january 2011 a&a update from frazier & deeter, llc
DESCRIPTION
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.TRANSCRIPT
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ACCOUNTING FOR LEASESA NEW ACCOUNTING MODEL EMERGES
Rebekah Walters, Manager
Frazier & Deeter, LLC
Atlanta, GA
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WHY CHANGE?– Create consistency, comparability and
transparencyWHAT’S CHANGING?
– Right-of-use-model– Effectively eliminate operating leases– Lessor hybrid accounting model– The proposed guidance would
supersede Topic 840 (previously SFAS13) on Leases (U.S. GAAP) and IAS 17Leases (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)
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• Scope of Exposure Draft (ED)
• Lessee Accounting
• Lessor Accounting
• Short-term Leases
• Other Changes
• Transition
DISCUSSION SUMMARY
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SCOPE OF EXPOSURE DRAFT
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SCOPE
ED would not apply to:
– Leases of intangible assets
– Leases to explore for or use minerals, oil,natural gas, and other non-regenerativeresources
– Leases of biological assets
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SCOPE (CON’T)
ED would not apply to a purchase or asale:– 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 purchaseoption
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LESSEE ACCOUNTING
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RECOGNITION
Lessee model
– “Right-Of-Use” asset
– “Obligation to MakeLease Payments” liability
– Applicable to all leases
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MEASUREMENT
Obligation to make lease payments liability
– Present value of Lease Payments discounted using lessee’sincremental 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 directcosts
– Starting amount is same as liability
ED does not address the effect of lease incentives
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MEASUREMENT
Lease term
– The longest possible term that is more likelythan not to occur
– Estimate the probability of each possiblelease term
– Likely that lease terms may be longer undernew model
– Consider all facts and circumstances
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EXAMPLE
A company leases a manufacturingfacility beginning on January 1, 2010and has a reporting year end ofDecember 31. The lease provides fora non-cancellable 10 year term withan option to renew for 5 years at theend of the 10 year period and anadditional option to renew at the endof the 15 year period and fixed annualpayments of $3,000,000, includingrenewal periods. Contingent rentalsare due annually at a rate of 2% ofrevenue. The company’s incrementalborrowing rate is 8%.
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EXAMPLE (CON’T)
Exercise 2 FiveYear Renewals
Exercise 1 FiveYear Renewal
No renewalsexercised
Total Lease Term 20 15 10
Probability 30% 25% 45%
Cumulative Probability 30% 55% 100%
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MEASUREMENT
Initial Measurement of Lease payments– Measure using “Expected Outcome Approach”
• The present value of the probability-weighted average of thecash 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
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MEASUREMENT
How do you determine present value ofpayment stream (Expected OutcomesApproach)?
1. Develop reasonably possible outcomes overthe [calculated] life of the lease
2. Estimate amount and timing of cash flows foreach outcome
3. Calculate the present value of the cash flows
4. Probability-weigh each outcome
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EXAMPLE (CON’T)
A company leases a manufacturingfacility beginning on January 1, 2010and has a reporting year end ofDecember 31. The lease provides fora non-cancellable 10-year term withan option to renew for 5-years at theend of the 10-year period and anadditional option to renew at the endof the 15-year period and fixedannual payments of $3,000,000,including renewal periods.Contingent rentals are due annuallyat a rate of 2% of revenue. Thecompany’s incremental borrowingrate is 8%.
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EXAMPLE (CON’T)
ExpectedOutcome
Sales over 15years*
TotalContingent
RentalsPresentValue Probability
Probability-weighted
2% decline insales
261,430,897 5,228,618 3,068,069 10% 306,869
Flat sales 300,000,000 6,000,000 3,423,791 30% 1,027,137
4% increase insales
400,471,753 8,009,435 4,322,675 40% 1,729,070
8% increase insales
543,042,279 10,860,846 5,555,556 20% 1,111,111
Total 4,174,187
* - assuming $20,000,000 in first year Calculation:Lease_Accounting_Model_Example.xls
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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 4,174,187Right-of-use asset/obligation to make lease payments $ 29,852,623
At the inception of the lease, the company would record the following accountingentry:
Dr. Right-of-use asset $29,852,623
Cr. Obligation to make lease payments $29,852,623
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MEASUREMENT
Subsequent measurement andreassessment
– Subsequent measurement
• Liability - amortized cost under the effective interestmethod
• Right-of-use asset - amortized cost on a systematicbasis over life of lease or useful life, if shorter
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MEASUREMENT
Subsequent measurement and reassessment
– Reassessment• If facts or circumstances indicate that there would be a
significant change in the liability since the previousreporting 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 relatedto future periods
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LESSOR ACCOUNTING
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LESSOR MODEL
Hybrid accounting model
– Performance obligation• Lessor retains significant risks and
rewards
– Derecognition• Lessor transfers significant risks
and rewards
– Intended to follow the businessmodel of the lessor
– No bright lines in makingdetermination
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PERFORMANCE OBLIGATION
Recognition
– Performanceobligation liability
• permit the lessee touse the asset
• Measure at ratecharged by lessor
– Asset [receivable]
• the right to receivelease payments
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PERFORMANCE OBLIGATION
Measurement of right to receive lease payments
– Longest possible term that is more likely than not tooccur
– Present value of lease payments utilizing the expectedoutcome approach
– Similar to lessee calculation; however
• Contingent rentals and residual value guarantees aresubject to reliability criterion (i.e. measured reliably)
• Include term option penalties
Evaluation and Remeasurement
• Similar to lessee requirements
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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 whichdid 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 guaranteesand term option penalties would be identical to the performance obligationapproach.
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DERECOGNITION
Asset derecognized
The portion of the derecognized asset iscalculated 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
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DERECOGNITION
Subsequent measurement
– Measure lease receivable at amortized cost using theeffective interest method
Remeasurement
• Change in lease term would provide for acorresponding adjustment to the residual asset,after allocation between the derecognized assetand residual asset
• Changes in estimated payment streams arerecognized in income
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SHORT TERM LEASES
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SHORT TERM LEASES
Lessees– Short term lease – a lease that, at the date of
commencement of the lease, has a maximumpossible lease term, including options to renew orextend, of 12 months or less
– Lessee has an election to measure (on a lease-by-lease basis)
• Liability to make lease payments at the undiscountedamount of lease payments
• Right-of-use asset at undiscounted amount plus initialdirect costs
• Would not apply to immaterial items
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SHORT TERM LEASES,Cont’d
Lessors
May elect not to recognize, on a lease-by-leasebasis, assets or liabilities arising from short-termleases
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TRANSITION
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TRANSITION
Initial recognition for lessees and lessors
– All outstanding lease arrangements would besubject to the new standard
– Apply simplified retrospective approach as of thebeginning of the first comparative period presented
•Date of initial application is thebeginning of the first comparativeperiod presented in the first financialstatements in which the entity appliesthis guidance.
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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 forprepaid or accrued lease payments
– Adjustment may not be necessary for capitalleases that do not have options, contingentrentals, term option penalties or residual valueguarantees
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TRANSITION (CON’T)
Lessor
– Performance obligation approach
• Recognize a right to receive lease paymentsmeasured at the present value of the remaininglease payments, discounted using the rate chargedin the lease determined at the date of inception ofthe lease,
• Recognize a corresponding lease liability,
• Reinstate any previously derecognized assets atdepreciated cost, determined as if the asset hadnever been derecognized.
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TRANSITION (CON’T)
Lessor
– Derecognition approach
• Recognize a right to receive lease paymentsmeasured at the present value of the remaininglease payments, discounted using the ratecharged in the lease determined at the date ofinception of the lease,
• Recognize a residual asset measured at fair valueat date of initial application.
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OTHER CHANGES
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• Sales leasebacktransactions
• Sub leasearrangements
• Leases with servicecomponents
OTHER CHANGES
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QUESTIONS?
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CONVERGENCE ACCOUNTING:IMPACT ON INFORMATION TECHNOLOGY
PREPARING YOUR SYSTEMS TO MEETFINANCIAL CONSOLIDATION AND
REPORTING REQUIREMENTS
January 2011 A&A Update
Sabrina Serafin
Chris Kyriakakis
January 7, 2011
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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
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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
CONVERGENCE ACCOUNTING –Benefits to Convergence
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Deadlines
Parallel reporting
Broad implications
Transaction changes
CONVERGENCE ACCOUNTING –Key Challenges
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Adoption of convergence-specific consolidation rulesand report layout
Embedding requirements into General Ledger andsubsystems Removing the need for manual adjustments Minimize compliance risks
CONVERGENCE ACCOUNTING –Impact
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Underestimating challenges
Implementation delays
Introduction of unnecessary risk and complianceissues
Increased number of errors; costs
Outsourcing
Weakened control environment
Risk to the accuracy of current reporting environment
CONVERGENCE ACCOUNTING –Risks
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Key enabler in the transition
Leads the phased, embedding process to conversion
Coordinates upgrades and conversions withConvergence/IFRS planning
CONVERGENCE ACCOUNTING –Working with Information Technology
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Is your current application ready?
Where are existing US GAAP rules configured in yoursystem?
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?
CONVERGENCE ACCOUNTING –Evaluating Your Existing Applications
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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
CONVERGENCE ACCOUNTING –Evaluating Your Existing Applications
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Multiple frameworks
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
CONVERGENCE ACCOUNTING –Managing the Transition Process
US GAAPIFRS
Convergence
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Examine systems to:
Ensure transactions are analyzed to include baseinformation necessary to support US GAAPConvergence and IFRS reporting
Support increased volumes of data Identify/manage potential delays in closing and
reporting cycles
CONVERGENCE ACCOUNTING –Transition Issues to Consider
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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
CONVERGENCE ACCOUNTING –Transition Issues to Consider
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Be aware of new Convergence/IFRS language:
Legal, IT, HR, etc. Include descriptive information along with financial
values
Avoid storing Convergence/IFRS adjustments in Excelspreadsheets:
Creates additional work Increases risk of errors Risk of inconsistencies in published financial
statements
CONVERGENCE ACCOUNTING –Transition Issues to Consider
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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
CONVERGENCE ACCOUNTING –Transition Issues to Consider
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QUESTIONS?
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Revenue From Contracts WithCustomers
January 2011 A&A Update
Michael Warren
January 7, 2011
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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 performanceobligation
• Other issues
• Disclosures and transition
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GAAP Analysis
Current US GAAP
• Persuasive evidence ofan arrangement
• Delivery of product orservice
• Collectability isreasonable assured
• Price is fixed ordeterminable
Proposed Model• Identify the contract(s) with
a customer• Identify the separate
performance obligations inthe contract
• Determine the transactionprice
• Allocate the transactionprice to separateperformance obligations
• Recognize revenue whenthe entity satisfies eachperformance obligation
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Identify the contract(s) with acustomer
A contract exists if:1. The contract has commercial substance2. The parties to the contract have approved the
contract and are committed to satisfying theirrespective obligations
3. The entities can identify each party’s enforceablerights regarding the goods or services to be delivered
4. The entity can identify the terms and manner ofpayment for those goods or services
A contract does NOT exist if either party can terminate awholly unperformed contract without penalty
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Identify the contract(s) with acustomer (cont’d)
• Combine separate contracts if prices areinterdependent:
– Indicators of interdependence include:
• Entered into at or near the same time
• Negotiated as a package with a single commercialobjective
• Performed concurrently or consecutively
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Identify the contract(s) with acustomer (cont’d)
• Segment a single contract if goods orservices are priced independently
– Goods and services are priced independentlyif:
• Entity or another entity sells identical/similargoods/services; and
• Customer does not receive a significant discountfor buying some goods/services with others
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Identify the contract(s) with acustomer (CON’T)
• Is a contract modification, in effect, aseparate contract or an extension of theoriginal?– Extension of original if prices are interdependent
• Show cumulative effect in the period of modification as if theoriginal contract had always contained modification
– Separate contract if prices are not interdependent• Apply revenue recognition criteria to contract alone
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Modification Example
• Company A is contracted to provide cleaningservices under a three year contract for$2,000 per year
• One first day of third year the contract isrenegotiated such that it will be extended forone year and the annual fee will be $1,800per year
• How is revenue recognised if:a.$1,800 is current market price for work; orb.The fees for years 3 and 4 are not independent of
those charged in years 1 and 2
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Modification Example(cont’d.)
a. If modification prices are independent ofthose charged earlier then:– Revenue in year 3 = $1,800
– Revenue in year 4 = $1,800
b. If modification prices are not independent ofthose 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
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Identify the separate performanceobligations in the contract
• If an entity promises to deliver more thanone good or service, the entity shallaccount for each promised good or serviceas a separate performance obligation onlyif it is distinct
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Identify the separate performanceobligations in the contract, cont’d.
A good or service is distinct if it is either:
1. The entity, or another entity, sells anidentical or similar good or service separately
2. The entity could sell the good or serviceseparately because the good or servicemeets both the following conditions:
a. It has a distinct function
b. It has a distinct profit margin
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Example – design and buildcontract
• An entity enters into a construction contract forcustomer
• Performance obligations include:– Design– Procurement of materials– Construction
• Site preparation• Foundation development• Structural erection• Plumbing• Wiring• Site finishing
• Which are separate obligations?
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Example – design and buildcontract cont’d.
• Per ED application guidance– Design – separate
– Procurement – control only passed oninstallation, so part of construction
– Site preparation – separate
– Site finishing– separate
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Example – design and buildcontract cont’d.
– All else – combined because:• “Other tasks are highly inter-related, which
requires a significant contract managementservice”
• “Similar management services are not soldseparately”
• “Contract management service is not subject todistinct risks as they are inseparable from risks ofintegrated tasks”
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Identify the separate performanceobligations in the contract, cont’d.
Examples of performance obligations
• Rights of return
• Product warranties
• Principal versus agent
• Options for additional goods or services
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Right of Return - Example
• Entity sells asset of $100,000 with right toreturn for full refund. Cost of asset was$70,000. 50% probability of return1.Dr Cost of sales $35k
Dr Right to receive asset $35kCr Inventory $70k
2.Dr Cash $100kCr Repurchase liability
$50kCr Revenue $50k
• If goods are returned – reverse all entries
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Determine the transactionpriceThe transaction price reflects the probability-
weighted amount of consideration that anentity expects to receive in exchange for goodsor services• An entity shall consider the effects of the
following when determining the transactionprice:– Collectability– Time value of money– Noncash consideration– Consideration payable to the customer
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Example - Time Value ofMoney
• Give a customer 2 years credit to pay an invoice of $10,000
– Discount rate that would be “reflected in a separate financingtransaction 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
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Collectability / Credit Risk
• Sell 1,000 goods for $5,000 each
• Historical experience shows 2% ofcustomers do not pay
Dr Receivable $5,000k
Cr Revenue $4,900k
Cr Allowance for losses $100k
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Collectability / Credit Risk,cont’d.
• Any subsequent deteriorations in creditrisk would be accounted for as a bad debtexpense
• When a particular customer defaults is itone that was expected to default givenhistoric averages or an unexpectedfailure?
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Allocate the transaction price toseparate performance obligations
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Recognize revenue when the entitysatisfies each performance obligation
• When an entity satisfies a performance obligation, it shallrecognize as revenue the amount of the transaction priceallocated to that performance obligation.
• A good or service is transferred when a customer obtainscontrol of that good or service. A customer obtains controlwhen the customer has the ability to direct the use of, andreceive benefit from the good or service.
• Indicators of control include1. The customer has an unconditional obligation to pay2. The customer has legal title3. The customer has taken physical possession4. The design or function of the good or service is customer-
specific
• Continuance transfer of goods or services (no morepercentage-of-completion) - Input / output / passage of time
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Other issues
• Onerous performance obligations (losscontracts)
• Contract costs
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Disclosures and transition
• Effective date – TBD
• Transition – Not concluded on yet, butretroactive application is anticipated
• Disclosures
– Disaggregated disclosure of revenue
– Rollforwards of contract assets and liabilities
– Maturity analysis
– Information regarding performance obligations
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Questions?