What’s going on with the FASB?

By Patrick Frambes, CPA

The international convergence project, along with a push for consistency among industries, is causing the Financial Accounting Standards Board (the FASB) to reconsider some of its previously issued standards. It will cause significant changes to U.S. Generally Accepted Accounting Principles (GAAP) down the road, which in turn could cause significant changes to a company’s bottom line, so it is important that your company’s financial leaders fully understand the changes.

Barnes Dennig Director Thomas J. Groskopf, CPA, recently explained these issues to more than 100 CEOs and CFOs at our Accounting & Auditing Standards Seminar. What follows is a recap of the key changes related to accounting for leases and revenue recognition.

Lease accounting: In the FASB’s attempt to get a better handle on off-balance sheet transactions, the Board is proposing that all leasing arrangements be capitalized as a “right-to-use” asset, with an off-setting “lease obligation” liability recognized at the present value of future lease payments.  For current operating leases, the transition could have a significant negative impact on profit and loss, due to the combination of interest on the lease obligation and amortization of the right-to-use asset generally being larger than the straight-line rent expense in the early years of a lease.

For leases with renewal options, leases would be capitalzed based on the lease term that is more likely than not to occur. The lease term would need to be reassessed at each reporting date, with any changes to the obligation to pay rentals being recorded as an adjustment to the right-to-use asset and lease obligation. Contingent rental and residual guarantees would be estimated at lease inception and capitalized as part of the right-to-use asset and lease obligation. Changes in contingent rentals and residual value guarantees for current or prior periods would be charged to profit and loss. This puts a premium on accurate estimates for contingent rentals and residual value guarantees. Changes in contingent rentals and residual value guarantees for future periods would require adjustment to the right-to-use asset and lease obligation.

Short-term leases (12 months or less) would be capitalized at undiscounted, gross payment amounts. The transition guidance for this standard includes application to remaining terms of all existing leases, with an exception for “simple capital/finance leases” for lessors only.

Some implementation guidelines with respect to the new lease accounting are to 

1. Develop a process for tracking rental agreements upon inception,
2. Begin looking into leases with related parties to determine the lease term that is more likely than not to occur and
3. Consider  impact on loan covenants.

One way to mitigate exposure to the impact from accounting standards changes would be to have loan covenants computed based on “current GAAP” instead of “GAAP”. Service-based arrangements are not within the scope of the exposure draft. Business practice may evolve to provide service arrangements instead of leases of assets. One example of this would be contracting for a copy service versus leasing a copier.

Companies with certain types of contracts will need to pay attention to changes with lease accounting. Some contracts, such as defense and Medicare contracts, allow for reimbursement of rent but not interest and asset amortization. Software considerations also could be significant. Many fixed asset depreciation systems do not easily permit assets to be revalued during their useful lives. As a result of the “more likely than not” lease term and renewal options, asset revaluations will be much more common.

Revenue recognition: International Financial Reporting Standards do not have industry specific revenue recognition guidance. U.S. GAAP includes specific revenue recognition guidance for over 25 industries. The Boards have agreed on a broad-based revenue recognition principle in the exposure draft which is intended to replace all industry-specific revenue recognition guidance. The principle focuses on recognizing revenue as assets are transferred and/or performance obligations are satisfied. When evaluating the contract, an entity must identify all promised goods or services and determine whether to account for each promised good or service as a separate performance obligation. Examples of separate performance obligations include loyalty points, installation, training, and warranties that are included with the product or service sold. This evaluation also includes a review of the entity’s customary business practices (implied performance obligations). Management should consider what “customary business practices” (goodwill gestures) will now need to be recognized as a separate performance obligation. 

If more than one good or service is promised to be transferred, then the entity shall account for each promised good or service as a separate performance obligation only if it is distinct. A good or service, or a bundle of goods or services, are considered distinct if either:

1. The entity, or another entity, sells an identical or similar good or service separately; or
2. The entity could sell the good or service separately because the good or service meets both of the following conditions:
   • It has a distinct function
   • It has a distinct profit margin

Continuous asset transfer arrangements (such as some construction contracts) would recognize revenue continuously throughout the contract. If a contract does not continuously transfer assets, revenue would be recognized upon completion of the contract. The exposure draft has four factors to determine whether an arrangement is a continuous transfer arrangement. These factors are:

• Customer has unconditional obligation to pay
• Customer has legal title
• Customer has physical possession
• Design or function of the good is customer specific

These factors are judgmentally applied and many commentators are concerned that significant diversity in practice will result in accounting for long-term contracts.

For continuous transfer arrangements, the exposure draft states that the entity shall apply one revenue recognition method that best depicts the transfer of goods or services to the customer. These methods include, but are not limited to: output methods, input methods, or passage of time. This may or may not mean that cost to total estimated cost method is appropriate. 

Warranty accounting would also change significantly from current practice. Warranties for post-purchase deficiencies would be considered separate performance obligations and be broken out from the purchase price of the warranted asset at estimated selling price. Warranties for latent defects at purchase would be considered a failed sale. In either case, the revenue is deferred based on the estimated standalone selling price of a warranty instead of current practice where the estimated cost of a warranty is accrued. For many companies this will result in additional revenue deferral - the margin on warranties.

Some other notable changes that the exposure draft has identified are:

1. Consideration of contingent revenues, which if reasonably estimable, are added to the transaction price,
2. Combination of contracts with interdependent prices
3. Options for goods and services are to be evaluated for a material right, creating separate performance obligations if a material right exists, and
4. A distinction between exclusive and non-exclusive licenses for deferred revenue recognition versus upfront revenue recognition.

The exposure draft also proposes changes to recognition of credit impairment, which is required to be recognized as an offset to revenues at the date of sale if known and reasonably estimable and expensed if the impairment occurs after the date of the sale.

The construction industry may be the most significantly affected as it will open the door to broad interpretations by CPAs throughout the industry and potentially may reduce reliance for the readers, such as banks and sureties. For many industries, the impact of the exposure draft will require a higher level of understanding of contracts, industry practices, and customary business practices by management and their auditors. It will be important to have advisors that are current with evolving industry applications of the principles-based revenue recognition exposure draft.

The goal of this integration project is to consolidate and unify revenue recognition guidance globally as the IFRS have limited or no industry guidance as compared to the FASB, which has extensive industry guidance. As we move to a more global economy, consistency among revenue recognition standards is essential to achieve comparability between various revenue generating subsidiaries around the world.

The seminar also covered other potential changes, including financial instruments, contingencies, and accounting for variable interest entities.

For more information or to request a copy of the handouts from our Accounting & Auditing Standards Seminar, contact your Barnes Dennig representative.