We recently delivered this slide deck to clients and associates of Frazier & Deeter concerning recent developments with proposed convergence accounting standards. These standards are linked to IFRS, but will be effective for all US GAAP entities, regardless of status of IFRS in the US.
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January 2011 A&A update from Frazier & Deeter, LLC
1. Frazier & Deeter Client A&A
Update –
Key Convergence Topics
Bill Godshall
Bill.godshall@frazierdeeter.com
January 7, 2011
2. ACCOUNTING FOR LEASES
A NEW ACCOUNTING MODEL EMERGES
Rebekah Walters, Manager
Frazier & Deeter, LLC
Atlanta, GA
3.
4. WHY CHANGE?
– Create consistency, comparability and
transparency
WHAT’S CHANGING?
– Right-of-use-model
– Effectively eliminate operating leases
– Lessor hybrid accounting model
– The proposed guidance would
supersede Topic 840 (previously SFAS
13) on Leases (U.S. GAAP) and IAS 17
Leases (IFRS).
WHEN?
– Exposure Draft (ED) issued on August
17, 2010
– Comments due December 15, 2010
– Final issuance June 2011 (estimate)
– Effective date is TBD (best guess is
2013)
7. SCOPE
ED would not apply to:
– Leases of intangible assets
– Leases to explore for or use minerals, oil,
natural gas, and other non-regenerative
resources
– Leases of biological assets
8. SCOPE (CON’T)
ED would not apply to a purchase or a
sale:
– Transfer of control and all but a trivial amount
of risks and rewards
Examples of transferring control
– Automatically transfers title to the underlying
asset, or
– The contract contains a bargain purchase
option
10. RECOGNITION
Lessee model
– “Right-Of-Use” asset
– “Obligation to Make
Lease Payments” liability
– Applicable to all leases
11. MEASUREMENT
Obligation to make lease payments liability
– Present value of Lease Payments discounted using lessee’s
incremental borrowing rate
• Or rate lessor charges in lease, if readily determinable
• Relief for short term leases
– Measured over the Lease Term
Right-of-use asset
– Cost – present value of lease payment plus any initial direct
costs
– Starting amount is same as liability
ED does not address the effect of lease incentives
12. MEASUREMENT
Lease term
– The longest possible term that is more likely
than not to occur
– Estimate the probability of each possible
lease term
– Likely that lease terms may be longer under
new model
– Consider all facts and circumstances
13. EXAMPLE
A company leases a manufacturing
facility beginning on January 1, 2010
and has a reporting year end of
December 31. The lease provides for
a non-cancellable 10 year term with
an option to renew for 5 years at the
end of the 10 year period and an
additional option to renew at the end
of the 15 year period and fixed annual
payments of $3,000,000, including
renewal periods. Contingent rentals
are due annually at a rate of 2% of
revenue. The company’s incremental
borrowing rate is 8%.
14. EXAMPLE (CON’T)
Exercise 2 Five Exercise 1 Five No renewals
Year Renewals Year Renewal exercised
Total Lease Term 20 15 10
Probability 30% 25% 45%
Cumulative Probability 30% 55% 100%
15. MEASUREMENT
Initial Measurement of Lease payments
– Measure using “Expected Outcome Approach”
• The present value of the probability-weighted average of the
cash flows for a reasonable number of outcomes
– Contingent rentals (e.g. based on index or rate)
• Use forward rates, if available
• Prevailing rates (If no forward rates are available)
– Residual value guarantees
– Term option penalties
16. MEASUREMENT
How do you determine present value of
payment stream (Expected Outcomes
Approach)?
1. Develop reasonably possible outcomes over
the [calculated] life of the lease
2. Estimate amount and timing of cash flows for
each outcome
3. Calculate the present value of the cash flows
4. Probability-weigh each outcome
17. EXAMPLE (CON’T)
A company leases a manufacturing
facility beginning on January 1, 2010
and has a reporting year end of
December 31. The lease provides for
a non-cancellable 10-year term with
an option to renew for 5-years at the
end of the 10-year period and an
additional option to renew at the end
of the 15-year period and fixed
annual payments of $3,000,000,
including renewal periods.
Contingent rentals are due annually
at a rate of 2% of revenue. The
company’s incremental borrowing
rate is 8%.
18. EXAMPLE (CON’T)
Total
Expected Sales over 15 Contingent Present Probability-
Outcome years* Rentals Value Probability weighted
2% decline in 261,430,897 5,228,618 3,068,069 10% 306,869
sales
Flat sales 300,000,000 6,000,000 3,423,791 30% 1,027,137
4% increase in 400,471,753 8,009,435 4,322,675 40% 1,729,070
sales
8% increase in 543,042,279 10,860,846 5,555,556 20% 1,111,111
sales
Total 4,174,187
* - assuming $20,000,000 in first year Calculation:
Lease_Accounting_Model_Example.xls
19. EXAMPLE (CON’T)
The company would recognize a right-of-use asset for $29,852,623
Net present value of fixed lease payments $ 25,678,436
Net present value of contingent rentals 4,174,187
Right-of-use asset/obligation to make lease payments $ 29,852,623
At the inception of the lease, the company would record the following accounting
entry:
Dr. Right-of-use asset $29,852,623
Cr. Obligation to make lease payments $29,852,623
20. MEASUREMENT
Subsequent measurement and
reassessment
– Subsequent measurement
• Liability - amortized cost under the effective interest
method
• Right-of-use asset - amortized cost on a systematic
basis over life of lease or useful life, if shorter
21. MEASUREMENT
Subsequent measurement and reassessment
– Reassessment
• If facts or circumstances indicate that there would be a
significant change in the liability since the previous
reporting period
– Remeasurement
• Change in lease term would provide for a
corresponding adjustment to the right-of-use asset
• Changes in estimated payment stream
– Recognized in income to extent [adjustment] changes
related to prior or current periods
– Adjust right-of-use asset for [adjustment] changes related
to future periods
23. LESSOR MODEL
Hybrid accounting model
– Performance obligation
• Lessor retains significant risks and
rewards
– Derecognition
• Lessor transfers significant risks
and rewards
– Intended to follow the business
model of the lessor
– No bright lines in making
determination
24. PERFORMANCE OBLIGATION
Recognition
– Performance
obligation liability
• permit the lessee to
use the asset
• Measure at rate
charged by lessor
– Asset [receivable]
• the right to receive
lease payments
25. PERFORMANCE OBLIGATION
Measurement of right to receive lease payments
– Longest possible term that is more likely than not to
occur
– Present value of lease payments utilizing the expected
outcome approach
– Similar to lessee calculation; however
• Contingent rentals and residual value guarantees are
subject to reliability criterion (i.e. measured reliably)
• Include term option penalties
Evaluation and Remeasurement
• Similar to lessee requirements
26. DERECOGNITION
Balance sheet
– Recognize the right to receive lease payments
– Remove a portion of the asset
• Reclassify as a residual asset the lessor’s right in the asset which
did not transfer to lessee
Income statement
– Lease income for the present value of the lease payments
– Lease expense for the asset derecognized
• The measurement of the lease term, contingent rentals, residual value guarantees
and term option penalties would be identical to the performance obligation
approach.
27. DERECOGNITION
Asset derecognized
The portion of the derecognized asset is
calculated as follows:
Fair value of the right to receive lease payments x Carrying amount of the underlying asset
Fair value of the underlying asset
The remaining asset is classified as a residual asset
28. DERECOGNITION
Subsequent measurement
– Measure lease receivable at amortized cost using the
effective interest method
Remeasurement
• Change in lease term would provide for a
corresponding adjustment to the residual asset,
after allocation between the derecognized asset
and residual asset
• Changes in estimated payment streams are
recognized in income
30. SHORT TERM LEASES
Lessees
– Short term lease – a lease that, at the date of
commencement of the lease, has a maximum
possible lease term, including options to renew or
extend, of 12 months or less
– Lessee has an election to measure (on a lease-by-
lease basis)
• Liability to make lease payments at the undiscounted
amount of lease payments
• Right-of-use asset at undiscounted amount plus initial
direct costs
• Would not apply to immaterial items
31. SHORT TERM LEASES,
Cont’d
Lessors
May elect not to recognize, on a lease-by-lease
basis, assets or liabilities arising from short-term
leases
33. TRANSITION
Initial recognition for lessees and lessors
– All outstanding lease arrangements would be
subject to the new standard
– Apply simplified retrospective approach as of the
beginning of the first comparative period presented
•Date of initial application is the
beginning of the first comparative
period presented in the first financial
statements in which the entity applies
this guidance.
34. TRANSITION (CON’T)
Lessee
– Recognize a liability to make lease payments as
of the date of application
• Present value of lease payments
• Lessee discount rate at date of adoption
– Recognize a right-of-use asset, adjusted for
prepaid or accrued lease payments
– Adjustment may not be necessary for capital
leases that do not have options, contingent
rentals, term option penalties or residual value
guarantees
35. TRANSITION (CON’T)
Lessor
– Performance obligation approach
• Recognize a right to receive lease payments
measured at the present value of the remaining
lease payments, discounted using the rate charged
in the lease determined at the date of inception of
the lease,
• Recognize a corresponding lease liability,
• Reinstate any previously derecognized assets at
depreciated cost, determined as if the asset had
never been derecognized.
36. TRANSITION (CON’T)
Lessor
– Derecognition approach
• Recognize a right to receive lease payments
measured at the present value of the remaining
lease payments, discounted using the rate
charged in the lease determined at the date of
inception of the lease,
• Recognize a residual asset measured at fair value
at date of initial application.
40. CONVERGENCE ACCOUNTING:
IMPACT ON INFORMATION TECHNOLOGY
PREPARING YOUR SYSTEMS TO MEET
FINANCIAL CONSOLIDATION AND
REPORTING REQUIREMENTS
January 2011 A&A Update
Sabrina Serafin
Chris Kyriakakis
January 7, 2011
41. This session will address:
Benefits to Convergence
Key Challenges
Potential Impact
Risks
Working with IT
Evaluating Your Existing Application
Managing the Transition Process
Transition Issues to Consider
42. CONVERGENCE ACCOUNTING –
Benefits to Convergence
Increased potential for process and cost efficiencies
Comprehensive reassessment of financial reporting
process
Update financial policies and processes
Transparency and investor confidence
Reduced accounting complexity
Process optimization
Can lead to improved quality of reporting
Technology optimization
Opportunity for upgrade
44. CONVERGENCE ACCOUNTING –
Impact
Adoption of convergence-specific consolidation rules
and report layout
Embedding requirements into General Ledger and
subsystems
Removing the need for manual adjustments
Minimize compliance risks
45. CONVERGENCE ACCOUNTING –
Risks
Underestimating challenges
Implementation delays
Introduction of unnecessary risk and compliance
issues
Increased number of errors; costs
Outsourcing
Weakened control environment
Risk to the accuracy of current reporting environment
46. CONVERGENCE ACCOUNTING –
Working with Information Technology
Key enabler in the transition
Leads the phased, embedding process to conversion
Coordinates upgrades and conversions with
Convergence/IFRS planning
47. CONVERGENCE ACCOUNTING –
Evaluating Your Existing Applications
Is your current application ready?
Where are existing US GAAP rules configured in your
system?
Are rules hard coded?
Can they be changed?
If so, are they easy to change?
Is there scope to add new/amended Convergence/IFRS
rules?
48. CONVERGENCE ACCOUNTING –
Evaluating Your Existing Applications
Issues with legacy applications:
Customization
Significant need for manual intervention
Data enrichment
Sub ledger reconciliation
Other items to consider:
Is the original implementation team still in place?
Intellectual property
49. CONVERGENCE ACCOUNTING –
Managing the Transition Process
Multiple frameworks
US GAAP
IFRS
Convergence
Tax and other reporting needs (e.g. Debt covenants)
Statutory GAAP formats
Opening balances; two years of comparative financial
statements
Need for reconciliation reports; explain differences
Additional disclosures/commentary
50. CONVERGENCE ACCOUNTING –
Transition Issues to Consider
Examine systems to:
Ensure transactions are analyzed to include base
information necessary to support US GAAP
Convergence and IFRS reporting
Support increased volumes of data
Identify/manage potential delays in closing and
reporting cycles
51. CONVERGENCE ACCOUNTING –
Transition Issues to Consider
Financial consolidation and reporting system should:
Hold data in US GAAP format
Hold a number of sets of manual journal entries
Automate calculation and storage of as many
adjustments as possible
Perform complex calculations
Perform and store multiple consolidations
Report in different formats
Be amended to include necessary account lines
Hold data in a single database
52. CONVERGENCE ACCOUNTING –
Transition Issues to Consider
Be aware of new Convergence/IFRS language:
Legal, IT, HR, etc.
Include descriptive information along with financial
values
Avoid storing Convergence/IFRS adjustments in Excel
spreadsheets:
Creates additional work
Increases risk of errors
Risk of inconsistencies in published financial
statements
53. CONVERGENCE ACCOUNTING –
Transition Issues to Consider
Need for additional internal controls
Manual adjustments
Compliance/control issues
Long term objective:
• Embed Convergence/IFRS needs into transaction systems
and General Ledger
• Reduce/eliminate need for manual journal entries
55. Revenue From Contracts With
Customers
January 2011 A&A Update
Michael Warren
January 7, 2011
56. Agenda
• Background on converged exposure draft
• The proposed model
– Identify the contract(s) with a customer
– Identify the separate performance obligations in the contract
– Determine the transaction price
– Allocate the transaction price to separate performance obligations
– Recognize revenue when the entity satisfies each performance
obligation
• Other issues
• Disclosures and transition
57. GAAP Analysis
Current US GAAP Proposed Model
• Persuasive evidence of • Identify the contract(s) with
a customer
an arrangement • Identify the separate
• Delivery of product or performance obligations in
service the contract
• Determine the transaction
• Collectability is price
reasonable assured • Allocate the transaction
price to separate
• Price is fixed or performance obligations
determinable • Recognize revenue when
the entity satisfies each
performance obligation
58. Identify the contract(s) with a
customer
A contract exists if:
1. The contract has commercial substance
2. The parties to the contract have approved the
contract and are committed to satisfying their
respective obligations
3. The entities can identify each party’s enforceable
rights regarding the goods or services to be delivered
4. The entity can identify the terms and manner of
payment for those goods or services
A contract does NOT exist if either party can terminate a
wholly unperformed contract without penalty
59. Identify the contract(s) with a
customer (cont’d)
• Combine separate contracts if prices are
interdependent:
– Indicators of interdependence include:
• Entered into at or near the same time
• Negotiated as a package with a single commercial
objective
• Performed concurrently or consecutively
60. Identify the contract(s) with a
customer (cont’d)
• Segment a single contract if goods or
services are priced independently
– Goods and services are priced independently
if:
• Entity or another entity sells identical/similar
goods/services; and
• Customer does not receive a significant discount
for buying some goods/services with others
61. Identify the contract(s) with a
customer (CON’T)
• Is a contract modification, in effect, a
separate contract or an extension of the
original?
– Extension of original if prices are interdependent
• Show cumulative effect in the period of modification as if the
original contract had always contained modification
– Separate contract if prices are not interdependent
• Apply revenue recognition criteria to contract alone
62. Modification Example
• Company A is contracted to provide cleaning
services under a three year contract for
$2,000 per year
• One first day of third year the contract is
renegotiated such that it will be extended for
one year and the annual fee will be $1,800
per year
• How is revenue recognised if:
a.$1,800 is current market price for work; or
b.The fees for years 3 and 4 are not independent of
those charged in years 1 and 2
63. Modification Example
(cont’d.)
a. If modification prices are independent of
those charged earlier then:
– Revenue in year 3 = $1,800
– Revenue in year 4 = $1,800
b. If modification prices are not independent of
those charged earlier then:
– Revenue in year 3 = ($4,000 + $3,600) * 3/4) less
$4,000 already charged = $1,700
– Revenue in year 4 = ($4,000 + $3,600)/4 =
$1,900
64. Identify the separate performance
obligations in the contract
• If an entity promises to deliver more than
one good or service, the entity shall
account for each promised good or service
as a separate performance obligation only
if it is distinct
65. Identify the separate performance
obligations in the contract, cont’d.
A good or service is distinct if it is either:
1. The entity, or another entity, sells an
identical or similar good or service separately
2. The entity could sell the good or service
separately because the good or service
meets both the following conditions:
a. It has a distinct function
b. It has a distinct profit margin
66. Example – design and build
contract
• An entity enters into a construction contract for
customer
• Performance obligations include:
– Design
– Procurement of materials
– Construction
• Site preparation
• Foundation development
• Structural erection
• Plumbing
• Wiring
• Site finishing
• Which are separate obligations?
67. Example – design and build
contract cont’d.
• Per ED application guidance
– Design – separate
– Procurement – control only passed on
installation, so part of construction
– Site preparation – separate
– Site finishing– separate
68. Example – design and build
contract cont’d.
– All else – combined because:
• “Other tasks are highly inter-related, which
requires a significant contract management
service”
• “Similar management services are not sold
separately”
• “Contract management service is not subject to
distinct risks as they are inseparable from risks of
integrated tasks”
69. Identify the separate performance
obligations in the contract, cont’d.
Examples of performance obligations
• Rights of return
• Product warranties
• Principal versus agent
• Options for additional goods or services
70. Right of Return - Example
• Entity sells asset of $100,000 with right to
return for full refund. Cost of asset was
$70,000. 50% probability of return
1.Dr Cost of sales $35k
Dr Right to receive asset $35k
Cr Inventory $70k
2.Dr Cash $100k
Cr Repurchase liability
$50k
Cr Revenue $50k
• If goods are returned – reverse all entries
71. Determine the transaction
The transaction price price the probability-
reflects
weighted amount of consideration that an
entity expects to receive in exchange for goods
or services
• An entity shall consider the effects of the
following when determining the transaction
price:
– Collectability
– Time value of money
– Noncash consideration
– Consideration payable to the customer
72. Example - Time Value of
Money
• Give a customer 2 years credit to pay an invoice of $10,000
– Discount rate that would be “reflected in a separate financing
transaction between entity and customer is 6%”
Dr Receivable $8,900
Cr Revenue $8,900
• A customer pays 1 year in advance of revenue recognition:
Dr Cash $10,000
Cr deferred income $10,000
Dr Interest expense $600
Cr deferred income $600
Dr Deferred income $10,600
Cr Revenue $10,600
73. Collectability / Credit Risk
• Sell 1,000 goods for $5,000 each
• Historical experience shows 2% of
customers do not pay
Dr Receivable $5,000k
Cr Revenue $4,900k
Cr Allowance for losses $100k
74. Collectability / Credit Risk,
cont’d.
• Any subsequent deteriorations in credit
risk would be accounted for as a bad debt
expense
• When a particular customer defaults is it
one that was expected to default given
historic averages or an unexpected
failure?
76. Recognize revenue when the entity
satisfies each performance obligation
• When an entity satisfies a performance obligation, it shall
recognize as revenue the amount of the transaction price
allocated to that performance obligation.
• A good or service is transferred when a customer obtains
control of that good or service. A customer obtains control
when the customer has the ability to direct the use of, and
receive benefit from the good or service.
• Indicators of control include
1. The customer has an unconditional obligation to pay
2. The customer has legal title
3. The customer has taken physical possession
4. The design or function of the good or service is customer-
specific
• Continuance transfer of goods or services (no more
percentage-of-completion) - Input / output / passage of time
78. Disclosures and transition
• Effective date – TBD
• Transition – Not concluded on yet, but
retroactive application is anticipated
• Disclosures
– Disaggregated disclosure of revenue
– Rollforwards of contract assets and liabilities
– Maturity analysis
– Information regarding performance obligations