Remarks before the 2014 AICPA National Conference on Current SEC and PCAOB Developments
T. Kirk Crews
Professional Accounting Fellow, Office of the Chief Accountant
Dec. 8, 2014
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 the views of the Commission or of the author’s colleagues upon the staff of the Commission.
Good morning. I would like to highlight some observations about the statement of cash flows, make a quick point about mortality assumptions in defined benefit accounting and then turn our attention to accounting for amendments to or exchanges of preferred stock.
Statement of cash flows
From time to time, the staff reviews restatement data to understand current trends and potential practice issues. One observation that we felt warranted further understanding was that while the total number of restatements over the past five years has been relatively consistent, restatements due to errors in the statement of cash flows continue to increase year over year.[i] Given these results, the staff spent time trying to understand what might be driving recent cash flow restatements. While this process involved reading disclosures and making certain assumptions, the staff noted that in the sample of items we reviewed the majority of the errors were due to relatively less complex applications of GAAP,[ii] such as failure to appropriately account for capital expenditures purchased on credit.[iii] The staff has been considering why the statement of cash flows seems to be increasingly prone to error. While we do not have the information that would be necessary to perform a thorough root cause analysis, given we are in the midst of calendar year ends, let me suggest you consider the following aspects of your process and controls for preparing the statement of cash flows.
- Information – How are you collecting the financial data necessary to prepare the statement of cash flows? What processes are in place to ensure this information is complete and accurate, especially to the extent new or nonrecurring transactions have occurred? Are there manual processes that are ad hoc that could be standardized or automated?
- People – Do those individuals preparing the statement of cash flows understand the principles in Topic 230?[iv] Are there ways you can provide them with better training to perform their job? Do those individuals reviewing the statement of cash flows have enough expertise to identify and prevent misstatements in their review process?
- Timing – Are there ways to prepare and review the statement of cash flows earlier in the financial statement closing process?
Of course all of this implicates internal control over financial reporting, and based on the continuing trend of restatements in this area, the staff thinks it is appropriate for management to consider and evaluate the existing controls around the preparation and review of the statement of cash flows. Given the increasing nature of misstatements, this should likely include Risk Assessment and Monitoring controls in addition to Control Activity level controls.
Let me briefly comment on defined benefit accounting. As you know, mortality is a key assumption utilized to measure a plan’s cost and obligation. Subtopic 715-30[v] and Subtopic 715-60[vi] are clear that each individual assumption, including mortality, should reflect the plan’s best estimate.[vii] The staff understands that historically registrants have utilized the Society of Actuaries’ (SOA) published mortality data in developing their best estimate of mortality. In October 2014, the SOA published updated mortality tables and an updated improvement scale, which both reflect improved longevity. The staff understands there has been some discussion among companies about whether the SOA’s recent mortality data can be ignored for current year measurements. Given plan sponsors have historically utilized the SOA’s mortality data and that data has been updated, the staff does not believe it would be appropriate for a registrant to disregard the SOA’s new mortality data in determining their best estimate of mortality. Finally, management should consider the guidance in Subtopic 715-20[viii] and disclose the impact of mortality to the extent it results in a significant change in the benefit obligation.[ix]
Accounting for amendments to or exchanges of preferred stock
Let’s shift our attention now to a preferred stock issue. As most of you are aware, the Financial Accounting Standard Board’s (FASB) Codification does not explain how to determine whether amendments to preferred stock represent an extinguishment or modification. Before we move forward, I want to be clear my focus today is only on equity-classified[x] preferred stock, as liability-classified preferred stock should follow the existing debt modification and extinguishment guidance.[xi]
The staff believes that an amendment to preferred stock can be of such significance that it represents an extinguishment of the existing preferred stock and the issuance of new preferred stock. On the other hand, the staff also believes that an amendment to preferred stock, while important to the parties, can lack the same level of significance and is more appropriately characterized as a modification. We believe current accounting literature supports this view. First, debt literature acknowledges that certain changes are merely modifications while other changes should be captured by extinguishment accounting.[xii] The staff believes it is appropriate to apply similar analysis to preferred stock. Second, in September 2009 when technical corrections were made to the scoping guidance to ASC 260-10-S99, the staff believed exchanges of preferred stock could be either extinguishments or modifications.[xiii]
Two issues remain:
- How do you determine whether an amendment or exchange is a modification or extinguishment?
- If you conclude the amendment or exchange is a modification, what is the appropriate accounting?
Determining whether an amendment or exchange is a modification or extinguishment
The staff has observed that the most common approach to determining whether an amendment or exchange is a modification or extinguishment is what I will call a “Qualitative Approach.” Under this approach, one considers the significance of any contractual terms added, contractual terms removed, and changes to existing contractual terms. It is also necessary to evaluate the business purpose for the changes and how the changes may influence the economic decisions of the investor. If these changes are judged to be significant, the amendments or exchange would be treated as an extinguishment; otherwise, the changes are considered a modification to the preferred stock.
We are also aware of other approaches in practice that would seem to yield reasonable conclusions.
We have seen what I will call a “Fair Value Approach” used in practice. Under this approach, the fair value of the preferred stock after the amendment is compared to the fair value of the preferred stock immediately before the amendment to determine if the preferred stock is substantially different. For purposes of this approach, if there is a 10% or greater change in the fair value of the preferred stock, the preferred stock is considered substantially different and the amendment or exchange would be accounted for as an extinguishment. If the change is less than 10% the preferred stock was simply modified.
We have also seen what I will call a “Cash Flow Approach.” This approach is similar to the “Fair Value Approach” except that contractual cash flows are evaluated, rather than the fair value. This approach may only be reasonable, however, when the preferred stock has well-defined periodic contractual cash flows.
Finally, we have seen what I will call a “Legal Form Approach.” Under this approach, any legal exchange resulting in the issuance of new preferred stock would be viewed as an extinguishment. Otherwise, any change in terms (regardless of significance) that does not result in the legal exchange of the preferred stock would be captured as a modification. We understand that debt and equity literature can be form driven, however, the staff cautions that the legal form is merely one data point to consider and should not be viewed as determinative with respect to this issue.
Accounting for preferred stock modifications
Assuming a registrant concludes an amendment to or exchange of preferred stock does not represent an extinguishment, the next question is how to account for the modification.[xiv]
The staff often observes and believes it is appropriate to analogize to the modification guidance contained in Subtopic 718-20,[xv] which addresses modifications to equity-classified share-based payment awards. With respect to measurement, one compares the fair value of the preferred stock after the modification to the fair value of the preferred stock immediately before the modification. If the modified instrument’s fair value exceeds the fair value of the original instrument, then the entity recognizes the additional fair value to reflect the modification. With respect to recognition, the staff has not objected to recording the additional fair value to retained earnings as a deemed dividend from the entity to the preferred stock holders. In certain unique circumstances, it may be appropriate to reflect the debit as a charge to earnings as a form of compensation for agreeing to restructure. While the staff has accepted both views, our conclusion is highly dependent on the underlying purpose for and circumstances surrounding the modification.
Thank you for your kind attention and please enjoy the remainder of the conference.
[i] Audit Analytics, 2013 Financial Restatements: A Thirteen Year Comparison (April 2014).
[ii] Generally accepted accounting principles (“GAAP”).
[iii] Accounting Standards Codification (“ASC”) 230-10-50-4.
[iv] ASC 230, Statement of Cash Flows (“Topic 230”).
[v] ASC 715-30, Compensation – Retirement Benefits: Defined Benefit Plans – Pension (“Subtopic 715-30”).
[vi] ASC 715-60, Compensation – Retirement Benefits: Defined Benefit Plans – Other Postretirement (“Subtopic 715-60”).
[vii] ASC 715-30-35-42; ASC 715-60-35-72.
[viii] ASC 715-20, Compensation – Retirement Benefits: Defined Benefit Plans – General (“Subtopic 715-20”).
[ix] ASC 715-20-50-1(r).
[x] Both permanent and temporary equity.
[xi] ASC 470-50, Debt: Modifications and Extinguishment (“Subtopic 470-50”).
[xiii] Accounting Standards Update No. 2009-08, Earnings Per Share – Amendments to Section 260-10-S99.
[xiv] The staff has provided guidance to registrants in ASC 260-10-S99 (formerly, EITF Topic No. D-42, The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock) to clarify how to reflect redemptions of preferred stock in the earnings per share calculation. The staff also provided extinguishment accounting guidance, explaining that the redemption should result in the removal of the carrying value of the preferred stock offset by recording the fair value of the consideration transferred to the holders of the preferred stock with the difference reflected in equity as a deemed dividend. The consideration transferred could be cash or another instrument, which, in the context of this discussion, would be a new preferred stock instrument.
[xv] ASC 718-20, Compensation – Stock Compensation: Awards Classified as Equity (“Subtopic 718-20”).