Codification Has Officially Arrived

For those of you calendar year end issuers the time to eliminate references to the pre-codification GAAP standards is here.  Your 3^rd quarter interim financial information will no longer contain references to the various layers of GAAP.  Instead of taking the time to use the cross-reference tool to the old standards and inserting long paragraph number references in place of the SFASs, EITFs, SOPS, and SABs, a better approach would be to transform your footnote disclosures to what the SEC continually refers to as “plain English”.

The benefit of using this approach is actually providing your investors with a meaningful description as to how your company actually applies the appropriate accounting guidance, instead of simply regurgitating accounting standards that few, and a lessening number of people, honestly understand.

A good starting point is to review your internal accounting policies and procedures, which in my experience, do not generally reference or contain any language from the accounting standards.  Further, remember the following keys when drafting financial statement footnotes and compliance documents in general:

• Know your audience – remember these compliance documents are designed to provide useful information to investors and prospective investors, so be aware of the general level of sophistication and educational backgrounds of these groups.
• Focus on the significant and material items – Don’t spend a lot of time writing about things that ultimately are not going to be material to the financial statements or operations of the Company.
• Write concisely and avoid redundancy – Run-on sentences are the best way to lose the interest of your reader in addition to confusing them.  Redundancy leads to inconsistency leads to SEC Comment Letters.

For more tips you can find a “plain English” handbook on the SEC’s website.

Don’t fear codification, overcome the learning curve as quickly as possible; it should ultimately make complying with the accounting standards easier and provide more understandable disclosure to keep your investors interested.

EITF 07-5 Highlights

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

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

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

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

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

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

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