Speech by SEC Staff:
Remarks before the 2010 AICPA National Conference on Current SEC and PCAOB Developments
Sagar S. Teotia
Professional Accounting Fellow
U.S. Securities and Exchange Commission
December 6, 2010
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect those of the Commission or of the author's colleagues upon the staff of the Commission.
Good morning. Today, I would like to spend some time talking about two debt versus equity issues and one long-lived assets issue that we have considered in recent months.
Interpretative Questions Received Under IFRS
As many of you know, OCA sometimes receives interpretative questions related to the application of IFRS, as issued by the IASB, from foreign filers and other regulators. Some have asked OCA whether interpretative questions dealing with IFRS issues are analyzed in the same manner as questions dealing with U.S. GAAP. To answer this question, I would like to point out that we in OCA do approach a question under IFRS with a similar process as we do under U.S. GAAP.
Let me provide you with an example to highlight the process that we go through when resolving an interpretative question on the application of IFRS. Recently, a debt versus equity classification issue arose regarding the application of IAS 321 that we were asked to consider through the OCA consultation process. The inquiry centered on the appropriate classification for the conversion feature of a convertible preferred instrument that was convertible into a variable number of common shares (with a floor and a cap on the number of common shares that could be issued). The specific question related to the classification for this conversion feature.
In thinking about the question, the staff went through a number of steps. First, the staff followed its normal process of researching and analyzing the issue.2 As many of you know, this process is outlined on the SEC website and consists of a number of steps including internal research, discussing the issue amongst several members of the OCA staff, and discussions with the Company.
Additionally, the staff also discussed the issue generically with one of our foreign securities regulator counterparts (who in this case was a foreign regulator of a different jurisdiction than the Company's own jurisdiction). We also reached out and discussed the issue informally with the IASB staff. These last two steps were simply elements that we in OCA used in our decision making process and are analogous to our outreach to the FASB staff or other regulators that we sometimes do in our consultation process for U.S. GAAP issuers.
Only after going through this full process did the staff express a view on the issue — which in this case was an objection to the Company's proposed accounting treatment. As a final note, while in this case there was a discussion with another regulator, I wanted to confirm that this step is not a necessary requirement in us reaching a final conclusion on a formal consultation.
Debt Extinguishment — Related Party
Let me turn to a second topic that also deals with a debt versus equity issue. Over the past year, the staff has received a couple inquiries related to early extinguishment of debt in non-troubled debt situations. These inquiries have focused on when the language in U.S. GAAP3, which states that "extinguishment transactions between related entities may be in essence capital transactions," should be applied to certain transactions.
To be clear, the staff has not formed any bright line views on these types of transactions and analyzes these questions individually on a specific facts and circumstances basis.
To illustrate one example and how we thought about the issue, consider the following fact pattern. A Company has non-convertible debt outstanding to a related party4 (An executive of the Company who is also a significant shareholder). Assume that at a later date the related party accepts an offer from the Company to exchange the debt for the Company's common stock. At the date of exchange, assume that the value of the common stock that was accepted by the related party was significantly lower than the carrying value of the Company's debt.
At issue is whether the Company's exchange of common stock for the debt held by the related party should be accounted for as an early extinguishment gain or as a capital contribution. As part of its considerations on this issue, the staff approached the analysis by asking the following questions (please note that this is not an exhaustive list):
What was the role of the related party in the transaction?
Why would the related party accept the Company's offer which resulted in the related party accepting common stock that was significantly lower in value than the carrying value of the debt?
Was the substance of the arrangement a forgiveness of debt that was owed to a related party?
Based on its analysis, which included the information provided in response to these questions, the staff believed the substance of the transaction was in essence a capital contribution from a related party. The staff believes that a full analysis is required in assessing the substance of these types of transactions. Accordingly, the staff would expect that registrants consider all of the facts and circumstances and related party relationships in a particular transaction when making its accounting assessment.
Allocation of Goodwill in a Partial Disposal
I would like to now change subjects and cover an accounting topic associated with long-lived assets. The issue is how an entity should allocate goodwill when it disposes of a portion of a reporting unit. One type of transaction that the staff has recently considered is a franchising arrangement. To illustrate this type of arrangement, assume that there is a transaction where a previously wholly-owned entity is franchised to a third party. As part of the arrangement, the franchisor receives upfront proceeds for the existing assets of the location from the franchisee and separately a franchise agreement is contemporaneously signed which requires the franchisee to make royalty payments at a market rate to the franchisor based on future sales volume.
The relevant accounting guidance5 requires that upon a partial disposal of a reporting unit, goodwill associated with that business shall be included in the carrying amount in determining the gain or loss on disposal. The amount of goodwill that should be included in the carrying value is based on the relative fair values of the business disposed of and the portion of the reporting unit that is retained.
The question we addressed is how the value of the franchise agreement should be considered in the relative fair value calculation in determining how much goodwill should be allocated to the carrying value. Specifically, we were asked whether the value of the franchise arrangement should be included as part of the fair value of the business that was disposed of or part of the reporting unit that was retained.
Based on the facts provided in the consultation, the staff did not object to a Company including the value of the franchise agreement as part of the fair value that was retained. The staff believes that this interpretation of the guidance is an acceptable analysis of the applicable accounting guidance highlighted above.
That concludes my prepared remarks. I hope you enjoy the rest of the conference. Thank you.