Speech by SEC Staff:
2003 Thirty-First AICPA National Conference on Current SEC Developments
Gregory A. Faucette
Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities and Exchange Commission
December 11, 2003
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 and I will be sharing our views on a number of these issues, including those on: (1) classification and disclosure of certain derivatives under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended; (2) the "day two" accounting for certain written guarantees; and (3) a reminder to registrants on aspects of the recent deferral of certain provisions of FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.
Classification and Disclosure under Statement 133
Statement 133 is often described as being "silent on geography." There is very little guidance on where derivatives should be presented in the financial statements in either the standard itself or the issues addressed by the Derivatives Implementation Group (DIG), although the Emerging Issues Task Force (EITF) has recently provided limited guidance.1 The SEC staff has also provided some guidance in the past on general geography and disclosure matters.2 Recently, we answered some questions about another issue related to the income statement presentation for derivatives used as economic hedges, but not designated as accounting hedges under Statement 133.3
We have seen situations where registrants used financially settled derivatives as what were referred to as "economic hedges."4 The economic hedges consisted of both forward-based and option-based derivatives that either were not designated as or did not qualify as hedges under Statement 133. Changes in fair value of the economic hedges were classified in a single line item on the income statement, perhaps captioned something like "risk management activities." However, realized gains and losses, represented by the periodic or final cash settlements from those economic hedges, were reclassified in the period realized out of risk management activities and into revenue or expense lines associated with the related exposure. Some registrants clearly disclosed this practice in the footnotes and included tabular reconciliations and roll-forwards of all derivative changes, amounts, and reclassifications.
We do not believe that the presentation of unrealized gains and losses in one income statement line with reclassification of realized gains and losses to another line is appropriate. While Statement 133 is essentially "silent on geography," it was the clear intention of the FASB to eliminate the practice of synthetic instrument accounting.5 We believe that the presentation described above is essentially a form of synthetic instrument accounting from an income statement perspective.
In addition, Statement 133 is clear that any special accounting for derivatives requires special efforts. That standard only allows the fair value adjustment of a derivative to be split into various components within the context of applying specific hedge accounting models. Reclassifying realized gains and losses, as described, essentially presents hedge accounting-like results for some captions, without a registrant necessarily applying the rigors of hedge accounting. For example, there may not be specific designations of economic hedging instruments against specific exposures or, even more troubling, a lack of genuine consideration of hedge effectiveness.
We have asked registrants that were applying this practice of reclassifying realized gains and losses on economic hedges to change their presentation in future filings.
Broader Application of the Staff's View
We have been asked whether we intend this view to be applied to all income statement presentations of derivative activity. For example, would we always object to splitting the components of a derivative into different line items on the income statement? How about splitting cash inflows and outflows into different line items? Those are certainly broader questions than the fact patterns we addressed and difficult to answer given Statement 133's silence on geography. We have not taken positions on specific matters in the area but have some thoughts, which might be helpful.
In addressing geography, could one make an argument that a split presentation would be more appropriate for the writer of a derivative instrument as opposed to the end user? It would seem that answer is maybe. First of all, outside of option-based instruments, it is not always easy to determine which party is the writer and which is the end user of a derivative. In addition, even if the end user can be determined, the limited existing literature may not be entirely helpful.
In EITF Issue 02-3, the Task Force addressed a derivative held for trading purposes. It would seem that held in that sense could apply to either the writer or end user and that any party with a trading view would have to apply the net presentation required in the consensus.6 Slightly extending that consensus, it would seem that a derivative held for speculation would likewise not be eligible for any split accounting, whether by the writer or the end user. EITF Issue 03-11 is also not particularly helpful, stating that the classification for certain physically settled derivatives not held for trading purposes is based on facts and circumstances.7
For some entities, such as investment banks or certain types of insurance companies, writing freestanding derivatives may be a significant part of the basic business model. Those entities may feel they have a business model that, in their view, would suggest certain presentations. A contrary view could be taken that if a contract required derivative accounting, that contract should not receive an income statement presentation based on any other model.
It seems this broader classification question can only be addressed in generalities. Generally, it would seem that reclassification or split presentation would not be appropriate for the end user of a derivative outside of a specific Statement 133 hedge accounting model. A writer of a derivative may have a better argument for splitting a derivative in the income statement, but that would be facts and circumstances dependent. In those cases, the writer would be expected to clearly disclose the carrying amount and classification of derivatives in the balance sheet and the amounts and classification of the components of a derivative's change in fair value in the income statement, including any premiums received, any other changes realized in a cash settlement, and any unrealized changes in fair value. Disclosure of the classification schemes would be critical to an investor's ability to perform "apples-to-apples" comparisons where two companies had different classification policies.
Classification of Derivatives Used as Economic Hedges
Finally, for economic hedges, we have been asked where the changes in the fair value of the derivative could or should be classified. In this case, we again recognize that Statement 133 does not provide specific guidance on geography, but at the same time would note that some classifications may not make sense. For example, a financial institution classifying in the provision for loan losses all changes in credit derivatives used as economic hedges would not seem appropriate given the importance of that line item to certain credit quality analyses.
In the past, we have noted the need for specific disclosure, within the notes to the financial statements, as to the registrant's policy of how and where the impact of hedge effectiveness is recorded in the income statement as well as where ineffectiveness is recorded. We have also encouraged disclosure of where derivatives are recorded in the balance sheet if not apparent from the captions. Similarly, we would encourage disclosure of the location in the income statement where the changes in the fair value of non-hedge accounting derivatives are reflected as well as the amount.
Registrants are reminded they can, and likely should, discuss the reasons for entering into economic hedge derivatives in Management's Discussion and Analysis and provide whatever information is necessary and appropriate through disclosure. In doing so, they should keep in mind the Commission's recent rules applicable to non-GAAP measures.8 We would also encourage registrants to focus on the clarity of their disclosures when they use both hedges that qualify for hedge accounting under Statement 133 and economic hedges. For example, calling a derivative something like a "designated non-qualified Statement 133 hedge" may be confusing to investors. In addition, clear distinction of the discussion of accounting hedges versus economic hedges would be helpful.
Many are aware of what is affectionately referred to in practice as "the SEC staff's longstanding position on written options." We have received questions on the application of that position to guarantees in the context of FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. But before discussing our thoughts on that issue, it may be useful to put that staff position in historical context.
The view that registrants should account for written options at fair value is historically found in a few EITF issues, the first being EITF Issue 91-4, "Hedging Foreign Currency Risks with Complex Options and Similar Transactions." Although that issue was nullified by Statement 133, at that time the SEC Observer noted, "The SEC staff also will object to deferral of losses with respect to written foreign currency options because they do not reduce but increase risk." This position was developed in an environment where many thought that there should be no recognition of written options other than the premium received.
At that time, there was little authoritative literature addressing derivatives, and it was in 1992 that the FASB began in earnest the project that ultimately led to the issuance of Statement 133, which finally became effective in 2001. During the intervening time, the staff's thoughts on written options were further communicated in remarks at various AICPA Current SEC Developments conferences.9 Once effective, however, some contracts traditionally considered written options escaped Statement 133 either by failure to meet the technical definition of the derivative or through various scope exceptions. As a result, the SEC Observer at the EITF again reiterated the staff position in EITF Issue 00-6, "Accounting for Freestanding Derivative Financial Instruments Indexed to, and Potentially Settled in, the Stock of a Consolidated Subsidiary" in the context of the instruments discussed in that issue. The SEC Observer noted that "the staff's longstanding position that written options initially should be reported at fair value and subsequently marked to fair value through earnings" for options sold by the parent that permitted the option holder to buy or sale shares of the subsidiary.
Historically, the staff's view was consistent with the 1986 AICPA Issues Paper, "Accounting for Options." The paper concluded that options should be carried at "market price" and further provided some conclusions on hedging issues. Important to the interpretation of the historical staff position is the scope of that paper.10 The Issues Paper addressed all options traded on exchanges, all options on fungible items not traded on exchanges, and all options settled in cash only, such as options on stock indices. The scope excluded options on land or real estate, options on large blocks of stock, options issued by an enterprise on its securities, and agreements that obligated enterprises to make or acquire loans under specified conditions. Of interest, and perhaps relevant to the questions we have received, is that the Issues Paper did not mention guarantees.
Fast forward to the present day, where many financial guarantees that qualify for the exception in paragraph 10(d) of Statement 133 will likely fall within the initial recognition and measurement guidance of Interpretation 45. Interpretation 45 does not address "day two" issues for those guarantees but notes that the initial liability, an "obligation to stand ready," would typically be reduced through earnings as the guarantor was released from risk under the guarantee.11 It observes the pattern of reduction typically has been upon either expiration or settlement, by an amortization method, or as the fair value of the guarantee changes. The recently released FSP FIN 45-2, "Whether FASB Interpretation No. 45 Provides Support for Subsequently Accounting for a Guarantor's Liability at Fair Value," clarifies that the selection of the method for the subsequent accounting for the obligation to stand ready is not a free choice and that:
A guarantor should not use fair value in subsequently accounting for the liability for its obligations under a previously issued guarantee unless the use of that method can be justified under generally accepted accounting principles, as is the case, for example, for guarantees accounted for as derivatives under [Statement 133].
We have been asked whether the staff's previously communicated view on certain written options provides the basis for applying fair value measurement to the obligation to stand ready subsequent to initial recognition. The short answer is that we believe the staff's historical position was not intended to apply to guarantees. In addition, we are not convinced that the appropriate analogy for day two accounting is to the existing literature requiring fair value, such as Statement 133.
As discussed previously, the staff's position on written options was developed pre-Statement 133 and based predominately on the scope of the AICPA Issues Paper, which did not address guarantees. EITF Issue No. 85-20, "Recognition of Fees for Guaranteeing a Loan," provided limited guidance on accounting for loan guarantees and required an ongoing assessment for liability recognition under FASB Statement No. 5, Accounting for Contingencies. While Issue 85-20 was addressed during a period where several EITF issues focused on put options, it did not draw attention as an option-related issue, further suggesting that a guarantee was not necessarily the type of arrangement thought of as a written option in a traditional sense. It is also interesting to note that during the years leading up to Statement 133, there is little if any evidence of consideration given to applying the staff's position on written options to financial guarantees, either by industry or the SEC staff itself. In summary, it appears that the staff position has been applied in the case of written options based on share prices, market prices or indices, exchange rates, or similar underlyings and not necessarily options based on other contingencies.
So can any literature be applied by analogy to support fair value accounting on day two for a written guarantee? First, it helps to examine what the obligation to stand ready is intended to represent. Interpretation 45 states that it represents "a noncontingent obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur."12 The obligation to stand ready is to be initially measured at fair value, usually represented by the premium received or calculated using the expected present value approach in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements.
The Board noted that both financial and non-financial contracts are included in the scope of the interpretation.13 For both types of contracts, however, unless it is probable that there will be a future settlement under the guarantee such that a Statement 5 liability is recognized at inception, the amount initially recorded is not an obligation to deliver assets to the guaranteed party but rather an obligation to "provide or stand ready to provide services, or to use assets," which is more akin to a performance obligation.14 It would seem that a subsequent measurement of a nonfinancial performance obligation at fair value is not easily supported elsewhere in the literature.
In addition to the arguments above, we would note that financial guarantees that fall within the initial recognition and measurement guidance of Interpretation 45 have likely passed through Statement 133 via the paragraph 10(d) exception, essentially bypassing a fair value model. Those guarantees were granted that exception because the FASB thought they were similar enough to insurance contracts, which received a similar exception. The SEC staff notes that insurance contracts are currently subject to a Statement 5 model, not a fair value model.
So what do we believe the appropriate "day two" accounting for the obligation to stand ready would be? Applying Statement 5 to the liability and reducing it to zero, as payment is not probable, would not be appropriate. As discussed previously, this credit is not a contingent obligation but a noncontingent obligation to stand ready.15 It would seem a systematic and rational amortization method would most likely be the appropriate accounting.
We would also note that the recourse obligations that often result from transfers of financial assets under FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, would likely meet the definition of a guarantee in Interpretation 45.16 If so, this would equally call into question the accounting for such a recourse obligation at fair value subsequent to initial recognition. Similar to Interpretation 45, Statement 140 requires fair value as the initial measurement attribute but does not discuss subsequent measurement.
We understand that some believe that a fair value model for these guarantee liabilities and recourse obligations is the right accounting. However, we find it difficult to support such an approach in the current literature.
Updated SEC Literature and the Deferral of Certain Provisions in Statement 150
Hopefully you are aware of the issuance of Staff Accounting Bulletin No. 103, "Update of Codification of Staff Accounting Bulletins," which updated the SAB codification for changes in the authoritative literature for the first time in a while. A similar effort is being made currently to update Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements." Some may accuse us of being slow in updating our own literature as the authoritative guidance has evolved, but these recent efforts are indicative of our intention to provide more timely updates in the future.
As another example of updating guidance on a timely basis, with the issuance of Statement 150, the SEC staff did update the guidance in EITF Topic D-98, "Classification and Measurement of Redeemable Securities," in May of this year. It was modified to acknowledge that it would no longer be applicable to instruments that fell within the scope of Statement 150 once that Statement was effective. However, in early November of this year, the FASB staff issued FSP FAS 150-3, "Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." That FSP contains several deferral provisions that may be of interest to registrants, and we want to emphasize two points.
Interaction with Topic D-98
Entities with instruments that qualify for the deferral in FSP FAS 150-3 should refer to Topic D-98 for guidance related to classification and/or measurement, as applicable, for those securities that, for the time being, will not be fully accounted for in accordance with Statement 150. In other words, if both the classification and measurement guidance in Statement 150 has been deferred for an instrument, look to Topic D-98 for both classification and measurement guidance. If only the measurement guidance in Statement 150 has been deferred for an instrument, look to Topic D-98 for continued measurement guidance.
As an example, assume that prior to the effective date of Statement 150, a registrant had been classifying mandatorily redeemable preferred stock of a consolidated subsidiary as minority interest and adjusting it periodically using one of the methods discussed in Topic D-98. Statement 150, as temporarily modified by FSP FAS 150-3, would still require reclassification of the minority interest to a liability, but would defer requirements for subsequent adjustments to the carrying value. As an SEC registrant, the company would continue to follow its previous measurement methodology under Topic D-98 in consolidation. Taking the example further, if that consolidated subsidiary was itself a registrant, it would reclassify the mandatorily redeemable preferred stock to a liability in its standalone financial statements and continue to follow its previous measurement method under Topic D-98.
Also as a result of FSP FAS 150-3, some broker-dealers have asserted that they should be eligible for the deferrals for mandatorily redeemable financial instruments of certain nonpublic entities described in Part 1 the FSP. For certain nonpublic entities, the FSP would defer the effective date for mandatorily redeemable financial instruments until periods beginning after December 15, 2004 or indefinitely, depending on the characteristics of the instruments. However, certain nonpublic entities are defined as entities other than SEC registrants. The definition of an SEC registrant in the FSP includes entities that are required to file financial statements with the SEC.17 Thus, the definition of an SEC registrant includes any broker-dealer that is required to file financial statements with the SEC, even if they do not issue publicly-traded stock or debt. Therefore, we believe that any broker-dealer that files statements with the SEC is not eligible for the additional deferrals under FSP FAS 150-3.