John Carroll University Symposium

John Carroll University Symposium

May 17, 2012

Pete [email protected]

Delivering on the Promise.


AreasWe Will

Cover(Accounting)

• Lease Accounting• Revenue Recognition• Convergence with International Standards• Big GAAP – Little GAAP• Other Comprehensive Income• Goodwill impairment– qualitative analysis• Financial Statement Disclosures

• Long Term Receivables• ERISA - Multiemployer Benefit Plans• Health Care Organizations•Offsets•Principal or Agent (“gross or net”)


AreasWe Will

Cover(Auditing)

• SAS 70 morphs into SOC 1/2/3• PCAOB Matters:

• Releases on “audit failures”• Proposed auditor “MD&A” • Proposal on related parties

• EC proposal for mandatory five year rotation and prohibition on other services


Lease Accounting

Delivering on the Promise.Delivering on the Promise.

• FAS 13 (1976) and many amendments established a rules based, bright line standard. Only capital leases are reflected on the balance sheet.

• August 2010 ED would require operating leases be reflected on the balance sheet as a liability and a “right to use” asset. A revised ED is coming.

• Expense pattern would be front loaded (see next slide), because operating lease rent expense would be replaced by depreciation AND interest expense (just like the early years of a house mortgage).

• Existing leases would not be grandfathered, although there would not be a one-time expense charge upon adoption. Rather, the P/L effect on existing leases would be spread.

• Companies will be inclined to seek leases with short terms, or month-to-month arrangements. Even short term (1 year or less) leases get recorded on an undiscounted basis.

Lease Accounting


Proposed Lease Accounting• Graph is a 10 year lease, 8%, $1,000 asset. Annual payment = $149• For a new lease, record net present value of the obligation as an

asset and a liability of $1,000.

Depreciation expense

Interest expense

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• Companies may have to renegotiate debt covenants.• Leverage and capital ratios will be negatively impacted.• EBITDA will improve (early adoption of the ED not permitted!).• For lessors, an assessment of ongoing risk is performed. In many cases, a

“performance obligation method” that mirrors the capital lease accounting model is used. Ongoing service components within the lease are carved out and accounted for separately.

Revised ED expected in 2012 to address concerns (960 nasty letters):• Retroactive implementation burden.• Front-loading expense pattern is controversial. FASB may create

financing/other than financing model, or just cave in.• Difficulty of assessing “more likely than not” lease renewals and contingent

rentals, which are included in the initial entry.• Effective date may be synced with revenue recognition ~ 2015.

Other Nuances


• Client should determine the potential impact on financials, ratios and covenants.

• Review existing capitalization policies – an appropriate threshold policy can avoid undue administrative burden for smaller leases (e.g., office copiers).

• Audit the information flow within the accounting department to ensure all new leases and any modifications to existing leases are properly evaluated and recorded.

• Evaluate the impact of the proposed rule on tax accounting, as the new model will likely result in additional differences for income tax accounting purposes. There may also be a negative impact on some state and local income taxes if book amounts are required to be used.

• Watch for the revised ED.

Lease Accounting Action Steps


Revenue Recognition


• Some 200 industry specific rules in GAAP will be wiped clean.• Replace rules based with a single model based on clear principles.• Core criteria for revenue recognition is transfer of control of the asset to the

customer. You record an amount that reflects the consideration expected to be received.

• Requires identification and segmentation of contract into “performance obligations” or units of accounting that are distinct/delivered at different times.

• Must consider elements such as: transaction price, credit risk, time value and variable consideration.

• Contractors will see significant changes (percentage of completion method).• Revised presentation on the income statement.• Extensive disclosure requirements.• Conceptually, the P&L matching concept is effectively replaced with a net

balance sheet approach. (We saw this years ago with income taxes.)• ED would require retroactive restatement (controversial).

Revenue Recognition (Revised ED issued Nov 2011)


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• Must have commercial substance (can be verbal or implied).• Parties have approved the contract and are committed.• Identify enforceable rights.• Identify terms and manner of payment.

Step 2 – Performance Obligation• An example of separation into units of accounting is a warranty. A two year

service plan on a TV would be accounted for separately. Instead of recording 100% of revenue with a related estimate of warranty cost, under the ED, you would record less revenue up front. Some of the gross profit belongs to the warranty. Another common example is a “free” cell phone with a 2 year service contract.

Step 1 - Criteria to Identify a Contract


• Collectability – today, if not reasonably assured, no revenue is recognized. Under the ED, you would use some sort of probability-weighted estimate, but would likely record something. Subsequent changes in this assessment may become elements of income or expense, NOT revenue.

• Time value of money – if there is a material financing arrangement, you discount the consideration.

• Any noncash consideration – use fair value of what is received.

More use of estimates will be required.

Steps 3 + 4 – Transaction Price, consider:


• Bill and Hold arrangements – the tough current rules would end up being relaxed.

• Loyalty programs – would be a separate performance obligation. An airline would not be able to use the incremental cost model for its frequent flyer points.

Other Examples of Changes


• Inventory existing sales agreements.• Consider potential impact on marketing,

bundling, pricing strategy.• Evaluate existing IT systems and data

collection processes.• Monitor final standard (~ 1Q 2013) and

effective date, especially if the retroactive restatement element is retained.

Action Steps


Convergence of US GAAPwith

International Standards


• SEC signaled in December 2011 that it’s original timeline for convergence or acceptance of IFRS for US public company reporting is still “months away.”

• Once staff issues a study, then the SEC will consider endorsement, convergence or something in between.

• Issues include a “big bang” adoption of IFRS by all companies, or a more gradual approach based on size, as we saw for SOX requirements.

Convergence


Big GAAP vs Little GAAP


Blue Ribbon Panel for Private Company GAAP• December 2010 proposal to form a group similar to the FASB, under

the same umbrella foundation.• Proposed using US GAAP “with exceptions.”• Financial Accounting Foundation said no to a separate standard

setter in October 2011.• FASB does seem to be addressing private company concerns now.

– Qualitative assessment (“Step 0”) for goodwill impairment– Proposal to follow the same process for other intangible assets– Simplification of OCI– Another look at Fair Value disclosures (Level 1/2/3 table may go away)– Less onerous disclosures for revenue recognition matters

• AICPA may take over!

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Other Comprehensive Income


• Will have to show it on the fact of the income statement, not on a statement of changes in equity.

• Might get rid of the hated “reclassification adjustment” that nobody understands (2013).

Other Comprehensive Income


Goodwill and Intangibles Impairment:

Qualitative assessments


Management can now qualitatively assess (“Step 0”) whether it is more likely than not (50%) that carrying value exceeds fair value. If so, you can stop. Consider things such as:• Macroeconomic conditions in the general economy• Change in the industry, including company trends related to peers• Cost factors, such as increases in raw materials or labor• Losses, negative or declining cash flows or EBITDA• Changes in management, litigation, customer base

Theoretically, it only takes one negative characteristic to “fail” – i.e., require the mathematical Step 1 computation and possibly the Step 2 analysis.

Goodwill Impairment -- Qualitative Characteristics To Consider under ASU 2011-08


Financial Statement Disclosures


• ASU 2010-20 (ASC 310.10) was effective for private companies in 2011. Any long-term receivables (e.g., sales type lease receivables, shareholder loans, related party receivables) meet the definition. Only short-term trade receivables are exempted. It requires:

• An accounting policy footnote.• A table of maturities, disaggregated by broad type of receivables.• A table of activity for any allowance for bad debts applicable to these

receivables, disaggregated by broad type of receivable.

Sample policy:As a part of our normal business operations, we enter into agreements with other parties to pursue business opportunities, including loans and long-term receivables to certain affiliate and non-affiliate companies. These are assessed for impairment when events indicate the loan balance may not be fully recoverable.

Long Term Receivables


Multiemployer Benefit Plans• Many of these union or similar plans are significantly underfunded.• May need to assess and disclose or record a liability for additional

required contributions, if probable.

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Health Care Organizations• Can not net a medical malpractice claim liability against a potential

insurance recovery receivable.• Must now show bad debts as a negative revenue line rather than an

operation expense. • There is a footnote disclosure table of contractual allowances and

activity in the allowance for bad debts by major payer type.

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• Effective for 2013, the long standing rule for offsets (formerly the 1966 APB10 + FIN 39) is confirmed, but you will have to disclose the gross amounts in the footnotes anyway.

Offsets


• A November 2011 ED under the guise of tweaking ASC 810 / FAS 167 / FIN 46 on variable interest entities and consolidations would take a fresh look at whether a decision-making arrangement exists (and if so consolidation might be required). This could also affect existing accounting for gross versus net reporting.

• Currently, there are a number of criteria contained in EITF 99-19 that are used to evaluate the facts; mostly having to do with risk.

Gross vs. Net


• Loss Contingencies – an Exposure Draft would revamp FAS 5 to require booking something, based on weighted probabilities. It received 380 letters, nearly all negative. FASB has signaled a slow down for this project.

On the more distant horizon …


Auditing Matters


SAS 70 Audits = SOC 1The new types and applicable standards for Service Organization Control reports are:• As of June 30, 2011, SAS 70 became SOC 1 or “SSAE 16

Attestations.”• Management must conclude and assert that all risk areas have been

included in the scope of the project – can’t scope out problem areas.

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SOC 2• A SOC 2 engagement that deals with only IT controls where the

third party service provides does not directly affect the financial statements of the user is now a different sort of report, governed by different technical standards (AT 101// SSAE 11).

• AICPA published a guide “Reporting on Controls at a Service Organization Relevant to Security, Availability, Processing Integrity, Confidentiality, or Privacy (SOC 2).” Appendix B to this guide contains “Trust Service Principles.” Several hundred pages of “one size fits all” requirements that don’t seem to make a lot of sense.

• The distribution of both SOC 1 and SOC 2 reports are limited. Like the former SAS 70 audits, SOC 1 and SOC 2 reports can be either a type 1 (design only) or type 2 (design and effectiveness for a period of time).

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SOC 3 – an entirely new type of report dealing with certain web based trust principles, where certification is intended to be broadly disseminated to the general public. It is based on the AICPA’s Trust Services Criteria.

GAAS - Finally, “clarity project” guidance to the auditor on how to use a SOC report is now found in auditing literature (section AU402).

SOC 3


• Inadequate physical inventory observations or no expansion of scope to other locations when significant physical inventory differences existed.

• Presence of going concern indicators not linked to goodwill impairment as a risk area, or inadequate testing of budget or other assumptions used for goodwill impairment testing.

• Collectability not considered in assessing revenue recognition.• Failure to audit “Other Than Temporary Impairment” of investments.• Failure to test the input of data to an actuary.• No test of inventory cut-off performed.• Ineffective general IT controls that should have resulted in increased

substantive testing.• Failure to test impairment of long-lived assets and related assumptions of

future cash flows.• Failure to test for impairment of finite life intangibles.• No test of a construction contractor’s provision for loss contracts.

PCAOB’s most recent “ding” on auditors: [26/57 were deficient]


• Proposal would be effective for 2013.• Expand the auditor’s responsibility to audit accounting & disclosures for

issuers to include specific procedures for each disclosed or significant risk.• Perform other procedures when a previously undisclosed transaction is

identified. Some examples:• Buying/selling at prices significantly different than market• Sales with unusual terms• Bill and hold // round-trip transactions• Borrowing/lending at zero interest or no fixed repayment terms; making

loans without collateral or the ability to repay• Occupying a premise or receiving/providing management services

without consideration• Guarantees outside the normal course of business

PCAOB proposal – auditing related parties


• In November 2011, the European Commission proposed a 6 year maximum term for any auditing firm to serve (not just engagement partner rotation).

• No other nonaudit services (e.g., taxes or consulting) could be performed.• PCAOB is also studying the issue, but with a 10 year term.• PCAOB has another proposal that would require the outside auditor to include

a sort of MD&A on their thought process on accounting and auditing issues for the company.

EC proposals


• Positive Pay – continued instances of fraudulent checks being presented by fabricating authentic looking checks

• Form 5500 filed for medical plans – even though these plans generally have no assets, a filing is required and we are seeing the assessment of fines for noncompliance

• Common peer review issues:• Engagement letters (or other documentation) about Rule 101-3 on non-

attest services• Documentation of required communications with “those charged with

governance” [SAS 114 in 2007]• Failure to properly consider VIE / FIN 46 / ASC 810 / just issued TIS

9150.29 (just issued GAAP departure language for a compilation/review engagement […many elements would be materially affected …])

A few last minute zingers:


Questions ?

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