In November, FASB and the IASB reaffirmed their commitment to a 2006 Memorandum of Understanding (MoU) that outlines major convergence projects scheduled for completion by June 2011. The affirmed convergence plan continues the commitment made by the two boards seven years ago in “The Norwalk Agreement” to “make their existing financial reporting standards fully compatible as soon as is practicable.” But it also expands the convergence plan to include the much more ambitious goal of creating new standards where the existing standards of both boards were deemed to need improvement. As a result, many of the MoU projects—and all of the projects covered in this article—are collaborative efforts by the boards to develop entirely new standards.
By changing much of what has been commonplace in financial reporting for the past 30 years, the current projects will significantly affect all CPAs and all companies that report under U.S. GAAP or IFRS.
As of this writing, of the 11 projects outlined in the 2006 MoU, only one, Business Combinations, has been completed. Another, Intangible Assets, has been removed from the active agendas of both boards. And a third, Post- Employment Benefits, though still on the IASB’s agenda, was removed from the list of priority MoU projects at the boards’ October joint meeting.
Of the remaining projects in the MoU, the boards provided fewer details on their plans to complete standards for Fair Value Measurement and Financial Instruments with Characteristics of Equity.
This article provides a synopsis of the six remaining priority projects in the MoU. Because the projects are active and subject to change, updates will be posted periodically to the online version of this article at journalofaccountancy.com; enter 20091933 in the search box.
Three of the convergence projects—Financial Instruments, Consolidation and Derecognition—have taken on greater significance and are thus subject to more scrutiny because of the financial crisis that began in 2008; as a result, the standard setters have been pressed to deal with them on an accelerated schedule. The remaining projects deal with important fundamental accounting issues such as Revenue Recognition, Financial Statement Presentation, and Leases. See Exhibit 1 for the boards’ project plan timeline.
For two major accounting standard setters to complete such a large number of difficult joint projects in less than two years would be unprecedented. The June 2011 deadline, however, has been affirmed by the Group of 20 (G-20) leaders; former Federal Reserve Chairman Paul Volcker, who chairs the President’s Economic Recovery Advisory Board; the SEC; and the Financial Crisis Advisory Group that was set up to advise FASB and the IASB on how they should respond to the financial crisis.
(Click here to open Exhibit 1)
As a result of the subprime mortgage collapse, accounting for loans and securities derived from loans was widely criticized. When the financial crisis started in 2008, this project was already on the active agendas of both standard setters, but the crisis has put enormous political pressure on the IASB and FASB to improve their standards as soon as possible.
In a move that was not followed by FASB, the IASB split its project to replace IAS 39, Financial Instruments: Recognition and Measurement, into three parts to deal separately with classification and measurement; impairment; and hedging, respectively. FASB is dealing with financial instruments in a single project and plans to issue an exposure draft in the first quarter of 2010.
Classification and measurement. Despite intense joint deliberations, FASB and the IASB were unable to agree on a common approach for classification and measurement. The IASB published its approach on Nov. 12, 2009, with the release of IFRS 9, Financial Instruments. IFRS 9 may be adopted early but is not effective until Jan. 1, 2013.
IASB Board Member James Leisenring, a former FASB board member who serves as liaison between the boards, said at an AICPA conference in December that he would not recommend anyone adopt IFRS 9 early because both boards have recommitted to achieving convergence on financial instruments, which will likely bring significant changes to IFRS 9.
Under the proposed FASB model:
All instruments would be measured on the statement of financial position at fair value with changes in fair value reflected in net income, or net income and other comprehensive income;
A limited amortized cost option would be available for financial liabilities; and
No reclassification would be permitted between categories.
Under the IASB model (IFRS 9):
The scope of the standard is limited to assets only;
Amortized cost is used when it matches the entity’s business model and cash flow characteristics of the asset;
Fair value is used for equity instruments, most derivatives and some hybrid instruments; and
Bifurcation of embedded derivatives is not permitted.
Impairment. The IASB published its exposure draft dealing with impairment on Nov. 5, 2009, with comments due July 5. The IASB plans to publish a request for views on FASB’s model when FASB publishes its ED. The boards plan to jointly consider the comments received on respective proposed models. They will also discuss feedback received from an expert advisory panel that has been established to advise the boards on operational issues on the application of their credit impairment models and how those issues might be resolved.
Under the proposed FASB model:
A credit impairment would be recognized when information is available indicating that there is an adverse change in the expected future cash flows of the financial asset;
An entity must consider all available information on past events and existing conditions but not future scenarios; and
Creditors would not be prevented from evaluating losses on a pool or portfolio basis.
The IASB published on Nov. 5, 2009, a proposed impairment model for those financial assets measured at amortized cost. The model uses expected cash flows. Comments are due June 30.
The proposed IASB model requires an entity:
To determine the expected credit losses on a financial asset when that asset is first obtained;
To recognize contractual interest revenue, less the initial expected credit losses, over the life of the instrument;
To build up a provision over the life of the instrument for the expected credit losses; and
To reassess the expected credit loss each period and to recognize immediately the effects of any changes in credit loss expectations.
Hedging. The IASB plans to publish an ED on hedging, the third part of its financial instruments project, in the first quarter of 2010 to coordinate with publication of FASB’s ED. At this writing, no decisions had been made by either board.
The subprime mortgage crisis highlighted the complexity of determining what entities must be consolidated. FASB and the IASB are working jointly to improve consolidation guidance so that financial statements are fully informative.
In response to the recommendations of the Financial Stability Board (an organization created by the G-20 to deal with the global financial crisis), the IASB accelerated its consolidation project and published an ED in December 2008. The comment period ended March 20, 2009. At their October 2009 joint meeting, the boards agreed to conduct their respective consolidation projects jointly. They also concluded that the objectives and principles for assessing control of structures that would be classified as variable-interest entities are fundamentally the same under the recent amendments to U.S. GAAP on consolidation and in the proposed IASB model.
FASB is expected to publish an ED in the second quarter of 2010. The IASB will make available a staff draft of its proposed final standard and will also publish a request for views on the FASB proposals. The IASB and FASB are aiming to publish final, converged standards on consolidation by the third quarter of 2010.
Control. The December 2008 IASB exposure draft ED 10, Consolidated Financial Statements, defined control as the “power to direct the activities of [another] entity to generate returns for the reporting entity.”
Under the definition, the IASB has tentatively decided that:
Power requires judgment and is “the current ability to enforce one’s will in directing the activities of the entity that significantly affect the returns”;
Power does not need to be exercised nor does it need to be absolute;
Power must be assessed based on current facts and circumstances;
Activities are those that significantly affect its returns;
Returns “vary with the activities of the entity” and can be “wholly positive, wholly negative, or positive and negative.”
FASB amended its requirements in relation to the derecognition of some financial assets and liabilities last June by issuing Statement no. 166, Accounting for Transfers of Financial Assets, and Statement no. 167, Amendments to FASB Interpretation No. 46(R).
FASB’s main change was the elimination of qualifying special-purpose entities, or QSPEs. Eliminating the QSPE requirements potentially could cause many entities applying U.S. GAAP to retain more assets and liabilities in their statement of financial position.
Remaining differences between IFRS and U.S. GAAP derecognition requirements include: U.S. GAAP relies on the concept of legal isolation, while IFRS includes the concept of retention or transfer of substantial risks and rewards relating to the asset transferred. The models also differ in the accounting for transfer of portions of assets and the accounting for retained interests.
In March 2009, the IASB published an ED proposing a derecognition model based on control. The comment period closed in July 2009. The proposal was not well received, although there was qualified support for an alternative model also included in the ED. The IASB plans to continue developing derecognition requirements based on that alternative model.
The boards have agreed to assess in the first half of 2010 the differences between IFRS and U.S. GAAP. The boards will then consider together the model that the IASB has been developing.
Key issues that the boards will need to address include:
What criteria should be applied when derecognizing financial assets; how is derecognition different from impairment?
At what amount should gains/losses be reported?
How should those gains/losses be presented in the financial statements (realized or unrealized)?
Under what circumstances would it be appropriate to re-recognize previously derecognized financial assets?
What disclosures are needed to adequately inform financial statement users about remaining risks and their potential outcomes?
The boards published a discussion paper, Preliminary Views on Revenue Recognition in Contracts with Customers, together in December 2008. U.S. GAAP provides detailed guidance that is often industry-specific. The new converged standard is expected to apply one model and certain basic principles across all industries.
Under the proposed new model presented in the discussion paper, an entity should recognize revenue when it satisfies its performance obligations in a contract by transferring control of goods and services to a customer. The boards have agreed to publish a joint ED in the second quarter of 2010 and a final standard by the second quarter of 2011.
At an AICPA conference in December, IASB Board Member Patrick Finnegan presented the following six-step process to demonstrate how the proposed model would be applied:
Step 1: Identify the contract.
Step 2: Identify the performance obligations.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price.
Step 5: Recognize revenue when performance obligations are satisfied.
Step 6: Account for contract costs.
Percentage of completion accounting. In response to what he said was a common misconception among readers of the discussion paper, Finnegan said the boards do not intend to abolish percentage of completion accounting under the new model. He pointed out that the notion of a “continuous sale” contained in SOP 81-1 has been incorporated into the new model in the notion of a “continuous delivery.” However, FASB Technical Director Russell Golden said the new model moves away from the matching principle because, under the new model, incurring a percentage of costs associated with a performance obligation is no longer a criterion for recognizing associated revenues.
Definition of control. Finnegan said many comments received on the discussion paper focused on the need to clarify the meaning of control. He said the IASB, after consulting with FASB, tentatively decided at its September 2009 board meeting that the principle of control involved a customer’s “unconditional obligation to pay for an asset, legal title to an asset, the ability to sell the asset or physical possession of the asset.”
Allocation to contract segments. Another concern raised in comments, Finnegan said, was whether the model would be operational, particularly in regard to allocating the transaction price to individual performance obligations. In response, Finnegan says, the boards introduced the notion of a “contract segment” that would allow similar performance obligations to be grouped together for the purpose of allocating the transaction price. Preparers in multiple countries tested the concept in the fourth quarter of 2009.
Estimated stand-alone selling prices. In October, FASB issued Accounting Standards Codification (ASC) Update no. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force, which applies to multiple-deliverable revenue arrangements that were within the scope of EITF Issue no. 00-21, Revenue Arrangements with Multiple Deliverables. Both ASC Update no. 2009-13 and EITF Issue no. 00-21 have been codified under ASC 605-25.
ASC Update no. 2009-13 provides principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated. It also requires an entity to allocate revenue in an arrangement using estimated selling prices of deliverables if a vendor does not have vendor-specific objective evidence or third-party evidence of selling price. The guidance eliminates the use of the residual method, requires entities to allocate revenue using the relative-selling-price method and significantly expands the disclosure requirements for multiple-deliverable revenue arrangements.
The approach taken in ASC Update no. 2009-13 is basically the same as the approach revealed in FASB’s preliminary views document for its joint revenue recognition project with the IASB, according to AICPA Accounting Standards Executive Committee (AcSEC) Chairman Jay Hanson, who is also a member of the EITF.
FINANCIAL STATEMENT PRESENTATION
FASB and the IASB have undertaken the largest revamp of financial statements ever conducted in a single step. The work is being conducted in three phases. The boards completed deliberations on Phase A in December 2005, and on Sept. 6, 2007, the IASB published a revised version of IAS 1, Presentation of Financial Statements, that brought IAS 1 largely in line with FASB Statement no. 130, Reporting Comprehensive Income.
On Oct. 16, 2008, both boards published a discussion paper, Preliminary Views on Financial Statement Presentation, in which they set out the principles for presenting financial statements in a manner that portrays a cohesive financial picture of an entity’s activities, disaggregates information so that it is useful in predicting future cash flows, and helps users assess an entity’s liquidity and financial flexibility.
The boards plan to publish an ED in the first quarter of 2010 that proposes to eliminate an option in U.S. GAAP and IFRS that allows entities to present some components of total comprehensive income either in a separate statement or directly in equity. In the second quarter, the boards plan to publish a comprehensive ED on financial statement presentation.
Tentative decisions include:
A complete set of financial statements for a reporting period should include a statement of financial position; a statement of comprehensive income; a statement of changes in equity; and a statement of cash flows. In addition, each financial statement should be shown with equal prominence, and a minimum of two years’ comparative information is required.
The proposed financial statements are intended to help predict cash flows for equity valuation. These statements shift focus from net income to total comprehensive income, as all other comprehensive income items are now presented on the face of the statement.
The boards decided that the financial statement presentation project should not seek to alter existing standards relating to what items are recognized outside of profit or loss. Because of that stance, existing guidance remains unchanged on presentation of other comprehensive income (OCI) items in a statement of comprehensive income and on the recycling mechanism.
The proposed format of the cash flow statement is similar to FASB Statement no. 95, Statement of Cash Flows, and IAS 7, Statement of Cash Flows, with two major changes. First, the notion of cash equivalents is scrapped. In addition, cash flow will be presented in the direct method.
The boards tentatively decided to replace the reconciliation schedule proposed in the discussion paper with a requirement to analyze the changes in balances of significant asset and liability line items.
The stated objective of this project is to ensure that the assets and liabilities arising from lease contracts are recognized on companies’ balance sheets. On March 19, 2009, the boards published for public comment a discussion paper, Leases: Preliminary Views. They plan to publish an exposure draft in the second quarter of 2010.
Lessee accounting. The boards tentatively decided to adopt an approach to lessee accounting that would require the lessee in all leases to recognize:
An asset representing its right to use the leased item for the lease term (measured initially at its fair value, which may be estimated using the leased property’s fair value or an estimate of the value of the lease obligation based on a present value of the lease payments discounted at a market rate for similar liabilities).
A liability for its obligation to pay rentals (measured initially at a present value of the lease payments that approximates the fair value of the liability).
This differs from the current U.S. GAAP model, which separates leases into capital leases, which recognize an asset and a liability, and operating leases, which do not. Under the proposed new model, all leases except those that represent the purchase or sale of an item would result in asset and liability recognition. In addition, subsequent income statements will report interest costs and depreciation of the asset, the sum of which will be different from the cash payments.
Lessor accounting. The boards tentatively decided to adopt the performance obligation approach to lessor accounting.
Under that approach, a lessor would:
Recognize an asset representing its right to receive rental payments (a lease receivable).
Recognize a liability representing its performance obligation under the lease—that is, its obligation to permit the lessee the right to use one of its assets (the leased item). The lessor would recognize revenue as that performance obligation is satisfied over the lease term. That means that a lessor would not recognize revenue at the inception of a lease contract.
The JofA thanks professor Paul Gillis of Peking University, Beijing, China; professor Paul B.W. Miller, University of Colorado at Colorado Springs; Paul Parks, manager of the AICPA-produced IFRS.com; and Richard Roomberg, director of financial reporting for Washington, D.C.-based NCI Inc., for their contributions to this article.
Matthew G. Lamoreaux is a JofA senior editor. To comment on this article or to suggest an idea for another article, you can contact him at firstname.lastname@example.org or 919-402-4435.
Consolidation and Derecognition
Financial Statement Presentation
“Shaking Up Financial Statement Presentation,” Nov. 08, page 56
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