Recent Activities at the FASB

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Recent Activities at the FASB

Corporate Reporting and Governance Conference

California State University, Fullerton

September 2005

Katherine Schipper, Financial Accounting Standards Board

The views expressed in this presentation are my own, and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation.

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Overview

• Financial reporting topics

• Exposure draft, Business Combinations (joint with the IASB)

• Exposure draft, Consolidated Financial Statements, Including Accounting and Reporting of Noncontrolling Interests in Subsidiaries (a replacement of ARB 51)

• Fair value measurement

•Proposals for optional fair value measurements

• Exposure draft, Accounting for Uncertain Tax Positions, an interpretation of SFAS 109

• Performance reporting

• Share based payment (SFAS 123R)

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Joint IASB-FASB project on business combinations

• Intent => replace SFAS 141 and converge with international standards– Will include mutual enterprises– Will include acquisitions of businesses through means other than

a purchase of net assets or equity interests– A separate project is addressing business combinations involving

not-for-profit organizations

• General principle: recognize assets acquired and liabilities assumed in a business combination at fair value– Exceptions: income taxes, benefit plan obligations, operating

leases– Departure from the cost-based provisions in APB 16, which also

appeared in SFAS 141 as originally issued

• Joint IASB-FASB Exposure Draft is available at the FASB’s website

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• Examples of proposed changes, relative to current practice– Business combination achieved in stages

• Sometimes called a step acquisition• Purchase consideration includes the fair value of an existing

noncontrolling equity investment• Remeasure existing noncontrolling equity investment at fair

value, with gain/loss recognized in income• Recognize all the net assets at fair value, not just the acquirer’s

share• Recognize 100% of the goodwill (if any) not just the acquirer’s

share– Allocate goodwill between controlling and noncontrolling interests

(if any)

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• Examples of proposed changes, relative to current practice– Broaden the definition of a “business” to include more than would

be included under EITF 98-3• Implication: Goodwill would be recognized in more cases

– Payments to third parties (e.g., professional fees) are an expense– Negative goodwill to be recognized in income immediately– Acquirer must assess whether any part of the transaction price, and

any assets acquired or liabilities assumed, are not part of the exchange

• Example: effective settlement of a pre-existing arrangement such as a supply contract or a lawsuit

– The acquirer’s expected restructuring costs are not assumed liabilities and therefore are not part of the business combination

– Measurement date is closing date (not announcement date)– The measurement period (the time during which the entity gathers

information to recognize and measure assets and liabilities at fair value) cannot exceed one year

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• Examples of proposed changes, relative to current practice– Receivables (including loans) measured at fair value

• No separate valuation allowance for uncollectible accounts as of the acquisition date

– Contingent liabilities (per SFAS 5) initially recognized at fair value• Subsequent measurement based on applicable GAAP, except

for items that would be in the scope of SFAS 5. Those items would continue to be measured at fair value

– Contingent consideration initially measured at fair value• Liabilities should be remeasured through settlement, with

changes in the income statement– IPRD no longer expensed (to be recorded as an asset)

• Test for impairment per SFAS 142

• Subsequent expenditures will be expensed

• Begin amortization of the IPRD asset when the related product has been developed (and has been launched)

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Replacement of ARB 51

• Exposure draft, Consolidated Financial Statements, Including Accounting and Reporting of Noncontrolling Interests in Subsidiaries, available on the FASB’s website• Carry forward without reconsideration some provisions of ARB 51,

as amended by SFAS 94• Consolidation policy (that is, consolidation criterion is a controlling

financial interest)• Consolidation purpose• Some procedural provisions

• Noncontrolling interest (shares of a subsidiary not owned by the parent)

• Classification• Display• EPS calculations

• Accounting for loss of control (remeasure remaining investment at fair value, with gain/loss in income)

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Replacement of ARB 51

• Define noncontrolling interest as shares of a subsidiary not owned by controlling interest

• Classified as equity in the consolidated balance sheet• Consolidated income (loss) and OCI attributed to controlling

and noncontrolling interests based on ownership (unless a contractual arrangement specifies otherwise)

• Losses continue to be attributed to noncontrolling interest even if the result is a debit balance

• Display• Balance sheet: Reported as equity, separate from parent

shareholders equity• Income statement: Separate display of income attributable to

noncontrolling and controlling interests• Increases/decreases in ownership interests are accounted

for as capital transactions (transactions with owners)

Observation: This is the third time the FASB has considered this issue

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Fair value measurement project

• Exposure Draft (June 2004) available at the FASB’s website– Explain intent of fair value measurements for financial reporting

• Use quoted prices where available, for identical items (or similar items, with adjustment)

• If no prices available, use models, techniques and assumptions that marketplace participants would use

– Intent of this guidance is to increase the consistency and comparability of fair value measurements

• Include revised and clarified discussion of valuation techniques from Concepts Statement 7

• Include discussions of techniques used by valuation professionals (market approach, income approach, cost approach)

– Enhanced disclosures about the nature and source of fair value measurements

• Separate recurring from periodic remeasurements• Explain how fair values were determined (prices versus models)

– Exposure Draft does not propose extending the use of fair value measurements

– Final statement expected late 2005

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Fair value measures—recent decisions

Key attributes of fair value:

1. Need not be based on an actual transaction

2. No requirement that a market exist

3. Current transaction => fair value measurement is not intended to capture the most likely settlement amount

Example: An arrangement will settle for 100 with probability .30 and for 0 with probability .70. The most likely settlement amount is 0. A current transaction would reflect the dispersion of outcomes: .30 x 100 + .70 x 0 => 30.

Observation: The third attribute is not consistent with the perspective in SFAS 5.

Revised (tentative) definition of fair value: an estimate of the price that could be received for an asset or paid to settle a liability in a current transaction between marketplace participants in the reference market for the asset and liability

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• The 2004 exposure draft identified 3 levels of fair values• In recent decisions, the FASB decided to expand to 5 levels

– Level 1: Quoted prices in active markets, for identical items– Level 2: Quoted prices for similar items, with objectively

determinable adjustments– Level 3: Measurements based on direct market inputs that are

observable over the term of the item• Examples: interest rates, yield curves, volatilities, prepayment speeds,

credit risks, foreign exchange rates, published indexes

– Level 4: Measurements based on indirect market inputs that are observable over the term of the item, including correlated, interpolated or extrapolated inputs that are corroborated by direct market inputs

– Level 5: Measurements based on entity inputs

• Disclosures would separate the five levels by categories– Current proposal: Level 1, Levels 2-4, Level 5

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• The 2004 exposure draft permitted block discounts– Refer to note 5 of the exposure draft– Unspecified decrement to price x quantity for actively traded

instruments that are traded in large quantities– Decision reversed in redeliberations

• The 2004 exposure draft required credit quality (credit standing) to be considered in fair value of an entity’s own liabilities (note 4)– Currently would apply only to derivatives but this could change if a

fair value option is permitted – Many comment letters questioned this decision– The FASB has not reached a conclusion on this issue

• One proposal: discontinue the use of fair value for an entity’s own liabilities when credit quality of that instrument (or the entity as a whole) drops below a certain threshold (which has yet to be defined)

• Another proposal: Issue Statement with deferral of provisions that would require credit standing to be considered in measuring liabilities

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Fair value measures

• Use of fair values is intended to increase the relevance of reported numbers– Only measurement attribute for certain derivatives

• Example: Interest rate swap

– Most relevant attribute for (many) incomplete transactions– Alternative is allocations of transaction amounts

• Examples: EITF 00-21 (revenue recognition); SFAS 140 (retained interests in securitizations)

• These allocations require their own estimations (which may be based on fair values) and so are not free of estimation error

• Some question the reliability of fair values based on measurements (not actual transaction prices)– What is the actual reliability of fair value measures?– How reliable are fair value measures compared to the reliability

of other measures that are based on estimates and judgments?– What are the auditing considerations?

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Fair value measures—reliability

Reliability => users of financial reports can depend on the reported numbers to represent the economic conditions (events, transactions) they purport to represent

– Representational faithfulness => correspondence between the measure and the phenomenon being measured

– Verifiability => consensus among various measurers of the same construct

• Implies low dispersion of independent measurements

• Does not require that the measure can be vouched or confirmed to a separate source (although vouching is one way to achieve a low dispersion of measurements)

• Key issue: Can this reliability construct be made operational for auditors?

Observation: The FASB has tentatively decided (as part of its joint Conceptual Framework project with the IASB) to replace the concept reliability with the concept faithful representation. The reasoning is that verifiability is a necessary condition for faithful representation.

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Possible extensions of fair value measurement

• Exposure draft, Accounting for Servicing of Financial Assets– Would require separately recognized servicing rights to be

measured at fair value.

– Would also allow (not require) subsequent fair value remeasurement of separately recognized servicing rights

– Current treatment is LOCOM, so this change would allow entities to apply fair value measures when fair value > original carrying value

• Proposal is to allow the choice to be made by class of servicing rights

– Additional disclosures about servicing rights and their measurement

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Possible extensions of fair value measurement

• Exposure draft, Accounting for Certain Hybrid Financial Instruments– Would require evaluation of beneficial interests in securitized

financial assets to identify derivatives (freestanding or embedded)• Clarify that concentration of credit risk in the form of subordination is not

a derivative

– Would permit free choice between fair value measurement of financial instruments with embedded derivatives and the application of SFAS 133.

• Applies when SFAS 133 would require bifurcation of an embedded derivative

• Choice would be made instrument by instrument

• Objective is to ease implementation, because of the complexities associated with identifying and bifurcating embedded derivatives

– Clarify which interest-only and principal-only strips are exempted from SFAS 133

• Separate contractual cash flows labeled principal and interest and do not add any new risks

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Fair values—FASB activities

•Exploration of a possible “fair value election” along the lines of IAS 39

– Permit (not require) entities to account for financial instruments at fair value by making an irrevocable designation at inception

– Intent is to alleviate the problematic outcomes associated with a mixed attribute measurement model where these are most acute

– Questions to consider:• What instruments and arrangements should be subject to a “fair value

election”?

• The IASB has restricted the circumstances in which the IAS 39 fair value option can be used. Should the FASB establish similar conditions that must be met?

Observation: This treatment alternative would increase noncomparability, as would the treatment alternatives for servicing rights and instruments with embedded derivatives. What is the most appropriate way to mitigate the problems associated with noncomparability?

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Exposure draft on uncertain tax positions

• Tax law is complicated and subject to varying interpretations– Tax positions (deductions, credits) reported in a tax return may be

disputed by the taxing authority• Step 1 is detection of the position by examination • Step 2 is the taxing authority’s position• Step 3 is the resolution (which may require many steps and take several

years)

• How should tax positions be reported in financial statements?– Record the amounts reported on tax returns and use valuation

allowances (reserves), arrived at by applying SFAS 5 contingency accounting?

– Wait until the matter is resolved to show financial statement impact?– Record an estimate that reflects the probability of

examination/detection?

Background

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Exposure draft on uncertain tax positions

• Initial recognition: a tax position must be probable of being sustained in the event of an audit– Assume the return will be examined – Apply a probability criterion per SFAS 5. In practice, this

appears to imply about 70-75% confidence the position will be sustained

• Exposure Draft lists factors to be considered (e.g., having a “should prevail” tax opinion; legal precedent)

• Initial measurement– Best estimate (per SFAS 5, the most likely amount), not an

expected value– Difference between amounts recognized for financial reporting

and the amount of the tax position => liability (but not a deferred tax liability) or reduction of deferred tax asset

• Derecognize if it becomes more likely than not that the tax position will not be sustained– Asymmetry between recognition and derecognition– Valuation allowances not permitted

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Reasons for the joint FASB-IASB revenue recognition project

• Practical reasons• No general standard for revenue recognition and little

guidance for service activities; over 200 pieces of ad hoc guidance that are hard to retrieve and sometimes inconsistent

• As business models evolve, selecting the appropriate rules becomes more difficult, since much of the existing guidance is transaction-specific or industry-specific.

• Conceptual reasons • Much US GAAP for revenues was developed before the

Conceptual Framework. Revenue recognition is often based on ideas of earned and realized/realizable, as well as matching. However, the idea of matching has been debunked in the Conceptual Framework.

• User reasons• Noncomparability between entities and industries, with little

information to assist in identifying and adjusting for the differences.

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Project will result in 3 levels of guidance.

Level I. Revision and Expansion of Concept Statements 5 and 6– CON 6 defines Revenue in terms of Assets and Liabilities– CON 5 describes recognition criteria unique to Revenue

Level II. General Standard on Revenue Recognition– Replace some existing guidance such as APB No. 29,

SFAS No. 48, EITF 00-21 and SAB No. 104– Guidance in the general standard would be derived from

the revised Concept Statements

Level III. Application Guidance– Provide guidance for 3 types of activities

• Rights of Use – for example, leasing• Services – for example, lending• Products

– Identify portions of current guidance that will be superseded by the application guidance

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Accounting challenges in revenue recognition

Multiple element arrangements in which performance occurs in more than one reporting period.

• Identifying elements, measuring the elements (obligations), determining when the element’s revenue should be recognized (obligation is extinguished) and identifying conditions that would require remeasurement of the obligation

• Examples: SOP 97-2, SABs 101/104, EITF 00-21, SOP 81-1

Standby obligations which remain after products or services are delivered

• How to measure initially and subsequently.• Rights of refund and return, warranties, guarantees, contract

price adjustments (price protection, volume discounts, claims, rebates)

• Examples: Statement 48, Statement 5, Interpretation 45, numerous EITFs, SOP 81-1

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Accounting challenges in revenue recognition

Changes in arrangements during the contract performance period

• When to reflect changes and how

• Examples: Change orders and contract modifications (SOP 81-1)

Customer acquisition and marketing costs that affect revenue or create an obligation

• When and how to measure, remeasure and report

• Examples: Discounts, loss leaders, promotion allowances, cooperative advertising arrangements (Numerous EITFs, SOP 93-7)

Executory contracts with fixed prices.

• When to recognize price changes.

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Possible approach for a general standard

• Focus on the definition of revenue and base the accounting on assets and liabilities related to activities with customers.

– Do not rely on matching or culmination of earnings process

• Measure assets initially (and possibly subsequently) at fair value

• Measure liabilities at an amount that is determined by the price to a customer for each element of the contract on a standalone basis

• Allocate or defer the difference between the contract price and the sum of the performance values

Observation: FASB board members have not at this point been able to develop and agree on an approach to a general standard for revenue recognition.

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Concerns with the possible approach for a general standard

Identification risk

• Identifying assets and liabilities and determining net or separate reporting.

• Determining when a liability (performance and standby obligation) is extinguished or should be remeasured.

• Determining the level of disaggregation of revenue and disclosure.

• Pressure to call cost deferrals assets

Measurement risk

• Difficulties in determining the appropriate standalone price for some contract elements

• Differences between the contract price and the total performance value must be allocated or assigned based on rules. It is not clear how many sets of rules will be required.

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Joint IASB-FASB project on performance reporting

• Segment A– What should be included in a complete set of financial

statements?• Require a statement of shareholders equity?

– Tentative decision: Yes (the FASB will revisit for private companies)

• How many years of comparative statements?– Tentative decision: two annual periods (three balance sheets, two

statements of comprehensive income, two statements of changes in equity and two statements of cash flows)

• Should there be a single statement of comprehensive income (as opposed to the three display alternatives in SFAS 130)? If a single statement, should there be a subtotal for net income?

– Tentative decision: Yes to both, with no changes in the current definition of net income

• Current plan is to develop an Exposure Draft with these decisions, including consideration of how the decisions would affect interim reporting

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Joint IASB-FASB project on performance reporting

• Segment B– With regard to the statement of comprehensive income:

• If a subtotal for net income, what should be the criteria for inclusion in net income?

• If a subtotal for net income, should items be recycled from other comprehensive income to net income?

– How should information be disaggregated?• Observation: several approaches have been proposed,

including separating remeasurements from other items• Observation: both the IASB and the FASB have considered

organizing the income statement the same way as the statement of cash flows (separate operating from financing items)

– Should the direct method be required for the statement of cash flows?

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Share-based payment (SFAS 123R)

• SFAS 123 allowed free choice between a fair value-based measurement approach and the intrinsic value method of APB Opinion 25.

• SFAS 123R removes the free choice, requires a fair-value based measurement, and adds some guidance– Under Opinion 25, at-the-money, fixed-plan options issued to

employees created zero compensation cost, because those options were measured at grant date intrinsic value

– The “zero cost” outcome applied to one narrow class of share-based payment arrangements, and was a consequence of the intrinsic value method.

• Consequence: Noncomparability and a possible tendency to use at-the-money, fixed-plan options even if other arrangements might have more desirable properties

– Opinion 25 did not provide much application guidance• Consequence: Interpretation 44 (20 detailed questions) and

EITF 00-23 (51 detailed questions). This guidance has been described as disjointed, rule-based and form-driven by the SEC

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Share based payment (SFAS 123R)

• Key dates– Grant date => time when both parties to the arrangement

understand the terms and conditions; all necessary approvals have been obtained.

• SFAS 123R specifies grant date as the measurement date

• Equity instruments are not remeasured; liabilities are

– Service inception date => start of the requisite service period (often the grant date)

– Vesting date => time when the employee has satisfied conditions and can exercise. Employer has received the requisite service and the benefit (and risk) of future price changes are the employee’s. The exchange transaction is complete.

– Exercise date => time when the employee exercises options

• Key construct => requisite service– Service required of the employee in exchange for a share based

payment (may be defined by the vesting period)

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• Measurement of the cost of employee services => based on the fair value of the instruments awarded– Measurement is to be based on observable prices if they are

available. Otherwise, measurement is to be based on a pricing model that takes into account the following (no particular model is specified)

• Exercise price

• Expected term

• Current price of the underlying share

• Expected volatility

• Expected dividends

• Risk free rate

– Nonpublic entities for whom it is not practicable to estimate expected volatility may use a calculated value for volatility, based on historical volatility of an appropriate industry index

– Entities that are not able to measure fair value reliably may measure at intrinsic value, remeasured at each reporting date through settlement

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• Measurement objective => fair value of the instruments to which the employee becomes entitled upon satisfying vesting conditions. This measurement objective implies the cost attribution method– Cost is based on the number of instruments for which the requisite

service is rendered. No compensation cost for instruments that do not vest if:

• Fail to satisfy service or performance conditions• Fail to satisfy (derived) requisite service period that is associated with

(derived from) a market condition

– Initial accruals => Estimate the instruments expected to vest• Revisions are changes in estimates, with effects recognized in the

current period

– Special treatment for performance conditions (vesting conditions tied to the entity’s operations) => recognize cost only if the performance condition is probable of being achieved

– Recognize cost over the requisite service period• Debit to compensation cost (which may be an expense)• Credit to paid in capital

– Special treatment for graded vesting (parallels SFAS 123)

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• Examples of requisite service periods– An employee will vest in options as follows:

• 100 options if EPS growth exceeds 5% annually over the next 3 years and 200 options if EPS growth exceeds 7% annually over the next 3 years

• The explicit service period is 3 years and this is also the requisite service period

– An employee will vest in options when a divestiture is completed. Analysis of the divestiture plan indicates completion is expected in 20 months. The implicit service period is 20 months and this is also the requisite service period.

– An employee will vest in options if the share price increases by 15% (relative to the current price) at any time within the next 3 years.

• This is a market based condition and the likelihood that it will be satisfied is a function of volatility. The derived service period, which is also the requisite service period, is the duration of the most frequent path, of a path-dependent option pricing model, on which the condition is satisfied. If volatility is high, the derived service period could be shorter than 3 years.

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• Example of cost attribution—options with a three year service condition– Estimate the fair value based measurement for an option– Estimate expected forfeitures per year– At inception of the arrangement, use number of options granted,

adjusted for expected forfeitures over requisite service period, and estimated fair value to measure compensation cost

• Example: Estimated forfeitures of 3% per year• Cost = .97 x .97 x .97 x number of options x fair value based

measurement for an option– Journal entry in first year

• Charge 1/3 of the cost to the current year (credit is to APIC)• Establish a deferred tax asset

– A change in estimated forfeitures => change in accounting estimate • Cumulative effect from applying the change retrospectively is

recognized in the period of the change in estimate

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Recent Activities at the FASB

Corporate Reporting and Governance Conference

California State University, Fullerton

September 2005

Katherine Schipper, Financial Accounting Standards Board

The views expressed in this presentation are my own, and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation.

Recent Activities at the FASB

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Transcript of Recent Activities at the FASB