registrant's financial statements may violate Section 13(b)(2) of the
Exchange Act and thus be an illegal act. When such a violation occurs,
an auditor must take steps to see that the registrant's audit committee
is ``adequately informed'' about the illegal act. Because Section
10A(b)(1) is triggered regardless of whether an illegal

act has a material effect on the registrant's financial statements,
where the illegal act consists of a misstatement in the registrant's
financial statements, the auditor will be required to report that
illegal act to the audit committee irrespective of any ``netting'' of
the misstatements with other financial statement items.
    The requirements of Section 10A echo the auditing literature. See,
e.g., Statement on Auditing Standards (SAS) Nos. 54 and 99. Pursuant to
paragraph 77 of SAS 99, if the auditor determines there is evidence
that fraud may exist, the auditor must discuss the matter with the
appropriate level of management that is at least one level above those
involved, and with senior management and the audit committee. The
auditor must report directly to the audit committee fraud involving
senior management and fraud that causes a material misstatement of the
financial statements. Paragraph 6 of SAS 99 states that ``misstatements
arising from fraudulent financial reporting are intentional
misstatements or omissions of amounts or disclosures in financial
statements designed to deceive financial statement users * * *'' \65\
SAS 99 further states that fraudulent financial reporting may involve
falsification or alteration of accounting records; misrepresenting or
omitting events, transactions or other information in the financial
statements; and the intentional misapplication of accounting principles
relating to amounts, classifications, the manner of presentation, or
disclosures in the financial statements.\66\ The clear implication of
SAS 99 is that immaterial misstatements may be fraudulent financial
reporting.\67\
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    \65\ An unintentional illegal act triggers the same procedures
and considerations by the auditor as a fraudulent misstatement if
the illegal act has a direct and material effect on the financial
statements. See AU 110 n. 1, 317.05 and 317.07. Although
distinguishing between intentional and unintentional misstatements
is often difficult, the auditor must plan and perform the audit to
obtain reasonable assurance that the financial statements are free
of material misstatements in either case.
    \66\ Although the auditor is not required to plan or perform the
audit to detect misstatements that are immaterial to the financial
statements, SAS 99 requires the auditor to evaluate several fraud
``risk factors'' that may bring such misstatements to his or her
attention. For example, an analysis of fraud risk factors under SAS
99 must include, among other things, consideration of management's
interest in maintaining or increasing the registrant's stock price
or earnings trend through the use of unusually aggressive accounting
practices, whether management has a practice of committing to
analysts or others that it will achieve unduly aggressive or clearly
unrealistic forecasts, and the existence of assets, liabilities,
revenues, or expenses based on significant estimates that involve
unusually subjective judgments or uncertainties.
    \67\ In requiring the auditor to consider whether fraudulent
misstatements are material, and in requiring differing responses
depending on whether the misstatement is material, SAS 99 makes
clear that fraud can involve immaterial misstatements. Indeed, a
misstatement can be ``inconsequential'' and still involve fraud.
Under SAS 99, assessing whether misstatements due to fraud are
material to the financial statements is a ``cumulative process''
that should occur both during and at the completion of the audit.
SAS 99 further states that this accumulation is primarily a
``qualitative matter'' based on the auditor's judgment. The staff
believes that in making these assessments, management and auditors
should refer to the discussion in Part 1 of this SAB.
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    Auditors that learn of intentional misstatements may also be
required to (1) re-evaluate the degree of audit risk involved in the
audit engagement, (2) determine whether to revise the nature, timing,
and extent of audit procedures accordingly, and (3) consider whether to
resign.\68\
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    \68\ Auditors should document their determinations in accordance
with SAS 96, SAS 99, and other appropriate sections of the audit
literature.
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    Intentional misstatements also may signal the existence of
reportable conditions or material weaknesses in the registrant's system
of internal accounting control designed to detect and deter improper
accounting and financial reporting.\69\ As stated by the National
Commission on Fraudulent Financial Reporting, also known as the
Treadway Commission, in its 1987 report,
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    \69\ See, e.g., SAS 99.

    The tone set by top management--the corporate environment or
culture within which financial reporting occurs--is the most
important factor contributing to the integrity of the financial
reporting process. Notwithstanding an impressive set of written
rules and procedures, if the tone set by management is lax,
fraudulent financial reporting is more likely to occur.\70\
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    \70\ Report of the National Commission on Fraudulent Financial
Reporting at 32 (October 1987). See also Report and Recommendations
of the Blue Ribbon Committee on Improving the Effectiveness of
Corporate Audit Committees (February 8, 1999).

    An auditor is required to report to a registrant's audit committee
any reportable conditions or material weaknesses in a registrant's
system of internal accounting control that the auditor discovers in the
course of the examination of the registrant's financial statements.\71\
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    \71\ AU 325.02. See also AU 380.09, which, in discussing matters
to be communicated by the auditor to the audit committee, states:
    The auditor should inform the audit committee about adjustments
arising from the audit that could, in his judgment, either
individually or in the aggregate, have a significant effect on the
entity's financial reporting process. For purposes of this section,
an audit adjustment, whether or not recorded by the entity, is a
proposed correction of the financial statements. * * *
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GAAP Precedence Over Industry Practice
    Some have argued to the staff that registrants should be permitted
to follow an industry accounting practice even though that practice is
inconsistent with authoritative accounting literature. This situation
might occur if a practice is developed when there are few transactions
and the accounting results are clearly inconsequential, and that
practice never changes despite a subsequent growth in the number or
materiality of such transactions. The staff disagrees with this
argument. Authoritative literature takes precedence over industry
practice that is contrary to GAAP.\72\
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    \72\ See AU 411.05.
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General Comments
    This SAB is not intended to change current law or guidance in the
accounting or auditing literature.\73\ This SAB and the authoritative
accounting literature cannot specifically address all of the novel and
complex business transactions and events that may occur. Accordingly,
registrants may account for, and make disclosures about, these
transactions and events based on analogies to similar situations or
other factors. The staff may not, however, always be persuaded that a
registrant's determination is the most appropriate under the
circumstances. When disagreements occur after a transaction or an event
has been reported, the consequences may be severe for registrants,
auditors, and, most importantly, the users of financial statements who
have a right to expect consistent accounting and reporting for, and
disclosure of, similar transactions and events. The staff, therefore,

encourages registrants and auditors to discuss on a timely basis with
the staff proposed accounting treatments for, or disclosures about,
transactions or events that are not specifically covered by the
existing accounting literature.
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    \73\ The FASB Discussion Memorandum, ``Criteria for Determining
Materiality,'' states that the financial accounting and reporting
process considers that ``a great deal of the time might be spent
during the accounting process considering insignificant matters. * *
* If presentations of financial information are to be prepared
economically on a timely basis and presented in a concise
intelligible form, the concept of materiality is crucial.'' This SAB
is not intended to require that misstatements arising from
insignificant errors and omissions (individually and in the
aggregate) arising from the normal recurring accounting close
processes, such as a clerical error or an adjustment for a missed
accounts payable invoice, always be corrected, even if the error is
identified in the audit process and known to management. Management
and the auditor would need to consider the various factors described
elsewhere in this SAB in assessing whether such misstatements are
material, need to be corrected to comply with the FCPA, or trigger
procedures under Section 10A of the Exchange Act. Because this SAB
does not change current law or guidance in the accounting or
auditing literature, adherence to the principles described in this
SAB should not raise the costs associated with recordkeeping or with
audits of financial statements.
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N. Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements

(Added by SAB 108)
    Facts: During the course of preparing annual financial statements,
a registrant is evaluating the materiality of an improper expense
accrual (e.g., overstated liability) in the amount of $100, which has
built up over 5 years, at $20 per year.\74\ The registrant previously
evaluated the misstatement as being immaterial to each of the prior
year financial statements (i.e., years 1-4). For the purpose of
evaluating materiality in the current year (i.e., year 5), the
registrant quantifies the error as a $20 overstatement of expenses.
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    \74\ For purposes of these facts, assume the registrant properly
determined that the overstatement of the liability resulted from an
error rather than a change in accounting estimate. See the FASB ASC
Master Glossary for the distinction between an error in previously
issued financial statements and a change in accounting estimate.
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    Question 1: Has the registrant appropriately quantified the amount
of this error for the purpose of evaluating materiality for the current
year?
    Interpretive Response: No. In this example, the registrant has only
quantified the effects of the identified unadjusted error that arose in
the current year income statement. The staff believes a registrant's
materiality evaluation of an identified unadjusted error should
quantify the effects of the identified unadjusted error on each
financial statement and related financial statement disclosure.
    Topic 1M notes that a materiality evaluation must be based on all
relevant quantitative and qualitative factors.\75\ This analysis
generally begins with quantifying potential misstatements to be
evaluated. There has been diversity in practice with respect to this
initial step of a materiality analysis.
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    \75\ Topic 1N addresses certain of these quantitative issues,
but does not alter the analysis required by Topic 1M.
---------------------------------------------------------------------------

    The diversity in approaches for quantifying the amount of
misstatements primarily stems from the effects of misstatements that
were not corrected at the end of the prior year (``prior year
misstatements''). These prior year misstatements should be considered
in quantifying misstatements in current year financial statements.
    The techniques most commonly used in practice to accumulate and
quantify misstatements are generally referred to as the ``rollover''
and ``iron curtain'' approaches.
    The rollover approach, which is the approach used by the registrant
in this example, quantifies a misstatement based on the amount of the
error originating in the current year income statement. Thus, this
approach ignores the effects of correcting the portion of the current
year balance sheet misstatement that originated in prior years (i.e.,
it ignores the ``carryover effects'' of prior year misstatements).
    The iron curtain approach quantifies a misstatement based on the
effects of correcting the misstatement existing in the balance sheet at
the end of the current year, irrespective of the misstatement's year(s)
of origination. Had the registrant in this fact pattern applied the
iron curtain approach, the misstatement would have been quantified as a
$100 misstatement based on the end of year balance sheet misstatement.
Thus, the adjustment needed to correct the financial statements for the
end of year error would be to reduce the liability by $100 with a
corresponding decrease in current year expense.
    As demonstrated in this example, the primary weakness of the
rollover approach is that it can result in the accumulation of
significant misstatements on the balance sheet that are deemed
immaterial in part because the amount that originates in each year is
quantitatively small. The staff is aware of situations in which a
registrant, relying on the rollover approach, has allowed an erroneous
item to accumulate on the balance sheet to the point where eliminating
the improper asset or liability would itself result in a material error
in the income statement if adjusted in the current year. Such
registrants have sometimes concluded that the improper asset or
liability should remain on the balance sheet into perpetuity.
    In contrast, the primary weakness of the iron curtain approach is
that it does not consider the correction of prior year misstatements in
the current year (i.e., the reversal of the carryover effects) to be
errors. Therefore, in this example, if the misstatement was corrected
during the current year such that no error existed in the balance sheet
at the end of the current year, the reversal of the $80 prior year
misstatement would not be considered an error in the current year
financial statements under the iron curtain approach. Implicitly, the
iron curtain approach assumes that because the prior year financial
statements were not materially misstated, correcting any immaterial
errors that existed in those statements in the current year is the
``correct'' accounting, and is therefore not considered an error in the
current year. Thus, utilization of the iron curtain approach can result
in a misstatement in the current year income statement not being
evaluated as an error at all.
    The staff does not believe the exclusive reliance on either the
rollover or iron curtain approach appropriately quantifies all
misstatements that could be material to users of financial statements.
    In describing the concept of materiality, Concepts Statement 2,
Qualitative Characteristics of Accounting Information, indicates that
materiality determinations are based on whether ``it is probable that
the judgment of a reasonable person relying upon the report would have
been changed or influenced by the inclusion or correction of the item''
(emphasis added).\76\ The staff believes registrants must quantify the
impact of correcting all misstatements, including both the carryover
and reversing effects of prior year misstatements, on the current year
financial statements. The staff believes that this can be accomplished
by quantifying an error under both the rollover and iron curtain
approaches as described above and by evaluating the error measured
under each approach. Thus, a registrant's financial statements would
require adjustment when either approach results in quantifying a
misstatement that is material, after considering all relevant
quantitative and qualitative factors.
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    \76\ Concepts Statement 2, paragraph 132. See also Concepts
Statement 2, Glossary of Terms--Materiality.
---------------------------------------------------------------------------

    As a reminder, a change from an accounting principle that is not
generally accepted to one that is generally accepted is a correction of
an error.\77\
---------------------------------------------------------------------------

    \77\ See definition of ``error in previously issued financial
statements'' in the FASB ASC Master Glossary.
---------------------------------------------------------------------------

    The staff believes that the registrant should quantify the current
year misstatement in this example using both the iron curtain approach
(i.e., $100) and the rollover approach (i.e., $20). Therefore, if the
$100 misstatement is considered material to the financial statements,
after all of the relevant quantitative and qualitative factors are
considered, the registrant's financial statements would need to be
adjusted.
    It is possible that correcting an error in the current year could
materially misstate the current year's income statement. For example,
correcting the

$100 misstatement in the current year will:
     Correct the $20 error originating in the current year;
     Correct the $80 balance sheet carryover error that
originated in Years 1 through 4; but also
     Misstate the current year income statement by $80.
    If the $80 understatement of current year expense is material to
the current year, after all of the relevant quantitative and
qualitative factors are considered, the prior year financial statements
should be corrected, even though such revision previously was and
continues to be immaterial to the prior year financial statements.
Correcting prior year financial statements for immaterial errors would
not require previously filed reports to be amended. Such correction may
be made the next time the registrant files the prior year financial
statements.
    The following example further illustrates the staff's views on
quantifying misstatements, including the consideration of the effects
of prior year misstatements:
    Facts: During the course of preparing annual financial statements,
a registrant is evaluating the materiality of a sales cut-off error in
which $50 of revenue from the following year was recorded in the
current year, thereby overstating accounts receivable by $50 at the end
of the current year. In addition, a similar sales cut-off error existed
at the end of the prior year in which $110 of revenue from the current
year was recorded in the prior year. As a result of the combination of
the current year and prior year cut-off errors, revenues in the current
year are understated by $60 ($110 understatement of revenues at the
beginning of the current year partially offset by a $50 overstatement
of revenues at the end of the current year). The prior year error was
evaluated in the prior year as being immaterial to those financial
statements.
    Question 2: How should the registrant quantify the misstatement in
the current year financial statements?
    Interpretive Response: The staff believes the registrant should
quantify the current year misstatement in this example using both the
iron curtain approach (i.e., $50) and the rollover approach (i.e.,
$60). Therefore, assuming a $60 misstatement is considered material to
the financial statements, after all relevant quantitative and
qualitative factors are considered, the registrant's financial
statements would need to be adjusted.
    Further, in this example, recording an adjustment in the current
year could alter the amount of the error affecting the current year
financial statements. For instance:
     If only the $60 understatement of revenues were to be
corrected in the current year, then the overstatement of current year
end accounts receivable would increase to $110; or,
     If only the $50 overstatement of accounts receivable were
to be corrected in the current year, then the understatement of current
year revenues would increase to $110.
    If the misstatement that exists after recording the adjustment in
the current year financial statements is material (considering all
relevant quantitative and qualitative factors), the prior year
financial statements should be corrected, even though such revision
previously was and continues to be immaterial to the prior year
financial statements. Correcting prior year financial statements for
immaterial errors would not require previously filed reports to be
amended. Such correction may be made the next time the registrant files
the prior year financial statements.
    If the cut-off error that existed in the prior year was not
discovered until the current year, a separate analysis of the financial
statements of the prior year (and any other prior year in which
previously undiscovered errors existed) would need to be performed to
determine whether such prior year financial statements were materially
misstated. If that analysis indicates that the prior year financial
statements are materially misstated, they would need to be restated in
accordance with FASB ASC Topic 250, Accounting Changes and Error
Corrections.\78\
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    \78\ FASB ASC paragraph 250-10-45-23.
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    Facts: When preparing its financial statements for years ending on
or before November 15, 2006, a registrant quantified errors by using
either the iron curtain approach or the rollover approach, but not
both. Based on consideration of the guidance in this Staff Accounting
Bulletin, the registrant concludes that errors existing in previously
issued financial statements are material.
    Question 3: Will the staff expect the registrant to restate prior
period financial statements when first applying this guidance?
    Interpretive Response: The staff will not object if a registrant
\79\ does not restate financial statements for fiscal years ending on
or before November 15, 2006, if management properly applied its
previous approach, either iron curtain or rollover, so long as all
relevant qualitative factors were considered.
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    \79\ If a registrant's initial registration statement is not
effective on or before November 15, 2006, and the registrant's prior
year(s) financial statements are materially misstated based on
consideration of the guidance in this Staff Accounting Bulletin, the
prior year financial statements should be restated in accordance
with FASB ASC paragraph 250-10-45-23. If a registrant's initial
registration statement is effective on or before November 15, 2006,
the guidance in the interpretive response to Question 3 is
applicable.
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    To provide full disclosure, registrants electing not to restate
prior periods should reflect the effects of initially applying the
guidance in Topic 1N in their annual financial statements covering the
first fiscal year ending after November 15, 2006. The cumulative effect
of the initial application should be reported in the carrying amounts
of assets and liabilities as of the beginning of that fiscal year, and
the offsetting adjustment should be made to the opening balance of
retained earnings for that year. Registrants should disclose the nature
and amount of each individual error being corrected in the cumulative
adjustment. The disclosure should also include when and how each error
being corrected arose and the fact that the errors had previously been
considered immaterial.
    Early application of the guidance in Topic 1N is encouraged in any
report for an interim period of the first fiscal year ending after
November 15, 2006, filed after the publication of this Staff Accounting
Bulletin. In the event that the cumulative effect of application of the
guidance in Topic 1N is first reported in an interim period other than
the first interim period of the first fiscal year ending after November
15, 2006, previously filed interim reports need not be amended.
However, comparative information presented in reports for interim
periods of the first year subsequent to initial application should be
adjusted to reflect the cumulative effect adjustment as of the
beginning of the year of initial application. In addition, the
disclosures of selected quarterly information required by Item 302 of
Regulation S-K should reflect the adjusted results.

TOPIC 2: BUSINESS COMBINATIONS

A. Acquisition Method

1. Removed by SAB 103
2. Removed by SAB 103
3. Removed by SAB 103
4. Removed by SAB 103
5. Removed by SAB 112
6. Debt Issue Costs
    Facts: Company A is to acquire the net assets of Company B in a
transaction

to be accounted for as a business combination. In connection with the
transaction, Company A has retained an investment banker to provide
advisory services in structuring the acquisition and to provide the
necessary financing. It is expected that the acquisition will be
financed on an interim basis using ``bridge financing'' provided by the
investment banker. Permanent financing will be arranged at a later date
through a debt offering, which will be underwritten by the investment
banker. Fees will be paid to the investment banker for the advisory
services, the bridge financing, and the underwriting of the permanent
financing. These services may be billed separately or as a single
amount.
    Question 1: Should total fees paid to the investment banker for
acquisition-related services and the issuance of debt securities be
allocated between the services received?
    Interpretive Response: Yes. Fees paid to an investment banker in
connection with a business combination or asset acquisition, when the
investment banker is also providing interim financing or underwriting
services, must be allocated between acquisition related services and
debt issue costs.
    When an investment banker provides services in connection with a
business combination or asset acquisition and also provides
underwriting services associated with the issuance of debt or equity
securities, the total fees incurred by an entity should be allocated
between the services received on a relative fair value basis. The
objective of the allocation is to ascribe the total fees incurred to
the actual services provided by the investment banker.
    FASB ASC Topic 805, Business Combinations, provides guidance for
the portion of the costs that represent acquisition-related services.
The portion of the costs pertaining to the issuance of debt or equity
securities should be accounted for in accordance with other applicable
GAAP.
    Question 2: May the debt issue costs of the interim ``bridge
financing'' be amortized over the anticipated combined life of the
bridge and permanent financings?
    1. Interpretive Response: No. Debt issue costs should be amortized
by the interest method over the life of the debt to which they relate.
Debt issue costs related to the bridge financing should be recognized
as interest cost during the estimated interim period preceding the
placement of the permanent financing with any unamortized amounts
charged to expense if the bridge loan is repaid prior to the expiration
of the estimated period. Where the bridged financing consists of
increasing rate debt, the guidance issued in FASB ASC Topic 470, Debt,
should be followed.\1\
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    \1\ As noted in FASB ASC paragraph 470-10-35-2, the term-
extending provisions of the debt instrument should be analyzed to
determine whether they constitute an embedded derivative requiring
separate accounting in accordance with FASB ASC Topic 815,
Derivatives and Hedging.
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7. Removed by SAB 112
8. Business Combinations Prior to an Initial Public Offering
    Facts: Two or more businesses combine in a single combination just
prior to or contemporaneously with an initial public offering.
    Question: Does the guidance in SAB Topic 5.G apply to business
combinations entered into just prior to or contemporaneously with an
initial public offering?
    Interpretive Response: No. The guidance in SAB Topic 5.G is
intended to address the transfer, just prior to or contemporaneously
with an initial public offering, of nonmonetary assets in exchange for
a company's stock. The guidance in SAB Topic 5.G is not intended to
modify the requirements of FASB ASC Topic 805. Accordingly, the staff
believes that the combination of two or more businesses should be
accounted for in accordance with FASB ASC Topic 805.
9. Removed by SAB 112

B. Removed by SAB 103

C. Removed by SAB 103

D. Financial Statements of Oil And Gas Exchange Offers

    Facts: The oil and gas industry has experienced periods of time
where there have been a significant number of ``exchange offers'' (also
referred to as ``roll-ups'' or ``put-togethers'') to form a publicly
held company, take an existing private company public, or increase the
size of an existing publicly held company. An exchange offer
transaction involves a swap of shares in a corporation for interests in
properties, typically limited partnership interests. Such interests
could include direct interests such as working interests and royalties
related to developed or undeveloped properties and indirect interests
such as limited partnership interests or shares of existing oil and gas
companies. Generally, such transactions are structured to be tax-free
to the individual or entity trading the property interest for shares of
the corporation. Under certain circumstances, however, part or all of
the transaction may be taxable. For purposes of the discussion in this
Topic, in each of these situations, the entity (or entities) or
property (or properties) are deemed to constitute a business.
    One financial reporting issue in exchange transactions involves
deciding which prior financial results of the entities should be
reported.
    Question 1: In Form 10-K filings with the Commission, the staff has
permitted limited partnerships to omit certain of the oil and gas
reserve value information and the supplemental summary of oil and gas
activities disclosures required by FASB ASC Subtopic 932-235,
Extractive Activities--Oil and Gas--Notes to Financial Statements, in
some circumstances. Is it permissible to omit these disclosures from
the financial statements included in an exchange offering?
    Interpretive Response: No. Normally full disclosures of reserve
data and related information are required. The exemptions previously
allowed relate only to partnerships where value-oriented data are
otherwise available to the limited partners pursuant to the partnership
agreement. The staff has previously stated that it will require all of
the required disclosures for partnerships which are the subject of
exchange offers.\2\ These disclosures may, however, be presented on a
combined basis if the entities are under common control.
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    \2\ See SAB 40, Topic 12.A.3.c.
---------------------------------------------------------------------------

    The staff believes that the financial statements in an exchange
offer registration statement should provide sufficient historical
reserve quantity and value-based disclosures to enable offerees and
secondary market public investors to evaluate the effect of the
exchange proposal. Accordingly, in all cases, it will be necessary to
present information as of the latest year-end on reserve quantities and
the future net revenues associated with such quantities. In certain
circumstances, where the exchange is accounted for using the
acquisition method of accounting, the staff will consider, on a case-
by-case basis, granting exemptions from (i) the disclosure requirements
for year-to-year reconciliations of reserve quantities, and (ii) the
requirements for a summary of oil and gas producing activities and a
summary of changes in the net present value of reserves. For instance,
the staff may consider requests for exemptions in cases where the
properties acquired in the exchange transaction are fully explored and
developed, particularly if the management of the emerging company has
not been involved in the exploration and development of such
properties.

    Question 2: If the exchange company will use the full cost method
of accounting, does the full cost ceiling limitation apply as of the
date of the financial statements reflecting the exchange?
    Interpretive Response: Yes. The full cost ceiling limitation on
costs capitalized does apply. However, as discussed under Topic 12.D.3,
the Commission has stated that in unusual circumstances, registrants
may request an exemption if as a result of a major purchase, a write-
down would be required even though it can be demonstrated that the fair
value of the properties clearly exceeds the unamortized costs.
    Question 3: How should ``common control accounting'' be applied to
the specific assets and liabilities of the new exchange company?
    Interpretive Response: Consistent with SAB Topic 12.C.2, under
``common control accounting'' the various accounting methods followed
by the offeree entities should be conformed to the methods adopted by
the new exchange company. It is not appropriate to combine assets and
liabilities accounted for on different bases. Accordingly, all of the
oil and gas properties of the new entity must be accounted for on the
same basis (either full cost or successful efforts) applied
retrospectively.
    Question 4: What pro forma financial information is required in an
exchange offer filing?
    Interpretive Response: The requirements for pro forma financial
information in exchange offer filings are the same as in any other
filings with the Commission and are detailed in Article 11 of
Regulation S-X.\3\ Rule 11-02(b) specifies the presentation
requirements, including periods presented and types of adjustments to
be made. The general criteria of Rule 11-02(b)(6) are that pro forma
adjustments should give effect to events that are (i) directly
attributable to the transaction, (ii) expected to have a continuing
impact on the registrant, and (iii) factually supportable. In the case
of an exchange offer, such adjustments typically are made to:
---------------------------------------------------------------------------

    \3\ As announced in Financial Reporting Release No. 2 (July 9,
1982).
---------------------------------------------------------------------------

    (1) Show varying levels of acceptance of the offer.
    (2) Conform the accounting methods used in the historical financial
statements to those to be applied by the new entity.
    (3) Recompute the depreciation, depletion and amortization charges,
in cases where the new entity will use full-cost accounting, on a
combined basis. If this computation is not practicable, and the
exchange offer is accounted for as a transaction among entities under
common control, historical depreciation, depletion and amortization
provisions may be aggregated, with appropriate disclosure.
    (4) Reflect the acquisition in the pro forma statements where the
exchange offer is accounted for using the acquisition method of
accounting, including depreciation, depletion and amortization based on
the measurement guidance in FASB ASC Topic 805, Business Combinations.
    (5) Provide pro forma reserve information comparable to the
disclosures required by FASB ASC paragraphs 932-235-50-3 through 932-
235-50-11B and FASB ASC paragraphs 932-235-50-29 through 932-235-50-36.
    (6) Reflect significant changes, if any, in levels of operations
(revenues or costs), or in income tax status and to reflect debt
incurred in connection with the transaction.

In addition, the depreciation, depletion and amortization rate which
will apply for the initial period subsequent to consummation of the
exchange offer should be disclosed.
    Question 5: Are there conditions under which the presentation of
other than full historical financial statements would be acceptable?
    Interpretive Response: Generally, full historical financial
statements as specified in Rules 3-01 and 3-02 of Regulation S-X are
considered necessary to enable offerees and secondary market investors
to evaluate the transaction. Where securities are being registered to
offer to the security holders (including limited partners and other
ownership interests) of the businesses to be acquired, such financial
statements are normally required pursuant to Rule 3-05 of Regulation S-
X, either individually for each entity or, where appropriate,
separately for the offeror and on a combined basis for other entities,
generally excluding corporations. However, certain exceptions may apply
as explained in the outline below:
A. Acquisition Method Accounting
    1. If the registrant can demonstrate that full historical financial
statements of the offeree businesses are not reasonably available, the
staff may permit presentation of audited Statements of Combined Gross
Revenues and Direct Lease Operating Expenses for all years for which an
income statement would otherwise be required. In these circumstances,
the registrant should also disclose in an unaudited footnote the
amounts of total exploration and development costs, and general and
administrative expenses along with the reasons why presentation of full
historical financial statements is not practicable.
    2. The staff will consider requests to waive the requirement for
prior year financial statements of the offerees and instead allow
presentation of only the latest fiscal year and interim period, if the
registrant can demonstrate that the prior years' data would not be
meaningful because the offerees had no material quantity of production.
B. Common Control Accounting
    The staff would expect that the full historical financial
statements as specified in Rules 3-01 and 3-02 of Regulation S-X would
be included in the registration statement for exchange offers accounted
for as transactions among entities under common control, including all
required supplemental reserve information. The presentation of
individual or combined financial statements would depend on the
circumstances of the particular exchange offer.
    Registrants are also reminded that wherever historical results are
presented, it may be appropriate to explain the reasons why historical
costs are not necessarily indicative of future expenditures.

E. Removed by SAB 103

F. Removed by SAB 103

TOPIC 3: SENIOR SECURITIES

A. Convertible Securities

    Facts: Company B proposes to file a registration statement covering
convertible securities.
    Question: In registration, what consideration should be given to
the dilutive effects of convertible securities?
    Interpretive Response: In a registration statement of convertible
preferred stock or debentures, the staff believes that disclosure of
pro forma earnings per share (EPS) is important to investors when the
proceeds will be used to extinguish existing preferred stock or debt
and such extinguishments will have a material effect on EPS. That
disclosure is required by Article 11, Rule 11-01(a)(8) and Rule 11-
02(b)(7) of Regulation S-X, if material.

B. Removed by ASR 307

C. Redeemable Preferred Stock

    Facts: Rule 5-02.27 of Regulation S-X states that redeemable
preferred stocks are not to be included in amounts reported as
stockholders' equity, and that their redemption amounts are to be

shown on the face of the balance sheet. However, the Commission's rules
and regulations do not address the carrying amount at which redeemable
preferred stock should be reported, or how changes in its carrying
amount should be treated in calculations of earnings per share and the
ratio of earnings to combined fixed charges and preferred stock
dividends.
    Question 1: How should the carrying amount of redeemable preferred
stock be determined?
    Interpretive Response: The initial carrying amount of redeemable
preferred stock should be its fair value at date of issue. Where fair
value at date of issue is less than the mandatory redemption amount,
the carrying amount shall be increased by periodic accretions, using
the interest method, so that the carrying amount will equal the
mandatory redemption amount at the mandatory redemption date. The
carrying amount shall be further periodically increased by amounts
representing dividends not currently declared or paid, but which will
be payable under the mandatory redemption features, or for which
ultimate payment is not solely within the control of the registrant
(e.g., dividends that will be payable out of future earnings). Each
type of increase in carrying amount shall be effected by charges
against retained earnings or, in the absence of retained earnings, by
charges against paid-in capital.
    The accounting described in the preceding paragraph would apply
irrespective of whether the redeemable preferred stock may be
voluntarily redeemed by the issuer prior to the mandatory redemption
date, or whether it may be converted into another class of securities
by the holder. Companies also should consider the guidance in FASB ASC
paragraph 480-10-S99-3A (Distinguishing Liabilities from Equity Topic).
    Question 2: How should periodic increases in the carrying amount of
redeemable preferred stock be treated in calculations of earnings per
share and ratios of earnings to combined fixed charges and preferred
stock dividends?
    Interpretive Response: Each type of increase in carrying amount
described in the Interpretive Response to Question 1 should be treated
in the same manner as dividends on nonredeemable preferred stock.

TOPIC 4: EQUITY ACCOUNTS

A. Subordinated Debt

    Facts: Company E proposes to include in its registration statement
a balance sheet showing its subordinate debt as a portion of
stockholders' equity.
    Question: Is this presentation appropriate?
    Interpretive Response: Subordinated debt may not be included in the
stockholders' equity section of the balance sheet. Any presentation
describing such debt as a component of stockholders' equity must be
eliminated. Furthermore, any caption representing the combination of
stockholders' equity and only subordinated debts must be deleted.

B. S Corporations

    Facts: An S corporation has undistributed earnings on the date its
S election is terminated.
    Question: How should such earnings be reflected in the financial
statements?
    Interpretive Response: Such earnings must be included in the
financial statements as additional paid-in capital. This assumes a
constructive distribution to the owners followed by a contribution to
the capital of the corporation.

C. Change in Capital Structure

    Facts: A capital structure change to a stock dividend, stock split
or reverse split occurs after the date of the latest reported balance
sheet but before the release of the financial statements or the
effective date of the registration statement, whichever is later.
    Question: What effect must be given to such a change?
    Interpretive Response: Such changes in the capital structure must
be given retroactive effect in the balance sheet. An appropriately
cross-referenced note should disclose the retroactive treatment,
explain the change made and state the date the change became effective.

D. Earnings per Share Computations in an Initial Public Offering

    Facts: A registration statement is filed in connection with an
initial public offering (IPO) of common stock. During the periods
covered by income statements that are included in the registration
statement or in the subsequent period prior to the effective date of
the IPO, the registrant issued for nominal consideration \1\ common
stock, options or warrants to purchase common stock or other
potentially dilutive instruments (collectively, referred to hereafter
as ``nominal issuances'').
---------------------------------------------------------------------------

    \1\ Whether a security was issued for nominal consideration
should be determined based on facts and circumstances. The
consideration the entity receives for the issuance should be
compared to the security's fair value to determine whether the
consideration is nominal.
---------------------------------------------------------------------------

    Prior to the effective date of FASB ASC Topic 260, Earnings Per
Share, the staff believed that certain stock and warrants \2\ should be
treated as outstanding for all reporting periods in the same manner as
shares issued in a stock split or a recapitalization effected
contemporaneously with the IPO. The dilutive effect of such stock and
warrants could be measured using the treasury stock method.
---------------------------------------------------------------------------

    \2\ The stock and warrants encompasses by the prior guidance
were those issuances of common stock at prices below the IPO price
and options or warrants with exercise prices below the IPO price
that were issued within a one-year period prior to the initial
filing of the registration statement relating to the IPO through the
registration statement's effective date.
---------------------------------------------------------------------------

    Question 1: Does the staff continue to believe that such treatment
for stock and warrants would be appropriate upon adoption of FASB ASC
Topic 260?
    Interpretive Response: Generally, no. Historical EPS should be
prepared and presented in conformity with FASB ASC Topic 260.
    In applying the requirements of FASB ASC Topic 260, the staff
believes that nominal issuances are recapitalizations in substance. In
computing basic EPS for the periods covered by income statements
included in the registration statement and in subsequent filings with
the SEC, nominal issuances of common stock should be reflected in a
manner similar to a stock split or stock dividend for which retroactive
treatment is required by FASB ASC paragraph 260-10-55-12. In computing
diluted EPS for such periods, nominal issuances of common stock and
potential common stock \3\ should be reflected in a manner similar to a
stock split or stock dividend.
---------------------------------------------------------------------------

    \3\ The FASB ASC Master Glossary defines potential common stock
as ``a security or other contract that may entitle its holder to
obtain common stock during the reporting period or after the end of
the reporting period.''
---------------------------------------------------------------------------

    Registrants are reminded that disclosure about materially dilutive
issuances is required outside the financial statements. Item 506 of
Regulation S-K requires presentation of the dilutive effects of those
issuances on net tangible book value. The effects of dilutive issuances
on the registrant's liquidity, capital resources and results of
operations should be addressed in Management's Discussion and Analysis.
    Question 2: Does reflecting nominal issuances as outstanding for
all historical periods in the computation of earnings per share alter
the registrant's responsibility to determine whether compensation
expense must be

recognized for such issuances to employees?
    Interpretive Response: No. Registrants must follow GAAP in
determining whether the recognition of compensation expense for any
issuances of equity instruments to employees is necessary.\4\
Reflecting nominal issuances as outstanding for all historical periods
in the computation of earnings per share does not alter that existing
responsibility under GAAP.
---------------------------------------------------------------------------

    \4\ As prescribed by FASB ASC Topic 718, Compensation--Stock
Compensation.
---------------------------------------------------------------------------

E. Receivables From Sale of Stock

    Facts: Capital stock is sometimes issued to officers or other
employees before the cash payment is received.
    Question: How should the receivables from the officers or other
employees be presented in the balance sheet?
    Interpretive Response: The amount recorded as a receivable should
be presented in the balance sheet as a deduction from stockholders'
equity. This is generally consistent with Rule 5-02.30 of Regulation S-
X which states that accounts or notes receivable arising from
transactions involving the registrant's capital stock should be
presented as deductions from stockholders' equity and not as assets.
    It should be noted generally that all amounts receivable from
officers and directors resulting from sales of stock or from other
transactions (other than expense advances or sales on normal trade
terms) should be separately stated in the balance sheet irrespective of
whether such amounts may be shown as assets or are required to be
reported as deductions from stockholders' equity.
    The staff will not suggest that a receivable from an officer or
director be deducted from stockholders' equity if the receivable was
paid in cash prior to the publication of the financial statements and
the payment date is stated in a note to the financial statements.
However, the staff would consider the subsequent return of such cash
payment to the officer or director to be part of a scheme or plan to
evade the registration or reporting requirements of the securities
laws.

F. Limited Partnerships

    Facts: There exist a number of publicly held partnerships having
one or more corporate or individual general partners and a relatively
larger number of limited partners. There are no specific requirements
or guidelines relating to the presentation of the partnership equity
accounts in the financial statements. In addition, there are many
approaches to the parallel problem of relating the results of
operations to the two classes of partnership equity interests.
    Question: How should the financial statements of limited
partnerships be presented so that the two ownership classes can readily
determine their relative participations in both the net assets of the
partnership and in the results of its operations?
    Interpretive Response: The equity section of a partnership balance
sheet should distinguish between amounts ascribed to each ownership
class. The equity attributed to the general partners should be stated
separately from the equity of the limited partners, and changes in the
number of equity units authorized and outstanding should be shown for
each ownership class. A statement of changes in partnership equity for
each ownership class should be furnished for each period for which an
income statement is included.
    The income statements of partnerships should be presented in a
manner which clearly shows the aggregate amount of net income (loss)
allocated to the general partners and the aggregate amount allocated to
the limited partners. The statement of income should also state the
results of operations on a per unit basis.

G. Notes and Other Receivables From Affiliates

    Facts: The balance sheet of a corporate general partner is often
presented in a registration statement. Frequently, the balance sheet of
the general partner discloses that it holds notes or other receivables
from a parent or another affiliate. Often the notes or other
receivables were created in order to meet the ``substantial assets''
test which the Internal Revenue Service utilizes in applying its ``Safe
Harbor'' doctrine in the classification of organizations for income tax
purposes.
    Question: How should such notes and other receivables be reported
in the balance sheet of the general partner?
    Interpretive Response: While these notes and other receivables
evidencing a promise to contribute capital are often legally
enforceable, they seldom are actually paid. In substance, these
receivables are equivalent to unpaid subscriptions receivable for
capital shares which Rule 5-02.30 of Regulation S-X requires to be
deducted from the dollar amount of capital shares subscribed.
    The balance sheet display of these or similar items is not
determined by the quality or actual value of the receivable or other
asset ``contributed'' to the capital of the affiliated general partner,
but rather by the relationship of the parties and the control inherent
in that relationship. Accordingly, in these situations, the receivable
must be treated as a deduction from stockholders' equity in the balance
sheet of the corporate general partner.

TOPIC 5: MISCELLANEOUS ACCOUNTING

A. Expenses of Offering

    Facts: Prior to the effective date of an offering of equity
securities, Company Y incurs certain expenses related to the offering.
    Question: Should such costs be deferred?
    Interpretive Response: Specific incremental costs directly
attributable to a proposed or actual offering of securities may
properly be deferred and charged against the gross proceeds of the
offering. However, management salaries or other general and
administrative expenses may not be allocated as costs of the offering
and deferred costs of an aborted offering may not be deferred and
charged against proceeds of a subsequent offering. A short postponement
(up to 90 days) does not represent an aborted offering.

B. Gain or Loss From Disposition of Equipment

    Facts: Company A has adopted the policy of treating gains and
losses from disposition of revenue producing equipment as adjustments
to the current year's provision for depreciation. Company B reflects
such gains and losses as a separate item in the statement of income.
    Question: Does the staff have any views as to which method is
preferable?
    Interpretive Response: Gains and losses resulting from the
disposition of revenue producing equipment should not be treated as
adjustments to the provision for depreciation in the year of
disposition, but should be shown as a separate item in the statement of
income.
    If such equipment is depreciated on the basis of group of composite
accounts for fleets of like vehicles, gains (or losses) may be charged
(or credited) to accumulated depreciation with the result that
depreciation is adjusted over a period of years on an average basis. It
should be noted that the latter treatment would not be appropriate for
(1) an enterprise (such as an airline) which replaces its fleet on an
episodic rather than a continuing basis or (2) an enterprise (such as a
car leasing company) where equipment is sold after limited use so that
the equipment on hand is both fairly new and carried at amounts closely
related to current acquisition cost.

C.1. Removed by SAB 103

C.2. Removed by SAB 103

D. Organization and Offering Expenses and Selling Commissions--Limited
Partnerships Trading in Commodity Futures

    Facts: Partnerships formed for the purpose of engaging in
speculative trading in commodity futures contracts sell limited
partnership interests to the public and frequently have a general
partner who is an affiliate of the partnership's commodity broker or
the principal underwriter selling the limited partnership interests.
The commodity broker or a subsidiary typically assumes the liability
for all or part of the organization and offering expenses and selling
commissions in connection with the sale of limited partnership
interests. Funds raised from the sale of partnership interests are
deposited in a margin account with the commodity broker and are
invested in Treasury Bills or similar securities. The arrangement
further provides that interest earned on the investments for an initial
period is to be retained by the broker until it has been reimbursed for
all or a specified portion of the aforementioned expenses and
commissions and that thereafter interest earned accrues to the
partnership.
    In some instances, there may be no reference to reimbursement of
the broker for expenses and commissions to be assumed. The arrangements
may provide that all interest earned on investments accrues to the
partnership but that commissions on commodity transactions paid to the
broker are at higher rates for a specified initial period and at lower
rates subsequently.
    Question 1: Should the partnership recognize a commitment to
reimburse the commodity broker for the organization and offering
expenses and selling commissions?
    Interpretive Response: Yes. A commitment should be recognized by
reducing partnership capital and establishing a liability for the
estimated amount of expenses and commissions for which the broker is to
be reimbursed.
    Question 2: Should the interest income retained by the broker for
reimbursement of expenses be recognized as income by the partnership?
    Interpretive Response: Yes. All the interest income on the margin
account investments should be recognized as accruing to the partnership
as earned. The portion of income retained by the broker and not
actually realized by the partnership in cash should be applied to
reduce the liability for the estimated amount of reimbursable expenses
and commissions.
    Question 3: If the broker retains all of the interest income for a
specified period and thereafter it accrues to the partnership, should
an equivalent amount of interest income be reflected on the
partnership's financial statements during the specified period?
    Interpretive Response: Yes. If it appears from the terms of the
arrangement that it was the intent of the parties to provide for full
or partial reimbursement for the expenses and commissions paid by the
broker, then a commitment to reimbursement should be recognized by the
partnership and an equivalent amount of interest income should be
recognized on the partnership's financial statements as earned.
    Question 4: Under the arrangements where commissions on commodity
transactions are at a lower rate after a specified period and there is
no reference to reimbursement of the broker for expenses and
commissions, should recognition be given on the partnership's financial
statements to a commitment to reimburse the broker for all or part of
the expenses and commissions?
    Interpretive Response: If it appears from the terms of the
arrangement that the intent of the parties was to provide for full or
partial reimbursement of the broker's expenses and commissions, then
the estimated commitment should be recognized on the partnership's
financial statements. During the specified initial period commissions
on commodity transactions should be charged to operations at the lower
commission rate with the difference applied to reduce the
aforementioned commitment.

E. Accounting for Divestiture of a Subsidiary or Other Business
Operation

    Facts: Company X transferred certain operations (including several
subsidiaries) to a group of former employees who had been responsible
for managing those operations. Assets and liabilities with a net book
value of approximately $8 million were transferred to a newly formed
entity--Company Y--wholly owned by the former employees. The
consideration received consisted of $1,000 in cash and interest bearing
promissory notes for $10 million, payable in equal annual installments
of $1 million each, plus interest, beginning two years from the date of
the transaction. The former employees possessed insufficient assets to
pay the notes and Company X expected the funds for payments to come
exclusively from future operations of the transferred business. Company
X remained contingently liable for performance on existing contracts
transferred and agreed to guarantee, at its discretion, performance on
future contracts entered into by the newly formed entity. Company X
also acted as guarantor under a line of credit established by Company
Y.
    The nature of Company Y's business was such that Company X's
guarantees were considered a necessary predicate to obtaining future
contracts until such time as Company Y achieved profitable operations
and substantial financial independence from Company X.
    Question: If deconsolidation of the subsidiaries and business
operations is appropriate, can Company X recognize a gain?
    Interpretive Response: Before recognizing any gain, Company X
should identify all of the elements of the divesture arrangement and
allocate the consideration exchanged to each of those elements. In this
regard, we believe that Company X would recognize the guarantees at
fair value in accordance with FASB ASC Topic 460, Guarantees; the
contingent liability for performance on existing contracts in
accordance with FASB ASC Topic 450, Contingencies; and the promissory
notes in accordance with FASB ASC Topic 310, Receivables, and FASB ASC
Topic 835, Interest.

F. Accounting Changes Not Retroactively Applied Due to Immateriality

    Facts: A registrant is required to adopt an accounting principle by
means of retrospective adjustment of prior periods' financial
statements. However, the registrant determines that the accounting
change does not have a material effect on prior periods' financial
statements and, accordingly, decides not to retrospectively adjust such
financial statements.
    Question: In these circumstances, is it acceptable to adjust the
beginning balance of retained earnings of the period in which the
change is made for the cumulative effect of the change on the financial
statements of prior periods?
    Interpretive Response: No. If prior periods are not retrospectively
adjusted, the cumulative effect of the change should be included in the
statement of income for the period in which the change is made. Even in
cases where the total cumulative effect is not significant, the staff
believes that the amount should be reflected in the results of
operations for the period in which the change is made. However, if the
cumulative effect

is material to current operations or to the trend of the reported
results of operations, then the individual income statements of the
earlier years should be retrospectively adjusted.

G. Transfers of Nonmonetary Assets by Promoters or Shareholders

    Facts: Nonmonetary assets are exchanged by promoters or
shareholders for all or part of a company's common stock just prior to
or contemporaneously with a first-time public offering.
    Question: Since FASB ASC paragraph 845-10-15-4 (Nonmonetary
Transactions Topic) states that the guidance in this topic is not
applicable to transactions involving the acquisition of nonmonetary
assets or services on issuance of the capital stock of an enterprise,
what value should be ascribed to the acquired assets by the company?
    Interpretive Response: The staff believes that transfers of
nonmonetary assets to a company by its promoters or shareholders in
exchange for stock prior to or at the time of the company's initial
public offering normally should be recorded at the transferors'
historical cost basis determined under GAAP.
    The staff will not always require that predecessor cost be used to
value nonmonetary assets received from an enterprise's promoters or
shareholders. However, deviations from this policy have been rare
applying generally to situations where the fair value of either the
stock issued \1\ or assets acquired is objectively measurable and the
transferor's stock ownership following the transaction was not so
significant that the transferor had retained a substantial indirect
interest in the assets as a result of stock ownership in the company.
---------------------------------------------------------------------------

    \1\ Estimating the fair value of the common stock issued,
however, is not appropriate when the stock is closely held and/or
seldom or ever traded.
---------------------------------------------------------------------------

H. Removed by SAB 112

I. Removed by SAB 70

J. New Basis of Accounting Required in Certain Circumstances

    Facts: Company A (or Company A and related persons) acquired
substantially all of the common stock of Company B in one or a series
of purchase transactions.
    Question 1: Must Company B's financial statements presented in
either its own or Company A's subsequent filings with the Commission
reflect the new basis of accounting arising from Company A's
acquisition of Company B when Company B's separate corporate entity is
retained?
    Interpretive Response: Yes. The staff believes that purchase
transactions that result in an entity becoming substantially wholly
owned (as defined in Rule 1-02(aa) of Regulation S-X) establish a new
basis of accounting for the purchased assets and liabilities.
    When the form of ownership is within the control of the parent, the
basis of accounting for purchased assets and liabilities should be the
same regardless of whether the entity continues to exist or is merged
into the parent's operations. Therefore, Company B's separate financial
statements should reflect the new basis of accounting recorded by
Company A upon acquisition (i.e., ``pushed down'' basis).
    Question 2: What is the staff's position if Company A acquired less
than substantially all of the common stock of Company B or Company B
had publicly held debt or preferred stock at the time Company B became
wholly owned?
    Interpretive Response: The staff recognizes that the existence of
outstanding public debt, preferred stock or a significant
noncontrolling interest in a subsidiary might impact the parent's
ability to control the form of ownership. Although encouraging its use,
the staff generally does not insist on the application of push down
accounting in these circumstances.
    Question 3: Company A borrows funds to acquire substantially all of
the common stock of Company B. Company B subsequently files a
registration statement in connection with a public offering of its
stock or debt.\2\ Should Company B's new basis (``push down'')
financial statements include Company A's debt related to its purchase
of Company B?
---------------------------------------------------------------------------

    \2\ The guidance in this SAB should also be considered for
Company B's separate financial statements included in its public
offering following Company B's spin-off or carve-out from Company A.
---------------------------------------------------------------------------

    Interpretive Response: The staff believes that Company A's debt,\3\
related interest expense, and allocable debt issue costs should be
reflected in Company B's financial statements included in the public
offering (or an initial registration under the Exchange Act) if: (1)
Company B is to assume the debt of Company A, either presently or in a
planned transaction in the future; (2) the proceeds of a debt or equity
offering of Company B will be used to retire all or a part of Company
A's debt; or (3) Company B guarantees or pledges its assets as
collateral for Company A's debt. Other relationships may exist between
Company A and Company B, such as the pledge of Company B's stock as
collateral for Company A's debt.\4\ While in this latter situation, it
may be clear that Company B's cash flows will service all or part of
Company A's debt, the staff does not insist that the debt be reflected
in Company B's financial statements providing there is full and
prominent disclosure of the relationship between Companies A and B and
the actual or potential cash flow commitment. In this regard, the staff
believes that FASB ASC Topic 450, Contingencies, FASB ASC Topic 850,
Related Party Disclosures, and FASB ASC Topic 460, Guarantees, require
sufficient disclosure to allow users of Company B's financial
statements to fully understand the impact of the relationship on
Company B's present and future cash flows. Rule 4-08(e) of Regulation
S-X also requires disclosure of restrictions which limit the payment of
dividends.
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    \3\ The guidance in this SAB should also be considered where
Company A has financed the acquisition of Company B through the
issuance of mandatory redeemable preferred stock.
    \4\ The staff does not believe Company B's financial statements
must reflect the debt in this situation because in the event of
default on the debt by Company A, the debt holder(s) would only be
entitled to Company B's stock held by Company A. Other equity or
debt holders of Company B would retain their priority with respect
to the net assets of Company B.
---------------------------------------------------------------------------

    Therefore, the staff believes that the equity section of Company
B's balance sheet and any pro forma financial information and
capitalization tables should clearly disclose that this arrangement
exists.\5\ Regardless of whether the debt is reflected in Company B's
financial statements, the notes to Company B's financial statements
should generally disclose, at a minimum: (1) The relationship between
Company A and Company B; (2) a description of any arrangements that
result in Company B's guarantee, pledge of assets \6\ or stock, etc.
that provides security for Company A's debt; (3) the extent (in the
aggregate and for each of the five years subsequent to the date of the
latest balance sheet presented) to which Company A is dependent on
Company B's cash flows to service its debt and the method by

which this will occur; and (4) the impact of such cash flows on Company
B's ability to pay dividends or other amounts to holders of its
securities. Additionally, the staff believes Company B's Management's
Discussion and Analysis of Financial Condition and Results of
Operations should discuss any material impact of its servicing of
Company A's debt on its own liquidity pursuant to Item 303(a)(1) of
Regulation S-K.
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    \5\ For example, the staff has noted that certain registrants
have indicated on the face of such financial statements (as part of
the stockholder's equity section) the actual or potential financing
arrangement and the registrant's intent to pay dividends to satisfy
its parent's debt service requirements. The staff believes such
disclosures are useful to highlight the existence of arrangements
that could result in the use of Company B's cash to service Company
A's debt.
    \6\ A material asset pledge should be clearly indicated on the
face of the balance sheet. For example, if all or substantially all
of the assets are pledged, the ``assets'' and ``total assets''
captions should include parenthetically: ``pledged for parent
company debt--See Note X.''
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K. Removed by SAB 95

L. LIFO Inventory Practices

    Facts: On November 30, 1984, AcSEC and its Task Force on LIFO
Inventory Problems (task force) issued a paper, ``Identification and
Discussion of Certain Financial Accounting and Reporting Issues
Concerning LIFO Inventories.'' This paper identifies and discusses
certain financial accounting and reporting issues related to the last-
in, first-out (LIFO) inventory method for which authoritative
accounting literature presently provides no definitive guidance. For
some issues, the task force's advisory conclusions recommend changes in
current practice to narrow the diversity which the task force believes
exists. For other issues, the task force's advisory conclusions
recommend that current practice should be continued for financial
reporting purposes and that additional accounting guidance is
unnecessary. Except as otherwise noted in the paper, AcSEC generally
supports the task force's advisory conclusions. As stated in the issues
paper, ``Issues papers of the AICPA's accounting standards division are
developed primarily to identify financial accounting and reporting
issues the division believes need to be addressed or clarified by the
Financial Accounting Standards Board.'' On February 6, 1985, the FASB
decided not to add to its agenda a narrow project on the subject of
LIFO inventory practices.
    Question 1: What is the SEC staff's position on the issues paper?
    Interpretive Response: In the absence of existing authoritative
literature on LIFO accounting, the staff believes that registrants and
their independent accountants should look to the paper for guidance in
determining what constitutes acceptable LIFO accounting practice.\7\ In
this connection, the staff considers the paper to be an accumulation of
existing acceptable LIFO accounting practices which does not establish
any new standards and does not diverge from GAAP.
---------------------------------------------------------------------------

    \7\ In ASR 293 (July 2, 1981) see Financial Reporting
Codification Sec.  205, the Commission expressed its concerns about
the inappropriate use of Internal Revenue Service (IRS) LIFO
practices for financial statement preparation. Because the IRS
amended its regulations concerning the LIFO conformity rule on
January 13, 1981, allowing companies to apply LIFO differently for
financial reporting purposes than for tax purposes, the Commission
strongly encouraged registrants and their independent accountants to
examine their financial reporting LIFO practices. In that release,
the Commission acknowledged the ``task force which has been
established by AcSEC to accumulate information about [LIFO]
application problems'' and noted that ``This type of effort, in
addition to self-examination [of LIFO practices] by individual
registrants, is appropriate * * *''
---------------------------------------------------------------------------

    The staff also believes that the advisory conclusions recommended
in the issues paper are generally consistent with conclusions
previously expressed by the Commission, such as:
    1. Pooling-paragraph 4-6 of the paper discusses LIFO inventory
pooling and concludes ``establishing separate pools with the principal
objective of facilitating inventory liquidations is unacceptable.'' In
Accounting and Auditing Enforcement Release 35, August 13, 1984, the
Commission stated that it believes that the Company improperly
realigned its LIFO pools in such a way as to maximize the likelihood
and magnitude of LIFO liquidations and thus, overstated net income.
    2. New Items-paragraph 4-27 of the paper discusses determination of
the cost of new items and concludes ``if the double extension or an
index technique is used, the objective of LIFO is achieved by
reconstructing the base year cost of new items added to existing
pools.'' In ASR 293, the Commission stated that when the effects of
inflation on the cost of new products are measured by making a
comparison with current cost as the base-year cost, rather than a
reconstructed base-year cost, income is improperly increased.
    Question 2: If a registrant utilizes a LIFO practice other than one
recommended by an advisory conclusion in the issues paper, must the
registrant change its practice to one specified in the paper?
    Interpretive Response: Now that the issues paper is available, the
staff believes that a registrant and its independent accountants should
re-examine previously adopted LIFO practices and compare them to the
recommendations in the paper. In the event that the registrant and its
independent accountants conclude that the registrant's LIFO practices
are preferable in the circumstances, they should be prepared to justify
their position in the event that a question is raised by the staff.
    Question 3: If a registrant elects to change its LIFO practices to
be consistent with the guidance in the issues paper and discloses such
changes in accordance with FASB ASC Topic 250, Accounting Changes and
Error Corrections, will the registrant be requested by the staff to
explain its past practices and its justification for those practices?
    Interpretive Response: The staff does not expect to routinely raise
questions about changes in LIFO practices which are made to make a
company's accounting consistent with the recommendations in the issues
paper.

M. Other Than Temporary Impairment of Certain Investments in Equity
Securities

    Facts: FASB ASC paragraph 320-10-35-33 (Investments--Debt and
Equity Securities Topic) does not define the phrase ``other than
temporary'' for available-for-sale equity securities. For its
available-for-sale equity securities, Company A has interpreted ``other
than temporary'' to mean permanent impairment. Therefore, because
Company A's management has not been able to determine that its
investment in Company B's equity securities is permanently impaired, no
realized loss has been recognized even though the market price of
Company B's equity securities is currently less than one-third of
Company A's average acquisition price.
    Question: For equity securities classified as available-for-sale,
does the staff believe that the phrase ``other than temporary'' should
be interpreted to mean ``permanent''?
    Interpretive Response: No. The staff believes that the FASB
consciously chose the phrase ``other than temporary'' because it did
not intend that the test be ``permanent impairment,'' as has been used
elsewhere in accounting practice.\8\
---------------------------------------------------------------------------

    \8\ [Original footnote removed by SAB 114.]
---------------------------------------------------------------------------

    The value of investments in equity securities classified as
available-for-sale may decline for various reasons. The market price
may be affected by general market conditions which reflect prospects
for the economy as a whole or by specific information pertaining to an
industry or an individual company. Such declines require further
investigation by management. Acting upon the premise that a write-down
may be required, management should consider all available evidence to
evaluate the realizable value of its investment in equity securities
classified as available-for-sale.
    There are numerous factors to be considered in such an evaluation
and their relative significance will vary from case to case. The staff
believes that the

following are only a few examples of the factors which, individually or
in combination, indicate that a decline in value of an equity security
classified as available-for-sale is other than temporary and that a
write-down of the carrying value is required:
    a. The length of the time and the extent to which the market value
has been less than cost;
    b. The financial condition and near-term prospects of the issuer,
including any specific events which may influence the operations of the
issuer such as changes in technology that may impair the earnings
potential of the investment or the discontinuance of a segment of the
business that may affect the future earnings potential; or
    c. The intent and ability of the holder to retain its investment in
the issuer for a period of time sufficient to allow for any anticipated
recovery in market value.
    Unless evidence exists to support a realizable value equal to or
greater than the carrying value of the investment in equity securities
classified as available-for-sale, a write-down to fair value accounted
for as a realized loss should be recorded. Such loss should be
recognized in the determination of net income of the period in which it
occurs and the written down value of the investment in the company
becomes the new cost basis of the investment.

N. Discounting by Property-Casualty Insurance Companies

    Facts: A registrant which is an insurance company discounts certain
unpaid claims liabilities related to short-duration \9\ insurance
contracts for purposes of reporting to state regulatory authorities,
using discount rates permitted or prescribed by those authorities
(``statutory rates'') which approximate 3\1/2\ percent. The registrant
follows the same practice in preparing its financial statements in
accordance with GAAP. It proposes to change for GAAP purposes, to using
a discount rate related to the historical yield on its investment
portfolio (``investment related rate'') which is represented to
approximate 7 percent, and to account for the change as a change in
accounting estimate, applying the investment related rate to claims
settled in the current and subsequent years while the statutory rate
would continue to be applied to claims settled in all prior years.
---------------------------------------------------------------------------

    \9\ The term ``short-duration'' refers to the period of coverage
(see FASB ASC paragraph 944-20-15-7 (Financial Services--Insurance
Topic)), not the period that the liabilities are expected to be
outstanding.
---------------------------------------------------------------------------

    Question 1: What is the staff's position with respect to
discounting claims liabilities related to short-duration insurance
contracts?
    Interpretive Response: The staff is aware of efforts by the
accounting profession to assess the circumstances under which
discounting may be appropriate in financial statements. Pending
authoritative guidance resulting from those efforts however, the staff
will raise no objection if a registrant follows a policy for GAAP
reporting purposes of:
     Discounting liabilities for unpaid claims and claim
adjustment expenses at the same rates that it uses for reporting to
state regulatory authorities with respect to the same claims
liabilities, or
     Discounting liabilities with respect to settled claims
under the following circumstances:
    (1) The payment pattern and ultimate cost are fixed and
determinable on an individual claim basis, and
    (2) The discount rate used is reasonable on the facts and
circumstances applicable to the registrant at the time the claims are
settled.
    Question 2: Does the staff agree with the registrant's proposal
that the change from a statutory rate to an investment related rate be
accounted for as a change in accounting estimate?
    Interpretive Response: No. The staff believes that such a change
involves a change in the method of applying an accounting principle,
i.e., the method of selecting the discount rate was changed. The staff
therefore believes that the registrant should reflect the cumulative
effect of the change in accounting by applying the new selection method
retroactively to liabilities for claims settled in all prior years, in
accordance with the requirements of FASB ASC Topic 250, Accounting
Changes and Error Corrections. Initial adoption of discounting for GAAP
purposes would be treated similarly. In either case, in addition to the
disclosures required by FASB ASC Topic 250 concerning the change in
accounting principle, a preferability letter from the registrant's
independent accountant is required.

O. Research and Development Arrangements

    Facts: FASB ASC paragraph 730-20-25-5 (Research and Development
Topic) states that conditions other than a written agreement may exist
which create a presumption that the enterprise will repay the funds
provided by other parties under a research and development arrangement.
FASB ASC subparagraph 730-20-25-6(c) lists as one of those conditions
the existence of a ``significant related party relationship'' between
the enterprise and the parties funding the research and development.
    Question 1: What does the staff consider a ``significant related
party relationship'' as that term is used in FASB ASC subparagraph 730-
20-25-6(c)?
    Interpretive Response: The staff believes that a significant
related party relationship exists when 10 percent or more of the entity
providing the funds is owned by related parties.\10\ In unusual
circumstances, the staff may also question the appropriateness of
treating a research and development arrangement as a contract to
perform service for others at the less than 10 percent level. In
reviewing these matters the staff will consider, among other factors,
the percentage of the funding entity owned by the related parties in
relationship to their ownership in and degree of influence or control
over the enterprise receiving the funds.
---------------------------------------------------------------------------

    \10\ Related parties as used herein are as defined in the FASB
ASC Master Glossary.
---------------------------------------------------------------------------

    Question 2: FASB ASC paragraph 730-20-25-5 states that the
presumption of repayment ``can be overcome only by substantial evidence
to the contrary.'' Can the presumption be overcome by evidence that the
funding parties were assuming the risk of the research and development
activities since they could not reasonably expect the enterprise to
have resources to repay the funds based on its current and projected
future financial condition?
    Interpretive Response: No. FASB ASC paragraph 730-20-25-3
specifically indicates that the enterprise ``may settle the liability
by paying cash, by issuing securities, or by some other means.'' While
the enterprise may not be in a position to pay cash or issue debt,
repayment could be accomplished through the issuance of stock or
various other means. Therefore, an apparent or projected inability to
repay the funds with cash (or debt which would later be paid with cash)
does not necessarily demonstrate that the funding parties were
accepting the entire risks of the activities.

P. Restructuring Charges

1. Removed by SAB 103
2. Removed by SAB 103
3. Income Statement Presentation of Restructuring Charges
    Facts: Restructuring charges often do not relate to a separate
component of the entity, and, as such, they would not qualify for
presentation as losses on the disposal of a discontinued operation.

Additionally, since the charges are not both unusual and infrequent\11\
they are not presented in the income statement as extraordinary items.
---------------------------------------------------------------------------

    \11\ See FASB ASC paragraph 225-20-45-2.
---------------------------------------------------------------------------

    Question 1: May such restructuring charges be presented in the
income statement as a separate caption after income from continuing
operations before income taxes (i.e., preceding income taxes and/or
discontinued operations)?
    Interpretive Response: No. FASB ASC paragraph 225-20-45-16 (Income
Statement Topic) states that items that do not meet the criteria for
classification as an extraordinary item should be reported as a
component of income from continuing operations.\12\ Neither FASB ASC
Subtopic 225-20, Income Statement--Extraordinary and Unusual Items, nor
Rule 5-03 of Regulation S-X contemplate a category in between
continuing and discontinued operations. Accordingly, the staff believes
that restructuring charges should be presented as a component of income
from continuing operations, separately disclosed if material.
Furthermore, the staff believes that a separately presented
restructuring charge should not be preceded by a sub-total representing
``income from continuing operations before restructuring charge''
(whether or not it is so captioned). Such a presentation would be
inconsistent with the intent of FASB ASC Subtopic 225-20.
---------------------------------------------------------------------------

    \12\ FASB ASC paragraph 225-20-45-16 further provides that such
items should not be reported on the income statement net of income
taxes or in any manner that implies that they are similar to
extraordinary items.
---------------------------------------------------------------------------

    Question 2: Some registrants utilize a classified or ``two-step''
income statement format (i.e., one which presents operating revenues,
expenses and income followed by other income and expense items). May a
charge which relates to assets or activities for which the associated
revenues and expenses have historically been included in operating
income be presented as an item of ``other expense'' in such an income
statement?
    Interpretive Response: No. The staff believes that the proper
classification of a restructuring charge depends on the nature of the
charge and the assets and operations to which it relates. Therefore,
charges which relate to activities for which the revenues and expenses
have historically been included in operating income should generally be
classified as an operating expense, separately disclosed if material.
Furthermore, when a restructuring charge is classified as an operating
expense, the staff believes that it is generally inappropriate to
present a preceding subtotal captioned or representing operating income
before restructuring charges. Such an amount does not represent a
measurement of operating results under GAAP.
    Conversely, charges relating to activities previously included
under ``other income and expenses'' should be similarly classified,
also separately disclosed if material.
    Question 3: Is it permissible to disclose the effect on net income
and earnings per share of such a restructuring charge?
    Interpretive Response: Discussions in MD&A and elsewhere which
quantify the effects of unusual or infrequent items on net income and
earnings per share are beneficial to a reader's understanding of the
financial statements and are therefore acceptable.
    MD&A also should discuss the events and decisions which gave rise
to the restructuring, the nature of the charge and the expected impact
of the restructuring on future results of operations, liquidity and
sources and uses of capital resources.
4. Disclosures
    Beginning with the period in which the exit plan is initiated, FASB
ASC Topic 420, Exit or Disposal Cost Obligations, requires disclosure,
in all periods, including interim periods, until the exit plan is
completed, of the following:
    a. A description of the exit or disposal activity, including the
facts and circumstances leading to the expected activity and the
expected completion date
    b. For each major type of cost associated with the activity (for
example, one-time termination benefits, contract termination costs, and
other associated costs):
    (1) The total amount expected to be incurred in connection with the
activity, the amount incurred in the period, and the cumulative amount
incurred to date
    (2) A reconciliation of the beginning and ending liability balances
showing separately the changes during the period attributable to costs
incurred and charged to expense, costs paid or otherwise settled, and
any adjustments to the liability with an explanation of the reason(s)
therefor
    c. The line item(s) in the income statement or the statement of
activities in which the costs in (b) above are aggregated
    d. For each reportable segment, the total amount of costs expected
to be incurred in connection with the activity, the amount incurred in
the period, and the cumulative amount incurred to date, net of any
adjustments to the liability with an explanation of the reason(s)
therefor
    e. If a liability for a cost associated with the activity is not
recognized because fair value cannot be reasonably estimated, that fact
and the reasons therefor
    Question: What specific disclosures about restructuring charges has
the staff requested to fulfill the disclosure requirements of FASB ASC
Topic 420 and MD&A?
    Interpretive Response: The staff often has requested greater
disaggregation and more precise labeling when exit and involuntary
termination costs are grouped in a note or income statement line item
with items unrelated to the exit plan. For the reader's understanding,
the staff has requested that discretionary, or decision-dependent,
costs of a period, such as exit costs, be disclosed and explained in
MD&A separately. Also to improve transparency, the staff has requested
disclosure of the nature and amounts of additional types of exit costs
and other types of restructuring charges \13\ that appear
quantitatively or qualitatively material, and requested that losses
relating to asset impairments be identified separately from charges
based on estimates of future cash expenditures.
---------------------------------------------------------------------------

    \13\ Examples of common components of exit costs and other types
of restructuring charges which should be considered for separate
disclosure include, but are not limited to, involuntary employee
terminations and related costs, changes in valuation of current
assets such as inventory writedowns, long term asset disposals,
adjustments for warranties and product returns, leasehold
termination payments, and other facility exit costs, among others.
---------------------------------------------------------------------------

    The staff frequently reminds registrants that in periods subsequent
to the initiation date that material changes and activity in the
liability balances of each significant type of exit cost and
involuntary employee termination benefits \14\ (either as a result of
expenditures or changes in/reversals of estimates or the fair value of
the liability) should be disclosed in the footnotes to the interim and
annual financial statements and discussed in MD&A. In the event a
company recognized liabilities for exit costs and involuntary employee
termination benefits relating to multiple exit plans, the staff
believes presentation of separate information for each individual exit
plan that has a material effect on

the balance sheet, results of operations or cash flows generally is
appropriate.
---------------------------------------------------------------------------

    \14\ The staff would expect similar disclosures for employee
termination benefits whether those costs have been recognized
pursuant to FASB ASC Topic 420, FASB ASC Topic 712, Compensation--
Nonretirement Postemployment Benefits, or FASB ASC Topic 715,
Compensation--Retirement Benefits.
---------------------------------------------------------------------------

    For material exit or involuntary employee termination costs related
to an acquired business, the staff has requested disclosure in either
MD&A or the financial statements of:
    1. When the registrant began formulating exit plans for which
accrual may be necessary,
    2. The types and amounts of liabilities recognized for exit costs
and involuntary employee termination benefits and included in the
acquisition cost allocation, and
    3. Any unresolved contingencies or purchase price allocation issues
and the types of additional liabilities that may result in an
adjustment of the acquisition cost allocation.
    The staff has noted that the economic or other events that cause a
registrant to consider and/or adopt an exit plan or that impair the
carrying amount of assets, generally occur over time. Accordingly, the
staff believes that as those events and the resulting trends and
uncertainties evolve, they often will meet the requirement for
disclosure pursuant to the Commission's MD&A rules prior to the period
in which the exit costs and liabilities are recorded pursuant to GAAP.
Whether or not currently recognizable in the financial statements,
material exit or involuntary termination costs that affect a known
trend, demand, commitment, event, or uncertainty to management, should
be disclosed in MD&A. The staff believes that MD&A should include
discussion of the events and decisions which gave rise to the exit
costs and exit plan, and the likely effects of management's plans on
financial position, future operating results and liquidity unless it is
determined that a material effect is not reasonably likely to occur.
Registrants should identify the periods in which material cash outlays
are anticipated and the expected source of their funding. Registrants
should also discuss material revisions to exit plans, exit costs, or
the timing of the plan's execution, including the nature and reasons
for the revisions.
    The staff believes that the expected effects on future earnings and
cash flows resulting from the exit plan (for example, reduced
depreciation, reduced employee expense, etc.) should be quantified and
disclosed, along with the initial period in which those effects are
expected to be realized. This includes whether the cost savings are
expected to be offset by anticipated increases in other expenses or
reduced revenues. This discussion should clearly identify the income
statement line items to be impacted (for example, cost of sales;
marketing; selling, general and administrative expenses; etc.). In
later periods if actual savings anticipated by the exit plan are not
achieved as expected or are achieved in periods other than as expected,
MD&A should discuss that outcome, its reasons, and its likely effects
on future operating results and liquidity.
    The staff often finds that, because of the discretionary nature of
exit plans and the components thereof, presenting and analyzing
material exit and involuntary termination charges in tabular form, with
the related liability balances and activity (e.g., beginning balance,
new charges, cash payments, other adjustments with explanations, and
ending balances) from balance sheet date to balance sheet date, is
necessary to explain fully the components and effects of significant
restructuring charges. The staff believes that such a tabular analysis
aids a financial statement user's ability to disaggregate the
restructuring charge by income statement line item in which the costs
would have otherwise been recognized, absent the restructuring plan,
(for example, cost of sales; selling, general, and administrative;
etc.).

Q. Increasing Rate Preferred Stock

    Facts: A registrant issues Class A and Class B nonredeemable
preferred stock \15\ on 1/1/X1. Class A, by its terms, will pay no
dividends during the years 20X1 through 20X3. Class B, by its terms,
will pay dividends at annual rates of $2, $4 and $6 per share in the
years 20X1, 20X2 and 20X3, respectively. Beginning in the year 20X4 and
thereafter as long as they remain outstanding, each instrument will pay
dividends at an annual rate of $8 per share. In all periods, the
scheduled dividends are cumulative.
---------------------------------------------------------------------------

    \15\ ``Nonredeemable'' preferred stock, as used in this SAB,
refers to preferred stocks which are not redeemable or are
redeemable only at the option of the issuer.
---------------------------------------------------------------------------

    At the time of issuance, eight percent per annum was considered to
be a market rate for dividend yield on Class A, given its
characteristics other than scheduled cash dividend entitlements (voting
rights, liquidation preference, etc.), as well as the registrant's
financial condition and future economic prospects. Thus, the registrant
could have expected to receive proceeds of approximately $100 per share
for Class A if the dividend rate of $8 per share (the ``perpetual
dividend'') had been in effect at date of issuance. In consideration of
the dividend payment terms, however, Class A was issued for proceeds of
$79\3/8\ per share. The difference, $20\5/8\, approximated the value of
the absence of $8 per share dividends annually for three years,
discounted at 8%.
    The issuance price of Class B shares was determined by a similar
approach, based on the terms and characteristics of the Class B shares.
    Question 1: How should preferred stocks of this general type
(referred to as ``increasing rate preferred stocks'') be reported in
the balance sheet?
    Interpretive Response: As is normally the case with other types of
securities, increasing rate preferred stock should be recorded
initially at its fair value on date of issuance. Thereafter, the
carrying amount should be increased periodically as discussed in the
Interpretive Response to Question 2.
    Question 2: Is it acceptable to recognize the dividend costs of
increasing rate preferred stocks according to their stated dividend
schedules?
    Interpretive Response: No. The staff believes that when
consideration received for preferred stocks reflects expectations of
future dividend streams, as is normally the case with cumulative
preferred stocks, any discount due to an absence of dividends (as with
Class A) or gradually increasing dividends (as with Class B) for an
initial period represents prepaid, unstated dividend cost.\16\
Recognizing the dividend cost of these instruments according to their
stated dividend schedules would report Class A as being cost-free, and
would report the cost of Class B at less than its effective cost, from
the standpoint of common stock interests (i.e., for purposes of
computing income applicable to common stock and earnings per common
share) during the years 20X1 through 20X3.
---------------------------------------------------------------------------

    \16\ As described in the ``Facts'' section of this issue, a
registrant would receive less in proceeds for a preferred stock, if
the stock were to pay less than its perpetual dividend for some
initial period(s), than if it were to pay the perpetual dividend
from date of issuance. The staff views the discount on increasing
rate preferred stock as equivalent to a prepayment of dividends by
the issuer, as though the issuer had concurrently (a) issued the
stock with the perpetual dividend being payable from date of
issuance, and (b) returned to the investor a portion of the proceeds
representing the present value of certain future dividend
entitlements which the investor agreed to forgo.
---------------------------------------------------------------------------

    Accordingly, the staff believes that discounts on increasing rate
preferred stock should be amortized over the period(s) preceding
commencement of the perpetual dividend, by charging imputed dividend
cost against retained earnings and increasing the carrying amount of
the preferred stock by a corresponding amount. The discount at time of
issuance should be computed as

the present value of the difference between (a) dividends that will be
payable, if any, in the period(s) preceding commencement of the
perpetual dividend; and (b) the perpetual dividend amount for a
corresponding number of periods; discounted at a market rate for
dividend yield on preferred stocks that are comparable (other than with
respect to dividend payment schedules) from an investment standpoint.
The amortization in each period should be the amount which, together
with any stated dividend for the period (ignoring fluctuations in
stated dividend amounts that might result from variable rates,\17\
results in a constant rate of effective cost vis-a-vis the carrying
amount of the preferred stock (the market rate that was used to compute
the discount).
---------------------------------------------------------------------------

    \17\ See Question 3 regarding variable increasing rate preferred
stocks.
---------------------------------------------------------------------------

    Simplified (ignoring quarterly calculations) application of this
accounting to the Class A preferred stock described in the ``Facts''
section of this bulletin would produce the following results on a per
share basis:

                                       Carrying Amount of Preferred Stock
----------------------------------------------------------------------------------------------------------------
                                                                             Imputed dividend
                                                         Beginning of year   (8% of carrying      End of year
                                                                (BOY)         amount at BOY)
----------------------------------------------------------------------------------------------------------------
Year 20x1..............................................             $79.38               6.35              85.73
Year 20x2..............................................              85.73               6.86              92.59
Year 20x3..............................................              92.59               7.41             100.00
----------------------------------------------------------------------------------------------------------------

    During 20X4 and thereafter, the stated dividend of $8 measured
against the carrying amount of $100\18\ would reflect dividend cost of
8%, the market rate at time of issuance.
---------------------------------------------------------------------------

    \18\ It should be noted that the $100 per share amount used in
this issue is for illustrative purposes, and is not intended to
imply that application of this issue will necessarily result in the
carrying amount of a nonredeemable preferred stock being accreted to
its par value, stated value, voluntary redemption value or
involuntary liquidation value.
---------------------------------------------------------------------------

    The staff believes that existing authoritative literature, while
not explicitly addressing increasing rate preferred stocks, implicitly
calls for the accounting described in this bulletin.
    The pervasive, fundamental principle of accrual accounting would,
in the staff's view, preclude registrants from recognizing the dividend
cost on the basis of whatever cash payment schedule might be arranged.
Furthermore, recognition of the effective cost of unstated rights and
privileges is well-established in accounting, and is specifically
called for by FASB ASC Subtopic 835-30, Interest--Imputation of
Interest, and Topic 3.C of this codification for unstated interest
costs of debt capital and unstated dividend costs of redeemable
preferred stock capital, respectively. The staff believes that the
requirement to recognize the effective periodic cost of capital applies
also to nonredeemable preferred stocks because, for that purpose, the
distinction between debt capital and preferred equity capital (whether
redeemable \19\ or nonredeemable) is irrelevant from the standpoint of
common stock interests.
---------------------------------------------------------------------------

    \19\ Application of the interest method with respect to
redeemable preferred stocks pursuant to Topic 3.C results in
accounting consistent with the provisions of this bulletin
irrespective of whether the redeemable preferred stocks have
constant or increasing stated dividend rates. The interest method,
as described in FASB ASC Subtopic 835-30, produces a constant
effective periodic rate of cost that is comprised of amortization of
discount as well as the stated cost in each period.
---------------------------------------------------------------------------

    Question 3: Would the accounting for discounts on increasing rate
preferred stock be affected by variable stated dividend rates?
    Interpretive Response: No. If stated dividends on an increasing
rate preferred stock are variable, computations of initial discount and
subsequent amortization should be based on the value of the applicable
index at date of issuance and should not be affected by subsequent
changes in the index.
    For example, assume that a preferred stock issued 1/1/X1 is
scheduled to pay dividends at annual rates, applied to the stock's par
value, equal to 20% of the actual (fluctuating) market yield on a
particular Treasury security in 20X1 and 20X2, and 90% of the
fluctuating market yield in 20X3 and thereafter. The discount would be
computed as the present value of a two-year dividend stream equal to
70% (90% less 20%) of the 1/1/X1 Treasury security yield, annually, on
the stock's par value. The discount would be amortized in years 20X1
and 20X2 so that, together with 20% of the 1/1/X1 Treasury yield on the
stock's par value, a constant rate of cost vis-a-vis the stock's
carrying amount would result. Changes in the Treasury security yield
during 20X1 and 20X2 would, of course, cause the rate of total reported
preferred dividend cost (amortization of discount plus cash dividends)
in those years to be more or less than the rate indicated by discount
amortization plus 20% of the 1/1/X1 Treasury security yield. However,
the fluctuations would be due solely to the impact of changes in the
index on the stated dividends for those periods.
    Question 4: Will the staff expect retroactive changes by
registrants to comply with the accounting described in this bulletin?
    Interpretive Response: All registrants will be expected to follow
the accounting described in this bulletin for increasing rate preferred
stocks issued after December 4, 1986.\20\ Registrants that have not
followed this accounting for increasing rate preferred stocks issued
before that date were encouraged to retroactively change their
accounting for those preferred stocks in the financial statements next
filed with the Commission. The staff did not object if registrants did
not make retroactive changes for those preferred stocks, provided that
all presentations of and discussions regarding income applicable to
common stock and earnings per share in future filings and shareholders'
reports are accompanied by equally prominent supplemental disclosures
(on the face of the income statement, in presentations of selected
financial data, in MD&A, etc.) of the impact of not changing their
accounting and an explanation of such impact (e.g., that dividend cost
has been recognized on a cash basis).
---------------------------------------------------------------------------

    \20\ The staff first publicly expressed its view as to the
appropriate accounting at the December 3-4, 1986 meeting of the
EITF.
---------------------------------------------------------------------------

R. Removed by SAB 103

S. Quasi-Reorganization

    Facts: As a consequence of significant operating losses and/or
recent write-downs of property, plant and equipment, a company's
financial statements reflect an accumulated deficit. The company
desires to eliminate the deficit by reclassifying amounts from paid-in-
capital. In addition, the company anticipates adopting a discretionary
change in

accounting principles \21\ that will be recorded as a cumulative-effect
type of accounting change. The recording of the cumulative effect will
have the result of increasing the company's retained earnings.
---------------------------------------------------------------------------

    \21\ Discretionary accounting changes require the filing of a
preferability letter by the registrant's independent accountant
pursuant to Item 601 of Regulation S-K and Rule 10-01(b)(6) of
Regulation S-X, respectively.
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    Question 1: May the company reclassify its capital accounts to
eliminate the accumulated deficit without satisfying all of the
conditions enumerated in Section 210 \22\ of the Codification of
Financial Reporting Policies for a quasi-reorganization?
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    \22\ ASR 25.
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    Interpretive Response: No. The staff believes a deficit
reclassification of any nature is considered to be a quasi-
reorganization. As such, a company may not reclassify or eliminate a
deficit in retained earnings unless all requisite conditions set forth
in Section 210 \23\ for a quasi-reorganization are satisfied. \24\
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    \23\ Section 210 (ASR 25) indicates the following conditions
under which a quasi-reorganization can be effected without the
creation of a new corporate entity and without the intervention of
formal court proceedings:
    1. Earned surplus, as of the date selected, is exhausted;
    2. Upon consummation of the quasi-reorganization, no deficit
exists in any surplus account;
    3. The entire procedure is made known to all persons entitled to
vote on matters of general corporate policy and the appropriate
consents to the particular transactions are obtained in advance in
accordance with the applicable laws and charter provisions;
    The procedure accomplishes, with respect to the accounts,
substantially what might be accomplished in a reorganization by
legal proceedings--namely, the restatement of assets in terms of
present considerations as well as appropriate modifications of
capital and capital surplus, in order to obviate, so far as
possible, the necessity of future reorganization of like nature.
    \24\ In addition, FASB ASC Subtopic 852-20, Reorganizations--
Quasi-Reorganizations, outlines procedures that must be followed in
connection with and after a quasi-reorganization.
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    Question 2: Must the company implement the discretionary change in
accounting principle simultaneously with the quasi-reorganization or
may it adopt the change after the quasi-reorganization has been
effected?
    Interpretive Response: The staff has taken the position that the
company should adopt the anticipated accounting change prior to or as
an integral part of the quasi-reorganization. Any such accounting
change should be effected by following GAAP with respect to the change.
\25\
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    \25\ FASB ASC Topic 250 provides accounting principles to be
followed when adopting accounting changes. In addition, many newly-
issued accounting pronouncements provide specific guidance to be
followed when adopting the accounting specified in such
pronouncements.
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    FASB ASC paragraph 852-20-25-5 (Reorganizations Topic) indicates
that, following a quasi-reorganization, an ``entity's accounting shall
be substantially similar to that appropriate for a new entity.'' The
staff believes that implicit in this ``fresh-start'' concept is the
need for the company's accounting principles in place at the time of
the quasi-reorganization to be those planned to be used following the
reorganization to avoid a misstatement of earnings and retained
earnings after the reorganization.\26\ FASB ASC paragraph 852-20-30-2
states, in part, ``* * * in general, assets should be carried forward
as of the date of the readjustment at fair and not unduly conservative
amounts, determined with due regard for the accounting to be
subsequently employed by the entity.'' (emphasis added)
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    \26\ Certain newly-issued accounting standards do not require
adoption until some future date. The staff believes, however, that
if the registrant intends or is required to adopt those standards
within 12 months following the quasi-reorganization, the registrant
should adopt those standards prior to or as an integral part of the
quasi-reorganization. Further, registrants should consider early
adoption of standards with effective dates more than 12 months
subsequent to a quasi-reorganization.
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    In addition, the staff believes that adopting a discretionary
change in accounting principle that will be reflected in the financial
statements within 12 months following the consummation of a quasi-
reorganization leads to a presumption that the accounting change was
contemplated at the time of the quasi-reorganization.\27\
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    \27\ Certain accounting changes require restatement of prior
financial statements. The staff believes that if a quasi-
reorganization had been recorded in a restated period, the effects
of the accounting change on quasi-reorganization adjustments should
also be restated to properly reflect the quasi-reorganization in the
restated financial statements.
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    Question 3: In connection with a quasi-reorganization, may there be
a write-up of net assets?
    Interpretive Response: No. The staff believes that increases in the
recorded values of specific assets (or reductions in liabilities) to
fair value are appropriate providing such adjustments are factually
supportable; however, the amount of such increases is limited to
offsetting adjustments to reflect decreases in other assets (or
increases in liabilities) to reflect their new fair value. In other
words, a quasi-reorganization should not result in a write-up of net
assets of the registrant.
    Question 4: The interpretive response to question 1 indicates that
the staff believes that a deficit reclassification of any nature is
considered to be a quasi-reorganization, and accordingly, must satisfy
all the conditions of Section 210.\28\ Assume a company has satisfied
all the requisite conditions of Section 210, and has eliminated a
deficit in retained earnings by a concurrent reduction in paid-in
capital, but did not need to restate assets and liabilities by a charge
to capital because assets and liabilities were already stated at fair
values. How should the company reflect the tax benefits of operating
loss or tax credit carryforwards for financial reporting purposes that
existed as of the date of the quasi-reorganization when such tax
benefits are subsequently recognized for financial reporting purposes?
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    \28\ See footnote 27.
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    Interpretive Response: The staff believes FASB ASC Subtopic 852-
740, Reorganizations--Income Taxes, requires that any subsequently
recognized tax benefits of operating loss or tax credit carryforwards
that existed as of the date of a quasi-reorganization be reported as a
direct addition to paid-in capital. The staff believes that this
position is consistent with the ``new company'' or ``fresh-start''
concept embodied in Section 210,\29\ and in existing accounting
literature regarding quasi-reorganizations, and with the FASB staff's
justification for such a position when they stated that a ``new
enterprise would not have tax benefits attributable to operating losses
or tax credits that arose prior to its organization date. \30\
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    \29\ Section 210 (ASR 25) discusses the ``conditions under which
a quasi-reorganization has come to be applied in accounting to the
corporate procedures in the course of which a company, without
creation of new corporate entity and without intervention of formal
court proceedings, is enabled to eliminate a deficit whether
resulting from operations or recognition of other losses or both and
to establish a new earned surplus account for the accumulation of
earnings subsequent to the date selected as the effective date of
the quasi-reorganization.'' It further indicates that ``it is
implicit in a procedure of this kind that it is not to be employed
recurrently, but only under circumstances which would justify an
actual reorganization or formation of a new corporation,
particularly if the sole purpose of the quasi-reorganization is the
elimination of a deficit in earned surplus resulting from operating
losses.'' (emphasis added)
    \30\ FASB ASC paragraph 852-740-55-4 states in part: ``As
indicated in paragraph 852-20-25-5, after a quasi-reorganization,
the entity's accounting shall be substantially similar to that
appropriate for a new entity. As such, any subsequently recognized
tax benefit of an operating loss or tax credit carryforward that
existed at the date of a quasi-reorganization shall not be included
in the determination of income of the ``new'' entity, regardless of
whether losses that gave rise to an operating loss carryforward were
charged to income before the quasi-reorganization or directly to
contributed capital as part of the quasi-reorganization. A new
entity would not have tax benefits attributable to operating losses
or tax credits that arose before its organization date.''
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    The staff believes that all registrants that comply with the
requirements of Section 210 in effecting a quasi-

reorganization should apply the accounting required by FASB ASC
paragraph 852-740-45-3 for the tax benefits of tax carryforward
items.31, 32 Therefore, even though the only effect of a
quasi-reorganization is the elimination of a deficit in retained
earnings because assets and liabilities are already stated at fair
values and the revaluation of assets and liabilities is unnecessary (or
a write-up of net assets is prohibited as indicated in the interpretive
response to question 3 above), subsequently recognized tax benefits of
operating loss or tax credit carryforward items should be recorded as a
direct addition to paid-in capital.
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    \31\ [Original footnote removed by SAB 114.]
    \32\ FASB ASC paragraph 852-740-45-3 states: ``[t]he tax benefit
of deductible temporary differences and carryforwards as of the date
of a quasi reorganization as defined and contemplated in FASB ASC
Subtopic 852-20, ordinarily are reported as a direct addition to
contributed capital if the tax benefits are recognized in subsequent
years.''
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    Question 5: If a company had previously recorded a quasi-
reorganization that only resulted in the elimination of a deficit in
retained earnings, may the company reverse such entry and ``undo'' its
quasi-reorganization?
    Interpretive Response: No. The staff believes FASB ASC Topic 250,
Accounting Changes and Error Corrections, would preclude such a change
in accounting. It states: ``a method of accounting that was previously
adopted for a type of transaction or event that is being terminated or
that was a single, nonrecurring event in the past shall not be
changed.'' (emphasis added.) \33\
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    \33\ FASB ASC paragraph 250-10-45-12.
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T. Accounting for Expenses or Liabilities Paid by Principal
Stockholder(s)

(Replaced by SAB 107)
    Facts: Company X was a defendant in litigation for which the
company had not recorded a liability in accordance with FASB ASC Topic
450, Contingencies. A principal stockholder \34\ of the company
transfers a portion of his shares to the plaintiff to settle such
litigation. If the company had settled the litigation directly, the
company would have recorded the settlement as an expense.
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    \34\ The FASB ASC Master Glossary defines principal owners as
``owners of record or known beneficial owners of more than 10
percent of the voting interests of the enterprise.''
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    Question: Must the settlement be reflected as an expense in the
company's financial statements, and if so, how?
    Interpretive Response: Yes. The value of the shares transferred
should be reflected as an expense in the company's financial statements
with a corresponding credit to contributed (paid-in) capital.
    The staff believes that such a transaction is similar to those
described in FASB ASC paragraph 718-10-15-4 (Compensation--Stock
Compensation Topic), which states that ``share-based payments awarded
to an employee of the reporting entity by a related party or other
holder of an economic interest \35\ in the entity as compensation for
services provided to the entity are share-based payment transactions to
be accounted for under this Topic unless the transfer is clearly for a
purpose other than compensation for services to the reporting entity.''
As explained in this paragraph, the substance of such a transaction is
that the economic interest holder makes a capital contribution to the
reporting entity, and the reporting entity makes a share-based payment
to its employee in exchange for services rendered.
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    \35\ The FASB ASC Master Glossary defines an economic interest
in an entity as ``any type or form of pecuniary interest or
arrangement that an entity could issue or be a party to, including
equity securities; financial instruments with characteristics of
equity, liabilities or both; long-term debt and other debt-financing
arrangements; leases; and contractual arrangements such as
management contracts, service contracts, or intellectual property
licenses.'' Accordingly, a principal stockholder would be considered
a holder of an economic interest in an entity.