I have always felt like the ideal of one set of global accounting standards made sense. If business is global and accounting is the language of business, we need one language, not several different ones. The ideal of a single set of global standards took on a hard reality with the creation of the IASB, the adoption by all of Europe as its single source of accounting standards and the famous or infamous Memorandum of Understanding between the FASB and IASB last decade. With country after country adopting IFRS as its accounting standards and the SEC allowing foreign companies to file financial statements under IFRS unreconciled to U.S. GAAP and poised to tell U.S. public companies they would have to file under IFRS as well, it seemed the path to a single set of international standards was set and inevitable.
Then something happened.
I don’t know if the SEC got cold feet, had legitimate concerns or simply got distracted by its many other duties, but for whatever reason, the SEC stopped the push toward requiring domestic U.S. companies to adopt IFRS. Then the camaraderie of the FASB and IASB working on standards together started to crumble; first with differences on financial instrument impairment, then deciding to go their own ways on insurance and finally taking completely different directions on the income statement presentation of leases. Even the crowning achievement of a single revenue standard is starting to show the cracks in the relationship with the Boards taking different positions on the need for additional guidance on revenue related to licenses and more guidance on how to determine performance obligations.
Through all of this, I still thought that global standards made sense, if only we could work together. Then an IASB Board member opened their mouth and changed my opinion, maybe forever. In discussing potential additional guidance on the revenue standard the IASB Board member said (I paraphrase) “I never thought you would actually have to do this revenue accounting on a contract by contract basis.” The worst part was no IASB Board member called him out for such a statement.
In the U.S. when a standard says “the objective of the guidance on this topic is to establish principles that an entity shall apply to report useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue and cash flows from A CONTRACT WITH A CUSTOMER” as ASC 606-10-10-1 states, that means the standard is intended to be accounted for on a contract by contract basis. That fact is made even clearer by ASC 606-10-10-4 which states “this guidance specifies the accounting for an individual contract,” but says we can use a portfolio approach if the results “would not differ materially from applying this guidance to the individual contracts.” For those of you saying I am quoting the FASB codification and not IFRS 15 which the IASB member would be referencing, IFRS 15 says the exact same thing.
The rest of the world is clearly a very different place legally and regulatorily than the U.S. If members of the IASB can say the standard wasn’t meant to do what it says in plain English and not be called out, then my only conclusion is that the rest of the world views accounting standards very differently from the SEC and the U.S. Courts and we dare never subject ourselves to a standard setting body that doesn’t recognize and help preparers and auditors deal with such differences.
The FASB and the SEC each have projects underway to look at and understand how to increase the effectiveness of disclosure. While most preparers hope these projects will reduce the volume of disclosures, I think recent comments make it clear that the ability to do that is really in the hands of preparers themselves already.
GAAP already includes a requirement that the codification, including disclosures, does not apply to immaterial items. And, the SEC is clear that they allow cross-reference to other disclosures and do not want, or expect, the repetition of the same language from section to section in the 10-K. For example, the critical accounting estimates section is not supposed to be a repeat of accounting policies from footnote 1. Instead, this section of MD&A is supposed to have information about the assumptions and process of developing critical estimates, rather than the policy statement.
The issue with reducing disclosure is twofold. First, there is no penalty for over disclosure, but there is risk related to under disclosure in the form of comment letters and lawsuits. When asked at the AICPA SEC and PCAOB Developments Conference if the SEC would ever provide a comment on a company including excessive disclosures which might therefore make it harder to determine the relevant, important information, the answer was a quick no. So the legal situation is there is no penalty for over disclosure and there is a possibly significant penalty for under disclosure. Given that dynamic, is it any surprise that we are being overwhelmed in disclosure.
A statement was also made at the AICPA conference that what it really takes to eliminate disclosure is courage by the preparer to hold their ground with the auditor, and audit committee, that certain disclosures are not material. The reality is that even if a disclosure is not material today, you have to set up the infrastructure to monitor every year in the future to continue to conclude it is immaterial. So you are essentially asking a preparer to save no time and resources, and have a discussion every year about why something should not be disclosed. That may actually take more time for the preparer than just simply providing the unnecessary disclosure. As the saying goes, “I apologize for the length of this letter, but I didn’t have the time to make it short.”
Given the risk math discussed above and the lack of savings from the preparer perspective, is it any surprise we are disclosing more than ever? I say no, and until these root causes are addressed, we won’t ever be able to reduce the volume of disclosures.
At the recent AICPA SEC and PCAOB Developments Conference, James Shnurr, SEC Chief Accountant, noted that preparers have lots of questions about accounting for transactions under the new standard and they need answers in order to implement the standard. If those answers require additional rule making this might cause a delay in the effective date of the standard. He also pointed out that comparability was a hallmark of the standard setting process. You can find more on his comments this Journal of Accountancy article.
In addition to the FASB/IASB Transition Resource Group which is looking at 28 issues and counting, the AICPA is trying to aid comparability through 16 industry focused task forces to assist in understanding the standard and provide examples. These task forces have been hard at work, but are just now coming to the point of sending information up to the AICPA Finance Reporting Executive Committee for review with publication of results not expected to happen any time soon. If comparability is a real key, I think it behooves the FASB to consider a delay to allow these groups to positively impact comparability within each industry as a result of their work.
The FASB is in the middle of outreach to understand where preparers are in implementing the standard and the issues they are encountering. They are considering a possible delay in the standard based on what they find during the research. The FASB has been clear that simply not getting around to the work is not a reason for a delay. Instead, they are looking for real substantive issues preparers are having with implementing the standard in time for a retrospective application. Either way, we should hear from the FASB in the first half of 2015 about a potential delay. Interestingly the IASB is saying they are not hearing any requests for a delay in the standard, but this is probably greatly influenced by the fact that under IFRS you only have to provide two years of income statements rather than three as required by the SEC. If US preparers only had to provide restated income statements for 2016 and 2017 and not 2015, I think you would be hearing a lot less about the need for a delay.
There is so much going on with the revenue standard I can’t possibly cover it all here. Bottom line is that the issuance of the final standard wasn’t the end, but really was only the end of the beginning of the process of changing the accounting for what is the most important number in the financial statements.
On more than one occasion I have taken the FASB to task in this blog, so when they do something right it is only fair that I express some praise. The FASB has recently issued three exposure drafts that actually simplify accounting rules, disclosures and procedures. I talk briefly about each below.
Simplify Inventory Lower of Cost or Market (LCM) test – the FASB is proposing to change the “market” component to a single net realizable value calculation. They are proposing to get rid of floors and ceilings in the calculation which added complexity with no real benefit. Less calculations is good, eliminating calculations that do not materially change financial results 99.9999% of the time is even better.
Accounting for Cloud Computing costs – there have been rules for years on how sellers of cloud computing services should account for such services. The question is does the service include a separate deliverable of a software license or is the software license so integrated into the service they are considered a single unit of account for revenue recognition purposes. The FASB has essentially said those same rules apply to purchasers of cloud computing services. Some companies already followed this model by analogizing to the seller accounting, but other companies did not follow that accounting resulting in the dreaded “diversity of practice.” By adopting the standard the FASB will eliminate a difference that does not need to exist without adding a ton of work for most preparers of financial statements.
Eliminate Extraordinary Items – I could be cynical and say the FASB is finally facing up to reality. When was the last time you saw a company with an extraordinary item. The reality is the regulators got so picky on what was unusual AND infrequent that nothing seems to meet the definition. Actually I think the regulatory elimination of extraordinary items is why you have seen a proliferation of non-GAAP “adjusted” earnings and “adjusted” EPS numbers. Investors want to understand what is non-recurring and recurring in nature. Extraordinary items were supposed to handle that in the financial statements, but the regulators’ actions eliminated that option for preparers so we went outside GAAP to supply the information investors want. With the elimination of extraordinary items maybe we can then move onto a discussion of splitting the income statement up into something truly useful for investors. A place to start would be to look at non-GAAP disclosures in this area.
So the FASBs new targeted approach to improving GAAP looks to be a winner so far. These three exposure drafts appear to be truly useful improvements to GAAP and I for one want to recognize the FASB’s effort to make things better. Thanks FASB!
One of the most significant changes to revenue recognition on the new standard may be the elimination of the contingent, or cash, cap requirement. There are those that did not like the contingent cap requirements because they linked revenue recognition to cash payments and that did not seem to follow the spirit of accrual accounting. That view, however, seems based on believing the contingent cap requirement is in place due to a collectability issue with recognizing revenue before the cash is due from the customer. While that view may be applicable in some cases, the primary driver of the contingent cap rules is that you should not recognize revenue until delivery is complete. If the vendor is still required to provide a significant service in order to be entitled to a payment, you cannot recognize revenue under current GAAP.
In practical terms, if I need to provide wireless service in order to be entitled to a payment, I cannot and should not recognize any portion of that revenue even if today’s multi-element rules say a portion of that service charge should be allocated to a deliverable that is already completed (providing the subsidized handset), because if I don’t provide that second deliverable (the wireless service) I will never be entitled to the revenue. I acknowledge that the future service is almost always delivered and there is very little question about the ability to continue to deliver that service in the future. In fact, the business model of subsidizing wireless handsets is built upon delivering that service in the future, otherwise a business would go bankrupt very quickly selling smartphones to hundreds of dollars below cost.
The FASB has decided that if you have a contract, or even an implied contract, then the revenue from performance obligations (the new term for deliverables) is not contingent at all on the future performance because they start with the assumption that both parties will fully deliver on all elements of the contract (the vendor will provide all performance obligations and the customer will make all required payments). Given that is the way it works a significant majority of the time that assumption is not unreasonable even though it is less conservative than the previous assumption.
The result of this position is that revenue will get recorded earlier under the new standard compared to existing GAAP. It also brings into question other “conservative” elements in existing GAAP. For example, the general practice is that no matter how likely a gain contingency is under ASC 450, you simply do not record it until it is legally owed because to do so “might be to recognize revenue before its realization” (ASC 450-30-25-1). On the other hand, you recognize losses as soon as they are probable and estimable. The asymmetrical answer under ASC 450 would seem to be the opposite of the answer the FASB has come up with under the new revenue standard and I wonder if and when the Board will decide to address that difference.
The FASB and IASB issued their converged revenue recognition standard on Wednesday, May 28. The 700 page document can be found here (ASC 606, Other ASC Conforming Changes, Basis for Conclusions and Implementation Guidance). While the standard is not effective until 2017, there is no time to wait to begin your implementation work on this one. If you are at a public company planning a retrospective approach you have just 7 months until you need to start computing those “prior year” amounts for your 2017 financials. You have an extra year if you are a private company and only have to report one year of comparative income statement amounts, but if you enter into long-term contracts you may already be past the time when you need to start gathering information for changes to your revenue recognition related to those contracts.
The new revenue recognition standard may be the most significant change to accounting standards in the 40 year history of the FASB. The exact impact depends on the type of business on which you report. Software, telecom and technology in general are likely to see the most significant impacts, but every type of business is likely to see some level of changes which will require new processes, new controls and possibly new accounting systems. You can see more about the changes in a Journal of Accountancy Article here. If you want to hear more about the telecom industry impact you can listen to a podcast interview of me by JOA editor Ken Tysac here.
The most significant changes in the revenue recognition standard are:
- Elimination of the contingent (cash) cap on recognizing revenue
- Deferral of all costs to obtain and fulfill a contract – this is no longer a policy election (where upfront recognition was considered “better” accounting – how ironic) and the deferral can no longer limited to the amount of revenue that you deferred
- Sales incentives that used to be considered an expense are now considered a (separate) performance obligation and must have revenue allocated to that obligation.
- Change in the hierarchy of support for “stand-alone selling price” (SSP) and the return, in some cases, of the residual method for computing SSP
I will cover each of these changes in more detail in future blogs, but in summary this standard will likely require earlier recognition of revenue and later recognition of expenses than currently allowed in GAAP. Whether that is good or bad is up to you.
I was originally going to title this blog “FASB Opposes Diversity…In Business Reporting.” Yes, it is a little sensationalist, but isn’t that what we are supposed to do to get you to read these things? And isn’t opposing diversity in reporting one of the lynchpins of many FASB projects? In fact it often times seems to be the primary reason for an item being added to the EITF agenda. (For those of you thinking that is the EITF and not the FASB, I would note for you that in its current structure all EITF decisions must be approved by the full FASB Board before they are issued.) If you don’t believe me look at the recent spate of ASUs that have been issued through the EITF process. In almost every case one of the cited reasons for needing to address the issue in the first place is “diversity in practice” on how the underlying transactions were being reported from one business to another.
So why did I decide against naming the blog “FASB Opposed Diversity…?” Because I read a recent letter from Russ Golden, the FASB Chairman, which made it clear that FASB is willing to tolerate diversity – differences – in reporting, at least when it comes to differences in standards issued from the FASB and IASB. That letter made it clear that converging standards for convergence sake is not enough of a reason to change U.S. GAAP. Or in Russ Golden’s words “When standards proposed for convergence do not represent an improvement to U.S. GAAP, we have no choice but to do what we believe is in the best interests of investors who use it.”
Of course “improvement” is like beauty and is based on the eye of the beholder. In the FASB’s case, they focus on users of financial statements (investors) to determine if changes are an improvement. That is not to say they don’t listen to auditors and preparers, but users of financial statements are clearly “more equal” than other constituents to borrow a phrase from Animal Farm. And it appears that the FASB may have an attitude that U.S. GAAP is “more equal” than IFRS when it comes to accounting standards. If that is true, then the leasing and financial instrument standards may be the last “converged” (or maybe not so converged) standards we see for a long time.
The FASB has been looking quite a lot at Goodwill lately. First, they changed the impairment testing standard to allow an option of performing a qualitative test first. While most public companies did not use this option, up to 30% of all companies (public and private) used the standard for at least some of their reporting units in 2012. One of the biggest complaints about the qualitative test was not the test itself, but how the auditors were interpreting the requirements of the standard which resulted in almost as much or more work as performing a step one test in the first place.
The second action was taken by the Private Company Council (PCC) and recently approved by the FASB to allow private companies the option of simply amortizing goodwill over a default 10 year or other more appropriate period. The amortization option would eliminate the required annual impairment test and only require an impairment test when certain triggering events occur; much like the way impairment testing for PP&E is handled today.
The PCC action caused the FASB to relook at the whole concept of goodwill and how it should be accounted for in the financial statements. The FASB recently met to discuss possible options and the discussion was truly far ranging from whether goodwill is an asset at all to keeping it as an asset but changing the why we look at and test for impairment.
The question of goodwill being an asset is an interesting one. When it comes to goodwill as a distinct asset, you can’t buy it or sell it, but clearly companies paying more than the fair value of the hard and intangible assets of a company are buying something. The questions are does that “something” diminish in value over time and should that “something” be supported solely by the acquired business or can you build new businesses that continue to support that value in the future. Current accounting for goodwill would seem to answer those questions with a maybe and a yes. Impairment would indicate the value can diminish, but because we don’t amortize goodwill, the diminishment is not a given. In addition, the way goodwill is tested at the reporting unit level (rather than the acquisition unit level for example) would indicate that we believe goodwill can be supported by new businesses only tangentially related to the business acquired that created the goodwill in the first place.
The FASB has instructed its staff to look further into the issues around goodwill accounting by completing research on two alternatives to today’s accounting for goodwill. The first is a simplified one-step impairment test process and the second is a much more radical direct write-off approach (although not necessarily through the income or comprehensive income statements).
The FASB is dealing with lots of questions about the costs and benefits of current goodwill accounting. Goodwill impairments seem to have little to no impact on stock price which would seem to mean that there is little value (benefit) in the information provided by a goodwill impairment. On the other hand, a direct write-off may eliminate important information of the return on assets that investors need to know and understand.
While not as impactful as revenue recognition, lease accounting or financial instruments, the accounting for goodwill might bring out the passionate accounting purest viewpoints much like happens whenever the topic of the accounting for share-based compensation is brought up. (If you want to start an argument with another technical accountant just take the position that share-based compensation is 100% expense or 100% an equity transaction see what happens). This one might be worth keeping an eye on as the FASB continues to revisit the issue throughout this year.
With the revenue recognition standard about to be issued and Financial Instruments, Leases and Insurance contracts in various stages of deliberations, the FASB is starting to spend some time thinking about what should come next on its agenda. While the FASB has its own list, here are a few of my suggestions (some of which are on the FASB’s list):
- Segment reporting – If nothing else, some of the concepts behind the current segment reporting standard need to be revisited. In a world where anyone in the company from the CEO to the first line manager can dive into any level of detail about financial transactions in seconds, the concept of “a” report the Chief Operating Decision Maker uses to decide where and how to allocate resources is so ‘90’s as to be laughable.
- Whatever per share – If Other Comprehensive Income and Cash Flow are so important then why won’t the FASB relent and finally allow/require companies to report OCI per share or Operating Cash Flow per share. It’s not like investors can’t compute these numbers on their own today and maybe by thinking about it we can decide if the calculations of dilutive shares that we compute for net income per share should be the same or different for these other amounts per share.
- Intangible Assets – in a world where a many companies’ values are no longer linked to the assets recorded on the balance sheet we have to ask what are we missing. The answer is Intangible assets. If you truly want to help investors predict future cash flow, then we need to consider valuing the assets that are going to create that value. While our current depreciation model for PP&E is not perfect, it is at least a somewhat reasonable approach to such assets. Most PP&E does decline in value over time as it is used up and the parts of PP&E that don’t use up value like land and artwork are not depreciated. I understand that well maintained office buildings and retail space does go up in value, but maybe the chief issue there is the way we require/allow the expensing of so much maintenance cost. Either way, at least PP&E has some value on the balance sheet unlike most intangibles that are created by businesses each day.
- Share-based compensation – I will probably get a lot of hate mail on this one, but if we would all just finally admit that share-based compensation is just that – compensation – and record compensation expense to the current value of shares owed each period, the accounting would be a lot simpler and lot more accurate and comparable across companies. And I won’t even mention how much simpler the footnote would be!
That’s enough from me. What do you think the FASB should be working on to make financial reporting better, more transparent and easier to understand?
The FASB issued an Exposure Draft (ED) on Going Concern Reporting last month. At a high level, the ED will require preparers to evaluate and potentially report on their going concern status. The evaluation is a multi-part process including different criteria for twelve months out and twenty-four months out; in addition, SEC filers might also determine if there is substantial doubt about their ability to continue as a going concern. The big change here is that the preparer is required to evaluate and report on their going concern status where as today that is generally considered an auditor requirement. I say generally considered because many SEC filers address much of the going concern evaluation criteria and disclosures in their current MD&A disclosures.
That leaves us two ways to look at this. One is that for SEC filers this is just a geography issue while for private companies this is truly new disclosure. The other is that for both types of filers, the FASB is continuing to advance that line of including forward looking information in the historical financial statements. Of course MD&A disclosures of forward looking information get some protection under SEC safe harbor regulation while information in the financial statements receives no such protection. In addition, because of the difference in the exact disclosure language, it is likely that most SEC filers will not be able to simply reference the financial statements, but instead will have to include the appropriate disclosures in both places once again expanding the size of the annual report. Another consideration is that due to the safe harbor provisions, the preparer might be willing and able to discuss other going concern impacting issues that make the disclosures more transparent and complete than anything that would ever be included in the financial statements.
I began to wonder if this standard was really necessary at all, but that kept bringing me back to the fact that private companies do not have the same disclosure requirements as SEC filers and therefore are not including anything about going concern currently in their annual report. With the Private Company Council working hard to eliminate or simplify accounting standards and disclosures for private companies I thought maybe this going concern disclosure issue is really something that goes the opposite direction. Maybe this is a standard that is needed for private companies, but is not necessary for SEC filers. That certainly would be an interesting development – truly different disclosures for private companies – rather than just a subset that subtracts from what is required of public companies. Now that would be a truly interesting debate.