January 2011 A&A update from Frazier & Deeter, LLC

Bill [email protected]

January 7, 2011

Frazier & Deeter Client A&AUpdate –

Key Convergence Topics

ACCOUNTING FOR LEASESA NEW ACCOUNTING MODEL EMERGES

Rebekah Walters, Manager

Frazier & Deeter, LLC

Atlanta, GA

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)

• 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

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

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

RECOGNITION

Lessee model

– “Right-Of-Use” asset

– “Obligation to MakeLease Payments” liability

– Applicable to all leases

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

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

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%.

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%

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

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

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%.

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

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

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

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

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

PERFORMANCE OBLIGATION

Recognition

– Performanceobligation liability

• permit the lessee touse the asset

• Measure at ratecharged by lessor

– Asset [receivable]

• the right to receivelease payments

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

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.

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

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

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

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

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.

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


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.


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.

OTHER CHANGES

• Sales leasebacktransactions

• Sub leasearrangements

• Leases with servicecomponents

OTHER CHANGES

QUESTIONS?

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

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

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

Deadlines

Parallel reporting

Broad implications

Transaction changes

CONVERGENCE ACCOUNTING –Key Challenges

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

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

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

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

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

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

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

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


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


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


QUESTIONS?

Revenue From Contracts WithCustomers

January 2011 A&A Update

Michael Warren

January 7, 2011

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

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

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

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

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

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

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

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

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

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

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?

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

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”

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

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

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

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

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

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?

Allocate the transaction price toseparate performance obligations

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

Other issues

• Onerous performance obligations (losscontracts)

• Contract costs

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

Questions?

January 2011 A&A update from Frazier & Deeter, LLC

Technology

Transcript of January 2011 A&A update from Frazier & Deeter, LLC