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Beyond debt: Accounting for other liability-classified arrangements · PwC's accounting podcast

• 0:00
  SPEAKER_02: Thought Leadership from PWC's National Office.
• 0:07
  SPEAKER_00: Hello, and welcome to PWC's Accounting Podcast.
• 0:11
  SPEAKER_00: I'm Heather Horn.
• 0:13
  SPEAKER_00: Thanks for joining us today as we jump into current topics in accounting and reporting.
• 0:18
  SPEAKER_00: For today's discussion, I'm pleased to welcome guest host, Diana Stoltzfest, a partner in PWC's National Office and a podcast regular.
• 0:27
  SPEAKER_00: I'll hand it over to Diana for more details on today's episode.
• 0:35
  SPEAKER_01: Welcome to our mini-series on debt and financing transactions.
• 0:39
  SPEAKER_01: Today we're focusing on instruments and arrangements that may not look like traditional debt, but can still end up being accounted for as liabilities.
• 0:47
  SPEAKER_01: This is an area where the accounting can get especially complicated because there isn't one comprehensive liability model.
• 0:54
  SPEAKER_01: Instead, the guidance has evolved over time through different standard setting projects and EITF issues, which can sometimes lead to accounting outcomes that surprise people.
• 1:03
  SPEAKER_01: Joining me today are Brett Dooley, a deputy chief accountant, and Chip Curry, a partner from PWC's national office.
• 1:10
  SPEAKER_01: Between the two of them, they've probably seen just about every type of instrument out there.
• 1:14
  SPEAKER_01: So I'm really looking forward to getting their insights as we walk through some of the more common examples and accounting considerations in this area.
• 1:21
  SPEAKER_01: So maybe Brett, I'll start with you.
• 1:24
  SPEAKER_01: Thank you so much for joining me today on the podcast.
• 1:27
  SPEAKER_01: Let's start at a high level.
• 1:28
  SPEAKER_01: When people hear the term liability, they often think about traditional debt like loans or bonds.
• 1:35
  SPEAKER_01: But there are lots of other types of instruments and arrangements that can end up being accounted for as liabilities under US GAAP.
• 1:43
  SPEAKER_01: Maybe can you help frame the landscape for us for our listeners?
• 1:47
  SPEAKER_03: Yeah, thanks for having us today, Diana.
• 1:50
  SPEAKER_03: The um there are a lot of instruments uh and different transactions that that just don't read debt at the top of that contract, uh, but still are accounted for as liabilities on uh on the balance sheet.
• 2:01
  SPEAKER_03: And I thought today we're not going to go through a comprehensive list of that.
• 2:04
  SPEAKER_03: Sure.
• 2:05
  SPEAKER_03: It probably takes us a few hours to try to go through them.
• 2:08
  SPEAKER_03: Um, and we probably an incomplete list.
• 2:11
  SPEAKER_03: Um but we thought we'd talk about a few types of transactions we commonly see in practice and then spread it around a bit and and and talk through those.
• 2:19
  SPEAKER_03: I think one of the things you touched on uh that's important to realize we're talking about things that are accounted for as liabilities, but we don't have a single comprehensive model for how to account for a liability.
• 2:31
  SPEAKER_03: And so as we go through these, we'll find that some of the instruments we talk about have their own accounting models, um, and others are gonna fall into the debt instrument guidance uh in ASC 470.
• 2:42
  SPEAKER_03: When we go through these, uh maybe three different general buckets of the accounting that we'd see uh for these types of instruments.
• 2:50
  SPEAKER_03: Some liabilities, like traditional debt, are gonna be accounted for on an amortized cost basis.
• 2:56
  SPEAKER_03: Uh, there are other liabilities that we're gonna see, like derivatives that are accounted for at fair value through earnings.
• 3:03
  SPEAKER_03: And then some liabilities have their own unique accounting model.
• 3:06
  SPEAKER_03: A lot of these, like you talked about, um, are our liabilities because they were addressed in an EITF topic or a specific FASBI project over the years.
• 3:16
  SPEAKER_03: And those types of instruments may have an accounting model that was specified when the FASBI addressed those those issues.
• 3:22
  SPEAKER_01: Okay, that's helpful to help set the landscape.
• 3:25
  SPEAKER_01: So, Chip, it's really helpful a lot of times when we get into some examples of some of these different types of instruments.
• 3:32
  SPEAKER_01: So maybe you can share what are some common things that may not be traditional debt, but ended up being accounted for as a liability.
• 3:40
  unknown: Yeah.
• 3:40
  SPEAKER_04: So, like Brett said earlier, we we could go through a list and it would take us hours.
• 3:43
  SPEAKER_04: And so maybe what we'll do is just start with a couple of examples that are sort of more in the traditional financing area.
• 3:51
  SPEAKER_04: So issuances of preferred stock or issuances of warrants.
• 3:55
  SPEAKER_04: So just a level set for everybody a preferred security is a legal form equity instrument.
• 4:00
  SPEAKER_04: So it's not legally debt.
• 4:02
  SPEAKER_04: Um, and a warrant is a contract to issue a legal form equity instrument uh if the holder chooses to exercise the warrant.
• 4:10
  SPEAKER_04: So it's an option to issue equity shares.
• 4:12
  SPEAKER_04: So, like I said, neither of these are a debt security or a loan.
• 4:16
  SPEAKER_04: But from an accounting perspective, further Brett's point, we may have to record these instruments as liabilities on your balance sheet.
• 4:23
  SPEAKER_04: So maybe we'll start with a preferred stock.
• 4:25
  SPEAKER_04: Um, so for preferred stock instrument, there's the guidance in ASC 480 for those of you who are keeping track at home that will determine whether or not it needs to be classified as a liability.
• 4:37
  SPEAKER_04: Okay, so the most simple example of when that would happen is when you have a mandatorily redeemable preferred stock instrument.
• 4:44
  SPEAKER_04: And when you look at 480, the definition of a mandatorily redeemable preferred stock would be a preferred stock that, for example, has a contractual maturity date.
• 4:53
  SPEAKER_04: It has to be redeemed on December 31st, 2030.
• 4:58
  SPEAKER_04: Or it could also be a preferred stock that has a feature that creates an unconditional obligation for the issuer to redeem those shares by transferring assets either on a specified date or on a date that's certain to occur.
• 5:15
  SPEAKER_04: So think about I have an unconditional obligation that is going to happen where I'm going to have to redeem that preferred security by transferring assets, that's going to be a liability under 480.
• 5:26
  SPEAKER_01: Okay.
• 5:27
  SPEAKER_04: So, like I said, if it meets the criteria in 480, we would have to classify it as a liability.
• 5:31
  SPEAKER_04: When you're dealing with mandatorily redeemable preferred stock, 480 also gives you to Brett's point, like a subsequent recognition model.
• 5:38
  SPEAKER_04: Um, so if it's redeemable on a fixed date at a fixed price.
• 5:43
  SPEAKER_04: So, my example, I issued a preferred security, I have to redeem it on December 31st of 2030, I have to redeem it for$100.
• 5:52
  SPEAKER_04: Then what 480 tells us to do is we're gonna basically measure it at the present value of the settlement amount.
• 5:58
  SPEAKER_04: So, so what does that mean?
• 6:00
  SPEAKER_04: Sort of simplified.
• 6:01
  SPEAKER_04: It's gonna look a lot like we're accounting for it as debt using an accretion model.
• 6:06
  SPEAKER_04: So even though it's legally a preferred stock, to Brett's point, it doesn't say debt anywhere in the agreement.
• 6:11
  SPEAKER_04: We're gonna effectively account for it like that.
• 6:13
  SPEAKER_04: If the settlement amount varies or the maturity date varies, our measurement model changes a little bit under 480.
• 6:20
  SPEAKER_04: And what we're basically gonna do is try to make sure that um it's on the balance at every reporting date, it's on the balance sheet date as if we were redeeming it that date.
• 6:29
  SPEAKER_04: So I use the words mandatory redeemable, unconditional obligation a couple of times.
• 6:35
  SPEAKER_04: The guidance in 480 would not apply, you're not a liability under 480.
• 6:40
  SPEAKER_04: If you have preferred stock, that is where the redemption is conditional, right?
• 6:44
  SPEAKER_04: So the opposite of unconditional, it's conditional.
• 6:47
  SPEAKER_04: So, for example, if you had a preferred security that the holder or the investor could put back to the company, they could make a choice to put it back to the company.
• 6:57
  SPEAKER_04: That would not be a liability under the 480 guidance.
• 7:01
  SPEAKER_04: Now, there is other guidance from the SEC that talks about mezzanine equity, but we're we're not going to get into that today since we're talking about liabilities and things that are required to be reported as liabilities.
• 7:12
  SPEAKER_04: Um, another area that comes up sometimes with liability classification of preferred stock is when you have to redeem preferred stock on a specific date, but instead of transferring assets, I have to transfer a variable number of shares.
• 7:27
  SPEAKER_04: Shares my own equity are on assets, but that variable amount is predominantly calculated off of a fixed dollar amount.
• 7:36
  SPEAKER_04: So some of some companies issue instruments that the the market calls mandatorily convertible preferred stock.
• 7:42
  SPEAKER_04: Um and these are preferred stock instruments that convert to common on a fixed date.
• 7:47
  SPEAKER_04: However, the key is what how many shares does it convert into?
• 7:53
  SPEAKER_04: And a way a lot of these arrangements work, the conversion rate, how many shares they'll convert into, is based upon the stock price at the maturity date of the instrument.
• 8:02
  SPEAKER_04: So a way a lot of these work is under certain stock price scenarios, the instrument will convert into a fixed number of shares, but in other stock price scenarios, it'll convert into a variable number of shares equal to a fixed dollar amount.
• 8:16
  SPEAKER_04: Okay, so what do I do?
• 8:17
  SPEAKER_04: Right?
• 8:17
  SPEAKER_04: Because I told you if it had to be redeemed for a variable number of shares equal to a fixed dollar amount, it's a liability.
• 8:24
  SPEAKER_04: But here we've got scenarios where it's being redeemed for a variable number of shares equal to a fixed dollar amount, it sounds like a liability.
• 8:32
  SPEAKER_04: But in other scenarios, it's gonna be redeemed for a fixed number of common shares.
• 8:36
  SPEAKER_04: Okay, so what do we do in that case?
• 8:38
  SPEAKER_04: We basically base the classification on the predominance of the instrument.
• 8:43
  SPEAKER_04: And generally what you have to do is sort of a probability analysis to determine where do I think this is gonna land?
• 8:49
  SPEAKER_04: Is it gonna land with a fixed number of shares or a variable number of shares?
• 8:53
  SPEAKER_04: And if it's predominantly, we think it's gonna be in a space where it's based upon a fixed monetary amount, we're gonna call that a liability.
• 9:01
  SPEAKER_04: So again, these are examples of preferred stock arrangements that you wouldn't traditionally think of as a liability because it's not a loan, it's not legally a debt security.
• 9:10
  SPEAKER_04: It it in many cases does they don't convey creditor rights.
• 9:13
  SPEAKER_04: But because of the guidance in 480, notwithstanding all of that, we're still gonna report it as a liability.
• 9:18
  SPEAKER_04: So it's gonna look like debt in the balance sheet.
• 9:21
  SPEAKER_01: Okay, that's helpful.
• 9:22
  SPEAKER_01: One of the other things, Brett, that Chip mentioned was another area was warrants.
• 9:26
  SPEAKER_01: So can you walk us through how warrants end up being accounted for as liabilities?
• 9:31
  SPEAKER_03: Sure.
• 9:31
  SPEAKER_03: Uh, you know, building on what Chip just walked through for preferred stock, the first area of guidance we're gonna look to for a warrant is ASC 480.
• 9:40
  SPEAKER_03: Uh, and in practice, the most common examples we see of warrants that have to be accounted for as liabilities under 480 are warrants that are potable for cash, meaning the holder can force the company to redeem the warrant or warrants to issue redeemable shares.
• 9:58
  SPEAKER_03: And now here, when we refer to redeemable shares, we're not just referring to the mandatory redeemable shares that Chip just talked about when he was talking about preferred stock, but also contingently redeemable shares.
• 10:11
  SPEAKER_03: So the shares themselves don't have to be liability classified once issued in order for the warrants to issue them to be classified as liabilities.
• 10:21
  SPEAKER_03: It's sort of not intuitive.
• 10:22
  SPEAKER_03: Right.
• 10:23
  SPEAKER_03: Like the fact that this as Chip went through that contingently redeemable share may not be required to be accounted for as liability, but the warrant to issue it does.
• 10:35
  SPEAKER_03: Okay.
• 10:35
  SPEAKER_03: Um and often we find that uh warrants to issue preferred shares will be classified as liability because the preferred shares often contain at least a contingent redemption option.
• 10:48
  SPEAKER_03: And so the the warrant ends up to be a liability.
• 10:52
  SPEAKER_03: However, even if you get through 480 and it's not a liability under 480, the next step is to analyze the warrant under the derivative literature, ASC 81540, for our listeners at home who are looking it up, um, to see if they meet the all the conditions to be classified in equity.
• 11:12
  SPEAKER_03: And the derivative model here is extremely complicated.
• 11:16
  SPEAKER_03: And I don't want to get into all those details on the podcast, uh, but it's important to look for any provisions that can change the settlement amount of the warrant or provisions that could force the issuer to cash settle the warrant as opposed to share settling.
• 11:31
  SPEAKER_03: And so not every settlement adjustment you see in the warrant will is going to result in that warrant being uh liability classified.
• 11:38
  SPEAKER_03: All these adjustments do need to go through the indexation model in the derivative literature, um, which is which is really complicated.
• 11:46
  SPEAKER_03: Um, and I think it's worth pointing out the FASB currently has a project on their agenda that they're working on to try to simplify this indexation model because it is it is very complicated to go through.
• 11:58
  SPEAKER_03: And so, like I mentioned in my intro, warrant uh instruments uh that are required to be classified as liability would be subsequently measured at fair value with all the changes in fair value going through income, like a derivative instrument.
• 12:14
  SPEAKER_01: Okay.
• 12:15
  SPEAKER_01: At the beginning of the podcast, one of the one of the things that you guys said was that US GAAP doesn't have a comprehensive model for liabilities accounting.
• 12:24
  SPEAKER_01: And instead it's kind of like a collection of different pieces of guidance that are out there, and that there can be, you know, unique or unexpected accounting outcomes that come from that.
• 12:34
  SPEAKER_01: So maybe you could give us a couple examples, Chip, of where we would get into some of these unique outcomes.
• 12:41
  SPEAKER_04: Yeah.
• 12:41
  SPEAKER_04: And I think, you know, to your point, if we don't have a comprehensive model, it's a model that's kind of been developed over a number of years through a variety of projects, some from the FASB, some through the emerging issue task force.
• 12:53
  SPEAKER_04: And when that happens and you bolt all these things together, sometimes there's inconsistencies or things that look odd.
• 13:01
  SPEAKER_04: So Brett just covered a good example, right?
• 13:03
  SPEAKER_04: Like uh uh a preferred stock that the holder can force the issuer to redeem that at their option is not a liability.
• 13:11
  SPEAKER_04: But if you have a warrant on a preferred stock that's puttable, the warrant is a liability.
• 13:18
  SPEAKER_04: Bit unusual, bit odd.
• 13:20
  SPEAKER_04: Another good example of that is if uh if you look at some of the guidance that exists that's very specific to non-controlling interests.
• 13:28
  SPEAKER_04: So, quicker refresher for everyone, what's a non-controlling interest?
• 13:32
  SPEAKER_04: That is when I consolidate a subsidiary, so a company that I own and control, if there's a minority holder, is if some of that equity is owned by someone other than me, that's what we call what uh a non-controlling interest.
• 13:45
  SPEAKER_04: Okay, so where does this guidance come from?
• 13:47
  SPEAKER_04: This comes from uh an EITF issue that was done a number of years ago, is now codified within ASC 480.
• 13:54
  SPEAKER_04: And and the reason I bring it up and the reason I think it's interesting is because it creates a special rule that only applies to NCI and we don't apply it to other equity instruments.
• 14:04
  SPEAKER_04: So, what the guidance basically says is if you have non-controlling interest and embedded in that non-controlling interest is a written put option, so gives the investor the right to force me to redeem it and a purchase call option, which gives me, the issuer, the ability to redeem it.
• 14:20
  SPEAKER_04: Um, if they have the same fixed price and they are exercisable at the same time, this specific guidance says the NCI has to be reported as a liability.
• 14:30
  SPEAKER_04: Um basically what the guidance is saying is because you have a call and a put for the same price occurring at the same time, that effectively creates a uh, you know, an essentially a maturity date.
• 14:41
  SPEAKER_04: Because you would expect either the call or the put to be exercised.
• 14:45
  SPEAKER_04: It kind of looks like debt, it kind of feels like debt, and so the EITF concluded that it was a liability.
• 14:51
  SPEAKER_04: Um, and they concluded that economically what you've done is you haven't really issued non-controlling issue interest, you've done a financing.
• 14:58
  SPEAKER_04: Now that guidance would would not be applied if instead of it being like a fixed price that these options got exercisable, if they were exercisable at let's say then current fair value.
• 15:08
  SPEAKER_04: We wouldn't do that because it that doesn't look like a financing because the holders are bearing equity risk because it's redeemable at fair value.
• 15:16
  SPEAKER_04: Okay, so so what?
• 15:18
  SPEAKER_04: Okay, so that's specific guidance that applies to non-controlling interests.
• 15:23
  SPEAKER_04: If we were dealing with a preferred stock agreement issued by the parent and the facts were the same, we had a preferred stock agreement, not an NCI, it was putable by the investor and callable by the issuer, we would not report that as a liability.
• 15:37
  SPEAKER_04: And the theory there is there is a chance that neither the issuer nor the investor will exercise the option and the instrument will remain outstanding.
• 15:48
  SPEAKER_04: So same fact pattern, put call, same price overlaps, different answer if you're talking about NCI versus another instrument.
• 15:58
  SPEAKER_04: That's a good example of guidance that has been developed at different points and different times.
• 16:04
  SPEAKER_04: And when you try to mash it all together and look at it, there's not really a consistent theme that plays throughout, which back to one of the points Brett made at the beginning of the podcast, that's one of the elements that makes this literature so difficult to apply because there's not one single theory that you could always default back to when making these determinations.
• 16:25
  SPEAKER_01: And a little bit, it seems like some of this guidance is all over the place.
• 16:28
  SPEAKER_01: So you have to look for it and make sure you're looking in the right places to make sure you haven't missed anything.
• 16:34
  SPEAKER_01: Okay.
• 16:34
  SPEAKER_01: So we've covered a couple types of examples of common financing instruments outside of debt securities and traditional bank lending that could be accounted for as liabilities.
• 16:44
  SPEAKER_01: What are some of the other arrangements, Brett, that our listener should be aware of?
• 16:49
  SPEAKER_03: Maybe the next bucket of transactions we talk through are ones that that may not strike people as a traditional financing arrangement, but it comes from an accounting construct related to a transaction that requires to record a liability.
• 17:02
  SPEAKER_03: So an example of where this comes up is in what we call failed sale accounting.
• 17:08
  SPEAKER_03: Um maybe a company transfers an asset to a third party, but the accounting guidance doesn't allow the company to de-recognize that asset.
• 17:17
  SPEAKER_03: Uh in these instruments or in these uh transactions, the proceeds received, um, and for our discussions, let's just assume it's cash.
• 17:25
  SPEAKER_03: They're recognized, uh, but you have to record a liability uh for the proceeds.
• 17:30
  SPEAKER_03: A couple of common examples, we have failed sale liabilities under ASC 860, dealing with transfers of financial assets.
• 17:39
  SPEAKER_03: You have to transfer a financial asset, but there's you know complex criteria for derecognition.
• 17:45
  SPEAKER_03: You don't meet those.
• 17:46
  SPEAKER_03: And so you have to record a liability for the cash received.
• 17:49
  SPEAKER_03: It's treated as debt, essentially a collateralized financing transaction for accounting purposes.
• 17:54
  SPEAKER_03: And in some areas, this accounting is expected and seems very normal to us, like a repurchase agreement uh or reversed repos at financial services companies.
• 18:04
  SPEAKER_03: But at other times, it can come to a as a surprise to people.
• 18:08
  SPEAKER_03: I think the same thing can happen in revenue transactions when you have the sale of goods uh that doesn't achieve derecognition uh or revenue under 606 or uh you have a failed sale of a nonfinancial asset to someone who's not a customer under 61020.
• 18:25
  SPEAKER_03: All of these uh situations where you have a failed sale can result in a liability.
• 18:31
  SPEAKER_01: I think that's a really interesting point that you know you may not even have an the company may not have an actual legal obligation, but because they've sold the asset, but because of this failed sale, they still, you know, have it on the books and are reflecting the failed sale.
• 18:45
  SPEAKER_01: So, Chip, another area where we get questions is the sales of future revenue arrangements.
• 18:51
  SPEAKER_01: Can you talk to us about that?
• 18:53
  SPEAKER_04: Yeah, so so Brett just went through an example of where we have a liability on the balance sheet that, as you brought up, is not really a legal liability.
• 19:02
  SPEAKER_04: It's it's more of an accounting construct.
• 19:04
  SPEAKER_04: Sales of future revenue is a little bit in between.
• 19:07
  SPEAKER_04: Um it's sort of an accounting construct where we create a liability, but in this case, we actually do have like a legal obligation to do something.
• 19:15
  SPEAKER_04: Um so what it what is a sale of future revenue?
• 19:18
  SPEAKER_04: So these are arrangements that are typically structured where one party, um, generally in exchange for like an upfront cash payment that they receive, will agree to sell a portion of a revenue stream that they will earn in the future.
• 19:31
  SPEAKER_04: So here we're selling something that's not a recognized asset on the balance sheet because I haven't earned the revenue yet.
• 19:37
  SPEAKER_04: I haven't performed the services.
• 19:39
  SPEAKER_04: Um, and so there is no asset that we could do recognize upon selling this future revenue.
• 19:45
  SPEAKER_04: And so because we're selling this, you know, something that's not an asset yet, we're gonna create a liability through through the sale.
• 19:52
  SPEAKER_04: You see these transactions sort of more commonly in the pharmaceutical space, um, where one party agrees to sell to another like a like a future percentage of a particular drugs earnings or revenue.
• 20:04
  SPEAKER_04: And sometimes you see this in the media industry as well, where they'll sell like a percentage of future royalties off.
• 20:10
  SPEAKER_04: Um, so as I said earlier, it's gonna be debit cash and credit liability.
• 20:14
  SPEAKER_04: The real step and the real accounting analysis is to determine um, well, the first thing you need to do is determine if they're derivatives and whether they're derivatives in their entirety or they have embedded derivatives.
• 20:24
  SPEAKER_04: You know how I love to talk about derivatives, but um here in most cases, because the variability that's associated with the arrangement is based upon the revenue of one of the parties to the contract, generally there's gonna qualify for a scope exception in 815.
• 20:42
  SPEAKER_04: Um I should point out too the FASB just issued some guidance um which changed the scope of 815 and added a new scope exception, which will make even more of these arrangements, not derivatives under 815.
• 20:55
  SPEAKER_04: So you got to look at 815, you got to make a stop there.
• 20:59
  SPEAKER_04: A lot of these are gonna get scoped out of 815, which then brings you to the next real question, which is okay, if we're gonna debit cash and credit liability and the liability is not a derivative, what do we call it?
• 21:10
  SPEAKER_01: Yeah.
• 21:11
  SPEAKER_04: So um there's two things we can call it.
• 21:14
  SPEAKER_04: We either call it deferred revenue or we call it debt.
• 21:17
  SPEAKER_04: The vast majority of these arrangements are not gonna meet the criteria to be qualified as deferred revenue.
• 21:22
  SPEAKER_04: So, for example, one of the criteria says that if the seller of the future revenue has significant continuing involvement in the generation of the cash flows, that then there's a presumption it's debt.
• 21:35
  SPEAKER_04: So most sales of future revenue arrangements that aren't derivatives, they end up as debt.
• 21:40
  SPEAKER_01: Okay.
• 21:41
  SPEAKER_01: That's really interesting.
• 21:43
  SPEAKER_01: So maybe staying on the topic of future revenue sales, Brett, I know there's still some complexities in the subsequent accounting of these arrangements.
• 21:52
  SPEAKER_01: Um, can you highlight some of those?
• 21:54
  SPEAKER_03: Yeah, I think it's a good point to touch on um, because we're applying here some kind.
• 22:00
  SPEAKER_03: Concepts that come from traditional debt would have a maybe a stated maturity and a stated principal amount to some arrangements that don't have that.
• 22:09
  SPEAKER_03: For example, um in these sales future revenue transactions, a lot of times the timing and the amount of cash flows that's going to be paid to the investor are not certain.
• 22:20
  SPEAKER_03: I think there's a wide range of these types of arrangements.
• 22:23
  SPEAKER_03: You know, some will have a cap on the total amount of cash flows that's passed along to the investor.
• 22:28
  SPEAKER_03: That cap may be highly likely of being met, or it may not be.
• 22:33
  SPEAKER_03: But even if you have a cap, you still have variations in the timing of those cash flows.
• 22:38
  SPEAKER_03: Uh and other arrangements sell a specified percentage of the revenue for a set period of time where the total amount is much more uncertain.
• 22:48
  SPEAKER_03: So the guidance in the accounting literature in ASC 470 does state that for these types of transactions, you should still follow the effective interest rate method.
• 22:58
  SPEAKER_03: And so it's kind of a complicated application of the effective interest rate method because uh the cash flows are variable and the entity's best estimate of those cash flows to be paid is going to change every period.
• 23:11
  SPEAKER_03: Uh, and so reporting entities had to have to develop an accounting policy for how to deal with those changes in in cash flow estimates as a part of applying that effective yield method.
• 23:22
  SPEAKER_03: There's not clear guidance on how to do that.
• 23:24
  SPEAKER_03: I should say there's not specific guidance.
• 23:26
  SPEAKER_03: So many entities leverage guidance in some of the concept statements and what you see in other gap.
• 23:31
  SPEAKER_03: Uh, and we see in practice, you most companies apply one of three approaches in dealing with those changes.
• 23:37
  SPEAKER_03: Um, some may apply a prospective method, some do a retrospective method, and there's cumulative catch-up approaches as well.
• 23:45
  SPEAKER_03: And each of these kind of describes its own way to adjust the effective yield, the current carrying value, or both to try to capture those changes in cash flows.
• 23:55
  SPEAKER_03: One overarching principle, I think, uh, do we generally see is that companies generally don't record negative yield when applying those uh methodologies.
• 24:04
  SPEAKER_03: But the choice of exactly which method to use is an accounting policy election that should just be applied consistently and then disclosed.
• 24:12
  SPEAKER_01: Okay.
• 24:13
  SPEAKER_01: That's helpful.
• 24:14
  SPEAKER_01: So maybe the last type of arrangement to touch on is how companies deal with transacting with their vendors or suppliers.
• 24:21
  SPEAKER_01: There's lots of times where companies will structure with a financial intermediary that might create a debt obligation to record.
• 24:30
  SPEAKER_01: Can you talk through some of those examples?
• 24:32
  SPEAKER_04: Yeah, I would go through two examples where you think this can occur.
• 24:36
  SPEAKER_04: One first example we'll talk about is when purchasing inventory with suppliers or transactions involved with purchasing inventory suppliers.
• 24:44
  SPEAKER_04: And the other is actually paying off suppliers for goods and services that you've you've purchased.
• 24:50
  SPEAKER_04: So the first one's um we'll call it product financing arrangements.
• 24:53
  SPEAKER_04: So at times, what an entity will do is maybe arrange for like a third-party institution to purchase inventory on its behalf.
• 25:01
  SPEAKER_04: Um, and depending on the terms of the arrangement, if it meets some scoping criteria that's in, again, for those caring along home 470-40, the entity will be deemed the owner of the inventory, even though I don't legally own the inventory.
• 25:17
  SPEAKER_04: And as a result, from an accounting perspective, I'll have to reflect the inventory on the balance sheet as if it's mine.
• 25:24
  SPEAKER_04: And then what's the offset to that debit?
• 25:26
  SPEAKER_04: It's good credit to debt.
• 25:28
  SPEAKER_04: So basically, what we do is we impute a product financing arrangement because that's the economic substance of the arrangement.
• 25:35
  SPEAKER_04: Um, another example or the second example I wanted to cover was supplier finance arrangements.
• 25:40
  SPEAKER_04: So in this in these programs, a company will use a program that's generally arranged by a bank, which is designed to provide um its suppliers of goods and services access to payment from a bank, from a third-party provider or intermediary in advance of the actual invoice date.
• 26:01
  SPEAKER_04: So I buy goods, the inventory says I have to pay you in 180 days, and there's this program set up where through a financial intermediary, the person who I bought those goods for might be able to get money from the bank before 180 days.
• 26:16
  SPEAKER_04: Um, now these arrangements, I already have a liability on my books.
• 26:20
  SPEAKER_04: I bought the inventory and I put a vendor payable on my books.
• 26:23
  SPEAKER_04: So the question that arises with these sorts of transactions is whether or not it's still appropriate to categorize that liability as a vendor payable or if it uh if I should flip it to debt.
• 26:34
  SPEAKER_04: And so what you're really looking at here is did the arrangement with the bank effectively change the nature of this relationship from a vendor payable to basically financing from a bank?
• 26:44
  SPEAKER_04: There's a lot of factors that you would consider in the analysis, and you need to think about like the total arrangement that you have with the financial institution.
• 26:53
  SPEAKER_04: And a lot of times what we're looking for is have the terms of the liability changed once the bank agrees to step in and make a payment?
• 27:02
  SPEAKER_04: Is has has the agreement really morphed and changed?
• 27:05
  SPEAKER_04: Has the terms changed?
• 27:06
  SPEAKER_04: And if so, it probably becomes debt at that point.
• 27:09
  SPEAKER_04: So those are two examples of where we might end up with a liability or debt on the balance sheet when you're dealing with with more structured transactions with sort of your suppliers and vendors.
• 27:19
  SPEAKER_01: Okay.
• 27:20
  SPEAKER_01: Well, this has been really helpful.
• 27:21
  SPEAKER_01: We've covered a lot of different types of arrangements today that may not be traditional debt, but end up being accounted for as liabilities or debt under US GAAP.
• 27:31
  SPEAKER_01: And it can get pretty complicated.
• 27:33
  SPEAKER_01: So maybe taking a step back and I'll ask each of you um, what are some practical advice that you can give teams when it comes to identifying these arrangements and figuring out where to look for the accounting?
• 27:44
  SPEAKER_01: Brett, maybe I'll start with you.
• 27:46
  SPEAKER_03: Yeah, I I think this is an area where a lot of times the details matter.
• 27:51
  SPEAKER_03: You know, so start out understanding the economic substance of the arrangement uh and then get into the contract, especially when you're dealing with warrants and some of the preferred stock, like some of the settlement features and the redemption provisions, you really have to understand the different scenarios that would that would cause redemption to understand whether it's going to meet the definition of a liability.
• 28:12
  SPEAKER_03: Um, as far as like thinking about you know where to start with the accounting, it's a little like like we just talked through, it's that's all over the place in the literature.
• 28:22
  SPEAKER_03: We've tried to put some of this in our financing guide.
• 28:24
  SPEAKER_03: So maybe that's a a good place to start.
• 28:27
  SPEAKER_03: But I think especially as you're getting into these arrangements, you know, you may end up being if you're in a revenue arrangement, you're gonna be looking at 606 a little bit to understand whether you met the, you know, the either derecognition requirements or the revenue recognition requirements.
• 28:43
  SPEAKER_03: You may be looking at in 860 to understand same thing for transfers of financial assets.
• 28:48
  SPEAKER_03: It's all going to be starting with understanding the the nature of your arrangement and then follow the literature where where you need to go.
• 28:55
  SPEAKER_01: Okay.
• 28:55
  SPEAKER_01: Well, that's helpful.
• 28:56
  SPEAKER_01: Chip?
• 28:57
  SPEAKER_04: Yeah, I mean, I I would echo what Brett said.
• 28:59
  SPEAKER_04: There's not one section of the codification titled, you know, codification X stuff that's got to be reported as debt.
• 29:06
  SPEAKER_04: Um, there is no codification section, as as Brett pointed out, it's a little bit of a hunt and peck, you know.
• 29:11
  SPEAKER_04: There's we mentioned 480, which talks about when certain things be reported as liability.
• 29:16
  SPEAKER_04: Brett mentioned 470 for for certain things.
• 29:19
  SPEAKER_04: Um, 815 was another codification.
• 29:22
  SPEAKER_04: So we only touched on a couple things.
• 29:23
  SPEAKER_04: We already hit three different codification sections.
• 29:26
  SPEAKER_04: Um I guess my my reminder for people would be when you read the contract, in addition to understanding the economics behind the contract, the details really matter.
• 29:38
  SPEAKER_04: Um, particularly when you're dealing with like 480 and a 1540, where you can have a feature of a contract that doesn't have a tremendous amount of economic value, um, but it can absolutely drive the accounting.
• 29:51
  SPEAKER_04: So unfortunately, in figuring out the accounting for these things, it's it's not only important to understand them, like Brett said, at a high level, because you do, and and that'll drive some accounting.
• 30:01
  SPEAKER_04: But there are other instances where you really need to understand the details because I said small details can really change the accounting.
• 30:08
  SPEAKER_01: Okay.
• 30:09
  SPEAKER_01: Well, this has been some great advice, and thank you both so much for joining me today.
• 30:13
  SPEAKER_03: Thank you.
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