1. New rules on guarantees of debt
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New rules on guarantees of debt
ASC 460 (FIN No. 45) Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others
An interpretation of FASB No. 5, 57, This interpretation replaces FIN No. 34
Scope: Covers disclosures to be made in interim and annual reports regarding guarantees of indebtedness of others (disclosed under FASB No. 5 even though the probability is generally “remote”
Prepared by Teresa Gordon

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ASC 460 (FIN45) Covers guarantee contracts that have any of these 4 characteristics
1. Contracts that contingently require the guarantor to make payments to the guaranteed party based on an “underlying”
Examples:
Irrevocable standby letter of credit which guarantees payment of a specified obligation Market value guarantee of asset owned by the guaranteed party Guarantee of the market price of common stock of the guaranteed party Guarantee of the collection of cash flows from assets held by special purpose entity
2. Performance standby letter of credit or similar arrangements in which guarantor must make payments to the guaranteed party in the event of another entity’s failure to perform under a nonfinancial contract
Arrangements NOT covered
1. Commercial letters of credit and loan commitments
2. Subordination of some securities that gives another class or tranche priority in the event of liquidation, etc.
3. Guarantees excluded from scope of FASB 5, para. 7
4. A lessee’s guarantee of the residual value of leased asset (capital lease only)
5. A contract that is accounted for as contingent rent under FASB 13
6. Guarantee issued by insurance company under FASB No. 60, No. 97, No. 113, or No. 120
7. A contract that meets the criteria BUT provides for payments that constitute a vendor rebate (by the guarantor) based on either sales revenue of, or number of units sold by, the guaranteed party.
8. Guarantee whose existence prevents the guarantor from being able to either account for a transaction as the sale of an asset that is related to the guarantee’s underlying or recognize in earnings the profit from that sale transaction.
Prepared by Teresa Gordon

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Covers guarantee contracts that have any of the following 4 characteristics
3. Indemnification agreements that require guarantor to make payments to the indemnified party (guaranteed party) based on changes in an “underlying” such as an adverse judgment in a lawsuit, imposition of additional taxes due to adverse interpretation of the law
4. Indirect guarantees of the indebtedness of others even though the payment to the guaranteed party may not be based on an underlying asset, liability, etc., of the guaranteed party.
Scope exceptions – initial recognition provisions only
1. Guarantees accounted for as a derivative under Statement 133
2. Product warranties (the disclosure requirements of FIN 45 do apply – see below)
3. Guarantees issued in a business combination (Statement 141)
4. Guarantees for which the guarantor’s obligation would be reported as an equity item (rather than a liability) under GAAP
5. Guarantee by an original lessee that has become secondarily liable under a new lease that relieved the original lessee from being the primary obligor (principal debtor) – says to not apply this section to secondary obligations that are not accounted for under Statement 13, paragraph 38.
6. Guarantees between parents and subsidiaries or between corporation under common control
7. Parent’s guarantee of debt of its subsidiary to a third party
8. A subsidiary’s guarantee of debt owed to a third party by its parent or a sibling subsidiary.
Prepared by Teresa Gordon

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THE INTERPRETATION
The issuance of a guarantee obligates the guarantor (issuer) in two respects:
1. The guarantor undertakes an obligation to stand ready to perform over the term of the guarantee if the event that the specified triggering events or conditions occur
This is the noncontingent part of the obligation
2. The guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur
This is the contingent part of the obligation New Disclosure – FIN 45
Prepared by Teresa Gordon

5. Key point that FIN 45 made:
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Key point that FIN 45 made:
FASB 5 should not be interpreted as prohibiting the guarantor from initially recognizing a liability for a guarantee even though it is not probable that the payments will be required under that guarantee.
Prepared by Teresa Gordon

6. Measurement of obligation
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Measurement of obligation
a. The premium received or receivable – when the guarantee is issued in a standalone arm’s-length transaction with an unrelated party
b. When the guarantee is part of a transaction with multiple elements, estimate the fair value of the guarantee.
Consider the premium which would be required by the guarantor to issue a standalone guarantee with an unrelated party
In the absence of observable transactions for identical or similar guarantees, use expected present value measurement techniques
Prepared by Teresa Gordon

7. Measurement of obligation
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Measurement of obligation
c. If a guarantor must recognize a guarantee at inception because it is probable and can be estimated (FASB 5), the amount to initially recognize is the GREATER of the fair value of the guarantee (as measured above) or the contingent liability amount required under paragraph 8 of Statement 5.
d Not for profit situation: guarantees provided as a contribution to an unrelated party (like a loan guarantee by a community foundation to a nonprofit entity), the guarantee (gift) should be measured at the fair value of the guarantee and NOT considered merely a conditional promise to give.
Prepared by Teresa Gordon

8. The debit side is not prescribed
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The debit side is not prescribed
Some examples provided in FIN 45 include:
a. If a premium is received, the debit would be to cash or receivable.
b. If the fair value of the premium is an allocation of the receivable or cash received on a transaction that involves other assets, liabilities, etc., the allocation to the guarantee will affect the calculation of the gain or loss on the transaction.
c. If the guarantee is associated with the acquisition of a business accounted for under the equity method, the guarantee would increase the carrying value of the investment.
d. In an operating lease situation, the guarantee would affect prepaid rent.
e. If no consideration is received, the offsetting entry would be to expense.
Prepared by Teresa Gordon

9. Disclosures Required (added by FIN 45)
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Disclosures Required (added by FIN 45)
a. Nature of the guarantee including, the approximate term, how the guarantee arose, and the event or circumstance that would require the guarantor to perform under the guarantee.
b. Maximum potential amount of future payments
c. Current carrying amount of the liability
d. Nature of (1) any recourse provisions that would enable guarantor to recover from third parties any of the amounts paid under the guarantee and (2) any assets held either as collateral or by third parties that the guarantor would be able to liquidate to recover any of the amounts paid.
Prepared by Teresa Gordon

10. Disclosures Required – con’t
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Disclosures Required – con’t
e. FOR PRODUCT WARRANTIES. The disclosure of the maximum amount of future payments requirement above is waived. Instead:
1. The accounting policy and methodology used to determine its liability for product warranties including any deferred revenues associated with extended warranties.
2. A tabular reconciliation of the changes in the guarantor’s aggregate product warranty for the reporting period.
Beginning balance
Aggregate reduction for payments made or services provided
Aggregate increase for new warranties issued during period
Aggregate changes in the liability related to pre-existing warranties (changes in estimate)
Ending balance
Prepared by Teresa Gordon

11. Example from Recent F/S
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Example from Recent F/S
Prepared by Teresa Gordon

12. New (2003) rules on redeemable preferred stock
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New (2003) rules on redeemable preferred stock
ASC 480 (FAS150) related to Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity
SFAS No. 150 – Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (May 2003)
Applies to “freestanding financial instruments” only
Does not apply to features “embedded” in a financial instrument that is not a derivative in its entirety (i.e., stock-based compensation and, as best I can tell, convertible bonds)
Defines obligation as “conditional or unconditional duty or responsibility to transfer assets or to issue equity shares”
In the past, redeemable preferred stock have been treated as equity or shown in the “mezzanine” level of balance sheet (between liabilities and owners’ equity). This statement removes the mezzanine!
Prepared by Teresa Gordon

13. EXAMPLES OF INSTRUMENTS COVERED BY STATEMENT 150
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EXAMPLES OF INSTRUMENTS COVERED BY STATEMENT 150
Mandatorily Redeemable Instruments
❒ Stock that must be redeemed on a certain date (for example, December 31, 2030)
❒ Stock that must be redeemed upon the death of the holder
Instruments with Repurchase Obligations
❒ Written put options that are physically or net cash settled
❒ Forward purchase contracts that are physically or net cash settled
The following mandatorily redeemable instruments are outside the scope of the Statement, and the applicable accounting for them is unchanged.
■ Preferred stock that is convertible to common stock with a redemption date (for example, December 31, 2030)
■ Puttable, callable, or puttable and callable stock
■ Stock that must be redeemed upon an unknown liquidation or termination date of the reporting entity
■ Contingently redeemable stock (However, when the contingency is satisfied, the stock is within the scope of Statement 150.)
Instruments with Repurchase Obligations –
Instruments embodying, or indexed to, an obligation to repurchase an issuer’s own equity shares that require or may require settlement by transfer of assets.
Instruments with Obligations to Issue a Variable Number of Shares – Instruments embodying an obligation that the issuer must or could settle by issuing a variable number of its equity shares if the monetary value of the obligation is based solely or predominately on: a fixed monetary amount known at inception, variations in something other than the fair value of the issuer’s equity shares, or variations in the fair value of the issuer’s equity shares, but in the opposite direction.
Prepared by Teresa Gordon

14. EXAMPLES OF INSTRUMENTS COVERED BY STATEMENT 150
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EXAMPLES OF INSTRUMENTS COVERED BY STATEMENT 150
Instruments with Obligations to Issue a Variable Number of Shares
❒ Debt settleable with a variable number of the issuer’s equity shares
❒ Instruments indexed to the S&P 500 and settleable with a variable number of the issuer’s equity shares
❒ Written put options that can be settled by one party delivering stock equal to current fair value of the counterparty’s gain (“net share settled”)
❒ Forward purchase contracts that are net share settled
From KPMG Defining Issues
CLASSIFICATION AND COMBINATION OF INSTRUMENTS
The following guidance on combining and separating freestanding financial instruments is essential to applying the classification requirements.
■ A freestanding financial instrument that is within the scope of the Statement cannot be combined with any other instrument when applying the classification requirements unless Statement 133 specifically requires separate contracts to be viewed as a unit.
■ Statement 150’s provisions determine whether freestanding instruments should be classified as liabilities or equity, but those instruments must still be analyzed to determine whether they contain embedded derivatives subject to the provisions of Statement 133.
This guidance will require entities to examine the terms of individual contracts carefully. The terms of the contract will govern the accounting, not necessarily the economic substance of the arrangement. In addition, the Statement’s classification requirements for freestanding derivatives do not apply to embedded derivatives.
Prepared by Teresa Gordon

15. Redeemable financial instruments
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Redeemable financial instruments
Mandatorily redeemable financial instrument shall be classified as liability
Exceptions
Redemption is contingent
Required only upon liquidation or termination of the reporting entity
Required only if an uncertain future event occurs
Becomes liability only when the event becomes certain to occur
Mandatorily redeemable financial instrument shall be classified as liability
Exceptions
The redemption is contingent on future event
Treat as liability when the event occurs, the condition is resolved, or the event becomes certain to occur
In this case, the liability is measured at fair value when reclassified to the liability section.
Equity is reduced and no gain or loss is recognized.
The redemption is required only upon liquidation or termination of the reporting entity
Do not classify as liability
Certain not probable!
Prepared by Teresa Gordon

16. Other redeemable securities
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Other redeemable securities
Classify as liability:
Obligation to repurchase equity
Obligations to issue variable number of shares
Obligation to Repurchase Equity
Classify as a liability:
A financial instrument (other than outstanding shares of stock) that at inception
Embodies an obligation to repurchase the issuer’s equity shares or is indexed to shares
Requires or may require the issuer to settle the obligation by transferring assets
Examples
Forward purchase contracts
Written put options on issuer’s equity shares that are to be physically settled or net cash settled
Obligations to issue variable number of shares
Classify as a liability (or sometimes an asset) a financial instrument other than outstanding shares that embody a conditional obligation to settle by issuing a variable number of its equity shares
Fixed monetary amount payable with variable number of issuer’s shares
Indexed or similar obligations to be settled in variable number of issuer’s equity shares
Variations inversely related to changes in fair value of issuer’s equity shares – like a written put option that could be net share settled
Prepared by Teresa Gordon

17. Measurement of liability
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Measurement of liability
Financial instruments that meet these requirements are initially measured at fair value
Most are then re-measured at fair value and the subsequent changes in fair value are recognized in earnings
From KPMG Defining Issues
MEASUREMENT
All instruments within the scope of the Statement are initially measured at fair value, with this exception: Freestanding “physically-settled” forward purchase contracts that obligate the issuer to purchase a fixed number of its own shares for cash are initially measured at the present value of the amount to be paid at the settlement date and classified as a liability. A contract is physically-settled if it designates a buyer and a seller who settle by exchanging cash or other financial instruments for shares of stock or financial or nonfinancial instruments. The difference in measurement requirements is based on the FASB’s conclusion that physically-settled forward purchase contracts are similar to treasury-share purchases except that payment will be in the future.
With two exceptions, all instruments are subsequently measured at fair value with changes in the liability flowing through the income statement. The exceptions are physically-settled forward purchase contracts discussed above and mandatorily redeemable instruments. Instead, those instruments should be adjusted to their earliest redemption/settlement amount using the implicit interest rate at inception.
Prepared by Teresa Gordon

18. Reporting on Statements
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Reporting on Statements
Balance sheet required description:
“Shares subject to mandatory redemption”
Should be on separate line and not commingled with other liabilities
Income statement transition
Through “cumulative effect of a change in accounting principle”
Impact – more debt, less equity!
From KPMG “Defining Issues” EFFECT ON FINANCIAL PRESENTATIONS AND REQUIREMENTS
Statement 150 will affect companies’ ratios and performance measures, certain stock buy-back programs, and could affect regulatory-capital requirements.
Ratios and Performance Measures. The Statement’s requirements will increase some entities’ liabilities and make them more volatile, while their equity decreases. This can affect ratios and performance measures. Companies should therefore review the Statement’s potential economic consequences. They should consider the effect on debt covenants and similar requirements.
Stock Buy-Back Programs. Instruments used in stock buy-back programs that formerly qualified for equity classification might have to be classified as liabilities with changes in that liability flowing through the income statement. For example, some companies that expected their share prices to increase may have written put options to help finance purchases of shares to be held in treasury or shares to be issued when employee stock options are exercised. Other companies may have entered into forward purchase agreements to lock in a repurchase price for similar reasons. Statement 150 requires all such instruments to be classified as liabilities.
Minimum Capital Requirements. Regulatory authorities require various entities to maintain specified capital levels that might be based on equity as determined under generally accepted accounting principles. Depending on the entity’s circumstances, Statement 150’s requirements might affect these determinations. For example, a bank that previously treated a mandatorily redeemable trust-preferred security as capital in accordance with regulatory rules should determine whether Statement 150’s requirements to record those instruments as liabilities will affect the regulatory rules.
Prepared by Teresa Gordon

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Disclosures
Nature and terms of the financial instruments including rights and obligations
Amount that would be paid or number of shares that would be issued and their fair value “as if settled” at reporting date
How changes in fair value of issuer’s equity shares impact the settlement amount
Maximum amount issuer could be required to pay
Maximum number of shares that might have to be issued
And several more items (see paragraph 27)
Prepared by Teresa Gordon

20. Example financial instrument
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Example financial instrument
Trust-preferred securities
A financial institution establishes a trust or other entity that is consolidated with the financial institution
The trust issues mandatorily redeemable preferred stock and uses the proceeds to purchase from the financial institution an equivalent amount of junior subordinated debt
The financial institution pays interest to the trust, the trust uses the funds to pay the dividends
Why they exist
Upon consolidation, the intercompany transaction (payment of interest) disappears along with the debt (and the receivable on the trust’s books)
Haven’t pasted in the exact new language yet – this is from FAS 150
Prepared by Teresa Gordon

21. Example financial instrument
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Example financial instrument
Trust-preferred securities
Under the new rules, the financial institution will have to report INTEREST EXPENSE and DEBT instead of dividends and redeemable preferred stock
Be sure to check for examples to aid implementation of the rules (ASC )
Prepared by Teresa Gordon

22. Key terms – from ASC Glossary
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Key terms – from ASC Glossary
Financial instrument – a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity.
A freestanding financial instrument is one that is entered into separately and apart from any of the entity’s other financial instruments or equity transactions, or that is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
Prepared by Teresa Gordon

23. Key terms – from Glossary
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Key terms – from Glossary
A mandatorily redeemable financial instrument is issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.
Example – shares redeemable upon death of share holder (as in small business). Death is CERTAIN therefore the ENTIRE equity of the company could be classified as a liability ! See Example in FAS 150, para A6 that shows presentation.
Prepared by Teresa Gordon

24. Key terms – from Glossary
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Key terms – from Glossary
  Net cash settlement - A form of settling a financial instrument under which the party with a loss delivers to the party with a gain cash equal to the gain.
 Net share settlement - A form of settling a financial instrument under which the party with a loss delivers to the party with a gain shares of stock with a current fair value equal to the gain.
Prepared by Teresa Gordon

25. Key terms – from Glossary
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Key terms – from Glossary
 Monetary value - What the fair value of the cash, shares, or other instruments that a financial instrument obligates the issuer to convey to the holder would be at the settlement date under specified market conditions.
  Shares, as the term is used in SFAS No. 150, indicates various types of ownership interests that are not necessarily securities such as a partnership interest. In contrast, the term equity shares refers only to shares that are accounted for as equity.
Prepared by Teresa Gordon

26. Handout flow chart There is a whole “practice aid” on applying FAS150
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Handout flow chart
There is a whole “practice aid” on applying FAS150
The flow chart distributed is from a draft version of one of the chapters.
Prepared by Teresa Gordon

27. ASC 815-40 (EITF 07-5) Warrants and convertible instruments
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ASC (EITF 07-5) Warrants and convertible instruments
“Round-down” provisions
Warrants with round-down provisions will no longer be recorded in equity
Many convertible instruments with round-down provisions will have to “bifurcated” to show the conversion option separately as a derivative under FAS133
Effective years beginning after 12/15/08
The adoption of EITF 07-5’s requirements will affect issuers’ accounting for warrants and many convertible instruments with provisions that protect holders from declines in the stock price (“down-round” provisions).1 Warrants with such provisions will no longer be recorded in equity, and many of the convertible instruments with such provisions will have to be “bifurcated,” with the conversion option separately accounted for as a derivative under Statement EITF 07-5’s requirements go into effect for fiscal years beginning after December 15, 2008, which means beginning January 1, 2009, for calendar-year-end companies.
Down-round provisions reduce the exercise price of a warrant or convertible instrument if the company either issues equity shares for a price that is lower than the exercise price of those instruments or issues new warrants or convertible instruments that have a lower exercise price. The provisions are commonly found in warrants and convertible instruments that are issued to venture capital firms and other private equity investors. The newly effective guidance will therefore affect many nonpublic, pre-IPO entities. However, as a result of current market conditions, a number of investors that have provided capital to publicly traded entities in private-placement transactions have also obtained down-round protection.
Prepared by Teresa Gordon

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Round-down provision
Reduce the exercise price of a warrant on convertible instrument if the company either
issues equity shares for a price that is lower than the exercise price of those instruments, or
issues new warrants or convertible instruments that have a lower exercise price
Common in pre-IPO entities that issue instruments to venture capital firms
From KPMG Defining Issues Dec 08
EITF 07-5 specifies that an instrument or embedded feature would be considered indexed to a company’s own stock if its settlement amount will equal the difference between the fair value of a fixed number of the company’s equity shares and a fixed monetary amount or a fixed amount of a debt instrument issued by the company. For example, a warrant or conversion option that gives the counterparty a right to purchase a fixed number of the company’s shares for a fixed price or for a fixed stated principal amount of a bond issued by the company would be considered indexed to the company’s own stock. However, if the instrument’s strike price or the number of shares used to calculate the settlement amount are not fixed, the instrument or embedded feature would still be considered indexed to a company’s own stock if the only variables that could affect the settlement amount would be inputs to the fair-value measurement of a “fixed-for-fixed” forward or option on equity shares.
Conclusions on Down-Round Provisions. Instruments or embedded features with down-round protection are not considered indexed to a company’s own stock under EITF 07-5, because neither the occurrence of a sale of common stock by the company at market nor the issuance of another equity-linked instrument with a lower strike price is an input to the fair value of a fixed-for-fixed option on equity shares. The appendix to the Consensus contains an example of warrants with down-round provisions that concludes they are not indexed to the company’s own stock.4 A down-round provision may be viewed by some as a form of guarantee provided to the holder of the instrument, which is inconsistent with equity classification.
Prepared by Teresa Gordon

29. From KPMG “Defining Issues” Dec 2008, No. 08-51
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From KPMG “Defining Issues” Dec 2008, No
From KPMG Defining Issues
Standard Antidilution Provisions
EITF 07-5 does not contain specific guidance on standard antidilution provisions. However, the appendix to the Consensus contains an example of a forward contract that is adjusted to offset the dilution resulting from specified events that are commonly characterized as standard antidilution provisions (as in the case of stock splits).5 The example concludes that the provisions it describes do not preclude the instrument from being indexed to the company’s own stock. Contractual agreements sometimes characterize down-round protection as a standard antidilution provision. However, EITF 07-5’s conclusion that an equity-linked instrument or embedded feature with down-round protection should not be considered indexed to a company’s own stock applies to down-round protection even if it is referred to as an antidilution provision in the related transaction documents.
Eliminating Down-Round Protection Prior to the Effective Date
The EITF 07-5 Consensus is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Earlier application by a company that had previously adopted an accounting policy that is inconsistent with the Consensus is not permitted. The Consensus must be applied to instruments that are outstanding at adoption by recognizing a cumulative-effect adjustment to the opening balance of retained earnings.
We believe that the existence of a down-round provision in earlier periods would not affect a company’s accounting when EITF 07-5 is adopted or subsequently if the provision is eliminated prior to the adoption date. However, calendar-year-end companies have very little time remaining to complete such modifications because the new guidance will be effective on January 1, If a company completes
Prepared by Teresa Gordon