Recent FASB Standard Setting Activities including Convergence Decisions

1. Recent FASB Standard Setting Activities including Convergence Decisions Katherine SCHIPPER • Board Member, • Financial Accounting Standards Board • United States

2. FASB—Summary of Current Activities Katherine Schipper Financial Accounting Standards Board World Congress of Accounting Educators Hong Kong November 2002 The views expressed in this presentation are my own and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation.

3. FASB Structure • Independent private sector accounting standard setting organization • Established 1973 • Currently responsible for setting US GAAP • US GAAP (or reconciliation, if a non-US firm) required of all SEC registrants • Board consists of 7 full time members • All members are independent • Represent: preparer (2), user (1), audit (3), academic (1) • 5 year terms, staggered across members • Supported by approximately 40 professional staff

4. Overview of presentation • Principles-based standards • Revenue recognition (joint with IASB) • Performance reporting • Short-term convergence project, with IASB • Fair value measurements

5. Principles based standards Response to claims that US GAAP is “rules based” or “check box” • Favorable comments (in the financial press) on International Accounting Standards, which are described as broad, principles-based, requiring the appropriate exercise of professional judgment Remark: The FASB uses its Conceptual Framework to set standards, so the “rules based” approach might be viewed as arising from deviations from the precepts of the Conceptual Framework, or from the addition of unnecessary detailed implementation guidance

6. What would “principles based standards” imply? Proposal paper is available at www.fasb.org • No scope exceptions? • No treatment alternatives? • Extremely limited implementation guidance? • Noncomparability? • Implications for preparers? • Implications for auditors? • Implications for enforcement? • Implications for other sources of financial reporting guidance?

7. Possible approach to setting principles based standards • Articulate the objective [what is intended] of the standard, within the context of the Conceptual Framework • Requires explicit expectations about the exercise of professional judgment in meeting the stated objective of the standard • Eliminate (drastically reduce) exceptions and alternatives • Provide limited implementation guidance • Sufficient detail to apply provisions consistently [over time] • Accept some noncomparability across entities • Reconsider arrangements for implementation guidance • Roles of other bodies such as EITF and AcSEC • Convergence arrangements with the IASB • Requires shifts in behavior from all involved parties: FASB, other standard setting bodies, preparers, auditors, SEC

8. Revenue recognition Project added to FASB’s agenda May 15, 2002 • Project is joint with IASB • Revenue recognition issues are significant and pervasive • Largest single item in most financial statements • US GAAP contains no general standard on revenue recognition • Broad conceptual guidance is hard to apply and may be inconsistent • Detailed guidance is ad hoc and industry/transaction specific • FASB research indicates over 100 sources of revenue recognition guidance in the US • Revenue recognition issues increase in number and complexity as commercial arrangements to deliver goods/services increase in complexity

9. Revenue recognition Project goal: Develop a general standard on revenue recognition and reconcile inconsistencies in the FASB’s conceptual framework • Concepts Statement 6 defines revenues in terms of changes in assets and liabilities • Concepts Statement 5 adds several paragraphs of recognition criteria that are specific to components of earnings • Realized or realizable => readily convertible to cash or claims to cash • Earned => process or set of activities; “entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.”

10. Revenue recognition Issues to be considered • Should revenue recognition be subject to special criteria (over and above asset and liability recognition criteria)? • Can result in “deferred revenues” that are not liabilities • Is “earnings process” useful as a basis for revenue recognition? • Earnings process seems to be the basis for SAB 101 (which is based on SOP 97-2, Software revenue recognition) and for several other key pieces of US GAAP reporting guidance • Earnings processes are specific to, and derived from, business models • Revenue recognition approaches based on earnings process => reflect industry-specific and business-model-specific factors • Volume and complexity of guidance will increase as business models evolve • Is the distinction between revenues and gains useful?

11. Revenue recognition Examples of liability and asset recognition issues • Customer has paid in advance, and the entity has a performance obligation • Does it matter whether the customer has a continuing obligation? • Does the nature of the entity’s performance obligation matter? • Customer does not pay until the entity has fully performed • Does it matter if some of the revenue is contingent? • Does it matter if the entity must estimate the amount of cash to be collected? • How should the components of overall performance be accounted for?

12. Revenue recognition Should revenue recognition differ for specific kinds of performance obligations? • Provide access (e.g., connect a customer to a public utility network) • Provide services • Stand ready (e.g., guarantees; warranties) • Stand aside (e.g., noncompete arrangements) • Repurchase an asset (e.g., specific trade-in rights) Should revenue recognition differ, depending on the sacrifice the entity must make? • Refund cash • Provide goods • Provide services • Provide use of an asset (e.g., a lease)

13. Revenue recognition What should be the accounting for linked transactions and components? • Contracts for the provision of both goods and services • Installation of asset and subsequent service that requires the asset • Sales linked to incentives (e.g., discounts on future purchases) How should revenues be displayed? • Are revenues conceptually distinct from gains? • Under what conditions should revenues be shown gross? • Under what conditions should revenues be shown net (of some cost)?

14. Performance reporting • IASB and the UK’s ASB have undertaken a joint project • FASB is monitoring • Discussed at joint FASB-IASB meeting September 18 • Project scope and activities (FASB) • Display, classification and aggregation of all four basic financial statements • Will not concern segment reporting, MD&A • FASB has consulted extensively with users of financial statements • Tentative decisions and ongoing discussions • Single statement of comprehensive income • Classification by function (e.g., sales) not by nature (e.g., depreciation) except for income taxes and discontinued operations

15. Performance reporting • Ongoing discussions (joint meeting with IASB) about display in a statement of comprehensive income • Goal is to enhance predictive value and feedback value • Separate financing from operating elements? • Separate initial measurements from remeasurements? • Initial measurements => close to income flows • Remeasurements => valuation adjustments • Distinctions can be very difficult in some cases • FASB goals • Co-ordinate activities and approach with the IASB-ASB project • Attempt to resolve issues in ways that increase convergence • Exposure Draft expected sometime in 2003

16. International convergence • Convergence, as a concept, has few or no detractors • Convergence, as a process, is yet to be fully specified • Added sense of urgency => 2005 requirement that listed firms in European Union jurisdictions must use international standards (IFRS) • New standards • Joint with IASB • Monitor IASB’s projects • Goal => develop the same standard and (eventually) converge agendas • Hundreds of existing differences • New standards on financial instruments could add more

17. International convergence • “Short term” convergence project to address existing differences • Goal => choose between existing IASB and FASB standards Examples: Asset exchanges, transition, voluntary accounting changes, interim reporting, research and development • Achieve “substantial convergence” by 2005? • Most frequently occurring differences? • Largest items in magnitude? • How will this project affect U.S. GAAP? • Convergence => changes to U.S. reporting requirements in the absence of complaints and identified problems • Immediate costs to preparers and users • Benefits to be realized in the future

18. Fair value measurement issues • US GAAP is increasingly requiring fair value measures • Examples: • Asset retirement obligations (except for historical discount rate) • Acquired assets and liabilities in a business combination • Impaired assets (inventory, fixed assets, goodwill) • (Disclosed) fair values of financial instruments • Guarantees (whether or not a cash premium is received) • Derivatives • Intent is to increase the relevance of financial reports • Fair value => relevant measure for incomplete transactions • Fair value => the only measure for certain derivatives • Key question: what is the reliability of the reported numbers?

19. Fair value measurement issues • Assessing the reliability of fair value measures • Reliability => users of financial reports can depend on the reported numbers to represent the economic conditions (transactions, events) they purport to represent • Verifiability => consensus among various measurers of the same construct (low dispersion of independent measurements) • Representational faithfulness => correspondence between the measure and the phenomenon being measured

20. Fair value measurement issues • An empirical question: What is the actual reliability of reported fair value measures? • Fair values of impaired goodwill or fixed assets • Fair values of financial instruments • How does the reliability of fair value measures compare with the reliability of other estimates in financial reports? • What causes unreliable measures? • Intrinsic error in the measurement tools (models) • Management-induced error • Research design issues • Lack of benchmarks for reliability assessments • Lack of access to underlying data used to generate measures