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


Robert J. Comerford

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.


The SEC staff has dealt with a variety of registrant and standard-setting issues over the past year. In dealing with those issues, I discovered that I have unfinished business relating to two topics that I spoke about at this venue last year: (1) the application of EITF Issue No. 96-19, Debtor's Accounting for a Modification or Exchange of Debt Instruments, to modified convertible bond transactions and (2) the classification of certain trade accounts payable transactions involving an intermediary.

Application of EITF Issue No. 96-19 to modified convertible bond transactions

Last year I talked about how certain modifications of debt instruments should be considered under the provisions of EITF Issue No. 96-19 for purposes of determining whether the modification is accounted for as an extinguishment or a modification. I did not, however, discuss modifications of convertible instruments.

Recently, there have been a number of modifications of convertible instruments, in part because some registrants have elected to modify the terms of their existing contingently convertible debt instruments in order to minimize the EPS dilution that would otherwise have resulted from the adoption of EITF Issue 04-8.1 Specifically, some issuers have modified their debt to conform the terms, and thus the accounting with the security described as Instrument C in EITF Issue 90-19.2 Pursuant to the terms of Instrument C, issuers have the option of satisfying the excess of the bond's conversion value over the bond's accreted value, commonly referred to as the conversion spread, in either cash or stock. At the same time, Instrument C issuers are required to satisfy the bond's accreted value (the amount accrued to the benefit of the holder exclusive of the conversion spread) in cash.

The purpose of my speech today is not to second guess the accounting for Instrument C. EITF Issue 90-19 describes an accounting and EPS model that was developed specifically for that instrument. However, I will observe that to the extent that a market price conversion contingency is included in the terms of Instrument C, the conversion spread is within the scope of EITF Issue 04-8. Thus, in these instances, the conversion spread must be included in an entity's diluted EPS calculation in all periods in which it would be dilutive to do so, regardless of whether the conversion contingency has been met.

Now for the main purpose of today's speech. In light of the flurry of modifications taking place in the convertible market right now, I thought that today would be a good time to share some thoughts regarding the manner in which modifications of convertible debt should be factored into an entity's EITF Issue 96-19 analysis. Modifications of convertible bonds require further consideration because such modifications may result in direct or indirect changes to the conversion feature itself.

EITF Issue 96-19 requires that debtors compare the present value of cash flows associated with a modified instrument with those associated with the original instrument in order to determine if the present value of the cash flows differ by 10 percent or more. To the extent that the present values of these instruments do differ by 10 percent or more, the modification transaction must be accounted for as the extinguishment of the original instrument and the issuance of a new one. In all other instances, the issuer accounts for the transaction as a modification of the original instrument. EITF Issue 96-19 addresses the subsequent accounting for both scenarios.

EITF Issue 96-19 prescribes the way in which various aspects of a modification transaction should be incorporated into the discounted cash flow analysis that I have just described. However, EITF Issue 96-19 is silent as to whether or how changes in the value of a conversion option should be incorporated. At this point I would like to observe that changes to the value of a conversion option may be direct, indirect or some combination thereof. Direct changes include, but are not limited to, changes to the conversion price, changes to the number of shares underlying the option and/or changes to the nature of any conversion contingencies. An example of an indirect change would be the lengthening or shortening of the bond's maturity, with the result that the term of the conversion option has also been extended or diminished. Each of the changes I have described could impact the intrinsic and/or time value of a conversion option.

Some have expressed a view that changes in embedded conversion options do not impact the cash flows of the bond, and thus should not be considered when performing an EITF 96-19 discounted cash flow analysis. Others believe that changes in embedded conversion options need only be considered to the extent that a difference can be identified when comparing the intrinsic value of the conversion option immediately prior to the modification with the intrinsic value of the conversion option immediately following the modification. The OCA Staff disagrees with both of these views.

When an issuer modifies a convertible security, the issuer must compare the fair value of the conversion option immediately following such modification with its fair value immediately prior to the modification. In using the term fair value, I am referring to both the intrinsic and time value components of the conversion option. To the extent that a difference is identified, that difference should be included in any EITF Issue 96-19 analysis in the same way as one would include a current period cash flow.3 An example of a current period cash flow would be any fees exchanged between the debtor and the creditor, the treatment of which is explicitly addressed in the provisions of EITF 96-19.

Investor behavior demonstrates that on issuance, there is a direct correlation between the fair value of a conversion option and the yields demanded on the security. Specifically, investors in convertible bonds typically accept reduced or non-existent yields in exchange for a conversion option whose fair value consists entirely of time value. The OCA Staff believes that investors that are negotiating a modification to convertible debt terms behave in a similar manner. Thus, notwithstanding the Task Force's silence on the matter, we believe that any EITF 96-19 analysis of a convertible bond modification that does not take into consideration changes in the fair value of the embedded conversion option would be incomplete.

Classification and disclosure of certain trade accounts payable transactions involving an intermediary

Changing gears, I would now like to revisit the topic I spoke about at last year's conference regarding two transactions that I dubbed the "securitization" of accounts payable. As some were quick to point out, these transactions do not involve the securitization of anything. So instead, I will refer to these transactions as "structured payable transactions."

For those of you who may not have been at last year's conference, the transactions I described had one goal in common. A third party financial institution paid, or facilitated payment of, amounts due to a client's trade creditor. These payments were made within the time period necessary to secure a trade discount. The financial institution's client was then obligated to pay the financial institution within a specified window of time. The financial institution's client benefited by securing either (a) a repayment date from the financial institution that extended beyond the due date of the original trade payable, or (b) a portion of the trade discount taken by the financial institution via a slight reduction in the amount due to the financial institution on the payables' original due date. Some entities continued to classify amounts now due to their financial institution as amounts due to trade creditors. As I mentioned last year, the OCA Staff objects to such classification. Regulation S-X, Article 5, requires separate and clear display of amounts payable for borrowings and amounts payable to trade creditors.

Shortly after my speech last year, a former colleague called to congratulate me on being the only individual in the accounting profession that was capable of making accounts payable sexy again. I must admit that I was a bit puzzled at her comment. Quite frankly I had never known accounts payable to be sexy in the first place. All joking aside, the volume of inquiries that I have received over the past year coupled with continued structuring activity in this arena has helped to put her comment in context.

As I demonstrated last year, I often find it helpful to put discussions of technical accounting matters in the context of a real life example. It seems that some perceived last year's discussion of two troubling transactions as the equivalent of a Staff roll-out of a "model" for determining when short term borrowings should be classified as trade payables. I'd like to confirm once and for all that this is not the case. As a general rule, the OCA Staff does not believe that it is possible to determine the appropriate accounting for structured transactions simply via reference to checklists and templates. Rather, we believe that an entity must perform a thorough analysis of all the facts and circumstances specific to the individual transaction in order to ensure that the entity's accounting for the transaction serves investors well. As Scott and Andy both mentioned earlier this morning, this necessitates meeting not just the letter, but the spirit of the accounting literature.

Since making last year's speech, the Office of the Chief Accountant has not received any pre-filing submissions from registrants entering into structured payable transactions with their vendors and financial institutions. On the other hand, some pitch books have been floating around purporting that the FASB Staff has analyzed the transaction being pitched, and has agreed with the pitchmen that continued trade payable classification is appropriate. I find this claim difficult, if not impossible to believe.

So, taking my cue from Hollywood's decision to make this year the year of the sequel (Shrek 2, Spiderman 2), I thought this year's conference might be a good time to revisit the topic of structured payable transactions. So as to avoid any confusion regarding whether I am presenting a model - let me be clear - I am not. Instead, I thought it might be helpful to make a couple more observations, and ask a couple of thought provoking questions.

First and foremost, I would like to encourage preparers and auditors to take a close look at the roles, responsibilities and relationships of each party to a structured payable transaction. Then take a step back and look at the totality of the arrangement. Does the financial institution make any sort of referral or rebate payments to its client? Has the financial institution reduced the amount due from its client, such that the amount due is less than the amount the client would have had to pay to the vendor on the original payable due date? Has the financial institution extended beyond the payable's original due date, the date on which payment is due from its client? Next, spend a few moments thinking about the literal definition of the term "trade creditor." The OCA Staff believes that a trade creditor is a supplier that has provided an entity with goods and services in advance of payment. Taking all of this into account, does it still seem appropriate that amounts payable to a financial institution be classified on the balance sheet as a trade payable?

At this point, some may attempt to analogize structured payable transactions to accounts receivable factoring arrangements. Here again, I have a couple of thoughts.

Investorwords.com defines factoring as "The selling of a company's accounts receivable, at a discount, to a factor, who then assumes the credit risk of the account debtor and receives cash as the debtor settles their account." You'll notice that this definition does not make any mention of the company's customer actively or passively participating in the process. Nor does the definition make any mention of the company's customer receiving any reductions in the amount of its obligation, any referral fees or rebates, or any extension of its trade payable maturity dates beyond that which were customary prior to inception of the arrangement. (E.g. 2/10 net 30)

Pondering this myself, I find that I am naturally drawn to the following conclusions. If a transaction walks, talks and smells like a short term borrowing it probably is. If a transaction makes smart business/economic sense on its own, without giving consideration to its accounting treatment, do it. If you are spending an inordinate amount of time and money trying to convince yourself and/or your auditors that the transaction is something that it is not, take a step back and ask yourself whether achieving your desired accounting outcome will influence your decision to proceed with the transaction. If the answer to this question is yes, then ask yourself whether your desired accounting meets the spirit of the accounting literature and provides investors with a meaningful, transparent and representative snapshot of your finances?

Over the past year or so, the "buzz term" in the profession has been a return to "the basics." Over the past few minutes I have attempted to do just that. I would encourage those considering the accounting for these types of transactions to do the same.

On that note, I would like to close by extending the same invitation that I did when the credits were rolling on Accounts Payable 1 during last year's speech. The Office of the Chief Accountant is always willing to meet with registrants to discuss their accounting for transactions that impact their books and records. Structured payable transactions seem like the perfect candidate for such consultations. For those who might be interested in doing so, after lunch, Chad Kokenge will be speaking briefly about the protocol for such consultations.



Modified: 12/06/2004