Speech by SEC Staff:
Remarks Before the 2004 AICPA National Conference on Current SEC and PCAOB Developments
John M. James
Professional Accounting Fellow
Office of the Chief Accountant
U.S. Securities and Exchange Commission
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.
As is always the case, we’ve seen issues in many areas of accounting over the past year. Although issues like FIN 46R1 and FASB Statement No. 1332 have generated their share of questions, I’d like to focus my time on a couple of issues related to an older piece of financial instrument literature, FASB Statement No. 1153. Although this statement has been in place for 11 years, it seems to generate a never ending stream of questions. Interestingly, guidance on many of the questions that we continue to get regarding Statement 115 is available in the FASB Staff Implementation Guide to Statement 115, which was originally published in 1995 (and which has been subsequently revised three times since) and includes answers to 61 questions regarding the accounting for securities within the scope of Statement 115. I encourage those who deal with the accounting for these securities frequently to refresh their familiarity with this Staff Implementation Guide.
Transfers Into and From the Trading Account
The first issue that I would like to address relates to transfers into and from the trading account for securities accounted for under Statement 115. While this issue has been around for a number of years and may seem very basic, we believe that it is prudent to again to remind registrants of the requirements of Statement 115 as it relates to this issue.
Paragraph 15 of Statement 115 states in part “Given the nature of a trading security, transfers into or from the trading account also should be rare.” This point is further reiterated in Question 44 to the FASB Staff Implementation Guide to Statement 115. The staff believes that Statement 115’s limitations on transfers into or from the trading category (as well as those limitations related to transfers or sales of securities from the held-to-maturity category) provide rigor and discipline to the application of the standard, thus improving the credibility of reported earnings as it relates to the accounting for certain debt and equity securities.
We are aware of instances where registrants have transferred Statement 115 securities into or from the trading account that were not made in conjunction with the adoption of a new accounting standard that would have permitted such transfer, such as Statement 133. Upon further review, the registrants’ noted a variety of reasons for the transfers into or from the trading account including changes in investment strategies, achieving accounting results more closely matching economic hedging activities and repositioning the portfolio due to anticipated changes in the economic outlook. The staff does not believe the reasons noted above are consistent with the notion of “rare” as contemplated in Statement 115, as they represent factors that are frequently present.
The follow on question would obviously be how the staff views the term “rare” for these purposes. First, despite rumors to the contrary, “rare” does not mean “never”. However, “rare” would seem to establish a very high threshold. For example, it may be acceptable to transfer securities between the trading and available for sale categories due to a change in statutory or regulatory requirements. Similar transfers might be appropriate if a significant business combination or other event greatly alters the company’s liquidity position or investing strategy. Other facts and circumstances might also exist that would make such transfers acceptable, but those facts and circumstances would need to clearly indicate an event that is unusual and highly unlikely to recur in the near term. The point to be taken away from this discussion is that the staff continues to have a high level of interest related to this issue and will continue to question (and/or challenge) registrants that have transferred securities into or from the trading category. As a result, registrants should consider discussing the issue with us prior to transferring securities into or from the trading category.
Accounting for Other than Temporary Impairments on Certain Investments
The next issue that I would like to talk about is one that has been addressed in previous conferences and other venues, but again deserves a few words. Hopefully, I can help to clear up some confusion that seems to exist on the accounting for impairments of certain investments in debt and equity securities. The Emerging Issues Task Force (the “EITF”) addressed the issue in EITF Issue 03-14. The disclosure provisions of Issue 03-1 became effective for annual financial statements for fiscal years ending after December 15, 2003 and the recognition and measurement guidance was required to be applied to impairment evaluations in reporting periods beginning after June 15, 2004. I am sure that most everyone here is aware that the recognition and measurement guidance in Issue 03-1 has been deferred and that the FASB will be reconsidering this recognition and measurement guidance in its entirety. Based on the responses to the proposed FASB Staff Position (“FSP”) on Issue 03-1, I am sure that many of you are supportive of the FASB’s decision to reconsider the issue. Given the issues raised in the numerous comment letters, we are also supportive of the decision to reconsider the issue in its entirety.
In the FSP delaying the effective date of the recognition and measurement portions of Issue 03-1, the FASB staff noted that “During the period of the delay, an entity holding investments should continue to apply relevant other-than-temporary guidance”. I would like to remind registrants that amongst this guidance that should continue to be applied are the provisions of Staff Accounting Bulletin Topic 5M5 (“Topic 5M”). During the past few months, we have noted that there appears to be concern as to what the staff’s views are on this issue. As a result, I will attempt to address the concern by summarizing some of those views.
Topic 5M specifies that declines in the value of investments in marketable securities classified as either available for sale or held to maturity under Statement 115 caused by general market conditions or by specific information pertaining to an industry or an individual company require further investigation by management. In this regard, Topic 5M states: “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.” Therefore, in conducting its investigation, management should consider the possibility that each decline may be other than temporary and reach its determination only after consideration of all available evidence relating to the realizable value of the security. Once a security is in an unrealized loss position that is, once its fair value is below its carrying value management should perform an assessment to determine whether the impairment is other than temporary.
Topic 5M states that “there are numerous factors to be considered in such an evaluation and their relative significance will vary from case to case. The staff believes that the following are only a few examples of the factors which, individually or in combination, indicate that a decline is other-than-temporary and that a write-down of the carrying value is required: (1) the length of the time and extent to which the market value has been less than cost; (2) 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 (3) 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.” The staff expects that registrants will employ a systematic methodology that includes the documentation of the factors considered.
Let me summarize some of our thinking on a few points. One key focus of the staff’s views is the length of time and the extent to which the market value has been less than cost. The staff expects that the impairment analysis performed by a registrant would be more robust and extensive as the length of time in which a recovery needs to occur becomes shorter and the magnitude of the decline in value becomes more significant.
An additional point that I want to address relates to whether an entity’s intent and ability to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value becomes tainted in situations where the entity disposes of a security at a loss for which it had previously asserted its intent to hold until recovery. The staff has heard that some view the consideration of an entity’s intent and ability to hold until recovery in the same context as would be done under paragraph 8 of Statement 115 which addresses sales or transfers of held-to-maturity securities. That is, if a security is sold from that portfolio and doesn’t meet one of the few exceptions, then the whole portfolio becomes tainted, requiring a change in the measurement basis of such securities. The staff does not believe that the tainting concept resulting from paragraph 8 of Statement 115 should be applied in the same manner to the Topic 5M analysis. The staff believes that the individual facts and circumstances around individual (or larger groups of) sales of securities should be evaluated in determining whether the hold to recovery assertion for the remaining securities continues to be valid.
In closing, I would like to remind registrants of their need to remain diligent in the application of Statement 115 (and related interpretive guidance) and Topic 5M to certain investments in debt and equity securities. Additionally, I would encourage registrants to actively participate in the FASB’s due process on the reconsideration of EITF 03-1. Thank you for your time.
1 FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities
2 FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities
3 FASB Statement No. 115, Accounting for Certain Investments In Debt and Equity Securities
4 EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments
5 Staff Accounting Bulletin Topic 5M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities