Posted by & filed under Debt, Derivatives.

I’ve had numerous requests to show how the constant yield rate for debt cost amortization is computed in the sample Excel effective interest method calculations. The idea is pretty simple once you have the formulas set up. The objective is to determine the rate that drives the amortization balance to zero on the maturity date of the note. All of the cell formulas are available in the downloaded spreadsheet, but here are two important calculations in words:

Periodic amortization (quarterly in the example) is:

Beginning principal balance x annual rate / # calculation periods in the year (we are dividing by 4 in the example since there are 4 quarters)

Debt issuance cost at the end of each quarter is therefore:

Beginning issuance cost balance – periodic (i.e., quarterly) interest amortization

Since the effective interest method is be definition a constant interest rate, all you are doing is solving for the rate that drives the interest cost balance to zero by the notes maturity date. The screen shots below show how to use Excel’s Goal Seek feature.

Before the Goal Seek function is run:

Before

Setup of the Goal Seek Inputs:

During

After the Goal Seek function has run:

After

 

Posted by & filed under Debt, Equity-Linked Transactions.

The effective interest rate method, or interest method as it is referred to by the FASB in the codification, spreads the total cost of debt over the life of the debt at a constant interest rate.

This constant interest rate is also referred to as the constant interest yield. The constant interest rate includes the contractual interest rate stated in the debt agreement PLUS other borrowing costs such as original issue discount or premium, up-front borrowing costs, and any other costs associated with the debt that should be spread over the life of the debt as interest cost. These can include some rather complicated items when the borrowing is associated with equity-linked components such as warrants or conversion features which may cause recognition of a beneficial conversion feature. All of these costs must be spread over the term of the debt in a manner that yields a constant interest rate. As a result, the actual interest cost may fluctuate from period-to-period as the principle balance changes (which would include accrued interest costs that add to principle!) over time. Once the constant yield rate is set it does not change UNLESS there is a modification of the debt agreement that changes its terms. Any unamortized costs at the time of the modification, plus any costs incurred as a result of the modification, would be spread over the remaining modified term of the debt. This will most likely result in a change to the constant yield rate.

Posted by & filed under Variable Interest Entity.

Here’s a high-level look at the consolidation process under ASC 810, Consolidation. The focus is on the variable interest entity model with an overview of the analysis process as well as more detailed comments on the scope exceptions and characteristics of a VIE.

Posted by & filed under Revenue Recognition, Software.

I’m looking forward to the day when revenue recognition falls under one overarching model. The FASB and the IASB are working on a converged model for customer contracts that will completely revamp the revenue recognition rules and replace much of the guidance currently in place. As of this writing, the effective date for the guidance would be January 1, 2017. That may shift was the deliberation process continues. Until then we have ASC 985-605 to guide us through software revenue recognition.

What follows is a summary of the current accounting guidance. There is much nuance in software revenue accounting which will be addressed in future posts. So, use what follows with that caveat in mind.

In an arrangement with a single deliverable, software revenue recognition is not difficult. It’s just a matter of selecting the correct method for the deliverable. Here’s a chart of the most common software deliverables and related revenue recognition methods:

Deliverable Revenue recognition method
Tangible software product (e.g., CD, download) Upon 1) physical delivery or download, as applicable and 2) delivery of access code or keys, if applicable for access by the customer
Software license On date license period begins
Post-Contract Services (PCS) Ratably over the PCS term
Software services Depends upon the nature of the services. Available methods include: Specific Performance (use if the services involve a single act); Upon Completion (use if the services have little to no value to the customer until completion); Proportional Performance (use if the services are provided over a period of time and have value to the customer as provided; performance should be measured using either an input method, an output method or ratably over the services period, as applicable); Subscription (use if the services are made available to the customer for consumption over a specified period of time and for certain discounts on future purchases)
Development, modification and customization services Use Contract Account under ASC 605-35
Software hosting (must meet specific requirements to be considered a software element) Subscription

An arrangement with multiple deliverables offers much more complexity due to 1) the need to allocate arrangement consideration (the fee) to the various deliverables, including deliverables that may not fall within the software guidance, 2) the concept of vendor-specific objective evidence (VSOE) of fair value as the basis of allocation, 3) the treatment of incremental discounts on future purchases, 4) the impact on revenue recognition amount, timing and methods if VSOE is not available for one or more of the deliverables, and 5) the multiple revenue recognition methods that may arise out of one arrangement.

Allocation

The starting point in most allocation situations is selling price. The term selling price can have many meanings, but in revenue recognition it is the price that the entity would transact a sale of the deliverable on a stand-alone basis. Thus, selling price is frequently not list price or rate card price. In fact, selling price for a deliverable on a stand-alone basis may not be easy to determine if the deliverable has never been sold separately. Selling price may then be either the selling price of a third party for a substantially similar deliverable, or a management’s estimate. A full discussion of the hierarchy of evidence of selling price follows in the “Selling Price” section.

If the arrangement includes both software and non-software elements, then the allocation process must first start with allocating the arrangement consideration to the software and non-software elements as groups then proceed to allocating the amount allocated to each group to the individual elements within each group. This group-level allocation process is governed primarily by ASC 605-25, but can be impacted by the GAAP guidance applicable to each type of deliverable in the arrangement. This is a subject worthy of separate coverage and will be addressed in a later post.

Once you have the amount of arrangement allocation applicable to the software elements, or if the arrangement contains only software elements, allocation of consideration to individual software elements is based on relative selling price. There are a few important exceptions to this general rule as follows:

  • Specified upgrade right – If the arrangement includes a “specified upgrade” right, the right should be an amount equal to its selling price. The theory here is that it is difficult to know whether the customer is purchasing the current version or the upgraded version, so the guidance presumes that it is the latter. The effect is that any discount in the arrangement, express or inherent, is allocated to the other elements and away from the specified upgrade right.
  • Discount on a future purchase – An incremental and “significant” discount on a future purchase must be allocated among the arrangement elements. The discount allocation process depends upon the nature of the discount and is address in the “Discounts” section below.of
  • Reallocation of consideration – The general rule that the allocation of proceeds occurs at inception of the arrangement and does change subsequently (see Selling Price below)  is broken when the only undelivered elements remaining from the arrangement have a selling price evidenced by VSOE. In this situation, two things happen. First, revenue on the delivered elements, including those that do not have VSOE (see Selling Price and Timing discussions below), can be recognized. Secondly, arrangement consideration is reallocated so that all undelivered elements are reflected at full selling price as evidenced by VSOE instead of at the original allocated amount based on relative selling price. This is called the “Residual Method” and has the effect of allocated any discount in the arrangement, express or inherent, to the delivered elements.

Selling Price

The hierarchy of evidence of selling price is as follows:

  1.  Vendor-specific objective evidence (VSOE) – VSOE is defined as the price of the deliverable when sold separately and is evidenced by actual sales of the deliverable on a stand-alone basis. If the deliverable is not yet sold separately, then price of the deliverable  established by management with relevant authority may be used. If this price is subsequently proved wrong by actual sale transactions, then the company will have to consider whether the original price was used in error and correct the previously-issued financial statements.
  2. Third party evidence – Third party evidence includes prices charged by competitors on a stand-alone basis for products and/or services, as applicable, with substantially similar features. Since many software elements are by nature unique, third party evidence of selling price is infrequently available.
  3. Management estimate – If neither VSOE or third party evidence is available, then the company should use management’s estimate of selling price on a stand-alone basis.

The selling prices used for allocation should be as of the contract date and should not change subsequently, even of the changed price is based on subsequently available VSOE. Additionally, if VSOE is subsequently available and supports the selling price originally used in the allocation, the availability of VSOE should impact the revenue recognition analysis in the period the VSOE becomes available in a manner similar to a subsequent event.

As noted above, selling price is defined as the price at which entity would transact a sale of the deliverable on a stand-alone basis. Selling price may or may not be objectively determinable and this will have a significant impact on revenue recognition. Unlike for other deliverables, the availability of VSOE of selling price for software elements will affect the timing, and potentially the amount, of revenue recognition. Here’s how. If VSOE is available for ALL elements, then revenue may be recognized as delivery occurs assuming all other conditions for revenue recognition are met. If VSOE does not exist for all software elements, then revenue must generally be deferred until all elements have been delivered (except under the Residual Method as noted above). Since many software elements, such as post-contract services (PCS), are not sold separately, there is frequently VSOE lacking for at least some of the software elements in the arrangement. So, while VSOE is not an absolute requirement for purposes of allocating arrangement consideration, lack of VSOE for one or more software elements will retard revenue recognition for all software elements, including those with VSOE.

Incremental Discounts

Generally, an incremental discount on a future purchase, if significant, must be allocated to each of the arrangement elements. The type of discount, however, will significantly affect the allocation process.

  • Discount on a specified future purchase – A discount on a future purchase for which the monetary amount of the discount is known or can be computed should be treated as a separate element and allocated to the other software elements in the arrangement based on relative selling price ONLY IF VSOE exists for all software elements. If VSOE is available for all elements except the future purchase element, then the consideration allocated to the discount as well as all other elements may need to be deferred and recognized upon the earlier of (assuming all other conditions for revenue recognition have been met) 1) VSOE becomes available, 2) the customer makes the future purchase and uses the discount or 3) the discount period expires. Finally, if VSOE is not available for one or more of the current elements, then all arrangement consideration, including that allocated to the discount, should be deferred and recognized as revenue when either VSOE becomes available for all arrangement elements, or all elements have been delivered (assuming all other conditions have been met).
  • Discount on specified upgrade right – As noted previously, a discount on a specified upgrade right should not be allocated to the upgrade right. Instead, the discount should be allocated to the other software element such that the upgrade right is reflected at full selling price of the upgrade software.
  • Discount on an unspecified future purchase – If the arrangement is silent on the future product or services purchases to which the incremental discount applies, then a portion of the arrangement fee should be allocated to both the current and future elements based on relative selling price assuming the maximum discount will be taken. If the maximum discount amount is not determinable because either 1) the amount of the future purchases is not specified or capped and/or 2) VSOE is not available for the future purchase elements, then the consideration allocated to each software element should be reduced by the discount percentage. If this is the case, the portion of arrangement consideration allocated to the future purchases should be recognized over the discount period as a subscription. If no discount period is specified, then revenue should be recognized as delivery of the future purchases occur, assuming all other conditions for revenue recognition are met.

Timing

If all software elements have VSOE, then revenue is recognized as delivery occurs (assuming all other conditions have been met). If the VSOE is NOT available for all elements, then revenue for all elements, including those with VSOE, is deferred and recognized when 1) VSOE for all elements becomes available (and all other conditions, including delivery, are met) or 2) all elements have been delivered. Here are two additional special cases that affect the timing of revenue recognition:

  • Last deliverable is PCS – If the last deliverable under the arrangement is PCS, then the entire arrangement fee should be recognized ratably over the PCS term, including any expected renewal period(s) is renewal is probable.
  • Last deliverable is services – Similarly, if the last deliverable under the arrangement is services, then the entire arrangement fee should be recognized as the services are performed based on the revenue recognition method applicable to the services performance pattern (i.e., based on inputs, outputs or ratably over the service period).

Posted by & filed under Variable Interest Entity.

It’s nice when I can reuse some language from a previous post on a different topic. Today, the topic is materiality in the context of the variable interest entity (VIE) consolidation model. Here’s the recycled language from my post on derivatives and materiality:

 “When I think about materiality I do so from both a qualitative and quantitative perspective. In most cases, the quantitative approach is sufficient since there is generally not a lot of sensitivity around the ‘what’ it is. It’s mostly about ‘how much’ it is. So materiality becomes primarily a percentage of total assets, net assets (i.e., equity), revenue, net income/loss, or whatever the most appropriate measure is in the circumstances. The qualitative aspect is less relevant in these instances and usually enters when the item in question takes a reporting entity over a threshold…from profit to loss, for example. Some issues, on the other hand, are material from a qualitative perspective without regard to the amount.”

A VIE falls into the netherworld of the not-so-well-understood accounting areas. The analysis is time consuming and very complicated and I fully understand the desire to avoid the cost and brain damage. But, sorry to say, this is one of those areas that is in my opinion virtually always qualitatively material. That does not mean ALWAYS, but it does mean you’re probably begging for a fight with your auditors.

Here are my reasons:

  • Recall that the VIE guidance is a direct result of the Enron scandal. This makes it a lightning rod. Failure to apply the guidance based on a quantitative materiality theory begs for “What are you hiding?” questions from users of the financial statements.
  •  

  • Quantitative materiality is rarely, if ever, brought up in the context of the voting interest consolidation model. It is assumed that if you own a subsidiary, you will consolidate. Period. So what is the justification for applying a different standard to the VIE consolidation model?
  •  

  • For many VIE’s, the material issues are in the disclosures, not on the face of the balance sheet, operating statement or cash flow statement.
  •  

  • The VIE model is a two-edged sword in that it can force consolidation when the voting interest model does not, and it can force deconsolidation when the voting interest model would require consolidation. A materiality claim starts to look like selective application of the guidance when you find yourself in both situations. I just don’t think it is wise to deconsolidate a VIE but not consolidate another VIE based on materiality. And vice versa. Apply the guidance uniformly.
  •  

  • In most circumstances you will have to do the analysis whether you choose to consolidate or not based on materiality. You have to determine whether or not you have a VIE first. All of the cost and effort of applying the VIE guidance is incurred in the analysis phase. The actual process of consolidation is mechanical and trivial in comparison. A cost-benefit argument does not hold water when the cost is already sunk.
  •  

  • The guidance requires application when the reporting entity first has a relationship with a potential VIE and/or when the relationship with the potential VIE changes in some way such that the reporting entity now holds, or now no longer holds, a variable interest. So, again, you have to perform this determination at inception of the relationship and at each change in the relationship. Even if the amounts are not quantitatively material, you still have to go through the vast majority of the effort and expense regardless.
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Posted by & filed under Variable Interest Entity.

I’ll start out this post by reminding you that the entire point of the variable interest entity (VIE) analysis is to determine if a party other than an entity’s majority shareholder should consolidate the entity into its financial statements. The VIE consolidation model is premised on the notion that, under certain conditions, parties other than voting shareholders can control an entity. If the voting interests do not have control, then they should not consolidate the entity.

The VIE model is an outgrowth of the Enron accounting nightmare that saw that company use an extensive, complex network of unconsolidated special purpose entities to shift debt and losses off its books. Had those entities been consolidated, Enron’s financial statements would have shown the company as the sham it was. Alas.

The VIE model is not, however, the only consolidation model. The so-called “voting interests model” is still alive an well and applies when the VIE model does not. The VIE model was not intended to replace the voting interest model. They are co-existing but mutually exclusive consolidation models. When an entity’s voting equity interests control the entity, then the VIE model does not apply. And vice versa. In order to apply the voting interest model, however, the VIE model must first be eliminated. That’s the rule. No exceptions. The VIE model is complex and requires serious analysis. The VIE analysis can be avoided, however, if one of its scope exception applies. The scope exceptions do not offer a way out of consolidation since the voting interest would still apply; rather, the scope exceptions offer a way out of the onerous VIE analysis.

The VIE scope exception list is rather long and reflects the FASB desire to leave much of the previously existing consolidation guidance in place. Of all the scope exception, the so-called “business” scope exception seems to provide the most confusion and that’s what I want to address here.

The business scope exception renders the VIE model inapplicable if the entity is a ‘business”, as defined by the FASB, and as long as certain other conditions are met. These conditions are critical to the scope exception and provide an view as to the FASB’s intent in providing the scope exception in the first place. How? Remember what I said previously. The intent of the VIE model is to force consolidation of an entity by a party other than its majority shareholder when that shareholder does not control entity. When the majority shareholder DOES control the entity, then the VIE model will not apply.

So with that in mind, let’s look at the business scope exception. Accounting Standards Codification (ASC) 815-10-15-12(d) states, in part,

“A legal entity that is deemed to be a business need not be evaluated by a reporting entity to determine if the legal entity is a VIE . . . unless any of the following conditions exist . . . :

a) The reporting entity, its related parties . . ., or both participated significantly in the design or redesign of the legal entity. However, this condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchise.

b) The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties.

c) The reporting entity and its related parties provide more than half of the total equity, subordinated debt, and other forms of subordinated financial support to the legal entity based on an analysis of the fair values of the interests in the entity.

d) The activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements.”

An entity that meets the accounting definition of a business and does NOT meet any of the other four conditions is excepted out of the VIE analysis. When you look at this scope exception in its totality, you begin to see how it works. It does not, as many people mistakenly believe, except out a “business”. Instead, it excepts out a “business” that would not be considered a VIE. Just meeting the business definition is not enough. The entity must also not have any characteristics that might lead to the conclusion that it is a VIE. That is the point and purpose of the additional conditions.

Once you have your head around this concept, I believe the actual analysis of the business scope exception becomes rather simple. The accounting definition of a business can be found in ASC 805. ASC 805-10-20 defines as business as, “An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members or participants.” In addition to this definition, ASC 805-10-55-4 through 9 provide implementation guidance that is helpful in determining what constitutes a business.

The evaluation of whether an entity is a business or not can get messy.The definition of a business in ASC 805 is principles based and therefore open to interpretation and judgment. The definition is provided above. ASC 805-10-55-4 provides further guidance by declaring that, “A business consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business.” This last element is important when evaluating a development stage entity which will likely have no outputs for an extended period of time. In the case of a development stage entity, ASC 805-10-55-7 provides other factors that should be considered.

All of this guidance is principles-based. I believe that most people with some experience will know whether the entity is a “business” based on the nature of its operations, its financing and capital structure, and its overall purpose. There is no rules-based approach to this evaluation. Don’t look for a bright line definition.

Also, it is important to note that ASC 805 changed the definition of a business for this scope exception. Prior to ASC 805, the definition was provided by ASC 810-10-55-19 through 25. An entity determined to be a business under the previous definition did not need to reassess simply because the definition changed. However, if a redetermination event has occurred requiring redetermination of the entity as a VIE, then the new ASC 805 definition must be applied. This may result in an entity previously exempted from the VIE model as a business no longer qualifying for this scope exception.

Reconsideration

The conditions necessary to qualify for this scope exception (ASC 810-10-15-17(d)) must be evaluated as of each reporting date. If all of the conditions are not met, then the business scope exception is no longer available.

Conclusion

Remember, all that this scope exception does is except the entity out of the VIE analysis. The voting interest consolidation model is still in play and must be applied if the VIE model is ruled out.

Posted by & filed under Variable Interest Entity.

A variable interest entity is typically designed for a very specific purpose and to create very specific risks. These risks are then, by design, absorbed by the legal entity’s variable interests. The absorption of variability often creates significant control over the legal entity that is not vested in the voting equity of the entity. The variable interest entity consolidation model is designed to determine which party should consolidate the entity when actual control is not held by the equity investors. This is a complex model to implement in large part because the language is new to most people, and because it is principles based instead of rules based.

One of the more difficult steps is identifying the entity’s risks and the variable interests that absorb those risks. My preferred approach is to go  through the balance sheet, the entity’s governing documents (e.g., articles of formation, operating agreement) and other contracts and list out each one’s role in the entity. If it is a creator of variability (it is the source of changes to the entity’s fair value and/or cash flows) then it is by definition NOT a variable interest. Variable interests absorb variability and are therefore the interests that receive the impact of the risk created.

For example, a building is an asset that is subject to changes in its fair value due to shifting real estate market prices, the availability of reasonable financing and other factors. The build is a creator a variability If the building was purchased using mortgage debt, the lender is probably the party most impacted by the buildings changing fair value. If the building declines in value, then the lender is exposed to the risk of not collecting its principal and interest payments. Thus, the lender is an absorber of the building’s negative variability. The entity’s equity investor is probably (in the absence of other variable interests) the party that absorbs the building’s positive variability since the equity investor receives the benefit of any residual value over and above the mortgage balance. However, the equity investor’s interest in the residual value can be shifted contractually to another party. One way to do this is to sell an option on the building. The option holder then absorbs the positive variability since the value of the option is directly affected by the changes in the value of the property relative to the option price.

Here are some common items and contracts found in an entity and the typical role each plays as either a creator or absorber of variability:

Assets – Assets almost always create variability and are usually the greatest source of variability in a legal entity.  Assets are rarely variabile interests. Examples of instruments that may assets and that are almost always variable interests include purchased guarantees, put options and similar arrangements (see further discussion below). See ASC 810-10-25-55 to 56.

Accounts payable – Accounts payable are generally not variable interests as long as they are short-term, no subordinate to any other liability, fixed in amount, and not concentrated with one or a few vendors. Accounts payable that do not have these characteristics are likely variable interests.

Debt – Loans to the company, in whatever form they take, can be variable interests because they expose the lender to credit risk (collectability of interest and principal payments) and potentially interest rate risk. Even a collateralized loan is exposed to variability since the collateral, an asset, creates risk and therefore variability. If the collateral value is not sufficient to satisfy the loan, the the lender is exposed to the credit quality of the legal entity. Generally, exposure to variability diminishes as priority claim to assets rise, yet even the most senior debt is ultimately exposed to the variability created by the legal entity’s credit standing.

Equity instruments – equity investors are typically the most subordinate interest in a legal entity and are exposed to the legal entity’s losses and returns. Equity includes instruments and amounts classified in mezzanine and temporary equity. ASC 810 draws a distinction between equity at risk (ASC 810-10-15-14(a) and all other equity for purposes of determining whether a legal entity has sufficient capital to finance its activities, and for certain other purposes. Regardless, equity that is not at risk may still be a variable interest.

Beneficial interests – Beneficial interests can be evaluated is a manner similar to debt, particularly with respect to the general rule that exposure to variability diminishes relative to the level of priority of claim of the legal entity’s assets.

Written guarantees, put options, and similar arrangements – The writer (seller) of guarantees and puts absorbs variability since risk is transferred to the writer. Thus, a written (sold) guarantee, put option or similar arrangement creates variability in the legal entity and are generally not variable interests to the counterparty (buyer).

Written call options – A call option written (sold) by the legal entity on an owned asset is a variable interest. The counterparty has the optional right to buy the asset at a fixed price. If the price increase above the option strike prices, then the call option absorbs this positive variability. If the asset is more than 50% of the entity’s total assets (measured at fair value), then the variable interest is in the legal entity as a whole, not just the subject asset.

Purchased guarantees, puts and similar arrangements – Writer absorbs variability. Guarantees on specific assets need to be evaluated as to whether or not the asset is greater than 50% of the legal entity’s total assets (at fair value). Of so, the the variable interest is treated as a variable interest in the legal entity as a whole, not just the subject assets.

A put option behaves economically similar to a guarantee on an asset and should be evaluated in same way. Guarantees on debt do not receive this treatment and are therefore treated as variable interests in the legal entity.

A purchased call option, on the other hand, is not a variable interest since it creates risk. The option fair value is determined by a number of factors including the fair value of the asset into which it is exercisable. The holder of a call option, in this case the legal entity, is exposed to variability. Thus, a call creates variability in the legal entity.

Guarantees, puts and similar arrangements between variable interest holders – These are implicit interests since they do not directly involve the legal entity. These contracts serve to shift exposure to risk among the parties. Since these arrangements affect the losses and benefits absorbed by the parties to the arrangements, they must be evaluated as implicit variable interests.

Total return swaps – Total return swaps purchased by the legal entity transfer risk to the counterparty and are therefore variable interests. If the related owned asset is more than 50% of the legal entity’s total assets measured at fair value, then the variable interest is in the legal entity taken as a whole and not just the specified asset.

Service/decision maker arrangements – Service and decision maker fees receive special treatment under ASC 810. These fees are considered variable interests unless all of the conditions listed in ASC 810-10-55-37: 1) the fee is commensurate with the level of effort required, 2) the fee is senior to other operating liabilities, 3) the service provider (and de facto agents and related parties) do not hold other variable interests in the legal entity, 4) the contract contains customary terms, conditions and amounts, and 5) the total fee and variability thereof are insignificant to the legal entity.

Franchise arrangements – A franchise fee paid by the legal entity that are based on a percentage of revenue, gross profit, net income or some other operational measure of the legal entity absorbs variability and is therefore a variable interest. The fee should be evaluated in a manner similar to service provider/decision maker fee (above). This could be significant to the VIE analysis since franchise agreements provide the franchisor (variable interest holder) with potentially significant powers over the activities of the legal entity.

Operating and capital leases (legal entity is lessor) – The leasing of its assets creates a cash flow stream to the legal entity which is effectively a receivable (an asset) that creates variability in the legal entity. This element of the lease is therefore not a variable interest. However, certain other provisions in the lease may absorb variability. These include: 1) a lessee purchase option if based on a fixed price or formula instead of fair value at the time of exercise, 2) a lessee residual value guarantee, and 3) a lessee renewal option at a price other than fair value at the time of exercise.

Operating leases (legal entity is lessee) – The legal entity as lessee has the opposite effect of the lessor position above. The lease payments absorb variability since the the lessor is subject to the credit standing of the legal entity and its ability to make the payments. The other lease provisions as described above, however, create variability in the legal entity and are therefore not variable interests.

Forward contracts – As a general rule, forward contracts to sell owned assets of the legal entity at a fixed price or based on a fixed-price formula (cost plus a fixed spread) absorb variability and are therefore variable interests.

A similar forward contract to sell an asset not owned by the legal entity typically creates variability (from the asset that must be purchased and delivered) and is therefore not a variable interest.

Alternatively, forward contracts to buy assets based upon a fixed price or fixed-price formula will generally create variability and are therefore generally not variable interests.

Forward contracts can be very difficult to evaluate and their final treatment in the VIE analysis will depend upon the purpose and design of the legal entity. Also, if the forward contract meets the definition of a derivative under ASC 815, the contract should be evaluated as such. See “Derivatives” below. Finally, if the forward contract involves an owned asset that is greater than 50% of the legal entity’s total assets, then the contract is considered a variable interest in the legal entity as a whole, not just the subject asset.

Supply agreements (legal entity is the supplier) – If the supply agreement has a variable cost component, then the counterparty absorbs variability by protecting the legal entity’s equity investment from absorbing losses (whether fully protected or only partially protected).

Derivatives – Derivatives require particular attention since their treatment in VIE analysis is highly dependent upon the design and purpose of the legal entity, and the characteristics of the derivative instrument. A speculative investment in a derivative will generally create variability and the counterparty will therefore generally not hold a variable interest. A hedging arrangement may or may not be a variable interest depending upon the design of the legal entity and the risks its was designed to create. See ASC 810-10-25-21 through 36.

Embedded derivatives require a further consideration. Is the the embedded derivative clearly and closely related with its host asset or liability?  If not, then the embedded derivative should evaluated as if a stand-alone instrument as discussed above. Otherwise, the embedded derivative does not require separate consideration. An embedded derivative is not clearly and closely related to its host asset or liability when it introduces leverage as a factor in the settlement amount, is tied to another party in some way (e.g., operational measurements or credit standing), or is tied (i.e., its underlying) to a market-based index or price.

Asset value guarantees – An asset value guarantee issued by the legal entity will create variability and is therefore not a variable interest. A similar guarantee granted in favor of the entity does absorb variability and is therefore a variable interest.

Licenses – A license based on a percentage of revenue or similar measure is a variable interest in the legal entity when the legal entity is the licensee, and a creator of variability in the legal entity (thus not a variable interest) when the legal entity is the licensor.

 

Posted by & filed under Debt, Derivatives, Equity-Linked Transactions.

One of the interesting side benefits of using Google Analytics on this web site is that I can see the search terms people are using to find the site. When I see a common theme often enough, I write a post to address the search term directly. Today’s topic is derivatives and materiality.

When I think about materiality I do so from both a qualitative and quantitative perspective. In most cases, the quantitative approach is sufficient since there is generally not a lot of sensitivity around the ‘what’ it is. It’s mostly about ‘how much’ it is. So materiality becomes primarily a percentage of total assets, net assets (i.e., equity), revenue, net income/loss, or whatever the most appropriate measure is in the circumstances. The qualitative aspect is less relevant in these instances and usually enters when the item in question takes a reporting entity over a threshold…from profit to loss, for example.

Some issues, on the other hand, are material from a qualitative perspective without regard to the amount. Derivatives instruments fall into this category. People rarely understand them and even more rarely understand the accounting rules around them. For many of these people, that a reporting entity even has them is a material issue. That is enough to warrant recognition, even if the amount is otherwise immaterial to the financial statements. And, with recognition comes disclosure which accomplishes two objectives: 1) transparency…we, the reporting entity, think it is immaterial quantitatively, but we think you may find it important qualitatively, so here it is, and 2) CYA…derivatives have a way of becoming material quantitatively since they are by definition tied to an outside observable measurement or event that the reporting entity does not control. Both are good reasons to disclose.

I think embedded derivatives are a little tougher to handle. First of all, the entire concept of an embedded derivative is foreign to most users of financial statements…and to many accountants for that matter. Secondly, some provisions in contracts that rise to the level of ’embedded derivative’ are just plain silly. Take the case of an interest rate increase in a debt agreement due to an event of default. If the triggering event is beyond the company’s control, then the provision is likely an embedded derivative. The most common version of this I see is the failure to deliver audited financial statements on time, or at all. The issuance of the auditors’ opinion is not controlled by the company…so it’s an embedded derivative. Try explaining this one to even the most sophisticated investor. The universal response is, “You accountants have lost touch with reality”, or something a bit more crass. From a qualitative perspective, disclosure of quantitatively immaterial embedded derivatives can actually be detrimental to the usefulness of financial statements.

In the end, these are your financial statements and you need to ask yourself that toughest of questions, “Does it matter to the user?” As accountants, we like to rely on math to answer that question. Derivatives, and embedded derivatives, are a special case where math is not enough.

Posted by & filed under Uncategorized.

Our Variable Interest Entity (VIE) module will be release in beta this week. The accounting guidance applicable to variable interest entities is among the most complex ever issued by the Financial Accounting Standards Board (FASB). Our analysis module, which includes plain English explanations of the guidance, FAQs, examples and a web-based decision tree analysis tool, is designed to take the mystery out the guidance and make accessible to anyone with a general understanding of accounting.

The VIE consolidation model came into being in 2003 through FIN 46(R) primarily in response to the abuses of the so-called “voting interest entity” model by Enron that, in theory anyway, allowed Enron to keep significant losses off its books. The voting interest model focuses on voting rights as the key determinate of which party, if any, should consolidate an entity. The variable interest entity model does not replace the voting interest model; rather, it subordinates the voting interest entity model to a secondary position. If, after applying an incredibly complex analysis, the variable interest entity model is determined to not apply, then the voting interest entity model is used. The variable interest entity model considers factors other than voting rights to determine which party, if any, should consolidate an entity. The VIE model focuses on controlling financial interests in an entity other than voting rights.

Posted by & filed under Derivatives, Equity-Linked Transactions.

Over the last three days, I went through the accounting definition of a derivative. If you have an agreement, or embedded feature within an agreement, that meets the definition, then derivative accounting has entered your life. Unless, of course, one of the scope exceptions applies! And there are many.

The vast majority of derivative accounting scope exceptions apply to specialized transactions and are designed to preclude the use of a specific aspect of derivative accounting…hedge accounting. Hedge accounting can allow part or all of changes in fair value (aka gain or loss) to stay on the balance sheet in the equity section known as “Other Comprehensive Income”. These gains and losses never hit the income statement and therefore do not affect earnings. You can sense the potential abuse this opens up from a dizzy height, so the FASB placed a lot of roadblocks in the way in the form of scope exceptions. And, on a less cynical note, there was also the idea derivative accounting would swamp a number of industries in which the purchasing and selling of contracts that meet the definition of a derivative is a common practice. These industries already have their own accounting practices and guidance and the FASB was not looking to make changes there when it issue derivative accounting guidance in its original form, FAS 133.

So I said that most of the scope exceptions apply to specialized transactions (and contracts). Here’s the list from ASC 815-10-15-13:

  • Regular-way security trades
  • Normal purchases and normal sales
  • Certain insurance contracts
  • Certain financial guarantee contracts
  • Certain contracts that are not traded on an exchange
  • Derivative instruments that impede sales accounting
  • Investments in life insurance
  • Certain investment contracts
  • Certain loan commitments
  • Certain interest-only strips and principal-only strips
  • Certain contracts involving an entity’s own stock
  • Leases
  • Residual value guarantees
  • Registration payment arrangements

ASC 815-10-14 through 82 goes into each scope exception in detail. The language is not always easy to understand, but my fundamental view is that for the most part the nomenclature is very familiar to people who deal in these transactions and contracts routinely. There are some exceptions, of course, and that’s what I want to focus on here, with particular emphasis on the scope exception for certain contracts involving an entity’s own stock. My reason is very simple. While companies outside of specific industries are very unlikely to deal in transactions and contracts to which most of the scope exceptions apply, companies do raise capital all the time, and it very common for capital raising transactions to bump into the derivative accounting rules. So, I’ll dive right into that scope exception and then hit a few others that I think are important to the average company to be aware of.

Certain Contracts Involving an Entity’s Own Stock

Contracts involving an entity’s own stock include both freestanding contracts and so-called ‘equity-linked’ features embedded in otherwise non-equity contracts (like debt for example). This discussion applies equally to both. I’ve already written a post about freestanding instruments versus embedded features, so I’ll leave you to read that on your own.

This scope exception can be boiled down to meeting two basic criteria. If a contract, or an embedded feature, is excepted out of derivative accounting if it is both 1) indexed to the company’s own stock and 2) classified in equity. Simple enough, right? Well, yes, if you understand the rules. And there are lots and lots of rules applicable to these two simple criteria. Here we go.

Indexed to the entity’s own stock

To be considered indexed to the entity’s own stock, the contract, or embedded feature must pass a two-part test. The first questions is: Is the contract’s (or embedded feature’s) exercise contingent and, if so, is the contingency based on a) an observable market, other than the market for the entity’s own stock or b) an observable index, other than one measured solely by reference to the entity’s own operations. Let’s break this down.

Is exercise contingent? If not, then you can ignore the rest of question. If the equity-linked contract or feature is immediately exercisable or becomes exercisable based only on the passage of time, then this test is passed. If, however, exercise is contingent on some event or observable measure, then you have to evaluate that event or measurement. If the contingency is based on anything other than the entity itself…its stock price, its trading volume, its revenue, its number of employees, its net income, whatever…then it is not indexed to the company’s own stock. An index or market that includes the company does not count. Nor does an inflation index that includes the company’s industry. The contingency must be based on the company, and solely on the company. Period.

The second question in this two-part test is: Is the settlement amount equal to the difference between the fair value of a fixed number of the entity’s shares and a) a fixed monetary amount or b) a fixed amount of debt issued by the company? As opposed to the first question above, which in my mind is very objective and easily evaluated, this one is very tricky. The reason is that the settlement amount can get a bit complicated when provisions are added that affect the settlement amount. If any of these provisions are not, to use the FASB’s language, “…inputs to fair value” then this test can not be passed. What this requires, then, is some knowledge about what the inputs to fair value are. But, most accountants are not valuation experts, and most accountants who do some valuation work rely primarily on established, accepted valuation processes (like the Black-Scholes valuation model) without giving much thought to all the theory and concepts that went into heir development.

My rule of thumb in applying this test is to take a hard look at any provision that affects the settlement amount. If the settlement calculation is not a straightforward price times quantity calculation, I dig in. These types of provisions tend to remove the equity-like risks and characteristics of the settlement amount and that is exactly what the FASB is after with this test. Great in concept, but very difficult to apply. Gratefully, the FASB provides a list (ASC 815-40-15-7E) of the most common inputs to fair value. This is not a complete list, but it’s pretty good and better than nothing:

  • Strike price of the instrument or feature
  • Term or duration
  • Expected dividends or other dilutive activities
  • Stock margin costs
  • Interest rates
  • Stock price volatility
  • The entity’s credit spread over benchmark interest rate(s)
  • The ability to maintain a standard hedge in the underlying stock

Some of these will be recognizable as inputs to the Black-Scholes option value model. Others, such as the credit spread over a benchmark rate, may not be as obvious. The last item in the list, the ability to maintain a standard hedge, is baked into the Black-Scholes model as a core assumption and basically means that it is possible to eliminate price risk by hold a long position in the stock and a short position in the option. Fortunately, in practice the primary provisions that run afoul of the fair value input test are either price adjustments based on contingent events (regardless of whether a contingent event is based solely on the company’s operations) or leverage features that are pegged to one or more fair value inputs.

The big one, though, is what is known as a “down-round price protection”. This is a very common provision in conversion options and warrant agreements and is designed to give today’s investor the economic benefit of a subsequent financing that is at an effective price that lower than the price the investor paid today. For example, if the company issues a warrant with a strike price of $1.00 today and then issues a warrant at some point in the future with a lower strike, say $.75, then the earlier warrant’s strike will be adjusted downward by some percentage of the strike price difference. This is often called a “ratchet” adjustment since the adjustment is only down, never up. A “half-ratchet” gives the investor 50% of the strike difference while a full ratchet provides 100% of the price difference. It’s also interesting that this adjustment is often referred to as “anti-dilution”. The traditional concept of anti-dilution is that the adjustment does not improve the investor’s position; rather, the adjustment serves only to maintain the economic value of his or her holding. The traditional anti-dilution adjustment is for events like stock dividends  and stock splits and is designed to offset effect of the event. A ratchet actually improves the holder’s position relative to other holders of equity that do not also enjoy the adjustment.

Any price adjustment that is not purely anti-dilutive as that term is traditionally used violates this test and the contract or embedded feature can not be considered indexed to the company’s own stock.

One other significant point to make here. The probability of any of these provisions occurring nor which party, the company of the holder, controls control the event(s) has no bearing on the analysis. The only test is whether one or more of the violating provisions is present in the agreement.

Classified in Equity

If, and only if, the contract or embedded feature is considered indexed to the entity’s own stock, the next step is to evaluate whether it meets the conditions necessary for equity classification. The equity classification analysis is aimed entirely at the form of settlement of the contract or feature. Specifically, if it is possible that the contract will be net cash settled, regardless of how remote that possibility is, then equity classification is prohibited. Let me note here that conventional convertible debt is specifically excepted out of the equity classification requirements.

The FASB uses a control model to evaluate the possibility of net cash settlement. Here is the basic model:

1. If the contract or embedded feature REQUIRES net cash settlement, then equity classification is prohibited.

2. If the contact or embedded feature REQUIRES net cash settlement upon occurrence of one or more contingent events, then equity classification is prohibited unless the company controls the occurrence of the contingent event(s). Certain events are clearly outside the company’s control, such as governmental approvals, weather events, geological events, and market indexes reaching specified levels, to name just a few. Other events are not so obvious, such as sales of assets, tender offers and other capital events that can may be controlled by shareholders, or even the holder of the instrument you are evaluating. These situations require a very good understanding of shareholder rights and powers as well as state law. Evaluating these types of events will usually require input from the company’s legal counsel.

3. If the contract REQUIRES share settlement, the equity classification is permitted so long as all other conditions for equity classification are met. I’ll get into those conditions below.

4. If the contract provides the HOLDER with the choice of either net cash settlement or share settlement, then net cash settlement is assumed and equity classification is prohibited. This assumption is rarely overcome by facts and circumstances. There would have to be a significantly greater economic value from share settlement over net cash settlement, after factoring in costs and other factors to convert the shares to cash, for this assumption to be reversed.

5. If the contract provides the COMPANY with the choice of either net cash settlement or share settlement, then share settlement is assumed and equity classification is permitted so long as all other conditions for equity classification are met.

Additional conditions for equity classification

The additional conditions for equity classification is not a particularly long list, but the explanation of certain of the conditions is lengthy. I’ll provide the list here and go into the details of each condition in a separate post. The conditions are:

    • Except in certain specific circumstances, the company must be able to settle the contract or embedded feature in unregistered shares.
    • The company must have sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of shares during the period that the contract or embedded feature is outstanding.
    • The contract or embedded feature must contain an explicit limit on the number of shares issuable on share settlement.
    • The company can not be required by the contract or embedded feature to make a cash payment to the holder in settlement of the contract or embedded feature if the company fails to make timely filings with the SEC.
    • The company can not be required to make a cash payment (a so-called “make whole” or “top off” payment) to the holder if the shares delivered in share settlement and subsequently sold by the holder do not provide sufficient proceeds to cover the amount due.
    • If the contract provides for net cash settlement, then such net cash settlement can only occur in circumstances in which the holders of the underlying stock would also receive a cash payment in exchange for their shares.
    • There must be no provisions in the contract that provide rights to the holder that are greater than that of the stock underlying the contract.
    • There must be no requirement to post collateral as credit support for the contract or embedded feature.

If all of these conditions are met, the equity classification is permitted. Please note, however, that this evaluation is not a one-time process. These conditions must be evaluated at each balance sheet date. If one or more of the conditions is not met, then equity classification is no longer permitted and the contract or embedded feature no longer qualifies for this scope exception.

Hedge Accounting

Oddly enough, if the contract is not indexed to the company’s own stock and not eligible for equity classification, and therefore subject to derivative accounting, there is still one more possible scope exception, at least from an income statement perspective. This one, however, is not available to an embedded feature.

You’ll recall that there are two parts to derivative accounting, hedge accounting and non-hedge accounting. Contracts involving an entity’s own stock are not typically thought of in the context of a hedge; however, the ASC specifically notes that an equity-linked contract may indeed be a hedge and qualify for hedge accounting. If the criteria for hedge accounting are met, then the derivative contract is still subject to derivative accounting, but part or all of the changes in fair value (i.e., gains and losses) can be classified in the Other Comprehensive Income section of the equity section. That leaves the fair value swings on the balance sheet and out of your income statement. Nice!

BUT, please have a look the hedge accounting criteria. They are strict and the hedging strategy must be formally documented in advance of entering the hedge transaction. You can’t declare your contract a hedge after the fact. In other words, qualifying for hedge accounting is a practical impossibility without having entered into the contract for the express purpose of hedging.

Embedded Feature that is Clearly and Closely Related to the Host Contract

This scope exception applies only to an embedded derivative feature and would actually come ahead of the ‘own stock’ analysis above. This exception looks at the risks and characteristic of the embedded derivative feature and those of the host contract, and, if clearly and closely related to each other, then the feature does not need to be bifurcated from the host contract. My post on the clearly and closely related scope exception goes into the details.

Leases

Yes, leases are indeed exempt from hedge accounting. However, embedded features within a lease are NOT exempt. If you have a lease with payments terms that are tied to the company’s stock, a stock market index, weather or geological events, interest rates or any other observable event, you need to evaluate that feature as a possible embedded derivative. The feature would have certain scope exceptions available, of course, including the possibility that the feature is clearly and closely related to the host contract…the lease.

Registration Payment Arrangements

This one brings up a lot of questions. Registration payment arrangements are accounted for as contingencies. That’s clear and I’ve already written a post on subject. The confusion comes up around why this is even mentioned as a scope exception. Well, the reason is actually simple. When the derivative accounting guidance was first issued and applied to equity-linked transactions, registration rights agreements, which contained provisions that often met all of the criteria of a derivative, were producing a long list of derivatives that companies had to bifurcate and account for separately. The FASB determined that this was not the intent of the derivative accounting guidance which was instead focused on the specific financial instruments. The EITF quickly addressed this in an EITF issue. It now falls under the contingency guidance.