Financial Reporting Alert 07-1: FVO Not Available for Equity Interests or Other FIs With a Significant Future-Services Component
June 1, 2007
On the basis of discussions with the staffs of the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB), a financial instrument is not eligible for the fair value option under FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities , when that financial instrument, explicitly or implicitly, encompasses a significant compensation component for providing future services.
Statement 159 permits entities to make an irrevocable election to measure most financial instruments and certain nonfinancial insurance and warranty contracts at fair value (see Deloitte & Touche LLP’s February 22, 2007, Heads Up), with changes in fair value recognized through earnings. The FASB had considered providing a fair value option for financial and nonfinancial assets and liabilities, but ultimately decided to address nonfinancial assets and liabilities in Phase 2 of its fair value project. Thus, the Board clearly intended to limit the scope of Statement 159 to financial instruments (other than nonfinancial insurance and warranty contracts explicitly included in the scope).
Certain nonconsolidated equity investments subject to the equity method or cost method of accounting (i.e., otherwise not measured at fair value), such as the one described below, technically meet the definition of a financial asset because they represent an ownership interest. However in addition to providing the holder with an equity-like residual return, the instrument also compensates the investor for significant future services it will perform.
On the basis of discussions with the SEC and the FASB staffs, financial instruments with significant components providing compensation for future services are not eligible for the fair value option under Statement 159. An example of such a financial instrument is a general partnership interest in which the general partner has significant management responsibilities (such as managing the partnership’s assets) and is entitled to a return that is disproportionate to the capital, if any, it contributes to the partnership. Another example is a joint venture in which an investor will provide future services to the venture and the return from the venture is greater than if the venture paid an unrelated third party for those services. This conclusion rests on the concern that if an investor were permitted to recognize the investment at fair value, it might record a gain (e.g., profit at inception) that includes profits associated with the future services to be provided, resulting in revenue recognition before the related services are performed. Because paragraph 5(c) of Statement 159 requires that the fair value option be applied to an entire instrument, unless there is other GAAP requiring bifurcation, there is no opportunity to separate the element for future services and elect the fair value option for the portion of the instrument that is purely financial.
|Editor’s Note: We do not believe that this conclusion applies to securities within the scope of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities . For example, Statement 115 requires equity securities in its scope (e.g., those not subject to the equity method of accounting and that have readily determinable fair values) to be measured at fair value with unrealized gains or losses recognized either through earnings (when classified as trading) or other comprehensive income (when classified as available for sale). However, careful analysis needs to be performed because associated services that are provided by the holder may indicate that the holder has significant influence over the operating and financial policies of the investee (i.e., the equity interest may be required to be accounted for under the equity method).|
An evaluation of whether a financial instrument is eligible for the fair value option under Statement 159 should involve careful consideration of all the instrument’s terms. It may not always be obvious when an instrument contains a service element, and judgment is necessary. For example, the investor’s obligation to provide services may be set out in a different contract from the equity ownership interest. Consideration should be given to the substance of the arrangement and whether the financial instrument and the contract for services are interdependent or inseparable. Further, it is possible that the service contract contains only a portion of the economic compensation and that the remainder is an element of the “equity instrument.”
The following are some indicators that the equity investment may contain a significant element compensating the investor for future services:
- The fair value of the investment encompasses a provision providing a return disproportionately greater (relative to its investment) than the return to other passive investors, and the services that are provided by the investor to the investee affect the future payout under the provision.
- The fair value of the interest at inception is greater than the investor’s investment, and the investor is expected to provide services to the investee in the future that are above and beyond those customary of an investor acting solely as a non-management owner.
The impact of significant servicing elements in financial instruments should be evaluated according to specific facts and circumstances. An entity’s management should consider consultation with appropriate parties if it intends to elect the fair value option under Statement 159 for financial instruments with terms that may encompass a significant servicing element.
Note that Deloitte & Touche LLP professionals encountering situations in which an election of the fair value option under Statement 159 is being considered for a financial instrument that may contain a significant service element are encouraged to consult with a professional practice director and National Office — Accounting Consultation.
The Appendix contains some examples of the application of this guidance.
Manager A (A) is the only general partner (GP) of Partnership X (X). Manager A invested a nominal amount, 1 percent of the total capital, for its GP interest. The GP interest entitles A to 5 percent of the net income of X. Manager A does not provide any services to X other than some insignificant administrative tasks; the assets of X are managed by an unrelated third party. Manager A receives a disproportionately higher return than the limited partners because of its unlimited liability as general partner for the partnership’s obligations. Manager A estimates the fair value of its GP interest to be equal to the amount invested at inception. The GP interest does not appear to encompass an element for significant future services. We believe the GP interest in this example is eligible for the fair value option under Statement 159.
Manager A (A) is also the general partner (GP) of Partnership Y (Y). Manager A invested a nominal amount, 1 percent of the total capital, for its GP interest. The GP interest entitles A to 10 percent of the net income of Y and provides significant additional compensation if the operating margin of Y reaches certain thresholds. At inception, A estimates that the fair value of the GP interest is greater than the amount invested. Manager A also manages the assets of Y through a separate services contract and receives a servicing fee. There are certain restrictions on the sale of GP interest during the term of the services contract. Finally, A also holds a limited partnership (LP) interest in Y. Manager A invested the same amount as other limited partners for its LP interest and receives the same return on its LP interest as the other limited partners. Manager A estimates the fair value of the LP interest is equal to the amount invested for this instrument. We believe that in this example, A would not be able to elect to measure the GP interest at fair value under the fair value option in Statement 159 because the interest appears to encompass compensation for significant future services. However, we believe that A could elect to measure its LP interest at fair value under the fair value option in Statement 159 because the interest does not appear to encompass an element for significant future services.
Bank B (B) transfers financial assets to a securitization trust in a transfer that is accounted for as a sale. Bank B provides servicing of the financial assets (e.g., collection) for the trust. The servicing contract is initially measured at fair value under FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities , as amended by FASB Statement No. 156, Accounting for Servicing of Financial Assets . (Note that B may elect to subsequently measure a class of servicing assets or servicing liabilities at fair value pursuant to Statement 156.) Bank B holds the residual beneficial interest issued by the trust and determines that the fair value of its residual interest is greater than the allocated cost of this retained interest. Bank B also determines that the residual interest meets the definition of a debt security within Statement 115. We believe B could classify its residual interest as a trading security under Statement 115 and measure it at fair value with changes in fair value recognized in earnings. Because B may classify the security as trading under Statement 115, the option to elect to measure the security at fair value under Statement 159 is not needed.