Financial Reporting Presents: Year-End Accounting Issues: Are You Prepared?

Transcription

1 Financial Reporting Presents: Year-End Accounting Issues: Are You Prepared?

2 Agenda 1. Leasing Issues 2. Consolidation of Variable Interest Entities 3. Hedging and Hedge Documentation 4. Asset Securitizations 5. Share-Based Payment Randy Green Lisa Delfini Jon Howard Rob Comerford Bernie De Jager

3 Leasing Issues

4 Sale-Leaseback of Real Estate Applicable Accounting Guidance SFAS No. 13, Accounting for Leases SFAS No. 66, Accounting for Sales of Real Estate SFAS No. 98, Accounting for Leases Interpretation No. 43: Real Estate Sales - an Interpretation of FASB Statement No. 66 EITF Issue No (Question 2), Implementation Issues in Accounting for Leasing Transactions, including those involving Special-Purpose Entities EITF Issue No , Determining Whether Equipment is Integral Equipment Subject to FASB Statements No. 66, Accounting for Sales of Real Estate, and No. 98, Accounting for Leases 1.1

5 Typical Sale-leaseback Structure Property Seller/ Lessee Cash Rent Absolute Net Lease Buyer/ Lessor Sale Leaseback Loan Lender Rent Assignment 1.2

6 Continuing Involvement Common Forms of Continuing Involvement Fair value purchase option Residual value guarantee Fixed price renewal options that extend over substantially all the estimated life of the leased asset Funding of cost overruns in a build to suit transaction Sales price less than fair value Lessor default remedies (put options) 1.3

7 Effect of Lessee Involvement in Asset Construction (EITF 97-10) Lessee Involvement Prior to Lease Inception A lessee who commences construction before entering into a lease agreement would be deemed to have purchased, sold and leased back the asset Construction has commenced if the lessee has: Begun construction (broken ground) Incurred ANY hard costs (e.g. site prep, construction costs, and equipment expenditures) Incurred soft costs (e.g. architectural fees, survey costs, and zoning fees) that represent more than 10% of the expected fair value of the leased property 1.4

8 Effect of Lessee Involvement in Asset Construction (EITF 97-10) Examples of Automatic Indicators of Ownership Responsibility of lessee to directly pay (without right of reimbursement) costs other than normal tenant improvements Lessee owns/leases the land and does not lease/sublease to lessor prior to construction Indemnities to any party other than the owner-lessor (except for preexisting environmental risks) Lessee indemnities for anything other than costs associated with lessee s own actions or failures to act (i.e. casualty and condemnation) Indemnities for pre-existing environmental risk if risk of loss is more than remote 1.5

9 Effect of Lessee Involvement in Asset Construction (EITF 97-10) Maximum Guarantee Limitation Lessee is considered accounting owner if the contractual documents could require that the lessee pay 90% or more of total project costs Assessment is done without regard to probability Assessment performed at inception and must consider all points in time during the construction period Examples Lessee construction cost reimbursement is capped Date-certain lease payments 1.6

10 Lessor Issues Accounting for leasehold improvement related allowances Substance of any lessor payment Lessor or lessee property? Revenue recognition Balance sheet presentation 1.7

11 Capital Lease Modifications- Lessee Accounting Modifications of a capital lease that result in a new agreement classified as an operating lease are subject to the guidance for saleleaseback transactions (FAS No. 98 for real estate or integral equipment) FAS No. 145 amended FAS No. 13 Guidance prior to FAS No. 145 didn t subject the revised agreement to sale leaseback accounting 1.8

12 Contingent Rent Contingent Rent, defined (in part): Changes in lease payments resulting from changes occurring subsequent to lease inception in the factors on which lease payments are based Lease payments that depend on an existing index or rate, such as CPI or the prime rate, shall be included in minimum lease payments based on the index or rate existing at lease inception Changes in lease payments that result from subsequent changes in the index or rate are contingent rentals 1.9

13 Contingent Rent, Example CPI Increase: Lease is signed on January 1, 2005 Annual rent for 2005 is $100 For each year after 2005 rent is increased by the same percentage as the increase in CPI from January 1 of the prior year until January 1 of each respective year Example: If the CPI as of January 1, 2005 is 200 and the CPI as of January 1, 2006 is 205, then the rent for 2006 would be ( )/200= 2.5% higher than rent for 2005 The 2.5% increase in 2006 is contingent rent It would not be appropriate, in this fact pattern, to look at the change in CPI for the year prior to lease inception and impute a minimum increase 1.10

14 Polling question Leasing Issues Do you believe the FASB should add a lease accounting project to its technical agenda? Yes No N/A; don t know

15 Consolidation of Variable Interest Entities FIN 46(R)-Common Misconceptions

16 FIN 46(R)-Common Misconceptions FIN 46R Variable interest entities Party that absorbs a majority of expected losses / expected residual returns consolidates Initial consolidation generally both parent and minority interest are recorded at fair value ARB 51 All entities excluded from the scope of FIN 46R Party that controls consolidates Initial consolidation generally the portion owned by parent is recorded at fair value and minority interest is recorded at carryover basis

17 FIN 46(R)-Common Misconceptions Business Scope Exception Step 1: Does the entity qualify as a business? Step 2: Do any of the following conditions exist? (if so, the scope exception does not apply) Did the enterprise or its related parties participate significantly in the design or redesign of the entity (unless the entity is a franchisee or a joint venture)? Are substantially all of the entity s activities performed on behalf of the enterprise? Did the enterprise provide more than half of the total equity or other subordinated financial support? Are the activities of the entity primarily related to securitizations or other forms of asset-backed financings, or single-lessee leasing arrangements Yes???????? 2.2

18 FIN 46(R)-Common Misconceptions An entity is a Variable Interest Entity if: Its equity is not sufficient, OR The equity holders do not make decisions about the entity, OR The equity holders do not absorb the expected losses of the entity, OR The equity holders do not receive the expected residual returns of the entity, OR The voting rights of some investors are disproportionate to their absorption/receipt of expected losses/expected residual returns AND the entities activities are substantially on behalf of the investors with disproportionately few voting rights 2.3

19 FIN 46(R)-Common Misconceptions 2.4

20 FIN 46(R)-Common Misconceptions Apex Apex Construction Company 20% Equity Interest Apex Board Member Construction Pension Plan 10% Equity Interest Guarantee Guardrail Inc. (VIE) Holds 5% Debt Apex Board Member 2.5

21 FSP FIN 46(R)-5 Each FIN 46R analysis must consider whether an implicit variable interest (such as an implicit guarantee) exists especially in related party transactions 100% Real Estate Sub CEO Operating Lease Company Y Example: Operating Lease between Related Parties Loan Element of protection Significant judgment Bank 2.6

22 Polling question - VIE s Has your company considered implicit variable interests in your application of FIN46(R)? Yes No, but now we will N/A; don t know

23 Hedging and Hedge Documentation

24 Hedge Documentation Issues Specificity of the designated hedged item Sufficient specificity ( s 28a, 461) Test: when a transaction occurs, is it clear whether that transaction IS or IS NOT the hedged transaction? Example: Company ABC expects to sell at least 100 widgets in January 2006 and would like to hedge sales of 100 widgets. Can ABC designate ANY 100 widgets sold? The FIRST 100 widgets sold? The LAST 100 widgets sold? Contemporaneous documentation. 3.1

25 Strategy Issues Assessment (prospective and retrospective) of hedge effectiveness Qualitative vs. Quantitative Short-cut Method ( 68, qualitative) Critical Terms Match ( 65, qualitative) Close Enough Method (??, qualitative) Long-haul Method ( s 20b and 28b and DIG E7, quantitative) Short-cut and Critical Terms if all criteria are met, assume high effectiveness and no ineffectiveness Long-haul method apply effectiveness assessment methodology and measure ineffectiveness 3.2

26 Strategy Issues Assessment (prospective and retrospective) of hedge effectiveness Ratio Dollar Offset and the De Minimis Principle Period-to-Period Compare prices over distinct intervals Cumulative Compare prices at two different points in time (beginning of hedge vs. today) Small dollar changes may cause a hedge to fail because the test is based on a ratio (%) Entity issues $1B debt and hedges with a $1B notional swap If swap fv change is $100 and hedged item fv change is $50 Dollar offset ratio in period 1 is 200% No hedge accounting or apply the De Minimis Principle? 3.3

27 Strategy Issues Assessment (prospective and retrospective) of hedge effectiveness Ratio Dollar Offset and the De Minimis Principle Period-to-Period Compare prices over distinct intervals Cumulative Compare prices at two different points in time (beginning of hedge vs. today) Small dollar changes may cause a hedge to fail because the test is based on a ratio (%) Entity issues $1B debt and hedges with a $1B notional swap If swap fv change is $100 and hedged item fv change is $50 Dollar offset ratio in period 1 is 200% No hedge accounting 3.4

28 Terminated Hedge Terminated Hedges and Amounts in AOCI Fact pattern: Company ABC hedges interest payments on a 5-year variable rate bond with an interest rate swap. After year 1, Company ABC terminates the swap and discontinues hedge accounting. Interest payments remain probable of occurring and, therefore, amounts remain in AOCI. What is the appropriate method for re-classing amounts on a quarterly basis into earnings? Swaplet Method interest rate swap is a series of individual forward contracts, each one hedges a specific interest payment ( s and 498, DIGs G17, G18 and G20) Effective Yield Method amortized into earnings on a level yield basis over the number of years remaining on the original hedge Straight-line Method amount amortized into earnings per period = AOCI Balance / # hedged periods remaining 3.5

29 Polling question Hedging In assessing hedge effectiveness, do you primarily use: Short-cut method Critical terms match Long-haul method Combination of the above N/A; don t know

30 Asset Securitizations

31 Polling question Asset Securitizations Does your company currently enter into securitization transactions that utilize QSPEs? Yes No N/A; don t know

32 A Simplified Securitization Structure SELLER* ASSETS CASH VEHICLE INTER- ESTS CASH I N V E S T O R S *Ignores details of 2 steps 4.1

33 Transferred Financial Assets On or Off Balance Sheet? Off, if On, if All sale conditions of FAS 140 satisfied (para 9) (current GAAP) a. Assets legally isolated b. Transferee (investors if QSPE) not constrained c. Transferor relinquishes effective control One or more sale conditions of FAS 140 (para 9) not met, or Transferee is consolidated Transferee is not consolidated 4.2

34 Impact of a QSPE SELLER VEHICLE INTER- ESTS CASH I N V E S T O R S IS A QSPE 4.3

35 QSPE Requirements Demonstrably distinct from the transferor Limits on permitted activities: Significantly limited Entirely specified in the legal documents that established the SPE or created the BIs in the transferred assets Limits on the assets it can hold Limits on permitted sales, exchanges, puts, or distributions of its assets 4.4

36 Katrina and Qs Do workouts/forbearance related to Katrina affect Q status? No, per SEC staff if parameters met: These occur during a short period of time (90 days mentioned as short) Restricted to FEMA-designated disaster areas resulting only from Katrina Any amendments to QSPE docs: Must be made quickly (including approvals) Provision for future events must be of epic proportions (e.g. Rita and Wilma are not epic) 4.5

37 CMBS Issue CMSA/BIG 4 Meeting with SEC October 2005 Focused on current CMBS practices Ability of SPE to waive due on sale provisions Ability of borrowers to substitute collateral Ability of SPE to sell foreclosed property as soon as practicable, consistent with goal of minimizing losses, within a specified time frame Practices were in effect prior to Topic D-99 and FAS 125/FAS 140 Debate as to whether practices comply with QSPE provisions of FAS

38 CMBS Issue CMSA/BIG 4 Meeting with SEC October 2005 SEC prefers a standard-setting resolution SEC may request that FASB address these issues Strongly encourage disclosure Issues related to qualifying status being discussed by regulators and standard-setters Impact of changes to existing / prospective structures 4.7

39 QSPE Requirements Demonstrably distinct from the transferor Limits on permitted activities: Significantly limited Entirely specified in the legal documents that established the SPE or created the BIs in the transferred assets Limits on the assets it can hold Limits on permitted sales, exchanges, puts, or distributions of its assets 4.8

40 Polling question Asset Securitizations Does your QSPE hold passive derivatives? Yes No N/A; don t know

41 Passive Derivative Financial Instruments FAS 140 QSPE may hold passive derivatives that only pertain to third party BI holders Notional amount cannot initially exceed amount of third party BIs and it is not expected to exceed them subsequently Proposed FSP FAS 140-c Clarifying affect of situations that cause the derivative notional to exceed third party BIs (e.g., prepayments, market-making activities) FAS 140 ED QSPE may hold passive derivatives that pertain to all BIs issued Remove restriction on a QSPE from holding a derivative that pertains to a BI that is a derivative instrument 4.9

42 Passive Derivative Financial Instruments Facts: ABC transfers $100M fixed-rate mortgages to a special purpose entity (SPE) that issues $100M of variable-rate beneficial interests (BIs). SPE also holds a $100M notional pay-fixed receive-variable interest rate swap. SPE issues three senior classes of BIs to third party investors and a residual tranche. The transferor retains 50% of the residual tranche, or $1M, and the remaining $1M is sold to third party investors. Is the interest rate swap considered to be a passive derivative financial instrument? 4.10

43 Passive Derivative Financial Instruments Facts: On January 1, 2005, ABC transfers $100M fixed-rate mortgages to a SPE that issues $100M of BIs. SPE also holds a $100M notional pay-fixed receive-variable interest rate swap. SPE issues three senior classes and a residual class of BIs to third party investors. On January 15, 2005, ABC s wholly-owned broker-dealer subsidiary purchased certain of these BIs in its marketmaking activities. On January 15, 2005, third party investors held $98M and ABC (consolidated) owned $2M of the BIs. Is the interest rate swap considered to be a passive derivative financial instrument? 4.11

44 Sale Criteria Control is surrendered in a transfer if: Transferred assets have been isolated from the transferor Transferee can pledge or exchange Transferor does not effectively control 4.12

45 Legal Opinions Do I need one? Auditing Interpretation (AU9336) Consider obtaining a legal opinion if: Complex legal structure Continuing seller involvement Other legal issues that make it difficult to determine whether the isolation criterion is met May not be necessary if: Routine transfer of financial assets without continuing involvement by the transferor No servicing No participation in future cash flows No recourse obligations (other than reps and warranties) Consider whether to obtain an update to a legal opinion 4.13

46 Share-Based Payment

47 Share-Based Payments SAB Topic 11-M (SAB 74) Disclose the impact that SFAS 123R will have on the financial statements when adopted in a future period. MD&A requires disclosure of presently known material changes, trends and uncertainties that the registrant reasonably expects will have a material impact on income from continuing operations The SEC Staff believes that recently issued accounting standards may constitute material matters and, therefore disclosure in the financial statements should also be considered in situations where the change to the new accounting standard will be accounted for in financial statements of future periods. 5.1

48 Share-Based Payments Objectives of disclosures: Notify reader that SFAS 123R has been issued and the registrant is required to adopt on January 1, Assist the reader in assessing the significance of impact that SFAS 123R will have on the financial statements. Specific items to disclose: Description of SFAS 123R and date of adoption Method of adoption Impact of adoption, unless not known or reasonably estimable Potential impact of other significant matters that might result from adoption (e.g. changes in business practices) 5.2

49 Share-Based Payments Transition under MPA Compensation cost for the portion of awards for which the requisite service has not been rendered that are outstanding at the date of adoption shall be recognized as the requisite service is rendered after the date of adoption Compensation cost shall be based on the grant date fair value as calculated for either recognition or pro forma disclosures under SFAS 123 Compensation cost shall be attributed using the attribution method that was used under SFAS 123, except forfeitures shall be estimated. 5.3

50 Polling question - Share-based payments Which transition method do you plan on using? Modified prospective application Modified retrospective application Prospective application (e.g., private enterprises) N/A; don t know

51 Share-Based Payments Forfeitures An entity that had a policy of recognizing the effect of forfeitures only as they occurred shall estimate the number of outstanding instruments for which requisite service is not expected to be rendered When computing the SAB Topic 11-M disclosures remember to include the impact of estimating forfeitures, for both: Future share-based payment expense Cumulative effect of change in accounting principle, if any. 5.4

52 Share-Based Payments Forfeitures Entities may need to recognize a cumulative effect of a change in accounting principle upon adoption: If they have adopted SFAS 123 for recognition purposes. Recognized share-based payment expense under APB 25 Entities that previously did not recognize sharebased payments in the income statement should not recognize a cumulative effect. 5.5

53 Share-Based Payments Awards granted to Retirement Eligible Employees Awards that provide for acceleration upon retirement or continued vesting after retirement does not have a substantive service period if granted to employees that are retirement eligible. Under SFAS 123R such awards should be expensed at the date of grant rather than over the stated vesting period. Prior to adoption of SFAS 123R it is acceptable to expense these awards over the stated vesting period. Consider impact on SAB Topic 11-M disclosures 5.6

54 Share-Based Payments Liability Awards: Certain awards that were classified as equity awards under SFAS 123 may be liability awards under SFAS 123R Contingently puttable shares Awards subject SFAS 150 Transition Guidance: Recognize liability at its fair value Difference between (1) fair value of liability and (2) previously recognized compensation cost, should be recognized in equity to the extent of previously recognized compensation expense. The remainder should be recognized as a cumulative effect of a change in accounting principle. 5.7

55 Share-Based Payments APIC Pool Simplified Method Final FSP issued on November 10, 2005 Intent is to provide a practical transition method for calculating beginning APIC pool However, APIC pool can be calculated using FSP guidance OR the transition guidelines in paragraph 81 of SFAS 123R 5.8

56 Share-Based Payments APIC Pool Simplified Method Beginning balance of APIC pool calculated as follows: The sum of all increases of APIC recognized in an entity s financial statements related to tax benefits from sharebased payments since the adoption of SFAS 123 but prior to the adoption of SFAS 123R LESS: Cumulative incremental pretax employee compensation costs that would have been recognized under SFAS 123 MULTIPLIED BY: The entity s blended statutory tax rate upon adoption of SFAS 123R 5.9

57 Share-Based Payments APIC Pool Simplified Method Effective Date and Transition Effective after November 10, 2005 One time election to use the simplified method Make election within one year of the latter of: November 10, 2005, or Adoption Date Prior to election follow the guidance in par. 81 of SFAS 123R Do not need to demonstrate preferability 5.10