Emerging Accounting Matters

1. Emerging Accounting Matters CFMA Day - November 4, 2013 Brandon Maves

2. Remember • This presentation does not provide official McGladrey LLP accounting guidance. • The views expressed are solely those of the presenter and are not official McGladrey LLP positions.

3. Presenter Brandon Maves Partner National Construction Industry Leader McGladrey LLP 612.376.9324 brandon.maves@mcgladrey.com

4. Contents • Lease accounting • Revenue recognition • Private Company Council

5. Lease Accounting To provide a financial statement reader with a more accurate presentation of the assets an entity has the right to use and obligations the entity must pay to use those assets. Expected effective in 2017-2018 Exception: Leases whose maximum term, including options, is 12 months or less. These are treated as off-balance sheet operating leases consistent with current practice.

6. Lease Accounting (continued) Industries impacted: • Banking • Retail • Construction • Real Estate “I want fly in a plane that sits on somebody’s balance sheet” –IASB Board.

7. Lease Accounting (continued) Existing operating versus capital criteria: • Is there a transfer of title at the end of the lease? • Does the lease contain a bargain purchase option? • Is the term of the lease = or > 75% of the life of the leased asset? • Is the present value of the minimum lease payments = or > 90% of the fair market value of the leased asset? If YES to any of the above, then the lease is considered capital (on-balance sheet). If NO to all then lease is considered operating (off-balance sheet)

8. Lease Accounting (continued) Lessee/Lessor: Lease term: All periods the lessee has the right to use the asset, including any optional periods for which the lessee has significant economic incentive to exercise these options. Ex: Customization (nontransferable) vital to the lessee business, significant economic penalties for cancellation or nonrenewal.

9. Lease Accounting (continued) Lessee/Lessor: Lease payments: • All fixed lease payments • Residual value guarantees • Exercise cost of purchase price options • Penalties to terminate the lease if the lessee has significant economic incentive to terminate the lease early.

10. Lease Accounting (continued) Lessee/Lessor: Discount rate: • The rate the lessor charges the lessee (rate implicit in the lease) OR, if unable to determine • The lessee’s incremental borrowing rate.

11. Lease Accounting (continued) Lessee/Lessor: Type: Dependent on if the lessee’s economic consumption of the leased asset is expected to be more than insignificant (Type A) or insignificant (Type B) .

12. Lease Accounting (continued) Lessee/Lessor: Practical expedients: • If there is a significant economic incentive to exercise purchase option, Type A. • Non real estate asset leases are presumed to be Type A. • Real estate leases are presumed to be Type B. • Lease classification is not reassessed after the commencement date.

13. Lease Accounting (continued) Lessee (Inception): At inception the lessee will recognize an asset and a liability equal to the present value of the lease payments incurred over the term of the lease.

14. Lease Accounting (continued) Lessee (Type A): Asset: The leased asset is amortized over the lesser of the term of the lease or its useful economic life. Liability: The lease obligation will be reduced in a manner similar to the payment of long-term debt. The lessee will recognize interest expense and reduce the liability for “principal” payments. “Rent expense” consists of amortization and interest.

15. Lease Accounting (continued) Lessee (Type B): Asset: The leased asset is amortized over the term of the lease at a rate necessary to create a straight-line “rent expense”. Liability: The lease obligation will be reduced in a manner similar to the payment of long-term debt. The lessee will recognize interest expense and reduce the liability for “principal” payments. “Rent expense” consists of amortization and interest.

16. Lease Accounting (continued) Lessee (Type A vs. B): Type A: Rent expense is front end loaded with a greater expense in the early lease periods. Type B: Rent expense is the same over the lease term.

17. Lease Accounting (continued) Lessor (Type A): At inception: • Derecognize the carrying amount of the underlying asset. • Recognize a lease receivable at the present value of the lease payments, discounted at the rate the lessor charges the lessee. • Recognize a residual asset at the present value of the leased asset’s expected value at the end of the lease term, less any unearned profit. • Recognize any profit or loss resulting from the lease.

18. Lease Accounting (continued) Lessor (Type A): Lease receivable: The leased asset value increases to reflect the unwinding of the discount and is reduced by lease payments. Residual asset: The residual asset value increases to reflect the unwinding of the discount. At the end of the lease term the asset is reclassified to the appropriate asset class and accounted for accordingly into the future.

19. Lease Accounting (continued) Lessor (Type B): Type B leases are accounted for in a manner to current practice for operating leases with rental income being recognized on a straight-line basis over the term of the lease.

20. Lease Accounting (continued) Considerations: • No “grandfather”clause – significant transition cost • Own versus lease on: • Equipment • Single tenant , single use properties, particularly customized solutions • Implications on existing and future contracts: • Compensation agreements • Earn-out agreements • Distributions

21. Lease Accounting (continued) Considerations: • Financial compliance • Debt to equity • EBITDA, EBIT and NI based metrics • Business development • Need to understand your customers • Suggested solution: • Consider implications of guidance change and evaluate cost/benefit of addressing now versus later.

22. Revenue Recognition To provide a single revenue recognition model that would replace all (or most) current U.S. GAAP and IFRS revenue recognition guidance. Expected effective in 2018

23. Revenue Recognition (continued) Steps: • Identify the contract with a customer. • Identify the separate performance obligations in the contract. • Determine the transaction price. • Allocate the transaction price to the separate performance obligations. • Recognize revenue when (or as) each performance obligation is satisfied.

24. Revenue Recognition (continued) Use of existing guidance: “The board would not expect…accounting firms to be developing guidance based on old…GAAP to supplement the new standard” – Leslie Siedman, FASB Chairman Management should develop criteria for determining the appropriate revenue recognition.

25. Revenue Recognition (continued) In practice, existing guidance is expected to play a factor in determining the resolution of performance obligations. • Task forces in place to evaluate industries. • Nuanced differences: • Construction contacts not at contract level but at service level (design, mobilization, construction, management) Devil’s in the details!

26. Revenue Recognition (continued) Considerations: • Contract value in total and its components • Consider change orders, claims, discounts,. • Link to collectability – is their significant risk about customer’s ability to pay? • Net revenue versus bad debt. • Commitment • Separate the delivery of a service and a good, if the customer can benefit from either individually. Ex: design/development services and construction of a building.

27. Revenue Recognition (continued) Considerations: • How are performance obligations satisfied and measured. • Model is more control based rather than transfer of risks and reward. • Contract costs – direct costs of fulfilling a contract or anticipated contract are capitalized if: • Costs generate a resource that will be used to satisfy a performance obligation.

28. Revenue Recognition (continued) Considerations: • Time value of money considerations • Present value if there is a significant financing component. • Retention on construction contracts. • Multiple services/goods or combination • Allocate based on stand-alone selling prices

29. Private Company Exceptions To modify financial reporting to meet the needs of private companies by: • Providing the Private Company Council (PCC) as the primary advisory body to the FASB • Determining when modifications to US GAAP should be considered for private companies

30. Private Company Exceptions (continued) A nonpublic (private) entity includes, with some exceptions: • A privately held business, whose ownership is not traded on an exchange. • A privately held financial institution • A consolidated subsidiary of a public entity • A private company that consolidates or controls a public entity.

31. Private Company Exceptions (continued) Identifying and recognizing intangible assets in a business combination: • Intangible assets only from recognized enforceable and noncancellable (except in default) contractual/legal rights. • Less likely to recognize: • Customer related intangibles are less likely to be recognized, particularly noncontractual customer lists • Trademark names

32. Private Company Exceptions (continued) Accounting for goodwill subsequent to a business combination: • Amortize over the useful life of the primary asset of the acquired business, not to exceed 10 years. • Goodwill will be tested for impairment in the event of a trigger. This assessment will be done at the entity-wide level not the reporting unit level. • Impairment assessment would be a one-step test. The impairment, if any, would be the difference between the fair value and the carrying value of the entity.

33. Private Company Exceptions (continued) Accounting for certain receive-variable, pay-fixed interest rate swaps: • A nonpublic entity seeks to convert variable rate debt to fixed rate debt through an interest rate swap agreement has two alternatives: • A swap that meets the criteria (next slide) would not be required to be accounted for under the current interest rate cash flow hedge accounting model. Eliminates need for derivative accounting. • A “simplified method” could be used, which would may applying hedge accounting easier and avoid P/L swings.

34. Private Company Exceptions (continued) Criteria: • Variablerate on swap and the debt are based on the same index. • Terms of the swap are typical with no floors or caps, unless debt has a comparable floor or cap. • Re-pricing and settlement dates for the swap and debt match (differ by no more than a few days) • Swaps fair value at inception is zero or near zero • Swap is not a forward-starting swap

35. Private Company Exceptions (continued) Criteria: • Notional amount of swap is equal to or less than the principal amount of the debt. • Term of the swap is equal to the term of the debt (differ by no more than a few days) • Swap is effective at the same time as the debt (differ by no more than a few days) .

36. Private Company Exceptions (continued) VIE Guidance to Common Control Leasing Arrangements: • Pertains only between two entities under common control. • That are involved in a leasing arrangement. • Where the only activity between the two entities is the leasing arrangement. Management would make a policy decision to not consolidate the lessor entity but instead would…

37. Private Company Exceptions (continued) …would add the following disclosures: • The key terms of the leasing arrangement • The amount of debt or significant liabilities held by the lessor entity. • The key terms of the debt agreements of the lessor entity, such as: • Interest rate • Maturity • Collateral • Guarantees, if any. • The key terms of any other explicit variable interest in the lessor entity.

38. Private Company Exceptions (continued) The reporting entity would apply this policy to all its leasing arrangements that meet the requirements for applying this approach. A full retrospective approach would be used to apply this policy alternative.

39. Questions?

40. McGladrey LLP Brandon Maves 612.376.9324www.mcgladrey.com