Accounting Alert 07-5

April 13, 2007

Introduction

This Accounting Alert supplements Accounting Alert 07-4 ¹ to:

· Present the SEC staff’s concerns, expressed in a meeting with the large accounting firms, about the financial reporting for the adoption of FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, in conjunction with certain strategies involving a plan to sell financial assets or extinguish financial liabilities for which the fair value option was elected (a “sale strategy”).

· Elaborate on a strategy involving the extinguishment of callable debt (an “extinguishment strategy”).

· Expand on disclosures that will help users of financial statements understand these strategies and their impact on the financial statements.

The SEC staff has expressed concern that certain proposed accounting for a sale and/or extinguishment strategy results in financial reporting that is not transparent.

Background

Statement 159 permits entities to make an irrevocable election to carry almost any financial instrument at fair value. Upon the effective date (or early adoption date) of Statement 159, when an entity elects to apply the fair value option to specific items, the entity reports the difference between the items’ carrying value and their fair value as a cumulative-effect adjustment to the opening balance of retained earnings.

One sale strategy being considered by entities involves financial assets and works as follows:

· At the adoption date, management elects the fair value option for financial assets with unrealized losses that have not been recognized in earnings (e.g., available-for-sale or held-to-maturity securities). The unrealized losses at adoption will be recognized as a component of the cumulative-effect adjustment to beginning retained earnings.

· Soon after the adoption date, management sells the financial assets for which the fair value option was elected upon adoption.

· Management uses the proceeds from the sale to purchase other financial assets that will not be accounted for at fair value with changes in fair value currently reported in earnings.

A similar extinguishment strategy relating to financial liabilities involves the following steps:

· At the adoption date, management elects the fair value option for callable debt whose carrying value is less than the call price and fair value of the debt and currently requires a coupon that is above the current market rate. The unrealized loss between the fair value and carrying value of the debt is recognized as a component of the cumulative-effect adjustment to the opening balance of retained earnings.

· Soon after the adoption date, management calls and extinguishes the debt.

· Management obtains the proceeds necessary to extinguish the previous debt by issuing new debt. The new debt has a lower coupon than the previous debt and will not be accounted for at fair value.

A common concern with these strategies is that soon after it makes the fair value election upon adoption of Statement 159, the reporting entity derecognizes the financial asset or financial liability optionally carried at fair value, and if the financial asset or liability is replaced, it is replaced with an item that will not be accounted for at fair value.²

In particularly egregious cases, the replacement financial assets or financial liabilities may be the same as or substantially similar to those subjected to the fair value option upon adoption that were subsequently sold or extinguished. In these cases, the entity is in a similar economic position before adoption and after the purchase or issuance of the same or similar financial instruments, but:

1. It has recognized a loss as a cumulative-effect adjustment in beginning retained earnings which will never be recognized in earnings.

2. It may increase, for financial reporting purposes, its earnings in future periods because of higher yields on replacement investment assets or lower coupons on replacement debt.

3. On an ongoing basis it will not, despite electing the fair value option, account for financial assets or financial liabilities at fair value under Statement 159 with changes recognized in earnings after completion of the sale or extinguishment strategy.

Such transactions may not meet Statement 159 objectives such as increased use of fair value for measuring financial instruments.

Accounting Considerations

The SEC staff has not yet expressed a view on the accounting for any registrant’s specific sale or extinguishment strategy. However, it has advised that if, in conjunction with the adoption of Statement 159, an entity plans to employ a sale or extinguishment strategy such as those described above, a registrant should examine whether its accounting is consistent with the objective and spirit of Statement 159. For instance, some of these strategies may raise questions about whether the purpose of adopting Statement 159 and electing the fair value option for certain financial assets or financial liabilities is to avoid recognizing unrealized losses in income rather than to measure financial assets or financial liabilities at fair value in future periods. The SEC staff has indicated it may question financial reporting that does not appear consistent with the objectives or spirit of Statement 159.

Disclosure Considerations

The SEC staff stressed that if the accounting for a sale or extinguishment strategy is appropriate, disclosures to provide sufficient transparency to users should be made. As indicated in Accounting Alert 07-4, management may need to go beyond the disclosures required by Statement 159. Among the many disclosures required by Statement 159 are the following:

· For items existing at the effective date of Statement 159, a schedule that presents the following by line item in the statement of financial position:

o The pretax portion of the cumulative-effective adjustment to retained earnings (or appropriate classes of net assets) for items on that line.

o The fair value at the effective date of eligible items for which the fair value option is elected and the carrying amount of those same items immediately before election of the fair value option (paragraph 27(a)).

· Management’s reasons for electing a fair value option for each eligible item or group of similar eligible items (paragraphs 18(a) and 27(c)).

· If the fair value option is elected for some but not all eligible items within a group of similar eligible items:

o A description of those similar items and the reasons for partial election.

o Information to enable users to understand how the group of similar items relates to individual line items on the statement of financial position (paragraph 18(b) and 27(d)).

Additional disclosures such as the following will help investors better understand the sale and/or extinguishment strategy, its connection to the adoption of Statement 159, and its impact on the financial statements, thus providing increased financial statement transparency:³

1. A description of the sale and/or extinguishment strategy, including an explanation of why financial assets were sold and how soon they were sold after the election of the fair value option (or why financial liabilities were extinguished and how soon they were called after the election of the fair value option).

2. Information about how the proceeds from the sale of the financial assets were used and if new financial assets were purchased, whether those assets are similar to the assets sold and how the purchased assets will be measured in the future (or if new debt was issued to extinguish the previous debt, whether the terms were similar and how the new debt will be subsequently measured).

3. A statement that the entity will report enhanced yields on its portfolio (or decreased expense on its debt) in future periods as a result of adopting the sale and/or extinguishment strategy, even though the entity’s financial position, from an economic perspective, remains largely unchanged before and after the adoption of the sale and/or extinguishment strategy.

4. The amount of the unrealized loss recognized in the cumulative-effect adjustment related to assets and liabilities that are part of a sale and/or extinguishment strategy.

Other Accounting Considerations

As also indicated in Accounting Alert 07-4, if management employs a sale strategy that involves the sale of financial assets after the end of a financial reporting period, management should consider whether those assets were impaired and whether the loss should have been reported in earnings of the prior period. For example, if at year-end management does not have the intent to hold securities to recovery because it may elect the fair value option upon adoption of Statement 159 and sell these securities in a future period, those securities would be considered other-than-temporarily impaired at year-end.

Corporate Governance Considerations

Management of an entity should consider having discussions with its audit committee and consulting with its independent auditor if it employs a sale or extinguishment strategy. The discussion or consultation should include an explanation of the concerns raised by the SEC staff and the sufficiency of its disclosures. In addition, if a registrant is unsure about the accounting for its specific sale or extinguishment strategy, management is encouraged to discuss its specific issues with the SEC staff.

Note that Deloitte & Touche LLP professionals encountering situations in which a sale or extinguishment strategy is being considered or has been adopted are encouraged to consult with a professional practice director and National Office — Accounting Consultation.


1	Accounting Consequences of Certain Investment Strategies in Connection With the Adoption of FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, April 4, 2007.
2	Some concerns have been raised even if the financial asset or financial liability is not replaced; a key factor is that the entity does not have relatively significant financial assets or financial liabilities measured at fair value pursuant to Statement 159 after completion of the sale or extinguishment strategy.
3	Disclosure 2 is an addition to those recommended in Accounting Alert 07-4. The other disclosure recommendations have been modified to incorporate strategies involving callable debt.