New rules on guarantees of debt

1. New rules on guarantees of debt ASC 460 (FIN No. 45) Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others

2. ASC 460 (FIN45) Covers guarantee contracts that have any of these 4 characteristics 1. Contracts that contingently require the guarantor to make payments to the guaranteed party based on an “underlying” • Examples: • Irrevocable standby letter of credit which guarantees payment of a specified obligationMarket value guarantee of asset owned by the guaranteed partyGuarantee of the market price of common stock of the guaranteed partyGuarantee of the collection of cash flows from assets held by special purpose entity 2. Performancestandby letter of credit or similar arrangements in which guarantor must make payments to the guaranteed party in the event of another entity’s failure to perform under a nonfinancial contract

3. Covers guarantee contracts that have any of the following 4 characteristics 3. Indemnification agreements that require guarantor to make payments to the indemnified party (guaranteed party) based on changes in an “underlying” such as an adverse judgment in a lawsuit, imposition of additional taxes due to adverse interpretation of the law 4. Indirect guarantees of the indebtedness of others even though the payment to the guaranteed party may not be based on an underlying asset, liability, etc., of the guaranteed party.

4. THE INTERPRETATION • The issuance of a guarantee obligates the guarantor (issuer) in two respects: 1. The guarantor undertakes an obligation to stand ready to perform over the term of the guarantee if the event that the specified triggering events or conditions occur • This is the noncontingent part of the obligation 2. The guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur • This is the contingent part of the obligationNew Disclosure – FIN 45

5. Key point that FIN 45 made: • FASB 5 should not be interpreted as prohibiting the guarantor from initially recognizing a liability for a guarantee even though it is not probable that the payments will be required under that guarantee.

6. Measurement of obligation a. The premium received or receivable – when the guarantee is issued in a standalone arm’s-length transaction with an unrelated party b. When the guarantee is part of a transaction with multiple elements, estimate the fair value of the guarantee. • Consider the premium which would be required by the guarantor to issue a standalone guarantee with an unrelated party • In the absence of observable transactions for identical or similar guarantees, use expected present value measurement techniques

7. Measurement of obligation c. If a guarantor must recognize a guarantee at inception because it is probable and can be estimated (FASB 5), the amount to initially recognize is the GREATER of the fair value of the guarantee (as measured above) or the contingent liability amount required under paragraph 8 of Statement 5. d Not for profit situation: guarantees provided as a contribution to an unrelated party (like a loan guarantee by a community foundation to a nonprofit entity), the guarantee (gift) should be measured at the fair value of the guarantee and NOT considered merely a conditional promise to give.

8. The debit side is not prescribed • Some examples provided in FIN 45 include: a. If a premium is received, the debit would be to cash or receivable. b. If the fair value of the premium is an allocation of the receivable or cash received on a transaction that involves other assets, liabilities, etc., the allocation to the guarantee will affect the calculation of the gain or loss on the transaction. c. If the guarantee is associated with the acquisition of a business accounted for under the equity method, the guarantee would increase the carrying value of the investment. d. In an operating lease situation, the guarantee would affect prepaid rent. e. If no consideration is received, the offsetting entry would be to expense.

9. Disclosures Required (added by FIN 45) a. Nature of the guarantee including, the approximate term, how the guarantee arose, and the event or circumstance that would require the guarantor to perform under the guarantee. b. Maximum potential amount of future payments c. Current carrying amount of the liability d. Nature of (1) any recourse provisions that would enable guarantor to recover from third parties any of the amounts paid under the guarantee and (2) any assets held either as collateral or by third parties that the guarantor would be able to liquidate to recover any of the amounts paid.

10. Disclosures Required – con’t e. FOR PRODUCT WARRANTIES. The disclosure of the maximum amount of future payments requirement above is waived. Instead: • 1. The accounting policy and methodology used to determine its liability for product warranties including any deferred revenues associated with extended warranties. • 2. A tabular reconciliation of the changes in the guarantor’s aggregate product warranty for the reporting period. • Beginning balance • Aggregate reduction for payments made or services provided • Aggregate increase for new warranties issued during period • Aggregate changes in the liability related to pre-existing warranties (changes in estimate) • Ending balance

11. Example from Recent F/S

12. New (2003) rules on redeemable preferred stock ASC 480 (FAS150) related to Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity

13. EXAMPLES OF INSTRUMENTS COVERED BY STATEMENT 150 Mandatorily Redeemable Instruments • ❒ Stock that must be redeemed on a certain date (for example, December 31, 2030) • ❒ Stock that must be redeemed upon the death of the holder Instruments with Repurchase Obligations • ❒ Written put options that are physically or net cash settled • ❒ Forward purchase contracts that are physically or net cash settled

14. EXAMPLES OF INSTRUMENTS COVERED BY STATEMENT 150 Instruments with Obligations to Issue a Variable Number of Shares • ❒ Debt settleable with a variable number of the issuer’s equity shares • ❒ Instruments indexed to the S&P 500 and settleable with a variable number of the issuer’s equity shares • ❒ Written put options that can be settled by one party delivering stock equal to current fair value of the counterparty’s gain (“net share settled”) • ❒ Forward purchase contracts that are net share settled

15. Redeemable financial instruments • Mandatorily redeemable financial instrument shall be classified as liability • Exceptions • Redemption is contingent • Required only upon liquidation or termination of the reporting entity • Required only if an uncertain future event occurs • Becomes liability only when the event becomes certain to occur Certain not probable!

16. Other redeemable securities • Classify as liability: • Obligation to repurchase equity • Obligations to issue variable number of shares

17. Measurement of liability • Financial instruments that meet these requirements are initially measured at fair value • Most are then re-measured at fair value and the subsequent changes in fair value are recognized in earnings

18. Reporting on Statements • Balance sheet required description: • “Shares subject to mandatory redemption” • Should be on separate line and not commingled with other liabilities • Income statement transition • Through “cumulative effect of a change in accounting principle” • Impact – more debt, less equity!

19. Disclosures • Nature and terms of the financial instruments including rights and obligations • Amount that would be paid or number of shares that would be issued and their fair value “as if settled” at reporting date • How changes in fair value of issuer’s equity shares impact the settlement amount • Maximum amount issuer could be required to pay • Maximum number of shares that might have to be issued • And several more items (see paragraph 27)

20. Example financial instrument • Trust-preferred securities • A financial institution establishes a trust or other entity that is consolidated with the financial institution • The trust issues mandatorily redeemable preferred stock and uses the proceeds to purchase from the financial institution an equivalent amount of junior subordinated debt • The financial institution pays interest to the trust, the trust uses the funds to pay the dividends • Why they exist • Upon consolidation, the intercompany transaction (payment of interest) disappears along with the debt (and the receivable on the trust’s books)

21. Example financial instrument • Trust-preferred securities • Under the new rules, the financial institution will have to report INTEREST EXPENSE and DEBT instead of dividends and redeemable preferred stock • Be sure to check for examples to aid implementation of the rules (ASC 480-10-55)

22. Key terms – from ASC Glossary Financial instrument – a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. • A freestanding financial instrument is one that is entered into separately and apart from any of the entity’s other financial instruments or equity transactions, or that is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

23. Key terms – from Glossary A mandatorily redeemable financial instrument is issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.

24. Key terms – from Glossary Net cash settlement - A form of settling a financial instrument under which the party with a loss delivers to the party with a gain cash equal to the gain. Net share settlement - A form of settling a financial instrument under which the party with a loss delivers to the party with a gain shares of stock with a current fair value equal to the gain.

25. Key terms – from Glossary Monetary value - What the fair value of the cash, shares, or other instruments that a financial instrument obligates the issuer to convey to the holder would be at the settlement date under specified market conditions. Shares, as the term is used in SFAS No. 150, indicates various types of ownership interests that are not necessarily securities such as a partnership interest. In contrast, the term equity shares refers only to shares that are accounted for as equity.

26. Handout flow chart There is a whole “practice aid” on applying FAS150 The flow chart distributed is from a draft version of one of the chapters.

27. ASC 815-40 (EITF 07-5) Warrants and convertible instruments “Round-down” provisions Warrants with round-down provisions will no longer be recorded in equity Many convertible instruments with round-down provisions will have to “bifurcated” to show the conversion option separately as a derivative under FAS133 Effective years beginning after 12/15/08

28. Round-down provision Reduce the exercise price of a warrant on convertible instrument if the company either • issues equity shares for a price that is lower than the exercise price of those instruments, or • issues new warrants or convertible instruments that have a lower exercise price Common in pre-IPO entities that issue instruments to venture capital firms

29. From KPMG “Defining Issues” Dec 2008, No. 08-51