Update to SEC's Current Accounting and Disclosure Outline

By: Cydney Posner

The SEC has recently updated its Current Accounting and Disclosure Issues Outline, adding a couple of new sections worthy of note.

Classification and Measurement of Warrants and Embedded Conversion Features

One new section of the Outline addresses the accounting treatment of financial instruments such as warrants and preferred stock and debt with embedded conversion features. Under some circumstances, companies are required to determine whether instruments should be classified as equity or liability. Apparently, this issue has been the subject of staff reviews in recent months.

Warrants. In evaluating whether warrants should be accounted for as liability or equity instruments, companies should ensure that they have appropriately analyzed all warrant and registration rights agreements. The Outline states that the two most common reasons that warrants should be accounted for as liabilities are:

• the warrants could be required to be settled in cash if certain events occurred, such as delisting or failure to have an effective registration statement covering the underlying shares by a certain date; and
• the warrants grant the holders registration rights that provide significant liquidated damages in the event the company fails to register the underlying shares on a timely basis or to maintain the effectiveness of the registration statement for a specified time period. The liquidated damages usually are expressed as a percentage of the original amount invested by the holder and may or may not be capped at a maximum percentage. The liquidated damages must be analyzed to determine if they were meant to compensate the holder for the difference between a registered share and an unregistered share, which may require significant judgment.

Embedded Conversion Features – Convertible Debt and Convertible Preferred Stock. Conversion features within convertible debt and convertible preferred stock must be analyzed to determine if the conversion feature must be bifurcated and accounted for separately. If the feature is classified as a liability, it would be accounted for as a derivative at fair value, with changes in fair value recorded in earnings. If the

feature is classified as equity (and meets certain other criteria), the embedded conversion option would not be bifurcated from the host instrument. The Outline states that the two most common causes of improper accounting stem from the fact that

• the number of shares issuable upon conversion is variable and uncapped; and
• the agreements grant the instrument holders registration rights that provide significant liquidated damages in the event the company fails to register the underlying shares on a timely basis or to maintain the effectiveness of the registration statement for a specified time period.

Pre-Approval of Audits of Employee Benefit Plans

If a company is an employee benefit plan sponsor, the plan may be considered an affiliate of the company. The SEC's independence rules related to pre-approval of audit services do not address services provided to affiliates of the issuer that are not subsidiaries and, therefore, the independence rules do not require the audit committee of the plan sponsor to pre-approve audits of the employee benefit plans (although the audit committee is encouraged to do so). Where an employee benefit plan is a separate issuer required to file a Form 11-K, it is subject to the pre-approval requirements, which pre-approval can be provided by either the audit committee of the plan sponsor or the appropriate entity overseeing the activities of the employee benefit plan, such as the trustee, plan administrator or responsible party.

The SEC's rules require that all fees, including fees related to audits of employee benefit plans, paid to the principal auditor be included in the company’s fee disclosures, regardless of whether or not the audit committee of the company pre-approved those fees. The Outline states that, as part of the exercise to gather the information for the required fee disclosures, the audit committee should be made aware of all fees paid to the principal auditor, including those related to audits of the employee benefit plans. The company may elect to separately indicate in its disclosures those fees paid to the principal auditor that were not subject to the pre-approval requirements.