A Global Reach with a Local Perspective 2011 Rocket City Gov Con Conference September 22, 2011 www.decosimo.comFASB Proposals Affecting Gov‟t ContractorsROBERT BELCHER, CPAKEN CONNER, CPA
Agenda Overview and scope of the exposure draft Core principles and implementation guidance Recap of some key changes affecting government contractors Preparing for the adoption of the new revenue recognition standard
FASB/IASB PROJECTS AND TARGET DATE 2011/2012 2012 Project 3Q 4Q 1H Balance Sheet - Offsetting F Consolidation: Policy & Procedures E Consolidation: Investment Companies E Revenue Recognition E Accounting for Financial Instruments E Leases E Insurance Contracts E Emissions Trading Schemes L Financial Instruments with Characteristics of Equity L Financial Statement Presentation L Reporting Discontinued Operations L F - Final document E - Exposure draft
FASB-ONLY PROJECTS Expected Date 2011 Project 3Q 4Q Disclosure about an Employers Participation in a Multi-Employer Plan F Goodwill Impairment Assessment F Codification Technical Corrections E Investment Properties E Disclosure about Risks and Uncertainties and the Liquidation Basis of Accounting E Disclosure Framework D Disclosure of Certain Loss Contingencies F - Final document E - Exposure draft D – Discussion paper
Goodwill Impairment Test for Reporting Units with Zero or Negative CarryingAmountsWhen Will the Amendments Be Effective? For public entities, the amendments in this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. For nonpublic entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Nonpublic entities may early adopt the amendments using the effective date for public entities. Upon adoption of the amendments, an entity with reporting units that have carrying amounts that are zero or negative is required to assess whether it is more likely than not that the reporting units’ goodwill is impaired. If the entity determines that it is more likely than not that the goodwill of one or more of its reporting units is impaired, the entity should perform Step 2 of the goodwill impairment test for those reporting unit(s). Any resulting goodwill impairment should be recorded as a cumulative-effect adjustment to beginning retained earnings in the period of adoption. Any goodwill impairments occurring after the initial adoption of the amendments should be included in earnings as required by Section 350-20-35.
FASB Going Concern Project The going concern assumption is fundamental to accrual accounting. To assume that an entity will continue in business is to say that the entity expects to realize its assets at the recorded amounts and to extinguish its liabilities in the normal course of business. If the going concern assumption fails, then the amount and classification of assets and liabilities in the balance sheet may need to be adjusted, with consequences to revenues, expenses, and equity. Among other things, the going concern assumption justifies the current and non-current classification within the balance sheet, the allocation of costs over periods benefited, historical cost accounting, and most aspects of the revenue recognition and matching principles. Continuation of an entity as a going concern is assumed in financial reporting in the absence of significant information to the contrary. Therefore, going concern is an accounting assumption. In other words, the financial statements (which are the assertions and responsibility of management) should convey this going concern assumption (or lack thereof).
FASB Going Concern Project During 2007, 2008 and 2009 (no figures for 2010 as of the date this presentation was prepared), over 3,000 public companies (or about 20% of U.S. public companies) had going concern paragraphs in their audit report during each year. Some people say, “going concern opinions,” but that is not true because having that paragraph in an audit report does not affect the opinion on the financial statements. It is an “explanatory paragraph,” so it should be called, “a paragraph in the report” rather than a “going concern opinion.” It’s not a death sentence. All 3,000 of these companies did not go out of business since they were classified as a going concern.
FASB Going Concern Project The Financial Accounting Standards Board (FASB) has proposed changes that would provide guidance on the preparation of financial statements as a going concern and on managements responsibility to evaluate a reporting entitys ability to continue as a going concern. It also would require certain disclosures when the financial statements are not prepared on a going concern basis, as well as provide guidance on the adoption and application of the liquidation basis of accounting. The FASB proposal states that accounting guidance about the going concern assumption should be directed specifically to management of a reporting entity because management is responsible for preparing an entitys financial statements and evaluating its ability to continue as a going concern. As an auditor, we are evaluating managements assertion about the entitys ability to continue as a going concern. The consideration of an entitys ability to continue as a going concern is required in every audit performed under GAAS, and is an especially important consideration in the current state of the economy.
FASB Going Concern ProjectTIME HORIZON AU §341 states that there is "a responsibility to evaluate whether there is substantial doubt about the entitys ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited." International Accounting Standard (IAS 1), Presentation of Financial Statements, requires that an entity consider "all available information about the future, which is at least, but is not limited to 12 months from the end of the reporting period" when assessing whether the going concern assumption is appropriate. The FASB decided to use the time horizon in IAS 1 because it avoids the inherent problems that a bright-line time horizon would create for events or conditions occurring just beyond the one-year time horizon that are significant and most likely would have to be disclosed.
Consolidation issues Both the FASB and the IASB agreed that the contractual ability to direct the activities of an entity arises from having: More than half of the voting rights in an entity controlled by voting rights Contractual rights within other contractual arrangements that relate to the substantive activities of the entity A combination of contractual rights within other contractual arrangements and holding voting rights in the entity.
Consolidation issues The FASB tentatively decided not to amend its current consolidation guidance to include the concept of “effective control,” which is when a reporting entity can have control over an entity by holding less than half of the entity‟s voting rights. The assessment of whether a reporting entity has ”effective control” would have required a reporting entity to analyze: The reporting entitys voting or other rights relative to the size and dispersion of holdings of other vote holders, together with voting patterns at previous shareholder meetings Indicators of power that provide evidence of having the ability to direct. Potential Voting Rights (Options and Convertible Instruments)
A Global Reach with a Local Perspective 2011 Rocket City Gov Con Conference September 22, 2011 www.decosimo.comRevenue RecognitionRobert Belcher, CPAPrincipal
Exposure draft overview June 2010 FASB and IASB each issued exposure drafts entitled “Revenue from Contracts with Customers” Benefits: Removes inconsistencies in existing standards Provides a more robust framework Improves comparability across companies, industries and capital markets Simplifies the preparation of financial statements by reducing the number of requirements Applies to ALL entities except for rate-regulated entities Comment period June 24 – October 22, 2010, almost 1,000 letters received
Exposure draft status Redeliberations were substantially completed at the July 21, 2011 meeting IASB and FASB announced they will re-expose proposals in Q3 2011 for a 120 day comment period Effective date – likely not earlier than annual periods beginning on or after January 1, 2015; early adoption probably not permitted
Five Distinct Revenue Recognition StepsCore principle: Recognize revenue to depict the transfer of goods or services in an amount that reflects the consideration that an entity receives, or expects to receive, in exchange for those goods or services.Applying core principle:Step #1 - Identify the contract(s) with the customerStep #2 - Identify separate performance obligations “SPOs”Step #3 - Determine the transaction priceStep #4 - Allocate transaction price to the SPOsStep #5 - Recognize the allocated revenue when SPO satisfied
Step #1 – Identify the contract(s) with thecustomerKey provision: An entity should apply the proposed guidance to each contract identified.Government contractors will need to consider: Contract existence i.e. right to receive consideration and obligations to transfer goods/services Combine two or more contracts if certain criteria met Determine if contract modification results in SPO
Contract modifications i.e. change ordersContract modifications are any change in the scope or price of a contract.Treatment of contract modifications: Account for as separate contract if modification results in the addition of a SPO at a price that is commensurate with that additional performance obligation. OR Combine the modification with the contract and reevaluate the performance obligation and reallocate the transaction price to each SPO.
Step #2 – Identify SPOs Key provision: Evaluate the terms of the contract and your customary business practice to identify all promised goods and services and determine whether to account for each as a SPO. A performance obligation is a promise whether explicit or implicit in a contract to transfer a good or service to the customer. You will need to consider your customary business practices.
Economic units of measure Previously the economic unit of measure was the entire contract but now is the SPOs. Likely impact on government contractors is that more economic units of measure will be identified (i.e. design phase, construction phase, warranty). Identifying SPOs and allocating the transaction price will require judgment and therefore experienced personnel familiar with the new standard will be needed. Revenue recognition is tied to satisfaction of SPOs which may not be directly related to cost incurred; cost capitalization rules will have an impact.
Separate vs. bundle SPOs If more than one good or service is provided, you will need to make a determination whether to bundle or separate the performance obligation. Account for each promised good or service as a separate performance obligation only if it is distinct. If not distinct, combine good or service with other promised goods or services until you identify a bundle of goods or services that is distinct. In some cases, that would result in accounting for all the goods or services promised in the contract as a single performance obligation.
Distinct performance obligationsDistinct if either: 1. You regularly sell the good or service separately, or 2. The customer can use the good or service either on its own or together with resources that are readily available to the customer.Exception: If you transfer goods or services at the same time, it is not necessary to apply the proposed requirements to each performance obligation separately if accounting for those obligations together would result in the same amount and timing of revenue recognition as if they were accounted for separately.
Step #3 – Determine the transaction priceKey provision: The transaction price is the amount of consideration an entity expects to receive in exchange for transferring goods or services to a customer.To meet that objective, estimate the transaction price using one of the following methods depending on which is most predictive of the amount of entitled consideration: The probability-weighted amount; or The most likely amount. This amount would then be allocated to the SPOs.
Step #4 – Allocate the transaction price Key provision: Allocate the transaction price to all SPOs in proportion to the standalone selling price of the good or service underlying each performance obligation at contract inception. The best evidence of a standalone selling price would be the observable price of a good or service when you sell it separately.
Step #5 – Recognize revenue whenperformance obligation satisfied Key provision: Recognize revenue when a performance obligation is satisfied. In order to transfer a good or service, the customer must obtain control. Indications the customer has taken control: Customer has unconditional obligation to pay Customer has legal title Customer has physical possession; exceptions allowed for consignments and bill and holds. Design or function is customer specific Risk of ownership has passed to customer
Two options for revenue recognition: point in timeor over time Identify each performance obligation within a contract and determine if performance obligation is satisfied: At a point in time, or Recognize revenue when control of asset is transferred to customer. Over time i.e. continuous transfer. Recognize revenue as performance obligation is satisfied.
Over time i.e. continuous transferRecognize a performance obligation over time if: Your performance creates or enhances an asset that the customer controls as the asset is being created, or Your performance does not create an asset with an alternative use to you and at least one of the following: Customer receives a benefit as you perform each task; Another entity would not need to re-perform the tasks performed to date if that other entity were to fulfill the remaining obligation to the customer, or You have a right to payment for performance to date even if the customer could cancel the contract for convenience.
Over time revenue recognition methods1. Output method – Recognize on basis of units produced or delivered, contract milestones or surveys of goods or services transferred to date relative to the total.2. Input method – Recognize on basis of efforts expended to date (cost of resources consumed, labor hours expended, machine hours used) relative to total efforts to be expended.3. Passage of time method – Recognize revenue on a straight-line basis over the expected duration of the contract if services are transferred evenly over time (licenses).
Recap of key concepts Fewer contracts may qualify for over time i.e. continuous transfer revenue recognition. Need to review contract terms closely. You need to meet over time i.e. continuous transfer requirements to be able to recognize revenue on an incomplete asset. Determine if you must account for change orders as separate contracts or modifications to existing contracts (and potentially new SPO). The total transaction price is allocated to SPOs based on relative standalone selling prices.
Recap of key concepts Contract cost have been divorced/separated from contract revenues therefore the new standard will address accounting for cost capitalization. If cost capitalization rules were not added, many government contractors might incur negative margins in the early stages of contracts if performance obligation not yet met. Changes to estimated future COST are not recognized immediately unless you expect a loss on the specific SPO.
Other significant items in exposure draft Warranties Account for a product warranty that related to quality assurance by accruing warranty cost of the time revenue is recognized rather than by deferring revenue. A warranty is a SPO if: Customer has option to purchase the warranty separately from the vendor, or Warranty provides a service to customer in addition to assurance that the vendor’s past performance occurred as specified in the contract.
WHAT YOU NEED TO DO Apply the proposed standard to your specific customer contracts to determine the impact. It will be challenging to truly know the impact of this proposed guidance without applying it directly to your contracts and working through each of the principles. Are your current internal controls and operating systems sufficient? Budget and plan for training for your staff Remember retroactive application Will the new standard impact debt covenants? Discuss with your tax preparer.
RESOURCES FASB Proposed Accounting Standards Update – Revenue Recognition (Topic 605) FASB In Focus –short 2-page summary of proposal FASB website – technical plan and project updates tab AICPA Accounting and Auditing Brief June 16, 2011 - good information on redeliberation impact on exposure draft Revenue Recognition Guide – Chapter 13 Future Expectations – Short 13-page summary of exposure draft however redeliberation impact is not incorporated
Example – Long-term contract An entity enters into a contract to construct a facility or produce a product for a customer Requires engineering (design), procurement and production activities Design is specific to the customer’s requirements and they are involved in specifying major elements The entity procures materials and equipment as they are needed during production Customer obtains control of materials and equipment as they are installed Production is expected to take 3 years
Example – Long-term contractHow would the entity recognize revenue?(Under current GAAP, combine all activities and apply percentage of completion or completed contract.)
Example – Long-term contractDesign services: Distinct? Yes, contractor regularly sells design services separately. When do you recognize? Over time as service is performed - The vendor’s performance does not create an asset with an alternative use to the vendor AND the vendor has a right to payment for performance to date even if the customer could cancel the contract for convenience.
Example – Long-term contractProcurement service: Distinct? No, construction company doesn’t regularly provide procurement services. Procurement is an activity that is necessary for the entity to obtain control of the promised materials and equipment. When do you recognize? N/A
Example – Long-term contractConstruction: Distinct? Divide into separate performance obligations if the pattern of transfer of the good or service is different from the pattern of transfer of other promised goods or services in the contract, and the good or service has a distinct function. When do you recognize? Recognize revenue for each performance obligation over time or with the passage of time when it is satisfied.
A Global Reach with a Local Perspective 2011 Rocket City Gov Con Conference September 22, 2011 www.decosimo.comLeases – The Winding Road AheadA Review of Current and Proposed Lease TreatmentKEN CONNER, CPAPrincipal
Objectives Review of current GAAP related to leases Case study on Capital versus Operating Leases Current Exposure Draft for Leases – What is the objective What are they proposing How will it work Examples of calculations
Leases – Current GAAP Capital leases meet one or more of the following criteria: 1) The lease conveys ownership to the lessee at the end of the lease term. 2) The lessee has an option to purchase the asset at a bargain price at the end of the lease term. 3) The term of the lease is 75% or more of the economic life of the asset. 4) The present value of the rents, using the lessees implicit or incremental borrowing rate, is 90% or more of the fair market value of the asset. Operating leases - All other leases
Leases – Current GAAP Lessee’s incremental borrowing rate - The rate that, at the inception of the lease, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. Interest rate implicit in the lease - The discount rate that, when applied to (i) the minimum lease payments, excluding that portion of the payments representing executory costs to be paid by the lessor, together with any profit thereon, and (ii) the unguaranteed residual value accruing to the benefit of the lessor, causes the aggregate present value at the beginning of the lease term to be equal to the fair value of the leased property to the lessor at the inception of the lease, minus any investment tax credit retained by the lessor and expected to be realized by him.
Capital or Operating – what is important? When does the reader of the financial statements really care about lease obligations of any type? What is material? 15 year building lease that qualifies as operating Five year equipment lease that has a NPV of 75%, 80%, 89% How is a three year lease obligation different from a three year note payable?
Why are FASB and IASB Looking at LeaseAccounting Leasing is an important source of finance. Provides users of financial statements with a complete and understandable picture of an entity‟s leasing activities. The models also lead to a lack of comparability and undue complexity because of the sharp „bright-line‟ distinction between capital leases and operating leases. A new approach to lease accounting that would ensure that assets and liabilities arising under leases are recognized in the statement of financial position. From FASB Exposure Draft Leases - August 17, 2010
General rules The right-to-use model, what today we would term a Capital Lease, – any lease greater than a year Use of the old “Operating lease model”– all other leases
Lessee Accounting - General“A lessee would recognize an asset (the right-of-use asset) representing its right to use an underlying asset during the lease term, and a liability to make lease payments. The lessee would amortize the right- of-use asset over the expected lease term or the useful life of the underlying asset if shorter. The lessee would incur interest expense on the liability to make lease payments.” • SOURCE: Exposure Draft and FASB LEASE UPDATES APRIL 2011
Does not apply to - Short term leases – defined by FASB at its meeting of June 23, 2011 as, “A lease that, at the date of commencement of the lease, has a maximum possible term, including any options to renew, of 12 months or less.” (Emphasis added) An entity can elect to treat short term leases on a right-to-use basis on a case-by-case basis “Leases” covered elsewhere in GAAP Leases with the right to explore for oil and minerals Leases for intangibles Leases for biological assets (i.e. timber or agricultural products) SOURCE: Exposure Draft, minutes of June 23, 2011 FASB meeting
What would it do? (a) A lessee would recognize an asset representing its right to use the leased („underlying‟) asset for the lease term (the „right- of-use‟ asset) and a liability to make lease payments. (b) A lessor would recognize an asset representing its right to receive lease payments and, depending on its exposure to risks or benefits associated with the underlying asset, would either: (i) recognize a lease liability while continuing to recognize the underlying asset (a performance obligation approach); or (ii) derecognize the rights in the underlying asset that it transfers to the lessee and continue to recognize a residual asset representing its rights to the underlying asset at the end of the lease term (a derecognition approach). SOURCE: Exposure Draft and FASB LEASE UPDATES APRIL 2011
Key Components to Measurement Assets and liabilities recognized by lessees and lessors would be measured on a basis that: (a) assumes the initial term of the lease and options to renew if there is an economic incentive to extend the lease term. (Origin Exposure Draft included option to renew, “that is more likely than not to occur”, taking into account the effect of any options to extend or terminate the lease). (b) included fixed lease payments, variable payments that are effectively fixed payment and variable payments tied to a rate or index. (Original Exposure Draft included contingent payment based on an expected outcome technique to reflect the lease payments, including contingent rentals and expected payments under term option penalties and residual value guarantees, specified by the lease). (c) is updated when changes in facts or circumstances indicate that there would be a significant change in those assets or liabilities since the previous reporting period. • SOURCE: Exposure Draft and FASB LEASE UPDATES APRIL 2011
Key Components to Measurement Other measurement notes Don’t change the interest rate on the original measurement unless there has been a significant change Election of option to renew Renegotiation of key lease terms The lessee should allocate payments as follows: If the purchase price of each component is observable, the lessee would allocate the payments on the basis of the relative purchase prices of individual components; If the purchase price of one or more, but not all, of the components is observable, the lessee would allocate the payments on the basis of a residual method; or If there are no observable purchase prices, the lessee would account for all the payments required by the contract as a lease.
Example A Terms of the Lease – Five year triple net operating lease at $48,000 in year one due on the first day of the month Lease payments escalate at 3% per year with no contingent payments Incremental borrowing rate is 7%
Example A Record lease value – Lease Rights $218,042 Lease Obligation $218,042 Entry to record payment in month two – Lease Obligation $2,752 Interest Expense $1,248 Cash $4,000 Entry to record „use‟ of lease property Lease Amortization - $3,634 Accumulated Amortization $3,634
Renewal Options ED: longest possible term that is more likely than not to occur Changes: Options to extend or terminate when there is a significant economic incentive to extend, or not to terminate the lease Reassess only when there is a significant change in relevant factors • SOURCE: FASB LEASE UPDATES APRIL 2011
Transition There is no grandfather clause. Speculation is that there will be a long lead time to the effective date- (i.e. 2015). Interest rate determined at the date of application. Any prepaid or deferred rent at the date of application included in the amortization of lease rights. Capital leases with no economic incentives to renew will use the carrying value established under capital lease treatment.
Consequences How will lenders view the change in the short term? In the long term? Raises EBITDA, by adding an interest component previously imbedded in operating leases Raises „debt‟ obligation and debt to equity ratio If we know what the numbers are, do the bankers and lawyers know what the documents say? Will it make as much sense to use debt as leases in the future?
Consequences Lowers debt service coverage – increases „debt‟ payments and money available for debt service by same amount, raising the denominator by a greater percentage Existing - Old New Lease Revised Debt Rule Amounts Service Available for Debt Service $4,000,000 $500,000 $4,500,000 Debt Service Requirement $2,000,000 $500,000 $2,500,000 Debt Coverage Ratio 2.00 1.80
What is next - FASB – intends to release another exposure draft for public comment before the end of 2011 Implementation – pending final
Reference Sources Lease Update – Most current (September 16, 2011) http://www.fasb.org/cs/ContentServer?c=FASBConten t_C&pagename=FASB%2FFASBContent_C%2FProje ctUpdatePage&cid=900000011123#decisions Original Exposure Draft http://www.fasb.org/cs/BlobServer?blobcol=urldata&bl obtable=MungoBlobs&blobkey=id&blobwhere=11758 21125393&blobheader=application%2Fpdf
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Connect with me H. Kennedy (Ken) Conner, CPA Principal – North Alabama Development 423.756.7100 firstname.lastname@example.org On LinkedIn: http://www.linkedin.com/in/kenconner Disclaimer: The contents of this presentation are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals or specific situations.
CONTACT ROBERT BELCHER Robert Belcher, CPA Assurance Principal email@example.com 423-756-7100 DISCLAIMER: The contents and opinions contained in this presentation are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals.