BoardMatters Quarterly, June 2013

Standard-setting update

Revenue recognition, leases and financial instruments

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Final revenue standard taking shape

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the Boards) have substantially completed their redeliberations on a comprehensive new revenue recognition standard that will apply to all companies around the world that follow either US GAAP or IFRS. The Boards plan to issue a final standard this summer.

One of the Boards’ most significant decisions was determining an effective date. Because entities need time to adopt the new guidance, the Boards decided to set an effective date of 2017.

Therefore, a public company with a calendar year-end would be required to apply the standard (including the new disclosure requirements) in the first quarter ended 31 March 2017. The FASB decided that non-public entities could apply the new standard one year later.

The Boards tentatively decided to allow either full retrospective application or a modified retrospective approach for both public and non-public companies. This is a change from the proposal that would have required retrospective application with only limited relief available.

Under the modified retrospective approach, entities would:

  • Present comparative periods under today’s guidance
  • Apply the standard to new and existing contracts as of the effective date
  • Recognize a cumulative catch-up adjustment to the opening balance of retained earnings at the effective date for existing contracts that still require performance by the entity
  • Disclose all line items in the year of adoption as if they were prepared under today’s revenue guidance

The new standard may significantly increase the volume of required disclosures that companies applying US GAAP will have to include in both their annual and interim financial statements.

During the transition period, entities will need to determine that their systems can properly capture the data needed to comply with these requirements. In addition, companies will have to evaluate their revenue arrangements to determine any significant differences in the timing of revenue recognition.

Even if there are not significant differences to reported revenue, companies will need to understand the new judgments and estimates that may be required, as well as any related changes in systems or internal controls.

Leases project proposal re-exposed

In May 2013, the Boards issued a new proposal that would require lessees to record assets and liabilities arising from their involvement in most leases.

The proposal attempts to address conceptual and operational concerns constituents raised about the Boards’ 2010 exposure draft. Comments on the new proposal are due by 13 September 2013.

Under the proposal, entities would classify leases in one of two categories to determine how to recognize lease-related revenue and expense. However, lease classification would no longer be based on bright-line criteria. Under the revised proposal, classification would be based on whether the lessee is expected to consume more than an insignificant portion of the economic benefits of the underlying asset over the lease term. The proposed classification also could affect lessors’ balance sheets.

The revised proposal would require lessors and lessees to make a number of judgments and to periodically reassess them. The business implications for lessees could be significant, including:

Financial instruments and credit losses

Recognition and measurement

The FASB proposed a new classification and measurement model for financial instruments that would apply to all entities. After receiving significant pushback from constituents on its 2010 proposal to measure virtually all financial instruments at fair value, the FASB returned to a familiar three-category approach. This approach attempts to align the classification and measurement of financial instrument assets with a company’s business model for managing them.

However, the result, while much closer to current US GAAP than the previous proposal, still introduces some notable changes that could have significant effects on a company’s existing processes. For example, the proposal would require more financial instruments, including certain common debt instruments, to be measured at fair value with changes in fair value recognized in net income.

The FASB’s proposal outlines different models for financial assets and financial liabilities. Financial assets would be classified and measured based on (1) an individual asset’s cash flow characteristics and (2) the company’s business model for managing assets.

Assets would be classified into one of three categories:

  1. Amortized cost (AC)
  2. Fair value through other comprehensive income (FV-OCI)
  3. Fair value through net income (FV-NI)

Assets with cash flows that are solely principal and interest would be classified and subsequently measured based on the business model.

Assets held for collection of contractual cash flows would be measured at AC.

Assets held for both collection and sale would be measured at FV-OCI. FV-NI would be the default category.

Financial liabilities would be measured at amortized cost, except for two limited cases.

Credit losses

The FASB proposed its current expected credit loss (CECL) model that requires earlier recognition of credit losses for loans, receivables and debt securities than the current “incurred loss” model. The current model was criticized during the financial crisis for allowing banks to recognize too little in losses too late. The proposal would affect all companies, not just financial institutions.

The proposed CECL model for all debt instruments would replace the five different models in current US GAAP and would apply to loans, debt securities, trade receivables, lease receivables, reinsurance receivables and loan commitments.

Management’s current estimate of expected credit losses would be recognized at each reporting date through the use of an allowance (contra-asset) account, with any subsequent changes in expected credit losses (both favorable and unfavorable) recognized in earnings. Companies would be required to consider currently available forward-looking information in their estimates and to disclose the factors that influence management’s estimate of expected losses, along with changes to those factors.

The Boards had worked on a joint solution and developed the three-bucket expected loss model. But the FASB simplified its proposal in response to feedback from constituents who expressed concern about the model’s complexity and how it would work in practice. The IASB proposed its three-bucket model in March 2013.

 Questions for the audit committee to consider

Questions for the audit committee to consider

  • Has the company performed a preliminary assessment of the effects of these proposals on the company’s financial statements, processes and internal controls and presented the assessment to the audit committee?
  • Have management and the audit committee discussed which transition alternative the company will select with respect to the new revenue recognition standard and why?
  • Has management determined what planned or ongoing IT system initiatives could be affected by these accounting changes and, if so, informed the audit committee of these changes?