UW Madison Big 3 Update 1
FASB Leadership FASB board members Leslie Seidman (2013) Chairman Tom Linsmeier (2016) Russ Golden (2017) Larry Smith (2017) Marc Siegel (2013) Daryl Buck (2015) Hal Schroeder (2015) Advisory groups to the FASB Financial Accounting Standards Advisory Council (FASAC) Investors Technical Advisory Committee (ITAC) Not-for-profit Advisory Committee (NAC) Small Business Advisory Committee (SBAC) Valuation Resource Group (VRG) 2
The current state of convergence projects FASB Timeline FI classification & measurement (1) FI impairment FI hedging (2) Revenue recognition Leases Insurance contracts (3) Investment companies Consolidation Q1 2013 Q2 2013 2H 2013 Comment period Deliberations / Re-deliberations Exposure draft (or re-exposure) Final standard 1. Although the IASB finalized its classification and measurement standard in October 2010, it exposed limited amendments to its standard (IFRS 9) in November, 2012. 2. The FASB s timing for hedge accounting is uncertain. The IASB issued a review draft of its general hedge accounting standard in September 2012. The IASB directed the staff to prepare an Exposure Draft for proposed amendments, which was scheduled to be published in February 2013, but likely will not be published until Q2 2013. The IASB is expected to issue a discussion paper on macro hedging in 2013. 3. The FASB intends to issue an exposure draft in Q2 2013. The IASB is considering re-exposure. 3
The current state of FASB Only projects Liquidity and interest rate disclosure (1) Liquidation basis of accounting Going concern Definition of nonpublic entity Reclassification out of accumulated OCI Repurchase agreements Balance sheet off-setting Discontinued operations Q1 2013 Q2 2013 2H 2013 Comment period Deliberations / Re-deliberations Exposure draft (or re-exposure) Final standard 1. FASB has instructed staff to reconsider objectives of project. May re-expose once objectives reconsidered. 4
Revenue Recognition 5
Revenue recognition Project timeline 2002 2008 2010 2011 2012 2013 2017 Deliberations began Discussion paper issued First exposure draft issued First comment period Redeliberations November 14, 2011 2 nd exposure draft March 13, 2012 2 nd comment period ended April / May Roundtables / outreach July 2012 to February 2013 Redeliberations Q2 2013 Final standard planned Effective date January 1, 2017 6
Revenue recognition Background Single comprehensive revenue recognition model Applicable to all entities / industries Objective to improve consistency and comparability Core principle Recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services 7
Revenue recognition Scope Applies to all contracts with customers Contracts that are scoped out: - Financial instruments - Insurance contracts - Lease contracts - Guarantees (excluding warranties) - Certain nonmonetary exchanges 8
Revenue recognition Proposed model Step 1: Identify the contract with the customer Step 2: Identify the separate performance obligations in the contract Step 3: Determine the transaction price Step 4: Allocate the transaction price Step 5: Recognize revenue when (or as) a performance obligation is satisfied 9
Revenue recognition Proposed model Step 1 Identify the contract Contract creates enforceable rights and obligations May be written, verbal or implied by customary business practice Combine contracts when they are entered into at or near the same time, and: - Negotiated as a package - Payment of one depends on the other - Goods/services promised are a single performance obligation Contract modifications accounting depends on whether distinct goods or services added The above reflects decisions made by the boards to date, but the decisions are tentative and subject to change until a final standard is issued 10
Revenue recognition Proposed model (continued) Step 2 Separate performance obligations Performance obligations are promises in a contract to transfer goods or services to the customer Include offers to provide goods or services that the customer can resell or provide to its customer Distinct replaces standalone value for multiple element arrangements Separate performance obligation if: - Capable of being distinct Customer can benefit from the good or service either on its own or together with other readily available resources - Distinct based on the substance of the contract Good or service is not highly dependent on or highly interrelated with other promised goods or services in the contract Indicators rather than criteria provided to assess performance obligations based on contract s substance The above reflects decisions made by the boards to date, but the decisions are tentative and subject to change until a final standard is issued 11
Revenue recognition Proposed model (continued) Step 3 Determine the transaction price Transaction price includes estimate of expected consideration - Probability-weighted amount, or - Most likely outcome amount - Constrained unless have relevant experience Consider - Variable consideration - Time value of money significant financing component - Noncash consideration - Consideration payable to the customer Collectibility no longer a hurdle for recognition - Allowance presented in separate line as expense below gross margin - Subsequent changes also recorded on this line Constraint for measuring the transaction price - thereby constraining recognition of variable consideration The above reflects decisions made by the boards to date, but the decisions are tentative and subject to change until a final standard is issued 12
Revenue recognition Proposed model (continued) Step 3 Determine the transaction price Step 4 Allocate transaction price Revenue to be recognized from variable consideration is constrained unless: - Entity has experience with similar contracts, and is able to estimate cumulative amount of revenue - Based on its experience, entity does not expect a significant reversal in the cumulative amount of revenue recognized Indicators to assess when experience is predictive or relevant Transaction price allocated to separate performance obligations based on relative standalone selling price - Price when sold separately, or - Estimate if no actual standalone sales Residual approach permitted in limited situations (standalone selling price is highly variable or uncertain) Discounts and variable amounts can be allocated to specific performance obligations, if certain criteria are met The above reflects decisions made by the boards to date, but the decisions are tentative and subject to change until a final standard is issued 13
Revenue recognition Proposed model (continued) Step 5 Recognize revenue Model is based on control (satisfied at a point in time or over time) Specific criteria for when performance obligations are satisfied over time - Customer receives and consumes benefits of an entity s performance as the entity performs, or - Entity s performance creates an asset the customer controls as the asset is created, or - Entity s performance does not create an asset with alternative use, the customer does not control the asset, and the entity has a right to payment for the performance completed to date Use measure of progress that depicts transfer to customer Indicators for when control transfers at a point in time Licenses Licenses are either: - A promise to provide a right - A promise to provide access to an entity s intellectual property Promises to provide a right - transfers at a point in time Promises to provide access to an entity's intellectual property - transfers over time Indicators will be provided to help determine the accounting depending on the nature of the license and the commercial substance of the agreement The above reflects decisions made by the boards to date, but the decisions are tentative and subject to change until a final standard is issued 14
Revenue recognition Proposed model (continued) Other aspects of the proposals Onerous performance obligations requirement has been removed from the proposed revenue standard Right of return similar to current guidance Warranties - Not sold separately cost accrual - Sold separately or provides a service separate performance obligations Options to acquire additional goods or services consider whether provides a material right Impact of repurchase agreements Disclosure Qualitative and quantitative information about performance obligations Amount and timing of recognition for remaining performance obligations Significant judgments and changes in judgments Qualitative description of significant changes in contract asset/liability balances How an entity determines the minimum amount of revenue not subject to the variable consideration constraint Expanded interim disclosures Non-public entities exempt from certain disclosure requirements (FASB only) The above reflects decisions made by the boards to date, but the decisions are tentative and subject to change until a final standard is issued 15
Revenue recognition Proposed model (continued) Transition Effective for annual periods beginning on or after January 1, 2017 Entities may apply the final standard retrospectively or use the following practical expedient: - Apply to all contracts as of the effective date and all contracts executed subsequently - Recognize the cumulative effect of applying the new standard to existing contracts in the opening balance of retained earnings on the effective date - For existing and new contracts accounted for under the new standard, disclose the impact of adopting the standard on all affected financial statement line items in the period the standard is adopted Early adoption not permitted The above reflects decisions made by the boards to date, but the decisions are tentative and subject to change until a final standard is issued 16
Leasing 17
Lease accounting overhaul Perceived Problems with existing lease accounting rules Lessee Financial statements do not clearly depict the impact of operating leases Bright lines reduce transparency and comparability Opportunities to structure transactions to achieve a particular lease classification Current accounting believed to be conceptually flawed 18
Lease project Timeline Effective Date Years Presented in SEC Financial Statements FY 2017 FY 2015, FY 2016, FY 2017 FY 2018 FY 2016, FY 2017, FY 2018 Aug. 2010 Dec. 2010 Jan. 2011 2Q 2013 2014? 2017/2018? Exposure Draft issued Comment period ended Re-deliberations begin Re-exposure Final standard? Effective date? 19
Summary of proposals in the 2010 leasing ED Operating lease accounting eliminated Lease term, contingent rents, residual value guarantees estimated and remeasured Existing leases are not grandfathered Leases of tangible assets, short term leases and embedded leases scoped in Leases of intangible assets, purchase/sale transactions, immaterial items, investment property accounted for at FV scoped out Hybrid approach for lessor accounting Balance sheet Assets Liabilities Income statement Rent expense Amortization Interest expense EBIT EBITDA EBITDAR EPS Cash flow statement Cash from ops Cash from finance 20
Annual Expense (in $) Summary of proposals in the 2010 leasing ED, continued $2,700 $2,600 $2,500 $2,400 $2,300 $2,200 $2,100 $2,000 $1,900 $1,800 $1,700 $1,600 Lessee accounting 1 2 3 4 5 6 7 8 9 10 Years Proposed Model Current model Cash Rents The chart above depicts the impact on earnings for a basic 10-year lease with an initial annual rent of $2,000, a 2% annual escalation rate and an assumed incremental borrowing rate of 7%. 21
Redeliberations - preliminary decisions reached Lessee accounting The Boards tentatively decided on a two method approach based on the type of lease An interest and amortization model and a single lease expense model The dividing line is based on a principle of consumption supplemented with a practical expedient presumption based on the nature of the underlying asset Both models would require the right-of-use asset (ROU) and lease liability to be recorded on the balance sheet except for leases meeting the definition of short-term Initial measurement of the ROU and liability under both methods would be as follows: The lease liability would initially be measured at the present value of the lease payments and subsequently measured at amortized cost using the effective interest method The ROU would initially be measured at an amount equal to the lease liability (plus initial direct costs) 22
Redeliberations - preliminary decisions reached Lessee accounting (continued) Differences between the model arise in the geography of expense on the P&L and the expense recognition pattern Interest and Amortization Model (I&A) Single Lease Expense Model (SLE) The lease liability would be measured at amortized cost using an effective interest rate method while the right-of-use asset would be measured at amortized cost. The lessee would allocate the total lease payments, including initial direct cost, evenly over the lease term, irrespective of the timing of lease payments, to calculate the periodic straight-line expense. Interest expense and amortization expense would be reported separately in the income statement. The right-of-use asset amortization expense would be a balancing figure, calculated as the difference between the periodic straight-line expense and the interest cost on the lease liability. Right-of-use asset and lease liability amortization expense would be reported in a single line item in the income statement - lease expense. The notes to the financial statements would include the components of interest expense and the expense associated with the right-of-use asset. 23
Dual Model The new dividing lines Lessee accounting Straight- Line Insignificant Lease duration* Property: Innocent until proven guilty Commercial real estate (10 yr/40 yr) Straight-Line Financing Financing Non-property: Guilty until proven innocent Vessel (5 yr/40 yr) Truck (4 yr/10 yr) Commercial real estate (30 yr/40 yr) Airplane (8 yr/25 yr) Vessel (20 yr/40 yr) Car fleet (3 yr/6 yr) Significant Lease duration* Rebut the presumption of insignificant consumption if: Lease term major part of economic life of the underlying asset OR PV of fixed lease payments are substantially all FV of underlying asset Rebut the presumption of more than insignificant consumption if: Lease term an insignificant portion of economic life of the underlying asset OR PV of fixed lease payments are insignificant relative to the FV of underlying asset PV of payments *Lease duration with respect to economic life PV of payments 24
Summary of key changes from the starting point Current Model 2010 ED Re-deliberations Definition of a lease Many embedded leases are operating leases (similar treatment as service/supply arrangements) On balance-sheet treatment for embedded leases On balance-sheet treatment for embedded leases Lease term Include renewal options that are "reasonably assured" of being exercised Include more likely than not lease term Re-measure and update the estimates Include renewal options where lessee has a significant economic incentive to exercise Variable lease payments Contingent rentals are generally expensed as incurred Rents based on index/rate or are in-substance fixed are included Contingent rents are estimated and included at lease inception Estimates are reassessed Rents based on index/rate or are in-substance fixed are included Usage or performance-based rents are not included Estimates are reassessed Lessee accounting Operating lease Capital lease Right of use model Short term leases not scoped out Interest and amortization approach Single lease expense approach Short term leases not scoped out 25
Redeliberations other tentative decisions Other areas - Scope - Short term leases - Inception vs. commencement date - Discount rate - Initial direct costs - Sale-leaseback transactions - Lease incentives - Lessor receivables - Intercompany leases - Residual value guarantees - Foreign exchange differences - Impairment - Subleases - Lease and non-lease components - Contract modifications - In-substance sales and purchases - Business combinations - Embedded derivatives - Purchase options - Leveraged leases (FASB only) - Lessee presentation and disclosure - Lessor presentation and disclosure - Transition (retrospective approach with certain reliefs) - Cancellable leases (aka month to month leases ) 26
Unprecedented changes are coming Business Impacts Financial Ratios will change - Balance sheets would expand; leverage and capital ratios may suffer - Expense recognition pattern may change (depending on the type of lease) - Rent expense recast as interest and amortization expense will change performance metrics such as EBITDA and, in the statement of cash flows, cash flows from operations (depending on the type of lease) - Loan covenants, credit ratings, internal budgeting, compensation plans and other agreements may be affected - Real estate/ equipment financing strategy (lease vs. buy), forecasting models, incentive compensation plan metrics, etc. Systems and controls evaluation - Record-keeping and accounting under the new model would likely need to be computer-based - New process and controls will need to be developed especially around changes in estimate Business Impacts (cont.) Functional Areas Impacted - Accounting/reporting - Tax implications (for example, impact to the provision through increase in DTL) - Treasury - Legal/regulatory - Operations (including corporate real estate) - Regulatory capital Other - Sale-leaseback transactions may change focus (if the leaseback is on balance sheet, transactions may become more borrowing or tax-driven than accounting driven) 27
Financial instruments 28
Financial instruments Classification and measurement (continued) Debt investments (1) Classify based on: Business strategy Instrument characteristics Amortized cost Primary objective is to hold to collect contractual cash flows Fair value through OCI Primary objective is to hold to collect contractual cash flows and realize fair value changes through sale Fair value through net income Residual category No bifurcation of hybrid instruments Fair value option available for measurement mismatches (IASB only) Fair value option for debt investments that qualify for fair value through OCI (FASB only) Reclassification if business strategy changes (1) FASB s proposal and IFRS 9 adjusted for joint decisions 29
Financial instruments Classification and measurement (continued) Equity investments IFRS 9 FASB s Proposal Fair value through P&L Default Fair value through OCI Irrevocable election Fair value through net income Default Cost less impairment Exception for certain investments in specialized industries Cost Provided representative of fair value Practical expedient for unquoted equity investments Cost less impairment adjusted for observable prices Practicability exception for nonmarketable equities 30
Financial instruments Classification and measurement (continued) Financial liabilities IFRS 9 Retains IAS 39 classification FASB s Proposal Retains current GAAP except limits fair value option and changes treatment of own credit Amortized cost Non-trading Fair value through P&L Trading Amortized cost Required unless business strategy is to transact at fair value or for short sales Fair value through net income Short positions, if elect FVO, and if intend to subsequently transact at FV. Retains bifurcation of hybrid instruments Fair value option available in certain cases If elect fair value option, changes due to own credit go to OCI Retains bifurcation of hybrid instruments Fair value option available in certain cases If elect fair value option, changes due to own credit go to OCI For non-recourse debt that can only be settled with certain assets, the measurement of the debt follows the measurement of the assets 31
Financial Instruments Impairment Estimating expected losses under FASB and IASB models Both the credit deterioration model (IASB) and the CECL (FASB) model focus on an expected value measurement for credit losses Both models require credit loss estimates to be based on internally and externally available information considered relevant in making the estimate, including information about past events, current conditions, and reasonable and supportable forecasts Both models require the estimate of credit losses to consider a scenario where a credit loss results and a scenario where no credit loss results. Entities are prohibited from estimating expected credit losses based solely on the most likely outcome. Estimates under both models should include consideration of the time value of money 32
Financial Instruments Impairment The FASB s Current Expected Credit Loss (CECL) model After deciding not to move forward with the three bucket model, the FASB staff has developed a revised model referred to as the CECL model The model removes the dual measurement approach of the IASB model and creates a single measurement of current expected credit losses, which reflects management s best estimate of the future contractual cash flows that the entity does not expect to collect Interest income is generally recognized on the basis of contractual terms with the exception of purchased credit impaired (PCI) assets, where only the non-credit portion of the purchase discount/premium is recognized in income over the life of the asset The CECL model requires interest income recognition to cease when it is no longer probable that the full amount of principal and interest payments will be collected 33
Financial Instruments Impairment The IASB s Credit Deterioration Model The guiding principle of the IASB s model is to reflect the general pattern of credit deterioration associated with a financial asset over its life n financial assets The IASB model only requires a full expected loss recognition when there has been a significant increase in the probability of default since origination or acquisition. For all other assets, credit losses are recorded based on the probability of a default occurring in the next twelve months. Interest income generally recognized on the basis of contractual terms with the exception of PCI assets, where income is recognized on the basis of expected cash flows The IASB model requires interest income to be recognized on a net basis (net of allowance) when the asset becomes impaired 34
Financial Instruments Impairment The IASB s Credit Deterioration Model (cont) 12-month expected credit loss Lifetime expected credit loss The present value of all cash shortfalls expected over the remaining life of the financial asset associated with the probability of a default occurring on the financial asset in the 12 months after the reporting date. The present value of all cash shortfalls expected over the remaining life of the financial asset associated with the probability of a default occurring on the financial asset over the remaining life of the asset. 35
Financial Instruments impairment Three bucket model Credit deteriorates Credit improves Credit improves Bucket 3 Bucket 1 Bucket 2 Financial assets assessed individually with a more than insignificant deterioration of credit quality Financial assets with insignificant deterioration in credit Portfolios of financial assets with a more than insignificant deterioration of credit quality 36
Financial Instruments impairment Reserves for each bucket Credit deteriorates Credit improves Credit improves Bucket 3 Bucket 1 Bucket 2 Reserve full expected losses for loss events expected to occur over remaining life (individual assets) Reserve full expected losses for loss events expected to occur over next 12 mos. Reserve full expected losses for loss events expected to occur over remaining life (portfolios) 37
Next steps for impairment Comments on the FASB proposal are due April 30, 2013 The IASB will expose their document in March of 2013 with a likely comment period of 120 days 38
Financial instruments Hedge accounting Timeline June 2008: FASB issues ED with goal of simplification; defers changes to joint financial instruments project December 2010: IASB issues exposure draft on general model only; comment period ended March 2011 September 2012: IASB issues review draft of the general hedging final standard; effective January 1, 2015 May 2010: FASB issues hedge accounting proposals as part of financial instruments project February 2011: FASB issues discussion paper seeking views on IASB s proposal; comment period ended April 2011 On the horizon IASB discussion paper on macro hedging; FASB timing to be determined on general hedging and has nothing pending on macro hedging 39
Financial instruments Hedge accounting (continued) Overview Comparing the boards proposals FASB 2010 proposal IASB revised draft FASB discussion paper Objective is simplification; targeted changes proposed Easier to qualify for hedge accounting (reasonably effective) Less onerous hedge effectiveness assessment requirements Removal of shortcut and critical terms match methods Cannot elect to stop hedge accounting Objective is simplification and linkage to risk management activities Proposals are broader and in some cases more flexible than the FASB s Concept of effectiveness, as well as what can be hedged, is different from FASB s proposal Cannot elect to stop hedge accounting Requires new disclosures Sought views regarding understandability, operability, and auditability of the IASB s proposal Asks whether FASB should aim for convergence, or targeted improvements to US GAAP for hedge accounting Feedback to be considered in redeliberations 40
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