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Speech by SEC Staff:
Remarks before the 2004 AICPA National Conference on Current SEC and PCAOB Developments


Chad A. Kokenge

Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 6, 2004

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. I would like to share with you some views on a few technical issues including those related to: (1) disclosure of modifications to equity-based compensation arrangements, and (2) various issues regarding intangible assets. In addition, I will provide some thoughts on the consulting protocol when issues are submitted to the staff in the Office of the Chief Accountant.

Disclosure of modifications to equity-based compensation arrangements

As you are probably aware, the Financial Accounting Standards Board is nearing completion of its project on share-based payment. I do not intend to provide thoughts on the provisions of this new guidance, but rather, some SEC staff views on the disclosure of modifications to certain arrangements that may take place prior to adoption of the new standard. In particular, we are aware of an issue that has surfaced as companies prepare to adopt the fair value model for recognizing compensation expense for employee stock options. The issue relates to the accounting for the acceleration of vesting of stock options having an exercise price in excess of the stock's current market price (i.e., options that are out-of-the-money). To the extent that a company is currently applying the recognition provisions of APB 251 and intends to adopt the modified prospective method of accounting under FAS 123R,2 we understand the "perceived" accounting benefit for modifying the awards to accelerate the vesting before adopting the new standard is that it allows the company to accelerate the "recognition" of compensation cost such that it only impacts the fair value pro forma disclosures required under FAS 123.3

First, I would like to point out that there are different ways accountants have thought about the accounting for this particular modification. The difference of view comes about depending on one's view of the service condition requirements of FAS 123. There are those that have proposed that no acceleration of compensation cost should be allowed upon modification under the guidance in FAS 123, while others have argued that under the guidance in FAS 123 an acceleration of vesting of these options would allow for an acceleration of recognition of compensation cost, so long as the employees could exercise the options in a circumstance they would not have otherwise been able to absent the modification.

Although the arguments regarding the accounting may vary, one point in FAS 123 is clear - that is the disclosure requirement under paragraph 47. Paragraph 47 indicates that for each year an income statement is provided, the terms of significant modifications of outstanding awards shall be disclosed. Subject to this guidance, we believe that, specifically, disclosure of any modifications to accelerate the vesting of out-of-the-money options in anticipation of adopting the new accounting standard is necessary. Consistent with Scott Taub's comments about the need to disclose the reasons for undertaking transactions that appear to have a significant accounting-related purpose, we also believe that the disclosure should include the reasons the option terms were modified. We understand that the intent of these modifications may be primarily, or in large part, to avoid recognizing an expense in future financial statements. Disclosure of this underlying reasoning is needed to inform investors as to how and why management makes decisions regarding the company. In this vein, we do not believe disclosure along the lines of, "…during fiscal 2004 certain of the company's stock options were modified to accelerate vesting…" would be sufficient. My parting thought on this topic is that if you have engaged in this type of transaction or are planning to, be prepared to explain your actions to your investors in your SEC filings.

Intangible assets

Last year I discussed certain issues related to intangible assets. This year, I would like to discuss certain of those issues again, and provide some thoughts about some of the matters that were discussed in EITF Issue 03-9.4 Over the course of the last year or so, the EITF wrestled with the material modification and substantial cost concepts of FAS 142,5 in addition to the determination of an intangible asset's useful life and amortization pattern. The Task Force ultimately removed Issue 03-9 from its agenda and the FASB will now address some of the key aspects. However, in the meantime, I thought it would be useful to explain some of the SEC staff's thinking in this area.

Evaluation of material modification and substantial cost

Consistent with the general direction of the Task Force discussion at the June 30-July 1, 2004 EITF meeting, the SEC staff believes the types of costs and modifications that should be evaluated under paragraph 11(d) of FAS 142 for renewable intangible assets are those expected costs and modifications that an entity would not expect to incur if the intangible asset was perpetual in nature. Following on this theme, in the context of the paragraph 11 evaluation, we also believe the definitions of "renewal cost" and "modification" that were developed for the issue supplement6 used at the September 2004 EITF meeting are helpful. That is, renewal costs are, "costs that an entity reasonably would expect to incur that it would not otherwise incur if the renewable intangible asset was perpetual rather than renewable", and modifications are, "changes to the terms and conditions that an entity reasonably would expect to occur that it would not otherwise expect to occur if the renewable intangible asset was perpetual rather than renewable." So, notwithstanding the lack of consensus from the EITF, we believe these views should be helpful in analyzing transactions under paragraph 11.

Conceptual differences between Statements 141 and 142

Part of the debate that the Task Force wrestled with in Issue 03-9 was the linkage of the fair value assessment of the underlying intangible asset under FAS 1417 and the associated useful life assigned to the intangible asset under FAS 142. Although the distinctions garnered some debate, I believe the fair value concept in FAS 141 and the useful life concept in FAS 142 can co-exist. Let me explain.

An underpinning to the determination of fair value of an acquired intangible asset under FAS 141 is that it is determined from the perspective of a market-place participant. This is clear in FAS 141, paragraph B174, which indicates that the fair value estimate, "…should incorporate assumptions that marketplace participants would use in making estimates of fair value, such as assumptions about future contract renewals and other benefits such as those that might result from acquisition-related synergies…" In contrast, the useful life concept in FAS 142 is not necessarily viewed from that of a marketplace participant. Rather the useful life of an intangible asset is inherently related to the expectations of the particular entity and therefore would incorporate entity specific assumptions. FAS 142, paragraph 11 refers to useful life to the reporting entity. This is in contrast to the marketplace participant notion or the useful life concept in general. This latter distinction is clarified in FAS 142, paragraph B55. Further to the entity specific point, the language in FAS 142, paragraph B47 is supportive of this view as it indicates that, "Because the useful lives of certain intangible assets depend on renewal and on the associated costs, the Board concluded that the useful lives assigned to those assets may reflect renewal only if there is evidence to support renewal without substantial cost." The practical issue is that many times, entities may determine the fair value of an intangible asset using an income approach and consider the assumptions in the approach from the perspective of the acquiring entity given that there may be limitations on the availability of other information to assess the fair value. In this context, the entity may believe that the fair value determination should therefore be entirely consistent with the useful life then assigned to the intangible asset as in this case, both were developed based on entity specific assumptions. I would point out, however, that the utilization of entity specific assumptions to determine fair value in this case is just a proxy for those assumptions that may be developed by a marketplace participant. An entity might expect to realize cash flows differently from others in the marketplace due to differences in settlement alternatives, risk tolerance, firm specific advantages or perhaps differences in resources or access to capital. Although not an exhaustive list, such variances could give rise to differing values. In addition, as to another distinction, the probability of contract renewal, even if low, would impact the fair value determination of the related intangible asset under FAS 141; however, if there was a low expectation of renewal, it probably would not meet the threshold outlined in FAS 142, paragraph B47 and therefore would not be factored into the estimate of useful life of the intangible asset.

Some may believe the estimate of the fair value assigned to the intangible asset and its useful life are inextricably linked, and therefore, may believe it to be appropriate to alter the fair value determination of the intangible asset under FAS 141 by "truncating" the life of the cash flows utilized in an income approach to be consistent with the "useful life" as determined under FAS 142. However, given these aforementioned distinctions, the SEC staff believes this practice would be inappropriate and that the resulting value would not be "fair value" as contemplated by FAS 141.

Protocol when discussing issues with the staff in the Office of the Chief Accountant

Last year I discussed some thoughts regarding OCA's consulting protocol,8 specifically indicating that it would be helpful if registrants include the business purpose of the transaction in the submission. Consistent with the message from last year, we would like to continue to encourage registrants to consult with the staff in OCA on complex or unusual accounting, financial reporting, and auditing issues. We appreciate all of you who have been willing to discuss your issues and concerns with us.

This year, I would like to make one additional point. When matters are addressed by the staff in OCA, you can expect the staff to ask about the views of the company's auditors and whether the matter has been discussed with the auditor's national office or other technical resource. This will be true whether the issue is a direct submission to OCA, or whether the issue comes to OCA by way of a filing review from the Division of Corporation Finance or the Division of Investment Management. To these latter sources, sometimes novel issues are brought to our attention in the filing process and we have had experiences where the auditors were not what I would characterize as "totally engaged" with respect to the issue at hand. I would point out that at the time an issue is being addressed by the staff during a filing review, it is probably time for the auditor to engage in the accounting discussion. If the transaction is ready for presentation to investors in the registration statement pro formas or financial statements, we will expect the auditor to have a thought-out view regarding the related accounting. In addition, it is highly likely that if the issue results in significant discussion with the SEC staff, it is worth some discussion with the auditor's technical experts or national office professionals. We encourage active involvement at that time as it is beneficial to the end result - good financial reporting for investors.


That concludes the discussion for today. We will have representatives available later in the day to address questions. Thank you.



Modified: 12/06/2004