17192 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

SECURITIES AND EXCHANGE 

COMMISSION 

17 CFR Part 211 

[Release No. SAB 114] 

Staff Accounting Bulletin No. 114 

AGENCY: Securities and Exchange 

Commission. 

ACTION: Publication of Staff Accounting 

Bulletin. 

SUMMARY: This Staff Accounting 

Bulletin (SAB) revises or rescinds 

portions of the interpretive guidance 

included in the codification of the Staff 

Accounting Bulletin Series. This update 

is intended to make the relevant 

interpretive guidance consistent with 

current authoritative accounting 

guidance issued as part of the Financial 

Accounting Standards Board’s 

Accounting Standards Codification. The 

principal changes involve revision or 

removal of accounting guidance 

references and other conforming 

changes to ensure consistency of 

referencing throughout the SAB Series. 

DATES: Effective Date: March 28, 2011. 

FOR FURTHER INFORMATION CONTACT: Lisa 

Tapley, Assistant Chief Accountant, or 

Annemarie Ettinger, Senior Special 

Counsel, Office of the Chief Accountant, 

at (202) 551–5300, or Craig Olinger, 

Deputy Chief Accountant, Division of 

Corporation Finance, at (202) 551–3400, 

Securities and Exchange Commission, 

100 F Street, NE., Washington, DC 

20549. 

SUPPLEMENTARY INFORMATION: The 

statements in staff accounting bulletins 

are not rules or interpretations of the 

Commission, nor are they published as 

bearing the Commission’s official 

approval. They represent interpretations 

and practices followed by the Division 

of Corporation Finance and the Office of 

the Chief Accountant in administering 

the disclosure requirements of the 

Federal securities laws. 

Dated: March 7, 2011. 

Elizabeth M. Murphy, 

Secretary. 

PART 211—[AMENDED] 

■ Accordingly, Part 211 of Title 17 of 

the Code of Federal Regulations is 

amended by adding Staff Accounting 

Bulletin No. 114 to the table found in 

Subpart B. 

Staff Accounting Bulletin No. 114 

This Staff Accounting Bulletin (SAB) 

revises or rescinds portions of the 

interpretive guidance included in the 

codification of the Staff Accounting 

Bulletin Series. This update is intended 

to make the relevant interpretive 

guidance consistent with current 

authoritative accounting guidance 

issued as part of the Financial 

Accounting Standards Board’s 

Accounting Standards Codification 

(FASB ASC). The principal changes 

involve revision or removal of 

accounting guidance references and 

other conforming changes to ensure 

consistency of referencing throughout 

the SAB Series. 

The following describes the changes 

made to the Staff Accounting Bulletin 

Series and certain specific topics that 

are presented at the end of this release: 

a. The SAB Series is amended to 

update authoritative accounting 

literature references to the FASB ASC 

throughout. In addition, several 

conforming formatting changes were 

made for consistency across SAB topics. 

Due to the number of these changes, the 

SAB Series is represented in its entirety 

in this release. All of the changes are 

technical in nature, and none of the 

changes are intended to change the 

guidance provided in the SAB Series. 

Topic 1: Financial Statements 

a. Topic 1.D.1, the introductory facts 

are amended to conform to changes 

made to Items 17 and 18 of Form 20– 

F to reflect that certain disclosures are 

required only if a basis of accounting 

other than U.S. generally accepted 

accounting principles (GAAP) or 

International Financial Reporting 

Standards as issued by the International 

Accounting Standards Board is used. 

The introductory facts are also amended 

to remove the reference to Form F–2, as 

this form was eliminated effective 

December 1, 2005. Finally, the 

introductory facts are amended to reflect 

the foreign issuer reporting 

enhancements contained in SEC Release 

No. 33–8959. 

b. Topic 1.I, the footnote previously 

numbered 6 within the interpretive 

response to question 1 is removed as the 

referenced guidance is now within the 

FASB ASC, and thus a history of the 

prior source is no longer relevant. 

c. Topic 1.I, the footnote previously 

numbered 7 within the interpretive 

response to question 2 is removed as the 

term ‘‘ADC’’ is now defined within the 

body of SAB Topic 1.I. 

d. Topic 1.K, the interpretive response 

to question 3 is amended to conform to 

the accounting guidance contained in 

FASB ASC Topic 350, Intangible 

Assets—Goodwill and Other. This 

conforming change reflects the fact that 

goodwill is no longer subject to 

amortization. The interpretive response 

to question 3 is also amended to replace 

the term ‘‘carrying value’’ with the term 

‘‘fair value’’ to reflect the measurement 

guidance for financial assets and 

liabilities as stated in FASB ASC Topic 

820, Fair Value Measurements and 

Disclosures. 

e. Topic 1.K, the interpretive response 

to question 4, is amended to replace 

Item 7 of Form 8–K with Item 9.01 of 

Form 8–K. 

Topic 3: Senior Securities 

a. Topic 3.A, the interpretive response 

is amended to replace Rule 11–02(a)(7) 

of Regulation S–X with Rule 11–02(b)(7) 

of Regulation S–X. 

Topic 5: Miscellaneous Accounting 

a. Topic 5.F, the introductory facts 

and interpretive response are amended 

to replace the term ‘‘restatement’’ with 

the term ‘‘retrospective adjustment,’’ to 

replace the term ‘‘restate(d)’’ with the 

term ‘‘retrospectively adjust(ed)’’ and to 

replace the term ‘‘retroactively’’ with the 

term ‘‘retrospectively’’ to conform to the 

accounting guidance contained in FASB 

ASC Topic 250, Accounting Changes 

and Error Corrections. 

b. Topic 5.F, the interpretive response 

is amended to remove an unnecessary 

reference to FASB Statement No. 5 and 

FASB Statement No. 13. 

c. Topic 5.M, the footnote previously 

numbered 8 within the interpretive 

response is removed to delete a 

reference which is not included in the 

FASB ASC. 

d. Topic 5.S, the interpretive 

responses to questions 2, 4 (including 

footnote 29) and 5 are amended to revise 

the quoted accounting guidance to 

conform to the language as published in 

the FASB ASC. The interpretive 

response to question 4 is amended to 

remove guidance which is not included 

in the FASB ASC. The footnote 

previously numbered 31 within the 

interpretive response to question 4 is 

removed to delete a reference which is 

not included in the FASB ASC. 

e. Topic 5.V, the interpretive response 

to question 1 is amended to remove an 

unnecessary reference to SAB Topic 5.E, 

as the referenced guidance in SAB 

Topic 5.E was removed with the 

issuance of SAB No. 112. As a result, 

the related footnote previously 

numbered 38 is removed. 

f. Topic 5.Y, the interpretive response 

to question 3 is amended to remove the 

reference to Regulation S–B, as this 

Regulation was eliminated effective 

February 4, 2008. 

g. Topic 5.Z.4, footnote 51 is amended 

to remove an unnecessary reference to 

SAB Topic 5.E. 

h. Topic 5.BB, the introductory facts 

are amended to revise the quoted 


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accounting guidance to conform to the 

language as published in the FASB ASC. 

Topic 6: Interpretations of Accounting 

Series Releases and Financial Reporting 

Releases 

a. Topic 6.K.3, the interpretive 

response is amended to conform to the 

accounting guidance contained in FASB 

ASC Topic 350, Intangible Assets— 

Goodwill and Other. This conforming 

change reflects the fact that goodwill is 

not amortized, but rather only tested for 

impairment. 

b. Topic 6.L is amended throughout to 

update the references to the AICPA 

Audit and Accounting Guide, 

Depository and Lending Institutions 

with Conforming Changes as of June 1, 

2009 (Audit Guide). Quoted guidance 

has been amended to conform to the 

language as published in the Audit 

Guide. 

Topic 8: Retail Companies 

a. Topic 8.A, the interpretive response 

is amended to remove unnecessary 

background information on the issuance 

of pre-FASB Codification standards. 

Topic 13: Revenue Recognition 

a. Topic 13.A.4.c, the interpretive 

response is amended to revise the 

quoted accounting guidance to conform 

to the language as published in the 

FASB ASC. 

b. Topic 13.B, questions 2, 3, 4 and 5 

and the interpretive responses and 

footnotes related to questions 2, 3, 4 and 

5 are removed to eliminate unnecessary 

references and guidance specifically 

related to the original adoption of this 

SAB Topic. 

Topic 14: Share-Based Payment 

a. Topic 14.G is removed to eliminate 

unnecessary guidance on non-GAAP 

financial measures. Staff guidance on 

non-GAAP financial measures can be 

found in the Division of Corporation 

Finance’s Compliance and Disclosure 

Interpretations. 

b. Topics 14.H, 14.J, 14.K and 14.M 

are removed to eliminate unnecessary 

transition guidance specifically related 

to the first time adoption of FASB 

Statement No. 123(R), Share-Based 

Payment. Companies that had sharebased payment arrangements prior to 

the adoption of FASB Statement No. 

123(R) were required to apply this 

transition guidance in 2006 and 

therefore for these companies the 

guidance in Topics 14.H, 14.J, 14.K and 

14.M is no longer relevant. For 

companies now entering into sharebased payment arrangements for the 

first time, the guidance in FASB ASC 

Topic 718, Compensation—Stock 

Compensation, should be applied. 

c. Topic 14.L is removed to conform 

to changes made to Items 17 and 18 of 

Form 20–F to reflect that reconciling 

items are required for disclosure only if 

a basis of accounting other than U.S. 

generally accepted accounting 

principles or International Financial 

Reporting Standards as issued by the 

International Accounting Standards 

Board is used.[ 

Note: The text of SAB 114 will not appear 

in the Code of Federal Regulations. 

Table of Contents 

TOPIC 1: FINANCIAL STATEMENTS 

A. Target Companies 

B. Allocation of Expenses and Related 

Disclosure in Financial Statements of 

Subsidiaries, Divisions or Lesser 

Business Components of Another Entity 

1. Costs Reflected in Historical Financial 

Statements 

2. Pro Forma Financial Statements and 

Earnings per Share 

3. Other Matters 

C. Unaudited Financial Statements for a Full 

Fiscal Year 

D. Foreign Companies 

1. Disclosures Required of Companies 

Complying With Item 17 of Form 20–F 

2. ‘‘Free distributions’’ by Japanese 

Companies 

E. Requirements for Audited or Certified 

Financial Statements 

1. Removed by SAB 103 

2. Qualified Auditors’ Opinions 

F. Financial Statement Requirements in 

Filings Involving the Formation of a 

One-Bank Holding Company 

G. Removed by Financial Reporting Release 

(FRR) 55 

H. Removed by FRR 55 

I. Financial Statements of Properties Securing 

Mortgage Loans 

J. Application of Rule 3–05 in Initial Public 

Offerings 

K. Financial Statements of Acquired 

Troubled Financial Institutions 

L. Removed by SAB 103 

M. Materiality 

1. Assessing Materiality 

2. Immaterial Misstatements That Are 

Intentional 

N. Considering the Effects of Prior Year 

Misstatements When Quantifying 

Misstatements in Current Year Financial 

Statements 

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 

7. Removed by SAB 112 

8. Business Combinations Prior to an Initial 

Public Offering 

9. Removed by SAB 112 

B. Removed by SAB 103 

C. Removed by SAB 103 

D. Financial Statements of Oil and Gas 

Exchange Offers 

E. Removed by SAB 103 

F. Removed by SAB 103 

TOPIC 3: SENIOR SECURITIES 

A. Convertible Securities 

B. Removed by ASR 307 

C. Redeemable Preferred Stock 

TOPIC 4: EQUITY ACCOUNTS 

A. Subordinated Debt 

B. S Corporations 

C. Change in Capital Structure 

D. Earnings per Share Computations in an 

Initial Public Offering 

E. Receivables From Sale of Stock 

F. Limited Partnerships 

G. Notes and Other Receivables From 

Affiliates 

TOPIC 5: MISCELLANEOUS ACCOUNTING 

A. Expenses of Offering 

B. Gain or Loss From Disposition of 

Equipment 

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 

E. Accounting for Divestiture of a Subsidiary 

or Other Business Operation 

F. Accounting Changes Not Retroactively 

Applied Due to Immateriality 

G. Transfers of Nonmonetary Assets by 

Promoters or Shareholders 

H. Removed by SAB 112 

I. Removed by SAB 70 

J. New Basis of Accounting Required in 

Certain Circumstances 

K. Removed by SAB 95 

L. LIFO Inventory Practices 

M. Other Than Temporary Impairment of 

Certain Investments in Equity Securities 

N. Discounting by Property-Casualty 

Insurance Companies 

O. Research and Development Arrangements 

P. Restructuring Charges 

1. Removed by SAB 103 

2. Removed by SAB 103 

3. Income Statement Presentation of 

Restructuring Charges 

4. Disclosures 

Q. Increasing Rate Preferred Stock 

R. Removed by SAB 103 

S. Quasi-Reorganization 

T. Accounting for Expenses or Liabilities 

Paid by Principal Stockholder(s) 

U. Removed by SAB 112 

V. Certain Transfers of Nonperforming Assets 

W. Contingency Disclosures Regarding 

Property-Casualty Insurance Reserves for 

Unpaid Claim Costs 

X. Removed by SAB 103 

Y. Accounting and Disclosures Relating to 

Loss Contingencies 

Z. Accounting and Disclosure Regarding 

Discontinued Operations 

1. Removed by SAB 103 

2. Removed by SAB 103 

3. Removed by SAB 103 

4. Disposal of Operation With Significant 

Interest Retained 

6. Removed by SAB 103 

7. Accounting for the Spin-Off of a 

Subsidiary 


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AA. Removed by SAB 103 

BB. Inventory Valuation Allowances 

CC. Impairments 

DD. Written Loan Commitments Recorded at 

Fair Value Through Earnings 

TOPIC 6: INTERPRETATIONS OF 

ACCOUNTING SERIES RELEASES AND 

FINANCIAL REPORTING RELEASES 

A.1. Removed by SAB 103 

B. Accounting Series Release 280—General 

Revision of Regulation S–X: Income or 

Loss Applicable to Common Stock 

C. Accounting Series Release 180— 

Institution of Staff Accounting Bulletins 

(SABs)—Applicability of Guidance 

Contained in SABs 

D. Redesignated as Topic 12.A by SAB 47 

E. Redesignated as Topic 12.B by SAB 47 

F. Removed by SAB 103 

G. Accounting Series Releases 177 and 286— 

Relating to Amendments to Form 10–Q, 

Regulation S–K, and Regulations S–X 

Regarding Interim Financial Reporting 

1. Selected Quarterly Financial Data (Item 

302(a) of Regulation S–K) 

a. Disclosure of Selected Quarterly Financial 

Data 

b. Financial Statements Presented on Other 

Than a Quarterly Basis 

c. Removed by SAB 103 

2. Amendments to Form 10–Q 

a. Form of Condensed Financial Statements 

b. Reporting Requirements for Accounting 

Changes 

1. Preferability 

2. Filing of a Letter From the Accountants 

H. Accounting Series Release 148-Disclosure 

Of Compensating Balances And ShortTerm Borrowing Arrangements (Adopted 

November 13, 1973 As Modified By ASR 

172 Adopted On June 13, 1975 And ASR 

280 Adopted On September 2, 1980) 

1. Applicability 

a. Arrangements With Other Lending 

Institutions 

b. Bank Holding Companies and Brokerage 

Firms 

c. Financial Statements of Parent Company 

and Unconsolidated Subsidiaries 

d. Foreign Lenders 

2. Classification of Short-Term ObligationsDebt Related to Long-Term Projects 

3. Compensating Balances 

a. Compensating Balances for Future Credit 

Availability 

b. Changes in Compensating Balances 

c. Float 

4. Miscellaneous 

a. Periods Required 

b. 10–Q Disclosures 

I. Accounting Series Release 149-Improved 

Disclosure Of Income Tax Expense 

(Adopted November 28, 1973 And 

Modified By ASR 280 Adopted On 

September 2, 1980) 

1. Tax Rate 

2. Taxes of Investee Company 

3. Net of Tax Presentation 

4. Loss Years 

5. Foreign Registrants 

6. Securities Gains and Losses 

7. Tax Expense Components v. ‘‘Overall’’ 

Presentation 

J. Removed by SAB 47 

K. Accounting Series Release 302—Separate 

Financial Statements Required by 

Regulation S–X 

1. Removed by SAB 103 

2. Parent Company Financial Information 

a. Computation of Restricted Net Assets of 

Subsidiaries 

b. Application of Tests for Parent Company 

Disclosures 

3. Undistributed Earnings of 50% or Less 

Owned Persons 

4. Application of Significant Subsidiary Test 

to Investees and Unconsolidated 

Subsidiaries 

a. Separate Financial Statement 

Requirements 

b. Summarized Financial Statement 

Requirements 

L. Financial Reporting Release 28— 

Accounting for Loan Losses by 

Registrants Engaged in Lending 

Activities 

1. Accounting for loan losses 

2. Developing and Documenting a Systematic 

Methodology 

a. Developing a Systematic Methodology 

b. Documenting a Systematic Methodology 

3. Applying a Systematic Methodology— 

Measuring and Documenting Loan 

Losses Under FASB ASC Subtopic 310– 

10 

a. Measuring and Documenting Loan Losses 

Under FASB ASC Subtopic 310–10— 

General 

b. Measuring and Documenting Loan Losses 

Under FASB ASC Subtopic 310–10 for a 

Collateral Dependent Loan 

c. Measuring and Documenting Loan Losses 

Under FASB ASC Subtopic 310–10— 

Fully Collateralized Loans 

4. Applying a Systematic Methodology— 

Measuring and Documenting Loan 

Losses Under FASB ASC Subtopic 450– 

20 

a. Measuring and Documenting Loan Losses 

Under FASB ASC Subtopic 450–20— 

General 

b. Measuring and Documenting Loan Losses 

Under FASB ASC Subtopic 450–20— 

Adjusting Loss Rates 

c. Measuring and Documenting Loan Losses 

Under FASB ASC Subtopic 450–20— 

Estimating Losses on Loans Individually 

Reviewed for Impairment but not 

Considered Individually Impaired 

5. Documenting the Results of a Systematic 

Methodology 

a. Documenting the Results of a Systematic 

Methodology—General 

b. Documenting the Results of a Systematic 

Methodology—Allowance Adjustments 

6. Validating a Systematic Methodology 

TOPIC 7: REAL ESTATE COMPANIES 

A. Removed by SAB 103 

B. Removed by SAB 103 

C. Schedules of Real Estate and Accumulated 

Depreciation, and of Mortgage Loans on 

Real Estate 

D. Income Before Depreciation 

TOPIC 8: RETAIL COMPANIES 

A. Sales Of Leased Or Licensed Departments 

B. Finance Charges 

TOPIC 9: FINANCE COMPANIES 

A. Removed by SAB 103 

B. Removed by ASR 307 

TOPIC 10: UTILITY COMPANIES 

A. Financing by Electric Utility Companies 

Through Use of Construction 

Intermediaries 

B. Removed by SAB 103 

C. Jointly Owned Electric Utility Plants 

D. Long-Term Contracts for Purchase of 

Electric Power 

E. Classification of Charges for 

Abandonments and Disallowances 

F. Presentation of Liabilities for 

Environmental Costs 

TOPIC 11: MISCELLANEOUS DISCLOSURE 

A. Operating-Differential Subsidies 

B. Depreciation and Depletion Excluded 

From Cost of Sales 

C. Tax Holidays 

D. Removed by SAB 103 

E. Chronological Ordering of Data 

F. LIFO Liquidations 

G. Tax Equivalent Adjustment in Financial 

Statements of Bank Holding Companies 

H. Disclosures by Bank Holding Companies 

Regarding Certain Foreign Loans 

1. Deposit/Relending Arrangements 

2. Accounting and Disclosures by Bank 

Holding Companies for a ‘‘Mexican Debt 

Exchange’’ Transaction 

I. Reporting of an Allocated Transfer Risk 

Reserve in Filings Under the Federal 

Securities Laws 

J. Removed by SAB 103 

K. Application of Article 9 and Guide 3 

L. Income Statement Presentation of CasinoHotels 

M. Disclosure of the Impact That Recently 

Issued Accounting Standards Will Have 

on the Financial Statements of the 

Registrant When Adopted in a Future 

Period 

N. Disclosures of the Impact of Assistance 

From Federal Financial Institution 

Regulatory Agencies 

TOPIC 12: OIL AND GAS PRODUCING 

ACTIVITIES 

A. Accounting Series Release 257— 

Requirements for Financial Accounting 

and Reporting Practices for Oil and Gas 

Producing Activities 

1. Estimates of Reserve Quantities 

2. Estimates of Future Net Revenues 

3. Disclosure of Reserve Information 

a. Removed by SAB 103 

b. Removed by SAB 113 

c. Limited Partnership 10–K Reports 

d. Removed by SAB 113 

e. Rate Regulated Companies 

4. Removed by SAB 103 

B. Removed by SAB 103 

C. Methods of Accounting by Oil and Gas 

Producers 

1. First-Time Registrants 

2. Consistent Use of Accounting Methods 

Within a Consolidated Entity 

D. Application of Full Cost Method of 

Accounting 

1. Treatment of Income Tax Effects in the 

Computation of the Limitation on 

Capitalized Costs 

2. Exclusion of Costs From Amortization 

3. Full Cost Ceiling Limitation 

a. Exemptions for Purchased Properties 


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b. Use of Cash Flow Hedges in the 

Computation of the Limitation on 

Capitalized Costs 

c. Effect of Subsequent Events on the 

Computation of the Limitation on 

Capitalized Costs 

4. Interaction of FASB ASC Subtopic 410–20, 

Asset Retirement and Environmental 

Obligations—Asset Retirement 

Obligations, and the Full Cost Rules 

a. Impact of FASB ASC Subtopic 410–20 on 

the Full Cost Ceiling Test 

b. Impact of FASB ASC Subtopic 410–20 on 

the Calculation of Depreciation, 

Depletion, and Amortization 

c. Removed by SAB 113 

E. Financial Statements of Royalty Trusts 

F. Gross Revenue Method of Amortizing 

Capitalized Costs 

G. Removed by SAB 113 

TOPIC 13: REVENUE RECOGNITION 

A. Selected Revenue Recognition Issues 

1. Revenue Recognition—General 

2. Persuasive Evidence of an Arrangement 

3. Delivery and Performance 

a. Bill and Hold Arrangements 

b. Customer Acceptance 

c. Inconsequential or Perfunctory 

Performance Obligations 

d. License Fee Revenue 

e. Layaway Sales Arrangements 

f. Nonrefundable Up-Front Fees 

g. Deliverables Within an Arrangement 

4. Fixed or Determinable Sales Price 

a. Refundable Fees for Services 

b. Estimates and Changes in Estimates 

d. Claims Processing and Billing Services 

B. Disclosures 

TOPIC 14: SHARE–BASED PAYMENT 

A. Share-Based Payment Transactions with 

Nonemployees 

B. Transition From Nonpublic to Public 

Entity Status 

C. Valuation Methods 

D. Certain Assumptions Used in Valuation 

Methods 

E. FASB ASC Topic 718, Compensation— 

Stock Compensation, and Certain 

Redeemable Financial Instruments 

F. Classification of Compensation Expense 

Associated With Share-Based Payment 

Arrangements 

G. Removed by SAB 114 

H. Removed by SAB 114 

I. Capitalization of Compensation Cost 

Related to Share-Based Payment 

Arrangements 

J. Removed by SAB 114 

K. Removed by SAB 114 

L. Removed by SAB 114 

M. Removed by SAB 114 

TOPIC 1: FINANCIAL STATEMENTS 

A. Target Companies 

Facts: Company X proposes to file a 

registration statement covering an 

exchange offer to stockholders of 

Company Y, a publicly held company. 

Company X asks Company Y to furnish 

information about its business, 

including current audited financial 

statements, for inclusion in the 

prospectus. Company Y declines to 

furnish such information. 

Question 1: In filing the registration 

statement without the required 

information about Company Y, may 

Company X rely on Rule 409 in that the 

information is ‘‘unknown or not 

reasonably available?’’ 

Interpretive Response: Yes, but to 

determine whether such reliance is 

justified, the staff requests the registrant 

to submit as supplemental information 

copies of correspondence between the 

registrant and the target company 

evidencing the request for and the 

refusal to furnish the financial 

statements. In addition, the prospectus 

must include any financial statements 

which are relevant and available from 

the Commission’s public files and must 

contain a statement adequately 

describing the situation and the sources 

of information about the target 

company. Other reliable sources of 

financial information should also be 

utilized. 

Question 2: Would the response 

change if Company Y was a closely held 

company? 

Interpretive Response: Yes. The staff 

does not believe that Rule 409 is 

applicable to negotiated transactions of 

this type. 

B. Allocation of Expenses and Related 

Disclosure in Financial Statements of 

Subsidiaries, Divisions or Lesser 

Business Components of Another Entity 

Facts: A company (the registrant) 

operates as a subsidiary of another 

company (parent). Certain expenses 

incurred by the parent on behalf of the 

subsidiary have not been charged to the 

subsidiary in the past. The subsidiary 

files a registration statement under the 

Securities Act of 1933 in connection 

with an initial public offering. 

1. Costs Reflected in Historical 

Financial Statements 

Question 1: Should the subsidiary’s 

historical income statements reflect all 

of the expenses that the parent incurred 

on its behalf? 

Interpretive Response: In general, the 

staff believes that the historical income 

statements of a registrant should reflect 

all of its costs of doing business. 

Therefore, in specific situations, the 

staff has required the subsidiary to 

revise its financial statements to include 

certain expenses incurred by the parent 

on its behalf. Examples of such 

expenses may include, but are not 

necessarily limited to, the following 

(income taxes and interest are discussed 

separately below): 

1. Officer and employee salaries, 

2. Rent or depreciation, 

3. Advertising, 

4. Accounting and legal services, and 

5. Other selling, general and 

administrative expenses. 

When the subsidiary’s financial 

statements have been previously 

reported on by independent accountants 

and have been used other than for 

internal purposes, the staff has accepted 

a presentation that shows income before 

tax as previously reported, followed by 

adjustments for expenses not previously 

allocated, income taxes, and adjusted 

net income. 

Question 2: How should the amount 

of expenses incurred on the subsidiary’s 

behalf by its parent be determined, and 

what disclosure is required in the 

financial statements? 

Interpretive Response: The staff 

expects any expenses clearly applicable 

to the subsidiary to be reflected in its 

income statements. However, the staff 

understands that in some situations a 

reasonable method of allocating 

common expenses to the subsidiary 

(e.g., incremental or proportional cost 

allocation) must be chosen because 

specific identification of expenses is not 

practicable. In these situations, the staff 

has required an explanation of the 

allocation method used in the notes to 

the financial statements along with 

management’s assertion that the method 

used is reasonable. 

In addition, since agreements with 

related parties are by definition not at 

arms length and may be changed at any 

time, the staff has required footnote 

disclosure, when practicable, of 

management’s estimate of what the 

expenses (other than income taxes and 

interest discussed separately below) 

would have been on a stand alone basis, 

that is, the cost that would have been 

incurred if the subsidiary had operated 

as an unaffiliated entity. The disclosure 

has been presented for each year for 

which an income statement was 

required when such basis produced 

materially different results. 

Question 3: What are the staff’s views 

with respect to the accounting for and 

disclosure of the subsidiary’s income 

tax expense? 

Interpretive Response: Recently, a 

number of parent companies have sold 

interests in subsidiaries, but have 

retained sufficient ownership interests 

to permit continued inclusion of the 

subsidiaries in their consolidated tax 

returns. The staff believes that it is 

material to investors to know what the 

effect on income would have been if the 

registrant had not been eligible to be 

included in a consolidated income tax 

return with its parent. Some of these 

subsidiaries have calculated their tax 

provision on the separate return basis, 


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1FASB ASC paragraph 740–10–30–27 (Income 

Taxes Topic) states: ‘‘The consolidated amount of 

current and deferred tax expense for a group that 

files a consolidated tax return shall be allocated 

among the members of the group when those 

members issue separate financial statements. * * * 

The method adopted * * * shall be systematic, 

rational, and consistent with the broad principles 

established by this Subtopic. A method that 

allocates current and deferred taxes to members of 

the group by applying this Topic to each member 

as if it were a separate taxpayer meets those 

criteria.’’ 

which the staff believes is the preferable 

method. Others, however, have used 

different allocation methods. When the 

historical income statements in the 

filing do not reflect the tax provision on 

the separate return basis, the staff has 

required a pro forma income statement 

for the most recent year and interim 

period reflecting a tax provision 

calculated on the separate return basis.1

Question 4: Should the historical 

income statements reflect a charge for 

interest on intercompany debt if no such 

charge had been previously provided? 

Interpretive Response: The staff 

generally believes that financial 

statements are more useful to investors 

if they reflect all costs of doing business, 

including interest costs. Because of the 

inherent difficulty in distinguishing the 

elements of a subsidiary’s capital 

structure, the staff has not insisted that 

the historical income statements include 

an interest charge on intercompany debt 

if such a charge was not provided in the 

past, except when debt specifically 

related to the operations of the 

subsidiary and previously carried on the 

parent’s books will henceforth be 

recorded in the subsidiary’s books. In 

any case, financing arrangements with 

the parent must be discussed in a note 

to the financial statements. In this 

connection, the staff has taken the 

position that, where an interest charge 

on intercompany debt has not been 

provided, appropriate disclosure would 

include an analysis of the intercompany 

accounts as well as the average balance 

due to or from related parties for each 

period for which an income statement is 

required. The analysis of the 

intercompany accounts has taken the 

form of a listing of transactions (e.g., the 

allocation of costs to the subsidiary, 

intercompany purchases, and cash 

transfers between entities) for each 

period for which an income statement 

was required, reconciled to the 

intercompany accounts reflected in the 

balance sheets. 

2. Pro Forma Financial Statements and 

Earnings per Share 

Question: What disclosure should be 

made if the registrant’s historical 

financial statements are not indicative 

of the ongoing entity (e.g., tax or other 

cost sharing agreements will be 

terminated or revised)? 

Interpretive Response: The 

registration statement should include 

pro forma financial information that is 

in accordance with Article 11 of 

Regulation S–X and reflects the impact 

of terminated or revised cost sharing 

agreements and other significant 

changes. 

3. Other matters 

Question: What is the staff’s position 

with respect to dividends declared by 

the subsidiary subsequent to the balance 

sheet date? 

Interpretive Response: The staff 

believes that such dividends either be 

given retroactive effect in the balance 

sheet with appropriate footnote 

disclosure, or reflected in a pro forma 

balance sheet. In addition, when the 

dividends are to be paid from the 

proceeds of the offering, the staff 

believes it is appropriate to include pro 

forma per share data (for the latest year 

and interim period only) giving effect to 

the number of shares whose proceeds 

were to be used to pay the dividend. A 

similar presentation is appropriate 

when dividends exceed earnings in the 

current year, even though the stated use 

of proceeds is other than for the 

payment of dividends. In these 

situations, pro forma per share data 

should give effect to the increase in the 

number of shares which, when 

multiplied by the offering price, would 

be sufficient to replace the capital in 

excess of earnings being withdrawn. 

C. Unaudited Financial Statements for a 

Full Fiscal Year 

Facts: Company A, which is a 

reporting company under the Securities 

Exchange Act of 1934, proposes to file 

a registration statement within 90 days 

of its fiscal year end but does not have 

audited year-end financial statements 

available. The company meets the 

criteria under Rule 3–01(c) of 

Regulation S–X and is therefore not 

required to include year-end audited 

financial statements in its registration 

statement. However, the Company does 

propose to include in the prospectus the 

unaudited results of operations for its 

entire fiscal year. 

Question: Would the staff find this 

objectionable? 

Interpretive Response: The staff 

recognizes that many registrants publish 

the results of their most recent year’s 

operations prior to the availability of 

year-end audited financial statements. 

The staff will not object to the inclusion 

of unaudited results for a full fiscal year 

and indeed would expect such data in 

the registration statement if the 

registrant has published such 

information. When such data is 

included in a prospectus, it must be 

covered by a management’s 

representation that all adjustments 

necessary for a fair statement of the 

results have been made. 

D. Foreign Companies 

1. Disclosures Required of Companies 

Complying With Item 17 of Form 20–F 

Facts: A foreign private issuer may 

use Form 20–F as a registration 

statement under section 12 or as an 

annual report under section 13(a) or 

15(d) of the Exchange Act. The 

registrant must furnish the financial 

statements specified in Item 17 of that 

form (Effective for fiscal years ending on 

or after December 15, 2011, compliance 

with Item 18 rather than Item 17 will be 

required for all issuer financial 

statements in all Securities Act 

registration statements, Exchange Act 

registration statements on Form 20–F, 

and annual reports on Form 20–F. See 

SEC Release No. 33–8959). However, in 

certain circumstances, Form F–3 

requires that the annual report include 

financial statements complying with 

Item 18 of the form. Also, financial 

statements complying with Item 18 are 

required for registration of securities 

under the Securities Act in most 

circumstances. Item 17 permits the 

registrant to use its financial statements 

that are prepared on a comprehensive 

basis other than U.S. GAAP, but 

requires quantification of the material 

differences in the principles, practices 

and methods of accounting for any basis 

other than International Financial 

Reporting Standards (IFRS) as issued by 

the International Accounting Standards 

Board (IASB). An issuer complying with 

Item 18, other than those using IFRS as 

issued by the IASB, must satisfy the 

requirements of Item 17 and also must 

provide all other information required 

by U.S. GAAP and Regulation S–X. 

Question: Assuming that the 

registrant’s financial statements include 

a discussion of material variances from 

U.S. GAAP along with quantitative 

reconciliations of net income and 

material balance sheet items, does Item 

17 of Form 20–F require other 

disclosures in addition to those 

prescribed by the standards and 

practices which comprise the 

comprehensive basis on which the 

registrant’s primary financial statements 

are prepared? 

Interpretive Response: No. The 

distinction between Items 17 and 18 is 

premised on a classification of the 

requirements of U.S. GAAP and 


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Regulation S–X into those that specify 

the methods of measuring the amounts 

shown on the face of the financial 

statements and those prescribing 

disclosures that explain, modify or 

supplement the accounting 

measurements. Disclosures required by 

U.S. GAAP but not required under the 

foreign GAAP on which the financial 

statements are prepared need not be 

furnished pursuant to Item 17. 

Notwithstanding the absence of a 

requirement for certain disclosures 

within the body of the financial 

statements, some matters routinely 

disclosed pursuant to U.S. GAAP may 

rise to a level of materiality such that 

their disclosure is required by Item 5 

(Management’s Discussion and 

Analysis) of Form 20–F. Among other 

things, this item calls for a discussion of 

any known trends, demands, 

commitments, events or uncertainties 

that are reasonably likely to affect 

liquidity, capital resources or the results 

of operations in a material way. Also, 

instruction 2 of this item requires ‘‘a 

discussion of any aspects of the 

differences between foreign and U.S. 

GAAP, not discussed in the 

reconciliation, that the registrant 

believes is necessary for an 

understanding of the financial 

statements as a whole.’’ Matters that may 

warrant discussion in response to Item 

5 include the following: 

• Material undisclosed uncertainties 

(such as reasonably possible loss 

contingencies), commitments (such as 

those arising from leases), and credit 

risk exposures and concentrations; 

• Material unrecognized obligations 

(such as pension obligations); 

• Material changes in estimates and 

accounting methods, and other factors 

or events affecting comparability; 

• Defaults on debt and material 

restrictions on dividends or other legal 

constraints on the registrant’s use of its 

assets; 

• Material changes in the relative 

amounts of constituent elements 

comprising line items presented on the 

face of the financial statements; 

• Significant terms of financings 

which would reveal material cash 

requirements or constraints; 

• Material subsequent events, such as 

events that affect the recoverability of 

recorded assets; 

• Material related party transactions 

(as addressed by FASB ASC Topic 850, 

Related Party Disclosures) that may 

affect the terms under which material 

revenues or expenses are recorded; and 

• Significant accounting policies and 

measurement assumptions not disclosed 

in the financial statements, including 

methods of costing inventory, 

recognizing revenues, and recording and 

amortizing assets, which may bear upon 

an understanding of operating trends or 

financial condition. 

2. ‘‘Free Distributions’’ by Japanese 

Companies 

Facts: It is the general practice in 

Japan for corporations to issue ‘‘free 

distributions’’ of common stock to 

existing shareholders in conjunction 

with offerings of common stock so that 

such offerings may be made at less than 

market. These free distributions usually 

are from 5 to 10 percent of outstanding 

stock and are accounted for in 

accordance with provisions of the 

Commercial Code of Japan by a transfer 

of the par value of the stock distributed 

from paid-in capital to the common 

stock account. Similar distributions are 

sometimes made at times other than 

when offering new stock and are also 

designated ‘‘free distributions.’’ U.S. 

accounting practice would require that 

the fair value of such shares, if issued 

by U.S. companies, be transferred from 

retained earnings to the appropriate 

capital accounts. 

Question: Should the financial 

statements of Japanese corporations 

included in Commission filings which 

are stated to be prepared in accordance 

with U.S. GAAP be adjusted to account 

for stock distributions of less than 25 

percent of outstanding stock by 

transferring the fair value of such stock 

from retained earnings to appropriate 

capital accounts? 

Interpretive Response: If registrants 

and their independent accountants 

believe that the institutional and 

economic environment in Japan with 

respect to the registrant is sufficiently 

different that U.S. accounting principles 

for stock dividends should not apply to 

free distributions, the staff will not 

object to such distributions being 

accounted for at par value in accordance 

with Japanese practice. If such financial 

statements are identified as being 

prepared in accordance with U.S. 

GAAP, then there should be footnote 

disclosure of the method being used 

which indicates that U.S. companies 

issuing shares in comparable amounts 

would be required to account for them 

as stock dividends, and including in 

such disclosure the fair value of any 

such shares issued during the year and 

the cumulative amount (either in an 

aggregate figure or a listing of the 

amounts by year) of the fair value of 

shares issued over time. 

E. Requirements for Audited or Certified 

Financial Statements 

1. Removed by SAB 103 

2. Qualified Auditors’ Opinions 

Facts: The accountants’ report is 

qualified as to scope of audit, or the 

accounting principles used. 

Question: Does the staff consider the 

requirements for audited or certified 

financial statements met when the 

auditors’ opinion is so qualified? 

Interpretive Response: No. The staff 

does not accept as consistent with the 

requirements of Rule 2–02(b) of 

Regulation S–X financial statements on 

which the auditors’ opinions are 

qualified because of a limitation on the 

scope of the audit, since in these 

situations the auditor was unable to 

perform all the procedures required by 

professional standards to support the 

expression of an opinion. This position 

was discussed in Accounting Series 

Release (ASR) 90 in connection with 

representations concerning the 

verification of prior years’ inventories in 

first audits. 

Financial statements for which the 

auditors’ opinions contain qualifications 

relating to the acceptability of 

accounting principles used or the 

completeness of disclosures made are 

also unacceptable. (See ASR 4, and with 

respect to a ‘‘going concern’’ 

qualification, ASR 115.) 

F. Financial Statement Requirements in 

Filings Involving the Formation of a 

One-Bank Holding Company 

Facts: Holding Company A is 

organized for the purpose of issuing 

common stock to acquire all of the 

common stock of Bank A. Under the 

plan of reorganization, each share of 

common stock of Bank A will be 

exchanged for one share of common 

stock of the holding company. The 

shares of the holding company to be 

issued in the transaction will be 

registered on Form S–4. The holding 

company will not engage in any 

operations prior to consummation of the 

reorganization, and its only significant 

asset after the transaction will be its 

investment in the bank. The bank has 

been furnishing its shareholders with an 

annual report that includes financial 

statements that comply with GAAP. 

Item 14 of Schedule 14A of the proxy 

rules provides that financial statements 

generally are not necessary in proxy 

material relating only to changes in legal 

organization (such as reorganizations 

involving the issuer and one or more of 

its totally held subsidiaries). 

Question 1: Must the financial 

statements and the information required 


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2 Item 801 of Regulation S–K. 

3Rule 3–13 of Regulation S–X. 

4Rule 15d–2 would be applicable if the annual 

report furnished with the Form S–4 was not for the 

registrant’s most recent fiscal year. In such a 

situation, Rule 15d–2 would require the registrant 

to file a special report within 90 days after the 

effective date of the Form S–4 furnishing audited 

financial statements for the most recent fiscal year. 

5Unaudited statements of income and cash flows 

should be furnished for the earliest period. 

by Securities Act Industry Guide 

(‘‘Guide 3’’) 2 for Bank A be included in 

the initial registration statement on 

Form S–4? 

Interpretive Response: No, provided 

that certain conditions are met. The staff 

will not take exception to the omission 

of financial statements and Guide 3 

information in the initial registration 

statement on Form S–4 if all of the 

following conditions are met: 

• There are no anticipated changes in 

the shareholders’ relative equity 

ownership interest in the underlying 

bank assets, except for redemption of no 

more than a nominal number of shares 

of unaffiliated persons who dissent; 

• In the aggregate, only nominal 

borrowings are to be incurred for such 

purposes as organizing the holding 

company, to pay nonaffiliated persons 

who dissent, or to meet minimum 

capital requirements; 

• There are no new classes of stock 

authorized other than those 

corresponding to the stock of Bank A 

immediately prior to the reorganization; 

• There are no plans or arrangements 

to issue any additional shares to acquire 

any business other than Bank A; and, 

• There has been no material adverse 

change in the financial condition of the 

bank since the latest fiscal year-end 

included in the annual report to 

shareholders. 

If at the time of filing the S–4, a letter 

is furnished to the staff stating that all 

of these conditions are met, it will not 

be necessary to request the Division of 

Corporation Finance to waive the 

financial statement or Guide 3 

requirements of Form S–4. 

Although the financial statements 

may be omitted, the filing should 

include a section captioned, ‘‘Financial 

Statements,’’ which states either that an 

annual report containing financial 

statements for at least the latest fiscal 

year prepared in conformity with GAAP 

was previously furnished to 

shareholders or is being delivered with 

the prospectus. If financial statements 

have been previously furnished, it 

should be indicated that an additional 

copy of such report for the latest fiscal 

year will be furnished promptly upon 

request without charge to shareholders. 

The name and address of the person to 

whom the request should be made 

should be provided. One copy of such 

annual report should be furnished 

supplementally with the initial filing for 

purposes of staff review. 

If any nominal amounts are to be 

borrowed in connection with the 

formation of the holding company, a 

statement of capitalization should be 

included in the filing which shows 

Bank A on an historical basis, the pro 

forma adjustments, and the holding 

company on a pro forma basis. A note 

should also explain the pro forma effect, 

in total and per share, which the 

borrowings would have had on net 

income for the latest fiscal year if the 

transaction had occurred at the 

beginning of the period. 

Question 2: Are the financial 

statements of Bank A required to be 

audited for purposes of the initial Form 

S–4 or the subsequent Form 10–K 

report? 

Interpretive Response: The staff will 

not insist that the financial statements 

in the annual report to shareholders 

used to satisfy the requirement of the 

initial Form S–4 be audited. 

The consolidated financial statements 

of the holding company to be included 

in the registrant’s initial report on Form 

10–K should comply with the 

applicable financial statement 

requirements in Regulation S–X at the 

time such annual report is filed. 

However, the regulations also provide 

that the staff may allow one or more of 

the required statements to be unaudited 

where it is consistent with the 

protection of investors.3 Accordingly, 

the policy of the Division of Corporation 

Finance is as follows: 

The registrant should file audited balance 

sheets as of the two most recent fiscal years 

and audited statements of income and cash 

flows for each of the three latest fiscal years, 

with appropriate footnotes and schedules as 

required by Regulation S–X unless the 

financial statements have not previously 

been audited for the periods required to be 

filed. In such cases, the Division will not 

object if the financial statements in the first 

annual report on Form 10–K (or the special 

report filed pursuant to Rule 15d–2) 4 are 

audited only for the two latest fiscal years.5

This policy only applies to filings on Form 

10–K, and not to any Securities Act filings 

made after the initial S–4 filing. 

The above procedure may be followed 

without making a specific request of the 

Division of Corporation Finance for a 

waiver of the financial statement 

requirements of Form 10–K. 

The information required by Guide 3 

should also be provided in the Form 10– 

K for at least the periods for which 

audited financial statements are 

furnished. If some of the statistical 

information for the two most recent 

fiscal years for which audited financial 

statements are included (other than 

information on nonperforming loans 

and the summary of loan loss 

experience) is unavailable and cannot 

be obtained without unwarranted or 

undue burden or expense, such data 

may be omitted provided a brief 

explanation in support of such 

representation is included in the report 

on Form 10–K. In all cases, however, 

information with respect to 

nonperforming loans and loan loss 

experience, or reasonably comparable 

data, must be furnished for at least the 

two latest fiscal years in the initial 10– 

K. Thereafter, for subsequent years in 

reports on Form 10–K, all of the Guide 

3 information is required; Guide 3 

information which had been omitted in 

the initial 10–K in accordance with the 

above procedure can be excluded in any 

subsequent 10–Ks. 

G. Removed by Financial Reporting 

Release (FRR) 55 

H. Removed by FRR 55 

I. Financial Statements of Properties 

Securing Mortgage Loans 

Facts: A registrant files a Securities 

Act registration statement covering a 

maximum of $100 million of securities. 

Proceeds of the offering will be used to 

make mortgage loans on operating 

residential or commercial property. 

Proceeds of the offering will be placed 

in escrow until $1 million of securities 

are sold at which point escrow may be 

broken, making the proceeds 

immediately available for lending, while 

the selling of securities would continue. 

Question 1: Under what 

circumstances are the financial 

statements of a property on which the 

registrant makes or expects to make a 

loan required to be included in a filing? 

Interpretive Response: Rule 3–14 of 

Regulation S–X specifies the 

requirements for financial statements 

when the registrant has acquired one or 

more properties which in the aggregate 

are significant, or since the date of the 

latest balance sheet required has 

acquired or proposes to acquire one or 

more properties which in the aggregate 

are significant. 

Included in the category of properties 

acquired or to be acquired under Rule 

3–14 are operating properties 

underlying certain mortgage loans, 

which in economic substance represent 

an investment in real estate or a joint 

venture rather than a loan. Certain 

characteristics of a lending arrangement 

indicate that the ‘‘lender’’ has the same 

risks and potential rewards as an owner 

or joint venturer. Those characteristics 


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6 [Original footnote removed by SAB 114.] 

7 [Original footnote removed by SAB 114.] 

8The Emerging Issues Task Force (‘‘EITF’’) was 

formed in 1984 to assist the Financial Accounting 

Standards Board in the early identification and 

resolution of emerging accounting issues. Topics to 

be discussed by the EITF are publicly announced 

prior to its meetings and minutes of all EITF 

meetings are available to the public. 

9FASB ASC paragraph 310–10–05–9. 

10The equity kicker (the expected residual profit) 

would typically not be separated from the host 

contract and accounted for as a derivative because 

FASB ASC subparagraph 815–15–25–1(c) exempts 

a hybrid contract from bifurcation if a separate 

instrument with the same terms as the embedded 

equity kicker is not a derivative instrument subject 

to the requirements of FASB ASC Topic 815. 

11Expected residual profit is defined in the ADC 

Arrangements Subsection of FASB ASC Subtopic 

310–10 as the amount of profit, whether called 

interest or another name, such as equity kicker, 

above a reasonable amount of interest and fees 

expected to be earned by the ‘‘lender.’’ 

12FASB ASC Subtopic 360–20 establishes 

standards for the recognition of profit on real estate 

sales transactions. FASB ASC paragraph 360–20– 

40–18 states that the buyer’s initial investment shall 

be adequate to demonstrate the buyer’s commitment 

to pay for the property and shall indicate a 

reasonable likelihood that the seller will collect the 

receivable. Guidance on minimum initial 

investments in various types of real estate is 

provided in FASB ASC paragraphs 360–20–40–55– 

1 and 360–20–40–55–2. 

13FASB ASC paragraph 360–20–40–19 states that 

the buyer’s continuing investment in a real estate 

transaction shall not qualify unless the buyer is 

contractually required to pay each year on its total 

debt for the purchase price of the property an 

amount at least equal to the level annual payment 

that would be needed to pay that debt and interest 

on the unpaid balance over not more than (a) 20 

years for debt for land and (b) the customary 

amortization term of a first mortgage loan by an 

independent established lending institution for 

other real estate. 

14Rule 3–14 states that the financial statements 

of an acquired property should be furnished if the 

acquisition took place during the period for which 

the registrant’s income statements are required. 

Paragraph (b) of the Rule states that the information 

required by the Rule is not required to be included 

in a filing on Form 10–K. That exception is 

consistent with Item 8 of Form 10–K which 

excludes acquired company financial statements, 

which would otherwise be required by Rule 3–05 

of Regulation S–X, from inclusion in filings on that 

Form. Those exceptions are based, in part, on the 

fact that acquired properties and acquired 

companies will generally be included in the 

registrant’s consolidated financial statements from 

the acquisition date. 

are set forth in the Acquisition, 

Development, and Construction 

Arrangements (ADC Arrangements) 

Subsection of FASB ASC Subtopic 310– 

10, Receivables—Overall.6 7 In 

September 1986 the EITF 8 reached a 

consensus on this issue 9 to the effect 

that, although the guidance in the ADC 

Arrangements Subsection of FASB ASC 

Subtopic 310–10 was issued to address 

the real estate ADC arrangements of 

financial institutions, preparers and 

auditors should consider that guidance 

in accounting for shared appreciation 

mortgages, loans on operating real estate 

and real estate ADC arrangements 

entered into by enterprises other than 

financial institutions. 

FASB ASC Subtopic 815–15, 

Derivatives and Hedging—Embedded 

Derivatives, generally requires that 

embedded instruments meeting the 

definition of a derivative and not clearly 

and closely related to the host contract 

be accounted for separately from the 

host instrument. If the embedded 

expected residual profit component of 

an ADC arrangement need not be 

separately accounted for as a derivative 

under FASB ASC Topic 815, then the 

disclosure requirements discussed 

below for ADC loans and similar 

arrangements should be followed.10

In certain cases the ‘‘lender’’ has 

virtually the same potential rewards as 

those of an owner or a joint venturer by 

virtue of participating in expected 

residual profit.11 In addition, the ADC 

Arrangements Subsection of FASB ASC 

Subtopic 310–10 includes a number of 

other characteristics which, when 

considered individually or in 

combination, would suggest that the 

risks of an ADC arrangement are similar 

to those associated with an investment 

in real estate or a joint venture or, 

conversely, that they are similar to those 

associated with a loan. Among those 

other characteristics is whether the 

lender agrees to provide all or 

substantially all necessary funds to 

acquire the property, resulting in the 

borrower having title to, but little or no 

equity in, the underlying property. The 

staff believes that the borrower’s equity 

in the property is adequate to support 

accounting for the transaction as a 

mortgage loan when the borrower’s 

initial investment meets the criteria in 

FASB ASC paragraph 360–20–40–18 

(Property, Plant, and Equipment 

Topic) 12 and the borrower’s payments 

of principal and interest on the loan are 

adequate to maintain a continuing 

investment in the property which meets 

the criteria in FASB ASC paragraph 

360–20–40–19.13

The financial statements of properties 

which will secure mortgage loans made 

or to be made from the proceeds of the 

offering which have the characteristics 

of real estate investments or joint 

ventures should be included as required 

by Rule 3–14 in the registration 

statement when such properties secure 

loans previously made, or have been 

identified as security for probable loans 

prior to effectiveness, and in filings 

made pursuant to the undertaking in 

Item 20D of Securities Act Industry 

Guide 5. 

Rule 1–02(w) of Regulation S–X 

includes the conditions used in 

determining whether an acquisition is 

significant. The separate financial 

statements of an individual property 

should be provided when a property 

would meet the requirements for a 

significant subsidiary under this rule 

using the amount of the ‘‘loan’’ as a 

substitute for the ‘‘investment in the 

subsidiary’’ in computing the specified 

conditions. The combined financial 

statements of properties which are not 

individually significant should also be 

provided. However, the staff will not 

object if the combined financial 

statements of such properties are not 

included if none of the conditions 

specified in Rule 1–02(w), with respect 

to all such properties combined, 

exceeds 20% in the aggregate. 

Under certain circumstances, 

information may also be required 

regarding operating properties 

underlying mortgage loans where the 

terms do not result in the lender having 

virtually the same risks and potential 

rewards as those of owners or joint 

venturers. Generally, the staff believes 

that, where investment risks exist due to 

substantial asset concentration, 

financial and other information should 

be included regarding operating 

properties underlying a mortgage loan 

that represents a significant amount of 

the registrant’s assets. Such presentation 

is consistent with Rule 3–13 of 

Regulation S–X and Rule 408 under the 

Securities Act of 1933. 

Where the amount of a loan exceeds 

20% of the amount in good faith 

expected to be raised in the offering, 

disclosures would be expected to 

consist of financial statements for the 

underlying operating properties for the 

periods contemplated by Rule 3–14. 

Further, where loans on related 

properties are made to a single person 

or group of affiliated persons which in 

the aggregate amount to more than 20% 

of the amount expected to be raised, the 

staff believes that such lending 

arrangements result in a sufficient 

concentration of assets so as to warrant 

the inclusion of financial and other 

information regarding the underlying 

properties. 

Question 2: Will the financial 

statements of the mortgaged properties 

be required in filings made under the 

1934 Act? 

Interpretive Response: Rule 3–09 of 

Regulation S–X specifies the 

requirement for significant, as defined, 

investments in operating entities, the 

operations of which are not included in 

the registrant’s consolidated financial 

statements.14 Accordingly, the staff 

believes that the financial statements of 

properties securing significant loans 

which have the characteristics of real 


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15Rule 3–09(a) states, in part, that ‘‘[i]f any of the 

conditions set forth in [Rule] 1–02(w), substituting 

20 percent for 10 percent in the tests used therein 

to determine significant subsidiary, are met * * * 

separate financial statements * * * shall be filed.’’ 

16Regarding the composition of the borrower’s 

investment, FASB ASC paragraph 310–10–25–20 

indicates that the borrower’s investment may 

include the value of land or other assets contributed 

by the borrower, net of encumbrances. The staff 

emphasizes that such paragraph indicates, ‘‘* * * 

recently acquired property generally should be 

valued at no higher than cost * * *’’ Thus, for such 

recently acquired property, appraisals will not be 

sufficient to justify the use of a value in excess of 

cost. 

17Registrants are reminded that in filings on 

Form 8–K that are triggered in connection with an 

acquisition of an investment-type arrangement, 

separate audited financial statements are required 

for any such arrangement that individually 

constitutes 10% or more. 

estate investments or joint ventures 

should be included in subsequent 

filings as required by Rule 3–09. The 

materiality threshold for determining 

whether such an investment is 

significant is the same as set forth in 

paragraph (a) of that Rule.15

Likewise, the staff believes that filings 

made under the 1934 Act should 

include the same financial and other 

information relating to properties 

underlying any loans which are 

significant as discussed in the last 

paragraph of Question 1, except that in 

the determination of significance the 

20% disclosure threshold should be 

measured using total assets. The staff 

believes that this presentation would be 

consistent with Rule 12b–20 under the 

Securities Exchange Act of 1934. 

Question 3: The interpretive response 

to question 1 indicates that the staff 

believes that the borrower’s equity in an 

operating property is adequate to 

support accounting for the transaction 

as a mortgage loan when the borrower’s 

initial investment meets the criteria in 

FASB ASC paragraph 360–20–40–18 

and the borrower’s payments of 

principal and interest on the loan are 

adequate to maintain a continuing 

investment in the property which meets 

the criteria in FASB ASC paragraph 

360–20–40–19. Is it the staff’s view that 

meeting these criteria is the only way 

the borrower’s equity in the property is 

considered adequate to support 

accounting for the transaction as a 

mortgage loan? 

Interpretive Response: No. It is the 

staff’s position that the determination of 

whether loan accounting is appropriate 

for these arrangements should be made 

by the registrant and its independent 

accountants based on the facts and 

circumstances of the individual 

arrangements, using the guidance 

provided in the ADC Arrangements 

Subsection of FASB ASC Subtopic 310– 

10. As stated in that Subsection, loan 

accounting may not be appropriate 

when the lender participates in 

expected residual profit and has 

virtually the same risks as those of an 

owner, or joint venturer. In assessing the 

question of whether the lender has 

virtually the same risks as an owner, or 

joint venturer, the essential test that 

needs to be addressed is whether the 

borrower has and is expected to 

continue to have a substantial amount at 

risk in the project.16 The criteria 

described in FASB ASC Subtopic 360– 

20, Property, Plant, and Equipment— 

Real Estate Sales, provide a ‘‘safe 

harbor’’ for determining whether the 

borrower has a substantial amount at 

risk in the form of a substantial equity 

investment. The borrower may have a 

substantial amount at risk without 

meeting the criteria described in FASB 

ASC Subtopic 360–20. 

Question 4: What financial statements 

should be included in filings made 

under the Securities Act regarding 

investment-type arrangements that 

individually amount to 10% or more of 

total assets? 

Interpretive Response: In the staff’s 

view, separate audited financial 

statements should be provided for any 

investment-type arrangement that 

constitutes 10% or more of the greater 

of (i) the amount of minimum proceeds 

or (ii) the total assets of the registrant, 

including the amount of proceeds 

raised, as of the date the filing is 

required to be made. Of course, the 

narrative information required by items 

14 and 15 of Form S–11 should also be 

included with respect to these 

investment-type arrangements. 

Question 5: What information must be 

provided under the Securities Act for 

investment-type arrangements that 

individually amount to less than 10%? 

Interpretive Response: No specific 

financial information need be presented 

for investment-type arrangements that 

amount to less than 10%. However, 

where such arrangements aggregate 

more than 20%, a narrative description 

of the general character of the properties 

and arrangements should be included 

that gives an investor an understanding 

of the risks and rewards associated with 

these arrangements. Such information 

may, for example, include a description 

of the terms of the arrangements, 

participation by the registrant in 

expected residual profits, and property 

types and locations. 

Question 6: What financial statements 

should be included in annual reports 

filed under the Exchange Act with 

respect to investment-type arrangements 

that constitute 10% or more of the 

registrant’s total assets? 

Interpretive Response: In annual 

reports filed with the Commission, the 

staff has advised registrants that 

separate audited financial statements 

should be provided for each 

nonconsolidated investment-type 

arrangement that is 20% or more of the 

registrant’s total assets. While the 

distribution is on-going, however, the 

percentage may be calculated using the 

greater of (i) the amount of the 

minimum proceeds or (ii) the total 

assets of the registrant, including the 

amount of proceeds raised, as of the 

date the filing is required to be made. 

In annual reports to shareholders 

registrants may either include the 

separate audited financial statements for 

20% or more nonconsolidated 

investment-type arrangements or, if 

those financial statements are not 

included, present summarized financial 

information for those arrangements in 

the notes to the registrant’s financial 

statements. 

The staff has also indicated that 

separate summarized financial 

information (as defined in Rule 1–02(bb) 

of Regulation S–X) should be provided 

in the footnotes to the registrant’s 

financial statements for each 

nonconsolidated investment-type 

arrangement that is 10% or more but 

less than 20%. Of course, registrants 

should also make appropriate textural 

disclosure with respect to material 

investment-type arrangements in the 

‘‘business’’ and ‘‘property’’ sections of 

their annual reports to the 

Commission.17

Question 7: What information should 

be provided in annual reports filed 

under the Exchange Act with respect to 

investment-type arrangements that do 

not meet the 10% threshold? 

Interpretive Response: The staff 

believes it will not be necessary to 

provide any financial information (full 

or summarized) for investment-type 

arrangements that do not meet the 10% 

threshold. However, in the staff’s view, 

where such arrangements aggregate 

more than 20%, a narrative description 

of the general character of the properties 

and arrangements would be necessary. 

The staff believes that information 

should be included that would give an 

investor an understanding of the risks 

and rewards associated with these 

arrangements. Such information may, 

for example, include a description of the 

terms of the arrangements, participation 

by the registrant in expected residual 

profits, and property types and 

locations. Of course, disclosure 

regarding the operations of such 

components should be included as part 


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18An acquisition which was relatively significant 

in the earliest year for which a registrant is required 

to file financial statements may be insignificant to 

its latest fiscal year due to internal growth and/or 

subsequent acquisitions. Literally applied, Rules 3– 

05 and 1–02(w) might still require separate 

financial statements for the now insignificant 

acquisition. 

19For example, nursing homes, hospitals or cable 

TV systems. This interpretation would not apply to 

businesses for which the relative significance of one 

portion of the business to the total business may be 

altered by post-acquisition decisions as to the 

allocation of incoming orders between plants or 

locations. This bulletin does not address all 

possible cases in which similar relief may be 

appropriate but, rather, attempts to describe a 

general framework within which administrative 

policy has been established. In other 

distinguishable situations, registrants may request 

relief as appropriate to their individual facts and 

circumstances. 

20 If audited pre-acquisition financial statements 

of a business are necessary pursuant to the 

alternative tests described here, the interim period 

following that entity’s latest pre-acquisition fiscal 

year end but prior to its acquisition by the registrant 

generally would be required to be audited. 

21As a matter of policy the staff accepts financial 

statements for periods of not less than 9, 21 and 33 

consecutive months (not more than 12 months may 

be included in any period reported on) as 

substantial compliance with requirements for 

financial statements for 1, 2 and 3 years, 

respectively. 

of the Management’s Discussion and 

Analysis where there is a known trend 

or uncertainty in the operations of such 

properties, either individually or in the 

aggregate, which would be reasonably 

likely to result in a material impact on 

the registrant’s future operations, 

liquidity or capital resources. 

J. Application of Rule 3–05 in Initial 

Public Offerings 

Facts: Rule 3–05 of Regulation S–X 

establishes the financial statement 

requirements for businesses acquired or 

to be acquired. If required, financial 

statements must be provided for one, 

two or three years depending upon the 

relative significance of the acquired 

entity as determined by the application 

of Rule 1–02(w) of Regulation S–X. The 

calculations required for these tests are 

applied by comparison of the financial 

data of the registrant and acquiree(s) for 

the fiscal years most recently completed 

prior to the acquisition. The staff has 

recognized that these tests literally 

applied in some initial public offerings 

may require financial statements for an 

acquired entity which may not be 

significant to investors because the 

registrant has had substantial growth in 

assets and earnings in recent years.18

Question: How should Rules 3–05 and 

1–02(w) of Regulation S–X be applied in 

determining the periods for which 

financial statements of acquirees are 

required to be included in registration 

statements for initial public offerings? 

Interpretive Response: It is the staff’s 

view that initial public offerings 

involving businesses that have been 

built by the aggregation of discrete 

businesses that remain substantially 

intact after acquisition 19 were not 

contemplated during the drafting of 

Rule 3–05 and that the significance of 

an acquired entity in such situations 

may be better measured in relation to 

the size of the registrant at the time the 

registration statement is filed, rather 

than its size at the time the acquisition 

was made. Therefore, for a first time 

registrant, the staff has indicated that in 

applying the significance tests in Rule 

3–05, the three tests in Rule 1–02(w) 

generally can be measured against the 

combined entities, including those to be 

acquired, which comprise the registrant 

at the time the registration statement is 

filed. The staff’s policy is intended to 

ensure that the registration statement 

will include not less than three, two and 

one year(s) of audited financial 

statements for not less than 60%, 80% 

and 90%, respectively, of the 

constituent businesses that will 

comprise the registrant on an ongoing 

basis. In all circumstances, the audited 

financial statements of the registrant are 

required for three years, or since its 

inception if less than three years. The 

requirement to provide the audited 

financial statements of a constituent 

business in the registration statement is 

satisfied for the post-acquisition period 

by including the entity’s results in the 

audited consolidated financial 

statements of the registrant. If additional 

periods are required, the entity’s 

separate audited financial statements for 

the immediate pre-acquisition period(s) 

should be presented.20

In order for the pre-acquisition 

audited financial statements of an 

acquiree to be omitted from the 

registration statement, the following 

conditions must be met: 

a. The combined significance of 

businesses acquired or to be acquired 

for which audited financial statements 

cover a period of less than 9 months 21

may not exceed 10%; 

b. The combined significance of 

businesses acquired or to be acquired 

for which audited financial statements 

cover a period of less than 21 months 

may not exceed 20%; and 

c. The combined significance of 

businesses acquired or to be acquired 

for which audited financial statements 

cover a period of less than 33 months 

may not exceed 40%. 

Combined significance is the total, for 

all included companies, of each 

individual company’s highest level of 

significance computed under the three 

tests of significance. The significance 

tests should be applied to pro forma 

financial statements of the registrant, 

prepared in a manner consistent with 

Article 11 of Regulation S–X. The pro 

forma balance sheet should be as of the 

date of the registrant’s latest balance 

sheet included in the registration 

statement, and should give effect to 

businesses acquired subsequent to the 

end of the latest year or to be acquired 

as if they had been acquired on that 

date. The pro forma statement of 

operations should be for the registrant’s 

most recent fiscal year included in the 

registration statement and should give 

effect to all acquisitions consummated 

during and subsequent to the end of the 

year and probable acquisitions as if they 

had been consummated at the beginning 

of that fiscal year. 

The three tests specified in Rule 1– 

02(w) should be made in comparison to 

the registrant’s pro forma consolidated 

assets and pretax income from 

continuing operations. The assets and 

pretax income of the acquired 

businesses which are being evaluated 

for significance should reflect any new 

cost basis arising from purchase 

accounting. 

Example: On February 20, 20X9 Registrant 

files Form S–1 containing its audited 

consolidated financial statements as of and 

for the three years ended December 31, 20X8. 

Acquisitions since inception have been: 

Acquiree Fiscal year end Date of 

acquisition 

Highest 

significance at 

acquisition 

(percent) 

A ................................................................................................................................. 3/31 1/1/x7 .................. 60 

B ................................................................................................................................. 7/31 4/1/x7 .................. 45 

C ................................................................................................................................. 9/30 9/1/x7 .................. 40 

D ................................................................................................................................. 12/31 2/1/x8 .................. 21 

E ................................................................................................................................. 3/31 11/1/x8 ................ 11 


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22Combined significance is the sum of the 

significance of D’s investment test (13%), E’s 

earnings test (9%) and F’s earnings test (11%). 

23The audited pre-acquisition period need not 

correspond to the acquiree’s pre-acquisition fiscal 

year. However, audited periods must not be for 

periods in excess of 12 months. 

Acquiree Fiscal year end Date of 

acquisition 

Highest 

significance at 

acquisition 

(percent) 

F ................................................................................................................................. 12/31 To be acquired. ... 11 

The following table reflects the application 

of the significance tests to the combined 

financial information at the time the 

registration statement is filed. 

Component entity 

Significance of 

Highest level of 

Assets significance 

(percent) 

Earnings 

(percent) 

Investment 

percent) 

A ............................................................................................... 12 23 12 23 

B ............................................................................................... 10 21 10 21 

C .............................................................................................. 21 3 4 21 

D .............................................................................................. 10 5 13 13 

E ............................................................................................... 4 * 9 3 9 

F ............................................................................................... 2 11 6 11 

* Loss. 

Year 1 (most recent fiscal year)— 

Entity E is the only acquiree for which 

pre-acquisition financial statements may 

be omitted for the latest year since 

significance for each other entity 

exceeds 10% under one or more test. 

Year 2 (preceding fiscal year)— 

Financial statements for E and F may be 

omitted since their combined 

significance is 20% and no other 

combination can be formed with E 

which would not exceed 20%. 

Year 3 (second preceding fiscal 

year)—Financial statements for D, E and 

F may be omitted since the combined 

significance of these entities is 33%22

and no other combination can be formed 

with E and F which would not exceed 

40%. 

The financial statement requirements 

must be satisfied by filing separate preacquisition audited financial statements 

for each entity that was not included in 

the consolidated financial statements for 

the periods set forth above. The 

following table illustrates the 

requirements for this example. 

Component entity Date of acquisition Minimum financial statement 

requirement 

Period in 

consolidated 

financial 

statements 

(months) 

Separate preacquisition audited financial 

statement 

Registrant ............ N/A 33 36 ...............................................

A .......................... 1/1/x7 33 24 9 

B .......................... 4/1/x7 33 21 23 12 

C .......................... 9/1/x7 33 16 17 

D .......................... 2/1/x8 21 11 10 

E .......................... 11/1/x8 ............................................... 2 ...............................................

F .......................... To be acquired. 9 ............................................... 9 

K. Financial Statements of Acquired 

Troubled Financial Institutions 

Facts: Federally insured depository 

institutions are subject to regulatory 

oversight by various Federal agencies 

including the Federal Reserve, Office of 

the Comptroller of the Currency, Federal 

Deposit Insurance Corporation and 

Office of Thrift Supervision. During the 

1980s, certain of these institutions 

experienced significant financial 

difficulties resulting in their inability to 

meet necessary capital and other 

regulatory requirements. The Financial 

Institutions Reform, Recovery and 

Enforcement Act of 1989 was adopted to 

address various issues affecting this 

industry. 

Many troubled institutions have 

merged into stronger institutions or 

reduced the scale of their operations 

through the sale of branches and other 

assets pursuant to recommendation or 

directives of the regulatory agencies. In 

other situations, institutions that were 

taken over by or operated under the 

management of a Federal regulator have 

been reorganized, sold or transferred by 

that Federal agency to financial and 

nonfinancial companies. 

A number of registrants have 

acquired, or are contemplating 

acquisition of, these troubled financial 

institutions. Complete audited financial 

statements of the institutions for the 

periods necessary to comply fully with 

Rule 3–05 of Regulation S–X may not be 

reasonably available in some cases. 

Some troubled institutions have never 

obtained an audit while others have 

been operated under receivership by 

regulators for a significant period 

without audit. Auditors’ reports on the 

financial statements of some of these 

acquirees may not satisfy the 

requirements of Rule 2–02 of Regulation 

S–X because they contain qualifications 

due to audit scope limitations or 

disclaim an opinion. 


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A registrant that acquires a troubled 

financial institution for which complete 

audited financial statements are not 

reasonably available may be precluded 

from raising capital through a public 

offering of securities for up to three 

years following the acquisition because 

of the inability to comply with Rule 3– 

05. 

Question 1: Are there circumstances 

under which the staff would conclude 

that financial statements of an acquired 

troubled financial institution are not 

required by Rule 3–05? 

Interpretive Response: Yes. In some 

case, financial statements will not be 

required because there is not sufficient 

continuity of the acquired entity’s 

operations prior to and after the 

acquisition, so that disclosure of prior 

financial information is material to an 

understanding of future operations, as 

discussed in Rule 11–01 of Regulation 

S–X. For example, such a circumstance 

may exist in the case of an acquisition 

solely of the physical facilities of a 

banking branch with assumption of the 

related deposits if neither incomeproducing assets (other than treasury 

bills and similar low-risk investment) 

nor the management responsible for its 

historical investment and lending 

activities transfer with the branch to the 

registrant. In this and other 

circumstances, where the registrant can 

persuasively demonstrate that 

continuity of operations is substantially 

lacking and a representation to this 

effect is included in the filing, the staff 

will not object to the omission of 

financial statements. However, 

applicable disclosures specified by 

Industry Guide 3, Article 11 of 

Regulation S–X (pro forma information), 

and other information which is 

descriptive of the transaction and of the 

assets acquired and liabilities assumed 

should be furnished to the extent 

reasonably available. 

Question 2: If the acquired financial 

institution is found to constitute a 

business having material continuity of 

operations after the transaction, are 

there circumstances in which the staff 

will waive the requirements of Rule 3– 

05? 

Interpretive Response: Yes. The staff 

believes the circumstances surrounding 

the present restructuring of U.S. 

depository institutions are unique. 

Accordingly, the staff has identified 

situations in which it will grant a 

waiver of the requirements of Rule 3–05 

of Regulation S–X to the extent that 

audited financial statements are not 

reasonably available. 

For purposes of this waiver a 

‘‘troubled financial institution’’ is one 

which either: 

1. Is in receivership, conservatorship 

or is otherwise operating under a similar 

supervisory agreement with a Federal 

financial regulatory agency; or 

2. Is controlled by a Federal 

regulatory agency; or 

3. Is acquired in a Federally assisted 

transaction. 

A registrant that acquires a troubled 

financial institution that is deemed 

significant pursuant to Rule 3–05 may 

omit audited financial statements of the 

acquired entity, if such statements are 

not reasonably available and the total 

acquired assets of the troubled 

institution do not exceed 20% of the 

registrant’s assets before giving effect to 

the acquisition. The staff will consider 

requests for waivers in situations 

involving more significant acquisitions, 

where Federal financial assistance or 

guarantees are an essential part of the 

transaction, or where the nature and 

magnitude of Federal assistance is so 

pervasive as to substantially reduce the 

relevance of such information to an 

assessment of future operations. Where 

financial statements are waived, 

disclosure concerning the acquired 

business as outlined in response to 

Question 3 must be furnished. 

Question 3: Where historical financial 

statements meeting the requirements of 

Rule 3–05 of Regulation S–X are 

waived, what financial statements and 

other disclosures would the staff expect 

to be provided in filings with the 

Commission? 

Interpretive Response: Where 

complete audited historical financial 

statements of a significant acquiree that 

is a troubled financial institution are not 

provided, the staff would expect filings 

to include an audited statement of assets 

acquired and liabilities assumed if the 

acquisition is not already reflected in 

the registrant’s most recent audited 

balance sheet at the time the filing is 

made. Where reasonably available, 

unaudited statement of operations and 

cash flows that are prepared in 

accordance with GAAP and otherwise 

comply with Regulation S–X should be 

filed in lieu of any audited financial 

statements which are not provided if 

historical information may be relevant. 

In all cases where a registrant 

succeeds to assets and/or liabilities of a 

troubled financial institution which are 

significant to the registrant pursuant to 

the tests in Rule 1–02(w) of Regulation 

S–X, narrative description should be 

required, quantified to the extent 

practicable, of the anticipated effects of 

the acquisition on the registrant’s 

financial condition, liquidity, capital 

resources and operating results. If 

Federal financial assistance (including 

any commitments, agreements or 

understandings made with respect to 

capital, accounting or other 

forbearances) may be material, the 

limits, conditions and other variables 

affecting its availability should be 

disclosed, along with an analysis of its 

likely short term and long term effects 

on cash flows and reported results. 

If the transaction will result in the 

recognition of any significant 

intangibles that cannot be separately 

sold, such as goodwill or a core deposit 

intangible, the discussion of the 

transaction should describe the amount 

of such intangibles, the necessarily 

subjective nature of the estimation of 

the life (in the case of intangibles 

subject to amortization) and value of 

such intangibles, and the effects upon 

future results of operations, liquidity 

and capital resources, including any 

consequences if a recognized intangible 

will be excluded from the calculation of 

capital for regulatory purposes. The 

discussion of the impact on future 

operations should specifically address 

the period over which intangibles 

subject to amortization will be 

amortized and the period over which 

any discounts on acquired assets will be 

taken into income. If amortization of 

intangibles subject to amortization will 

be over a period which differs from the 

period over which income from 

discounts on acquired assets will be 

recognized (whether from amortization 

of discounts or sale of discounted 

assets), disclosure should be provided 

concerning the disparate effects of the 

amortization and income recognition on 

operating results for all affected periods. 

Information specified by Industry 

Guide 3 should be furnished to the 

extent applicable and reasonably 

available. For the categories identified 

in the Industry Guide, the registrant 

should disclose the fair value of loans 

and investments acquired, as well as 

their principal amount and average 

contractual yield and term. Amounts of 

acquired investments, loans, or other 

assets that are nonaccrual, past due or 

restructured, or for which other 

collectibility problems are indicated 

should be disclosed. Where historical 

financial statements of the acquired 

entity are furnished, pro forma 

information presented pursuant to Rule 

11–02 should be supplemented as 

necessary with a discussion of the likely 

effects of any Federal assistance and 

changes in operations subsequent to the 

acquisition. To the extent historical 

financial statements meeting all the 

requirements of Rule 3–05 are not 

furnished, the filing should include an 

explanation of the basis for their 

omission. 


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24AU 312 states that the auditor should consider 

audit risk and materiality both in (a) planning and 

setting the scope for the audit and (b) evaluating 

whether the financial statements taken as a whole 

are fairly presented in all material respects in 

conformity with GAAP. The purpose of this SAB is 

to provide guidance to financial management and 

independent auditors with respect to the evaluation 

of the materiality of misstatements that are 

identified in the audit process or preparation of the 

financial statements (i.e., (b) above). This SAB is not 

intended to provide definitive guidance for 

assessing ‘‘materiality’’ in other contexts, such as 

evaluations of auditor independence, as other 

factors may apply. There may be other rules that 

address financial presentation. See, e.g., Rule 2a–4, 

17 CFR 270.2a–4, under the Investment Company 

Act of 1940. 

25As used in this SAB, ‘‘misstatement’’ or 

‘‘omission’’ refers to a financial statement assertion 

that would not be in conformity with GAAP. 

26Concepts Statement 2, paragraph 132. See also 

Concepts Statement 2, Glossary of Terms— 

Materiality. 

27TSC Industries v. Northway, Inc., 426 U.S. 438, 

449 (1976). See also Basic, Inc. v. Levinson, 485 

U.S. 224 (1988). As the Supreme Court has noted, 

determinations of materiality require ‘‘delicate 

assessments of the inferences a ‘reasonable 

shareholder’ would draw from a given set of facts 

and the significance of those inferences to 

him.* * *’’ TSC Industries, 426 U.S. at 450. 

28See, e.g., Concepts Statement 2, paragraphs 

123–124; AU 312A.10 (materiality judgments are 

made in light of surrounding circumstances and 

necessarily involve both quantitative and 

qualitative considerations); AU 312A.34 

(‘‘Qualitative considerations also influence the 

auditor in reaching a conclusion as to whether 

misstatements are material.’’). As used in the 

accounting literature and in this SAB, ‘‘qualitative’’ 

materiality refers to the surrounding circumstances 

that inform an investor’s evaluation of financial 

statement entries. Whether events may be material 

to investors for non-financial reasons is a matter not 

addressed by this SAB. 

29See, e.g., Rule 1–02(o) of Regulation S–X, 17 

CFR 210.1–02(o), Rule 405 of Regulation C, 17 CFR 

230.405, and Rule 12b–2, 17 CFR 240.12b–2; AU 

312A.10–.11, 317.13, 411.04 n. 1, and 508.36; In re 

Kidder Peabody Securities Litigation, 10 F. Supp. 

2d 398 (S.D.N.Y. 1998); Parnes v. Gateway 2000, 

Inc., 122 F.3d 539 (8th Cir. 1997); In re 

Question 4: If an audited statement of 

assets acquired and liabilities assumed 

is required, but certain of the assets 

conveyed in the transaction are subject 

to rights allowing the registrant to put 

the assets back to the seller upon 

completion of a due diligence review, 

will the staff grant an extension of time 

for filing the required financial 

statement until the put period lapses? 

Interpretive Response: If it is 

impracticable to provide an audited 

statement at the time the Form 8–K 

reporting the transaction is filed, an 

extension of time is available under 

certain circumstances. Specifically, if 

more than 25% of the acquired assets 

may be put and the put period does not 

exceed 120 days, the registrant should 

timely file a statement of assets acquired 

and liabilities assumed on an unaudited 

basis with full disclosure of the terms 

and amounts of the put arrangement. 

Within 21 days after the put period 

lapses, the registrant should furnish an 

audited statement of assets acquired and 

liabilities assumed unless the effects of 

the transaction are already reflected in 

an audited balance sheet which has 

been filed with the Commission. 

However, until the audited financial 

statement has been filed, certain 

offerings under the Securities Act of 

1933 would be prevented, as described 

in the instructions to Item 9.01 of Form 

8–K. 

L. Removed by SAB 103 

M. Materiality 

1. Assessing Materiality 

Facts: During the course of preparing 

or auditing year-end financial 

statements, financial management or the 

registrant’s independent auditor 

becomes aware of misstatements in a 

registrant’s financial statements. When 

combined, the misstatements result in a 

4% overstatement of net income and a 

$.02 (4%) overstatement of earnings per 

share. Because no item in the 

registrant’s consolidated financial 

statements is misstated by more than 

5%, management and the independent 

auditor conclude that the deviation from 

GAAP is immaterial and that the 

accounting is permissible.24

Question: FASB ASC paragraph 105– 

10–05–6 (Generally Accepted 

Accounting Principles Topic) states, 

‘‘The provisions of the Codification need 

not be applied to immaterial items.’’ In 

the staff’s view, may a registrant or the 

auditor of its financial statements 

assume the immateriality of items that 

fall below a percentage threshold set by 

management or the auditor to determine 

whether amounts and items are material 

to the financial statements? 

Interpretive Response: No. The staff is 

aware that certain registrants, over time, 

have developed quantitative thresholds 

as ‘‘rules of thumb’’ to assist in the 

preparation of their financial 

statements, and that auditors also have 

used these thresholds in their 

evaluation of whether items might be 

considered material to users of a 

registrant’s financial statements. One 

rule of thumb in particular suggests that 

the misstatement or omission 25 of an 

item that falls under a 5% threshold is 

not material in the absence of 

particularly egregious circumstances, 

such as self-dealing or misappropriation 

by senior management. The staff 

reminds registrants and the auditors of 

their financial statements that exclusive 

reliance on this or any percentage or 

numerical threshold has no basis in the 

accounting literature or the law. 

The use of a percentage as a 

numerical threshold, such as 5%, may 

provide the basis for a preliminary 

assumption that—without considering 

all relevant circumstances—a deviation 

of less than the specified percentage 

with respect to a particular item on the 

registrant’s financial statements is 

unlikely to be material. The staff has no 

objection to such a ‘‘rule of thumb’’ as 

an initial step in assessing materiality. 

But quantifying, in percentage terms, 

the magnitude of a misstatement is only 

the beginning of an analysis of 

materiality; it cannot appropriately be 

used as a substitute for a full analysis of 

all relevant considerations. Materiality 

concerns the significance of an item to 

users of a registrant’s financial 

statements. A matter is ‘‘material’’ if 

there is a substantial likelihood that a 

reasonable person would consider it 

important. In its Concepts Statement 2, 

Qualitative Characteristics of 

Accounting Information, the FASB 

stated the essence of the concept of 

materiality as follows: 

The omission or misstatement of an item 

in a financial report is material if, in the light 

of surrounding circumstances, the magnitude 

of the item is such that 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.26

This formulation in the accounting 

literature is in substance identical to the 

formulation used by the courts in 

interpreting the Federal securities laws. 

The Supreme Court has held that a fact 

is material if there is— 

a substantial likelihood that the * * * fact 

would have been viewed by the reasonable 

investor as having significantly altered the 

‘‘total mix’’ of information made available.27

Under the governing principles, an 

assessment of materiality requires that 

one views the facts in the context of the 

‘‘surrounding circumstances,’’ as the 

accounting literature puts it, or the 

‘‘total mix’’ of information, in the words 

of the Supreme Court. In the context of 

a misstatement of a financial statement 

item, while the ‘‘total mix’’ includes the 

size in numerical or percentage terms of 

the misstatement, it also includes the 

factual context in which the user of 

financial statements would view the 

financial statement item. The shorthand 

in the accounting and auditing literature 

for this analysis is that financial 

management and the auditor must 

consider both ‘‘quantitative’’ and 

‘‘qualitative’’ factors in assessing an 

item’s materiality.28 Court decisions, 

Commission rules and enforcement 

actions, and accounting and auditing 

literature 29 have all considered 

‘‘qualitative’’ factors in various contexts. 


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Westinghouse Securities Litigation, 90 F.3d 696 (3d 

Cir. 1996); In the Matter of W.R. Grace & Co., 

Accounting and Auditing Enforcement Release 

(‘‘AAER’’) 1140 (June 30, 1999); In the Matter of 

Eugene Gaughan, AAER 1141 (June 30, 1999); In the 

Matter of Thomas Scanlon, AAER 1142 (June 30, 

1999); and In re Sensormatic Electronics 

Corporation, Sec. Act Rel. No. 7518 (March 25, 

1998). 

30Concepts Statement 2, paragraph 131. 

31Concepts Statement 2, paragraphs 131 and 166. 

32Concepts Statement 2, paragraph 167. 

33Concepts Statement 2, paragraphs 168–169. 

34Concepts Statement 2, paragraph 170. 

35Concepts Statement 2, paragraph 125. 

36AU 312.11. 

37As stated in Concepts Statement 2, paragraph 

130: 

Another factor in materiality judgments is the 

degree of precision that is attainable in estimating 

the judgment item. The amount of deviation that is 

considered immaterial may increase as the 

attainable degree of precision decreases. For 

example, accounts payable usually can be estimated 

more accurately than can contingent liabilities 

arising from litigation or threats of it, and a 

deviation considered to be material in the first case 

may be quite trivial in the second. 

This SAB is not intended to change current law 

or guidance in the accounting literature regarding 

accounting estimates. See, e.g., FASB ASC Topic 

250, Accounting Changes and Error Corrections. 

38The staff understands that the Big Five Audit 

Materiality Task Force (‘‘Task Force’’) was convened 

in March of 1998 and has made recommendations 

to the Auditing Standards Board including 

suggestions regarding communications with audit 

committees about unadjusted misstatements. See 

generally Big Five Audit Materiality Task Force. 

‘‘Materiality in a Financial Statement Audit— 

Considering Qualitative Factors When Evaluating 

Audit Findings’’ (August 1998). 

39See Concepts Statement 2, paragraph 169. 

40 If management does not expect a significant 

market reaction, a misstatement still may be 

material and should be evaluated under the criteria 

discussed in this SAB. 

41 Intentional management of earnings and 

intentional misstatements, as used in this SAB, do 

not include insignificant errors and omissions that 

may occur in systems and recurring processes in the 

normal course of business. See notes 37 and 49 

infra. 

42Assessments of materiality should occur not 

only at year-end, but also during the preparation of 

each quarterly or interim financial statement. See, 

e.g., In the Matter of Venator Group, Inc., AAER 

1049 (June 29, 1998). 

The FASB has long emphasized that 

materiality cannot be reduced to a 

numerical formula. In its Concepts 

Statement 2, the FASB noted that some 

had urged it to promulgate quantitative 

materiality guides for use in a variety of 

situations. The FASB rejected such an 

approach as representing only a 

‘‘minority view, stating— 

The predominant view is that materiality 

judgments can properly be made only by 

those who have all the facts. The Board’s 

present position is that no general standards 

of materiality could be formulated to take 

into account all the considerations that enter 

into an experienced human judgment.30

The FASB noted that, in certain 

limited circumstances, the Commission 

and other authoritative bodies had 

issued quantitative materiality 

guidance, citing as examples guidelines 

ranging from one to ten percent with 

respect to a variety of disclosures.31 And 

it took account of contradictory studies, 

one showing a lack of uniformity among 

auditors on materiality judgments, and 

another suggesting widespread use of a 

‘‘rule of thumb’’ of five to ten percent of 

net income.32 The FASB also considered 

whether an evaluation of materiality 

could be based solely on anticipating 

the market’s reaction to accounting 

information.33

The FASB rejected a formulaic 

approach to discharging ‘‘the onerous 

duty of making materiality decisions’’ 34

in favor of an approach that takes into 

account all the relevant considerations. 

In so doing, it made clear that— 

[M]agnitude by itself, without regard to the 

nature of the item and the circumstances in 

which the judgment has to be made, will not 

generally be a sufficient basis for a 

materiality judgment.35

Evaluation of materiality requires a 

registrant and its auditor to consider all 

the relevant circumstances, and the staff 

believes that there are numerous 

circumstances in which misstatements 

below 5% could well be material. 

Qualitative factors may cause 

misstatements of quantitatively small 

amounts to be material; as stated in the 

auditing literature: 

As a result of the interaction of quantitative 

and qualitative considerations in materiality 

judgments, misstatements of relatively small 

amounts that come to the auditor’s attention 

could have a material effect on the financial 

statements.36

Among the considerations that may 

well render material a quantitatively 

small misstatement of a financial 

statement item are— 

• Whether the misstatement arises 

from an item capable of precise 

measurement or whether it arises from 

an estimate and, if so, the degree of 

imprecision inherent in the estimate.37

• Whether the misstatement masks a 

change in earnings or other trends. 

• Whether the misstatement hides a 

failure to meet analysts’ consensus 

expectations for the enterprise. 

• Whether the misstatement changes 

a loss into income or vice versa. 

• Whether the misstatement concerns 

a segment or other portion of the 

registrant’s business that has been 

identified as playing a significant role in 

the registrant’s operations or 

profitability. 

• Whether the misstatement affects 

the registrant’s compliance with 

regulatory requirements. 

• Whether the misstatement affects 

the registrant’s compliance with loan 

covenants or other contractual 

requirements. 

• Whether the misstatement has the 

effect of increasing management’s 

compensation—for example, by 

satisfying requirements for the award of 

bonuses or other forms of incentive 

compensation. 

• Whether the misstatement involves 

concealment of an unlawful transaction. 

This is not an exhaustive list of the 

circumstances that may affect the 

materiality of a quantitatively small 

misstatement.38 Among other factors, 

the demonstrated volatility of the price 

of a registrant’s securities in response to 

certain types of disclosures may provide 

guidance as to whether investors regard 

quantitatively small misstatements as 

material. Consideration of potential 

market reaction to disclosure of a 

misstatement is by itself ‘‘too blunt an 

instrument to be depended on’’ in 

considering whether a fact is material.39

When, however, management or the 

independent auditor expects (based, for 

example, on a pattern of market 

performance) that a known 

misstatement may result in a significant 

positive or negative market reaction, 

that expected reaction should be taken 

into account when considering whether 

a misstatement is material.40

For the reasons noted above, the staff 

believes that a registrant and the 

auditors of its financial statements 

should not assume that even small 

intentional misstatements in financial 

statements, for example those pursuant 

to actions to ‘‘manage’’ earnings, are 

immaterial.41 While the intent of 

management does not render a 

misstatement material, it may provide 

significant evidence of materiality. The 

evidence may be particularly 

compelling where management has 

intentionally misstated items in the 

financial statements to ‘‘manage’’ 

reported earnings. In that instance, it 

presumably has done so believing that 

the resulting amounts and trends would 

be significant to users of the registrant’s 

financial statements.42 The staff believes 

that investors generally would regard as 

significant a management practice to 

over- or under-state earnings up to an 

amount just short of a percentage 

threshold in order to ‘‘manage’’ earnings. 

Investors presumably also would regard 

as significant an accounting practice 

that, in essence, rendered all earnings 

figures subject to a managementdirected margin of misstatement. 

The materiality of a misstatement may 

turn on where it appears in the financial 

statements. For example, a misstatement 

may involve a segment of the 


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43See, e.g., In the Matter of W.R. Grace & Co., 

AAER 1140 (June 30, 1999). 

44AU 9326.33. 

45 Id. 

46The auditing literature notes that the ‘‘concept 

of materiality recognizes that some matters, either 

individually or in the aggregate, are important for 

fair presentation of financial statements in 

conformity with generally accepted accounting 

principles.’’ AU 312.03. See also AU 312.04. 

47AU 312.34. Quantitative materiality 

assessments often are made by comparing 

adjustments to revenues, gross profit, pretax and net 

income, total assets, stockholders’ equity, or 

individual line items in the financial statements. 

The particular items in the financial statements to 

be considered as a basis for the materiality 

determination depend on the proposed adjustment 

to be made and other factors, such as those 

identified in this SAB. For example, an adjustment 

to inventory that is immaterial to pretax income or 

net income may be material to the financial 

statements because it may affect a working capital 

ratio or cause the registrant to be in default of loan 

covenants. 

48AU 508.36. 

49AU 312.34. 

50AU 380.09. 

51FASB ASC paragraph 105–10–05–6 states that 

‘‘[t]he provisions of the Codification need not be 

applied to immaterial items.’’ This SAB is 

consistent with that provision of the Codification. 

In theory, this language is subject to the 

interpretation that the registrant is free intentionally 

to set forth immaterial items in financial statements 

in a manner that plainly would be contrary to 

GAAP if the misstatement were material. The staff 

believes that the FASB did not intend this result. 

52 15 U.S.C. 78m(b)(2)–(7). 

registrant’s operations. In that instance, 

in assessing materiality of a 

misstatement to the financial statements 

taken as a whole, registrants and their 

auditors should consider not only the 

size of the misstatement but also the 

significance of the segment information 

to the financial statements taken as a 

whole.43 ‘‘A misstatement of the revenue 

and operating profit of a relatively small 

segment that is represented by 

management to be important to the 

future profitability of the entity’’ 44 is 

more likely to be material to investors 

than a misstatement in a segment that 

management has not identified as 

especially important. In assessing the 

materiality of misstatements in segment 

information—as with materiality 

generally— 

situations may arise in practice where the 

auditor will conclude that a matter relating 

to segment information is qualitatively 

material even though, in his or her judgment, 

it is quantitatively immaterial to the financial 

statements taken as a whole.45

Aggregating and Netting Misstatements 

In determining whether multiple 

misstatements cause the financial 

statements to be materially misstated, 

registrants and the auditors of their 

financial statements should consider 

each misstatement separately and the 

aggregate effect of all misstatements.46 A 

registrant and its auditor should 

evaluate misstatements in light of 

quantitative and qualitative factors and 

‘‘consider whether, in relation to 

individual amounts, subtotals, or totals 

in the financial statements, they 

materially misstate the financial 

statements taken as a whole.’’ 47 This 

requires consideration of— 

the significance of an item to a particular 

entity (for example, inventories to a 

manufacturing company), the pervasiveness 

of the misstatement (such as whether it 

affects the presentation of numerous 

financial statement items), and the effect of 

the misstatement on the financial statements 

taken as a whole.* * * 48

Registrants and their auditors first 

should consider whether each 

misstatement is material, irrespective of 

its effect when combined with other 

misstatements. The literature notes that 

the analysis should consider whether 

the misstatement of ‘‘individual 

amounts’’ causes a material 

misstatement of the financial statements 

taken as a whole. As with materiality 

generally, this analysis requires 

consideration of both quantitative and 

qualitative factors. 

If the misstatement of an individual 

amount causes the financial statements 

as a whole to be materially misstated, 

that effect cannot be eliminated by other 

misstatements whose effect may be to 

diminish the impact of the misstatement 

on other financial statement items. To 

take an obvious example, if a registrant’s 

revenues are a material financial 

statement item and if they are materially 

overstated, the financial statements 

taken as a whole will be materially 

misleading even if the effect on earnings 

is completely offset by an equivalent 

overstatement of expenses. 

Even though a misstatement of an 

individual amount may not cause the 

financial statements taken as a whole to 

be materially misstated, it may 

nonetheless, when aggregated with 

other misstatements, render the 

financial statements taken as a whole to 

be materially misleading. Registrants 

and the auditors of their financial 

statements accordingly should consider 

the effect of the misstatement on 

subtotals or totals. The auditor should 

aggregate all misstatements that affect 

each subtotal or total and consider 

whether the misstatements in the 

aggregate affect the subtotal or total in 

a way that causes the registrant’s 

financial statements taken as a whole to 

be materially misleading.49

The staff believes that, in considering 

the aggregate effect of multiple 

misstatements on a subtotal or total, 

registrants and the auditors of their 

financial statements should exercise 

particular care when considering 

whether to offset (or the appropriateness 

of offsetting) a misstatement of an 

estimated amount with a misstatement 

of an item capable of precise 

measurement. As noted above, 

assessments of materiality should never 

be purely mechanical; given the 

imprecision inherent in estimates, there 

is by definition a corresponding 

imprecision in the aggregation of 

misstatements involving estimates with 

those that do not involve an estimate. 

Registrants and auditors also should 

consider the effect of misstatements 

from prior periods on the current 

financial statements. For example, the 

auditing literature states, 

Matters underlying adjustments proposed 

by the auditor but not recorded by the entity 

could potentially cause future financial 

statements to be materially misstated, even 

though the auditor has concluded that the 

adjustments are not material to the current 

financial statements.50

This may be particularly the case where 

immaterial misstatements recur in 

several years and the cumulative effect 

becomes material in the current year. 

2. Immaterial Misstatements That Are 

Intentional 

Facts: A registrant’s management 

intentionally has made adjustments to 

various financial statement items in a 

manner inconsistent with GAAP. In 

each accounting period in which such 

actions were taken, none of the 

individual adjustments is by itself 

material, nor is the aggregate effect on 

the financial statements taken as a 

whole material for the period. The 

registrant’s earnings ‘‘management’’ has 

been effected at the direction or 

acquiescence of management in the 

belief that any deviations from GAAP 

have been immaterial and that 

accordingly the accounting is 

permissible. 

Question: In the staff’s view, may a 

registrant make intentional immaterial 

misstatements in its financial 

statements? 

Interpretive Response: No. In certain 

circumstances, intentional immaterial 

misstatements are unlawful. 

Considerations of the Books and 

Records Provisions Under the Exchange 

Act 

Even if misstatements are 

immaterial,51 registrants must comply 

with Sections 13(b)(2)—(7) of the 

Securities Exchange Act of 1934 (the 

‘‘Exchange Act’’).52 Under these 

provisions, each registrant with 


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53 15 U.S.C. 78l. 

54 15 U.S.C. 78o(d). 

55Criminal liability may be imposed if a person 

knowingly circumvents or knowingly fails to 

implement a system of internal accounting controls 

or knowingly falsifies books, records or accounts. 

15 U.S.C. 78m(4) and (5). See also Rule 13b2–1 

under the Exchange Act, 17 CFR 240.13b2–1, which 

states, ‘‘No person shall, directly or indirectly, 

falsify or cause to be falsified, any book, record or 

account subject to Section 13(b)(2)(A) of the 

Securities Exchange Act.’’ 

56 15 U.S.C. 78m(b)(7). The books and records 

provisions of section 13(b) of the Exchange Act 

originally were passed as part of the Foreign 

Corrupt Practices Act (‘‘FCPA’’). In the conference 

committee report regarding the 1988 amendments 

to the FCPA, the committee stated: 

The conference committee adopted the prudent 

man qualification in order to clarify that the current 

standard does not connote an unrealistic degree of 

exactitude or precision. The concept of 

reasonableness of necessity contemplates the 

weighing of a number of relevant factors, including 

the costs of compliance. 

Cong. Rec. H2116 (daily ed. April 20, 1988). 

57So far as the staff is aware, there is only one 

judicial decision that discusses Section 13(b)(2) of 

the Exchange Act in any detail, SEC v. World-Wide 

Coin Investments, Ltd., 567 F. Supp. 724 (N.D. Ga. 

1983), and the courts generally have found that no 

private right of action exists under the accounting 

and books and records provisions of the Exchange 

Act. See e.g., Lamb v. Phillip Morris Inc., 915 F.2d 

1024 (6th Cir. 1990) and JS Service Center 

Corporation v. General Electric Technical Services 

Company, 937 F. Supp. 216 (S.D.N.Y. 1996). 

58The Commission adopted the address as a 

formal statement of policy in Securities Exchange 

Act Release No. 17500 (January 29, 1981), 46 FR 

11544 (February 9, 1981), 21 SEC Docket 1466 

(February 10, 1981). 

59 Id. at 46 FR 11546. 

60 Id. 

61For example, the conference report regarding 

the 1988 amendments to the FCPA stated: 

The Conferees intend to codify current Securities 

and Exchange Commission (SEC) enforcement 

policy that penalties not be imposed for 

insignificant or technical infractions or inadvertent 

conduct. The amendment adopted by the Conferees 

[Section 13(b)(4)] accomplishes this by providing 

that criminal penalties shall not be imposed for 

failing to comply with the FCPA’s books and 

records or accounting provisions. This provision 

[Section 13(b)(5)] is meant to ensure that criminal 

penalties would be imposed where acts of 

commission or omission in keeping books or 

records or administering accounting controls have 

the purpose of falsifying books, records or accounts, 

or of circumventing the accounting controls set 

forth in the Act. This would include the deliberate 

falsification of books and records and other conduct 

calculated to evade the internal accounting controls 

requirement. 

Cong. Rec. H2115 (daily ed. April 20, 1988). 

62As Chairman Williams noted with respect to 

the internal control provisions of the FCPA, 

‘‘[t]housands of dollars ordinarily should not be 

spent conserving hundreds.’’ 46 FR 11546. 

63 Id., at 11547. 

64Section 10A(f) defines, for purposes of Section 

10A, an ‘‘illegal act’’ as ‘‘an act or omission that 

violates any law, or any rule or regulation having 

the force of law.’’ This is broader than the definition 

of an ‘‘illegal act’’ in AU 317.02, which states, 

‘‘Illegal acts by clients do not include personal 

misconduct by the entity’s personnel unrelated to 

their business activities.’’ 

securities registered pursuant to Section 

12 of the Exchange Act,53 or required to 

file reports pursuant to Section 15(d),54

must make and keep books, records, and 

accounts, which, in reasonable detail, 

accurately and fairly reflect the 

transactions and dispositions of assets 

of the registrant and must maintain 

internal accounting controls that are 

sufficient to provide reasonable 

assurances that, among other things, 

transactions are recorded as necessary to 

permit the preparation of financial 

statements in conformity with GAAP.55

In this context, determinations of what 

constitutes ‘‘reasonable assurance’’ and 

‘‘reasonable detail’’ are based not on a 

‘‘materiality’’ analysis but on the level of 

detail and degree of assurance that 

would satisfy prudent officials in the 

conduct of their own affairs.56

Accordingly, failure to record accurately 

immaterial items, in some instances, 

may result in violations of the securities 

laws. 

The staff recognizes that there is 

limited authoritative guidance 57

regarding the ‘‘reasonableness’’ standard 

in Section 13(b)(2) of the Exchange Act. 

A principal statement of the 

Commission’s policy in this area is set 

forth in an address given in 1981 by 

then Chairman Harold M. Williams.58 In 

his address, Chairman Williams noted 

that, like materiality, ‘‘reasonableness’’ is 

not an ‘‘absolute standard of exactitude 

for corporate records.’’ 59 Unlike 

materiality, however, ‘‘reasonableness’’ 

is not solely a measure of the 

significance of a financial statement 

item to investors. ‘‘Reasonableness,’’ in 

this context, reflects a judgment as to 

whether an issuer’s failure to correct a 

known misstatement implicates the 

purposes underlying the accounting 

provisions of Sections 13(b)(2)—(7) of 

the Exchange Act.60

In assessing whether a misstatement 

results in a violation of a registrant’s 

obligation to keep books and records 

that are accurate ‘‘in reasonable detail,’’ 

registrants and their auditors should 

consider, in addition to the factors 

discussed above concerning an 

evaluation of a misstatement’s potential 

materiality, the factors set forth below. 

• The significance of the 

misstatement. Though the staff does not 

believe that registrants need to make 

finely calibrated determinations of 

significance with respect to immaterial 

items, plainly it is ‘‘reasonable’’ to treat 

misstatements whose effects are clearly 

inconsequential differently than more 

significant ones. 

• How the misstatement arose. It is 

unlikely that it is ever ‘‘reasonable’’ for 

registrants to record misstatements or 

not to correct known misstatements— 

even immaterial ones—as part of an 

ongoing effort directed by or known to 

senior management for the purposes of 

‘‘managing’’ earnings. On the other hand, 

insignificant misstatements that arise 

from the operation of systems or 

recurring processes in the normal course 

of business generally will not cause a 

registrant’s books to be inaccurate ‘‘in 

reasonable detail.’’ 61

• The cost of correcting the 

misstatement. The books and records 

provisions of the Exchange Act do not 

require registrants to make major 

expenditures to correct small 

misstatements.62 Conversely, where 

there is little cost or delay involved in 

correcting a misstatement, failing to do 

so is unlikely to be ‘‘reasonable.’’ 

• The clarity of authoritative 

accounting guidance with respect to the 

misstatement. Where reasonable minds 

may differ about the appropriate 

accounting treatment of a financial 

statement item, a failure to correct it 

may not render the registrant’s financial 

statements inaccurate ‘‘in reasonable 

detail.’’ Where, however, there is little 

ground for reasonable disagreement, the 

case for leaving a misstatement 

uncorrected is correspondingly weaker. 

There may be other indicators of 

‘‘reasonableness’’ that registrants and 

their auditors may ordinarily consider. 

Because the judgment is not 

mechanical, the staff will be inclined to 

continue to defer to judgments that 

‘‘allow a business, acting in good faith, 

to comply with the Act’s accounting 

provisions in an innovative and costeffective way.’’ 63

The Auditor’s Response to Intentional 

Misstatements 

Section 10A(b) of the Exchange Act 

requires auditors to take certain actions 

upon discovery of an ‘‘illegal act.’’ 64 The 

statute specifies that these obligations 

are triggered ‘‘whether or not [the illegal 

acts are] perceived to have a material 

effect on the financial statements of the 

issuer. * * *’’ Among other things, 

Section 10A(b)(1) requires the auditor to 

inform the appropriate level of 

management of an illegal act (unless 

clearly inconsequential) and assure that 

the registrant’s audit committee is 

‘‘adequately informed’’ with respect to 

the illegal act. 

As noted, an intentional misstatement 

of immaterial items in a 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 


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65An 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. 

66Although 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. 

68Auditors should document their 

determinations in accordance with SAS 96, SAS 99, 

and other appropriate sections of the audit 

literature. 

69See, e.g., SAS 99. 

70Report 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). 

71AU 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. * * * 

72See AU 411.05. 

73The 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. 

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

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

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, 

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

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

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

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, 


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74For 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. 

75Topic 1N addresses certain of these 

quantitative issues, but does not alter the analysis 

required by Topic 1M. 

76Concepts Statement 2, paragraph 132. See also 

Concepts Statement 2, Glossary of Terms— 

Materiality. 

77See definition of ‘‘error in previously issued 

financial statements’’ in the FASB ASC Master 

Glossary. 

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. 

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. 

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. 

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. 

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

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 


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78FASB ASC paragraph 250–10–45–23. 

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. 

$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

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. 

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 


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1As 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. 2See SAB 40, Topic 12.A.3.c. 

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 acquisitionrelated 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

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 valueoriented 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. 

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. 


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3As announced in Financial Reporting Release 

No. 2 (July 9, 1982). 

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: 

(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 fullcost 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 


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1Whether 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. 

2The 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. 

3The 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.’’ 

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’’). 

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. 

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. 

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 


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4As prescribed by FASB ASC Topic 718, 

Compensation—Stock Compensation. 

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. 

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. 


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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 


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1Estimating the fair value of the common stock 

issued, however, is not appropriate when the stock 

is closely held and/or seldom or ever traded. 

2The 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. 

3The 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. 

4The 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. 

5For 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. 

6A 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.’’ 

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. 

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? 

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. 

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 


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Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17217 

7 In ASR 293 (July 2, 1981) see Financial 

Reporting Codification § 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 * * *’’ 8 [Original footnote removed by SAB 114.] 

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. 

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. 

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 reexamine 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 onethird 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

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 


jlentini on DSKJ8SOYB1PROD with RULES2
17218 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

9The 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. 

10Related parties as used herein are as defined in 

the FASB ASC Master Glossary. 

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 nearterm 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 availablefor-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 31⁄2 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. 

Question 1: What is the staff’s 

position with respect to discounting 

claims liabilities related to shortduration 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. 

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. 


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Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17219 

11See FASB ASC paragraph 225–20–45–2. 

12FASB 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. 

13Examples 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. 

14The 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. 

Additionally, since the charges are not 

both unusual and infrequent11 they are 

not presented in the income statement 

as extraordinary items. 

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 subtotal 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. 

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 decisiondependent, 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. 

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 


jlentini on DSKJ8SOYB1PROD with RULES2
17220 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

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. 

16As 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. 

the balance sheet, results of operations 

or cash flows generally is appropriate. 

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. 

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 $793⁄8 per share. The 

difference, $205⁄8, 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. 

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 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17221 

17See Question 3 regarding variable increasing 

rate preferred stocks. 

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. 

19Application 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. 

20The staff first publicly expressed its view as to 

the appropriate accounting at the December 3–4, 

1986 meeting of the EITF. 

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). 

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

Beginning of year 

(BOY) 

Imputed dividend 

(8% of carrying 

amount at BOY) 

End of year 

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 $10018 would reflect 

dividend cost of 8%, the market rate at 

time of issuance. 

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. 

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). 

R. Removed by SAB 103 

S. Quasi-Reorganization 

Facts: As a consequence of significant 

operating losses and/or recent writedowns 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 


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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. 

22ASR 25. 

23Section 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 quasireorganization, 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. 

25FASB 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. 

26Certain 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. 

27Certain 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. 

28See footnote 27. 29Section 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) 

30FASB 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 quasireorganization 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 quasireorganization. A new entity would not have tax 

benefits attributable to operating losses or tax 

credits that arose before its organization date.’’ 

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. 

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? 

Interpretive Response: No. The staff 

believes a deficit reclassification of any 

nature is considered to be a quasireorganization. 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

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 quasireorganization 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

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) 

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

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 quasireorganization, 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? 

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 paidin 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

The staff believes that all registrants 

that comply with the requirements of 

Section 210 in effecting a quasiVerDate Mar<15>2010 18:17 Mar 25, 2011 Jkt 223001 PO 00000 Frm 00032 Fmt 4701 Sfmt 4700 E:\FR\FM\28MRR2.SGM 28MRR2

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31 [Original footnote removed by SAB 114.] 

32FASB 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.’’ 

33FASB ASC paragraph 250–10–45–12. 

34The 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.’’ 

35The 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; longterm 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. 

36For example, SAB Topic 1.B indicates that the 

separate financial statements of a subsidiary should 

reflect any costs of its operations which are 

incurred by the parent on its behalf. Additionally, 

the staff notes that AICPA Technical Practice Aids 

§ 4160 also indicates that the payment by principal 

stockholders of a company’s debt should be 

accounted for as a capital contribution. 

37However, in some circumstances it is necessary 

to reflect, either in the historical financial 

statements or a pro forma presentation (depending 

on the circumstances), related party transactions at 

amounts other than those indicated by their terms. 

Two such circumstances are addressed in Staff 

Accounting Bulletin Topic 1.B.1, Questions 3 and 

4. Another example is where the terms of a material 

contract with a related party are expected to change 

upon the completion of an offering (i.e., the 

principal shareholder requires payment for services 

which had previously been contributed by the 

shareholder to the company). 

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 paidin capital. 

Question 5: If a company had 

previously recorded a quasireorganization that only resulted in the 

elimination of a deficit in retained 

earnings, may the company reverse such 

entry and ‘‘undo’’ its quasireorganization? 

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

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. 

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 sharebased 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. 

The staff believes that the problem of 

separating the benefit to the principal 

stockholder from the benefit to the 

company cited in FASB ASC Topic 718 

is not limited to transactions involving 

stock compensation. Therefore, similar 

accounting is required in this and 

other 36 transactions where a principal 

stockholder pays an expense for the 

company, unless the stockholder’s 

action is caused by a relationship or 

obligation completely unrelated to his 

position as a stockholder or such action 

clearly does not benefit the company. 

Some registrants and their 

accountants have taken the position that 

since FASB ASC Topic 850, Related 

Party Disclosures, applies to these 

transactions and requires only the 

disclosure of material related party 

transactions, the staff should not 

analogize to the accounting called for by 

FASB ASC paragraph 718–10–15–4 for 

transactions other than those 

specifically covered by it. The staff 

notes, however, that FASB ASC Topic 

850 does not address the measurement 

of related party transactions and that, as 

a result, such transactions are generally 

recorded at the amounts indicated by 

their terms.37 However, the staff 

believes that transactions of the type 

described above differ from the typical 

related party transactions. 

The transactions for which FASB ASC 

Topic 850 requires disclosure generally 

are those in which a company receives 

goods or services directly from, or 

provides goods or services directly to, a 

related party, and the form and terms of 

such transactions may be structured to 

produce either a direct or indirect 

benefit to the related party. The 

participation of a related party in such 

a transaction negates the presumption 

that transactions reflected in the 

financial statements have been 

consummated at arm’s length. 

Disclosure is therefore required to 

compensate for the fact that, due to the 

related party’s involvement, the terms of 

the transaction may produce an 

accounting measurement for which a 

more faithful measurement may not be 

determinable. 

However, transactions of the type 

discussed in the facts given do not have 

such problems of measurement and 

appear to be transacted to provide a 

benefit to the stockholder through the 

enhancement or maintenance of the 

value of the stockholder’s investment. 

The staff believes that the substance of 

such transactions is the payment of an 

expense of the company through 

contributions by the stockholder. 

Therefore, the staff believes it would be 

inappropriate to account for such 

transactions according to the form of the 

transaction. 

U. Removed by SAB 112 

V. Certain Transfers of Nonperforming 

Assets 

Facts: A financial institution desires 

to reduce its nonaccrual or reduced rate 

loans and other nonearning assets, 

including foreclosed real estate 

(collectively, ‘‘nonperforming assets’’). 

Some or all of such nonperforming 

assets are transferred to a newly-formed 

entity (the ‘‘new entity’’). The financial 


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38 [Original footnote removed by SAB 114.] 

39The staff recognizes that the determination of 

whether the financial institution retains a 

participation in the rewards of ownership will 

require an analysis of the facts and circumstances 

of each individual transaction. Generally, the staff 

believes that, in order to conclude that the financial 

institution has disposed of the assets in substance, 

the management fee arrangement should not enable 

the financial institution to participate to any 

significant extent in the potential increases in cash 

flows or value of the assets, and the terms of the 

arrangement, including provisions for 

discontinuance of services, must be substantially 

similar to management arrangements with third 

parties. 

40The carrying value should be reduced by any 

allocable allowance for credit losses or other 

valuation allowances. The staff believes that the 

loss recognized for the excess of the net carrying 

value over the fair value should be considered a 

credit loss and this should not be included by the 

financial institution as loss on disposition. 

41The staff notes that FASB ASC paragraph 942– 

810–45–2 (Financial Services—Depository and 

Lending Topic) provides guidance that the newly 

created ‘‘liquidating bank’’ should continue to report 

its assets and liabilities at fair values at the date of 

the financial statements. 

42FASB ASC paragraph 845–10–30–14 

(Nonmonetary Transactions Topic) provides 

guidance that an enterprise that distributes loans to 

its owners should report such distribution at fair 

value. 

institution, as consideration for 

transferring the nonperforming assets, 

may receive (a) the cash proceeds of 

debt issued by the new entity to third 

parties, (b) a note or other redeemable 

instrument issued by the new entity, or 

(c) a combination of (a) and (b). The 

residual equity interests in the new 

entity, which carry voting rights, 

initially owned by the financial 

institution, are transferred to outsiders 

(for example, via distribution to the 

financial institution’s shareholders or 

sale or contribution to an unrelated 

third party). 

The financial institution typically will 

manage the assets for a fee, providing 

necessary services to liquidate the 

assets, but otherwise does not have the 

right to appoint directors or legally 

control the operations of the new entity. 

FASB ASC Topic 860, Transfers and 

Servicing, provides guidance for 

determining when a transfer of financial 

assets can be recognized as a sale. The 

interpretive guidance provided in 

response to Questions 1 and 2 of this 

SAB does not apply to transfers of 

financial assets falling within the scope 

of FASB ASC Topic 860. Because FASB 

ASC Topic 860 does not apply to 

distributions of financial assets to 

shareholders or a contribution of such 

assets to unrelated third parties, the 

interpretive guidance provided in 

response to Questions 1 and 2 of this 

SAB would apply to such conveyances. 

Further, registrants should consider 

the guidance contained in FASB ASC 

Topic 810, Consolidation, in 

determining whether it should 

consolidate the newly-formed entity. 

Question 1: What factors should be 

considered in determining whether such 

transfer of nonperforming assets can be 

accounted for as a disposition by the 

financial institution? 

Interpretive Response: The staff 

believes that determining whether 

nonperforming assets have been 

disposed of in substance requires an 

assessment as to whether the risks and 

rewards of ownership have been 

transferred.38 The staff believes that the 

transfer described should not be 

accounted for as a sale or disposition if 

(a) the transfer of nonperforming assets 

to the new entity provides for recourse 

by the new entity to the transferor 

financial institution, (b) the financial 

institution directly or indirectly 

guarantees debt of the new entity in 

whole or in part, (c) the financial 

institution retains a participation in the 

rewards of ownership of the transferred 

assets, for example through a higher 

than normal incentive or other 

management fee arrangement,39 or (d) 

the fair value of any material non-cash 

consideration received by the financial 

institution (for example, a note or other 

redeemable instrument) cannot be 

reasonably estimated. Additionally, the 

staff believes that the accounting for the 

transfer as a sale or disposition 

generally is not appropriate where the 

financial institution retains rewards of 

ownership through the holding of 

significant residual equity interests or 

where third party holders of such 

interests do not have a significant 

amount of capital at risk. 

Where accounting for the transfer as 

a sale or disposition is not appropriate, 

the nonperforming assets should remain 

on the financial institution’s balance 

sheet and should continue to be 

disclosed as nonaccrual, past due, 

restructured or foreclosed, as 

appropriate, and the debt of the new 

entity should be recorded by the 

financial institution. 

Question 2: If the transaction is 

accounted for as a sale to an 

unconsolidated party, at what value 

should the transfer be recorded by the 

financial institution? 

Interpretive Response: The staff 

believes that the transfer should be 

recorded by the financial institution at 

the fair value of assets transferred (or, if 

more clearly evident, the fair value of 

assets received) and a loss recognized by 

the financial institution for any excess 

of the net carrying value 40 over the fair 

value.41 Fair value is the amount that 

would be realizable in an outright sale 

to an unrelated third party for cash.42

The same concepts should be applied in 

determining fair value of the transferred 

assets, i.e., if an active market exists for 

the assets transferred, then fair value is 

equal to the market value. If no active 

market exists, but one exists for similar 

assets, the selling prices in that market 

may be helpful in estimating the fair 

value. If no such market price is 

available, a forecast of expected cash 

flows, discounted at a rate 

commensurate with the risks involved, 

may be used to aid in estimating the fair 

value. In situations where discounted 

cash flows are used to estimate fair 

value of nonperforming assets, the staff 

would expect that the interest rate used 

in such computations will be 

substantially higher than the cost of 

funds of the financial institution and 

appropriately reflect the risk of holding 

these nonperforming assets. Therefore, 

the fair value determined in such a way 

will be lower than the amount at which 

the assets would have been carried by 

the financial institution had the transfer 

not occurred, unless the financial 

institution had been required under 

GAAP to carry such assets at market 

value or the lower of cost or market 

value. 

Question 3: Where the transaction 

may appropriately be accounted for as a 

sale to an unconsolidated party and the 

financial institution receives a note 

receivable or other redeemable 

instrument from the new entity, how 

should such asset be disclosed pursuant 

to Item III C, ‘‘Risk Elements,’’ of 

Industry Guide 3? What factors should 

be considered related to the subsequent 

accounting for such instruments 

received? 

Interpretive Response: The staff 

believes that the financial institution 

may exclude the note receivable or other 

asset from its Risk Elements disclosures 

under Guide 3 provided that: (a) The 

receivable itself does not constitute a 

nonaccrual, past due, restructured, or 

potential problem loan that would 

require disclosure under Guide 3, and 

(b) the underlying collateral is described 

in sufficient detail to enable investors to 

understand the nature of the note 

receivable or other asset, if material, 

including the extent of any overcollateralization. The description of the 

collateral normally would include 

material information similar to that 

which would be provided if such assets 

were owned by the financial institution, 

including pertinent Risk Element 

disclosures. 

The staff notes that, in situations in 

which the transaction is accounted for 

as a sale to an unconsolidated party and 

a portion of the consideration received 

by the registrant is debt or another 


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43Typically, the financial institution’s claim on 

the new entity is subordinate to other debt 

instruments and thus the financial institution will 

incur any losses beyond those incurred by the 

permanent equity holders. 

44FASB ASC paragraph 944–40–30–1 prescribes 

that ‘‘[t]he liability for unpaid claims shall be based 

on the estimated ultimate cost of settling the claims 

(including the effects of inflation and other societal 

and economic factors), using past experience 

adjusted for current trends, and any other factors 

that would modify past experience.’’ [Footnote 

reference omitted] 

45FASB ASC paragraphs 450–20–50–3 through 

450–20–50–4 provide guidance that if no accrual is 

made for a loss contingency because one or both of 

the conditions in FASB ASC paragraph 450–20–25– 

2 are not met, or if an exposure to loss exists in 

excess of the amount accrued pursuant to the 

provisions of FASB ASC paragraph 450–20–25–2, 

disclosure of the contingency shall be made when 

there is at least a reasonable possibility that a loss 

or an additional loss may have been incurred. The 

disclosure shall indicate the nature of the 

contingency and shall give an estimate of the 

possible loss or range of loss or state that such an 

estimate cannot be made.’’ [Footnote reference 

omitted and emphasis added.] 

46FASB ASC Topic 275 provides that disclosures 

regarding certain significant estimates should be 

made when certain criteria are met. The guidance 

provides that the disclosure shall indicate the 

nature of the uncertainty and include an indication 

that it is at least reasonably possible that a change 

in the estimate will occur in the near term. If the 

estimate involves a loss contingency covered by 

FASB ASC Topic 450, the disclosure also should 

include an estimate of the possible loss or range of 

loss, or state that such an estimate cannot be made. 

Disclosure of the factors that cause the estimate to 

be sensitive to change is encouraged but not 

required. 

FASB ASC Topic 275 requires disclosures 

regarding current vulnerability due to certain 

concentrations which may be applicable as well. 

47The loss contingency referred to in this 

document is the potential for a material 

understatement of reserves for unpaid claims. 

redeemable instrument, careful 

consideration must be given to the 

appropriateness of recording profits on 

the management fee arrangement, or 

interest or dividends on the instrument 

received, including consideration of 

whether it is necessary to defer such 

amounts or to treat such payments on a 

cost recovery basis. Further, if the new 

entity incurs losses to the point that its 

permanent equity based on GAAP is 

eliminated, it would ordinarily be 

necessary for the financial institution, at 

a minimum, to record further operating 

losses as its best estimate of the loss in 

realizable value of its investment.43

W. Contingency Disclosures Regarding 

Property-Casualty Insurance Reserves 

for Unpaid Claim Costs 

Facts: A property-casualty insurance 

company (the ‘‘Company’’) has 

established reserves, in accordance with 

FASB ASC Topic 944, Financial 

Services—Insurance, for unpaid claim 

costs, including estimates of costs 

relating to claims incurred but not 

reported (‘‘IBNR’’).44 The reserve 

estimate for IBNR claims was based on 

past loss experience and current trends 

except that the estimate has been 

adjusted for recent significant 

unfavorable claims experience that the 

Company considers to be nonrecurring 

and abnormal. The Company attributes 

the abnormal claims experience to a 

recent acquisition and accelerated 

claims processing; however, actuarial 

studies have been inconclusive and 

subject to varying interpretations. 

Although the reserve is deemed 

adequate to cover all probable claims, 

there is a reasonable possibility that the 

abnormal claims experience could 

continue, resulting in a material 

understatement of claim reserves. 

FASB ASC Topic 450, Contingencies, 

requires, among other things, disclosure 

of loss contingencies.45 However, FASB 

ASC paragraph 450–10–05–6 notes that 

‘‘[n]ot all uncertainties inherent in the 

accounting process give rise to 

contingencies.’’ 

FASB ASC Topic 275, Risks and 

Uncertainties,46 also provides 

disclosure guidance regarding certain 

significant estimates. 

Question 1: In the staff’s view, do 

FASB ASC Topics 450 and 275 

disclosure requirements apply to 

property-casualty insurance reserves for 

unpaid claim costs? If so, how? 

Interpretive Response: Yes. The staff 

believes that specific uncertainties 

(conditions, situations and/or sets of 

circumstances) not considered to be 

normal and recurring because of their 

significance and/or nature can result in 

loss contingencies 47 for purposes of 

applying FASB ASC Topics 450 and 275 

disclosure requirements. General 

uncertainties, such as the amount and 

timing of claims, that are normal, 

recurring, and inherent to estimations of 

property-casualty insurance reserves are 

not considered subject to the disclosure 

requirements of FASB ASC Topic 450. 

Some specific uncertainties that may 

result in loss contingencies pursuant to 

FASB ASC Topic 450, depending on 

significance and/or nature, include 

insufficiently understood trends in 

claims activity; judgmental adjustments 

to historical experience for purposes of 

estimating future claim costs (other than 

for normal recurring general 

uncertainties); significant risks to an 

individual claim or group of related 

claims; or catastrophe losses. The 

requirements of FASB ASC Topic 275 

apply when ‘‘[i]t is at least reasonably 

possible that the estimate of the effect 

on the financial statements of a 

condition, situation, or set of 

circumstances that existed at the date of 

the financial statements will change in 

the near term due to one or more future 

confirming events * * * [and] the effect 

of the change would be material to the 

financial statements.’’ 

Question 2: Do the facts presented 

above describe an uncertainty that 

requires disclosures under FASB ASC 

Topics 450 and 275? 

Interpretive Response: Yes. The staff 

believes the judgmental adjustments to 

historical experience for insufficiently 

understood claims activity noted above 

results in a loss contingency within the 

scope of FASB ASC Topics 450 and 275. 

Based on the facts presented above, at 

a minimum the Company’s financial 

statements should disclose that for 

purposes of estimating IBNR claim 

reserves, past experience was adjusted 

for what management believes to be 

abnormal claims experience related to 

the recent acquisition of Company A 

and accelerated claims processing. It 

should also be disclosed that there is a 

reasonable possibility that the claims 

experience could be the indication of an 

unfavorable trend which would require 

additional IBNR claim reserves in the 

approximate range of $XX–$XX million 

(alternatively, if Company management 

is unable to estimate the possible loss or 

range of loss, a statement to that effect 

should be disclosed). 

Additionally, the staff also expects 

companies to disclose the nature of the 

loss contingency and the potential 

impact on trends in their loss reserve 

development discussions provided 

pursuant to Property-Casualty Industry 

Guides 4 and 6. Consideration should 

also be given to the need to provide 

disclosure in MD&A. 

Question 3: Does the staff have an 

example in which specific uncertainties 

involving an individual claim or group 

of related claims result in a loss 

contingency the staff believes requires 

disclosure? 

Interpretive Response: Yes. A 

property-casualty insurance company 

(the ‘‘Company’’) underwrites product 

liability insurance for an insured 

manufacturer which has produced and 

sold millions of units of a particular 

product which has been used effectively 

and without problems for many years. 

Users of the product have recently 

begun to report serious health problems 

that they attribute to long term use of 

the product and have asserted claims 

under the insurance policy 

underwritten and retained by the 

Company. To date, the number of users 

reporting such problems is relatively 

small, and there is presently no 

conclusive evidence that demonstrates a 

causal link between long term use of the 

product and the health problems 

experienced by the claimants. However, 


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48As described in Concepts Statement 7, Using 

Cash Flow Information and Present Value in 

Accounting Measurements. 

49The staff believes there is a rebuttable 

presumption that no asset should be recognized for 

a claim for recovery from a party that is asserting 

that it is not liable to indemnify the registrant. 

Registrants that overcome that presumption should 

disclose the amount of recorded recoveries that are 

being contested and discuss the reasons for 

concluding that the amounts are probable of 

recovery. 

50See Securities Act Release No. 6130, FR 36, 

Securities Act Release No. 33–8040, Securities Act 

Release No. 33–8039, and Securities Act Release 

33–8176. 

51See, e.g., footnote 30 of FR 36 (footnote 17 of 

Section 501.02 of the Codification of Financial 

Reporting Policies). 

the evidence generated to date indicates 

that there is at least a reasonable 

possibility that the product is 

responsible for the problems and the 

assertion of additional claims is 

considered probable, and therefore the 

potential exposure of the Company is 

material. While an accrual may not be 

warranted since the loss exposure may 

not be both probable and estimable, in 

view of the reasonable possibility of 

material future claim payments, the staff 

believes that disclosures made in 

accordance with FASB ASC Topics 450 

and 275 would be required under these 

circumstances. 

The disclosure concepts expressed in 

this example would also apply to an 

individual claim or group of claims that 

are related to a single catastrophic event 

or multiple events having a similar 

effect. 

X. Removed by SAB 103 

Y. Accounting and Disclosures Relating 

to Loss Contingencies 

Facts: A registrant believes it may be 

obligated to pay material amounts as a 

result of product or environmental 

remediation liability. These amounts 

may relate to, for example, damages 

attributed to the registrant’s products or 

processes, clean-up of hazardous 

wastes, reclamation costs, fines, and 

litigation costs. The registrant may seek 

to recover a portion or all of these 

amounts by filing a claim against an 

insurance carrier or other third parties. 

Question 1: Assuming that the 

registrant’s estimate of an 

environmental remediation or product 

liability meets the conditions set forth 

in FASB ASC paragraph 410–30–35–12 

(Asset Retirement and Environmental 

Obligations Topic) for recognition on a 

discounted basis, what discount rate 

should be applied and what, if any, 

special disclosures are required in the 

notes to the financial statements? 

Interpretive Response: The rate used 

to discount the cash payments should 

be the rate that will produce an amount 

at which the environmental or product 

liability could be settled in an arm’slength transaction with a third party. 

Further, the discount rate used to 

discount the cash payments should not 

exceed the interest rate on monetary 

assets that are essentially risk free 48 and 

have maturities comparable to that of 

the environmental or product liability. 

If the liability is recognized on a 

discounted basis to reflect the time 

value of money, the notes to the 

financial statements should, at a 

minimum, include disclosures of the 

discount rate used, the expected 

aggregate undiscounted amount, 

expected payments for each of the five 

succeeding years and the aggregate 

amount thereafter, and a reconciliation 

of the expected aggregate undiscounted 

amount to amounts recognized in the 

statements of financial position. 

Material changes in the expected 

aggregate amount since the prior 

balance sheet date, other than those 

resulting from pay-down of the 

obligation, should be explained. 

Question 2: What financial statement 

disclosures should be furnished with 

respect to recorded and unrecorded 

product or environmental remediation 

liabilities? 

Interpretive Response: FASB ASC 

Section 450–20–50, Contingencies— 

Loss Contingencies—Disclosure, 

identify disclosures regarding loss 

contingencies that generally are 

furnished in notes to financial 

statements. FASB ASC Section 410–30– 

50, Asset Retirement and Environmental 

Obligations—Environmental 

Obligations—Disclosure, identifies 

disclosures that are required and 

recommended regarding both recorded 

and unrecorded environmental 

remediation liabilities. The staff 

believes that product and environmental 

remediation liabilities typically are of 

such significance that detailed 

disclosures regarding the judgments and 

assumptions underlying the recognition 

and measurement of the liabilities are 

necessary to prevent the financial 

statements from being misleading and to 

inform readers fully regarding the range 

of reasonably possible outcomes that 

could have a material effect on the 

registrant’s financial condition, results 

of operations, or liquidity. In addition to 

the disclosures required by FASB ASC 

Section 450–20–50 and FASB ASC 

Section 410–30–50, examples of 

disclosures that may be necessary 

include: 

• Circumstances affecting the 

reliability and precision of loss 

estimates. 

• The extent to which unasserted 

claims are reflected in any accrual or 

may affect the magnitude of the 

contingency. 

• Uncertainties with respect to joint 

and several liability that may affect the 

magnitude of the contingency, including 

disclosure of the aggregate expected cost 

to remediate particular sites that are 

individually material if the likelihood of 

contribution by the other significant 

parties has not been established. 

• Disclosure of the nature and terms 

of cost-sharing arrangements with other 

potentially responsible parties. 

• The extent to which disclosed but 

unrecognized contingent losses are 

expected to be recoverable through 

insurance, indemnification 

arrangements, or other sources, with 

disclosure of any material limitations of 

that recovery. 

• Uncertainties regarding the legal 

sufficiency of insurance claims or 

solvency of insurance carriers.49

• The time frame over which the 

accrued or presently unrecognized 

amounts may be paid out. 

• Material components of the accruals 

and significant assumptions underlying 

estimates. 

Registrants are cautioned that a 

statement that the contingency is not 

expected to be material does not satisfy 

the requirements of FASB ASC Topic 

450 if there is at least a reasonable 

possibility that a loss exceeding 

amounts already recognized may have 

been incurred and the amount of that 

additional loss would be material to a 

decision to buy or sell the registrant’s 

securities. In that case, the registrant 

must either (a) disclose the estimated 

additional loss, or range of loss, that is 

reasonably possible, or (b) state that 

such an estimate cannot be made. 

Question 3: What disclosures 

regarding loss contingencies may be 

necessary outside the financial 

statements? 

Interpretive Response: Registrants 

should consider the requirements of 

Items 101 (Description of Business), 103 

(Legal Proceedings), and 303 (MD&A) of 

Regulation S–K. The Commission has 

issued interpretive releases that provide 

additional guidance with respect to 

these items.50 In a 1989 interpretive 

release, the Commission noted that the 

availability of insurance, 

indemnification, or contribution may be 

relevant in determining whether the 

criteria for disclosure have been met 

with respect to a contingency.51 The 

registrant’s assessment in this regard 

should include consideration of facts 

such as the periods in which claims for 

recovery may be realized, the likelihood 

that the claims may be contested, and 


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52Registrants are reminded that FASB ASC 

Subtopic 410–20, Asset Retirement and 

Environmental Obligations—Asset Retirement 

Obligations, provides guidance for accounting and 

reporting for costs associated with asset retirement 

obligations. 

53 If the company has a guarantee as defined by 

FASB ASC Topic 460, Guarantees, the entity is 

required to provide the disclosures and recognize 

the fair value of the guarantee in the company’s 

financial statements even if the ‘‘contingent’’ aspect 

of the guarantee is deemed to be remote. 

54 In some circumstances, the seller’s continuing 

interest may be so great that divestiture accounting 

is inappropriate. 55However, a plan of disposal that contemplates 

the transfer of assets to a limited-life entity created 

for the single purpose of liquidating the assets of 

a component of an entity would not necessitate 

classification within continuing operations solely 

because the registrant retains control or significant 

influence over the liquidating entity. 

the financial condition of third parties 

from which recovery is expected. 

Disclosures made pursuant to the 

guidance identified in the preceding 

paragraph should be sufficiently 

specific to enable a reader to understand 

the scope of the contingencies affecting 

the registrant. For example, a 

registrant’s discussion of historical and 

anticipated environmental expenditures 

should, to the extent material, describe 

separately (a) recurring costs associated 

with managing hazardous substances 

and pollution in on-going operations, (b) 

capital expenditures to limit or monitor 

hazardous substances or pollutants, (c) 

mandated expenditures to remediate 

previously contaminated sites, and (d) 

other infrequent or non-recurring cleanup expenditures that can be anticipated 

but which are not required in the 

present circumstances. Disaggregated 

disclosure that describes accrued and 

reasonably likely losses with respect to 

particular environmental sites that are 

individually material may be necessary 

for a full understanding of these 

contingencies. Also, if management’s 

investigation of potential liability and 

remediation cost is at different stages 

with respect to individual sites, the 

consequences of this with respect to 

amounts accrued and disclosed should 

be discussed. 

Examples of specific disclosures 

typically relevant to an understanding 

of historical and anticipated product 

liability costs include the nature of 

personal injury or property damages 

alleged by claimants, aggregate 

settlement costs by type of claim, and 

related costs of administering and 

litigating claims. Disaggregated 

disclosure that describes accrued and 

reasonably likely losses with respect to 

particular claims may be necessary if 

they are individually material. If the 

contingency involves a large number of 

relatively small individual claims of a 

similar type, such as personal injury 

from exposure to asbestos, disclosure of 

the number of claims pending at each 

balance sheet date, the number of claims 

filed for each period presented, the 

number of claims dismissed, settled, or 

otherwise resolved for each period, and 

the average settlement amount per claim 

may be necessary. Disclosures should 

address historical and expected trends 

in these amounts and their reasonably 

likely effects on operating results and 

liquidity. 

Question 4: What disclosures should 

be furnished with respect to site 

restoration costs or other environmental 

remediation costs? 52

Interpretive Response: The staff 

believes that material liabilities for site 

restoration, post-closure, and 

monitoring commitments, or other exit 

costs that may occur on the sale, 

disposal, or abandonment of a property 

as a result of unanticipated 

contamination of the asset should be 

disclosed in the notes to the financial 

statements. Appropriate disclosures 

generally would include the nature of 

the costs involved, the total anticipated 

cost, the total costs accrued to date, the 

balance sheet classification of accrued 

amounts, and the range or amount of 

reasonably possible additional losses. If 

an asset held for sale or development 

will require remediation to be 

performed by the registrant prior to 

development, sale, or as a condition of 

sale, a note to the financial statements 

should describe how the necessary 

expenditures are considered in the 

assessment of the asset’s value and the 

possible need to reflect an impairment 

loss. Additionally, if the registrant may 

be liable for remediation of 

environmental damage relating to assets 

or businesses previously disposed, 

disclosure should be made in the 

financial statements unless the 

likelihood of a material unfavorable 

outcome of that contingency is 

remote.53 The registrant’s accounting 

policy with respect to such costs should 

be disclosed in accordance with FASB 

ASC Topic 235, Notes to Financial 

Statements. 

Z. Accounting and Disclosure Regarding 

Discontinued Operations 

1. Removed by SAB 103 

2. Removed by SAB 103 

3. Removed by SAB 103 

4. Disposal of Operation With 

Significant Interest Retained 

Facts: A Company disposes of its 

controlling interest in a component of 

an entity as defined by the FASB ASC 

Master Glossary. The Company retains a 

minority voting interest directly in the 

component or it holds a minority voting 

interest in the buyer of the component. 

Controlling interest includes those 

controlling interests established through 

other means, such as variable interests. 

Because the Company’s voting interest 

enables it to exert significant influence 

over the operating and financial policies 

of the investee, the Company is required 

by FASB ASC Subtopic 323–10, 

Investments—Equity Method and Joint 

Ventures—Overall, to account for its 

residual investment using the equity 

method.54

Question: May the historical operating 

results of the component and the gain or 

loss on the sale of the majority interest 

in the component be classified in the 

Company’s statement of operations as 

‘‘discontinued operations’’ pursuant to 

FASB ASC Subtopic 205–20, 

Presentation of Financial Statements— 

Discontinued Operations? 

Interpretive Response: No. A 

condition necessary for discontinued 

operations reporting, as indicated in 

FASB ASC paragraph 205–20–45–1 is 

that an entity ‘‘not have any significant 

continuing involvement in the 

operations of the component after the 

disposal transaction.’’ In these 

circumstances, the transaction should 

be accounted for as the disposal of a 

group of assets that is not a component 

of an entity and classified within 

continuing operations pursuant to FASB 

ASC paragraph 360–10–45–5 (Property, 

Plant, and Equipment Topic).55

5. Classification and Disclosure of 

Contingencies Relating to Discontinued 

Operations 

Facts: A company disposed of a 

component of an entity in a previous 

accounting period. The Company 

received debt and/or equity securities of 

the buyer of the component or of the 

disposed component as consideration in 

the sale, but this financial interest is not 

sufficient to enable the Company to 

apply the equity method with respect to 

its investment in the buyer. The 

Company made certain warranties to the 

buyer with respect to the discontinued 

business, or remains liable under 

environmental or other laws with 

respect to certain facilities or operations 

transferred to the buyer. The disposition 

satisfied the criteria of FASB ASC 

Subtopic 205–20 for presentation as 

‘‘discontinued operations.’’ The 

Company estimated the fair value of the 

securities received in the transaction for 

purposes of calculating the gain or loss 

on disposal that was recognized in its 

financial statements. The results of 

discontinued operations prior to the 


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56Registrants are reminded that FASB ASC Topic 

460, Guarantees, requires recognition and 

disclosure of certain guarantees which may impose 

accounting and disclosure requirements in addition 

to those discussed in this SAB Topic. 

57 Item 303 of Regulation S–K. 

58Registrants also should consider the disclosure 

requirements of FASB ASC Topic 460. 

date of disposal or classification as held 

for sale included provisions for the 

Company’s existing obligations under 

environmental laws, product warranties, 

or other contingencies. The calculation 

of gain or loss on disposal included 

estimates of the Company’s obligations 

arising as a direct result of its decision 

to dispose of the component, under its 

warranties to the buyer, and under 

environmental or other laws. In a period 

subsequent to the disposal date, the 

Company records a charge to income 

with respect to the securities because 

their fair value declined materially and 

the Company determined that the 

decline was other than temporary. The 

Company also records adjustments of its 

previously estimated liabilities arising 

under the warranties and under 

environmental or other laws. 

Question 1: Should the writedown of 

the carrying value of the securities and 

the adjustments of the contingent 

liabilities be classified in the current 

period’s statement of operations within 

continuing operations or as an element 

of discontinued operations? 

Interpretive Response: Adjustments of 

estimates of contingent liabilities or 

contingent assets that remain after 

disposal of a component of an entity or 

that arose pursuant to the terms of the 

disposal generally should be classified 

within discontinued operations.56

However, the staff believes that changes 

in the carrying value of assets received 

as consideration in the disposal or of 

residual interests in the business should 

be classified within continuing 

operations. 

FASB ASC paragraph 205–20–45–4 

requires that ‘‘adjustments to amounts 

previously reported in discontinued 

operations that are directly related to 

the disposal of a component of an entity 

in a prior period shall be classified 

separately in the current period in 

discontinued operations.’’ The staff 

believes that the provisions of FASB 

ASC paragraph 205–20–45–4 apply only 

to adjustments that are necessary to 

reflect new information about events 

that have occurred that becomes 

available prior to disposal of the 

component of the entity, to reflect the 

actual timing and terms of the disposal 

when it is consummated, and to reflect 

the resolution of contingencies 

associated with that component, such as 

warranties and environmental liabilities 

retained by the seller. 

Developments subsequent to the 

disposal date that are not directly 

related to the disposal of the component 

or the operations of the component prior 

to disposal are not ‘‘directly related to 

the disposal’’ as contemplated by FASB 

ASC paragraph 205–20–45–4. 

Subsequent changes in the carrying 

value of assets received upon 

disposition of a component do not affect 

the determination of gain or loss at the 

disposal date, but represent the 

consequences of management’s 

subsequent decisions to hold or sell 

those assets. Gains and losses, dividend 

and interest income, and portfolio 

management expenses associated with 

assets received as consideration for 

discontinued operations should be 

reported within continuing operations. 

Question 2: What disclosures would 

the staff expect regarding discontinued 

operations prior to the disposal date and 

with respect to risks retained 

subsequent to the disposal date? 

Interpretive Response: MD&A 57

should include disclosure of known 

trends, events, and uncertainties 

involving discontinued operations that 

may materially affect the Company’s 

liquidity, financial condition, and 

results of operations (including net 

income) between the date when a 

component of an entity is classified as 

discontinued and the date when the 

risks of those operations will be 

transferred or otherwise terminated. 

Disclosure should include discussion of 

the impact on the Company’s liquidity, 

financial condition, and results of 

operations of changes in the plan of 

disposal or changes in circumstances 

related to the plan. Material contingent 

liabilities,58 such as product or 

environmental liabilities or litigation, 

that may remain with the Company 

notwithstanding disposal of the 

underlying business should be 

identified in notes to the financial 

statements and any reasonably likely 

range of possible loss should be 

disclosed pursuant to FASB ASC Topic 

450, Contingencies. MD&A should 

include discussion of the reasonably 

likely effects of these contingencies on 

reported results and liquidity. If the 

Company retains a financial interest in 

the discontinued component or in the 

buyer of that component that is material 

to the Company, MD&A should include 

discussion of known trends, events, and 

uncertainties, such as the financial 

condition and operating results of the 

issuer of the security, that may be 

reasonably expected to affect the 

amounts ultimately realized on the 

investments. 

6. Removed by SAB 103 

7. Accounting for the Spin-Off of a 

Subsidiary 

Facts: A Company disposes of a 

business through the distribution of a 

subsidiary’s stock to the Company’s 

shareholders on a pro rata basis in a 

transaction that is referred to as a spinoff. 

Question: May the Company elect to 

characterize the spin-off transaction as 

resulting in a change in the reporting 

entity and restate its historical financial 

statements as if the Company never had 

an investment in the subsidiary, in the 

manner specified by FASB ASC Topic 

250, Accounting Changes and Error 

Corrections? 

Interpretive Response: Not ordinarily. 

If the Company was required to file 

periodic reports under the Exchange Act 

within one year prior to the spin-off, the 

staff believes the Company should 

reflect the disposition in conformity 

with FASB ASC Topic 360. This 

presentation most fairly and completely 

depicts for investors the effects of the 

previous and current organization of the 

Company. However, in limited 

circumstances involving the initial 

registration of a company under the 

Exchange Act or Securities Act, the staff 

has not objected to financial statements 

that retroactively reflect the 

reorganization of the business as a 

change in the reporting entity if the 

spin-off transaction occurs prior to 

effectiveness of the registration 

statement. This presentation may be 

acceptable in an initial registration if the 

Company and the subsidiary are in 

dissimilar businesses, have been 

managed and financed historically as if 

they were autonomous, have no more 

than incidental common facilities and 

costs, will be operated and financed 

autonomously after the spin-off, and 

will not have material financial 

commitments, guarantees, or contingent 

liabilities to each other after the spinoff. This exception to the prohibition 

against retroactive omission of the 

subsidiary is intended for companies 

that have not distributed widely 

financial statements that include the 

spun-off subsidiary. Also, dissimilarity 

contemplates substantially greater 

differences in the nature of the 

businesses than those that would 

ordinarily distinguish reportable 

segments as defined by FASB ASC 

paragraph 280–10–50–10 (Segment 

Reporting Topic). 


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59See also disclosure requirement for inventory 

balances in Rule 5–02(6) of Regulation S–X. 

AA. Removed by SAB 103 

BB. Inventory Valuation Allowances 

Facts: FASB ASC paragraph 330–10– 

35–1 (Inventory Topic), specifies that: 

‘‘[a] departure from the cost basis of 

pricing the inventory is required when 

the utility of the goods is no longer as 

great as its cost. Where there is evidence 

that the utility of goods, in their 

disposal in the ordinary course of 

business, will be less than cost, whether 

due to physical deterioration, 

obsolescence, changes in price levels, or 

other causes, the difference shall be 

recognized as a loss of the current 

period. This is generally accomplished 

by stating such goods at a lower level 

commonly designated as market.’’ 

FASB ASC paragraph 330–10–35–14 

indicates that ‘‘[i]n the case of goods 

which have been written down below 

cost at the close of a fiscal year, such 

reduced amount is to be considered the 

cost for subsequent accounting 

purposes.’’ 

Lastly, the FASB ASC Master Glossary 

provides ‘‘inventory obsolescence’’ as 

one of the items subject to a change in 

accounting estimate. 

Question: Does the write-down of 

inventory to the lower of cost or market, 

as required by FASB ASC Topic 330, 

create a new cost basis for the inventory 

or may a subsequent change in facts and 

circumstances allow for restoration of 

inventory value, not to exceed original 

historical cost? 

Interpretive Response: Based on FASB 

ASC paragraph 330–10–35–14, the staff 

believes that a write-down of inventory 

to the lower of cost or market at the 

close of a fiscal period creates a new 

cost basis that subsequently cannot be 

marked up based on changes in 

underlying facts and circumstances.59

CC. Impairments 

Standards for recognizing and 

measuring impairment of the carrying 

amount of long-lived assets including 

certain identifiable intangibles to be 

held and used in operations are found 

in FASB ASC Topic 360, Property, 

Plant, and Equipment. Standards for 

recognizing and measuring impairment 

of the carrying amount of goodwill and 

identifiable intangible assets that are not 

currently being amortized are found in 

FASB ASC Topic 350, Intangibles— 

Goodwill and Other. 

Facts: Company X has mainframe 

computers that are to be abandoned in 

six to nine months as replacement 

computers are put in place. The 

mainframe computers were placed in 

service in January 20X0 and were being 

depreciated on a straight-line basis over 

seven years. No salvage value had been 

projected at the end of seven years and 

the original cost of the computers was 

$8,400. The board of directors, with the 

appropriate authority, approved the 

abandonment of the computers in 

March 20X3 when the computers had a 

remaining carrying value of $4,600. No 

proceeds are expected upon 

abandonment. Abandonment cannot 

occur prior to the receipt and 

installation of replacement computers, 

which is expected prior to the end of 

20X3. Management had begun 

reevaluating its mainframe computer 

capabilities in January 20X2 and had 

included in its 20X3 capital 

expenditures budget an estimated 

amount for new mainframe computers. 

The 20X3 capital expenditures budget 

had been prepared by management in 

August 20X2, had been discussed with 

the company’s board of directors in 

September 20X2 and was formally 

approved by the board of directors in 

March 20X3. Management had also 

begun soliciting bids for new mainframe 

computers beginning in the fall of 20X2. 

The mainframe computers, when 

grouped with assets at the lowest level 

of identifiable cash flows, were not 

impaired on a ‘‘held and used’’ basis 

throughout this time period. 

Management had not adjusted the 

original estimated useful life of the 

computers (seven years) since 20X0. 

Question 1: Company X proposes to 

recognize an impairment charge under 

FASB ASC Topic 360 for the carrying 

value of the mainframe computers of 

$4,600 in March 20X3. Does Company 

X meet the requirements in FASB ASC 

Topic 360 to classify the mainframe 

computer assets as ‘‘to be abandoned?’’ 

Interpretive Response: No. FASB ASC 

paragraph 360–10–35–47 provides that 

‘‘a long-lived asset to be abandoned is 

disposed of when it ceases to be used. 

If an entity commits to a plan to 

abandon a long-lived asset before the 

end of its previously estimated useful 

life, depreciation estimates shall be 

revised in accordance with FASB ASC 

Topic 250, Accounting Changes and 

Error Corrections, to reflect the use of 

the asset over its shortened useful life.’’ 

Question 2: Would the staff accept an 

adjustment to write down the carrying 

value of the computers to reflect a 

‘‘normalized depreciation’’ rate for the 

period from March 20X3 through actual 

abandonment (e.g., December 20X3)? 

Normalized depreciation would 

represent the amount of depreciation 

otherwise expected to be recognized 

during that period without adjustment 

of the asset’s useful life, or $1,000 

($100/month for ten months) in the 

example fact pattern. 

Interpretive Response: No. The 

mainframe computers would be viewed 

as ‘‘held and used’’ at March 20X3 under 

the fact pattern described. There is no 

basis under FASB ASC Topic 360 to 

write down an asset to an amount that 

would subsequently result in a 

‘‘normalized depreciation’’ charge 

through the disposal date, whether 

disposal is to be by sale, abandonment, 

or other means. FASB ASC paragraph 

360–10–35–43 requires the asset to be 

valued at the lower of carrying amount 

or fair value less cost to sell in order to 

be classified as ‘‘held for sale.’’ For assets 

that are classified as ‘‘held and used’’ 

under FASB ASC Topic 360, an 

assessment must first be made as to 

whether the asset (asset group) is 

impaired. FASB ASC paragraph 360– 

10–35–17 indicates that an impairment 

loss shall be recognized only if the 

carrying amount of a long-lived asset 

(asset group) is not recoverable and 

exceeds its fair value. The carrying 

amount of a long-lived asset (asset 

group) is not recoverable if it exceeds 

the sum of the undiscounted cash flows 

expected to result from the use and 

eventual disposition of the asset (asset 

group). The staff would object to a write 

down of long-lived assets to a 

‘‘normalized depreciation’’ value as 

representing an acceptable alternative to 

the approaches required in FASB ASC 

Topic 360. 

The staff also believes that registrants 

must continually evaluate the 

appropriateness of useful lives assigned 

to long-lived assets, including 

identifiable intangible assets and 

goodwill. In the above fact pattern, 

management had contemplated removal 

of the mainframe computers beginning 

in January 20X2 and, more formally, in 

August 20X2 as part of compiling the 

20X3 capital expenditures budget. At 

those times, at a minimum, management 

should have reevaluated the original 

useful life assigned to the computers to 

determine whether a seven year 

amortization period remained 

appropriate given the company’s current 

facts and circumstances, including 

ongoing technological changes in the 

market place. This reevaluation process 

should have continued at the time of the 

September 20X2 board of directors’ 

meeting to discuss capital expenditure 

plans and, further, as the company 

pursued mainframe computer bids. 

Given the contemporaneous evidence 

that management’s best estimate during 

much of 20X2 was that the current 

mainframe computers would be 

removed from service in 20X3, the 

depreciable life of the computers should 


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60FASB ASC Subtopic 860–50 permits an entity 

to subsequently measure recognized servicing assets 

and servicing liabilities (which are nonfinancial 

instruments) at fair value through earnings. 

have been adjusted prior to 20X3 to 

reflect this new estimate. The staff does 

not view the recognition of an 

impairment charge to be an acceptable 

substitute for choosing the appropriate 

initial amortization or depreciation 

period or subsequently adjusting this 

period as company or industry 

conditions change. The staff’s view 

applies also to selection of, and changes 

to, estimated residual values. 

Consequently, the staff may challenge 

impairment charges for which the 

timely evaluation of useful life and 

residual value cannot be demonstrated. 

Question 3: Has the staff expressed 

any views with respect to companydetermined estimates of cash flows used 

for assessing and measuring impairment 

of assets under FASB ASC Topic 360? 

Interpretive Response: In providing 

guidance on the development of cash 

flows for purposes of applying the 

provisions of that Topic, FASB ASC 

paragraph 360–10–35–30 indicates that 

‘‘estimates of future cash flows used to 

test the recoverability of a long-lived 

asset (asset group) shall incorporate the 

entity’s own assumptions about its use 

of the asset (asset group) and shall 

consider all available evidence. The 

assumptions used in developing those 

estimates shall be reasonable in relation 

to the assumptions used in developing 

other information used by the entity for 

comparable periods, such as internal 

budgets and projections, accruals 

related to incentive compensation plans, 

or information communicated to 

others.’’ 

The staff recognizes that various 

factors, including management’s 

judgments and assumptions about the 

business plans and strategies, affect the 

development of future cash flow 

projections for purposes of applying 

FASB ASC Topic 360. The staff, 

however, cautions registrants that the 

judgments and assumptions made for 

purposes of applying FASB ASC Topic 

360 must be consistent with other 

financial statement calculations and 

disclosures and disclosures in MD&A. 

The staff also expects that forecasts 

made for purposes of applying FASB 

ASC Topic 360 be consistent with other 

forward-looking information prepared 

by the company, such as that used for 

internal budgets, incentive 

compensation plans, discussions with 

lenders or third parties, and/or reporting 

to management or the board of directors. 

For example, the staff has reviewed a 

fact pattern where a registrant 

developed cash flow projections for 

purposes of applying the provisions of 

FASB ASC Topic 360 using one set of 

assumptions and utilized a second, 

more conservative set of assumptions 

for purposes of determining whether 

deferred tax valuation allowances were 

necessary when applying the provisions 

of FASB ASC Topic 740, Income Taxes. 

In this case, the staff objected to the use 

of inconsistent assumptions. 

In addition to disclosure of key 

assumptions used in the development of 

cash flow projections, the staff also has 

required discussion in MD&A of the 

implications of assumptions. For 

example, do the projections indicate 

that a company is likely to violate debt 

covenants in the future? What are the 

ramifications to the cash flow 

projections used in the impairment 

analysis? If growth rates used in the 

impairment analysis are lower than 

those used by outside analysts, has the 

company had discussions with the 

analysts regarding their overly 

optimistic projections? Has the 

company appropriately informed the 

market and its shareholders of its 

reduced expectations for the future that 

are sufficient to cause an impairment 

charge? The staff believes that cash flow 

projections used in the impairment 

analysis must be both internally 

consistent with the company’s other 

projections and externally consistent 

with financial statement and other 

public disclosures. 

DD. Written Loan Commitments 

Recorded at Fair Value Through 

Earnings 

Facts: Bank A enters into a loan 

commitment with a customer to 

originate a mortgage loan at a specified 

rate. As part of this written loan 

commitment, Bank A expects to receive 

future net cash flows related to servicing 

rights from servicing fees (included in 

the loan’s interest rate or otherwise), 

late charges, and other ancillary sources, 

or from selling the servicing rights to a 

third party. If Bank A intends to sell the 

mortgage loan after it is funded, 

pursuant to FASB ASC paragraph 815– 

10–15–83 (Derivatives and Hedging 

Topic), the written loan commitment is 

accounted for as a derivative instrument 

and recorded at fair value through 

earnings (referred to hereafter as a 

‘‘derivative loan commitment’’). If Bank 

A does not intend to sell the mortgage 

loan after it is funded, the written loan 

commitment is not accounted for as a 

derivative under FASB ASC Subtopic 

815–10, Derivatives and Hedging— 

Overall. However, FASB ASC 

subparagraph 825–10–15–4(c) 

(Financial Instruments Topic) permits 

Bank A to record the written loan 

commitment at fair value through 

earnings (referred to hereafter as a 

‘‘written loan commitment’’). Pursuant 

to FASB ASC Subtopic 825–10, 

Financial Instruments—Overall, the fair 

value measurement for a written loan 

commitment would include the 

expected net future cash flows related to 

the associated servicing of the loan. 

Question 1: In measuring the fair 

value of a derivative loan commitment 

accounted for under FASB ASC 

Subtopic 815–10, should Bank A 

include the expected net future cash 

flows related to the associated servicing 

of the loan? 

Interpretive Response: Yes. The staff 

believes that, consistent with the 

guidance in FASB ASC Subtopic 860– 

50, Transfers and Servicing—Servicing 

Assets and Liabilities,60 and FASB ASC 

Subtopic 825–10, the expected net 

future cash flows related to the 

associated servicing of the loan should 

be included in the fair value 

measurement of a derivative loan 

commitment. The expected net future 

cash flows related to the associated 

servicing of the loan that are included 

in the fair value measurement of a 

derivative loan commitment or a written 

loan commitment should be determined 

in the same manner that the fair value 

of a recognized servicing asset or 

liability is measured under FASB ASC 

Subtopic 860–50. However, as discussed 

in FASB ASC paragraph 860–50–25–1, a 

separate and distinct servicing asset or 

liability is not recognized for accounting 

purposes until the servicing rights have 

been contractually separated from the 

underlying loan by sale or securitization 

of the loan with servicing retained. 

The views in Question 1 apply to all 

loan commitments that are accounted 

for at fair value through earnings. 

However, for purposes of electing fair 

value accounting pursuant to FASB ASC 

Subtopic 825–10, the views in Question 

1 are not intended to be applied by 

analogy to any other instrument that 

contains a nonfinancial element. 

Question 2: In measuring the fair 

value of a derivative loan commitment 

accounted for under FASB ASC 

Subtopic 815–10 or a written loan 

commitment accounted for under FASB 

ASC Subtopic 825–10, should Bank A 

include the expected net future cash 

flows related to internally-developed 

intangible assets? 

Interpretive Response: No. The staff 

does not believe that internallydeveloped intangible assets (such as 

customer relationship intangible assets) 

should be recorded as part of the fair 

value of a derivative loan commitment 

or a written loan commitment. Such 


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Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17231 

1When a registrant reports net income and total 

comprehensive income in one continuous financial 

statement, the registrant must continue to follow 

the guidance set forth in the SAB Topic. One 

approach may be to provide a separate 

reconciliation of net income to income available to 

common stock below comprehensive income 

reported on a statement of income and 

comprehensive income. 

2The assessment of materiality is the 

responsibility of each registrant. However, absent 

concerns about trends or other qualitative 

considerations, the staff generally will not insist on 

the reporting of income or loss applicable to 

common stock if the amount differs from net 

income or loss by less than ten percent. 

3These requirements have been further revised to 

require the company’s CEO and CFO to certify to 

the information contained in the company’s 

periodic filing. 

4See question 5 for a discussion of the meaning 

of components of an entity as used in Item 

302(a)(2). 

nonfinancial elements of value should 

not be considered a component of the 

related instrument. Recognition of such 

assets would only be appropriate in a 

third-party transaction. For example, in 

the purchase of a portfolio of derivative 

loan commitments in a business 

combination, a customer relationship 

intangible asset is recorded separately 

from the fair value of such loan 

commitments. Similarly, when an entity 

purchases a credit card portfolio, FASB 

ASC paragraph 310–10–25–7 

(Receivables Topic) requires an 

allocation of the purchase price to a 

separately recorded cardholder 

relationship intangible asset. 

The view in Question 2 applies to all 

loan commitments that are accounted 

for at fair value through earnings. 

TOPIC 6: INTERPRETATIONS OF 

ACCOUNTING SERIES RELEASES 

AND FINANCIAL REPORTING 

RELEASES 

A.1. Removed by SAB 103 

B. Accounting Series Release 280— 

General Revision of Regulation S–X: 

Income or Loss Applicable to Common 

Stock 

Facts: A registrant has various classes 

of preferred stock. Dividends on those 

preferred stocks and accretions of their 

carrying amounts cause income 

applicable to common stock to be less 

than reported net income. 

Question: In ASR 280, the 

Commission stated that although it had 

determined not to mandate presentation 

of income or loss applicable to common 

stock in all cases, it believes that 

disclosure of that amount is of value in 

certain situations. In what situations 

should the amount be reported, where 

should it be reported, and how should 

it be computed? 

Interpretive Response: Income or loss 

applicable to common stock should be 

reported on the face of the income 

statement 1 when it is materially 

different in quantitative terms from 

reported net income or loss 2 or when it 

is indicative of significant trends or 

other qualitative considerations. The 

amount to be reported should be 

computed for each period as net income 

or loss less: (a) Dividends on preferred 

stock, including undeclared or unpaid 

dividends if cumulative; and (b) 

periodic increases in the carrying 

amounts of instruments reported as 

redeemable preferred stock (as 

discussed in Topic 3.C) or increasing 

rate preferred stock (as discussed in 

Topic 5.Q). 

C. Accounting Series Release 180— 

Institution of Staff Accounting Bulletins 

(SABs)—Applicability of Guidance 

Contained in SABs 

Facts: The series of SABs was 

instituted to achieve wide 

dissemination of administrative 

interpretations and practices of the 

Commission’s staff. In illustration of 

certain interpretations and practices, 

SABs may be written narrowly to 

describe the circumstances of particular 

matters which resulted in expression of 

the staff’s views on those particular 

matters. 

Question: How does the staff intend 

SABs to be applied in circumstances 

analogous to those addressed in SABs? 

Interpretive Response: The staff’s 

purpose in issuing SABs is to 

disseminate guidance for application 

not only in the narrowly described 

circumstances, but also, unless 

authoritative accounting literature calls 

for different treatment, in other 

circumstances where events and 

transactions have similar accounting 

and/or disclosure implications. 

Registrants and independent 

accountants are encouraged to consult 

with the staff if they believe that 

particular circumstances call for 

accounting and/or disclosure different 

from that which would result from 

application of a SAB addressing those 

same or analogous circumstances. 

D. Redesignated as Topic 12.A by SAB 

47 

E. Redesignated as Topic 12.B by SAB 

47 

F. Removed by SAB 103 

G. Accounting Series Releases 177 and 

286—Relating to Amendments to Form 

10–Q, Regulation S–K, and Regulations 

S–X Regarding Interim Financial 

Reporting 

General Facts: Disclosure 

requirements for quarterly data on Form 

10–Q were amended in ASR 177 and 

286 to include condensed interim 

financial statements, a narrative analysis 

of financial condition and results of 

operations, a letter from the registrant’s 

independent public accountant 

commenting on any accounting change, 

and a signature by the registrant’s chief 

financial officer or chief accounting 

officer.3 In addition, certain selected 

quarterly data is required to be 

disclosed by virtually all registrants (see 

Item 302(a)(5) of Regulation S–K). 

1. Selected Quarterly Financial Data 

(Item 302(a) of Regulation S–K) 

a. Disclosure of Selected Quarterly 

Financial Data 

Facts: Item 302(a)(1) of Regulation S– 

K requires disclosure of net sales, gross 

profit, income before extraordinary 

items and cumulative effect of a change 

in accounting, per share data based 

upon such income (loss), net income 

(loss), and net income (loss) attributable 

to the registrant for each full quarter 

within the two most recent fiscal years 

and any subsequent interim period for 

which financial statements are 

included. Item 302(a)(3) requires the 

registrant to describe the effect of any 

disposals of components of an entity 4

and extraordinary, unusual or 

infrequently occurring items recognized 

in each quarter, as well as the aggregate 

effect and the nature of year-end or 

other adjustments which are material to 

the results of that quarter. Furthermore, 

Item 302(a)(2) requires a reconciliation 

of amounts previously reported on Form 

10–Q to the quarterly data presented if 

the amounts differ. 

Question 1: Are these disclosure 

requirements applicable to 

supplemental financial statements 

included in a filing with the SEC for 

unconsolidated subsidiaries and 50% or 

less owned persons? 

Interpretive Response: The 

summarized quarterly financial data 

required by Item 302(a)(1) need not be 

included in supplemental financial 

statements for unconsolidated 

subsidiaries and 50% or less owned 

persons unless the financial statements 

are for a subsidiary or affiliate that is 

itself a registrant which meets the 

criteria set forth in Item 302(a)(5). 

Question 2: If a company is in a 

specialized industry where ‘‘gross 

profit’’ generally is not computed (e.g., 

banks, insurance companies and finance 

companies), what disclosure should be 

made to comply with the requirements 

of Item 302(a)(1)? 

Interpretive Response: Companies in 

specialized industries should present 

summarized quarterly financial data 

which are most meaningful in their 


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17232 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

particular circumstances. For example, a 

bank might present interest income, 

interest expense, provision for loan 

losses, security gains or losses and net 

income. Similarly, an insurance 

company might present net premiums 

earned, underwriting costs and 

expenses, investment income, security 

gains or losses and net income. 

Question 3: If a company wishes to 

make its quarterly and annual 

disclosures on the same basis, would 

disclosure of costs and expenses 

associated directly with or allocated to 

products sold or services rendered, or 

other appropriate data to enable users to 

compute ‘‘gross profit,’’ satisfy the 

requirements of Item 302(a)(1)? 

Interpretive Response: Yes. 

Question 4: What is meant by ‘‘pershare data based upon such income’’ as 

used in Item 302(a)(1)? 

Interpretive Response: Item 302(a)(1) 

only requires disclosure of per share 

amounts for income before 

extraordinary items and cumulative 

effect of a change in accounting. It is 

expected that when per share data is 

calculated for each full quarter based 

upon such income, the per share 

amounts would be both basic and 

diluted. Although it is not required by 

the rule, there are many instances where 

it would be desirable to disclose other 

per share figures such as net earnings 

per share and the per share effect of 

extraordinary items also. Where such 

disclosure is made, per share data 

should be both basic and diluted. 

Question 5: What is intended by the 

requirement set forth in Item 302(a)(3) 

that registrants ‘‘describe the effect of’’ 

disposals of segments of a business, 

etc.? 

Interpretive Response: The rule uses 

the language of segments of a business 

that was previously found in the 

authoritative literature. Consistent with 

the terminology used in FASB ASC 

Subtopic 205–20, Presentation of 

Financial Statements—Discontinued 

Operations, as used here, segments of a 

business is intended to mean 

components of an entity. The rule is 

intended to require registrants to 

‘‘disclose the amount’’ of such unusual 

transactions and events included in the 

results reported for each quarter. Such 

disclosure would be made in narrative 

form. However, it would not require that 

matters covered by MD&A be repeated. 

In this situation, registrants should 

disclose the nature and amount of the 

unusual transaction or event and refer to 

MD&A for further discussion of the 

matter. 

Question 6: What is intended by the 

requirement of Item 302(a)(3) to disclose 

‘‘the aggregate effect and the nature of 

year-end or other adjustments which are 

material to the results of that quarter’’? 

Interpretive Response: This language 

is taken directly from FASB ASC 

paragraph 270–10–50–2 (Interim 

Reporting Topic) which relates to 

disclosures required for the fourth 

quarter of the year. FASB ASC Topic 

270 indicates that earlier quarters 

should not be restated to reflect a 

change in accounting estimate recorded 

at year end. However, changes in an 

accounting estimate made in an interim 

period that materially affect the quarter 

in which the change occurred are 

required to be disclosed in order to 

avoid misleading comparisons. In 

making such disclosure, registrants may 

wish to identify (but not restate) the 

prior periods in which transactions 

were recorded which relate to the 

change in the quarter. 

Question 7: If company has filed a 

Form 10–Q/A amending a previously 

filed Form 10–Q, is a reconciliation of 

quarterly data in annual financial 

statements with the amounts originally 

reported on Form 10–Q required? 

Interpretive Response: Yes. However, 

if the company publishes quarterly 

reports to shareholders and has 

previously made detailed disclosure to 

shareholders in such reports of the 

change reported on the Form 10–Q/A, 

no reconciliation would be required. 

b. Financial Statements Presented on 

Other Than a Quarterly Basis 

Facts: Item 302(a)(1) requires 

disclosure of quarterly financial data for 

each full quarter of the last two fiscal 

years and in any subsequent interim 

period for which an income statement is 

presented. 

Question: If a company reports at 

interim dates on other than a calendarquarter basis (e.g., 12–12–16–12 week 

basis), will it be precluded from 

reporting on such basis in the future? 

Interpretive Response: No, as long as 

it discloses the basis of interim fiscal 

period reporting and the interim fiscal 

periods on which it reports are 

consistently determined from year to 

year (or, if not, the lack of comparability 

is disclosed). 

c. Removed by SAB 103 

2. Amendments to Form 10–Q 

a. Form of Condensed Financial 

Statements 

Facts: Rules 10–01(a)(2) and (3) of 

Regulation S–X provide that interim 

balance sheets and statements of income 

shall include only major captions (i.e., 

numbered captions) set forth in 

Regulation S–X, with the exception of 

inventories where data as to raw 

materials, work in process and finished 

goods shall be included, if applicable, 

either on the face of the balance sheet 

or in notes thereto. Where any major 

balance sheet caption is less than 10% 

of total assets and the amount in the 

caption has not increased or decreased 

by more than 25% since the end of the 

preceding fiscal year, the caption may 

be combined with others. When any 

major income statement caption is less 

than 15% of average net income 

attributable to the registrant for the most 

recent three fiscal years and the amount 

in the caption has not increased or 

decreased by more than 20% as 

compared to the corresponding interim 

period of the preceding fiscal year, the 

caption may be combined with others. 

Similarly, the statement of cash flows 

may be abbreviated, starting with a 

single figure of cash flows provided by 

operations and showing other changes 

individually only when they exceed 

10% of the average of cash flows 

provided by operations for the most 

recent three years. 

Question 1: If a company previously 

combined captions in a Form 10–Q but 

is required to present such captions 

separately in the Form 10–Q for the 

current quarter, must it retroactively 

reclassify amounts included in the 

prior-year financial statements 

presented for comparative purposes to 

conform with the captions presented for 

the current-year quarter? 

Interpretive Response: Yes. 

Question 2: If a company uses the 

gross profit method or some other 

method to determine cost of goods sold 

for interim periods, will it be acceptable 

to state only that it is not practicable to 

determine components of inventory at 

interim periods? 

Interpretive Response: The staff 

believes disclosure of inventory 

components is important to investors. In 

reaching this decision, the staff 

recognizes that registrants may not take 

inventories during interim periods and 

that managements, therefore, will have 

to estimate the inventory components. 

However, the staff believes that 

management will be able to make 

reasonable estimates of inventory 

components based upon their 

knowledge of the company’s production 

cycle, the costs (labor and overhead) 

associated with this cycle as well as the 

relative sales and purchasing volume of 

the company. 

Question 3: If a company has years 

during which operations resulted in a 

net outflow of cash and cash 

equivalents, should it exclude such 

years from the computation of cash and 

cash equivalents provided by operations 

for the three most recent years in 


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Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17233 

5Registrants also are reminded that FASB ASC 

paragraph 250–10–50–1 (Accounting Changes and 

Error Corrections Topic) requires that companies 

disclose the nature of and justification for the 

change as well as the effects of the change on net 

income for the period in which the change is made. 

Furthermore, the justification for the change should 

explain clearly why the newly adopted principle is 

preferable to the previously-applied principle. 

determining what sources and 

applications must be shown separately? 

Interpretive Response: Yes. Similar to 

the determination of average net 

income, if operations resulted in a net 

outflow of cash and cash equivalents 

during any year, such amount should be 

excluded in making the computation of 

cash flow provided by operations for the 

three most recent years unless 

operations resulted in a net outflow of 

cash and cash equivalents in all three 

years, in which case the average of the 

net outflow of cash and cash equivalents 

should be used for the test. 

b. Reporting Requirements for 

Accounting Changes 

1. Preferability 

Facts: Rule 10–01(b)(6) of Regulation 

S–X requires that a registrant who 

makes a material change in its method 

of accounting shall indicate the date of 

and the reason for the change. The 

registrant also must include as an 

exhibit in the first Form 10–Q filed 

subsequent to the date of an accounting 

change, a letter from the registrant’s 

independent accountants indicating 

whether or not the change is to an 

alternative principle which in his 

judgment is preferable under the 

circumstances. A letter from the 

independent accountant is not required 

when the change is made in response to 

a standard adopted by the Financial 

Accounting Standards Board which 

requires such a change. 

Question 1: For some alternative 

accounting principles, authoritative 

bodies have specified when one 

alternative is preferable to another. 

However, for other alternative 

accounting principles, no authoritative 

body has specified criteria for 

determining the preferability of one 

alternative over another. In such 

situations, how should preferability be 

determined? 

Interpretive Response: In such cases, 

where objective criteria for determining 

the preferability among alternative 

accounting principles have not been 

established by authoritative bodies, the 

determination of preferability should be 

based on the particular circumstances 

described by and discussed with the 

registrant. In addition, the independent 

accountant should consider other 

significant information of which he is 

aware.5

Question 2: Management may offer, as 

justification for a change in accounting 

principle, circumstances such as: their 

expectation as to the effect of general 

economic trends on their business (e.g., 

the impact of inflation), their 

expectation regarding expanding 

consumer demand for the company’s 

products, or plans for change in 

marketing methods. Are these 

circumstances which enter into the 

determination of preferability? 

Interpretive Response: Yes. Those 

circumstances are examples of business 

judgment and planning and should be 

evaluated in determining preferability. 

In the case of changes for which 

objective criteria for determining 

preferability have not been established 

by authoritative bodies, business 

judgment and business planning often 

are major considerations in determining 

that the change is to a preferable method 

because the change results in improved 

financial reporting. 

Question 3: What responsibility does 

the independent accountant have for 

evaluating the business judgment and 

business planning of the registrant? 

Interpretive Response: Business 

judgment and business planning are 

within the province of the registrant. 

Thus, the independent accountant may 

accept the registrant’s business 

judgment and business planning and 

express reliance thereon in his letter. 

However, if either the plans or judgment 

appear to be unreasonable to the 

independent accountant, he should not 

accept them as justification. For 

example, an independent accountant 

should not accept a registrant’s plans for 

a major expansion if he believes the 

registrant does not have the means of 

obtaining the funds necessary for the 

expansion program. 

Question 4: If a registrant, who has 

changed to an accounting method which 

was preferable under the circumstances, 

later finds that it must abandon its 

business plans or change its business 

judgment because of economic or other 

factors, is the registrant’s justification 

nullified? 

Interpretive Response: No. A 

registrant must in good faith justify a 

change in its method of accounting 

under the circumstances which exist at 

the time of the change. The existence of 

different circumstances at a later time 

does not nullify the previous 

justification for the change. 

Question 5: If a registrant justified a 

change in accounting method as 

preferable under the circumstances, and 

the circumstances change, may the 

registrant revert to the method of 

accounting used before the change? 

Interpretive Response: Any time a 

registrant makes a change in accounting 

method, the change must be justified as 

preferable under the circumstances. 

Thus, a registrant may not change back 

to a principle previously used unless it 

can justify that the previously used 

principle is preferable in the 

circumstances as they currently exist. 

Question 6: If one client of an 

independent accounting firm changes 

its method of accounting and the 

accountant submits the required letter 

stating his view of the preferability of 

the principle in the circumstances, does 

this mean that all clients of that firm are 

constrained from making the converse 

change in accounting (e.g., if one client 

changes from FIFO to LIFO, can no 

other client change from LIFO to FIFO)? 

Interpretive Response: No. Each 

registrant must justify a change in 

accounting method on the basis that the 

method is preferable under the 

circumstances of that registrant. In 

addition, a registrant must furnish a 

letter from its independent accountant 

stating that in the judgment of the 

independent accountant the change in 

method is preferable under the 

circumstances of that registrant. If 

registrants in apparently similar 

circumstances make changes in opposite 

directions, the staff has a responsibility 

to inquire as to the factors which were 

considered in arriving at the 

determination by each registrant and its 

independent accountant that the change 

was preferable under the circumstances 

because it resulted in improved 

financial reporting. The staff recognizes 

the importance, in many circumstances, 

of the judgments and plans of 

management and recognizes that such 

management judgments may, in good 

faith, differ. As indicated above, the 

concern relates to registrants in 

apparently similar circumstances, no 

matter who their independent 

accountants may be. 

Question 7: If a registrant changes its 

accounting to one of two methods 

specifically approved by the FASB in 

the Accounting Standards Codification, 

need the independent accountant 

express his view as to the preferability 

of the method selected? 

Interpretive Response: If a registrant 

was formerly using a method of 

accounting no longer deemed 

acceptable, a change to either method 

approved by the FASB may be 

presumed to be a change to a preferable 

method and no letter will be required 

from the independent accountant. If, 

however, the registrant was formerly 

using one of the methods approved by 


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the FASB for current use and wishes to 

change to an alternative approved 

method, then the registrant must justify 

its change as being one to a preferable 

method in the circumstances and the 

independent accountant must submit a 

letter stating that in his view the change 

is to a principle that is preferable in the 

circumstances. 

2. Filing of a Letter From the 

Accountants 

Facts: The registrant makes an 

accounting change in the fourth quarter 

of its fiscal year. Rule 10–01(b)(6) of 

Regulation S–X requires that the 

registrant file a letter from its 

independent accountants stating 

whether or not the change is preferable 

in the circumstances in the next Form 

10–Q. Item 601(b)(18) of Regulation S– 

K provides that the independent 

accountant’s preferability letter be filed 

as an exhibit to reports on Forms 10–K 

or 10–Q. 

Question: When the independent 

accountant’s letter is filed with the 

Form 10–K, must another letter also be 

filed with the first quarter’s Form 10–Q 

in the following year? 

Interpretive Response: No. A letter is 

not required to be filed with Form 10– 

Q if it has been previously filed as an 

exhibit to the Form 10–K. 

H. Accounting Series Release 148— 

Disclosure of Compensating Balances 

and Short-Term Borrowing 

Arrangements (Adopted November 13, 

1973 as Modified by ASR 172 Adopted 

on June 13, 1975 and ASR 280 Adopted 

on September 2, 1980) 

Facts: ASR 148 (as modified) amends 

Regulation S–X to include: 

1. Disclosure of compensating balance 

arrangements. 

2. Segregation of cash for 

compensating balance arrangements that 

are legal restrictions on the availability 

of cash. 

1. Applicability 

a. Arrangements With Other Lending 

Institutions 

Question: In addition to banks, is ASR 

148 applicable to arrangements with 

factors, commercial finance companies 

or other lending entities? 

Interpretive Response: Yes. 

b. Bank Holding Companies and 

Brokerage Firms 

Question: Do the provisions of ASR 

148 apply to bank holding companies 

and to brokerage firms filing under Rule 

17a–5? 

Interpretive Response: Yes; however, 

brokerage firms are not expected to meet 

these requirements when filing Form X– 

17a–5. 

c. Financial Statements of Parent 

Company and Unconsolidated 

Subsidiaries 

Question: Are the provisions of ASR 

148 applicable to parent company 

financial statements in addition to 

consolidated financial statements? To 

financial statements of unconsolidated 

subsidiaries? 

Interpretive Response: ASR 148 data 

for consolidated financial statements 

only will generally be sufficient when a 

filing includes consolidated and parent 

company financial statements. Such 

data are required for each 

unconsolidated subsidiary or other 

entity when a filing is required to 

include complete financial statements of 

those entities. When the filing includes 

summarized financial data in a footnote 

about such entities, the disclosures 

under ASR 148 relating to the 

consolidated financial statements will 

be sufficient. 

d. Foreign Lenders 

Question: Are ASR 148 disclosure 

requirements applicable to 

arrangements with foreign lenders? 

Interpretive Response: Yes. 

2. Classification of Short-Term 

Obligations—Debt Related to Long-Term 

Projects 

Facts: Companies engaging in 

significant long-term construction 

programs frequently arrange for 

revolving cover loans which extend 

until the completion of long-term 

construction projects. Such revolving 

cover loans are typically arranged with 

substantial financial institutions and 

typically have the following 

characteristics: 

1. A firm long-term mortgage 

commitment is obtained for each 

project. 

2. Interest rates and terms are in line 

with the company’s normal borrowing 

arrangements. 

3. Amounts are equal to the expected 

full mortgage amount of all projects. 

4. The company may draw down 

funds at its option up to the maximum 

amount of the agreement. 

5. The company uses short-term 

interim construction financing 

(commercial paper, bank loans, etc.) 

against the revolving cover loan. Such 

indebtedness is rolled over or drawn 

down on the revolving cover loan at the 

company’s option. The company 

typically has regular bank lines of 

credit, but these generally are not legally 

enforceable. 

Question: Under FASB ASC Subtopic 

470–10, Debt—Overall, will the 

classification of loans such as described 

above as long-term be acceptable? 

Interpretive Response: Where such 

conditions exist providing for a firm 

commitment throughout the 

construction program as well as a firm 

commitment for permanent mortgage 

financing, and where there are no 

contingencies other than the completion 

of construction, the guideline criteria 

are met and the borrowing under such 

a program should be classified as longterm with appropriate disclosure. 

3. Compensating Balances 

a. Compensating Balances for Future 

Credit Availability 

Facts: Rule 5–02.1 of Regulation S–X 

requires disclosure of compensating 

balances in order to avoid undisclosed 

commingling of such balances with 

other funds having different liquidity 

characteristics and bearing no 

determinable relationship to borrowing 

arrangements. It also requires footnote 

disclosure distinguishing the amounts 

of such balances maintained under a 

formal agreement to assure future credit 

availability. 

Question: In disclosing compensating 

balances maintained to assure future 

credit availability, is it necessary to 

segregate compensating balances for an 

unused portion of a regular line of credit 

when a total compensating balance 

amount covering both used and unused 

amounts of a line of credit is disclosed? 

Interpretive Response: No. 

b. Changes in Compensating Balances 

Facts: ASR 148 guidelines indicate 

the need for additional disclosures 

where compensating balances were 

materially greater during the period 

than at the end of the period. 

Question: Does this disclosure relate 

to changes in the arrangement (e.g., the 

required compensating balance 

percentage) or changes in borrowing 

levels? 

Interpretive Response: Both. 

c. Float 

Facts: ASR 148 states that 

‘‘compensating balance arrangements 

* * * are normally expressed in terms 

of collected bank ledger balances but the 

financial statements are presented on 

the basis of the company’s books. In 

order to make the disclosure of 

compensating balance amounts * * * 

consistent with the cash amounts 

reflected in the financial statements, the 

balance figure agreed upon by the bank 

and the company should be adjusted if 

possible by the estimated float.’’ 


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Question: In determining the amount 

of ‘‘float’’ as suggested by ASR 148 

guidelines, frequently an adjustment to 

the bank balance is required for 

‘‘uncollected funds.’’ On what basis 

should this adjustment be estimated? 

Interpretive Response: The adjustment 

should be estimated based upon the 

method used by the bank or a 

reasonable approximation of that 

method. The following is a sample 

computation of the amount of 

compensating balances to be disclosed 

where uncollected funds are involved. 

Assumptions: The company has 

agreed to maintain compensating 

balances equal to 20% of short-term 

borrowings. 

Short-term borrowings ........ $10,000,000 

Compensating balances per 

bank balances ................... 2,000,000 

Estimated float (approximates the excess of outstanding checks over deposits in transit) ............... 480,000 

Estimated uncollected funds 320,000 

Computation: 

Compensating balances 

per bank balances ......... 2,000,000 

Estimated uncollected 

funds ............................. 320,000 

Estimated float ................. (480,000) 

Compensating balances stated in terms of a book 

cash balance and to be 

disclosed ........................... 1,840,000 

4. Miscellaneous 

a. Periods required 

Question: For what periods are ASR 

148 disclosures required? 

Interpretive Response: Disclosure of 

compensating balance arrangements and 

other disclosures called for in ASR 148 

are required for the latest fiscal year but 

are generally not required for any later 

interim period unless a material change 

has occurred since year end. 

b. 10–Q Disclosures 

Question: Are ASR 148 disclosures 

required in 10–Q’s? 

Interpretive Response: In general, ASR 

148 disclosures are not required in Form 

10–Q. However, in some instances 

material changes in borrowing 

arrangements or borrowing levels may 

give rise to the need for disclosure 

either in Form 10–Q or Form 8–K. 

I. Accounting Series Release 149— 

Improved Disclosure of Income Tax 

Expense (Adopted November 28, 1973 

and Modified by ASR 280 Adopted on 

September 2, 1980) 

Facts: ASR 149 and 280 amend 

Regulation S–X to include: 

1. Disclosure of tax effect of timing 

differences comprising deferred income 

tax expense. 

2. Disclosure of the components of 

income tax expense, including currently 

payable and the net tax effects of timing 

differences. 

3. Disclosure of the components of 

income [loss] before income tax expense 

[benefit] as either domestic or foreign. 

4. Reconciliation between the 

statutory Federal income tax rate and 

the effective tax rate. 

1. Tax rate 

Question 1: In reconciling to the 

effective tax rate should the rate used be 

a combination of state and Federal 

income tax rates? 

Interpretive Response: No, the 

reconciliation should be made to the 

Federal income tax rate only. 

Question 2: What is the ‘‘applicable 

statutory Federal income tax rate’’? 

Interpretive Response: The applicable 

statutory Federal income tax rate is the 

normal rate applicable to the reporting 

entity. Hence, the statutory rate for a 

U.S. partnership is zero. If, for example, 

the statutory rate for U.S. corporations 

is 22% on the first $25,000 of taxable 

income and 46% on the excess over 

$25,000, the ‘‘normalized rate’’ for 

corporations would fluctuate in the 

range between 22% and 46% depending 

on the amount of pretax accounting 

income a corporation has. 

2. Taxes of Investee Company 

Question: If a registrant records its 

share of earnings or losses of a 50% or 

less owned person on the equity basis 

and such person has an effective tax rate 

which differs by more than 5% from the 

applicable statutory Federal income tax 

rate, is a reconciliation as required by 

Rule 4–08(g) necessary? 

Interpretive Response: Whenever the 

tax components are known and material 

to the investor’s (registrant’s) financial 

position or results of operations, 

appropriate disclosure should be made. 

In some instances where 50% or less 

owned persons are accounted for by the 

equity method of accounting in the 

financial statements of the registrant, 

the registrant may not know the rate at 

which the various components of 

income are taxed and it may not be 

practicable to provide disclosure 

concerning such components. 

It should also be noted that it is 

generally necessary to disclose the 

aggregate dollar and per-share effect of 

situations where temporary tax 

exemptions or ‘‘tax holidays’’ exist, and 

that such disclosures are also applicable 

to 50% or less owned persons. Such 

disclosures should include a brief 

description of the factual circumstances 

and give the date on which the special 

tax status will terminate. See Topic 

11.C. 

3. Net of Tax Presentation 

Question: What disclosure is required 

when an item is reported on a net of tax 

basis (e.g., extraordinary items, 

discontinued operations, or cumulative 

adjustment related to accounting 

change)? 

Interpretive Response: When an item 

is reported on a net of tax basis, 

additional disclosure of the nature of 

the tax component should be provided 

by reconciling the tax component 

associated with the item to the 

applicable statutory Federal income tax 

rate or rates. 

4. Loss Years 

Question: Is a reconciliation of a tax 

recovery in a loss year required? 

Interpretive Response: Yes, in loss 

years the actual book tax benefit of the 

loss should be reconciled to expected 

normal book tax benefit based on the 

applicable statutory Federal income tax 

rate. 

5. Foreign Registrants 

Question 1: Occasionally, reporting 

foreign persons may not operate under 

a normal income tax base rate such as 

the current U.S. Federal corporate 

income tax rate. What form of disclosure 

is acceptable in these circumstances? 

Interpretive Response: In such 

instances, reconciliations between yearto-year effective rates or between a 

weighted average effective rate and the 

current effective rate of total tax expense 

may be appropriate in meeting the 

requirements of Rule 4–08(h)(2). A brief 

description of how such a rate was 

determined would be required in 

addition to other required disclosures. 

Such an approach would not be 

acceptable for a U.S. registrant with 

foreign operations. Foreign registrants 

with unusual tax situations may find 

that these guidelines are not fully 

responsive to their needs. In such 

instances, registrants should discuss the 

matter with the staff. 

Question 2: Where there are 

significant reconciling items that relate 

in significant part to foreign operations 

as well as domestic operations, is it 

necessary to disclose the separate 

amounts of the tax component by 

geographical area, e.g., statutory 

depletion allowances provided for by 

U.S. and by other foreign jurisdictions? 

Interpretive Response: It is not 

practicable to give an all-encompassing 

answer to this question. However, in 

many cases such disclosure would seem 

appropriate. 


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6. Securities Gains and Losses 

Question: If the tax on the securities 

gains and losses of banks and insurance 

companies varies by more than 5% from 

the applicable statutory Federal income 

tax rate, should a reconciliation to the 

statutory rate be provided? 

Interpretive Response: Yes. 

Tax Expense Components v. ‘‘Overall’’ 

Presentation 

Facts: Rule 4–08(h) requires that the 

various components of income tax 

expense be disclosed, e.g., currently 

payable domestic taxes, deferred foreign 

taxes, etc. Frequently income tax 

expense will be included in more than 

one caption in the financial statements. 

For example, income taxes may be 

allocated to continuing operations, 

discontinued operations, extraordinary 

items, cumulative effects of an 

accounting change and direct charges 

and credits to shareholders’ equity. 

Question: In instances where income 

tax expense is allocated to more than 

one caption in the financial statements, 

must the components of income tax 

expense included in each caption be 

disclosed or will an ‘‘overall’’ 

presentation such as the following be 

acceptable? 

The components of income tax 

expense are: 

Currently payable (per tax 

return): 

Federal ................................. $350,000 

Foreign ................................. 150,000 

State ...................................... 50,000 

Deferred: 

Federal .............................. 125,000 

Foreign .............................. 75,000 

State .................................. 50,000 

800,000 

Income tax expense is included in the 

financial statements as follows: 

Continuing operations ......... $600,000 

Discontinued operations ..... (200,000) 

Extraordinary income .......... 300,000 

Cumulative effect of change 

in accounting principle ... 100,000 

800,000 

Interpretive Response: An overall 

presentation of the nature described will 

be acceptable. 

J. Removed by SAB 47 

K. Accounting Series Release 302— 

Separate Financial Statements Required 

By Regulation S–X 

1. Removed by SAB 103 

2. Parent Company Financial 

Information 

a. Computation of Restricted Net Assets 

of Subsidiaries 

Facts: The revised rules for parent 

company disclosures adopted in ASR 

302 require, in certain circumstances, 

(1) footnote disclosure in the 

consolidated financial statements about 

the nature and amount of significant 

restrictions on the ability of subsidiaries 

to transfer funds to the parent through 

intercompany loans, advances or cash 

dividends [Rule 4–08(e)(3)], and (2) the 

presentation of condensed parent 

company financial information and 

other data in a schedule (Rule 12–04). 

To determine which disclosures, if any, 

are required, a registrant must compute 

its proportionate share of the net assets 

of its consolidated and unconsolidated 

subsidiary companies as of the end of 

the most recent fiscal year which are 

restricted as to transfer to the parent 

company because the consent of a third 

party (a lender, regulatory agency, 

foreign government, etc.) is required. If 

the registrant’s proportionate share of 

the restricted net assets of consolidated 

subsidiaries exceeds 25% of the 

registrant’s consolidated net assets, both 

the footnote and schedule information 

are required. If the amount of such 

restrictions is less than 25%, but the 

sum of these restrictions plus the 

amount of the registrant’s proportionate 

share of restricted net assets of 

unconsolidated subsidiaries plus the 

registrant’s equity in the undistributed 

earnings of 50% or less owned persons 

(investees) accounted for by the equity 

method exceed 25% of consolidated net 

assets, the footnote disclosure is 

required. 

Question 1: How are restricted net 

assets of subsidiaries computed? 

Interpretative Response: The 

calculation of restricted net assets 

requires an evaluation of each 

subsidiary to identify any circumstances 

where third parties may limit the 

subsidiary’s ability to loan, advance or 

dividend funds to the parent. This 

evaluation normally comprises a review 

of loan agreements, statutory and 

regulatory requirements, etc., to 

determine the dollar amount of each 

subsidiary’s restrictions. The related 

amount of the subsidiary’s net assets 

designated as restricted, however, 

should not exceed the amount of the 

subsidiary’s net assets included in 

consolidated net assets, since parent 

company disclosures are triggered when 

a significant amount of consolidated net 

assets are restricted. The amount of each 

subsidiary’s net assets included in 

consolidated net assets is determined by 

allocating (pushing down) to each 

subsidiary any related consolidation 

adjustments such as intercompany 

balances, intercompany profits, and 

differences between fair value and 

historical cost arising from a business 

combination accounted for as a 

purchase. This amount is referred to as 

the subsidiary’s adjusted net assets. If 

the subsidiary’s adjusted net assets are 

less than the amount of its restrictions 

because the push down of consolidating 

adjustments reduced its net assets, the 

subsidiary’s adjusted net assets is the 

amount of the subsidiary’s restricted net 

assets used in the tests. 

Registrants with numerous 

subsidiaries and investees may wish to 

develop approaches to facilitate the 

determination of its parent company 

disclosure requirements. For example, if 

the parent company’s adjusted net 

assets (excluding any interest in its 

subsidiaries) exceed 75% of 

consolidated net assets, or if the total of 

all of the registrant’s consolidated and 

unconsolidated subsidiaries’ restrictions 

and its equity in investees’ earnings is 

less than 25% of consolidated net 

assets, then the allocation of 

consolidating adjustments to the 

subsidiaries to determine the amount of 

their adjusted net assets would not be 

necessary since no parent company 

disclosures would be required. 

Question 2: If a registrant makes a 

decision that it will permanently 

reinvest the undistributed earnings of a 

subsidiary, and thus does not provide 

for income taxes thereon because it 

meets the criteria set forth in FASB ASC 

Subtopic 740–30, Income Taxes—Other 

Considerations or Special Areas, is there 

considered to be a restriction for 

purposes of the test? 

Interpretive Response: No. The rules 

require that only third party restrictions 

be considered. Restrictions on 

subsidiary net assets imposed by 

management are not included. 

b. Application of Tests for Parent 

Company Disclosures 

Facts: The balance sheet of the 

registrant’s 100%-owned subsidiary at 

the most recent fiscal year-end is 

summarized as follows: 


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Current assets .......................................................... $120 Current liabilities ...................................................... $30 

Noncurrent assets .................................................... 45 Long-term debt ......................................................... 60 

90 

Common stock ......................................................... 25 

Retained earnings .................................................... 50 

75 

165 165 

Net assets of the subsidiary are $75. 

Assume there are no consolidating 

adjustments to be allocated to the 

subsidiary. Restrictive covenants of the 

subsidiary’s debt agreements provide 

that: 

Net assets, excluding intercompany 

loans, cannot be less than $35 

60% of accumulated earnings must be 

maintained 

Question 1: What is the amount of the 

subsidiary’s restricted net assets? 

Interpretive Response: 

Restriction Computed 

restrictions 

Net assets: Currently $75, 

cannot be less than $35; 

therefore ............................ $35 

Dividends: 60% of accumulated earnings ($50) cannot be paid out; therefore 30 

Restricted net assets for purposes of 

the test are $35. The maximum amount 

that can be loaned or advanced to the 

parent without violating the net asset 

covenant is $40 ($75 ¥ 35). 

Alternatively, the subsidiary could pay 

a dividend of up to $20 ($50 ¥ 30) 

without violating the dividend 

covenant, and loan or advance up to 

$20, without violating the net asset 

provision. 

Facts: The registrant has one 100%- 

owned subsidiary. The balance sheet of 

the subsidiary at the latest fiscal yearend is summarized as follows: 

Current assets .......................................................... $75 Current liabilities ...................................................... $23 

Noncurrent assets .................................................... 90 Long-term debt ......................................................... 57 

Redeemable preferred stock ................................... 10 

Common stock ......................................................... 30 

Retained earnings .................................................... 45 

75 

165 165 

Assume that the registrant’s 

consolidated net assets are $130 and 

there are no consolidating adjustments 

to be allocated to the subsidiary. The 

subsidiary’s net assets are $75. The 

subsidiary’s noncurrent assets are 

comprised of $40 in operating plant and 

equipment used in the subsidiary’s 

business and a $50 investment in a 30% 

investee. The subsidiary’s equity in this 

investee’s undistributed earnings is $18. 

Restrictive covenants of the subsidiary’s 

debt agreements are as follows: 

1. Net assets, excluding intercompany 

balances, cannot be less than $20. 

2. 80% of accumulated earnings must 

be reinvested in the subsidiary. 

3. Current ratio of 2:1 must be 

maintained. 

Question 2: Are parent company 

footnote or schedule disclosures 

required? 

Interpretive Response: Only the 

parent company footnote disclosures are 

required. The subsidiary’s restricted net 

assets are computed as follows: 

Restriction Computed 

restriction 

Net assets: Currently $75, 

cannot be less than $20; 

therefore ............................ $20 

Dividends: 80% of accumulated earnings ($45) cannot be paid; therefore ....... 36 

Restriction Computed 

restriction 

Current ratio: Must be at 

least 2:1 ($46 current assets must be maintained 

since current liabilities are 

$23 at fiscal year-end); 

therefore ............................ 46 

Restricted net assets for purposes of 

the test are $20. The amount computed 

from the dividend restriction ($36) and 

the current ratio requirement ($46) are 

not used because net assets may be 

transferred by the subsidiary up to the 

limitation imposed by the requirement 

to maintain net assets of at least $20, 

without violating the other restrictions. 

For example, a transfer to the parent of 

up to $55 of net assets could be 

accomplished by a combination of 

dividends of current assets of $9 ($45 ¥ 

36), and loans or advances of current 

assets of up to $20 and noncurrent 

assets of up to $26. 

Parent company footnote disclosures 

are required in this example since the 

restricted net assets of the subsidiary 

and the registrant’s equity in the 

earnings of its 100%-owned subsidiary’s 

investee exceed 25% of consolidated net 

assets [($20 + 18)/$130 = 29%]. The 

parent company schedule information is 

not required since the restricted net 

assets of the subsidiary are only 15% of 

consolidated net assets ($20/$130 = 

15%). 

Although the subsidiary’s noncurrent 

assets are not in a form which is readily 

transferable to the parent company, the 

illiquid nature of the assets is not 

relevant for purposes of the parent 

company tests. The objective of the tests 

is to require parent company disclosures 

when the parent company does not have 

control of its subsidiaries’ funds because 

it does not have unrestricted access to 

their net assets. The tests trigger parent 

company disclosures only when there 

are significant third party restrictions on 

transfers by subsidiaries of net assets 

and the subsidiaries’ net assets comprise 

a significant portion of consolidated net 

assets. Practical limitations, other than 

third party restrictions on transferability 

at the measurement date (most recent 

fiscal year-end), such as subsidiary 

illiquidity, are not considered in 

computing restricted net assets. 

However, the potential effect of any 

limitations other than those imposed by 

third parties should be considered for 

inclusion in Management’s Discussion 

and Analysis of liquidity. 

Facts: 

Net assets 

Subsidiary A ......................... $(500) 

Subsidiary B ......................... 2,000 


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Net assets 

Consolidated ......................... 3,700 

Subsidiaries A and B are 100% owned 

by the registrant. Assume there are no 

consolidating adjustments to be 

allocated to the subsidiaries. Subsidiary 

A has restrictions amounting to $200. 

Subsidiary B’s restrictions are $1,000. 

Question 3: What parent company 

disclosures are required for the 

registrant? 

Interpretive Response: Since 

subsidiary A has an excess of liabilities 

over assets, it has no restricted net 

assets for purposes of the test. However, 

both parent company footnote and 

schedule disclosures are required, since 

the restricted net assets of subsidiary B 

exceed 25% of consolidated net assets 

($1,000/3,700 = 27%). 

Facts: 

Net assets 

Subsidiary A ................. $850 

Subsidiary B ................. 300 

Consolidated ................. 3,700 

The registrant owns 80% of 

subsidiary A. Subsidiary A owns 100% 

of subsidiary B. Assume there are no 

consolidating adjustments to be 

allocated to the subsidiaries. A may not 

pay any dividends or make any affiliate 

loans or advances. B has no restrictions. 

A’s net assets of $850 do not include its 

investment in B. 

Question 4: Are parent company 

footnote or schedule disclosures 

required for this registrant? 

Interpretive Response: No. All of the 

registrant’s share of subsidiary A’s net 

assets ($680) are restricted. Although B 

may pay dividends and loan or advance 

funds to A, the parent’s access to B’s 

funds through A is restricted. However, 

since there are no limitations on B’s 

ability to loan or advance funds to the 

parent, none of the parent’s share of B’s 

net assets are restricted. Since A’s 

restricted net assets are less than 25% 

of consolidated net assets ($680/3700 = 

18%), no parent company disclosures 

are required. 

Facts: The consolidating balance 

sheet of the registrant at the latest fiscal 

year-end is summarized as follows: 

Registrant Subsidiary Consolidating 

adjustments Consolidated 

Current assets ................................................................................................. $800 $700 $0 $1,500 

30% investment in affiliate ............................................................................... 175 0 0 175 

Investment in subsidiary .................................................................................. 350 0 (350) 0 

Other noncurrent assets .................................................................................. 625 300 (100) 825 

1,950 1,000 (450) 2,500 

Current liabilities .............................................................................................. 600 400 0 1,000 

Concurrent liabilities ........................................................................................ 375 150 0 525 

Redeemable preferred stock ........................................................................... 275 0 0 275 

Common stock ................................................................................................. 110 1 (1) 110 

Paid-in capital .................................................................................................. 290 49 (49) 290 

Retained earnings ............................................................................................ 300 400 (400) 300 

700 450 (450) 700 

1,950 1,000 (450) 2,500 

The acquisition of the 100%-owned 

subsidiary was consummated on the last 

day of the most recent fiscal year. 

Immediately preceding the acquisition, 

the registrant had net assets of $700, 

which included its equity in the 

undistributed earnings of its 30% 

investee of $75. Immediately after 

acquiring the subsidiary’s net assets, 

which had an historical cost of $450 and 

a fair value of $350, the registrant’s net 

assets were still $700 since debt and 

preferred stock totaling $350 were 

issued in the purchase. The subsidiary 

has debt covenants which permit 

dividends, loans or advances, to the 

extent, if any, that net assets exceed an 

amount which is determined by the sum 

of $100 plus 75% of the subsidiary’s 

accumulated earnings. 

Question 5: What is the amount of the 

subsidiary’s restricted net assets? Are 

parent company footnote or schedule 

disclosures required? 

Interpretive Response: Restricted net 

assets for purposes of the test are $350, 

and both the parent company footnote 

and schedule disclosures are required. 

The amount of the subsidiary’s 

restrictions at year-end is $400 [$100 + 

(75% × $400)]. The subsidiary’s 

adjusted net assets after the push down 

of the consolidation entry to the 

subsidiary to record the noncurrent 

assets acquired at their fair value is $350 

($450 ¥ $100). Since the subsidiary’s 

adjusted net assets ($350) are less than 

the amount of its restrictions ($400), 

restricted net assets are $350. The 

computed percentages applicable to 

each of the disclosure tests is in excess 

of 25%. Therefore, both parent company 

footnote and schedule information are 

required. The percentage applicable to 

the footnote disclosure test is 61% [($75 

+ 350)/$700]. The computed percentage 

for the schedule disclosure is 50% 

($350/$700). 

3. Undistributed Earnings of 50% or 

Less Owned Persons 

Facts: Rule 4–08(e)(2) of Regulation 

SX requires footnote disclosures of the 

amount of consolidated retained 

earnings which represents undistributed 

earnings of 50% or less owned persons 

(investee) accounted for by the equity 

method. The test adopted in ASR 302 to 

trigger disclosures about the registrant’s 

restricted net assets (Rule 4–08(e)(3)) 

includes the parent’s equity in the 

undistributed earnings of investees. 

Question: Is the amount required for 

footnote disclosure the same as the 

amount included in the test to 

determine disclosures about 

restrictions? 

Interpretive Response: Yes. The 

amount used in the test in Rule 4– 

08(e)(3) should be the same as the 

amount required to be disclosed by Rule 

4–08(e)(2). This is the portion of the 

registrant’s consolidated retained 

earnings which represents the 

undistributed earnings of an investee 

since the date(s) of acquisition. It is 

computed by determining the 

registrant’s cumulative equity in the 

investee’s earnings, adjusted by any 

dividends received, related goodwill 


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6 [Original footnote removed by SAB 114.] 

7FASB ASC paragraph 450–20–25–2. 

8For purposes of this interpretation, a loan is 

defined (consistent with the FASB ASC Master 

Glossary) as a contractual right to receive money on 

demand or on fixed or determinable dates that is 

recognized as an asset in the creditor’s statement of 

financial position. For purposes of this 

interpretation, loans do not include trade accounts 

Continued 

write-downs, and any related income 

taxes provided. 

4. Application of Significant Subsidiary 

Test to Investees and Unconsolidated 

Subsidiaries 

a. Separate Financial Statement 

Requirements 

Facts: Rule 3–09 of Regulation SX 

requires the presentation of separate 

financial statements of unconsolidated 

subsidiaries and of 50% or less owned 

persons (investee) accounted for by the 

equity method either by the registrant or 

by a subsidiary of the registrant in 

filings with the Commission if any of 

the tests of a significant subsidiary are 

met at a 20% level. 

Question 1: Are the requirements for 

separate financial statements also 

applicable to an investee accounted for 

by the equity method by an investee of 

the registrant? 

Interpretive Response: Yes. Rule 3–09 

is intended to apply to all investees 

which are material to the financial 

position or results of operations of the 

registrant, regardless of whether the 

investee is held by the registrant, a 

subsidiary or another investee. Separate 

financial statements should be provided 

for any lower tier investee where such 

an entity is significant to the registrant’s 

consolidated financial statements. 

Question 2: How is the significant 

subsidiary test applied to the lower tier 

investee in the situation described in 

Question 1? 

Interpretive Response: Since the 

disclosures provided by separate 

financial statements of an investee are 

considered necessary to evaluate the 

overall financial condition of the 

registrant, the significant subsidiary test 

is computed based on the materiality of 

the lower tier investee to the registrant 

consolidated. An example of the 

application of the assets test of the 

significant subsidiary rules to such an 

investee situation will illustrate the 

materiality measurement. A registrant 

with total consolidated assets of $5,000 

owns 50% of Investee A, whose total 

assets are $3,800. Investee A has a 45% 

investment in Investee B, whose total 

assets are $4,800. There are no 

intercompany eliminations. Separate 

financial statements are required for 

Investee A, and they are required for 

Investee B because the registrant’s share 

of B’s total assets exceeds 20% of 

consolidated assets [(50% × 45% × 

$4800)/$5000 = 22%]. 

b. Summarized Financial Statement 

Requirements 

Facts: Rule 4–08(g) of Regulation S–X 

requires summarized financial 

information about unconsolidated 

subsidiaries and 50% or less owned 

persons (investee) to be included in the 

footnotes to the financial statements if, 

in the aggregate, they meet the tests of 

a significant subsidiary set forth in Rule 

1–02(w). 

Question 1: Must a registrant which 

includes separate financial statements 

or condensed financial statements for 

unconsolidated subsidiaries or investees 

in its annual report to shareholders also 

include in such report the summarized 

financial information for these entities 

pursuant to Rule 4–08(g)? 

Interpretive Response: No. The 

purpose of the summarized information 

is to provide minimum standards of 

disclosure when the impact of such 

entities on the consolidated financial 

statements is significant. If the registrant 

furnishes more information in the 

annual report than is required by these 

minimum disclosure standards, such as 

condensed financial information or 

separate audited financial statements, 

the summarized data can be excluded. 

The Commission’s rules are not 

intended to conflict with the provisions 

of FASB ASC subparagraph 323–10–50– 

3(c) (Investments—Equity Method and 

Joint Ventures Topic), which provide 

that either separate financial statements 

of investees be presented with the 

financial statements of the reporting 

entity or that summarized information 

be included in the reporting entity’s 

financial statement footnotes. 

Question 2: Can summarized 

information be omitted for individual 

entities as long as the aggregate 

information for the omitted entity(s) 

does not exceed 10% under any of the 

significance tests of Rule 1–02(w)? 

Interpretive Response: The 10% 

measurement level of the significant 

subsidiary rule was not intended to 

establish a materiality criteria for 

omission, and the arbitrary exclusion of 

summarized information for selected 

entities up to a 10% level is not 

appropriate. Rule 4–08(g) requires that 

the summarized information be 

included for all unconsolidated 

subsidiaries and investees. However, the 

staff recognizes that exclusion of the 

summarized information for certain 

entities is appropriate in some 

circumstances where it is impracticable 

to accumulate such information and the 

summarized information to be excluded 

is de minimis. 

L. Financial Reporting Release 28— 

Accounting for Loan Losses by 

Registrants Engaged in Lending 

Activities 

1. Accounting for Loan Losses 

General: GAAP for recognition of loan 

losses is provided by FASB ASC 

Subtopic 450–20, Contingencies—Loss 

Contingencies, and FASB ASC Subtopic 

310–10, Receivables—Overall.6 An 

estimated loss from a loss contingency, 

such as the collectibility of receivables, 

should be accrued when, based on 

information available prior to the 

issuance of the financial statements, it is 

probable that an asset has been impaired 

or a liability has been incurred at the 

date of the financial statements and the 

amount of the loss can be reasonably 

estimated.7 FASB ASC Subtopic 310–10 

provides more specific guidance on 

measurement of loan impairment and 

related disclosures but does not change 

the fundamental recognition criteria for 

loan losses provided by FASB ASC 

Subtopic 450–20. 

Further guidance for SEC registrants 

is provided by FRR 28, which added 

subsection (b), Procedural Discipline in 

Determining the Allowance and 

Provision for Loan Losses to be 

Reported, of Section 401.09, Accounting 

for Loan Losses by Registrants Engaged 

in Lending Activities, to the 

Codification of Financial Reporting 

Policies (hereafter referred to as FRR 

28). Additionally, public companies are 

required to comply with the books and 

records provisions of the Securities 

Exchange Act of 1934 (Exchange Act). 

Under Sections 13(b)(2)—(7) of the 

Exchange Act, registrants must make 

and keep books, records, and accounts, 

which, in reasonable detail, accurately 

and fairly reflect the transactions and 

dispositions of assets of the registrant. 

Registrants also must maintain internal 

accounting controls that are sufficient to 

provide reasonable assurances that, 

among other things, transactions are 

recorded as necessary to permit the 

preparation of financial statements in 

conformity with GAAP. 

This staff interpretation applies to all 

registrants that are creditors in loan 

transactions that, individually or in the 

aggregate, have a material effect on the 

registrant’s financial statements.8


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receivable or notes receivable with terms less than 

one year or debt securities subject to the provisions 

of FASB ASC Topic 320, Investments—Debt and 

Equity Securities. 

9FRR 28 states that ‘‘the Commission’s staff 

normally would expect to find that the books and 

records of registrants engaged in lending activities 

include documentation of [the]: (a) Systematic 

methodology to be employed each period in 

determining the amount of the loan losses to be 

reported, and (b) rationale supporting each period’s 

determination that the amounts reported were 

adequate.’’ 

10See paragraph 9.05 of the Audit Guide. 

11 Ibid. 

12For Federally insured depository institutions, 

the December 21, 1993 ‘‘Interagency Policy 

Statement on the Allowance for Loan and Lease 

Losses (ALLL)’’ (the 1993 Interagency Policy 

Statement) indicates that boards of directors and 

management have certain responsibilities for the 

ALLL process and amounts reported. For example, 

as indicated on page 4 of that statement, ‘‘the board 

of directors and management are expected to: 

Ensure that the institution has an effective loan 

review system and controls[;] Ensure the prompt 

charge-off of loans, or portions of loans, that 

available information confirms to be uncollectible[; 

and] Ensure that the institution’s process for 

determining an adequate level for the ALLL is based 

on a comprehensive, adequately documented, and 

consistently applied analysis of the institution’s 

loan and lease portfolio.’’ 

13SAS 61 (as amended by SAS 90) states, in part: 

‘‘In connection with each SEC engagement the 

auditor should discuss with the audit committee 

the auditor’s judgments about the quality, not just 

the acceptability, of the entity’s accounting 

principles as applied in its financial reporting. The 

discussion should include items that have a 

significant impact on the representational 

faithfulness, verifiability, and neutrality of the 

accounting information included in the financial 

statements. [Footnote omitted.] Examples of items 

that may have such an impact are the following: 

1. Selection of new or changes to accounting 

policies 

2. Estimates, judgments, and uncertainties 

3. Unusual transactions 

Accounting policies relating to significant 

financial statement items, including the timing or 

transactions and the period in which they are 

recorded.’’ 

14Registrants should also refer to FASB ASC 

Section 450–20–30, Contingencies—Loss 

Contingencies—Initial Measurement, which 

provides accounting and disclosure guidance for 

situations in which a range of loss can be 

reasonably estimated but no single amount within 

the range appears to be a better estimate than any 

other amount within the range. 

15Registrants should refer to the guidance on 

materiality in SAB Topic 1.M. 

16FRR 28 states: ‘‘The specific rationale upon 

which the [loan loss allowance and provision] 

amount actually reported is based—i.e., the bridge 

2. Developing and Documenting a 

Systematic Methodology 

a. Developing a Systematic Methodology 

Facts: Registrant A, or one of its 

consolidated subsidiaries, engages in 

lending activities and is developing or 

performing a review of its loan loss 

allowance methodology. 

Question: What are some of the 

factors or elements that the staff 

normally would expect Registrant A to 

consider when developing (or 

subsequently performing an assessment 

of) its methodology for determining its 

loan loss allowance under GAAP? 

Interpretive Response: The staff 

normally would expect a registrant that 

engages in lending activities to develop 

and document a systematic 

methodology 9 to determine its 

provision for loan losses and allowance 

for loan losses as of each financial 

reporting date. It is critical that loan loss 

allowance methodologies incorporate 

management’s current judgments about 

the credit quality of the loan portfolio 

through a disciplined and consistently 

applied process. A registrant’s loan loss 

allowance methodology is influenced by 

entity-specific factors, such as an 

entity’s size, organizational structure, 

business environment and strategy, 

management style, loan portfolio 

characteristics, loan administration 

procedures, and management 

information systems. 

However, as indicated in the AICPA 

Audit and Accounting Guide, 

Depository and Lending Institutions 

with Conforming Changes as of June 1, 

2009 (Audit Guide), while different 

institutions may use different methods, 

there are certain common elements that 

should be included in any [loan loss 

allowance] methodology for it to be 

effective.10 A registrant’s loan loss 

allowance methodology generally 

should: 11

• Include a detailed analysis of the 

loan portfolio, performed on a regular 

basis; 

• Consider all loans (whether on an 

individual or group basis); 

• Identify loans to be evaluated for 

impairment on an individual basis 

under FASB ASC Subtopic 310–10 and 

segment the remainder of the portfolio 

into groups of loans with similar risk 

characteristics for evaluation and 

analysis under FASB ASC Subtopic 

450–20; 

• Consider all known relevant 

internal and external factors that may 

affect loan collectibility; 

• Be applied consistently but, when 

appropriate, be modified for new factors 

affecting collectibility; 

• Consider the particular risks 

inherent in different kinds of lending; 

• Consider current collateral values 

(less costs to sell), where applicable; 

• Require that analyses, estimates, 

reviews and other loan loss allowance 

methodology functions be performed by 

competent and well-trained personnel; 

• Be based on current and reliable 

data; 

• Be well documented, in writing, 

with clear explanations of the 

supporting analyses and rationale (see 

Question 2 below for staff views on 

documenting a loan loss allowance 

methodology); and 

• Include a systematic and logical 

method to consolidate the loss estimates 

and ensure the loan loss allowance 

balance is recorded in accordance with 

GAAP. 

For many entities engaged in lending 

activities, the allowance and provision 

for loan losses are significant elements 

of the financial statements. 

Therefore, the staff believes it is 

appropriate for an entity’s management 

to review, on a periodic basis, its 

methodology for determining its 

allowance for loan losses.12

Additionally, for registrants that have 

audit committees, the staff believes that 

oversight of the financial reporting and 

auditing of the loan loss allowance by 

the audit committee can strengthen the 

registrant’s control system and process 

for determining its allowance for loan 

losses.13

A systematic methodology that is 

properly designed and implemented 

should result in a registrant’s best 

estimate of its allowance for loan 

losses.14 Accordingly, the staff normally 

would expect registrants to adjust their 

loan loss allowance balance, either 

upward or downward, in each period 

for differences between the results of the 

systematic determination process and 

the unadjusted loan loss allowance 

balance in the general ledger.15

b. Documenting a Systematic 

Methodology 

Question 1: Assume the same facts as 

in Question 1. What would the staff 

normally expect Registrant A to include 

in its documentation of its loan loss 

allowance methodology? 

Interpretive Response: In FRR 28, the 

Commission provided guidance for 

documentation of loan loss provisions 

and allowances for registrants engaged 

in lending activities. The staff believes 

that appropriate written supporting 

documentation for the loan loss 

provision and allowance facilitates 

review of the loan loss allowance 

process and reported amounts, builds 

discipline and consistency into the loan 

loss allowance determination process, 

and improves the process for estimating 

loan losses by helping to ensure that all 

relevant factors are appropriately 

considered in the allowance analysis. 

The staff, therefore, normally would 

expect a registrant to document the 

relationship between the findings of its 

detailed review of the loan portfolio and 

the amount of the loan loss allowance 

and the provision for loan losses 

reported in each period.16


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Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17241 

between the findings of the detailed review [of the 

loan portfolio] and the amount actually reported in 

each period—would be documented to help ensure 

the adequacy of the reported amount, to improve 

auditability, and to serve as a benchmark for 

exercise of prudent judgment in future periods.’’ 

17Paragraph 9.64 in the Audit Guide outlines 

specific aspects of effective internal control related 

to the allowance for loan losses. These specific 

aspects include the control environment 

(‘‘management communication of the need for 

proper reporting of the allowance’’); management 

reports that summarize loan activity and the 

institution’s procedures and controls 

(‘‘accumulation of relevant, sufficient, and reliable 

data on which to base management’s estimate of the 

allowance’’); ‘‘independent loan review;’’ review of 

information and assumptions (‘‘adequate review and 

approval of the allowance estimates by the 

individuals specified in management’s written 

policy’’); and assessment of the process 

(‘‘comparison of prior estimates related to the 

allowance with subsequent results to assess the 

reliability of the process used to develop the 

allowance’’). 

18Paragraph 9.64 of the Audit Guide discusses 

‘‘management communication of the need for proper 

reporting of the allowance.’’ As indicated in that 

paragraph, the ‘‘control environment strongly 

influences the effectiveness of the system of 

controls and reflects the overall attitude, awareness, 

and action of the board of directors and 

management concerning the importance of control.’’ 

19Paragraph 9.56 of the Audit Guide refers to the 

documentation, for disclosure purposes, that an 

entity should include in the notes to the financial 

statements describing the accounting policies the 

entity used to estimate its allowance and related 

provision for loan losses. 

20 Ibid. As indicated in paragraph 9.56, ‘‘[s]uch a 

description should identify the factors that 

influenced management’s judgment (for example, 

historical losses and existing economic conditions) 

and may also include discussion of risk elements 

relevant to particular categories of financial 

instruments.’’ 

21See also paragraph 9.64 in the Audit Guide 

which provides information about specific aspects 

of effective internal control related to the allowance 

for loan losses. 

22 Ibid. Public companies are required to comply 

with the books and records provisions of the 

Exchange Act. Under Sections 13(b)(2)—(7) of the 

Exchange Act, registrants must make and keep 

books, records, and accounts, which, in reasonable 

detail, accurately and fairly reflect the transactions 

and dispositions of assets of the registrant. 

Registrants also must maintain internal accounting 

controls that are sufficient to provide reasonable 

assurances that, among other things, transactions 

are recorded as necessary to permit the preparation 

of financial statements in conformity with GAAP. 

23Concepts Statement 2, Qualitative 

Characteristics of Accounting Information, provides 

guidance on ‘‘reliability’’ as a primary quality of 

accounting information. 

24Section 13(b)(2)–(7) of the Exchange Act. 

25As indicated in paragraph 9.05, item a, in the 

Audit Guide, a loan loss allowance methodology 

should ‘‘include a detailed and regular analysis of 

the loan portfolio.’’ Paragraphs 9.06 to 9.13 provide 

additional information on how creditors 

traditionally identify and review loans on an 

individual basis and review or analyze loans on a 

group or pool basis. 

26 Ibid. Additionally, paragraph 9.64 in the Audit 

Guide provides guidance on the loan review 

process. As stated in that paragraph, ‘‘[m]anagement 

reports summarizing loan activity, renewals, and 

delinquencies are vital to the timely identification 

of problem loans.’’ The paragraph further states: 

‘‘Loan reviews should be conducted by competent 

institution personnel who are independent of the 

underwriting, supervision, and collections 

functions. The specific lines of reporting depend on 

the complexity of the institution’s organizational 

structure, but the loan reviewers should report to 

a high level of management that is independent 

from the lending process in the institution.’’ 

27 Ibid. 

28 Ibid. 

29 Ibid. 

The staff normally would expect to 

find that registrants maintain written 

supporting documentation for the 

following decisions, strategies, and 

processes:17

• Policies and procedures: 

Æ Over the systems and controls that 

maintain an appropriate loan loss 

allowance, and 

Æ Over the loan loss allowance 

methodology; 

• Loan grading system or process; 

• Summary or consolidation of the loan 

loss allowance balance; 

• Validation of the loan loss allowance 

methodology; and 

• Periodic adjustments to the loan loss 

allowance process. 

Question 2: The Interpretive Response 

to Question 2 indicates that the staff 

normally would expect to find that 

registrants maintain written supporting 

documentation for their loan loss 

allowance policies and procedures. In 

the staff’s view, what aspects of a 

registrant’s loan loss allowance internal 

accounting control systems and 

processes would appropriately be 

addressed in its written policies and 

procedures? 

Interpretive Response: The staff is 

aware that registrants utilize a wide 

range of policies, procedures, and 

control systems in their loan loss 

allowance processes, and these policies, 

procedures, and systems are tailored to 

the size and complexity of the registrant 

and its loan portfolio. However, the staff 

believes that, in order for a registrant’s 

loan loss allowance methodology to be 

effective, the registrant’s written 

policies and procedures for the systems 

and controls that maintain an 

appropriate loan loss allowance would 

likely address the following: 

• The roles and responsibilities of the 

registrant’s departments and personnel 

(including the lending function, credit 

review, financial reporting, internal 

audit, senior management, audit 

committee, board of directors, and 

others, as applicable) who determine or 

review, as applicable, the loan loss 

allowance to be reported in the financial 

statements; 18

• The registrant’s accounting policies 

for loans and loan losses, including the 

policies for charge-offs and recoveries 

and for estimating the fair value of 

collateral, where applicable; 19

• The description of the registrant’s 

systematic methodology, which should 

be consistent with the registrant’s 

accounting policies for determining its 

loan loss allowance (see Question 4 

below for further discussion); 20 and 

• The system of internal controls 

used to ensure that the loan loss 

allowance process is maintained in 

accordance with GAAP.21

The staff normally would expect an 

internal control system 22 for the loan 

loss allowance estimation process to: 

• Include measures to provide 

assurance regarding the reliability 23 and 

integrity of information and compliance 

with laws, regulations, and internal 

policies and procedures; 24

• Reasonably assure that the 

registrant’s financial statements are 

prepared in accordance with GAAP; and 

• Include a well-defined loan review 

process.25

A well-defined loan review process 26

typically contains: 

• An effective loan grading system 

that is consistently applied, identifies 

differing risk characteristics and loan 

quality problems accurately and in a 

timely manner, and prompts 

appropriate administrative actions; 27

• Sufficient internal controls to 

ensure that all relevant loan review 

information is appropriately considered 

in estimating losses. This includes 

maintaining appropriate reports, details 

of reviews performed, and identification 

of personnel involved; 28 and 

• Clear formal communication and 

coordination between a registrant’s 

credit administration function, financial 

reporting group, management, board of 

directors, and others who are involved 

in the loan loss allowance 

determination or review process, as 

applicable (e.g., written policies and 

procedures, management reports, audit 

programs, and committee minutes).29

Question 3: The Interpretive Response 

to Question 3 indicates that the staff 

normally would expect a registrant’s 

written loan loss allowance policies and 

procedures to include a description of 

the registrant’s systematic allowance 

methodology, which should be 

consistent with its accounting policies 

for determining its loan loss allowance. 

What elements of a registrant’s loan loss 

allowance methodology would the staff 

normally expect to be described in the 

registrant’s written policies and 

procedures? 

Interpretive Response: The staff 

normally would expect a registrant’s 

written policies and procedures to 

describe the primary elements of its 

loan loss allowance methodology, 

including portfolio segmentation and 


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17242 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

30Paragraph 9.07 in the Audit Guide states that 

‘‘creditors have traditionally identified loans that 

are to be evaluated for collectibility by dividing the 

loan portfolio into different segments. Loans with 

similar risk characteristics, such as risk 

classification, past-due status, and type of loan 

should be grouped together.’’ Paragraph 9.08 

provides additional guidance on classifying 

individual loans and paragraph 9.13 indicates 

considerations for groups or pools of loans. 

31See FASB ASC paragraphs 310–10–35–16 

through 310–10–35–19 on recognition of 

impairment and FASB ASC paragraphs 310–10–35– 

20 through 310–10–35–37 on measurement of 

impairment. 

32See FASB ASC paragraph 310–10–35–36. 

33See FASB ASC paragraph 450–20–25–2 on 

accrual of loss contingencies and FASB ASC 

paragraphs 310–10–35–5 through 310–10–35–11 on 

collectibility of receivables. 

34FASB ASC paragraph 310–10–35–8 provides 

that a loan is impaired when, based on current 

information and events, it is probable that all 

amounts due will not be collected pursuant to the 

terms of the loan agreement. 

35See FASB ASC paragraph 310–10–35–22. 

36Under GAAS, auditors should obtain 

‘‘sufficient competent evidential matter’’ to support 

its audit opinion. See AU Section 326. The staff 

normally would expect registrants to maintain such 

evidential matter for its allowances for loan losses 

for use by the auditors in conducting their annual 

audit. 

37Paragraph 9.74 in the Audit Guide outlines 

sources of information, available from management, 

that the independent accountant should consider in 

identifying loans that contain high credit risk or 

other significant exposures and concentrations. 

These sources of information would also likely 

include documentation of loan impairment under 

FASB ASC Subtopic 310–10 or FASB ASC Subtopic 

450–20. Additionally, as indicated in paragraphs 

9.85 to 9.97 of the Audit Guide, the independent 

accountant, in conducting an audit, may perform a 

detailed loan file review for selected loans. A 

registrant’s loan files may contain documentation 

about borrowers’ financial resources and cash flows 

(see paragraph 9.92) or about the collateral securing 

the loans, if applicable (see paragraphs 9.94 and 

9.95). 

38FASB ASC paragraph 310–10–35–27 indicates 

that environmental factors include existing 

industry, geographical, economic, and political 

factors. 

39See paragraphs 9.94 and 9.95 in the Audit 

Guide for additional information about 

documentation of loan collateral. 

impairment measurement. The staff 

normally would expect that, in order for 

a registrant’s loan loss allowance 

methodology to be effective, the 

registrant’s written policies and 

procedures would describe the 

methodology: 

• For segmenting the portfolio: 

Æ How the segmentation process is 

performed (i.e., by loan type, 

industry, risk rates, etc.); 30

Æ When a loan grading system is used 

to segment the portfolio: 

• The definitions of each loan grade; 

• A reconciliation of the internal loan 

grades to supervisory loan grades, if 

applicable; and 

• The delineation of responsibilities 

for the loan grading system. 

• For determining and measuring 

impairment under FASB ASC 

Subtopic 310–10: 31

Æ The methods used to identify loans 

to be analyzed individually; 

Æ For individually reviewed loans 

that are impaired, how the amount 

of any impairment is determined 

and measured, including: 

• Procedures describing the 

impairment measurement 

techniques available; and 

• Steps performed to determine 

which technique is most 

appropriate in a given situation. 

Æ The methods used to determine 

whether and how loans 

individually evaluated under FASB 

Subtopic 310–10, but not 

considered to be individually 

impaired, should be grouped with 

other loans that share common 

characteristics for impairment 

evaluation under FASB ASC 

Subtopic 450–20.32

• For determining and measuring 

impairment under FASB ASC 

Subtopic 450–20: 33

Æ How loans with similar 

characteristics are grouped to be 

evaluated for loan collectibility 

(such as loan type, past-due status, 

and risk); 

Æ How loss rates are determined (e.g., 

historical loss rates adjusted for 

environmental factors or migration 

analysis) and what factors are 

considered when establishing 

appropriate time frames over which 

to evaluate loss experience; and 

Æ Descriptions of qualitative factors 

(e.g., industry, geographical, 

economic, and political factors) that 

may affect loss rates or other loss 

measurements. 

3. Applying a Systematic 

Methodology—Measuring and 

Documenting Loan Losses Under FASB 

ASC Subtopic 310–10 

a. Measuring and Documenting Loan 

Losses Under FASB ASC Subtopic 310– 

10—General 

Facts: Approximately one-third of 

Registrant B’s commercial loan portfolio 

consists of large balance, nonhomogeneous loans. Due to their large 

individual balances, these loans meet 

the criteria under Registrant B’s policies 

and procedures for individual review 

for impairment under FASB ASC 

Subtopic 310–10. 

Upon review of the large balance 

loans, Registrant B determines that 

certain of the loans are impaired as 

defined by FASB ASC Subtopic 310– 

10.34

Question: For the commercial loans 

reviewed under FASB ASC Subtopic 

310–10 that are individually impaired, 

how would the staff normally expect 

Registrant B to measure and document 

the impairment on those loans? Can it 

use an impairment measurement 

method other than the methods allowed 

by FASB ASC Subtopic 310–10? 

Interpretive Response: For those loans 

that are reviewed individually under 

FASB ASC Subtopic 310–10 and 

considered individually impaired, 

Registrant B must use one of the 

methods for measuring impairment that 

is specified by FASB ASC Subtopic 

310–10 (that is, the present value of 

expected future cash flows, the loan’s 

observable market price, or the fair 

value of collateral).35 Accordingly, in 

the circumstances described above, for 

the loans considered individually 

impaired under FASB ASC Subtopic 

310–10, it would not be appropriate for 

Registrant B to choose a measurement 

method not prescribed by FASB ASC 

Subtopic 310–10. For example, it would 

not be appropriate to measure loan 

impairment by applying a loss rate to 

each loan based on the average 

historical loss percentage for all of its 

commercial loans for the past five years. 

The staff normally would expect 

Registrant B to maintain as sufficient, 

objective evidence 36 written 

documentation to support its 

measurement of loan impairment under 

FASB ASC Subtopic 310–10.37 If 

Registrant B uses the present value of 

expected future cash flows to measure 

impairment of a loan, it should 

document the amount and timing of 

cash flows, the effective interest rate 

used to discount the cash flows, and the 

basis for the determination of cash 

flows, including consideration of 

current environmental factors 38 and 

other information reflecting past events 

and current conditions. If Registrant B 

uses the fair value of collateral to 

measure impairment, the staff normally 

would expect to find that Registrant B 

had documented how it determined the 

fair value, including the use of 

appraisals, valuation assumptions and 

calculations, the supporting rationale 

for adjustments to appraised values, if 

any, and the determination of costs to 

sell, if applicable, appraisal quality, and 

the expertise and independence of the 

appraiser.39 Similarly, the staff normally 

would expect to find that Registrant B 

had documented the amount, source, 

and date of the observable market price 

of a loan, if that method of measuring 

loan impairment is used. 


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40When reviewing collateral dependent loans, 

Registrant C may often find it more appropriate to 

obtain an updated appraisal to estimate the effect 

of current market conditions on the appraised value 

instead of internally estimating an adjustment. 

41An auditor who uses the work of a specialist, 

such as an appraiser, in performing an audit in 

accordance with GAAS should refer to the guidance 

in SAS 73 (AU Section 336). 

42See paragraphs 9.94 to 9.95 in the Audit Guide 

for further information about documentation of loan 

collateral and associated audit procedures that may 

be performed by the independent accountant. 

43As stated in paragraph 9.14 of the Audit Guide, 

‘‘[t]he approach for determination of the allowance 

should be well documented.’’ 

b. Measuring and Documenting Loan 

Losses Under FASB ASC Subtopic 310– 

10 for a Collateral Dependent Loan 

Facts: Registrant C has a $10 million 

loan outstanding to Company X that is 

secured by real estate, which Registrant 

C individually evaluates under FASB 

ASC Subtopic 310–10 due to the loan’s 

size. Company X is delinquent in its 

loan payments under the terms of the 

loan agreement. Accordingly, Registrant 

C determines that its loan to Company 

X is impaired, as defined by FASB ASC 

Subtopic 310–10. Because the loan is 

collateral dependent, Registrant C 

measures impairment of the loan based 

on the fair value of the collateral. 

Registrant C determines that the most 

recent valuation of the collateral was 

performed by an appraiser eighteen 

months ago and, at that time, the 

estimated value of the collateral (fair 

value less costs to sell) was $12 million. 

Registrant C believes that certain of 

the assumptions that were used to value 

the collateral eighteen months ago do 

not reflect current market conditions 

and, therefore, the appraiser’s valuation 

does not approximate current fair value 

of the collateral. 

Several buildings, which are 

comparable to the real estate collateral, 

were recently completed in the area, 

increasing vacancy rates, decreasing 

lease rates, and attracting several 

tenants away from the borrower. 

Accordingly, credit review personnel at 

Registrant C adjust certain of the 

valuation assumptions to better reflect 

the current market conditions as they 

relate to the loan’s collateral.40 After 

adjusting the collateral valuation 

assumptions, the credit review 

department determines that the current 

estimated fair value of the collateral, 

less costs to sell, is $8 million.41 Given 

that the recorded investment in the loan 

is $10 million, Registrant C concludes 

that the loan is impaired by $2 million 

and records an allowance for loan losses 

of $2 million. 

Question: What documentation would 

the staff normally expect Registrant C to 

maintain to support its determination of 

the allowance for loan losses of $2 

million for the loan to Company X? 

Interpretive Response: The staff 

normally would expect Registrant C to 

document that it measured impairment 

of the loan to Company X by using the 

fair value of the loan’s collateral, less 

costs to sell, which it estimated to be $8 

million.42 This documentation 43 should 

include the registrant’s rationale and 

basis for the $8 million valuation, 

including the revised valuation 

assumptions it used, the valuation 

calculation, and the determination of 

costs to sell, if applicable. 

Because Registrant C arrived at the 

valuation of $8 million by modifying an 

earlier appraisal, it should document its 

rationale and basis for the changes it 

made to the valuation assumptions that 

resulted in the collateral value declining 

from $12 million eighteen months ago to 

$8 million in the current period. 

c. Measuring and Documenting Loan 

Losses Under FASB ASC Subtopic 310– 

10—Fully Collateralized Loans 

Question: In the staff’s view, what is 

an example of an acceptable 

documentation practice for a registrant 

to adequately support its determination 

that no allowance for loan losses should 

be recorded for a group of loans because 

the loans are fully collateralized? 

Interpretive Response: Consider the 

following fact pattern: Registrant D has 

$10 million in loans that are fully 

collateralized by highly rated debt 

securities with readily determinable 

market values. The loan agreement for 

each of these loans requires the 

borrower to provide qualifying collateral 

sufficient to maintain a loan-to-value 

ratio with sufficient margin to absorb 

volatility in the securities’ market 

prices. Registrant D’s collateral 

department has physical control of the 

debt securities through safekeeping 

arrangements. In addition, Registrant D 

perfected its security interest in the 

collateral when the funds were 

originally distributed. On a quarterly 

basis, Registrant D’s credit 

administration function determines the 

market value of the collateral for each 

loan using two independent market 

quotes and compares the collateral 

value to the loan carrying value. If there 

are any collateral deficiencies, 

Registrant D notifies the borrower and 

requests that the borrower immediately 

remedy the deficiency. Due in part to its 

efficient operation, Registrant D has 

historically not incurred any material 

losses on these loans. Registrant D 

believes these loans are fullycollateralized and therefore does not 

maintain any loan loss allowance 

balance for these loans. 

Registrant D’s management summary 

of the loan loss allowance includes 

documentation indicating that, in 

accordance with its loan loss allowance 

policy, the collateral protection on these 

loans has been verified by the registrant, 

no probable loss has been incurred, and 

no loan loss allowance is necessary. 

Documentation in Registrant D’s loan 

files includes the two independent 

market quotes obtained each quarter for 

each loan’s collateral amount, the 

documents evidencing the perfection of 

the security interest in the collateral, 

and other relevant supporting 

documents. Additionally, Registrant D’s 

loan loss allowance policy includes a 

discussion of how to determine when a 

loan is considered ‘‘fully collateralized’’ 

and does not require a loan loss 

allowance. Registrant D’s policy 

requires the following factors to be 

considered and its findings concerning 

these factors to be fully documented: 

• Volatility of the market value of the 

collateral; 

• Recency and reliability of the 

appraisal or other valuation; 

• Recency of the registrant’s or third 

party’s inspection of the collateral; 

• Historical losses on similar loans; 

• Confidence in the registrant’s lien 

or security position including 

appropriate: 

Æ Type of security perfection (e.g., 

physical possession of collateral or 

secured filing); 

Æ Filing of security perfection (i.e., 

correct documents and with the 

appropriate officials); and 

Æ Relationship to other liens; and 

• Other factors as appropriate for the 

loan type. 

In the staff’s view, Registrant D’s 

documentation supporting its 

determination that certain of its loans 

are fully collateralized, and no loan loss 

allowance should be recorded for those 

loans, is acceptable under FRR 28. 

4. Applying a Systematic 

Methodology—Measuring and 

Documenting Loan Losses Under FASB 

ASC Subtopic 450–20 

a. Measuring and Documenting Loan 

Losses Under FASB ASC Subtopic 450– 

20—General 

Question 1: In the staff’s view, what 

are some general considerations for a 

registrant in applying its systematic 

methodology to measure and document 

loan losses under FASB ASC Subtopic 

450–20? 

Interpretive Response: For loans 

evaluated on a group basis under FASB 

ASC Subtopic 450–20, the staff believes 


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44Paragraph 9.07 of the Audit Guide indicates 

that ‘‘loans with similar risk characteristics, such as 

risk classification, past-due status, and type of loan, 

should be grouped together.’’ 

45Segmentation of the loan portfolio is a standard 

element in a loan loss allowance methodology. As 

indicated in paragraph 9.05 of the Audit Guide, the 

loan loss allowance methodology ‘‘should be well 

documented, with clear explanations of the 

supporting analyses and rationale.’’ 

46An example of a loan segment that does not 

generally require an allowance for loan losses is a 

group of loans that are fully secured by deposits 

maintained at the lending institution. 

47FRR 28 refers to a ‘‘systematic methodology to 

be employed each period’’ in determining 

provisions and allowances for loan losses. As 

indicated in FRR 28, the staff normally would 

expect that the systematic methodology would be 

documented ‘‘to help ensure that all matters 

affecting loan collectibility will consistently be 

identified in the detailed [loan] review process.’’ 

48 Ibid. Also, as indicated in paragraph 9.05 of the 

Audit Guide, the loan loss allowance methodology 

‘‘should be well documented, with clear 

explanations of the supporting analyses and 

rationale.’’ Further, as indicated in paragraph 9.14 

of the Audit Guide, ‘‘[t]he approach for 

determination of the allowance should be well 

documented.’’ 

49Refer to FASB ASC subparagraph 450–20–25– 

2(b). Also, as indicated in FASB ASC subparagraph 

310–10–35–4(c), ‘‘[t]he approach for determination 

of the allowance shall be well documented and 

applied consistently from period to period.’’ 

50Refer to FASB ASC paragraphs 310–10–35–10 

through 310–10–35–11. 

51Registrants should also refer to FASB ASC 

Subtopic 450–20, which provides guidance for 

situations in which a range of loss can be 

reasonably estimated but no single amount within 

the range appears to be a better estimate than any 

other amount within the range. Also, paragraph 

9.14 of the Audit Guide notes the use of ‘‘a method 

that results in a range of estimates for the 

allowance,’’ except for impairment measurement 

under FASB ASC Subtopic 310–10, which is based 

on a single best estimate and not a range of 

estimates. Paragraph 9.14 also states that ‘‘[t]he 

approach for determination of the allowance should 

be well documented.’’ 

52The systematic methodology (including, if 

applicable, loss estimation models) used to 

determine loan loss provisions and allowances 

should be documented in accordance with FRR 28, 

paragraph 9.05 of the Audit Guide, and FASB ASC 

Subtopic 310–10. 

53Refer to paragraph 9.13 in the Audit Guide. 

54AU 326 describes the ‘‘sufficient competent 

evidential matter’’ that auditors must consider in 

accordance with GAAS. 

that a registrant should segment the loan 

portfolio by identifying risk 

characteristics that are common to 

groups of loans.44 Registrants typically 

decide how to segment their loan 

portfolios based on many factors, which 

vary with their business strategies as 

well as their information system 

capabilities. Regardless of the 

segmentation method used, the staff 

normally would expect a registrant to 

maintain documentation to support its 

conclusion that the loans in each 

segment have similar attributes or 

characteristics. As economic and other 

business conditions change, registrants 

often modify their business strategies, 

which may result in adjustments to the 

way in which they segment their loan 

portfolio for purposes of estimating loan 

losses. The staff normally would expect 

registrants to maintain documentation 

to support these segmentation 

adjustments.45

Based on the segmentation of the loan 

portfolio, a registrant should estimate 

the FASB ASC Subtopic 450–20 portion 

of its loan loss allowance. For those 

segments that require an allowance for 

loan losses,46 the registrant should 

estimate the loan losses, on at least a 

quarterly basis, based upon its ongoing 

loan review process and analysis of loan 

performance.47 The registrant should 

follow a systematic and consistently 

applied approach to select the most 

appropriate loss measurement methods 

and support its conclusions and 

rationale with written documentation.48

Facts: After identifying certain loans 

for evaluation under FASB ASC 

Subtopic 310–10, Registrant E segments 

its remaining loan portfolio into five 

pools of loans. For three of the pools, it 

measures loan impairment under FASB 

ASC Subtopic 450–20 by applying 

historical loss rates, adjusted for 

relevant environmental factors, to the 

pools’ aggregate loan balances. For the 

remaining two pools of loans, Registrant 

E uses a loss estimation model that is 

consistent with GAAP to measure loan 

impairment under FASB ASC Subtopic 

450–20. 

Question 2: What documentation 

would the staff normally expect 

Registrant E to prepare to support its 

loan loss allowance for its pools of loans 

under FASB ASC Subtopic 450–20? 

Interpretive Response: Regardless of 

the method used to determine loan loss 

measurements under FASB ASC 

Subtopic 450–20, Registrant E should 

demonstrate and document that the loss 

measurement methods used to estimate 

the loan loss allowance for each 

segment of its loan portfolio are 

determined in accordance with GAAP 

as of the financial statement date.49

As indicated for Registrant E, one 

method of estimating loan losses for 

groups of loans is through the 

application of loss rates to the groups’ 

aggregate loan balances. Such loss rates 

typically reflect the registrant’s 

historical loan loss experience for each 

group of loans, adjusted for relevant 

environmental factors (e.g., industry, 

geographical, economic, and political 

factors) over a defined period of time. If 

a registrant does not have loss 

experience of its own, it may be 

appropriate to reference the loss 

experience of other companies in the 

same business, provided that the 

registrant demonstrates that the 

attributes of the loans in its portfolio 

segment are similar to those of the loans 

included in the portfolio of the 

registrant providing the loss 

experience.50 Registrants should 

maintain supporting documentation for 

the technique used to develop their loss 

rates, including the period of time over 

which the losses were incurred. If a 

range of loss is determined, registrants 

should maintain documentation to 

support the identified range and the 

rationale used for determining which 

estimate is the best estimate within the 

range of loan losses.51

The staff normally would expect that, 

before employing a loss estimation 

model, a registrant would evaluate and 

modify, as needed, the model’s 

assumptions to ensure that the resulting 

loss estimate is consistent with GAAP. 

In order to demonstrate consistency 

with GAAP, registrants that use loss 

estimation models should typically 

document the evaluation, the 

conclusions regarding the 

appropriateness of estimating loan 

losses with a model or other loss 

estimation tool, and the objective 

support for adjustments to the model or 

its results.52

In developing loss measurements, 

registrants should consider the impact 

of current environmental factors and 

then document which factors were used 

in the analysis and how those factors 

affected the loss measurements. Factors 

that should be considered in developing 

loss measurements include the 

following: 53

• Levels of and trends in 

delinquencies and impaired loans; 

• Levels of and trends in charge-offs 

and recoveries; 

• Trends in volume and terms of 

loans; 

• Effects of any changes in risk 

selection and underwriting standards, 

and other changes in lending policies, 

procedures, and practices; 

• Experience, ability, and depth of 

lending management and other relevant 

staff; 

• National and local economic trends 

and conditions; 

• Industry conditions; and 

• Effects of changes in credit 

concentrations. 

For any adjustment of loss 

measurements for environmental 

factors, a registrant should maintain 

sufficient, objective evidence 54 (a) to 

support the amount of the adjustment 

and (b) to explain why the adjustment 

is necessary to reflect current 


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55This question and response would also apply 

to other registrant fact patterns in which the 

registrant adjusts loss rates for environmental 

factors. 

56Paragraph 9.56 of the Audit Guide refers to the 

documentation, for disclosure purposes, that an 

entity should include in the notes to the financial 

statements describing the accounting policies and 

methodology the entity used to estimate its 

allowance and related provision for loan losses. As 

indicated in paragraph 9.56, ‘‘[s]uch a description 

should identify the factors that influenced 

management’s judgment (for example, historical 

losses and existing economic conditions) and may 

also include discussion of risk elements relevant to 

particular categories of financial instruments.’’ 

57Paragraph 9.64 in the Audit Guide indicates 

that effective internal control related to the 

allowance for loan losses should include 

‘‘accumulation of relevant, sufficient, and reliable 

data on which to base management’s estimate of the 

allowance.’’ 

58These groups of loans do not include any loans 

that have been individually reviewed for 

impairment under FASB ASC Section 310–10–35, 

Receivables—Overall—Subsequent Measurement, 

and determined to be impaired as defined by FASB 

ASC Section 310–10–35. 

59FASB ASC paragraph 310–10–35–36 states that 

if a creditor concludes that an individual loan 

specifically identified for evaluation is not impaired 

under FASB ASC Subtopic 310–10, that loan may 

be included in the assessment of the allowance for 

loan losses under FASB ASC Subtopic 450–20, but 

only if specific characteristics of the loan indicate 

that it is probable that there would be an incurred 

loss in a group of loans with those characteristics. 

60Paragraph 9.05 in the Audit Guide indicates 

that an entity’s method of estimating credit losses 

should ‘‘include a detailed and regular analysis of 

Continued 

information, events, circumstances, and 

conditions in the loss measurements. 

b. Measuring and Documenting Loan 

Losses Under FASB ASC Subtopic 450– 

20—Adjusting Loss Rates 

Facts: Registrant F’s lending area 

includes a metropolitan area that is 

financially dependent upon the 

profitability of a number of 

manufacturing businesses. These 

businesses use highly specialized 

equipment and significant quantities of 

rare metals in the manufacturing 

process. Due to increased low-cost 

foreign competition, several of the parts 

suppliers servicing these manufacturing 

firms declared bankruptcy. The foreign 

suppliers have subsequently increased 

prices and the manufacturing firms have 

suffered from increased equipment 

maintenance costs and smaller profit 

margins. 

Additionally, the cost of the rare 

metals used in the manufacturing 

process increased and has now 

stabilized at double last year’s price. 

Due to these events, the manufacturing 

businesses are experiencing financial 

difficulties and have recently 

announced downsizing plans. 

Although Registrant F has yet to 

confirm an increase in its loss 

experience as a result of these events, 

management knows that it lends to a 

significant number of businesses and 

individuals whose repayment ability 

depends upon the long-term viability of 

the manufacturing businesses. 

Registrant F’s management has 

identified particular segments of its 

commercial and consumer customer 

bases that include borrowers highly 

dependent upon sales or salary from the 

manufacturing businesses. Registrant F’s 

management performs an analysis of the 

affected portfolio segments to adjust its 

historical loss rates used to determine 

the loan loss allowance. In this 

particular case, Registrant F has 

experienced similar business and 

lending conditions in the past that it can 

compare to current conditions. 

Question: How would the staff 

normally expect Registrant F to 

document its support for the loss rate 

adjustments that result from considering 

these manufacturing firms’ financial 

downturns? 55

Interpretive Response: The staff 

normally would expect Registrant F to 

document its identification of the 

particular segments of its commercial 

and consumer loan portfolio for which 

it is probable that the manufacturing 

business’ financial downturn has 

resulted in loan losses. In addition, the 

staff normally would expect Registrant F 

to document its analysis that resulted in 

the adjustments to the loss rates for the 

affected portfolio segments.56 The staff 

normally would expect that, as part of 

its documentation, Registrant F would 

maintain copies of the documents 

supporting the analysis, which may 

include relevant economic reports, 

economic data, and information from 

individual borrowers. 

Because in this case Registrant F has 

experienced similar business and 

lending conditions in the past, it should 

consider including in its supporting 

documentation an analysis of how the 

current conditions compare to its 

previous loss experiences in similar 

circumstances. The staff normally 

would expect that, as part of Registrant 

F’s effective loan loss allowance 

methodology, it would create a 

summary of the amount and rationale 

for the adjustment factor for review by 

management prior to the issuance of the 

financial statements.57

c. Measuring and Documenting Loan 

Losses Under FASB ASC Subtopic 450– 

20—Estimating Losses on Loans 

Individually Reviewed for Impairment 

But Not Considered Individually 

Impaired 

Facts: Registrant G has outstanding 

loans of $2 million to Company Y and 

$1 million to Company Z, both of which 

are paying as agreed upon in the loan 

documents. The registrant’s loan loss 

allowance policy specifies that all loans 

greater than $750,000 must be 

individually reviewed for impairment 

under FASB ASC Subtopic 310–10. 

Company Y’s financial statements 

reflect a strong net worth, good profits, 

and ongoing ability to meet debt service 

requirements. In contrast, recent 

information indicates Company Z’s 

profitability is declining and its cash 

flow is tight. Accordingly, this loan is 

rated substandard under the registrant’s 

loan grading system. Despite its 

concern, management believes 

Company Z will resolve its problems 

and determines that neither loan is 

individually impaired as defined by 

FASB ASC Subtopic 310–10. 

Registrant G segments its loan 

portfolio to estimate loan losses under 

FASB ASC Subtopic 450–20. Two of its 

loan portfolio segments are Segment 1 

and Segment 2. The loan to Company Y 

has risk characteristics similar to the 

loans included in Segment 1 and the 

loan to Company Z has risk 

characteristics similar to the loans 

included in Segment 2.58

In its determination of its loan loss 

allowance under FASB ASC Subtopic 

450–20, Registrant G includes its loans 

to Company Y and Company Z in the 

groups of loans with similar 

characteristics (i.e., Segment 1 for 

Company Y’s loan and Segment 2 for 

Company Z’s loan).59 Management’s 

analyses of Segment 1 and Segment 2 

indicate that it is probable that each 

segment includes some losses, even 

though the losses cannot be identified to 

one or more specific loans. Management 

estimates that the use of its historical 

loss rates for these two segments, with 

adjustments for changes in 

environmental factors, provides a 

reasonable estimate of the registrant’s 

probable loan losses in these segments. 

Question: How would the staff 

normally expect Registrant G to 

adequately document a loan loss 

allowance under FASB ASC Subtopic 

450–20 for these loans that were 

individually reviewed for impairment 

but are not considered individually 

impaired? 

Interpretive Response: The staff 

normally would expect that, as part of 

Registrant G’s effective loan loss 

allowance methodology, it would 

document its decision to include its 

loans to Company Y and Company Z in 

its determination of its loan loss 

allowance under FASB ASC Subtopic 

450–20.60 The staff also normally would 


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the loan portfolio,’’ ‘‘consider all loans (whether on 

an individual or pool-of-loans basis),’’ ‘‘be based on 

current and reliable data,’’ and ‘‘be well 

documented, with clear explanations of the 

supporting analyses and rationale.’’ FASB ASC 

paragraph 310–10–35–36 provides guidance as to 

the analysis to be performed when determining 

whether a loan that is not individually impaired 

under FASB ASC Subtopic 310–10 should be 

included in the assessment of the loan loss 

allowance under FASB ASC Subtopic 450–20. 

61 Ibid. 

62 Ibid. 

63FRR 28 states: ‘‘[t]he specific rationale upon 

which the [loan loss allowance and provision] 

amount actually reported is based—i.e., the bridge 

between the findings of the detailed review [of the 

loan portfolio] and the amount actually reported in 

each period—would be documented to help ensure 

the adequacy of the reported amount, to improve 

auditability, and to serve as a benchmark for 

exercise of prudent judgment in future periods.’’ 

64See also paragraph 9.14 of the Audit Guide. 

65Subsequent to adjustments, the staff normally 

would expect that there would be no material 

differences between the consolidated loss estimate, 

as determined by the methodology, and the final 

loan loss allowance balance reported in the 

financial statements. Registrants should refer to 

SAB 99 and SAS 89 and its amendments to AU 

Section 310. 

66Paragraph 9.64 in the Audit Guide indicates 

that effective internal control related to the 

allowance for loan losses should include ‘‘adequate 

review and approval of the allowance estimates by 

the individuals specified in management’s written 

policy.’’ 

67See the guidance in paragraph 9.14 of the Audit 

Guide (‘‘[t]he approach for determination of the 

allowance should be well documented’’) and in FRR 

28 (‘‘the specific rationale upon which the amount 

actually reported in each individual period is based 

would be documented’’). 

68 Ibid. 

69 Ibid. 

expect that Registrant G would 

document the specific characteristics of 

the loans that were the basis for 

grouping these loans with other loans in 

Segment 1 and Segment 2, 

respectively.61 Additionally, the staff 

normally would expect Registrant G to 

maintain documentation to support its 

method of estimating loan losses for 

Segment 1 and Segment 2, which 

typically would include the average loss 

rate used, the analysis of historical 

losses by loan type and by internal risk 

rating, and support for any adjustments 

to its historical loss rates.62 The 

registrant would typically maintain 

copies of the economic and other 

reports that provided source data. 

When measuring and documenting 

loan losses, Registrant G should take 

steps to prevent layering loan loss 

allowances. Layering is the 

inappropriate practice of recording in 

the allowance more than one amount for 

the same probable loan loss. Layering 

can happen when a registrant includes 

a loan in one segment, determines its 

best estimate of loss for that loan either 

individually or on a group basis (after 

taking into account all appropriate 

environmental factors, conditions, and 

events), and then includes the loan in 

another group, which receives an 

additional loan loss allowance amount. 

5. Documenting the Results of a 

Systematic Methodology 

a. Documenting the Results of a 

Systematic Methodology—General 

Facts: Registrant H has completed its 

estimation of its loan loss allowance for 

the current reporting period, in 

accordance with GAAP, using its 

established systematic methodology. 

Question: What summary 

documentation would the staff normally 

expect Registrant H to prepare to 

support the amount of its loan loss 

allowance to be reported in its financial 

statements? 

Interpretive Response: The staff 

normally would expect that, to verify 

that loan loss allowance balances are 

presented fairly in accordance with 

GAAP and are auditable, management 

would prepare a document that 

summarizes the amount to be reported 

in the financial statements for the loan 

loss allowance.63 Common elements 

that the staff normally would expect to 

find documented in loan loss allowance 

summaries include: 64

• The estimate of the probable loss or 

range of loss incurred for each category 

evaluated (e.g., individually evaluated 

impaired loans, homogeneous pools, 

and other groups of loans that are 

collectively evaluated for impairment); 

• The aggregate probable loss 

estimated using the registrant’s 

methodology; 

• A summary of the current loan loss 

allowance balance; 

• The amount, if any, by which the 

loan loss allowance balance is to be 

adjusted; 65 and 

• Depending on the level of detail 

that supports the loan loss allowance 

analysis, detailed subschedules of loss 

estimates that reconcile to the summary 

schedule. 

Generally, a registrant’s review and 

approval process for the loan loss 

allowance relies upon the data provided 

in these consolidated summaries. There 

may be instances in which individuals 

or committees that review the loan loss 

allowance methodology and resulting 

allowance balance identify adjustments 

that need to be made to the loss 

estimates to provide a better estimate of 

loan losses. These changes may be due 

to information not known at the time of 

the initial loss estimate (e.g., 

information that surfaces after 

determining and adjusting, as necessary, 

historical loss rates, or a recent decline 

in the marketability of property after 

conducting a FASB ASC Subtopic 310– 

10 valuation based upon the fair value 

of collateral). It is important that these 

adjustments are consistent with GAAP 

and are reviewed and approved by 

appropriate personnel.66 Additionally, 

it would typically be appropriate for the 

summary to provide each subsequent 

reviewer with an understanding of the 

support behind these adjustments. 

Therefore, the staff normally would 

expect management to document the 

nature of any adjustments and the 

underlying rationale for making the 

changes.67

The staff also normally would expect 

this documentation to be provided to 

those among management making the 

final determination of the loan loss 

allowance amount.68

b. Documenting the Results of a 

Systematic Methodology—Allowance 

Adjustments 

Facts: Registrant I determines its loan 

loss allowance using an established 

systematic process. At the end of each 

reporting period, the accounting 

department prepares a summary 

schedule that includes the amount of 

each of the components of the loan loss 

allowance, as well as the total loan loss 

allowance amount, for review by senior 

management, including the Credit 

Committee. Members of senior 

management meet to discuss the loan 

loss allowance. During these 

discussions, they identify changes that 

are required by GAAP to be made to 

certain of the loan loss allowance 

estimates. As a result of the adjustments 

made by senior management, the total 

amount of the loan loss allowance 

changes. However, senior management 

(or its designee) does not update the 

loan loss allowance summary schedule 

to reflect the adjustments or reasons for 

the adjustments. When performing their 

audit of the financial statements, the 

independent accountants are provided 

with the original loan loss allowance 

summary schedule reviewed by senior 

management, as well as a verbal 

explanation of the changes made by 

senior management when they met to 

discuss the loan loss allowance. 

Question: In the staff’s view, are 

Registrant I’s documentation practices 

related to the balance of its loan loss 

allowance in compliance with existing 

documentation guidance in this area? 

Interpretive Response: No. A 

registrant should maintain supporting 

documentation for the loan loss 

allowance amount reported in its 

financial statements.69 As illustrated 

above, there may be instances in which 

loan loss allowance reviewers identify 


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70 Ibid. 

71As outlined in paragraph 9.64 of the Audit 

Guide, effective internal controls related to the 

allowance for loan losses should include adequate 

review and approval of allowance estimates, 

including review of sources of relevant information, 

review of development of assumptions, review of 

reasonableness of assumptions and resulting 

estimates, and consideration of changes in 

previously established methods to arrive at the 

allowance. 

72 Ibid. 73See paragraph 9.64 of the Audit Guide. 

1The FASB ASC Master Glossary defines a lease 

as ‘‘an agreement conveying the right to use 

property, plant, or equipment (land and/or 

depreciable assets) usually for a stated period of 

time.’’ 

adjustments that need to be made to the 

loan loss estimates. The staff normally 

would expect the nature of the 

adjustments, how they were measured 

or determined, and the underlying 

rationale for making the changes to the 

loan loss allowance balance to be 

documented.70 The staff also normally 

would expect appropriate 

documentation of the adjustments to be 

provided to management for review of 

the final loan loss allowance amount to 

be reported in the financial statements. 

This documentation should also be 

made available to the independent 

accountants. If changes frequently occur 

during management or credit committee 

reviews of the loan loss allowance, 

management may find it appropriate to 

analyze the reasons for the frequent 

changes and to reassess the 

methodology the registrant uses.71

6. Validating a Systematic Methodology 

Question: What is the staff’s guidance 

to a registrant on validating, and 

documenting the validation of, its 

systematic methodology used to 

estimate loan loss allowances? 

Interpretive Response: The staff 

believes that a registrant’s loan loss 

allowance methodology is considered 

valid when it accurately estimates the 

amount of loss contained in the 

portfolio. Thus, the staff normally 

would expect the registrant’s 

methodology to include procedures that 

adjust loan loss estimation methods to 

reduce differences between estimated 

losses and actual subsequent chargeoffs, as necessary. To verify that the loan 

loss allowance methodology is valid and 

conforms to GAAP, the staff believes it 

is appropriate for management to 

establish internal control policies,72

appropriate for the size of the registrant 

and the type and complexity of its loan 

products. These policies may include 

procedures for a review, by a party who 

is independent of the allowance for loan 

losses estimation process, of the 

allowance for loan losses methodology 

and its application in order to confirm 

its effectiveness. 

In practice, registrants employ 

numerous procedures when validating 

the reasonableness of their loan loss 

allowance methodology and 

determining whether there may be 

deficiencies in their overall 

methodology or loan grading process. 

Examples are: 

• A review of trends in loan volume, 

delinquencies, restructurings, and 

concentrations. 

• A review of previous charge-off and 

recovery history, including an 

evaluation of the timeliness of the 

entries to record both the charge-offs 

and the recoveries. 

• A review by a party that is 

independent of the loan loss allowance 

estimation process. This often involves 

the independent party reviewing, on a 

test basis, source documents and 

underlying assumptions to determine 

that the established methodology 

develops reasonable loss estimates. 

• An evaluation of the appraisal 

process of the underlying collateral. 

This may be accomplished by 

periodically comparing the appraised 

value to the actual sales price on 

selected properties sold. 

It is the staff’s understanding that, in 

practice, management usually supports 

the validation process with the 

workpapers from the loan loss 

allowance review function. Additional 

documentation often includes the 

summary findings of the independent 

reviewer. The staff normally would 

expect that, if the methodology is 

changed based upon the findings of the 

validation process, documentation that 

describes and supports the changes 

would be maintained.73

TOPIC 7: REAL ESTATE COMPANIES 

A. Removed by SAB 103 

B. Removed by SAB 103 

C. Schedules of Real Estate and 

Accumulated Depreciation, and of 

Mortgage Loans on Real Estate 

Facts: Whenever investments in real 

estate or mortgage loans on real estate 

are significant, the schedules of such 

items (see Rules 12–28 and 12–29 of 

Regulation S–X) are required in a 

prospectus. 

Question: Is such information also 

required in annual reports to 

shareholders? 

Interpretive Response: Although Rules 

14a–3 and 14c–3 permit the omission of 

financial statement schedules from 

annual reports to shareholders, the staff 

is of the view that the information 

required by these schedules is of such 

significance within the real estate 

industry that the information should be 

included in the financial statements in 

the annual report to shareholders. 

D. Income Before Depreciation 

Facts: Occasionally an income 

statement format will contain a subtitle 

or caption titled ‘‘Income before 

depreciation and depletion.’’ 

Question: Is this caption appropriate? 

Interpretive Response: The staff 

objects to this presentation because in 

the staff’s view the presentation may 

suggest to the reader that the amount so 

captioned represents cash flow for the 

period, which is rarely the case (see 

ASR 142). 

TOPIC 8: RETAIL COMPANIES 

A. Sales of Leased or Licensed 

Departments 

Facts: At times, department stores and 

other retailers have included the sales of 

leased or licensed departments in the 

amount reported as ‘‘total revenues.’’ 

Question: Does the staff have any 

objection to this practice? 

Interpretive Response: The staff 

believes that FASB ASC Topic 840, 

Leases, requires department stores and 

other retailers that lease or license store 

space to account for rental income from 

leased departments in accordance with 

FASB ASC Topic 840. Accordingly, it 

would be inappropriate for a 

department store or other retailer to 

include in its revenue the sales of the 

leased or licensed departments. Rather, 

the department store or other retailer 

should include the rental income as part 

of its gross revenue. The staff would not 

object to disclosure in the footnotes to 

the financial statements of the amount 

of the lessee’s sales from leased 

departments. If the arrangement is not a 

lease 1 but rather a service arrangement 

that provides for payment of a fee or 

commission, the retailer should 

recognize the fee or commission as 

revenue when earned. If the retailer 

assumes the risk of bad debts associated 

with the lessee’s merchandise sales, the 

retailer generally should present bad 

debt expense in accordance with Rule 

5–03 of Regulation S–X. 

B. Finance Charges 

Facts: Department stores and other 

retailers impose finance charges on 

credit sales. 

Question: How should such charges 

be disclosed? 

Interpretive Response: As a minimum, 

the staff requests that the amount of 

gross revenue from such charges be 

stated in a footnote and that the income 

statement classification which includes 


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such revenue be identified. The 

following are examples of acceptable 

disclosure: 

Example 1 

Consumer Credit Operations: 

The results of the Consumer Credit 

Operations which are included in the 

Statement of Earnings as a separate line 

item are as follows for the fiscal year 

ended January 31, 20x0: 

Service charges ................................................................................................................................................................................. $167,000,000 

Operating expenses: 

Interest ........................................................................................................................................................................................ 60,000,000 

Payroll ......................................................................................................................................................................................... 35,000,000 

Provision for uncollected accounts ............................................................................................................................................. 29,000,000 

All other credit and collection expenses .................................................................................................................................... 32,000,000 

Provision for Federal income taxes ............................................................................................................................................ 5,000,000 

Total operating expenses .................................................................................................................................................... 161,000,000 

Consumer credit operations earnings ............................................................................................................................................... 6,000,000 

Example 2 

Service charges on retail credit 

accounts are netted against selling, 

general and administrative expense. The 

cost of administering retail credit 

program continued to exceed service 

charges on customer receivables as 

follows: 

In millions 

20x2 20x1 

Percent 

increase 

(decrease) 

Costs: 

Regional office operations .................................................................................................. $45 $42 9 

Interest ................................................................................................................................ 51 44 13 

Provision for doubtful accounts .......................................................................................... 21 15 34 

Total ............................................................................................................................. 117 102 15 

Less service charge income ............................................................................................... 96 79 22 

Net cost of credit ................................................................................................................ 21 23 (10 ) 

Net cost as percent of credit sales .................................................................................... 1.4% 1.6% 

The above results do not reflect either 

‘‘in store’’ costs related to credit 

operations or any allocation of corporate 

overhead expenses. 

This SAB is not intended to change 

current guidance in the accounting 

literature. For this reason, adherence to 

the principles described in this SAB 

should not raise the costs associated 

with record-keeping or with audits of 

financial statements. 

TOPIC 9: FINANCE COMPANIES 

A. Removed by SAB 103 

B. Removed by ASR 307 

TOPIC 10: UTILITY COMPANIES 

A. Financing by Electric Utility 

Companies Through Use of 

Construction Intermediaries 

Facts: Some electric utility companies 

finance construction of a generating 

plant or their share of a jointly owned 

plant through the use of a ‘‘construction 

intermediary’’ which may be organized 

as a trust or a corporation. Typically the 

utility assigns its interest in property 

and other contract rights to the 

construction intermediary with the 

latter authorized to obtain funds to 

finance construction with term loans, 

bank loans, commercial paper and other 

sources of funds and that may be 

available. The intermediary’s 

borrowings are guaranteed in part of the 

work in progress but more significantly, 

although indirectly, by the obligation of 

the utility to purchase the project upon 

completion and assume or otherwise 

settle the borrowings. The utility may be 

committed to provide any deficiency of 

funds which the intermediary cannot 

obtain and excess funds may be loaned 

to the utility by the intermediary. (In 

one case involving construction of an 

entire generating plant, the intermediary 

appointed the utility as its agent to 

complete construction.) On the 

occurrence of an event such as 

commencement of the testing period for 

the plant or placing the plant in 

commercial service (but not later than a 

specified date) the interest in the plant 

reverts to the utility and concurrently 

the utility must either assume the 

obligations issued by the intermediary 

or purchase them from the holders. The 

intermediary also may be authorized to 

borrow amounts for accrued interest 

when due and those amounts are added 

to the balance of the outstanding 

indebtedness. Interest is thus 

capitalized during the construction 

period at rates being charged by the 

lenders; however, it is deductible by the 

utility for tax purposes in the year of 

accrual. 

Question: How should construction 

work in progress and related liabilities 

and interest expense being financed 

through a construction intermediary be 

reflected in an electric utility’s financial 

statements? 

Interpretive Response: The balance 

sheet of an electric utility company 

using a construction intermediary to 

finance construction should include the 

intermediary’s work in progress in the 

appropriate caption under utility plant. 

The related debt should be included in 

long-term liabilities and disclosed either 

on the balance sheet or in a note. 

The amount of interest cost incurred 

and the respective amounts expensed or 

capitalized shall be disclosed for each 

period for which an income statement is 

presented. Consequently, capitalized 

interest included as part of an 

intermediary’s construction work in 

progress on the balance sheet should be 

recognized on the current income 

statement as interest expense with a 

corresponding offset to allowance for 

borrowed funds used during 

construction. Income statements for 


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1Before considering the guidance in this SAB 

Topic, registrants are reminded that the 

arrangement should be evaluated in accordance 

with the provisions of FASB ASC Topic 810, 

Consolidation. 

2Registrants are reminded that the arrangement 

may contain a guarantee that is within the scope of 

FASB ASC Topic 460, Guarantees. Further, 

registrants should consider the guidance of FASB 

ASC Topic 810, Consolidation. Also, registrants 

would need to consider whether the arrangement 

contains a derivative that should be accounted for 

according to FASB ASC Topic 815, Derivatives and 

Hedging. 

3FASB ASC paragraphs 980–360–35–1 through 

980–360–35–3 requires that costs of abandoned 

plants in excess of the present value of the future 

revenues expected to be provided to recover any 

allowable costs be charged to expense in the period 

that the abandonment becomes probable. Also, 

FASB ASC paragraph 980–360–35–12 requires that 

disallowed costs for recently completed plants be 

charged to expense when the disallowance becomes 

probable and can be reasonably estimated. 

prior periods should also be restated. 

The amounts may be shown separately 

on the statement or included with 

interest expense and allowance for 

borrowed funds used during 

construction. 

A note to the financial statements 

should describe briefly the organization 

and purpose of the intermediary and the 

nature of its authorization to incur debt 

to finance construction. The note should 

disclose the rate at which interest on 

this debt has been capitalized and the 

dollar amount for each period for which 

an income statement is presented. 

B. Removed by SAB 103 

C. Jointly Owned Electric Utility Plants 

Facts: Groups of electric utility 

companies have been building and 

operating utility plants under joint 

ownership agreements or arrangements 

which do not create legal entities for 

which separate financial statements are 

presented.1 Under these arrangements, a 

participating utility has an undivided 

interest in a utility plant and is 

responsible for its proportionate share of 

the costs of construction and operation 

and its entitled to its proportionate 

share of the energy produced. 

During the construction period a 

participating utility finances its own 

share of a utility plant using its own 

financial resources and not the 

combined resources of the group. 

Allowance for funds used during 

construction is provided in the same 

manner and at the same rates as for 

plants constructed to be used entirely by 

the participant utility. 

When a joint-owned plant becomes 

operational, one of the participant 

utilities acts as operator and bills the 

other participants for their 

proportionate share of the direct 

expenses incurred. Each individual 

participant incurs other expenses 

related to transmission, distribution, 

supervision and control which cannot 

be related to the energy generated or 

received from any particular source. 

Many companies maintain depreciation 

records on a composite basis for each 

class of property so that neither the 

accumulated allowance for depreciation 

nor the periodic expense can be 

allocated to specific generating units 

whether jointly or wholly owned. 

Question: What disclosure should be 

made on the financial statements or in 

the notes concerning interests in jointly 

owned utility plants? 

Interpretive Response: A participating 

utility should include information 

concerning the extent of its interests in 

jointly owned plants in a note to its 

financial statements. The note should 

include a table showing separately for 

each interest in a jointly owned plant 

the amount of utility plant in service, 

the accumulated provision for 

depreciation (if available), the amount 

of plant under construction, and the 

proportionate share. The amounts 

presented for plant in service or plant 

under construction may be further 

subdivided to show amounts applicable 

to plant subcategories such as 

production, transmission, and 

distribution. The note should include 

statements that the dollar amounts 

represent the participating utility’s 

share in each joint plant and that each 

participant must provide its own 

financing. Information concerning two 

or more generating plants on the same 

site may be combined if appropriate. 

The note should state that the 

participating utility’s share of direct 

expenses of the joint plants is included 

in the corresponding operating expenses 

on its income statement (e.g., fuel, 

maintenance of plant, other operating 

expense). If the share of direct expenses 

is charged to purchased power then the 

note should disclose the amount so 

charged and the proportionate amounts 

charged to specific operating expenses 

on the records maintained for the joint 

plants. 

D. Long-Term Contracts for Purchase of 

Electric Power 

Facts: Under long-term contracts with 

public utility districts, cooperatives or 

other organizations, a utility company 

receives a portion of the output of a 

production plant constructed and 

financed by the district or cooperative. 

The utility has only a nominal or no 

investment at all in the plant but pays 

a proportionate part of the plant’s costs, 

including debt service. The contract 

may be in the form of a sale of a 

generating plant and its immediate lease 

back. The utility is obligated to pay 

certain minimum amounts which cover 

debt service requirements whether or 

not the plant is operating. At the option 

of other parties to the contract and in 

accordance with a predetermined 

schedule, the utility’s proportionate 

share of the output may be reduced. 

Separate agreements may exist for the 

transmission of power to the utility’s 

system.2

Question: How should the cost of 

power obtained under long-term 

purchase contracts be reflected on the 

financial statements and what 

supplemental disclosures should be 

made in notes to the statements? 

Interpretive Response: The cost of 

power obtained under long-term 

purchase contracts, including payments 

required to be made when a production 

plant is not operating, should be 

included in the operating expenses 

section of the income statement. A note 

to the financial statements should 

present information concerning the 

terms and significance of such contracts 

to the utility company including date of 

contract expiration, share of plant 

output being purchased, estimated 

annual cost, annual minimum debt 

service payment required and amount of 

related long-term debt or lease 

obligations outstanding. 

Additional disclosure should be given 

if the contract provides, or is expected 

to provide, in excess of five percent of 

current or estimated future system 

capability. This additional disclosure 

may be in the form of separate financial 

statements of the vendor entity or 

inclusion of the amount of the 

obligation under the contract as a 

liability on the balance sheet with a 

corresponding amount as an asset 

representing the right to purchase power 

under the contract. 

The note to the financial statements 

should disclose the allocable portion of 

interest included in charges under such 

contracts. 

E. Classification of Charges for 

Abandonments and Disallowances 

Facts: A public utility company 

abandons the construction of a plant 

and, under the provisions of FASB ASC 

Subtopic 980–360, Regulated 

Operations—Property, Plant, and 

Equipment, must charge a portion of the 

costs of the abandoned plant to 

expense.3 Also, the utility determines 

that it is probable that certain costs of 

a recently completed plant will be 

disallowed, and charges those costs to 


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4Additionally, the registrant was reminded that 

FASB ASC paragraph 225–20–45–16 provides that 

items which are not reported as extraordinary 

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. 

5The staff also notes that FASB ASC paragraphs 

980–360–35–1 through 980–360–35–3 and 980– 

360–35–12, in requiring that such costs be 

‘‘recognized as a loss,’’ do not specify extraordinary 

item treatment. The staff believes that it generally 

has been the FASB’s practice to affirmatively 

require extraordinary item treatment when it 

believes that it is appropriate for charges or credits 

to income specifically required by a provision of a 

statement. 

6FASB ASC paragraph 980–340–25–16 requires a 

rate-regulated enterprise to capitalize all or part of 

an incurred cost that would otherwise be charged 

to expense if it is probable that future revenue will 

be provided to recover the previously incurred cost 

from inclusion of the costs in allowable costs for 

rate-making purposes. 

7Registrants also should apply the guidance of 

FASB ASC Subtopic 410–30, Asset Retirement and 

Environmental Obligations—Environmental 

Obligations, in determining the appropriate 

recognition of environmental remediation costs. 

expense as required by FASB ASC 

Subtopic 980–360. 

Question: May such charges for 

abandonments and disallowances be 

reported as extraordinary items in the 

statement of income? 

Interpretive Response: No. The staff 

does not believe that such charges meet 

the requirements of FASB ASC Subtopic 

225–20, Income Statement— 

Extraordinary and Unusual Items, that 

an item be both unusual and infrequent 

to be classified as an extraordinary item. 

Accordingly, the public utility was 

advised by the staff that such charges 

should be reported as a component of 

income from continuing operations, 

separately presented, if material.4

FASB ASC paragraph 225–20–45–2 

indicates that to be unusual, an item 

must ‘‘possess a high degree of 

abnormality and be of a type clearly 

unrelated to, or only incidentally related 

to, the ordinary and typical activities of 

the entity, taking into account the 

environment in which the entity 

operates.’’ Similarly, that paragraph 

indicates that, to be infrequent, an event 

should ‘‘not reasonably be expected to 

recur in the foreseeable future.’’ 

Electric utilities operate under a 

franchise that requires them to furnish 

adequate supplies of electricity for their 

service area. That undertaking requires 

utilities to continually forecast the 

future demand for electricity, and the 

costs to be incurred in constructing the 

plants necessary to meet that demand. 

Abandonments and disallowances result 

from the failure of demand to reach 

projected levels and/or plant 

construction costs that exceed 

anticipated amounts. Neither event 

qualifies as being both unusual and 

infrequent in the environment in which 

electric utilities operate. 

Accordingly, the staff believes that 

charges for abandonments and 

disallowances under FASB ASC 

Subtopic 980–360 should not be 

presented as extraordinary items.5

F. Presentation of Liabilities for 

Environmental Costs 

Facts: A public utility company 

determines that it is obligated to pay 

material amounts as a result of an 

environmental liability. These amounts 

may relate to, for example, damages 

attributed to clean-up of hazardous 

wastes, reclamation costs, fines, and 

litigation costs. 

Question 1: May a rate-regulated 

enterprise present on its balance sheet 

the amount of its estimated liability for 

environmental costs net of probable 

future revenue resulting from the 

inclusion of such costs in allowable 

costs for rate-making purposes? 

Interpretive Response: No. FASB ASC 

Subtopic 980–340, Regulated 

Operations—Other Assets and Deferred 

Costs, specifies the conditions under 

which rate actions of a regulator can 

provide reasonable assurance of the 

existence of an asset. The staff believes 

that environmental costs meeting the 

criteria of FASB ASC paragraph 980– 

340–25–1 6 should be presented on the 

balance sheet as an asset and should not 

be offset against the liability. Contingent 

recoveries through rates that do not 

meet the criteria of FASB ASC 

paragraph 980–340–25–1 should not be 

recognized either as an asset or as a 

reduction of the probable liability. 

Question 2: May a rate-regulated 

enterprise delay recognition of a 

probable and estimable liability for 

environmental costs which it has 

incurred at the date of the latest balance 

sheet until the regulator’s deliberations 

have proceeded to a point enabling 

management to determine whether this 

cost is likely to be included in allowable 

costs for rate-making purposes? 

Interpretive Response: No. FASB ASC 

Subtopic 450–20, Contingencies—Loss 

Contingencies, states that an estimated 

loss from a loss contingency shall be 

accrued by a charge to income if it is 

probable that a liability has been 

incurred and the amount of the loss can 

be reasonably estimated.7 The staff 

believes that actions of a regulator can 

affect whether an incurred cost is 

capitalized or expensed pursuant to 

FASB ASC Subtopic 980–340, but the 

regulator’s actions cannot affect the 

timing of the recognition of the liability. 

TOPIC 11: MISCELLANEOUS 

DISCLOSURE 

A. Operating-Differential Subsidies 

Facts: Company A has received an 

operating-differential subsidy pursuant 

to the Merchant Marine Act of 1936, as 

amended. 

Question: How should such subsidies 

be displayed in the income statement? 

Interpretive Response: Revenue 

representing an operating-differential 

subsidy under the Merchant Marine Act 

of 1936, as amended, must be set forth 

as a separate line item in the income 

statement either under a revenue 

caption or as credit in the costs and 

expenses section. 

B. Depreciation and Depletion Excluded 

From Cost of Sales 

Facts: Company B excludes 

depreciation and depletion from cost of 

sales in its income statement. 

Question: How should this exclusion 

be disclosed? 

Interpretive Response: If cost of sales 

or operating expenses exclude charges 

for depreciation, depletion and 

amortization of property, plant and 

equipment, the description of the line 

item should read somewhat as follows: 

‘‘Cost of goods sold (exclusive of items 

shown separately below)’’ or ‘‘Cost of 

goods sold (exclusive of depreciation 

shown separately below).’’ To avoid 

placing undue emphasis on ‘‘cash flow,’’ 

depreciation, depletion and 

amortization should not be positioned 

in the income statement in a manner 

which results in reporting a figure for 

income before depreciation. 

C. Tax Holidays 

Facts: Company C conducts business 

in a foreign jurisdiction which attracts 

industry by granting a ‘‘holiday’’ from 

income taxes for a specified period. 

Question: Does the staff generally 

request disclosure of this fact? 

Interpretive Response: Yes. In such 

event, a note must (1) disclose the 

aggregate dollar and per share effects of 

the tax holiday and (2) briefly describe 

the factual circumstances including the 

date on which the special tax status will 

terminate. 

D. Removed by SAB 103 

E. Chronological Ordering of Data 

Question: Does the staff have any 

preference in what order data are 

presented (e.g., the most current data 

displayed first, etc.)? 

Interpretive Response: The staff has 

no preference as to order; however, 


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1 Instruction (6)(a) calls for description of the 

nature and impact of developments in countries 

experiencing liquidity problems which are expected 

to have a material impact on timely repayment of 

principal or interest. Additionally, Instruction 

(6)(d)(ii) to Item III.C.3. calls for disclosure of 

commitments to relend, or to maintain on deposit, 

arising in connection with certain restructurings of 

foreign outstanding. 

financial statements and other data 

presented in tabular form should read 

consistently from left to right in the 

same chronological order throughout 

the filing. Similarly, numerical data 

included in narrative sections should be 

consistently ordered. 

F. LIFO Liquidations 

Facts: Registrant on LIFO basis of 

accounting liquidates a substantial 

portion of its LIFO inventory and as a 

result includes a material amount of 

income in its income statement which 

would not have been recorded had the 

inventory liquidation not taken place. 

Question: Is disclosure required of the 

amount of income realized as a result of 

the inventory liquidation? 

Interpretive Response: Yes. Such 

disclosure would be required in order to 

make the financial statements not 

misleading. Disclosure may be made 

either in a footnote or parenthetically on 

the face of the income statement. 

G. Tax Equivalent Adjustment in 

Financial Statements of Bank Holding 

Companies 

Facts: Bank subsidiaries of bank 

holding companies frequently hold 

substantial amounts of state and 

municipal bonds, interest income from 

which is exempt from Federal income 

taxes. Because of the tax exemption the 

stated yield on these securities is lower 

than the yield on securities with similar 

risk and maturity characteristics whose 

interest is subject to Federal tax. In 

order to make the interest income and 

resultant yields on tax exempt 

obligations comparable to those on 

taxable investments and loans, a ‘‘tax 

equivalent adjustment’’ is often added to 

interest income when presented in 

analytical tables or charts. When the 

data presented also includes income 

taxes, a corresponding amount is added 

to income tax expense so that there is 

no effect on net income. Adjustment 

may also be made for the tax equivalent 

effect of exemption from state and local 

taxes. 

Question 1: Is the concept of the tax 

equivalent adjustment appropriate for 

inclusion in financial statements and 

related notes? 

Interpretive Response: No. The tax 

equivalent adjustment represents a 

credit to interest income which is not 

actually earned and realized and a 

corresponding charge to taxes (or other 

expense) which will never be paid. 

Consequently, it should not be reflected 

on the income statement or in notes to 

financial statements included in reports 

to shareholders or in a report or 

registration statement filed with the 

Commission. 

Question 2: May amounts 

representing tax equivalent adjustments 

be included in the body of a statement 

of income provided they are designated 

as not being included in the totals and 

balances on the statement? 

Interpretive Response: No. The tabular 

format of a statement develops 

information in an orderly manner which 

becomes confusing when additional 

numbers not an integral part of the 

statement are inserted into it. 

Question 3: May revenues on a tax 

equivalent adjusted basis be included in 

selected financial data? 

Interpretive Response: Revenues may 

be included in selected financial data on 

a tax equivalent basis if the respective 

captions state which amounts are tax 

equivalent adjusted and if the 

corresponding unadjusted amounts are 

also reported in the selected financial 

data. 

Because of differences among 

registrants in making the tax 

equivalency computation, a brief note 

should describe the extent of 

recognition of exemption from Federal, 

state and local taxes and the combined 

marginal or incremental rate used. 

Where net operating losses exist, the 

note should indicate the nature of the 

tax equivalency adjustment made. 

Question 4: May information adjusted 

to a tax equivalent basis be included in 

management’s discussion and analysis 

of financial condition and results of 

operations? 

Interpretive Response: One of the 

purposes of MD&A is to enable investors 

to appraise the extent that earnings have 

been affected by changes in business 

activity and accounting principles or 

methods. Material changes in items of 

revenue or expense should be analyzed 

and explained in textual discussion and 

statistical tables. It may be appropriate 

to use amounts or to present yields on 

a tax equivalent basis. If appropriate, the 

discussion should include a comment 

on material changes in investment 

securities positions that affect tax 

exempt interest income. For example, 

there might be a comment on a change 

from investments in tax exempt 

securities because of the availability of 

net operating losses to offset taxable 

income of current and future periods, or 

a comment on a change in the quality 

level of the tax exempt investments 

resulting in increased interest income 

and risk and a corresponding increase in 

the tax equivalent adjustment. 

Tax equivalent adjusted amounts 

should be clearly identified and related 

to the corresponding unadjusted 

amounts in the financial statements. A 

descriptive note similar to that 

suggested to accompany adjusted 

amounts included in selected financial 

data should be provided. 

H. Disclosures by Bank Holding 

Companies Regarding Certain Foreign 

Loans 

1. Deposit/Relending Arrangements 

Facts: Certain foreign countries 

experiencing liquidity problems, by 

agreement with U.S. banks, have 

instituted arrangements whereby 

borrowers in the foreign country may 

remit local currency to the foreign 

country’s central bank, in return for the 

central bank’s assumption of the 

borrowers’ non-local currency 

obligations to the U.S. banks. The local 

currency is held on deposit at the 

central bank, for the account of the U.S. 

banks, and may be subject to relending 

to other borrowers in the country. 

Ultimate repayment of the obligations to 

the U.S. banks, in the requisite nonlocal currency, may not be due until a 

number of years hence. 

Question: What disclosures are 

appropriate regarding deposit/relending 

arrangements of this general type? 

Interpretive Response: The staff 

emphasizes that it is the responsibility 

of each registrant to determine the 

appropriate financial statement 

treatment and classification of foreign 

outstandings. The facts and 

circumstances surrounding deposit/ 

relending arrangements should be 

carefully analyzed to determine whether 

the local currency payments to the 

foreign central bank represent 

collections of outstandings for financial 

reporting purposes, and whether such 

outstandings should be classified as 

nonaccrual, past due or restructured 

loans pursuant to Item III.C.1. of 

Industry Guide 3, Statistical Disclosure 

by Bank Holding Companies (‘‘Guide 

3’’). 

The staff believes, however, that the 

impact of deposit/relending 

arrangements covering significant 

amounts of outstandings to a foreign 

country should be disclosed pursuant to 

Guide 3, Item III.C.3., Instruction (6)(a).1

The disclosures should include a 

general description of the arrangements 

and, if significant, the amounts of 

interest income recognized for financial 

reporting purposes which has not been 


jlentini on DSKJ8SOYB1PROD with RULES2
17252 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

2Registrants also are reminded that if the security 

received in the exchange constitutes a debt security 

within the scope of FASB ASC Topic 320, 

Investments—Debt and Equity Securities, the 

disclosures required by FASB ASC Topic 320 also 

would need to be provided. 

remitted in the requisite non-local 

currency to the U.S. bank. 

2. Accounting and Disclosures by Bank 

Holding Companies for a ‘‘Mexican Debt 

Exchange’’ Transaction 

Facts: Inquiries have been made of the 

staff regarding certain accounting and 

disclosure issues raised by a proposed 

‘‘Mexican Debt Exchange’’ transaction 

which could involve numerous bank 

holding companies with existing 

obligations of the United Mexican States 

(‘‘Mexico’’) or other Mexican public 

sector entities (collectively, ‘‘Existing 

Obligations’’). The key elements of the 

Mexican Debt Exchange are as follows: 

Mexico will offer for sale bonds 

(‘‘Bonds’’), denominated in U.S. dollars, 

which will pay interest at a LIBORbased floating rate and mature in twenty 

years. Mexico will undertake to list the 

Bonds on the Luxembourg Stock 

Exchange. The Bonds will be secured, as 

to their ultimate principal value only, 

by non-interest bearing securities of the 

U.S. Treasury (‘‘Zero Coupon Treasury 

Securities’’) which will be purchased by 

Mexico. The Zero Coupon Treasury 

Securities will be pledged to holders of 

the Bonds and held in custody at the 

Federal Reserve Bank of New York and 

will have a maturity date and ultimate 

principal value which match the 

maturity date and principal value of the 

Bonds. While the Bonds will have 

default and acceleration provisions, the 

holder of a Bond will not be permitted 

to have access to the collateral prior to 

the final scheduled maturity date, at 

which time the proceeds of the 

collateral will be available to pay the 

full principal amount of the Bonds. As 

such, the holder of a Bond ultimately 

will be secured as to principal at 

maturity; however, the interest 

payments will not be secured. The 

Bonds will not be subject to future 

restructurings of Mexico’s Existing 

Obligations, and Mexico has indicated 

that neither the Bonds nor the Existing 

Obligations exchanged therefore will be 

considered part of a base amount with 

respect to any future requests by Mexico 

for new money. 

The Mexican Debt Exchange will be 

structured in such a way that potential 

purchasers of the Bonds will submit 

bids on a voluntary basis to the auction 

agent. These bids will specify the face 

dollar amount of existing restructured 

commercial bank obligations of Mexico 

or of other Mexican public sector 

entities that the potential purchaser is 

willing to tender and the face dollar 

amount of Bonds that the purchaser is 

willing to accept in exchange for the 

Existing Obligations. Following the 

auction date, Mexico will determine the 

face dollar amount of Bonds to be issued 

and will exchange the Bonds for 

Existing Obligations taking first the offer 

of the largest face dollar amount of 

Existing Obligations per face dollar 

amount of Bonds, and so on, until all 

Bonds which Mexico is willing to issue 

have been subscribed. It is therefore 

possible that a greater amount of 

Existing Obligations could be tendered 

than Mexico is willing to accept. 

The lender has appropriately 

accounted for the transaction as a 

troubled debt restructuring in 

accordance with the provisions of FASB 

ASC Subtopic 310–40, Receivables— 

Troubled Debt Restructurings by 

Creditors. 

Question 1: What financial statement 

and other disclosure issues regarding 

the Mexican Debt Exchange and the 

Bonds received should be considered by 

registrants? 

Interpretive Response: The staff 

believes that disclosure of the nature of 

the transaction would be necessary, 

including: 

• Carrying value and terms of 

Existing Obligations exchanged; 

• Face value, carrying value, market 

value and terms of Bonds received; 

• The effect of the transaction on the 

allowance for loan losses and the 

provision for losses in the current 

period; and 

• Annual interest income on Existing 

Obligations exchanged and annual 

interest income on Bonds received. 

On an ongoing basis, the staff believes 

that the terms, carrying value and 

market value of the Bonds should be 

disclosed, if material, due to their 

unique features.2

Question 2: What disclosure with 

respect to the Bonds received would be 

acceptable under Industry Guide 3? 

Interpretive Response: Instruction (4) 

to Item III.C.3. of Industry Guide 3 

states: ‘‘The value of any tangible, liquid 

collateral may also be netted against 

cross-border outstandings of a country if 

it is held and realizable by the lender 

outside of the borrower’s country.’’ 

Given the unique features of the Bonds 

in that the ultimate repayment of the 

principal amount (but not interest) at 

maturity is assured, the staff will not 

object to either of two presentations. 

Under the first presentation, the 

carrying value of the Bonds, including 

any accrued but unpaid interest, would 

be included as a ‘‘cross-border 

outstanding’’ to the extent it exceeds the 

current fair value of the Zero Coupon 

Treasury Securities which collateralize 

the bonds. Alternatively, under the 

second presentation, the carrying value 

of the Bond principal would be 

excluded from Mexican cross-border 

outstandings provided (a) disclosure is 

made of the exclusion, (b) for purposes 

of determining the 1% and .75% of total 

assets disclosure thresholds of Item 

III.C.3. of Industry Guide 3, such 

carrying values are not excluded, and (c) 

all the Guide 3 disclosures relating to 

cross-border outstandings continue to be 

made, as discussed further below. 

For registrants that adopt the 

alternative disclosure approach and 

whose Mexican cross-border 

outstandings (excluding the carrying 

value of the Bond principal) exceed 1% 

of total assets, appropriate footnote 

disclosure of the exclusions should be 

made. Such footnote should indicate the 

face amount and carrying value of the 

Bonds excluded, the market value of 

such Bonds, and the face amount and 

current fair value of the Zero Coupon 

Treasury Securities which secure the 

Bonds. 

If the Mexican cross-border 

outstandings (excluding the carrying 

value of the Bond principal) are less 

than 1% of total assets but with the 

addition of the carrying value of the 

Bond principal would exceed 1%, the 

carrying value of the Mexican crossborder outstandings may be excluded 

from the list of countries whose crossborder outstandings exceed 1% of total 

assets provided that a footnote discloses 

the amount of Mexican cross-border 

outstandings (excluding the carrying 

value of the Bond principal) along with 

the footnote-type disclosure concerning 

the Bonds discussed in the previous 

paragraph. This disclosure and any 

other material disclosure specified by 

Item III.C.3. of Industry Guide 3 would 

continue to be made as long as Mexican 

exposure, including the carrying value 

of the Bond principal, exceeded 1%. 

If the Mexican cross-border 

outstandings (excluding the carrying 

value of the Bond principal) are less 

than .75% of total assets but with the 

addition of the carrying value of the 

Mexican Bond principal would exceed 

.75% but be less than 1%, cross-border 

outstandings disclosed pursuant to 

Instruction (7) to Item III.C.3. of 

Industry Guide 3 may exclude Mexico 

provided a footnote is added to the 

aggregate disclosure which discloses the 

amount of Mexican cross-border 

outstandings and the fact that they have 

not been included. The carrying value of 

the Bond principal may be excluded 

from the amount of Mexican crossborder outstandings disclosed in the 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17253 

3The following represents proposed disclosure 

using the alternative method discussed above. Of 

course, it would be necessary to supplement this 

disclosure with the additional disclosures regarding 

foreign outstandings that are called for by Guide 3 

(e.g., an analysis of the changes in aggregate 

outstandings), and the disclosures called for by the 

Interpretive Responses to Question 1. 

footnote provided the footnote-type 

disclosure discussed in the second 

preceding paragraph is also made. 

In essence, the alternative discussed 

herein results in a change only in the 

method of presenting information, not 

in the total information required.3

The appropriate disclosure would 

depend on the level of Mexican crossborder outstandings as follows: 

A. Assuming that the remaining 

Mexican cross-border outstandings are 

in excess of 1% of total assets: 

• Mexican cross-border outstandings 

(which excludes the total amount of the 

carrying value of Bond principal) would 

be disclosed in the table presenting all 

such outstandings in excess of 1%. 

• Proposed footnote disclosure— 

Not included in this amount is $__ million 

of Mexican Government Bonds maturing in 

2008, with a carrying value of $__ million [if 

different from face value]. These Mexican 

Government Bonds had a market value of $__ 

million on [reporting date]. The principal 

amount of these bonds is fully secured, at 

maturity, by $__ million face value of U.S. 

zero coupon treasury securities that mature 

on the same date. The current fair value of 

these U.S. Government securities is $__ 

million at [reporting date]. This collateral is 

pledged to holders of the bonds and held in 

custody at the Federal Reserve Bank of New 

York. The details of the transaction in which 

these bonds were acquired was reported in 

the Corporation’s Form (8–K, 10–Q or 10–K) 

for (date). Accrued interest on the bonds, 

which is not secured, is included in the 

outstandings reported [amount to be 

disclosed if material]. Future interest on the 

bonds remains a cross-border risk. 

B. Assuming that remaining Mexican 

cross-border outstandings are less than 

1% of total assets but with the addition 

of the carrying value of the Mexican 

Bond principal would exceed 1%: 

• There would not be any disclosure 

included in any cross-border table. 

• The total amount of remaining 

cross-border Mexican outstandings 

would be disclosed in a footnote to the 

table. Such footnote would also explain 

that the Mexican outstandings are 

excluded from the table. 

• Additional footnote disclosure— 

(same disclosure in A above) 

• The disclosure required under this 

paragraph (plus any other disclosure 

required by Item III.C.3. of Guide 3) 

would continue so long as Mexican 

exposure, including the carrying value 

of the Mexican Bond principal, 

exceeded 1%. 

C. Assuming that the remaining 

Mexican cross-border outstandings is 

less than .75% of total assets but with 

the addition of the carrying value of the 

Mexican Bond principal is greater than 

.75% but less than 1%: 

• Mexico would not be included in 

the list of names of countries required 

by Instruction 7 to Item III.C.3. of 

Industry Guide 3 and the amount of 

Mexican cross-border outstandings 

would not be included in the aggregate 

amount of outstandings attributable to 

all such countries. 

• A footnote would be added to this 

disclosure of aggregate outstandings 

which discusses the Mexican 

outstandings and the Mexican Bonds. 

An example follows: 

Not included in the above aggregate 

outstandings are the Corporation’s crossborder outstandings to Mexico which totaled 

$__ million at (reporting date). This amount 

is less than .75% of total assets. (The 

remaining portion of this footnote is the same 

disclosure in A above.) 

D. Assuming that the total of the 

Mexican cross-border outstanding plus 

the carrying value of the Bond principal 

is less than the .75% of total assets: 

• No disclosure would be required. 

• However, same disclosure as in A 

above would be provided if any other 

aspects of the financial statements are 

materially affected by this transaction 

(such as the allowance for loan losses). 

Changes in aggregate outstandings to 

certain countries experiencing liquidity 

problems are required to be presented in 

tabular form in compliance with 

Instruction (6)(b) to Item III.C.3. In this 

table, Existing Obligations exchanged 

for the Bonds would generally be 

included in the aggregate cross-border 

outstandings at the beginning of the 

period during which the exchange 

occurred. For registrants using the 

alternative method, the amount of 

Existing Obligations which were 

exchanged would be included as a 

deduction in the ‘‘other changes’’ 

caption in the table. In addition, a 

footnote will be provided to the table as 

follows: 

• Relates primarily to the exchange of 

unsecured Mexican outstandings for Mexican 

bonds. The principal amount of these bonds 

is secured at maturity by $___ face U.S. Zero 

Coupon Treasury Securities which mature on 

the same date and have a current fair value 

of $___. Future interest on the bonds remains 

a cross-border risk.] 

I. Reporting of an Allocated Transfer 

Risk Reserve in Filings Under the 

Federal Securities Laws 

Facts: The Comptroller of the 

Currency, Board of Governors of the 

Federal Reserve System and Federal 

Deposit Insurance Corporation jointly 

issued final rules, pursuant to the 

International Lending Supervision Act 

of 1983, requiring banking institutions 

to establish special reserves (Allocated 

Transfer Risk Reserve ‘‘ATRR’’) against 

the risks presented in certain 

international assets when the Federal 

banking agencies determine that such 

reserves are necessary. The rules 

provide that the ATRR is to be 

accounted for separately from the 

General Allowances for Possible Loan 

Losses, and shall not be included in the 

banking institution’s capital or surplus. 

The rules also provide that no ATRR 

provisions are required if the banking 

institution writes down the assets in the 

requisite amount. 

Question: How should the ATRR be 

reported in filings under the Federal 

Securities Laws? 

Interpretive Response: It is the staff’s 

understanding that the three banking 

agencies believe that those bank holding 

companies that have not written down 

the designated assets by the requisite 

amount and, therefore, are required to 

establish an ATRR should disclose the 

amount of the ATRR. The staff believes 

that such disclosure should be part of 

the discussion of Loan Loss Experience, 

Item IV of Guide 3. Part A under Item 

IV calls for an analysis of loss 

experience in the form of a 

reconciliation of the allowance for loan 

losses, and the staff believes that it 

would be appropriate to show and 

discuss separately the ATRR in the 

context of that reconciliation. 

Registrants should recognize that the 

amount provided as an ATRR, or the 

write off of the requisite amount, 

represents the identification of an 

amount which those regulatory agencies 

have determined should not be included 

as a part of the institution’s capital or 

surplus for purposes of administration 

of the regulatory and supervisory 

functions of those agencies. In this 

context, the staff believes that disclosure 

of the ATRR, as part of the footnote 

required to be presented in a registrant’s 

financial statements by Item 7(d) of Rule 

9–03 of Regulation S–X, may provide a 

more complete explanation of charge 

offs and provisions for loan losses. It 

should be noted, however, that the 

ATRR amount to be excluded from the 

institution’s capital and surplus does 

not address the more general issue of 

the adequacy of allowances for any 

particular bank holding company’s 

loans. It is still the responsibility of each 

registrant to determine whether GAAP 

require an additional provision for 

losses in excess of the amount required 

to be included in an ATRR (or the 

requisite amount written off). 


jlentini on DSKJ8SOYB1PROD with RULES2
17254 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

4The Commission staff has been considering the 

need for more specific guidance in the area but 

believes that the FASB project on financial 

instruments may make Commission action in this 

area unnecessary. In the interim, this bulletin 

provides the staff’s views with respect to filings by 

similar entities such as saving and loan holding 

companies. 

5Some registrants may want to disclose the 

potential effects of proposed accounting standards 

not yet issued, (e.g., exposure drafts). Such 

disclosures, which generally are not required 

because the final standard may differ from the 

exposure draft, are not addressed by this SAB. See 

also FRR 26. 

6FRR 6, Section 2. 

7 In those instances where a recently issued 

standard will impact the preparation of, but not 

materially affect, the financial statements, the 

registrant is encouraged to disclose that a standard 

has been issued and that its adoption will not have 

a material effect on its financial position or results 

of operations. 

8 Item 303 of Regulation S–K. 

J. Removed by SAB 103 

K. Application of Article 9 and Guide 3 

Facts: Article 9 of Regulation S–X 

specifies the form and content of and 

requirements for financial statements for 

bank holding companies filing with the 

Commission. Similarly, bank holding 

companies disclose supplemental 

statistical disclosures in filings, 

pursuant to Industry Guide 3. No 

specific guidance as to the form and 

content of financial statements or 

supplemental disclosures has been 

promulgated for registrants which are 

not bank holding companies but which 

are engaged in similar lending and 

deposit activities.4

Question: Should non-bank holding 

company registrants with material 

amounts of lending and deposit 

activities file financial statements and 

make disclosures called for by Article 9 

of Regulation S–X and Industry Guide 

3? 

Interpretive Response: In the staff’s 

view, Article 9 and Guide 3, while 

applying literally only to bank holding 

companies, provide useful guidance to 

certain other registrants, including 

savings and loan holding companies, on 

certain disclosures relevant to an 

understanding of the registrant’s 

operations. Thus, to the extent 

particular guidance is relevant and 

material to the operations of an entity, 

the staff believes the specified 

information, or comparable data, should 

be provided. 

For example, in accordance with 

Guide 3, bank holding companies 

disclose information about yields and 

costs of various assets and liabilities. 

Further, bank holding companies 

provide certain information about 

maturities and repricing characteristics 

of various assets and liabilities. Such 

companies also disclose risk elements, 

such as nonaccrual and past due items 

in the lending portfolio. The staff 

believes that this information and other 

relevant data would be material to a 

description of business of other 

registrants with material lending and 

deposit activities and accordingly, the 

specified information and/or 

comparable data (such as scheduled 

item disclosure for risk elements) 

should be provided. 

In contrast, other requirements of 

Article 9 and Guide 3 may not be 

material or relevant to an understanding 

of the financial statements of some 

financial institutions. For example, bank 

holding companies present average 

balance sheet information, because 

period-end statements might not be 

representative of bank activity 

throughout the year. Some financial 

institutions other than bank holding 

companies may determine that average 

balance sheet disclosure does not 

provide significant additional 

information. Others may determine that 

assets and liabilities are subject to 

sufficient volatility that average balance 

information should be presented. 

Pursuant to Article 9, the income 

statements of bank holding companies 

use a ‘‘net interest income’’ presentation. 

Similarly, bank holding companies 

present the aggregate market value, at 

the balance sheet date, of investment 

securities, on the face of the balance 

sheet. The staff believes that such 

disclosures and other relevant 

information should also be provided by 

other registrants with material lending 

and deposit activities. 

L. Income Statement Presentation of 

Casino-Hotels 

Facts: Registrants having casino-hotel 

operations present separately within the 

income statement amounts of revenue 

attributable to casino, hotel and 

restaurant operations, respectively. 

Question: What is the appropriate 

income statement presentation of 

expenses attributable to casino-hotel 

activities? 

Interpretive Response: The staff 

believes that the expenses attributable to 

each of the separate revenue producing 

activities of casino, hotel and restaurant 

operations should be separately 

presented on the face of the income 

statement. Such a presentation is 

consistent with the general reporting 

format for income statement 

presentation under Regulation S–X 

(Rules 5–03.1 and 5–03.2) which 

requires presentation of amounts of 

revenues and related costs and expenses 

applicable to major revenue providing 

activities. This detailed presentation 

affords an analysis of the relative 

contribution to operating profits of each 

of the revenue producing activities of a 

typical casino-hotel operation. 

M. Disclosure of The Impact That 

Recently Issued Accounting Standards 

Will Have on the Financial Statements 

of the Registrant When Adopted in a 

Future Period 

Facts: An accounting standard has 

been issued 5 that does not require 

adoption until some future date. A 

registrant is required to include 

financial statements in filings with the 

Commission after the issuance of the 

standard but before it is adopted by the 

registrant. 

Question 1: Does the staff believe that 

these filings should include disclosure 

of the impact that the recently issued 

accounting standard will have on the 

financial position and results of 

operations of the registrant when such 

standard is adopted in a future period? 

Interpretive Response: Yes. The 

Commission addressed a similar issue 

and concluded that registrants should 

discuss the potential effects of adoption 

of recently issued accounting standards 

in registration statements and reports 

filed with the Commission.6 The staff 

believes that this disclosure guidance 

applies to all accounting standards 

which have been issued but not yet 

adopted by the registrant unless the 

impact on its financial position and 

results of operations is not expected to 

be material.7 MD&A 8 requires 

registrants to provide information with 

respect to liquidity, capital resources 

and results of operations and such other 

information that the registrant believes 

to be necessary to understand its 

financial condition and results of 

operations. In addition, MD&A requires 

disclosure of presently known material 

changes, trends and uncertainties that 

have had or that the registrant 

reasonably expects will have a material 

impact on future sales, revenues or 

income from continuing operations. The 

staff believes that disclosure of 

impending accounting changes is 

necessary to inform the reader about 

expected impacts on financial 

information to be reported in the future 

and, therefore, should be disclosed in 

accordance with the existing MD&A 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17255 

9See AU 9410.13–18. 

10The staff has previously expressed its views 

regarding acceptable methods of compliance with 

this principle in FASB ASC paragraph 942–10– 

S99–6 (Financial Services—Depository and Lending 

Topic). 

11See FASB ASC paragraph 942–10–S99–6 for 

guidance on the appropriate period in which to 

record certain types of regulatory assistance. 

12See Section 501.06.c. of the Financial 

Reporting Codification for further discussion of the 

MD&A disclosures of the effects of regulatory 

assistance. 

requirements. With respect to financial 

statement disclosure, GAAS 9

specifically address the need for the 

auditor to consider the adequacy of the 

disclosure of impending changes in 

accounting principles if (a) the financial 

statements have been prepared on the 

basis of accounting principles that were 

acceptable at the financial statement 

date but that will not be acceptable in 

the future and (b) the financial 

statements will be retrospectively 

adjusted in the future as a result of the 

change. The staff believes that recently 

issued accounting standards may 

constitute material matters and, 

therefore, disclosure in the financial 

statements should also be considered in 

situations where the change to the new 

accounting standard will be accounted 

for in financial statements of future 

periods, prospectively or with a 

cumulative catch-up adjustment. 

Question 2: Does the staff have a view 

on the types of disclosure that would be 

meaningful and appropriate when a new 

accounting standard has been issued but 

not yet adopted by the registrant? 

Interpretive Response: The staff 

believes that the registrant should 

evaluate each new accounting standard 

to determine the appropriate disclosure 

and recognizes that the level of 

information available to the registrant 

will differ with respect to various 

standards and from one registrant to 

another. The objectives of the disclosure 

should be to (1) notify the reader of the 

disclosure documents that a standard 

has been issued which the registrant 

will be required to adopt in the future 

and (2) assist the reader in assessing the 

significance of the impact that the 

standard will have on the financial 

statements of the registrant when 

adopted. The staff understands that the 

registrant will only be able to disclose 

information that is known. 

The following disclosures should 

generally be considered by the 

registrant: 

• A brief description of the new 

standard, the date that adoption is 

required and the date that the registrant 

plans to adopt, if earlier. 

• A discussion of the methods of 

adoption allowed by the standard and 

the method expected to be utilized by 

the registrant, if determined. 

• A discussion of the impact that 

adoption of the standard is expected to 

have on the financial statements of the 

registrant, unless not known or 

reasonably estimable. In that case, a 

statement to that effect may be made. 

• Disclosure of the potential impact 

of other significant matters that the 

registrant believes might result from the 

adoption of the standard (such as 

technical violations of debt covenant 

agreements, planned or intended 

changes in business practices, etc.) is 

encouraged. 

N. Disclosures of The Impact of 

Assistance From Federal Financial 

Institution Regulatory Agencies 

Facts: An entity receives financial 

assistance from a Federal regulatory 

agency in conjunction with either an 

acquisition of a troubled financial 

institution, transfer of nonperforming 

assets to a newly-formed entity, or other 

reorganization. 

Question: What are the disclosure 

implications of the existence of 

regulatory assistance? 

Interpretive Response: The staff 

believes that users of financial 

statements must be able to assess the 

impact of credit and other risks on a 

company following a regulatory assisted 

acquisition, transfer or other 

reorganization on a basis comparable to 

that disclosed by other institutions, i.e., 

as if the assistance did not exist. In this 

regard, the staff believes that the amount 

of regulatory assistance should be 

disclosed separately and should be 

separately identified in the statistical 

information furnished pursuant to 

Industry Guide 3, to the extent it 

impacts such information.10, 11 Further, 

the nature, extent and impact of such 

assistance needs to be fully discussed in 

Management’s Discussion and 

Analysis.12

TOPIC 12: OIL AND GAS PRODUCING 

ACTIVITIES 

A. Accounting Series Release 257— 

Requirements for Financial Accounting 

and Reporting Practices for Oil and Gas 

Producing Activities 

1. Estimates of Reserve Quantities 

Facts: Rule 4–10 of Regulation S–X 

contains definitions of possible reserves, 

probable reserves, and proved and 

developed oil and gas reserves to be 

used in determining quantities of oil 

and gas reserves to be reported in filings 

with the Commission. 

Question: What pressure base should 

be used for reporting gas and 

production, 14.73 psia or the pressure 

base specified by the state? 

Interpretive Response: The reporting 

instructions to the Department of 

Energy’s Form EIA–28 specify that 

natural gas reserves are to be reported at 

14.73 psia and 60 degrees F. There is no 

pressure base specified in Regulation S– 

X or S–K. At the present time staff will 

not object to natural gas reserves and 

production data calculated at other 

pressure bases, if such pressure bases 

are identified in the filing. 

2. Estimates of Future Net Revenues 

Facts: U.S. GAAP requires the 

disclosure of the standardized measure 

of discounted future net cash flows from 

production of proved oil and gas 

reserves. 

Question: F or purposes of 

determining reserves and estimated 

future net revenues, what price should 

be used for oil and gas which will be 

produced after an existing contract 

expires or after the redetermination date 

in a contract? 

Interpretive Response: The price to be 

used for oil and gas which will be 

produced after a contract expires or has 

a redetermination is the average price 

during the 12-month period prior to the 

ending date of the period covered by the 

balance sheet, determined as an 

unweighted arithmetic average of the 

first-day-of-the-month price for each 

month within such period for that oil 

and gas. This average price, which 

should be based on the first-day-of-themonth market prices, may be increased 

thereafter only for additional fixed and 

determinable escalations, as 

appropriate. A fixed and determinable 

escalation is one which is specified in 

amount and is not based on future 

events such as rates of inflation. 

3. Disclosure of Reserve Information 

a. Removed by SAB 103 

b. Removed by SAB 113 

c. Limited Partnership 10–K Reports 

Facts: Item 1201(a) of Regulation S–K 

contains an exemption from the 

requirements to disclose certain 

information relating to oil and gas 

operations for ‘‘limited partnerships or 

joint ventures that conduct, operate, 

manage, or report upon oil and gas 

drilling income programs that acquire 

properties either for drilling and 

production, or for production of oil, gas, 

or geothermal steam. * * *’’ 

Limited partnership agreements often 

contain buy-out provisions under which 

the general partner agrees to purchase 

limited partnership interests that are 

offered for sale, based upon a specified 

valuation formula. Because of these 

arrangements, the requirements for 


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disclosure of reserve value information 

may be of little significance to the 

limited partners. 

Question: Must the financial 

statements of limited partnerships 

included in reports on Form 10–K 

contain the disclosures of estimated 

future net revenues, present values and 

changes therein, and supplemental 

summary of oil and gas activities 

specified in FASB ASC paragraphs 932– 

235–50–23 through 932–235–50–36 

(Extractive Activities—Oil and Gas 

Topic)? 

Interpretive Response: The staff will 

not take exception to the omission of 

these disclosures in a limited 

partnership Form 10–K if reserve value 

information is available to the limited 

partners pursuant to the partnership 

agreement (even though the valuations 

may be computed differently and may 

be as of a date other than year end). 

However, the staff will require all of the 

information listed in FASB ASC 

paragraphs 932–235–50–23 through 

932–235–50–36 for partnerships which 

are the subject of a business 

combination or exchange offer under 

which various limited partnerships are 

to be consolidated or combined into a 

single entity. 

d. Removed by SAB 113 

e. Rate Regulated Companies 

Question: If a company has cost-ofservice oil and gas producing properties, 

how should they be treated in the 

supplemental disclosures of reserve 

quantities and related future net 

revenues provided pursuant to FASB 

ASC paragraphs 932–235–50–29 

through 932–235–50–36? 

Interpretive Response: Rule 4–10 

provides that registrants may give effect 

to differences arising from the 

ratemaking process for cost-of-service 

oil and gas properties. Accordingly, in 

these circumstances, the staff believes 

that the company’s supplemental 

reserve quantity disclosures should 

indicate separately the quantities 

associated with properties subject to 

cost-of-service ratemaking, and that it is 

appropriate to exclude those quantities 

from the future net revenue disclosures. 

The company should also disclose the 

nature and impact of its cost-of-service 

ratemaking, including the unamortized 

cost included in the balance sheet. 

4. Removed by SAB 103 

B. Removed by SAB 103 

C. Methods of Accounting by Oil and 

Gas Producers 

1. First-Time Registrants 

Facts: In ASR 300, the Commission 

announced that it would allow 

registrants to change methods of 

accounting for oil and gas producing 

activities so long as such changes were 

in accordance with GAAP. Accordingly, 

the Commission stated that changes 

from the full cost method to the 

successful efforts method would not 

require a preferability letter. Changes to 

full cost, however, would require 

justification by the company making the 

change and filing of a preferability letter 

from the company’s independent 

accountants. 

Question: How does this policy apply 

to a nonpublic company which changes 

its accounting method in connection 

with a forthcoming public offering or 

initial registration under either the 1933 

Act or 1934 Act? 

Interpretive Response: The 

Commission’s policy that first-time 

registrants may change their previous 

accounting methods without filing a 

preferability letter is applicable. 

Therefore, such a company may change 

to the full cost method without filing a 

preferability letter. 

2. Consistent Use of Accounting 

Methods Within a Consolidated Entity 

Facts: Rule 4–10(c) of Regulation S–X 

states in part that ‘‘[a] reporting entity 

that follows the full cost method shall 

apply that method to all of its 

operations and to the operations of its 

subsidiaries * * *’’ 

Question 1: May a subsidiary of the 

parent use the full cost method if the 

parent company uses the successful 

efforts method of accounting for oil and 

gas producing activities? 

Interpretive Response: No. The use of 

different methods of accounting in the 

consolidated financial statements by a 

parent company and its subsidiary 

would be inconsistent with the full cost 

requirement that a parent and its 

subsidiaries all use the same method of 

accounting. 

The staff’s general policy is that an 

enterprise should account for all its like 

operations in the same manner. 

However, Rule 4–10 of Regulation S–X 

provides that oil and gas companies 

with cost-of-service oil and gas 

properties may give effect to any 

differences resulting from the 

ratemaking process, including 

regulatory requirements that a certain 

accounting method be used for the costof-service properties. 

Question 2: Must the method of 

accounting (full cost or successful 

efforts) followed by a registrant for its 

oil and gas producing activities also be 

followed by any fifty percent or less 

owned companies in which the 

registrant carries its investment on the 

equity method (equity investees)? 

Interpretive Response: No. Conformity 

of accounting methods between a 

registrant and its equity investees, 

although desirable, may not be 

practicable and thus is not required. 

However, if a registrant proportionately 

consolidates its equity investees, it will 

be necessary to present them all on the 

same basis of accounting. 

D. Application of Full Cost Method of 

Accounting 

1. Treatment of Income Tax Effects in 

the Computation of the Limitation on 

Capitalized Costs 

Facts: Item (D) in Rule 4–10(c)(4)(i) of 

Regulation S–X provides that the 

income tax effects related to the 

properties involved should be deducted 

in computing the full cost ceiling. 

Question 1: What specific types of 

income tax effects should be considered 

in computing the income tax effects to 

be deducted from estimated future net 

revenues? 

Interpretive Response: The rule refers 

to income tax effects generally. Thus, 

the computation should take into 

account (i) the tax basis of oil and gas 

properties, (ii) net operating loss 

carryforwards, (iii) foreign tax credit 

carryforwards, (iv) investment tax 

credits, (v) alternative minimum taxes 

on tax preference items, and (vi) the 

impact of statutory (percentage) 

depletion. 

It may often be difficult to allocate a 

net operating loss (NOL) carryforward 

between oil and gas assets and other 

assets. However, to the extent that the 

NOL is clearly attributable to oil and gas 

operations and is expected to be 

realized within the carryforward period, 

it should be added to tax basis. 

Similarly, to the extent that 

investment tax credit (ITC) 

carryforwards and foreign tax credit 

carryforwards are attributable to oil and 

gas operations and are expected to be 

realized within the carryforward period, 

they should be considered as a 

deduction from the tax effect otherwise 

computed. Consideration of NOL and 

ITC or foreign tax credit carryforwards 

should not, of course, reduce the total 

tax effect below zero. 

Question 2: How should the tax effect 

be computed considering the various 

factors discussed above? 


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Interpretive Response: Theoretically, 

taxable income and tax could be 

determined on a year-by-year basis and 

the present value of the related tax 

computed. However, the ‘‘shortcut’’ 

method illustrated below is also 

acceptable. 

ASSUMPTIONS: 

Cost of proved properties being amortized ...................................................................................... .................... $396,000 ....................

Lower of cost or estimated fair value of unproved properties to be amortized ............................... .................... 49,000 ....................

Cost of properties not being amortized ............................................................................................ .................... 55,000 ....................

Capitalized costs of oil and gas assets ............................................................................................ .................... 500,000 ....................

Accumulated DD&A .......................................................................................................................... .................... (100,000) ....................

Book basis of oil and gas assets ..................................................................................................... .................... .................... $400,000 

Excess of book basis over tax basis ($270,000) of oil and gas assets .......................................... .................... $(130,000) ....................

NOL carryforward* ............................................................................................................................ .................... 20,000 

(110,000) 

Statutory tax rate (percent) .............................................................................................................. .................... × 46% 

(50,600) 

....................

Foreign tax credit carryforward * ...................................................................................................... .................... 1,000 ....................

ITC carryforward* ............................................................................................................................. .................... 2,000 ....................

Related net deferred income tax liability .......................................................................................... .................... .................... (47,600) 

Net book basis to be recovered ....................................................................................................... .................... .................... $352,400 

Other Assumptions: 

Present value of ITC relating to future development costs ............................................................. .................... $1,500 ....................

Present value of statutory depletion attributable to future deductions ............................................ .................... $10,000 ....................

Estimated preference (minimum) tax on percentage depletion in excess of cost depletion ........... .................... $500 ....................

Present value of future net revenue from proved oil and gas reserves .......................................... .................... $272,000 ....................

CALCULATION: 

Present value of future net revenue ................................................................................................. .................... $272,000 ....................

Cost of properties not being amortized ............................................................................................ .................... 55,000 ....................

Lower of cost or estimated fair value of unproved properties included in costs being amortized .. .................... 49,000 ....................

Total ceiling limitation before tax effects .......................................................................................... .................... .................... $376,000 

Tax Effects: 

Total ceiling limitation before tax effects .......................................................................................... .................... $376,000 ....................

Less: Tax basis of properties ........................................................................................................... $(270,000) .................... ....................

Statutory depletion ............................................................................................................................ (10,000) .................... ....................

NOL carryforward ............................................................................................................................. (20,000) .................... ....................

(300,000) 

Future taxable income ...................................................................................................................... .................... 76,000 ....................

Tax rate (percent) ............................................................................................................................. .................... × 46% ....................

Tax at statutory rate ......................................................................................................................... .................... (34,960) ....................

ITC (future development costs and carryforward) ........................................................................... .................... 3,500 ....................

Foreign tax credit carryforward ........................................................................................................ .................... 1,000 ....................

Estimated preference tax ................................................................................................................. .................... (500) ....................

Net tax effects .................................................................................................................................. .................... .................... (30,960) 

Cost Center Ceiling .......................................................................................................................... .................... .................... $345,040 

Less: Net book basis to be recovered ............................................................................................. .................... .................... 352,400 

REQUIRED WRITE-OFF, net of tax ** ............................................................................................. .................... .................... $(7,360) 

* All carryforward amounts in this example represent amounts which are available for tax purposes and which relate to oil and gas operations. 

** For accounting purposes, the gross write-off should be recorded to adjust both the oil and gas properties account and the related deferred 

income taxes. 

CALCULATION OF GROSS PRE-TAX WRITE-OFF: 

Required write-off, net of tax ............................................................................................................ .................... .................... $(7,360) 

Divided by (100% minus the statutory rate of 46%) ........................................................................ .................... .................... 54% 

Gross pre-tax write-off ...................................................................................................................... .................... .................... $(13,630) 

Related Journal Entries DR CR 

Full cost ceiling impairment ..................................................................................................................... $13,630 .................... ....................

Oil and gas assets ................................................................................................................................... .................... $13,630 ....................

Deferred income tax liability .................................................................................................................... $6,270 .................... ....................

Deferred income tax benefit .................................................................................................................... .................... $6,270 ....................

2. Exclusion of Costs From Amortization 

Facts: Rule 4–10(c)(3)(ii) indicates 

that the costs of acquiring and 

evaluating unproved properties may be 

excluded from capitalized costs to be 

amortized if the costs are unusually 

significant in relation to aggregate costs 

to be amortized. Costs of major 

development projects may also be 

incurred prior to ascertaining the 

quantities of proved reserves 

attributable to such properties. 

Question: At what point should 

amortization of previously excluded 

costs commence—when proved reserves 

have been established or when those 

reserves become marketable? For 

instance, a determination of proved 

reserves may be made before completion 

of an extraction plant necessary to 

process sour crude or a pipeline 

necessary to market the reserves. May 

the costs continue to be excluded from 

amortization until the plant or pipeline 

is in service? 


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Interpretive Response: No. The proved 

reserves and the costs allocable to such 

reserves should be transferred into the 

amortization base on an ongoing (wellby-well or property-by-property) basis 

as the project is evaluated and proved 

reserves are established. 

Once the determination of proved 

reserves has been made, there is no 

justification for continued exclusion 

from the full cost pool, regardless of 

whether other factors prevent 

immediate marketing. Moreover, at the 

same time that the costs are transferred 

into the amortization base, it is also 

necessary in accordance with FASB 

ASC Subtopic 932–835, Extractive 

Activities—Oil and Gas—Interest, and 

FASB ASC Subtopic 835–20, Interest— 

Capitalization of Interest, to terminate 

capitalization of interest on such 

properties. 

In this regard, registrants are 

reminded of their responsibilities not to 

delay recognizing reserves as proved 

once they have met the engineering 

standards. 

3. Full Cost Ceiling Limitation 

a. Exemptions for Purchased Properties 

Facts: During 20x1, a registrant 

purchases proved oil and gas reserves in 

place (‘‘the purchased reserves’’) in an 

arm’s-length transaction for the sum of 

$9.8 million. Primarily because the 

registrant expects oil and gas prices to 

escalate, it paid $1.2 million more for 

the purchased reserves than the ‘‘Present 

Value of Estimated Future Net 

Revenues’’ computed as defined in Rule 

4–10(c)(4)(i)(A) of Regulation S–X. An 

analysis of the registrant’s full cost 

center in which the purchased reserves 

are located at December 31, 20x1 is as 

follows: 

Total Purchased 

reserves 

Other 

proved 

properties 

Unproved 

properties 

(Amounts in thousands) 

Present value of estimated future net revenues ............................................................. $14,100 8,600 5,500 

Cost, net of amortization ................................................................................................. 16,300 9,800 5,500 1,000 

Related deferred taxes .................................................................................................... 2,300 2,000 300 

Income tax effects related to properties .......................................................................... 2,500 2,500 

Comparison of capitalized costs with limitation on capitalized costs at December 31, 

20x1: 

Including 

purchased 

reserves 

Excluding 

purchased 

reserves 

Capitalized costs, net of amortization ............................................................................. .................... $16,300 $6,500 ....................

Related deferred taxes .................................................................................................... .................... (2,300) (2,300) ....................

Net book cost ................................................................................................................... .................... 14,000 4,200 ....................

Present value of estimated future net revenues ............................................................. .................... 14,100 5,500 ....................

Lower of cost or market of unproved properties ............................................................. .................... 1,000 1,000 ....................

Income tax effects related to properties .......................................................................... .................... (2,500) (2,500) ....................

Limitation on capitalized costs ......................................................................................... .................... 12,600 4,000 ....................

Excess of capitalized costs over limitation on Capitalized costs, net of tax * ................. .................... 1,400 200 ....................

* For accounting purposes, the gross write-off should be recorded to adjust both the oil and gas properties account and the related deferred income taxes. 

Question: Is it necessary for the 

registrant to write down the carrying 

value of its full cost center at December 

31, 20x1 by $1,400,000? 

Interpretive Response: Although the 

net carrying value of the full cost center 

exceeds the cost center’s limitation on 

capitalized costs, the text of ASR 258 

provides that a registrant may request an 

exemption from the rule if as a result of 

a major purchase of proved properties, 

a write down would be required even 

though the registrant believes the fair 

value of the properties in a cost center 

clearly exceeds the unamortized costs. 

Therefore, to the extent that the 

excess carrying value relates to the 

purchased reserves, the registrant may 

seek a temporary waiver of the full-cost 

ceiling limitation from the staff of the 

Commission. Registrants requesting a 

waiver should be prepared to 

demonstrate that the additional value 

exists beyond reasonable doubt. 

To the extent that the excess costs 

relate to properties other than the 

purchased reserves, however, a write-off 

should be recorded in the current 

period. In order to determine the 

portion of the total excess carrying value 

which is attributable to properties other 

than the purchased reserves, it is 

necessary to perform the ceiling 

computation on a ‘‘with and without’’ 

basis as shown in the example above. 

Thus in this case, the registrant must 

record a write-down of $200,000 

applicable to other reserves. An 

additional $1,200,000 write-down 

would be necessary unless a waiver was 

obtained. 

b. Use of Cash Flow Hedges in the 

Computation of the Limitation on 

Capitalized Costs 

Facts: Rule 4–10(c)(4) of Regulation 

S–X provides, in pertinent part, that 

capitalized costs, net of accumulated 

depreciation and amortization, and 

deferred income taxes, should not 

exceed an amount equal to the sum of 

components that include the present 

value of estimated future net revenues 

computed by applying current prices of 

oil and gas reserves (with consideration 

of price changes only to the extent 

provided by contractual arrangements) 

to estimated future production of 

proved oil and gas reserves as of the 

date of the latest balance sheet 

presented. 

As of the reported balance sheet date, 

capitalized costs of an oil and gas 

producing company exceed the full cost 

limitation calculated under the abovedescribed rule based on current prices, 

as defined in Rule 4–10(c)(8) of 

Regulation S–X, for oil and natural gas. 

However, prior to the balance sheet 

date, the company entered into certain 

hedging arrangements for a portion of its 

future natural gas and oil production, 

thereby enabling the company to receive 

future cash flows that are higher or 

lower than the estimated future cash 

flows indicated by use of the average 

price during the 12-month period prior 

to the balance sheet date, determined as 


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an unweighted arithmetic average of the 

first-day-of-the-month price for each 

month within such period. These 

arrangements qualify as cash flow 

hedges under the provisions of FASB 

ASC Topic 815, Derivatives and 

Hedging, and are documented, 

designated, and accounted for as such 

under the criteria of that standard. 

Question: Under these circumstances, 

must the company use the higher or 

lower prices to be received after taking 

into account the hedging arrangements 

(‘‘hedge-adjusted prices’’) in calculating 

the estimated cash flows from future 

production of oil and gas reserves 

covered by the hedges as of the reported 

balance sheet date? 

Interpretive Response: Yes. Derivative 

contracts that qualify as a hedging 

instrument in a cash flow hedge and are 

accounted for as such pursuant to FASB 

ASC Topic 815 represent the type of 

contractual arrangements for which 

consideration of price changes should 

be given under the existing rule. While 

the SEC staff has objected to previous 

proposals to consider various hedging 

techniques as being equivalent to the 

contractual arrangements permitted 

under the existing rules, the staff’s 

objection was based on concerns that 

the lack of clear, consistent guidance in 

the accounting literature would lead to 

inconsistent application in practice. 

However, the staff believes that FASB 

ASC Topic 815 and related guidance 

(including a more systematic approach 

to documentation) provides sufficient 

guidance so that comparable financial 

reporting in comparable factual 

circumstances should result. 

This interpretive response reflects the 

SEC staff’s view that, assuming 

compliance with the prerequisite 

accounting requirements, hedgeadjusted prices represent the best 

measure of estimated cash flows from 

future production of the affected oil and 

gas reserves to use in calculating the 

ceiling limitation. Nonetheless, the staff 

expects that oil and gas producing 

companies subject to the full cost rules 

will clearly indicate the effects of using 

cash flow hedges in calculating ceiling 

limitations within their financial 

statement footnotes. The staff further 

expects that disclosures will indicate 

the portion of future oil and gas 

production being hedged. The dollar 

amount that would have been charged 

to income had the effects of the cash 

flow hedges not been considered in 

calculating the ceiling limitation also 

should be disclosed. 

The use of hedge-adjusted prices 

should be consistently applied in all 

reporting periods, including periods in 

which the hedge-adjusted price is more 

or less than the average price during the 

12-month period prior to the balance 

sheet date, determined as an 

unweighted arithmetic average of the 

first-day-of-the-month price for each 

month within such period. Oil and gas 

producers whose computation of the 

ceiling limitation includes hedgeadjusted prices because of the use of 

cash flow hedges also should consider 

the disclosure requirements under 

FASB ASC Section 275–10–50, Risks 

and Uncertainties—Overall—Disclosure. 

FASB ASC paragraph 275–10–50–9 calls 

for disclosure when it is at least 

reasonably possible that the effects of 

cash flow hedges on capitalized costs on 

the reported balance sheet date will 

change in the near term due to one or 

more confirming events, such as 

potential future changes in commodity 

prices. 

In addition, the use of cash flow 

hedges in calculating the ceiling 

limitation may represent a type of 

critical accounting policy that oil and 

gas producers should consider 

disclosing consistent with the 

cautionary advice provided in Financial 

Reporting Release No. 60 (Release Nos. 

33–8040; 34–45149), Cautionary Advice 

Regarding Disclosure about Critical 

Accounting Policies (December 12, 

2001), and Financial Reporting Release 

No. 72 (Release Nos. 33–8350; 34– 

48960), Commission Guidance 

Regarding Management’s Discussion 

and Analysis of Financial Condition and 

Results of Operations (December 29, 

2003). Through these releases, the 

Commission has encouraged companies 

to include, within their MD&A 

disclosures, full explanations, in plain 

English, of the judgments and 

uncertainties affecting the application of 

critical accounting policies, and the 

likelihood that materially different 

amounts would be reported under 

different conditions or using different 

assumptions. 

The staff’s guidance on this issue 

would apply to calculations of ceiling 

limitations both in interim and annual 

reporting periods. 

c. Effect of Subsequent Events on the 

Computation of the Limitation on 

Capitalized Costs 

Facts: Rule 4–10(c)(4)(ii) of 

Regulation S–X provides that an excess 

of unamortized capitalized costs within 

a cost center over the related cost ceiling 

shall be charged to expense in the 

period the excess occurs. 

Question: Assume that at the date of 

the company’s fiscal year-end, its 

capitalized costs of oil and gas 

producing properties exceed the 

limitation prescribed by Rule 4–10(c)(4) 

of Regulation S–X. Thus, a write-down 

is indicated. Subsequent to year-end but 

before the date of the auditor’s report on 

the company’s financial statements, 

assume that additional reserves are 

proved up (excluding the effect of 

increased oil and gas prices subsequent 

to year-end) on properties owned at 

year-end. The present value of future 

net revenues from the additional 

reserves is sufficiently large that if the 

full cost ceiling limitation were 

recomputed giving effect to those factors 

as of year-end, the ceiling would more 

than cover the costs. Is it necessary to 

record a write-down? 

Interpretive Response: No. In this 

case, the proving up of additional 

reserves on properties owned at yearend indicates that the capitalized costs 

were not in fact impaired at year-end. 

However, for purposes of the revised 

computation of the ‘‘ceiling,’’ the net 

book costs capitalized as of year-end 

should be increased by the amount of 

any additional costs incurred 

subsequent to year-end to prove the 

additional reserves or by any related 

costs previously excluded from 

amortization. 

While the fact pattern described 

herein relates to annual periods, the 

guidance on the effects of subsequent 

events applies equally to interim period 

calculations of the ceiling limitation. 

The registrant’s financial statements 

should disclose that capitalized costs 

exceeded the limitation thereon at yearend and should explain why the excess 

was not charged against earnings. In 

addition, the registrant’s supplemental 

disclosures of estimated proved reserve 

quantities and related future net 

revenues and costs should not give 

effect to the reserves proved up or the 

cost incurred after year-end. However, 

such quantities may be disclosed 

separately, with appropriate 

explanations. 

Registrants should be aware that oil 

and gas reserves related to properties 

acquired after year-end would not 

justify avoiding a write-off indicated as 

of year-end. Similarly, the effects of 

cash flow hedging arrangements entered 

into after year-end cannot be factored 

into the calculation of the ceiling 

limitation at year-end. Such acquisitions 

and financial arrangements do not 

confirm situations existing at year-end. 


jlentini on DSKJ8SOYB1PROD with RULES2
17260 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

1 If an obligation for expected asset retirement 

costs has not been accrued under FASB ASC 

Subtopic 410–20 for certain asset retirement costs 

required to be included in the full cost ceiling 

calculation under Rule 4–10(c)(4) of Regulation S– 

X, such costs should continue to be included in the 

full cost ceiling calculation. 

2This approach is consistent with the guidance 

in FASB ASC Subtopic 410–20 on testing for 

impairment under FASB ASC Section 360–10–35, 

Property, Plant, and Equipment—Overall— 

Subsequent Measurement. Under that guidance, the 

asset tested should include capitalized asset 

retirement costs. The estimated cash flows related 

to the associated ARO that has been recognized in 

the financial statements are to be excluded from 

both the undiscounted cash flows used to test for 

recoverability and the discounted cash flows used 

to measure the asset’s fair value. 

3The reference to ‘‘cost of properties described in 

paragraph (ii) below’’ relates to the costs of 

investments in unproved properties and major 

development projects, as defined. 

4Rule 4–10(c)(8) of Regulation S–X defines 

current price as the average price during the 12- 

month period prior to the ending date of the period 

covered by the report, determined as an unweighted 

4. Interaction of FASB ASC Subtopic 

410–20, Asset Retirement and 

Environmental Obligations—Asset 

Retirement Obligations, and the Full 

Cost Rules 

a. Impact of FASB ASC Subtopic 410– 

20 on the Full Cost Ceiling Test 

Facts: A company following the full 

cost method of accounting under Rule 

4–10(c) of Regulation S–X must 

periodically calculate a limitation on 

capitalized costs, i.e., the full cost 

ceiling. Under FASB ASC Subtopic 

410–20, a company must recognize a 

liability for an asset retirement 

obligation (ARO) at fair value in the 

period in which the obligation is 

incurred, if a reasonable estimate of fair 

value can be made. The company also 

must initially capitalize the associated 

asset retirement costs by increasing 

long-lived oil and gas assets by the same 

amount as the liability. Any asset 

retirement costs capitalized pursuant to 

FASB ASC Subtopic 410–20 are subject 

to the full cost ceiling limitation under 

Rule 4–10(c)(4) of Regulation S–X. If a 

company were to calculate the full cost 

ceiling by reducing expected future net 

revenues by the cash flows required to 

settle the ARO, then the effect would be 

to ‘‘double-count’’ such costs in the 

ceiling test. The assets that must be 

recovered would be increased while the 

future net revenues available to recover 

the assets continue to be reduced by the 

amount of the ARO settlement cash 

flows. 

Question: How should a company 

compute the full cost ceiling to avoid 

double-counting the expected future 

cash outflows associated with asset 

retirement costs? 

Interpretive Response: The future cash 

outflows associated with settling AROs 

that have been accrued on the balance 

sheet should be excluded from the 

computation of the present value of 

estimated future net revenues for 

purposes of the full cost ceiling 

calculation.1,2

b. Impact of FASB ASC Subtopic 410– 

20 on the Calculation of Depreciation, 

Depletion, and Amortization 

Facts: Regarding the base for 

depreciation, depletion, and 

amortization (DD&A) of proved reserves, 

Rule 4–10(c)(3)(i) of Regulation S–X 

states that ‘‘[c]osts to be amortized shall 

include (A) all capitalized costs, less 

accumulated amortization, other than 

the cost of properties described in 

paragraph (ii) below; 3 (B) the estimated 

future expenditures (based on current 

costs) to be incurred in developing 

proved reserves; and (C) estimated 

dismantlement and abandonment costs, 

net of estimated salvage values.’’ FASB 

ASC Subtopic 410–20 requires that 

upon initial recognition of an ARO, the 

associated asset retirement costs be 

included in the capitalized costs of the 

company. Therefore, the estimated 

dismantlement and abandonment costs 

described in (C) above may be included 

in the capitalized costs described in (A) 

above, at least to the extent that an ARO 

has been incurred as a result of 

acquisition, exploration and 

development activities to date. Future 

development activities on proved 

reserves may result in additional asset 

retirement obligations when such 

activities are performed and the 

associated asset retirement costs will be 

capitalized at that time. 

Question: Should the costs to be 

amortized under Rule 4–10(c)(3) of 

Regulation S–X include an amount for 

estimated dismantlement and 

abandonment costs, net of estimated 

salvage values, that are expected to 

result from future development 

activities? 

Interpretive Response: Yes. 

Companies should estimate the amount 

of dismantlement and abandonment 

costs that will be incurred as a result of 

future development activities on proved 

reserves and include those amounts in 

the costs to be amortized. 

c. Removed by SAB 113 

E. Financial Statements of Royalty 

Trusts 

Facts: Several oil and gas exploration 

and production companies have created 

‘‘royalty trusts.’’ Typically, the creating 

company conveys a net profits interest 

in certain of its oil and gas properties to 

the newly created trust and then 

distributes units in the trust to its 

shareholders. The trust is a passive 

entity which is prohibited from entering 

into or engaging in any business or 

commercial activity of any kind and 

from acquiring any oil and gas lease, 

royalty or other mineral interest. The 

function of the trust is to serve as an 

agent to distribute the income from the 

net profits interest. The amount to be 

periodically distributed to the 

unitholders is defined in the trust 

agreement and is typically determined 

based on the cash received from the net 

profits interest less expenses of the 

trustee. Royalty trusts have typically 

reported their earnings on the basis of 

cash distributions to unitholders. The 

net profits interest paid to the trust for 

any month is based on production from 

a preceding month; therefore, the 

method of accounting followed by the 

trust for the net profits interest income 

is different from the creating company’s 

method of accounting for the related 

revenue. 

Question: Will the staff accept a 

statement of distributable income which 

reflects the amounts to be distributed for 

the period in question under the terms 

of the trust agreement in lieu of a 

statement of income prepared under 

GAAP? 

Interpretive Response: Yes. Although 

financial statements filed with the 

Commission are normally required to be 

prepared in accordance with GAAP, the 

Commission’s rules provide that other 

presentations may be acceptable in 

unusual situations. Since the operations 

of a royalty trust are limited to the 

distribution of income from the net 

profits interests contributed to it, the 

staff believes that the item of primary 

importance to the reader of the financial 

statements of the royalty trust is the 

amount of the cash distributions to the 

unitholders for the period reported. 

Should there be any change in the 

nature of the trust’s operations due to 

revisions in the tax laws or other factors, 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17261 

4Rule 4–10(c)(8) of Regulation S–X defines 

current price as the average price during the 12- 

month period prior to the ending date of the period 

covered by the report, determined as an unweighted 

arithmetic average of the first-day-of-the-month 

price for each month within such period, unless 

prices are defined by contractual arrangements, 

excluding escalations based upon future conditions. 

1The February 1999 AICPA publication ‘‘Audit 

Issues in Revenue Recognition’’ provides an 

overview of the authoritative accounting literature 

and auditing procedures for revenue recognition 

and identifies indicators of improper revenue 

recognition. 

2Concepts Statement 5, paragraphs 83–84; FASB 

ASC paragraph 605–10–25–1 (Revenue Recognition 

Topic); FASB ASC paragraph 605–10–25–3; FASB 

ASC paragraph 605–10–25–5. The citations 

provided herein are not intended to present the 

complete population of citations where a particular 

criterion is relevant. Rather, the citations are 

intended to provide the reader with additional 

reference material. 

3Concepts Statement 2, paragraph 63 states 

‘‘Representational faithfulness is correspondence or 

agreement between a measure or description and 

the phenomenon it purports to represent.’’ The staff 

believes that evidence of an exchange arrangement 

must exist to determine if the accounting treatment 

represents faithfully the transaction. See also FASB 

ASC paragraph 985–605–25–3 (Software Topic). 

The use of the term ‘‘arrangement’’ in this SAB 

Topic is meant to identify the final understanding 

between the parties as to the specific nature and 

terms of the agreed-upon transaction. 

4Concepts Statement 5, paragraph 84(a), (b), and 

(d). Revenue should not be recognized until the 

seller has substantially accomplished what it must 

do pursuant to the terms of the arrangement, which 

usually occurs upon delivery or performance of the 

services. 

5Concepts Statement 5, paragraph 83(a); FASB 

ASC subparagraph 605–15–25–1(a); FASB ASC 

paragraph 985–605–25–3. The FASB ASC Master 

Glossary defines a ‘‘fixed fee’’ as a ‘‘fee required to 

be paid at a set amount that is not subject to refund 

or adjustment. A fixed fee includes amounts 

designated as minimum royalties.’’ FASB ASC 

paragraphs 985–605–25–30 through 985–605–25–40 

discuss how to apply the fixed or determinable fee 

criterion in software transactions. The staff believes 

that the guidance in FASB ASC paragraphs 985– 

605–25–30 through 985–605–25–31 and 985–605– 

25–36 through 985–605–25–40 is appropriate for 

other sales transactions where authoritative 

guidance does not otherwise exist. The staff notes 

that FASB ASC paragraphs 985–605–25–33 through 

985–605–25–35 specifically consider software 

transactions, however, the staff believes that 

guidance should be considered in other sales 

transactions in which the risk of technological 

obsolescence is high. 

6FASB ASC paragraph 605–10–25–3 through 

605–10–25–5. See also Concepts Statement 5, 

paragraph 84(g) and FASB ASC paragraph 985– 

605–25–3. 

7See FASB ASC paragraph 605–25–15–2 through 

605–25–15–3 for additional discussion. 

the staff’s interpretation would be 

reexamined. 

A note to the financial statements 

should disclose the method used in 

determining distributable income and 

should also describe how distributable 

income as reported differs from income 

determined on the basis of GAAP. 

F. Gross Revenue Method of Amortizing 

Capitalized Costs 

Facts: Rule 4–10(c)(3)(iii) of 

Regulation S–X states in part: 

‘‘Amortization shall be computed on the 

basis of physical units, with oil and gas 

converted to a common unit of measure on 

the basis of their approximate relative energy 

content, unless economic circumstances 

(related to the effects of regulated prices) 

indicate that use of units of revenue is a more 

appropriate basis of computing amortization. 

In the latter case, amortization shall be 

computed on the basis of current gross 

revenues (excluding royalty payments and 

net profits disbursements) from production 

in relation to future gross revenues based on 

current prices (including consideration of 

changes in existing prices provided only by 

contractual arrangements), from estimated 

production of proved oil and gas reserves.’’ 4

Question: May entities using the full 

cost method of accounting for oil and 

gas producing activities compute 

amortization based on the gross revenue 

method described in the above rule 

when substantial production is not 

subject to pricing regulation? 

Interpretive Response: Yes. Under the 

existing rules for cost amortization 

adopted in ASR 258, the use of the gross 

revenue method of amortization was 

permitted in those circumstances where, 

because of the effect of existing pricing 

regulations, the use of the units of 

production method would result in an 

amortization provision that would be 

inconsistent with the current sales 

prices being received. While the effect 

of regulation on gas prices has lessened, 

factors other than price regulation (such 

as changes in typical contract lengths 

and methods of marketing natural gas) 

have caused oil and gas prices to be 

disproportionate to their relative energy 

content. The staff therefore believes that 

it may be more appropriate for 

registrants to compute amortization 

based on the gross revenue method 

whenever oil and gas sales prices are 

disproportionate to their relative energy 

content to the extent that the use of the 

units of production method would 

result in an improper matching of the 

costs of oil and gas production against 

the related revenue received. The 

method should be consistently applied 

and appropriately disclosed within the 

financial statements. 

G. Removed by SAB 113 

TOPIC 13: REVENUE RECOGNITION 

A. Selected Revenue Recognition Issues 

1. Revenue Recognition—General 

The accounting literature on revenue 

recognition includes both broad 

conceptual discussions as well as 

certain industry-specific guidance.1 If a 

transaction is within the scope of 

specific authoritative literature that 

provides revenue recognition guidance, 

that literature should be applied. 

However, in the absence of authoritative 

literature addressing a specific 

arrangement or a specific industry, the 

staff will consider the existing 

authoritative accounting standards as 

well as the broad revenue recognition 

criteria specified in the FASB’s 

conceptual framework that contain basic 

guidelines for revenue recognition. 

Based on these guidelines, revenue 

should not be recognized until it is 

realized or realizable and earned.2

Concepts Statement 5, Recognition and 

Measurement in Financial Statements of 

Business Enterprises, paragraph 83(b) 

states that ‘‘an entity’s revenue-earning 

activities involve delivering or 

producing goods, rendering services, or 

other activities that constitute its 

ongoing major or central operations, and 

revenues are considered to have been 

earned when the entity has substantially 

accomplished what it must do to be 

entitled to the benefits represented by 

the revenues’’ [footnote reference 

omitted]. Paragraph 84(a) continues ‘‘the 

two conditions (being realized or 

realizable and being earned) are usually 

met by the time product or merchandise 

is delivered or services are rendered to 

customers, and revenues from 

manufacturing and selling activities and 

gains and losses from sales of other 

assets are commonly recognized at time 

of sale (usually meaning delivery)’’ 

[footnote reference omitted]. In 

addition, paragraph 84(d) states that ‘‘If 

services are rendered or rights to use 

assets extend continuously over time 

(for example, interest or rent), reliable 

measures based on contractual prices 

established in advance are commonly 

available, and revenues may be 

recognized as earned as time passes.’’ 

The staff believes that revenue 

generally is realized or realizable and 

earned when all of the following criteria 

are met: 

• Persuasive evidence of an 

arrangement exists,3

• Delivery has occurred or services 

have been rendered,4

• The seller’s price to the buyer is 

fixed or determinable,5 and 

• Collectibility is reasonably 

assured.6

Some revenue arrangements contain 

multiple revenue-generating activities. 

The staff believes that the determination 

of the units of accounting within an 

arrangement should be made prior to 

the application of the guidance in this 

SAB Topic by reference to the 

applicable accounting literature.7


jlentini on DSKJ8SOYB1PROD with RULES2
17262 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

8AU Section 560.05. 

9FASB ASC subparagraph 605–15–25–1(b). 

10FASB ASC subparagraph 605–15–25–1(b). The 

arrangement may not specify that payment is 

contingent upon subsequent resale or consumption. 

However, if the seller has an established business 

practice permitting customers to defer payment 

beyond the specified due date(s) until the products 

are resold or consumed, then the staff believes that 

the seller’s right to receive cash representing the 

sales price is contingent. 

11FASB ASC subparagraph 605–15–25–1(c). 

12FASB ASC subparagraph 605–15–25–1(d). 

13FASB ASC subparagraph 605–15–25–1(e). 

14FASB ASC subparagraph 470–40–15–2(a) (Debt 

Topic). This paragraph provides examples of 

circumstances that meet this requirement. As 

discussed further therein, this condition is present 

if (a) a resale price guarantee exists, (b) the seller 

has an option to purchase the product, the 

economic effect of which compels the seller to 

purchase the product, or (c) the buyer has an option 

whereby it can require the seller to purchase the 

product. 

2. Persuasive Evidence of an 

Arrangement 

Question 1 

Facts: Company A has product 

available to ship to customers prior to 

the end of its current fiscal quarter. 

Customer Beta places an order for the 

product, and Company A delivers the 

product prior to the end of its current 

fiscal quarter. Company A’s normal and 

customary business practice for this 

class of customer is to enter into a 

written sales agreement that requires the 

signatures of the authorized 

representatives of the Company and its 

customer to be binding. Company A 

prepares a written sales agreement, and 

its authorized representative signs the 

agreement before the end of the quarter. 

However, Customer Beta does not sign 

the agreement because Customer Beta is 

awaiting the requisite approval by its 

legal department. Customer Beta’s 

purchasing department has orally 

agreed to the sale and stated that it is 

highly likely that the contract will be 

approved the first week of Company A’s 

next fiscal quarter. 

Question: May Company A recognize 

the revenue in the current fiscal quarter 

for the sale of the product to Customer 

Beta when (1) the product is delivered 

by the end of its current fiscal quarter 

and (2) the final written sales agreement 

is executed by Customer Beta’s 

authorized representative within a few 

days after the end of the current fiscal 

quarter? 

Interpretive Response: No. Generally 

the staff believes that, in view of 

Company A’s business practice of 

requiring a written sales agreement for 

this class of customer, persuasive 

evidence of an arrangement would 

require a final agreement that has been 

executed by the properly authorized 

personnel of the customer. In the staff’s 

view, Customer Beta’s execution of the 

sales agreement after the end of the 

quarter causes the transaction to be 

considered a transaction of the 

subsequent period.8 Further, if an 

arrangement is subject to subsequent 

approval (e.g., by the management 

committee or board of directors) or 

execution of another agreement, revenue 

recognition would be inappropriate 

until that subsequent approval or 

agreement is complete. 

Customary business practices and 

processes for documenting sales 

transactions vary among companies and 

industries. Business practices and 

processes may also vary within 

individual companies (e.g., based on the 

class of customer, nature of product or 

service, or other distinguishable factors). 

If a company does not have a standard 

or customary business practice of 

relying on written contracts to 

document a sales arrangement, it 

usually would be expected to have other 

forms of written or electronic evidence 

to document the transaction. For 

example, a company may not use 

written contracts but instead may rely 

on binding purchase orders from third 

parties or on-line authorizations that 

include the terms of the sale and that 

are binding on the customer. In that 

situation, that documentation could 

represent persuasive evidence of an 

arrangement. 

The staff is aware that sometimes a 

customer and seller enter into ‘‘side’’ 

agreements to a master contract that 

effectively amend the master contract. 

Registrants should ensure that 

appropriate policies, procedures, and 

internal controls exist and are properly 

documented so as to provide reasonable 

assurances that sales transactions, 

including those affected by side 

agreements, are properly accounted for 

in accordance with GAAP and to ensure 

compliance with Section 13 of the 

Securities Exchange Act of 1934 (i.e., 

the Foreign Corrupt Practices Act). Side 

agreements could include cancellation, 

termination, or other provisions that 

affect revenue recognition. The 

existence of a subsequently executed 

side agreement may be an indicator that 

the original agreement was not final and 

revenue recognition was not 

appropriate. 

Question 2 

Facts: Company Z enters into an 

arrangement with Customer A to deliver 

Company Z’s products to Customer A 

on a consignment basis. Pursuant to the 

terms of the arrangement, Customer A is 

a consignee, and title to the products 

does not pass from Company Z to 

Customer A until Customer A consumes 

the products in its operations. Company 

Z delivers product to Customer A under 

the terms of their arrangement. 

Question: May Company Z recognize 

revenue upon delivery of its product to 

Customer A? 

Interpretive Response: No. Products 

delivered to a consignee pursuant to a 

consignment arrangement are not sales 

and do not qualify for revenue 

recognition until a sale occurs. The staff 

believes that revenue recognition is not 

appropriate because the seller retains 

the risks and rewards of ownership of 

the product and title usually does not 

pass to the consignee. 

Other situations may exist where title 

to delivered products passes to a buyer, 

but the substance of the transaction is 

that of a consignment or a financing. 

Such arrangements require a careful 

analysis of the facts and circumstances 

of the transaction, as well as an 

understanding of the rights and 

obligations of the parties, and the 

seller’s customary business practices in 

such arrangements. The staff believes 

that the presence of one or more of the 

following characteristics in a transaction 

precludes revenue recognition even if 

title to the product has passed to the 

buyer: 

1. The buyer has the right to return 

the product and: 

(a) The buyer does not pay the seller 

at the time of sale, and the buyer is not 

obligated to pay the seller at a specified 

date or dates,9

(b) The buyer does not pay the seller 

at the time of sale but rather is obligated 

to pay at a specified date or dates, and 

the buyer’s obligation to pay is 

contractually or implicitly excused until 

the buyer resells the product or 

subsequently consumes or uses the 

product,10

(c) The buyer’s obligation to the seller 

would be changed (e.g., the seller would 

forgive the obligation or grant a refund) 

in the event of theft or physical 

destruction or damage of the product,11

(d) The buyer acquiring the product 

for resale does not have economic 

substance apart from that provided by 

the seller,12 or 

(e) The seller has significant 

obligations for future performance to 

directly bring about resale of the 

product by the buyer.13

2. The seller is required to repurchase 

the product (or a substantially identical 

product or processed goods of which the 

product is a component) at specified 

prices that are not subject to change 

except for fluctuations due to finance 

and holding costs,14 and the amounts to 

be paid by the seller will be adjusted, as 

necessary, to cover substantially all 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17263 

15FASB ASC subparagraph 470–40–15–2(b). 

16See FASB ASC paragraphs 985–605–25–28 

through 985–605–25–29. 

17See In the Matter of Stewart Parness, AAER 108 

(August 5, 1986); SEC v. Bollinger Industries, Inc., 

et al., LR 15093 (September 30, 1996); In the Matter 

of Laser Photonics, Inc., AAER 971 (September 30, 

1997); In the Matter of Cypress Bioscience Inc., 

AAER 817 (September 19, 1996). See also Concepts 

Statement 5, paragraph 84(a) and FASB ASC 

paragraph 985–605–25–25. 

18Such requests typically should be set forth in 

writing by the buyer. 

19See Note 17, supra. 

20Such individuals should consider whether 

FASB ASC Subtopic 835–30, Interest—Imputation 

of Interest, pertaining to the need for discounting 

the related receivable, is applicable. FASB ASC 

subparagraph 835–30–15–3(a) indicates that the 

requirements of that Subtopic to record receivables 

at a discounted value are not intended to apply to 

‘‘receivables and payables arising from transactions 

with customers or suppliers in the normal course 

of business which are due in customary trade terms 

not exceeding approximately one year’’ (emphasis 

added). 

fluctuations in costs incurred by the 

buyer in purchasing and holding the 

product (including interest).15 The staff 

believes that indicators of the latter 

condition include: 

(a) The seller provides interest-free or 

significantly below market financing to 

the buyer beyond the seller’s customary 

sales terms and until the products are 

resold, 

(b) The seller pays interest costs on 

behalf of the buyer under a third-party 

financing arrangement, or 

(c) The seller has a practice of 

refunding (or intends to refund) a 

portion of the original sales price 

representative of interest expense for the 

period from when the buyer paid the 

seller until the buyer resells the 

product. 

3. The transaction possesses the 

characteristics set forth in FASB ASC 

paragraphs 840–10–55–12 through 840– 

10–55–21 (Leases Topic) and does not 

qualify for sales-type lease accounting. 

4. The product is delivered for 

demonstration purposes.16

This list is not meant to be a checklist 

of all characteristics of a consignment or 

financing arrangement, and other 

characteristics may exist. Accordingly, 

the staff believes that judgment is 

necessary in assessing whether the 

substance of a transaction is a 

consignment, a financing, or other 

arrangement for which revenue 

recognition is not appropriate. If title to 

the goods has passed but the substance 

of the arrangement is not a sale, the 

consigned inventory should be reported 

separately from other inventory in the 

consignor’s financial statements as 

‘‘inventory consigned to others’’ or 

another appropriate caption. 

Question 3 

Facts: The laws of some countries do 

not provide for a seller’s retention of a 

security interest in goods in the same 

manner as established in the U.S. 

Uniform Commercial Code (UCC). In 

these countries, it is common for a seller 

to retain a form of title to goods 

delivered to customers until the 

customer makes payment so that the 

seller can recover the goods in the event 

of customer default on payment. 

Question: Is it acceptable to recognize 

revenue in these transactions before 

payment is made and title has 

transferred? 

Interpretive Response: Presuming all 

other revenue recognition criteria have 

been met, the staff would not object to 

revenue recognition at delivery if the 

only rights that a seller retains with the 

title are those enabling recovery of the 

goods in the event of customer default 

on payment. This limited form of 

ownership may exist in some foreign 

jurisdictions where, despite technically 

holding title, the seller is not entitled to 

direct the disposition of the goods, 

cannot rescind the transaction, cannot 

prohibit its customer from moving, 

selling, or otherwise using the goods in 

the ordinary course of business, and has 

no other rights that rest with a 

titleholder of property that is subject to 

a lien under the U.S. UCC. On the other 

hand, if retaining title results in the 

seller retaining rights normally held by 

an owner of goods, the situation is not 

sufficiently different from a delivery of 

goods on consignment. In this particular 

case, revenue should not be recognized 

until payment is received. Registrants 

and their auditors may wish to consult 

legal counsel knowledgeable of the local 

law and customs outside the U.S. to 

determine the seller’s rights. 

3. Delivery and Performance 

a. Bill and Hold Arrangements 

Facts: Company A receives purchase 

orders for products it manufactures. At 

the end of its fiscal quarters, customers 

may not yet be ready to take delivery of 

the products for various reasons. These 

reasons may include, but are not limited 

to, a lack of available space for 

inventory, having more than sufficient 

inventory in their distribution channel, 

or delays in customers’ production 

schedules. 

Question: May Company A recognize 

revenue for the sale of its products once 

it has completed manufacturing if it 

segregates the inventory of the products 

in its own warehouse from its own 

products? 

May Company A recognize revenue 

for the sale if it ships the products to a 

third-party warehouse but (1) Company 

A retains title to the product and (2) 

payment by the customer is dependent 

upon ultimate delivery to a customerspecified site? 

Interpretative Response: Generally, 

no. The staff believes that delivery 

generally is not considered to have 

occurred unless the customer has taken 

title and assumed the risks and rewards 

of ownership of the products specified 

in the customer’s purchase order or 

sales agreement. Typically this occurs 

when a product is delivered to the 

customer’s delivery site (if the terms of 

the sale are ‘‘FOB destination’’) or when 

a product is shipped to the customer (if 

the terms are ‘‘FOB shipping point’’). 

The Commission has set forth criteria 

to be met in order to recognize revenue 

when delivery has not occurred.17

These include: 

1. The risks of ownership must have 

passed to the buyer; 

2. The customer must have made a 

fixed commitment to purchase the 

goods, preferably in written 

documentation; 

3. The buyer, not the seller, must 

request that the transaction be on a bill 

and hold basis.18 The buyer must have 

a substantial business purpose for 

ordering the goods on a bill and hold 

basis; 

4. There must be a fixed schedule for 

delivery of the goods. The date for 

delivery must be reasonable and must 

be consistent with the buyer’s business 

purpose (e.g., storage periods are 

customary in the industry); 

5. The seller must not have retained 

any specific performance obligations 

such that the earning process is not 

complete; 

6. The ordered goods must have been 

segregated from the seller’s inventory 

and not be subject to being used to fill 

other orders; and 

7. The equipment [product] must be 

complete and ready for shipment. 

The above listed conditions are the 

important conceptual criteria that 

should be used in evaluating any 

purported bill and hold sale. This listing 

is not intended as a checklist. In some 

circumstances, a transaction may meet 

all factors listed above but not meet the 

requirements for revenue recognition. 

The Commission also has noted that in 

applying the above criteria to a 

purported bill and hold sale, the 

individuals responsible for the 

preparation and filing of financial 

statements also should consider the 

following factors: 19

1. The date by which the seller 

expects payment, and whether the seller 

has modified its normal billing and 

credit terms for this buyer; 20


jlentini on DSKJ8SOYB1PROD with RULES2
17264 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

21FASB ASC paragraph 985–605–25–25. 22FASB ASC paragraph 985–605–25–21. Also, 

Concepts Statement 5, paragraph 83(b) states 

‘‘revenues are considered to have been earned when 

the entity has substantially accomplished what it 

must do to be entitled to the benefits represented 

by the revenues.’’ If an arrangement expressly 

requires customer acceptance, the staff generally 

believes that customer acceptance should occur 

before the entity has substantially accomplished 

what it must do to be entitled to the benefits 

represented by the revenues, especially when the 

seller is obligated to perform additional steps. 

23See, for example, FASB ASC paragraphs 985– 

605–25–28 through 985–605–25–29. 

24FASB ASC paragraph 605–15–05–3. 

25FASB ASC subparagraph 605–15–25–1(f). 

26FASB ASC subparagraphs 605–15–25–3(c) and 

605–15–25–3(d). 

27FASB ASC paragraph 460–10–25–5 

(Guarantees Topic) and FASB ASC subparagraph 

605–15–15–3(c). 

28FASB ASC paragraph 460–10–25–6. 

2. The seller’s past experiences with 

and pattern of bill and hold 

transactions; 

3. Whether the buyer has the expected 

risk of loss in the event of a decline in 

the market value of goods; 

4. Whether the seller’s custodial risks 

are insurable and insured; 

5. Whether extended procedures are 

necessary in order to assure that there 

are no exceptions to the buyer’s 

commitment to accept and pay for the 

goods sold (i.e., that the business 

reasons for the bill and hold have not 

introduced a contingency to the buyer’s 

commitment). 

Delivery generally is not considered 

to have occurred unless the product has 

been delivered to the customer’s place 

of business or another site specified by 

the customer. If the customer specifies 

an intermediate site but a substantial 

portion of the sales price is not payable 

until delivery is made to a final site, 

then revenue should not be recognized 

until final delivery has occurred.21

b. Customer Acceptance 

After delivery of a product or 

performance of a service, if uncertainty 

exists about customer acceptance, 

revenue should not be recognized until 

acceptance occurs.22 Customer 

acceptance provisions may be included 

in a contract, among other reasons, to 

enforce a customer’s rights to (1) test the 

delivered product, (2) require the seller 

to perform additional services 

subsequent to delivery of an initial 

product or performance of an initial 

service (e.g., a seller is required to 

install or activate delivered equipment), 

or (3) identify other work necessary to 

be done before accepting the product. 

The staff presumes that such contractual 

customer acceptance provisions are 

substantive, bargained-for terms of an 

arrangement. Accordingly, when such 

contractual customer acceptance 

provisions exist, the staff generally 

believes that the seller should not 

recognize revenue until customer 

acceptance occurs or the acceptance 

provisions lapse. 

Question 1 

Question: Do circumstances exist in 

which formal customer sign-off (that a 

contractual customer acceptance 

provision is met) is unnecessary to meet 

the requirements to recognize revenue? 

Interpretive Response: Yes. Formal 

customer sign-off is not always 

necessary to recognize revenue provided 

that the seller objectively demonstrates 

that the criteria specified in the 

acceptance provisions are satisfied. 

Customer acceptance provisions 

generally allow the customer to cancel 

the arrangement when a seller delivers 

a product that the customer has not yet 

agreed to purchase or delivers a product 

that does not meet the specifications of 

the customer’s order. In those cases, 

revenue should not be recognized 

because a sale has not occurred. In 

applying this concept, the staff observes 

that customer acceptance provisions 

normally take one of four general forms. 

Those forms, and how the staff generally 

assesses whether customer acceptance 

provisions should result in revenue 

deferral, are described below: 

(a) Acceptance provisions in 

arrangements that purport to be for trial 

or evaluation purposes.23 In these 

arrangements, the seller delivers a 

product to a customer, and the customer 

agrees to receive the product, solely to 

give the customer the ability to evaluate 

the delivered product prior to 

acceptance. The customer does not 

agree to purchase the delivered product 

until it accepts the product. In some 

cases, the acceptance provisions lapse 

by the passage of time without the 

customer rejecting the delivered 

product, and in other cases affirmative 

acceptance from the customer is 

necessary to trigger a sales transaction. 

Frequently, the title to the product does 

not transfer and payment terms are not 

established prior to customer 

acceptance. These arrangements are, in 

substance, consignment arrangements 

until the customer accepts the product 

as set forth in the contract with the 

seller. Accordingly, in arrangements 

where products are delivered for trial or 

evaluation purposes, revenue should 

not be recognized until the earlier of 

when acceptance occurs or the 

acceptance provisions lapse. 

In contrast, other arrangements do not 

purport to be for trial or evaluation 

purposes. In these instances, the seller 

delivers a specified product pursuant to 

a customer’s order, establishes payment 

terms, and transfers title to the delivered 

product to the customer. However, 

customer acceptance provisions may be 

included in the arrangement to give the 

purchaser the ability to ensure the 

delivered product meets the criteria set 

forth in its order. The staff evaluates 

these provisions as follows: 

(b) Acceptance provisions that grant a 

right of return or exchange on the basis 

of subjective matters. An example of 

such a provision is one that allows the 

customer to return a product if the 

customer is dissatisfied with the 

product.24 The staff believes these 

provisions are not different from general 

rights of return and should be accounted 

for in accordance with FASB ASC 

Subtopic 605–15, Revenue 

Recognition—Products. This Subtopic 

requires that the amount of future 

returns must be reasonably estimable in 

order for revenue to be recognized prior 

to the expiration of return rights.25 That 

estimate may not be made in the 

absence of a large volume of 

homogeneous transactions or if 

customer acceptance is likely to depend 

on conditions for which sufficient 

historical experience is absent.26

Satisfaction of these requirements may 

vary from product-to-product, locationto-location, customer-to-customer, and 

vendor-to-vendor. 

(c) Acceptance provisions based on 

seller-specified objective criteria. An 

example of such a provision is one that 

gives the customer a right of return or 

replacement if the delivered product is 

defective or fails to meet the vendor’s 

published specifications for the 

product.27 Such rights are generally 

identical to those granted to all others 

within the same class of customer and 

for which satisfaction can be generally 

assured without consideration of 

conditions specific to the customer. 

Provided the seller has previously 

demonstrated that the product meets the 

specified criteria, the staff believes that 

these provisions are not different from 

general or specific warranties and 

should be accounted for as warranties in 

accordance with FASB ASC Subtopic 

450–20, Contingencies—Loss 

Contingencies. In this case, the cost of 

potentially defective goods must be 

reliably estimable based on a 

demonstrated history of substantially 

similar transactions.28 However, if the 

seller has not previously demonstrated 

that the delivered product meets the 

seller’s specifications, the staff believes 

that revenue should be deferred until 

the specifications have been objectively 

achieved. 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17265 

29This fact is provided as an assumption to 

facilitate an analysis of revenue recognition in this 

fact pattern. No interpretation of FASB ASC 

Subtopic 605–25 is intended. 

(d) Acceptance provisions based on 

customer-specified objective criteria. 

These provisions are referred to in this 

document as ‘‘customer-specific 

acceptance provisions’’ against which 

substantial completion and contract 

fulfillment must be evaluated. While 

formal customer sign-off provides the 

best evidence that these acceptance 

criteria have been met, revenue 

recognition also would be appropriate, 

presuming all other revenue recognition 

criteria have been met, if the seller 

reliably demonstrates that the delivered 

products or services meet all of the 

specified criteria prior to customer 

acceptance. For example, if a seller 

reliably demonstrates that a delivered 

product meets the customer-specified 

objective criteria set forth in the 

arrangement, the delivery criterion 

would generally be satisfied when title 

and the risks and rewards of ownership 

transfers unless product performance 

may reasonably be different under the 

customer’s testing conditions specified 

by the acceptance provisions. Further, 

the seller should consider whether it 

would be successful in enforcing a 

claim for payment even in the absence 

of formal sign-off. Whether the vendor 

has fulfilled the terms of the contract 

before customer acceptance is a matter 

of contract law, and depending on the 

facts and circumstances, an opinion of 

counsel may be necessary to reach a 

conclusion. 

Question 2 

Facts: Consider an arrangement that 

calls for the transfer of title to 

equipment upon delivery to a 

customer’s site. However, customerspecific acceptance provisions permit 

the customer to return the equipment 

unless the equipment satisfies certain 

performance tests. The arrangement 

calls for the vendor to perform the 

installation. Assume the equipment and 

the installation are separate units of 

accounting under FASB ASC Subtopic 

605–25, Revenue Recognition— 

Multiple-Element Arrangements.29

Question: Must revenue allocated to 

the equipment always be deferred until 

installation and on-site testing are 

successfully completed? 

Interpretive Response: No. The staff 

would not object to revenue recognition 

for the equipment upon delivery 

(presuming all other revenue 

recognition criteria have been met for 

the equipment) if the seller 

demonstrates that, at the time of 

delivery, the equipment already meets 

all of the criteria and specifications in 

the customer-specific acceptance 

provisions. This may be demonstrated if 

conditions under which the customer 

intends to operate the equipment are 

replicated in pre-shipment testing, 

unless the performance of the 

equipment, once installed and operated 

at the customer’s facility, may 

reasonably be different from that tested 

prior to shipment. 

Determining whether the delivered 

equipment meets all of a product’s 

criteria and specifications is a matter of 

judgment that must be evaluated in light 

of the facts and circumstances of a 

particular transaction. Consultation 

with knowledgeable project managers or 

engineers may be necessary in such 

circumstances. 

For example, if the customer 

acceptance provisions were based on 

meeting certain size and weight 

characteristics, it should be possible to 

determine whether those criteria have 

been met before shipment. Historical 

experience with the same specifications 

and functionality of a particular 

machine that demonstrates that the 

equipment meets the customer’s 

specifications also may provide 

sufficient evidence that the currently 

shipped equipment satisfies the 

customer-specific acceptance 

provisions. 

If an arrangement includes customer 

acceptance criteria or specifications that 

cannot be effectively tested before 

delivery or installation at the customer’s 

site, the staff believes that revenue 

recognition should be deferred until it 

can be demonstrated that the criteria are 

met. This situation usually will exist 

when equipment performance can vary 

based on how the equipment works in 

combination with the customer’s other 

equipment, software, or environmental 

conditions. In these situations, testing to 

determine whether the criteria are met 

cannot be reasonably performed until 

the products are installed or integrated 

at the customer’s facility. 

Although the following questions 

provide several examples illustrating 

how the staff evaluates customer 

acceptance, the determination of when 

customer-specific acceptance provisions 

of an arrangement are met in the 

absence of the customer’s formal 

notification of acceptance depends on 

the weight of the evidence in the 

particular circumstances. Different 

conclusions could be reached in similar 

circumstances that vary only with 

respect to a single variable, such as 

complexity of the equipment, nature of 

the interface with the customer’s 

environment, extent of the seller’s 

experience with the same type of 

transactions, or a particular clause in 

the agreement. The staff believes 

management and auditors are uniquely 

positioned to evaluate the facts and 

arrive at a reasoned conclusion. The 

staff will not object to a determination 

that is well reasoned on the basis of this 

guidance. 

Question 3 

Facts: Company E is an equipment 

manufacturer whose main product is 

generally sold in a standard model. The 

contracts for sale of that model provide 

for customer acceptance to occur after 

the equipment is received and tested by 

the customer. The acceptance 

provisions state that if the equipment 

does not perform to Company E’s 

published specifications, the customer 

may return the equipment for a full 

refund or a replacement unit, or may 

require Company E to repair the 

equipment so that it performs up to 

published specifications. Customer 

acceptance is indicated by either a 

formal sign-off by the customer or by the 

passage of 90 days without a claim 

under the acceptance provisions. Title 

to the equipment passes upon delivery 

to the customer. Company E does not 

perform any installation or other 

services on the equipment it sells and 

tests each piece of equipment against its 

specifications before shipment. Payment 

is due under Company E’s normal 

payment terms for that product 30 days 

after customer acceptance. 

Company E receives an order from a 

new customer for a standard model of 

its main product. Based on the 

customer’s intended use of the product, 

location and other factors, there is no 

reason that the equipment would 

operate differently in the customer’s 

environment than it does in Company 

E’s facility. 

Question: Assuming all other revenue 

recognition criteria are met (other than 

the issue raised with respect to the 

acceptance provision), when should 

Company E recognize revenue from the 

sale of this piece of equipment? 

Interpretive Response: While the staff 

presumes that customer acceptance 

provisions are substantive provisions 

that generally result in revenue deferral, 

that presumption can be overcome as 

discussed above. Although the contract 

includes a customer acceptance clause, 

acceptance is based on meeting 

Company E’s published specifications 

for a standard model. Company E 

demonstrates that the equipment 

shipped meets the specifications before 

shipment, and the equipment is 

expected to operate the same in the 

customer’s environment as it does in 


jlentini on DSKJ8SOYB1PROD with RULES2
17266 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

30Concepts Statement 5, paragraph 83(b) states 

‘‘revenues are considered to have been earned when 

the entity has substantially accomplished what it 

must do to be entitled the benefits represented by 

the revenues.’’ 

Company E’s. In this situation, 

Company E should evaluate the 

customer acceptance provision as a 

warranty under FASB ASC Subtopic 

450–20. If Company E can reasonably 

and reliably estimate the amount of 

warranty obligations, the staff believes 

that it should recognize revenue upon 

delivery of the equipment, with an 

appropriate liability for probable 

warranty obligations. 

Question 4 

Facts: Assume the same facts about 

Company E’s equipment, contract terms 

and customary practices as in Question 

3 above. Company E enters into an 

arrangement with a new customer to 

deliver a version of its standard product 

modified as necessary to fit into a space 

of specific dimensions while still 

meeting all of the published vendor 

specifications with regard to 

performance. In addition to the 

customer acceptance provisions relating 

to the standard performance 

specifications, the customer may reject 

the equipment if it does not conform to 

the specified dimensions. Company E 

creates a testing chamber of the exact 

same dimensions as specified by the 

customer and makes simple design 

changes to the product so that it fits into 

the testing chamber. The equipment still 

meets all of the standard performance 

specifications. 

Question: Assuming all other revenue 

recognition criteria are met (other than 

the issue raised with respect to the 

acceptance provision), when should 

Company E recognize revenue from the 

sale of this piece of equipment? 

Interpretive Response: Although the 

contract includes a customer acceptance 

clause that is based, in part, on a 

customer specific criterion, Company E 

demonstrates that the equipment 

shipped meets that objective criterion, 

as well as the published specifications, 

before shipment. The staff believes that 

the customer acceptance provisions 

related to the standard performance 

specifications should be evaluated as a 

warranty under FASB ASC Subtopic 

450–20. If Company E can reasonably 

and reliably estimate the amount of 

warranty obligations, it should 

recognize revenue upon delivery of the 

equipment, with an appropriate liability 

for probable warranty obligations. 

Question 5 

Facts: Assume the same facts about 

Company E’s equipment, contract terms 

and customary practices as in Question 

3 above. Company E enters into an 

arrangement with a new customer to 

deliver a version of its standard product 

modified as necessary to be integrated 

into the customer’s new assembly line 

while still meeting all of the standard 

published vendor specifications with 

regard to performance. The customer 

may reject the equipment if it fails to 

meet the standard published 

performance specifications or cannot be 

satisfactorily integrated into the new 

line. Company E has never modified its 

equipment to work on an integrated 

basis in the type of assembly line the 

customer has proposed. In response to 

the request, Company E designs a 

version of its standard equipment that is 

modified as believed necessary to 

operate in the new assembly line. The 

modified equipment still meets all of 

the standard published performance 

specifications, and Company E believes 

the equipment will meet the requested 

specifications when integrated into the 

new assembly line. However, Company 

E is unable to replicate the new 

assembly line conditions in its testing. 

Question: Assuming all other revenue 

recognition criteria are met (other than 

the issue raised with respect to the 

acceptance provision), when should 

Company E recognize revenue from the 

sale of this piece of equipment? 

Interpretive Response: This contract 

includes a customer acceptance clause 

that is based, in part, on a customer 

specific criterion, and Company E 

cannot demonstrate that the equipment 

shipped meets that criterion before 

shipment. Accordingly, the staff 

believes that the contractual customer 

acceptance provision has not been met 

at shipment. Therefore, the staff believes 

that Company E should wait until the 

product is successfully integrated at its 

customer’s location and meets the 

customer-specific criteria before 

recognizing revenue. While this is best 

evidenced by formal customer 

acceptance, other objective evidence 

that the equipment has met the 

customer-specific criteria may also exist 

(e.g., confirmation from the customer 

that the specifications were met). 

c. Inconsequential or Perfunctory 

Performance Obligations 

Question 1 

Question: Does the failure to complete 

all activities related to a unit of 

accounting preclude recognition of 

revenue for that unit of accounting? 

Interpretive Response: No. Assuming 

all other recognition criteria are met, 

revenue for the unit of accounting may 

be recognized in its entirety if the 

seller’s remaining obligation is 

inconsequential or perfunctory. 

A seller should substantially complete 

or fulfill the terms specified in the 

arrangement related to the unit of 

accounting at issue in order for delivery 

or performance to have occurred.30

When applying the substantially 

complete notion, the staff believes that 

only inconsequential or perfunctory 

actions may remain incomplete such 

that the failure to complete the actions 

would not result in the customer 

receiving a refund or rejecting the 

delivered products or services 

performed to date. In addition, the seller 

should have a demonstrated history of 

completing the remaining tasks in a 

timely manner and reliably estimating 

the remaining costs. If revenue is 

recognized upon substantial completion 

of the terms specified in the 

arrangement related to the unit of 

accounting at issue, all related costs of 

performance or delivery should be 

accrued. 

Question 2 

Question: What factors should be 

considered in the evaluation of whether 

a remaining obligation related to a unit 

of accounting is inconsequential or 

perfunctory? 

Interpretive Response: A remaining 

performance obligation is not 

inconsequential or perfunctory if it is 

essential to the functionality of the 

delivered products or services. In 

addition, remaining activities are not 

inconsequential or perfunctory if failure 

to complete the activities would result 

in the customer receiving a full or 

partial refund or rejecting (or a right to 

a refund or to reject) the products 

delivered or services performed to date. 

The terms of the sales contract regarding 

both the right to a full or partial refund 

and the right of return or rejection 

should be considered when evaluating 

whether a portion of the purchase price 

would be refundable. If the company 

has a historical pattern of granting such 

rights, that historical pattern should also 

be considered even if the current 

contract expressly precludes such 

rights. Further, other factors should be 

considered in assessing whether 

remaining obligations are 

inconsequential or perfunctory. For 

example, the staff also considers the 

following factors, which are not allinclusive, to be indicators that a 

remaining performance obligation is 

substantive rather than inconsequential 

or perfunctory: 

• The seller does not have a 

demonstrated history of completing the 

remaining tasks in a timely manner and 

reliably estimating their costs. 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17267 

31FASB ASC paragraph 985–605–25–12. 

32See FASB ASC paragraphs 985–605–25–81 

through 985–605–25–85 for analogous guidance. 

33 Ibid. 

34Concepts Statement 5, paragraph 83(a) and 

FASB ASC subparagraph 605–15–25–1(b). 

35FASB ASC paragraph 926–605–25–1 

(Entertainment—Films Topic). 

• The cost or time to perform the 

remaining obligations for similar 

contracts historically has varied 

significantly from one instance to 

another. 

• The skills or equipment required to 

complete the remaining activity are 

specialized or are not readily available 

in the marketplace. 

• The cost of completing the 

obligation, or the fair value of that 

obligation, is more than insignificant in 

relation to such items as the contract 

fee, gross profit, and operating income 

allocable to the unit of accounting. 

• The period before the remaining 

obligation will be extinguished is 

lengthy. Registrants should consider 

whether reasonably possible variations 

in the period to complete performance 

affect the certainty that the remaining 

obligations will be completed 

successfully and on budget. 

• The timing of payment of a portion 

of the sales price is coincident with 

completing performance of the 

remaining activity. 

Registrants’ determinations of 

whether remaining obligations are 

inconsequential or perfunctory should 

be consistently applied. 

Question 3 

Facts: Consider a unit of accounting 

that includes both equipment and 

installation because the two deliverables 

do not meet the separation criteria 

under FASB ASC Subtopic 605–25. This 

may be because the equipment does not 

have value to the customer on a 

standalone basis, there is no objective 

and reliable evidence of fair value for 

the installation or there is a general right 

of return when the installation is not 

considered probable and in control of 

the vendor. 

Question: In this situation, must all 

revenue be deferred until installation is 

performed? 

Interpretive Response: Yes, if 

installation is essential to the 

functionality of the equipment.31

Examples of indicators that installation 

is essential to the functionality of 

equipment include: 

• The installation involves significant 

changes to the features or capabilities of 

the equipment or building complex 

interfaces or connections; 

• The installation services are 

unavailable from other vendors.32

Conversely, examples of indicators 

that installation is not essential to the 

functionality of the equipment include: 

• The equipment is a standard 

product; 

• Installation does not significantly 

alter the equipment’s capabilities; 

• Other companies are available to 

perform the installation.33

If it is determined that the 

undelivered service is not essential to 

the functionality of the delivered 

product but a portion of the contract fee 

is not payable until the undelivered 

service is delivered, the staff would not 

consider that obligation to be 

inconsequential or perfunctory. 

Generally, the portion of the contract 

price that is withheld or refundable 

should be deferred until the outstanding 

service is delivered because that portion 

would not be realized or realizable.34

d. License Fee Revenue 

Facts: Assume that intellectual 

property is physically delivered and 

payment is received on December 20, 

upon the registrant’s consummation of 

an agreement granting its customer a 

license to use the intellectual property 

for a term beginning on the following 

January 1. 

Question: Should the license fee be 

recognized in the period ending 

December 31? 

Interpretive Response: No. In 

licensing and similar arrangements (e.g., 

licenses of motion pictures, software, 

technology, and other intangibles), the 

staff believes that delivery does not 

occur for revenue recognition purposes 

until the license term begins.35

Accordingly, if a licensed product or 

technology is physically delivered to the 

customer, but the license term has not 

yet begun, revenue should not be 

recognized prior to inception of the 

license term. Upon inception of the 

license term, revenue should be 

recognized in a manner consistent with 

the nature of the transaction and the 

earnings process. 

e. Layaway Sales Arrangements 

Facts: Company R is a retailer that 

offers ‘‘layaway’’ sales to its customers. 

Company R retains the merchandise, 

sets it aside in its inventory, and 

collects a cash deposit from the 

customer. Although Company R may set 

a time period within which the 

customer must finalize the purchase, 

Company R does not require the 

customer to enter into an installment 

note or other fixed payment 

commitment or agreement when the 

initial deposit is received. The 

merchandise generally is not released to 

the customer until the customer pays 

the full purchase price. In the event that 

the customer fails to pay the remaining 

purchase price, the customer forfeits its 

cash deposit. In the event the 

merchandise is lost, damaged, or 

destroyed, Company R either must 

refund the cash deposit to the customer 

or provide replacement merchandise. 

Question: In the staff’s view, when 

may Company R recognize revenue for 

merchandise sold under its layaway 

program? 

Interpretive Response: Provided that 

the other criteria for revenue recognition 

are met, the staff believes that Company 

R should recognize revenue from sales 

made under its layaway program upon 

delivery of the merchandise to the 

customer. Until then, the amount of 

cash received should be recognized as a 

liability entitled such as ‘‘deposits 

received from customers for layaway 

sales’’ or a similarly descriptive caption. 

Because Company R retains the risks of 

ownership of the merchandise, receives 

only a deposit from the customer, and 

does not have an enforceable right to the 

remainder of the purchase price, the 

staff would object to Company R 

recognizing any revenue upon receipt of 

the cash deposit. This is consistent with 

item two (2) in the Commission’s 

criteria for bill-and-hold transactions 

which states ‘‘the customer must have 

made a fixed commitment to purchase 

the goods.’’ 

f. Nonrefundable Up-front Fees 

Question 1 

Facts: Registrants may negotiate 

arrangements pursuant to which they 

may receive nonrefundable fees upon 

entering into arrangements or on certain 

specified dates. The fees may ostensibly 

be received for conveyance of a license 

or other intangible right or for delivery 

of particular products or services. 

Various business factors may influence 

how the registrant and customer 

structure the payment terms. For 

example, in exchange for a greater upfront fee for an intangible right, the 

registrant may be willing to receive 

lower unit prices for related products to 

be delivered in the future. In some 

circumstances, the right, product, or 

service conveyed in conjunction with 

the nonrefundable fee has no utility to 

the purchaser separate and independent 

of the registrant’s performance of the 

other elements of the arrangement. 

Therefore, in the absence of the 

registrant’s continuing involvement 

under the arrangement, the customer 

would not have paid the fee. Examples 

of this type of arrangement include the 

following: 


jlentini on DSKJ8SOYB1PROD with RULES2
17268 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

36The staff believes that the vendor activities 

associated with the up-front fee, even if considered 

a deliverable to be evaluated under FASB ASC 

Subtopic 605–25, will rarely provide value to the 

customer on a standalone basis. 

37See Concepts Statement 5, footnote 51, for a 

description of the ‘‘earning process.’’ 

38 In a similar situation, lenders may collect 

nonrefundable loan origination fees in connection 

with lending activities. The FASB concluded in 

FASB ASC Subtopic 310–20, Receivables— 

Nonrefundable Fees and Other Costs, that loan 

origination is not a separate revenue-producing 

activity of a lender, and therefore, those 

nonrefundable fees collected at the outset of the 

loan arrangement are not recognized as revenue 

upon receipt but are deferred and recognized over 

the life of the loan (FASB ASC paragraph 310–20– 

35–2). 

39The revenue recognition period should extend 

beyond the initial contractual period if the 

relationship with the customer is expected to 

extend beyond the initial term and the customer 

continues to benefit from the payment of the upfront fee (e.g., if subsequent renewals are priced at 

a bargain to the initial up-front fee). 

40A systematic method would be on a straightline basis, unless evidence suggests that revenue is 

earned or obligations are fulfilled in a different 

pattern, in which case that pattern should be 

followed. 

41Concepts Statement 5, paragraph 84(d). 

• A registrant sells a lifetime 

membership in a health club. After 

paying a nonrefundable ‘‘initiation fee,’’ 

the customer is permitted to use the 

health club indefinitely, so long as the 

customer also pays an additional usage 

fee each month. The monthly usage fees 

collected from all customers are 

adequate to cover the operating costs of 

the health club. 

• A registrant in the biotechnology 

industry agrees to provide research and 

development activities for a customer 

for a specified term. The customer needs 

to use certain technology owned by the 

registrant for use in the research and 

development activities. The technology 

is not sold or licensed separately 

without the research and development 

activities. Under the terms of the 

arrangement, the customer is required to 

pay a nonrefundable ‘‘technology access 

fee’’ in addition to periodic payments for 

research and development activities 

over the term of the contract. 

• A registrant requires a customer to 

pay a nonrefundable ‘‘activation fee’’ 

when entering into an arrangement to 

provide telecommunications services. 

The terms of the arrangement require 

the customer to pay a monthly usage fee 

that is adequate to recover the 

registrant’s operating costs. The costs 

incurred to activate the 

telecommunications service are 

nominal. 

• A registrant charges users a fee for 

non-exclusive access to its Web site that 

contains proprietary databases. The fee 

allows access to the Web site for a oneyear period. After the customer is 

provided with an identification number 

and trained in the use of the database, 

there are no incremental costs that will 

be incurred in serving this customer. 

• A registrant charges a fee to users 

for advertising a product for sale or 

auction on certain pages of its Web site. 

The company agrees to maintain the 

listing for a period of time. The cost of 

maintaining the advertisement on the 

Web site for the stated period is 

minimal. 

• A registrant charges a fee for 

hosting another company’s Web site for 

one year. The arrangement does not 

involve exclusive use of any of the 

hosting company’s servers or other 

equipment. Almost all of the projected 

costs to be incurred will be incurred in 

the initial loading of information on the 

host company’s Internet server and 

setting up appropriate links and 

network connections. 

Question: Assuming these 

arrangements qualify as single units of 

accounting under FASB ASC Subtopic 

605–25,36 when should the revenue 

relating to nonrefundable, up-front fees 

in these types of arrangements be 

recognized? 

Interpretive Response: The staff 

believes that registrants should consider 

the specific facts and circumstances to 

determine the appropriate accounting 

for nonrefundable, up-front fees. Unless 

the up-front fee is in exchange for 

products delivered or services 

performed that represent the 

culmination of a separate earnings 

process,37 the deferral of revenue is 

appropriate. 

In the situations described above, the 

staff does not view the activities 

completed by the registrants (i.e., selling 

the membership, signing the contract, 

enrolling the customer, activating 

telecommunications services or 

providing initial set-up services) as 

discrete earnings events.38 The terms, 

conditions, and amounts of these fees 

typically are negotiated in conjunction 

with the pricing of all the elements of 

the arrangement, and the customer 

would ascribe a significantly lower, and 

perhaps no, value to elements ostensibly 

associated with the up-front fee in the 

absence of the registrant’s performance 

of other contract elements. The fact that 

the registrants do not sell the initial 

rights, products, or services separately 

(i.e., without the registrants’ continuing 

involvement) supports the staff’s view. 

The staff believes that the customers are 

purchasing the on-going rights, 

products, or services being provided 

through the registrants’ continuing 

involvement. Further, the staff believes 

that the earnings process is completed 

by performing under the terms of the 

arrangements, not simply by originating 

a revenue-generating arrangement. 

While the incurrence of nominal upfront costs helps make it clear that there 

is not a separate earnings event in the 

telecommunications example above, 

incurrence of substantive costs, such as 

in the Web hosting example above, does 

not necessarily indicate that there is a 

separate earnings event. Whether there 

is a separate earnings event should be 

evaluated on a case-by-case basis. Some 

have questioned whether revenue may 

be recognized in these transactions to 

the extent of the incremental direct 

costs incurred in the activation. Because 

there is no separable deliverable or 

earnings event, the staff would generally 

object to that approach, except where it 

is provided for in the authoritative 

literature (e.g., FASB ASC Subtopic 

922–605, Entertainment—Cable 

Television—Revenue Recognition). 

Supply or service transactions may 

involve the charge of a nonrefundable 

initial fee with subsequent periodic 

payments for future products or 

services. The initial fees may, in 

substance, be wholly or partly an 

advance payment for future products or 

services. In the examples above, the ongoing rights or services being provided 

or products being delivered are essential 

to the customers receiving the expected 

benefit of the up-front payment. 

Therefore, the up-front fee and the 

continuing performance obligation 

related to the services to be provided or 

products to be delivered are assessed as 

an integrated package. In such 

circumstances, the staff believes that upfront fees, even if nonrefundable, are 

earned as the products and/or services 

are delivered and/or performed over the 

term of the arrangement or the expected 

period of performance 39 and generally 

should be deferred and recognized 

systematically over the periods that the 

fees are earned.40

Some propose that revenue should be 

recognized when the initial set-up is 

completed in cases where the on-going 

obligation involves minimal or no cost 

or effort and should, therefore, be 

considered perfunctory or 

inconsequential. However, the staff 

believes that the substance of each of 

these transactions indicates that the 

purchaser is paying for a service that is 

delivered over time. Therefore, revenue 

recognition should occur over time, 

reflecting the provision of service.41

Question 2 

Facts: Company A provides its 

customers with activity tracking or 


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42See Note 36, supra. 

43See Note 39, supra. 44FASB ASC paragraph 605–20–25–4. 

similar services (e.g., tracking of 

property tax payment activity, sending 

delinquency letters on overdue 

accounts, etc.) for a ten-year period. 

Company A requires customers to 

prepay for all the services for the term 

specified in the arrangement. The ongoing services to be provided are 

generally automated after the initial 

customer set-up. At the outset of the 

arrangement, Company A performs setup procedures to facilitate delivery of its 

on-going services to the customers. Such 

procedures consist primarily of 

establishing the necessary records and 

files in Company A’s pre-existing 

computer systems in order to provide 

the services. Once the initial customer 

set-up activities are complete, Company 

A provides its services in accordance 

with the arrangement. Company A is not 

required to refund any portion of the fee 

if the customer terminates the services 

or does not utilize all of the services to 

which it is entitled. However, Company 

A is required to provide a refund if 

Company A terminates the arrangement 

early. Assume Company A’s activities 

are not within the scope of FASB ASC 

Subtopic 310–20, Receivables— 

Nonrefundable Fees and Other Costs, 

and that this arrangement qualifies as a 

single unit of accounting under FASB 

ASC Subtopic 605–25.42

Question: When should Company A 

recognize the service revenue? 

Interpretive Response: The staff 

believes that, provided all other revenue 

recognition criteria are met, service 

revenue should be recognized on a 

straight-line basis, unless evidence 

suggests that the revenue is earned or 

obligations are fulfilled in a different 

pattern, over the contractual term of the 

arrangement or the expected period 

during which those specified services 

will be performed,43 whichever is 

longer. In this case, the customer 

contracted for the on-going activity 

tracking service, not for the set-up 

activities. The staff notes that the 

customer could not, and would not, 

separately purchase the set-up services 

without the on-going services. The 

services specified in the arrangement 

are performed continuously over the 

contractual term of the arrangement 

(and any subsequent renewals). 

Therefore, the staff believes that 

Company A should recognize revenue 

on a straight-line basis, unless evidence 

suggests that the revenue is earned or 

obligations are fulfilled in a different 

pattern, over the contractual term of the 

arrangement or the expected period 

during which those specified services 

will be performed, whichever is longer. 

In this situation, the staff would 

object to Company A recognizing 

revenue in proportion to the costs 

incurred because the set-up costs 

incurred bear no direct relationship to 

the performance of services specified in 

the arrangement. The staff also believes 

that it is inappropriate to recognize the 

entire amount of the prepayment as 

revenue at the outset of the arrangement 

by accruing the remaining costs because 

the services required by the contract 

have not been performed. 

Question 3 

Facts: Assume the same facts as in 

Question 2 above. 

Question: Are the initial customer setup costs incurred by Company A within 

the scope of FASB ASC Subtopic 720– 

15, Other Expenses—Start-Up Costs? 

Interpretive Response: FASB ASC 

paragraph 720–15–15–4 states that the 

guidance does not address the financial 

reporting of costs incurred related to 

‘‘ongoing customer acquisition costs, 

such as policy acquisition costs’’ 

addressed in FASB ASC Subtopic 944– 

30, Financial Services—Insurance— 

Acquisition Costs, and ‘‘loan origination 

costs’’ addressed in FASB ASC Subtopic 

310–20. This guidance addresses the 

more substantive one-time efforts to 

establish business with an entirely new 

class of customers (for example, a 

manufacturer who does all of its 

business with retailers attempts to sell 

merchandise directly to the public). As 

such, the set-up costs incurred in this 

example are not within the scope of 

FASB ASC Subtopic 720–15. 

The staff believes that the incremental 

direct costs (the FASB ASC Master 

Glossary provides a definition) incurred 

related to the acquisition or origination 

of a customer contract in a transaction 

that results in the deferral of revenue, 

unless specifically provided for in the 

authoritative literature, may be either 

expensed as incurred or accounted for 

in accordance with FASB ASC 

paragraph 605–20–25–4 or FASB ASC 

paragraph 310–20–25–2. The staff 

believes the accounting policy chosen 

for these costs should be disclosed and 

applied consistently. 

Question 4 

Facts: Assume the same facts as in 

Question 2 above. 

Question: What is the staff’s view of 

the pool of contract acquisition and 

origination costs that are eligible for 

capitalization? 

Interpretive Response: As noted in 

Question 3 above, the FASB ASC Master 

Glossary includes a definition of 

incremental direct costs. FASB ASC 

Subtopic 310–10, Receivables—Overall, 

provides further guidance on the types 

of costs eligible for capitalization as 

customer acquisition costs indicating 

that only costs that result from 

successful loan origination efforts are 

capitalized. Further, FASB ASC 

Subtopic 605–20, Revenue 

Recognition—Services, also requires 

capitalization of incremental direct 

customer acquisition costs. Although 

the facts of a particular situation should 

be analyzed closely to capture those 

costs that are truly direct and 

incremental, the staff generally would 

not object to an accounting policy that 

results in the capitalization of costs in 

accordance with FASB ASC Subtopic 

310–20, Receivables—Nonrefundable 

Fees and Other Costs, or FASB ASC 

Subtopic 605–20. Registrants should 

disclose their policies for determining 

which costs to capitalize as contract 

acquisition and origination costs. 

Question 5 

Facts: Assume the same facts as in 

Question 2 above. Based on the 

guidance in Questions 2, 3 and 4 above, 

Company A has capitalized certain 

direct and incremental customer set-up 

costs associated with the deferred 

revenue. 

Question: Over what period should 

Company A amortize these costs? 

Interpretive Response: When both 

costs and revenue (in an amount equal 

to or greater than the costs) are deferred, 

the staff believes that the capitalized 

costs should be charged to expense 

proportionally and over the same period 

that deferred revenue is recognized as 

revenue.44

g. Deliverables Within an Arrangement 

Question: If a company (the seller) has 

a patent to its intellectual property 

which it licenses to customers, the seller 

may represent and warrant to its 

licensees that it has a valid patent, and 

will defend and maintain that patent. 

Does that obligation to maintain and 

defend patent rights, in and of itself, 

constitute a deliverable to be evaluated 

under FASB ASC Subtopic 605–25? 

Interpretive Response: No. Provided 

the seller has legal and valid patents 

upon entering the license arrangement, 

existing GAAP on licenses of 

intellectual property (e.g., FASB ASC 

Subtopic 985–605, Software—Revenue 

Recognition, FASB ASC Subtopic 926– 

605, Entertainment—Films—Revenue 

Recognition, and FASB ASC Subtopic 

928–605, Entertainment—Music— 

Revenue Recognition) does not indicate 


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45Note, however, the staff believes that this 

obligation qualifies as a guarantee within the scope 

of FASB ASC Topic 460, subject to a scope 

exception from the initial recognition and 

measurement provisions. 

46FASB ASC paragraph 985–605–25–37. 

47 Ibid. 

48 Ibid. 

49FASB ASC paragraph 405–20–40–1 (Liabilities 

Topic). 

50FASB ASC paragraph 605–15–15–3. 

that an obligation to defend valid 

patents represents an additional 

deliverable to which a portion of an 

arrangement fee should be allocated in 

an arrangement that otherwise qualifies 

for sales-type accounting. While this 

clause may obligate the licenser to incur 

costs in the defense and maintenance of 

the patent, that obligation does not 

involve an additional deliverable to the 

customer. Defending the patent is 

generally consistent with the seller’s 

representation in the license that such 

patent is legal and valid. Therefore, the 

staff would not consider a clause like 

this to represent an additional 

deliverable in the arrangement.45

4. Fixed or Determinable Sales Price 

a. Refundable Fees for Services 

A company’s contracts may include 

customer cancellation or termination 

clauses. Cancellation or termination 

provisions may be indicative of a 

demonstration period or an otherwise 

incomplete transaction. Examples of 

transactions that financial management 

and auditors should be aware of and 

where such provisions may exist 

include ‘‘side’’ agreements and 

significant transactions with unusual 

terms and conditions. These contractual 

provisions raise questions as to whether 

the sales price is fixed or determinable. 

The sales price in arrangements that are 

cancelable by the customer is neither 

fixed nor determinable until the 

cancellation privileges lapse.46 If the 

cancellation privileges expire ratably 

over a stated contractual term, the sales 

price is considered to become 

determinable ratably over the stated 

term.47 Short-term rights of return, such 

as thirty-day money-back guarantees, 

and other customary rights to return 

products are not considered to be 

cancellation privileges, but should be 

accounted for in accordance with FASB 

ASC Subtopic 605–15, Revenue 

Recognition—Products.48

Question 1 

Facts: Company M is a discount 

retailer. It generates revenue from 

annual membership fees it charges 

customers to shop at its stores and from 

the sale of products at a discount price 

to those customers. The membership 

arrangements with retail customers 

require the customer to pay the entire 

membership fee (e.g., $35) at the outset 

of the arrangement. However, the 

customer has the unilateral right to 

cancel the arrangement at any time 

during its term and receive a full refund 

of the initial fee. Based on historical 

data collected over time for a large 

number of homogeneous transactions, 

Company M estimates that 

approximately 40% of the customers 

will request a refund before the end of 

the membership contract term. 

Company M’s data for the past five years 

indicates that significant variations 

between actual and estimated 

cancellations have not occurred, and 

Company M does not expect significant 

variations to occur in the foreseeable 

future. 

Question: May Company M recognize 

in earnings the revenue for the 

membership fees and accrue the costs to 

provide membership services at the 

outset of the arrangement? 

Interpretive Response: No. In the 

staff’s view, it would be inappropriate 

for Company M to recognize the 

membership fees as earned revenue 

upon billing or receipt of the initial fee 

with a corresponding accrual for 

estimated costs to provide the 

membership services. This conclusion is 

based on Company M’s remaining and 

unfulfilled contractual obligation to 

perform services (i.e., make available 

and offer products for sale at a 

discounted price) throughout the 

membership period. Therefore, the 

earnings process, irrespective of 

whether a cancellation clause exists, is 

not complete. 

In addition, the ability of the member 

to receive a full refund of the 

membership fee up to the last day of the 

membership term raises an uncertainty 

as to whether the fee is fixed or 

determinable at any point before the end 

of the term. Generally, the staff believes 

that a sales price is not fixed or 

determinable when a customer has the 

unilateral right to terminate or cancel 

the contract and receive a cash refund. 

A sales price or fee that is variable until 

the occurrence of future events (other 

than product returns that are within the 

scope of FASB ASC Subtopic 605–15) 

generally is not fixed or determinable 

until the future event occurs. The 

revenue from such transactions should 

not be recognized in earnings until the 

sales price or fee becomes fixed or 

determinable. Moreover, revenue should 

not be recognized in earnings by 

assessing the probability that 

significant, but unfulfilled, terms of a 

contract will be fulfilled at some point 

in the future. Accordingly, the revenue 

from such transactions should not be 

recognized in earnings prior to the 

refund privileges expiring. The amounts 

received from customers or subscribers 

(i.e., the $35 fee mentioned above) 

should be credited to a monetary 

liability account such as ‘‘customers’ 

refundable fees.’’ 

The staff believes that if a customer 

has the unilateral right to receive both 

(1) the seller’s substantial performance 

under an arrangement (e.g., providing 

services or delivering product) and (2) a 

cash refund of prepaid fees, then the 

prepaid fees should be accounted for as 

a monetary liability. In consideration of 

whether the monetary liability can be 

derecognized, FASB ASC Topic 860, 

Transfers and Servicing, provides that 

liabilities may be derecognized only if 

(1) the debtor pays the creditor and is 

relieved of its obligation for the liability 

(paying the creditor includes delivery of 

cash, other financial assets, goods, or 

services or reacquisition by the debtor of 

its outstanding debt securities) or (2) the 

debtor is legally released from being the 

primary obligor under the liability.49 If 

a customer has the unilateral right to 

receive both (1) the seller’s substantial 

performance under the arrangement and 

(2) a cash refund of prepaid fees, then 

the refund obligation is not relieved 

upon performance of the service or 

delivery of the products. Rather, the 

seller’s refund obligation is relieved 

only upon refunding the cash or 

expiration of the refund privilege. 

Some have argued that there may be 

a limited exception to the general rule 

that revenue from membership or other 

service transaction fees should not be 

recognized in earnings prior to the 

refund privileges expiring. Despite the 

fact that FASB ASC Subtopic 605–15 

expressly does not apply to the 

accounting for service revenue if part or 

all of the service fee is refundable under 

cancellation privileges granted to the 

buyer,50 they believe that in certain 

circumstances a potential refund of a 

membership fee may be seen as being 

similar to a right of return of products 

under FASB ASC Subtopic 605–15. 

They argue that revenue from 

membership fees, net of estimated 

refunds, may be recognized ratably over 

the period the services are performed 

whenever pertinent conditions of FASB 

ASC Subtopic 605–15 are met, namely, 

there is a large population of 

transactions that grant customers the 

same unilateral termination or 

cancellation rights and reasonable 

estimates can be made of how many 

customers likely will exercise those 

rights. 


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51The staff will question further analogies to the 

guidance in FASB ASC Subtopic 605–15 for 

transactions expressly excluded from its scope. 

52Reliability is defined in Concepts Statement 2 

as ‘‘the quality of information that assures that 

information is reasonably free from error and bias 

and faithfully represents what it purports to 

represent.’’ Paragraph 63 of Concepts Statement 5 

reiterates the definition of reliability, requiring that 

‘‘the information is representationally faithful, 

verifiable, and neutral.’’ 

53For example, if an estimate of the expected 

cancellation rate varies from the actual cancellation 

rate by 100% but the dollar amount of the error is 

immaterial to the consolidated financial statements, 

some would argue that the estimate could still be 

viewed as reliable. The staff disagrees with that 

argument. 

54The term ‘‘remote’’ is used here with the same 

definition as used in the FASB ASC Master 

Glossary. 

55FASB ASC paragraph 605–15–25–3 notes 

various factors that may impair the ability to make 

a reasonable estimate of returns, including the lack 

of sufficient historical experience. The staff 

typically expects that the historical experience be 

based on the particular registrant’s historical 

experience for a service and/or class of customer. 

In general, the staff typically expects a start-up 

company, a company introducing new services, or 

a company introducing services to a new class of 

customer to have at least two years of experience 

to be able to make reasonable and reliable estimates. 

56The staff believes deferred costs being 

amortized on a basis consistent with the deferred 

revenue should be similarly adjusted. Such an 

approach is generally consistent with the 

amortization methodology in FASB ASC paragraph 

310–20–35–26. 

The staff believes that, because 

service arrangements are specifically 

excluded from the scope of FASB ASC 

Subtopic 605–15, the most direct 

authoritative literature to be applied to 

the extinguishment of obligations under 

such contracts is FASB ASC Topic 860. 

As noted above, because the refund 

privilege extends to the end of the 

contract term irrespective of the amount 

of the service performed, FASB ASC 

Topic 860 indicates that the liability 

would not be extinguished (and 

therefore no revenue would be 

recognized in earnings) until the 

cancellation or termination and related 

refund privileges expire. Nonetheless, 

the staff recognizes that over the years 

the accounting for membership refunds 

evolved based on analogy to FASB ASC 

Subtopic 605–15 and that practice did 

not change when FASB ASC Topic 860 

became effective. Reasonable people 

held, and continue to hold, different 

views about the application of the 

accounting literature. 

Pending further action in this area by 

the FASB, the staff will not object to the 

recognition of refundable membership 

fees, net of estimated refunds, as earned 

revenue over the membership term in 

the limited circumstances where all of 

the following criteria have been met: 51

The estimates of terminations or 

cancellations and refunded revenues are 

being made for a large pool of 

homogeneous items (e.g., membership 

or other service transactions with the 

same characteristics such as terms, 

periods, class of customers, nature of 

service, etc.). 

• Reliable estimates of the expected 

refunds can be made on a timely basis.52

Either of the following two items would 

be considered indicative of an inability 

to make reliable estimates: (1) recurring, 

significant differences between actual 

experience and estimated cancellation 

or termination rates (e.g., an actual 

cancellation rate of 40% versus an 

estimated rate of 25%) even if the 

impact of the difference on the amount 

of estimated refunds is not material to 

the consolidated financial statements 53

or (2) recurring variances between the 

actual and estimated amount of refunds 

that are material to either revenue or net 

income in quarterly or annual financial 

statements. In addition, the staff 

believes that an estimate, for purposes 

of meeting this criterion, would not be 

reliable unless it is remote 54 that 

material adjustments (both individually 

and in the aggregate) to previously 

recognized revenue would be required. 

The staff presumes that reliable 

estimates cannot be made if the 

customer’s termination or cancellation 

and refund privileges exceed one year. 

• There is a sufficient companyspecific historical basis upon which to 

estimate the refunds,55 and the company 

believes that such historical experience 

is predictive of future events. In 

assessing these items, the staff believes 

that estimates of future refunds should 

take into consideration, among other 

things, such factors as historical 

experience by service type and class of 

customer, changing trends in historical 

experience and the basis thereof (e.g., 

economic conditions), the impact or 

introduction of competing services or 

products, and changes in the customer’s 

‘‘accessibility’’ to the refund (i.e., how 

easy it is for customers to obtain the 

refund). 

• The amount of the membership fee 

specified in the agreement at the outset 

of the arrangement is fixed, other than 

the customer’s right to request a refund. 

If Company M does not meet all of the 

foregoing criteria, the staff believes that 

Company M should not recognize in 

earnings any revenue for the 

membership fee until the cancellation 

privileges and refund rights expire. 

If revenue is recognized in earnings 

over the membership period pursuant to 

the above criteria, the initial amounts 

received from customer or subscribers 

(i.e., the $35 fee mentioned above) 

should be allocated to two liability 

accounts. The amount of the fee 

representing estimated refunds should 

be credited to a monetary liability 

account, such as ‘‘customers’ refundable 

fees,’’ and the remaining amount of the 

fee representing unearned revenue 

should be credited to a nonmonetary 

liability account, such as ‘‘unearned 

revenues.’’ For each income statement 

presented, registrants should disclose in 

the footnotes to the financial statements 

the amounts of (1) the unearned revenue 

and (2) refund obligations as of the 

beginning of each period, the amount of 

cash received from customers, the 

amount of revenue recognized in 

earnings, the amount of refunds paid, 

other adjustments (with an explanation 

thereof), and the ending balance of (1) 

unearned revenue and (2) refund 

obligations. 

If revenue is recognized in earnings 

over the membership period pursuant to 

the above criteria, the staff believes that 

adjustments for changes in estimated 

refunds should be recorded using a 

retrospective approach whereby the 

unearned revenue and refund 

obligations are remeasured and adjusted 

at each balance sheet date with the 

offset being recorded as earned 

revenue.56

Companies offering memberships 

often distribute membership packets 

describing and discussing the terms, 

conditions, and benefits of membership. 

Packets may include vouchers, for 

example, that provide new members 

with discounts or other benefits from 

third parties. The costs associated with 

the vouchers should be expensed when 

distributed. Advertising costs to solicit 

members should be accounted for in 

accordance with FASB ASC Subtopic 

720–35, Other Expenses—Advertising 

Costs. Incremental direct costs incurred 

in connection with enrolling customers 

(e.g., commissions paid to agents) 

should be accounted for as follows: (1) 

If revenue is deferred until the 

cancellation or termination privileges 

expire, incremental direct costs should 

be either (a) charged to expense when 

incurred if the costs are not refundable 

to the company in the event the 

customer obtains a refund of the 

membership fee, or (b) if the costs are 

refundable to the company in the event 

the customer obtains a refund of the 

membership fee, recorded as an asset 

until the earlier of termination or 

cancellation or refund; or (2) if revenue, 

net of estimated refunds, is recognized 

in earnings over the membership period, 

a like percentage of incremental direct 

costs should be deferred and recognized 

in earnings in the same pattern as 

revenue is recognized, and the 


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57FASB ASC paragraphs 310–20–25–2 and 605– 

20–25–4 both provide for the deferral of 

incremental direct costs associated with acquiring 

a revenue-producing contract. Even though the 

revenue discussed in this example is refundable, if 

a registrant meets the aforementioned criteria for 

revenue recognition over the membership period, 

the staff would analogize to this guidance. 

However, if neither a nonrefundable contract nor a 

reliable basis for estimating net cash inflows under 

refundable contracts exists to provide a basis for 

recovery of incremental direct costs, the staff 

believes that such costs should be expensed as 

incurred. See SAB Topic 13.A.3.f. Question 3. 

58These factors include ‘‘(a) the susceptibility of 

the product to significant external factors, such as 

technological obsolescence or changes in demand, 

(b) relatively long periods in which a particular 

product may be returned, (c) absence of historical 

experience with similar types of sales of similar 

products, or inability to apply such experience 

because of changing circumstances, for example, 

changes in the selling enterprise’s marketing 

policies and relationships with its customers, and 

(d) absence of a large volume of relatively 

homogeneous transactions.’’ 

remaining portion should be either (a) 

charged to expense when incurred if the 

costs are not refundable to the company 

in the event the customer obtains a 

refund of the membership fee, or (b) if 

the costs are refundable to the company 

in the event the customer obtains a 

refund of the membership fee, recorded 

as an asset until the refund occurs.57 All 

costs other than incremental direct costs 

(e.g., indirect costs) should be expensed 

as incurred. 

Question 2 

Question: Will the staff accept an 

analogy to FASB ASC Subtopic 605–15 

for service transactions subject to 

customer cancellation privileges other 

than those specifically addressed in the 

previous question? 

Interpretive Response: The staff has 

accepted the analogy in limited 

circumstances due to the existence of a 

large pool of homogeneous transactions 

and satisfaction of the criteria in the 

previous question. Examples of other 

arrangements involving customer 

cancellation privileges and refundable 

service fees that the staff has addressed 

include the following: 

• A leasing broker whose commission 

from the lessor upon a commercial 

tenant’s signing of a lease agreement is 

refundable (or in some cases, is not due) 

under lessor cancellation privileges if 

the tenant fails to move into the leased 

premises by a specified date. 

• A talent agent whose fee receivable 

from its principal (i.e., a celebrity) for 

arranging a celebrity endorsement for a 

five-year term is cancelable by the 

celebrity if the celebrity breaches the 

endorsement contract with its customer. 

• An insurance agent whose 

commission received from the insurer 

upon selling an insurance policy is 

refundable in whole for the 30-day 

period that state law permits the 

consumer to repudiate the contract and 

then refundable on a declining pro rata 

basis until the consumer has made six 

monthly payments. 

In the first two of these cases, the staff 

advised the registrants that the portion 

of revenue subject to customer 

cancellation and refund must be 

deferred until no longer subject to that 

contingency because the registrants did 

not have an ability to make reliable 

estimates of customer cancellations due 

to the lack of a large pool of 

homogeneous transactions. In the case 

of the insurance agent, however, the 

particular registrant demonstrated that it 

had a sufficient history of homogeneous 

transactions with the same 

characteristics from which to reliably 

estimate contract cancellations and 

satisfy all the criteria specified in the 

previous question. Accordingly, the staff 

did not object to that registrant’s policy 

of recognizing its sales commission as 

revenue when its performance was 

complete, with an appropriate 

allowance for estimated cancellations. 

Question 3 

Question: Must a registrant analogize 

to FASB ASC Subtopic 605–15, or may 

it choose to defer all revenue until the 

refund period lapses as suggested by 

FASB ASC Topic 860 even if the criteria 

above for analogy to FASB ASC 

Subtopic 605–15 are met? 

Interpretive Response: The analogy to 

FASB ASC Subtopic 605–15 is 

presented as an alternative that would 

be acceptable to the staff when the listed 

conditions are met. However, a 

registrant may choose to defer all 

revenue until the refund period lapses. 

The policy chosen should be disclosed 

and applied consistently. 

Question 4 

Question: May a registrant that meets 

the above criteria for reliable estimates 

of cancellations choose at some point in 

the future to change from the FASB ASC 

Subtopic 605–15 method to the FASB 

ASC Topic 860 method of accounting 

for these refundable fees? May a 

registrant change from the FASB ASC 

Topic 860 method to the FASB ASC 

Subtopic 605–15 method? 

Interpretive Response: The staff 

believes that FASB ASC Topic 860 

provides a preferable accounting model 

for service transactions subject to 

potential refunds. Therefore, the staff 

would not object to a change from the 

FASB ASC Subtopic 605–15 method to 

the FASB ASC Topic 860 method. 

However, if a registrant had previously 

chosen the FASB ASC Topic 860 

method, the staff would object to a 

change to the FASB ASC Subtopic 605– 

15 method. 

Question 5 

Question: Is there a minimum level of 

customers that must be projected not to 

cancel before use of FASB ASC 

Subtopic 605–15 type accounting is 

appropriate? 

Interpretive Response: FASB ASC 

Subtopic 605–15 does not include any 

such minimum. Therefore, the staff does 

not believe that a minimum must apply 

in service transactions either. However, 

as the refund rate increases, it may be 

increasingly difficult to make reasonable 

and reliable estimates of cancellation 

rates. 

Question 6 

Question: When a registrant first 

determines that reliable estimates of 

cancellations of service contracts can be 

made (e.g., two years of historical 

evidence becomes available), how 

should the change from the complete 

deferral method to the method of 

recognizing revenue, net of estimated 

cancellations, over time be reflected? 

Interpretive Response: Changes in the 

ability to meet the criteria set forth 

above should be accounted for in the 

manner described in FASB ASC 

paragraph 605–15–25–1, which 

addresses the accounting when a 

company experiences a change in the 

ability to make reasonable estimates of 

future product returns. 

b. Estimates and Changes in Estimates 

Accounting for revenues and costs of 

revenues requires estimates in many 

cases; those estimates sometimes 

change. Registrants should ensure that 

they have appropriate internal controls 

and adequate books and records that 

will result in timely identification of 

necessary changes in estimates that 

should be reflected in the financial 

statements and notes thereto. 

Question 1 

Facts: FASB ASC paragraph 605–15– 

25–3 lists a number of factors that may 

impair the ability to make a reasonable 

estimate of product returns in sales 

transactions when a right of return 

exists.58 The paragraph concludes by 

stating ‘‘other factors may preclude a 

reasonable estimate.’’ 

Question: What ‘‘other factors,’’ in 

addition to those listed in FASB ASC 

paragraph 605–15–25–3, has the staff 

identified that may preclude a registrant 

from making a reasonable and reliable 

estimate of product returns? 

Interpretive Response: The staff 

believes that the following additional 


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59FASB ASC paragraph 605–15–25–1. 

60FASB ASC subparagraph 605–15–25–1(f). 

61Lessees should follow the guidance established 

in FASB ASC Subtopic 840–10. 

factors, among others, may affect or 

preclude the ability to make reasonable 

and reliable estimates of product 

returns: (1) Significant increases in or 

excess levels of inventory in a 

distribution channel (sometimes 

referred to as ‘‘channel stuffing’’), (2) 

lack of ‘‘visibility’’ into or the inability 

to determine or observe the levels of 

inventory in a distribution channel and 

the current level of sales to end users, 

(3) expected introductions of new 

products that may result in the 

technological obsolescence of and larger 

than expected returns of current 

products, (4) the significance of a 

particular distributor to the registrant’s 

(or a reporting segment’s) business, sales 

and marketing, (5) the newness of a 

product, (6) the introduction of 

competitors’ products with superior 

technology or greater expected market 

acceptance, and (7) other factors that 

affect market demand and changing 

trends in that demand for the 

registrant’s products. Registrants and 

their auditors should carefully analyze 

all factors, including trends in historical 

data, which may affect registrants’ 

ability to make reasonable and reliable 

estimates of product returns. 

The staff reminds registrants that if a 

transaction fails to meet all of the 

conditions of FASB ASC paragraphs 

605–15–25–1 and 605–15–25–3, no 

revenue may be recognized until those 

conditions are subsequently met or the 

return privilege has substantially 

expired, whichever occurs first.59

Simply deferring recognition of the 

gross margin on the transaction is not 

appropriate. 

Question 2 

Question: Is the requirement cited in 

the previous question for ‘‘reliable’’ 

estimates meant to imply a new, higher 

requirement than the ‘‘reasonable’’ 

estimates discussed in FASB ASC 

Subtopic 605–15? 

Interpretive Response: No. 

‘‘Reliability’’ of financial information is 

one of the qualities of accounting 

information discussed in Concepts 

Statement 2, Qualitative Characteristics 

of Accounting Information. The staff’s 

expectation that estimates be reliable 

does not change the existing 

requirement of FASB ASC Subtopic 

605–15. If management cannot develop 

an estimate that is sufficiently reliable 

for use by investors, the staff believes it 

cannot make a reasonable estimate 

meeting the requirements of that 

standard. 

Question 3 

Question: Does the staff expect 

registrants to apply the guidance in 

Question 1 of Topic 13.A.4(a) above to 

sales of tangible goods and other 

transactions specifically within the 

scope of FASB ASC Subtopic 605–15? 

Interpretive Response: The specific 

guidance above does not apply to 

transactions within the scope of FASB 

ASC Subtopic 605–15. The views set 

forth in Question 1 of Topic 13.A.4(a) 

are applicable to the service transactions 

discussed in that Question. Service 

transactions are explicitly outside the 

scope of FASB ASC Subtopic 605–15. 

Question 4 

Question: Question 1 of Topic 

13.A.4(a) above states that the staff 

would expect a two-year history of 

selling a new service in order to be able 

to make reliable estimates of 

cancellations. How long a history does 

the staff believe is necessary to estimate 

returns in a product sale transaction that 

is within the scope of FASB ASC 

Subtopic 605–15? 

Interpretive Response: The staff does 

not believe there is any specific length 

of time necessary in a product 

transaction. However, FASB ASC 

Subtopic 605–15 states that returns 

must be subject to reasonable 

estimation. Preparers and auditors 

should be skeptical of estimates of 

product returns when little history with 

a particular product line exists, when 

there is inadequate verifiable evidence 

of historical experience, or when there 

are inadequate internal controls that 

ensure the reliability and timeliness of 

the reporting of the appropriate 

historical information. Start-up 

companies and companies selling new 

or significantly modified products are 

frequently unable to develop the 

requisite historical data on which to 

base estimates of returns. 

Question 5 

Question: If a company selling 

products subject to a right of return 

concludes that it cannot reasonably 

estimate the actual return rate due to its 

limited history, but it can conservatively 

estimate the maximum possible returns, 

does the staff believe that the company 

may recognize revenue for the portion of 

the sales that exceeds the maximum 

estimated return rate? 

Interpretive Response: No. If a 

reasonable estimate of future returns 

cannot be made, FASB ASC Subtopic 

605–15 requires that revenue not be 

recognized until the return period 

lapses or a reasonable estimate can be 

made.60 Deferring revenue recognition 

based on the upper end of a wide range 

of potential return rates is inconsistent 

with the provisions of FASB ASC 

Subtopic 605–15. 

c. Contingent Rental Income 

Facts: Company A owns and leases 

retail space to retailers. Company A 

(lessor) renews a lease with a customer 

(lessee) that is classified as an operating 

lease. The lease term is one year and 

provides that the lease payments are 

$1.2 million, payable in equal monthly 

installments on the first day of each 

month, plus one percent of the lessee’s 

net sales in excess of $25 million if the 

net sales exceed $25 million during the 

lease term (i.e., contingent rental). The 

lessee has historically experienced 

annual net sales in excess of $25 million 

in the particular space being leased, and 

it is probable that the lessee will 

generate in excess of $25 million net 

sales during the term of the lease. 

Question: In the staff’s view, should 

the lessor recognize any rental income 

attributable to the one percent of the 

lessee’s net sales exceeding $25 million 

before the lessee actually achieves the 

$25 million net sales threshold? 

Interpretive Response: No. The staff 

believes that contingent rental income 

‘‘accrues’’ (i.e., it should be recognized 

as revenue) when the changes in the 

factor(s) on which the contingent lease 

payments is (are) based actually occur.61

FASB ASC paragraph 840–20–25–1 

states that ‘‘[r]ent shall be charged to 

expense by lessees (reported as income 

by lessors) over the lease term as it 

becomes payable (receivable). If rental 

payments are not made on a straightline basis, rental expense nevertheless 

shall be recognized on a straight-line 

basis unless another systematic and 

rational basis is more representative of 

the time pattern in which use benefit is 

derived from the leased property, in 

which case that basis shall be used.’’ 

FASB ASC paragraph 840–10–25–4 

clarifies that ‘‘lease payments that 

depend on a factor that does not exist 

or is not measurable at the inception of 

the lease, such as future sales volume, 

would be contingent rentals in their 

entirety and, accordingly, would be 

excluded from minimum lease 

payments and included in the 

determination of income as they 

accrue.’’ FASB ASC paragraph 840–10– 

55–38 provides the following example 

of determining contingent rentals: 

Assume that a lease agreement for retail store 

space stipulates a monthly base rental of 


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62Concepts Statement 5, paragraph 83(a). 

63Concepts Statement 5, paragraph 83(b). 

64See Regulation S–X, Article 5–03(1) and (2). 

65See Regulation S–K, Item 303 and FRR 36. 

$200 and a monthly supplemental rental of 

one-fourth of one percent of monthly sales 

volume during the lease term. Even if the 

lease agreement is a renewal for store space 

that had averaged monthly sales of $25,000 

for the past 2 years, minimum lease 

payments would include only the $200 

monthly base rental; the supplemental rental 

is a contingent rental that is excluded from 

minimum lease payments. The future sales 

for the lease term do not exist at the 

inception of the lease, and future rentals 

would be limited to $200 per month if the 

store were subsequently closed and no sales 

were made thereafter. 

FASB ASC Section 840–20–25 

addresses whether it is appropriate for 

lessors in operating leases to recognize 

scheduled rent increases on a basis 

other than as required in FASB ASC 

paragraph 840–20–25–1. FASB ASC 

subparagraph 840–20–25–2(a) states 

‘‘using factors such as the time value of 

money, anticipated inflation, or 

expected future revenues [emphasis 

added] to allocate scheduled rent 

increases is inappropriate because these 

factors do not relate to the time pattern 

of the physical usage of the leased 

property. However, such factors may 

affect the periodic reported rental 

income or expense if the lease 

agreement involves contingent rentals, 

which are excluded from minimum 

lease payments and accounted for 

separately.’’ In developing the basis for 

why scheduled rent increases should be 

recognized on a straight-line basis, the 

FASB distinguishes the accounting for 

scheduled rent increases from 

contingent rentals. FASB ASC 

subparagraph 840–20–25–2(b) states ‘‘[i]f 

the lessee and lessor eliminate the risk 

of variable payments inherent in 

contingent rentals by agreeing to 

scheduled rent increases, the accounting 

shall reflect those different 

circumstances.’’ 

The example provided in FASB ASC 

paragraph 840–10–55–39 implies that 

contingent rental income in leases 

classified as sales-type or directfinancing leases becomes ‘‘accruable’’ 

when the changes in the factors on 

which the contingent lease payments 

are based actually occur. FASB ASC 

paragraph 840–20–25–2 indicates that 

contingent rental income in operating 

leases should not be recognized in a 

manner consistent with scheduled rent 

increases (i.e., on a straight-line basis 

over the lease term or another 

systematic and rational allocation basis 

if it is more representative of the time 

pattern in which the leased property is 

physically employed) because the risk 

of variable payments inherent in 

contingent rentals is substantively 

different than scheduled rent increases. 

The staff believes that the reasoning in 

FASB ASC Section 840–20–25 supports 

the conclusion that the risks inherent in 

variable payments associated with 

contingent rentals should be reflected in 

financial statements on a basis different 

than rental payments that adjust on a 

scheduled basis and, therefore, 

operating lease income associated with 

contingent rents would not be 

recognized as time passes or as the 

leased property is physically employed. 

Furthermore, prior to the lessee’s 

achievement of the target upon which 

contingent rentals are based, the lessor 

has no legal claims on the contingent 

amounts. Consequently, the staff 

believes that it is inappropriate to 

anticipate changes in the factors on 

which contingent rental income in 

operating leases is based and recognize 

rental income prior to the resolution of 

the lease contingencies. 

Because Company A’s contingent 

rental income is based upon whether 

the customer achieves net sales of $25 

million, the contingent rentals, which 

may not materialize, should not be 

recognized until the customer’s net sales 

actually exceed $25 million. Once the 

$25 million threshold is met, Company 

A would recognize the contingent rental 

income as it becomes accruable, in this 

case, as the customer recognizes net 

sales. The staff does not believe that it 

is appropriate to recognize revenue 

based upon the probability of a factor 

being achieved. The contingent revenue 

should be recorded in the period in 

which the contingency is resolved. 

d. Claims Processing and Billing 

Services 

Facts: Company M performs claims 

processing and medical billing services 

for healthcare providers. In this role, 

Company M is responsible for preparing 

and submitting claims to third-party 

payers, tracking outstanding billings, 

and collecting amounts billed. Company 

M’s fee is a fixed percentage (e.g., five 

percent) of the amount collected. If no 

collections are made, no fee is due to 

Company M. Company M has historical 

evidence indicating that the third-party 

payers pay 85 percent of the billings 

submitted with no further effort by 

Company M. Company M has 

determined that the services performed 

under the arrangement are a single unit 

of accounting. 

Question: May Company M recognize 

as revenue its five percent fee on 85 

percent of the gross billings at the time 

it prepares and submits billings, or 

should it wait until collections occur to 

recognize any revenue? 

Interpretive Response: The staff 

believes that Company M must wait 

until collections occur before 

recognizing revenue. Before the thirdparty payer has remitted payment to 

Company M’s customers for the services 

billed, Company M is not entitled to any 

revenue. That is, its revenue is not yet 

realized or realizable.62 Until Company 

M’s customers collect on the billings, 

Company M has not performed the 

requisite activity under its contract to be 

entitled to a fee.63 Further, no amount 

of the fee is fixed or determinable or 

collectible until Company M’s 

customers collect on the billings. 

B. Disclosures 

Question: What disclosures are 

required with respect to the recognition 

of revenue? 

Interpretive Response: A registrant 

should disclose its accounting policy for 

the recognition of revenue pursuant to 

FASB ASC Topic 235, Notes to 

Financial Statements. FASB ASC 

paragraph 235–10–50–3 thereof states 

that ‘‘the disclosure should encompass 

important judgments as to 

appropriateness of principles relating to 

recognition of revenue * * * .’’ Because 

revenue recognition generally involves 

some level of judgment, the staff 

believes that a registrant should always 

disclose its revenue recognition policy. 

If a company has different policies for 

different types of revenue transactions, 

including barter sales, the policy for 

each material type of transaction should 

be disclosed. If sales transactions have 

multiple units of accounting, such as a 

product and service, the accounting 

policy should clearly state the 

accounting policy for each unit of 

accounting as well as how units of 

accounting are determined and valued. 

In addition, the staff believes that 

changes in estimated returns recognized 

in accordance with FASB ASC Subtopic 

605–15 should be disclosed, if material 

(e.g., a change in estimate from two 

percent of sales to one percent of sales). 

Regulation S–X requires that revenue 

from the sales of products, services, and 

other products each be separately 

disclosed on the face of the income 

statement.64 The staff believes that costs 

relating to each type of revenue 

similarly should be reported separately 

on the face of the income statement. 

MD&A requires a discussion of 

liquidity, capital resources, results of 

operations and other information 

necessary to an understanding of a 

registrant’s financial condition, changes 

in financial condition and results of 

operations.65 This includes unusual or 


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66FRR 36; See also In the Matter of Caterpillar 

Inc., AAER 363 (March 31, 1992). 

67FASB ASC Subtopic 825–10, Financial 

Instruments—Overall. 

68 Gains or losses from the sale of assets should 

be reported as ‘‘other general expenses’’ pursuant to 

Regulation S–X, Article 5–03(6). Any material item 

should be stated separately. 

1FASB ASC paragraphs 718–10–30–2 through 

718–10–30–4. 

2 [Original footnote removed by SAB 114.] 

3 Defined in the FASB ASC Master Glossary. 4FASB ASC paragraph 718–10–30–2. 

infrequent transactions, known trends 

or uncertainties that have had, or might 

reasonably be expected to have, a 

favorable or unfavorable material effect 

on revenue, operating income or net 

income and the relationship between 

revenue and the costs of the revenue. 

Changes in revenue should not be 

evaluated solely in terms of volume and 

price changes, but should also include 

an analysis of the reasons and factors 

contributing to the increase or decrease. 

The Commission stated in FRR 36 that 

MD&A should ‘‘give investors an 

opportunity to look at the registrant 

through the eyes of management by 

providing a historical and prospective 

analysis of the registrant’s financial 

condition and results of operations, 

with a particular emphasis on the 

registrant’s prospects for the future.’’ 66

Examples of such revenue transactions 

or events that the staff has asked to be 

disclosed and discussed in accordance 

with FRR 36 are: 

• Shipments of product at the end of 

a reporting period that significantly 

reduce customer backlog and that 

reasonably might be expected to result 

in lower shipments and revenue in the 

next period. 

• Granting of extended payment 

terms that will result in a longer 

collection period for accounts receivable 

(regardless of whether revenue has been 

recognized) and slower cash inflows 

from operations, and the effect on 

liquidity and capital resources. (The fair 

value of trade receivables should be 

disclosed in the footnotes to the 

financial statements when the fair value 

does not approximate the carrying 

amount.)67

• Changing trends in shipments into, 

and sales from, a sales channel or 

separate class of customer that could be 

expected to have a significant effect on 

future sales or sales returns. 

• An increasing trend toward sales to 

a different class of customer, such as a 

reseller distribution channel that has a 

lower gross profit margin than existing 

sales that are principally made to end 

users. Also, increasing service revenue 

that has a higher profit margin than 

product sales. 

• Seasonal trends or variations in 

sales. 

• A gain or loss from the sale of an 

asset(s).68

TOPIC 14: SHARE–BASED PAYMENT 

The interpretations in this SAB 

express views of the staff regarding the 

interaction between FASB ASC Topic 

718, Compensation—Stock 

Compensation, and certain SEC rules 

and regulations and provide the staff’s 

views regarding the valuation of sharebased payment arrangements for public 

companies. FASB ASC Topic 718 is 

based on the underlying accounting 

principle that compensation cost 

resulting from share-based payment 

transactions be recognized in financial 

statements at fair value.1 Recognition of 

compensation cost at fair value will 

provide investors and other users of 

financial statements with more 

complete and comparable financial 

information.2

FASB ASC Topic 718 addresses a 

wide range of share-based compensation 

arrangements including share options, 

restricted share plans, performancebased awards, share appreciation rights, 

and employee share purchase plans. 

FASB ASC Topic 718 replaces 

guidance as originally issued in 1995, 

that established as preferable, but did 

not require, a fair-value-based method of 

accounting for share-based payment 

transactions with employees. 

The staff believes the guidance in this 

SAB will assist issuers in their initial 

implementation of FASB ASC Topic 718 

and enhance the information received 

by investors and other users of financial 

statements, thereby assisting them in 

making investment and other decisions. 

This SAB includes interpretive 

guidance related to share-based 

payment transactions with 

nonemployees, the transition from 

nonpublic to public entity 3 status, 

valuation methods (including 

assumptions such as expected volatility 

and expected term), the accounting for 

certain redeemable financial 

instruments issued under share-based 

payment arrangements, the 

classification of compensation expense, 

non-GAAP financial measures, first-time 

adoption of FASB ASC Topic 718 in an 

interim period, capitalization of 

compensation cost related to sharebased payment arrangements, the 

accounting for income tax effects of 

share-based payment arrangements 

upon adoption of FASB ASC Topic 718, 

the modification of employee share 

options prior to adoption of FASB ASC 

Topic 718 and disclosures in MD&A 

subsequent to adoption of FASB ASC 

Topic 718. 

The staff recognizes that there is a 

range of conduct that a reasonable issuer 

might use to make estimates and 

valuations and otherwise implement 

FASB ASC Topic 718, and the 

interpretive guidance provided by this 

SAB, particularly during the period of 

the Topic’s initial implementation. 

Thus, throughout this SAB the use of 

the terms ‘‘reasonable’’ and ‘‘reasonably’’ 

is not meant to imply a single 

conclusion or methodology, but to 

encompass the full range of potential 

conduct, conclusions or methodologies 

upon which an issuer may reasonably 

base its valuation decisions. Different 

conduct, conclusions or methodologies 

by different issuers in a given situation 

does not of itself raise an inference that 

any of those issuers is acting 

unreasonably. While the zone of 

reasonable conduct is not unlimited, the 

staff expects that it will be rare when 

there is only one acceptable choice in 

estimating the fair value of share-based 

payment arrangements under the 

provisions of FASB ASC Topic 718 and 

the interpretive guidance provided by 

this SAB in any given situation. In 

addition, as discussed in the 

Interpretive Response to Question 1 of 

Section C, Valuation Methods, estimates 

of fair value are not intended to predict 

actual future events, and subsequent 

events are not indicative of the 

reasonableness of the original estimates 

of fair value made under FASB ASC 

Topic 718. Over time, as issuers and 

accountants gain more experience in 

applying FASB ASC Topic 718 and the 

guidance provided in this SAB, the staff 

anticipates that particular approaches 

may begin to emerge as best practices 

and that the range of reasonable 

conduct, conclusions and 

methodologies will likely narrow. 

* * * * * 

A. Share-Based Payment Transactions 

with Nonemployees 

Question: Are share-based payment 

transactions with nonemployees 

included in the scope of FASB ASC 

Topic 718? 

Interpretive Response: Only certain 

aspects of the accounting for sharebased payment transactions with 

nonemployees are explicitly addressed 

by FASB ASC Topic 718. This Topic 

explicitly: 

• Establishes fair value as the 

measurement objective in accounting for 

all share-based payments; 4 and 

• Requires that an entity record the 

value of a transaction with a 


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5 Ibid. 

6 [Original footnote removed by SAB 114.] 

7For example, due to the nature of specific terms 

in employee share options, including 

nontransferability, nonhedgability and the 

truncation of the contractual term due to postvesting service termination, FASB ASC Topic 718 

requires that when valuing an employee share 

option under the Black-Scholes-Merton framework, 

the fair value of an employee share option be based 

on the option’s expected term rather than the 

contractual term. If these features (i.e., 

nontransferability, nonhedgability and the 

truncation of the contractual term) were not present 

in a nonemployee share option arrangement, the 

use of an expected term assumption shorter than 

the contractual term would generally not be 

appropriate in estimating the fair value of the 

nonemployee share options. 

8 Defined in the FASB ASC Master Glossary. 

9For the purposes of these illustrations, assume 

all of Company A’s equity-based awards granted to 

its employees were granted after the adoption of 

FASB ASC Topic 718. 

10For purposes of this staff accounting bulletin, 

the phrase ‘‘share options’’ is used to refer to ‘‘share 

options or similar instruments.’’ 

11FASB ASC paragraph 718–10–30–20 requires a 

nonpublic entity to use the calculated value method 

when it is not able to reasonably estimate the fair 

value of its equity share options and similar 

instruments because it is not practicable for it to 

estimate the expected volatility of its share price. 

FASB ASC paragraph 718–10–55–51 indicates that 

a nonpublic entity may be able to identify similar 

public entities for which share or option price 

information is available and may consider the 

historical, expected, or implied volatility of those 

entities’ share prices in estimating expected 

volatility. The staff would expect an entity that 

becomes a public entity and had previously 

measured its share options under the calculated 

value method to be able to support its previous 

decision to use calculated value and to provide the 

disclosures required by FASB ASC subparagraph 

718–10–50–2(f)(2)(ii). 

12This view is consistent with the FASB’s basis 

for rejecting full retrospective application of FASB 

ASC Topic 718 as described in the basis for 

conclusions of Statement 123R, paragraph B251. 

13FASB ASC paragraph 718–20–55–94. The staff 

believes that because Company A is a public entity 

as of the date of the modification, it would be 

inappropriate to use the calculated value method to 

measure the original share options immediately 

before the terms were modified. 

14FASB ASC paragraph 718–30–30–2. 

15FASB ASC paragraph 718–30–35–3. 

16 $15 fair value less $10 intrinsic value equals $5 

of incremental cost. 

nonemployee based on the more reliably 

measurable fair value of either the good 

or service received or the equity 

instrument issued.5

FASB ASC Topic 718 does not 

supersede any of the authoritative 

literature that specifically addresses 

accounting for share-based payments 

with nonemployees. For example, FASB 

ASC Topic 718 does not specify the 

measurement date for share-based 

payment transactions with 

nonemployees when the measurement 

of the transaction is based on the fair 

value of the equity instruments issued.6

For determining the measurement date 

of equity instruments issued in sharebased transactions with nonemployees, 

a company should refer to FASB ASC 

Subtopic 505–50, Equity—Equity Based 

Payments to Non-Employees. 

With respect to questions regarding 

nonemployee arrangements that are not 

specifically addressed in other 

authoritative literature, the staff believes 

that the application of guidance in 

FASB ASC Topic 718 would generally 

result in relevant and reliable financial 

statement information. As such, the staff 

believes it would generally be 

appropriate for entities to apply the 

guidance in FASB ASC Topic 718 by 

analogy to share-based payment 

transactions with nonemployees unless 

other authoritative accounting literature 

more clearly addresses the appropriate 

accounting, or the application of the 

guidance in FASB ASC Topic 718 

would be inconsistent with the terms of 

the instrument issued to a nonemployee 

in a share-based payment arrangement.7

For example, the staff believes the 

guidance in FASB ASC Topic 718 on 

certain transactions with related parties 

or other holders of an economic interest 

in the entity would generally be 

applicable to share-based payment 

transactions with nonemployees. The 

staff encourages registrants that have 

additional questions related to 

accounting for share-based payment 

transactions with nonemployees to 

discuss those questions with the staff. 

B. Transition From Nonpublic to Public 

Entity Status 

Facts: Company A is a nonpublic 

entity 8 that first files a registration 

statement with the SEC to register its 

equity securities for sale in a public 

market on January 2, 20X8.9 As a 

nonpublic entity, Company A had been 

assigning value to its share options 10

under the calculated value method 

prescribed by FASB ASC Topic 718, 

Compensation—Stock Compensation,11

and had elected to measure its liability 

awards based on intrinsic value. 

Company A is considered a public 

entity on January 2, 20X8 when it makes 

its initial filing with the SEC in 

preparation for the sale of its shares in 

a public market. 

Question 1: How should Company A 

account for the share options that were 

granted to its employees prior to January 

2, 20X8 for which the requisite service 

has not been rendered by January 2, 

20X8? 

Interpretive Response: Prior to 

becoming a public entity, Company A 

had been assigning value to its share 

options under the calculated value 

method. The staff believes that 

Company A should continue to follow 

that approach for those share options 

that were granted prior to January 2, 

20X8, unless those share options are 

subsequently modified, repurchased or 

cancelled.12 If the share options are 

subsequently modified, repurchased or 

cancelled, Company A would assess the 

event under the public company 

provisions of FASB ASC Topic 718. For 

example, if Company A modified the 

share options on February 1, 20X8, any 

incremental compensation cost would 

be measured under FASB ASC 

subparagraph 718–20–35–3(a), as the 

fair value of the modified share options 

over the fair value of the original share 

options measured immediately before 

the terms were modified.13

Question 2: How should Company A 

account for its liability awards granted 

to its employees prior to January 2, 

20X8 which are fully vested but have 

not been settled by January 2, 20X8? 

Interpretive Response: As a nonpublic 

entity, Company A had elected to 

measure its liability awards subject to 

FASB ASC Topic 718 at intrinsic 

value.14 When Company A becomes a 

public entity, it should measure the 

liability awards at their fair value 

determined in accordance with FASB 

ASC Topic 718.15 In that reporting 

period there will be an incremental 

amount of measured cost for the 

difference between fair value as 

determined under FASB ASC Topic 718 

and intrinsic value. For example, 

assume the intrinsic value in the period 

ended December 31, 20X7 was $10 per 

award. At the end of the first reporting 

period ending after January 2, 20X8 

(when Company A becomes a public 

entity), assume the intrinsic value of the 

award is $12 and the fair value as 

determined in accordance with FASB 

ASC Topic 718 is $15. The measured 

cost in the first reporting period after 

December 31, 20X7 would be $5.16

Question 3: After becoming a public 

entity, may Company A retrospectively 

apply the fair-value-based method to its 

awards that were granted prior to the 

date Company A became a public 

entity? 

Interpretive Response: No. Before 

becoming a public entity, Company A 

did not use the fair-value-based method 

for either its share options or its liability 

awards granted to the Company’s 

employees. The staff does not believe it 

is appropriate for Company A to apply 

the fair-value-based method on a 

retrospective basis, because it would 

require the entity to make estimates of 

a prior period, which, due to hindsight, 

may vary significantly from estimates 


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17This view is consistent with the FASB’s basis 

for rejecting full retrospective application of FASB 

ASC Topic 718 as described in the basis for 

conclusions of Statement 123R, paragraph B251. 

18FASB ASC Section 718–10–50. 

19See generally SEC Release No. FR–72, 

‘‘Commission Guidance Regarding Management’s 

Discussion and Analysis of Financial Condition and 

Results of Operations.’’ 

20SEC Release No. FR–60, ‘‘Cautionary Advice 

Regarding Disclosure About Critical Accounting 

Policies.’’ 

21SEC Release No. FR–72, ‘‘Commission 

Guidance Regarding Management’s Discussion and 

Analysis of Financial Condition and Results of 

Operations.’’ 

22FASB ASC paragraph 718–10–55–10. 

23FASB ASC paragraph 718–10–55–11. 

24FASB ASC paragraph 718–10–55–15 states 

‘‘The fair value of those instruments at a single 

point in time is not a forecast of what the estimated 

fair value of those instruments may be in the 

future.’’ 

25See FASB ASC paragraphs 718–10–55–16 and 

718–10–55–20. 

26FASB ASC paragraph 718–10–55–17 indicates 

that an entity may use different valuation 

techniques or models for instruments with different 

characteristics. 

27The staff believes that a company should take 

into account the reason for the change in technique 

or model in determining whether the new 

technique or model meets the fair value 

measurement objective. For example, changing a 

technique or model from period to period for the 

sole purpose of lowering the fair value estimate of 

a share option would not meet the fair value 

measurement objective of the Topic. 

that would have been made 

contemporaneously in prior periods.17

Question 4: Upon becoming a public 

entity, what disclosures should 

Company A consider in addition to 

those prescribed by FASB ASC Topic 

718? 18

Interpretive Response: In the 

registration statement filed on January 2, 

20X8, Company A should clearly 

describe in MD&A the change in 

accounting policy that will be required 

by FASB ASC Topic 718 in subsequent 

periods and the reasonably likely 

material future effects.19 In subsequent 

filings, Company A should provide 

financial statement disclosure of the 

effects of the changes in accounting 

policy. In addition, Company A should 

consider the applicability of SEC 

Release No. FR–60 20 and Section V, 

‘‘Critical Accounting Estimates,’’ in SEC 

Release No. FR–72 21 regarding critical 

accounting policies and estimates in 

MD&A. 

C. Valuation Methods 

FASB ASC paragraph 718–10–30–6 

(Compensation—Stock Compensation 

Topic) indicates that the measurement 

objective for equity instruments 

awarded to employees is to estimate at 

the grant date the fair value of the equity 

instruments the entity is obligated to 

issue when employees have rendered 

the requisite service and satisfied any 

other conditions necessary to earn the 

right to benefit from the instruments. 

The Topic also states that observable 

market prices of identical or similar 

equity or liability instruments in active 

markets are the best evidence of fair 

value and, if available, should be used 

as the basis for the measurement for 

equity and liability instruments 

awarded in a share-based payment 

transaction with employees.22 However, 

if observable market prices of identical 

or similar equity or liability instruments 

are not available, the fair value shall be 

estimated by using a valuation 

technique or model that complies with 

the measurement objective, as described 

in FASB ASC Topic 718.23

Question 1: If a valuation technique or 

model is used to estimate fair value, to 

what extent will the staff consider a 

company’s estimates of fair value to be 

materially misleading because the 

estimates of fair value do not 

correspond to the value ultimately 

realized by the employees who received 

the share options? 

Interpretive Response: The staff 

understands that estimates of fair value 

of employee share options, while 

derived from expected value 

calculations, cannot predict actual 

future events.24 The estimate of fair 

value represents the measurement of the 

cost of the employee services to the 

company. The estimate of fair value 

should reflect the assumptions 

marketplace participants would use in 

determining how much to pay for an 

instrument on the date of the 

measurement (generally the grant date 

for equity awards). For example, 

valuation techniques used in estimating 

the fair value of employee share options 

may consider information about a large 

number of possible share price paths, 

while, of course, only one share price 

path will ultimately emerge. If a 

company makes a good faith fair value 

estimate in accordance with the 

provisions of FASB ASC Topic 718 in 

a way that is designed to take into 

account the assumptions that underlie 

the instrument’s value that marketplace 

participants would reasonably make, 

then subsequent future events that affect 

the instrument’s value do not provide 

meaningful information about the 

quality of the original fair value 

estimate. As long as the share options 

were originally so measured, changes in 

an employee share option’s value, no 

matter how significant, subsequent to its 

grant date do not call into question the 

reasonableness of the grant date fair 

value estimate. 

Question 2: In order to meet the fair 

value measurement objective in FASB 

ASC Topic 718, are certain valuation 

techniques preferred over others? 

Interpretive Response: FASB ASC 

paragraph 718–10–55–17 clarifies that 

the Topic does not specify a preference 

for a particular valuation technique or 

model. As stated in FASB ASC 

paragraph 718–10–55–11 in order to 

meet the fair value measurement 

objective, a company should select a 

valuation technique or model that (a) is 

applied in a manner consistent with the 

fair value measurement objective and 

other requirements of FASB ASC Topic 

718, (b) is based on established 

principles of financial economic theory 

and generally applied in that field and 

(c) reflects all substantive characteristics 

of the instrument. 

The chosen valuation technique or 

model must meet all three of the 

requirements stated above. In valuing a 

particular instrument, certain 

techniques or models may meet the first 

and second criteria but may not meet 

the third criterion because the 

techniques or models are not designed 

to reflect certain characteristics 

contained in the instrument. For 

example, for a share option in which the 

exercisability is conditional on a 

specified increase in the price of the 

underlying shares, the Black-ScholesMerton closed-form model would not 

generally be an appropriate valuation 

model because, while it meets both the 

first and second criteria, it is not 

designed to take into account that type 

of market condition.25

Further, the staff understands that a 

company may consider multiple 

techniques or models that meet the fair 

value measurement objective before 

making its selection as to the 

appropriate technique or model. The 

staff would not object to a company’s 

choice of a technique or model as long 

as the technique or model meets the fair 

value measurement objective. For 

example, a company is not required to 

use a lattice model simply because that 

model was the most complex of the 

models the company considered. 

Question 3: In subsequent periods, 

may a company change the valuation 

technique or model chosen to value 

instruments with similar 

characteristics? 26

Interpretive Response: As long as the 

new technique or model meets the fair 

value measurement objective as 

described in Question 2 above, the staff 

would not object to a company changing 

its valuation technique or model.27 A 

change in the valuation technique or 

model used to meet the fair value 


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28FASB ASC paragraph 718–10–55–27. 

29See generally FASB ASC paragraph 718–10– 

50–1. 

30FASB ASC paragraph 718–10–55–4. 

31FASB ASC paragraph 718–10–50–2. 

32FASB ASC paragraph 718–10–55–35. 

33FASB ASC paragraph 718–10–55–37. 

34FASB ASC paragraph 718–10–55–40. 

35 Ibid. 

36 Implied volatility is the volatility assumption 

inherent in the market prices of a company’s traded 

options or other financial instruments that have 

option-like features. Implied volatility is derived by 

entering the market price of the traded financial 

instrument, along with assumptions specific to the 

financial options being valued, into a model based 

on a constant volatility estimate (e.g., the BlackScholes-Merton closed-form model) and solving for 

the unknown assumption of volatility. 

37The staff believes implied volatility derived 

from embedded options can be utilized in 

determining expected volatility if, in deriving the 

implied volatility, the company considers all 

relevant features of the instruments (e.g., value of 

the host instrument, value of the option, etc.). The 

staff believes the derivation of implied volatility 

from other than simple instruments (e.g., a simple 

convertible bond) can, in some cases, be 

impracticable due to the complexity of multiple 

features. 

38See FASB ASC paragraph 718–10–55–37. 

39For purposes of this staff accounting bulletin, 

the phrase ‘‘expected or contractual term, as 

applicable’’ has the same meaning as the phrase 

‘‘expected (if using a Black-Scholes-Merton closedform model) or contractual (if using a lattice model) 

term of an employee share option.’’ 

measurement objective would not be 

considered a change in accounting 

principle. As such, a company would 

not be required to file a preferability 

letter from its independent accountants 

as described in Rule 10–01(b)(6) of 

Regulation S–X when it changes 

valuation techniques or models.28

However, the staff would not expect that 

a company would frequently switch 

between valuation techniques or 

models, particularly in circumstances 

where there was no significant variation 

in the form of share-based payments 

being valued. Disclosure in the 

footnotes of the basis for any change in 

technique or model would be 

appropriate.29

Question 4: Must every company that 

issues share options or similar 

instruments hire an outside third party 

to assist in determining the fair value of 

the share options? 

Interpretive Response: No. However, 

the valuation of a company’s share 

options or similar instruments should 

be performed by a person with the 

requisite expertise. 

D. Certain Assumptions Used in 

Valuation Methods 

FASB ASC Topic 718’s 

(Compensation—Stock Compensation 

Topic) fair value measurement objective 

for equity instruments awarded to 

employees is to estimate the grant-date 

fair value of the equity instruments that 

the entity is obligated to issue when 

employees have rendered the requisite 

service and satisfied any other 

conditions necessary to earn the right to 

benefit from the instruments.30 In order 

to meet this fair value measurement 

objective, management will be required 

to develop estimates regarding the 

expected volatility of its company’s 

share price and the exercise behavior of 

its employees. The staff is providing 

guidance in the following sections 

related to the expected volatility and 

expected term assumptions to assist 

public entities in applying those 

requirements. 

The staff understands that companies 

may refine their estimates of expected 

volatility and expected term as a result 

of the guidance provided in FASB ASC 

Topic 718 and in sections (1) and (2) 

below. Changes in assumptions during 

the periods presented in the financial 

statements should be disclosed in the 

footnotes.31

1. Expected Volatility 

FASB ASC paragraph 718–10–55–36 

states, ‘‘Volatility is a measure of the 

amount by which a financial variable, 

such as share price, has fluctuated 

(historical volatility) or is expected to 

fluctuate (expected volatility) during a 

period. Option-pricing models require 

an estimate of expected volatility as an 

assumption because an option’s value is 

dependent on potential share returns 

over the option’s term. The higher the 

volatility, the more the returns on the 

share can be expected to vary—up or 

down. Because an option’s value is 

unaffected by expected negative returns 

on the shares, other things [being] equal, 

an option on a share with higher 

volatility is worth more than an option 

on a share with lower volatility.’’ 

Facts: Company B is a public entity 

whose common shares have been 

publicly traded for over twenty years. 

Company B also has multiple options on 

its shares outstanding that are traded on 

an exchange (‘‘traded options’’). 

Company B grants share options on 

January 2, 20X6. 

Question 1: What should Company B 

consider when estimating expected 

volatility for purposes of measuring the 

fair value of its share options? 

Interpretive Response: FASB ASC 

Topic 718 does not specify a particular 

method of estimating expected 

volatility. However, the Topic does 

clarify that the objective in estimating 

expected volatility is to ascertain the 

assumption about expected volatility 

that marketplace participants would 

likely use in determining an exchange 

price for an option.32 FASB ASC Topic 

718 provides a list of factors entities 

should consider in estimating expected 

volatility.33 Company B may begin its 

process of estimating expected volatility 

by considering its historical volatility.34

However, Company B should also then 

consider, based on available 

information, how the expected volatility 

of its share price may differ from 

historical volatility.35 Implied 

volatility 36 can be useful in estimating 

expected volatility because it is 

generally reflective of both historical 

volatility and expectations of how 

future volatility will differ from 

historical volatility. 

The staff believes that companies 

should make good faith efforts to 

identify and use sufficient information 

in determining whether taking historical 

volatility, implied volatility or a 

combination of both into account will 

result in the best estimate of expected 

volatility. The staff believes companies 

that have appropriate traded financial 

instruments from which they can derive 

an implied volatility should generally 

consider this measure. The extent of the 

ultimate reliance on implied volatility 

will depend on a company’s facts and 

circumstances; however, the staff 

believes that a company with actively 

traded options or other financial 

instruments with embedded options 37

generally could place greater (or even 

exclusive) reliance on implied volatility. 

(See the Interpretive Responses to 

Questions 3 and 4 below.) 

The process used to gather and review 

available information to estimate 

expected volatility should be applied 

consistently from period to period. 

When circumstances indicate the 

availability of new or different 

information that would be useful in 

estimating expected volatility, a 

company should incorporate that 

information. 

Question 2: What should Company B 

consider if computing historical 

volatility? 38

Interpretive Response: The following 

should be considered in the 

computation of historical volatility: 

1. Method of Computing Historical 

Volatility— 

The staff believes the method selected 

by Company B to compute its historical 

volatility should produce an estimate 

that is representative of Company B’s 

expectations about its future volatility 

over the expected (if using a BlackScholes-Merton closed-form model) or 

contractual (if using a lattice model) 

term 39 of its employee share options. 

Certain methods may not be appropriate 


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40FASB ASC subparagraph 718–10–55–37(a) 

states that entities should consider historical 

volatility over a period generally commensurate 

with the expected or contractual term, as 

applicable, of the share option. Accordingly, the 

staff believes methods that place extreme emphasis 

on the most recent periods may be inconsistent 

with this guidance. 

41 Generalized Autoregressive Conditional 

Heteroskedasticity (‘‘GARCH’’) is an example of a 

method that demonstrates this characteristic. 

42Further, if shares of a company are thinly 

traded the staff believes the use of weekly or 

monthly price observations would generally be 

more appropriate than the use of daily price 

observations. The volatility calculation using daily 

observations for such shares could be artificially 

inflated due to a larger spread between the bid and 

asked quotes and lack of consistent trading in the 

market. 

43FASB ASC paragraph 718–10–55–40 states that 

a company should establish a process for estimating 

expected volatility and apply that process 

consistently from period to period. In addition, 

FASB ASC paragraph 718–10–55–27 indicates that 

assumptions used to estimate the fair value of 

instruments granted to employees should be 

determined in a consistent manner from period to 

period. 

44FASB ASC paragraph 718–10–55–35. 

45FASB ASC paragraph 718–10–55–37. 

46See generally Options, Futures, and Other 

Derivatives by John C. Hull (Prentice Hall, 5th 

Edition, 2003). 

47 Implied volatilities of options differ 

systematically over the ‘‘moneyness’’ of the option. 

This pattern of implied volatilities across exercise 

prices is known as the ‘‘volatility smile’’ or 

‘‘volatility skew.’’ Studies such as ‘‘Implied 

Volatility’’ by Stewart Mayhew, Financial Analysts 

Journal, July-August 1995, have found that implied 

volatilities based on near-the-money options do as 

well as sophisticated weighted implied volatilities 

in estimating expected volatility. In addition, the 

staff believes that because near-the-money options 

are generally more actively traded, they may 

provide a better basis for deriving implied 

volatility. 

48The staff believes a company could use a 

weighted-average implied volatility based on traded 

options that are either in-the-money or out-of-themoney. For example, if the employee share option 

has an exercise price of $52, but the only traded 

options available have exercise prices of $50 and 

Continued 

for longer term employee share options 

if they weight the most recent periods 

of Company B’s historical volatility 

much more heavily than earlier 

periods.40 For example, a method that 

applies a factor to certain historical 

price intervals to reflect a decay or loss 

of relevance of that historical 

information emphasizes the most recent 

historical periods and thus would likely 

bias the estimate to this recent history.41

2. Amount of Historical Data— 

FASB ASC subparagraph 718–10–55– 

37(a) indicates entities should consider 

historical volatility over a period 

generally commensurate with the 

expected or contractual term, as 

applicable, of the share option. The staff 

believes Company B could utilize a 

period of historical data longer than the 

expected or contractual term, as 

applicable, if it reasonably believes the 

additional historical information will 

improve the estimate. For example, 

assume Company B decided to utilize a 

Black-Scholes-Merton closed-form 

model to estimate the value of the share 

options granted on January 2, 20X6 and 

determined that the expected term was 

six years. Company B would not be 

precluded from using historical data 

longer than six years if it concludes that 

data would be relevant. 

3. Frequency of Price Observations— 

FASB ASC subparagraph 718–10–55– 

37(d) indicates an entity should use 

appropriate and regular intervals for 

price observations based on facts and 

circumstances that provide the basis for 

a reasonable fair value estimate. 

Accordingly, the staff believes Company 

B should consider the frequency of the 

trading of its shares and the length of its 

trading history in determining the 

appropriate frequency of price 

observations. The staff believes using 

daily, weekly or monthly price 

observations may provide a sufficient 

basis to estimate expected volatility if 

the history provides enough data points 

on which to base the estimate.42

Company B should select a consistent 

point in time within each interval when 

selecting data points.43

4. Consideration of Future Events— 

The objective in estimating expected 

volatility is to ascertain the assumptions 

that marketplace participants would 

likely use in determining an exchange 

price for an option.44 Accordingly, the 

staff believes that Company B should 

consider those future events that it 

reasonably concludes a marketplace 

participant would also consider in 

making the estimation. For example, if 

Company B has recently announced a 

merger with a company that would 

change its business risk in the future, 

then it should consider the impact of 

the merger in estimating the expected 

volatility if it reasonably believes a 

marketplace participant would also 

consider this event. 

5. Exclusion of Periods of Historical 

Data— 

In some instances, due to a company’s 

particular business situations, a period 

of historical volatility data may not be 

relevant in evaluating expected 

volatility.45 In these instances, that 

period should be disregarded. The staff 

believes that if Company B disregards a 

period of historical volatility, it should 

be prepared to support its conclusion 

that its historical share price during that 

previous period is not relevant to 

estimating expected volatility due to 

one or more discrete and specific 

historical events and that similar events 

are not expected to occur during the 

expected term of the share option. The 

staff believes these situations would be 

rare. 

Question 3: What should Company B 

consider when evaluating the extent of 

its reliance on the implied volatility 

derived from its traded options? 

Interpretive Response: To achieve the 

objective of estimating expected 

volatility as stated in FASB ASC 

paragraphs 718–10–55–35 through 718– 

10–55–41, the staff believes Company B 

generally should consider the following 

in its evaluation: 1) the volume of 

market activity of the underlying shares 

and traded options; 2) the ability to 

synchronize the variables used to derive 

implied volatility; 3) the similarity of 

the exercise prices of the traded options 

to the exercise price of the employee 

share options; and 4) the similarity of 

the length of the term of the traded and 

employee share options.46

1. Volume of Market Activity— 

The staff believes Company B should 

consider the volume of trading in its 

underlying shares as well as the traded 

options. For example, prices for 

instruments in actively traded markets 

are more likely to reflect a marketplace 

participant’s expectations regarding 

expected volatility. 

2. Synchronization of the Variables— 

Company B should synchronize the 

variables used to derive implied 

volatility. For example, to the extent 

reasonably practicable, Company B 

should use market prices (either traded 

prices or the average of bid and asked 

quotes) of the traded options and its 

shares measured at the same point in 

time. This measurement should also be 

synchronized with the grant of the 

employee share options; however, when 

this is not reasonably practicable, the 

staff believes Company B should derive 

implied volatility as of a point in time 

as close to the grant of the employee 

share options as reasonably practicable. 

3. Similarity of the Exercise Prices— 

The staff believes that when valuing 

an at-the-money employee share option, 

the implied volatility derived from at- or 

near-the-money traded options generally 

would be most relevant.47 If, however, 

it is not possible to find at- or near-themoney traded options, Company B 

should select multiple traded options 

with an average exercise price close to 

the exercise price of the employee share 

option.48


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$55, then the staff believes that it is appropriate to 

use a weighted average based on the implied 

volatilities from the two traded options; for this 

example, a 40% weight on the implied volatility 

calculated from the option with an exercise price 

of $55 and a 60% weight on the option with an 

exercise price of $50. 

49The staff believes it may also be appropriate to 

consider the entire term structure of volatility 

provided by traded options with a variety of 

remaining maturities. If a company considers the 

entire term structure in deriving implied volatility, 

the staff would expect a company to include some 

options in the term structure with a remaining 

maturity of six months or greater. 

50The staff believes the implied volatility derived 

from a traded option with a term of one year or 

greater would typically not be significantly different 

from the implied volatility that would be derived 

from a traded option with a significantly longer 

term. 

51FASB ASC paragraphs 718–10–55–36 through 

718–10–55–37. 

52FASB ASC paragraph 718–10–55–35. 

53FASB ASC paragraphs 718–10–55–18 and 718– 

10–55–39 discuss the incorporation of a range of 

expected volatilities into option pricing models. 

The staff believes that a company that utilizes an 

option pricing model that incorporates a range of 

expected volatilities over the option’s contractual 

term should consider the factors listed in FASB 

ASC Topic 718, and those discussed in the 

Interpretive Responses to Questions 2 and 3 above, 

to determine the extent of its reliance (including 

exclusive reliance) on the derived implied 

volatility. 

54When near-the-money options are not 

available, the staff believes the use of a weightedaverage approach, as noted in a previous footnote, 

may be appropriate. 

55See FASB ASC paragraph 718–10–55–38. A 

change in a company’s business model that results 

in a material alteration to the company’s risk profile 

is an example of a circumstance in which the 

company’s future volatility would be expected to 

differ from its past volatility. Other examples may 

include, but are not limited to, the introduction of 

a new product that is central to a company’s 

business model or the receipt of U.S. Food and Drug 

Administration approval for the sale of a new 

prescription drug. 

56 If the expected or contractual term, as 

applicable, of the employee share option is less 

than three years, the staff believes monthly price 

observations would not provide a sufficient amount 

of data. 

57FASB ASC Section 718–10–50. 

58FASB ASC subparagraph 718–10–50–2(f) (2) 

(ii). 

4. Similarity of Length of Terms— 

The staff believes that when valuing 

an employee share option with a given 

expected or contractual term, as 

applicable, the implied volatility 

derived from a traded option with a 

similar term would be the most relevant. 

However, if there are no traded options 

with maturities that are similar to the 

share option’s contractual or expected 

term, as applicable, then the staff 

believes Company B could consider 

traded options with a remaining 

maturity of six months or greater.49

However, when using traded options 

with a term of less than one year,50 the 

staff would expect the company to also 

consider other relevant information in 

estimating expected volatility. In 

general, the staff believes more reliance 

on the implied volatility derived from a 

traded option would be expected the 

closer the remaining term of the traded 

option is to the expected or contractual 

term, as applicable, of the employee 

share option. 

The staff believes Company B’s 

evaluation of the factors above should 

assist in determining whether the 

implied volatility appropriately reflects 

the market’s expectations of future 

volatility and thus the extent of reliance 

that Company B reasonably places on 

the implied volatility. 

Question 4: Are there situations in 

which it is acceptable for Company B to 

rely exclusively on either implied 

volatility or historical volatility in its 

estimate of expected volatility? 

Interpretive Response: As stated 

above, FASB ASC Topic 718 does not 

specify a method of estimating expected 

volatility; rather, it provides a list of 

factors that should be considered and 

requires that an entity’s estimate of 

expected volatility be reasonable and 

supportable.51 Many of the factors listed 

in FASB ASC Topic 718 are discussed 

in Questions 2 and 3 above. The 

objective of estimating volatility, as 

stated in FASB ASC Topic 718, is to 

ascertain the assumption about expected 

volatility that marketplace participants 

would likely use in determining a price 

for an option.52 The staff believes that 

a company, after considering the factors 

listed in FASB ASC Topic 718, could, 

in certain situations, reasonably 

conclude that exclusive reliance on 

either historical or implied volatility 

would provide an estimate of expected 

volatility that meets this stated 

objective. 

The staff would not object to 

Company B placing exclusive reliance 

on implied volatility when the 

following factors are present, as long as 

the methodology is consistently applied: 

• Company B utilizes a valuation 

model that is based upon a constant 

volatility assumption to value its 

employee share options;53

• The implied volatility is derived 

from options that are actively traded; 

• The market prices (trades or quotes) 

of both the traded options and 

underlying shares are measured at a 

similar point in time to each other and 

on a date reasonably close to the grant 

date of the employee share options; 

• The traded options have exercise 

prices that are both (a) near-the-money 

and (b) close to the exercise price of the 

employee share options; 54 and 

• The remaining maturities of the 

traded options on which the estimate is 

based are at least one year. 

The staff would not object to 

Company B placing exclusive reliance 

on historical volatility when the 

following factors are present, so long as 

the methodology is consistently applied: 

• Company B has no reason to believe 

that its future volatility over the 

expected or contractual term, as 

applicable, is likely to differ from its 

past; 55

• The computation of historical 

volatility uses a simple average 

calculation method; 

• A sequential period of historical 

data at least equal to the expected or 

contractual term of the share option, as 

applicable, is used; and 

• A reasonably sufficient number of 

price observations are used, measured at 

a consistent point throughout the 

applicable historical period.56

Question 5: What disclosures would 

the staff expect Company B to include 

in its financial statements and MD&A 

regarding its assumption of expected 

volatility? 

Interpretive Response: FASB ASC 

paragraph 718–10–50–2 prescribes the 

minimum information needed to 

achieve the Topic’s disclosure 

objectives.57 Under that guidance, 

Company B is required to disclose the 

expected volatility and the method used 

to estimate it.58 Accordingly, the staff 

expects that at a minimum Company B 

would disclose in a footnote to its 

financial statements how it determined 

the expected volatility assumption for 

purposes of determining the fair value 

of its share options in accordance with 

FASB ASC Topic 718. For example, at 

a minimum, the staff would expect 

Company B to disclose whether it used 

only implied volatility, historical 

volatility, or a combination of both. 

In addition, Company B should 

consider the applicability of SEC 

Release No. FR–60 and Section V, 

‘‘Critical Accounting Estimates,’’ in SEC 

Release No. FR–72 regarding critical 

accounting policies and estimates in 

MD&A. The staff would expect such 

disclosures to include an explanation of 

the method used to estimate the 

expected volatility of its share price. 

This explanation generally should 

include a discussion of the basis for the 

company’s conclusions regarding the 

extent to which it used historical 

volatility, implied volatility or a 

combination of both. A company could 

consider summarizing its evaluation of 

the factors listed in Questions 2 and 3 

of this section as part of these 

disclosures in MD&A. 

Facts: Company C is a newly public 

entity with limited historical data on the 


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59FASB ASC paragraphs 718–10–55–25 and 718– 

10–55–51. 

60FASB ASC paragraph 718–1055–25. 

61 If a company operates in a number of different 

industries, it could look to several industry indices. 

However, when considering the volatilities of 

multiple companies, each operating only in a single 

industry, the staff believes a company should take 

into account its own leverage, the leverages of each 

of the entities, and the correlation of the entities’ 

stock returns. 

62FASB ASC paragraph 718–10–55–51. 

63FASB ASC paragraph 718–10–55–25. 

64FASB ASC paragraph 718–10–55–37. The staff 

believes that at least two years of daily or weekly 

historical data could provide a reasonable basis on 

which to base an estimate of expected volatility if 

a company has no reason to believe that its future 

volatility will differ materially during the expected 

or contractual term, as applicable, from the 

volatility calculated from this past information. If 

the expected or contractual term, as applicable, of 

a share option is shorter than two years, the staff 

believes a company should use daily or weekly 

historical data for at least the length of that 

applicable term. 

65FASB ASC paragraph 718–10–55–40. 

66The staff notes the existence of academic 

literature that supports the assertion that the BlackScholes-Merton closed-form model, with expected 

term as an input, can produce reasonable estimates 

of fair value. Such literature includes J. Carpenter, 

‘‘The exercise and valuation of executive stock 

options,’’ Journal of Financial Economics, May 

1998, pp.127–158; C. Marquardt, ‘‘The Cost of 

Employee Stock Option Grants: An Empirical 

Analysis,’’ Journal of Accounting Research, 

September 2002, p. 1191–1217); and J. Bettis, J. 

Bizjak and M. Lemmon, ‘‘Exercise behavior, 

valuation, and the incentive effect of employee 

stock options,’’ Journal of Financial Economics, 

forthcoming, 2005. 

price of its publicly traded shares and 

no other traded financial instruments. 

Company C believes that it does not 

have sufficient company specific 

information regarding the volatility of 

its share price on which to base an 

estimate of expected volatility. 

Question 6: What other sources of 

information should Company C 

consider in order to estimate the 

expected volatility of its share price? 

Interpretive Response: FASB ASC 

Topic 718 provides guidance on 

estimating expected volatility for newly 

public and nonpublic entities that do 

not have company specific historical or 

implied volatility information 

available.59 Company C may base its 

estimate of expected volatility on the 

historical, expected or implied volatility 

of similar entities whose share or option 

prices are publicly available. In making 

its determination as to similarity, 

Company C would likely consider the 

industry, stage of life cycle, size and 

financial leverage of such other 

entities.60

The staff would not object to 

Company C looking to an industry 

sector index (e.g., NASDAQ Computer 

Index) that is representative of Company 

C’s industry, and possibly its size, to 

identify one or more similar entities.61

Once Company C has identified similar 

entities, it would substitute a measure of 

the individual volatilities of the similar 

entities for the expected volatility of its 

share price as an assumption in its 

valuation model.62 Because of the 

effects of diversification that are present 

in an industry sector index, Company C 

should not substitute the volatility of an 

index for the expected volatility of its 

share price as an assumption in its 

valuation model.63

After similar entities have been 

identified, Company C should continue 

to consider the volatilities of those 

entities unless circumstances change 

such that the identified entities are no 

longer similar to Company C. Until 

Company C has sufficient information 

available, the staff would not object to 

Company C basing its estimate of 

expected volatility on the volatility of 

similar entities for those periods for 

which it does not have sufficient 

information available.64 Until Company 

C has either a sufficient amount of 

historical information regarding the 

volatility of its share price or other 

traded financial instruments are 

available to derive an implied volatility 

to support an estimate of expected 

volatility, it should consistently apply a 

process as described above to estimate 

expected volatility based on the 

volatilities of similar entities.65

2. Expected Term 

FASB ASC paragraph 718–10–55–29 

states ‘‘The fair value of a traded (or 

transferable) share option is based on its 

contractual term because rarely is it 

economically advantageous to exercise, 

rather than sell, a transferable share 

option before the end of its contractual 

term. Employee share options generally 

differ from transferable [or tradable] 

share options in that employees cannot 

sell (or hedge) their share options—they 

can only exercise them; because of this, 

employees generally exercise their 

options before the end of the options’ 

contractual term. Thus, the inability to 

sell or hedge an employee share option 

effectively reduces the option’s value 

[compared to a transferable option] 

because exercise prior to the option’s 

expiration terminates its remaining life 

and thus its remaining time value.’’ 

Accordingly, FASB ASC Topic 718 

requires that when valuing an employee 

share option under the Black-ScholesMerton framework the fair value of 

employee share options be based on the 

share options’ expected term rather than 

the contractual term. 

The staff believes the estimate of 

expected term should be based on the 

facts and circumstances available in 

each particular case. Consistent with 

our guidance regarding reasonableness 

immediately preceding Topic 14.A, the 

fact that other possible estimates are 

later determined to have more 

accurately reflected the term does not 

necessarily mean that the particular 

choice was unreasonable. The staff 

reminds registrants of the expected term 

disclosure requirements described in 

FASB ASC subparagraph 718–10–50– 

2(f)(2)(i). 

Facts: Company D utilizes the BlackScholes-Merton closed-form model to 

value its share options for the purposes 

of determining the fair value of the 

options under FASB ASC Topic 718. 

Company D recently granted share 

options to its employees. Based on its 

review of various factors, Company D 

determines that the expected term of the 

options is six years, which is less than 

the contractual term of ten years. 

Question 1: When determining the 

fair value of the share options in 

accordance with FASB ASC Topic 718, 

should Company D consider an 

additional discount for nonhedgability 

and nontransferability? 

Interpretive Response: No. FASB ASC 

paragraph 718–10–55–29 indicates that 

nonhedgability and nontransferability 

have the effect of increasing the 

likelihood that an employee share 

option will be exercised before the end 

of its contractual term. Nonhedgability 

and nontransferability therefore factor 

into the expected term assumption (in 

this case reducing the term assumption 

from ten years to six years), and the 

expected term reasonably adjusts for the 

effect of these factors. Accordingly, the 

staff believes that no additional 

reduction in the term assumption or 

other discount to the estimated fair 

value is appropriate for these particular 

factors.66

Question 2: Should forfeitures or 

terms that stem from forfeitability be 

factored into the determination of 

expected term? 

Interpretive Response: No. FASB ASC 

Topic 718 indicates that the expected 

term that is utilized as an assumption in 

a closed-form option-pricing model or a 

resulting output of a lattice option 

pricing model when determining the 

fair value of the share options should 

not incorporate restrictions or other 

terms that stem from the pre-vesting 

forfeitability of the instruments. Under 

FASB ASC Topic 718, these pre-vesting 

restrictions or other terms are taken into 

account by ultimately recognizing 

compensation cost only for awards for 


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67FASB ASC paragraph 718–10–30–11. 

68FASB ASC paragraph 718–10–55–31. 

69The staff believes the focus should be on 

groups of employees with significantly different 

expected exercise behavior. Academic research 

suggests two such groups might be executives and 

non-executives. A study by S. Huddart found 

executives and other senior managers to be 

significantly more patient in their exercise behavior 

than more junior employees. (Employee rank was 

proxied for by the number of options issued to that 

employee.) See S. Huddart, ‘‘Patterns of stock option 

exercise in the United States,’’ in: J. Carpenter and 

D. Yermack, eds., Executive Compensation and 

Shareholder Value: Theory and Evidence (Kluwer, 

Boston, MA, 1999), pp. 115–142. See also S. 

Huddart and M. Lang, ‘‘Employee stock option 

exercises: An empirical analysis,’’ Journal of 

Accounting and Economics, 1996, pp. 5–43. 

70FASB ASC paragraph 718–10–55–13. 

71Historical share option exercise experience 

encompasses data related to share option exercise, 

post-vesting termination, and share option 

contractual term expiration. 

72For example, if a company had historically 

granted share options that were always in-themoney, and will grant at-the-money options 

prospectively, the exercise behavior related to the 

in-the-money options may not be sufficient as the 

sole basis to form the estimate of expected term for 

the at-the-money grants. 

73For example, if a company had a history of 

previous equity-based share option grants and 

exercises only in periods in which the company’s 

share price was rising, the exercise behavior related 

to those options may not be sufficient as the sole 

basis to form the estimate of expected term for 

current option grants. 

74FASB ASC paragraph 718–10–55–30. 

75Employee share options with these features are 

sometimes referred to as ‘‘plain vanilla’’ options. 

76 In this fact pattern the requisite service period 

equals the vesting period. 

77Calculated as [[[1 year vesting term (for the first 

25% vested) plus 2 year vesting term (for the 

second 25% vested) plus 3 year vesting term (for 

the third 25% vested) plus 4 year vesting term (for 

the last 25% vested)] divided by 4 total years of 

vesting] plus 10 year contractual life] divided by 2; 

that is, (((1+2+3+4)/4) + 10)/2 = 6.25 years. 

78 J.N. Carpenter, ‘‘The exercise and valuation of 

executive stock options,’’ Journal of Financial 

Economics, 1998, pp.127–158 studies a sample of 

40 NYSE and AMEX firms over the period 1979– 

1994 with share option terms reasonably consistent 

to the terms presented in the fact set and example. 

The mean time to exercise after grant was 5.83 years 

and the median was 6.08 years. The ‘‘mean time to 

exercise’’ is shorter than expected term since the 

study’s sample included only exercised options. 

Other research on executive options includes (but 

is not limited to) J. Carr Bettis; John M. Bizjak; and 

Michael L. Lemmon, ‘‘Exercise behavior, valuation, 

and the incentive effects of employee stock 

options,’’ forthcoming in the Journal of Financial 

Economics. One of the few studies on nonexecutive 

employee options the staff is aware of is S. Huddart, 

‘‘Patterns of stock option exercise in the United 

States,’’ in: J. Carpenter and D. Yermack, eds., 

Executive Compensation and Shareholder Value: 

Theory and Evidence (Kluwer, Boston, MA, 1999), 

pp. 115–142. 

which employees render the requisite 

service.67

Question 3: Can a company’s estimate 

of expected term ever be shorter than 

the vesting period? 

Interpretive Response: No. The 

vesting period forms the lower bound of 

the estimate of expected term.68

Question 4: FASB ASC paragraph 

718–10–55–34 indicates that an entity 

shall aggregate individual awards into 

relatively homogenous groups with 

respect to exercise and post-vesting 

employment termination behaviors for 

the purpose of determining expected 

term, regardless of the valuation 

technique or model used to estimate the 

fair value. How many groupings are 

typically considered sufficient? 

Interpretive Response: As it relates to 

employee groupings, the staff believes 

that an entity may generally make a 

reasonable fair value estimate with as 

few as one or two groupings.69

Question 5: What approaches could a 

company use to estimate the expected 

term of its employee share options? 

Interpretive Response: A company 

should use an approach that is 

reasonable and supportable under FASB 

ASC Topic 718’s fair value 

measurement objective, which 

establishes that assumptions and 

measurement techniques should be 

consistent with those that marketplace 

participants would be likely to use in 

determining an exchange price for the 

share options.70 If, in developing its 

estimate of expected term, a company 

determines that its historical share 

option exercise experience is the best 

estimate of future exercise patterns, the 

staff will not object to the use of the 

historical share option exercise 

experience to estimate expected term.71

A company may also conclude that its 

historical share option exercise 

experience does not provide a 

reasonable basis upon which to estimate 

expected term. This may be the case for 

a variety of reasons, including, but not 

limited to, the life of the company and 

its relative stage of development, past or 

expected structural changes in the 

business, differences in terms of past 

equity-based share option grants,72 or a 

lack of variety of price paths that the 

company may have experienced.73

FASB ASC Topic 718 describes other 

alternative sources of information that 

might be used in those cases when a 

company determines that its historical 

share option exercise experience does 

not provide a reasonable basis upon 

which to estimate expected term. For 

example, a lattice model (which by 

definition incorporates multiple price 

paths) can be used to estimate expected 

term as an input into a Black-ScholesMerton closed-form model.74 In 

addition, FASB ASC paragraph 718–10– 

55–32 states ‘‘* * * expected term 

might be estimated in some other 

manner, taking into account whatever 

relevant and supportable information is 

available, including industry averages 

and other pertinent evidence such as 

published academic research.’’ For 

example, data about exercise patterns of 

employees in similar industries and/or 

situations as the company’s might be 

used. While such comparative 

information may not be widely available 

at present, the staff understands that 

various parties, including actuaries, 

valuation professionals and others are 

gathering such data. 

Facts: Company E grants equity share 

options to its employees that have the 

following basic characteristics:75

• The share options are granted atthe-money; 

• Exercisability is conditional only on 

performing service through the vesting 

date;76

• If an employee terminates service 

prior to vesting, the employee would 

forfeit the share options; 

• If an employee terminates service 

after vesting, the employee would have 

a limited time to exercise the share 

options (typically 30–90 days); and 

• The share options are 

nontransferable and nonhedgeable. 

Company E utilizes the BlackScholes-Merton closed-form model for 

valuing its employee share options. 

Question 6: As share options with 

these ‘‘plain vanilla’’ characteristics have 

been granted in significant quantities by 

many companies in the past, is the staff 

aware of any ‘‘simple’’ methodologies 

that can be used to estimate expected 

term? 

Interpretive Response: As noted 

above, the staff understands that an 

entity that is unable to rely on its 

historical exercise data may find that 

certain alternative information, such as 

exercise data relating to employees of 

other companies, is not easily 

obtainable. As such, some companies 

may encounter difficulties in making a 

refined estimate of expected term. 

Accordingly, if a company concludes 

that its historical share option exercise 

experience does not provide a 

reasonable basis upon which to estimate 

expected term, the staff will accept the 

following ‘‘simplified’’ method for ‘‘plain 

vanilla’’ options consistent with those in 

the fact set above: expected term = 

((vesting term + original contractual 

term)/2). Assuming a ten year original 

contractual term and graded vesting 

over four years (25% of the options in 

each grant vest annually) for the share 

options in the fact set described above, 

the resultant expected term would be 

6.25 years.77 Academic research on the 

exercise of options issued to executives 

provides some general support for 

outcomes that would be produced by 

the application of this method.78


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79The terminology ‘‘outside the control of the 

issuer’’ is used to refer to any of the three 

redemption conditions described in Rule 5–02.28 of 

Regulation S–X that would require classification 

outside permanent equity. That rule requires 

preferred securities that are redeemable for cash or 

other assets to be classified outside of permanent 

equity if they are redeemable (1) at a fixed or 

determinable price on a fixed or determinable date, 

(2) at the option of the holder, or (3) upon the 

occurrence of an event that is not solely within the 

control of the issuer. 

80FASB ASC paragraphs 718–10–25–6 through 

718–10–25–19. 

81ASR 268, July 27, 1979, Rule 5–02.28 of 

Regulation S–X. 

82Related guidance includes FASB ASC 

paragraph 480–10–S99–3 (Distinguishing Liabilities 

from Equity Topic). 

83FASB ASC paragraph 718–10–35–13 states that 

an instrument ceases to be subject to this Topic 

when ‘‘the rights conveyed by the instrument to the 

holder are no longer dependent on the holder being 

an employee of the entity (that is, no longer 

dependent on providing service).’’ 

84 Instruments granted in conjunction with sharebased payment arrangements with employees that 

do not by their terms require redemption for cash 

or other assets (at a fixed or determinable price on 

a fixed or determinable date, at the option of the 

holder, or upon the occurrence of an event that is 

not solely within the control of the issuer) would 

not be assumed by the staff to require net cash 

settlement for purposes of applying ASR 268 in 

circumstances in which FASB ASC Section 815– 

40–25, Derivatives and Hedging—Contracts in 

Entity’s Own Equity—Recognition, would 

otherwise require the assumption of net cash 

settlement. See FASB ASC paragraph 815–40–25– 

11, which states, in part: ‘‘* * *the events or 

actions necessary to deliver registered shares are 

not controlled by an entity and, therefore, except 

under the circumstances described in FASB ASC 

paragraph 815–40–25–16, if the contract permits the 

entity to net share or physically settle the contract 

only by delivering registered shares, it is assumed 

that the entity will be required to net cash settle the 

contract.’’ See also FASB ASC subparagraph 718– 

10–25–15(a). 

85 Depending on the fact pattern, this may be 

recorded as common stock and additional paid in 

capital. 

Examples of situations in which the 

staff believes that it may be appropriate 

to use this simplified method include 

the following: 

• A company does not have sufficient 

historical exercise data to provide a 

reasonable basis upon which to estimate 

expected term due to the limited period 

of time its equity shares have been 

publicly traded. 

• A company significantly changes 

the terms of its share option grants or 

the types of employees that receive 

share option grants such that its 

historical exercise data may no longer 

provide a reasonable basis upon which 

to estimate expected term. 

• A company has or expects to have 

significant structural changes in its 

business such that its historical exercise 

data may no longer provide a reasonable 

basis upon which to estimate expected 

term. 

The staff understands that a company 

may have sufficient historical exercise 

data for some of its share option grants 

but not for others. In such cases, the 

staff will accept the use of the 

simplified method for only some but not 

all share option grants. The staff also 

does not believe that it is necessary for 

a company to consider using a lattice 

model before it decides that it is eligible 

to use this simplified method. Further, 

the staff will not object to the use of this 

simplified method in periods prior to 

the time a company’s equity shares are 

traded in a public market. 

If a company uses this simplified 

method, the company should disclose in 

the notes to its financial statements the 

use of the method, the reason why the 

method was used, the types of share 

option grants for which the method was 

used if the method was not used for all 

share option grants, and the periods for 

which the method was used if the 

method was not used in all periods. 

Companies that have sufficient 

historical share option exercise 

experience upon which to estimate 

expected term may not apply this 

simplified method. In addition, this 

simplified method is not intended to be 

applied as a benchmark in evaluating 

the appropriateness of more refined 

estimates of expected term. 

Also, as noted above in Question 5, 

the staff believes that more detailed 

external information about exercise 

behavior will, over time, become readily 

available to companies. As such, the 

staff does not expect that such a 

simplified method would be used for 

share option grants when more relevant 

detailed information becomes widely 

available. 

E. FASB ASC Topic 718, 

Compensation—Stock Compensation, 

and Certain Redeemable Financial 

Instruments 

Certain financial instruments awarded 

in conjunction with share-based 

payment arrangements have redemption 

features that require settlement by cash 

or other assets upon the occurrence of 

events that are outside the control of the 

issuer.79 FASB ASC Topic 718 provides 

guidance for determining whether 

instruments granted in conjunction with 

share-based payment arrangements 

should be classified as liability or equity 

instruments. Under that guidance, most 

instruments with redemption features 

that are outside the control of the issuer 

are required to be classified as 

liabilities; however, some redeemable 

instruments will qualify for equity 

classification.80 SEC Accounting Series 

Release No. 268, Presentation in 

Financial Statements of ‘‘Redeemable 

Preferred Stocks,’’ 81 (‘‘ASR 268’’) and 

related guidance 82 address the 

classification and measurement of 

certain redeemable equity instruments. 

Facts: Under a share-based payment 

arrangement, Company F grants to an 

employee shares (or share options) that 

all vest at the end of four years (cliff 

vest). The shares (or shares underlying 

the share options) are redeemable for 

cash at fair value at the holder’s option, 

but only after six months from the date 

of share issuance (as defined in FASB 

ASC Topic 718). Company F has 

determined that the shares (or share 

options) would be classified as equity 

instruments under the guidance of 

FASB ASC Topic 718. However, under 

ASR 268 and related guidance, the 

instruments would be considered to be 

redeemable for cash or other assets upon 

the occurrence of events (e.g., 

redemption at the option of the holder) 

that are outside the control of the issuer. 

Question 1: While the instruments are 

subject to FASB ASC Topic 718,83 is 

ASR 268 and related guidance 

applicable to instruments issued under 

share-based payment arrangements that 

are classified as equity instruments 

under FASB ASC Topic 718? 

Interpretive Response: Yes. The staff 

believes that registrants must evaluate 

whether the terms of instruments 

granted in conjunction with share-based 

payment arrangements with employees 

that are not classified as liabilities under 

FASB ASC Topic 718 result in the need 

to present certain amounts outside of 

permanent equity (also referred to as 

being presented in ‘‘temporary equity’’) 

in accordance with ASR 268 and related 

guidance.84

When an instrument ceases to be 

subject to FASB ASC Topic 718 and 

becomes subject to the recognition and 

measurement requirements of other 

applicable GAAP, the staff believes that 

the company should reassess the 

classification of the instrument as a 

liability or equity at that time and 

consequently may need to reconsider 

the applicability of ASR 268. 

Question 2: How should Company F 

apply ASR 268 and related guidance to 

the shares (or share options) granted 

under the share-based payment 

arrangements with employees that may 

be unvested at the date of grant? 

Interpretive Response: Under FASB 

ASC Topic 718, when compensation 

cost is recognized for instruments 

classified as equity instruments, 

additional paid-in-capital 85 is 

increased. If the award is not fully 

vested at the grant date, compensation 

cost is recognized and additional paidin-capital is increased over time as 

services are rendered over the requisite 


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17284 Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 

86The potential redemption amount of the share 

option in this illustration is its intrinsic value 

because the holder would pay the exercise price 

upon exercise of the option and then, upon 

redemption of the underlying shares, the company 

would pay the holder the fair value of those shares. 

Thus, the net cash outflow from the arrangement 

would be equal to the intrinsic value of the share 

option. In situations where there would be no cash 

inflows from the share option holder, the cash 

required to be paid to redeem the underlying shares 

upon the exercise of the put option would be the 

redemption value. 

87FASB ASC Topic 718 does not identify a 

specific line item in the income statement for 

presentation of the expense related to share-based 

payment arrangements. 

88 [Original footnote removed by SAB 114.] 

89 [Original footnote removed by SAB 114.] 

90 [Original footnote removed by SAB 114.] 

91 [Original footnote removed by SAB 114.] 

92 [Original footnote removed by SAB 114.] 

93 [Original footnote removed by SAB 114.] 

94FASB ASC paragraph 718–10–25–2. 

service period. A similar pattern of 

recognition should be used to reflect the 

amount presented as temporary equity 

for share-based payment awards that 

have redemption features that are 

outside the issuer’s control but are 

classified as equity instruments under 

FASB ASC Topic 718. The staff believes 

Company F should present as temporary 

equity at each balance sheet date an 

amount that is based on the redemption 

amount of the instrument, but takes into 

account the proportion of consideration 

received in the form of employee 

services. Thus, for example, if a 

nonvested share that qualifies for equity 

classification under FASB ASC Topic 

718 is redeemable at fair value more 

than six months after vesting, and that 

nonvested share is 75% vested at the 

balance sheet date, an amount equal to 

75% of the fair value of the share should 

be presented as temporary equity at that 

date. Similarly, if an option on a share 

of redeemable stock that qualifies for 

equity classification under FASB ASC 

Topic 718 is 75% vested at the balance 

sheet date, an amount equal to 75% of 

the intrinsic 86 value of the option 

should be presented as temporary equity 

at that date. 

Question 3: Would the methodology 

described for employee awards in the 

Interpretive Response to Question 2 

above apply to nonemployee awards to 

be issued in exchange for goods or 

services with similar terms to those 

described above? 

Interpretive Response: See Topic 14.A 

for a discussion of the application of the 

principles in FASB ASC Topic 718 to 

nonemployee awards. The staff believes 

it would generally be appropriate to 

apply the methodology described in the 

Interpretive Response to Question 2 

above to nonemployee awards. 

F. Classification of Compensation 

Expense Associated with Share-Based 

Payment Arrangements 

Facts: Company G utilizes both cash 

and share-based payment arrangements 

to compensate its employees and 

nonemployee service providers. 

Company G would like to emphasize in 

its income statement the amount of its 

compensation that did not involve a 

cash outlay. 

Question: How should Company G 

present in its income statement the noncash nature of its expense related to 

share-based payment arrangements? 

Interpretive Response: The staff 

believes Company G should present the 

expense related to share-based payment 

arrangements in the same line or lines 

as cash compensation paid to the same 

employees.87 The staff believes a 

company could consider disclosing the 

amount of expense related to sharebased payment arrangements included 

in specific line items in the financial 

statements. Disclosure of this 

information might be appropriate in a 

parenthetical note to the appropriate 

income statement line items, on the 

cash flow statement, in the footnotes to 

the financial statements, or within 

MD&A. 

G. Removed by SAB 114 88,89

H. Removed by SAB 114 90,91,92,93

I. Capitalization of Compensation Cost 

Related to Share-Based Payment 

Arrangements 

Facts: Company K is a manufacturing 

company that grants share options to its 

production employees. Company K has 

determined that the cost of the 

production employees’ service is an 

inventoriable cost. As such, Company K 

is required to initially capitalize the cost 

of the share option grants to these 

production employees as inventory and 

later recognize the cost in the income 

statement when the inventory is 

consumed.94

Question: If Company K elects to 

adjust its period end inventory balance 

for the allocable amount of share-option 

cost through a period end adjustment to 

its financial statements, instead of 

incorporating the share-option cost 

through its inventory costing system, 

would this be considered a deficiency in 

internal controls? 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 76, No. 59 / Monday, March 28, 2011 / Rules and Regulations 17285 

95Release No. 34–47986, June 5, 2003, 

Management’s Report on Internal Control Over 

Financial Reporting and Certification of Disclosure 

in Exchange Act Period Reports. 

96 [Original footnote removed by SAB 114.] 

97 [Original footnote removed by SAB 114.] 

98 [Original footnote removed by SAB 114.] 

99 [Original footnote removed by SAB 114.] 

100 [Original footnote removed by SAB 114.] 

101 [Original footnote removed by SAB 114.] 

102 [Original footnote removed by SAB 114.] 

103 [Original footnote removed by SAB 114.] 

104 [Original footnote removed by SAB 114.] 

105 [Original footnote removed by SAB 114.] 

106 [Original footnote removed by SAB 114.] 

Interpretive Response: No. FASB ASC 

Topic 718, Compensation—Stock 

Compensation, does not prescribe the 

mechanism a company should use to 

incorporate a portion of share-option 

costs in an inventory-costing system. 

The staff believes Company K may 

accomplish this through a period end 

adjustment to its financial statements. 

Company K should establish 

appropriate controls surrounding the 

calculation and recording of this period 

end adjustment, as it would any other 

period end adjustment. The fact that the 

entry is recorded as a period end 

adjustment, by itself, should not impact 

management’s ability to determine that 

the internal control over financial 

reporting, as defined by the SEC’s rules 

implementing Section 404 of the 

Sarbanes-Oxley Act of 2002,95 is 

effective. 

J. Removed by SAB 114 96 97 98

K. Removed by SAB 114 99 100 101 102 103

L. Removed by SAB 114 104 105 106

M. Removed by SAB 114 

[FR Doc. 2011–5584 Filed 3–25–11; 8:45 am] 

BILLING CODE 8011–01–P 


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