The Accounting Onion

EITF 96-15: Godzilla and Frankenstein's Love Child

As I was researching a question for a client a couple of weeks ago, I happened upon a love child of two of my pet peeve accounting standards:

• FAS 115 (marketable securities) – especially the part permitting available-for-sale (AFS) classification;

• FAS 52 (foreign currency translation) – practically every word of it makes my blood boil.

I have written a number of posts on FAS 52, and this one here hits the basics, should you feel the need to get canned up on the topic before reading further.

The love child I speak of is EITF 96-15, Accounting for the Effects of Changes in Foreign Currency Exchange Rates on Foreign-Currency-Denominated Available-for-Sale Debt Securities. Based on the title, it obviously deals with an interaction between FAS 52 and FAS 115. But, as to why it was issued three years after FAS 115 is an interesting question. For every crime committed with accounting standards against investors there is some other special interest being served. In this case, I can only guess at what it was, because the EITF issue summaries gave no hint as to how this bee got under their bonnets.

U.S. companies with foreign subsidiaries are generally reluctant to repatriate excess cash from their subsidiaries if negative tax effects attach to the decision. While waiting for a more opportune time to bring the cash back to the mother ship, they have to figure out where to park it; and one strategy is to invest it in marketable securities issued by other companies based in the U.S. From a risk management perspective, at least the money is invested in dollars. However, as I'm about to explain, earnings-obsessed managers might shy away from that choice, even if it is clearly the right thing to do from an economic standpoint.

FAS 52 has many generous elements, but it is relatively demanding in the area of "foreign currency transactions," which, simply stated, are receivables and payables denominated in a currency other than the entity's functional (foreign) currency. Normally, the effect of translating from the subsidiary's functional currency to dollars gets carried into the translation adjustment without affecting income. However, (with certain limited exceptions) the translation of "foreign currency transactions" must be reflected in income. (I have written about this in a previous post, here.)

The question addressed in EITF 96-15 is whether a marketable debt security designated as available-for-sale is a foreign currency transaction. That sounds like a serious question, but it's actually quite ridiculous. Notice that the EITF is not questioning whether marketable debt securities designated as "trading," or designated as "held-to-maturity" are foreign currency transactions – but only those debt securities that are arbitrarily and capriciously designated by management to be AFS. Knowing only that ought to tell you that the fix was in before the first word of debate had been uttered.

The way I thought about the issue before I did my research was, if I must say so myself, perfectly straightforward. First, an AFS marketable debt security is still at bottom a receivable; some arbitrary AFS designation doesn't change that.  Second, FAS 52 is crystal clear as to the treatment of a receivable: it's a foreign currency transaction.

Notwithstanding the obvious, the EITF arrived at the opposite conclusion. By quasi-Talmudic logic that can only be fully appreciated by those ordained to be accounting policy makers, the EITF established a new record for the figurative hop, skip and jump that lead them to conclude that a marketable debt security designated as available-for-sale would not be a "monetary item" – whatever that has to do with the price of tea in China. Anyway, since only monetary items like receivables and payables qualify to be foreign currency transactions, an AFS marketable debt security cannot be one of them.

Eureka! Gold made from copper! In other words, make a loan marketable, arbitrarily and capriciously designate it as AFS to unmake its monetary item characteristics, and presto change-o, you no longer have to worry about income statement exposure. Do you remember the running gag on Late Nite with Conan O'Brien called "if they mated"?  That's EITF 96-15: two wierdos, FAS 52 and FAS 115, matched by a funny guy to beget horrible looking thing that only a CPA could love.

Prior to EITF 96-15, an earnings-obsessed manager might have chosen to invest excess cash in marketable equity securities despite the additional economic risks relative to investing in debt, because the accounting risks happened to be low. That's because marketable equity securities are not receivables; by the perversity of the way FAS 52 converts foreign currencies to dollars, marketable securities might as well be equipment or inventory. Paradoxically, investing in debt would have created income statement volatility, even though economic risks would be lower than by investing in equities.

The clearly evident purpose of the EITF was to create a discretionary safe haven for excess foreign currency. Whether you think that is a good thing or not, it is not my point. What should be clear is that it is for reasons like this the accounting oligarchs deigned to create the grand ole EITF in the first place: to do whatever it takes to spice the sausage we call GAAP to managers' tastes.

FSP APB 14-a: How Long Should it Take to Close a Loophole the Size of Arthur Andersen?

APB 14 was promulgated in 1969 when we were still pretty much in the dark ages with respect to the valuation of derivative financial instruments.  The Opinion addressed two issues, one of them being the accounting for convertible debt. Since the debt features were inseparable from the option to obtain shares (i.e., you gave up the right to the debt payments if you exercised the option to receive shares), separate accounting for the debt and equity features could not simultaneously value both components of this particular hybrid financial instrument. 

Thus, the APB found it in their hearts to allow that convertible debt would be accounted for as if it were straight debt--so long as the debt features were not set at nominal levels.  The rule was chicken salad for companies, for to account separately for the debt and equity components of convertible debt would have meant reporting interest expense at higher rates. 

Apparently, though, the earnings game knows no bounds, as CFOs soon began to tinker with the features of their convertible debt with the objective of circumventing the recognition of potential EPS dilution that could result from additional share issuance.  Eventually, the EITF 'jumped on their bandwagon in EITF 90-19 by conveniently making a bogus connection between cash-settled and equity-settled convertible debt.  But, as I just explained, the APB's justification for single instrument accounting was that if you exercise the option, you lose the cash; but, in a cash-settled option you don't have to give up cash to get the value of the shares. Notwithstanding that annoying detail, the EITF allowed that cash-settled equity conversion options, and variations thereof, could also be accounted for as a single debt instrument, and to sweeten the deal, would also be given more favorable EPS treatment than equity-settled convertible debt.   

"Questions Were Raised" ... "Mistakes Were Made"

Now, 17 years later, here is what the FASB has to say about EITF 90-19:

"Because of the proliferation of such instruments in the marketplace over the past several years, questions were raised [how beautiful the passive voice!] as to whether the accounting guidance in Issue 90-19 appropriately reflected the economics of those instruments." (Proposed FSP APB 14-a, para. B2)

Are we to believe that the EITF, FASB and SEC were unaware of these "questions" 17 years ago? The EITF was tasked earlier this year to finally take their chicken salad off the menu, but evidently they couldn't bring themselves to be the ones to deprive their constituency (basically, the clients of the large audit firms) of something that tasted so good, and could be swallowed practically without chewing.  So, the FASB gave its staff the dirty work, and the result is proposed FSP APB 14-a (in other words, it's not yet a done deal).   

The Even Bigger Issue that Keeps Me Blogging

Ed Teach of CFO.com has written a fine article explaining that separate accounting for the debt and equity features will be required, with the result being that reported interest expense will increase and EPS will decrease by adding shares to the denominator of the diluted EPS calculation.  Ed closes the article by quoting a bigwig investment banker lamenting that the new FSP would effectively put an end to cash-settled convertible debt. 

That last part really gets me. A popular tactic of 'financial management' owed its existence to a bad accounting rule.  Where have I heard this before? What portion of the productivity of enterprising managers has been wasted in self-interested quests to devise financial arrangements whose sole or main benefit is the exploitation of accounting rules that have been tailor-made for exploitation? 

In too many cases, the FASB and SEC should be held to account for the vast destruction of capital that has occurred by allowing abuses like this one to go on for far too long.  In addition to cash-settled securities, examples that easily come to mind are defined benefit pension plans, executive stock options, so-called 'special purpose entities,' ill-conceived mergers and acquisitions, ad nauseum.

Sadly, I don't anticipate that I will be running out of topics to blog about anytime soon.

EITF 07-1: Can a Good Accounting Rule Drive Out a Bad One?

It seems that business practice tends toward greater exploitation of opportunities for collaboration over time.  On a personal note, it has been said that people don't choose to become professors because they are smart, but because they couldn't play nicely (i.e., collaborate) with other children. 

My own neuroses aside, the first standard on the accounting for collaborative arrangements, APB 18, was the subject of one of my earlier rants--I mean posts.  EITF 07-1, Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property, is a recent and interesting sequel to APB 18. 

Setting the Stage for Evaluating EITF 07-1 

At the risk of appearing to re-invent the wheel, I'll start with a broad look at collaboration itself. It seems that there are two kinds:  (1) financial arrangements to provide capital (i.e., wealth or risk transfer), and (2) operational arrangements to use capital effectively (i.e., wealth creation).  There is no dearth of detailed accounting rules governing financial collaborations, with the multi-tentacled 'Liabilities and Equity' project being just the latest example.  However, operational collaborations have not received near the same attention, despite their prominence and importance to investors.

As EITF 07-1 is about operational collaboration (my term, not theirs), let's go deeper into that concept; it seems that there are two ways to operate a business: with and without collaboration.  Here's a list, including annotations of related accounting rules, to illustrate what I mean:

• Operating modes not involving collaboration
  • Develop a product, purchase equipment and inventory, pay salaries and overhead, sell finished goods. (All of the rules you were introduced to in Accounting 101)
  • Acquire a controlling interest in another company that will take over, or complement, one or more business functions. (FAS 94, FAS 141, FAS 142, FIN 46(R))
• Operating collaboratively
  • Acquire a stake in another company that is less than controlling, but large enough to be able to influence its operations in ways that can benefit your own. (APB 18)
  • Acquire a stake in a joint venture (JV) that will do part of the work.  No investor in the JV can act without the permission of the other venturers. (The AICPA has impaled JVs with APB 18.)
  • Retain an agent, compensated with commissions, to help you sell or buy inventory. (EITF 99-19 provides guidance to determine whether you should accounting for a transaction as an agent or as a principal.)
  • Contract with another company to divide up the work. (EITF 07-1)

EITF 07-1,considers four related issues:

1. What constitutes a collaborative arrangement for the purpose of the new rule about to be created?  This is a fence-building exercise for the purpose of preventing encroachment on the scope of other standards and practices--mainly APB 18.  It would not be necessary to do so if the FASB were to take instead a way overdue fresh look at collaborative arrangements.  But, for the purpose of this post, the following example of a collaborative arrangement will suffice:
   
   Company A, having secured patents for a new product, collaborates with Company B, which has a manufacturing facility and an established distribution channel.  The companies have entered into an agreement whereby A will perform the development activities and B will perform the commercialization activities.  All revenues and costs would be split equally.
2. Reporting costs incurred and revenues generated by the collaborators from transactions with third parties.  This is the issue (hereinafter, Issue 2) that I will focus on.


3. Reporting revenues and expenses generated by a collaborator from transactions with other collaborators.  This is an important issue, but not as important as Issue 2 in terms of examining how EITF 07-1 affects the tenor of the accounting for collaborative arrangements.


4. Disclosure. 

The EITF's tentative consensus on Issue 2 is that, unless one party is acting as an agent for the other (see EITF 99-19), each party records its share of expenses and revenues separately on their income statement. 

Get to the Point!

The tentative consensus on Issue 2 makes sense.  That means they contradict the nonsensical presentation provisions of APB 18.  Under APB 18, each collaborating party would report its share of revenues and expenses net, and not gross as would be required by EITF 07-1.  In other words, the legal form of the collaboration (whether or not the collaboration is housed in its own legal entity), and not its commercial substance, will dictate presentation.  This is especially curious since the stated reason for the EITF taking up the issue was to achieve greater uniformity. 

Finally, take note that EITF 07-1 has not yet been ratified by the FASB.  I wonder if they have considered the implications of the issue on APB 18 as I have.  If so, do they care?