FASB Update

1
FASB Update

• For Acct 592 Spring 2005

2
To be covered later in course

• Related to consolidations
• FIN 46 (as revised) related to consolidations
  of special purpose entities
• Well cover later and Ill distribute a
  readable discussion from our advanced textbook
  author

3
SFAS No. 123 (revised 2004)

• Related to Stock Compensation
• I believe the revised standard does away with the
  need for FIN 44, SFAS No. 148, APB Opinion 20
• Well get into details later in course

4
Financial Institutions

• SFAS No. 147 Acquisitions of Certain Financial
  Institutions (October 2002)
• These institutions are no longer excluded from
  coverage of FASB 141 and 142 and FASB 144.

5
Probably not covered

• FAS 149 an amendment of FAS 133 on Derivatives
• Objective To clarify early standards and settle
  implementation issues particularly with respect
  to embedded derivatives
• Derivatives are covered in Acct 415/515 so we
  probably wont be able to spend that kind of time
  on this complex topic this semester

6
New rules on redeemable preferred stock

• FAS150

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FAS 150

• SFAS No. 150 Accounting for Certain Financial
  Instruments with Characteristics of both
  Liabilities and Equity (May 2003)
• Applies to freestanding financial instruments
  only
• Does not apply to features embedded in a
  financial instrument that is not a derivative in
  its entirety (i.e., stock-based compensation and,
  as best I can tell, convertible bonds)

8
FAS 150

• Defines obligation as conditional or
  unconditional duty or responsibility to transfer
  assets or to issue equity shares
• In the past, redeemable preferred stock have been
  treated as equity or shown in the mezzanine
  level of balance sheet (between liabilities and
  owners equity). This statement removes the
  mezzanine!

9
Redeemable financial instruments

• Mandatorily redeemable financial instrument shall
  be classified as liability
• Exceptions
• The redemption is contingent on future event
• Treat as liability when the event occurs, the
  condition is resolved, or the event becomes
  certain to occur
• In this case, the liability is measured at fair
  value when reclassified to the liability section.
  
• Equity is reduced and no gain or loss is
  recognized.

Certain not probable!
10
Redeemable financial instruments

• Mandatorily redeemable financial instrument shall
  be classified as liability
• Exceptions
• The redemption is contingent on the occurrence of
  an uncertain future event
• The redemption is required only upon liquidation
  or termination of the reporting entity
• Do not classify as liability

11
Obligation to Repurchase Equity

• Classify as a liability
• A financial instrument (other than outstanding
  shares of stock) that at inception
• Embodies an obligation to repurchase the issuers
  equity shares or is indexed to shares
• Requires or may require the issuer to settle the
  obligation by transferring assets
• Examples
• Forward purchase contracts
• Written put options on issuers equity shares
  that are to be physically settled or net cash
  settled

12
Obligations to issue variable number of shares

• Classify as a liability (or sometimes an asset) a
  financial instrument other than outstanding
  shares that embody a conditional obligation to
  settle by issuing a variable number of its equity
  shares
• Examples
• Fixed monetary amount payable with variable
  number of issuers shares
• Indexed or similar obligations to be settled in
  variable number of issuers equity shares
• Variations inversely related to changes in fair
  value of issuers equity shares like a written
  put option that could be net share settled

13
Measurement of liability

• Financial instruments that meet these
  requirements are initially measured at fair value
• Most are then re-measured at fair value and the
  subsequent changes in fair value are recognized
  in earnings
• A present value alternative may be used when a
  fixed number of shares will be issued at a known
  or unknown future date
• Amount is determined using present value and
  interest expense is reported in earnings until
  redemption
• If amount paid or settlement date varies, the
  obligation is remeasured at present value on an
  as if settled at reporting date and any excess
  over original estimate is treated as interest
  expense on income statement (see paragraph 22)

14
Reporting on Statements

• Balance sheet required description
• Shares subject to mandatory redemption
• Should be on separate line and not commingled
  with other liabilities
• Income statement transition
• Through cumulative effect of a change in
  accounting principle

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Disclosures

• Nature and terms of the financial instruments
  including rights and obligations
• Amount that would be paid or number of shares
  that would be issued and their fair value as if
  settled at reporting date
• How changes in fair value of issuers equity
  shares impact the settlement amount
• Maximum amount issuer could be required to pay
• Maximum number of shares that might have to be
  issued
• And several more items (see paragraph 27)

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Example financial instrument

• Trust-preferred securities
• A financial institution establishes a trust or
  other entity that is consolidated with the
  financial institution
• The trust issues mandatorily redeemable preferred
  stock and uses the proceeds to purchase from the
  financial institution an equivalent amount of
  junior subordinated debt
• The financial institution pays interest to the
  trust, the trust uses the funds to pay the
  dividends
• Why they exist
• Upon consolidation, the intercompany transaction
  (payment of interest) disappears along with the
  debt (and the receivable on the trusts books)

17
Example financial instrument

• Trust-preferred securities
• Under the new rules, the financial institution
  will have to report INTEREST EXPENSE and DEBT
  instead of dividends and redeemable preferred
  stock
• FAS 150 Appendix A includes other examples to aid
  implementation of the new rules

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New rules on guarantees of debt

• FIN 45

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FIN 45

• FIN No. 45 Guarantors Accounting and
  Disclosure Requirements for Guarantees, Including
  Indirect Guarantees of Indebtedness of Others
  (November 2002)
• An interpretation of FASB No. 5, 57, 107. This
  interpretation REPLACES FIN No. 34
• Scope Covers disclosures to be made in interim
  and annual reports regarding guarantees of
  indebtedness of others (disclosed under FASB No.
  5 even though the probability is generally
  remote

20
Covers guarantee contracts that have any of the
following 4 characteristics

• 1. Contracts that contingently require the
  guarantor to make payments to the guaranteed
  party based on an underlying
• Examples
• Irrevocable standby letter of credit which
  guarantees payment of a specified
  obligationMarket value guarantee of asset owned
  by the guaranteed partyGuarantee of the market
  price of common stock of the guaranteed
  partyGuarantee of the collection of cash flows
  from assets held by special purpose entity
• 2. Performance standby letter of credit or
  similar arrangements in which guarantor must make
  payments to the guaranteed party in the event of
  another entitys failure to perform under a
  nonfinancial contract

21
Covers guarantee contracts that have any of the
following 4 characteristics

• 3. Indemnification agreements that require
  guarantor to make payments to the indemnified
  party (guaranteed party) based on changes in an
  underlying such as an adverse judgment in a
  lawsuit, imposition of additional taxes due to
  adverse interpretation of the law
• 4. Indirect guarantees of the indebtedness of
  others even though the payment to the guaranteed
  party may not be based on an underlying asset,
  liability, etc., of the guaranteed party.

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THE INTERPRETATION

• The issuance of a guarantee obligates the
  guarantor (issuer) in two respects
• 1. The guarantor undertakes an obligation to
  stand ready to perform over the term of the
  guarantee if the event that the specified
  triggering events or conditions occur
• This is the noncontingent part of the obligation
• 2. The guarantor undertakes a contingent
  obligation to make future payments if those
  triggering events or conditions occur
• This is the contingent part of the obligationNew
  Disclosure FIN 45

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Key point of FIN 45

• FASB 5 should not be interpreted as prohibiting
  the guarantor from initially recognizing a
  liability for a guarantee even though it is not
  probable that the payments will be required under
  that guarantee.

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Measurement of obligation

• a. The premium received or receivable when the
  guarantee is issued in a standalone arms-length
  transaction with an unrelated party
• b. When the guarantee is part of a transaction
  with multiple elements, estimate the fair value
  of the guarantee.
• Consider the premium which would be required by
  the guarantor to issue a standalone guarantee
  with an unrelated party
• In the absence of observable transactions for
  identical or similar guarantees, use expected
  present value measurement techniques

25
Measurement of obligation

• c. If a guarantor must recognize a guarantee at
  inception because it is probable and can be
  estimated (FASB 5), the amount to initially
  recognize is the GREATER of the fair value of the
  guarantee (as measured above) or the contingent
  liability amount required under paragraph 8 of
  Statement 5.
• d Not for profit situation guarantees provided
  as a contribution to an unrelated party (like a
  loan guarantee by a community foundation to a
  nonprofit entity), the guarantee (gift) should be
  measured at the fair value of the guarantee and
  NOT considered merely a conditional promise to
  give.

26
The debit side is not prescribed

• Some examples provided in FIN 45 include
• a. If a premium is received, the debit would be
  to cash or receivable.
• b. If the fair value of the premium is an
  allocation of the receivable or cash received on
  a transaction that involves other assets,
  liabilities, etc., the allocation to the
  guarantee will affect the calculation of the gain
  or loss on the transaction.
• c. If the guarantee is associated with the
  acquisition of a business accounted for under the
  equity method, the guarantee would increase the
  carrying value of the investment.
• d. In an operating lease situation, the guarantee
  would affect prepaid rent.
• e. If no consideration is received, the
  offsetting entry would be to expense.

27
Arrangements NOT covered

• 1. Commercial letters of credit and loan
  commitments
• 2. Subordination of some securities that gives
  another class or tranche priority in the event of
  liquidation, etc.
• 3. Guarantees excluded from scope of FASB 5,
  para. 7
• 4. A lessees guarantee of the residual value of
  leased asset (capital lease only)
• 5. A contract that is accounted for as contingent
  rent under FASB 13
• 6. Guarantee issued by insurance company under
  FASB No. 60, No. 97, No. 113, or No. 120
• 7. A contract that meets the criteria BUT
  provides for payments that constitute a vendor
  rebate (by the guarantor) based on either sales
  revenue of, or number of units sold by, the
  guaranteed party.
• 8. Guarantee whose existence prevents the
  guarantor from being able to either account for a
  transaction as the sale of an asset that is
  related to the guarantees underlying or
  recognize in earnings the profit from that sale
  transaction.

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Scope exceptions initial recognition provisions
only

• 1. Guarantees accounted for as a derivative under
  Statement 133
• 2. Product warranties (the disclosure
  requirements of FIN 45 do apply see below)
• 3. Guarantees issued in a business combination
  (Statement 141)
• 4. Guarantees for which the guarantors
  obligation would be reported as an equity item
  (rather than a liability) under GAAP
• 5. Guarantee by an original lessee that has
  become secondarily liable under a new lease that
  relieved the original lessee from being the
  primary obligor (principal debtor) says to not
  apply this section to secondary obligations that
  are not accounted for under Statement 13,
  paragraph 38.
• 6. Guarantees between parents and subsidiaries or
  between corporation under common control
• 7. Parents guarantee of debt of its subsidiary
  to a third party
• 8. A subsidiarys guarantee of debt owed to a
  third party by its parent or a sibling subsidiary.

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Disclosures Required FIN 45

• a. Nature of the guarantee including, the
  approximate term, how the guarantee arose, and
  the event or circumstance that would require the
  guarantor to perform under the guarantee.
• b. Maximum potential amount of future payments
• c. Current carrying amount of the liability
• d. Nature of (1) any recourse provisions that
  would enable guarantor to recover from third
  parties any of the amounts paid under the
  guarantee and (2) any assets held either as
  collateral or by third parties that the guarantor
  would be able to liquidate to recover any of the
  amounts paid.

30
Disclosures Required cont

• e. FOR PRODUCT WARRANTIES. The disclosure of the
  maximum amount of future payments requirement
  above is waived. Instead
• 1. The accounting policy and methodology used to
  determine its liability for product warranties
  including any deferred revenues associated with
  extended warranties.
• 2. A tabular reconciliation of the changes in the
  guarantors aggregate product warranty for the
  reporting period.
• Beginning balance
• Aggregate reduction for payments made or services
  provided
• Aggregate increase for new warranties issued
  during period
• Aggregate changes in the liability related to
  pre-existing warranties (changes in estimate)
• Ending balance

31
Example from Recent F/S
32
New Pension Disclosures

• FAS 132 (revised 2003)

33
Low interest rates pension difficulties

• Remember back to our computations for pensions
  and other post-retirement benefits
• We use a discount rate to determine the present
  value of future payments
• In recent years, very LOW interest rates have
  lead to VERY HIGH pension liabilities
• As a response, FASB is adding new disclosure
  requirements

34
New disclosures

• I counted about 9 new or expanded disclosures for
  public entities
• Big change is expanded disclosures for quarterly
  (interim) reports
• Nonpublic entities dont have to disclose as much
  as public entities, but I also counted 9 new or
  expanded disclosures for them

35
Revised FAS 132

• This revision should be on your FARS disk since
  it came out in December 2003.
• You can download a copy from the FASB web site
• You will need the revised standard to do the
  project for the semester

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New Disclosures for Public Entities

• Percentage of total plan assets by categories
  like equity securities and debt securities
• More detailed categories are encouraged if it
  would help assess risk and long-term expected
  rate of return
• Narrative discussion of investment policies and
  strategies
• Narrative discussion of how the expected rate of
  return was determined
• Accumulated benefit obligation

37
New Disclosures for Public Entities

• Benefits expected to be paid to retirees in each
  of the next five years and in aggregate
  thereafter (presumably NOT the present value of
  benefits)
• Estimated employer contribution that will be made
  during next fiscal year
• Weighted averages for assumptions in tabular form
• Discount rates
• Rates of compensation increase
• Expected long-term rate of return

38
New Disclosures for Public Entities

• Measurement dates used to determine obligation
  for plans that make up the majority of the plan
  assets obligations
• Remember there was a really long list of
  disclosures BEFORE the revision and this is just
  the NEW items dont use these lecture notes as
  your disclosure list when you write the note
  for the FAS Inc. project

39
Examples

• Appendix C provides illustrations that should be
  useful in doing the footnote for the ADQ Inc.
  project (Spring 2005)
• Illustration 1 is probably your best bet
• Remember, you may not be able to find any real
  examples of the new disclosures yet since the
  rules are so new

40
SFAS No. 151-153

• Added Jan 2005

41
SFAS No. 151 Inventory Costs

• Part of the international convergence project.
• Clarifies that abnormal costs of idle facilities
  should not be capitalized as product costs.
• Companies should use normal capacity for the
  allocation of overhead.
• Any unallocated overhead is expensed during the
  period in which they are incurred.
• Other abnormal handling costs or abnormal levels
  of spoilage might also need to be expensed.

42
SFAS No. 152 Accounting for Real Estate
Time-Sharing

• Amends SFAS Nos. 66 67
• Special industry accounting practices are
  clarified.

43
SFAS No. 153 Exchanges of Nonmonetary Assets

• APB Opinion No. 29 generally required that
  exchanges of nonmonetary assets would be based on
  the fair values of the assets exchanged
• Exception for exchanges of similar productive
  assets.
• This standard changes the exception to a lack of
  commercial substance rule

44
Commercial Substance

• A nonmonetary exchange has commercial substance
  if the entitys future cash flows are expected to
  significantly change as a result of the exchange.
  
• A significant change in future cash flows is
  defined to be meeting one or both of the
  following two conditions
• Configuration of cash flows is different
• The configuration (risk, timing, and amount) of
  the future cash flows of the asset received
  differs significantly from the configuration of
  the future cash flows of the asset transferred.
• The entity-specific value is different
• The entity-specific value of the asset received
  differs from the entity specific value of the
  asset transferred, and the difference is
  significant in relation to the fair values of the
  assets exchanged.

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SFAS No. 153, continued

• Nonmonetary exchanges are recognized at the fair
  value of the nonmonetary asset relinquished
  UNLESS
• 1. Fair value is not determinable for either
  asset
• 2. Exchange Facilitates Sales to Customers.
• The transaction is an exchange of a product or
  property held for sale in the ordinary course of
  business for a product or property to be sold in
  the same line of business to facilitate sales to
  customers other than the parties to the exchange.
• 3. The exchange lacks commercial substance.

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Forthcoming first half 2005

• Accounting Changes and Error Correctionsa
  replacement of APB Opinion No. 20 and FASB
  Statement No. 3 (Proposed Statement of Financial
  Accounting Standards)December 15, 2003
• Earnings per Sharean amendment of FASB Statement
  No. 128 (Proposed Statement of Financial
  Accounting Standards)December 15, 2003
• Accounting for Conditional Asset Retirement
  Obligationsan interpretation of FASB Statement
  No. 143 (Proposed Interpretation)June 17, 2004

47
Accounting changes and estimates

• Still in the exposure draft stage but expected to
  be issued first quarter 2005
• No more cumulative effect of change in accounting
  standards at bottom of income statement
• All changes in accounting principles would be
  handled through retroactive restatement of prior
  years

48
Accounting changes and estimates

• A change in depreciation method would now be
  classified as a change in estimate and would not
  require retroactive restatement of prior years

49
Earnings per share change

• Part of the international convergence project.
• Seems to be a minor point to me fairly
  technical
• We can discuss when we cover EPS
• Expected 2nd Qtr 2005

50
Asset retirement obligations

• The proposed Interpretation planned for 1st Qtr
  2005 would clarify that a legal obligation to
  perform an asset retirement activity that is
  conditional on a future event is within the scope
  of FASB Statement No. 143
• Uncertainty surrounding the timing and method of
  settlement that may be conditional on events
  occurring in the future would be factored into
  the measurement of the liability rather than the
  recognition of the liability.
• If there is insufficient information to estimate
  the fair value, the liability would be initially
  recognized in the period in which sufficient
  information is available for an entity to make a
  reasonable estimate of the liabilitys fair
  value.

51
Longer term projects

• Fair value measurement
• Definition of liability vs. equity
• Revenue recognition
• Looking toward an asset/liability approach so it
  may be quite different than current GAAP
• Business not-for-profit combinations
• We are still waiting for clear definition of
  control
• Eliminate parent co. method in favor of the
  economic entity approach