The Accounting Onion

Proposed ASU No. EITF100D – Helping Big Pharma Score Bullseyes on Its Earnings Targets

A couple of weeks ago, I concocted a cautionary tale for undergraduate students out of Proposed ASU No. EITF100F, which dealt with the accounting for a health insurer's legal costs arising from malpractice cases. If you are looking for a slightly more advanced case study, you should check out Proposed ASU No. EITF100D, Other Expenses (Topic 720): Fees Paid to the Federal Government by Pharmaceutical Manufacturers (a consensus of the FASB Emerging Issues Task Force). The problem is slightly more nuanced, but the proposed 'solution' is even more astounding. As I have mentioned before, a telltale sign that the fix is in is when application by analogy of an EITF consensus to similar circumstances is streng verboten.

A Somewhat Simplified Fact Pattern*

Company ABC is a manufacturer of flu vaccine and its fiscal year ends on December 31^st. Sales are extremely seasonal; approximately 20% generally occur in the company's third quarter, and the remaining sales occur in the fourth quarter. As a publically traded company, ABC issues quarterly reports for the first three quarters of its fiscal year, and an annual report at the end of the year. [Note: I made sales seasonal to simplify implementation in the first year; there is no loss of generality thereby.]

Health care legislation enacted during the third quarter of 2010 imposes an annual fee on branded prescription pharmaceutical manufacturers. The structure of the fee, and its effect on ABC, is as follows:

• The fee (technically, an excise tax) owed by each pharmaceutical manufacturer is to be announced in January of each year beginning in 2011; it is payable each March 31.
• Congress structured the program to raise "aggregate fees" from all pharmaceutical manufacturers of $2.5 billion in 2011, $2.8 billion in 2012 and 2013, $3 billion in 2014, 2015 and 2016, $4 billion in 2017, $4.1 billion in 2018, and $2.8 billion in both 2019 and years thereafter.
• The aggregate fee for a given year is apportioned among pharmaceutical manufacturers in proportion to the amount of each company's "covered sales taken into account" during the previous calendar year made to specified government programs (e.g., Medicare, Medicaid, military programs, etc.) in the previous year. The ratio of a company's covered sales taken into account and the corresponding total amount for the industry is term a company's "market share."
• For simplicity, we will assume ABC sells its flu vaccine only to the government programs specified by the new legislation.
• ABC's "covered sales" in 2010 were $250 million, calculated in the following table (all amounts stated in millions of dollars):

Statutory Scale	Covered Sales	Percentage of Sales Taken into Account	Covered Sales Taken Into Account
Up to $100	$100.0	20%	$ 20.0
More than $100	$460.0	50%	$230.0
Total Sales Taken Into Account			$250.0

 

• The aggregate industry sales taken into account across all pharmaceutical manufacturers for 2010 was $10 billion; therefore, ABC's market share of covered sales taken into account was 2.5% (=$250 million/$10 billion).
• Thus, ABC's pharmaceuticals fee payable on March 31, 2011 is $6,250,000 (=2.5% x $2.5 billion).

Question: How should ABC account for the fees it owes from its sales made in 2010?

The Common Sense Approach

While the situation is somewhat unusual, I don't think that a student would have any trouble applying general accrual accounting rules. A rudimentary solution would look like this:

• Let's say that $70 million worth of sales actually occurred in the third quarter of 2010. ABC should estimate its market share of covered sales assuming no further 2010 sales would occur, and accrue the appropriate amount of fees. If the estimated fees were $1 million, then ABC would make the following journal entry on September 30, 2010: debit "fee expense" for $1 million; and credit "fees payable" for the same amount.
• On December 31, 2010, ABC would undertake similar procedures. Assuming that the total amount of fees payable as of that date were estimated to be $6 million, it would the expense for $5 million; and credit the payable for the same amount.
• When ABC learns, in January 2011, that the precise amount of fees owed for 2010's sales is $6.25 million, it would debit the expense for an additional $0.25 million and credit the payable for the same amount.

Why should the EITF want to get involved if a conceptually valid and consistent solution were so easily obtained? Moreover, ABC could avail itself of the option in the interim reporting standards (ASC Topic 270) to normalize expenses of this nature. For example, those rules permit the accrual of bonuses in the early quarters of the year, even though they might not become earned and payable until the fourth quarter. In this particular case, third quarter sales look overly profitable compared to fourth quarter sales; this is due to the progressive nature of the excise 'tax rate.'

Well, dear students, the EITF did insert itself into this issue, and this is how their proposal would apply to the fact pattern I have provided you:

• Even though the fees were incurred in 2010, the EITF says that ABC may not recognize them until they become "payable." To the EITF, this means that the fees for the first year under the new law don't become payable until 2011. A pretty strange definition of "payable," don't you think?
• Accordingly, in January 2011, ABC would debit an asset, "deferred fees" for $6.25 million; and credit fees payable for the same amount. The deferred fees would generally be amortized to expense on a straight-line basis over 2011.

Wow. Even though the fees were incurred from making sales in 2010, the fee expense won't be recognized until 2011. That's practically cash basis accounting, since ABC won't be writing its check to the government until 2011 -- and that's the way the actual law works.

Moreover, the "balance sheet" view of accounting that the FASB professes adherence to is thrown out the window. The deferred fee account will be classified as an asset on the balance sheet, even though it doesn't meet the definition of an asset. (While it is true that there won't be a deferred fee "asset" on the year-end balance sheet of calendar fiscal year companies, there will be such an "asset" on every other balance sheet.)

What's the Point?

Why has the EITF proposed such a prosaic solution to a simple problem that any intermediate accounting student should be able to solve from application of the basic rules of accrual accounting? The answer, as is all too often the case, is that some powerful group of preparers is unwilling to apply the simple answer. The right accounting would require estimates, and those particular estimates will add unpredictably to the reported earnings of pharmaceutical manufacturers. In a nutshell, managers hate missing their quarterly EPS targets. It hurts the company's share price, they think, and that really hurts the value of their stock options, restricted stock and cash performance bonuses.  

I have to say that I really can't relate to the way the EITF thinks about accounting problems. What will they think of next? I doubt if it will be investors.

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*The facts of the case have been simplified from a description provided by the law firm of Foley Hoag LLP, available at: http://www.foleyhoag.com/NewsCenter/Publications/Alerts/Healthcare/Healthcare-Alert_032410.aspx.

Proposed ASU No. EITF100F: Health Care Entities Can Choose Their Poison

If you are teaching an accounting class, here's a simple and timely (I'll explain why, later) assignment for your students:

Facts: Company XYZ is a manufacturer that is being sued by a person claiming that she was injured from using one of XYZ's products. XYZ has retained outside counsel for the purpose of mounting a legal defense, which is expected to take at least two years.

Question: How should the legal defense costs be accounted for by XYZ: (A) record the legal costs as an expense when they are incurred; or (B) accrue the total legal costs expected to be incurred over the duration of the litigation as of the date the claim has been incurred?

When I was teacher, I would ask my students to forget about rules to start with, and to consider only what general principles would suggest as the most appropriate accounting treatment. Consequently, if one believed that it would be a cardinal sin to accrue a liability if the conceptual definition of a liability were not met, and expected future legal costs don't meet that definition, then the appropriate accounting for the above fact pattern should be fairly obvious—Option A, from above.

Unfortunately, you don't get to that answer under GAAP for public companies. Back in the late 90's, the Emerging Issues Task Force was asked to consider roughly the same fact pattern as the one above, and they declined to provide an answer—to a question that well-trained Accounting 101 student should be able to answer. However, the "SEC Observer" did deign to enter the following comment into the EITF's meeting minutes:

"The SEC Observer noted that the SEC staff would expect a registrant's accounting policy to be applied consistently and that APB Opinion No. 22, Disclosure of Accounting Policies, requires disclosure of material accounting policies and the methods of applying those policies.

In other words, 'Take your pick between Option A and Option B; but if you should ever decide to change, you'll need to pay your auditor for a preferability letter.'

This is my reconstruction of the events that caused such a silly state to come to be. First, the EITF knew that if they were to add the issue to their agenda, their only non-ridiculous response would have been to disallow accrual of future legal costs (Option B); but that would have gored a whole herd of oxen, so they decided to take a pass.

Second, the SEC Observer, could not let sleeping dogs lie, because the SEC's policy is to provide interpretive guidance to registrants when they have legitimate questions about the accounting for legitimate fact patterns. Notwithstanding its willingness to provide assistance, the Staff operates under a self-imposed constraint; it must avoid infringing upon the FASB's franchise to make new GAAP. Thus, the Staff Observer had little choice but to merely state the obvious, which is that absent specific guidance in GAAP, the treatment of litigation costs is an accounting policy choice.

That's Old News. Here's What's New

The reason I have raised this question now is because the pot has been stirred once again. During the EITF's recent deliberations on some other health care-related issue, the question of legal costs of malpractice claims arose. The problem to be dealt with was that, some time ago, the AICPA issued an Audit and Accounting Guide for health care entities, which provided that expected future legal costs must be accrued at the time of a malpractice claim (i.e., Option B). How it came to pass that the AAG would change the accounting for health care entities only, I'm not sure. But it eventually found its way into the Accounting Standards Codification (954-450-25-2).

So, the EITF came to be faced with three choices: (1) let it be; (2) make it right—i.e., give a principles-based response; or (3) grant health care companies the same options for managing their financial statements that any other entity has. There is no way that I would be writing this post if the EITF settled on (1) or (2). They chose (3), of course, as formally issued in an Exposure Draft (Proposed ASU No. EITF100F), Health Care Entities (Topic 954): Accounting for Legal Costs Associated with Medical Malpractice and Similar Claims (a consensus of the FASB Emerging Issues Task Force).

It is often the case that the "basis for conclusions" section of an exposure draft is more revealing for the absence of discussion than its presence as regards to key points of contention. I regret to report that this is one of those cases. The basis for conclusions section has a few hundred words to it, but they say absolutely nothing about how the conclusions reached are justified by the supporters of the exposure draft. Specifically, there is nothing about whether the definition of a liability is met under Option B, and there is nothing about whether providing a free choice to health care companies enhances the quality of industry GAAP or GAAP in general.

And, if you are wondering how the ED would affect convergence with IFRS, there is nothing about that either. That's because the provisions of the exposure draft would actually move GAAP further from IFRS.

Each exposure draft issued nowadays contains a separate section entitled, "How Do the Proposed Provisions Compare with IFRS?" This one states:

"IFRS does not provide any specific guidance on the accrual of legal fees." [italics supplied]

The word "specific" is critical to the truthiness of that statement, because IFRS clearly does not permit Option B, even though there is no "specific" statement to that effect. Unlike the FASB's concepts statements, which are explicitly not GAAP, the IASB's conceptual framework is an integral component of IFRS. Since the definition of a liability in the IFRS framework is virtually identical to the FASB's definition, the treatment of legal costs from defending a malpractice claim is clear: charge to expense as incurred (i.e., Option A).

So that, boys and girls, is how accounting standard setting really works. No accounting problem is simple once the EITF gets its hands on it. But, perhaps there is some consolation to be derived from the fact that two of the FASB's members (Bob Herz and Leslie Seidman) have noted their dissent from the exposure draft. Unfortunately, they did so only on the grounds that more free choices to issuers is the kind of thing the Board has been trying to curtail.

Even the courageous dissenters could not bring themselves to acknowledge the elephant in the room: that discretionary legal costs expected to be incurred in the future do not meet the conceptual definition of a liability.

ASU 2010-19: When a Dollar of Cash Is More Than a Dollar on the Balance Sheet

If you think you can find a larger wart on the backside of US GAAP than the one I am about to describe, then give it your best shot.

Here it is in a nutshell: a careful and cynical application of the foreign currency accounting rules (either US GAAP or IFRS) could result in a $10 million bank account balance being reported on the balance sheet at $25 million. That's right: balance sheet cash isn't the cash balance. I double dare you to top that one!

As you may have guessed, the rules I am referring to are part of FAS 52, Foreign Currency Translation (now Topic 830 of the Codification), which was finalized by a 4-3 vote. They have sat there unremarked upon for thirty years, until relatively recently as negative economic developments in Venezuela have elevated them from a few ounces of cream cheese on a bagel to six tons of chopped liver on a Ritz cracker.

So, into the muck gingerly wades the SEC with new guidance in the form of a staff announcement at a recent meeting of the Emerging Issues Task Force. The FASB has codified that guidance with the issuance of ASU 2010-19. As you'll see, the SEC's message to investors is ambivalent, to say the least, on an issue that is as black and white as it gets.

Setting the Stage for the Big Whopper

You may wish to refer to a related post, which I wrote almost 3 years ago, and in which I described how consolidated financial statements could actually report foreign exchange gains and losses on U.S. dollars. Here's an example from that post, albeit slightly tweaked, to set the stage for the whopper to come.

Alpha Co. is based in the U.S. and presents its financial statements in U.S. dollars (USD). Beta is Alpha's Venezuelan subsidiary, and its functional currency is the local currency of Venezuela, the Bolivar (VEB). Inflation has been high in Venezuela in recent years. For this reason, Beta holds its cash balances, worth $10 million, in USD-denominated accounts. Also, as a result of the high rate of inflation, the VEB has been steadily devaluing against the USD.

For simplicity, let's assume that the cash balances I mentioned are Beta's only asset. Under normal circumstances, this is the way that consolidation of Beta with Alpha would work:

1. The USD cash balances held by Beta would be "remeasured" into VEBs; the resulting gain (because the VEB is losing value) would be reported on Beta's income statement (in VEBs).
2. Beta's VEB financial statements (including the gain on holding USDs in Venezuela) would be "translated" to dollars for the purpose of consolidating Beta's financial statements with Alpha's.
3. The effects of the "translation" process on equity would be reported in a separate "translation adjustment" category, which would not affect income.

Thus, although total owners' equity does not change from the roundtrip that the USD is taking in the accounting records — USD Þ VEB (on the sub's books) Þ USD (in the consolidated financial statements) — the gain from the outbound leg of the trip would be reported in income, but the loss from the homeward leg would bypass the income statement and only be reported in a separate component of owners' equity, i.e., the so-called "translation adjustment."

Of course, it's a ludicrous outcome buttressed by extremely flimsy logic, but I have already beaten that drum. Here comes the whopper I've been fixin' to tell you about.

The Dual Exchange Rate Problem

Even if you absolutely detest the effect of FAS 52's remeasurement/translate procedures on reported earnings, there is the small consolation that cash (and other monetary items) are correctly stated—even after their round trip. However, this is not always the case for two reasons: (1) currency exchange controls by the country in which a foreign subsidiary is located; and (2) more bad accounting rules.

As to those currency exchange controls, they can result in multiple exchange rates. Here, for example, is how the SEC staff, in ASU 2010-19, describes the current situation in Venezuela:

"[C]urrent restrictions of foreign currency exchange in Venezuela provide that entities use the official rate of exchange to exchange funds.... As an alternative to the use of the official rate it may also be legal to utilize the parallel rate. It is possible that the parallel rate provides entities with a more liquid exchange and entities can access the parallel rate using a series of transactions via a broker."

When multiple exchange rates exist, US GAAP may permit the use of one of those exchange rates for remeasurement (per ASC 830-20-30-1, the "current rate of exchange") and another for translation (per ASC 830-30-45-6, the "dividends remittance rate"). Thus spake the SEC staff on these provisions as they apply to Venezuelan operations:

"[T]he staff has recently become aware that... certain entities may have used the parallel rate to remeasure certain US dollar denominated balances that the Venezuelan subsidiary held and then subsequently translated the Venezuelan subsidiary's assets, liabilities, and operations using the official rate. The effect of this accounting treatment resulted in reported balances in an entity's financial statements that differed from their underlying US dollar denominated values."

 [For example,] assume that at a period end … a U.S. entity's Venezuelan subsidiary held $10 million of cash denominated in U.S. dollars. Further assume that at the end of the period, the parallel rate was 5 Bolivars to every 1 U.S. dollar and the official rate was 2 Bolivars to every 1 U.S. dollar. Upon the remeasurement of the U.S. denominated cash to Bolivars and the subsequent translation of the Venezuelan subsidiary's financial statements, an entity would have reported cash of $25 million for financial reporting purposes. [Italics supplied]

 

Finally, after 30 years of sitting on its hands, the SEC has acknowledged the insanity of using one rate for remeasurement and another for translation: among other crazy things, $10 million in cash is transformed to $25 million on the balance sheet—with a hefty income statement gain in the process (due to the declining VEB).

Unfortunately, though, the SEC's solution is to soft pedal. If you're in Venezuela, but nowhere else, kindly provide some additional disclosures. Everybody else: you can keep doing that thing you do with multiple exchange rates. To all you investors out there, take comfort in knowng that the EITF, staffed with your good friends from the Big Four, has this 30-year-old emerging issue on its agenda; they'll know how to make things right—eventually.

I expect the SEC would respond that their longstanding policy is to stay away from overriding FASB rules until the Board has had its chance to fix a problem—no matter how insane and damaging those rules may be. My response is: that's not even close to good enough.  The feeling I'm left with is that the SEC, in ASU 2010-19, is conducting the orchestra with a wet noodle instead of a baton.

To help see why I think that the SEC's response is inadequate, let's try look at the problem from an auditor's perspective; or stated another way, how an investor should have expected an auditor to have resolved these kinds of problems as they arose. Let's imagine that an issuer shows the auditor the GAAP rules that lead to an actual $10 million in cash being reported as a fictitious $25 million; and the auditor perforce concludes that the issuer adhered to the letter of those rules. The auditor knows that the client's balance sheet is materially misleading: is there nothing more to be done?

For the answer to that question, I refer to Interpretation 203-1 of the AICPA's Code of Professional Conduct, Departures from Established Accounting Principles, which states as follows:

"[I]n the establishment of accounting principles it is difficult to anticipate all of the circumstances to which such principles might be applied. This rule therefore recognizes that upon occasion there may be unusual circumstances where the literal application of pronouncements on accounting principles would have the effect of rendering financial statements misleading. In such cases, the proper accounting treatment is that which will render the financial statements not misleading." [italics supplied]

 

If Interpretation 203-1 is anything more than hot air, then surely it must be invoked by an auditor faced with the now-codified Venezuela fact pattern. Never happened and never will, you say? Conclusion: Interpretation 203-1 is hot air.

Surely, when looking to the FASB for accounting standards, the SEC must hold itself and the Board to a standard that meets or exceeds the minimum (albeit nominal) ethical responsibilities of CPAs. In applying those standards to ASU 2010-19, I can only conclude that once again, little more than hot air has been produced.  If a GAAP rule fails to report dollars sitting in a bank account on the balance sheet according to their bank balances, that rule must be so arbitrary that it cannot be anything but misleading.  I cringe at the fact that such a rule is referred to by people who should know better as "accounting."   

 Chief Accountant Kroeker, I challenge you to find me an uglier wart in GAAP than this one. If you won't act decisively, and with the integrity expected of all CPAs, to repair dysfunctional rules that materially misstate cash no less, then kindly explain to investors what exactly it is that you are doing.

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?