For release on December 9, 1997 1997 Twenty-Fifth Annual National Conference on Current SEC Developments December 9, 1997 Remarks by Donna L. Coallier Professional Accounting Fellow Current Accounting Projects Office of the Chief Accountant U.S. Securities and Exchange Commission (c) Copyright 1997. All rights reserved.As a matter of policy, the Commission disclaims responsibility for any private publications or statements by any of its employees. The views expressed are those of the author, and do not necessarily represent the views of the Commission or the author's colleagues on the staff. Introduction Good morning; its a pleasure to be here again this year. I will focus my prepared remarks on several topics of current and continued interest: cost allocations among parts of a transaction that must be accounted for separately, systematic patterns of treasury stock acquisition, and transactions between entities with a high degree of common ownership. There will be an opportunity for questions regarding these and other topics at the end of this session, and again at the end of the day. Cost Allocations First I will address cost allocations or unbundling, as it is often called, and I'll start by describing a recent EITF issue. EITF Issue No. 97-13 [1] addresses the accounting for business process reengineering (BPR) costs, specifically whether to capitalize such costs and if not, how to unbundle them from other capitalized costs incurred in the same transaction. The EITF concluded the BPR costs should not be capitalized, regardless of whether they are incurred at the same time, or in the same project as other costs that can be capitalized. As a result, BPR costs which are incurred in connection with the cost of an internal use software project, for example, must be accounted for separately from the software and expensed as incurred. Questions related to how to allocate cost among components that have been bundled into one transaction but must be accounted for differently seem to be increasing in frequency. The staff has reviewed several examples of similar allocations during this year and there are also other examples throughout the literature. The staff's examples encompass both costs and revenues and include: * A contract specifying a single fee to pay for future services and also to pay an early termination penalty related to the preceding contract; * An amount paid to acquire a group of assets and employees from a service provider and also to terminate the service contract with the provider; and * An amount paid for purchased in-process research and development acquired in a business combination. Both APB 16 and APB 17 provide guidance on allocating cost to groups of assets and liabilities acquired. Paragraph 68 of APB 16 states: "Acquiring assets in groups requires not only ascertaining the cost of the assets as a group but also allocating the cost to the individual assets which comprise the group...A portion of the total cost is then assigned to each individual asset acquired on the basis of its fair value." Paragraph 26 of APB 17 states that "the cost of identifiable assets is an assigned part of the total cost of the group of assets or enterprise acquired, normally based on the fair values of the individual assets." More recent examples of literature that provide guidance on how to unbundle costs are AcSEC's draft statement of position on accounting for the costs of computer software developed or obtained for internal use ("internal use software"), and SOP 97-2 [2] on software revenue recognition. Both documents require that an allocation among the elements of a transaction should be based on objective evidence of fair value of those elements, not necessarily on the separate prices stated within the contract for each element[3]. An example of this concept is in SOP 97-2. SOP 97-2 requires vendor-specific objective evidence of fair value and limits that evidence to the price charged when the same element is sold separately, or under certain conditions, for an element not yet being sold separately, the price established by management.To summarize, although there are a variety of allocation techniques used in financial reporting, there are some key concepts found in many places where the literature addresses how to allocate costs among different parts of a transaction. Those key concepts are that the allocation should be based on fair value, as supported by objective evidence. In addition, the fair value of each element assessed may differ from the prices or benchmarks specified in the contract. The staff is guided by those concepts in a variety of circumstances where costs must be unbundled. I'll move on now to a pooling of interest topic: systematic patterns of treasury stock acquisition. Systematic Patterns of Treasury Stock Acquisition Over the last year, the staff has addressed several questions about systematic patterns of treasury stock acquisition. To explain how the staff approaches these practice questions, first I will review some background information on systematic patterns, and then I will share some examples of what we have seen. There are two pieces of literature that address systematic patterns: paragraph 47(d) of APB 16 [4] and ASR 146 [5]. Under paragraph 47(d) a company may purchase treasury stock for certain business purposes without precluding pooling of interest accounting, as long as the shares are repurchased in a systematic pattern. As a result, the staff is often asked to agree with a registrant's conclusion that it has purchased treasury stock in a systematic pattern. In 1973, the Commission set forth its conclusions as to certain problems relating to the effect of treasury stock transactions on accounting for business combinations in ASR 146. In that release, the Commission reiterated the APB 16 concepts that shares repurchased in connection with recurring share distributions are considered to be untainted only if, (1) they are purchased pursuant to a systematic pattern of reacquisitions, and (2) there is a reasonable expectation that the shares will be reissued for their intended purpose. In demonstrating that a systematic pattern exists, registrants often point to the fact that actual repurchases were roughly equivalent to annual issuances under recurring benefit programs and that an excessive amount of treasury stock has not accumulated as a result of shares repurchased. This type of evidence may be an indication that there is a reasonable expectation treasury shares will be reissued for their intended purpose. However, when reviewing stock repurchase programs, the staff has required that additional evidence be provided to demonstrate that shares have been repurchased in a systematic pattern. Specifically, to demonstrate a systematic pattern of reacquisitions, ASR 146 requires that the reacquisitions be made pursuant to specified criteria. Further, the criteria must be sufficiently explicit so that the pattern of actual repurchases may be objectively compared to the plan. In applying ASR 146, the staff has not objected to systematic patterns with formula-based criteria that leave little or no discretion in determining the number and timing of share repurchases, provided that the pattern of actual repurchases may be objectively compared to the plan. The staff has objected to systematic patterns with discretionary criteria that require judgment to determine when or in what amount shares should be repurchased. I'd like to share two examples of share repurchase programs to show how the staff assessed whether the repurchase criteria were sufficiently explicit, as to both amount and timing, to demonstrate a systematic pattern of repurchases. In the first example, the staff did not object to the registrant's conclusions that it purchased its treasury stock in a systematic pattern. In the second example, the registrant did not provide explicit criteria that the staff could use to compare actual and planned repurchases. In the first program, the registrant estimated the amount of shares expected to be issued for its stock option plan on an annual basis and updated its estimate each quarter. The estimate was based on the degree to which exercisable options were in or out of the money, and exercise experience for historical differences between exercise and stock price. Treasury stock was to be purchased ratably each quarter based on expected annual issuances, as computed each quarter. That is, expected annual issuances were divided by four to arrive at the number of shares to be purchased in a quarter. Within each quarter, treasury stock was purchased ratably each day, after giving effect to legal black out dates. The staff agreed that shares repurchased under the program were in fact repurchased pursuant to explicit criteria under a systematic pattern. The second program had features that were described to the staff as follows: * Monthly issuances under employee benefit plans are forecasted; * Repurchases are curtailed when significant cash or liquidity needs arise; * Repurchases are made only for reissuance under the company's recurring employee benefit plans; * Repurchases comply with legal blackout periods or trading restrictions; and * Regulatory capital requirements must be maintained. Because actual repurchases bore no relationship to monthly forecasted issuances, the staff did not believe the forecast feature provided evidence of explicit criteria that could be used to compare with actual repurchases. Because the registrant applied the second feature with discretion, the registrant could not provide the staff with explicit criteria to use to evaluate actual curtailed repurchases given cash and liquidity needs. The remaining features are constraints applicable to all stock repurchase programs, so the staff did not view them to be explicit criteria that were alone representative of a systematic pattern. As a result, the staff could not agree that the registrant had a systematic pattern of repurchases. I'll turn now to a new basis topic: transactions between entities with a high degree of common ownership. Transactions between entities with a high degree of common ownership Another frequent question in registrant submissions over the last year is: How to account for combinations of, or transfers or exchanges between, entities with a high degree of common ownership? Specifically, the staff is asked to concur that these transactions should be accounted for at historical cost. In assessing whether to account for these transactions at historical cost or fair value, two questions are relevant: * Are the entities under common control as described in AIN 39 [6], and * Does the transfer lack substance as described in FTB 85- 5 [7]? Common Control When there is a transfer or an exchange between companies under common control, AIN 39 states that "assets and liabilities so transferred would be accounted for at historical cost in a manner similar to that in pooling-of- interests accounting".[8] Registrants have asserted that common control exists between different companies when there is common majority ownership by an individual, a family, or a group affiliated in some other way.Common control between different companies often exists when one shareholder holds more than 50% of the voting ownership of each company. Common control may also exist when a group of shareholders holds more than 50% of the voting ownership of each company, and all members of the group agree to vote those shares in concert. The staff generally does not object to assertions that immediate family members vote their shares in concert absent evidence contradicting those assertions. The staff believes immediate family members include a married couple and their children, but not the married couple's grandchildren. Businesses owned in varying combinations by a married couple and their children or among living siblings and their children may be viewed by the staff to be under common control. However, the staff has objected to assertions that different companies owned by individuals that are not members of an immediate family are under common control unless there is contemporaneous written evidence of an agreement to vote a majority of an entity's shares in concert. The staff has not accepted oral agreements as evidence of common control outside of an immediate family. Nor has the staff accepted new agreements as evidence that the companies were operated under common control in the past. Nonsubstantive exchange When there is a transaction between entities with a high degree of common ownership, but that are not under common control, the staff assesses the transaction to determine whether the transaction lacks substance. FTB 85-5 provides an example of a similar assessment in an exchange between a parent and a minority shareholder in one of the parent's partially owned subsidiaries. Paragraph 6 of FTB 85-5 states, in part: ...if the minority interest does not change and if in substance the only assets of the combined entity after the exchange are those of the partially owned subsidiary prior to the exchange, a change in ownership has not taken place, and the exchange should be accounted for based on the carrying amounts of the partially owned subsidiary's assets and liabilities. Similarly, in a transfer or exchange between entities with a high degree of common ownership, the staff compares the percentages owned by shareholders in the combined company to the percentages owned in each of the combining companies before the transaction. When the percentages have changed or the owned interests are not in substance the same before and after the transaction, the staff believes a substantive transaction has occurred and has objected to historical cost accounting. Closing Thank you once again for the opportunity to speak here at the conference today. Please pass along any questions you have related to the topics I have discussed or any others related to the staff's activities. Any questions that we can't answer this morning will be addressed in the session at the end of the day. [1] EITF Issue No. 97-13, Accounting for Costs Incurred in Connection with a Consulting Contract That Combines Business Process Reengineering and Information Technology Transformation (Issue 97-13). [2] AICPA Statement of Position 97-2, Software Revenue Recognition (SOP 97-2). [3] See paragraphs 33 and 81-83 of the draft statement of position on accounting for the costs of computer software developed or obtained for internal use, and paragraph 10 and 99-105 of SOP 97-2. [4] APB Opinion No. 16, Business Combinations (APB 16). [5] Accounting Series Release No. 146, Effect of Treasury Stock Transactions on Accounting for Business Combinations (ASR 146). [6] AICPA Accounting Interpretation 39 to APB Opinion No. 16, Business Combinations (AIN 39), addresses transfers and exchanges between entities under common control. [7] FASB Technical Bulletin No. 85-5 (FTB 85-5) addresses issues relating to accounting for business combinations, including stock transactions between companies under common control. [8] AIN 39 also states that "purchase accounting applies when the effect of a transfer or exchange is to acquire all or part of the outstanding shares held by the minority interest of a subsidiary". FTB 85-5 provides guidance on determining whether a minority interest is acquired.