PURPOSE Board Meeting Handout ACCOUNTING FOR CONTINGENCIES September 6, 2007 At today s meeting, the Board will discuss whether to add to its technical agenda a project considering whether to revise the guidance on accounting for contingencies, as currently provided for in FASB Statement No. 5, Accounting for Contingencies (including gain contingencies). OBJECTIVE Statement 5 was issued by the FASB in March of 1975. Statement 5 continues to impact many areas of accounting. Users of financial statements have communicated concerns that, as a result of the Statement 5 recognition criteria, delayed recognition of assets and liabilities occurs in practice. Similarly, users of financial statements consider the disclosure criteria in Statement 5 to be inadequate or ineffective, as application in practice seems limited. In addition, the existing conceptual framework, including the definition of financial statement elements, was not in place when Statement 5 was issued, which results in inconsistency when comparing the definition of the elements and the items recognized under Statement 5. Consequently, the Board has been contemplating adding a project to reconsider the accounting for contingencies. In recent years, the Board has deviated from the Statement 5 recognition and measurement criteria in certain standards and implementation issues, including FASB Statement No. 143, Accounting for Asset Retirement Obligations, FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities, FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, and, most recently, within proposed Statement No. 141(R), Business Combinations. In those cases, the Board decided that recognition and measurement under the new guidance is more appropriate than the Statement 5 approach. For example, in proposed Statement 141(R), contractual contingencies acquired in a business combination that would have otherwise been accounted for under Statement 5 would be measured at fair value both at and following the date of acquisition. Noncontractual contingencies that otherwise would have been within the scope of Statement 5 would be recognized and measured at fair value if it is more likely than not that these contingencies meet the definitions of the elements in FASB Concept Statement No. 6, Elements of Financial Statements. Statement 5 would continue to apply for contingencies not assumed as part of a business combination. The staff has been made aware that certain key constituents oppose the difference in measurement guidance for contingencies arising in the normal course of business and for the subsequent measurement of contingencies arising in business combinations. From an international perspective, the IASB is reconsidering its standard on contingencies, International Accounting Standard No. 37, Provisions, Contingent Liabilities and Contingent Assets, in a project that commenced in 2002. The IASB is currently redeliberating many issues in that project, including recognition and, more broadly, the definition of a liability. The FASB staff understands that the reconsideration of IAS 37 may not be finalized in the near-term. The staff prepares meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.
QUESTION FOR THE BOARD: Does the Board want to add a project on contingencies to its agenda? If so, the staff has identified two alternative approaches. Alternative A Add a short term project to the Board s agenda to address a narrow scope of contingencies that would reconsider recognition, measurement and disclosure with the goal of aligning the guidance reached with the guidance for contingencies in proposed Statement 141(R). Due to the short-term nature of this alternative, convergence would not be a goal. Alternative B Add a phased project to address the accounting for contingencies to the Board s agenda. Phase 1 Eliminate the inconsistencies for subsequent measurement of contingencies between proposed Statement 141(R) and Statement 5 by requiring contingencies to be subsequently measured at the higher of the Statement 5 amount and the acquisition date fair value for contingent liabilities and the lower of the acquisition date fair value and the best estimate of a future settlement amount for contingent assets. Phase 2 Develop enhanced disclosure requirements for contingencies in Statement 5. Phase 3 Add a long-term project to comprehensively reconsider all accounting models for contingencies. The scope, timing and potential for convergence would be explored by the staff and presented to the Board at a future date. 2
Useful Life and Amortization of Intangible Assets Board Meeting Handout September 6, 2007 BACKGROUND At the July 11, 2007 Board meeting, the Board agreed that the concept of material modification should be removed from subparagraph 11(d) of Statement 142. They also agreed that in situations where an intangible asset was originally measured using an income-based valuation technique, the undiscounted cash flows considered in the fair value measurement shall be utilized to assist in the determination of useful life (adjusted for certain entity specific factors, including an entity s historical experience with renewing or extending similar arrangements). Part of their rationale for accepting this alternative was that if the cash flows were reliably determinable for valuation and measurement purposes, then they should also be reliably determinable for amortization purposes. The Board agreed, however, that this decision could cause implementation questions around the method of amortization. At the July 11, 2007 Board meeting, the Board asked the staff to draft alternatives for the method of amortization, renewal costs, disclosures, and transition/effective date. PURPOSE At this meeting the staff intends to ask the Board: 1. If the Board wants to limit the scope of this project solely to the practice issue that was initially presented to the Board. That is, the scope of the project would be limited to providing guidance on the determination of the useful life of intangible assets. 2. If the Board does not want to limit the scope of this project to providing guidance on the determination of the useful life of intangible assets, then whether the Board would like to provide guidance on amortization and renewal costs. The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.
3. If the Board agrees with proposed additional disclosures to Statement 142. 4. If the Board agrees that a proposed FSP should be effective for fiscal years beginning after June 15, 2008 and applied prospectively to intangible assets acquired after the effective date of the proposed FSP. 5. If the Board wants the staff to proceed with a preballot draft of a proposed FSP that would have a 45-day comment period. ISSUE 1: SCOPE The staff has provided the Board with alternatives for addressing the method of amortization and the accounting for renewal costs. However, the staff would like the Board to reconsider its decision to expand the scope beyond the original issue that the Board was asked to address (that is, the determination of the useful life of intangible assets). The staff believes that neither amortization (a non-cash charge) nor renewal costs represent significant current practice issues and therefore should not be addressed in this project. In fact, the staff believes that raising issues related to the pattern of economic benefit will lead to additional questions with widely divergent alternatives. Providing guidance on these divergent alternatives would create unnecessary complexity, and would delay the resolution of a current practice issue. Therefore, the staff recommends that the proposed FSP address only the determination of the useful life of intangible assets. If the Board agrees with the staff s recommendation, then the staff proposes that paragraph 11 of Statement 142 be modified as follows: Determining the Useful Life of an Intangible Asset 11. The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. The estimate of the useful life of an intangible asset to an entity shall be based on an analysis of all pertinent factors, in particular: a. The expected use of the asset by the entity b. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate 2
c. Any legal, regulatory, or contractual provisions that may limit the useful life d. Any legal, regulatory, or contractual provisions that enable renewal or extension of the asset s legal or contractual life without substantial cost (provided there is evidence to support renewal or extension and renewal or extension can be accomplished without material modifications of the existing terms and conditions) d. The entity s historical experience in renewing or extending similar arrangements, regardless of whether such arrangements have explicit renewal or extension provisions. If the entity has no historical experience in renewing or extending similar arrangements, the entity may use market participant assumptions about renewing or extending similar arrangements e. The effects of obsolescence, demand, competition, and other economic factors (such as the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels) f. The level of maintenance expenditures required to obtain the expected future cash flows from the asset (for example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life). [Footnote references omitted.] It is common for an income-based valuation technique to be utilized in the determination of fair value for an intangible asset. In cases where this technique is used, the remaining useful life shall also consider the periods of undiscounted cash flows used in the fair value determination (adjusted downward as appropriate for the entity specific factors summarized above in subparagraphs 11(a) to 11(f)). If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an intangible asset to the reporting entity, the useful life of the asset shall be considered to be indefinite. The term indefinite does not mean infinite. Appendix A includes illustrative examples of different intangible assets and how they should be accounted for in accordance with this Statement, including determining whether the useful life of an intangible asset is indefinite. Question 1a for the Board: Does the Board agree with the staff s recommendation that a proposed FSP should only address the determination of the useful life of intangible assets? Question 1b for the Board: If the answer to 1a is yes, then does the Board agree with the proposed modifications to paragraph 11 of Statement 142 that are illustrated in the Board handout? If the answer to Question 1 is no, then the staff will ask questions relating to amortization and renewal costs (below). If the answer to Question 1a is yes, then proceed to Issue 4. 3
ISSUE 2: METHOD OF AMORTIZATION There are various amortization methods that are currently being used in practice, as well as methods that have been suggested as alternatives. These include: a. Straight-line. b. Modified straight-line. In this method, preparers will determine the period at which, say 80 or 90 percent of the cash flows have been realized, and then apply a straightline amortization over that period. c. Pattern of economic benefit. Negative amortization is allowed. The staff is not aware of this method being currently used in practice. d. Pattern of economic benefit. If undiscounted cash flows include periods of zero or negative cash flows, then amortization is based on a straight-line methodology (thus, the same as (a) above). e. Pattern of economic benefit. In periods where undiscounted cash flows are zero or negative, amortization is suspended. In periods with positive undiscounted cash flows, amortization is calculated based on the ratio of undiscounted positive cash flows in a reporting period to the total undiscounted positive cash flows over the useful life of the intangible asset. The staff recommends that the more theoretically sound pattern of economic benefit be utilized to amortize intangible assets. The staff acknowledges that while the straight-line and modified straight-line methods are significantly less complex than the pattern of economic benefit method, they still do not match the use/consumption of the asset with the amortization. The staff believes that the Board s intention was not to require a new pattern (which may require a new valuation) at each reporting period, but rather to only require an adjustment to the pattern when a change in events or circumstances would significantly change the pattern of economic benefit. The staff would propose including a modification to paragraph 14 of Statement 142 to include the use of the word significantly when describing the degree to which the pattern of economic benefit would need to be changed for a modification to the pattern of amortization to be required. The staff believes that this modification will reduce constituents concerns about the cost and complexity of adopting a pure pattern of economic benefit amortization method. Further, the staff recommends that during periods of negative or zero cash flows, amortization is suspended (including in interim periods). At the time in which the undiscounted cash flows become positive, then amortization will be based on the ratio of positive undiscounted cash flows 4
for a reporting period to the total positive undiscounted cash flows over the useful life of the intangible asset. Question 2a for the Board: Does the Board agree with the staff recommendation that during periods of negative or zero undiscounted cash flows, amortization would be suspended until positive undiscounted cash flows occur, at which time amortization will be calculated based on the ratio of positive undiscounted cash flows for the period divided by the total positive undiscounted cash flows over the useful life of the intangible asset? Question 2b for the Board: Does the Board agree to modify paragraph 14 to include the word significantly in a proposed FSP when describing the degree to which the pattern of economic benefit would need to be changed for a modification to the pattern of amortization to be required? ISSUE 3: RENEWAL COSTS The staff believes that the first question that should be addressed is whether or not the incremental and direct costs of renewal should be capitalized or expensed as incurred (see alternatives that follow). Should the Board decide that renewal costs should be capitalized, the staff believes that the Board must then address the period over which those costs should be amortized. (See discussion that follows.) Capitalize versus Expense The staff believes that the characterization of renewal costs will depend upon whether the costs maintained or extended the useful life of the intangible asset. Under this model, costs incurred to maintain the value and useful life of the intangible asset would be expensed as incurred in accordance with paragraph 10 of Statement 142. The staff believes that when the determination of the useful life includes renewal periods, then expending funds on renewal costs simply maintains the value and useful life originally ascribed to the intangible asset. Had the entity not expended funds to renew the agreement, then the value associated with the renewals would have to be written off. The staff acknowledges that the valuation of the intangible asset is reduced for the amount of the renewal costs (at initial measurement), but also notes that these costs are offset due to the inclusion of income associated with the renewal that would not have been included had the entity not incurred the renewal costs. 5
Costs incurred to extend the useful life of the intangible asset would be capitalized as incurred. The staff believes that when the determination of the useful life excludes renewal periods, then expending funds on renewal costs is an enhancement to the intangible asset because it extends the useful life of the intangible asset. Question 3a for the Board: Does the Board agree with the staff s recommendation that incremental and direct costs of renewal should be accounted for based on the nature of the cost? Question 3b for the Board: If the Board answers yes to Question 3a, does the Board agree with the staff s characterization of maintenance and enhancement costs and the proposed accounting for maintenance and enhancement costs? Amortization of Renewal Costs The staff believes that each renewal provides an economic benefit that is not limited to the new contractual period that is created by the exercise of the renewal right. The staff believes that the current exercise of a renewal right impacts the value of all future periods (that is, without the exercise of the renewal right, all future renewals inherently have zero value). Accordingly, the staff believes that all renewals have an economic benefit that extends through the remaining useful life of the asset and as such, it should be reflected in the amortization period. Additionally, the staff does not believe that a single asset should have multiple useful life determinations (that is, separate useful lives for the underlying asset and capitalized costs of renewal). The staff notes that limiting the amortization of the renewal costs to the contractual period created by the renewal is inconsistent with how the asset s initial value is recognized (that is, the initial value of the asset is amortized over the useful life of the asset and is not limited to the initial period of contractual use). Question 3c for the Board: Does the Board agree with the staff s recommendation that incremental and direct costs of renewal that are capitalized should be amortized over the remaining useful life of the intangible asset? 6
ISSUE 4: DISCLOSURES The staff believes that some additional disclosures on intangible assets with renewal or extension terms are necessary to provide users with insight into key event risks, such as the loss of customers or licenses, which may or may not result in future cash flows. Therefore, the staff is recommending that paragraphs 44 and 45 of Statement 142 be amended as follows: 44. For intangible assets acquired either individually or with a group of assets, the following information shall be disclosed in the notes to the financial statements in the period of acquisition: a. For intangible assets subject to amortization: (1) The total amount assigned and the amount assigned to any major intangible asset class (2) The amount of any significant residual value, in total and by major intangible asset class (3) The weighted-average amortization period, in total and by major intangible asset class (4) For intangible assets with renewal or extension terms (both explicit and implicit), the weighted-average initial contract period and the entity s history of renewal, by major intangible asset class b. For intangible assets not subject to amortization, the total amount assigned and the amount assigned to any major intangible asset class c. The amount of research and development assets acquired and written off in the period and the line item in the income statement in which the amounts written off are aggregated. 45. The following information shall be disclosed in the financial statements or the notes to the financial statements for each period for which a statement of financial position is presented: a. For intangible assets subject to amortization: (1) The gross carrying amount and accumulated amortization, in total and by major intangible asset class (2) The aggregate amortization expense for the period (3) The estimated aggregate amortization expense for each of the five succeeding fiscal years b. For intangible assets not subject to amortization, the total carrying amount and the carrying amount for each major intangible asset class c. For intangible assets with renewal or extension terms (both explicit and implicit): (1) The total amount expended for the period to renew or extend the contractual term of an intangible asset and the line item in either the balance sheet or income statement in which the amounts are aggregated 7
(2) A qualitative description of the likelihood of renewal for contracts with initial contractual periods or renewal periods ending within the next fiscal year, by major intangible asset class d. The changes in the carrying amount of goodwill during the period including: (1) The aggregate amount of goodwill acquired (2) The aggregate amount of impairment losses recognized (3) The amount of goodwill included in the gain or loss on disposal of all or a portion of a reporting unit. The staff believes that these additional disclosures, coupled with the existing requirement to disclose the amount assigned to major intangible asset classes and the weighted-average amortization period by major intangible asset class, will enable users to assess the value attributable to renewal periods without requiring disclosures that may be burdensome to preparers. Question 4 for the Board: Does the Board agree with the additional disclosures as described above? ISSUE 5: TRANSITION AND EFFECTIVE DATE The staff recommends an effective date for fiscal years beginning after June 15, 2008 with early adoption being prohibited. In accordance with the Board s effective date guidelines, the Notice for Recipients will indicate when the staff expects to finalize the proposed FSP and ask whether the proposed effective date provides sufficient time for affected entities to understand and apply the requirements of the FSP. The staff is recommending that the proposed FSP should be applied prospectively to intangible assets acquired after the effective date of the proposed FSP. The staff believes that retrospective application for intangible assets acquired or renewed prior to the effective date of the proposed FSP is impracticable because there would be substantial cost and effort associated with the recalculation of amortization for assets previously acquired. Question 5 for the Board: Does the Board agree with the staff s recommendation that the proposed FSP should be applied prospectively to intangible assets acquired after the effective date of the proposed FSP with an effective date for fiscal years beginning after June 15, 2008? 8
Question 6 for the Board: Does the Board want to proceed with a preballot draft of a proposed FSP that would have a comment period of 45 days? 9