Statement by SEC Staff:
Remarks before the 2005 AICPA National Conference on Current SEC and PCAOB Developments
Professional Accounting Fellow
U.S. Securities and Exchange Commission
December 5, 2005
As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
Good afternoon. Today I would like to share with you some views on a number of technical issues including those on: (1) the shortcut method of assessing hedge effectiveness under Statement 133,1 (2) the identification of implicit variable interests in the application of FIN 46(R),2 and finally (3) the classification and measurement of redeemable equity securities.
Shortcut Method of Assessing Hedge Effectiveness
At previous conferences, the staff has given particular attention to some of the fundamental concepts in Statement 133 such as hedge documentation and effectiveness testing. I am going to take the next few minutes to talk about some of these areas again today, however my comments will focus on hedges of interest rate risk under a method that has been termed "the shortcut method.
One of the general requirements of Statement 133 is that hedge accounting is only appropriate for hedging relationships that an entity expects to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the risk being hedged.3 To meet this requirement, companies must assess the effectiveness of a hedging relationship both prospectively and retrospectively. The prospective assessment is made both at the inception of a hedging relationship and on an ongoing basis and requires that companies justify their expectation that the relationship will be highly effective over future periods. The retrospective assessment is also performed on an ongoing basis and requires companies to determine whether or not the hedging relationship has actually been effective. If a company concludes, through a retrospective evaluation, that hedge accounting is appropriate for the current period then it measures the amount of hedge ineffectiveness to be recognized in earnings.
The shortcut method is an exception from these periodic assessment and measurement requirements. It would seem that this exception was provided in response to preparers and other constituents who argued that these requirements were overly burdensome for certain "straightforward hedges of interest rate risk.
While the Board did grant the shortcut method as an exception, the circumstances in which it can be applied are limited. Statement 133 limits its use to hedges of interest rate risk that involve interest-rate swaps and recognized interest-bearing assets or liabilities. It also requires that general hedge requirements such as contemporaneous formal documentation be met. It then adds nine additional criteria, specific to shortcut method hedges, which must also be met.4
We have seen several instances in which the shortcut method has been inappropriately applied. I will briefly touch on a couple of these situations. In the first situation, the company had entered into a "tailored" derivative instrument that was intended to mirror the terms of the hedged item. This company assumed that it did not need to assess or measure ineffectiveness because it had met the "spirit" of the shortcut method. Although these relationships did appear to provide economic offset, they failed to meet one or more of the criteria necessary to qualify for the shortcut method. The staff has therefore objected to the use of the shortcut method in these and other situations in which the specific criteria in Statement 133 were not met. In other words, the staff does not believe that the shortcut criteria have a "spirit" or a principle that can be met without strictly complying with the stated requirements. This view is consistent with DIG Issue E45 which indicates that each and every one of the shortcut criteria must be met and that "a hedging relationship cannot qualify for application of the shortcut method based on an assumption of no ineffectiveness justified by applying other criteria.
The other example focuses on the requirement that interest rate swaps must have a fair value of zero at the inception of the hedging relationship.6 In some situations, companies have incorporated a financing element in the interest rate swap that results in a fair value other than zero. The financing element is included as an adjustment to the "pay or "receive legs of the interest rate swap. These adjustments are often made in lieu of paying or receiving a dealer or broker fee or some other component of the transaction that was being exchanged. Companies have argued that the fair value must have been zero since no cash was paid or received when the swap was entered into. The staff has rejected this argument because there were multiple components involved in the transaction with the financing element causing the swap to have a fair value other than zero at inception.
Finally, one of the more frequent questions that we have been asked relates to the quantification of errors that arose from an inappropriate application of the shortcut method. Some believe that the amount of the error should be measured as the ineffectiveness that would have been recognized under other hedge accounting methods. The staff has often objected to this approach for quantification of errors for these hedging relationships because it assumes that the error only concerned the measurement of ineffectiveness and that the requirements for hedge accounting were still met. As I stated earlier, one of the general hedge accounting requirements is prospective and retrospective testing of hedge effectiveness. If a company has been relying on the application of the shortcut method, these tests may very well not have been performed. As such, the provisions to allow hedge accounting under other methods may not have been complied with. Thus, if the shortcut method has been applied inappropriately, it may be that the error needs to be quantified as if hedge accounting was not applied in those periods.
Implicit Variable Interests
Changing topics now, another area that I would like to highlight is the identification of implicit variable interests when applying FIN 46(R).
At this conference last year, Jane Poulin briefly mentioned the need to consider "activities around the entity when applying FIN 46(R) and that certain types of activities could impact both the determination of whether an entity is a variable interest entity as well as identification of the primary beneficiary.7
The FASB staff addressed some of these issues earlier this year when they issued a staff position on implicit variable interests.8 This FSP provides guidance for determining when activities around the entity would cause a reporting enterprise to have a variable interest. The FSP describes an implicit variable interest as an interest that absorbs or receives the variability of an entity indirectly rather than through contractual interests in the entity.9 The guidance does not however provide a "bright-line for determining when an implicit variable interest exists. Instead, the FSP indicates that such determinations are a matter of judgment and will depend on the relevant facts and circumstances.10
At the end of the FSP, the FASB staff provides one comprehensive example of the how the FSP should be applied. In that example a company leases an asset from an entity that is entirely owned by a related party. Under the FSP, the lessee company would hold an implicit interest in the lessor company if it effectively guaranteed the related party's investment.
The guidance on implicit variable interests is important for a number of reasons. In particular, it helps meet the objective in FIN 46(R) that variable interest entities should be consolidated by a company that has a majority of the risks and rewards.11 It also prevents registrants from circumventing the provisions of FIN 46(R) by absorbing variability indirectly such as through an arrangement with another interest holder rather than directly from the entity.
With these thoughts in mind, I would like to highlight a few things about implicit variable interests. First, while much of the discussion in the FSP focuses on the example of a noncontractual interest in a leasing transaction between related parties, it is important to note that implicit interests can also result from contractual arrangements with unrelated variable interest holders. For instance, we recently evaluated a registrant's conclusion that it was not the primary beneficiary of a variable interest entity because it did not have any interest in the entity whatsoever. However, following several inquiries from the staff it became clear that the registrant had entered into contractual agreements with several of the variable interest holders that effectively protected those holders from absorbing a significant amount of the entity's variability. In this circumstance, we concluded that the contractual agreements with the variable interest holders were implicit interests in the variable interest entity. The registrant was, in fact, absorbing a majority of the expected losses through those implicit interests and was therefore the primary beneficiary despite having no direct contractual interest in the variable interest entity.
Consistent with the FASB staff's guidance, we believe that identification of implicit variable interests is a matter of judgment that depends on individual facts and circumstances. Again, there are no "bright-line tests that can be applied to easily identify these arrangements. However, with this in mind, registrants should consider the following questions in evaluating whether or not a contractual arrangement with a variable interest holder is an interest in the entity:
- Was the arrangement entered into in contemplation of the entity's formation?
- Was the arrangement entered into contemporaneously with the issuance of a variable interest?
- Why was the arrangement entered into with a variable interest holder instead of with the entity?
- And lastly, did the arrangement reference specified assets of the variable interest entity?
While answers to these questions might not provide definitive conclusions for every circumstance, we believe that they will provide a good starting point for evaluating whether an implicit variable interest exists.
Redeemable Equity Securities
My last topic today focuses on redeemable equity securities. The staff has become aware of questions in practice regarding the application of ASR 26812 to equity securities with redemption features and other options. The question that I will address today concerns preferred securities that include multiple mutually exclusive options that are exercisable by the holder. In one example, the first option is a conversion option that is currently exercisable. This option gives the holder the right to convert the security into a fixed number of common shares. The second option, which is not currently exercisable, is a redemption option that gives the holder the right to redeem the shares for cash. The second option would become exercisable following the passage of a specified period of time.
Under the staff guidance in Topic D-9813, these instruments are required to be classified outside of permanent equity because of the existence of a redemption feature.
The inquiries received by the staff concern the subsequent measurement of these securities following initial measurement at fair value. Topic D-98 has differing guidance on subsequent measurement for redeemable securities that depends upon whether the securities are currently redeemable, or whether it is probable or not that the security will become currently redeemable in the future.
When applying this guidance to a security with both a conversion option and a redemption option like the one described earlier, some have argued that it is not probable that the security will become currently redeemable because of the likelihood that the holder will exercise the conversion option first. We have objected to this view because the exercise of the conversion option was controlled entirely by the holder. Absent that action by the holder, the security will become redeemable following only the passage of time. The probability assessment that is required by Topic D-98 would not factor in the likelihood that other options held by the holder may or may not be exercised first. Thus, the instrument that I have described would be considered to be probable of becoming currently redeemable regardless of the likelihood of earlier conversion. As a result, the changes in the redemption values for this instrument would be recognized over the period from the date of issuance to the earliest possible redemption date using either of the two methods specified in Topic D-98.
That concludes my remarks. Thank you for your time.
|1 || FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities
|2 || FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities
|3 || Refer to paragraphs 20(b) and 28(b) of Statement 133.
|4 || Refer to paragraph 68 of Statement 133.
|5 || Derivatives Implementation Group Issue No. E4, Hedging-General: Application of the Shortcut Method
|6 || The fair value might not need to be zero if a premium has been exchanged for a mirror-image call or put option. Refer to paragraph 68(b) of Statement 133.
|7 || See remarks by Jane Poulin at the 2004 AICPA National Conference on SEC and PCAOB Developments
|8 || FSP No. FIN 46(R)-5, Implicit Variable Interests under FASB Interpretation No. 46(R)
|9 || Refer to paragraph 4 of FSP No. FIN 46(R)-5.
|10 || Refer to paragraph 4 of FSP No. FIN 46(R)-5.
|11 || Refer to paragraph E7 of FIN 46(R) which states that "risks, benefits, or both are the determinants of consolidation in this Interpretation.
|12 || Accounting Series Release No. 268
|13 || EITF Topic No. D-98, Classification and Measurement of Redeemable Securities