The company filed a non-reliance 8-K on Friday, due to “embedded derivatives” in an issue of preferred stock that need to be de-embedded and accounted for as stand-alone derivatives. Why? That’s because Statement 133 requires contracts for financial instruments to be evaluated by the issuer to see if they contain derivatives that wind up getting historical cost treatment just because they’re plopped into just such a contract.
Put it this way: a company might enter an onerous derivative contract that would have to be accounted for at fair value, with the result that investors would see changes in that contract each quarter. To avoid that, the terms of the derivative might be embedded in another contract - like preferred stock or convertible debt - that doesn’t get re-measured at fair value. Statement 133 prevents such end runs by requiring separation of such an embedded derivative from a host contract when all three of these conditions are met:
• The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract.
• The contract containing both the embedded derivative instrument and the host contract is carried at historical cost unless GAAP requires it to be carried at fair value with changes in fair value reported in earnings.
• If the embedded derivative instrument was a separate instrument in the first place, it would be considered a derivative instrument under Statement 133.
The company issued convertible preferred stock in June 2004 - without the proper separation of embedded derivatives. It also issued warrants which should have been classified as liabilities, instead of equity. The firm hasn’t finalized its figures yet, but from the ranges given in the 8-K, it looks like reclassification will slightly improve the net loss in 2004, increase it in 2005, and improve it again slightly in 2006. The balance sheet is more leveraged in 2004, less leveraged in 2005, and unchanged in 2006.
It’s already a fair value reporting world, and only likely to become more so with the issuance of Statement 157, “Fair Value Measurements,” which will pave the way for more fair value reporting standards. Statement 133 was one of the more broadly-sweeping fair value standards issue to date. Before new ones get issued, the SEC might be doing some broad sweeping of its own to make sure that current GAAP is being followed before new fair value GAAP arrives.