Laying the Odds
In 2006, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) agreed on a Memorandum of Understanding that identified major convergence projects intended to improve and converge U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). While there has been some progress over the past eight years, three of the most important projects, revenue, financial instruments and leases, have proved to be the most contentious. With all of the noise in the marketplace related to these three proposals, we would like to bring you up to date and explain how and when these three standards will affect you.
Revenue: A Photo Finish
After much deliberation, the FASB and IASB released a final global revenue recognition standard on May 28 that will do away with current industry-specific accounting and instead apply a single set of principles to all revenue transactions.
Current U.S. GAAP includes broad revenue recognition concepts and numerous requirements for particular industries or transactions that can result in different accounting for economically similar transactions. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration that an entity receives or expects to receive. To apply that principle, an entity should:
- Identify the contract with a customer
- Identify the separate performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the separate performance obligations, and
- Recognize revenue as each performance obligation is satisfied.
Elliott Davis Observation: The five steps might appear simple but significant judgment will be needed to apply the underlying principles. Most difficult may be the change of mindset needed about revenue recognition to move from an evaluation of risk and rewards under existing guidance to an evaluation of transfer of control under the new standard.
Management will need to perform a comprehensive review of existing contracts, business models, company practices, accounting policies, information technology systems, and internal processes and controls to assess the extent of changes needed as a result of the new standard. This may be the case even if the entity’s revenue recognition model has not significantly changed. The following areas of the guidance, among others, could result in significant changes from current practice and an increase in the use of estimates:
- Determining a stand-alone selling price
- Licensing and rights to use
- Accounting for contract related costs
- Accounting for variable consideration
- Accounting for contract options
- Reflecting time value of money
Key financial measures and ratios may also be impacted, affecting analyst expectations, earnouts, bonuses and compliance with contractual covenants. IT systems may need to be changed to capture additional data (e.g., data used to make revenue transaction estimates and to support disclosures) and sales and contracting processes may need to be reconsidered. Accounting processes and internal controls will also need to be revised for the forthcoming standard, which may include increased judgment and use of estimates.
The revenue standard will be effective for public companies for annual reporting periods beginning January 1, 2017. For nonpublic companies, the effective date will be for annual periods beginning January 1, 2018.
Financial Instruments: Going the Distance
The financial instruments project has three primary areas that are being individually addressed, (1) classification and measurement, (2), impairment and (3) hedging. This project took on heightened significance in the wake of the 2008 financial crisis and once was considered an essential international accounting convergence project. However, negotiations with the IASB to write global accounting guidelines have since fallen apart, and the amendments the FASB plans to publish this year are expected to change U.S. GAAP and not match the IASB’s revisions to its standards.
At its December meeting, the FASB made two significant decisions in its financial instruments projects that reduce the likelihood of convergence with the IASB:
- Classification and measurement – the FASB tentatively decided to retain the separate models in current U.S. GAAP for classifying and measuring loans and debt securities rather than overhaul its guidance in this area, as it had proposed in 2013. In a change from today’s accounting, however, equity securities would be measured at fair value with changes in fair value recognized in net income.
- Impairment – the FASB confirmed that its proposed “current expected credit loss” (CECL) model would be applied to financial assets that are debt instruments measured at amortized cost (i.e., loans and debt securities). Impairments on financial assets measured at fair value through other comprehensive income would follow a slightly different approach. The FASB had proposed applying the CECL model to all debt instruments.
Both of these decisions diverge from the IASB’s approach in their parallel projects, leaving the prospects for convergence in jeopardy.
If the FASB finalizes its decision, loans would continue to be considered either held for investment and measured at amortized cost, or held for sale and measured at either cost or fair value, whichever is lower. Debt securities would be categorized as either trading, available for sale, or held to maturity. Securities for trade would be measured at fair value with changes recorded in net income, those for sale would be measured at fair value with changes in other comprehensive income, and those held to maturity would be measured at amortized cost.
The FASB expects to issue final guidance in the second half of 2014. Separately, the FASB decided that the FASB staff will perform research on the hedging phase of the project. The IASB issued its final guidance on hedging late last year.
Leases: Hitting the Wall
In May 2013, the FASB issued a proposed leasing standard, which was a revision of the 2010 proposal. The core principle of the proposed requirements is that an entity should recognize assets and liabilities arising from a lease. In accordance with that principle, a lessee would recognize assets and liabilities for leases with a maximum possible term of more than 12 months. A lessee would recognize a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the leased asset (the underlying asset) for the lease term.
The recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee would depend on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset. For practical purposes, this assessment would often depend on whether the underlying asset is property or assets other than property.
The FASB has received nearly 600 comment letters on the proposal from trade groups, companies, and individuals all over the world. Many of the comments have been negative. For example, a consortium of 30 trade associations plus the U.S. Chamber of Commerce signed a comment letter raising concerns about the proposed standards’ impact.
In their 2014 meetings, the FASB and the IASB have begun to back away from the accounting model they proposed in May 2013. In redeliberations, the IASB supported a single on-balance sheet model, while the FASB supported a dual on-balance sheet model that is similar to current U.S. GAAP but without bright lines. Redeliberations are expected to continue through much of 2014.
Crossing the Finish Line
Rest assured, Elliott Davis is ready to answer your questions and provide the resources and training that you need to understand and properly implement the landmark revenue recognition guidance. We will also closely follow the financial instruments and leasing standards, as well as other developments, and notify you as these move closer to reality.
In the meantime, if you have questions, please contact your Elliott Davis adviser.