FASB Update with Comparison to IFRS

1. FASB Update with Comparison to IFRS For Acct 592 Spring 2008

2. 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.

3. Changes in Principles, Estimates, Entities & Corrections of Errors SFAS No. 154 - Accounting Changes and Error Corrections

4. 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

5. SFAS No. 154 - 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

6. 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

7. Depreciation Example • Consider these facts related to an asset acquired January 1, 2010: • The company uses straight-line depreciation • Assume that after 2 years, it becomes obvious that the asset will be used for a total of 8 years • At the end of 8 years, it will be worth $10,000 • What depreciation expense should be recorded for 2012?

8. 160,000 -10,000 = 6 Solution – Prospective Method • $240,000 - 40,000- 40,000 =$160,000Carrying Value • new estimate • $ 25,000 • 8 - 2

9. 240,000 -10,000 = $28,750 8 Alternate treatment – IFRS (Cumulative effect method) • If we had originally known new facts: • We would have had $57,500 in accumulated depreciation at end of 2011. • Actually in acc’d depreciation = $80,000 • Make adjusting JE and then continue with $28,750 depreciation for remaining useful life

10. 240,000 -10,000 = $28,750 8 Alternate treatment – IFRS method? 2012 Correcting JE: Acc’d Depr 22,500 Depr Exp 22,500 Record 2012 depreciation: Depr Exp 28,750 Acc’d Depr 28,750

11. Example - Coal Mine • Cost of property $9,000,000 • Cost to restore property $1,200,000* • Value after restoration $1,000,000 • Recoverable resources 4,000,000 tons • First year production 150,000 tons • Sold for $30 per ton • Statutory depletion rate for tax purposes = 10% • * Present value (asset retirement obligation measured in accordance with SFAS No. 143)

12. Coal mine example: • Cost basis + cost to restore - residual value after restoration Total estimated recoverable units • $9,000,000 + 1,200,000 - 1,000,000 = 4,000,000 tons $2.30 per ton • Sold 150,000 tons, therefore cost depletion = 150,000 * 2.30 = $345,000

13. Coal mine example, continued • Assume that 250,000 tons of coal were produced and sold during the second year of operation • However, new EPA regulations increased the projected restoration costs to $2,000,000 (asset retirement obligation) • At the beginning of the second year of production, geologist estimate 4,050,000 tons remain • We start over estimating the depletion rate per ton -- using the current BOOK VALUE instead of cost

14. Coal Mine Example • Cost basis + cost to restore - residual value after restoration Remaining recoverable units (estimated) • Cost basis is now $9,000,000 - $345,000 = $8,655,000 • The new estimate of recoverable units (including 2nd year’s production) is 4,050,000 tons(3,800K left + 250K mined this year) • The cost to restore is now $2,000,000 • $8,655,000 + $2,000,000 - $1,000,000 = $2.38 per ton 4,050,000 • 250,000 tons * $2.38 = $595,000 depletion expense

15. Statutory Depletion • Note that the tax deduction would be much higher using statutory depletion allowance (a permanent difference between accounting and tax return) • Year 1 - 150,000 tons * $30 per ton = $4,500,000 revenue * 10% statutory rate = $450,000 on tax deduction vs. $345,000 on income statement • Year 2 - 250,000 tons * $33 per ton = • $8,250,000 Revenue * 10% statutory rate = $825,000 tax deduction vs. $595,000 on income statement

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. Fair Value Measurements SFAS No. 157 Signs of the Future!

19. FAS157 Issued Sept. 2006 • With a few exceptions, it does not change WHAT is currently measured using fair value • Sets out a framework for measuring fair value • Requires additional disclosures about fair value measurements

20. FAS157 – Definition of Fair Value • Paragraph 5 - 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. • This is an exit-price definition of fair value (see paragraph 7)

21. FAS157 – Related definitions • Market Participants (4 criteria) • Independent of reporting entity • Have knowledge needed for reasonable understanding about transaction • Financial and legal ability to enter into the transaction • Be willing to enter into transaction without compulsion

22. Accounting Changes & Corrections - summary • SFAS No. 154 discusses 3 types of accounting changes plus correction of errors • Changes in Accounting Principle retroactive • Changes in Accounting Estimates prospective • Changes in Reporting Entity retroactive • Errors in Financial Statements retroactive

23. Fair Value Measurements SFAS No. 157 Signs of the Future!

24. FAS157 – Related definitions • Principal Market • Has the greatest volume and level of activity. • If there is no principal market, use the most advantageous market • Most Advantageous Market • Most advantageous market has price that maximizes the net amount that would be received or minimizes the net amount paid • Transactions costs are included in determining which market to use but do NOT become part of the fair value measurement

25. Example of which market… $48

26. FAS157 – Related definitions • Assumptions about the market • The asset or liability is exchanged in an orderly transaction between market participants • An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; • it is not a forced transaction (for example, a forced liquidation or distress sale). • The price is for a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the item

27. FAS157 – Related definitions • Valuation premise – the assumption about how market participants would use an asset • Choose the premise based on “highest and best use” • In-use premise • Provides maximum value through use in combination with other assets • In-exchange premise • Provides maximum value principally on a stand-alone basis

28. Valuation Techniques • Market approach • Uses observable prices from market transactions for comparable assets or liabilities • Income approach • Analysis of future cash flows using present values • Cost approach • Estimates cost to replace an asset’s service capacity A change in valuation technique is a change in accounting estimate, not a change in accounting principle

29. The “Fair Value Hierarchy”

30. Valuing Liabilities • The valuation technique must consider the reporting entity’s credit standing • A reporting entity could record a GAIN for derivatives at a measurement date because the fair value of the liability decreases in response to a credit downgrade if all other inputs remain unchanged

31. Restrictions on Assets • Restrictions are evaluated to determine whether they are an attribute of the asset or an attribute of the reporting entity • If sold, would the restriction transfer to another holder? • If yes, the impact of the restriction would be taken into consideration (adjust asset fair value downward) • If no, the restriction would not reduce the fair value

32. Other provisions of FAS157 • It is now possible to recognize a gain on the day recognized (previously prohibited under EITF 02-3) • Blockage adjustments are not permitted in pricing • Bid-ask spreads • Use the price within the bid-ask spread that is most representative of fair value in the circumstances

33. FAS 157 Disclosures • Will be extensive and reported in three sections (see paragraph A33-A36 for examples) • Assets and liabilities measured at fair value on a recurring basis • Tabular display reconciles beginning and ending amounts when significant Level 3 inputs are used • Assets and liabilities measured at fair value on a nonrecurring basis (impairment of assets, etc.) • For all fair value measurements, a table showing the reliance on Level 1, 2 or 3 inputs plus discussion of the valuation techniques used for the measurements

34. FAS 157 – effective date • Implementation is prospective • Required for financial statements issued for fiscal years beginning AFTER Nov. 15, 2007 • A new FSP has delayed the effective date for ‘HIERARCHY LEVEL 3’ measurements like asset retirement obligations

35. FAS 159 – The Fair Value Option Optional use of fair value for certain assets and liabilities

36. Essentially a one-time election • On a contract by contract basis, company can designate specified financial instrument to be accounted for using fair value instead of the usual measurement technique • Companies may be able to reduce volatility in reported earnings caused by measuring assets and liabilities differently

37. Other “benefits” • Movement toward accounting for all financial instruments at fair value • Brings US GAAP into closer agreement with IASB 39 which already contains a fair value election • However, it is not “perfect agreement”

38. Eligible assets & liabilities • Most recognized investments including those currently accounted for using the equity method • But cannot be used to recognized investments that must be consolidated (VIEs, subsidiaries) • Many recognized liabilities • Excluding leases, demand deposits of banks, postretirement plans, etc.

39. Eligible assets & liabilities • Firm purchase commitments that would otherwise not be recognized at inception (but only for ones involving financial instruments) • Rights and obligations under warranties that meet certain requirements • Certain host financial instruments that result from separation of embedded nonfinancial hybrid instruments under FAS133

40. Irrevocable election • Must be applied to contracts as a whole and not to parts of contracts • Changes in fair value will be recognized in earnings during each reporting period

41. Election date • Transition – any eligible item as of the date that FAS159 is initially adopted • Thereafter: • The eligible item is first recognized (including entering into an eligible firm commitment) • Occurrence of a short list of other events

42. Disclosures • If fair value option is elected, company must disclose separately assets and liabilities measured at fair value from those not measured at fair value • Intended to help readers compare companies that choose the option to those that choose not to elect fair value accounting

43. Disclosures – specific (1) • Why fair value option was selected for each eligible item • Difference between fair value and aggregate unpaid principal amounts • Relation to other fair value measurements under FAS157 • Description of partial applications to groups of similar items and why company chose not to be consistent

44. Disclosures – specific (2) • Loans carried at assets at fair value that are past due by 90 days or more • APB18 disclosures about investments that would otherwise have been reported using equity method • Description of how interest and dividends are measured and reported for items with fair value election • Quantitative information (line by line) as to where gains and losses related to fair value option have been reported in the income statement

45. Comparison to IFRS • IFRS {IAS39} • Significant restrictions on applying FVO • Documented strategy required to support use of FVO • FVO must generally be applied to all eligible financial instruments that are managed and evaluated together • Entities cannot reclassify financial instruments into or out of FVO while held • FVO not available to insurance contracts and warranties • U.S. GAAP {FAS159} • Wider scope of application with fewer restrictions to use • FAS159 does not prescribe how documentation of the FVO should be created and maintained • FVO need not be applied to all instruments issued or acquired in a single transaction • Greater opportunity to elect the FVO • FVO can be applied to insurance contracts and warranties

46. What’s Next?

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

48. Exchanges of nonmonetary assets • Formerly had special rules for exchanges of “similar assets” • Losses were recognized • Gains were not recognized or only partially recognized (if boot {cash} was received) • Those rules are now GONE • Probably a good thing since the new rules are actually less complicated!

49. From Kieso Update2 for 11th ed.

50. SFAS No. 153 –Exchanges of Nonmonetary Assets • Nonmonetary exchanges are recognized at the fair value of the nonmonetary asset relinquished (unless fair value of asset received is more clearly evident) • EXCEPTIONS 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.