FINANCIAL REPORTING FLASH REPORT
Recent Developments in Financial Reporting Focus on Significant Potential,
Pending or Newly Required Reporting
July 9, 2007
This Financial Reporting Flash Report focuses on recent developments which may or will
significantly affect the form and content of financial reports for public companies. At the same time,
during recent months, several new important accounting pronouncements became effective.
Further, the Securities and Exchange Commission (SEC) published interpretive guidance for
management regarding a company’s evaluation and assessment of internal control over financial
reporting, including issuing for public commentary the much - anticipated Auditing Standard No. 5.
There are other important matters on the financial reporting agenda. From the potential for foreign
filers to be allowed to use International Financial Reporting Standards (IFRS) for US reporting
purposes – and even for US companies to do the same – to the challenges of implementing XBRL
reporting and to the currently required expanded disclosures regarding executive compensation,
there are a number of public-reporting-related “projects” on deck for many companies. While there
are articles in the press suggesting that a move toward acceptance of IFRS could foretell “an end to
US GAAP as we know it” along with reports of a virtual “do over” of the US GAAP financial reporting
model (as illustrated through “mock” example financial statements), US GAAP is still very much
alive and applicable to US companies for the foreseeable future. Accordingly, there are a variety of
new accounting pronouncements which must be considered by companies in their current and
future reporting.
The contents of this Flash Report are divided into two groups – (1) potential, pending and newly
required public reporting and (2) new accounting pronouncements.
1-Potential, Pending and Newly Required Reporting
Potential Reporting Changes:
•
•
•
•
IFRS may be allowed for foreign filers without reconciliation to US GAAP
IFRS may be allowed for US filers leading to potential harmonization with US GAAP
Business Combinations: Applying the Acquisition Method – Joint Project of the IASB and FASB
Proposed FSP FAS 140-d – Accounting for Transfers of Financial Assets and Repurchase
Financing Transactions
Reporting Changes:
•
•
SEC Publishes Final Interpretative Guidance to Management over Section 404
FIN 48 – Effective Settlement Criteria
New Public Reporting Requirements:
•
•
XBRL (eXtensible Business Reporting Language)
2006 Executive Compensation Disclosure – SEC Review and Feedback
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Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.
Potential Reporting Changes:
SEC Announcement regarding IFRS/US GAAP Reporting
At its open meeting on June 20, 2007, the SEC proposed to eliminate the long-standing
requirement for a foreign registrant that presents financial statements in accordance with
International Financial Reporting Standards (IFRS) to reconcile its financial statements to U.S.
generally accepted accounting principles (US GAAP). Following the meeting, the SEC acted by
releasing the approved proposal for public comment on July 3rd. The comment period extends for
75 days after the proposal is published in the Federal Register.
Under the proposal, a foreign private issuer that presents financial statements in accordance with
IFRS, as adopted by the International Accounting Standards Board (IASB), will no longer be
required to present a reconciliation to US GAAP. Such a reconciliation is currently required for
audited financial statements, and in particular in an annual report on Form 20-F. It is also currently
required for interim financial statements used in a registered offering of securities when the audited
financial statements are more than nine months old.
If the current SEC proposal is approved, foreign companies using IFRS would not have to provide a
separate reconciliation report for annual reports filed with the SEC, likely beginning in 2009.
Enactment of this rule would reduce the administrative burden of foreign filers in producing financial
statements which comply with SEC rules. Due to these administrative burdens, foreign filers are
allowed up to six months to file annual reports with the SEC.
In a related – but far less imminent – matter, the SEC is likely to issue a conceptual release this
summer on the subject of whether US companies should be allowed to use, at their election, either
IFRS or US GAAP in their financial reporting. While the use of IFRS for foreign filers would merely
eliminate a “step” for those companies, a switch to IFRS for US filers could, if allowed, be a
significant undertaking.
As this process moves forward over the next several years, there are a number of areas of
concurrent and intersecting activities, as well as administrative and logistical issues, which also
need to be considered. For example:
•
The Financial Accounting Standards Board (FASB) and IASB (the standard-setter for
IFRS) are already engaged in dialogue and have undertaken activities focusing on
eliminating many of the differences between IFRS and US GAAP.
•
Should US GAAP and IFRS be a choice for US filers, and should significant differences
remain between the two, the issues of clarity and comparability of filers in peer and analyst
groups will likely become significant.
•
If elimination of the need to reconcile IFRS to US GAAP also leads to elimination of the
extended filing deadlines, companies and their external auditors will need to assess their
ability to complete all of the activities required for an accelerated deadline in a timely
manner. As noted above, this reconciliation process is one of the drivers behind the SEC
allowing foreign filers up to six months to file annual reports with the Commission.
This proposal, when issued, is likely to generate significant attention and comments from the
potentially affected parties – foreign filers, their advisors, investor groups, external audit firms,
analysts, etc.
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©2007 Protiviti Inc. An Equal Opportunity Employer
Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.
Business Combinations: Applying the Acquisition Method – Joint
Project of the IASB and FASB
This initiative is part of an overall project on business combinations. It is a joint undertaking
between the FASB and the IASB in which the two boards are reconsidering the existing guidance
for applying the purchase method of accounting for business combinations (the acquisition method).
New rules on business combinations are expected shortly, with a final standard slated for
September of this year. The new standards are expected to be FAS 141R and FAS 160.
The primary objective of the project is to develop a single standard of accounting for business
combinations that can be used for both domestic and cross-border financial reporting – one that
includes a common set of principles and related guidance. The standard should improve the
completeness, relevance, and comparability of financial information about business combinations
by:
(1) Clarifying which assets and liabilities should be recognized in the initial accounting for the
business combination
(2) Requiring that the assets acquired, the liabilities assumed, and equity interests be
consistently measured using a relevant attribute
(3) Defining the scope of the standard in a way that ensures that similar economic events are
accounted for similarly. (In other words, the standard would require that all transactions or
other events in which an acquirer obtains control of a business be accounted for by
applying the acquisition method.)
Project Timeline
The following assertions, definitions, and principles are expected to form the foundation for the new
standard:
Business
Combination
A transaction or event in which an acquirer obtains control of one or
more businesses
Acquirer
In every business combination, an acquirer can be identified
Acquisition Date
The date the acquirer obtains control of the acquiree in a business
combination
Acquisition
Method
The method used to account for a business combination
Control
Regardless of the percentage of ownership, when an acquirer
obtains control of an acquiree, an acquirer becomes responsible
and accountable for all the acquiree's assets, liabilities and
activities
Recognition
The acquirer recognizes all of the assets acquired and liabilities
assumed
Fair Value
Measurement
The acquirer measures at the “acquisition-date fair value” of (i)
each recognized asset acquired and (ii) each liability assumed
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Disclosure
The acquirer includes information in the footnotes to the financial
statements to provide users with the ability to evaluate (i) the nature
of the business combination and (ii) the financial effect of the
business combination
Several transaction-specific issues around purchase accounting are also expected:
Partial, or “step”, acquisitions: The acquiree’s identifiable assets and liabilities would be
measured and recognized at their acquisition-date fair values. To illustrate:
•
All of the acquiree’s goodwill (not just the acquirer’s share) would be recognized. The
Board acknowledged that goodwill is an exception to the fair value measurement principle,
because it is measured as a residual.
•
Goodwill would be measured as the acquisition-date fair value of the acquiree, less the
acquisition-date fair value of the acquiree’s assets acquired and liabilities assumed
•
Previously held (if any) noncontrolling interests would be remeasured to fair value and the
resulting adjustment would be recognized in net income and clearly disclosed. The same
rules would apply to situations where a parent company loses control over a subsidiary.
Business combinations where equal value is not exchanged: In rare circumstances where a
business combination is not an exchange of equal values (an exception to the recognition
principle), the following principles would apply:
•
If a bargain purchase: The acquirer would reduce to zero any goodwill related to that
acquisition and recognize any excess as a gain with appropriate disclosure
•
If an overpayment: The acquirer would not recognize an expense; rather, any
overpayment amount would be included in goodwill and tested for impairment at
subsequent points in time.
Non-controlling interests in subsidiaries: These interests in subsidiaries would be a part of
equity. They would be included as a separate line item within the equity section of the
consolidated balance sheet. Acquisitions or dispositions of non-controlling interests that do not
result in a change of control would be accounted for as equity transactions and presented as
such in the statement of changes in equity, with appropriate disclosure.
During 2007, the IASB and FASB also made progress on certain issues requiring “alignment”,
including:
•
Recognition and presentation of intangible assets related to the off-market portion of an
operating lease
•
Classification of long-lived assets held for sale
•
Measurement of Non-Controlling Interests (“NCI”) at fair value, on a transaction-bytransaction basis.
•
Measurement of assets related to indemnifications consistent with the measurement of the
related liability.
•
Classification of leases and insurance contracts based on acquisition-date conditions.
•
Clarification of the rules around designating the effective date of an acquisition.
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©2007 Protiviti Inc. An Equal Opportunity Employer
Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.
June 28th FASB Meeting
At its June 28th meeting, the FASB reconsidered a few of its earlier decisions that were made as
part of the deliberations of its June 2005 Exposure Drafts, Business Combinations, and
Consolidated Financial Statements, Including Accounting and Reporting of Non-Controlling
Interests in Subsidiaries.
Additionally, with regard to financial statement presentation, the Board continued its discussion of
how such statements could best reflect information about what caused a change in reported
amounts of assets and liabilities, including the basis for disaggregating amounts recognized as
income or expense and alternative formats for presenting that disaggregated information. Detailed
information on the Board’s June 28th meeting can be found at:
http://www.fasb.org/action/aa062807.shtml
Next Steps
The FASB and IASB plan to schedule a series of follow up meetings to discuss concerns raised by
constituents and other issues that arise during the drafting of the final Statements. Final statements
are expected to be issued by September 30, 2007. Meanwhile, companies with an acquisitive
agenda will need to monitor this likely new standard and be prepared to ensure its accurate
implementation.
FASB Plans to Issue Proposed FSP FAS 140-d, Accounting for Transfers
of Financial Assets and Repurchase Financing Transactions
This month, the FASB staff plans to issue proposed FSP FAS 140-d to provide implementation
guidance on whether there are circumstances that would permit a transferor and a transferee to
separately evaluate the accounting for a transfer and the accounting for a repurchase financing
when the counterparties to the two transactions are the same.
A repurchase financing (often referred to as a “Repo”) is a repurchase agreement relating to a
previously transferred financial asset (or substantially the same asset) between the same
counterparties. In a repurchase financing, an initial transferor transfers a financial asset to an initial
transferee. The initial transferee simultaneously or subsequently transfers the financial asset back
to the initial transferor as collateral for a note and the initial transferor agrees to return the asset (or
substantially the same asset) when the note is paid at a fixed amount at a certain future date.
In recent meetings, the FASB reached the following decisions (subject to a comment period ending
in August 2007):
(1) The FSP should be effective for fiscal years beginning after November 15, 2007 and
interim periods within those fiscal years. Earlier application should not be permitted.
(2) The guidance should be applied to existing repurchase financings as of the beginning of
the fiscal year in which the FSP is initially applied as a cumulative effect adjustment to the
opening balance of retained earnings, with appropriate supporting disclosures.
(3) A transferee and transferor may evaluate the accounting for the transactions separately
under Statement 140 in certain circumstances.
(4) Guidance in the FSP will be applied to new transactions and to outstanding repurchase
agreements as of the beginning of the first fiscal year following the issuance date of the
FSP using a limited form of retrospective application. That is, the guidance will be
effective for (1) new transactions entered into as of the start of the first fiscal year
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©2007 Protiviti Inc. An Equal Opportunity Employer
Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.
beginning after November 15, 2007 and (2) repurchase financings outstanding on the start
of the first fiscal year beginning after November 15, 2007.
Reporting Changes:
SEC Publishes Final Interpretive Guidance, Issues Auditing Standard
No. 5 for Public Comment and Proposes a New Definition of Significant
Deficiency
On June 20th, 2007, the SEC finally published its long-awaited interpretive guidance for
management regarding a company’s evaluation and assessment of internal control over financial
reporting (ICFR). The final guidance is effective immediately once published in the Federal
Register. Our report on this guidance is available at:
http://www.protiviti.com/content/PRO/pro-us/pages/en/US/Knowledge/SEC_Reports/SECReports_20070621.pdf
See Protiviti’s SEC Flash Report dated June 21, 2007 for further explanation.
FIN 48: Effective Settlement Criteria
On April 11th, 2007, the FASB agreed to release a FASB Staff Position that would change the
criteria for determining the “settlement” for a tax position. In early May 2007, the FASB released
this staff position guidance on the meaning of a "settlement" as defined in FIN 48, Accounting for
Uncertainty in Income Taxes. This new guidance – FSP FIN 48-1, Definition of Settlement in FIN
48 – changes the definition of an effective settlement, provides for transition rules and is posted on
www.fasb.org.
When determining a “settlement” is effective, a company must evaluate all of the following
conditions:
•
The taxing authority has completed its examination procedures, including all appeals and
administrative reviews it is required and expected to perform for purposes of evaluating
the tax position.
•
The enterprise does not intend to appeal or litigate any aspect of the tax position related to
the completed examination.
•
A company considers it “remote” that the taxing authority would examine or reexamine any
aspect of the tax position.
•
The FSP is to be applied immediately upon initial adoption of FIN 48.
New Reporting Requirements:
XBRL (eXtensible Business Reporting Language)
The SEC’s eXtensible Business Reporting Language (XBRL) initiative has been called “bar coding”
for financial statements. In essence, XBRL provides an open standard for tagging business and
financial data using industry-adapted taxonomies for U.S. GAAP. It assigns an approved “tag” of
computer-readable explanatory information to each item on a company’s financial statements.
These tags are assigned to financial information as well as footnotes and MD&A. XBRL enables
regulators, analysts, business journalists, competitors, investment professionals and investors all
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©2007 Protiviti Inc. An Equal Opportunity Employer
Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.
over the world to access company information to extract, exchange, analyze, and present it for an
endless variety of purposes. For example, it is expected to increase analyst and investor visibility;
provide a single source for all external reporting; facilitate benchmarking, peer comparisons and
research; and reduce manual handling and manipulation of data.
This new “language” will not affect business management. It is not a new accounting standard. It is
simply a new format for a company’s financial data. XBRL does not require a tremendous amount
of work or people to implement. In fact, it is currently available for use in numerous software
programs that recognize XBRL tags such as, Microsoft Excel, Cartesis 10 and other analytical
software programs. Certain web sites are already converting public company financial fillings into
XBRL format.
If a company uses a software package that recognizes XBRL tags, they have the ability to save
tremendous amounts of time in comparing and analyzing business and financial data. A company
can consolidate information from different divisions or different accounting systems far more easily
and accurately using XBRL. On March 22, 2007, SEC Chairman Christopher Cox announced that
companies adopting XBRL for regulatory filings will not need an additional audit of the conversion of
their data. As part of an XBRL roundtable discussion, Cox said requiring an audit on converted
financial data could result in "crib death" for the XBRL project. Additionally, the SEC continues to
insist that there will be no mandate on using XBRL, and has stated that the Commission wants the
market to drive its implementation.
Currently, only about two dozen companies are participating in the SEC's voluntary XBRL pilot
program. Early adopters have reported that the costs for implementing XBRL – in terms of both
internal resources and external consulting fees - have not been significant to date. During the
roundtable, representative companies of the pilot program said their costs have been minimal -- as
low as $5,000 for the first year, according to Comcast Corp. CEO Larry Salva. According to
Reuters, the project's next step is to create more electronic tags for information such as
management’s discussion and analyses. This step is expected to be completed by the fourth
quarter of 2007.
Accounting standards-setting organizations all over the globe are pushing for the implementation of
XBRL because the core purpose of their existence is to enhance the investing public’s access to
quality financial information. XBRL does just this while helping to clarify the data and make it more
user-friendly.
The best part – XBRL is free (almost). It is being developed by a non-profit international consortium
known as XBRL International. This consortium consists of 450 companies and agencies worldwide
that are working together to build the XBRL language. They are also working to promote and
support its adoption. For more information on XBRL, visit www.xbrl.org.
2006 Executive Compensation Disclosure – SEC Review and Feedback
During the course of the past twelve months, the SEC has issued and clarified new executive
compensation rules – effective in time for this year’s proxy season – aimed at increasing the clarity
of executive and director compensation disclosures. The resulting requirements give investors
more detailed information with which to make better investment decisions, while possibly also
curbing the compensation excesses in corporate America alleged by many observers in Congress,
in the press and in the investor community. Simply stated, the new executive compensation rules
(1) require a compensation discussion and analysis (CD&A) section, (2) revise the Summary
Compensation Table and accompanying narratives, and (3) require new tables providing enhanced
compensation disclosure.
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As expected, the SEC has begun reviewing compensation disclosures under recent proxy
submissions to evaluate compliance with the new rules. As the SEC has mentioned previously,
they are reviewing disclosures filed for a larger number of companies, with a bias toward larger
filers. It is anticipated that that as a result of its review, comment letters will be issued to registrants
in the near term, but it is expected that the bulk of the SEC staff’s comments will be pointed toward
future compliance – that is, better and more complete disclosure in future filings.
That said, it is certainly still possible that the SEC staff may ask companies to amend their filings
due to issues regarding compensation disclosures. The staff will likely look for the quality of the
disclosures, including: (i) whether filers have provided an adequate or meaningful analysis, (ii) the
adequacy of performance target disclosures; and (iii) the justification for withholding certain
information if disclosures over performance targets are not provided. The staff will also look for
“plain English” disclosure language.
The SEC has publicly stated that it doesn’t anticipate many near-term changes, if any, to its new
compensation rules. While the SEC may issue more interpretive guidance related to its rules down
the road, don’t expect to see any additional rulemaking in advance of next year’s proxy season.
2-New Accounting Pronouncements
Currently Effective:
•
•
•
•
FAS 159 – The Fair Value Option for Financial Asset and Financial Liabilities – Including an
Amendment of FAS 115
FAS 157 – Fair Value Measurements
EITF 06-6 – Debtor’s Accounting for a Modification (or Exchange) of Convertible Debt Instruments
EITF 06-10 – Collateral Assignment Split-Dollar Life Insurance
To be Effective in the Near Term:
•
•
•
•
Proposed FSP FAS 128-a—Computational Guidance for Computing Diluted EPS under the TwoClass Method
EITF 06-11 – Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards
EITF 07-3 - Advance Payments for Research and Development Activities
FASB Exposure Draft, Disclosures about Derivative Instruments and Hedging Activities
Under Consideration:
•
•
•
EITF 07-1 - Collaborative Arrangements
EITF 07-2 - Complex Convertible Debt
EITF 07-4 - Earnings per Share for Master Limited Partnerships
Currently Effective:
FAS 159 – The Fair Value Option for Financial Assets and Financial
Liabilities – Including an Amendment of FAS 115
The FASB has issued FAS Statement No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities – Including an Amendment of FASB Statement No. 115 (FAS 159). FAS 159
guidance gives entities the choice of measuring various financial instruments and certain other
items at fair value. The FASB issued this pronouncement to improve financial reporting and lessen
the volatility of earnings reported due to the various ways financial instruments are measured.
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Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.
This statement gives entities the option of valuing many financial instruments at fair value rather
than applying complex hedge accounting provisions. FAS 159 applies to all entities, whether for
profit or not-for profit. Most of the provisions of FAS 159 apply only to entities that elect the fair
value option. However, the amendment to FAS 115, Accounting for Certain Investments in Debt
and Equity Securities, applies to all entities with available-for-sale and trading securities.
There are a few exceptions to the type of financial instruments that are eligible for fair value
measurement. For example, financial assets and liabilities which are recognized under leases as
defined in FAS 13, Accounting for Leases, are not eligible. Once the fair value option is applied, it
is unchangeable unless a new election date occurs. The option is applied only to entire instruments
and not to parts of instruments, and it may be applied instrument by instrument with only a few
exceptions.
The objectives of the required disclosures are to equip users of financial information with an
understanding of why management chose to utilize the fair value option and to understand how the
full or partial use of the fair value option affects earnings. The disclosures should also provide
information to the users regarding the differences between fair values and contractual cash flows
for certain items.
The effective date of FAS 159 is the beginning of a company’s first fiscal year that begins after
November 15, 2007. No entity is allowed to apply this guidance retrospectively; however, there is
an early adoption option. If early adoption is elected, a company can apply the fair value option at
the beginning of its fiscal year which begins on or before November 15, 2007, as long as it also
applies all of the applicable provisions of FAS 157, Fair Value Measurements.
FAS 159 allows for early adoption of the fair value option to held-to-maturity and available-for-sale
investment securities held as of the early adoption date. When including those securities in
unrecognized loss positions, companies should use care to not adopt FAS 159 in a manner that is
contrary to the principles and objectives outlined in the standard.
For example, assume an entity purports to adopt FAS 159 by electing the fair value option for
certain eligible ”loss-position” available-for-sale and held-to-maturity investment securities, as well
as certain financial liabilities. Shortly thereafter, the entity disposes of those investment securities
and settles those liabilities. Going forward, the entity does not elect the fair value option for newly
purchased investment securities and newly issued liability instruments. The totality of these actions
appears to indicate that the entity has little or no intent to utilize the fair value option with respect to
these classes of financial assets and liabilities on a go-forward basis, contrary to the principles and
objectives outlined in FAS 159. Accordingly, the entity's purported adoption of FAS 159 is not
substantive and would not be considered a proper application of the standard.
In other situations where the answer is less clear, entities should use judgment when considering
whether a purported adoption of FAS 159 is substantive based on the specific facts and
circumstances. Some of the factors to consider and potential implications that may impact an
entity's assessment of the appropriateness of early adoption of FAS 159 include:
•
Is the entity able to adopt all of the requirements of FAS 157 at the same time it plans to
early adopt FAS 159?
•
Is the planned approach for adoption of FAS 159 primarily to obtain a specific desired
accounting result?
•
Has the entity adequately communicated its intent to its board of directors, audit
committee, analysts, or others?
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•
How does the planned adoption approach compare to the entity's disclosures in prior
periods (under SEC SAB 74) of the potential impact of FAS 157 and FAS 159?
•
Have management and the audit committee considered the disclosure requirements
related to early adoption?
If an entity proposes to adopt the fair value option merely to achieve an accounting result that is
contrary to the principles and objectives in FAS 159, a conclusion may be reached that the entity's
proposed accounting departs from generally accepted accounting principles.
In those situations where early adoption of FAS 159 is deemed appropriate, and where unrealized
losses are being recorded directly in retained earnings in connection with the early adoption of FAS
159, entities should provide clear and transparent disclosure of the reasons for electing the fair
value option for specific eligible items and for not electing the fair value option for other eligible
items within a group of similar items – including a discussion of any accounting motivations of such
elections – along with the other required disclosures of FAS 159.
Additionally, the SEC staff recently announced (June 2007) that it will no longer accept liability
classification for financial instruments that meet the conditions for temporary equity classification
under ASR 268 and EITF D-98. As a consequence, the fair value option under FAS 159 may not be
applied to any financial instrument (or host contract) that qualifies as temporary equity. Registrants
that do not choose retrospective application should apply the announcement prospectively to all
affected instruments that are entered into, modified, or otherwise subject to a re-measurement
event in the registrant’s first fiscal quarter beginning after September 15, 2007.
FAS 157 – Fair Value Measurements
In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements ”, which defines fair
value, establishes a framework for measuring fair value in accordance with generally accepted
accounting principles (GAAP), and expands disclosures about fair value measurements. FAS 157 is
effective in fiscal years beginning after November 15, 2007.
Prior to FAS 157, there were different definitions of fair value and limited guidance for applying
those definitions under GAAP. Moreover, that guidance was dispersed among the many
accounting pronouncements that require fair value measurements. Differences in that guidance
created inconsistencies that added to the complexity in applying GAAP.
FAS 157 will change current practice by:
(1) Defining fair value: “Fair value is the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at the
measurement date.”
(2) Requiring certain methods to be used to measure fair value: The measurement of fair
value is determined as a market-based measurement, not an entity-specific measurement,
based on assumptions market participants would make in pricing the asset or liability.
FAS 157 establishes a three-level hierarchy for measuring fair value.
(3) Expanding disclosures about fair value measurements
Entities are to use inputs for measuring fair value according to the three-level hierarchy established
in FAS 157, using the highest level possible (i.e., Level 1) if such inputs are available, and if not,
going to the next lower level.
The three levels for measuring fair value are:
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•
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or
liabilities that the reporting entity has the ability to access at the measurement date.
•
Level 2 inputs are inputs other than quoted prices included within Level 1 that are
observable for the asset or liability, either directly or indirectly. Level 2 inputs include (i)
quoted prices for similar assets or liabilities in active markets, (ii)quoted prices for identical
or similar assets or liabilities in markets that are not active (where the nature of
transactions – frequency, consistency of values, etc. is not as reliable), (iii) inputs other
than quoted prices that are observable for the asset or liability (for example, interest rates
and yield curves observable at commonly quoted intervals, volatilities, prepayment
speeds, loss severities, credit risks, and default rates);and (iv) inputs that are derived
principally from or corroborated by observable market data by correlation or other means
(market-corroborated inputs).
•
Level 3 inputs are unobservable inputs for the specific asset or liability. They are only to
be used to the extent that Level 1 and Level 2 inputs are not available. However, the fair
value measurement objective remains the same – that is, an exit price from the
perspective of a market participant that holds the asset or owes the liability. Such
measurements need to reflect the reporting entity’s own assumptions about the behavior
of market participants in pricing the asset or liability (including assumptions about risk).
These estimates must be developed based on the best information available in the
circumstances, which might include the reporting entity’s own data. In developing Level 3
inputs, the reporting entity need not undertake all possible efforts to obtain information
about market participant assumptions. However, entities may not ignore information about
market participant assumptions that is reasonably available without undue cost and effort.
Therefore, the reporting entity’s own data used to develop unobservable inputs needs to
be adjusted, if information is reasonably available without undue cost and effort that
indicates that market participants would use different assumptions.
FAS 157 is effective for financial statements issued for fiscal years beginning after Nov. 15, 2007
and interim periods within those fiscal years. Earlier application is encouraged, provided that the
reporting entity has not yet issued financial statements for that fiscal year, including financial
statements for an interim period within that fiscal year.
FAS 157 is to be applied prospectively as of the beginning of the fiscal year in which it is initially
applied, with certain exceptions. The transition adjustment, measured as the difference between
the carrying amounts and the fair values of those financial instruments at the date FAS 157 is
initially applied, should be recognized as a cumulative-effect adjustment to the opening balance of
retained earnings (or other appropriate components of equity or net assets in the statement of
financial position) for the fiscal year in which FAS 157 is initially applied.
EITF 06-06 – Debtor’s Accounting for a Modification (or Exchange) of
Convertible Debt Instruments
This emerging issue addresses two questions:
(1) How a modification of a debt instrument (or an exchange of debt instruments) affecting the
terms of an embedded conversion option should be considered in the issuer's analysis of
whether debt extinguishment accounting should be applied.
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(2) How to account for a modification of a debt instrument (or an exchange of debt
instruments) affecting the terms of an embedded conversion option when extinguishment
accounting is not applied.
With regard to Issue (1), the change in fair value of an embedded conversion option resulting from
the exchange of debt instruments or a modification in the terms of an existing debt instrument do
not need to be included in the cash flow test under EITF Issue 96-19. However, a separate
analysis must be performed; in which, if the change in the carrying amount of the debt instrument is
at least 10% of the carrying amount of the original debt, then the issuer should use extinguishment
accounting to recognize the change. Also, if the modification or exchange adds or eliminates a
substantive conversion option, then extinguishment accounting would be required.
With regard to Issue (2), when such a transaction is not handled as an extinguishment, any
resulting increase in the embedded conversion option should reduce the carrying amount of the
debt instrument (increasing a debt discount or reducing a debt premium) and an increase in paid-in
capital. A decrease resulting from such a transaction should not be recognized. Note that the
embedded conversion option is calculated as the difference between the fair value of the embedded
conversion option immediately before and after the modification or exchange.
The FASB ratified the consensus reached by the EITF in November 2006. The new standard
should be applied to any conversions beginning with the first interim or annual reporting period after
the ratification (January 1, 2007 for most companies).
EITF 06-10 – Collateral Assignment Split-Dollar Life Insurance
Companies may purchase life insurance to protect against the loss of "key" employees, to fund
deferred compensation and postretirement benefit obligations, or to provide an investment return.
Endorsement split-dollar life insurance arrangements and collateral assignment split-dollar life
insurance arrangements are the two most common types of arrangements used for this purpose.
Generally, the difference between these arrangements depends upon the ownership and control of
the life insurance policy. In an endorsement split-dollar life insurance arrangement, the life
insurance policy is owned and controlled by the company, whereas in a collateral assignment splitdollar life insurance arrangement, the life insurance policy is owned and controlled by the employee
(or the employee's estate or a trust controlled by the employee, hereinafter referred to as the
"employee"). However, the employee and employer “split” either the policy’s cash surrender value
or death benefits in a pre-determined proportion.
The issues related to life insurance policies and addressed by EITF 06-10, Collateral Assignment
Split-Dollar Life Insurance, are:
(1) Whether an entity should record a liability for the postretirement benefit associated with a
collateral assignment split dollar life insurance arrangement in accordance with either FAS
106, Employers' Accounting for Postretirement Benefits Other Than Pensions (FAS 106),
(if, in substance, a postretirement benefit plan exists) or APB Opinion 12 (if the
arrangement is, in substance, an individual deferred compensation contract) based on the
substantive agreement with the employee.
(2) How an employer should recognize and measure the asset in a collateral assignment splitdollar life insurance arrangement.
With regard to Issue (1), an employer should recognize a liability for the postretirement benefit
related to a collateral assignment split-dollar life insurance arrangement in accordance with either
FAS 106 or APB Opinion 12, as applicable, based on the substantive agreement with the
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©2007 Protiviti Inc. An Equal Opportunity Employer
Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.
employee. With regard to Issue (2), an employer should recognize and measure an asset based on
the nature and substance of the collateral assignment split-dollar life insurance arrangement. An
employer should make an assessment as to what future cash flows the employer is entitled to, if
any, as well as the employee's obligation and ability to repay the employer.
The accounting for deferred compensation and postretirement benefits of endorsement split-dollar
life insurance arrangements (which are owned and controlled by the employer) is addressed in
EITF 06-4. For those arrangements, employers should recognize a liability for the postretirement
benefit related to a collateral assignment split-dollar life insurance arrangement because the
employer’s obligation is not effectively settled by the purchase of a life insurance policy.
At its March 28, 2007 meeting, the Board ratified the consensus reached by the Task Force on this
Issue. EITF 06-10 is effective for fiscal years beginning after December 15, 2007 (i.e., January 1,
2008 for calendar-year companies). Entities have the option of recognizing the effects of applying
EITF 06-10 as either:
•
A change in accounting principle through a cumulative-effect adjustment to beginning
retained earnings or to other components of equity or net assets in the statement of
financial position as of the beginning of the year of adoption; or
•
A change in accounting principle through retroactive application to all prior periods.
To be Effective in the Near Term:
Proposed FSP FAS 128-a – Computational Guidance for Computing
Diluted EPS under the Two-Class Method
The FASB has proposed an amendment to FAS 128, Earnings per Share – An Amendment to FAS
128 (FAS 128A). This amendment aims to provide computational guidance for computing diluted
earnings per share (EPS) under the two-class method. The guidance is particularly intended for
companies whose capital structure includes common stock, participating securities and potential
common stock.
FAS 128, Earnings per Share, issued in February 1997, provide guidance on the calculation and
disclosure of earnings per share. In its deliberations regarding FAS 128, the FASB decided to
require the use of the two-class method of computing earnings per share for those companies with
participating securities or multiple classes of common stock. In other words, for those securities
that are not convertible into a class of common stock, the “two-class” method of computing earnings
per share shall be used. The “two-class method” is an earnings allocation formula that determines
earnings per share for each class of common stock and participating security according to
dividends declared (or accumulated) and other participation rights in undistributed earnings.
As background, in March of 2004, the EITF issued EITF 03-6, Participating Securities and the TwoClass Method under FAS 128 to further clarify the definition of the types of participating securities to
be included in EPS calculations. EITF 03-6 reported a consensus that convertible participating
securities should always be included in the computation of basic earnings per share using the twoclass method. The FASB is proposing to issue FAS 128A due to continuing inquiries as to how to
calculate EPS and, in particular, which securities must be included in the calculation. This
amendment includes the application of the treasury stock method for year-to-date earnings per
share calculations.
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The FASB believes that diluted EPS should be computed using a three-step process. The first step
is to compute the basic EPS using the two-class method. Next, compute the diluted EPS using the
total earnings allocated to common stock, and the total common shares outstanding assuming all
instruments had been exercised, converted or issued. Finally, compute diluted EPS for the second
class of common stock, if applicable.
The Board agreed to codify the guidance in the proposed FSP into Statement 128 through its
agenda project on Earnings per Share, rather than that guidance being issued in the form of a final
FSP.
EITF 06-11 – Accounting for Income Tax Benefits of Dividends on ShareBased Payment Awards
EITF 06-11 addresses how a company should account for the tax benefits of dividends received
which are (1) paid to employees holding equity-classified non-vested shares, equity-classified nonvested share units, or equity-classified outstanding share options and (2) charged to retained
earnings under FAS 123R, Share-Based Payment.
During the EITF meeting held on June 14th, 2007, a consensus on this topic was reached by the
Task Force. This consensus was ratified at the FASB meeting of June 27, 2007 and is now
considered authoritative GAAP. The consensus will apply to share-based payment arrangements
in which the employee receives dividends on the award during the vesting period, the dividend
payment results in a tax deduction, and the employer realizes a related tax benefit during the
vesting period. Under Statement 123R, dividends paid during the vesting period on share-based
payments that are expected to vest are charged to retained earnings because the compensation
cost already reflects the expected value of those dividends, which are included in the grant date fair
value of the award. Dividends on awards that do not vest are recognized as additional
compensation cost.
The consensus requires the tax benefit received on dividends associated with share-based awards
that are charged to retained earnings to be recorded in additional paid-in capital and included in the
pool of excess tax benefits available to absorb potential future tax deficiencies on share-based
payment awards. A tax benefit recognized from a dividend on an award that is subsequently
forfeited or is no longer expected to vest (and that is therefore reclassified as additional
compensation expense) would be reclassified to the income statement if sufficient excess tax
benefits are available in the pool of excess tax benefits classified in additional paid-in capital as of
the date of the reclassification.
The consensus will be effective for the tax benefits of dividends declared in fiscal years beginning
after December 15, 2007.
EITF 07-3 – Advance Payments for Research and Development Activities
EITF 07-3 addresses how a company should account for advance payments for goods or services
that will be used in future research and development activities. The issue is whether nonrefundable
advance payments for goods or services that will be used or rendered for research and
development activities should be expensed when the advance payment is made or when the
research and development activity has been performed.
A consensus on this topic has been reached by the Task Force. The consensus was ratified by the
FASB at its June 27, 2007 meeting and is now considered authoritative GAAP.
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Under the consensus, the up-front payments would be recorded as an asset if the contracted party
has not yet performed the related activities. Subsequently, amounts capitalized would be
recognized as expense when the research-and-development activities are performed, that is, when
the goods without alternative future use are acquired or the service is rendered.
The consensus is to be applied prospectively for new contractual arrangements entered into in
fiscal years beginning after December 15, 2007.
FASB Exposure Draft – Disclosures about Derivative Instruments and
Hedging Activities
The FASB issued a proposal that would provide investors and others with better information about
the effects of derivative and hedging activities on a company’s financial statements. The proposed
Statement specifically addresses concerns that existing disclosure requirements associated with
FAS 133, Accounting for Derivative Instruments and Hedging Activities, do not provide adequate
information to financial statement users.
The proposed disclosure requirements are intended to enhance understanding of how and why
entities use derivatives, how they are accounted for in an entity’s financial statements, and how
they affect an entity’s financial position, results of operations, and cash flows. The exposure draft
would require that the objectives and strategies for using derivative instruments be discussed in
terms of the underlying risks and the accounting designation. Tabular disclosure of notional and fair
value amounts of derivatives instruments and the gains and losses on derivatives instruments and
related hedged items would be required, as would information about counterparty credit risk and the
existence and nature of contingent features in derivative instruments.
At a recent meeting, the Board discussed – but did not reach any decisions - on a number of
issues, including scope, the level of detail required in disclosures, issues around the ability of
operating systems to produce relevant data, the frequency of disclosures and the effective date of
any new standard.
Next Steps
The Board plans to consider the significant issues raised by respondents to the Exposure Draft
during the third quarter of 2007. The requirements of the proposed Statement would be effective
for financial statements issued for fiscal years and interim periods ending after December 15, 2007,
with early application encouraged.
Under Consideration:
EITF 07-1 – Collaborative Arrangements
In certain industries, entities may seek partners to jointly develop and commercialize intellectual
property through a collaborative arrangement. For example, in the biotechnology and
pharmaceutical industries, because the development of a drug candidate into a commercially viable
product may take many years, and because of the considerable number of resources required to
develop a product and the related financial risks involved, companies in the biotechnology or
pharmaceutical industries often enter into arrangements with other companies to jointly develop,
manufacture, distribute, and market a drug candidate, and thereby share in the risks and rewards.
Many companies in these industries jointly develop and commercialize intellectual property, in some
cases, without creating a separate legal entity. If there is no separate legal entity, the arrangement
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is sometimes operated as a “virtual joint venture” and is subject to oversight by a steering
committee that includes representatives of each party to the collaborative arrangement.
The EITF has tentatively concluded that a collaborative arrangement is an arrangement in which
the participants are actively involved and are exposed to significant risks and rewards that depend
on the ultimate commercial success of the endeavor. The Task Force also decided that the equity
method of accounting should not be applied to a collaborative arrangement unless a separate legal
entity is created to carry out its activities. Instead, revenues and costs incurred with third parties in
connection with collaborative arrangements would be presented gross or net based on the criteria
in EITF 99-19 and other accounting literature, with appropriate disclosure.
If the EITF reaches a consensus on this issue at a subsequent meeting and it is ratified by the
FASB, it would be effective for fiscal years beginning after December 15, 2007. The application of
the consensus would be reflected by retrospective reclassification in all periods presented, unless it
is impracticable to do so.
EITF 07-2 – Complex Convertible Debt
EITF 07-2 addresses how a company should account for a convertible debt instrument that requires
or permits partial cash settlement upon conversion if, at issuance, the embedded conversion option
is not required to be separately accounted for as a derivative under FAS 133.
The Task Force discussed whether convertible debt with complex features, such as partial cash
settlement provisions and variability in the number of shares to be issued upon conversion, should
be accounted for entirely as debt under APB Opinion 14, and, if not, what is the appropriate
accounting for these instruments. The convertible debt in question excludes instruments with
embedded conversion features that must be separated as derivatives under FAS 133.
In their recent meeting (June, 2007), the EITF was unable to reach a conclusion and agreed to
discontinue discussions of this issue. However, the FASB members attending the meeting agreed
to consider adding a short-term project to the Board’s agenda to evaluate whether additional
guidance is needed on the scope of APB Opinion 14, including which instruments should be
considered outside the scope of APB Opinion 14 and accounted for using a different model.
EITF 07-4 – Earnings per Share for Master Limited Partnerships
Publicly traded master limited partnerships (MLPs) often issue multiple classes of securities that
may participate in partnership distributions according to a formula specified in the partnership
agreement. A typical MLP consists of publicly-traded common units held by limited partners (the
Common Units), a general partner interest (the GP Interest), and incentive distribution rights (the
IDRs).
It is not uncommon for MLPs to encounter substantial timing differences between the distribution of
cash and the recognition of income. These partnerships often will distribute cash in excess of their
reported earnings. Alternatively, the partnership may operate in a seasonal industry, such that
earnings are generated primarily in one quarter, but cash distributions are made over the course of
a year. In periods during which earnings are not sufficient to cover distributions to the various
partnership interests, the capital accounts of the remaining classes of partnership interests will
absorb the "debit" created by the allocation of earnings to IDR holders.
The issue is around applying the two-class method under FAS 128. Should current period earnings
of an MLP be allocated to holders of IDRs?
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In their recent meeting (June, 2007), the EITF discussed whether incentive distribution rights in a
typical MLP are participating securities under FAS 128 and whether the partnership should record
an allocation of the partnership’s undistributed current-period earnings to the rights holders in
periods in which earnings exceed distributions. The Task Force asked the FASB staff to conduct
additional research on these arrangements and will continue its discussion of the issue at a future
meeting.
Summary
As with our prior Financial Reporting Flash Reports, this publication identifies some – but not all – of
the new standards and developments with existing standards which may affect companies in
current reporting periods. And, where it does identify new and impending standards, it does so in
summary fashion. The complexity and level of detail required to assess and adopt new financial
standards will vary based on a company’s size and industry, as well as on the level and nature of
operating systems and organizational structure available to support data requirements and provide
for proper external disclosures.
Careful diligence and analysis, and sufficient lead time, are often required to fully investigate and
implement new accounting standards. We recommend that companies do so in the context of two
important activities: (1) an overall financial reporting risk profile effort, in which companies map the
risks to their business processes affecting financial reporting and identify the controls mitigating
those risks, and (2) the underlying position papers and calculations supporting the accounting
conclusions being reached and implemented.
NOTE: The descriptive and summary statements in this Flash Report are not intended
to be a substitute for a careful reading of the texts of FASB pronouncements, AICPA
literature, SEC regulations or any other applicable or potential requirements.
Companies applying generally accepted accounting principles (GAAP) or filing
documents with the SEC should apply the texts of the relevant laws, regulations, and
accounting requirements, consider their particular circumstances, and consult with their
accounting and legal advisors.
In previous Financial Reporting Flash Reports, we have addressed issues such as Stock
Compensation and Accounting for Uncertain Tax Positions. Those Flash Reports can
be found at www.protiviti.com.
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©2007 Protiviti Inc. An Equal Opportunity Employer
Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.