1 FASB Update For Acct 592 – Spring 2006

2 What I’m Covering Some things we’ll talk about later  FIN 46 (Revised) – related to consolidations of special purpose entities Some standards relate to specialized industries  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  SFAS No. 152 – Accounting for Real Estate Time- Sharing (December 2004) Amends SFAS Nos. 66 & 67

3 What I’m Covering Some things are just too technical for in-depth coverage!  SFAS No Amendment of FAS 133 on Derivative Instruments and Hedging Activities (April 2003) Clarifies earlier standards and settle implementation issues particularly with respect to “embedded” derivatives  SFAS No Accounting for Certain Hybrid Financial Instruments (Feb 2006) Amends FAS 133 on derivatives and FAS 140 on securitization of certain derivatives

4 Additional Pension Disclosures FAS 132 (revised 2003)

5 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

6 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, etc. Measurement dates used to determine PBO, etc.

7 Examples Appendix C provides illustrations that should be useful in doing the footnote for the Peachbee project (Spring 2006) Illustration 1 is probably your “best bet” You should now be able to find “real examples” of the new disclosures since the rules were effective for fiscal years beginning after 12/15/03

8 More to come on pensions November 10, 2005, FASB decided to add a comprehensive project to its technical agenda on accounting for postretirement benefits including pensions and to conduct that project in two phases. Phase 1 (by 2 nd half of 2006)  Require that funded or unfunded status be recognized on blaance sheet (e.g., difference between PBO and Plan Assets for pensions) Phase 2 (multi-year project in collaboration with IASB)  Comprehensively consider measurement & display of various elements of post-retirement benefits

9 Exchanges of Nonmonetary Assets SFAS No. 153 – Exchanges of Nonmonetary Assets

10 Commercial Substance A nonmonetary exchange has commercial substance if the entity’s 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: 1.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. 2.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.

11 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.

12 Changes in Principles, Estimates, Entities & Corrections of Errors SFAS No Accounting Changes and Error Corrections

13 Accounting Changes & Corrections SFAS No. 154 discusses 3 types of accounting changes plus correction of errors  Changes in Accounting Principle  Changes in Accounting Estimates  Changes in Reporting Entity  Errors in Financial Statements

14 SFAS No Accounting Changes and Error Corrections Issued May 2005 – effective for fiscal years beginning after 12/15/2005 Applies to VOLUNTARY changes in choice of accounting principle  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 Change previously reported numbers so that they now represent what the numbers would have been had the new principle been in use during that time period

15 Some changes in principle = a change in estimate A change in depreciation method is now considered a change in estimate and would not require retroactive restatement of prior years  We already had the rule that if a change in principle cannot be distinguished from a change in estimate, it would be treated as a change in estimate  Example: Switch bad debt accounting from percentage of sales method to aging of accounts receivable (allowance) method

16 Restatement Example SFAS No. 154, Appendix A Illustration 1 - detailed example of a change from LIFO to FIFO inventory method Shows extensive disclosures that would be needed to communicate impact on balance sheet, income statement, and statement of cash flows

17 A simplification? Now all types of accounting changes are handled the same way – retroactive restatement  Only exception is when it is not practicable to determine impact on prior periods

18 Asset Retirement Obligations FIN 47 - Accounting for Conditional Asset Retirement Obligations: an interpretation of FASB Statement No. 143

19 Do we need to review FAS 143? If so, I’ll come back to this interpretation later in the semester!

20 Asset retirement obligations FIN 47 (March 2005) would clarifies 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 liability’s fair value.

21 ARO Examples Telephone company uses wood poles that are chemically treated  No legal requirement to remove poles from ground  However, if and when poles are removed from the ground, special disposal procedures are mandated by law  An asset retirement obligation should be estimated at date of purchase

22 ARO Example Facility currently owned contains asbestos  Since acquisition, regulations are put into place that require special handling if building is renovated or demolished  ARO should be recognized when regulations go into effect, if entity can reasonably estimate fair value of the liability

23 New rules on redeemable preferred stock SFAS No. 150 – Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (May 2003)

24 Redeemable financial instruments Mandatorily redeemable financial instrument shall be classified as liability Exceptions  Redemption is contingent Required only upon liquidation or termination of the reporting entity Required only if an uncertain future event occurs  Becomes liability only when the event becomes certain to occur Certain not probable!

25 Other redeemable securities Classify as liability:  Obligation to repurchase equity  Obligations to issue variable number of shares

26 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

27 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”

28 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 issuer’s 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)

29 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 trust’s books)

30 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

31 New rules on guarantees of debt FIN No. 45 – Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (November 2002)

32 FIN45 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 obligation Market value guarantee of asset owned by the guaranteed party Guarantee of the market price of common stock of the guaranteed party Guarantee 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 entity’s failure to perform under a nonfinancial contract

33 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.

34 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 obligation New Disclosure – FIN 45

35 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.

36 Measurement of obligation a.The premium received or receivable – when the guarantee is issued in a standalone arm’s-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

37 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. dNot 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.

38 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.

39 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.

40 Disclosures Required – con’t 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 guarantor’s 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

41 Example from Recent F/S

42 ST Convergence with IASB

43 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.

44 Coming soon Earnings per Share - Minor change to determination of earnings per share – due out 1 st Quarter 2006 Earnings per Share Income Taxes – exposure draft due 2 nd Quarter 2006 Income Taxes Research and Development - ? Research and Development

45 What’s Next?

46 Forthcoming – first half 2006 Earnings per Share—an amendment of FASB Statement No. 128 (Proposed Statement of Financial Accounting Standards) - December 15, 2003 Fair Value Measurements (Proposed Statement of Financial Accounting Standards) - June 23, 2004 Accounting for Uncertain Tax Positions—an interpretation of FASB Statement No. 109 (Proposed Interpretation) - July 14, 2005

47 Forthcoming – first half 2006 Statement 140 Issues:  Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140 (Proposed Statement of Financial Accounting Standards) August 11, 2005  Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140 (Proposed Statement of Financial Accounting Standards) August 11, 2005

48 Longer term projects Business & not-for-profit combinations (2007)  We are still waiting for clear definition of control  Eliminate parent co. method in favor of the economic entity approach 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