Financial Reporting Valuations

15Jan2011

SEC Observations at 2010 AICPA Conference (Equity-Linked Instruments — Debt vs. Equity Classification; Inadequacies of Black-Scholes Model)

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At the AICPA National Conference held in December 2010, invited members of the SEC and PCAOB presented their views on current developments in the Division of Corporate Finance.

In its remarks, the SEC discussed issues that its staff has encountered related to equity-linked instruments:

  • The SEC cited a failure by registrants to appropriately apply the guidance on distinguishing equity from liabilities (as outlined in Accounting Standards Codification Topic 815-40, Derivatives and Hedging – Contracts in Entity's Own Equity ) – in particular when evaluating whether an instrument (or an embedded feature) is considered indexed to an entity's own stock. The guidance in ASC 815-40 requires a company to evaluate the contingent exercise provisions (if any) and then determine the related settlement amount.
  • Two examples of instruments for which the SEC has raised issues were cited: (i) stock purchase warrants and (ii) debt instruments with embedded conversion options.
  • One of the common problems that the SEC staff has seen in these instruments relates to "down-round" protection provisions that specify that the strike or conversion price would be adjusted downward if a company subsequently issues stock at a lower price than the strike price or conversion price due to declining market prices. Such a provision often makes an instrument "not indexed to an entity's own stock" – resulting in a conclusion that the instrument or feature be presented as a derivative liability at fair value.
  • It was also noted that some registrants have not properly considered the guidance in ASC 815-40 when valuing equity-linked instruments with variable inputs (e.g., where certain aspects like exercise price or number of shares are subject to change). The SEC indicated that such instruments are often erroneously valued utilizing the Black-Scholes option pricing model. The Black-Scholes model relies on fixed inputs involving assumptions like term, price, and volatility to develop a fair value estimates. Companies attempting to estimate the fair value of an instrument with variable inputs should use a model that has the ability to address variability in assumptions, such as lattice models or Monte Carlo simulations.
  • Finally, the SEC stressed the need for improved disclosures about provisions of an instrument that may trigger an adjustment to the exercise price or the number of shares (like down-round provisions as referenced above). It was noted that the SEC may challenge generic disclosures like "the instrument contains standard anti-dilution provisions."
  • Click here for a copy of the slides from the 2010 AICPA National Conference. Please see pages 70 to 77 for details related to the issues highlighted above.
17Dec2010

FASB Issues ASU 2010-28, When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts

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Under the guidance in the new Accounting Standards Update, an entity must consider whether it is more likely than not that goodwill impairment exists for a reporting unit with a zero or negative carrying amount. If it is more likely than not that goodwill impairment exists, the second step of the goodwill impairment test must be performed to measure the amount of goodwill impairment loss, if any. To make this determination, an entity should consider whether there are adverse qualitative factors that could impact the amount of goodwill. These factors could include (but are not limited to) an adverse business climate, unexpected competition, and loss of key personnel.

As a result of the new guidance, an entity can no longer assert that a reporting unit is not required to perform the second step of the goodwill impairment test solely because the carrying amount of the reporting unit is zero or negative.

06Oct2010

FASB Issues Proposed ASU Related to Goodwill Impairment Test

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On October 6, 2010, the FASB issued a proposed ASU, How the Carrying Amount of a Reporting Unit Should Be Calculated When Performing Step 1 of the Goodwill Impairment Test. The proposed ASU requires that: (1) an entity use an equity premise to calculate the carrying amount of a reporting unit when performing Step 1 of the goodwill impairment test, and (2) if a reporting unit has a zero or negative carrying amount, the entity must assess, on the basis of qualitative factors, whether it is more likely than not that goodwill impairment exists (i.e., if it is more likely than not that goodwill impairment exists, Step 2 must be performed).
28Sep2010

FASB Could Be Persuaded to Modify Its Fair Value Plan

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Lawrence Smith, a member of the Financial Accounting Standards Board, said that rule makers could be persuaded to modify their plan to expand fair value accounting rules – an effort that has faced strong opposition. Smith said that comment letters are overwhelmingly against the proposal, which would require financial assets to be valued based on mark-to-market standards.
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19Aug2010

IASB Issues Staff Draft on Fair Value Measurements

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On August 19, 2010, the IASB posted a staff draft on fair value measurement. The draft reflected the decisions that the IASB and FASB had made through August 19th as part of their project to converge guidance in this area. Although the IASB did not release the staff draft for public comment, entities may wish to comment on the FASB's exposure draft since the two documents are very similar. Comments related to the FASB's exposure draft were due by September 7, 2010. The boards expect to issue a common fair value measurement standard in early 2011.

29Jul2010

EITF Meeting – Carrying Value Calculation Related to Goodwill Impairment Test

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At its July 29, 2010 Emerging Issues Task Force (the "Task Force") meeting, the Task Force discussed a variety of issues, including the calculation of a reporting unit's carrying value as part of Step 1 of the goodwill impairment Test (EITF Issue No. 10-A). The Task Force deferred a decision on this issue, with further discussion expected at future meetings.
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29Jun2010

Proposed Fair Value Exposure Drafts

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On June 29, 2010, the FASB released an exposure draft related to Accounting Standards Update Topic 820 (formerly known as SFAS 157) – Amendments for Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The FASB is accepting comments on the revision until September 7, 2010. In conjunction with FASB's draft, the International Accounting Standards Board also released a revision of its exposure draft – Measurement Uncertainty Analysis Disclosure for Fair Value Measurements.