Institutions

Restructured Loans. The staff expressed their view that the actual form of restructuring troubled loans should not affect the registrant's accounting for or disclosures regarding them. The staff cited the following examples.

Example 1: A registrant has a loan receivable and has established an appropriate SFAS 5 reserve. The registrant enters into an SFAS 15 troubled debt restructuring. The restructured debt instrument may have the characteristics of a marketable debt security. The staff believes that a change from a loan agreement to an investment security should not affect the accounting or disclosure requirements. Any SFAS 5 reserve would carry over to the restructured debt instrument, and thus the investment would be carried at an amount reduced by the reserve. If the loss is other than temporary a new cost basis would be established.

Example 2: A lender has entered into a troubled debt restructuring that carves up one loan agreement into two or three pieces. One or two of the loan agreements are fully performing market rate loans and the residual loan is a zero coupon financial instrument with an equity kicker. The residual loan is, in substance, the "risk" element of the restructured arrangement. The staff believes that in this situation, SFAS 15 should be considered for the total arrangement. The staff emphasized that it would look at the aggregate of the individual pieces to determine whether or not the projected cash flows would be sufficient to cover the combined carrying amount. The actual splitting of the loan and/or the actual form of the documentation should not affect the accounting or disclosure.

Disclosures of Nonaccrual Loans. The staff indicated that because of increases in nonaccrual loans resulting from the current economic environment, it may be necessary for registrants to provide supplemental information to adequately disclose material aspects of the nonaccrual loan portfolio. The staff indicated that Industry Guide 3, Statistical Disclosure by Bank Holdings Companies, specifically, Instruction (4) of Item C1, "Risk Elements," provides guidance for the type of disclosures that may be required. That guidance states, "... supplemental disclosures may be made to facilitate understanding of the aggregate amounts reported. These disclosures may include, for example, information as to the nature of the loans, guarantees, extent of collateral, or amounts in process of collection." The staff stated they will focus on financial institutions' disclosures, and if the MD&A and Guide 3 disclosures do not appear to be adequate, they may request that the registrant defend their adequacy.

The staff also indicated that when there has been an SFAS 15 debt restructuring with a loan split (as discussed above) and there was an appropriate charge-off prior to or contemporaneously with the restructuring, a registrant may consider putting the market rate loan back on accrual status and not classify it as non-performing as long as the loan has been adjusted to fair value.

Debt and Equity Securities Held as Assets. The staff indicated that when the carrying value of an equity or debt security is in excess of market value, an analysis should be made as to whether the decline is temporary. Guidance that should be considered includes SAB 59, Noncurrent Marketable Equity Securities, and SFAS 12, Accounting for Certain Marketable Securities.

When evaluating whether a decline in value is temporary, a registrant should consider whether a specific adverse condition, such as a general decline in the marketplace, has occurred that would indicate the decline is other than temporary. In addition, when the registrant believes the decline is temporary, there should be persuasive evidence to support that position.

The staff plans to focus on those situations where the carrying value is in excess of market value, regardless of whether the financial instruments are debt or equity securities, and they may request supplemental information to support a registrant's accounting.

ADC Arrangements Classified as Investments. The staff discussed income recognition to the extent of third-party investment in ADC arrangements classified as investments. The staff referred to paragraph 34 of SOP 78-9, Investments in Real Estate Ventures, which sets forth limitations on recognition of income from loans and advances to a venture. As part of the initial determination of whether a loan qualifies as an ADC arrangement, the registrant must determine whether there is sufficient investment by the borrower to consider the lending arrangement a loan. If there is little or no equity, the registrant should classify the ADC arrangement as an investment in real estate. Once a loan is classified as an investment, it would be inconsistent to conclude that there is sufficient equity for third parties to absorb losses, and income recognition to the extent of third-party interests would not be appropriate.

The staff also indicated that when there is an ADC arrangement classified as an investment, additional loans made under that arrangement should be similarly classified. If there is collateral independent of the original loan's collateral, i.e., not a second or third lien, then the institution should follow the guidance in paragraph 34 of SOP 78-9 to determine whether income recognition is appropriate.

The staff also discussed a situation where two loans were made to a single borrower. The significant loan was structured to qualify as an ADC loan under the current guidance. The less significant loan would have substantially all of the characteristics of an ADC investment. The staff indicated that in those situations, the ADC arrangement classification should be applied to the aggregated advances.

Impairment of Long-Lived Assets

Tangible Assets. The staff cited examples as to when the value of a business's assets may be impaired:

* A substantial reduction in the fair value of assets due to technological changes;

* Historical negative cash flows from operations; and

* A significant change in the manner in which the assets are used.

A writedown of the assets should be recorded when it is probable that the estimated undiscounted future cash flows will be less than the net book value of the business's tangible assets. The staff will also accept, but not require, recognition of impairments, based on discounted future cash flows from operations. In addition, the staff emphasized that pursuant to SAB 67, Income Statement Presentation of Restructuring Charges, any writedown resulting from an impairment should be presented as an operating charge.

The staff believes that disclosure of a potential writedown is required in the notes to the financial statements and MD&A if a registrant determines it is reasonably possible that the undiscounted future cash flows will be less than the net book value of the tangible assets.

Write-off of Goodwill. The staff cited a registrant who wanted to write off goodwill resulting from a recent business combination. The staff indicated that pursuant to APB Opinion 17, Intangible Assets, this is not appropriate unless a significant event has occurred, or the environment in which the business operates has changed significantly, which would suggest that the intangible asset has been impaired.

The need to consider a writedown of goodwill may exist in the situation where an acquired business has a history of operating losses and the registrant projects that the business will continue to incur operating losses in the foreseeable future. The staff stated that:

* When an analysis is made to determine whether there is an impairment of goodwill, the analysis should not be made on a consolidated basis but on the basis of the operations of the individual entity to which the goodwill relates;

* Impairment of goodwill and a change in period of goodwill amortization are two separate issues and should be analyzed separately; and

* It would generally be inappropriate to lengthen the period of amortization of goodwill, once established at an acquisition date.

The staff reemphasized that amortization of intangibles, including goodwill, should be classified in the income statement as an operating expense. The staff cited footnote 9 of SFAS 14, Financial Reporting for Segments of a Business Enterprise, which indicates that amortization expense is deducted in determining the operating profit of the industry segment.

Pre-opening costs

The staff members discussed a limited situation in which they may not object to the deferral of direct pre-opening costs that can be recovered from future revenues. Generally, this would be appropriate only in industries that have a history of deferring pre-opening costs, such as the hospitality industry, where the registrant has an established track record and the amortization period does not exceed two or three years. The staff further mentioned that they most likely would object to the deferral of pre-opening costs for a new line of business or if a company did not have previous operating profits.

Revenue Recognition

General. The staff reemphasized a variety of positions on revenue recognition:

* If a buyer has the right to return a product, the provisions of SFAS 48, Revenue Recognition When Right of Return Exists, should be followed.

* When there is a right by a customer to cancel the sale, revenue recognition is not appropriate. Examples cited by the staff include 1) situations when the customer has the ability to discuss the sales agreement with an attorney; and 2) the customer has the ability to search for a better sales price or to obtain regulatory approval.

* When there are rebates to customers, such as those common in the automobile industry, rebates should be accounted for similarly to sales returns under SFAS 48.

The staff also discussed situations in which the customary terms of sale are extended to accommodate the deteriorating financial condition of the buyer:

* When there is continuing involvement on the part of the seller, such as financing provided by the seller or financing guaranteed by the seller, the registrant should consider whether revenue recognition is appropriate.

* When the buyer makes an insignificant down payment, the registrant should consider whether the buyer has made an adequate commitment to make the ultimate payment, especially in a weakened economy. If collection is not reasonably assured and the uncollectible portion cannot be reasonably estimated, revenue recognition may not be appropriate.

Software. The staff stated their position on revenue recognition and software contracts that have fixed and nonrefundable fees.

Example: A registrant has a one-year contract with a distributor that contains a $1 million minimum nonrefundable fee/royalty, regardless of the number of units sold.

For any unit sold in excess of a specific number, additional royalties are paid. At the end of the year, the distributor has not sold units in excess of the minimum number contained in the contract and enters into a new one-year contract. The software company agrees to apply a portion of the $1 million fee to the new contract.

In these circumstances, the staff believes that the $1 million nonrefundable fee/royalty in substance is not a fixed and nonrefundable fee and should not be recognized in the first year of the contract; revenue should be recognized as units are shipped.

Equity Transactions

Redeemable Securities. The staff indicated that the provisions of ASR 268, Redeemable Securities, should be applied to any security that has characteristics that are similar to redeemable preferred stock described in that release. Probability of redemption is not a factor in determining whether a redeemable security should be classified as permanent equity.

The staff cited two examples of situations where they have not required redeemable securities to be classified in the "mezzanine."

Example 1: An issuer has an unconditional obligation or right to satisfy any redemption obligation through the issuance of permanent equity securities, or the issuer may have the right to limit the redemption to proceeds received from an offering of permanent equity.

Example 2: The registrant has issued stock to an officer or director that can be put back to the registrant upon the death of the officer, and the registrant is the beneficiary of a life insurance policy that would fund the redemption. If the registrant has recorded an asset in its financial statements related to the net cash surrender value of the life insurance, an equal amount of permanent equity should be reclassified in the mezzanine.

The staff reiterated their position on accretion of redeemable securities. If the redemption is based on attainment of some market value, the security must be marked to market every balance sheet date. If redemption is based on a contingent event, such as a change in control, then probability should determine when to accrete.

Environmental Costs

The staff emphasized that they believe the professional literature is clear that, generally, environmental preservation costs should be expensed. The criteria specified in EITF Consensus 90-8, Capitalization of Costs To Treat Environmental Contamination, must be met to capitalize such costs. The EITF consensus should not be applied to other situations not contemplated within its scope.

In determining when these costs should be accrued and disclosed, the criteria and guidance set forth in SFAS 5, Accounting for Contingencies, should be utilized. The staff also cited APB Opinion 21, Interest on Receivables and Payables, and SAB 62, Discounting by Property-Casualty Insurance Companies, as precluding discounting of contingencies unless payment dates are both fixed and determinable.

R&D Arrangements

The staff members discussed their positions on when enhancements to products could be capitalized. Significant enhancements to a product should be expensed as R&D in accordance with SFAS 2, Accounting for Research and Development Costs.

The staff made the following additional observations:

* As a general rule, R&D should be expensed. However, property and equipment or inventory that will be used in future R&D can be capitalized whether purchased or acquired in a business combination.

* If a registrant has a firm commitment to perform under an R&D arrangement and the funding is inadequate, a loss should be recognized currently. In addition, the disclosures related to such contracts set forth in the Audit Guide, Audits of Federal Government Contractors, should be made.

Bankruptcy Filings

The staff stated that bankruptcy does not relieve a registrant from the reporting requirements under the 1934 Act. The staff has previously allowed modifications of the requirements under certain circumstances. They cited, as an example, the granting of an exemption from an audit due to cost, and they accepted reports that were submitted to the bankruptcy court in lieu of audited financial statements. The staff pointed out, however, that as a general rule this type of exemption will not be granted if the request is made subsequent to the due date of the required filing. If the filing date of the Form 10-K has passed, the staff will not consider modifications to the reporting requirements.

The staff emphasized that it will not grant a complete waiver of the reporting requirements under any circumstances.

Significant Subsidiary Test

The staff expressed their views regarding various factors that should be considered when determining whether an entity meets the significant subsidiary tests under Rule 1.02(v), Significantly Subsidiary, of Regulation S-X.

The staff believes that contingent consideration in a business combination should be included in the evaluation of whether an acquired business is a "significant subsidiary." The staff uses the criterion of "reasonably possible" and not "probable" when determining whether to include contingent consideration in the test.

The staff also discussed the aggregation of individually insignificant acquisitions. When evaluating the aggregate significance of individually entities, separate calculations should be performed for profitable entities and those with losses. Each separate group is then measured against the consolidated totals.

When applying the significant subsidiary test for foreign acquisitions, the staff indicated that they would expect the calculation to be based on U.S. GAAP information. If the foreign company's financial statements are in that country's GAAP, the test should be applied after adjusting the financial statements to U.S. GAAP.

The staff indicated that in situations in which receivables are not being purchased, the receivables amount should be included in the test calculations because working capital will be required on a going-forward basis.

Reverse Acquisitions and Shell

Companies

The staff described the following facts and circumstances:

* Company A is a publicly held blind pool shell with no substantial operations;

* Company B is a privately held operating company; and

* Company B acquires Company A in a reverse acquisition to become public.

In these circumstances, the financial statements of Company B become the preacquisition financial statements. The stockholders' equity of Company B should be retroactively restated to reflect the equivalent number of shares that were deemed to be issued by Company B in the transaction. In addition, EPS should be retroactively restated for all periods presented.