item 302(a)(1) of Regulation S-K requires disclosure of net 
sales, gross profit, income before extraordinary items and cumulative 
effect of a change in accounting, per share data based upon such income 
(loss), net income (loss), and net income (loss) attributable to the 
registrant for each full quarter within the two most recent fiscal 
years and any subsequent interim period for which financial statements 
are included. Item 302(a)(3) requires the registrant to describe the 
effect of any disposals of components of an entity \4\ and 
extraordinary, unusual or infrequently occurring items recognized in 
each quarter, as well as the aggregate effect and the nature of year-
end or other adjustments which are material to the results of that 
quarter. Furthermore, Item 302(a)(2) requires a reconciliation of 
amounts previously reported on Form 10-Q to the quarterly data 
presented if the amounts differ.
---------------------------------------------------------------------------

    \4\ See question 5 for a discussion of the meaning of components 
of an entity as used in Item 302(a)(2).
---------------------------------------------------------------------------

    Question 1: Are these disclosure requirements applicable to 
supplemental financial statements included in a filing with the SEC for 
unconsolidated subsidiaries and 50% or less owned persons?
    Interpretive Response: The summarized quarterly financial data 
required by Item 302(a)(1) need not be included in supplemental 
financial statements for unconsolidated subsidiaries and 50% or less 
owned persons unless the financial statements are for a subsidiary or 
affiliate that is itself a registrant which meets the criteria set 
forth in Item 302(a)(5).
    Question 2: If a company is in a specialized industry where ``gross 
profit'' generally is not computed (e.g., banks, insurance companies 
and finance companies), what disclosure should be made to comply with 
the requirements of Item 302(a)(1)?
    Interpretive Response: Companies in specialized industries should 
present summarized quarterly financial data which are most meaningful 
in their

[[Page 17232]]

particular circumstances. For example, a bank might present interest 
income, interest expense, provision for loan losses, security gains or 
losses and net income. Similarly, an insurance company might present 
net premiums earned, underwriting costs and expenses, investment 
income, security gains or losses and net income.
    Question 3: If a company wishes to make its quarterly and annual 
disclosures on the same basis, would disclosure of costs and expenses 
associated directly with or allocated to products sold or services 
rendered, or other appropriate data to enable users to compute ``gross 
profit,'' satisfy the requirements of Item 302(a)(1)?
    Interpretive Response: Yes.
    Question 4: What is meant by ``per-share data based upon such 
income'' as used in Item 302(a)(1)?
    Interpretive Response: Item 302(a)(1) only requires disclosure of 
per share amounts for income before extraordinary items and cumulative 
effect of a change in accounting. It is expected that when per share 
data is calculated for each full quarter based upon such income, the 
per share amounts would be both basic and diluted. Although it is not 
required by the rule, there are many instances where it would be 
desirable to disclose other per share figures such as net earnings per 
share and the per share effect of extraordinary items also. Where such 
disclosure is made, per share data should be both basic and diluted.
    Question 5: What is intended by the requirement set forth in Item 
302(a)(3) that registrants ``describe the effect of'' disposals of 
segments of a business, etc.?
    Interpretive Response: The rule uses the language of segments of a 
business that was previously found in the authoritative literature. 
Consistent with the terminology used in FASB ASC Subtopic 205-20, 
Presentation of Financial Statements--Discontinued Operations, as used 
here, segments of a business is intended to mean components of an 
entity. The rule is intended to require registrants to ``disclose the 
amount'' of such unusual transactions and events included in the 
results reported for each quarter. Such disclosure would be made in 
narrative form. However, it would not require that matters covered by 
MD&A be repeated. In this situation, registrants should disclose the 
nature and amount of the unusual transaction or event and refer to MD&A 
for further discussion of the matter.
    Question 6: What is intended by the requirement of Item 302(a)(3) 
to disclose ``the aggregate effect and the nature of year-end or other 
adjustments which are material to the results of that quarter''?
    Interpretive Response: This language is taken directly from FASB 
ASC paragraph 270-10-50-2 (Interim Reporting Topic) which relates to 
disclosures required for the fourth quarter of the year. FASB ASC Topic 
270 indicates that earlier quarters should not be restated to reflect a 
change in accounting estimate recorded at year end. However, changes in 
an accounting estimate made in an interim period that materially affect 
the quarter in which the change occurred are required to be disclosed 
in order to avoid misleading comparisons. In making such disclosure, 
registrants may wish to identify (but not restate) the prior periods in 
which transactions were recorded which relate to the change in the 
quarter.
    Question 7: If company has filed a Form 10-Q/A amending a 
previously filed Form 10-Q, is a reconciliation of quarterly data in 
annual financial statements with the amounts originally reported on 
Form 10-Q required?
    Interpretive Response: Yes. However, if the company publishes 
quarterly reports to shareholders and has previously made detailed 
disclosure to shareholders in such reports of the change reported on 
the Form 10-Q/A, no reconciliation would be required.
b. Financial Statements Presented on Other Than a Quarterly Basis
    Facts: Item 302(a)(1) requires disclosure of quarterly financial 
data for each full quarter of the last two fiscal years and in any 
subsequent interim period for which an income statement is presented.
    Question: If a company reports at interim dates on other than a 
calendar-quarter basis (e.g., 12-12-16-12 week basis), will it be 
precluded from reporting on such basis in the future?
    Interpretive Response: No, as long as it discloses the basis of 
interim fiscal period reporting and the interim fiscal periods on which 
it reports are consistently determined from year to year (or, if not, 
the lack of comparability is disclosed).
c. Removed by SAB 103
2. Amendments to Form 10-Q
a. Form of Condensed Financial Statements
    Facts: Rules 10-01(a)(2) and (3) of Regulation S-X provide that 
interim balance sheets and statements of income shall include only 
major captions (i.e., numbered captions) set forth in Regulation S-X, 
with the exception of inventories where data as to raw materials, work 
in process and finished goods shall be included, if applicable, either 
on the face of the balance sheet or in notes thereto. Where any major 
balance sheet caption is less than 10% of total assets and the amount 
in the caption has not increased or decreased by more than 25% since 
the end of the preceding fiscal year, the caption may be combined with 
others. When any major income statement caption is less than 15% of 
average net income attributable to the registrant for the most recent 
three fiscal years and the amount in the caption has not increased or 
decreased by more than 20% as compared to the corresponding interim 
period of the preceding fiscal year, the caption may be combined with 
others. Similarly, the statement of cash flows may be abbreviated, 
starting with a single figure of cash flows provided by operations and 
showing other changes individually only when they exceed 10% of the 
average of cash flows provided by operations for the most recent three 
years.
    Question 1: If a company previously combined captions in a Form 10-
Q but is required to present such captions separately in the Form 10-Q 
for the current quarter, must it retroactively reclassify amounts 
included in the prior-year financial statements presented for 
comparative purposes to conform with the captions presented for the 
current-year quarter?
    Interpretive Response: Yes.
    Question 2: If a company uses the gross profit method or some other 
method to determine cost of goods sold for interim periods, will it be 
acceptable to state only that it is not practicable to determine 
components of inventory at interim periods?
    Interpretive Response: The staff believes disclosure of inventory 
components is important to investors. In reaching this decision, the 
staff recognizes that registrants may not take inventories during 
interim periods and that managements, therefore, will have to estimate 
the inventory components. However, the staff believes that management 
will be able to make reasonable estimates of inventory components based 
upon their knowledge of the company's production cycle, the costs 
(labor and overhead) associated with this cycle as well as the relative 
sales and purchasing volume of the company.
    Question 3: If a company has years during which operations resulted 
in a net outflow of cash and cash equivalents, should it exclude such 
years from the computation of cash and cash equivalents provided by 
operations for the three most recent years in

[[Page 17233]]

determining what sources and applications must be shown separately?
    Interpretive Response: Yes. Similar to the determination of average 
net income, if operations resulted in a net outflow of cash and cash 
equivalents during any year, such amount should be excluded in making 
the computation of cash flow provided by operations for the three most 
recent years unless operations resulted in a net outflow of cash and 
cash equivalents in all three years, in which case the average of the 
net outflow of cash and cash equivalents should be used for the test.
b. Reporting Requirements for Accounting Changes
1. Preferability
    Facts: Rule 10-01(b)(6) of Regulation S-X requires that a 
registrant who makes a material change in its method of accounting 
shall indicate the date of and the reason for the change. The 
registrant also must include as an exhibit in the first Form 10-Q filed 
subsequent to the date of an accounting change, a letter from the 
registrant's independent accountants indicating whether or not the 
change is to an alternative principle which in his judgment is 
preferable under the circumstances. A letter from the independent 
accountant is not required when the change is made in response to a 
standard adopted by the Financial Accounting Standards Board which 
requires such a change.
    Question 1: For some alternative accounting principles, 
authoritative bodies have specified when one alternative is preferable 
to another. However, for other alternative accounting principles, no 
authoritative body has specified criteria for determining the 
preferability of one alternative over another. In such situations, how 
should preferability be determined?
    Interpretive Response: In such cases, where objective criteria for 
determining the preferability among alternative accounting principles 
have not been established by authoritative bodies, the determination of 
preferability should be based on the particular circumstances described 
by and discussed with the registrant. In addition, the independent 
accountant should consider other significant information of which he is 
aware.\5\
---------------------------------------------------------------------------

    \5\ Registrants also are reminded that FASB ASC paragraph 250-
10-50-1 (Accounting Changes and Error Corrections Topic) requires 
that companies disclose the nature of and justification for the 
change as well as the effects of the change on net income for the 
period in which the change is made. Furthermore, the justification 
for the change should explain clearly why the newly adopted 
principle is preferable to the previously-applied principle.
---------------------------------------------------------------------------

    Question 2: Management may offer, as justification for a change in 
accounting principle, circumstances such as: their expectation as to 
the effect of general economic trends on their business (e.g., the 
impact of inflation), their expectation regarding expanding consumer 
demand for the company's products, or plans for change in marketing 
methods. Are these circumstances which enter into the determination of 
preferability?
    Interpretive Response: Yes. Those circumstances are examples of 
business judgment and planning and should be evaluated in determining 
preferability. In the case of changes for which objective criteria for 
determining preferability have not been established by authoritative 
bodies, business judgment and business planning often are major 
considerations in determining that the change is to a preferable method 
because the change results in improved financial reporting.
    Question 3: What responsibility does the independent accountant 
have for evaluating the business judgment and business planning of the 
registrant?
    Interpretive Response: Business judgment and business planning are 
within the province of the registrant. Thus, the independent accountant 
may accept the registrant's business judgment and business planning and 
express reliance thereon in his letter. However, if either the plans or 
judgment appear to be unreasonable to the independent accountant, he 
should not accept them as justification. For example, an independent 
accountant should not accept a registrant's plans for a major expansion 
if he believes the registrant does not have the means of obtaining the 
funds necessary for the expansion program.
    Question 4: If a registrant, who has changed to an accounting 
method which was preferable under the circumstances, later finds that 
it must abandon its business plans or change its business judgment 
because of economic or other factors, is the registrant's justification 
nullified?
    Interpretive Response: No. A registrant must in good faith justify 
a change in its method of accounting under the circumstances which 
exist at the time of the change. The existence of different 
circumstances at a later time does not nullify the previous 
justification for the change.
    Question 5: If a registrant justified a change in accounting method 
as preferable under the circumstances, and the circumstances change, 
may the registrant revert to the method of accounting used before the 
change?
    Interpretive Response: Any time a registrant makes a change in 
accounting method, the change must be justified as preferable under the 
circumstances. Thus, a registrant may not change back to a principle 
previously used unless it can justify that the previously used 
principle is preferable in the circumstances as they currently exist.
    Question 6: If one client of an independent accounting firm changes 
its method of accounting and the accountant submits the required letter 
stating his view of the preferability of the principle in the 
circumstances, does this mean that all clients of that firm are 
constrained from making the converse change in accounting (e.g., if one 
client changes from FIFO to LIFO, can no other client change from LIFO 
to FIFO)?
    Interpretive Response: No. Each registrant must justify a change in 
accounting method on the basis that the method is preferable under the 
circumstances of that registrant. In addition, a registrant must 
furnish a letter from its independent accountant stating that in the 
judgment of the independent accountant the change in method is 
preferable under the circumstances of that registrant. If registrants 
in apparently similar circumstances make changes in opposite 
directions, the staff has a responsibility to inquire as to the factors 
which were considered in arriving at the determination by each 
registrant and its independent accountant that the change was 
preferable under the circumstances because it resulted in improved 
financial reporting. The staff recognizes the importance, in many 
circumstances, of the judgments and plans of management and recognizes 
that such management judgments may, in good faith, differ. As indicated 
above, the concern relates to registrants in apparently similar 
circumstances, no matter who their independent accountants may be.
    Question 7: If a registrant changes its accounting to one of two 
methods specifically approved by the FASB in the Accounting Standards 
Codification, need the independent accountant express his view as to 
the preferability of the method selected?
    Interpretive Response: If a registrant was formerly using a method 
of accounting no longer deemed acceptable, a change to either method 
approved by the FASB may be presumed to be a change to a preferable 
method and no letter will be required from the independent accountant. 
If, however, the registrant was formerly using one of the methods 
approved by

[[Page 17234]]

the FASB for current use and wishes to change to an alternative 
approved method, then the registrant must justify its change as being 
one to a preferable method in the circumstances and the independent 
accountant must submit a letter stating that in his view the change is 
to a principle that is preferable in the circumstances.
2. Filing of a Letter From the Accountants
    Facts: The registrant makes an accounting change in the fourth 
quarter of its fiscal year. Rule 10-01(b)(6) of Regulation S-X requires 
that the registrant file a letter from its independent accountants 
stating whether or not the change is preferable in the circumstances in 
the next Form 10-Q. Item 601(b)(18) of Regulation S-K provides that the 
independent accountant's preferability letter be filed as an exhibit to 
reports on Forms 10-K or 10-Q.
    Question: When the independent accountant's letter is filed with 
the Form 10-K, must another letter also be filed with the first 
quarter's Form 10-Q in the following year?
    Interpretive Response: No. A letter is not required to be filed 
with Form 10-Q if it has been previously filed as an exhibit to the 
Form 10-K.

H. Accounting Series Release 148--Disclosure of Compensating Balances 
and Short-Term Borrowing Arrangements (Adopted November 13, 1973 as 
Modified by ASR 172 Adopted on June 13, 1975 and ASR 280 Adopted on 
September 2, 1980)

    Facts: ASR 148 (as modified) amends Regulation S-X to include:
    1. Disclosure of compensating balance arrangements.
    2. Segregation of cash for compensating balance arrangements that 
are legal restrictions on the availability of cash.
1. Applicability
a. Arrangements With Other Lending Institutions
    Question: In addition to banks, is ASR 148 applicable to 
arrangements with factors, commercial finance companies or other 
lending entities?
    Interpretive Response: Yes.
b. Bank Holding Companies and Brokerage Firms
    Question: Do the provisions of ASR 148 apply to bank holding 
companies and to brokerage firms filing under Rule 17a-5?
    Interpretive Response: Yes; however, brokerage firms are not 
expected to meet these requirements when filing Form X-17a-5.
c. Financial Statements of Parent Company and Unconsolidated 
Subsidiaries
    Question: Are the provisions of ASR 148 applicable to parent 
company financial statements in addition to consolidated financial 
statements? To financial statements of unconsolidated subsidiaries?
    Interpretive Response: ASR 148 data for consolidated financial 
statements only will generally be sufficient when a filing includes 
consolidated and parent company financial statements. Such data are 
required for each unconsolidated subsidiary or other entity when a 
filing is required to include complete financial statements of those 
entities. When the filing includes summarized financial data in a 
footnote about such entities, the disclosures under ASR 148 relating to 
the consolidated financial statements will be sufficient.
d. Foreign Lenders
    Question: Are ASR 148 disclosure requirements applicable to 
arrangements with foreign lenders?
    Interpretive Response: Yes.
2. Classification of Short-Term Obligations--Debt Related to Long-Term 
Projects
    Facts: Companies engaging in significant long-term construction 
programs frequently arrange for revolving cover loans which extend 
until the completion of long-term construction projects. Such revolving 
cover loans are typically arranged with substantial financial 
institutions and typically have the following characteristics:
    1. A firm long-term mortgage commitment is obtained for each 
project.
    2. Interest rates and terms are in line with the company's normal 
borrowing arrangements.
    3. Amounts are equal to the expected full mortgage amount of all 
projects.
    4. The company may draw down funds at its option up to the maximum 
amount of the agreement.
    5. The company uses short-term interim construction financing 
(commercial paper, bank loans, etc.) against the revolving cover loan. 
Such indebtedness is rolled over or drawn down on the revolving cover 
loan at the company's option. The company typically has regular bank 
lines of credit, but these generally are not legally enforceable.
    Question: Under FASB ASC Subtopic 470-10, Debt--Overall, will the 
classification of loans such as described above as long-term be 
acceptable?
    Interpretive Response: Where such conditions exist providing for a 
firm commitment throughout the construction program as well as a firm 
commitment for permanent mortgage financing, and where there are no 
contingencies other than the completion of construction, the guideline 
criteria are met and the borrowing under such a program should be 
classified as long-term with appropriate disclosure.
3. Compensating Balances
a. Compensating Balances for Future Credit Availability
    Facts: Rule 5-02.1 of Regulation S-X requires disclosure of 
compensating balances in order to avoid undisclosed commingling of such 
balances with other funds having different liquidity characteristics 
and bearing no determinable relationship to borrowing arrangements. It 
also requires footnote disclosure distinguishing the amounts of such 
balances maintained under a formal agreement to assure future credit 
availability.
    Question: In disclosing compensating balances maintained to assure 
future credit availability, is it necessary to segregate compensating 
balances for an unused portion of a regular line of credit when a total 
compensating balance amount covering both used and unused amounts of a 
line of credit is disclosed?
    Interpretive Response: No.
b. Changes in Compensating Balances
    Facts: ASR 148 guidelines indicate the need for additional 
disclosures where compensating balances were materially greater during 
the period than at the end of the period.
    Question: Does this disclosure relate to changes in the arrangement 
(e.g., the required compensating balance percentage) or changes in 
borrowing levels?
    Interpretive Response: Both.
c. Float
    Facts: ASR 148 states that ``compensating balance arrangements * * 
* are normally expressed in terms of collected bank ledger balances but 
the financial statements are presented on the basis of the company's 
books. In order to make the disclosure of compensating balance amounts 
* * * consistent with the cash amounts reflected in the financial 
statements, the balance figure agreed upon by the bank and the company 
should be adjusted if possible by the estimated float.''

[[Page 17235]]

    Question: In determining the amount of ``float'' as suggested by 
ASR 148 guidelines, frequently an adjustment to the bank balance is 
required for ``uncollected funds.'' On what basis should this 
adjustment be estimated?
    Interpretive Response: The adjustment should be estimated based 
upon the method used by the bank or a reasonable approximation of that 
method. The following is a sample computation of the amount of 
compensating balances to be disclosed where uncollected funds are 
involved.
    Assumptions: The company has agreed to maintain compensating 
balances equal to 20% of short-term borrowings.

 
 
 
Short-term borrowings...................................     $10,000,000
Compensating balances per bank balances.................       2,000,000
Estimated float (approximates the excess of outstanding          480,000
 checks over deposits in transit).......................
Estimated uncollected funds.............................         320,000
Computation:
  Compensating balances per bank balances...............       2,000,000
  Estimated uncollected funds...........................         320,000
  Estimated float.......................................       (480,000)
Compensating balances stated in terms of a book cash           1,840,000
 balance and to be disclosed............................
 

 4. Miscellaneous
a. Periods required
    Question: For what periods are ASR 148 disclosures required?
    Interpretive Response: Disclosure of compensating balance 
arrangements and other disclosures called for in ASR 148 are required 
for the latest fiscal year but are generally not required for any later 
interim period unless a material change has occurred since year end.
b. 10-Q Disclosures
    Question: Are ASR 148 disclosures required in 10-Q's?
    Interpretive Response: In general, ASR 148 disclosures are not 
required in Form 10-Q. However, in some instances material changes in 
borrowing arrangements or borrowing levels may give rise to the need 
for disclosure either in Form 10-Q or Form 8-K.

I. Accounting Series Release 149--Improved Disclosure of Income Tax 
Expense (Adopted November 28, 1973 and Modified by ASR 280 Adopted on 
September 2, 1980)

    Facts: ASR 149 and 280 amend Regulation S-X to include:
    1. Disclosure of tax effect of timing differences comprising 
deferred income tax expense.
    2. Disclosure of the components of income tax expense, including 
currently payable and the net tax effects of timing differences.
    3. Disclosure of the components of income [loss] before income tax 
expense [benefit] as either domestic or foreign.
    4. Reconciliation between the statutory Federal income tax rate and 
the effective tax rate.
1. Tax rate
    Question 1: In reconciling to the effective tax rate should the 
rate used be a combination of state and Federal income tax rates?
    Interpretive Response: No, the reconciliation should be made to the 
Federal income tax rate only.
    Question 2: What is the ``applicable statutory Federal income tax 
rate''?
    Interpretive Response: The applicable statutory Federal income tax 
rate is the normal rate applicable to the reporting entity. Hence, the 
statutory rate for a U.S. partnership is zero. If, for example, the 
statutory rate for U.S. corporations is 22% on the first $25,000 of 
taxable income and 46% on the excess over $25,000, the ``normalized 
rate'' for corporations would fluctuate in the range between 22% and 
46% depending on the amount of pretax accounting income a corporation 
has.
2. Taxes of Investee Company
    Question: If a registrant records its share of earnings or losses 
of a 50% or less owned person on the equity basis and such person has 
an effective tax rate which differs by more than 5% from the applicable 
statutory Federal income tax rate, is a reconciliation as required by 
Rule 4-08(g) necessary?
    Interpretive Response: Whenever the tax components are known and 
material to the investor's (registrant's) financial position or results 
of operations, appropriate disclosure should be made. In some instances 
where 50% or less owned persons are accounted for by the equity method 
of accounting in the financial statements of the registrant, the 
registrant may not know the rate at which the various components of 
income are taxed and it may not be practicable to provide disclosure 
concerning such components.
    It should also be noted that it is generally necessary to disclose 
the aggregate dollar and per-share effect of situations where temporary 
tax exemptions or ``tax holidays'' exist, and that such disclosures are 
also applicable to 50% or less owned persons. Such disclosures should 
include a brief description of the factual circumstances and give the 
date on which the special tax status will terminate. See Topic 11.C.
3. Net of Tax Presentation
    Question: What disclosure is required when an item is reported on a 
net of tax basis (e.g., extraordinary items, discontinued operations, 
or cumulative adjustment related to accounting change)?
    Interpretive Response: When an item is reported on a net of tax 
basis, additional disclosure of the nature of the tax component should 
be provided by reconciling the tax component associated with the item 
to the applicable statutory Federal income tax rate or rates.
4. Loss Years
    Question: Is a reconciliation of a tax recovery in a loss year 
required?
    Interpretive Response: Yes, in loss years the actual book tax 
benefit of the loss should be reconciled to expected normal book tax 
benefit based on the applicable statutory Federal income tax rate.
5. Foreign Registrants
    Question 1: Occasionally, reporting foreign persons may not operate 
under a normal income tax base rate such as the current U.S. Federal 
corporate income tax rate. What form of disclosure is acceptable in 
these circumstances?
    Interpretive Response: In such instances, reconciliations between 
year-to-year effective rates or between a weighted average effective 
rate and the current effective rate of total tax expense may be 
appropriate in meeting the requirements of Rule 4-08(h)(2). A brief 
description of how such a rate was determined would be required in 
addition to other required disclosures. Such an approach would not be 
acceptable for a U.S. registrant with foreign operations. Foreign 
registrants with unusual tax situations may find that these guidelines 
are not fully responsive to their needs. In such instances, registrants 
should discuss the matter with the staff.
    Question 2: Where there are significant reconciling items that 
relate in significant part to foreign operations as well as domestic 
operations, is it necessary to disclose the separate amounts of the tax 
component by geographical area, e.g., statutory depletion allowances 
provided for by U.S. and by other foreign jurisdictions?
    Interpretive Response: It is not practicable to give an all-
encompassing answer to this question. However, in many cases such 
disclosure would seem appropriate.

[[Page 17236]]

6. Securities Gains and Losses
    Question: If the tax on the securities gains and losses of banks 
and insurance companies varies by more than 5% from the applicable 
statutory Federal income tax rate, should a reconciliation to the 
statutory rate be provided?
    Interpretive Response: Yes.
Tax Expense Components v. ``Overall'' Presentation
    Facts: Rule 4-08(h) requires that the various components of income 
tax expense be disclosed, e.g., currently payable domestic taxes, 
deferred foreign taxes, etc. Frequently income tax expense will be 
included in more than one caption in the financial statements. For 
example, income taxes may be allocated to continuing operations, 
discontinued operations, extraordinary items, cumulative effects of an 
accounting change and direct charges and credits to shareholders' 
equity.
    Question: In instances where income tax expense is allocated to 
more than one caption in the financial statements, must the components 
of income tax expense included in each caption be disclosed or will an 
``overall'' presentation such as the following be acceptable?
    The components of income tax expense are:

 
 
 
Currently payable (per tax return):
Federal.................................................        $350,000
Foreign.................................................         150,000
State...................................................          50,000
Deferred:
  Federal...............................................         125,000
  Foreign...............................................          75,000
                                                         ---------------
  State.................................................          50,000
                                                                 800,000
 

    Income tax expense is included in the financial statements as 
follows:

 
 
 
Continuing operations...................................        $600,000
Discontinued operations.................................       (200,000)
Extraordinary income....................................         300,000
                                                         ---------------
Cumulative effect of change in accounting principle.....         100,000
                                                                 800,000
 

    Interpretive Response: An overall presentation of the nature 
described will be acceptable.

J. Removed by SAB 47

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

1. Removed by SAB 103
2. Parent Company Financial Information
a. Computation of Restricted Net Assets of Subsidiaries
    Facts: The revised rules for parent company disclosures adopted in 
ASR 302 require, in certain circumstances, (1) footnote disclosure in 
the consolidated financial statements about the nature and amount of 
significant restrictions on the ability of subsidiaries to transfer 
funds to the parent through intercompany loans, advances or cash 
dividends [Rule 4-08(e)(3)], and (2) the presentation of condensed 
parent company financial information and other data in a schedule (Rule 
12-04). To determine which disclosures, if any, are required, a 
registrant must compute its proportionate share of the net assets of 
its consolidated and unconsolidated subsidiary companies as of the end 
of the most recent fiscal year which are restricted as to transfer to 
the parent company because the consent of a third party (a lender, 
regulatory agency, foreign government, etc.) is required. If the 
registrant's proportionate share of the restricted net assets of 
consolidated subsidiaries exceeds 25% of the registrant's consolidated 
net assets, both the footnote and schedule information are required. If 
the amount of such restrictions is less than 25%, but the sum of these 
restrictions plus the amount of the registrant's proportionate share of 
restricted net assets of unconsolidated subsidiaries plus the 
registrant's equity in the undistributed earnings of 50% or less owned 
persons (investees) accounted for by the equity method exceed 25% of 
consolidated net assets, the footnote disclosure is required.
    Question 1: How are restricted net assets of subsidiaries computed?
    Interpretative Response: The calculation of restricted net assets 
requires an evaluation of each subsidiary to identify any circumstances 
where third parties may limit the subsidiary's ability to loan, advance 
or dividend funds to the parent. This evaluation normally comprises a 
review of loan agreements, statutory and regulatory requirements, etc., 
to determine the dollar amount of each subsidiary's restrictions. The 
related amount of the subsidiary's net assets designated as restricted, 
however, should not exceed the amount of the subsidiary's net assets 
included in consolidated net assets, since parent company disclosures 
are triggered when a significant amount of consolidated net assets are 
restricted. The amount of each subsidiary's net assets included in 
consolidated net assets is determined by allocating (pushing down) to 
each subsidiary any related consolidation adjustments such as 
intercompany balances, intercompany profits, and differences between 
fair value and historical cost arising from a business combination 
accounted for as a purchase. This amount is referred to as the 
subsidiary's adjusted net assets. If the subsidiary's adjusted net 
assets are less than the amount of its restrictions because the push 
down of consolidating adjustments reduced its net assets, the 
subsidiary's adjusted net assets is the amount of the subsidiary's 
restricted net assets used in the tests.
    Registrants with numerous subsidiaries and investees may wish to 
develop approaches to facilitate the determination of its parent 
company disclosure requirements. For example, if the parent company's 
adjusted net assets (excluding any interest in its subsidiaries) exceed 
75% of consolidated net assets, or if the total of all of the 
registrant's consolidated and unconsolidated subsidiaries' restrictions 
and its equity in investees' earnings is less than 25% of consolidated 
net assets, then the allocation of consolidating adjustments to the 
subsidiaries to determine the amount of their adjusted net assets would 
not be necessary since no parent company disclosures would be required.
    Question 2: If a registrant makes a decision that it will 
permanently reinvest the undistributed earnings of a subsidiary, and 
thus does not provide for income taxes thereon because it meets the 
criteria set forth in FASB ASC Subtopic 740-30, Income Taxes--Other 
Considerations or Special Areas, is there considered to be a 
restriction for purposes of the test?
    Interpretive Response: No. The rules require that only third party 
restrictions be considered. Restrictions on subsidiary net assets 
imposed by management are not included.
b. Application of Tests for Parent Company Disclosures
    Facts: The balance sheet of the registrant's 100%-owned subsidiary 
at the most recent fiscal year-end is summarized as follows:

[[Page 17237]]



----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Current assets.............................              $120   Current liabilities...........               $30
Noncurrent assets..........................                45   Long-term debt................                60
                                             .................                                                90
                                             .................  Common stock..................                25
                                             .................  Retained earnings.............                50
                                             .................                                                75
                                                          165                                                165
----------------------------------------------------------------------------------------------------------------

    Net assets of the subsidiary are $75. Assume there are no 
consolidating adjustments to be allocated to the subsidiary. 
Restrictive covenants of the subsidiary's debt agreements provide that:
    Net assets, excluding intercompany loans, cannot be less than $35
    60% of accumulated earnings must be maintained
    Question 1: What is the amount of the subsidiary's restricted net 
assets?
    Interpretive Response:

------------------------------------------------------------------------
                                                             Computed
                       Restriction                         restrictions
------------------------------------------------------------------------
Net assets: Currently $75, cannot be less than $35;                  $35
 therefore..............................................
Dividends: 60% of accumulated earnings ($50) cannot be                30
 paid out; therefore....................................
------------------------------------------------------------------------

    Restricted net assets for purposes of the test are $35. The maximum 
amount that can be loaned or advanced to the parent without violating 
the net asset covenant is $40 ($75 - 35). Alternatively, the subsidiary 
could pay a dividend of up to $20 ($50 - 30) without violating the 
dividend covenant, and loan or advance up to $20, without violating the 
net asset provision.
    Facts: The registrant has one 100%-owned subsidiary. The balance 
sheet of the subsidiary at the latest fiscal year-end is summarized as 
follows:

----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Current assets.............................               $75   Current liabilities...........               $23
Noncurrent assets..........................                90   Long-term debt................                57
                                             .................  Redeemable preferred stock....                10
                                             .................  Common stock..................                30
                                                                                               -----------------
                                             .................  Retained earnings.............                45
                                            -------------------                                -----------------
                                             .................                                                75
                                                          165                                                165
----------------------------------------------------------------------------------------------------------------

    Assume that the registrant's consolidated net assets are $130 and 
there are no consolidating adjustments to be allocated to the 
subsidiary. The subsidiary's net assets are $75. The subsidiary's 
noncurrent assets are comprised of $40 in operating plant and equipment 
used in the subsidiary's business and a $50 investment in a 30% 
investee. The subsidiary's equity in this investee's undistributed 
earnings is $18. Restrictive covenants of the subsidiary's debt 
agreements are as follows:
    1. Net assets, excluding intercompany balances, cannot be less than 
$20.
    2. 80% of accumulated earnings must be reinvested in the 
subsidiary.
    3. Current ratio of 2:1 must be maintained.
    Question 2: Are parent company footnote or schedule disclosures 
required?
    Interpretive Response: Only the parent company footnote disclosures 
are required. The subsidiary's restricted net assets are computed as 
follows:

------------------------------------------------------------------------
                                                             Computed
                       Restriction                          restriction
------------------------------------------------------------------------
Net assets: Currently $75, cannot be less than $20;                  $20
 therefore..............................................
Dividends: 80% of accumulated earnings ($45) cannot be                36
 paid; therefore........................................
Current ratio: Must be at least 2:1 ($46 current assets               46
 must be maintained since current liabilities are $23 at
 fiscal year-end); therefore............................
------------------------------------------------------------------------

    Restricted net assets for purposes of the test are $20. The amount 
computed from the dividend restriction ($36) and the current ratio 
requirement ($46) are not used because net assets may be transferred by 
the subsidiary up to the limitation imposed by the requirement to 
maintain net assets of at least $20, without violating the other 
restrictions. For example, a transfer to the parent of up to $55 of net 
assets could be accomplished by a combination of dividends of current 
assets of $9 ($45 - 36), and loans or advances of current assets of up 
to $20 and noncurrent assets of up to $26.
    Parent company footnote disclosures are required in this example 
since the restricted net assets of the subsidiary and the registrant's 
equity in the earnings of its 100%-owned subsidiary's investee exceed 
25% of consolidated net assets [($20 + 18)/$130 = 29%]. The parent 
company schedule information is not required since the restricted net 
assets of the subsidiary are only 15% of consolidated net assets ($20/
$130 = 15%).
    Although the subsidiary's noncurrent assets are not in a form which 
is readily transferable to the parent company, the illiquid nature of 
the assets is not relevant for purposes of the parent company tests. 
The objective of the tests is to require parent company disclosures 
when the parent company does not have control of its subsidiaries' 
funds because it does not have unrestricted access to their net assets. 
The tests trigger parent company disclosures only when there are 
significant third party restrictions on transfers by subsidiaries of 
net assets and the subsidiaries' net assets comprise a significant 
portion of consolidated net assets. Practical limitations, other than 
third party restrictions on transferability at the measurement date 
(most recent fiscal year-end), such as subsidiary illiquidity, are not 
considered in computing restricted net assets. However, the potential 
effect of any limitations other than those imposed by third parties 
should be considered for inclusion in Management's Discussion and 
Analysis of liquidity.
    Facts:

------------------------------------------------------------------------
                                                            Net assets
------------------------------------------------------------------------
Subsidiary A............................................          $(500)
Subsidiary B............................................           2,000

[[Page 17238]]

 
Consolidated............................................           3,700
------------------------------------------------------------------------

    Subsidiaries A and B are 100% owned by the registrant. Assume there 
are no consolidating adjustments to be allocated to the subsidiaries. 
Subsidiary A has restrictions amounting to $200. Subsidiary B's 
restrictions are $1,000.
    Question 3: What parent company disclosures are required for the 
registrant?
    Interpretive Response: Since subsidiary A has an excess of 
liabilities over assets, it has no restricted net assets for purposes 
of the test. However, both parent company footnote and schedule 
disclosures are required, since the restricted net assets of subsidiary 
B exceed 25% of consolidated net assets ($1,000/3,700 = 27%).
    Facts:

------------------------------------------------------------------------
                                                          Net assets
------------------------------------------------------------------------
Subsidiary A........................................                $850
Subsidiary B........................................                 300
Consolidated........................................               3,700
------------------------------------------------------------------------

    The registrant owns 80% of subsidiary A. Subsidiary A owns 100% of 
subsidiary B. Assume there are no consolidating adjustments to be 
allocated to the subsidiaries. A may not pay any dividends or make any 
affiliate loans or advances. B has no restrictions. A's net assets of 
$850 do not include its investment in B.
    Question 4: Are parent company footnote or schedule disclosures 
required for this registrant?
    Interpretive Response: No. All of the registrant's share of 
subsidiary A's net assets ($680) are restricted. Although B may pay 
dividends and loan or advance funds to A, the parent's access to B's 
funds through A is restricted. However, since there are no limitations 
on B's ability to loan or advance funds to the parent, none of the 
parent's share of B's net assets are restricted. Since A's restricted 
net assets are less than 25% of consolidated net assets ($680/3700 = 
18%), no parent company disclosures are required.
    Facts: The consolidating balance sheet of the registrant at the 
latest fiscal year-end is summarized as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                   Consolidating
                                                    Registrant      Subsidiary      adjustments    Consolidated
----------------------------------------------------------------------------------------------------------------
Current assets..................................            $800            $700              $0          $1,500
30% investment in affiliate.....................             175               0               0             175
Investment in subsidiary........................             350               0           (350)               0
Other noncurrent assets.........................             625             300           (100)             825
                                                 ---------------------------------------------------------------
                                                           1,950           1,000           (450)           2,500
----------------------------------------------------------------------------------------------------------------
Current liabilities.............................             600             400               0           1,000
Concurrent liabilities..........................             375             150               0             525
Redeemable preferred stock......................             275               0               0             275
Common stock....................................             110               1             (1)             110
Paid-in capital.................................             290              49            (49)             290
Retained earnings...............................             300             400           (400)             300
                                                 ---------------------------------------------------------------
                                                             700             450           (450)             700
                                                 ---------------------------------------------------------------
                                                           1,950           1,000           (450)           2,500
----------------------------------------------------------------------------------------------------------------

    The acquisition of the 100%-owned subsidiary was consummated on the 
last day of the most recent fiscal year. Immediately preceding the 
acquisition, the registrant had net assets of $700, which included its 
equity in the undistributed earnings of its 30% investee of $75. 
Immediately after acquiring the subsidiary's net assets, which had an 
historical cost of $450 and a fair value of $350, the registrant's net 
assets were still $700 since debt and preferred stock totaling $350 
were issued in the purchase. The subsidiary has debt covenants which 
permit dividends, loans or advances, to the extent, if any, that net 
assets exceed an amount which is determined by the sum of $100 plus 75% 
of the subsidiary's accumulated earnings.
    Question 5: What is the amount of the subsidiary's restricted net 
assets? Are parent company footnote or schedule disclosures required?
    Interpretive Response: Restricted net assets for purposes of the 
test are $350, and both the parent company footnote and schedule 
disclosures are required.
    The amount of the subsidiary's restrictions at year-end is $400 
[$100 + (75% x $400)]. The subsidiary's adjusted net assets after the 
push down of the consolidation entry to the subsidiary to record the 
noncurrent assets acquired at their fair value is $350 ($450 - $100). 
Since the subsidiary's adjusted net assets ($350) are less than the 
amount of its restrictions ($400), restricted net assets are $350. The 
computed percentages applicable to each of the disclosure tests is in 
excess of 25%. Therefore, both parent company footnote and schedule 
information are required. The percentage applicable to the footnote 
disclosure test is 61% [($75 + 350)/$700]. The computed percentage for 
the schedule disclosure is 50% ($350/$700).
3. Undistributed Earnings of 50% or Less Owned Persons
    Facts: Rule 4-08(e)(2) of Regulation SX requires footnote 
disclosures of the amount of consolidated retained earnings which 
represents undistributed earnings of 50% or less owned persons 
(investee) accounted for by the equity method. The test adopted in ASR 
302 to trigger disclosures about the registrant's restricted net assets 
(Rule 4-08(e)(3)) includes the parent's equity in the undistributed 
earnings of investees.
    Question: Is the amount required for footnote disclosure the same 
as the amount included in the test to determine disclosures about 
restrictions?
    Interpretive Response: Yes. The amount used in the test in Rule 4-
08(e)(3) should be the same as the amount required to be disclosed by 
Rule 4-08(e)(2). This is the portion of the registrant's consolidated 
retained earnings which represents the undistributed earnings of an 
investee since the date(s) of acquisition. It is computed by 
determining the registrant's cumulative equity in the investee's 
earnings, adjusted by any dividends received, related goodwill

[[Page 17239]]

write-downs, and any related income taxes provided.
4. Application of Significant Subsidiary Test to Investees and 
Unconsolidated Subsidiaries
a. Separate Financial Statement Requirements
    Facts: Rule 3-09 of Regulation SX requires the presentation of 
separate financial statements of unconsolidated subsidiaries and of 50% 
or less owned persons (investee) accounted for by the equity method 
either by the registrant or by a subsidiary of the registrant in 
filings with the Commission if any of the tests of a significant 
subsidiary are met at a 20% level.
    Question 1: Are the requirements for separate financial statements 
also applicable to an investee accounted for by the equity method by an 
investee of the registrant?
    Interpretive Response: Yes. Rule 3-09 is intended to apply to all 
investees which are material to the financial position or results of 
operations of the registrant, regardless of whether the investee is 
held by the registrant, a subsidiary or another investee. Separate 
financial statements should be provided for any lower tier investee 
where such an entity is significant to the registrant's consolidated 
financial statements.
    Question 2: How is the significant subsidiary test applied to the 
lower tier investee in the situation described in Question 1?
    Interpretive Response: Since the disclosures provided by separate 
financial statements of an investee are considered necessary to 
evaluate the overall financial condition of the registrant, the 
significant subsidiary test is computed based on the materiality of the 
lower tier investee to the registrant consolidated. An example of the 
application of the assets test of the significant subsidiary rules to 
such an investee situation will illustrate the materiality measurement. 
A registrant with total consolidated assets of $5,000 owns 50% of 
Investee A, whose total assets are $3,800. Investee A has a 45% 
investment in Investee B, whose total assets are $4,800. There are no 
intercompany eliminations. Separate financial statements are required 
for Investee A, and they are required for Investee B because the 
registrant's share of B's total assets exceeds 20% of consolidated 
assets [(50% x 45% x $4800)/$5000 = 22%].
b. Summarized Financial Statement Requirements
    Facts: Rule 4-08(g) of Regulation S-X requires summarized financial 
information about unconsolidated subsidiaries and 50% or less owned 
persons (investee) to be included in the footnotes to the financial 
statements if, in the aggregate, they meet the tests of a significant 
subsidiary set forth in Rule 1-02(w).
    Question 1: Must a registrant which includes separate financial 
statements or condensed financial statements for unconsolidated 
subsidiaries or investees in its annual report to shareholders also 
include in such report the summarized financial information for these 
entities pursuant to Rule 4-08(g)?
    Interpretive Response: No. The purpose of the summarized 
information is to provide minimum standards of disclosure when the 
impact of such entities on the consolidated financial statements is 
significant. If the registrant furnishes more information in the annual 
report than is required by these minimum disclosure standards, such as 
condensed financial information or separate audited financial 
statements, the summarized data can be excluded. The Commission's rules 
are not intended to conflict with the provisions of FASB ASC 
subparagraph 323-10-50-3(c) (Investments--Equity Method and Joint 
Ventures Topic), which provide that either separate financial 
statements of investees be presented with the financial statements of 
the reporting entity or that summarized information be included in the 
reporting entity's financial statement footnotes.
    Question 2: Can summarized information be omitted for individual 
entities as long as the aggregate information for the omitted entity(s) 
does not exceed 10% under any of the significance tests of Rule 1-
02(w)?
    Interpretive Response: The 10% measurement level of the significant 
subsidiary rule was not intended to establish a materiality criteria 
for omission, and the arbitrary exclusion of summarized information for 
selected entities up to a 10% level is not appropriate. Rule 4-08(g) 
requires that the summarized information be included for all 
unconsolidated subsidiaries and investees. However, the staff 
recognizes that exclusion of the summarized information for certain 
entities is appropriate in some circumstances where it is impracticable 
to accumulate such information and the summarized information to be 
excluded is de minimis.

L. Financial Reporting Release 28--Accounting for Loan Losses by 
Registrants Engaged in Lending Activities

1. Accounting for Loan Losses
    General: GAAP for recognition of loan losses is provided by FASB 
ASC Subtopic 450-20, Contingencies--Loss Contingencies, and FASB ASC 
Subtopic 310-10, Receivables--Overall.\6\ An estimated loss from a loss 
contingency, such as the collectibility of receivables, should be 
accrued when, based on information available prior to the issuance of 
the financial statements, it is probable that an asset has been 
impaired or a liability has been incurred at the date of the financial 
statements and the amount of the loss can be reasonably estimated.\7\ 
FASB ASC Subtopic 310-10 provides more specific guidance on measurement 
of loan impairment and related disclosures but does not change the 
fundamental recognition criteria for loan losses provided by FASB ASC 
Subtopic 450-20.
---------------------------------------------------------------------------

    \6\ [Original footnote removed by SAB 114.]
    \7\ FASB ASC paragraph 450-20-25-2.
---------------------------------------------------------------------------

    Further guidance for SEC registrants is provided by FRR 28, which 
added subsection (b), Procedural Discipline in Determining the 
Allowance and Provision for Loan Losses to be Reported, of Section 
401.09, Accounting for Loan Losses by Registrants Engaged in Lending 
Activities, to the Codification of Financial Reporting Policies 
(hereafter referred to as FRR 28). Additionally, public companies are 
required to comply with the books and records provisions of the 
Securities Exchange Act of 1934 (Exchange Act). Under Sections 
13(b)(2)--(7) of the Exchange Act, registrants must make and keep 
books, records, and accounts, which, in reasonable detail, accurately 
and fairly reflect the transactions and dispositions of assets of the 
registrant. Registrants also must maintain internal accounting controls 
that are sufficient to provide reasonable assurances that, among other 
things, transactions are recorded as necessary to permit the 
preparation of financial statements in conformity with GAAP.
    This staff interpretation applies to all registrants that are 
creditors in loan transactions that, individually or in the aggregate, 
have a material effect on the registrant's financial statements.\8\
---------------------------------------------------------------------------

    \8\ For purposes of this interpretation, a loan is defined 
(consistent with the FASB ASC Master Glossary) as a contractual 
right to receive money on demand or on fixed or determinable dates 
that is recognized as an asset in the creditor's statement of 
financial position. For purposes of this interpretation, loans do 
not include trade accounts receivable or notes receivable with terms 
less than one year or debt securities subject to the provisions of 
FASB ASC Topic 320, Investments--Debt and Equity Securities.

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

[[Page 17240]]

2. Developing and Documenting a Systematic Methodology
a. Developing a Systematic Methodology
    Facts: Registrant A, or one of its consolidated subsidiaries, 
engages in lending activities and is developing or performing a review 
of its loan loss allowance methodology.
    Question: What are some of the factors or elements that the staff 
normally would expect Registrant A to consider when developing (or 
subsequently performing an assessment of) its methodology for 
determining its loan loss allowance under GAAP?
    Interpretive Response: The staff normally would expect a registrant 
that engages in lending activities to develop and document a systematic 
methodology \9\ to determine its provision for loan losses and 
allowance for loan losses as of each financial reporting date. It is 
critical that loan loss allowance methodologies incorporate 
management's current judgments about the credit quality of the loan 
portfolio through a disciplined and consistently applied process. A 
registrant's loan loss allowance methodology is influenced by entity-
specific factors, such as an entity's size, organizational structure, 
business environment and strategy, management style, loan portfolio 
characteristics, loan administration procedures, and management 
information systems.
---------------------------------------------------------------------------

    \9\ FRR 28 states that ``the Commission's staff normally would 
expect to find that the books and records of registrants engaged in 
lending activities include documentation of [the]: (a) Systematic 
methodology to be employed each period in determining the amount of 
the loan losses to be reported, and (b) rationale supporting each 
period's determination that the amounts reported were adequate.''
---------------------------------------------------------------------------

    However, as indicated in the AICPA Audit and Accounting Guide, 
Depository and Lending Institutions with Conforming Changes as of June 
1, 2009 (Audit Guide), while different institutions may use different 
methods, there are certain common elements that should be included in 
any [loan loss allowance] methodology for it to be effective.\10\ A 
registrant's loan loss allowance methodology generally should: \11\
---------------------------------------------------------------------------

    \10\ See paragraph 9.05 of the Audit Guide.
    \11\ Ibid.
---------------------------------------------------------------------------

     Include a detailed analysis of the loan portfolio, 
performed on a regular basis;
     Consider all loans (whether on an individual or group 
basis);
     Identify loans to be evaluated for impairment on an 
individual basis under FASB ASC Subtopic 310-10 and segment the 
remainder of the portfolio into groups of loans with similar risk 
characteristics for evaluation and analysis under FASB ASC Subtopic 
450-20;
     Consider all known relevant internal and external factors 
that may affect loan collectibility;
     Be applied consistently but, when appropriate, be modified 
for new factors affecting collectibility;
     Consider the particular risks inherent in different kinds 
of lending;
     Consider current collateral values (less costs to sell), 
where applicable;
     Require that analyses, estimates, reviews and other loan 
loss allowance methodology functions be performed by competent and 
well-trained personnel;
     Be based on current and reliable data;
     Be well documented, in writing, with clear explanations of 
the supporting analyses and rationale (see Question 2 below for staff 
views on documenting a loan loss allowance methodology); and
     Include a systematic and logical method to consolidate the 
loss estimates and ensure the loan loss allowance balance is recorded 
in accordance with GAAP.

For many entities engaged in lending activities, the allowance and 
provision for loan losses are significant elements of the financial 
statements.
    Therefore, the staff believes it is appropriate for an entity's 
management to review, on a periodic basis, its methodology for 
determining its allowance for loan losses.\12\ Additionally, for 
registrants that have audit committees, the staff believes that 
oversight of the financial reporting and auditing of the loan loss 
allowance by the audit committee can strengthen the registrant's 
control system and process for determining its allowance for loan 
losses.\13\
---------------------------------------------------------------------------

    \12\ For Federally insured depository institutions, the December 
21, 1993 ``Interagency Policy Statement on the Allowance for Loan 
and Lease Losses (ALLL)'' (the 1993 Interagency Policy Statement) 
indicates that boards of directors and management have certain 
responsibilities for the ALLL process and amounts reported. For 
example, as indicated on page 4 of that statement, ``the board of 
directors and management are expected to: Ensure that the 
institution has an effective loan review system and controls[;] 
Ensure the prompt charge-off of loans, or portions of loans, that 
available information confirms to be uncollectible[; and] Ensure 
that the institution's process for determining an adequate level for 
the ALLL is based on a comprehensive, adequately documented, and 
consistently applied analysis of the institution's loan and lease 
portfolio.''
    \13\ SAS 61 (as amended by SAS 90) states, in part: ``In 
connection with each SEC engagement the auditor should discuss with 
the audit committee the auditor's judgments about the quality, not 
just the acceptability, of the entity's accounting principles as 
applied in its financial reporting. The discussion should include 
items that have a significant impact on the representational 
faithfulness, verifiability, and neutrality of the accounting 
information included in the financial statements. [Footnote 
omitted.] Examples of items that may have such an impact are the 
following:
    1. Selection of new or changes to accounting policies
    2. Estimates, judgments, and uncertainties
    3. Unusual transactions
    Accounting policies relating to significant financial statement 
items, including the timing or transactions and the period in which 
they are recorded.''
---------------------------------------------------------------------------

    A systematic methodology that is properly designed and implemented 
should result in a registrant's best estimate of its allowance for loan 
losses.\14\ Accordingly, the staff normally would expect registrants to 
adjust their loan loss allowance balance, either upward or downward, in 
each period for differences between the results of the systematic 
determination process and the unadjusted loan loss allowance balance in 
the general ledger.\15\
---------------------------------------------------------------------------

    \14\ Registrants should also refer to FASB ASC Section 450-20-
30, Contingencies--Loss Contingencies--Initial Measurement, which 
provides accounting and disclosure guidance for situations in which 
a range of loss can be reasonably estimated but no single amount 
within the range appears to be a better estimate than any other 
amount within the range.
    \15\ Registrants should refer to the guidance on materiality in 
SAB Topic 1.M.
---------------------------------------------------------------------------

b. Documenting a Systematic Methodology
    Question 1: Assume the same facts as in Question 1. What would the 
staff normally expect Registrant A to include in its documentation of 
its loan loss allowance methodology?
    Interpretive Response: In FRR 28, the Commission provided guidance 
for documentation of loan loss provisions and allowances for 
registrants engaged in lending activities. The staff believes that 
appropriate written supporting documentation for the loan loss 
provision and allowance facilitates review of the loan loss allowance 
process and reported amounts, builds discipline and consistency into 
the loan loss allowance determination process, and improves the process 
for estimating loan losses by helping to ensure that all relevant 
factors are appropriately considered in the allowance analysis.
    The staff, therefore, normally would expect a registrant to 
document the relationship between the findings of its detailed review 
of the loan portfolio and the amount of the loan loss allowance and the 
provision for loan losses reported in each period.\16\
---------------------------------------------------------------------------

    \16\ FRR 28 states: ``The specific rationale upon which the 
[loan loss allowance and provision] amount actually reported is 
based--i.e., the bridge between the findings of the detailed review 
[of the loan portfolio] and the amount actually reported in each 
period--would be documented to help ensure the adequacy of the 
reported amount, to improve auditability, and to serve as a 
benchmark for exercise of prudent judgment in future periods.''

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

[[Page 17241]]

    The staff normally would expect to find that registrants maintain 
written supporting documentation for the following decisions, 
---------------------------------------------------------------------------
strategies, and processes:\17\

    \17\ Paragraph 9.64 in the Audit Guide outlines specific aspects 
of effective internal control related to the allowance for loan 
losses. These specific aspects include the control environment 
(``management communication of the need for proper reporting of the 
allowance''); management reports that summarize loan activity and 
the institution's procedures and controls (``accumulation of 
relevant, sufficient, and reliable data on which to base 
management's estimate of the allowance''); ``independent loan 
review;'' review of information and assumptions (``adequate review 
and approval of the allowance estimates by the individuals specified 
in management's written policy''); and assessment of the process 
(``comparison of prior estimates related to the allowance with 
subsequent results to assess the reliability of the process used to 
develop the allowance'').
---------------------------------------------------------------------------

 Policies and procedures:
    [cir] Over the systems and controls that maintain an appropriate 
loan loss allowance, and
    [cir] Over the loan loss allowance methodology;
 Loan grading system or process;
 Summary or consolidation of the loan loss allowance balance;
 Validation of the loan loss allowance methodology; and
 Periodic adjustments to the loan loss allowance process.

    Question 2: The Interpretive Response to Question 2 indicates that 
the staff normally would expect to find that registrants maintain 
written supporting documentation for their loan loss allowance policies 
and procedures. In the staff's view, what aspects of a registrant's 
loan loss allowance internal accounting control systems and processes 
would appropriately be addressed in its written policies and 
procedures?
    Interpretive Response: The staff is aware that registrants utilize 
a wide range of policies, procedures, and control systems in their loan 
loss allowance processes, and these policies, procedures, and systems 
are tailored to the size and complexity of the registrant and its loan 
portfolio. However, the staff believes that, in order for a 
registrant's loan loss allowance methodology to be effective, the 
registrant's written policies and procedures for the systems and 
controls that maintain an appropriate loan loss allowance would likely 
address the following:
     The roles and responsibilities of the registrant's 
departments and personnel (including the lending function, credit 
review, financial reporting, internal audit, senior management, audit 
committee, board of directors, and others, as applicable) who determine 
or review, as applicable, the loan loss allowance to be reported in the 
financial statements; \18\
---------------------------------------------------------------------------

    \18\ Paragraph 9.64 of the Audit Guide discusses ``management 
communication of the need for proper reporting of the allowance.'' 
As indicated in that paragraph, the ``control environment strongly 
influences the effectiveness of the system of controls and reflects 
the overall attitude, awareness, and action of the board of 
directors and management concerning the importance of control.''
---------------------------------------------------------------------------

     The registrant's accounting policies for loans and loan 
losses, including the policies for charge-offs and recoveries and for 
estimating the fair value of collateral, where applicable; \19\
---------------------------------------------------------------------------

    \19\ Paragraph 9.56 of the Audit Guide refers to the 
documentation, for disclosure purposes, that an entity should 
include in the notes to the financial statements describing the 
accounting policies the entity used to estimate its allowance and 
related provision for loan losses.
---------------------------------------------------------------------------

     The description of the registrant's systematic 
methodology, which should be consistent with the registrant's 
accounting policies for determining its loan loss allowance (see 
Question 4 below for further discussion); \20\ and
---------------------------------------------------------------------------

    \20\ Ibid. As indicated in paragraph 9.56, ``[s]uch a 
description should identify the factors that influenced management's 
judgment (for example, historical losses and existing economic 
conditions) and may also include discussion of risk elements 
relevant to particular categories of financial instruments.''
---------------------------------------------------------------------------

     The system of internal controls used to ensure that the 
loan loss allowance process is maintained in accordance with GAAP.\21\
---------------------------------------------------------------------------

    \21\ See also paragraph 9.64 in the Audit Guide which provides 
information about specific aspects of effective internal control 
related to the allowance for loan losses.q2
---------------------------------------------------------------------------

The staff normally would expect an internal control system \22\ for the 
loan loss allowance estimation process to:
---------------------------------------------------------------------------

    \22\ Ibid. Public companies are required to comply with the 
books and records provisions of the Exchange Act. Under Sections 
13(b)(2)--(7) of the Exchange Act, registrants must make and keep 
books, records, and accounts, which, in reasonable detail, 
accurately and fairly reflect the transactions and dispositions of 
assets of the registrant. Registrants also must maintain internal 
accounting controls that are sufficient to provide reasonable 
assurances that, among other things, transactions are recorded as 
necessary to permit the preparation of financial statements in 
conformity with GAAP.
---------------------------------------------------------------------------

     Include measures to provide assurance regarding the 
reliability \23\ and integrity of information and compliance with laws, 
regulations, and internal policies and procedures; \24\
---------------------------------------------------------------------------

    \23\ Concepts Statement 2, Qualitative Characteristics of 
Accounting Information, provides guidance on ``reliability'' as a 
primary quality of accounting information.
    \24\ Section 13(b)(2)-(7) of the Exchange Act.
---------------------------------------------------------------------------

     Reasonably assure that the registrant's financial 
statements are prepared in accordance with GAAP; and
     Include a well-defined loan review process.\25\
---------------------------------------------------------------------------

    \25\ As indicated in paragraph 9.05, item a, in the Audit Guide, 
a loan loss allowance methodology should ``include a detailed and 
regular analysis of the loan portfolio.'' Paragraphs 9.06 to 9.13 
provide additional information on how creditors traditionally 
identify and review loans on an individual basis and review or 
analyze loans on a group or pool basis.
---------------------------------------------------------------------------

A well-defined loan review process \26\ typically contains:
---------------------------------------------------------------------------

    \26\ Ibid. Additionally, paragraph 9.64 in the Audit Guide 
provides guidance on the loan review process. As stated in that 
paragraph, ``[m]anagement reports summarizing loan activity, 
renewals, and delinquencies are vital to the timely identification 
of problem loans.'' The paragraph further states: ``Loan reviews 
should be conducted by competent institution personnel who are 
independent of the underwriting, supervision, and collections 
functions. The specific lines of reporting depend on the complexity 
of the institution's organizational structure, but the loan 
reviewers should report to a high level of management that is 
independent from the lending process in the institution.''
---------------------------------------------------------------------------

     An effective loan grading system that is consistently 
applied, identifies differing risk characteristics and loan quality 
problems accurately and in a timely manner, and prompts appropriate 
administrative actions; \27\
---------------------------------------------------------------------------

    \27\ Ibid.
---------------------------------------------------------------------------

     Sufficient internal controls to ensure that all relevant 
loan review information is appropriately considered in estimating 
losses. This includes maintaining appropriate reports, details of 
reviews performed, and identification of personnel involved; \28\ and
---------------------------------------------------------------------------

    \28\ Ibid.
---------------------------------------------------------------------------

     Clear formal communication and coordination between a 
registrant's credit administration function, financial reporting group, 
management, board of directors, and others who are involved in the loan 
loss allowance determination or review process, as applicable (e.g., 
written policies and procedures, management reports, audit programs, 
and committee minutes).\29\
---------------------------------------------------------------------------

    \29\ Ibid.
---------------------------------------------------------------------------

    Question 3: The Interpretive Response to Question 3 indicates that 
the staff normally would expect a registrant's written loan loss 
allowance policies and procedures to include a description of the 
registrant's systematic allowance methodology, which should be 
consistent with its accounting policies for determining its loan loss 
allowance. What elements of a registrant's loan loss allowance 
methodology would the staff normally expect to be described in the 
registrant's written policies and procedures?
    Interpretive Response: The staff normally would expect a 
registrant's written policies and procedures to describe the primary 
elements of its loan loss allowance methodology, including portfolio 
segmentation and

[[Page 17242]]

impairment measurement. The staff normally would expect that, in order 
for a registrant's loan loss allowance methodology to be effective, the 
registrant's written policies and procedures would describe the 
methodology:

 For segmenting the portfolio:
    [cir] How the segmentation process is performed (i.e., by loan 
type, industry, risk rates, etc.); \30\
---------------------------------------------------------------------------

    \30\ Paragraph 9.07 in the Audit Guide states that ``creditors 
have traditionally identified loans that are to be evaluated for 
collectibility by dividing the loan portfolio into different 
segments. Loans with similar risk characteristics, such as risk 
classification, past-due status, and type of loan should be grouped 
together.'' Paragraph 9.08 provides additional guidance on 
classifying individual loans and paragraph 9.13 indicates 
considerations for groups or pools of loans.
---------------------------------------------------------------------------

    [cir] When a loan grading system is used to segment the portfolio:
     The definitions of each loan grade;
     A reconciliation of the internal loan grades to 
supervisory loan grades, if applicable; and
     The delineation of responsibilities for the loan grading 
system.
 For determining and measuring impairment under FASB ASC 
Subtopic 310-10: \31\
---------------------------------------------------------------------------

    \31\ See FASB ASC paragraphs 310-10-35-16 through 310-10-35-19 
on recognition of impairment and FASB ASC paragraphs 310-10-35-20 
through 310-10-35-37 on measurement of impairment.
---------------------------------------------------------------------------

    [cir] The methods used to identify loans to be analyzed 
individually;
    [cir] For individually reviewed loans that are impaired, how the 
amount of any impairment is determined and measured, including:
     Procedures describing the impairment measurement 
techniques available; and
     Steps performed to determine which technique is most 
appropriate in a given situation.
    [cir] The methods used to determine whether and how loans 
individually evaluated under FASB Subtopic 310-10, but not considered 
to be individually impaired, should be grouped with other loans that 
share common characteristics for impairment evaluation under FASB ASC 
Subtopic 450-20.\32\
---------------------------------------------------------------------------

    \32\ See FASB ASC paragraph 310-10-35-36.
---------------------------------------------------------------------------

 For determining and measuring impairment under FASB ASC 
Subtopic 450-20: \33\
---------------------------------------------------------------------------

    \33\ See FASB ASC paragraph 450-20-25-2 on accrual of loss 
contingencies and FASB ASC paragraphs 310-10-35-5 through 310-10-35-
11 on collectibility of receivables.
---------------------------------------------------------------------------

    [cir] How loans with similar characteristics are grouped to be 
evaluated for loan collectibility (such as loan type, past-due status, 
and risk);
    [cir] How loss rates are determined (e.g., historical loss rates 
adjusted for environmental factors or migration analysis) and what 
factors are considered when establishing appropriate time frames over 
which to evaluate loss experience; and
    [cir] Descriptions of qualitative factors (e.g., industry, 
geographical, economic, and political factors) that may affect loss 
rates or other loss measurements.
3. Applying a Systematic Methodology--Measuring and Documenting Loan 
Losses Under FASB ASC Subtopic 310-10
a. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 310-
10--General
    Facts: Approximately one-third of Registrant B's commercial loan 
portfolio consists of large balance, non-homogeneous loans. Due to 
their large individual balances, these loans meet the criteria under 
Registrant B's policies and procedures for individual review for 
impairment under FASB ASC Subtopic 310-10.
    Upon review of the large balance loans, Registrant B determines 
that certain of the loans are impaired as defined by FASB ASC Subtopic 
310-10.\34\
---------------------------------------------------------------------------

    \34\ FASB ASC paragraph 310-10-35-8 provides that a loan is 
impaired when, based on current information and events, it is 
probable that all amounts due will not be collected pursuant to the 
terms of the loan agreement.
---------------------------------------------------------------------------

    Question: For the commercial loans reviewed under FASB ASC Subtopic 
310-10 that are individually impaired, how would the staff normally 
expect Registrant B to measure and document the impairment on those 
loans? Can it use an impairment measurement method other than the 
methods allowed by FASB ASC Subtopic 310-10?
    Interpretive Response: For those loans that are reviewed 
individually under FASB ASC Subtopic 310-10 and considered individually 
impaired, Registrant B must use one of the methods for measuring 
impairment that is specified by FASB ASC Subtopic 310-10 (that is, the 
present value of expected future cash flows, the loan's observable 
market price, or the fair value of collateral).\35\ Accordingly, in the 
circumstances described above, for the loans considered individually 
impaired under FASB ASC Subtopic 310-10, it would not be appropriate 
for Registrant B to choose a measurement method not prescribed by FASB 
ASC Subtopic 310-10. For example, it would not be appropriate to 
measure loan impairment by applying a loss rate to each loan based on 
the average historical loss percentage for all of its commercial loans 
for the past five years.
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    \35\ See FASB ASC paragraph 310-10-35-22.
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    The staff normally would expect Registrant B to maintain as 
sufficient, objective evidence \36\ written documentation to support 
its measurement of loan impairment under FASB ASC Subtopic 310-10.\37\ 
If Registrant B uses the present value of expected future cash flows to 
measure impairment of a loan, it should document the amount and timing 
of cash flows, the effective interest rate used to discount the cash 
flows, and the basis for the determination of cash flows, including 
consideration of current environmental factors \38\ and other 
information reflecting past events and current conditions. If 
Registrant B uses the fair value of collateral to measure impairment, 
the staff normally would expect to find that Registrant B had 
documented how it determined the fair value, including the use of 
appraisals, valuation assumptions and calculations, the supporting 
rationale for adjustments to appraised values, if any, and the 
determination of costs to sell, if applicable, appraisal quality, and 
the expertise and independence of the appraiser.\39\ Similarly, the 
staff normally would expect to find that Registrant B had documented 
the amount, source, and date of the observable market price of a loan, 
if that method of measuring loan impairment is used.
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    \36\ Under GAAS, auditors should obtain ``sufficient competent 
evidential matter'' to support its audit opinion. See AU Section 
326. The staff normally would expect registrants to maintain such 
evidential matter for its allowances for loan losses for use by the 
auditors in conducting their annual audit.
    \37\ Paragraph 9.74 in the Audit Guide outlines sources of 
information, available from management, that the independent 
accountant should consider in identifying loans that contain high 
credit risk or other significant exposures and concentrations. These 
sources of information would also likely include documentation of 
loan impairment under FASB ASC Subtopic 310-10 or FASB ASC Subtopic 
450-20. Additionally, as indicated in paragraphs 9.85 to 9.97 of the 
Audit Guide, the independent accountant, in conducting an audit, may 
perform a detailed loan file review for selected loans. A 
registrant's loan files may contain documentation about borrowers' 
financial resources and cash flows (see paragraph 9.92) or about the 
collateral securing the loans, if applicable (see paragraphs 9.94 
and 9.95).
    \38\ FASB ASC paragraph 310-10-35-27 indicates that 
environmental factors include existing industry, geographical, 
economic, and political factors.
    \39\ See paragraphs 9.94 and 9.95 in the Audit Guide for 
additional information about documentation of loan collateral.

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[[Page 17243]]

b. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 310-10 
for a Collateral Dependent Loan
    Facts: Registrant C has a $10 million loan outstanding to Company X 
that is secured by real estate, which Registrant C individually 
evaluates under FASB ASC Subtopic 310-10 due to the loan's size. 
Company X is delinquent in its loan payments under the terms of the 
loan agreement. Accordingly, Registrant C determines that its loan to 
Company X is impaired, as defined by FASB ASC Subtopic 310-10. Because 
the loan is collateral dependent, Registrant C measures impairment of 
the loan based on the fair value of the collateral. Registrant C 
determines that the most recent valuation of the collateral was 
performed by an appraiser eighteen months ago and, at that time, the 
estimated value of the collateral (fair value less costs to sell) was 
$12 million.
    Registrant C believes that certain of the assumptions that were 
used to value the collateral eighteen months ago do not reflect current 
market conditions and, therefore, the appraiser's valuation does not 
approximate current fair value of the collateral.
    Several buildings, which are comparable to the real estate 
collateral, were recently completed in the area, increasing vacancy 
rates, decreasing lease rates, and attracting several tenants away from 
the borrower. Accordingly, credit review personnel at Registrant C 
adjust certain of the valuation assumptions to better reflect the 
current market conditions as they relate to the loan's collateral.\40\ 
After adjusting the collateral valuation assumptions, the credit review 
department determines that the current estimated fair value of the 
collateral, less costs to sell, is $8 million.\41\ Given that the 
recorded investment in the loan is $10 million, Registrant C concludes 
that the loan is impaired by $2 million and records an allowance for 
loan losses of $2 million.
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    \40\ When reviewing collateral dependent loans, Registrant C may 
often find it more appropriate to obtain an updated appraisal to 
estimate the effect of current market conditions on the appraised 
value instead of internally estimating an adjustment.
    \41\ An auditor who uses the work of a specialist, such as an 
appraiser, in performing an audit in accordance with GAAS should 
refer to the guidance in SAS 73 (AU Section 336).
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    Question: What documentation would the staff normally expect 
Registrant C to maintain to support its determination of the allowance 
for loan losses of $2 million for the loan to Company X?
    Interpretive Response: The staff normally would expect Registrant C 
to document that it measured impairment of the loan to Company X by 
using the fair value of the loan's collateral, less costs to sell, 
which it estimated to be $8 million.\42\ This documentation \43\ should 
include the registrant's rationale and basis for the $8 million 
valuation, including the revised valuation assumptions it used, the 
valuation calculation, and the determination of costs to sell, if 
applicable.
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    \42\ See paragraphs 9.94 to 9.95 in the Audit Guide for further 
information about documentation of loan collateral and associated 
audit procedures that may be performed by the independent 
accountant.
    \43\ As stated in paragraph 9.14 of the Audit Guide, ``[t]he 
approach for determination of the allowance should be well 
documented.''
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    Because Registrant C arrived at the valuation of $8 million by 
modifying an earlier appraisal, it should document its rationale and 
basis for the changes it made to the valuation assumptions that 
resulted in the collateral value declining from $12 million eighteen 
months ago to $8 million in the current period.
c. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 310-
10--Fully Collateralized Loans
    Question: In the staff's view, what is an example of an acceptable 
documentation practice for a registrant to adequately support its 
determination that no allowance for loan losses should be recorded for 
a group of loans because the loans are fully collateralized?
    Interpretive Response: Consider the following fact pattern: 
Registrant D has $10 million in loans that are fully collateralized by 
highly rated debt securities with readily determinable market values. 
The loan agreement for each of these loans requires the borrower to 
provide qualifying collateral sufficient to maintain a loan-to-value 
ratio with sufficient margin to absorb volatility in the securities' 
market prices. Registrant D's collateral department has physical 
control of the debt securities through safekeeping arrangements. In 
addition, Registrant D perfected its security interest in the 
collateral when the funds were originally distributed. On a quarterly 
basis, Registrant D's credit administration function determines the 
market value of the collateral for each loan using two independent 
market quotes and compares the collateral value to the loan carrying 
value. If there are any collateral deficiencies, Registrant D notifies 
the borrower and requests that the borrower immediately remedy the 
deficiency. Due in part to its efficient operation, Registrant D has 
historically not incurred any material losses on these loans. 
Registrant D believes these loans are fully-collateralized and 
therefore does not maintain any loan loss allowance balance for these 
loans.
    Registrant D's management summary of the loan loss allowance 
includes documentation indicating that, in accordance with its loan 
loss allowance policy, the collateral protection on these loans has 
been verified by the registrant, no probable loss has been incurred, 
and no loan loss allowance is necessary.
    Documentation in Registrant D's loan files includes the two 
independent market quotes obtained each quarter for each loan's 
collateral amount, the documents evidencing the perfection of the 
security interest in the collateral, and other relevant supporting 
documents. Additionally, Registrant D's loan loss allowance policy 
includes a discussion of how to determine when a loan is considered 
``fully collateralized'' and does not require a loan loss allowance. 
Registrant D's policy requires the following factors to be considered 
and its findings concerning these factors to be fully documented:
     Volatility of the market value of the collateral;
     Recency and reliability of the appraisal or other 
valuation;
     Recency of the registrant's or third party's inspection of 
the collateral;
     Historical losses on similar loans;
     Confidence in the registrant's lien or security position 
including appropriate:
    [cir] Type of security perfection (e.g., physical possession of 
collateral or secured filing);
    [cir] Filing of security perfection (i.e., correct documents and 
with the appropriate officials); and
    [cir] Relationship to other liens; and
     Other factors as appropriate for the loan type.
    In the staff's view, Registrant D's documentation supporting its 
determination that certain of its loans are fully collateralized, and 
no loan loss allowance should be recorded for those loans, is 
acceptable under FRR 28.
4. Applying a Systematic Methodology--Measuring and Documenting Loan 
Losses Under FASB ASC Subtopic 450-20
a. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 450-
20--General
    Question 1: In the staff's view, what are some general 
considerations for a registrant in applying its systematic methodology 
to measure and document loan losses under FASB ASC Subtopic 450-20?
    Interpretive Response: For loans evaluated on a group basis under 
FASB ASC Subtopic 450-20, the staff believes

[[Page 17244]]

that a registrant should segment the loan portfolio by identifying risk 
characteristics that are common to groups of loans.\44\ Registrants 
typically decide how to segment their loan portfolios based on many 
factors, which vary with their business strategies as well as their 
information system capabilities. Regardless of the segmentation method 
used, the staff normally would expect a registrant to maintain 
documentation to support its conclusion that the loans in each segment 
have similar attributes or characteristics. As economic and other 
business conditions change, registrants often modify their business 
strategies, which may result in adjustments to the way in which they 
segment their loan portfolio for purposes of estimating loan losses. 
The staff normally would expect registrants to maintain documentation 
to support these segmentation adjustments.\45\
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    \44\ Paragraph 9.07 of the Audit Guide indicates that ``loans 
with similar risk characteristics, such as risk classification, 
past-due status, and type of loan, should be grouped together.''
    \45\ Segmentation of the loan portfolio is a standard element in 
a loan loss allowance methodology. As indicated in paragraph 9.05 of 
the Audit Guide, the loan loss allowance methodology ``should be 
well documented, with clear explanations of the supporting analyses 
and rationale.''
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    Based on the segmentation of the loan portfolio, a registrant 
should estimate the FASB ASC Subtopic 450-20 portion of its loan loss 
allowance. For those segments that require an allowance for loan 
losses,\46\ the registrant should estimate the loan losses, on at least 
a quarterly basis, based upon its ongoing loan review process and 
analysis of loan performance.\47\ The registrant should follow a 
systematic and consistently applied approach to select the most 
appropriate loss measurement methods and support its conclusions and 
rationale with written documentation.\48\
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    \46\ An example of a loan segment that does not generally 
require an allowance for loan losses is a group of loans that are 
fully secured by deposits maintained at the lending institution.
    \47\ FRR 28 refers to a ``systematic methodology to be employed 
each period'' in determining provisions and allowances for loan 
losses. As indicated in FRR 28, the staff normally would expect that 
the systematic methodology would be documented ``to help ensure that 
all matters affecting loan collectibility will consistently be 
identified in the detailed [loan] review process.''
    \48\ Ibid. Also, as indicated in paragraph 9.05 of the Audit 
Guide, the loan loss allowance methodology ``should be well 
documented, with clear explanations of the supporting analyses and 
rationale.'' Further, as indicated in paragraph 9.14 of the Audit 
Guide, ``[t]he approach for determination of the allowance should be 
well documented.''
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    Facts: After identifying certain loans for evaluation under FASB 
ASC Subtopic 310-10, Registrant E segments its remaining loan portfolio 
into five pools of loans. For three of the pools, it measures loan 
impairment under FASB ASC Subtopic 450-20 by applying historical loss 
rates, adjusted for relevant environmental factors, to the pools' 
aggregate loan balances. For the remaining two pools of loans, 
Registrant E uses a loss estimation model that is consistent with GAAP 
to measure loan impairment under FASB ASC Subtopic 450-20.
    Question 2: What documentation would the staff normally expect 
Registrant E to prepare to support its loan loss allowance for its 
pools of loans under FASB ASC Subtopic 450-20?
    Interpretive Response: Regardless of the method used to determine 
loan loss measurements under FASB ASC Subtopic 450-20, Registrant E 
should demonstrate and document that the loss measurement methods used 
to estimate the loan loss allowance for each segment of its loan 
portfolio are determined in accordance with GAAP as of the financial 
statement date.\49\
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    \49\ Refer to FASB ASC subparagraph 450-20-25-2(b). Also, as 
indicated in FASB ASC subparagraph 310-10-35-4(c), ``[t]he approach 
for determination of the allowance shall be well documented and 
applied consistently from period to period.''
---------------------------------------------------------------------------

    As indicated for Registrant E, one method of estimating loan losses 
for groups of loans is through the application of loss rates to the 
groups' aggregate loan balances. Such loss rates typically reflect the 
registrant's historical loan loss experience for each group of loans, 
adjusted for relevant environmental factors (e.g., industry, 
geographical, economic, and political factors) over a defined period of 
time. If a registrant does not have loss experience of its own, it may 
be appropriate to reference the loss experience of other companies in 
the same business, provided that the registrant demonstrates that the 
attributes of the loans in its portfolio segment are similar to those 
of the loans included in the portfolio of the registrant providing the 
loss experience.\50\ Registrants should maintain supporting 
documentation for the technique used to develop their loss rates, 
including the period of time over which the losses were incurred. If a 
range of loss is determined, registrants should maintain documentation 
to support the identified range and the rationale used for determining 
which estimate is the best estimate within the range of loan 
losses.\51\
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    \50\ Refer to FASB ASC paragraphs 310-10-35-10 through 310-10-
35-11.
    \51\ Registrants should also refer to FASB ASC Subtopic 450-20, 
which provides guidance for situations in which a range of loss can 
be reasonably estimated but no single amount within the range 
appears to be a better estimate than any other amount within the 
range. Also, paragraph 9.14 of the Audit Guide notes the use of ``a 
method that results in a range of estimates for the allowance,'' 
except for impairment measurement under FASB ASC Subtopic 310-10, 
which is based on a single best estimate and not a range of 
estimates. Paragraph 9.14 also states that ``[t]he approach for 
determination of the allowance should be well documented.''
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    The staff normally would expect that, before employing a loss 
estimation model, a registrant would evaluate and modify, as needed, 
the model's assumptions to ensure that the resulting loss estimate is 
consistent with GAAP. In order to demonstrate consistency with GAAP, 
registrants that use loss estimation models should typically document 
the evaluation, the conclusions regarding the appropriateness of 
estimating loan losses with a model or other loss estimation tool, and 
the objective support for adjustments to the model or its results.\52\
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    \52\ The systematic methodology (including, if applicable, loss 
estimation models) used to determine loan loss provisions and 
allowances should be documented in accordance with FRR 28, paragraph 
9.05 of the Audit Guide, and FASB ASC Subtopic 310-10.
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    In developing loss measurements, registrants should consider the 
impact of current environmental factors and then document which factors 
were used in the analysis and how those factors affected the loss 
measurements. Factors that should be considered in developing loss 
measurements include the following: \53\
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    \53\ Refer to paragraph 9.13 in the Audit Guide.
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     Levels of and trends in delinquencies and impaired loans;
     Levels of and trends in charge-offs and recoveries;
     Trends in volume and terms of loans;
     Effects of any changes in risk selection and underwriting 
standards, and other changes in lending policies, procedures, and 
practices;
     Experience, ability, and depth of lending management and 
other relevant staff;
     National and local economic trends and conditions;
     Industry conditions; and
     Effects of changes in credit concentrations.
    For any adjustment of loss measurements for environmental factors, 
a registrant should maintain sufficient, objective evidence \54\ (a) to 
support the amount of the adjustment and (b) to explain why the 
adjustment is necessary to reflect current

[[Page 17245]]

information, events, circumstances, and conditions in the loss 
measurements.
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    \54\ AU 326 describes the ``sufficient competent evidential 
matter'' that auditors must consider in accordance with GAAS.
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b. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 450-
20--Adjusting Loss Rates
    Facts: Registrant F's lending area includes a metropolitan area 
that is financially dependent upon the profitability of a number of 
manufacturing businesses. These businesses use highly specialized 
equipment and significant quantities of rare metals in the 
manufacturing process. Due to increased low-cost foreign competition, 
several of the parts suppliers servicing these manufacturing firms 
declared bankruptcy. The foreign suppliers have subsequently increased 
prices and the manufacturing firms have suffered from increased 
equipment maintenance costs and smaller profit margins.
    Additionally, the cost of the rare metals used in the manufacturing 
process increased and has now stabilized at double last year's price. 
Due to these events, the manufacturing businesses are experiencing 
financial difficulties and have recently announced downsizing plans.
    Although Registrant F has yet to confirm an increase in its loss 
experience as a result of these events, management knows that it lends 
to a significant number of businesses and individuals whose repayment 
ability depends upon the long-term viability of the manufacturing 
businesses. Registrant F's management has identified particular 
segments of its commercial and consumer customer bases that include 
borrowers highly dependent upon sales or salary from the manufacturing 
businesses. Registrant F's management performs an analysis of the 
affected portfolio segments to adjust its historical loss rates used to 
determine the loan loss allowance. In this particular case, Registrant 
F has experienced similar business and lending conditions in the past 
that it can compare to current conditions.
    Question: How would the staff normally expect Registrant F to 
document its support for the loss rate adjustments that result from 
considering these manufacturing firms' financial downturns? \55\
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    \55\ This question and response would also apply to other 
registrant fact patterns in which the registrant adjusts loss rates 
for environmental factors.
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    Interpretive Response: The staff normally would expect Registrant F 
to document its identification of the particular segments of its 
commercial and consumer loan portfolio for which it is probable that 
the manufacturing business' financial downturn has resulted in loan 
losses. In addition, the staff normally would expect Registrant F to 
document its analysis that resulted in the adjustments to the loss 
rates for the affected portfolio segments.\56\ The staff normally would 
expect that, as part of its documentation, Registrant F would maintain 
copies of the documents supporting the analysis, which may include 
relevant economic reports, economic data, and information from 
individual borrowers.
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    \56\ Paragraph 9.56 of the Audit Guide refers to the 
documentation, for disclosure purposes, that an entity should 
include in the notes to the financial statements describing the 
accounting policies and methodology the entity used to estimate its 
allowance and related provision for loan losses. As indicated in 
paragraph 9.56, ``[s]uch a description should identify the factors 
that influenced management's judgment (for example, historical 
losses and existing economic conditions) and may also include 
discussion of risk elements relevant to particular categories of 
financial instruments.''
---------------------------------------------------------------------------

    Because in this case Registrant F has experienced similar business 
and lending conditions in the past, it should consider including in its 
supporting documentation an analysis of how the current conditions 
compare to its previous loss experiences in similar circumstances. The 
staff normally would expect that, as part of Registrant F's effective 
loan loss allowance methodology, it would create a summary of the 
amount and rationale for the adjustment factor for review by management 
prior to the issuance of the financial statements.\57\
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    \57\ Paragraph 9.64 in the Audit Guide indicates that effective 
internal control related to the allowance for loan losses should 
include ``accumulation of relevant, sufficient, and reliable data on 
which to base management's estimate of the allowance.''
---------------------------------------------------------------------------

c. Measuring and Documenting Loan Losses Under FASB ASC Subtopic 450-
20--Estimating Losses on Loans Individually Reviewed for Impairment But 
Not Considered Individually Impaired
    Facts: Registrant G has outstanding loans of $2 million to Company 
Y and $1 million to Company Z, both of which are paying as agreed upon 
in the loan documents. The registrant's loan loss allowance policy 
specifies that all loans greater than $750,000 must be individually 
reviewed for impairment under FASB ASC Subtopic 310-10. Company Y's 
financial statements reflect a strong net worth, good profits, and 
ongoing ability to meet debt service requirements. In contrast, recent 
information indicates Company Z's profitability is declining and its 
cash flow is tight. Accordingly, this loan is rated substandard under 
the registrant's loan grading system. Despite its concern, management 
believes Company Z will resolve its problems and determines that 
neither loan is individually impaired as defined by FASB ASC Subtopic 
310-10.
    Registrant G segments its loan portfolio to estimate loan losses 
under FASB ASC Subtopic 450-20. Two of its loan portfolio segments are 
Segment 1 and Segment 2. The loan to Company Y has risk characteristics 
similar to the loans included in Segment 1 and the loan to Company Z 
has risk characteristics similar to the loans included in Segment 
2.\58\
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    \58\ These groups of loans do not include any loans that have 
been individually reviewed for impairment under FASB ASC Section 
310-10-35, Receivables--Overall--Subsequent Measurement, and 
determined to be impaired as defined by FASB ASC Section 310-10-35.
---------------------------------------------------------------------------

    In its determination of its loan loss allowance under FASB ASC 
Subtopic 450-20, Registrant G includes its loans to Company Y and 
Company Z in the groups of loans with similar characteristics (i.e., 
Segment 1 for Company Y's loan and Segment 2 for Company Z's loan).\59\ 
Management's analyses of Segment 1 and Segment 2 indicate that it is 
probable that each segment includes some losses, even though the losses 
cannot be identified to one or more specific loans. Management 
estimates that the use of its historical loss rates for these two 
segments, with adjustments for changes in environmental factors, 
provides a reasonable estimate of the registrant's probable loan losses 
in these segments.
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    \59\ FASB ASC paragraph 310-10-35-36 states that if a creditor 
concludes that an individual loan specifically identified for 
evaluation is not impaired under FASB ASC Subtopic 310-10, that loan 
may be included in the assessment of the allowance for loan losses 
under FASB ASC Subtopic 450-20, but only if specific characteristics 
of the loan indicate that it is probable that there would be an 
incurred loss in a group of loans with those characteristics.
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    Question: How would the staff normally expect Registrant G to 
adequately document a loan loss allowance under FASB ASC Subtopic 450-
20 for these loans that were individually reviewed for impairment but 
are not considered individually impaired?
    Interpretive Response: The staff normally would expect that, as 
part of Registrant G's effective loan loss allowance methodology, it 
would document its decision to include its loans to Company Y and 
Company Z in its determination of its loan loss allowance under FASB 
ASC Subtopic 450-20.\60\ The staff also normally would

[[Page 17246]]

expect that Registrant G would document the specific characteristics of 
the loans that were the basis for grouping these loans with other loans 
in Segment 1 and Segment 2, respectively.\61\ Additionally, the staff 
normally would expect Registrant G to maintain documentation to support 
its method of estimating loan losses for Segment 1 and Segment 2, which 
typically would include the average loss rate used, the analysis of 
historical losses by loan type and by internal risk rating, and support 
for any adjustments to its historical loss rates.\62\ The registrant 
would typically maintain copies of the economic and other reports that 
provided source data.
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    \60\ Paragraph 9.05 in the Audit Guide indicates that an 
entity's method of estimating credit losses should ``include a 
detailed and regular analysis of the loan portfolio,'' ``consider 
all loans (whether on an individual or pool-of-loans basis),'' ``be 
based on current and reliable data,'' and ``be well documented, with 
clear explanations of the supporting analyses and rationale.'' FASB 
ASC paragraph 310-10-35-36 provides guidance as to the analysis to 
be performed when determining whether a loan that is not 
individually impaired under FASB ASC Subtopic 310-10 should be 
included in the assessment of the loan loss allowance under FASB ASC 
Subtopic 450-20.
    \61\ Ibid.
    \62\ Ibid.
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    When measuring and documenting loan losses, Registrant G should 
take steps to prevent layering loan loss allowances. Layering is the 
inappropriate practice of recording in the allowance more than one 
amount for the same probable loan loss. Layering can happen when a 
registrant includes a loan in one segment, determines its best estimate 
of loss for that loan either individually or on a group basis (after 
taking into account all appropriate environmental factors, conditions, 
and events), and then includes the loan in another group, which 
receives an additional loan loss allowance amount.
5. Documenting the Results of a Systematic Methodology
a. Documenting the Results of a Systematic Methodology--General
    Facts: Registrant H has completed its estimation of its loan loss 
allowance for the current reporting period, in accordance with GAAP, 
using its established systematic methodology.
    Question: What summary documentation would the staff normally 
expect Registrant H to prepare to support the amount of its loan loss 
allowance to be reported in its financial statements?
    Interpretive Response: The staff normally would expect that, to 
verify that loan loss allowance balances are presented fairly in 
accordance with GAAP and are auditable, management would prepare a 
document that summarizes the amount to be reported in the financial 
statements for the loan loss allowance.\63\ Common elements that the 
staff normally would expect to find documented in loan loss allowance 
summaries include: \64\
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    \63\ FRR 28 states: ``[t]he specific rationale upon which the 
[loan loss allowance and provision] amount actually reported is 
based--i.e., the bridge between the findings of the detailed review 
[of the loan portfolio] and the amount actually reported in each 
period--would be documented to help ensure the adequacy of the 
reported amount, to improve auditability, and to serve as a 
benchmark for exercise of prudent judgment in future periods.''
    \64\ See also paragraph 9.14 of the Audit Guide.
---------------------------------------------------------------------------

     The estimate of the probable loss or range of loss 
incurred for each category evaluated (e.g., individually evaluated 
impaired loans, homogeneous pools, and other groups of loans that are 
collectively evaluated for impairment);
     The aggregate probable loss estimated using the 
registrant's methodology;
     A summary of the current loan loss allowance balance;
     The amount, if any, by which the loan loss allowance 
balance is to be adjusted; \65\ and
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    \65\ Subsequent to adjustments, the staff normally would expect 
that there would be no material differences between the consolidated 
loss estimate, as determined by the methodology, and the final loan 
loss allowance balance reported in the financial statements. 
Registrants should refer to SAB 99 and SAS 89 and its amendments to 
AU Section 310.
---------------------------------------------------------------------------

     Depending on the level of detail that supports the loan 
loss allowance analysis, detailed subschedules of loss estimates that 
reconcile to the summary schedule.
    Generally, a registrant's review and approval process for the loan 
loss allowance relies upon the data provided in these consolidated 
summaries. There may be instances in which individuals or committees 
that review the loan loss allowance methodology and resulting allowance 
balance identify adjustments that need to be made to the loss estimates 
to provide a better estimate of loan losses. These changes may be due 
to information not known at the time of the initial loss estimate 
(e.g., information that surfaces after determining and adjusting, as 
necessary, historical loss rates, or a recent decline in the 
marketability of property after conducting a FASB ASC Subtopic 310-10 
valuation based upon the fair value of collateral). It is important 
that these adjustments are consistent with GAAP and are reviewed and 
approved by appropriate personnel.\66\ Additionally, it would typically 
be appropriate for the summary to provide each subsequent reviewer with 
an understanding of the support behind these adjustments. Therefore, 
the staff normally would expect management to document the nature of 
any adjustments and the underlying rationale for making the 
changes.\67\
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    \66\ Paragraph 9.64 in the Audit Guide indicates that effective 
internal control related to the allowance for loan losses should 
include ``adequate review and approval of the allowance estimates by 
the individuals specified in management's written policy.''
    \67\ See the guidance in paragraph 9.14 of the Audit Guide 
(``[t]he approach for determination of the allowance should be well 
documented'') and in FRR 28 (``the specific rationale upon which the 
amount actually reported in each individual period is based would be 
documented'').
---------------------------------------------------------------------------

    The staff also normally would expect this documentation to be 
provided to those among management making the final determination of 
the loan loss allowance amount.\68\
---------------------------------------------------------------------------

    \68\ Ibid.
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b. Documenting the Results of a Systematic Methodology--Allowance 
Adjustments
    Facts: Registrant I determines its loan loss allowance using an 
established systematic process. At the end of each reporting period, 
the accounting department prepares a summary schedule that includes the 
amount of each of the components of the loan loss allowance, as well as 
the total loan loss allowance amount, for review by senior management, 
including the Credit Committee. Members of senior management meet to 
discuss the loan loss allowance. During these discussions, they 
identify changes that are required by GAAP to be made to certain of the 
loan loss allowance estimates. As a result of the adjustments made by 
senior management, the total amount of the loan loss allowance changes. 
However, senior management (or its designee) does not update the loan 
loss allowance summary schedule to reflect the adjustments or reasons 
for the adjustments. When performing their audit of the financial 
statements, the independent accountants are provided with the original 
loan loss allowance summary schedule reviewed by senior management, as 
well as a verbal explanation of the changes made by senior management 
when they met to discuss the loan loss allowance.
    Question: In the staff's view, are Registrant I's documentation 
practices related to the balance of its loan loss allowance in 
compliance with existing documentation guidance in this area?
    Interpretive Response: No. A registrant should maintain supporting 
documentation for the loan loss allowance amount reported in its 
financial statements.\69\ As illustrated above, there may be instances 
in which loan loss allowance reviewers identify

[[Page 17247]]

adjustments that need to be made to the loan loss estimates. The staff 
normally would expect the nature of the adjustments, how they were 
measured or determined, and the underlying rationale for making the 
changes to the loan loss allowance balance to be documented.\70\ The 
staff also normally would expect appropriate documentation of the 
adjustments to be provided to management for review of the final loan 
loss allowance amount to be reported in the financial statements. This 
documentation should also be made available to the independent 
accountants. If changes frequently occur during management or credit 
committee reviews of the loan loss allowance, management may find it 
appropriate to analyze the reasons for the frequent changes and to 
reassess the methodology the registrant uses.\71\
---------------------------------------------------------------------------

    \69\ Ibid.
    \70\ Ibid.
    \71\ As outlined in paragraph 9.64 of the Audit Guide, effective 
internal controls related to the allowance for loan losses should 
include adequate review and approval of allowance estimates, 
including review of sources of relevant information, review of 
development of assumptions, review of reasonableness of assumptions 
and resulting estimates, and consideration of changes in previously 
established methods to arrive at the allowance.
---------------------------------------------------------------------------

6. Validating a Systematic Methodology
    Question: What is the staff's guidance to a registrant on 
validating, and documenting the validation of, its systematic 
methodology used to estimate loan loss allowances?
    Interpretive Response: The staff believes that a registrant's loan 
loss allowance methodology is considered valid when it accurately 
estimates the amount of loss contained in the portfolio. Thus, the 
staff normally would expect the registrant's methodology to include 
procedures that adjust loan loss estimation methods to reduce 
differences between estimated losses and actual subsequent charge-offs, 
as necessary. To verify that the loan loss allowance methodology is 
valid and conforms to GAAP, the staff believes it is appropriate for 
management to establish internal control policies,\72\ appropriate for 
the size of the registrant and the type and complexity of its loan 
products. These policies may include procedures for a review, by a 
party who is independent of the allowance for loan losses estimation 
process, of the allowance for loan losses methodology and its 
application in order to confirm its effectiveness.
---------------------------------------------------------------------------

    \72\ Ibid.
---------------------------------------------------------------------------

    In practice, registrants employ numerous procedures when validating 
the reasonableness of their loan loss allowance methodology and 
determining whether there may be deficiencies in their overall 
methodology or loan grading process. Examples are:
     A review of trends in loan volume, delinquencies, 
restructurings, and concentrations.
     A review of previous charge-off and recovery history, 
including an evaluation of the timeliness of the entries to record both 
the charge-offs and the recoveries.
     A review by a party that is independent of the loan loss 
allowance estimation process. This often involves the independent party 
reviewing, on a test basis, source documents and underlying assumptions 
to determine that the established methodology develops reasonable loss 
estimates.
     An evaluation of the appraisal process of the underlying 
collateral. This may be accomplished by periodically comparing the 
appraised value to the actual sales price on selected properties sold.
    It is the staff's understanding that, in practice, management 
usually supports the validation process with the workpapers from the 
loan loss allowance review function. Additional documentation often 
includes the summary findings of the independent reviewer. The staff 
normally would expect that, if the methodology is changed based upon 
the findings of the validation process, documentation that describes 
and supports the changes would be maintained.\73\
---------------------------------------------------------------------------

    \73\ See paragraph 9.64 of the Audit Guide.
---------------------------------------------------------------------------

TOPIC 7: REAL ESTATE COMPANIES

A. Removed by SAB 103

B. Removed by SAB 103

C. Schedules of Real Estate and Accumulated Depreciation, and of 
Mortgage Loans on Real Estate

    Facts: Whenever investments in real estate or mortgage loans on 
real estate are significant, the schedules of such items (see Rules 12-
28 and 12-29 of Regulation S-X) are required in a prospectus.
    Question: Is such information also required in annual reports to 
shareholders?
    Interpretive Response: Although Rules 14a-3 and 14c-3 permit the 
omission of financial statement schedules from annual reports to 
shareholders, the staff is of the view that the information required by 
these schedules is of such significance within the real estate industry 
that the information should be included in the financial statements in 
the annual report to shareholders.

D. Income Before Depreciation

    Facts: Occasionally an income statement format will contain a 
subtitle or caption titled ``Income before depreciation and 
depletion.''
    Question: Is this caption appropriate?
    Interpretive Response: The staff objects to this presentation 
because in the staff's view the presentation may suggest to the reader 
that the amount so captioned represents cash flow for the period, which 
is rarely the case (see ASR 142).

TOPIC 8: RETAIL COMPANIES

A. Sales of Leased or Licensed Departments

    Facts: At times, department stores and other retailers have 
included the sales of leased or licensed departments in the amount 
reported as ``total revenues.''
    Question: Does the staff have any objection to this practice?
    Interpretive Response: The staff believes that FASB ASC Topic 840, 
Leases, requires department stores and other retailers that lease or 
license store space to account for rental income from leased 
departments in accordance with FASB ASC Topic 840. Accordingly, it 
would be inappropriate for a department store or other retailer to 
include in its revenue the sales of the leased or licensed departments. 
Rather, the department store or other retailer should include the 
rental income as part of its gross revenue. The staff would not object 
to disclosure in the footnotes to the financial statements of the 
amount of the lessee's sales from leased departments. If the 
arrangement is not a lease \1\ but rather a service arrangement that 
provides for payment of a fee or commission, the retailer should 
recognize the fee or commission as revenue when earned. If the retailer 
assumes the risk of bad debts associated with the lessee's merchandise 
sales, the retailer generally should present bad debt expense in 
accordance with Rule 5-03 of Regulation S-X.
---------------------------------------------------------------------------

    \1\ The FASB ASC Master Glossary defines a lease as ``an 
agreement conveying the right to use property, plant, or equipment 
(land and/or depreciable assets) usually for a stated period of 
time.''
---------------------------------------------------------------------------

B. Finance Charges

    Facts: Department stores and other retailers impose finance charges 
on credit sales.
    Question: How should such charges be disclosed?
    Interpretive Response: As a minimum, the staff requests that the 
amount of gross revenue from such charges be stated in a footnote and 
that the income statement classification which includes

[[Page 17248]]

such revenue be identified. The following are examples of acceptable 
disclosure:
Example 1
    Consumer Credit Operations:
    The results of the Consumer Credit Operations which are included in 
the Statement of Earnings as a separate line item are as follows for 
the fiscal year ended January 31, 20x0:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Service charges........................................     $167,000,000
Operating expenses:
    Interest...........................................       60,000,000
    Payroll............................................       35,000,000
    Provision for uncollected accounts.................       29,000,000
    All other credit and collection expenses...........       32,000,000
    Provision for Federal income taxes.................        5,000,000
                                                        ----------------
        Total operating expenses.......................      161,000,000
Consumer credit operations earnings....................        6,000,000
------------------------------------------------------------------------

Example 2
    Service charges on retail credit accounts are netted against 
selling, general and administrative expense. The cost of administering 
retail credit program continued to exceed service charges on customer 
receivables as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                   In millions
                                                                ------------------------------------------------
                                                                                                     Percent
                                                                      20x2            20x1           increase
                                                                                                    (decrease)
----------------------------------------------------------------------------------------------------------------
Costs:
    Regional office operations.................................             $45             $42               9
    Interest...................................................              51              44              13
    Provision for doubtful accounts............................              21              15              34
                                                                ------------------------------------------------
        Total..................................................             117             102              15
    Less service charge income.................................              96              79              22
    Net cost of credit.........................................              21              23             (10)
    Net cost as percent of credit sales........................            1.4%            1.6%  ...............
----------------------------------------------------------------------------------------------------------------

    The above results do not reflect either ``in store'' costs related 
to credit operations or any allocation of corporate overhead expenses.
    This SAB is not intended to change current guidance in the 
accounting literature. For this reason, adherence to the principles 
described in this SAB should not raise the costs associated with 
record-keeping or with audits of financial statements.

TOPIC 9: FINANCE COMPANIES

A. Removed by SAB 103

B. Removed by ASR 307

TOPIC 10: UTILITY COMPANIES

A. Financing by Electric Utility Companies Through Use of Construction 
Intermediaries

    Facts: Some electric utility companies finance construction of a 
generating plant or their share of a jointly owned plant through the 
use of a ``construction intermediary'' which may be organized as a 
trust or a corporation. Typically the utility assigns its interest in 
property and other contract rights to the construction intermediary 
with the latter authorized to obtain funds to finance construction with 
term loans, bank loans, commercial paper and other sources of funds and 
that may be available. The intermediary's borrowings are guaranteed in 
part of the work in progress but more significantly, although 
indirectly, by the obligation of the utility to purchase the project 
upon completion and assume or otherwise settle the borrowings. The 
utility may be committed to provide any deficiency of funds which the 
intermediary cannot obtain and excess funds may be loaned to the 
utility by the intermediary. (In one case involving construction of an 
entire generating plant, the intermediary appointed the utility as its 
agent to complete construction.) On the occurrence of an event such as 
commencement of the testing period for the plant or placing the plant 
in commercial service (but not later than a specified date) the 
interest in the plant reverts to the utility and concurrently the 
utility must either assume the obligations issued by the intermediary 
or purchase them from the holders. The intermediary also may be 
authorized to borrow amounts for accrued interest when due and those 
amounts are added to the balance of the outstanding indebtedness. 
Interest is thus capitalized during the construction period at rates 
being charged by the lenders; however, it is deductible by the utility 
for tax purposes in the year of accrual.
    Question: How should construction work in progress and related 
liabilities and interest expense being financed through a construction 
intermediary be reflected in an electric utility's financial 
statements?
    Interpretive Response: The balance sheet of an electric utility 
company using a construction intermediary to finance construction 
should include the intermediary's work in progress in the appropriate 
caption under utility plant. The related debt should be included in 
long-term liabilities and disclosed either on the balance sheet or in a 
note.
    The amount of interest cost incurred and the respective amounts 
expensed or capitalized shall be disclosed for each period for which an 
income statement is presented. Consequently, capitalized interest 
included as part of an intermediary's construction work in progress on 
the balance sheet should be recognized on the current income statement 
as interest expense with a corresponding offset to allowance for 
borrowed funds used during construction. Income statements for

[[Page 17249]]

prior periods should also be restated. The amounts may be shown 
separately on the statement or included with interest expense and 
allowance for borrowed funds used during construction.
    A note to the financial statements should describe briefly the 
organization and purpose of the intermediary and the nature of its 
authorization to incur debt to finance construction. The note should 
disclose the rate at which interest on this debt has been capitalized 
and the dollar amount for each period for which an income statement is 
presented.

B. Removed by SAB 103

C. Jointly Owned Electric Utility Plants

    Facts: Groups of electric utility companies have been building and 
operating utility plants under joint ownership agreements or 
arrangements which do not create legal entities for which separate 
financial statements are presented.\1\ Under these arrangements, a 
participating utility has an undivided interest in a utility plant and 
is responsible for its proportionate share of the costs of construction 
and operation and its entitled to its proportionate share of the energy 
produced.
---------------------------------------------------------------------------

    \1\ Before considering the guidance in this SAB Topic, 
registrants are reminded that the arrangement should be evaluated in 
accordance with the provisions of FASB ASC Topic 810, Consolidation.
---------------------------------------------------------------------------

    During the construction period a participating utility finances its 
own share of a utility plant using its own financial resources and not 
the combined resources of the group. Allowance for funds used during 
construction is provided in the same manner and at the same rates as 
for plants constructed to be used entirely by the participant utility.
    When a joint-owned plant becomes operational, one of the 
participant utilities acts as operator and bills the other participants 
for their proportionate share of the direct expenses incurred. Each 
individual participant incurs other expenses related to transmission, 
distribution, supervision and control which cannot be related to the 
energy generated or received from any particular source. Many companies 
maintain depreciation records on a composite basis for each class of 
property so that neither the accumulated allowance for depreciation nor 
the periodic expense can be allocated to specific generating units 
whether jointly or wholly owned.
    Question: What disclosure should be made on the financial 
statements or in the notes concerning interests in jointly owned 
utility plants?
    Interpretive Response: A participating utility should include 
information concerning the extent of its interests in jointly owned 
plants in a note to its financial statements. The note should include a 
table showing separately for each interest in a jointly owned plant the 
amount of utility plant in service, the accumulated provision for 
depreciation (if available), the amount of plant under construction, 
and the proportionate share. The amounts presented for plant in service 
or plant under construction may be further subdivided to show amounts 
applicable to plant subcategories such as production, transmission, and 
distribution. The note should include statements that the dollar 
amounts represent the participating utility's share in each joint plant 
and that each participant must provide its own financing. Information 
concerning two or more generating plants on the same site may be 
combined if appropriate.
    The note should state that the participating utility's share of 
direct expenses of the joint plants is included in the corresponding 
operating expenses on its income statement (e.g., fuel, maintenance of 
plant, other operating expense). If the share of direct expenses is 
charged to purchased power then the note should disclose the amount so 
charged and the proportionate amounts charged to specific operating 
expenses on the records maintained for the joint plants.

D. Long-Term Contracts for Purchase of Electric Power

    Facts: Under long-term contracts with public utility districts, 
cooperatives or other organizations, a utility company receives a 
portion of the output of a production plant constructed and financed by 
the district or cooperative. The utility has only a nominal or no 
investment at all in the plant but pays a proportionate part of the 
plant's costs, including debt service. The contract may be in the form 
of a sale of a generating plant and its immediate lease back. The 
utility is obligated to pay certain minimum amounts which cover debt 
service requirements whether or not the plant is operating. At the 
option of other parties to the contract and in accordance with a 
predetermined schedule, the utility's proportionate share of the output 
may be reduced. Separate agreements may exist for the transmission of 
power to the utility's system.\2\
---------------------------------------------------------------------------

    \2\ Registrants are reminded that the arrangement may contain a 
guarantee that is within the scope of FASB ASC Topic 460, 
Guarantees. Further, registrants should consider the guidance of 
FASB ASC Topic 810, Consolidation. Also, registrants would need to 
consider whether the arrangement contains a derivative that should 
be accounted for according to FASB ASC Topic 815, Derivatives and 
Hedging.
---------------------------------------------------------------------------

    Question: How should the cost of power obtained under long-term 
purchase contracts be reflected on the financial statements and what 
supplemental disclosures should be made in notes to the statements?
    Interpretive Response: The cost of power obtained under long-term 
purchase contracts, including payments required to be made when a 
production plant is not operating, should be included in the operating 
expenses section of the income statement. A note to the financial 
statements should present information concerning the terms and 
significance of such contracts to the utility company including date of 
contract expiration, share of plant output being purchased, estimated 
annual cost, annual minimum debt service payment required and amount of 
related long-term debt or lease obligations outstanding.
    Additional disclosure should be given if the contract provides, or 
is expected to provide, in excess of five percent of current or 
estimated future system capability. This additional disclosure may be 
in the form of separate financial statements of the vendor entity or 
inclusion of the amount of the obligation under the contract as a 
liability on the balance sheet with a corresponding amount as an asset 
representing the right to purchase power under the contract.
    The note to the financial statements should disclose the allocable 
portion of interest included in charges under such contracts.

E. Classification of Charges for Abandonments and Disallowances

    Facts: A public utility company abandons the construction of a 
plant and, under the provisions of FASB ASC Subtopic 980-360, Regulated 
Operations--Property, Plant, and Equipment, must charge a portion of 
the costs of the abandoned plant to expense.\3\ Also, the utility 
determines that it is probable that certain costs of a recently 
completed plant will be disallowed, and charges those costs to

[[Page 17250]]

expense as required by FASB ASC Subtopic 980-360.
---------------------------------------------------------------------------

    \3\ FASB ASC paragraphs 980-360-35-1 through 980-360-35-3 
requires that costs of abandoned plants in excess of the present 
value of the future revenues expected to be provided to recover any 
allowable costs be charged to expense in the period that the 
abandonment becomes probable. Also, FASB ASC paragraph 980-360-35-12 
requires that disallowed costs for recently completed plants be 
charged to expense when the disallowance becomes probable and can be 
reasonably estimated.
---------------------------------------------------------------------------

    Question: May such charges for abandonments and disallowances be 
reported as extraordinary items in the statement of income?
    Interpretive Response: No. The staff does not believe that such 
charges meet the requirements of FASB ASC Subtopic 225-20, Income 
Statement--Extraordinary and Unusual Items, that an item be both 
unusual and infrequent to be classified as an extraordinary item. 
Accordingly, the public utility was advised by the staff that such 
charges should be reported as a component of income from continuing 
operations, separately presented, if material.\4\
---------------------------------------------------------------------------

    \4\ Additionally, the registrant was reminded that FASB ASC 
paragraph 225-20-45-16 provides that items which are not reported as 
extraordinary should not be reported on the income statement net of 
income taxes or in any manner that implies that they are similar to 
extraordinary items.
---------------------------------------------------------------------------

    FASB ASC paragraph 225-20-45-2 indicates that to be unusual, an 
item must ``possess a high degree of abnormality and be of a type 
clearly unrelated to, or only incidentally related to, the ordinary and 
typical activities of the entity, taking into account the environment 
in which the entity operates.'' Similarly, that paragraph indicates 
that, to be infrequent, an event should ``not reasonably be expected to 
recur in the foreseeable future.''
    Electric utilities operate under a franchise that requires them to 
furnish adequate supplies of electricity for their service area. That 
undertaking requires utilities to continually forecast the future 
demand for electricity, and the costs to be incurred in constructing 
the plants necessary to meet that demand. Abandonments and 
disallowances result from the failure of demand to reach projected 
levels and/or plant construction costs that exceed anticipated amounts. 
Neither event qualifies as being both unusual and infrequent in the 
environment in which electric utilities operate.
    Accordingly, the staff believes that charges for abandonments and 
disallowances under FASB ASC Subtopic 980-360 should not be presented 
as extraordinary items.\5\
---------------------------------------------------------------------------

    \5\ The staff also notes that FASB ASC paragraphs 980-360-35-1 
through 980-360-35-3 and 980-360-35-12, in requiring that such costs 
be ``recognized as a loss,'' do not specify extraordinary item 
treatment. The staff believes that it generally has been the FASB's 
practice to affirmatively require extraordinary item treatment when 
it believes that it is appropriate for charges or credits to income 
specifically required by a provision of a statement.
---------------------------------------------------------------------------

F. Presentation of Liabilities for Environmental Costs

    Facts: A public utility company determines that it is obligated to 
pay material amounts as a result of an environmental liability. These 
amounts may relate to, for example, damages attributed to clean-up of 
hazardous wastes, reclamation costs, fines, and litigation costs.
    Question 1: May a rate-regulated enterprise present on its balance 
sheet the amount of its estimated liability for environmental costs net 
of probable future revenue resulting from the inclusion of such costs 
in allowable costs for rate-making purposes?
    Interpretive Response: No. FASB ASC Subtopic 980-340, Regulated 
Operations--Other Assets and Deferred Costs, specifies the conditions 
under which rate actions of a regulator can provide reasonable 
assurance of the existence of an asset. The staff believes that 
environmental costs meeting the criteria of FASB ASC paragraph 980-340-
25-1 \6\ should be presented on the balance sheet as an asset and 
should not be offset against the liability. Contingent recoveries 
through rates that do not meet the criteria of FASB ASC paragraph 980-
340-25-1 should not be recognized either as an asset or as a reduction 
of the probable liability.
---------------------------------------------------------------------------

    \6\ FASB ASC paragraph 980-340-25-16 requires a rate-regulated 
enterprise to capitalize all or part of an incurred cost that would 
otherwise be charged to expense if it is probable that future 
revenue will be provided to recover the previously incurred cost 
from inclusion of the costs in allowable costs for rate-making 
purposes.
---------------------------------------------------------------------------

    Question 2: May a rate-regulated enterprise delay recognition of a 
probable and estimable liability for environmental costs which it has 
incurred at the date of the latest balance sheet until the regulator's 
deliberations have proceeded to a point enabling management to 
determine whether this cost is likely to be included in allowable costs 
for rate-making purposes?
    Interpretive Response: No. FASB ASC Subtopic 450-20, 
Contingencies--Loss Contingencies, states that an estimated loss from a 
loss contingency shall be accrued by a charge to income if it is 
probable that a liability has been incurred and the amount of the loss 
can be reasonably estimated.\7\ The staff believes that actions of a 
regulator can affect whether an incurred cost is capitalized or 
expensed pursuant to FASB ASC Subtopic 980-340, but the regulator's 
actions cannot affect the timing of the recognition of the liability.
---------------------------------------------------------------------------

    \7\ Registrants also should apply the guidance of FASB ASC 
Subtopic 410-30, Asset Retirement and Environmental Obligations--
Environmental Obligations, in determining the appropriate 
recognition of environmental remediation costs.
---------------------------------------------------------------------------

TOPIC 11: MISCELLANEOUS DISCLOSURE

A. Operating-Differential Subsidies

    Facts: Company A has received an operating-differential subsidy 
pursuant to the Merchant Marine Act of 1936, as amended.
    Question: How should such subsidies be displayed in the income 
statement?
    Interpretive Response: Revenue representing an operating-
differential subsidy under the Merchant Marine Act of 1936, as amended, 
must be set forth as a separate line item in the income statement 
either under a revenue caption or as credit in the costs and expenses 
section.

B. Depreciation and Depletion Excluded From Cost of Sales

    Facts: Company B excludes depreciation and depletion from cost of 
sales in its income statement.
    Question: How should this exclusion be disclosed?
    Interpretive Response: If cost of sales or operating expenses 
exclude charges for depreciation, depletion and amortization of 
property, plant and equipment, the description of the line item should 
read somewhat as follows: ``Cost of goods sold (exclusive of items 
shown separately below)'' or ``Cost of goods sold (exclusive of 
depreciation shown separately below).'' To avoid placing undue emphasis 
on ``cash flow,'' depreciation, depletion and amortization should not 
be positioned in the income statement in a manner which results in 
reporting a figure for income before depreciation.

C. Tax Holidays

    Facts: Company C conducts business in a foreign jurisdiction which 
attracts industry by granting a ``holiday'' from income taxes for a 
specified period.
    Question: Does the staff generally request disclosure of this fact?
    Interpretive Response: Yes. In such event, a note must (1) disclose 
the aggregate dollar and per share effects of the tax holiday and (2) 
briefly describe the factual circumstances including the date on which 
the special tax status will terminate.

D. Removed by SAB 103

E. Chronological Ordering of Data

    Question: Does the staff have any preference in what order data are 
presented (e.g., the most current data displayed first, etc.)?
    Interpretive Response: The staff has no preference as to order; 
however,

[[Page 17251]]

financial statements and other data presented in tabular form should 
read consistently from left to right in the same chronological order 
throughout the filing. Similarly, numerical data included in narrative 
sections should be consistently ordered.

F. LIFO Liquidations

    Facts: Registrant on LIFO basis of accounting liquidates a 
substantial portion of its LIFO inventory and as a result includes a 
material amount of income in its income statement which would not have 
been recorded had the inventory liquidation not taken place.
    Question: Is disclosure required of the amount of income realized 
as a result of the inventory liquidation?
    Interpretive Response: Yes. Such disclosure would be required in 
order to make the financial statements not misleading. Disclosure may 
be made either in a footnote or parenthetically on the face of the 
income statement.

G. Tax Equivalent Adjustment in Financial Statements of Bank Holding 
Companies

    Facts: Bank subsidiaries of bank holding companies frequently hold 
substantial amounts of state and municipal bonds, interest income from 
which is exempt from Federal income taxes. Because of the tax exemption 
the stated yield on these securities is lower than the yield on 
securities with similar risk and maturity characteristics whose 
interest is subject to Federal tax. In order to make the interest 
income and resultant yields on tax exempt obligations comparable to 
those on taxable investments and loans, a ``tax equivalent adjustment'' 
is often added to interest income when presented in analytical tables 
or charts. When the data presented also includes income taxes, a 
corresponding amount is added to income tax expense so that there is no 
effect on net income. Adjustment may also be made for the tax 
equivalent effect of exemption from state and local taxes.
    Question 1: Is the concept of the tax equivalent adjustment 
appropriate for inclusion in financial statements and related notes?
    Interpretive Response: No. The tax equivalent adjustment represents 
a credit to interest income which is not actually earned and realized 
and a corresponding charge to taxes (or other expense) which will never 
be paid. Consequently, it should not be reflected on the income 
statement or in notes to financial statements included in reports to 
shareholders or in a report or registration statement filed with the 
Commission.
    Question 2: May amounts representing tax equivalent adjustments be 
included in the body of a statement of income provided they are 
designated as not being included in the totals and balances on the 
statement?
    Interpretive Response: No. The tabular format of a statement 
develops information in an orderly manner which becomes confusing when 
additional numbers not an integral part of the statement are inserted 
into it.
    Question 3: May revenues on a tax equivalent adjusted basis be 
included in selected financial data?
    Interpretive Response: Revenues may be included in selected 
financial data on a tax equivalent basis if the respective captions 
state which amounts are tax equivalent adjusted and if the 
corresponding unadjusted amounts are also reported in the selected 
financial data.
    Because of differences among registrants in making the tax 
equivalency computation, a brief note should describe the extent of 
recognition of exemption from Federal, state and local taxes and the 
combined marginal or incremental rate used. Where net operating losses 
exist, the note should indicate the nature of the tax equivalency 
adjustment made.
    Question 4: May information adjusted to a tax equivalent basis be 
included in management's discussion and analysis of financial condition 
and results of operations?
    Interpretive Response: One of the purposes of MD&A is to enable 
investors to appraise the extent that earnings have been affected by 
changes in business activity and accounting principles or methods. 
Material changes in items of revenue or expense should be analyzed and 
explained in textual discussion and statistical tables. It may be 
appropriate to use amounts or to present yields on a tax equivalent 
basis. If appropriate, the discussion should include a comment on 
material changes in investment securities positions that affect tax 
exempt interest income. For example, there might be a comment on a 
change from investments in tax exempt securities because of the 
availability of net operating losses to offset taxable income of 
current and future periods, or a comment on a change in the quality 
level of the tax exempt investments resulting in increased interest 
income and risk and a corresponding increase in the tax equivalent 
adjustment.
    Tax equivalent adjusted amounts should be clearly identified and 
related to the corresponding unadjusted amounts in the financial 
statements. A descriptive note similar to that suggested to accompany 
adjusted amounts included in selected financial data should be 
provided.

H. Disclosures by Bank Holding Companies Regarding Certain Foreign 
Loans

1. Deposit/Relending Arrangements
    Facts: Certain foreign countries experiencing liquidity problems, 
by agreement with U.S. banks, have instituted arrangements whereby 
borrowers in the foreign country may remit local currency to the 
foreign country's central bank, in return for the central bank's 
assumption of the borrowers' non-local currency obligations to the U.S. 
banks. The local currency is held on deposit at the central bank, for 
the account of the U.S. banks, and may be subject to relending to other 
borrowers in the country. Ultimate repayment of the obligations to the 
U.S. banks, in the requisite non-local currency, may not be due until a 
number of years hence.
    Question: What disclosures are appropriate regarding deposit/
relending arrangements of this general type?
    Interpretive Response: The staff emphasizes that it is the 
responsibility of each registrant to determine the appropriate 
financial statement treatment and classification of foreign 
outstandings. The facts and circumstances surrounding deposit/relending 
arrangements should be carefully analyzed to determine whether the 
local currency payments to the foreign central bank represent 
collections of outstandings for financial reporting purposes, and 
whether such outstandings should be classified as nonaccrual, past due 
or restructured loans pursuant to Item III.C.1. of Industry Guide 3, 
Statistical Disclosure by Bank Holding Companies (``Guide 3'').
    The staff believes, however, that the impact of deposit/relending 
arrangements covering significant amounts of outstandings to a foreign 
country should be disclosed pursuant to Guide 3, Item III.C.3., 
Instruction (6)(a).\1\ The disclosures should include a general 
description of the arrangements and, if significant, the amounts of 
interest income recognized for financial reporting purposes which has 
not been

[[Page 17252]]

remitted in the requisite non-local currency to the U.S. bank.
---------------------------------------------------------------------------

    \1\ Instruction (6)(a) calls for description of the nature and 
impact of developments in countries experiencing liquidity problems 
which are expected to have a material impact on timely repayment of 
principal or interest. Additionally, Instruction (6)(d)(ii) to Item 
III.C.3. calls for disclosure of commitments to relend, or to 
maintain on deposit, arising in connection with certain 
restructurings of foreign outstanding.
---------------------------------------------------------------------------

2. Accounting and Disclosures by Bank Holding Companies for a ``Mexican 
Debt Exchange'' Transaction
    Facts: Inquiries have been made of the staff regarding certain 
accounting and disclosure issues raised by a proposed ``Mexican Debt 
Exchange'' transaction which could involve numerous bank holding 
companies with existing obligations of the United Mexican States 
(``Mexico'') or other Mexican public sector entities (collectively, 
``Existing Obligations''). The key elements of the Mexican Debt 
Exchange are as follows:
    Mexico will offer for sale bonds (``Bonds''), denominated in U.S. 
dollars, which will pay interest at a LIBOR-based floating rate and 
mature in twenty years. Mexico will undertake to list the Bonds on the 
Luxembourg Stock Exchange. The Bonds will be secured, as to their 
ultimate principal value only, by non-interest bearing securities of 
the U.S. Treasury (``Zero Coupon Treasury Securities'') which will be 
purchased by Mexico. The Zero Coupon Treasury Securities will be 
pledged to holders of the Bonds and held in custody at the Federal 
Reserve Bank of New York and will have a maturity date and ultimate 
principal value which match the maturity date and principal value of 
the Bonds. While the Bonds will have default and acceleration 
provisions, the holder of a Bond will not be permitted to have access 
to the collateral prior to the final scheduled maturity date, at which 
time the proceeds of the collateral will be available to pay the full 
principal amount of the Bonds. As such, the holder of a Bond ultimately 
will be secured as to principal at maturity; however, the interest 
payments will not be secured. The Bonds will not be subject to future 
restructurings of Mexico's Existing Obligations, and Mexico has 
indicated that neither the Bonds nor the Existing Obligations exchanged 
therefore will be considered part of a base amount with respect to any 
future requests by Mexico for new money.
    The Mexican Debt Exchange will be structured in such a way that 
potential purchasers of the Bonds will submit bids on a voluntary basis 
to the auction agent. These bids will specify the face dollar amount of 
existing restructured commercial bank obligations of Mexico or of other 
Mexican public sector entities that the potential purchaser is willing 
to tender and the face dollar amount of Bonds that the purchaser is 
willing to accept in exchange for the Existing Obligations. Following 
the auction date, Mexico will determine the face dollar amount of Bonds 
to be issued and will exchange the Bonds for Existing Obligations 
taking first the offer of the largest face dollar amount of Existing 
Obligations per face dollar amount of Bonds, and so on, until all Bonds 
which Mexico is willing to issue have been subscribed. It is therefore 
possible that a greater amount of Existing Obligations could be 
tendered than Mexico is willing to accept.
    The lender has appropriately accounted for the transaction as a 
troubled debt restructuring in accordance with the provisions of FASB 
ASC Subtopic 310-40, Receivables--Troubled Debt Restructurings by 
Creditors.
    Question 1: What financial statement and other disclosure issues 
regarding the Mexican Debt Exchange and the Bonds received should be 
considered by registrants?
    Interpretive Response: The staff believes that disclosure of the 
nature of the transaction would be necessary, including:
     Carrying value and terms of Existing Obligations 
exchanged;
     Face value, carrying value, market value and terms of 
Bonds received;
     The effect of the transaction on the allowance for loan 
losses and the provision for losses in the current period; and
     Annual interest income on Existing Obligations exchanged 
and annual interest income on Bonds received.

On an ongoing basis, the staff believes that the terms, carrying value 
and market value of the Bonds should be disclosed, if material, due to 
their unique features.\2\

    \2\ Registrants also are reminded that if the security received 
in the exchange constitutes a debt security within the scope of FASB 
ASC Topic 320, Investments--Debt and Equity Securities, the 
disclosures required by FASB ASC Topic 320 also would need to be 
provided.
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    Question 2: What disclosure with respect to the Bonds received 
would be acceptable under Industry Guide 3?
    Interpretive Response: Instruction (4) to Item III.C.3. of Industry 
Guide 3 states: ``The value of any tangible, liquid collateral may also 
be netted against cross-border outstandings of a country if it is held 
and realizable by the lender outside of the borrower's country.'' Given 
the unique features of the Bonds in that the ultimate repayment of the 
principal amount (but not interest) at maturity is assured, the staff 
will not object to either of two presentations. Under the first 
presentation, the carrying value of the Bonds, including any accrued 
but unpaid interest, would be included as a ``cross-border 
outstanding'' to the extent it exceeds the current fair value of the 
Zero Coupon Treasury Securities which collateralize the bonds. 
Alternatively, under the second presentation, the carrying value of the 
Bond principal would be excluded from Mexican cross-border outstandings 
provided (a) disclosure is made of the exclusion, (b) for purposes of 
determining the 1% and .75% of total assets disclosure thresholds of 
Item III.C.3. of Industry Guide 3, such carrying values are not 
excluded, and (c) all the Guide 3 disclosures relating to cross-border 
outstandings continue to be made, as discussed further below.
    For registrants that adopt the alternative disclosure approach and 
whose Mexican cross-border outstandings (excluding the carrying value 
of the Bond principal) exceed 1% of total assets, appropriate footnote 
disclosure of the exclusions should be made. Such footnote should 
indicate the face amount and carrying value of the Bonds excluded, the 
market value of such Bonds, and the face amount and current fair value 
of the Zero Coupon Treasury Securities which secure the Bonds.
    If the Mexican cross-border outstandings (excluding the carrying 
value of the Bond principal) are less than 1% of total assets but with 
the addition of the carrying value of the Bond principal would exceed 
1%, the carrying value of the Mexican cross-border outstandings may be 
excluded from the list of countries whose cross-border outstandings 
exceed 1% of total assets provided that a footnote discloses the amount 
of Mexican cross-border outstandings (excluding the carrying value of 
the Bond principal) along with the footnote-type disclosure concerning 
the Bonds discussed in the previous paragraph. This disclosure and any 
other material disclosure specified by Item III.C.3. of Industry Guide 
3 would continue to be made as long as Mexican exposure, including the 
carrying value of the Bond principal, exceeded 1%.
    If the Mexican cross-border outstandings (excluding the carrying 
value of the Bond principal) are less than .75% of total assets but 
with the addition of the carrying value of the Mexican Bond principal 
would exceed .75% but be less than 1%, cross-border outstandings 
disclosed pursuant to Instruction (7) to Item III.C.3. of Industry 
Guide 3 may exclude Mexico provided a footnote is added to the 
aggregate disclosure which discloses the amount of Mexican cross-border 
outstandings and the fact that they have not been included. The 
carrying value of the Bond principal may be excluded from the amount of 
Mexican cross-border outstandings disclosed in the

[[Page 17253]]

footnote provided the footnote-type disclosure discussed in the second 
preceding paragraph is also made.
    In essence, the alternative discussed herein results in a change 
only in the method of presenting information, not in the total 
information required.\3\
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    \3\ The following represents proposed disclosure using the 
alternative method discussed above. Of course, it would be necessary 
to supplement this disclosure with the additional disclosures 
regarding foreign outstandings that are called for by Guide 3 (e.g., 
an analysis of the changes in aggregate outstandings), and the 
disclosures called for by the Interpretive Responses to Question 1.
---------------------------------------------------------------------------

    The appropriate disclosure would depend on the level of Mexican 
cross-border outstandings as follows:
    A. Assuming that the remaining Mexican cross-border outstandings 
are in excess of 1% of total assets:
     Mexican cross-border outstandings (which excludes the 
total amount of the carrying value of Bond principal) would be 
disclosed in the table presenting all such outstandings in excess of 
1%.
     Proposed footnote disclosure--

    Not included in this amount is $---- million of Mexican 
Government Bonds maturing in 2008, with a carrying value of $---- 
million [if different from face value]. These Mexican Government 
Bonds had a market value of $---- million on [reporting date]. The 
principal amount of these bonds is fully secured, at maturity, by 
$---- million face value of U.S. zero coupon treasury securities 
that mature on the same date. The current fair value of these U.S. 
Government securities is $---- million at [reporting date]. This 
collateral is pledged to holders of the bonds and held in custody at 
the Federal Reserve Bank of New York. The details of the transaction 
in which these bonds were acquired was reported in the Corporation's 
Form (8-K, 10-Q or 10-K) for (date). Accrued interest on the bonds, 
which is not secured, is included in the outstandings reported 
[amount to be disclosed if material]. Future interest on the bonds 
remains a cross-border risk.

    B. Assuming that remaining Mexican cross-border outstandings are 
less than 1% of total assets but with the addition of the carrying 
value of the Mexican Bond principal would exceed 1%:
     There would not be any disclosure included in any cross-
border table.
     The total amount of remaining cross-border Mexican 
outstandings would be disclosed in a footnote to the table. Such 
footnote would also explain that the Mexican outstandings are excluded 
from the table.
     Additional footnote disclosure--(same disclosure in A 
above)
     The disclosure required under this paragraph (plus any 
other disclosure required by Item III.C.3. of Guide 3) would continue 
so long as Mexican exposure, including the carrying value of the 
Mexican Bond principal, exceeded 1%.
    C. Assuming that the remaining Mexican cross-border outstandings is 
less than .75% of total assets but with the addition of the carrying 
value of the Mexican Bond principal is greater than .75% but less than 
1%:
     Mexico would not be included in the list of names of 
countries required by Instruction 7 to Item III.C.3. of Industry Guide 
3 and the amount of Mexican cross-border outstandings would not be 
included in the aggregate amount of outstandings attributable to all 
such countries.
     A footnote would be added to this disclosure of aggregate 
outstandings which discusses the Mexican outstandings and the Mexican 
Bonds. An example follows:

    Not included in the above aggregate outstandings are the 
Corporation's cross-border outstandings to Mexico which totaled $--
-- million at (reporting date). This amount is less than .75% of 
total assets. (The remaining portion of this footnote is the same 
disclosure in A above.)

    D. Assuming that the total of the Mexican cross-border outstanding 
plus the carrying value of the Bond principal is less than the .75% of 
total assets:
     No disclosure would be required.
     However, same disclosure as in A above would be provided 
if any other aspects of the financial statements are materially 
affected by this transaction (such as the allowance for loan losses).

Changes in aggregate outstandings to certain countries experiencing 
liquidity problems are required to be presented in tabular form in 
compliance with Instruction (6)(b) to Item III.C.3. In this table, 
Existing Obligations exchanged for the Bonds would generally be 
included in the aggregate cross-border outstandings at the beginning of 
the period during which the exchange occurred. For registrants using 
the alternative method, the amount of Existing Obligations which were 
exchanged would be included as a deduction in the ``other changes'' 
caption in the table. In addition, a footnote will be provided to the 
table as follows:

     Relates primarily to the exchange of unsecured Mexican 
outstandings for Mexican bonds. The principal amount of these bonds 
is secured at maturity by $------ face U.S. Zero Coupon Treasury 
Securities which mature on the same date and have a current fair 
value of $------. Future interest on the bonds remains a cross-
border risk.]

I. Reporting of an Allocated Transfer Risk Reserve in Filings Under the 
Federal Securities Laws

    Facts: The Comptroller of the Currency, Board of Governors of the 
Federal Reserve System and Federal Deposit Insurance Corporation 
jointly issued final rules, pursuant to the International Lending 
Supervision Act of 1983, requiring banking institutions to establish 
special reserves (Allocated Transfer Risk Reserve ``ATRR'') against the 
risks presented in certain international assets when the Federal 
banking agencies determine that such reserves are necessary. The rules 
provide that the ATRR is to be accounted for separately from the 
General Allowances for Possible Loan Losses, and shall not be included 
in the banking institution's capital or surplus. The rules also provide 
that no ATRR provisions are required if the banking institution writes 
down the assets in the requisite amount.
    Question: How should the ATRR be reported in filings under the 
Federal Securities Laws?
    Interpretive Response: It is the staff's understanding that the 
three banking agencies believe that those bank holding companies that 
have not written down the designated assets by the requisite amount 
and, therefore, are required to establish an ATRR should disclose the 
amount of the ATRR. The staff believes that such disclosure should be 
part of the discussion of Loan Loss Experience, Item IV of Guide 3. 
Part A under Item IV calls for an analysis of loss experience in the 
form of a reconciliation of the allowance for loan losses, and the 
staff believes that it would be appropriate to show and discuss 
separately the ATRR in the context of that reconciliation.
    Registrants should recognize that the amount provided as an ATRR, 
or the write off of the requisite amount, represents the identification 
of an amount which those regulatory agencies have determined should not 
be included as a part of the institution's capital or surplus for 
purposes of administration of the regulatory and supervisory functions 
of those agencies. In this context, the staff believes that disclosure 
of the ATRR, as part of the footnote required to be presented in a 
registrant's financial statements by Item 7(d) of Rule 9-03 of 
Regulation S-X, may provide a more complete explanation of charge offs 
and provisions for loan losses. It should be noted, however, that the 
ATRR amount to be excluded from the institution's capital and surplus 
does not address the more general issue of the adequacy of allowances 
for any particular bank holding company's loans. It is still the 
responsibility of each registrant to determine whether GAAP require an 
additional provision for losses in excess of the amount required to be 
included in an ATRR (or the requisite amount written off).

[[Page 17254]]

J. Removed by SAB 103

K. Application of Article 9 and Guide 3

    Facts: Article 9 of Regulation S-X specifies the form and content 
of and requirements for financial statements for bank holding companies 
filing with the Commission. Similarly, bank holding companies disclose 
supplemental statistical disclosures in filings, pursuant to Industry 
Guide 3. No specific guidance as to the form and content of financial 
statements or supplemental disclosures has been promulgated for 
registrants which are not bank holding companies but which are engaged 
in similar lending and deposit activities.\4\
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    \4\ The Commission staff has been considering the need for more 
specific guidance in the area but believes that the FASB project on 
financial instruments may make Commission action in this area 
unnecessary. In the interim, this bulletin provides the staff's 
views with respect to filings by similar entities such as saving and 
loan holding companies.
---------------------------------------------------------------------------

    Question: Should non-bank holding company registrants with material 
amounts of lending and deposit activities file financial statements and 
make disclosures called for by Article 9 of Regulation S-X and Industry 
Guide 3?
    Interpretive Response: In the staff's view, Article 9 and Guide 3, 
while applying literally only to bank holding companies, provide useful 
guidance to certain other registrants, including savings and loan 
holding companies, on certain disclosures relevant to an understanding 
of the registrant's operations. Thus, to the extent particular guidance 
is relevant and material to the operations of an entity, the staff 
believes the specified information, or comparable data, should be 
provided.
    For example, in accordance with Guide 3, bank holding companies 
disclose information about yields and costs of various assets and 
liabilities. Further, bank holding companies provide certain 
information about maturities and repricing characteristics of various 
assets and liabilities. Such companies also disclose risk elements, 
such as nonaccrual and past due items in the lending portfolio. The 
staff believes that this information and other relevant data would be 
material to a description of business of other registrants with 
material lending and deposit activities and accordingly, the specified 
information and/or comparable data (such as scheduled item disclosure 
for risk elements) should be provided.
    In contrast, other requirements of Article 9 and Guide 3 may not be 
material or relevant to an understanding of the financial statements of 
some financial institutions. For example, bank holding companies 
present average balance sheet information, because period-end 
statements might not be representative of bank activity throughout the 
year. Some financial institutions other than bank holding companies may 
determine that average balance sheet disclosure does not provide 
significant additional information. Others may determine that assets 
and liabilities are subject to sufficient volatility that average 
balance information should be presented.
    Pursuant to Article 9, the income statements of bank holding 
companies use a ``net interest income'' presentation. Similarly, bank 
holding companies present the aggregate market value, at the balance 
sheet date, of investment securities, on the face of the balance sheet. 
The staff believes that such disclosures and other relevant information 
should also be provided by other registrants with material lending and 
deposit activities.

L. Income Statement Presentation of Casino-Hotels

    Facts: Registrants having casino-hotel operations present 
separately within the income statement amounts of revenue attributable 
to casino, hotel and restaurant operations, respectively.
    Question: What is the appropriate income statement presentation of 
expenses attributable to casino-hotel activities?
    Interpretive Response: The staff believes that the expenses 
attributable to each of the separate revenue producing activities of 
casino, hotel and restaurant operations should be separately presented 
on the face of the income statement. Such a presentation is consistent 
with the general reporting format for income statement presentation 
under Regulation S-X (Rules 5-03.1 and 5-03.2) which requires 
presentation of amounts of revenues and related costs and expenses 
applicable to major revenue providing activities. This detailed 
presentation affords an analysis of the relative contribution to 
operating profits of each of the revenue producing activities of a 
typical casino-hotel operation.

M. Disclosure of The Impact That Recently Issued Accounting Standards 
Will Have on the Financial Statements of the Registrant When Adopted in 
a Future Period

    Facts: An accounting standard has been issued \5\ that does not 
require adoption until some future date. A registrant is required to 
include financial statements in filings with the Commission after the 
issuance of the standard but before it is adopted by the registrant.
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    \5\ Some registrants may want to disclose the potential effects 
of proposed accounting standards not yet issued, (e.g., exposure 
drafts). Such disclosures, which generally are not required because 
the final standard may differ from the exposure draft, are not 
addressed by this SAB. See also FRR 26.
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    Question 1: Does the staff believe that these filings should 
include disclosure of the impact that the recently issued accounting 
standard will have on the financial position and results of operations 
of the registrant when such standard is adopted in a future period?
    Interpretive Response: Yes. The Commission addressed a similar 
issue and concluded that registrants should discuss the potential 
effects of adoption of recently issued accounting standards in 
registration statements and reports filed with the Commission.\6\ The 
staff believes that this disclosure guidance applies to all accounting 
standards which have been issued but not yet adopted by the registrant 
unless the impact on its financial position and results of operations 
is not expected to be material.\7\ MD&A \8\ requires registrants to 
provide information with respect to liquidity, capital resources and 
results of operations and such other information that the registrant 
believes to be necessary to understand its financial condition and 
results of operations. In addition, MD&A requires disclosure of 
presently known material changes, trends and uncertainties that have 
had or that the registrant reasonably expects will have a material 
impact on future sales, revenues or income from continuing operations. 
The staff believes that disclosure of impending accounting changes is 
necessary to inform the reader about expected impacts on financial 
information to be reported in the future and, therefore, should be 
disclosed in accordance with the existing MD&A

[[Page 17255]]

requirements. With respect to financial statement disclosure, GAAS \9\ 
specifically address the need for the auditor to consider the adequacy 
of the disclosure of impending changes in accounting principles if (a) 
the financial statements have been prepared on the basis of accounting 
principles that were acceptable at the financial statement date but 
that will not be acceptable in the future and (b) the financial 
statements will be retrospectively adjusted in the future as a result 
of the change. The staff believes that recently issued accounting 
standards may constitute material matters and, therefore, disclosure in 
the financial statements should also be considered in situations where 
the change to the new accounting standard will be accounted for in 
financial statements of future periods, prospectively or with a 
cumulative catch-up adjustment.
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    \6\ FRR 6, Section 2.
    \7\ In those instances where a recently issued standard will 
impact the preparation of, but not materially affect, the financial 
statements, the registrant is encouraged to disclose that a standard 
has been issued and that its adoption will not have a material 
effect on its financial position or results of operations.
    \8\ Item 303 of Regulation S-K.
    \9\ See AU 9410.13-18.
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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:
     A brief description of the new standard, the date that 
adoption is required and the date that the registrant plans to adopt, 
if earlier.
     A discussion of the methods of adoption allowed by the 
standard and the method expected to be utilized by the registrant, if 
determined.
     A discussion of the impact that adoption of the standard 
is expected to have on the financial statements of the registrant, 
unless not known or reasonably estimable. In that case, a statement to 
that effect may be made.
     Disclosure of the potential impact of other significant 
matters that the registrant believes might result from the adoption of 
the standard (such as technical violations of debt covenant agreements, 
planned or intended changes in business practices, etc.) is encouraged.

N. Disclosures of The Impact of Assistance From Federal Financial 
Institution Regulatory Agencies

    Facts: An entity receives financial assistance from a Federal 
regulatory agency in conjunction with either an acquisition of a 
troubled financial institution, transfer of nonperforming assets to a 
newly-formed entity, or other reorganization.
    Question: What are the disclosure implications of the existence of 
regulatory assistance?
    Interpretive Response: The staff believes that users of financial 
statements must be able to assess the impact of credit and other risks 
on a company following a regulatory assisted acquisition, transfer or 
other reorganization on a basis comparable to that disclosed by other 
institutions, i.e., as if the assistance did not exist. In this regard, 
the staff believes that the amount of regulatory assistance should be 
disclosed separately and should be separately identified in the 
statistical information furnished pursuant to Industry Guide 3, to the 
extent it impacts such information.10, 11 Further, the 
nature, extent and impact of such assistance needs to be fully 
discussed in Management's Discussion and Analysis.\12\
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    \10\ The staff has previously expressed its views regarding 
acceptable methods of compliance with this principle in FASB ASC 
paragraph 942-10-S99-6 (Financial Services--Depository and Lending 
Topic).
    \11\ See FASB ASC paragraph 942-10-S99-6 for guidance on the 
appropriate period in which to record certain types of regulatory 
assistance.
    \12\ See Section 501.06.c. of the Financial Reporting 
Codification for further discussion of the MD&A disclosures of the 
effects of regulatory assistance.
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TOPIC 12: OIL AND GAS PRODUCING ACTIVITIES

A. Accounting Series Release 257--Requirements for Financial Accounting 
and Reporting Practices for Oil and Gas Producing Activities

1. Estimates of Reserve Quantities
    Facts: Rule 4-10 of Regulation S-X contains definitions of possible 
reserves, probable reserves, and proved and developed oil and gas 
reserves to be used in determining quantities of oil and gas reserves 
to be reported in filings with the Commission.
    Question: What pressure base should be used for reporting gas and 
production, 14.73 psia or the pressure base specified by the state?
    Interpretive Response: The reporting instructions to the Department 
of Energy's Form EIA-28 specify that natural gas reserves are to be 
reported at 14.73 psia and 60 degrees F. There is no pressure base 
specified in Regulation S-X or S-K. At the present time staff will not 
object to natural gas reserves and production data calculated at other 
pressure bases, if such pressure bases are identified in the filing.
2. Estimates of Future Net Revenues
    Facts: U.S. GAAP requires the disclosure of the standardized 
measure of discounted future net cash flows from production of proved 
oil and gas reserves.
    Question: F or purposes of determining reserves and estimated 
future net revenues, what price should be used for oil and gas which 
will be produced after an existing contract expires or after the 
redetermination date in a contract?
    Interpretive Response: The price to be used for oil and gas which 
will be produced after a contract expires or has a redetermination is 
the average price during the 12-month period prior to the ending date 
of the period covered by the balance sheet, determined as an unweighted 
arithmetic average of the first-day-of-the-month price for each month 
within such period for that oil and gas. This average price, which 
should be based on the first-day-of-the-month market prices, may be 
increased thereafter only for additional fixed and determinable 
escalations, as appropriate. A fixed and determinable escalation is one 
which is specified in amount and is not based on future events such as 
rates of inflation.
3. Disclosure of Reserve Information
    a. Removed by SAB 103
    b. Removed by SAB 113
    c. Limited Partnership 10-K Reports
    Facts: Item 1201(a) of Regulation S-K contains an exemption from 
the requirements to disclose certain information relating to oil and 
gas operations for ``limited partnerships or joint ventures that 
conduct, operate, manage, or report upon oil and gas drilling income 
programs that acquire properties either for drilling and production, or 
for production of oil, gas, or geothermal steam. * * *''
    Limited partnership agreements often contain buy-out provisions 
under which the general partner agrees to purchase limited partnership 
interests that are offered for sale, based upon a specified valuation 
formula. Because of these arrangements, the requirements for

[[Page 17256]]

disclosure of reserve value information may be of little significance 
to the limited partners.
    Question: Must the financial statements of limited partnerships 
included in reports on Form 10-K contain the disclosures of estimated 
future net revenues, present values and changes therein, and 
supplemental summary of oil and gas activities specified in FASB ASC 
paragraphs 932-235-50-23 through 932-235-50-36 (Extractive Activities--
Oil and Gas Topic)?
    Interpretive Response: The staff will not take exception to the 
omission of these disclosures in a limited partnership Form 10-K if 
reserve value information is available to the limited partners pursuant 
to the partnership agreement (even though the valuations may be 
computed differently and may be as of a date other than year end). 
However, the staff will require all of the information listed in FASB 
ASC paragraphs 932-235-50-23 through 932-235-50-36 for partnerships 
which are the subject of a business combination or exchange offer under 
which various limited partnerships are to be consolidated or combined 
into a single entity.
d. Removed by SAB 113
e. Rate Regulated Companies
    Question: If a company has cost-of-service oil and gas producing 
properties, how should they be treated in the supplemental disclosures 
of reserve quantities and related future net revenues provided pursuant 
to FASB ASC paragraphs 932-235-50-29 through 932-235-50-36?
    Interpretive Response: Rule 4-10 provides that registrants may give 
effect to differences arising from the ratemaking process for cost-of-
service oil and gas properties. Accordingly, in these circumstances, 
the staff believes that the company's supplemental reserve quantity 
disclosures should indicate separately the quantities associated with 
properties subject to cost-of-service ratemaking, and that it is 
appropriate to exclude those quantities from the future net revenue 
disclosures. The company should also disclose the nature and impact of 
its cost-of-service ratemaking, including the unamortized cost included 
in the balance sheet.
4. Removed by SAB 103

B. Removed by SAB 103

C. Methods of Accounting by Oil and Gas Producers

1. First-Time Registrants
    Facts: In ASR 300, the Commission announced that it would allow 
registrants to change methods of accounting for oil and gas producing 
activities so long as such changes were in accordance with GAAP. 
Accordingly, the Commission stated that changes from the full cost 
method to the successful efforts method would not require a 
preferability letter. Changes to full cost, however, would require 
justification by the company making the change and filing of a 
preferability letter from the company's independent accountants.
    Question: How does this policy apply to a nonpublic company which 
changes its accounting method in connection with a forthcoming public 
offering or initial registration under either the 1933 Act or 1934 Act?
    Interpretive Response: The Commission's policy that first-time 
registrants may change their previous accounting methods without filing 
a preferability letter is applicable. Therefore, such a company may 
change to the full cost method without filing a preferability letter.
2. Consistent Use of Accounting Methods Within a Consolidated Entity
    Facts: Rule 4-10(c) of Regulation S-X states in part that ``[a] 
reporting entity that follows the full cost method shall apply that 
method to all of its operations and to the operations of its 
subsidiaries * * *''
    Question 1: May a subsidiary of the parent use the full cost method 
if the parent company uses the successful efforts method of accounting 
for oil and gas producing activities?
    Interpretive Response: No. The use of different methods of 
accounting in the consolidated financial statements by a parent company 
and its subsidiary would be inconsistent with the full cost requirement 
that a parent and its subsidiaries all use the same method of 
accounting.
    The staff's general policy is that an enterprise should account for 
all its like operations in the same manner. However, Rule 4-10 of 
Regulation S-X provides that oil and gas companies with cost-of-service 
oil and gas properties may give effect to any differences resulting 
from the ratemaking process, including regulatory requirements that a 
certain accounting method be used for the cost-of-service properties.
    Question 2: Must the method of accounting (full cost or successful 
efforts) followed by a registrant for its oil and gas producing 
activities also be followed by any fifty percent or less owned 
companies in which the registrant carries its investment on the equity 
method (equity investees)?
    Interpretive Response: No. Conformity of accounting methods between 
a registrant and its equity investees, although desirable, may not be 
practicable and thus is not required. However, if a registrant 
proportionately consolidates its equity investees, it will be necessary 
to present them all on the same basis of accounting.

D. Application of Full Cost Method of Accounting

1. Treatment of Income Tax Effects in the Computation of the Limitation 
on Capitalized Costs
    Facts: Item (D) in Rule 4-10(c)(4)(i) of Regulation S-X provides 
that the income tax effects related to the properties involved should 
be deducted in computing the full cost ceiling.
    Question 1: What specific types of income tax effects should be 
considered in computing the income tax effects to be deducted from 
estimated future net revenues?
    Interpretive Response: The rule refers to income tax effects 
generally. Thus, the computation should take into account (i) the tax 
basis of oil and gas properties, (ii) net operating loss carryforwards, 
(iii) foreign tax credit carryforwards, (iv) investment tax credits, 
(v) alternative minimum taxes on tax preference items, and (vi) the 
impact of statutory (percentage) depletion.
    It may often be difficult to allocate a net operating loss (NOL) 
carryforward between oil and gas assets and other assets. However, to 
the extent that the NOL is clearly attributable to oil and gas 
operations and is expected to be realized within the carryforward 
period, it should be added to tax basis.
    Similarly, to the extent that investment tax credit (ITC) 
carryforwards and foreign tax credit carryforwards are attributable to 
oil and gas operations and are expected to be realized within the 
carryforward period, they should be considered as a deduction from the 
tax effect otherwise computed. Consideration of NOL and ITC or foreign 
tax credit carryforwards should not, of course, reduce the total tax 
effect below zero.
    Question 2: How should the tax effect be computed considering the 
various factors discussed above?

[[Page 17257]]

    Interpretive Response: Theoretically, taxable income and tax could 
be determined on a year-by-year basis and the present value of the 
related tax computed. However, the ``shortcut'' method illustrated 
below is also acceptable.

----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
ASSUMPTIONS:
    Cost of proved properties being amortized............................  ...........     $396,000  ...........
    Lower of cost or estimated fair value of unproved properties to be     ...........       49,000  ...........
     amortized...........................................................
    Cost of properties not being amortized...............................  ...........       55,000  ...........
    Capitalized costs of oil and gas assets..............................  ...........      500,000  ...........
    Accumulated DD&A.....................................................  ...........    (100,000)  ...........
    Book basis of oil and gas assets.....................................  ...........  ...........     $400,000
    Excess of book basis over tax basis ($270,000) of oil and gas assets.  ...........   $(130,000)  ...........
    NOL carryforward*....................................................  ...........       20,000
                                                                                          (110,000)
    Statutory tax rate (percent).........................................  ...........        x 46%  ...........
                                                                                           (50,600)
    Foreign tax credit carryforward *....................................  ...........        1,000  ...........
    ITC carryforward*....................................................  ...........        2,000  ...........
    Related net deferred income tax liability............................  ...........  ...........     (47,600)
    Net book basis to be recovered.......................................  ...........  ...........     $352,400
Other Assumptions:                                                         ...........  ...........  ...........
    Present value of ITC relating to future development costs............  ...........       $1,500  ...........
    Present value of statutory depletion attributable to future            ...........      $10,000  ...........
     deductions..........................................................
    Estimated preference (minimum) tax on percentage depletion in excess   ...........         $500  ...........
     of cost depletion...................................................
    Present value of future net revenue from proved oil and gas reserves.  ...........     $272,000  ...........
CALCULATION:
    Present value of future net revenue..................................  ...........     $272,000  ...........
    Cost of properties not being amortized...............................  ...........       55,000  ...........
    Lower of cost or estimated fair value of unproved properties included  ...........       49,000  ...........
     in costs being amortized............................................
    Total ceiling limitation before tax effects..........................  ...........  ...........     $376,000
Tax Effects:                                                               ...........  ...........  ...........
    Total ceiling limitation before tax effects..........................  ...........     $376,000  ...........
    Less: Tax basis of properties........................................   $(270,000)  ...........  ...........
    Statutory depletion..................................................     (10,000)  ...........  ...........
    NOL carryforward.....................................................     (20,000)  ...........  ...........
                                                                           ...........    (300,000)  ...........
    Future taxable income................................................  ...........       76,000  ...........
    Tax rate (percent)...................................................  ...........        x 46%  ...........
    Tax at statutory rate................................................  ...........     (34,960)  ...........
    ITC (future development costs and carryforward)......................  ...........        3,500  ...........
    Foreign tax credit carryforward......................................  ...........        1,000  ...........
    Estimated preference tax.............................................  ...........        (500)  ...........
    Net tax effects......................................................  ...........  ...........     (30,960)
    Cost Center Ceiling..................................................  ...........  ...........     $345,040
    Less: Net book basis to be recovered.................................  ...........  ...........      352,400
    REQUIRED WRITE-OFF, net of tax **....................................  ...........  ...........     $(7,360)
----------------------------------------------------------------------------------------------------------------
* All carryforward amounts in this example represent amounts which are available for tax purposes and which
  relate to oil and gas operations.
** For accounting purposes, the gross write-off should be recorded to adjust both the oil and gas properties
  account and the related deferred income taxes.


----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
CALCULATION OF GROSS PRE-TAX WRITE-OFF:
----------------------------------------------------------------------------------------------------------------
    Required write-off, net of tax.......................................  ...........  ...........     $(7,360)
    Divided by (100% minus the statutory rate of 46%)....................  ...........  ...........          54%
    Gross pre-tax write-off..............................................  ...........  ...........    $(13,630)
----------------------------------------------------------------------------------------------------------------
                         Related Journal Entries                                DR           CR      ...........
----------------------------------------------------------------------------------------------------------------
Full cost ceiling impairment.............................................      $13,630  ...........  ...........
Oil and gas assets.......................................................  ...........      $13,630  ...........
Deferred income tax liability............................................       $6,270  ...........  ...........
Deferred income tax benefit..............................................  ...........       $6,270  ...........
----------------------------------------------------------------------------------------------------------------

2. Exclusion of Costs From Amortization
    Facts: Rule 4-10(c)(3)(ii) indicates that the costs of acquiring 
and evaluating unproved properties may be excluded from capitalized 
costs to be amortized if the costs are unusually significant in 
relation to aggregate costs to be amortized. Costs of major development 
projects may also be incurred prior to ascertaining the quantities of 
proved reserves attributable to such properties.
    Question: At what point should amortization of previously excluded 
costs commence--when proved reserves have been established or when 
those reserves become marketable? For instance, a determination of 
proved reserves may be made before completion of an extraction plant 
necessary to process sour crude or a pipeline necessary to market the 
reserves. May the costs continue to be excluded from amortization until 
the plant or pipeline is in service?

[[Page 17258]]

    Interpretive Response: No. The proved reserves and the costs 
allocable to such reserves should be transferred into the amortization 
base on an ongoing (well-by-well or property-by-property) basis as the 
project is evaluated and proved reserves are established.
    Once the determination of proved reserves has been made, there is 
no justification for continued exclusion from the full cost pool, 
regardless of whether other factors prevent immediate marketing. 
Moreover, at the same time that the costs are transferred into the 
amortization base, it is also necessary in accordance with FASB ASC 
Subtopic 932-835, Extractive Activities--Oil and Gas--Interest, and 
FASB ASC Subtopic 835-20, Interest--Capitalization of Interest, to 
terminate capitalization of interest on such properties.
    In this regard, registrants are reminded of their responsibilities 
not to delay recognizing reserves as proved once they have met the 
engineering standards.
3. Full Cost Ceiling Limitation
a. Exemptions for Purchased Properties
    Facts: During 20x1, a registrant purchases proved oil and gas 
reserves in place (``the purchased reserves'') in an arm's-length 
transaction for the sum of $9.8 million. Primarily because the 
registrant expects oil and gas prices to escalate, it paid $1.2 million 
more for the purchased reserves than the ``Present Value of Estimated 
Future Net Revenues'' computed as defined in Rule 4-10(c)(4)(i)(A) of 
Regulation S-X. An analysis of the registrant's full cost center in 
which the purchased reserves are located at December 31, 20x1 is as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                                           Other
                                                                 Total      Purchased      proved      Unproved
                                                                             reserves    properties   properties
----------------------------------------------------------------------------------------------------------------
                          (Amounts in thousands)
----------------------------------------------------------------------------------------------------------------
Present value of estimated future net revenues..............      $14,100        8,600        5,500  ...........
Cost, net of amortization...................................       16,300        9,800        5,500        1,000
Related deferred taxes......................................        2,300  ...........        2,000          300
Income tax effects related to properties....................        2,500  ...........        2,500  ...........
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                            Including    Excluding
     Comparison of capitalized costs with limitation on                     purchased    purchased
           capitalized costs at December 31, 20x1:                           reserves     reserves
----------------------------------------------------------------------------------------------------------------
Capitalized costs, net of amortization......................  ...........      $16,300       $6,500  ...........
Related deferred taxes......................................  ...........      (2,300)      (2,300)  ...........
Net book cost...............................................  ...........       14,000        4,200  ...........
Present value of estimated future net revenues..............  ...........       14,100        5,500  ...........
Lower of cost or market of unproved properties..............  ...........        1,000        1,000  ...........
Income tax effects related to properties....................  ...........      (2,500)      (2,500)  ...........
Limitation on capitalized costs.............................  ...........       12,600        4,000  ...........
Excess of capitalized costs over limitation on Capitalized    ...........        1,400          200  ...........
 costs, net of tax *........................................
----------------------------------------------------------------------------------------------------------------
* For accounting purposes, the gross write-off should be recorded to adjust both the oil and gas properties
  account and the related deferred income taxes.

    Question: Is it necessary for the registrant to write down the 
carrying value of its full cost center at December 31, 20x1 by 
$1,400,000?
    Interpretive Response: Although the net carrying value of the full 
cost center exceeds the cost center's limitation on capitalized costs, 
the text of ASR 258 provides that a registrant may request an exemption 
from the rule if as a result of a major purchase of proved properties, 
a write down would be required even though the registrant believes the 
fair value of the properties in a cost center clearly exceeds the 
unamortized costs.
    Therefore, to the extent that the excess carrying value relates to 
the purchased reserves, the registrant may seek a temporary waiver of 
the full-cost ceiling limitation from the staff of the Commission. 
Registrants requesting a waiver should be prepared to demonstrate that 
the additional value exists beyond reasonable doubt.
    To the extent that the excess costs relate to properties other than 
the purchased reserves, however, a write-off should be recorded in the 
current period. In order to determine the portion of the total excess 
carrying value which is attributable to properties other than the 
purchased reserves, it is necessary to perform the ceiling computation 
on a ``with and without'' basis as shown in the example above. Thus in 
this case, the registrant must record a write-down of $200,000 
applicable to other reserves. An additional $1,200,000 write-down would 
be necessary unless a waiver was obtained.
b. Use of Cash Flow Hedges in the Computation of the Limitation on 
Capitalized Costs
    Facts: Rule 4-10(c)(4) of Regulation S-X provides, in pertinent 
part, that capitalized costs, net of accumulated depreciation and 
amortization, and deferred income taxes, should not exceed an amount 
equal to the sum of components that include the present value of 
estimated future net revenues computed by applying current prices of 
oil and gas reserves (with consideration of price changes only to the 
extent provided by contractual arrangements) to estimated future 
production of proved oil and gas reserves as of the date of the latest 
balance sheet presented.
    As of the reported balance sheet date, capitalized costs of an oil 
and gas producing company exceed the full cost limitation calculated 
under the above-described rule based on current prices, as defined in 
Rule 4-10(c)(8) of Regulation S-X, for oil and natural gas. However, 
prior to the balance sheet date, the company entered into certain 
hedging arrangements for a portion of its future natural gas and oil 
production, thereby enabling the company to receive future cash flows 
that are higher or lower than the estimated future cash flows indicated 
by use of the average price during the 12-month period prior to the 
balance sheet date, determined as

[[Page 17259]]

an unweighted arithmetic average of the first-day-of-the-month price 
for each month within such period. These arrangements qualify as cash 
flow hedges under the provisions of FASB ASC Topic 815, Derivatives and 
Hedging, and are documented, designated, and accounted for as such 
under the criteria of that standard.
    Question: Under these circumstances, must the company use the 
higher or lower prices to be received after taking into account the 
hedging arrangements (``hedge-adjusted prices'') in calculating the 
estimated cash flows from future production of oil and gas reserves 
covered by the hedges as of the reported balance sheet date?
    Interpretive Response: Yes. Derivative contracts that qualify as a 
hedging instrument in a cash flow hedge and are accounted for as such 
pursuant to FASB ASC Topic 815 represent the type of contractual 
arrangements for which consideration of price changes should be given 
under the existing rule. While the SEC staff has objected to previous 
proposals to consider various hedging techniques as being equivalent to 
the contractual arrangements permitted under the existing rules, the 
staff's objection was based on concerns that the lack of clear, 
consistent guidance in the accounting literature would lead to 
inconsistent application in practice. However, the staff believes that 
FASB ASC Topic 815 and related guidance (including a more systematic 
approach to documentation) provides sufficient guidance so that 
comparable financial reporting in comparable factual circumstances 
should result.
    This interpretive response reflects the SEC staff's view that, 
assuming compliance with the prerequisite accounting requirements, 
hedge-adjusted prices represent the best measure of estimated cash 
flows from future production of the affected oil and gas reserves to 
use in calculating the ceiling limitation. Nonetheless, the staff 
expects that oil and gas producing companies subject to the full cost 
rules will clearly indicate the effects of using cash flow hedges in 
calculating ceiling limitations within their financial statement 
footnotes. The staff further expects that disclosures will indicate the 
portion of future oil and gas production being hedged. The dollar 
amount that would have been charged to income had the effects of the 
cash flow hedges not been considered in calculating the ceiling 
limitation also should be disclosed.
    The use of hedge-adjusted prices should be consistently applied in 
all reporting periods, including periods in which the hedge-adjusted 
price is more or less than the average price during the 12-month period 
prior to the balance sheet date, determined as an unweighted arithmetic 
average of the first-day-of-the-month price for each month within such 
period. Oil and gas producers whose computation of the ceiling 
limitation includes hedge-adjusted prices because of the use of cash 
flow hedges also should consider the disclosure requirements under FASB 
ASC Section 275-10-50, Risks and Uncertainties--Overall--Disclosure. 
FASB ASC paragraph 275-10-50-9 calls for disclosure when it is at least 
reasonably possible that the effects of cash flow hedges on capitalized 
costs on the reported balance sheet date will change in the near term 
due to one or more confirming events, such as potential future changes 
in commodity prices.
    In addition, the use of cash flow hedges in calculating the ceiling 
limitation may represent a type of critical accounting policy that oil 
and gas producers should consider disclosing consistent with the 
cautionary advice provided in Financial Reporting Release No. 60 
(Release Nos. 33-8040; 34-45149), Cautionary Advice Regarding 
Disclosure about Critical Accounting Policies (December 12, 2001), and 
Financial Reporting Release No. 72 (Release Nos. 33-8350; 34-48960), 
Commission Guidance Regarding Management's Discussion and Analysis of 
Financial Condition and Results of Operations (December 29, 2003). 
Through these releases, the Commission has encouraged companies to 
include, within their MD&A disclosures, full explanations, in plain 
English, of the judgments and uncertainties affecting the application 
of critical accounting policies, and the likelihood that materially 
different amounts would be reported under different conditions or using 
different assumptions.
    The staff's guidance on this issue would apply to calculations of 
ceiling limitations both in interim and annual reporting periods.
c. Effect of Subsequent Events on the Computation of the Limitation on 
Capitalized Costs
    Facts: Rule 4-10(c)(4)(ii) of Regulation S-X provides that an 
excess of unamortized capitalized costs within a cost center over the 
related cost ceiling shall be charged to expense in the period the 
excess occurs.
    Question: Assume that at the date of the company's fiscal year-end, 
its capitalized costs of oil and gas producing properties exceed the 
limitation prescribed by Rule 4-10(c)(4) of Regulation S-X. Thus, a 
write-down is indicated. Subsequent to year-end but before the date of 
the auditor's report on the company's financial statements, assume that 
additional reserves are proved up (excluding the effect of increased 
oil and gas prices subsequent to year-end) on properties owned at year-
end. The present value of future net revenues from the additional 
reserves is sufficiently large that if the full cost ceiling limitation 
were recomputed giving effect to those factors as of year-end, the 
ceiling would more than cover the costs. Is it necessary to record a 
write-down?
    Interpretive Response: No. In this case, the proving up of 
additional reserves on properties owned at year-end indicates that the 
capitalized costs were not in fact impaired at year-end. However, for 
purposes of the revised computation of the ``ceiling,'' the net book 
costs capitalized as of year-end should be increased by the amount of 
any additional costs incurred subsequent to year-end to prove the 
additional reserves or by any related costs previously excluded from 
amortization.
    While the fact pattern described herein relates to annual periods, 
the guidance on the effects of subsequent events applies equally to 
interim period calculations of the ceiling limitation.
    The registrant's financial statements should disclose that 
capitalized costs exceeded the limitation thereon at year-end and 
should explain why the excess was not charged against earnings. In 
addition, the registrant's supplemental disclosures of estimated proved 
reserve quantities and related future net revenues and costs should not 
give effect to the reserves proved up or the cost incurred after year-
end. However, such quantities may be disclosed separately, with 
appropriate explanations.
    Registrants should be aware that oil and gas reserves related to 
properties acquired after year-end would not justify avoiding a write-
off indicated as of year-end. Similarly, the effects of cash flow 
hedging arrangements entered into after year-end cannot be factored 
into the calculation of the ceiling limitation at year-end. Such 
acquisitions and financial arrangements do not confirm situations 
existing at year-end.

[[Page 17260]]

4. Interaction of FASB ASC Subtopic 410-20, Asset Retirement and 
Environmental Obligations--Asset Retirement Obligations, and the Full 
Cost Rules
a. Impact of FASB ASC Subtopic 410-20 on the Full Cost Ceiling Test
    Facts: A company following the full cost method of accounting under 
Rule 4-10(c) of Regulation S-X must periodically calculate a limitation 
on capitalized costs, i.e., the full cost ceiling. Under FASB ASC 
Subtopic 410-20, a company must recognize a liability for an asset 
retirement obligation (ARO) at fair value in the period in which the 
obligation is incurred, if a reasonable estimate of fair value can be 
made. The company also must initially capitalize the associated asset 
retirement costs by increasing long-lived oil and gas assets by the 
same amount as the liability. Any asset retirement costs capitalized 
pursuant to FASB ASC Subtopic 410-20 are subject to the full cost 
ceiling limitation under Rule 4-10(c)(4) of Regulation S-X. If a 
company were to calculate the full cost ceiling by reducing expected 
future net revenues by the cash flows required to settle the ARO, then 
the effect would be to ``double-count'' such costs in the ceiling test. 
The assets that must be recovered would be increased while the future 
net revenues available to recover the assets continue to be reduced by 
the amount of the ARO settlement cash flows.
    Question: How should a company compute the full cost ceiling to 
avoid double-counting the expected future cash outflows associated with 
asset retirement costs?
    Interpretive Response: The future cash outflows associated with 
settling AROs that have been accrued on the balance sheet should be 
excluded from the computation of the present value of estimated future 
net revenues for purposes of the full cost ceiling calculation.\1,2\
---------------------------------------------------------------------------

    \1\ If an obligation for expected asset retirement costs has not 
been accrued under FASB ASC Subtopic 410-20 for certain asset 
retirement costs required to be included in the full cost ceiling 
calculation under Rule 4-10(c)(4) of Regulation S-X, such costs 
should continue to be included in the full cost ceiling calculation.
    \2\ This approach is consistent with the guidance in FASB ASC 
Subtopic 410-20 on testing for impairment under FASB ASC Section 
360-10-35, Property, Plant, and Equipment--Overall--Subsequent 
Measurement. Under that guidance, the asset tested should include 
capitalized asset retirement costs. The estimated cash flows related 
to the associated ARO that has been recognized in the financial 
statements are to be excluded from both the undiscounted cash flows 
used to test for recoverability and the discounted cash flows used 
to measure the asset's fair value.
---------------------------------------------------------------------------

b. Impact of FASB ASC Subtopic 410-20 on the Calculation of 
Depreciation, Depletion, and Amortization
    Facts: Regarding the base for depreciation, depletion, and 
amortization (DD&A) of proved reserves, Rule 4-10(c)(3)(i) of 
Regulation S-X states that ``[c]osts to be amortized shall include (A) 
all capitalized costs, less accumulated amortization, other than the 
cost of properties described in paragraph (ii) below; \3\ (B) the 
estimated future expenditures (based on current costs) to be incurred 
in developing proved reserves; and (C) estimated dismantlement and 
abandonment costs, net of estimated salvage values.'' FASB ASC Subtopic 
410-20 requires that upon initial recognition of an ARO, the associated 
asset retirement costs be included in the capitalized costs of the 
company. Therefore, the estimated dismantlement and abandonment costs 
described in (C) above may be included in the capitalized costs 
described in (A) above, at least to the extent that an ARO has been 
incurred as a result of acquisition, exploration and development 
activities to date. Future development activities on proved reserves 
may result in additional asset retirement obligations when such 
activities are performed and the associated asset retirement costs will 
be capitalized at that time.
---------------------------------------------------------------------------

    \3\ The reference to ``cost of properties described in paragraph 
(ii) below'' relates to the costs of investments in unproved 
properties and major development projects, as defined.
---------------------------------------------------------------------------

    Question: Should the costs to be amortized under Rule 4-10(c)(3) of 
Regulation S-X include an amount for estimated dismantlement and 
abandonment costs, net of estimated salvage values, that are expected 
to result from future development activities?
    Interpretive Response: Yes. Companies should estimate the amount of 
dismantlement and abandonment costs that will be incurred as a result 
of future development activities on proved reserves and include those 
amounts in the costs to be amortized.
c. Removed by SAB 113

E. Financial Statements of Royalty Trusts

    Facts: Several oil and gas exploration and production companies 
have created ``royalty trusts.'' Typically, the creating company 
conveys a net profits interest in certain of its oil and gas properties 
to the newly created trust and then distributes units in the trust to 
its shareholders. The trust is a passive entity which is prohibited 
from entering into or engaging in any business or commercial activity 
of any kind and from acquiring any oil and gas lease, royalty or other 
mineral interest. The function of the trust is to serve as an agent to 
distribute the income from the net profits interest. The amount to be 
periodically distributed to the unitholders is defined in the trust 
agreement and is typically determined based on the cash received from 
the net profits interest less expenses of the trustee. Royalty trusts 
have typically reported their earnings on the basis of cash 
distributions to unitholders. The net profits interest paid to the 
trust for any month is based on production from a preceding month; 
therefore, the method of accounting followed by the trust for the net 
profits interest income is different from the creating company's method 
of accounting for the related revenue.
    Question: Will the staff accept a statement of distributable income 
which reflects the amounts to be distributed for the period in question 
under the terms of the trust agreement in lieu of a statement of income 
prepared under GAAP?
    Interpretive Response: Yes. Although financial statements filed 
with the Commission are normally required to be prepared in accordance 
with GAAP, the Commission's rules provide that other presentations may 
be acceptable in unusual situations. Since the operations of a royalty 
trust are limited to the distribution of income from the net profits 
interests contributed to it, the staff believes that the item of 
primary importance to the reader of the financial statements of the 
royalty trust is the amount of the cash distributions to the 
unitholders for the period reported. Should there be any change in the 
nature of the trust's operations due to revisions in the tax laws or 
other factors,

[[Page 17261]]

the staff's interpretation would be reexamined.
    A note to the financial statements should disclose the method used 
in determining distributable income and should also describe how 
distributable income as reported differs from income determined on the 
basis of GAAP.

F. Gross Revenue Method of Amortizing Capitalized Costs

    Facts: Rule 4-10(c)(3)(iii) of Regulation S-X states in part:

    ``Amortization shall be computed on the basis of physical units, 
with oil and gas converted to a common unit of measure on the basis 
of their approximate relative energy content, unless economic 
circumstances (related to the effects of regulated prices) indicate 
that use of units of revenue is a more appropriate basis of 
computing amortization. In the latter case, amortization shall be 
computed on the basis of current gross revenues (excluding royalty 
payments and net profits disbursements) from production in relation 
to future gross revenues based on current prices (including 
consideration of changes in existing prices provided only by 
contractual arrangements), from estimated production of proved oil 
and gas reserves.'' \4\

    \4\ Rule 4-10(c)(8) of Regulation S-X defines current price as 
the average price during the 12-month period prior to the ending 
date of the period covered by the report, determined as an 
unweighted arithmetic average of the first-day-of-the-month price 
for each month within such period, unless prices are defined by 
contractual arrangements, excluding escalations based upon future 
conditions.
---------------------------------------------------------------------------

    Question: May entities using the full cost method of accounting for 
oil and gas producing activities compute amortization based on the 
gross revenue method described in the above rule when substantial 
production is not subject to pricing regulation?
    Interpretive Response: Yes. Under the existing rules for cost 
amortization adopted in ASR 258, the use of the gross revenue method of 
amortization was permitted in those circumstances where, because of the 
effect of existing pricing regulations, the use of the units of 
production method would result in an amortization provision that would 
be inconsistent with the current sales prices being received. While the 
effect of regulation on gas prices has lessened, factors other than 
price regulation (such as changes in typical contract lengths and 
methods of marketing natural gas) have caused oil and gas prices to be 
disproportionate to their relative energy content. The staff therefore 
believes that it may be more appropriate for registrants to compute 
amortization based on the gross revenue method whenever oil and gas 
sales prices are disproportionate to their relative energy content to 
the extent that the use of the units of production method would result 
in an improper matching of the costs of oil and gas production against 
the related revenue received. The method should be consistently applied 
and appropriately disclosed within the financial statements.

G. Removed by SAB 113

TOPIC 13: REVENUE RECOGNITION

A. Selected Revenue Recognition Issues

1. Revenue Recognition--General
    The accounting literature on revenue recognition includes both 
broad conceptual discussions as well as certain industry-specific 
guidance.\1\ If a transaction is within the scope of specific 
authoritative literature that provides revenue recognition guidance, 
that literature should be applied. However, in the absence of 
authoritative literature addressing a specific arrangement or a 
specific industry, the staff will consider the existing authoritative 
accounting standards as well as the broad revenue recognition criteria 
specified in the FASB's conceptual framework that contain basic 
guidelines for revenue recognition.
---------------------------------------------------------------------------

    \1\ The February 1999 AICPA publication ``Audit Issues in 
Revenue Recognition'' provides an overview of the authoritative 
accounting literature and auditing procedures for revenue 
recognition and identifies indicators of improper revenue 
recognition.
---------------------------------------------------------------------------

    Based on these guidelines, revenue should not be recognized until 
it is realized or realizable and earned.\2\ Concepts Statement 5, 
Recognition and Measurement in Financial Statements of Business 
Enterprises, paragraph 83(b) states that ``an entity's revenue-earning 
activities involve delivering or producing goods, rendering services, 
or other activities that constitute its ongoing major or central 
operations, and revenues are considered to have been earned when the 
entity has substantially accomplished what it must do to be entitled to 
the benefits represented by the revenues'' [footnote reference 
omitted]. Paragraph 84(a) continues ``the two conditions (being 
realized or realizable and being earned) are usually met by the time 
product or merchandise is delivered or services are rendered to 
customers, and revenues from manufacturing and selling activities and 
gains and losses from sales of other assets are commonly recognized at 
time of sale (usually meaning delivery)'' [footnote reference omitted]. 
In addition, paragraph 84(d) states that ``If services are rendered or 
rights to use assets extend continuously over time (for example, 
interest or rent), reliable measures based on contractual prices 
established in advance are commonly available, and revenues may be 
recognized as earned as time passes.''
---------------------------------------------------------------------------

    \2\ Concepts Statement 5, paragraphs 83-84; FASB ASC paragraph 
605-10-25-1 (Revenue Recognition Topic); FASB ASC paragraph 605-10-
25-3; FASB ASC paragraph 605-10-25-5. The citations provided herein 
are not intended to present the complete population of citations 
where a particular criterion is relevant. Rather, the citations are 
intended to provide the reader with additional reference material.
---------------------------------------------------------------------------

    The staff believes that revenue generally is realized or realizable 
and earned when all of the following criteria are met:
     Persuasive evidence of an arrangement exists,\3\
---------------------------------------------------------------------------

    \3\ Concepts Statement 2, paragraph 63 states ``Representational 
faithfulness is correspondence or agreement between a measure or 
description and the phenomenon it purports to represent.'' The staff 
believes that evidence of an exchange arrangement must exist to 
determine if the accounting treatment represents faithfully the 
transaction. See also FASB ASC paragraph 985-605-25-3 (Software 
Topic). The use of the term ``arrangement'' in this SAB Topic is 
meant to identify the final understanding between the parties as to 
the specific nature and terms of the agreed-upon transaction.
---------------------------------------------------------------------------

     Delivery has occurred or services have been rendered,\4\
---------------------------------------------------------------------------

    \4\ Concepts Statement 5, paragraph 84(a), (b), and (d). Revenue 
should not be recognized until the seller has substantially 
accomplished what it must do pursuant to the terms of the 
arrangement, which usually occurs upon delivery or performance of 
the services.
---------------------------------------------------------------------------

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

    \5\ Concepts Statement 5, paragraph 83(a); FASB ASC subparagraph 
605-15-25-1(a); FASB ASC paragraph 985-605-25-3. The FASB ASC Master 
Glossary defines a ``fixed fee'' as a ``fee required to be paid at a 
set amount that is not subject to refund or adjustment. A fixed fee 
includes amounts designated as minimum royalties.'' FASB ASC 
paragraphs 985-605-25-30 through 985-605-25-40 discuss how to apply 
the fixed or determinable fee criterion in software transactions. 
The staff believes that the guidance in FASB ASC paragraphs 985-605-
25-30 through 985-605-25-31 and 985-605-25-36 through 985-605-25-40 
is appropriate for other sales transactions where authoritative 
guidance does not otherwise exist. The staff notes that FASB ASC 
paragraphs 985-605-25-33 through 985-605-25-35 specifically consider 
software transactions, however, the staff believes that guidance 
should be considered in other sales transactions in which the risk 
of technological obsolescence is high.
---------------------------------------------------------------------------

     Collectibility is reasonably assured.\6\
---------------------------------------------------------------------------

    \6\ FASB ASC paragraph 605-10-25-3 through 605-10-25-5. See also 
Concepts Statement 5, paragraph 84(g) and FASB ASC paragraph 985-
605-25-3.
---------------------------------------------------------------------------

    Some revenue arrangements contain multiple revenue-generating 
activities. The staff believes that the determination of the units of 
accounting within an arrangement should be made prior to the 
application of the guidance in this SAB Topic by reference to the 
applicable accounting literature.\7\
---------------------------------------------------------------------------

    \7\ See FASB ASC paragraph 605-25-15-2 through 605-25-15-3 for 
additional discussion.

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[[Page 17262]]

2. Persuasive Evidence of an Arrangement

Question 1

    Facts: Company A has product available to ship to customers prior 
to the end of its current fiscal quarter. Customer Beta places an order 
for the product, and Company A delivers the product prior to the end of 
its current fiscal quarter. Company A's normal and customary business 
practice for this class of customer is to enter into a written sales 
agreement that requires the signatures of the authorized 
representatives of the Company and its customer to be binding. Company 
A prepares a written sales agreement, and its authorized representative 
signs the agreement before the end of the quarter. However, Customer 
Beta does not sign the agreement because Customer Beta is awaiting the 
requisite approval by its legal department. Customer Beta's purchasing 
department has orally agreed to the sale and stated that it is highly 
likely that the contract will be approved the first week of Company A's 
next fiscal quarter.
    Question: May Company A recognize the revenue in the current fiscal 
quarter for the sale of the product to Customer Beta when (1) the 
product is delivered by the end of its current fiscal quarter and (2) 
the final written sales agreement is executed by Customer Beta's 
authorized representative within a few days after the end of the 
current fiscal quarter?
    Interpretive Response: No. Generally the staff believes that, in 
view of Company A's business practice of requiring a written sales 
agreement for this class of customer, persuasive evidence of an 
arrangement would require a final agreement that has been executed by 
the properly authorized personnel of the customer. In the staff's view, 
Customer Beta's execution of the sales agreement after the end of the 
quarter causes the transaction to be considered a transaction of the 
subsequent period.\8\ Further, if an arrangement is subject to 
subsequent approval (e.g., by the management committee or board of 
directors) or execution of another agreement, revenue recognition would 
be inappropriate until that subsequent approval or agreement is 
complete.
---------------------------------------------------------------------------

    \8\ AU Section 560.05.
---------------------------------------------------------------------------

    Customary business practices and processes for documenting sales 
transactions vary among companies and industries. Business practices 
and processes may also vary within individual companies (e.g., based on 
the class of customer, nature of product or service, or other 
distinguishable factors). If a company does not have a standard or 
customary business practice of relying on written contracts to document 
a sales arrangement, it usually would be expected to have other forms 
of written or electronic evidence to document the transaction. For 
example, a company may not use written contracts but instead may rely 
on binding purchase orders from third parties or on-line authorizations 
that include the terms of the sale and that are binding on the 
customer. In that situation, that documentation could represent 
persuasive evidence of an arrangement.
    The staff is aware that sometimes a customer and seller enter into 
``side'' agreements to a master contract that effectively amend the 
master contract. Registrants should ensure that appropriate policies, 
procedures, and internal controls exist and are properly documented so 
as to provide reasonable assurances that sales transactions, including 
those affected by side agreements, are properly accounted for in 
accordance with GAAP and to ensure compliance with Section 13 of the 
Securities Exchange Act of 1934 (i.e., the Foreign Corrupt Practices 
Act). Side agreements could include cancellation, termination, or other 
provisions that affect revenue recognition. The existence of a 
subsequently executed side agreement may be an indicator that the 
original agreement was not final and revenue recognition was not 
appropriate.

Question 2

    Facts: Company Z enters into an arrangement with Customer A to 
deliver Company Z's products to Customer A on a consignment basis. 
Pursuant to the terms of the arrangement, Customer A is a consignee, 
and title to the products does not pass from Company Z to Customer A 
until Customer A consumes the products in its operations. Company Z 
delivers product to Customer A under the terms of their arrangement.
    Question: May Company Z recognize revenue upon delivery of its 
product to Customer A?
    Interpretive Response: No. Products delivered to a consignee 
pursuant to a consignment arrangement are not sales and do not qualify 
for revenue recognition until a sale occurs. The staff believes that 
revenue recognition is not appropriate because the seller retains the 
risks and rewards of ownership of the product and title usually does 
not pass to the consignee.
    Other situations may exist where title to delivered products passes 
to a buyer, but the substance of the transaction is that of a 
consignment or a financing. Such arrangements require a careful 
analysis of the facts and circumstances of the transaction, as well as 
an understanding of the rights and obligations of the parties, and the 
seller's customary business practices in such arrangements. The staff 
believes that the presence of one or more of the following 
characteristics in a transaction precludes revenue recognition even if 
title to the product has passed to the buyer:
    1. The buyer has the right to return the product and:
    (a) The buyer does not pay the seller at the time of sale, and the 
buyer is not obligated to pay the seller at a specified date or 
dates,\9\
---------------------------------------------------------------------------

    \9\ FASB ASC subparagraph 605-15-25-1(b).
---------------------------------------------------------------------------

    (b) The buyer does not pay the seller at the time of sale but 
rather is obligated to pay at a specified date or dates, and the 
buyer's obligation to pay is contractually or implicitly excused until 
the buyer resells the product or subsequently consumes or uses the 
product,\10\
---------------------------------------------------------------------------

    \10\ FASB ASC subparagraph 605-15-25-1(b). The arrangement may 
not specify that payment is contingent upon subsequent resale or 
consumption. However, if the seller has an established business 
practice permitting customers to defer payment beyond the specified 
due date(s) until the products are resold or consumed, then the 
staff believes that the seller's right to receive cash representing 
the sales price is contingent.
---------------------------------------------------------------------------

    (c) The buyer's obligation to the seller would be changed (e.g., 
the seller would forgive the obligation or grant a refund) in the event 
of theft or physical destruction or damage of the product,\11\
---------------------------------------------------------------------------

    \11\ FASB ASC subparagraph 605-15-25-1(c).
---------------------------------------------------------------------------

    (d) The buyer acquiring the product for resale does not have 
economic substance apart from that provided by the seller,\12\ or
---------------------------------------------------------------------------

    \12\ FASB ASC subparagraph 605-15-25-1(d).
---------------------------------------------------------------------------

    (e) The seller has significant obligations for future performance 
to directly bring about resale of the product by the buyer.\13\
---------------------------------------------------------------------------

    \13\ FASB ASC subparagraph 605-15-25-1(e).
---------------------------------------------------------------------------

    2. The seller is required to repurchase the product (or a 
substantially identical product or processed goods of which the product 
is a component) at specified prices that are not subject to change 
except for fluctuations due to finance and holding costs,\14\ and the 
amounts to be paid by the seller will be adjusted, as necessary, to 
cover substantially all

[[Page 17263]]

fluctuations in costs incurred by the buyer in purchasing and holding 
the product (including interest).\15\ The staff believes that 
indicators of the latter condition include:
---------------------------------------------------------------------------

    \14\ FASB ASC subparagraph 470-40-15-2(a) (Debt Topic). This 
paragraph provides examples of circumstances that meet this 
requirement. As discussed further therein, this condition is present 
if (a) a resale price guarantee exists, (b) the seller has an option 
to purchase the product, the economic effect of which compels the 
seller to purchase the product, or (c) the buyer has an option 
whereby it can require the seller to purchase the product.
    \15\ FASB ASC subparagraph 470-40-15-2(b).
---------------------------------------------------------------------------

    (a) The seller provides interest-free or significantly below market 
financing to the buyer beyond the seller's customary sales terms and 
until the products are resold,
    (b) The seller pays interest costs on behalf of the buyer under a 
third-party financing arrangement, or
    (c) The seller has a practice of refunding (or intends to refund) a 
portion of the original sales price representative of interest expense 
for the period from when the buyer paid the seller until the buyer 
resells the product.
    3. The transaction possesses the characteristics set forth in FASB 
ASC paragraphs 840-10-55-12 through 840-10-55-21 (Leases Topic) and 
does not qualify for sales-type lease accounting.
    4. The product is delivered for demonstration purposes.\16\
---------------------------------------------------------------------------

    \16\ See FASB ASC paragraphs 985-605-25-28 through 985-605-25-
29.
---------------------------------------------------------------------------

    This list is not meant to be a checklist of all characteristics of 
a consignment or financing arrangement, and other characteristics may 
exist. Accordingly, the staff believes that judgment is necessary in 
assessing whether the substance of a transaction is a consignment, a 
financing, or other arrangement for which revenue recognition is not 
appropriate. If title to the goods has passed but the substance of the 
arrangement is not a sale, the consigned inventory should be reported 
separately from other inventory in the consignor's financial statements 
as ``inventory consigned to others'' or another appropriate caption.

Question 3

    Facts: The laws of some countries do not provide for a seller's 
retention of a security interest in goods in the same manner as 
established in the U.S. Uniform Commercial Code (UCC). In these 
countries, it is common for a seller to retain a form of title to goods 
delivered to customers until the customer makes payment so that the 
seller can recover the goods in the event of customer default on 
payment.
    Question: Is it acceptable to recognize revenue in these 
transactions before payment is made and title has transferred?
    Interpretive Response: Presuming all other revenue recognition 
criteria have been met, the staff would not object to revenue 
recognition at delivery if the only rights that a seller retains with 
the title are those enabling recovery of the goods in the event of 
customer default on payment. This limited form of ownership may exist 
in some foreign jurisdictions where, despite technically holding title, 
the seller is not entitled to direct the disposition of the goods, 
cannot rescind the transaction, cannot prohibit its customer from 
moving, selling, or otherwise using the goods in the ordinary course of 
business, and has no other rights that rest with a titleholder of 
property that is subject to a lien under the U.S. UCC. On the other 
hand, if retaining title results in the seller retaining rights 
normally held by an owner of goods, the situation is not sufficiently 
different from a delivery of goods on consignment. In this particular 
case, revenue should not be recognized until payment is received. 
Registrants and their auditors may wish to consult legal counsel 
knowledgeable of the local law and customs outside the U.S. to 
determine the seller's rights.
3. Delivery and Performance
a. Bill and Hold Arrangements
    Facts: Company A receives purchase orders for products it 
manufactures. At the end of its fiscal quarters, customers may not yet 
be ready to take delivery of the products for various reasons. These 
reasons may include, but are not limited to, a lack of available space 
for inventory, having more than sufficient inventory in their 
distribution channel, or delays in customers' production schedules.
    Question: May Company A recognize revenue for the sale of its 
products once it has completed manufacturing if it segregates the 
inventory of the products in its own warehouse from its own products?
    May Company A recognize revenue for the sale if it ships the 
products to a third-party warehouse but (1) Company A retains title to 
the product and (2) payment by the customer is dependent upon ultimate 
delivery to a customer-specified site?
    Interpretative Response: Generally, no. The staff believes that 
delivery generally is not considered to have occurred unless the 
customer has taken title and assumed the risks and rewards of ownership 
of the products specified in the customer's purchase order or sales 
agreement. Typically this occurs when a product is delivered to the 
customer's delivery site (if the terms of the sale are ``FOB 
destination'') or when a product is shipped to the customer (if the 
terms are ``FOB shipping point'').
    The Commission has set forth criteria to be met in order to 
recognize revenue when delivery has not occurred.\17\ These include:
---------------------------------------------------------------------------

    \17\ See In the Matter of Stewart Parness, AAER 108 (August 5, 
1986); SEC v. Bollinger Industries, Inc., et al., LR 15093 
(September 30, 1996); In the Matter of Laser Photonics, Inc., AAER 
971 (September 30, 1997); In the Matter of Cypress Bioscience Inc., 
AAER 817 (September 19, 1996). See also Concepts Statement 5, 
paragraph 84(a) and FASB ASC paragraph 985-605-25-25.
---------------------------------------------------------------------------

    1. The risks of ownership must have passed to the buyer;
    2. The customer must have made a fixed commitment to purchase the 
goods, preferably in written documentation;
    3. The buyer, not the seller, must request that the transaction be 
on a bill and hold basis.\18\ The buyer must have a substantial 
business purpose for ordering the goods on a bill and hold basis;
---------------------------------------------------------------------------

    \18\ Such requests typically should be set forth in writing by 
the buyer.
---------------------------------------------------------------------------

    4. There must be a fixed schedule for delivery of the goods. The 
date for delivery must be reasonable and must be consistent with the 
buyer's business purpose (e.g., storage periods are customary in the 
industry);
    5. The seller must not have retained any specific performance 
obligations such that the earning process is not complete;
    6. The ordered goods must have been segregated from the seller's 
inventory and not be subject to being used to fill other orders; and
    7. The equipment [product] must be complete and ready for shipment.
    The above listed conditions are the important conceptual criteria 
that should be used in evaluating any purported bill and hold sale. 
This listing is not intended as a checklist. In some circumstances, a 
transaction may meet all factors listed above but not meet the 
requirements for revenue recognition. The Commission also has noted 
that in applying the above criteria to a purported bill and hold sale, 
the individuals responsible for the preparation and filing of financial 
statements also should consider the following factors: \19\
---------------------------------------------------------------------------

    \19\ See Note 17, supra.
---------------------------------------------------------------------------

    1. The date by which the seller expects payment, and whether the 
seller has modified its normal billing and credit terms for this buyer; 
\20\
---------------------------------------------------------------------------

    \20\ Such individuals should consider whether FASB ASC Subtopic 
835-30, Interest--Imputation of Interest, pertaining to the need for 
discounting the related receivable, is applicable. FASB ASC 
subparagraph 835-30-15-3(a) indicates that the requirements of that 
Subtopic to record receivables at a discounted value are not 
intended to apply to ``receivables and payables arising from 
transactions with customers or suppliers in the normal course of 
business which are due in customary trade terms not exceeding 
approximately one year'' (emphasis added).

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[[Page 17264]]

    2. The seller's past experiences with and pattern of bill and hold 
transactions;
    3. Whether the buyer has the expected risk of loss in the event of 
a decline in the market value of goods;
    4. Whether the seller's custodial risks are insurable and insured;
    5. Whether extended procedures are necessary in order to assure 
that there are no exceptions to the buyer's commitment to accept and 
pay for the goods sold (i.e., that the business reasons for the bill 
and hold have not introduced a contingency to the buyer's commitment).
    Delivery generally is not considered to have occurred unless the 
product has been delivered to the customer's place of business or 
another site specified by the customer. If the customer specifies an 
intermediate site but a substantial portion of the sales price is not 
payable until delivery is made to a final site, then revenue should not 
be recognized until final delivery has occurred.\21\
---------------------------------------------------------------------------

    \21\ FASB ASC paragraph 985-605-25-25.
---------------------------------------------------------------------------

b. Customer Acceptance
    After delivery of a product or performance of a service, if 
uncertainty exists about customer acceptance, revenue should not be 
recognized until acceptance occurs.\22\ Customer acceptance provisions 
may be included in a contract, among other reasons, to enforce a 
customer's rights to (1) test the delivered product, (2) require the 
seller to perform additional services subsequent to delivery of an 
initial product or performance of an initial service (e.g., a seller is 
required to install or activate delivered equipment), or (3) identify 
other work necessary to be done before accepting the product. The staff 
presumes that such contractual customer acceptance provisions are 
substantive, bargained-for terms of an arrangement. Accordingly, when 
such contractual customer acceptance provisions exist, the staff 
generally believes that the seller should not recognize revenue until 
customer acceptance occurs or the acceptance provisions lapse.
---------------------------------------------------------------------------

    \22\ FASB ASC paragraph 985-605-25-21. Also, Concepts Statement 
5, paragraph 83(b) states ``revenues are considered to have been 
earned when the entity has substantially accomplished what it must 
do to be entitled to the benefits represented by the revenues.'' If 
an arrangement expressly requires customer acceptance, the staff 
generally believes that customer acceptance should occur before the 
entity has substantially accomplished what it must do to be entitled 
to the benefits represented by the revenues, especially when the 
seller is obligated to perform additional steps.
---------------------------------------------------------------------------

Question 1

    Question: Do circumstances exist in which formal customer sign-off 
(that a contractual customer acceptance provision is met) is 
unnecessary to meet the requirements to recognize revenue?
    Interpretive Response: Yes. Formal customer sign-off is not always 
necessary to recognize revenue provided that the seller objectively 
demonstrates that the criteria specified in the acceptance provisions 
are satisfied. Customer acceptance provisions generally allow the 
customer to cancel the arrangement when a seller delivers a product 
that the customer has not yet agreed to purchase or delivers a product 
that does not meet the specifications of the customer's order. In those 
cases, revenue should not be recognized because a sale has not 
occurred. In applying this concept, the staff observes that customer 
acceptance provisions normally take one of four general forms. Those 
forms, and how the staff generally assesses whether customer acceptance 
provisions should result in revenue deferral, are described below:
    (a) Acceptance provisions in arrangements that purport to be for 
trial or evaluation purposes.\23\ In these arrangements, the seller 
delivers a product to a customer, and the customer agrees to receive 
the product, solely to give the customer the ability to evaluate the 
delivered product prior to acceptance. The customer does not agree to 
purchase the delivered product until it accepts the product. In some 
cases, the acceptance provisions lapse by the passage of time without 
the customer rejecting the delivered product, and in other cases 
affirmative acceptance from the customer is necessary to trigger a 
sales transaction. Frequently, the title to the product does not 
transfer and payment terms are not established prior to customer 
acceptance. These arrangements are, in substance, consignment 
arrangements until the customer accepts the product as set forth in the 
contract with the seller. Accordingly, in arrangements where products 
are delivered for trial or evaluation purposes, revenue should not be 
recognized until the earlier of when acceptance occurs or the 
acceptance provisions lapse.
---------------------------------------------------------------------------

    \23\ See, for example, FASB ASC paragraphs 985-605-25-28 through 
985-605-25-29.
---------------------------------------------------------------------------

    In contrast, other arrangements do not purport to be for trial or 
evaluation purposes. In these instances, the seller delivers a 
specified product pursuant to a customer's order, establishes payment 
terms, and transfers title to the delivered product to the customer. 
However, customer acceptance provisions may be included in the 
arrangement to give the purchaser the ability to ensure the delivered 
product meets the criteria set forth in its order. The staff evaluates 
these provisions as follows:
    (b) Acceptance provisions that grant a right of return or exchange 
on the basis of subjective matters. An example of such a provision is 
one that allows the customer to return a product if the customer is 
dissatisfied with the product.\24\ The staff believes these provisions 
are not different from general rights of return and should be accounted 
for in accordance with FASB ASC Subtopic 605-15, Revenue Recognition--
Products. This Subtopic requires that the amount of future returns must 
be reasonably estimable in order for revenue to be recognized prior to 
the expiration of return rights.\25\ That estimate may not be made in 
the absence of a large volume of homogeneous transactions or if 
customer acceptance is likely to depend on conditions for which 
sufficient historical experience is absent.\26\ Satisfaction of these 
requirements may vary from product-to-product, location-to-location, 
customer-to-customer, and vendor-to-vendor.
---------------------------------------------------------------------------

    \24\ FASB ASC paragraph 605-15-05-3.
    \25\ FASB ASC subparagraph 605-15-25-1(f).
    \26\ FASB ASC subparagraphs 605-15-25-3(c) and 605-15-25-3(d).
---------------------------------------------------------------------------

    (c) Acceptance provisions based on seller-specified objective 
criteria. An example of such a provision is one that gives the customer 
a right of return or replacement if the delivered product is defective 
or fails to meet the vendor's published specifications for the 
product.\27\ Such rights are generally identical to those granted to 
all others within the same class of customer and for which satisfaction 
can be generally assured without consideration of conditions specific 
to the customer. Provided the seller has previously demonstrated that 
the product meets the specified criteria, the staff believes that these 
provisions are not different from general or specific warranties and 
should be accounted for as warranties in accordance with FASB ASC 
Subtopic 450-20, Contingencies--Loss Contingencies. In this case, the 
cost of potentially defective goods must be reliably estimable based on 
a demonstrated history of substantially similar transactions.\28\ 
However, if the seller has not previously demonstrated that the 
delivered product meets the seller's specifications, the staff believes 
that revenue should be deferred until the specifications have been 
objectively achieved.
---------------------------------------------------------------------------

    \27\ FASB ASC paragraph 460-10-25-5 (Guarantees Topic) and FASB 
ASC subparagraph 605-15-15-3(c).
    \28\ FASB ASC paragraph 460-10-25-6.

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[[Page 17265]]

    (d) Acceptance provisions based on customer-specified objective 
criteria. These provisions are referred to in this document as 
``customer-specific acceptance provisions'' against which substantial 
completion and contract fulfillment must be evaluated. While formal 
customer sign-off provides the best evidence that these acceptance 
criteria have been met, revenue recognition also would be appropriate, 
presuming all other revenue recognition criteria have been met, if the 
seller reliably demonstrates that the delivered products or services 
meet all of the specified criteria prior to customer acceptance. For 
example, if a seller reliably demonstrates that a delivered product 
meets the customer-specified objective criteria set forth in the 
arrangement, the delivery criterion would generally be satisfied when 
title and the risks and rewards of ownership transfers unless product 
performance may reasonably be different under the customer's testing 
conditions specified by the acceptance provisions. Further, the seller 
should consider whether it would be successful in enforcing a claim for 
payment even in the absence of formal sign-off. Whether the vendor has 
fulfilled the terms of the contract before customer acceptance is a 
matter of contract law, and depending on the facts and circumstances, 
an opinion of counsel may be necessary to reach a conclusion.

Question 2

    Facts: Consider an arrangement that calls for the transfer of title 
to equipment upon delivery to a customer's site. However, customer-
specific acceptance provisions permit the customer to return the 
equipment unless the equipment satisfies certain performance tests. The 
arrangement calls for the vendor to perform the installation. Assume 
the equipment and the installation are separate units of accounting 
under FASB ASC Subtopic 605-25, Revenue Recognition--Multiple-Element 
Arrangements.\29\
---------------------------------------------------------------------------

    \29\ This fact is provided as an assumption to facilitate an 
analysis of revenue recognition in this fact pattern. No 
interpretation of FASB ASC Subtopic 605-25 is intended.
---------------------------------------------------------------------------

    Question: Must revenue allocated to the equipment always be 
deferred until installation and on-site testing are successfully 
completed?
    Interpretive Response: No. The staff would not object to revenue 
recognition for the equipment upon delivery (presuming all other 
revenue recognition criteria have been met for the equipment) if the 
seller demonstrates that, at the time of delivery, the equipment 
already meets all of the criteria and specifications in the customer-
specific acceptance provisions. This may be demonstrated if conditions 
under which the customer intends to operate the equipment are 
replicated in pre-shipment testing, unless the performance of the 
equipment, once installed and operated at the customer's facility, may 
reasonably be different from that tested prior to shipment.
    Determining whether the delivered equipment meets all of a 
product's criteria and specifications is a matter of judgment that must 
be evaluated in light of the facts and circumstances of a particular 
transaction. Consultation with knowledgeable project managers or 
engineers may be necessary in such circumstances.
    For example, if the customer acceptance provisions were based on 
meeting certain size and weight characteristics, it should be possible 
to determine whether those criteria have been met before shipment. 
Historical experience with the same specifications and functionality of 
a particular machine that demonstrates that the equipment meets the 
customer's specifications also may provide sufficient evidence that the 
currently shipped equipment satisfies the customer-specific acceptance 
provisions.
    If an arrangement includes customer acceptance criteria or 
specifications that cannot be effectively tested before delivery or 
installation at the customer's site, the staff believes that revenue 
recognition should be deferred until it can be demonstrated that the 
criteria are met. This situation usually will exist when equipment 
performance can vary based on how the equipment works in combination 
with the customer's other equipment, software, or environmental 
conditions. In these situations, testing to determine whether the 
criteria are met cannot be reasonably performed until the products are 
installed or integrated at the customer's facility.
    Although the following questions provide several examples 
illustrating how the staff evaluates customer acceptance, the 
determination of when customer-specific acceptance provisions of an 
arrangement are met in the absence of the customer's formal 
notification of acceptance depends on the weight of the evidence in the 
particular circumstances. Different conclusions could be reached in 
similar circumstances that vary only with respect to a single variable, 
such as complexity of the equipment, nature of the interface with the 
customer's environment, extent of the seller's experience with the same 
type of transactions, or a particular clause in the agreement. The 
staff believes management and auditors are uniquely positioned to 
evaluate the facts and arrive at a reasoned conclusion. The staff will 
not object to a determination that is well reasoned on the basis of 
this guidance.

Question 3

    Facts: Company E is an equipment manufacturer whose main product is 
generally sold in a standard model. The contracts for sale of that 
model provide for customer acceptance to occur after the equipment is 
received and tested by the customer. The acceptance provisions state 
that if the equipment does not perform to Company E's published 
specifications, the customer may return the equipment for a full refund 
or a replacement unit, or may require Company E to repair the equipment 
so that it performs up to published specifications. Customer acceptance 
is indicated by either a formal sign-off by the customer or by the 
passage of 90 days without a claim under the acceptance provisions. 
Title to the equipment passes upon delivery to the customer. Company E 
does not perform any installation or other services on the equipment it 
sells and tests each piece of equipment against its specifications 
before shipment. Payment is due under Company E's normal payment terms 
for that product 30 days after customer acceptance.
    Company E receives an order from a new customer for a standard 
model of its main product. Based on the customer's intended use of the 
product, location and other factors, there is no reason that the 
equipment would operate differently in the customer's environment than 
it does in Company E's facility.
    Question: Assuming all other revenue recognition criteria are met 
(other than the issue raised with respect to the acceptance provision), 
when should Company E recognize revenue from the sale of this piece of 
equipment?
    Interpretive Response: While the staff presumes that customer 
acceptance provisions are substantive provisions that generally result 
in revenue deferral, that presumption can be overcome as discussed 
above. Although the contract includes a customer acceptance clause, 
acceptance is based on meeting Company E's published specifications for 
a standard model. Company E demonstrates that the equipment shipped 
meets the specifications before shipment, and the equipment is expected 
to operate the same in the customer's environment as it does in

[[Page 17266]]

Company E's. In this situation, Company E should evaluate the customer 
acceptance provision as a warranty under FASB ASC Subtopic 450-20. If 
Company E can reasonably and reliably estimate the amount of warranty 
obligations, the staff believes that it should recognize revenue upon 
delivery of the equipment, with an appropriate liability for probable 
warranty obligations.

Question 4

    Facts: Assume the same facts about Company E's equipment, contract 
terms and customary practices as in Question 3 above. Company E enters 
into an arrangement with a new customer to deliver a version of its 
standard product modified as necessary to fit into a space of specific 
dimensions while still meeting all of the published vendor 
specifications with regard to performance. In addition to the customer 
acceptance provisions relating to the standard performance 
specifications, the customer may reject the equipment if it does not 
conform to the specified dimensions. Company E creates a testing 
chamber of the exact same dimensions as specified by the customer and 
makes simple design changes to the product so that it fits into the 
testing chamber. The equipment still meets all of the standard 
performance specifications.
    Question: Assuming all other revenue recognition criteria are met 
(other than the issue raised with respect to the acceptance provision), 
when should Company E recognize revenue from the sale of this piece of 
equipment?
    Interpretive Response: Although the contract includes a customer 
acceptance clause that is based, in part, on a customer specific 
criterion, Company E demonstrates that the equipment shipped meets that 
objective criterion, as well as the published specifications, before 
shipment. The staff believes that the customer acceptance provisions 
related to the standard performance specifications should be evaluated 
as a warranty under FASB ASC Subtopic 450-20. If Company E can 
reasonably and reliably estimate the amount of warranty obligations, it 
should recognize revenue upon delivery of the equipment, with an 
appropriate liability for probable warranty obligations.

Question 5

    Facts: Assume the same facts about Company E's equipment, contract 
terms and customary practices as in Question 3 above. Company E enters 
into an arrangement with a new customer to deliver a version of its 
standard product modified as necessary to be integrated into the 
customer's new assembly line while still meeting all of the standard 
published vendor specifications with regard to performance. The 
customer may reject the equipment if it fails to meet the standard 
published performance specifications or cannot be satisfactorily 
integrated into the new line. Company E has never modified its 
equipment to work on an integrated basis in the type of assembly line 
the customer has proposed. In response to the request, Company E 
designs a version of its standard equipment that is modified as 
believed necessary to operate in the new assembly line. The modified 
equipment still meets all of the standard published performance 
specifications, and Company E believes the equipment will meet the 
requested specifications when integrated into the new assembly line. 
However, Company E is unable to replicate the new assembly line 
conditions in its testing.
    Question: Assuming all other revenue recognition criteria are met 
(other than the issue raised with respect to the acceptance provision), 
when should Company E recognize revenue from the sale of this piece of 
equipment?
    Interpretive Response: This contract includes a customer acceptance 
clause that is based, in part, on a customer specific criterion, and 
Company E cannot demonstrate that the equipment shipped meets that 
criterion before shipment. Accordingly, the staff believes that the 
contractual customer acceptance provision has not been met at shipment. 
Therefore, the staff believes that Company E should wait until the 
product is successfully integrated at its customer's location and meets 
the customer-specific criteria before recognizing revenue. While this 
is best evidenced by formal customer acceptance, other objective 
evidence that the equipment has met the customer-specific criteria may 
also exist (e.g., confirmation from the customer that the 
specifications were met).
c. Inconsequential or Perfunctory Performance Obligations

Question 1

    Question: Does the failure to complete all activities related to a 
unit of accounting preclude recognition of revenue for that unit of 
accounting?
    Interpretive Response: No. Assuming all other recognition criteria 
are met, revenue for the unit of accounting may be recognized in its 
entirety if the seller's remaining obligation is inconsequential or 
perfunctory.
    A seller should substantially complete or fulfill the terms 
specified in the arrangement related to the unit of accounting at issue 
in order for delivery or performance to have occurred.\30\ When 
applying the substantially complete notion, the staff believes that 
only inconsequential or perfunctory actions may remain incomplete such 
that the failure to complete the actions would not result in the 
customer receiving a refund or rejecting the delivered products or 
services performed to date. In addition, the seller should have a 
demonstrated history of completing the remaining tasks in a timely 
manner and reliably estimating the remaining costs. If revenue is 
recognized upon substantial completion of the terms specified in the 
arrangement related to the unit of accounting at issue, all related 
costs of performance or delivery should be accrued.
---------------------------------------------------------------------------

    \30\ Concepts Statement 5, paragraph 83(b) states ``revenues are 
considered to have been earned when the entity has substantially 
accomplished what it must do to be entitled the benefits represented 
by the revenues.''
---------------------------------------------------------------------------

Question 2
    Question: What factors should be considered in the evaluation of 
whether a remaining obligation related to a unit of accounting is 
inconsequential or perfunctory?
    Interpretive Response: A remaining performance obligation is not 
inconsequential or perfunctory if it is essential to the functionality 
of the delivered products or services. In addition, remaining 
activities are not inconsequential or perfunctory if failure to 
complete the activities would result in the customer receiving a full 
or partial refund or rejecting (or a right to a refund or to reject) 
the products delivered or services performed to date. The terms of the 
sales contract regarding both the right to a full or partial refund and 
the right of return or rejection should be considered when evaluating 
whether a portion of the purchase price would be refundable. If the 
company has a historical pattern of granting such rights, that 
historical pattern should also be considered even if the current 
contract expressly precludes such rights. Further, other factors should 
be considered in assessing whether remaining obligations are 
inconsequential or perfunctory. For example, the staff also considers 
the following factors, which are not all-inclusive, to be indicators 
that a remaining performance obligation is substantive rather than 
inconsequential or perfunctory:
     The seller does not have a demonstrated history of 
completing the remaining tasks in a timely manner and reliably 
estimating their costs.

[[Page 17267]]

     The cost or time to perform the remaining obligations for 
similar contracts historically has varied significantly from one 
instance to another.
     The skills or equipment required to complete the remaining 
activity are specialized or are not readily available in the 
marketplace.
     The cost of completing the obligation, or the fair value 
of that obligation, is more than insignificant in relation to such 
items as the contract fee, gross profit, and operating income allocable 
to the unit of accounting.
     The period before the remaining obligation will be 
extinguished is lengthy. Registrants should consider whether reasonably 
possible variations in the period to complete performance affect the 
certainty that the remaining obligations will be completed successfully 
and on budget.
     The timing of payment of a portion of the sales price is 
coincident with completing performance of the remaining activity.
    Registrants' determinations of whether remaining obligations are 
inconsequential or perfunctory should be consistently applied.

Question 3

    Facts: Consider a unit of accounting that includes both equipment 
and installation because the two deliverables do not meet the 
separation criteria under FASB ASC Subtopic 605-25. This may be because 
the equipment does not have value to the customer on a standalone 
basis, there is no objective and reliable evidence of fair value for 
the installation or there is a general right of return when the 
installation is not considered probable and in control of the vendor.
    Question: In this situation, must all revenue be deferred until 
installation is performed?
    Interpretive Response: Yes, if installation is essential to the 
functionality of the equipment.\31\ Examples of indicators that 
installation is essential to the functionality of equipment include:
---------------------------------------------------------------------------

    \31\ FASB ASC paragraph 985-605-25-12.
---------------------------------------------------------------------------

     The installation involves significant changes to the 
features or capabilities of the equipment or building complex 
interfaces or connections;
     The installation services are unavailable from other 
vendors.\32\
---------------------------------------------------------------------------

    \32\ See FASB ASC paragraphs 985-605-25-81 through 985-605-25-85 
for analogous guidance.
---------------------------------------------------------------------------

    Conversely, examples of indicators that installation is not 
essential to the functionality of the equipment include:
     The equipment is a standard product;
     Installation does not significantly alter the equipment's 
capabilities;
     Other companies are available to perform the 
installation.\33\
---------------------------------------------------------------------------

    \33\ Ibid.
---------------------------------------------------------------------------

    If it is determined that the undelivered service is not essential 
to the functionality of the delivered product but a portion of the 
contract fee is not payable until the undelivered service is delivered, 
the staff would not consider that obligation to be inconsequential or 
perfunctory. Generally, the portion of the contract price that is 
withheld or refundable should be deferred until the outstanding service 
is delivered because that portion would not be realized or 
realizable.\34\
---------------------------------------------------------------------------

    \34\ Concepts Statement 5, paragraph 83(a) and FASB ASC 
subparagraph 605-15-25-1(b).
---------------------------------------------------------------------------

d. License Fee Revenue
    Facts: Assume that intellectual property is physically delivered 
and payment is received on December 20, upon the registrant's 
consummation of an agreement granting its customer a license to use the 
intellectual property for a term beginning on the following January 1.
    Question: Should the license fee be recognized in the period ending 
December 31?
    Interpretive Response: No. In licensing and similar arrangements 
(e.g., licenses of motion pictures, software, technology, and other 
intangibles), the staff believes that delivery does not occur for 
revenue recognition purposes until the license term begins.\35\ 
Accordingly, if a licensed product or technology is physically 
delivered to the customer, but the license term has not yet begun, 
revenue should not be recognized prior to inception of the license 
term. Upon inception of the license term, revenue should be recognized 
in a manner consistent with the nature of the transaction and the 
earnings process.
---------------------------------------------------------------------------

    \35\ FASB ASC paragraph 926-605-25-1 (Entertainment--Films 
Topic).
---------------------------------------------------------------------------

e. Layaway Sales Arrangements
    Facts: Company R is a retailer that offers ``layaway'' sales to its 
customers. Company R retains the merchandise, sets it aside in its 
inventory, and collects a cash deposit from the customer. Although 
Company R may set a time period within which the customer must finalize 
the purchase, Company R does not require the customer to enter into an 
installment note or other fixed payment commitment or agreement when 
the initial deposit is received. The merchandise generally is not 
released to the customer until the customer pays the full purchase 
price. In the event that the customer fails to pay the remaining 
purchase price, the customer forfeits its cash deposit. In the event 
the merchandise is lost, damaged, or destroyed, Company R either must 
refund the cash deposit to the customer or provide replacement 
merchandise.
    Question: In the staff's view, when may Company R recognize revenue 
for merchandise sold under its layaway program?
    Interpretive Response: Provided that the other criteria for revenue 
recognition are met, the staff believes that Company R should recognize 
revenue from sales made under its layaway program upon delivery of the 
merchandise to the customer. Until then, the amount of cash received 
should be recognized as a liability entitled such as ``deposits 
received from customers for layaway sales'' or a similarly descriptive 
caption. Because Company R retains the risks of ownership of the 
merchandise, receives only a deposit from the customer, and does not 
have an enforceable right to the remainder of the purchase price, the 
staff would object to Company R recognizing any revenue upon receipt of 
the cash deposit. This is consistent with item two (2) in the 
Commission's criteria for bill-and-hold transactions which states ``the 
customer must have made a fixed commitment to purchase the goods.''
f. Nonrefundable Up-front Fees

Question 1

    Facts: Registrants may negotiate arrangements pursuant to which 
they may receive nonrefundable fees upon entering into arrangements or 
on certain specified dates. The fees may ostensibly be received for 
conveyance of a license or other intangible right or for delivery of 
particular products or services. Various business factors may influence 
how the registrant and customer structure the payment terms. For 
example, in exchange for a greater up-front fee for an intangible 
right, the registrant may be willing to receive lower unit prices for 
related products to be delivered in the future. In some circumstances, 
the right, product, or service conveyed in conjunction with the 
nonrefundable fee has no utility to the purchaser separate and 
independent of the registrant's performance of the other elements of 
the arrangement. Therefore, in the absence of the registrant's 
continuing involvement under the arrangement, the customer would not 
have paid the fee. Examples of this type of arrangement include the 
following:

[[Page 17268]]

     A registrant sells a lifetime membership in a health club. 
After paying a nonrefundable ``initiation fee,'' the customer is 
permitted to use the health club indefinitely, so long as the customer 
also pays an additional usage fee each month. The monthly usage fees 
collected from all customers are adequate to cover the operating costs 
of the health club.
     A registrant in the biotechnology industry agrees to 
provide research and development activities for a customer for a 
specified term. The customer needs to use certain technology owned by 
the registrant for use in the research and development activities. The 
technology is not sold or licensed separately without the research and 
development activities. Under the terms of the arrangement, the 
customer is required to pay a nonrefundable ``technology access fee'' 
in addition to periodic payments for research and development 
activities over the term of the contract.
     A registrant requires a customer to pay a nonrefundable 
``activation fee'' when entering into an arrangement to provide 
telecommunications services. The terms of the arrangement require the 
customer to pay a monthly usage fee that is adequate to recover the 
registrant's operating costs. The costs incurred to activate the 
telecommunications service are nominal.
     A registrant charges users a fee for non-exclusive access 
to its Web site that contains proprietary databases. The fee allows 
access to the Web site for a one-year period. After the customer is 
provided with an identification number and trained in the use of the 
database, there are no incremental costs that will be incurred in 
serving this customer.
     A registrant charges a fee to users for advertising a 
product for sale or auction on certain pages of its Web site. The 
company agrees to maintain the listing for a period of time. The cost 
of maintaining the advertisement on the Web site for the stated period 
is minimal.
     A registrant charges a fee for hosting another company's 
Web site for one year. The arrangement does not involve exclusive use 
of any of the hosting company's servers or other equipment. Almost all 
of the projected costs to be incurred will be incurred in the initial 
loading of information on the host company's Internet server and 
setting up appropriate links and network connections.
    Question: Assuming these arrangements qualify as single units of 
accounting under FASB ASC Subtopic 605-25,\36\ when should the revenue 
relating to nonrefundable, up-front fees in these types of arrangements 
be recognized?
---------------------------------------------------------------------------

    \36\ The staff believes that the vendor activities associated 
with the up-front fee, even if considered a deliverable to be 
evaluated under FASB ASC Subtopic 605-25, will rarely provide value 
to the customer on a standalone basis.
---------------------------------------------------------------------------

    Interpretive Response: The staff believes that registrants should 
consider the specific facts and circumstances to determine the 
appropriate accounting for nonrefundable, up-front fees. Unless the up-
front fee is in exchange for products delivered or services performed 
that represent the culmination of a separate earnings process,\37\ the 
deferral of revenue is appropriate.
---------------------------------------------------------------------------

    \37\ See Concepts Statement 5, footnote 51, for a description of 
the ``earning process.''
---------------------------------------------------------------------------

    In the situations described above, the staff does not view the 
activities completed by the registrants (i.e., selling the membership, 
signing the contract, enrolling the customer, activating 
telecommunications services or providing initial set-up services) as 
discrete earnings events.\38\ The terms, conditions, and amounts of 
these fees typically are negotiated in conjunction with the pricing of 
all the elements of the arrangement, and the customer would ascribe a 
significantly lower, and perhaps no, value to elements ostensibly 
associated with the up-front fee in the absence of the registrant's 
performance of other contract elements. The fact that the registrants 
do not sell the initial rights, products, or services separately (i.e., 
without the registrants' continuing involvement) supports the staff's 
view. The staff believes that the customers are purchasing the on-going 
rights, products, or services being provided through the registrants' 
continuing involvement. Further, the staff believes that the earnings 
process is completed by performing under the terms of the arrangements, 
not simply by originating a revenue-generating arrangement.
---------------------------------------------------------------------------

    \38\ In a similar situation, lenders may collect nonrefundable 
loan origination fees in connection with lending activities. The 
FASB concluded in FASB ASC Subtopic 310-20, Receivables--
Nonrefundable Fees and Other Costs, that loan origination is not a 
separate revenue-producing activity of a lender, and therefore, 
those nonrefundable fees collected at the outset of the loan 
arrangement are not recognized as revenue upon receipt but are 
deferred and recognized over the life of the loan (FASB ASC 
paragraph 310-20-35-2).
---------------------------------------------------------------------------

    While the incurrence of nominal up-front costs helps make it clear 
that there is not a separate earnings event in the telecommunications 
example above, incurrence of substantive costs, such as in the Web 
hosting example above, does not necessarily indicate that there is a 
separate earnings event. Whether there is a separate earnings event 
should be evaluated on a case-by-case basis. Some have questioned 
whether revenue may be recognized in these transactions to the extent 
of the incremental direct costs incurred in the activation. Because 
there is no separable deliverable or earnings event, the staff would 
generally object to that approach, except where it is provided for in 
the authoritative literature (e.g., FASB ASC Subtopic 922-605, 
Entertainment--Cable Television--Revenue Recognition).
    Supply or service transactions may involve the charge of a 
nonrefundable initial fee with subsequent periodic payments for future 
products or services. The initial fees may, in substance, be wholly or 
partly an advance payment for future products or services. In the 
examples above, the on-going rights or services being provided or 
products being delivered are essential to the customers receiving the 
expected benefit of the up-front payment. Therefore, the up-front fee 
and the continuing performance obligation related to the services to be 
provided or products to be delivered are assessed as an integrated 
package. In such circumstances, the staff believes that up-front fees, 
even if nonrefundable, are earned as the products and/or services are 
delivered and/or performed over the term of the arrangement or the 
expected period of performance \39\ and generally should be deferred 
and recognized systematically over the periods that the fees are 
earned.\40\
---------------------------------------------------------------------------

    \39\ The revenue recognition period should extend beyond the 
initial contractual period if the relationship with the customer is 
expected to extend beyond the initial term and the customer 
continues to benefit from the payment of the up-front fee (e.g., if 
subsequent renewals are priced at a bargain to the initial up-front 
fee).
    \40\ A systematic method would be on a straight-line basis, 
unless evidence suggests that revenue is earned or obligations are 
fulfilled in a different pattern, in which case that pattern should 
be followed.
---------------------------------------------------------------------------

    Some propose that revenue should be recognized when the initial 
set-up is completed in cases where the on-going obligation involves 
minimal or no cost or effort and should, therefore, be considered 
perfunctory or inconsequential. However, the staff believes that the 
substance of each of these transactions indicates that the purchaser is 
paying for a service that is delivered over time. Therefore, revenue 
recognition should occur over time, reflecting the provision of 
service.\41\
---------------------------------------------------------------------------

    \41\ Concepts Statement 5, paragraph 84(d).
---------------------------------------------------------------------------

Question 2

    Facts: Company A provides its customers with activity tracking or

[[Page 17269]]

similar services (e.g., tracking of property tax payment activity, 
sending delinquency letters on overdue accounts, etc.) for a ten-year 
period. Company A requires customers to prepay for all the services for 
the term specified in the arrangement. The on-going services to be 
provided are generally automated after the initial customer set-up. At 
the outset of the arrangement, Company A performs set-up procedures to 
facilitate delivery of its on-going services to the customers. Such 
procedures consist primarily of establishing the necessary records and 
files in Company A's pre-existing computer systems in order to provide 
the services. Once the initial customer set-up activities are complete, 
Company A provides its services in accordance with the arrangement. 
Company A is not required to refund any portion of the fee if the 
customer terminates the services or does not utilize all of the 
services to which it is entitled. However, Company A is required to 
provide a refund if Company A terminates the arrangement early. Assume 
Company A's activities are not within the scope of FASB ASC Subtopic 
310-20, Receivables--Nonrefundable Fees and Other Costs, and that this 
arrangement qualifies as a single unit of accounting under FASB ASC 
Subtopic 605-25.\42\
---------------------------------------------------------------------------

    \42\ See Note 36, supra.
---------------------------------------------------------------------------

    Question: When should Company A recognize the service revenue?
    Interpretive Response: The staff believes that, provided all other 
revenue recognition criteria are met, service revenue should be 
recognized on a straight-line basis, unless evidence suggests that the 
revenue is earned or obligations are fulfilled in a different pattern, 
over the contractual term of the arrangement or the expected period 
during which those specified services will be performed,\43\ whichever 
is longer. In this case, the customer contracted for the on-going 
activity tracking service, not for the set-up activities. The staff 
notes that the customer could not, and would not, separately purchase 
the set-up services without the on-going services. The services 
specified in the arrangement are performed continuously over the 
contractual term of the arrangement (and any subsequent renewals). 
Therefore, the staff believes that Company A should recognize revenue 
on a straight-line basis, unless evidence suggests that the revenue is 
earned or obligations are fulfilled in a different pattern, over the 
contractual term of the arrangement or the expected period during which 
those specified services will be performed, whichever is longer.
---------------------------------------------------------------------------

    \43\ See Note 39, supra.
---------------------------------------------------------------------------

    In this situation, the staff would object to Company A recognizing 
revenue in proportion to the costs incurred because the set-up costs 
incurred bear no direct relationship to the performance of services 
specified in the arrangement. The staff also believes that it is 
inappropriate to recognize the entire amount of the prepayment as 
revenue at the outset of the arrangement by accruing the remaining 
costs because the services required by the contract have not been 
performed.

Question 3

    Facts: Assume the same facts as in Question 2 above.
    Question: Are the initial customer set-up costs incurred by Company 
A within the scope of FASB ASC Subtopic 720-15, Other Expenses--Start-
Up Costs?
    Interpretive Response: FASB ASC paragraph 720-15-15-4 states that 
the guidance does not address the financial reporting of costs incurred 
related to ``ongoing customer acquisition costs, such as policy 
acquisition costs'' addressed in FASB ASC Subtopic 944-30, Financial 
Services--Insurance--Acquisition Costs, and ``loan origination costs'' 
addressed in FASB ASC Subtopic 310-20. This guidance addresses the more 
substantive one-time efforts to establish business with an entirely new 
class of customers (for example, a manufacturer who does all of its 
business with retailers attempts to sell merchandise directly to the 
public). As such, the set-up costs incurred in this example are not 
within the scope of FASB ASC Subtopic 720-15.
    The staff believes that the incremental direct costs (the FASB ASC 
Master Glossary provides a definition) incurred related to the 
acquisition or origination of a customer contract in a transaction that 
results in the deferral of revenue, unless specifically provided for in 
the authoritative literature, may be either expensed as incurred or 
accounted for in accordance with FASB ASC paragraph 605-20-25-4 or FASB 
ASC paragraph 310-20-25-2. The staff believes the accounting policy 
chosen for these costs should be disclosed and applied consistently.

Question 4

    Facts: Assume the same facts as in Question 2 above.
    Question: What is the staff's view of the pool of contract 
acquisition and origination costs that are eligible for capitalization?
    Interpretive Response: As noted in Question 3 above, the FASB ASC 
Master Glossary includes a definition of incremental direct costs. FASB 
ASC Subtopic 310-10, Receivables--Overall, provides further guidance on 
the types of costs eligible for capitalization as customer acquisition 
costs indicating that only costs that result from successful loan 
origination efforts are capitalized. Further, FASB ASC Subtopic 605-20, 
Revenue Recognition--Services, also requires capitalization of 
incremental direct customer acquisition costs. Although the facts of a 
particular situation should be analyzed closely to capture those costs 
that are truly direct and incremental, the staff generally would not 
object to an accounting policy that results in the capitalization of 
costs in accordance with FASB ASC Subtopic 310-20, Receivables--
Nonrefundable Fees and Other Costs, or FASB ASC Subtopic 605-20. 
Registrants should disclose their policies for determining which costs 
to capitalize as contract acquisition and origination costs.

Question 5

    Facts: Assume the same facts as in Question 2 above. Based on the 
guidance in Questions 2, 3 and 4 above, Company A has capitalized 
certain direct and incremental customer set-up costs associated with 
the deferred revenue.
    Question: Over what period should Company A amortize these costs?
    Interpretive Response: When both costs and revenue (in an amount 
equal to or greater than the costs) are deferred, the staff believes 
that the capitalized costs should be charged to expense proportionally 
and over the same period that deferred revenue is recognized as 
revenue.\44\
---------------------------------------------------------------------------

    \44\ FASB ASC paragraph 605-20-25-4.
---------------------------------------------------------------------------

g. Deliverables Within an Arrangement
    Question: If a company (the seller) has a patent to its 
intellectual property which it licenses to customers, the seller may 
represent and warrant to its licensees that it has a valid patent, and 
will defend and maintain that patent. Does that obligation to maintain 
and defend patent rights, in and of itself, constitute a deliverable to 
be evaluated under FASB ASC Subtopic 605-25?
    Interpretive Response: No. Provided the seller has legal and valid 
patents upon entering the license arrangement, existing GAAP on 
licenses of intellectual property (e.g., FASB ASC Subtopic 985-605, 
Software--Revenue Recognition, FASB ASC Subtopic 926-605, 
Entertainment--Films--Revenue Recognition, and FASB ASC Subtopic 928-
605, Entertainment--Music--Revenue Recognition) does not indicate

[[Page 17270]]

that an obligation to defend valid patents represents an additional 
deliverable to which a portion of an arrangement fee should be 
allocated in an arrangement that otherwise qualifies for sales-type 
accounting. While this clause may obligate the licenser to incur costs 
in the defense and maintenance of the patent, that obligation does not 
involve an additional deliverable to the customer. Defending the patent 
is generally consistent with the seller's representation in the license 
that such patent is legal and valid. Therefore, the staff would not 
consider a clause like this to represent an additional deliverable in 
the arrangement.\45\
---------------------------------------------------------------------------

    \45\ Note, however, the staff believes that this obligation 
qualifies as a guarantee within the scope of FASB ASC Topic 460, 
subject to a scope exception from the initial recognition and 
measurement provisions.
---------------------------------------------------------------------------

4. Fixed or Determinable Sales Price
a. Refundable Fees for Services
    A company's contracts may include customer cancellation or 
termination clauses. Cancellation or termination provisions may be 
indicative of a demonstration period or an otherwise incomplete 
transaction. Examples of transactions that financial management and 
auditors should be aware of and where such provisions may exist include 
``side'' agreements and significant transactions with unusual terms and 
conditions. These contractual provisions raise questions as to whether 
the sales price is fixed or determinable. The sales price in 
arrangements that are cancelable by the customer is neither fixed nor 
determinable until the cancellation privileges lapse.\46\ If the 
cancellation privileges expire ratably over a stated contractual term, 
the sales price is considered to become determinable ratably over the 
stated term.\47\ Short-term rights of return, such as thirty-day money-
back guarantees, and other customary rights to return products are not 
considered to be cancellation privileges, but should be accounted for 
in accordance with FASB ASC Subtopic 605-15, Revenue Recognition--
Products.\48\
---------------------------------------------------------------------------

    \46\ FASB ASC paragraph 985-605-25-37.
    \47\ Ibid.
    \48\ Ibid.
---------------------------------------------------------------------------

Question 1

    Facts: Company M is a discount retailer. It generates revenue from 
annual membership fees it charges customers to shop at its stores and 
from the sale of products at a discount price to those customers. The 
membership arrangements with retail customers require the customer to 
pay the entire membership fee (e.g., $35) at the outset of the 
arrangement. However, the customer has the unilateral right to cancel 
the arrangement at any time during its term and receive a full refund 
of the initial fee. Based on historical data collected over time for a 
large number of homogeneous transactions, Company M estimates that 
approximately 40% of the customers will request a refund before the end 
of the membership contract term. Company M's data for the past five 
years indicates that significant variations between actual and 
estimated cancellations have not occurred, and Company M does not 
expect significant variations to occur in the foreseeable future.
    Question: May Company M recognize in earnings the revenue for the 
membership fees and accrue the costs to provide membership services at 
the outset of the arrangement?
    Interpretive Response: No. In the staff's view, it would be 
inappropriate for Company M to recognize the membership fees as earned 
revenue upon billing or receipt of the initial fee with a corresponding 
accrual for estimated costs to provide the membership services. This 
conclusion is based on Company M's remaining and unfulfilled 
contractual obligation to perform services (i.e., make available and 
offer products for sale at a discounted price) throughout the 
membership period. Therefore, the earnings process, irrespective of 
whether a cancellation clause exists, is not complete.
    In addition, the ability of the member to receive a full refund of 
the membership fee up to the last day of the membership term raises an 
uncertainty as to whether the fee is fixed or determinable at any point 
before the end of the term. Generally, the staff believes that a sales 
price is not fixed or determinable when a customer has the unilateral 
right to terminate or cancel the contract and receive a cash refund. A 
sales price or fee that is variable until the occurrence of future 
events (other than product returns that are within the scope of FASB 
ASC Subtopic 605-15) generally is not fixed or determinable until the 
future event occurs. The revenue from such transactions should not be 
recognized in earnings until the sales price or fee becomes fixed or 
determinable. Moreover, revenue should not be recognized in earnings by 
assessing the probability that significant, but unfulfilled, terms of a 
contract will be fulfilled at some point in the future. Accordingly, 
the revenue from such transactions should not be recognized in earnings 
prior to the refund privileges expiring. The amounts received from 
customers or subscribers (i.e., the $35 fee mentioned above) should be 
credited to a monetary liability account such as ``customers' 
refundable fees.''
    The staff believes that if a customer has the unilateral right to 
receive both (1) the seller's substantial performance under an 
arrangement (e.g., providing services or delivering product) and (2) a 
cash refund of prepaid fees, then the prepaid fees should be accounted 
for as a monetary liability. In consideration of whether the monetary 
liability can be derecognized, FASB ASC Topic 860, Transfers and 
Servicing, provides that liabilities may be derecognized only if (1) 
the debtor pays the creditor and is relieved of its obligation for the 
liability (paying the creditor includes delivery of cash, other 
financial assets, goods, or services or reacquisition by the debtor of 
its outstanding debt securities) or (2) the debtor is legally released 
from being the primary obligor under the liability.\49\ If a customer 
has the unilateral right to receive both (1) the seller's substantial 
performance under the arrangement and (2) a cash refund of prepaid 
fees, then the refund obligation is not relieved upon performance of 
the service or delivery of the products. Rather, the seller's refund 
obligation is relieved only upon refunding the cash or expiration of 
the refund privilege.
---------------------------------------------------------------------------

    \49\ FASB ASC paragraph 405-20-40-1 (Liabilities Topic).
---------------------------------------------------------------------------

    Some have argued that there may be a limited exception to the 
general rule that revenue from membership or other service transaction 
fees should not be recognized in earnings prior to the refund 
privileges expiring. Despite the fact that FASB ASC Subtopic 605-15 
expressly does not apply to the accounting for service revenue if part 
or all of the service fee is refundable under cancellation privileges 
granted to the buyer,\50\ they believe that in certain circumstances a 
potential refund of a membership fee may be seen as being similar to a 
right of return of products under FASB ASC Subtopic 605-15. They argue 
that revenue from membership fees, net of estimated refunds, may be 
recognized ratably over the period the services are performed whenever 
pertinent conditions of FASB ASC Subtopic 605-15 are met, namely, there 
is a large population of transactions that grant customers the same 
unilateral termination or cancellation rights and reasonable estimates 
can be made of how many customers likely will exercise those rights.
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    \50\ FASB ASC paragraph 605-15-15-3.

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[[Page 17271]]

    The staff believes that, because service arrangements are 
specifically excluded from the scope of FASB ASC Subtopic 605-15, the 
most direct authoritative literature to be applied to the 
extinguishment of obligations under such contracts is FASB ASC Topic 
860. As noted above, because the refund privilege extends to the end of 
the contract term irrespective of the amount of the service performed, 
FASB ASC Topic 860 indicates that the liability would not be 
extinguished (and therefore no revenue would be recognized in earnings) 
until the cancellation or termination and related refund privileges 
expire. Nonetheless, the staff recognizes that over the years the 
accounting for membership refunds evolved based on analogy to FASB ASC 
Subtopic 605-15 and that practice did not change when FASB ASC Topic 
860 became effective. Reasonable people held, and continue to hold, 
different views about the application of the accounting literature.
    Pending further action in this area by the FASB, the staff will not 
object to the recognition of refundable membership fees, net of 
estimated refunds, as earned revenue over the membership term in the 
limited circumstances where all of the following criteria have been 
met: \51\
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    \51\ The staff will question further analogies to the guidance 
in FASB ASC Subtopic 605-15 for transactions expressly excluded from 
its scope.
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    The estimates of terminations or cancellations and refunded 
revenues are being made for a large pool of homogeneous items (e.g., 
membership or other service transactions with the same characteristics 
such as terms, periods, class of customers, nature of service, etc.).
     Reliable estimates of the expected refunds can be made on 
a timely basis.\52\ Either of the following two items would be 
considered indicative of an inability to make reliable estimates: (1) 
recurring, significant differences between actual experience and 
estimated cancellation or termination rates (e.g., an actual 
cancellation rate of 40% versus an estimated rate of 25%) even if the 
impact of the difference on the amount of estimated refunds is not 
material to the consolidated financial statements \53\ or (2) recurring 
variances between the actual and estimated amount of refunds that are 
material to either revenue or net income in quarterly or annual 
financial statements. In addition, the staff believes that an estimate, 
for purposes of meeting this criterion, would not be reliable unless it 
is remote \54\ that material adjustments (both individually and in the 
aggregate) to previously recognized revenue would be required. The 
staff presumes that reliable estimates cannot be made if the customer's 
termination or cancellation and refund privileges exceed one year.
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    \52\ Reliability is defined in Concepts Statement 2 as ``the 
quality of information that assures that information is reasonably 
free from error and bias and faithfully represents what it purports 
to represent.'' Paragraph 63 of Concepts Statement 5 reiterates the 
definition of reliability, requiring that ``the information is 
representationally faithful, verifiable, and neutral.''
    \53\ For example, if an estimate of the expected cancellation 
rate varies from the actual cancellation rate by 100% but the dollar 
amount of the error is immaterial to the consolidated financial 
statements, some would argue that the estimate could still be viewed 
as reliable. The staff disagrees with that argument.
    \54\ The term ``remote'' is used here with the same definition 
as used in the FASB ASC Master Glossary.
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     There is a sufficient company-specific historical basis 
upon which to estimate the refunds,\55\ and the company believes that 
such historical experience is predictive of future events. In assessing 
these items, the staff believes that estimates of future refunds should 
take into consideration, among other things, such factors as historical 
experience by service type and class of customer, changing trends in 
historical experience and the basis thereof (e.g., economic 
conditions), the impact or introduction of competing services or 
products, and changes in the customer's ``accessibility'' to the refund 
(i.e., how easy it is for customers to obtain the refund).
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    \55\ FASB ASC paragraph 605-15-25-3 notes various factors that 
may impair the ability to make a reasonable estimate of returns, 
including the lack of sufficient historical experience. The staff 
typically expects that the historical experience be based on the 
particular registrant's historical experience for a service and/or 
class of customer. In general, the staff typically expects a start-
up company, a company introducing new services, or a company 
introducing services to a new class of customer to have at least two 
years of experience to be able to make reasonable and reliable 
estimates.
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     The amount of the membership fee specified in the 
agreement at the outset of the arrangement is fixed, other than the 
customer's right to request a refund.
    If Company M does not meet all of the foregoing criteria, the staff 
believes that Company M should not recognize in earnings any revenue 
for the membership fee until the cancellation privileges and refund 
rights expire.
    If revenue is recognized in earnings over the membership period 
pursuant to the above criteria, the initial amounts received from 
customer or subscribers (i.e., the $35 fee mentioned above) should be 
allocated to two liability accounts. The amount of the fee representing 
estimated refunds should be credited to a monetary liability account, 
such as ``customers' refundable fees,'' and the remaining amount of the 
fee representing unearned revenue should be credited to a nonmonetary 
liability account, such as ``unearned revenues.'' For each income 
statement presented, registrants should disclose in the footnotes to 
the financial statements the amounts of (1) the unearned revenue and 
(2) refund obligations as of the beginning of each period, the amount 
of cash received from customers, the amount of revenue recognized in 
earnings, the amount of refunds paid, other adjustments (with an 
explanation thereof), and the ending balance of (1) unearned revenue 
and (2) refund obligations.
    If revenue is recognized in earnings over the membership period 
pursuant to the above criteria, the staff believes that adjustments for 
changes in estimated refunds should be recorded using a retrospective 
approach whereby the unearned revenue and refund obligations are 
remeasured and adjusted at each balance sheet date with the offset 
being recorded as earned revenue.\56\
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    \56\ The staff believes deferred costs being amortized on a 
basis consistent with the deferred revenue should be similarly 
adjusted. Such an approach is generally consistent with the 
amortization methodology in FASB ASC paragraph 310-20-35-26.
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    Companies offering memberships often distribute membership packets 
describing and discussing the terms, conditions, and benefits of 
membership. Packets may include vouchers, for example, that provide new 
members with discounts or other benefits from third parties. The costs 
associated with the vouchers should be expensed when distributed. 
Advertising costs to solicit members should be accounted for in 
accordance with FASB ASC Subtopic 720-35, Other Expenses--Advertising 
Costs. Incremental direct costs incurred in connection with enrolling 
customers (e.g., commissions paid to agents) should be accounted for as 
follows: (1) If revenue is deferred until the cancellation or 
termination privileges expire, incremental direct costs should be 
either (a) charged to expense when incurred if the costs are not 
refundable to the company in the event the customer obtains a refund of 
the membership fee, or (b) if the costs are refundable to the company 
in the event the customer obtains a refund of the membership fee, 
recorded as an asset until the earlier of termination or cancellation 
or refund; or (2) if revenue, net of estimated refunds, is recognized 
in earnings over the membership period, a like percentage of 
incremental direct costs should be deferred and recognized in earnings 
in the same pattern as revenue is recognized, and the

[[Page 17272]]

remaining portion should be either (a) charged to expense when incurred 
if the costs are not refundable to the company in the event the 
customer obtains a refund of the membership fee, or (b) if the costs 
are refundable to the company in the event the customer obtains a 
refund of the membership fee, recorded as an asset until the refund 
occurs.\57\ All costs other than incremental direct costs (e.g., 
indirect costs) should be expensed as incurred.
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    \57\ FASB ASC paragraphs 310-20-25-2 and 605-20-25-4 both 
provide for the deferral of incremental direct costs associated with 
acquiring a revenue-producing contract. Even though the revenue 
discussed in this example is refundable, if a registrant meets the 
aforementioned criteria for revenue recognition over the membership 
period, the staff would analogize to this guidance. However, if 
neither a nonrefundable contract nor a reliable basis for estimating 
net cash inflows under refundable contracts exists to provide a 
basis for recovery of incremental direct costs, the staff believes 
that such costs should be expensed as incurred. See SAB Topic 
13.A.3.f. Question 3.
---------------------------------------------------------------------------

Question 2

    Question: Will the staff accept an analogy to FASB ASC Subtopic 
605-15 for service transactions subject to customer cancellation 
privileges other than those specifically addressed in the previous 
question?
    Interpretive Response: The staff has accepted the analogy in 
limited circumstances due to the existence of a large pool of 
homogeneous transactions and satisfaction of the criteria in the 
previous question. Examples of other arrangements involving customer 
cancellation privileges and refundable service fees that the staff has 
addressed include the following:
     A leasing broker whose commission from the lessor upon a 
commercial tenant's signing of a lease agreement is refundable (or in 
some cases, is not due) under lessor cancellation privileges if the 
tenant fails to move into the leased premises by a specified date.
     A talent agent whose fee receivable from its principal 
(i.e., a celebrity) for arranging a celebrity endorsement for a five-
year term is cancelable by the celebrity if the celebrity breaches the 
endorsement contract with its customer.
     An insurance agent whose commission received from the 
insurer upon selling an insurance policy is refundable in whole for the 
30-day period that state law permits the consumer to repudiate the 
contract and then refundable on a declining pro rata basis until the 
consumer has made six monthly payments.
    In the first two of these cases, the staff advised the registrants 
that the portion of revenue subject to customer cancellation and refund 
must be deferred until no longer subject to that contingency because 
the registrants did not have an ability to make reliable estimates of 
customer cancellations due to the lack of a large pool of homogeneous 
transactions. In the case of the insurance agent, however, the 
particular registrant demonstrated that it had a sufficient history of 
homogeneous transactions with the same characteristics from which to 
reliably estimate contract cancellations and satisfy all the criteria 
specified in the previous question. Accordingly, the staff did not 
object to that registrant's policy of recognizing its sales commission 
as revenue when its performance was complete, with an appropriate 
allowance for estimated cancellations.

Question 3

    Question: Must a registrant analogize to FASB ASC Subtopic 605-15, 
or may it choose to defer all revenue until the refund period lapses as 
suggested by FASB ASC Topic 860 even if the criteria above for analogy 
to FASB ASC Subtopic 605-15 are met?
    Interpretive Response: The analogy to FASB ASC Subtopic 605-15 is 
presented as an alternative that would be acceptable to the staff when 
the listed conditions are met. However, a registrant may choose to 
defer all revenue until the refund period lapses. The policy chosen 
should be disclosed and applied consistently.

Question 4

    Question: May a registrant that meets the above criteria for 
reliable estimates of cancellations choose at some point in the future 
to change from the FASB ASC Subtopic 605-15 method to the FASB ASC 
Topic 860 method of accounting for these refundable fees? May a 
registrant change from the FASB ASC Topic 860 method to the FASB ASC 
Subtopic 605-15 method?
    Interpretive Response: The staff believes that FASB ASC Topic 860 
provides a preferable accounting model for service transactions subject 
to potential refunds. Therefore, the staff would not object to a change 
from the FASB ASC Subtopic 605-15 method to the FASB ASC Topic 860 
method. However, if a registrant had previously chosen the FASB ASC 
Topic 860 method, the staff would object to a change to the FASB ASC 
Subtopic 605-15 method.

Question 5

    Question: Is there a minimum level of customers that must be 
projected not to cancel before use of FASB ASC Subtopic 605-15 type 
accounting is appropriate?
    Interpretive Response: FASB ASC Subtopic 605-15 does not include 
any such minimum. Therefore, the staff does not believe that a minimum 
must apply in service transactions either. However, as the refund rate 
increases, it may be increasingly difficult to make reasonable and 
reliable estimates of cancellation rates.

Question 6

    Question: When a registrant first determines that reliable 
estimates of cancellations of service contracts can be made (e.g., two 
years of historical evidence becomes available), how should the change 
from the complete deferral method to the method of recognizing revenue, 
net of estimated cancellations, over time be reflected?
    Interpretive Response: Changes in the ability to meet the criteria 
set forth above should be accounted for in the manner described in FASB 
ASC paragraph 605-15-25-1, which addresses the accounting when a 
company experiences a change in the ability to make reasonable 
estimates of future product returns.
b. Estimates and Changes in Estimates
    Accounting for revenues and costs of revenues requires estimates in 
many cases; those estimates sometimes change. Registrants should ensure 
that they have appropriate internal controls and adequate books and 
records that will result in timely identification of necessary changes 
in estimates that should be reflected in the financial statements and 
notes thereto.

Question 1

    Facts: FASB ASC paragraph 605-15-25-3 lists a number of factors 
that may impair the ability to make a reasonable estimate of product 
returns in sales transactions when a right of return exists.\58\ The 
paragraph concludes by stating ``other factors may preclude a 
reasonable estimate.''
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    \58\ These factors include ``(a) the susceptibility of the 
product to significant external factors, such as technological 
obsolescence or changes in demand, (b) relatively long periods in 
which a particular product may be returned, (c) absence of 
historical experience with similar types of sales of similar 
products, or inability to apply such experience because of changing 
circumstances, for example, changes in the selling enterprise's 
marketing policies and relationships with its customers, and (d) 
absence of a large volume of relatively homogeneous transactions.''
---------------------------------------------------------------------------

    Question: What ``other factors,'' in addition to those listed in 
FASB ASC paragraph 605-15-25-3, has the staff identified that may 
preclude a registrant from making a reasonable and reliable estimate of 
product returns?
    Interpretive Response: The staff believes that the following 
additional

[[Page 17273]]

factors, among others, may affect or preclude the ability to make 
reasonable and reliable estimates of product returns: (1) Significant 
increases in or excess levels of inventory in a distribution channel 
(sometimes referred to as ``channel stuffing''), (2) lack of 
``visibility'' into or the inability to determine or observe the levels 
of inventory in a distribution channel and the current level of sales 
to end users, (3) expected introductions of new products that may 
result in the technological obsolescence of and larger than expected 
returns of current products, (4) the significance of a particular 
distributor to the registrant's (or a reporting segment's) business, 
sales and marketing, (5) the newness of a product, (6) the introduction 
of competitors' products with superior technology or greater expected 
market acceptance, and (7) other factors that affect market demand and 
changing trends in that demand for the registrant's products. 
Registrants and their auditors should carefully analyze all factors, 
including trends in historical data, which may affect registrants' 
ability to make reasonable and reliable estimates of product returns.
    The staff reminds registrants that if a transaction fails to meet 
all of the conditions of FASB ASC paragraphs 605-15-25-1 and 605-15-25-
3, no revenue may be recognized until those conditions are subsequently 
met or the return privilege has substantially expired, whichever occurs 
first.\59\ Simply deferring recognition of the gross margin on the 
transaction is not appropriate.
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    \59\ FASB ASC paragraph 605-15-25-1.
---------------------------------------------------------------------------

Question 2

    Question: Is the requirement cited in the previous question for 
``reliable'' estimates meant to imply a new, higher requirement than 
the ``reasonable'' estimates discussed in FASB ASC Subtopic 605-15?
    Interpretive Response: No. ``Reliability'' of financial information 
is one of the qualities of accounting information discussed in Concepts 
Statement 2, Qualitative Characteristics of Accounting Information. The 
staff's expectation that estimates be reliable does not change the 
existing requirement of FASB ASC Subtopic 605-15. If management cannot 
develop an estimate that is sufficiently reliable for use by investors, 
the staff believes it cannot make a reasonable estimate meeting the 
requirements of that standard.

Question 3

    Question: Does the staff expect registrants to apply the guidance 
in Question 1 of Topic 13.A.4(a) above to sales of tangible goods and 
other transactions specifically within the scope of FASB ASC Subtopic 
605-15?
    Interpretive Response: The specific guidance above does not apply 
to transactions within the scope of FASB ASC Subtopic 605-15. The views 
set forth in Question 1 of Topic 13.A.4(a) are applicable to the 
service transactions discussed in that Question. Service transactions 
are explicitly outside the scope of FASB ASC Subtopic 605-15.

Question 4

    Question: Question 1 of Topic 13.A.4(a) above states that the staff 
would expect a two-year history of selling a new service in order to be 
able to make reliable estimates of cancellations. How long a history 
does the staff believe is necessary to estimate returns in a product 
sale transaction that is within the scope of FASB ASC Subtopic 605-15?
    Interpretive Response: The staff does not believe there is any 
specific length of time necessary in a product transaction. However, 
FASB ASC Subtopic 605-15 states that returns must be subject to 
reasonable estimation. Preparers and auditors should be skeptical of 
estimates of product returns when little history with a particular 
product line exists, when there is inadequate verifiable evidence of 
historical experience, or when there are inadequate internal controls 
that ensure the reliability and timeliness of the reporting of the 
appropriate historical information. Start-up companies and companies 
selling new or significantly modified products are frequently unable to 
develop the requisite historical data on which to base estimates of 
returns.

Question 5

    Question: If a company selling products subject to a right of 
return concludes that it cannot reasonably estimate the actual return 
rate due to its limited history, but it can conservatively estimate the 
maximum possible returns, does the staff believe that the company may 
recognize revenue for the portion of the sales that exceeds the maximum 
estimated return rate?
    Interpretive Response: No. If a reasonable estimate of future 
returns cannot be made, FASB ASC Subtopic 605-15 requires that revenue 
not be recognized until the return period lapses or a reasonable 
estimate can be made.\60\ Deferring revenue recognition based on the 
upper end of a wide range of potential return rates is inconsistent 
with the provisions of FASB ASC Subtopic 605-15.
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    \60\ FASB ASC subparagraph 605-15-25-1(f).
---------------------------------------------------------------------------

c. Contingent Rental Income
    Facts: Company A owns and leases retail space to retailers. Company 
A (lessor) renews a lease with a customer (lessee) that is classified 
as an operating lease. The lease term is one year and provides that the 
lease payments are $1.2 million, payable in equal monthly installments 
on the first day of each month, plus one percent of the lessee's net 
sales in excess of $25 million if the net sales exceed $25 million 
during the lease term (i.e., contingent rental). The lessee has 
historically experienced annual net sales in excess of $25 million in 
the particular space being leased, and it is probable that the lessee 
will generate in excess of $25 million net sales during the term of the 
lease.
    Question: In the staff's view, should the lessor recognize any 
rental income attributable to the one percent of the lessee's net sales 
exceeding $25 million before the lessee actually achieves the $25 
million net sales threshold?
    Interpretive Response: No. The staff believes that contingent 
rental income ``accrues'' (i.e., it should be recognized as revenue) 
when the changes in the factor(s) on which the contingent lease 
payments is (are) based actually occur.\61\
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    \61\ Lessees should follow the guidance established in FASB ASC 
Subtopic 840-10.
---------------------------------------------------------------------------

    FASB ASC paragraph 840-20-25-1 states that ``[r]ent shall be 
charged to expense by lessees (reported as income by lessors) over the 
lease term as it becomes payable (receivable). If rental payments are 
not made on a straight-line basis, rental expense nevertheless shall be 
recognized on a straight-line basis unless another systematic and 
rational basis is more representative of the time pattern in which use 
benefit is derived from the leased property, in which case that basis 
shall be used.''
    FASB ASC paragraph 840-10-25-4 clarifies that ``lease payments that 
depend on a factor that does not exist or is not measurable at the 
inception of the lease, such as future sales volume, would be 
contingent rentals in their entirety and, accordingly, would be 
excluded from minimum lease payments and included in the determination 
of income as they accrue.'' FASB ASC paragraph 840-10-55-38 provides 
the following example of determining contingent rentals:

Assume that a lease agreement for retail store space stipulates a 
monthly base rental of

[[Page 17274]]

$200 and a monthly supplemental rental of one-fourth of one percent 
of monthly sales volume during the lease term. Even if the lease 
agreement is a renewal for store space that had averaged monthly 
sales of $25,000 for the past 2 years, minimum lease payments would 
include only the $200 monthly base rental; the supplemental rental 
is a contingent rental that is excluded from minimum lease payments. 
The future sales for the lease term do not exist at the inception of 
the lease, and future rentals would be limited to $200 per month if 
the store were subsequently closed and no sales were made 
thereafter.

    FASB ASC Section 840-20-25 addresses whether it is appropriate for 
lessors in operating leases to recognize scheduled rent increases on a 
basis other than as required in FASB ASC paragraph 840-20-25-1. FASB 
ASC subparagraph 840-20-25-2(a) states ``using factors such as the time 
value of money, anticipated inflation, or expected future revenues 
[emphasis added] to allocate scheduled rent increases is inappropriate 
because these factors do not relate to the time pattern of the physical 
usage of the leased property. However, such factors may affect the 
periodic reported rental income or expense if the lease agreement 
involves contingent rentals, which are excluded from minimum lease 
payments and accounted for separately.'' In developing the basis for 
why scheduled rent increases should be recognized on a straight-line 
basis, the FASB distinguishes the accounting for scheduled rent 
increases from contingent rentals. FASB ASC subparagraph 840-20-25-2(b) 
states ``[i]f the lessee and lessor eliminate the risk of variable 
payments inherent in contingent rentals by agreeing to scheduled rent 
increases, the accounting shall reflect those different 
circumstances.''
    The example provided in FASB ASC paragraph 840-10-55-39 implies 
that contingent rental income in leases classified as sales-type or 
direct-financing leases becomes ``accruable'' when the changes in the 
factors on which the contingent lease payments are based actually 
occur. FASB ASC paragraph 840-20-25-2 indicates that contingent rental 
income in operating leases should not be recognized in a manner 
consistent with scheduled rent increases (i.e., on a straight-line 
basis over the lease term or another systematic and rational allocation 
basis if it is more representative of the time pattern in which the 
leased property is physically employed) because the risk of variable 
payments inherent in contingent rentals is substantively different than 
scheduled rent increases. The staff believes that the reasoning in FASB 
ASC Section 840-20-25 supports the conclusion that the risks inherent 
in variable payments associated with contingent rentals should be 
reflected in financial statements on a basis different than rental 
payments that adjust on a scheduled basis and, therefore, operating 
lease income associated with contingent rents would not be recognized 
as time passes or as the leased property is physically employed. 
Furthermore, prior to the lessee's achievement of the target upon which 
contingent rentals are based, the lessor has no legal claims on the 
contingent amounts. Consequently, the staff believes that it is 
inappropriate to anticipate changes in the factors on which contingent 
rental income in operating leases is based and recognize rental income 
prior to the resolution of the lease contingencies.
    Because Company A's contingent rental income is based upon whether 
the customer achieves net sales of $25 million, the contingent rentals, 
which may not materialize, should not be recognized until the 
customer's net sales actually exceed $25 million. Once the $25 million 
threshold is met, Company A would recognize the contingent rental 
income as it becomes accruable, in this case, as the customer 
recognizes net sales. The staff does not believe that it is appropriate 
to recognize revenue based upon the probability of a factor being 
achieved. The contingent revenue should be recorded in the period in 
which the contingency is resolved.
d. Claims Processing and Billing Services
    Facts: Company M performs claims processing and medical billing 
services for healthcare providers. In this role, Company M is 
responsible for preparing and submitting claims to third-party payers, 
tracking outstanding billings, and collecting amounts billed. Company 
M's fee is a fixed percentage (e.g., five percent) of the amount 
collected. If no collections are made, no fee is due to Company M. 
Company M has historical evidence indicating that the third-party 
payers pay 85 percent of the billings submitted with no further effort 
by Company M. Company M has determined that the services performed 
under the arrangement are a single unit of accounting.
    Question: May Company M recognize as revenue its five percent fee 
on 85 percent of the gross billings at the time it prepares and submits 
billings, or should it wait until collections occur to recognize any 
revenue?
    Interpretive Response: The staff believes that Company M must wait 
until collections occur before recognizing revenue. Before the third-
party payer has remitted payment to Company M's customers for the 
services billed, Company M is not entitled to any revenue. That is, its 
revenue is not yet realized or realizable.\62\ Until Company M's 
customers collect on the billings, Company M has not performed the 
requisite activity under its contract to be entitled to a fee.\63\ 
Further, no amount of the fee is fixed or determinable or collectible 
until Company M's customers collect on the billings.
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    \62\ Concepts Statement 5, paragraph 83(a).
    \63\ Concepts Statement 5, paragraph 83(b).
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B. Disclosures

    Question: What disclosures are required with respect to the 
recognition of revenue?
    Interpretive Response: A registrant should disclose its accounting 
policy for the recognition of revenue pursuant to FASB ASC Topic 235, 
Notes to Financial Statements. FASB ASC paragraph 235-10-50-3 thereof 
states that ``the disclosure should encompass important judgments as to 
appropriateness of principles relating to recognition of revenue * * * 
.'' Because revenue recognition generally involves some level of 
judgment, the staff believes that a registrant should always disclose 
its revenue recognition policy. If a company has different policies for 
different types of revenue transactions, including barter sales, the 
policy for each material type of transaction should be disclosed. If 
sales transactions have multiple units of accounting, such as a product 
and service, the accounting policy should clearly state the accounting 
policy for each unit of accounting as well as how units of accounting 
are determined and valued. In addition, the staff believes that changes 
in estimated returns recognized in accordance with FASB ASC Subtopic 
605-15 should be disclosed, if material (e.g., a change in estimate 
from two percent of sales to one percent of sales).
    Regulation S-X requires that revenue from the sales of products, 
services, and other products each be separately disclosed on the face 
of the income statement.\64\ The staff believes that costs relating to 
each type of revenue similarly should be reported separately on the 
face of the income statement.
---------------------------------------------------------------------------

    \64\ See Regulation S-X, Article 5-03(1) and (2).
---------------------------------------------------------------------------

    MD&A requires a discussion of liquidity, capital resources, results 
of operations and other information necessary to an understanding of a 
registrant's financial condition, changes in financial condition and 
results of operations.\65\ This includes unusual or

[[Page 17275]]

infrequent transactions, known trends or uncertainties that have had, 
or might reasonably be expected to have, a favorable or unfavorable 
material effect on revenue, operating income or net income and the 
relationship between revenue and the costs of the revenue. Changes in 
revenue should not be evaluated solely in terms of volume and price 
changes, but should also include an analysis of the reasons and factors 
contributing to the increase or decrease. The Commission stated in FRR 
36 that MD&A should ``give investors an opportunity to look at the 
registrant through the eyes of management by providing a historical and 
prospective analysis of the registrant's financial condition and 
results of operations, with a particular emphasis on the registrant's 
prospects for the future.'' \66\ Examples of such revenue transactions 
or events that the staff has asked to be disclosed and discussed in 
accordance with FRR 36 are:
---------------------------------------------------------------------------

    \65\ See Regulation S-K, Item 303 and FRR 36.
    \66\ FRR 36; See also In the Matter of Caterpillar Inc., AAER 
363 (March 31, 1992).
---------------------------------------------------------------------------

     Shipments of product at the end of a reporting period that 
significantly reduce customer backlog and that reasonably might be 
expected to result in lower shipments and revenue in the next period.
     Granting of extended payment terms that will result in a 
longer collection period for accounts receivable (regardless of whether 
revenue has been recognized) and slower cash inflows from operations, 
and the effect on liquidity and capital resources. (The fair value of 
trade receivables should be disclosed in the footnotes to the financial 
statements when the fair value does not approximate the carrying 
amount.)\67\
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    \67\ FASB ASC Subtopic 825-10, Financial Instruments--Overall.
---------------------------------------------------------------------------

     Changing trends in shipments into, and sales from, a sales 
channel or separate class of customer that could be expected to have a 
significant effect on future sales or sales returns.
     An increasing trend toward sales to a different class of 
customer, such as a reseller distribution channel that has a lower 
gross profit margin than existing sales that are principally made to 
end users. Also, increasing service revenue that has a higher profit 
margin than product sales.
     Seasonal trends or variations in sales.
     A gain or loss from the sale of an asset(s).\68\
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    \68\ Gains or losses from the sale of assets should be reported 
as ``other general expenses'' pursuant to Regulation S-X, Article 5-
03(6). Any material item should be stated separately.
---------------------------------------------------------------------------

TOPIC 14: SHARE-BASED PAYMENT

    The interpretations in this SAB express views of the staff 
regarding the interaction between FASB ASC Topic 718, Compensation--
Stock Compensation, and certain SEC rules and regulations and provide 
the staff's views regarding the valuation of share-based payment 
arrangements for public companies. FASB ASC Topic 718 is based on the 
underlying accounting principle that compensation cost resulting from 
share-based payment transactions be recognized in financial statements 
at fair value.\1\ Recognition of compensation cost at fair value will 
provide investors and other users of financial statements with more 
complete and comparable financial information.\2\
---------------------------------------------------------------------------

    \1\ FASB ASC paragraphs 718-10-30-2 through 718-10-30-4.
    \2\ [Original footnote removed by SAB 114.]
---------------------------------------------------------------------------

    FASB ASC Topic 718 addresses a wide range of share-based 
compensation arrangements including share options, restricted share 
plans, performance-based awards, share appreciation rights, and 
employee share purchase plans.
    FASB ASC Topic 718 replaces guidance as originally issued in 1995, 
that established as preferable, but did not require, a fair-value-based 
method of accounting for share-based payment transactions with 
employees.
    The staff believes the guidance in this SAB will assist issuers in 
their initial implementation of FASB ASC Topic 718 and enhance the 
information received by investors and other users of financial 
statements, thereby assisting them in making investment and other 
decisions. This SAB includes interpretive guidance related to share-
based payment transactions with nonemployees, the transition from 
nonpublic to public entity \3\ status, valuation methods (including 
assumptions such as expected volatility and expected term), the 
accounting for certain redeemable financial instruments issued under 
share-based payment arrangements, the classification of compensation 
expense, non-GAAP financial measures, first-time adoption of FASB ASC 
Topic 718 in an interim period, capitalization of compensation cost 
related to share-based payment arrangements, the accounting for income 
tax effects of share-based payment arrangements upon adoption of FASB 
ASC Topic 718, the modification of employee share options prior to 
adoption of FASB ASC Topic 718 and disclosures in MD&A subsequent to 
adoption of FASB ASC Topic 718.
---------------------------------------------------------------------------

    \3\ Defined in the FASB ASC Master Glossary.
---------------------------------------------------------------------------

    The staff recognizes that there is a range of conduct that a 
reasonable issuer might use to make estimates and valuations and 
otherwise implement FASB ASC Topic 718, and the interpretive guidance 
provided by this SAB, particularly during the period of the Topic's 
initial implementation. Thus, throughout this SAB the use of the terms 
``reasonable'' and ``reasonably'' is not meant to imply a single 
conclusion or methodology, but to encompass the full range of potential 
conduct, conclusions or methodologies upon which an issuer may 
reasonably base its valuation decisions. Different conduct, conclusions 
or methodologies by different issuers in a given situation does not of 
itself raise an inference that any of those issuers is acting 
unreasonably. While the zone of reasonable conduct is not unlimited, 
the staff expects that it will be rare when there is only one 
acceptable choice in estimating the fair value of share-based payment 
arrangements under the provisions of FASB ASC Topic 718 and the 
interpretive guidance provided by this SAB in any given situation. In 
addition, as discussed in the Interpretive Response to Question 1 of 
Section C, Valuation Methods, estimates of fair value are not intended 
to predict actual future events, and subsequent events are not 
indicative of the reasonableness of the original estimates of fair 
value made under FASB ASC Topic 718. Over time, as issuers and 
accountants gain more experience in applying FASB ASC Topic 718 and the 
guidance provided in this SAB, the staff anticipates that particular 
approaches may begin to emerge as best practices and that the range of 
reasonable conduct, conclusions and methodologies will likely narrow.
* * * * *

A. Share-Based Payment Transactions with Nonemployees

    Question: Are share-based payment transactions with nonemployees 
included in the scope of FASB ASC Topic 718?
    Interpretive Response: Only certain aspects of the accounting for 
share-based payment transactions with nonemployees are explicitly 
addressed by FASB ASC Topic 718. This Topic explicitly:
     Establishes fair value as the measurement objective in 
accounting for all share-based payments; \4\ and
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    \4\ FASB ASC paragraph 718-10-30-2.
---------------------------------------------------------------------------

     Requires that an entity record the value of a transaction 
with a

[[Page 17276]]

nonemployee based on the more reliably measurable fair value of either 
the good or service received or the equity instrument issued.\5\
---------------------------------------------------------------------------

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

    FASB ASC Topic 718 does not supersede any of the authoritative 
literature that specifically addresses accounting for share-based 
payments with nonemployees. For example, FASB ASC Topic 718 does not 
specify the measurement date for share-based payment transactions with 
nonemployees when the measurement of the transaction is based on the 
fair value of the equity instruments issued.\6\ For determining the 
measurement date of equity instruments issued in share-based 
transactions with nonemployees, a company should refer to FASB ASC 
Subtopic 505-50, Equity--Equity Based Payments to Non-Employees.
---------------------------------------------------------------------------

    \6\ [Original footnote removed by SAB 114.]
---------------------------------------------------------------------------

    With respect to questions regarding nonemployee arrangements that 
are not specifically addressed in other authoritative literature, the 
staff believes that the application of guidance in FASB ASC Topic 718 
would generally result in relevant and reliable financial statement 
information. As such, the staff believes it would generally be 
appropriate for entities to apply the guidance in FASB ASC Topic 718 by 
analogy to share-based payment transactions with nonemployees unless 
other authoritative accounting literature more clearly addresses the 
appropriate accounting, or the application of the guidance in FASB ASC 
Topic 718 would be inconsistent with the terms of the instrument issued 
to a nonemployee in a share-based payment arrangement.\7\ For example, 
the staff believes the guidance in FASB ASC Topic 718 on certain 
transactions with related parties or other holders of an economic 
interest in the entity would generally be applicable to share-based 
payment transactions with nonemployees. The staff encourages 
registrants that have additional questions related to accounting for 
share-based payment transactions with nonemployees to discuss those 
questions with the staff.
---------------------------------------------------------------------------

    \7\ For example, due to the nature of specific terms in employee 
share options, including nontransferability, nonhedgability and the 
truncation of the contractual term due to post-vesting service 
termination, FASB ASC Topic 718 requires that when valuing an 
employee share option under the Black-Scholes-Merton framework, the 
fair value of an employee share option be based on the option's 
expected term rather than the contractual term. If these features 
(i.e., nontransferability, nonhedgability and the truncation of the 
contractual term) were not present in a nonemployee share option 
arrangement, the use of an expected term assumption shorter than the 
contractual term would generally not be appropriate in estimating 
the fair value of the nonemployee share options.
---------------------------------------------------------------------------

B. Transition From Nonpublic to Public Entity Status

    Facts: Company A is a nonpublic entity \8\ that first files a 
registration statement with the SEC to register its equity securities 
for sale in a public market on January 2, 20X8.\9\ As a nonpublic 
entity, Company A had been assigning value to its share options \10\ 
under the calculated value method prescribed by FASB ASC Topic 718, 
Compensation--Stock Compensation,\11\ and had elected to measure its 
liability awards based on intrinsic value. Company A is considered a 
public entity on January 2, 20X8 when it makes its initial filing with 
the SEC in preparation for the sale of its shares in a public market.
---------------------------------------------------------------------------

    \8\ Defined in the FASB ASC Master Glossary.
    \9\ For the purposes of these illustrations, assume all of 
Company A's equity-based awards granted to its employees were 
granted after the adoption of FASB ASC Topic 718.
    \10\ For purposes of this staff accounting bulletin, the phrase 
``share options'' is used to refer to ``share options or similar 
instruments.''
    \11\ FASB ASC paragraph 718-10-30-20 requires a nonpublic entity 
to use the calculated value method when it is not able to reasonably 
estimate the fair value of its equity share options and similar 
instruments because it is not practicable for it to estimate the 
expected volatility of its share price. FASB ASC paragraph 718-10-
55-51 indicates that a nonpublic entity may be able to identify 
similar public entities for which share or option price information 
is available and may consider the historical, expected, or implied 
volatility of those entities' share prices in estimating expected 
volatility. The staff would expect an entity that becomes a public 
entity and had previously measured its share options under the 
calculated value method to be able to support its previous decision 
to use calculated value and to provide the disclosures required by 
FASB ASC subparagraph 718-10-50-2(f)(2)(ii).
---------------------------------------------------------------------------

    Question 1: How should Company A account for the share options that 
were granted to its employees prior to January 2, 20X8 for which the 
requisite service has not been rendered by January 2, 20X8?
    Interpretive Response: Prior to becoming a public entity, Company A 
had been assigning value to its share options under the calculated 
value method. The staff believes that Company A should continue to 
follow that approach for those share options that were granted prior to 
January 2, 20X8, unless those share options are subsequently modified, 
repurchased or cancelled.\12\ If the share options are subsequently 
modified, repurchased or cancelled, Company A would assess the event 
under the public company provisions of FASB ASC Topic 718. For example, 
if Company A modified the share options on February 1, 20X8, any 
incremental compensation cost would be measured under FASB ASC 
subparagraph 718-20-35-3(a), as the fair value of the modified share 
options over the fair value of the original share options measured 
immediately before the terms were modified.\13\
---------------------------------------------------------------------------

    \12\ This view is consistent with the FASB's basis for rejecting 
full retrospective application of FASB ASC Topic 718 as described in 
the basis for conclusions of Statement 123R, paragraph B251.
    \13\ FASB ASC paragraph 718-20-55-94. The staff believes that 
because Company A is a public entity as of the date of the 
modification, it would be inappropriate to use the calculated value 
method to measure the original share options immediately before the 
terms were modified.
---------------------------------------------------------------------------

    Question 2: How should Company A account for its liability awards 
granted to its employees prior to January 2, 20X8 which are fully 
vested but have not been settled by January 2, 20X8?
    Interpretive Response: As a nonpublic entity, Company A had elected 
to measure its liability awards subject to FASB ASC Topic 718 at 
intrinsic value.\14\ When Company A becomes a public entity, it should 
measure the liability awards at their fair value determined in 
accordance with FASB ASC Topic 718.\15\ In that reporting period there 
will be an incremental amount of measured cost for the difference 
between fair value as determined under FASB ASC Topic 718 and intrinsic 
value. For example, assume the intrinsic value in the period ended 
December 31, 20X7 was $10 per award. At the end of the first reporting 
period ending after January 2, 20X8 (when Company A becomes a public 
entity), assume the intrinsic value of the award is $12 and the fair 
value as determined in accordance with FASB ASC Topic 718 is $15. The 
measured cost in the first reporting period after December 31, 20X7 
would be $5.\16\
---------------------------------------------------------------------------

    \14\ FASB ASC paragraph 718-30-30-2.
    \15\ FASB ASC paragraph 718-30-35-3.
    \16\ $15 fair value less $10 intrinsic value equals $5 of 
incremental cost.
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    Question 3: After becoming a public entity, may Company A 
retrospectively apply the fair-value-based method to its awards that 
were granted prior to the date Company A became a public entity?
    Interpretive Response: No. Before becoming a public entity, Company 
A did not use the fair-value-based method for either its share options 
or its liability awards granted to the Company's employees. The staff 
does not believe it is appropriate for Company A to apply the fair-
value-based method on a retrospective basis, because it would require 
the entity to make estimates of a prior period, which, due to 
hindsight, may vary significantly from estimates

[[Page 17277]]

that would have been made contemporaneously in prior periods.\17\
---------------------------------------------------------------------------

    \17\ This view is consistent with the FASB's basis for rejecting 
full retrospective application of FASB ASC Topic 718 as described in 
the basis for conclusions of Statement 123R, paragraph B251.
---------------------------------------------------------------------------

    Question 4: Upon becoming a public entity, what disclosures should 
Company A consider in addition to those prescribed by FASB ASC Topic 
718? \18\
---------------------------------------------------------------------------

    \18\ FASB ASC Section 718-10-50.
---------------------------------------------------------------------------

    Interpretive Response: In the registration statement filed on 
January 2, 20X8, Company A should clearly describe in MD&A the change 
in accounting policy that will be required by FASB ASC Topic 718 in 
subsequent periods and the reasonably likely material future 
effects.\19\ In subsequent filings, Company A should provide financial 
statement disclosure of the effects of the changes in accounting 
policy. In addition, Company A should consider the applicability of SEC 
Release No. FR-60 \20\ and Section V, ``Critical Accounting 
Estimates,'' in SEC Release No. FR-72 \21\ regarding critical 
accounting policies and estimates in MD&A.
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    \19\ See generally SEC Release No. FR-72, ``Commission Guidance 
Regarding Management's Discussion and Analysis of Financial 
Condition and Results of Operations.''
    \20\ SEC Release No. FR-60, ``Cautionary Advice Regarding 
Disclosure About Critical Accounting Policies.''
    \21\ SEC Release No. FR-72, ``Commission Guidance Regarding 
Management's Discussion and Analysis of Financial Condition and 
Results of Operations.''
---------------------------------------------------------------------------

C. Valuation Methods

    FASB ASC paragraph 718-10-30-6 (Compensation--Stock Compensation 
Topic) indicates that the measurement objective for equity instruments 
awarded to employees is to estimate at the grant date the fair value of 
the equity instruments the entity is obligated to issue when employees 
have rendered the requisite service and satisfied any other conditions 
necessary to earn the right to benefit from the instruments. The Topic 
also states that observable market prices of identical or similar 
equity or liability instruments in active markets are the best evidence 
of fair value and, if available, should be used as the basis for the 
measurement for equity and liability instruments awarded in a share-
based payment transaction with employees.\22\ However, if observable 
market prices of identical or similar equity or liability instruments 
are not available, the fair value shall be estimated by using a 
valuation technique or model that complies with the measurement 
objective, as described in FASB ASC Topic 718.\23\
---------------------------------------------------------------------------

    \22\ FASB ASC paragraph 718-10-55-10.
    \23\ FASB ASC paragraph 718-10-55-11.
---------------------------------------------------------------------------

    Question 1: If a valuation technique or model is used to estimate 
fair value, to what extent will the staff consider a company's 
estimates of fair value to be materially misleading because the 
estimates of fair value do not correspond to the value ultimately 
realized by the employees who received the share options?
    Interpretive Response: The staff understands that estimates of fair 
value of employee share options, while derived from expected value 
calculations, cannot predict actual future events.\24\ The estimate of 
fair value represents the measurement of the cost of the employee 
services to the company. The estimate of fair value should reflect the 
assumptions marketplace participants would use in determining how much 
to pay for an instrument on the date of the measurement (generally the 
grant date for equity awards). For example, valuation techniques used 
in estimating the fair value of employee share options may consider 
information about a large number of possible share price paths, while, 
of course, only one share price path will ultimately emerge. If a 
company makes a good faith fair value estimate in accordance with the 
provisions of FASB ASC Topic 718 in a way that is designed to take into 
account the assumptions that underlie the instrument's value that 
marketplace participants would reasonably make, then subsequent future 
events that affect the instrument's value do not provide meaningful 
information about the quality of the original fair value estimate. As 
long as the share options were originally so measured, changes in an 
employee share option's value, no matter how significant, subsequent to 
its grant date do not call into question the reasonableness of the 
grant date fair value estimate.
---------------------------------------------------------------------------

    \24\ FASB ASC paragraph 718-10-55-15 states ``The fair value of 
those instruments at a single point in time is not a forecast of 
what the estimated fair value of those instruments may be in the 
future.''
---------------------------------------------------------------------------

    Question 2: In order to meet the fair value measurement objective 
in FASB ASC Topic 718, are certain valuation techniques preferred over 
others?
    Interpretive Response: FASB ASC paragraph 718-10-55-17 clarifies 
that the Topic does not specify a preference for a particular valuation 
technique or model. As stated in FASB ASC paragraph 718-10-55-11 in 
order to meet the fair value measurement objective, a company should 
select a valuation technique or model that (a) is applied in a manner 
consistent with the fair value measurement objective and other 
requirements of FASB ASC Topic 718, (b) is based on established 
principles of financial economic theory and generally applied in that 
field and (c) reflects all substantive characteristics of the 
instrument.
    The chosen valuation technique or model must meet all three of the 
requirements stated above. In valuing a particular instrument, certain 
techniques or models may meet the first and second criteria but may not 
meet the third criterion because the techniques or models are not 
designed to reflect certain characteristics contained in the 
instrument. For example, for a share option in which the exercisability 
is conditional on a specified increase in the price of the underlying 
shares, the Black-Scholes-Merton closed-form model would not generally 
be an appropriate valuation model because, while it meets both the 
first and second criteria, it is not designed to take into account that 
type of market condition.\25\
---------------------------------------------------------------------------

    \25\ See FASB ASC paragraphs 718-10-55-16 and 718-10-55-20.
---------------------------------------------------------------------------

    Further, the staff understands that a company may consider multiple 
techniques or models that meet the fair value measurement objective 
before making its selection as to the appropriate technique or model. 
The staff would not object to a company's choice of a technique or 
model as long as the technique or model meets the fair value 
measurement objective. For example, a company is not required to use a 
lattice model simply because that model was the most complex of the 
models the company considered.
    Question 3: In subsequent periods, may a company change the 
valuation technique or model chosen to value instruments with similar 
characteristics? \26\
---------------------------------------------------------------------------

    \26\ FASB ASC paragraph 718-10-55-17 indicates that an entity 
may use different valuation techniques or models for instruments 
with different characteristics.
---------------------------------------------------------------------------

    Interpretive Response: As long as the new technique or model meets 
the fair value measurement objective as described in Question 2 above, 
the staff would not object to a company changing its valuation 
technique or model.\27\ A change in the valuation technique or model 
used to meet the fair value

[[Page 17278]]

measurement objective would not be considered a change in accounting 
principle. As such, a company would not be required to file a 
preferability letter from its independent accountants as described in 
Rule 10-01(b)(6) of Regulation S-X when it changes valuation techniques 
or models.\28\ However, the staff would not expect that a company would 
frequently switch between valuation techniques or models, particularly 
in circumstances where there was no significant variation in the form 
of share-based payments being valued. Disclosure in the footnotes of 
the basis for any change in technique or model would be 
appropriate.\29\
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    \27\ The staff believes that a company should take into account 
the reason for the change in technique or model in determining 
whether the new technique or model meets the fair value measurement 
objective. For example, changing a technique or model from period to 
period for the sole purpose of lowering the fair value estimate of a 
share option would not meet the fair value measurement objective of 
the Topic.
    \28\ FASB ASC paragraph 718-10-55-27.
    \29\ See generally FASB ASC paragraph 718-10-50-1.
---------------------------------------------------------------------------

    Question 4: Must every company that issues share options or similar 
instruments hire an outside third party to assist in determining the 
fair value of the share options?
    Interpretive Response: No. However, the valuation of a company's 
share options or similar instruments should be performed by a person 
with the requisite expertise.

D. Certain Assumptions Used in Valuation Methods

    FASB ASC Topic 718's (Compensation--Stock Compensation Topic) fair 
value measurement objective for equity instruments awarded to employees 
is to estimate the grant-date fair value of the equity instruments that 
the entity is obligated to issue when employees have rendered the 
requisite service and satisfied any other conditions necessary to earn 
the right to benefit from the instruments.\30\ In order to meet this 
fair value measurement objective, management will be required to 
develop estimates regarding the expected volatility of its company's 
share price and the exercise behavior of its employees. The staff is 
providing guidance in the following sections related to the expected 
volatility and expected term assumptions to assist public entities in 
applying those requirements.
---------------------------------------------------------------------------

    \30\ FASB ASC paragraph 718-10-55-4.
---------------------------------------------------------------------------

    The staff understands that companies may refine their estimates of 
expected volatility and expected term as a result of the guidance 
provided in FASB ASC Topic 718 and in sections (1) and (2) below. 
Changes in assumptions during the periods presented in the financial 
statements should be disclosed in the footnotes.\31\
---------------------------------------------------------------------------

    \31\ FASB ASC paragraph 718-10-50-2.
---------------------------------------------------------------------------

1. Expected Volatility
    FASB ASC paragraph 718-10-55-36 states, ``Volatility is a measure 
of the amount by which a financial variable, such as share price, has 
fluctuated (historical volatility) or is expected to fluctuate 
(expected volatility) during a period. Option-pricing models require an 
estimate of expected volatility as an assumption because an option's 
value is dependent on potential share returns over the option's term. 
The higher the volatility, the more the returns on the share can be 
expected to vary--up or down. Because an option's value is unaffected 
by expected negative returns on the shares, other things [being] equal, 
an option on a share with higher volatility is worth more than an 
option on a share with lower volatility.''
    Facts: Company B is a public entity whose common shares have been 
publicly traded for over twenty years. Company B also has multiple 
options on its shares outstanding that are traded on an exchange 
(``traded options''). Company B grants share options on January 2, 
20X6.
    Question 1: What should Company B consider when estimating expected 
volatility for purposes of measuring the fair value of its share 
options?
    Interpretive Response: FASB ASC Topic 718 does not specify a 
particular method of estimating expected volatility. However, the Topic 
does clarify that the objective in estimating expected volatility is to 
ascertain the assumption about expected volatility that marketplace 
participants would likely use in determining an exchange price for an 
option.\32\ FASB ASC Topic 718 provides a list of factors entities 
should consider in estimating expected volatility.\33\ Company B may 
begin its process of estimating expected volatility by considering its 
historical volatility.\34\ However, Company B should also then 
consider, based on available information, how the expected volatility 
of its share price may differ from historical volatility.\35\ Implied 
volatility \36\ can be useful in estimating expected volatility because 
it is generally reflective of both historical volatility and 
expectations of how future volatility will differ from historical 
volatility.
---------------------------------------------------------------------------

    \32\ FASB ASC paragraph 718-10-55-35.
    \33\ FASB ASC paragraph 718-10-55-37.
    \34\ FASB ASC paragraph 718-10-55-40.
    \35\ Ibid.
    \36\ Implied volatility is the volatility assumption inherent in 
the market prices of a company's traded options or other financial 
instruments that have option-like features. Implied volatility is 
derived by entering the market price of the traded financial 
instrument, along with assumptions specific to the financial options 
being valued, into a model based on a constant volatility estimate 
(e.g., the Black-Scholes-Merton closed-form model) and solving for 
the unknown assumption of volatility.
---------------------------------------------------------------------------

    The staff believes that companies should make good faith efforts to 
identify and use sufficient information in determining whether taking 
historical volatility, implied volatility or a combination of both into 
account will result in the best estimate of expected volatility. The 
staff believes companies that have appropriate traded financial 
instruments from which they can derive an implied volatility should 
generally consider this measure. The extent of the ultimate reliance on 
implied volatility will depend on a company's facts and circumstances; 
however, the staff believes that a company with actively traded options 
or other financial instruments with embedded options \37\ generally 
could place greater (or even exclusive) reliance on implied volatility. 
(See the Interpretive Responses to Questions 3 and 4 below.)
---------------------------------------------------------------------------

    \37\ The staff believes implied volatility derived from embedded 
options can be utilized in determining expected volatility if, in 
deriving the implied volatility, the company considers all relevant 
features of the instruments (e.g., value of the host instrument, 
value of the option, etc.). The staff believes the derivation of 
implied volatility from other than simple instruments (e.g., a 
simple convertible bond) can, in some cases, be impracticable due to 
the complexity of multiple features.
---------------------------------------------------------------------------

    The process used to gather and review available information to 
estimate expected volatility should be applied consistently from period 
to period. When circumstances indicate the availability of new or 
different information that would be useful in estimating expected 
volatility, a company should incorporate that information.
    Question 2: What should Company B consider if computing historical 
volatility? \38\
---------------------------------------------------------------------------

    \38\ See FASB ASC paragraph 718-10-55-37.
---------------------------------------------------------------------------

    Interpretive Response: The following should be considered in the 
computation of historical volatility:
1. Method of Computing Historical Volatility--
    The staff believes the method selected by Company B to compute its 
historical volatility should produce an estimate that is representative 
of Company B's expectations about its future volatility over the 
expected (if using a Black-Scholes-Merton closed-form model) or 
contractual (if using a lattice model) term \39\ of its employee share 
options. Certain methods may not be appropriate

[[Page 17279]]

for longer term employee share options if they weight the most recent 
periods of Company B's historical volatility much more heavily than 
earlier periods.\40\ For example, a method that applies a factor to 
certain historical price intervals to reflect a decay or loss of 
relevance of that historical information emphasizes the most recent 
historical periods and thus would likely bias the estimate to this 
recent history.\41\
---------------------------------------------------------------------------

    \39\ For purposes of this staff accounting bulletin, the phrase 
``expected or contractual term, as applicable'' has the same meaning 
as the phrase ``expected (if using a Black-Scholes-Merton closed-
form model) or contractual (if using a lattice model) term of an 
employee share option.''
    \40\ FASB ASC subparagraph 718-10-55-37(a) states that entities 
should consider historical volatility over a period generally 
commensurate with the expected or contractual term, as applicable, 
of the share option. Accordingly, the staff believes methods that 
place extreme emphasis on the most recent periods may be 
inconsistent with this guidance.
    \41\ Generalized Autoregressive Conditional Heteroskedasticity 
(``GARCH'') is an example of a method that demonstrates this 
characteristic.
---------------------------------------------------------------------------

2. Amount of Historical Data--
    FASB ASC subparagraph 718-10-55-37(a) indicates entities should 
consider historical volatility over a period generally commensurate 
with the expected or contractual term, as applicable, of the share 
option. The staff believes Company B could utilize a period of 
historical data longer than the expected or contractual term, as 
applicable, if it reasonably believes the additional historical 
information will improve the estimate. For example, assume Company B 
decided to utilize a Black-Scholes-Merton closed-form model to estimate 
the value of the share options granted on January 2, 20X6 and 
determined that the expected term was six years. Company B would not be 
precluded from using historical data longer than six years if it 
concludes that data would be relevant.
3. Frequency of Price Observations--
    FASB ASC subparagraph 718-10-55-37(d) indicates an entity should 
use appropriate and regular intervals for price observations based on 
facts and circumstances that provide the basis for a reasonable fair 
value estimate. Accordingly, the staff believes Company B should 
consider the frequency of the trading of its shares and the length of 
its trading history in determining the appropriate frequency of price 
observations. The staff believes using daily, weekly or monthly price 
observations may provide a sufficient basis to estimate expected 
volatility if the history provides enough data points on which to base 
the estimate.\42\ Company B should select a consistent point in time 
within each interval when selecting data points.\43\
---------------------------------------------------------------------------

    \42\ Further, if shares of a company are thinly traded the staff 
believes the use of weekly or monthly price observations would 
generally be more appropriate than the use of daily price 
observations. The volatility calculation using daily observations 
for such shares could be artificially inflated due to a larger 
spread between the bid and asked quotes and lack of consistent 
trading in the market.
    \43\ FASB ASC paragraph 718-10-55-40 states that a company 
should establish a process for estimating expected volatility and 
apply that process consistently from period to period. In addition, 
FASB ASC paragraph 718-10-55-27 indicates that assumptions used to 
estimate the fair value of instruments granted to employees should 
be determined in a consistent manner from period to period.
---------------------------------------------------------------------------

4. Consideration of Future Events--
    The objective in estimating expected volatility is to ascertain the 
assumptions that marketplace participants would likely use in 
determining an exchange price for an option.\44\ Accordingly, the staff 
believes that Company B should consider those future events that it 
reasonably concludes a marketplace participant would also consider in 
making the estimation. For example, if Company B has recently announced 
a merger with a company that would change its business risk in the 
future, then it should consider the impact of the merger in estimating 
the expected volatility if it reasonably believes a marketplace 
participant would also consider this event.
---------------------------------------------------------------------------

    \44\ FASB ASC paragraph 718-10-55-35.
---------------------------------------------------------------------------

5. Exclusion of Periods of Historical Data--
    In some instances, due to a company's particular business 
situations, a period of historical volatility data may not be relevant 
in evaluating expected volatility.\45\ In these instances, that period 
should be disregarded. The staff believes that if Company B disregards 
a period of historical volatility, it should be prepared to support its 
conclusion that its historical share price during that previous period 
is not relevant to estimating expected volatility due to one or more 
discrete and specific historical events and that similar events are not 
expected to occur during the expected term of the share option. The 
staff believes these situations would be rare.
---------------------------------------------------------------------------

    \45\ FASB ASC paragraph 718-10-55-37.
---------------------------------------------------------------------------

    Question 3: What should Company B consider when evaluating the 
extent of its reliance on the implied volatility derived from its 
traded options?
    Interpretive Response: To achieve the objective of estimating 
expected volatility as stated in FASB ASC paragraphs 718-10-55-35 
through 718-10-55-41, the staff believes Company B generally should 
consider the following in its evaluation: 1) the volume of market 
activity of the underlying shares and traded options; 2) the ability to 
synchronize the variables used to derive implied volatility; 3) the 
similarity of the exercise prices of the traded options to the exercise 
price of the employee share options; and 4) the similarity of the 
length of the term of the traded and employee share options.\46\
---------------------------------------------------------------------------

    \46\ See generally Options, Futures, and Other Derivatives by 
John C. Hull (Prentice Hall, 5th Edition, 2003).
---------------------------------------------------------------------------

1. Volume of Market Activity--
    The staff believes Company B should consider the volume of trading 
in its underlying shares as well as the traded options. For example, 
prices for instruments in actively traded markets are more likely to 
reflect a marketplace participant's expectations regarding expected 
volatility.
2. Synchronization of the Variables--
    Company B should synchronize the variables used to derive implied 
volatility. For example, to the extent reasonably practicable, Company 
B should use market prices (either traded prices or the average of bid 
and asked quotes) of the traded options and its shares measured at the 
same point in time. This measurement should also be synchronized with 
the grant of the employee share options; however, when this is not 
reasonably practicable, the staff believes Company B should derive 
implied volatility as of a point in time as close to the grant of the 
employee share options as reasonably practicable.
3. Similarity of the Exercise Prices--
    The staff believes that when valuing an at-the-money employee share 
option, the implied volatility derived from at- or near-the-money 
traded options generally would be most relevant.\47\ If, however, it is 
not possible to find at- or near-the-money traded options, Company B 
should select multiple traded options with an average exercise price 
close to the exercise price of the employee share option.\48\
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    \47\ Implied volatilities of options differ systematically over 
the ``moneyness'' of the option. This pattern of implied 
volatilities across exercise prices is known as the ``volatility 
smile'' or ``volatility skew.'' Studies such as ``Implied 
Volatility'' by Stewart Mayhew, Financial Analysts Journal, July-
August 1995, have found that implied volatilities based on near-the-
money options do as well as sophisticated weighted implied 
volatilities in estimating expected volatility. In addition, the 
staff believes that because near-the-money options are generally 
more actively traded, they may provide a better basis for deriving 
implied volatility.
    \48\ The staff believes a company could use a weighted-average 
implied volatility based on traded options that are either in-the-
money or out-of-the-money. For example, if the employee share option 
has an exercise price of $52, but the only traded options available 
have exercise prices of $50 and $55, then the staff believes that it 
is appropriate to use a weighted average based on the implied 
volatilities from the two traded options; for this example, a 40% 
weight on the implied volatility calculated from the option with an 
exercise price of $55 and a 60% weight on the option with an 
exercise price of $50.

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[[Page 17280]]

4. Similarity of Length of Terms--
    The staff believes that when valuing an employee share option with 
a given expected or contractual term, as applicable, the implied 
volatility derived from a traded option with a similar term would be 
the most relevant. However, if there are no traded options with 
maturities that are similar to the share option's contractual or 
expected term, as applicable, then the staff believes Company B could 
consider traded options with a remaining maturity of six months or 
greater.\49\ However, when using traded options with a term of less 
than one year,\50\ the staff would expect the company to also consider 
other relevant information in estimating expected volatility. In 
general, the staff believes more reliance on the implied volatility 
derived from a traded option would be expected the closer the remaining 
term of the traded option is to the expected or contractual term, as 
applicable, of the employee share option.
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    \49\ The staff believes it may also be appropriate to consider 
the entire term structure of volatility provided by traded options 
with a variety of remaining maturities. If a company considers the 
entire term structure in deriving implied volatility, the staff 
would expect a company to include some options in the term structure 
with a remaining maturity of six months or greater.
    \50\ The staff believes the implied volatility derived from a 
traded option with a term of one year or greater would typically not 
be significantly different from the implied volatility that would be 
derived from a traded option with a significantly longer term.
---------------------------------------------------------------------------

    The staff believes Company B's evaluation of the factors above 
should assist in determining whether the implied volatility 
appropriately reflects the market's expectations of future volatility 
and thus the extent of reliance that Company B reasonably places on the 
implied volatility.
    Question 4: Are there situations in which it is acceptable for 
Company B to rely exclusively on either implied volatility or 
historical volatility in its estimate of expected volatility?
    Interpretive Response: As stated above, FASB ASC Topic 718 does not 
specify a method of estimating expected volatility; rather, it provides 
a list of factors that should be considered and requires that an 
entity's estimate of expected volatility be reasonable and 
supportable.\51\ Many of the factors listed in FASB ASC Topic 718 are 
discussed in Questions 2 and 3 above. The objective of estimating 
volatility, as stated in FASB ASC Topic 718, is to ascertain the 
assumption about expected volatility that marketplace participants 
would likely use in determining a price for an option.\52\ The staff 
believes that a company, after considering the factors listed in FASB 
ASC Topic 718, could, in certain situations, reasonably conclude that 
exclusive reliance on either historical or implied volatility would 
provide an estimate of expected volatility that meets this stated 
objective.
---------------------------------------------------------------------------

    \51\ FASB ASC paragraphs 718-10-55-36 through 718-10-55-37.
    \52\ FASB ASC paragraph 718-10-55-35.
---------------------------------------------------------------------------

    The staff would not object to Company B placing exclusive reliance 
on implied volatility when the following factors are present, as long 
as the methodology is consistently applied:
     Company B utilizes a valuation model that is based upon a 
constant volatility assumption to value its employee share options;\53\
---------------------------------------------------------------------------

    \53\ FASB ASC paragraphs 718-10-55-18 and 718-10-55-39 discuss 
the incorporation of a range of expected volatilities into option 
pricing models. The staff believes that a company that utilizes an 
option pricing model that incorporates a range of expected 
volatilities over the option's contractual term should consider the 
factors listed in FASB ASC Topic 718, and those discussed in the 
Interpretive Responses to Questions 2 and 3 above, to determine the 
extent of its reliance (including exclusive reliance) on the derived 
implied volatility.
---------------------------------------------------------------------------

     The implied volatility is derived from options that are 
actively traded;
     The market prices (trades or quotes) of both the traded 
options and underlying shares are measured at a similar point in time 
to each other and on a date reasonably close to the grant date of the 
employee share options;
     The traded options have exercise prices that are both (a) 
near-the-money and (b) close to the exercise price of the employee 
share options; \54\ and
---------------------------------------------------------------------------

    \54\ When near-the-money options are not available, the staff 
believes the use of a weighted-average approach, as noted in a 
previous footnote, may be appropriate.
---------------------------------------------------------------------------

     The remaining maturities of the traded options on which 
the estimate is based are at least one year.
    The staff would not object to Company B placing exclusive reliance 
on historical volatility when the following factors are present, so 
long as the methodology is consistently applied:
     Company B has no reason to believe that its future 
volatility over the expected or contractual term, as applicable, is 
likely to differ from its past; \55\
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    \55\ See FASB ASC paragraph 718-10-55-38. A change in a 
company's business model that results in a material alteration to 
the company's risk profile is an example of a circumstance in which 
the company's future volatility would be expected to differ from its 
past volatility. Other examples may include, but are not limited to, 
the introduction of a new product that is central to a company's 
business model or the receipt of U.S. Food and Drug Administration 
approval for the sale of a new prescription drug.
---------------------------------------------------------------------------

     The computation of historical volatility uses a simple 
average calculation method;
     A sequential period of historical data at least equal to 
the expected or contractual term of the share option, as applicable, is 
used; and
     A reasonably sufficient number of price observations are 
used, measured at a consistent point throughout the applicable 
historical period.\56\
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    \56\ If the expected or contractual term, as applicable, of the 
employee share option is less than three years, the staff believes 
monthly price observations would not provide a sufficient amount of 
data.
---------------------------------------------------------------------------

    Question 5: What disclosures would the staff expect Company B to 
include in its financial statements and MD&A regarding its assumption 
of expected volatility?
    Interpretive Response: FASB ASC paragraph 718-10-50-2 prescribes 
the minimum information needed to achieve the Topic's disclosure 
objectives.\57\ Under that guidance, Company B is required to disclose 
the expected volatility and the method used to estimate it.\58\ 
Accordingly, the staff expects that at a minimum Company B would 
disclose in a footnote to its financial statements how it determined 
the expected volatility assumption for purposes of determining the fair 
value of its share options in accordance with FASB ASC Topic 718. For 
example, at a minimum, the staff would expect Company B to disclose 
whether it used only implied volatility, historical volatility, or a 
combination of both.
---------------------------------------------------------------------------

    \57\ FASB ASC Section 718-10-50.
    \58\ FASB ASC subparagraph 718-10-50-2(f) (2) (ii).
---------------------------------------------------------------------------

    In addition, Company B should consider the applicability of SEC 
Release No. FR-60 and Section V, ``Critical Accounting Estimates,'' in 
SEC Release No. FR-72 regarding critical accounting policies and 
estimates in MD&A. The staff would expect such disclosures to include 
an explanation of the method used to estimate the expected volatility 
of its share price. This explanation generally should include a 
discussion of the basis for the company's conclusions regarding the 
extent to which it used historical volatility, implied volatility or a 
combination of both. A company could consider summarizing its 
evaluation of the factors listed in Questions 2 and 3 of this section 
as part of these disclosures in MD&A.
    Facts: Company C is a newly public entity with limited historical 
data on the

[[Page 17281]]

price of its publicly traded shares and no other traded financial 
instruments. Company C believes that it does not have sufficient 
company specific information regarding the volatility of its share 
price on which to base an estimate of expected volatility.
    Question 6: What other sources of information should Company C 
consider in order to estimate the expected volatility of its share 
price?
    Interpretive Response: FASB ASC Topic 718 provides guidance on 
estimating expected volatility for newly public and nonpublic entities 
that do not have company specific historical or implied volatility 
information available.\59\ Company C may base its estimate of expected 
volatility on the historical, expected or implied volatility of similar 
entities whose share or option prices are publicly available. In making 
its determination as to similarity, Company C would likely consider the 
industry, stage of life cycle, size and financial leverage of such 
other entities.\60\
---------------------------------------------------------------------------

    \59\ FASB ASC paragraphs 718-10-55-25 and 718-10-55-51.
    \60\ FASB ASC paragraph 718-1055-25.
---------------------------------------------------------------------------

    The staff would not object to Company C looking to an industry 
sector index (e.g., NASDAQ Computer Index) that is representative of 
Company C's industry, and possibly its size, to identify one or more 
similar entities.\61\ Once Company C has identified similar entities, 
it would substitute a measure of the individual volatilities of the 
similar entities for the expected volatility of its share price as an 
assumption in its valuation model.\62\ Because of the effects of 
diversification that are present in an industry sector index, Company C 
should not substitute the volatility of an index for the expected 
volatility of its share price as an assumption in its valuation 
model.\63\
---------------------------------------------------------------------------

    \61\ If a company operates in a number of different industries, 
it could look to several industry indices. However, when considering 
the volatilities of multiple companies, each operating only in a 
single industry, the staff believes a company should take into 
account its own leverage, the leverages of each of the entities, and 
the correlation of the entities' stock returns.
    \62\ FASB ASC paragraph 718-10-55-51.
    \63\ FASB ASC paragraph 718-10-55-25.
---------------------------------------------------------------------------

    After similar entities have been identified, Company C should 
continue to consider the volatilities of those entities unless 
circumstances change such that the identified entities are no longer 
similar to Company C. Until Company C has sufficient information 
available, the staff would not object to Company C basing its estimate 
of expected volatility on the volatility of similar entities for those 
periods for which it does not have sufficient information 
available.\64\ Until Company C has either a sufficient amount of 
historical information regarding the volatility of its share price or 
other traded financial instruments are available to derive an implied 
volatility to support an estimate of expected volatility, it should 
consistently apply a process as described above to estimate expected 
volatility based on the volatilities of similar entities.\65\
---------------------------------------------------------------------------

    \64\ FASB ASC paragraph 718-10-55-37. The staff believes that at 
least two years of daily or weekly historical data could provide a 
reasonable basis on which to base an estimate of expected volatility 
if a company has no reason to believe that its future volatility 
will differ materially during the expected or contractual term, as 
applicable, from the volatility calculated from this past 
information. If the expected or contractual term, as applicable, of 
a share option is shorter than two years, the staff believes a 
company should use daily or weekly historical data for at least the 
length of that applicable term.
    \65\ FASB ASC paragraph 718-10-55-40.
---------------------------------------------------------------------------

2. Expected Term
    FASB ASC paragraph 718-10-55-29 states ``The fair value of a traded 
(or transferable) share option is based on its contractual term because 
rarely is it economically advantageous to exercise, rather than sell, a 
transferable share option before the end of its contractual term. 
Employee share options generally differ from transferable [or tradable] 
share options in that employees cannot sell (or hedge) their share 
options--they can only exercise them; because of this, employees 
generally exercise their options before the end of the options' 
contractual term. Thus, the inability to sell or hedge an employee 
share option effectively reduces the option's value [compared to a 
transferable option] because exercise prior to the option's expiration 
terminates its remaining life and thus its remaining time value.'' 
Accordingly, FASB ASC Topic 718 requires that when valuing an employee 
share option under the Black-Scholes-Merton framework the fair value of 
employee share options be based on the share options' expected term 
rather than the contractual term.
    The staff believes the estimate of expected term should be based on 
the facts and circumstances available in each particular case. 
Consistent with our guidance regarding reasonableness immediately 
preceding Topic 14.A, the fact that other possible estimates are later 
determined to have more accurately reflected the term does not 
necessarily mean that the particular choice was unreasonable. The staff 
reminds registrants of the expected term disclosure requirements 
described in FASB ASC subparagraph 718-10-50-2(f)(2)(i).
    Facts: Company D utilizes the Black-Scholes-Merton closed-form 
model to value its share options for the purposes of determining the 
fair value of the options under FASB ASC Topic 718. Company D recently 
granted share options to its employees. Based on its review of various 
factors, Company D determines that the expected term of the options is 
six years, which is less than the contractual term of ten years.
    Question 1: When determining the fair value of the share options in 
accordance with FASB ASC Topic 718, should Company D consider an 
additional discount for nonhedgability and nontransferability?
    Interpretive Response: No. FASB ASC paragraph 718-10-55-29 
indicates that nonhedgability and nontransferability have the effect of 
increasing the likelihood that an employee share option will be 
exercised before the end of its contractual term. Nonhedgability and 
nontransferability therefore factor into the expected term assumption 
(in this case reducing the term assumption from ten years to six 
years), and the expected term reasonably adjusts for the effect of 
these factors. Accordingly, the staff believes that no additional 
reduction in the term assumption or other discount to the estimated 
fair value is appropriate for these particular factors.\66\
---------------------------------------------------------------------------

    \66\ The staff notes the existence of academic literature that 
supports the assertion that the Black-Scholes-Merton closed-form 
model, with expected term as an input, can produce reasonable 
estimates of fair value. Such literature includes J. Carpenter, 
``The exercise and valuation of executive stock options,'' Journal 
of Financial Economics, May 1998, pp.127-158; C. Marquardt, ``The 
Cost of Employee Stock Option Grants: An Empirical Analysis,'' 
Journal of Accounting Research, September 2002, p. 1191-1217); and 
J. Bettis, J. Bizjak and M. Lemmon, ``Exercise behavior, valuation, 
and the incentive effect of employee stock options,'' Journal of 
Financial Economics, forthcoming, 2005.
---------------------------------------------------------------------------

    Question 2: Should forfeitures or terms that stem from 
forfeitability be factored into the determination of expected term?
    Interpretive Response: No. FASB ASC Topic 718 indicates that the 
expected term that is utilized as an assumption in a closed-form 
option-pricing model or a resulting output of a lattice option pricing 
model when determining the fair value of the share options should not 
incorporate restrictions or other terms that stem from the pre-vesting 
forfeitability of the instruments. Under FASB ASC Topic 718, these pre-
vesting restrictions or other terms are taken into account by 
ultimately recognizing compensation cost only for awards for

[[Page 17282]]

which employees render the requisite service.\67\
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    \67\ FASB ASC paragraph 718-10-30-11.
---------------------------------------------------------------------------

    Question 3: Can a company's estimate of expected term ever be 
shorter than the vesting period?
    Interpretive Response: No. The vesting period forms the lower bound 
of the estimate of expected term.\68\
---------------------------------------------------------------------------

    \68\ FASB ASC paragraph 718-10-55-31.
---------------------------------------------------------------------------

    Question 4: FASB ASC paragraph 718-10-55-34 indicates that an 
entity shall aggregate individual awards into relatively homogenous 
groups with respect to exercise and post-vesting employment termination 
behaviors for the purpose of determining expected term, regardless of 
the valuation technique or model used to estimate the fair value. How 
many groupings are typically considered sufficient?
    Interpretive Response: As it relates to employee groupings, the 
staff believes that an entity may generally make a reasonable fair 
value estimate with as few as one or two groupings.\69\
---------------------------------------------------------------------------

    \69\ The staff believes the focus should be on groups of 
employees with significantly different expected exercise behavior. 
Academic research suggests two such groups might be executives and 
non-executives. A study by S. Huddart found executives and other 
senior managers to be significantly more patient in their exercise 
behavior than more junior employees. (Employee rank was proxied for 
by the number of options issued to that employee.) See S. Huddart, 
``Patterns of stock option exercise in the United States,'' in: J. 
Carpenter and D. Yermack, eds., Executive Compensation and 
Shareholder Value: Theory and Evidence (Kluwer, Boston, MA, 1999), 
pp. 115-142. See also S. Huddart and M. Lang, ``Employee stock 
option exercises: An empirical analysis,'' Journal of Accounting and 
Economics, 1996, pp. 5-43.
---------------------------------------------------------------------------

    Question 5: What approaches could a company use to estimate the 
expected term of its employee share options?
    Interpretive Response: A company should use an approach that is 
reasonable and supportable under FASB ASC Topic 718's fair value 
measurement objective, which establishes that assumptions and 
measurement techniques should be consistent with those that marketplace 
participants would be likely to use in determining an exchange price 
for the share options.\70\ If, in developing its estimate of expected 
term, a company determines that its historical share option exercise 
experience is the best estimate of future exercise patterns, the staff 
will not object to the use of the historical share option exercise 
experience to estimate expected term.\71\
---------------------------------------------------------------------------

    \70\ FASB ASC paragraph 718-10-55-13.
    \71\ Historical share option exercise experience encompasses 
data related to share option exercise, post-vesting termination, and 
share option contractual term expiration.
---------------------------------------------------------------------------

    A company may also conclude that its historical share option 
exercise experience does not provide a reasonable basis upon which to 
estimate expected term. This may be the case for a variety of reasons, 
including, but not limited to, the life of the company and its relative 
stage of development, past or expected structural changes in the 
business, differences in terms of past equity-based share option 
grants,\72\ or a lack of variety of price paths that the company may 
have experienced.\73\
---------------------------------------------------------------------------

    \72\ For example, if a company had historically granted share 
options that were always in-the-money, and will grant at-the-money 
options prospectively, the exercise behavior related to the in-the-
money options may not be sufficient as the sole basis to form the 
estimate of expected term for the at-the-money grants.
    \73\ For example, if a company had a history of previous equity-
based share option grants and exercises only in periods in which the 
company's share price was rising, the exercise behavior related to 
those options may not be sufficient as the sole basis to form the 
estimate of expected term for current option grants.
---------------------------------------------------------------------------

    FASB ASC Topic 718 describes other alternative sources of 
information that might be used in those cases when a company determines 
that its historical share option exercise experience does not provide a 
reasonable basis upon which to estimate expected term. For example, a 
lattice model (which by definition incorporates multiple price paths) 
can be used to estimate expected term as an input into a Black-Scholes-
Merton closed-form model.\74\ In addition, FASB ASC paragraph 718-10-
55-32 states ``* * * expected term might be estimated in some other 
manner, taking into account whatever relevant and supportable 
information is available, including industry averages and other 
pertinent evidence such as published academic research.'' For example, 
data about exercise patterns of employees in similar industries and/or 
situations as the company's might be used. While such comparative 
information may not be widely available at present, the staff 
understands that various parties, including actuaries, valuation 
professionals and others are gathering such data.
---------------------------------------------------------------------------

    \74\ FASB ASC paragraph 718-10-55-30.
---------------------------------------------------------------------------

    Facts: Company E grants equity share options to its employees that 
have the following basic characteristics:\75\
---------------------------------------------------------------------------

    \75\ Employee share options with these features are sometimes 
referred to as ``plain vanilla'' options.
---------------------------------------------------------------------------

     The share options are granted at-the-money;
     Exercisability is conditional only on performing service 
through the vesting date;\76\
---------------------------------------------------------------------------

    \76\ In this fact pattern the requisite service period equals 
the vesting period.
---------------------------------------------------------------------------

     If an employee terminates service prior to vesting, the 
employee would forfeit the share options;
     If an employee terminates service after vesting, the 
employee would have a limited time to exercise the share options 
(typically 30-90 days); and
     The share options are nontransferable and nonhedgeable.
    Company E utilizes the Black-Scholes-Merton closed-form model for 
valuing its employee share options.
    Question 6: As share options with these ``plain vanilla'' 
characteristics have been granted in significant quantities by many 
companies in the past, is the staff aware of any ``simple'' 
methodologies that can be used to estimate expected term?
    Interpretive Response: As noted above, the staff understands that 
an entity that is unable to rely on its historical exercise data may 
find that certain alternative information, such as exercise data 
relating to employees of other companies, is not easily obtainable. As 
such, some companies may encounter difficulties in making a refined 
estimate of expected term. Accordingly, if a company concludes that its 
historical share option exercise experience does not provide a 
reasonable basis upon which to estimate expected term, the staff will 
accept the following ``simplified'' method for ``plain vanilla'' 
options consistent with those in the fact set above: expected term = 
((vesting term + original contractual term)/2). Assuming a ten year 
original contractual term and graded vesting over four years (25% of 
the options in each grant vest annually) for the share options in the 
fact set described above, the resultant expected term would be 6.25 
years.\77\ Academic research on the exercise of options issued to 
executives provides some general support for outcomes that would be 
produced by the application of this method.\78\
---------------------------------------------------------------------------

    \77\ Calculated as [[[1 year vesting term (for the first 25% 
vested) plus 2 year vesting term (for the second 25% vested) plus 3 
year vesting term (for the third 25% vested) plus 4 year vesting 
term (for the last 25% vested)] divided by 4 total years of vesting] 
plus 10 year contractual life] divided by 2; that is, (((1+2+3+4)/4) 
+ 10)/2 = 6.25 years.
    \78\ J.N. Carpenter, ``The exercise and valuation of executive 
stock options,'' Journal of Financial Economics, 1998, pp.127-158 
studies a sample of 40 NYSE and AMEX firms over the period 1979-1994 
with share option terms reasonably consistent to the terms presented 
in the fact set and example. The mean time to exercise after grant 
was 5.83 years and the median was 6.08 years. The ``mean time to 
exercise'' is shorter than expected term since the study's sample 
included only exercised options. Other research on executive options 
includes (but is not limited to) J. Carr Bettis; John M. Bizjak; and 
Michael L. Lemmon, ``Exercise behavior, valuation, and the incentive 
effects of employee stock options,'' forthcoming in the Journal of 
Financial Economics. One of the few studies on nonexecutive employee 
options the staff is aware of is S. Huddart, ``Patterns of stock 
option exercise in the United States,'' in: J. Carpenter and D. 
Yermack, eds., Executive Compensation and Shareholder Value: Theory 
and Evidence (Kluwer, Boston, MA, 1999), pp. 115-142.

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[[Page 17283]]

    Examples of situations in which the staff believes that it may be 
appropriate to use this simplified method include the following:
     A company does not have sufficient historical exercise 
data to provide a reasonable basis upon which to estimate expected term 
due to the limited period of time its equity shares have been publicly 
traded.
     A company significantly changes the terms of its share 
option grants or the types of employees that receive share option 
grants such that its historical exercise data may no longer provide a 
reasonable basis upon which to estimate expected term.
     A company has or expects to have significant structural 
changes in its business such that its historical exercise data may no 
longer provide a reasonable basis upon which to estimate expected term.
    The staff understands that a company may have sufficient historical 
exercise data for some of its share option grants but not for others. 
In such cases, the staff will accept the use of the simplified method 
for only some but not all share option grants. The staff also does not 
believe that it is necessary for a company to consider using a lattice 
model before it decides that it is eligible to use this simplified 
method. Further, the staff will not object to the use of this 
simplified method in periods prior to the time a company's equity 
shares are traded in a public market.
    If a company uses this simplified method, the company should 
disclose in the notes to its financial statements the use of the 
method, the reason why the method was used, the types of share option 
grants for which the method was used if the method was not used for all 
share option grants, and the periods for which the method was used if 
the method was not used in all periods. Companies that have sufficient 
historical share option exercise experience upon which to estimate 
expected term may not apply this simplified method. In addition, this 
simplified method is not intended to be applied as a benchmark in 
evaluating the appropriateness of more refined estimates of expected 
term.
    Also, as noted above in Question 5, the staff believes that more 
detailed external information about exercise behavior will, over time, 
become readily available to companies. As such, the staff does not 
expect that such a simplified method would be used for share option 
grants when more relevant detailed information becomes widely 
available.

E. FASB ASC Topic 718, Compensation--Stock Compensation, and Certain 
Redeemable Financial Instruments

    Certain financial instruments awarded in conjunction with share-
based payment arrangements have redemption features that require 
settlement by cash or other assets upon the occurrence of events that 
are outside the control of the issuer.\79\ FASB ASC Topic 718 provides 
guidance for determining whether instruments granted in conjunction 
with share-based payment arrangements should be classified as liability 
or equity instruments. Under that guidance, most instruments with 
redemption features that are outside the control of the issuer are 
required to be classified as liabilities; however, some redeemable 
instruments will qualify for equity classification.\80\ SEC Accounting 
Series Release No. 268, Presentation in Financial Statements of 
``Redeemable Preferred Stocks,'' \81\ (``ASR 268'') and related 
guidance \82\ address the classification and measurement of certain 
redeemable equity instruments.
---------------------------------------------------------------------------

    \79\ The terminology ``outside the control of the issuer'' is 
used to refer to any of the three redemption conditions described in 
Rule 5-02.28 of Regulation S-X that would require classification 
outside permanent equity. That rule requires preferred securities 
that are redeemable for cash or other assets to be classified 
outside of permanent equity if they are redeemable (1) at a fixed or 
determinable price on a fixed or determinable date, (2) at the 
option of the holder, or (3) upon the occurrence of an event that is 
not solely within the control of the issuer.
    \80\ FASB ASC paragraphs 718-10-25-6 through 718-10-25-19.
    \81\ ASR 268, July 27, 1979, Rule 5-02.28 of Regulation S-X.
    \82\ Related guidance includes FASB ASC paragraph 480-10-S99-3 
(Distinguishing Liabilities from Equity Topic).
---------------------------------------------------------------------------

    Facts: Under a share-based payment arrangement, Company F grants to 
an employee shares (or share options) that all vest at the end of four 
years (cliff vest). The shares (or shares underlying the share options) 
are redeemable for cash at fair value at the holder's option, but only 
after six months from the date of share issuance (as defined in FASB 
ASC Topic 718). Company F has determined that the shares (or share 
options) would be classified as equity instruments under the guidance 
of FASB ASC Topic 718. However, under ASR 268 and related guidance, the 
instruments would be considered to be redeemable for cash or other 
assets upon the occurrence of events (e.g., redemption at the option of 
the holder) that are outside the control of the issuer.
    Question 1: While the instruments are subject to FASB ASC Topic 
718,\83\ is ASR 268 and related guidance applicable to instruments 
issued under share-based payment arrangements that are classified as 
equity instruments under FASB ASC Topic 718?
---------------------------------------------------------------------------

    \83\ FASB ASC paragraph 718-10-35-13 states that an instrument 
ceases to be subject to this Topic when ``the rights conveyed by the 
instrument to the holder are no longer dependent on the holder being 
an employee of the entity (that is, no longer dependent on providing 
service).''
---------------------------------------------------------------------------

    Interpretive Response: Yes. The staff believes that registrants 
must evaluate whether the terms of instruments granted in conjunction 
with share-based payment arrangements with employees that are not 
classified as liabilities under FASB ASC Topic 718 result in the need 
to present certain amounts outside of permanent equity (also referred 
to as being presented in ``temporary equity'') in accordance with ASR 
268 and related guidance.\84\
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    \84\ Instruments granted in conjunction with share-based payment 
arrangements with employees that do not by their terms require 
redemption for cash or other assets (at a fixed or determinable 
price on a fixed or determinable date, at the option of the holder, 
or upon the occurrence of an event that is not solely within the 
control of the issuer) would not be assumed by the staff to require 
net cash settlement for purposes of applying ASR 268 in 
circumstances in which FASB ASC Section 815-40-25, Derivatives and 
Hedging--Contracts in Entity's Own Equity--Recognition, would 
otherwise require the assumption of net cash settlement. See FASB 
ASC paragraph 815-40-25-11, which states, in part: ``* * *the events 
or actions necessary to deliver registered shares are not controlled 
by an entity and, therefore, except under the circumstances 
described in FASB ASC paragraph 815-40-25-16, if the contract 
permits the entity to net share or physically settle the contract 
only by delivering registered shares, it is assumed that the entity 
will be required to net cash settle the contract.'' See also FASB 
ASC subparagraph 718-10-25-15(a).
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    When an instrument ceases to be subject to FASB ASC Topic 718 and 
becomes subject to the recognition and measurement requirements of 
other applicable GAAP, the staff believes that the company should 
reassess the classification of the instrument as a liability or equity 
at that time and consequently may need to reconsider the applicability 
of ASR 268.
    Question 2: How should Company F apply ASR 268 and related guidance 
to the shares (or share options) granted under the share-based payment 
arrangements with employees that may be unvested at the date of grant?
    Interpretive Response: Under FASB ASC Topic 718, when compensation 
cost is recognized for instruments classified as equity instruments, 
additional paid-in-capital \85\ is increased. If the award is not fully 
vested at the grant date, compensation cost is recognized and 
additional paid-in-capital is increased over time as services are 
rendered over the requisite

[[Page 17284]]

service period. A similar pattern of recognition should be used to 
reflect the amount presented as temporary equity for share-based 
payment awards that have redemption features that are outside the 
issuer's control but are classified as equity instruments under FASB 
ASC Topic 718. The staff believes Company F should present as temporary 
equity at each balance sheet date an amount that is based on the 
redemption amount of the instrument, but takes into account the 
proportion of consideration received in the form of employee services. 
Thus, for example, if a nonvested share that qualifies for equity 
classification under FASB ASC Topic 718 is redeemable at fair value 
more than six months after vesting, and that nonvested share is 75% 
vested at the balance sheet date, an amount equal to 75% of the fair 
value of the share should be presented as temporary equity at that 
date. Similarly, if an option on a share of redeemable stock that 
qualifies for equity classification under FASB ASC Topic 718 is 75% 
vested at the balance sheet date, an amount equal to 75% of the 
intrinsic \86\ value of the option should be presented as temporary 
equity at that date.
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    \85\ Depending on the fact pattern, this may be recorded as 
common stock and additional paid in capital.
    \86\ The potential redemption amount of the share option in this 
illustration is its intrinsic value because the holder would pay the 
exercise price upon exercise of the option and then, upon redemption 
of the underlying shares, the company would pay the holder the fair 
value of those shares. Thus, the net cash outflow from the 
arrangement would be equal to the intrinsic value of the share 
option. In situations where there would be no cash inflows from the 
share option holder, the cash required to be paid to redeem the 
underlying shares upon the exercise of the put option would be the 
redemption value.
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    Question 3: Would the methodology described for employee awards in 
the Interpretive Response to Question 2 above apply to nonemployee 
awards to be issued in exchange for goods or services with similar 
terms to those described above?
    Interpretive Response: See Topic 14.A for a discussion of the 
application of the principles in FASB ASC Topic 718 to nonemployee 
awards. The staff believes it would generally be appropriate to apply 
the methodology described in the Interpretive Response to Question 2 
above to nonemployee awards.

F. Classification of Compensation Expense Associated with Share-Based 
Payment Arrangements

    Facts: Company G utilizes both cash and share-based payment 
arrangements to compensate its employees and nonemployee service 
providers. Company G would like to emphasize in its income statement 
the amount of its compensation that did not involve a cash outlay.
    Question: How should Company G present in its income statement the 
non-cash nature of its expense related to share-based payment 
arrangements?
    Interpretive Response: The staff believes Company G should present 
the expense related to share-based payment arrangements in the same 
line or lines as cash compensation paid to the same employees.\87\ The 
staff believes a company could consider disclosing the amount of 
expense related to share-based payment arrangements included in 
specific line items in the financial statements. Disclosure of this 
information might be appropriate in a parenthetical note to the 
appropriate income statement line items, on the cash flow statement, in 
the footnotes to the financial statements, or within MD&A.
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    \87\ FASB ASC Topic 718 does not identify a specific line item 
in the income statement for presentation of the expense related to 
share-based payment arrangements.
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G. Removed by SAB 114 \88,89\
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    \88\ [Original footnote removed by SAB 114.]

    \89\ [Original footnote removed by SAB 114.]
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H. Removed by SAB 114 \90,91,92,93\
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    \90\ [Original footnote removed by SAB 114.]

    \91\ [Original footnote removed by SAB 114.]

    \92\ [Original footnote removed by SAB 114.]

    \93\ [Original footnote removed by SAB 114.]
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I. Capitalization of Compensation Cost Related to Share-Based Payment 
Arrangements

    Facts: Company K is a manufacturing company that grants share 
options to its production employees. Company K has determined that the 
cost of the production employees' service is an inventoriable cost. As 
such, Company K is required to initially capitalize the cost of the 
share option grants to these production employees as inventory and 
later recognize the cost in the income statement when the inventory is 
consumed.\94\
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    \94\ FASB ASC paragraph 718-10-25-2.
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    Question: If Company K elects to adjust its period end inventory 
balance for the allocable amount of share-option cost through a period 
end adjustment to its financial statements, instead of incorporating 
the share-option cost through its inventory costing system, would this 
be considered a deficiency in internal controls?

[[Page 17285]]

    Interpretive Response: No. FASB ASC Topic 718, Compensation--Stock 
Compensation, does not prescribe the mechanism a company should use to 
incorporate a portion of share-option costs in an inventory-costing 
system. The staff believes Company K may accomplish this through a 
period end adjustment to its financial statements. Company K should 
establish appropriate controls surrounding the calculation and 
recording of this period end adjustment, as it would any other period 
end adjustment. The fact that the entry is recorded as a period end 
adjustment, by itself, should not impact management's ability to 
determine that the internal control over financial reporting, as 
defined by the SEC's rules implementing Section 404 of the Sarbanes-
Oxley Act of 2002,\95\ is effective.
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    \95\ Release No. 34-47986, June 5, 2003, Management's Report on 
Internal Control Over Financial Reporting and Certification of 
Disclosure in Exchange Act Period Reports.
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J. Removed by SAB 114 96 97 98

     
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    \96\ [Original footnote removed by SAB 114.]
    \97\ [Original footnote removed by SAB 114.]
    \98\ [Original footnote removed by SAB 114.]
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K. Removed by SAB 114 99 100 101 102 103

     
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    \99\ [Original footnote removed by SAB 114.]
    \100\ [Original footnote removed by SAB 114.]
    \101\ [Original footnote removed by SAB 114.]
    \102\ [Original footnote removed by SAB 114.]
    \103\ [Original footnote removed by SAB 114.]
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L. Removed by SAB 114 104 105 106

     
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    \104\ [Original footnote removed by SAB 114.]
    \105\ [Original footnote removed by SAB 114.]
    \106\ [Original footnote removed by SAB 114.]
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M. Removed by SAB 114

[FR Doc. 2011-5584 Filed 3-25-11; 8:45 am]
BILLING CODE 8011-01-P