Convertible Debt Showdown: SFAS 133 & EITF 00-19 VS. EITF 98-5 and EITF 00-27

The currently prevalent use of convertible instruments appears to highlight significant inconsistencies in the interpretation and application of the layers of US GAAP that must be navigated when simply trying to obtain the capital necessary to keep the doors open.

Most issuers that I see entering into these types of arrangements somehow find a way to treat embedded conversion features as equity, usually by ignoring the requirements of paragraphs 12-32 of EITF 00-19 and the recently implemented clarification contained in EITF 07-5for SFAS 133 exclusion.  These issuers appear to be at least acknowledging the embedded conversion feature by applying the guidance of EITF 98-5 and 00-27 and recognizing a debt discount that approximates the intrinsic value of the conversion feature, thereby increasing the effective interest rates of the debt, sometimes significantly.

The implementation of EITF 07-5 will almost always require derivative treatment under SFAS 133, particularly when the terms of the debt agreement contain holder protection (anti-dilution provisions) for future issuances of debt, equity, or equity linked instrument requiring adjustment to  the conversion price.

A few things to remember when analyzing a convertible instrument:

  • EITF 98-5 and 00-27 do not apply to instruments considered to be derivatives under SFAS 133 requiring bifurcation from the host contract.
  • Instruments accounted for under SFAS 133 require fair market valuation at the issuance date and re-valuation at the appropriate future cut-off dates in contrast to beneficial conversion features that are valued  at the intrinsic value onlyon the date of issuance.
  • Recognition of liabilities for embedded conversion features on the issuance date can result in significant gains in future periods.  Don’t get too excited about this as it is generally meaningless and usually means the issuer’s stock price is declining.

Don’t like any of this?  Have a look at SFAS 155…..

Do Your SEC Filings Paint the Appropriate Picture of the Company?

SEC Painting a Picture of Your BusinessDuring the recently completed filing season for calendar year-end Smaller Reporting Companies I frequently provide suggestions for improving the overall quality of the Form 10-K.  This generally includes suggestions to eliminate redundancy; provide concise and specific disclosures; provide useful analysis of historical results; and provide reasonable expectations related to future near term trends, commitments, liquidity, and other known material events and transactions.   These suggestions not only affect the financial statements, but they generally apply to other significant areas such as business overview, risk factors, and management’s discussion and analysis.

In my experience, issuers tend to rely on their attorneys for guidance on the non-financial statement portions of the Form 10-K.  Most attorneys that I have dealt with focus only on standard regulation compliance and lawsuit prevention.   While these things are obviously important, they generally do not improve the quality of the disclosures.  To be fair, most attorneys are not asked to help make improvements in order for issuers to somewhat manage attorney fees.

The SEC’s Corp Fin Staff recently published Staff Observations in the Review of Smaller Reporting Company IPOs at which provides a brief reminder for quality improvement and avoiding the comment process.  While these observations specifically relate to registration statements they are also applicable to Forms 10-Q and 10-K.

Some highlights:
Risk Factors – “Generic risk factor discussions that do not describe how a specific risk applies to the company or an investment are not helpful to understanding the risk.  Also, it is rarely helpful to state there can be no assurance of a particular outcome”

Description of Business – Reg. S-K requires a description of a company’s business development over the last three years and provides an overview of the material aspects of the business.  Further, “Where it was not clear what a company did to generate revenue or what its future growth strategy was, we (Corp Fin Staff) asked it to provide a discussion of its current or intended material sources of revenue”.  My experience is that several issuers focus on historical reverse merger and similar capitalization transactions while ignoring the current and near term future functional activities.

Management’s Discussion & Analysis – Financial based discussion should focus on “Any known material trends, demands, commitments, events, or uncertainties that will have, or are reasonable likely to have, a material impact on the company’s financial condition; short-term or long-term liquidity; and revenue or income from continuing operations”.  They further state this section should disclose “The past and future financial condition and results of operations of the company, with particular emphasis on the prospects of the future”.  I don’t believe that providing a narrative of the financial statements, by itself, meets the requirements of Item 303 of Reg S-K or provide any additional useful information.  The SEC’s observations indicate results of operations should “Disclose the reasons underlying the causes for the period to period changes”.

Financial Statements; Revenue Recognition – The SEC observations generally recommend an issuer’s revenue recognition policy discloses the “application of specific authoritative revenue recognition guidance for transactions within the scope of the appropriate GAAP literature; the nature and type of earned revenue; and separate revenue recognition policies for each type of earned revenue”.  I don’t think cutting and pasting the SAB 104 requirements or GAAP literature on its own meets these observations.
I realize compliance document improvement is probably not on the top of most Smaller Reporting Company’s priority list in today’s environment, but there is definite value in avoiding the SEC comment process.  Also, a Smaller Reporting Company’s SEC filings, to a certain extent, serve as the public face of the company and should reflect the high degree of professionalism the boards, officers, and employees of these companies possess.

EITF 07-5 Highlights

Financial IstrumentsIt appears the Emerging Issue Task Force (EITF) has provided some seemingly useful guidance as to the determination of the application of SFAS 133.  As I see more and more companies issuing various types of hybrid financial instruments in order to fund ongoing capital needs, I also see varying degrees of application of SFAS 133 and its next cousin EITF 00-19.

Sifting through the guidance and corresponding AICPA roadmap to properly account for these transactions seems to be the equivalent of ………  The recent issuance and 2009 implementation of EITF 07-5 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock seems to alleviate some of the confusion surrounding certain redundant conditions in most financial instrument agreements that we have seen.

For example, several recent issuers entering into convertible debt transactions, with certain similar terms, each have radically different balance sheet presentations.  Ignoring the SFAS 155 election (which is another matter of discussion), one issuer determined that SFAS 133 didn’t actual apply to the convertible debt and presented the standard convertible note payable; while another determined that SFAS 133 applied, jumped to EITF 00-19 to determine the classification of the derivative instrument requiring bifurcation, and concluded permanent equity treatment was appropriate; and the third issuer determined SFAS 133 in fact applied, required bifurcation, and treated the derivative instrument as an additional liability requiring periodic revaluation.

While having many recent discussions with CPAs, CFOs, University Professors, and anyone else that might have some insight, including the FASB Staff themselves, we were pointed to the seemingly useful guidance contained in EITF 07-5.  In the example above, I see most issuers spending most of the time reaching for non-application of SFAS 133 under the exceptions contained in paragraph 11(a) that states that “contracts issued that are both indexed to an entity’s own stock and classified in stockholders’ equity are not considered derivative instruments”.   If the complete blow off of SFAS 133 does not work, as in the case of the second issuer above, permanent equity treatment becomes the next best option under the general guise that the issuer has control over adjustments to conversion prices and amounts or that the likelihood of significant detrimental adjustment in the derivative value is de minimis.  This example, in particular, appears to be clarified by EITF 07-5.

For all instruments outstanding in fiscal years beginning after December 15, 2008 it appears the application of EITF 07-5 will correspond with increased application of SFAS 133.  The EITF guidance indicates several financial instruments are not actually indexed to a companies and stock and would infer SFAS 133 treatment (liability classification).  Paragraph 15 eliminates both common arguments against bifurcation:  i) the issuer has the ability to control any conversion adjustment and ii) the probably of making detrimental adjustments is de-minimis.  The paragraph further indicates that any adjustment to the fixed amount (either conversion price or number of shares) of the instrument, regardless of the probability or whether or not within the issuers’ control, is not indexed to the issuers own stock.

The inability to conclude that financial instruments are actually not indexed to the issuers own stock, thereby, significantly eliminating the derivative instrument exception paragraphs of SFAS 133 will likely result presentation changes of a large number of small reporting companies and may result in some interesting earnings swings.

Maybe the little used SFAS 155 election for financial instruments warrants further discussion?

E & Y Calls for More Regulation (More Cost)

In a speech at the Commonwealth Club in San Francisco recently, EY CEO James Turley called for more regulation of audit firms.  His premise that audit quality has improved as a result of SOX and the PCAOB while ‘possibly’ accurate (and I’m not conceding that) is irrelevant.  Foremost I don’t believe that quality has improved for quality firms.   I can’t speak for EY.  Perhaps they are better for it.  The SEC and the  PCAOB for all intents and purposes  initially  adopted the accounting and internal control standards that were already promulgated by the profession.  Adding another layer of regulation sufficed only in adding additional cost to public companies.  And now Mr. Turley wants to expand that further.  Why?

Since my introduction to the profession in the 1970’s when we were attacked by Michigan Democratic Congressman John Dingell, we have fought for self regulation.  Obviously the SEC Practice Section of the AICPA (the forerunner to the Center for Audit Quality CAQ) failed miserably and here we are.  Based on his leadership, it appears the CAQ is on the same course.   One of the defining characteristics of any  profession is self regulation.  So we apparently have failed as a profession if you are to subscribe to Mr. Turley’s pleading or does he have another motive?

Economists define this propensity of larger firms ‘getting cozy’ with regulators in order to drive up costs and limit competition from smaller firms as ‘regulatory capture’.  Banks, drug companies, airlines – accounting firms?  Bigger isn’t better, but it certainly seems to be more expensive.

From my days as a young corporate bank officer for a mid-sized California bank in the early 1970’s, I recall having regulatory audits by Federal regulators, the State of California examiners, and the Federal Depositors Insurance Corporation (FDIC).  We also had our own internal audit department as did every other bank.  And as every other bank has had since then.  Total regulation.  It’s obviously worked well Mr. Turley.  In my professional lifetime a list of the most heavily regulated industries would include banks, airlines, railroads,  banks, banks, banks.   More regulation.  Yeah!  That’s the answer.

More recently we have two great examples of failures by  federal regulation in Madoff and Stanford.  I challenge you to name one economy with more regulation than we have had in the US that has been more successful.  Ever.  I can list dozens that failed with more regulation.

I disagree vehemently with Jim Turley.  Additional regulation if warranted should come from inside the profession – specifically the CAQ which Mr. Turley happens to be the sitting Chair of.  Do the job you signed on for with the CAQ Mr Turley.   That he wants to abdicate that responsibility is incredibly disturbing.  That he proposes to add additonal layers of cost – cost that he and his firm will derive revenue  directly from- is unconscionable.

IFRS – No Big Deal!

Judging by the material that is coming out from the Big 4 accounting firms, it seems that accounting as we know it is about to disappear and a new behemoth called IFRSs are about to invade the US accounting scene.  Recently the office managing partner of one of those firms admitted to me that they viewed the issue as a consulting opportunity rather than a threat.  I agree.

Judging by the material that is coming out from the Big 4 accounting firms, it seems that accounting as we know it is about to disappear and a new behemoth called IFRSs are about to invade the US accounting scene.  Recently the office managing partner of one of those firms admitted to me that they viewed the issue as a consulting opportunity rather than a threat.  I agree.  Fear mongering is a great way to generate revenue for the consultants.  Just look at the millennium bug.

IFRS are already here and have been for quite some time. Most of the standards that have been issued since in the past four years have been designed to bring US GAAP standards and international GAAP standards (IFRS) closer and closer together.  This is commonly referred to as ‘convergence’.   FASB 141 (R) for business combination’s and FASB 160 on minority interests are typical examples. FASB has issued  standards that are  consistent with the international standards.  The International Accounting Standards Board (IASB) is doing the same thing as the FASB. They are issuing standards to bring them closer to US GAAP alternative over time where US GAAP is deemed preferable to IFRS. This convergence process has been going on for years and is nothing new.

What is new is the “road map” that has been put in place by the SEC, and it changed again recently. Foreign listers on the US exchanges are already allowed by the SEC to use IFRS. A limited group of about 100 US companies will experiment with early adoption of IFRS in the US in 2009. Most of these companies are already using IFRS for significant parts of their international operations anyway so they don’t need much outside help. For the rest of us, the SEC will make a decision in 2011 on whether to move to require all US listed companies to follow IFRS by 2014. Unless we get some xenophobic idiots appointed to the SEC  this is a done deal.  Although the new SEC Chairperson, Mary Shapiro, has announced that she is considering slowing down the process, it probably won’t change the FASBs agenda.

Is this a major issue? I don’t think so. By 2014, all of the major differences between US GAAP and IFRS will almost certainly have been eliminated. There are some problem issues to be resolved. Some are straightforward like the use of LIFO for inventory accounting. The problem here is that tax accounting in the US is impinging on real accounting. We will have to find some tax solution to unbundle the inbuilt tax problem that LIFO has created for many companies.

Other issues are more difficult and highly technical. The ugly issue of derivatives is always at the forefront here. Almost nobody understands the US standard FASB 133 and the same is true that almost nobody understands its international equivalent. All we know is that they have some differences and the financial institutions don’t like either of the standards anyway.

Some issues appear more frightening. For example, with IFRS we will lose those “bright line” guidelines that US accountants love so much. For example, the four tests for a capital lease that lawyers love to circumvent will be no more. Greater judgment will be required. This is an issue because you may have to get up in a court of law to defend your judgment. Looking on the bright side, at least you wont get tripped up by some smart trial lawyer because you did not follow some little known paragraph of one of the 14 FASs, 6 INTs, 10TBs, 2FASBSPs and about 25 EITFs that currently relate to leases in US GAAP. They will be gone as authoritative documents.

For non-listed companies, there are some proposals on the table on how to apply IFRS to smaller entities. Personally I don’t like the proposals because I don’t like having two-tier GAAP for large and small enterprises. Again, whatever changes occur will drift in over time largely unnoticed by most.  If you have any experience with IFRS please comment.

SFAS 157 – How 'Fair is Fair' Value?

No matter if you believe that “fair value” drives unnecessary market instability or that it provides enhanced transparency of financial information, the question remains unchanged.

No matter if you believe that “fair value” drives unnecessary market instability or that it provides enhanced transparency of financial information, the question remains unchanged. What is a supportable fair market value that reflects an orderly transaction between two or more willing market participants?

The SEC’s recently issued “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting” concludes, amongst other things, that “..additional measures should be taken to improve the application and practice related to existing fair value requirements – particularly as they relate to both Level 2 and Level 3 estimates”. In the report, the SEC’s Committee on Improvements to Financial Reporting (CIFiR) further recommended the SEC issue a statement of policy articulating how it evaluates the reasonableness of accounting judgments and include factors that it considers when making this evaluation, as well as that the PCAOB should also adopt a similar approach with respect to auditing judgments.

In light of these conclusions, and unlikely forthcoming judgment “guidance” for valuing financial instruments with primarily Level 2 and 3 inputs, it is important to gather all pertinent information and variables potentially used in building a valuation model. There are several keys to doing this including:

  • Monitor your investments and those similar throughout the reporting period, not just at the reporting date.
  • Stay in touch with general economic indicators.
  • Consider your true plans of instrument liquidation and whether the Company has the ability to wait out the market.
  • Get your non-accounting finance and analyst types involved as they are generally more comfortable with assumptions and judgment than most accounting types.
  • Provide your assumption documentation to your auditor as soon as possible – it is generally not difficult to audit the fair value model itself, however, getting reasonable documentation related to assumptions is where the time is spent, particularly when there is a difference in opinion as to what constitutes reasonable.
  • Try to keep it simple concise and as straightforward as possible. Tying certain assumptions to the lining up of the planets will likely not pass your auditor’s smell test.

By the way, the SEC’s Report concluded that the fair value accounting standards did not cause the bank failures of 2008.

Proactively Controlling Your Audit Fee

For many firms it is that time of year.  The annual invasion of that group of  mind numbing, routine interrupting, standards spouting unwelcome invaders – your independent auditors!  And they are expensive!  Reflectively they can make you want to trade their presence  for an unannounced three month visit from your cantankerous incontinent father-in-law who never speaks directly to you and who for fifteen years has  referred to you only  as “him / her”.  An article published in, Auditor Angst, has some great points to not only help you survive, but to reduce the expense at the same time.  While the article primarily focuses on what the company can/should do there is obviously a lot the auditors can do as well. Continue reading “Proactively Controlling Your Audit Fee”

Uncle Sam Needs You!

Uncle Sam Needs YouIn 1966, the finger pointed directly at you from the fierce visage of a red white and blue top hatted bearded Uncle Sam on the recruiting poster.  I couldn’t look away in good conscience then and it is no less difficult now.  In an article posted on titled Walker Makes Plea to CFO’s David Walker the former U.S. comptroller general asks CFO’s to help bail the country out of its’ current economic crisis and a $50 trillion deficit.  While, as with most of you, I’d be the first in line to offer my services, it won’t happen.  The first responsibility of every politician is to get re-elected.  Correspondingly as long as we have a system that allows for ‘pork’ trailers in legitimate bills, legislators unwilling to make the unpopular decision and lacking the intestinal fortitude to enforce a balanced budget, I’m not sure there is much we can do as advisors.  Because they just won’t listen!

The government bureaucratic system is not predicated on economic motivation from ‘self interest’ and individual benefit and correspondingly can’t be successful as a participant in a capitalistic economy. As Adam Smith, the father of modern economics, summarized in The Wealth of Nations – “I have never known much good done by those who affected to trade for the public good”.  If you haven’t read Free to Choose by Milton and Rose Friedman this would be a good time.  Here’s a great example found on the internet last week: Continue reading “Uncle Sam Needs You!”

How to create profits out of thin air

In my last posting I tried to make assets out of liabilities.  Now I want to make some profits out of my liabilities.  This is a piece of cake under current GAAP but my current favorite again relates to the issue of the convertible debt that seems to be so popular with companies with a bit of a going concern problem. Continue reading “How to create profits out of thin air”