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U.S. Securities and Exchange Commission

Remarks by

Pascal Desroches

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

27th Annual National AICPA Conference on Current SEC Developments

December 7, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its members or employees. The views expressed herein are those of Commissioner Johnson and do not necessarily reflect the views of the Commission or its staff.


Good morning. It's a pleasure to be here and have the opportunity to speak again at this conference. Today I will provide you with comments relating to: (1) Statement 133, Accounting for Derivative Instruments and Hedging Activities, (2) accounting for convertible securities with beneficial conversion features, and (3) written options.

Statement 133, Accounting for Derivative Instruments
and Hedging Activities

In June 1998, the FASB issued Statement 133, Accounting for Derivative Instruments and Hedging Activities (Statement 133). Statement 133 establishes, for the first time, a comprehensive accounting and reporting standard for derivative instruments and hedging activities. During this past year, we have identified some problems with the way a few early adopters of Statement 133 have applied the formal documentation requirements specified in the standard. Failure to comply with these requirements, in some cases, resulted in a request from the SEC staff (the staff) for restatement.

The staff has observed compliance issues in the following three aspects of the formal documentation requirements of Statement 133: (1) the need for contemporaneous formal documentation; (2) the requirement for specific designation of cash flow hedges and (3) the requirement to describe how an entity will assess hedge effectiveness.

Contemporaneous Formal Documentation

One of the fundamental requirements of Statement 133 is that formal documentation be prepared contemporaneously with the designation of a hedging relationship. In addition, upon initial adoption of Statement 133, all hedging relationships must be redesignated anew and documented pursuant to the requirements of the standard1. Specifically, upon designation of a hedging relationship and initial adoption of the standard, the documentation provisions of Statement 133 require written identification of:

  • An entity's risk management objectives and strategies for undertaking the hedge;

  • The nature of the hedged risk;

  • The derivative hedging instrument;

  • The hedged item or forecasted transaction; and

  • A description of how the entity will assess hedge effectiveness.

The staff has seen instances where documentation that meets these requirements has not been prepared contemporaneously with the inception of the hedging relationship or adoption of the standard. For example, the staff observed one instance where a registrant asserted that part of the documentation of its hedging relationship as of the date of adoption of Statement 133 was contained in its prior year Form 10-K. The staff did not believe that this assertion was consistent with Statement 133's requirements for formal documentation as of the date of adoption. The staff believes that contemporaneous designation and documentation of a hedging relationship are fundamental to the application of hedge accounting; without both, an entity could retroactively identify a hedged item, a hedged transaction, or a method of measuring effectiveness to achieve a desired accounting result. This is inconsistent with the limited and special nature of hedge accounting permitted in Statement 133. If such a retrospective approach were permissible, the result of 20/20 hindsight would be the equivalent of permitting an entity to pick its desired reported earnings number. Accordingly, we have challenged the appropriateness of hedge accounting in instances where we have found that there was not contemporaneous documentation prepared.

Specific Identification of the Hedged Forecasted Transaction
in a Cash Flow Hedge

In a cash flow hedge of a forecasted transaction, Statement 133 stresses that formal documentation must identify the hedged forecasted transaction with sufficient specificity such that when a transaction occurs, it is clear whether or not that particular transaction is the hedged transaction. Thus, the documentation of the forecasted transaction should include reference to the timing (i.e., the estimated date), nature, and amount (i.e., the hedged quantity or amount) of the forecasted transaction.

In reviewing filings during this past year, the staff has seen instances where the documentation of forecasted transactions was not sufficient to identify unambiguously when the forecasted transaction would occur. For example, in one instance a company asserted that it was hedging 50% of estimated forecasted sales of 9 million units of certain inventory in a fiscal quarter. We do not believe that such a high level assertion, even if documented contemporaneously, is sufficiently specific to meet the requirements for hedge accounting, because it is not clear when a sale of inventory occurs whether that particular sales transaction is the hedged transaction. The documentation would have been sufficient if, for example, the company indicated that it was hedging the first 4.5 million units of inventory sold in the quarter or the first 1.5 million units of inventory sold each month in the quarter.2 We have challenged the appropriateness of hedge accounting where we find that formal documentation does not specifically identify the hedged forecasted transaction.

Specific Description of How the Entity Will Assess
Hedge Effectiveness

While Statement 133 provides an entity with flexibility in determining how to assess hedge effectiveness, the methodology used must be reasonable, and must be documented at inception of the hedging relationship. The staff has seen instances where registrants have not included a description of how they will assess hedge effectiveness as part of their documentation of hedging relationships. We also have seen instances where the documentation of the way hedge effectiveness will be assessed was not sufficiently specific to ensure consistent application. As an example, one registrant's methodology for assessing hedge effectiveness was documented as: "The hedge will be deemed highly effective providing it remains within 80% - 125% of forecast." This method does not sufficiently describe the process that the entity will go through in making its periodic assessment that the hedging relationship has been and is expected to be highly effective at achieving offset. The staff believes that the methodology that will be used for assessing hedge effectiveness must be documented with sufficient specificity such that a third party reviewing the formal documentation would be able to objectively reperform the assessment of hedge effectiveness.

In summary, as registrants adopt Statement 133 they should establish the necessary policies and internal control procedures to ensure that the documentation requirements of Statement 133 have been satisfied. Similarly,auditors should ensure that they include the necessary steps in their audit programs to test their clients' compliance with these provisions of Statement 1333.

Accounting for Convertible Securities with Beneficial
Conversion Features

In March 1997, the staff provided guidance on accounting for convertible debt and preferred stock issued with beneficial conversion features in FASB Emerging Issues Task Force (EITF) Topic D-60, Accounting for the Issuance of Convertible Preferred Stock and Debt Securities with a Nondetachable Conversion Feature (Topic D-60). For beneficially convertible securities issued after May 20, 1999, the guidance in EITF Issue 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios (Issue 98-5) should be followed. An issue frequently encountered by the staff is determining whether a convertible debt or preferred security has a beneficial conversion feature when there is not yet a public market for the common shares.

Specifically, during this past year, the staff observed that several companies issued convertible securities within a short period before an initial public offering (IPO) with a conversion price below the expected IPO price. In each case, the company asserted that the conversion price was equal to the fair value of the common stock at the date of issuance (or commitment) of the securities and therefore the securities were not beneficially convertible. However, the fair value determined by the company was below the minimum estimated IPO price for the common stock. In some cases, this occurred even though the convertible securities were issued while the company was negotiating an IPO and the estimated IPO price range. For example, one company issued convertible preferred stock on June 8 at a price of $5.50 per share. The preferred stock was convertible at any time into common stock on a one-for-one basis. Upon the IPO, each share of preferred stock automatically converted to one share of common stock. Three days later, the company filed a registration statement for an IPO, with a price range of $11 to $13 per share. As of the date the preferred stock was issued, the company had information that the minimum estimated IPO price was $11 per share; however, the company continued to assert that the fair value of the common stock on June 8 was $5.50 per share and thus the convertible preferred stock did not contain a beneficial conversion feature.

The staff believes this issue to be a valuation issue similar to the issue of cheap stock and has approached it in a similar manner. The guidance on cheap stock and compensation issues in the Division of Corporation Finance's Staff Training Manual indicates that "[s]tock, options or warrants issued to employees, consultants, directors, or others providing services to the issuer within one year prior to the filing of an initial registration statement at a price (or exercise price) below the offering price are presumed to be compensatory."

Therefore, convertible securities issued within a year prior to the filing of an initial registration statement with a conversion price below the initial offering price are presumed to contain an embedded beneficial conversion feature. To overcome this presumption, a registrant should provide sufficient, objective, and verifiable evidence to support its assertion that the conversion price represented fair value at the issuance or commitment date. As part of this process, registrants and their auditors should consider any valuations that an underwriter has discussed with senior management and or the board of directors.

In instances where a registrant is unable to overcome the presumption that the security contains an embedded beneficial conversion feature, the beneficially convertible security should be accounted for pursuant to the guidance in Issue 98-5 or Topic D-60, as applicable.

A related issue involves the required accounting for convertible preferred securities with beneficial conversion features that are issued to consultants or others who provide goods or services. Specifically, in certain transactions reviewed by the staff, registrants have issued beneficially convertible preferred securities to third parties with whom they have existing or established business relationships beyond that of an investor-investee. On the surface these transactions appear to be purely financing transactions in which the issuer is issuing beneficially convertible preferred equity securities to raise capital. Registrants have asserted these transactions are financings that should be accounted for pursuant to the guidance in Issue 98-5. In cases where we have reviewed some of the governing agreements to these arrangements, however, the staff has observed that some of these arrangements may involve elements of compensation for goods or services. In such cases, the staff believes that such arrangements should be accounted for at fair value pursuant to the guidance in Statement 123, Accounting for Stock-Based Compensation (Statement 123).

One of the key distinctions between the guidance in Issue 98-5 and Statement 123 is that under Issue 98-5, the measure of the beneficial conversion feature is limited to the proceeds received for issuing the beneficially convertible security. In contrast, Statement 123 requires that transactions in which equity instruments are issued in exchange for the receipt of goods or services be accounted for based on the fair value of the consideration received or the fair value of the instrument issued, whichever is more reliably measurable. That is, the transaction is measured at fair value and is not limited to proceeds received from issuing the equity security.

In summary, the staff believes that Issue 98-5 should only be used to account for financing transactions involving beneficially convertible securities. In instances where beneficially convertible preferred securities are issued for goods or services, such transactions should be measured at fair value pursuant to the guidance in Statement 123. Accordingly, I would encourage registrants and their auditors to evaluate carefully the terms of the governing agreements to these arrangements to determine whether to apply the guidance in Issue 98-5 or Statement 123.

Accounting for Freestanding Written Options

Freestanding Written Options

The staff has recently received several questions about the accounting for freestanding written options. The transactions in question include options written on interest rates, equity prices, and commodity prices.

The staff believes that prior to the adoption of Statement 133, GAAP requires freestanding written options to be accounted for as liabilities at their fair value with subsequent changes in fair value reported in earnings each period.4 The staff believes that deferring losses on written options is not appropriate because written options do not reduce risk; rather, they increase risk. Accordingly, in the staff's view, freestanding written options, including those used in strategies such as "covered calls" and "call monetizations," 5 should be recorded at fair value with changes in fair value reported in earnings.

The staff has previously expressed its view on this issue at several forums including the March 21, 1996 meeting of the EITF during a discussion of EITF Issue No. 95-11, Accounting for Derivative Instruments Containing Both a Written Option-Based Component and a Forward-Based Component. Notwithstanding the staff's long standing position on this issue, during this past year the staff identified several instances where registrants were using written options as hedging instruments. In support of their use of hedge accounting for written options, some registrants observed that it was practice in some industries to use written options as hedging instruments. The staff did not find such justification to be persuasive. The general issue of looking to "industry practice" to excuse misapplication of GAAP was addressed recently by the staff in Staff Accounting Bulletin (SAB) No. 99, Materiality, which notes that authoritative literature takes precedence over industry accounting practice.

Combination Options

One challenge we have found in dealing with accounting for written options is a relatively basic one: determining the circumstances in which a transaction involves a written option. Specifically, in certain transactions a written option is issued in combination with a purchased option (rather than as a freestanding option), and in such circumstances the transaction must be analyzed carefully to determine whether the combination of instruments is in effect a net written option. In making this assessment the staff has used criteria similar to those specified in the FASB's Derivatives Implementation Group Issue E2, Hedging - General: Combinations of Options (DIG Issue E2). For example, consider the following transaction addressed recently by the staff in which a registrant entered into a combination of purchased put options and written call options on a commodity. The puts and calls were entered into simultaneously with the same counterparty. The significant characteristics of the combination of contracts were as follows:

  • No net premium was paid or received;

  • The purchased puts and written calls involved the same underlying commodity;

  • The notional amount of the purchased puts exceeded the notional value of the written calls; and

  • The purchased puts matured in 2 years and the written calls matured in 10 years.

The staff concluded that the combination of options entered into by the registrant was a net written option. Consistent with DIG Issue E2, the staff reached this conclusion even though no premium was received and the notional amount of the purchased puts exceeded the notional amount of the written calls, because the written calls had a longer term to maturity than the purchased puts. Accordingly, the staff advised the registrant that the written calls are required to be recorded at fair value with changes in fair value reported in earnings.


That concludes my prepared remarks. I would be pleased to answer any questions during the Q&A phase of this session.


1 Refer to paragraph 48 of Statement 133.
2Refer to paragraph 28(a)(2)(b) of Statement 133.
3Audit procedures should include audit tests that verify that formal documentation has been prepared contemporaneously with the inception of the hedging relationship or adoption of the standard.
4Statement 133 permits the use of net written options as hedging instruments in certain narrow circumstances specified in paragraphs 20(c) and 28(c).
5Call monetizations may be permitted to receive hedge accounting under Statement 133 if the requirements specified in paragraphs 20(c) and 28(c), as applicable, have been satisfied.


Modified: 03/25/2005