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

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

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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, ...

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.

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

    • Frazier & Deeter Client A&A Update – Key Convergence Topics Bill Godshall Bill.godshall@frazierdeeter.com January 7, 2011
    • ACCOUNTING FOR LEASES A 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 SFAS 13) on Leases (U.S. GAAP) and IAS 17 Leases (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)
    • DISCUSSION SUMMARY• Scope of Exposure Draft (ED)• Lessee Accounting• Lessor Accounting• Short-term Leases• Other Changes• Transition
    • SCOPE OF EXPOSURE DRAFT 6
    • SCOPEED would not apply to: – Leases of intangible assets – Leases to explore for or use minerals, oil, natural gas, and other non-regenerative resources – Leases of biological assets
    • SCOPE (CON’T)ED would not apply to a purchase or a sale: – Transfer of control and all but a trivial amount of risks and rewardsExamples of transferring control – Automatically transfers title to the underlying asset, or – The contract contains a bargain purchase option
    • LESSEE ACCOUNTING 9
    • RECOGNITIONLessee model – “Right-Of-Use” asset – “Obligation to Make Lease Payments” liability – Applicable to all leases
    • MEASUREMENTObligation to make lease payments liability – Present value of Lease Payments discounted using lessee’s incremental borrowing rate • Or rate lessor charges in lease, if readily determinable • Relief for short term leases – Measured over the Lease TermRight-of-use asset – Cost – present value of lease payment plus any initial direct costs – Starting amount is same as liabilityED does not address the effect of lease incentives
    • MEASUREMENTLease term – The longest possible term that is more likely than not to occur – Estimate the probability of each possible lease term – Likely that lease terms may be longer under new model – Consider all facts and circumstances
    • EXAMPLEA 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 Five Exercise 1 Five No renewals Year Renewals Year Renewal exercisedTotal Lease Term 20 15 10Probability 30% 25% 45%Cumulative Probability 30% 55% 100%
    • MEASUREMENTInitial Measurement of Lease payments – Measure using “Expected Outcome Approach” • The present value of the probability-weighted average of the cash 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
    • MEASUREMENTHow do you determine present value of payment stream (Expected Outcomes Approach)? 1. Develop reasonably possible outcomes over the [calculated] life of the lease 2. Estimate amount and timing of cash flows for each 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) Total Expected Sales over 15 Contingent Present Probability- Outcome years* Rentals Value Probability weighted2% decline in 261,430,897 5,228,618 3,068,069 10% 306,869salesFlat sales 300,000,000 6,000,000 3,423,791 30% 1,027,1374% increase in 400,471,753 8,009,435 4,322,675 40% 1,729,070sales8% increase in 543,042,279 10,860,846 5,555,556 20% 1,111,111sales 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 $ 29,852,623At 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
    • MEASUREMENTSubsequent measurement and reassessment – Subsequent measurement • Liability - amortized cost under the effective interest method • Right-of-use asset - amortized cost on a systematic basis over life of lease or useful life, if shorter
    • MEASUREMENTSubsequent measurement and reassessment – Reassessment • If facts or circumstances indicate that there would be a significant change in the liability since the previous reporting 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 related to future periods
    • LESSOR ACCOUNTING 22
    • LESSOR MODELHybrid accounting model – Performance obligation • Lessor retains significant risks and rewards – Derecognition • Lessor transfers significant risks and rewards – Intended to follow the business model of the lessor – No bright lines in making determination
    • PERFORMANCE OBLIGATIONRecognition – Performance obligation liability • permit the lessee to use the asset • Measure at rate charged by lessor – Asset [receivable] • the right to receive lease payments
    • PERFORMANCE OBLIGATIONMeasurement of right to receive lease payments – Longest possible term that is more likely than not to occur – Present value of lease payments utilizing the expected outcome approach – Similar to lessee calculation; however • Contingent rentals and residual value guarantees are subject to reliability criterion (i.e. measured reliably) • Include term option penaltiesEvaluation and Remeasurement • Similar to lessee requirements
    • DERECOGNITIONBalance 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 which did not transfer to lesseeIncome 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 guarantees and term option penalties would be identical to the performance obligation approach.
    • DERECOGNITIONAsset derecognizedThe portion of the derecognized asset is calculated as follows:Fair value of the right to receive lease payments x Carrying amount of the underlying asset Fair value of the underlying assetThe remaining asset is classified as a residual asset
    • DERECOGNITIONSubsequent measurement – Measure lease receivable at amortized cost using the effective interest methodRemeasurement • Change in lease term would provide for a corresponding adjustment to the residual asset, after allocation between the derecognized asset and residual asset • Changes in estimated payment streams are recognized in income
    • SHORT TERM LEASES 29
    • SHORT TERM LEASESLessees – Short term lease – a lease that, at the date of commencement of the lease, has a maximum possible lease term, including options to renew or extend, of 12 months or less – Lessee has an election to measure (on a lease-by- lease basis) • Liability to make lease payments at the undiscounted amount of lease payments • Right-of-use asset at undiscounted amount plus initial direct costs • Would not apply to immaterial items
    • SHORT TERM LEASES, Cont’dLessors May elect not to recognize, on a lease-by-lease basis, assets or liabilities arising from short-term leases
    • TRANSITION 32
    • TRANSITIONInitial recognition for lessees and lessors – All outstanding lease arrangements would be subject to the new standard – Apply simplified retrospective approach as of the beginning of the first comparative period presented •Date of initial application is the beginning of the first comparative period presented in the first financial statements in which the entity applies this 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 for prepaid or accrued lease payments – Adjustment may not be necessary for capital leases that do not have options, contingent rentals, term option penalties or residual value guarantees
    • TRANSITION (CON’T)Lessor – Performance obligation approach • Recognize a right to receive lease payments measured at the present value of the remaining lease payments, discounted using the rate charged in the lease determined at the date of inception of the lease, • Recognize a corresponding lease liability, • Reinstate any previously derecognized assets at depreciated cost, determined as if the asset had never been derecognized.
    • TRANSITION (CON’T)Lessor – Derecognition approach • Recognize a right to receive lease payments measured at the present value of the remaining lease payments, discounted using the rate charged in the lease determined at the date of inception of the lease, • Recognize a residual asset measured at fair value at date of initial application.
    • OTHER CHANGES
    • OTHER CHANGES• Sales leaseback transactions• Sub lease arrangements• Leases with service components
    • QUESTIONS?
    • CONVERGENCE ACCOUNTING:IMPACT ON INFORMATION TECHNOLOGYPREPARING YOUR SYSTEMS TO MEET FINANCIAL 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
    • CONVERGENCE ACCOUNTING – Benefits to Convergence 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 – Key Challenges Deadlines Parallel reporting Broad implications Transaction changes
    • CONVERGENCE ACCOUNTING – Impact Adoption of convergence-specific consolidation rules and report layout Embedding requirements into General Ledger and subsystems  Removing the need for manual adjustments  Minimize compliance risks
    • CONVERGENCE ACCOUNTING – Risks Underestimating challenges Implementation delays Introduction of unnecessary risk and compliance issues Increased number of errors; costs Outsourcing Weakened control environment Risk to the accuracy of current reporting environment
    • CONVERGENCE ACCOUNTING – Working with Information Technology Key enabler in the transition Leads the phased, embedding process to conversion Coordinates upgrades and conversions with Convergence/IFRS planning
    • CONVERGENCE ACCOUNTING – Evaluating Your Existing ApplicationsIs your current application ready? Where are existing US GAAP rules configured in your system? 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 ApplicationsIssues with legacy applications:  Customization  Significant need for manual intervention  Data enrichment  Sub ledger reconciliationOther items to consider:  Is the original implementation team still in place?  Intellectual property
    • CONVERGENCE ACCOUNTING – Managing the Transition Process Multiple frameworks US GAAP IFRS Convergence 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 – Transition Issues to ConsiderExamine systems to:  Ensure transactions are analyzed to include base information necessary to support US GAAP Convergence and IFRS reporting  Support increased volumes of data  Identify/manage potential delays in closing and reporting cycles
    • CONVERGENCE ACCOUNTING – Transition Issues to ConsiderFinancial 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 ConsiderBe aware of new Convergence/IFRS language:  Legal, IT, HR, etc.  Include descriptive information along with financial valuesAvoid 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 ConsiderNeed for additional internal controls  Manual adjustments  Compliance/control issuesLong term objective: • Embed Convergence/IFRS needs into transaction systems and General Ledger • Reduce/eliminate need for manual journal entries
    • QUESTIONS?
    • Revenue From Contracts With Customers 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 performance obligation• Other issues• Disclosures and transition
    • GAAP AnalysisCurrent US GAAP Proposed Model• Persuasive evidence of • Identify the contract(s) with a customer an arrangement • Identify the separate• Delivery of product or performance obligations in service the contract • Determine the transaction• Collectability is price reasonable assured • Allocate the transaction price to separate• Price is fixed or performance obligations determinable • Recognize revenue when the entity satisfies each performance obligation
    • Identify the contract(s) with a customerA contract exists if:1. The contract has commercial substance2. The parties to the contract have approved the contract and are committed to satisfying their respective obligations3. The entities can identify each party’s enforceable rights regarding the goods or services to be delivered4. The entity can identify the terms and manner of payment for those goods or servicesA contract does NOT exist if either party can terminate awholly unperformed contract without penalty
    • Identify the contract(s) with a customer (cont’d)• Combine separate contracts if prices are interdependent: – Indicators of interdependence include: • Entered into at or near the same time • Negotiated as a package with a single commercial objective • Performed concurrently or consecutively
    • Identify the contract(s) with a customer (cont’d)• Segment a single contract if goods or services are priced independently – Goods and services are priced independently if: • Entity or another entity sells identical/similar goods/services; and • Customer does not receive a significant discount for buying some goods/services with others
    • Identify the contract(s) with a customer (CON’T)• Is a contract modification, in effect, a separate contract or an extension of the original? – Extension of original if prices are interdependent • Show cumulative effect in the period of modification as if the original 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 cleaning services under a three year contract for $2,000 per year• One first day of third year the contract is renegotiated such that it will be extended for one year and the annual fee will be $1,800 per year• How is revenue recognised if: a.$1,800 is current market price for work; or b.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 of those charged earlier then: – Revenue in year 3 = $1,800 – Revenue in year 4 = $1,800b. If modification prices are not independent of those 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 performance obligations in the contract• If an entity promises to deliver more than one good or service, the entity shall account for each promised good or service as a separate performance obligation only if 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 an identical or similar good or service separately2. The entity could sell the good or service separately because the good or service meets both the following conditions: a. It has a distinct function b. It has a distinct profit margin
    • Example – design and build contract• An entity enters into a construction contract for customer• 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 build contract cont’d.• Per ED application guidance – Design – separate – Procurement – control only passed on installation, so part of construction – Site preparation – separate – Site finishing– separate
    • Example – design and build contract cont’d.– All else – combined because: • “Other tasks are highly inter-related, which requires a significant contract management service” • “Similar management services are not sold separately” • “Contract management service is not subject to distinct risks as they are inseparable from risks of integrated tasks”
    • Identify the separate performance obligations 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 to return for full refund. Cost of asset was $70,000. 50% probability of return 1.Dr Cost of sales $35k Dr Right to receive asset $35k Cr Inventory $70k 2.Dr Cash $100k Cr Repurchase liability $50k Cr Revenue $50k• If goods are returned – reverse all entries
    • Determine the transactionThe transaction price price the probability- reflectsweighted 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 transaction price: – Collectability – Time value of money – Noncash consideration – Consideration payable to the customer
    • Example - Time Value of Money• Give a customer 2 years credit to pay an invoice of $10,000 – Discount rate that would be “reflected in a separate financing transaction 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% of customers 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 credit risk would be accounted for as a bad debt expense• When a particular customer defaults is it one that was expected to default given historic averages or an unexpected failure?
    • Allocate the transaction price toseparate performance obligations
    • Recognize revenue when the entity satisfies each performance obligation• When an entity satisfies a performance obligation, it shall recognize as revenue the amount of the transaction price allocated to that performance obligation.• A good or service is transferred when a customer obtains control of that good or service. A customer obtains control when the customer has the ability to direct the use of, and receive benefit from the good or service.• Indicators of control include 1. The customer has an unconditional obligation to pay 2. The customer has legal title 3. The customer has taken physical possession 4. The design or function of the good or service is customer- specific• Continuance transfer of goods or services (no more percentage-of-completion) - Input / output / passage of time
    • Other issues• Onerous performance obligations (loss contracts)• Contract costs
    • Disclosures and transition• Effective date – TBD• Transition – Not concluded on yet, but retroactive application is anticipated• Disclosures – Disaggregated disclosure of revenue – Rollforwards of contract assets and liabilities – Maturity analysis – Information regarding performance obligations
    • Questions?