IFRS and GAAP Convergence Update Presented December 10, 2011 at Penn State University 611 Campus, Abington, PA by Joel Wagoner, MBA, CPA, CMA, CFM Assistant Professor of Business Administration Arcadia University

IFRS and GAAP Convergence Update Questions: Is the SEC going to require us to use IFRS? If so, when? Why aren’t we hearing as much about this as we did a few years ago? Are we going to have to learn IFRS? What will become of the FASB if we adopt IFRS?

IFRS and GAAP Convergence Update The potential conversion to IFRS has been a concern in the Accounting profession since the Securities and Exchange Commission first published their “roadmap” for conversion in 2008.

IFRS and GAAP Convergence Update The SEC released Publication in 2010, supporting “a single set of high-quality globally accepted accounting standards.”

IFRS and GAAP Convergence Update Few would disagree with the desirability of a single set of financial reporting standards and accounting principles. The question: How do we go from our divergent sets of principles, GAAP and IFRS, to a single set of high-quality standards?

IFRS and GAAP Convergence Update The SEC published a work plan to determine whether to require American publicly traded corporations to present their financial statements in accordance with International Financial Reporting Standards (IFRS.)

IFRS and GAAP Convergence Update The work plan “addresses [six] areas of concern that were highlighted by commenters” on the 2008 roadmap: 1 – Sufficient development and application of IFRS for the U. S. domestic reporting system;

IFRS and GAAP Convergence Update 2 – The independence of standard setting for the benefit of investors;

IFRS and GAAP Convergence Update 3 – Investor understanding and education regarding IFRS;

IFRS and GAAP Convergence Update 4 – Examination of the U. S. regulatory environment that would be affected by a change in accounting standards;

IFRS and GAAP Convergence Update 5 – The impact on issuers, both large and small, including changes to accounting systems, changes to contractual arrangements, corporate governance considerations, and litigation contingencies;

IFRS and GAAP Convergence Update 6 – Human capital readiness.

IFRS and GAAP Convergence Update In a progress report dated October 29, 2010, the SEC stated that a decision on whether or not to require IFRS in America would depend in part on the progress that the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are marking towards the convergence of American Generally Accepted Accounting Principles (GAAP) and IFRS.

IFRS and GAAP Convergence Update The FASB and IASB have been working towards the convergence of American and International standards since 2002.

IFRS and GAAP Convergence Update The two boards had an ambitious agenda for Here is the status of the items on their agenda:

Statement of Comprehensive Income The FASB published Accounting Standards Update , Comprehensive Income (Topic 220): Presentation of Comprehensive Income in June, 2011.

Statement of Comprehensive Income Net income and comprehensive income must either be presented on the same report, or on consecutive reports.

Statement of Comprehensive Income This is effective for publicly traded entities with reporting dates after December 15 of this year. It is effective for nonpublic entities with reporting dates after December 15, 2012.

Statement of Comprehensive Income The boards recognize that there remain differences in what constitutes “other comprehensive income” between GAAP and IFRS.

Statement of Comprehensive Income There will also be differences in the timing of reclassifications between other comprehensive income and net income.

Fair Value Measurement The FASB published Accounting Standards Update , Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value measurement and Disclosure Requirements in U. S. GAAP and IFRSs.

Fair Value Measurement The two boards sought to “ensure that fair value has the same meaning” in GAAP as in IFRS, “other than minor necessary differences in wording or style.”

Fair Value Measurement The amendments in ASU “explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting.”

Fair Value Measurement “The Board (FASB) does not intend for the amendments in this Update to result in a change in the application of the requirements in Topic 820.”

Fair Value Measurement “Some of the amendments clarify the Board’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements.”

Revenue Recognition On November 14, 2011, the FASB reissued a Proposed Accounting Standards Update (what we used to call an “exposure draft”) on Revenue Recognition (Codification Database Topic 605.)

Revenue Recognition The FASB and IASB had received almost 1,000 comments in response to an earlier version of the Proposed Accounting Standards Update (Exposure Draft). The earlier version had been released in June, 2010.

Revenue Recognition “[R]evenue recognition requirements in...GAAP differ from those in...[IFRS], and both sets of requirements are considered to be in need of improvement.”

Revenue Recognition GAAP “comprises broad revenue recognition concepts and numerous requirements for particular industries or transactions that can result in different accounting for economically similar transactions.”

Revenue Recognition “Although IFRSs provide less guidance on revenue recognition, the two main revenue recognition standards, IAS 18, Revenue, and IAS 11, Construction Contracts, can be difficult to understand and apply to transactions beyond simple.”

Revenue Recognition The objective of the Revenue Recognition project is to “clarify the principles for recognizing revenue and to develop a common revenue standard for U. S. GAAP and IFRSs that would:

Revenue Recognition (a) remove inconsistencies and weaknesses in existing revenue recognition standards and practices;

Revenue Recognition (b) provide a more robust framework for addressing revenue recognition issues;

Revenue Recognition (c) Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets; and

Revenue Recognition (d) Simplify the preparation of financial statements by reducing the number of requirements to which entities must refer.”

Revenue Recognition The core principle underlying the project is that “an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”

Revenue Recognition An entity accomplishes this through a five-step procedure:

Revenue Recognition 1 – Identify the contract with a customer.

Revenue Recognition 2 – Identify the separate performance obligations in the contract.

Revenue Recognition 3 - Determine the transaction price. In doing this, we must consider the effects of each of the following:

Revenue Recognition a - Variable consideration: “If the promised amount of consideration in a contract is variable, an entity would estimate the transaction price by using either the expected value...or the most likely amount, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled”;

Revenue Recognition b - The time value of money;

Revenue Recognition c: Non-cash consideration;

Revenue Recognition d: Consideration payable to the customer: “If an entity pays, or expects to pay, consideration to a customer...in the form of cash, credit, or other items that the customer can apply against amounts owed...the entity would account for the consideration payable...as a reduction of the transaction price unless the payment is in exchange for a distinct good or service.”

Revenue Recognition 4: Allocate the transaction price to the separate performance obligations in the contract.

Revenue Recognition 5 – Recognize revenue when (or as) the entity satisfies a performance obligation – by transferring a promised service or good to a customer.

Revenue Recognition A performance obligation is satisfied – control of a good or service has been transferred – when one of two criteria have been met:

Revenue Recognition 1 – The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced;

Revenue Recognition 2 – The entity’s performance does not create an asset with an alternative use to the entity and at least one of the following criteria is met:

Revenue Recognition a – The customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs;

Revenue Recognition b – Another entity would not need to substantially reperform the work the entity has completed to date if that other entity were to fulfill the remaining obligation to the customer;

Revenue Recognition c – The entity has a right to payment for performance completed to date and it expects to fulfill the contract as promised.

Revenue Recognition The amount of revenue recognized as a performance obligation is met is allocated based on the proportion of revenue that will ultimately be realized from the contract.

Revenue Recognition If the amount of revenue that an entity will recognize from a contract is variable, the cumulattive amount that it would recognize at any time “would not exceed the amount to which it is reasonably assured to be entitled.”

Revenue Recognition If an entity has an “onerous performance obligation” (“the lowest cost of settling the performance obligation exceeds the amount of the transaction price allocated to that performance obligation”), it would “recognize a liability and a corresponding expense.”

Revenue Recognition This Accounting Standards Update will not be effective before January 15, 2015 at the earliest. Early application will not be permitted.

Balance Sheet - Offsetting The FASB is currently drafting a final Accounting Standards Update. The FASB’s goal is to publish the Update by the end of this year.

Balance Sheet - Offsetting However, finalizing an Accounting Standards Update is contingent on the IASB and FASB agreeing on its contents. At this time there is disagreement on some related issues.

Balance Sheet - Offsetting What to expect: A requirement to offset assets and liabilities when an entity “has an unconditional and legally enforceable right of setoff and intends either to settle the asset and liability on a net basis or to realize the asset and settle the liability simultaneously.”

Balance Sheet - Offsetting The right to setoff must be legally enforceable “in all circumstances” and not contingent on a future event.

Consolidation: Policy and Procedures The FASB issued a proposed Accounting Standards Update on November 3. Comments will be accepted through January 17, 2012.

Consolidation: Policy and Procedures FASB Statement 167 (Codification Topic 810) requires an entity to “perform a qualitative evaluation of its power and economics to determine whether it should consolidate a variable interest entity.”

Consolidation: Policy and Procedures Accounting Standards Update , issued in February, 2010, had indefinitely deferred the effective date of the consolidation requirements for certain entities. The proposed ASU rescinds this deferral and requires “all variable interest entities to be evaluated for consolidation.”

Consolidation: Policy and Procedures Under the proposed ASU, a reporting entity “must determine whether it has a variable interest in the entity being evaluated for consolidation and whether that entity is a variable interest entity.”

Consolidation: Policy and Procedures The proposed ASU will continue to require a reporting entity to determine whether a decision maker has a variable interest in an entity, consistent with the current criteria in Codification Database Subtopic

Consolidation: Policy and Procedures However, the proposed ASU would “introduce a separate qualitative analysis to determine whether the decision maker is using its power in a principal or an agent capacity.”

Consolidation: Policy and Procedures This analysis will require the reporting entity “to assess whether a decision maker is using its power as a principal or an agent” focussing on:

Consolidation: Policy and Procedures 1 – The rights held by other parties – “unilateral substantive kick-out or participating rights held by an unrelated single party are determinative that a decision maker is not a principal”;

Consolidation: Policy and Procedures 2 – “The compensation to which the decision maker is entitled in accordance with its compensation agreements(s)”;

Consolidation: Policy and Procedures 3 – “The decision maker’s exposure to variability of returns from other interests that it holds in the entity.”

Consolidation: Investment Companies The FASB published proposed Accounting Standards Update on consolidating investment companies on October 21, The comment period for this proposed ASU runs through January 5, 2012.

Consolidation: Investment Companies “Investment companies carry all of their investments in operating entities at fair value, even if they hold a controlling financial interest in the investee. Therefore, the Boards agreed that, as part of the development of a consolidation standard, they would look to develop consistent criteria for determining whether an entity is an investment company.”

Consolidation: Investment Companies “The amendments in this proposed Update would affect the scope, measurement, presentation, and disclosure requirements for investment companies in U.S. generally accepted accounting principles (GAAP).” The proposed amendments would:

Consolidation: Investment Companies “1 - Amend the investment company definition in Topic 946 and provide comprehensive guidance for assessing whether an entity is an investment company.”

Consolidation: Investment Companies “2 - Require an investment company to consolidate another investment company or an investment property entity if it holds a controlling financial interest in the entity in a fund-of-funds structure. The investment company parent would retain the specialized guidance when consolidating another investment company or an investment property entity.”

Consolidation: Investment Companies “3 - Amend the financial statements and financial highlights presentation requirements for situations in which an investment company consolidates a less-than-wholly-owned investment company or a less-than-wholly-owned investment property entity.”

Consolidation: Investment Companies “4 - Prohibit an investment company that is able to exercise significant influence over another investment company or an investment property entity from accounting for its interest using the equity method of accounting. Rather, those investments would be measured at fair value.”

Consolidation: Investment Companies “5 - Require additional disclosures including changes in an entity’s status as an investment company, whether the investment company has provided support to any of its investees, and any significant restrictions on an investee’s ability to transfer funds to the investment company.”

Consolidation: Investment Companies “The amendments in the proposed update would change the definition of an investment company. Specifically, the criteria within the definition would be expanded and additional implementation guidance would be provided.”

Consolidation: Investment Companies “The proposed amendments would require that an investment company account for its controlling financial interests in other investment companies and investment property entities in a fund-of-funds structure.”

Financial Instruments The FASB and IASB hope to increase the usefulness and simplify the accounting requirements for financial instruments.

Financial Instruments “Although the project objective is comprehensive, it is also the Boards’ objective that the project should be completed expeditiously.”

Financial Instruments Three specific goals of this project are: 1 – Reconsider the recognition and measurement of financial instruments; 2 – Address issues related to impairment of financial instruments and hedge accounting; 3 – Increase convergence in accounting for financial instruments.

Financial Instruments On May 26, 2010, the FASB issued one comprehensive proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities (proposed Update), which addresses the measurement, classification, and impairment of financial instruments, as well as hedge accounting.

Financial Instruments On January 31, 2011, the FASB and IASB also issued a supplementary document, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments for Hedging Activities – Impairment.

Financial Instruments “The Boards continue to develop a comprehensive model for accounting for financial instruments, including hedge accounting. The Boards plan to deliberate certain issues relevant to this project separately and then meet subsequently to reconcile differences in their technical decisions.”

Financial Instruments The two Boards have tentatively decided the following:

Financial Instruments Financial Instruments will be classified both on “the characteristics of the financial instrument and the entity’s business strategy for the instrument.”

Financial Instruments Financial instruments that do not meet the criteria of debt instruments (as it will be defined) will be measured at fair value.

Financial Instruments The measurement of debt instruments will depend on the business activity that the instruments’ holder uses to manage its financial instruments, not on the intention regarding the specific instrument.

Financial Instruments A bondholder could treat identical bonds under any of three separate ways, depending on the activity under which it holds the bonds.

Financial Instruments The first activity, similar to the current “held-to- maturity”, would have the debt instrument measured at amortized cost.

Financial Instruments A debt instrument should be measured at amortized cost only if it meets all three of the following criteria:

Financial Instruments 1: The holder’s business strategy “is to manage the instruments through customer financing (lending or borrowing) activities. These activities primarily focus on the collection of substantially all of the contractual cash flows from the borrower or payment of contractual cash flows to the lender.”

Financial Instruments 2: The holder of the instrument “has the ability to manage credit risk by negotiating any potential adjustment of contractual cash flows with the counterparty in the event of a potential credit loss. Sales or settlements would be limited to circumstances that would minimize losses due to deteriorating credit.”

Financial Instruments 3 – The financial instruments are not held for sale or transfer.

Financial Instruments Debt instruments should be measured at fair value, with changes in value recognized in other comprehensive income, if all of the following conditions are met:

Financial Instruments 1 – The financial instruments are issued or acquired in a business activity for which the entity’s business strategy “is to invest the cash of the entity to either:

Financial Instruments a: Maximize total return by collecting contractual cash flows or selling the instrument, or”

Financial Instruments b: “Manage the interest rate or liquidity risk of the entity by either holding or selling the instrument.”

Financial Instruments 2. Financial assets that are not held for sale.

Financial Instruments Debt instruments should be measured at fair value, with changes in fair value reflected in net income, if the business activity for the debt instruments meets either of the following conditions:

Financial Instruments 1 - The debt instruments are held for sale or transfer; 2 – “The debt instruments are actively managed and monitored internally on a fair value basis but do not qualify” as debt instruments for which changes in value would be recognized in other comprehensive income.

Financial Instruments Once financial instruments are classified, they are not reclassified, regardless of changes in the entity’s business strategy.

Financial Instruments If debt instruments are being measured at amortized cost, then are subsequently identified for sale, they should continue to be measured at amortized cost (net of impairment) until the sale occurs.

Financial Instruments Impairment: The boards have added guidance that a financial asset that is uncollectible should be written off. An entity should “use the best available and supportable information at the date of estimation to estimate expected losses...”

Financial Instruments The FASB and IASB have tentatively decided “that the effect of unwinding the discounting of expected credit losses should be included in the credit losses line item on the statement of comprehensive income.”

Financial Instruments “Interest income should be determined by applying the effective interest rate to an amortized cost balance that is not reduced for credit impairment.”

Financial Instruments “[A]n entity should account for credit impairment of purchased financial assets for which the entity has no explicit expectation of losses based on an impairment analysis at the individual asset level, even when acquired as part of a portfolio...”

Financial Instruments Embedded derivative features of financial instruments will be bifurcated and “measured at fair value with all changes in fair value recognized in net income.”

Financial Instruments - Hedging The IASB last year issued an Exposure Draft that would have the effect of diverging IFRS from GAAP on the treatment of hedge accounting if it became effective.

Financial Instruments - Hedging The FASB issued a Discussion Paper on February 9, 2011 to solicit comments on an IASB Exposure Draft on Hedge Accounting. Comments on the Discussion Paper were accepted through April 25.

Financial Instruments - Hedging The issuance of this Discussion Paper has effectively expanded the scope of the Financial Instruments project to include Hedging Activities.

Financial Instruments - Hedging The goals of the Hedging Activities portion of the project are to:

Financial Instruments - Hedging 1 – Simplify and resolve practice issues in acccounting for hedging activities;

Financial Instruments - Hedging 2 – Improve the financial reporting of hedging activities to make the accounting model and associated disclosures easier to understand for users of financial statements;

Financial Instruments - Hedging 3 – Address differences in the accounting for derivative instruments and hedged items or transactions.

Financial Instruments - Hedging The IASB’s goals in its Exposure Draft are to: 1 – Align Hedge Accounting with risk management; 2 – Produce more “objective-based” Hedge Accounting; 3 – “Address weaknesses and inconsistencies” in current Hedge Accounting.

Financial Instruments The IASB’s Exposure Draft would expand the types of financial instruments that can be included as hedging instruments to include non-derivative financial assets and liabilities.

Financial Instruments The IASB’s Exposure Draft would change the accounting for the time value of an option when only the instrinsic value of the option is designated as a hedging instrument.

Financial Instruments Risk components of both financial and non- financial items could be designated as hedging items. “Changes in the cash flows or fair value of an item attributable to a specific risk” may be designated as a hedged item if the risk component is separately identifiable.

Financial Instruments The IASB’s Exposure Draft would permit an entity to designate a “net nil” position when the hedged items in a group fully offset each others’ risks. The group of items would be considered to be hedged without a separate item serving as a hedging instrument.

Financial Instruments The IASB’s Exposure Draft would widen the criteria for qualifying for Hedge Accounting from a hedge being “highly effective” to merely meeting the objective of a hedge effectiveness assessment. (The FASB has noted in its discussion paper the vagueness of this clause of the IASB’s Exposure Draft.)

Financial Instruments The IASB’s “Exposure Draft would remove the existing requirement to retrospectively test the effectiveness of a hedging relationship.”

Financial Instruments The IASB’s Exposure Draft would “permit and sometimes require an entity to adjust an existing hedging relationship and account for the revised hedging relationship as a continuation of an existing hedge...”

Leases The two boards published exposure drafts last year and accepted comments through December 15. They have also held roundtable meetings and published a questionaire.

Leases On July 21, 2011, the FASB and IASB “agreed unanimously to reexpose their revised proposals for a leases standard.” They expect to issue a new exposure draft (proposed Accounting Standards Update) during the first half of 2012.

Leases “Leslie F Seidman, Chairman of the FASB, said: During our discussions of the extensive comments we received on the exposure draft, the boards have reaffirmed the major change to lease accounting, which is to report lease obligations and the related right-to-use on the balance sheet.”

Leases ‘However, the boards decided to make many other changes to address the comments made by stakeholders. The boards decided that, while we still have other matters to discuss, stakeholders would appreciate the opportunity to comment on the revised package of conclusions.’”

Leases The two boards had tentatively decided: The distinction between an operating lease and a capital lease would be no more. All leases would be liabilities for the lessee and assets for the lessor.

Leases The lessee’s liability / lessor’s receivable would include: 1 – Lease payments that meet a high threshold (of probability of realization); 2 – Lease payments for which variability lacks economic substance; 3 – Lease payments that depend on an index or rate.

Leases There would be two accounting approaches, one for finance and one for non-finance leases.

Leases For all leases longer than one year, the lessee would recognize an asset and a liability for the present value of the lease payments. The liability will be amortized using the effective-interest method.

Leases For finance leases, the lessee would “amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits in accordance with... (Codification Database) Topic 350.”

Leases For other-than-finance leases, straight-line amortization of the asset would be used.

Leases For finance leases, the lessee would “amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits in accordance with... (Codification Database) Topic 350.”

Leases For sale-and-leaseback transactions, “the transaction would be accounted for as a sale and then a leaseback. If a sale has not occurred, the entire transaction would be accounted for as a financing.”

Insurance Contracts This project is in the early stages. The FASB issued a discussion paper in September, 2010, and accepted comments through last December. The two Boards expect to issue an Exposure Draft by the end of 2011.

Insurance Contracts The FASB expects to issue a proposed Accounting Standards Update during the first half of 2012.

Insurance Contracts It should be noted that there is an extensive body of GAAP concerning Insurance Accounting, but relatively little IFRS has been developed.

Insurance Contracts IFRS 4, “Insurance Contracts”, issued in 2004 (two years after the convergence movement began with the Norwalk Agreement) was essentially a makeshift pronouncement.

Insurance Contracts The IASB issued an Exposure Draft in 2010 that would refine IASB 4. The discussions that led to the development of IASB 4 were held jointly with the FASB.

Insurance Contracts Current discussions between the IASB and FASB are on such issues as the unbundling of insurance contracts from non-insurance components of the contracts.

Insurance Contracts The FASB and IASB are discussing whether “an insurer should measure an insurance contract using an explicit, unbiased, and probability-weighted estimate (expected value) of the future cash outflows, less future cash inflows that will arise as the insurer fulfills the insurance contract.”

Insurance Contracts Future costs of fulfilling contracts (including legal costs related to claims) should be included in the liability. Costs that do not relate directly to “insurance contracts or contract activities” should be recognized during the period in which they are incurred.

Insurance Contracts Unbundling would serve the purpose of separating insurance-related performance obligations from non-insurance performance obligations for the purpose of appropriately recognizing revenue.

Conceptual Framework Other than the Revenue Recognition project that we discussed earlier, this has been “reassessed as a lower priority project. Further action is not expected in the near term.”

Financial Statement Presentation This has been “reassessed as a lower priority project. Further action is not expected in the near term.” When this project is resumed, the potential effects will be very significant for anyone who prepares or uses financial statements.

Emissions Trading Schemes This has been “reassessed as a lower priority project. Further action is not expected in the near term.”

Discontinued Operations This has been “reassessed as a lower priority project. Further action is not expected in the near term.”

Financial Instruments with Characteristics of Equity This has been “reassessed as a lower priority project. Further action is not expected in the near term.”

Earnings per Share This has been “reassessed as a lower priority project. Further action is not expected in the near term.”

(Deferred) Income Taxes This has been “reassessed as a lower priority project. Further action is not expected in the near term.”

Postretirement Benefit Obligations This has been “reassessed as a lower priority project. Further action is not expected in the near term.”