1. FASB Update For Acct 592 – Spring 2005

2. To be covered later in course Related to consolidations FIN 46 (as revised) – related to consolidations of special purpose entities  We’ll cover later and I’ll distribute a “readable” discussion from our advanced textbook author

3. SFAS No. 123 (revised 2004) Related to Stock Compensation I believe the revised standard does away with the need for FIN 44, SFAS No. 148, APB Opinion 20 We’ll get into details later in course

4. Financial Institutions SFAS No. 147 – Acquisitions of Certain Financial Institutions (October 2002) These institutions are no longer excluded from coverage of FASB 141 and 142 and FASB 144.

5. Probably not covered FAS 149 – an amendment of FAS 133 on Derivatives  Objective: To clarify early standards and settle implementation issues particularly with respect to “embedded” derivatives  Derivatives are covered in Acct 415/515 so we probably won’t be able to spend that kind of time on this complex topic this semester

6. New rules on redeemable preferred stock FAS150

7. SFAS No. 150 – Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (May 2003)  Applies to “freestanding financial instruments” only  Does not apply to features “embedded” in a financial instrument that is not a derivative in its entirety (i.e., stock-based compensation and, as best I can tell, convertible bonds)

8. FAS 150 Defines obligation as “conditional or unconditional duty or responsibility to transfer assets or to issue equity shares  In the past, redeemable preferred stock have been treated as equity or shown in the “mezzanine” level of balance sheet (between liabilities and owners’ equity). This statement removes the mezzanine!

9. Redeemable financial instruments Mandatorily redeemable financial instrument shall be classified as liability  Exceptions  The redemption is contingent on future event Treat as liability when the event occurs, the condition is resolved, or the event becomes certain to occur  In this case, the liability is measured at fair value when reclassified to the liability section.  Equity is reduced and no gain or loss is recognized. Certain not probable!

10. Redeemable financial instruments Mandatorily redeemable financial instrument shall be classified as liability  Exceptions  The redemption is contingent on the occurrence of an uncertain future event  The redemption is required only upon liquidation or termination of the reporting entity Do not classify as liability

11. Obligation to Repurchase Equity Classify as a liability:  A financial instrument (other than outstanding shares of stock) that at inception Embodies an obligation to repurchase the issuer’s equity shares or is indexed to shares Requires or may require the issuer to settle the obligation by transferring assets Examples  Forward purchase contracts  Written put options on issuer’s equity shares that are to be physically settled or net cash settled

12. Obligations to issue variable number of shares Classify as a liability (or sometimes an asset) a financial instrument other than outstanding shares that embody a conditional obligation to settle by issuing a variable number of its equity shares Examples  Fixed monetary amount payable with variable number of issuer’s shares  Indexed or similar obligations to be settled in variable number of issuer’s equity shares  Variations inversely related to changes in fair value of issuer’s equity shares – like a written put option that could be net share settled

13. Measurement of liability Financial instruments that meet these requirements are initially measured at fair value Most are then re-measured at fair value and the subsequent changes in fair value are recognized in earnings  A present value alternative may be used when a fixed number of shares will be issued at a known or unknown future date Amount is determined using present value and interest expense is reported in earnings until redemption If amount paid or settlement date varies, the obligation is remeasured at present value on an “as if settled” at reporting date and any excess over original estimate is treated as interest expense on income statement (see paragraph 22)

14. Reporting on Statements Balance sheet required description:  “Shares subject to mandatory redemption”  Should be on separate line and not commingled with other liabilities Income statement transition  Through “cumulative effect of a change in accounting principle”

15. Disclosures Nature and terms of the financial instruments including rights and obligations  Amount that would be paid or number of shares that would be issued and their fair value “as if settled” at reporting date  How changes in fair value of issuer’s equity shares impact the settlement amount  Maximum amount issuer could be required to pay  Maximum number of shares that might have to be issued  And several more items (see paragraph 27)

16. Example financial instrument Trust-preferred securities  A financial institution establishes a trust or other entity that is consolidated with the financial institution  The trust issues mandatorily redeemable preferred stock and uses the proceeds to purchase from the financial institution an equivalent amount of junior subordinated debt  The financial institution pays interest to the trust, the trust uses the funds to pay the dividends Why they exist  Upon consolidation, the intercompany transaction (payment of interest) disappears along with the debt (and the receivable on the trust’s books)

17. Example financial instrument Trust-preferred securities  Under the new rules, the financial institution will have to report INTEREST EXPENSE and DEBT instead of dividends and redeemable preferred stock FAS 150 Appendix A includes other examples to aid implementation of the new rules

18. New rules on guarantees of debt FIN 45

19. FIN No. 45 – Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (November 2002)  An interpretation of FASB No. 5, 57, 107. This interpretation REPLACES FIN No. 34 Scope: Covers disclosures to be made in interim and annual reports regarding guarantees of indebtedness of others (disclosed under FASB No. 5 even though the probability is generally “remote”

20. Covers guarantee contracts that have any of the following 4 characteristics 1. Contracts that contingently require the guarantor to make payments to the guaranteed party based on an “underlying”  Examples: Irrevocable standby letter of credit which guarantees payment of a specified obligation Market value guarantee of asset owned by the guaranteed party Guarantee of the market price of common stock of the guaranteed party Guarantee of the collection of cash flows from assets held by special purpose entity 2. Performance standby letter of credit or similar arrangements in which guarantor must make payments to the guaranteed party in the event of another entity’s failure to perform under a nonfinancial contract

21. Covers guarantee contracts that have any of the following 4 characteristics 3. Indemnification agreements that require guarantor to make payments to the indemnified party (guaranteed party) based on changes in an “underlying” such as an adverse judgment in a lawsuit, imposition of additional taxes due to adverse interpretation of the law 4. Indirect guarantees of the indebtedness of others even though the payment to the guaranteed party may not be based on an underlying asset, liability, etc., of the guaranteed party.

22. THE INTERPRETATION The issuance of a guarantee obligates the guarantor (issuer) in two respects:  1. The guarantor undertakes an obligation to stand ready to perform over the term of the guarantee if the event that the specified triggering events or conditions occur This is the noncontingent part of the obligation  2. The guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur This is the contingent part of the obligation New Disclosure – FIN 45

23. Key point of FIN 45 FASB 5 should not be interpreted as prohibiting the guarantor from initially recognizing a liability for a guarantee even though it is not probable that the payments will be required under that guarantee.

24. Measurement of obligation a.The premium received or receivable – when the guarantee is issued in a standalone arm’s-length transaction with an unrelated party b.When the guarantee is part of a transaction with multiple elements, estimate the fair value of the guarantee.  Consider the premium which would be required by the guarantor to issue a standalone guarantee with an unrelated party  In the absence of observable transactions for identical or similar guarantees, use expected present value measurement techniques

25. Measurement of obligation c.If a guarantor must recognize a guarantee at inception because it is probable and can be estimated (FASB 5), the amount to initially recognize is the GREATER of the fair value of the guarantee (as measured above) or the contingent liability amount required under paragraph 8 of Statement 5. dNot for profit situation: guarantees provided as a contribution to an unrelated party (like a loan guarantee by a community foundation to a nonprofit entity), the guarantee (gift) should be measured at the fair value of the guarantee and NOT considered merely a conditional promise to give.

26. The debit side is not prescribed Some examples provided in FIN 45 include:  a. If a premium is received, the debit would be to cash or receivable.  b. If the fair value of the premium is an allocation of the receivable or cash received on a transaction that involves other assets, liabilities, etc., the allocation to the guarantee will affect the calculation of the gain or loss on the transaction.  c. If the guarantee is associated with the acquisition of a business accounted for under the equity method, the guarantee would increase the carrying value of the investment.  d. In an operating lease situation, the guarantee would affect prepaid rent.  e. If no consideration is received, the offsetting entry would be to expense.

27. Arrangements NOT covered 1. Commercial letters of credit and loan commitments 2. Subordination of some securities that gives another class or tranche priority in the event of liquidation, etc. 3. Guarantees excluded from scope of FASB 5, para. 7 4. A lessee’s guarantee of the residual value of leased asset (capital lease only) 5. A contract that is accounted for as contingent rent under FASB 13 6. Guarantee issued by insurance company under FASB No. 60, No. 97, No. 113, or No. 120 7. A contract that meets the criteria BUT provides for payments that constitute a vendor rebate (by the guarantor) based on either sales revenue of, or number of units sold by, the guaranteed party. 8. Guarantee whose existence prevents the guarantor from being able to either account for a transaction as the sale of an asset that is related to the guarantee’s underlying or recognize in earnings the profit from that sale transaction.

28. Scope exceptions – initial recognition provisions only 1. Guarantees accounted for as a derivative under Statement 133 2. Product warranties (the disclosure requirements of FIN 45 do apply – see below) 3. Guarantees issued in a business combination (Statement 141) 4. Guarantees for which the guarantor’s obligation would be reported as an equity item (rather than a liability) under GAAP 5. Guarantee by an original lessee that has become secondarily liable under a new lease that relieved the original lessee from being the primary obligor (principal debtor) – says to not apply this section to secondary obligations that are not accounted for under Statement 13, paragraph 38. 6. Guarantees between parents and subsidiaries or between corporation under common control 7. Parent’s guarantee of debt of its subsidiary to a third party 8. A subsidiary’s guarantee of debt owed to a third party by its parent or a sibling subsidiary.

29. Disclosures Required – FIN 45 a. Nature of the guarantee including, the approximate term, how the guarantee arose, and the event or circumstance that would require the guarantor to perform under the guarantee. b. Maximum potential amount of future payments c. Current carrying amount of the liability d. Nature of (1) any recourse provisions that would enable guarantor to recover from third parties any of the amounts paid under the guarantee and (2) any assets held either as collateral or by third parties that the guarantor would be able to liquidate to recover any of the amounts paid.

30. Disclosures Required – con’t e. FOR PRODUCT WARRANTIES. The disclosure of the maximum amount of future payments requirement above is waived. Instead:  1. The accounting policy and methodology used to determine its liability for product warranties including any deferred revenues associated with extended warranties.  2. A tabular reconciliation of the changes in the guarantor’s aggregate product warranty for the reporting period. Beginning balance Aggregate reduction for payments made or services provided Aggregate increase for new warranties issued during period Aggregate changes in the liability related to pre-existing warranties (changes in estimate) Ending balance

31. Example from Recent F/S

32. New Pension Disclosures FAS 132 (revised 2003)

33. Low interest rates = pension difficulties Remember back to our computations for pensions and other post-retirement benefits  We use a discount rate to determine the present value of future payments  In recent years, very LOW interest rates have lead to VERY HIGH pension liabilities As a response, FASB is adding new disclosure requirements

34. New disclosures I counted about 9 new or expanded disclosures for public entities  Big change is expanded disclosures for quarterly (interim) reports Nonpublic entities don’t have to disclose as much as public entities, but I also counted 9 new or expanded disclosures for them

35. Revised FAS 132 This revision should be on your FARS disk since it came out in December 2003. You can download a copy from the FASB web site You will need the revised standard to do the project for the semester

36. New Disclosures for Public Entities Percentage of total plan assets by categories like equity securities and debt securities  More detailed categories are encouraged if it would help assess risk and long-term expected rate of return Narrative discussion of investment policies and strategies Narrative discussion of how the expected rate of return was determined Accumulated benefit obligation

37. New Disclosures for Public Entities Benefits expected to be paid to retirees in each of the next five years and in aggregate thereafter (presumably NOT the present value of benefits) Estimated employer contribution that will be made during next fiscal year Weighted averages for assumptions in tabular form  Discount rates  Rates of compensation increase  Expected long-term rate of return

38. New Disclosures for Public Entities Measurement dates used to determine obligation for plans that make up the majority of the plan assets & obligations Remember – there was a really long list of disclosures BEFORE the revision and this is just the NEW items – don’t use these lecture notes as your “disclosure list” when you write the note for the FAS Inc. project

39. Examples Appendix C provides illustrations that should be useful in doing the footnote for the ADQ Inc. project (Spring 2005) Illustration 1 is probably your “best bet” Remember, you may not be able to find any “real examples” of the new disclosures yet since the rules are so new

40. SFAS No. 151-153 Added Jan 2005

41. 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.

42. SFAS No. 152 – Accounting for Real Estate Time-Sharing Amends SFAS Nos. 66 & 67 Special industry accounting practices are clarified.

43. SFAS No. 153 – Exchanges of Nonmonetary Assets APB Opinion No. 29 generally required that exchanges of nonmonetary assets would be based on the fair values of the assets exchanged  Exception for exchanges of similar productive assets. This standard changes the exception to a “lack of commercial substance” rule

44. Commercial Substance A nonmonetary exchange has commercial substance if the entity’s future cash flows are expected to significantly change as a result of the exchange. A significant change in future cash flows is defined to be meeting one or both of the following two conditions: 1. Configuration of cash flows is different The configuration (risk, timing, and amount) of the future cash flows of the asset received differs significantly from the configuration of the future cash flows of the asset transferred. 2. The entity-specific value is different The entity-specific value of the asset received differs from the entity specific value of the asset transferred, and the difference is significant in relation to the fair values of the assets exchanged.

45. SFAS No. 153, continued Nonmonetary exchanges are recognized at the fair value of the nonmonetary asset relinquished UNLESS: 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.

46. Forthcoming – first half 2005 Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3 (Proposed Statement of Financial Accounting Standards) December 15, 2003 Earnings per Share—an amendment of FASB Statement No. 128 (Proposed Statement of Financial Accounting Standards) December 15, 2003 Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143 (Proposed Interpretation) June 17, 2004

47. Accounting changes and estimates Still in the exposure draft stage but expected to be issued first quarter 2005  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

48. Accounting changes and estimates A change in depreciation method would now be classified as a change in estimate and would not require retroactive restatement of prior years

49. Earnings per share change Part of the “international convergence” project.  Seems to be a minor point to me – fairly technical We can discuss when we cover EPS Expected 2 nd Qtr 2005

50. Asset retirement obligations The proposed Interpretation [planned for 1 st Qtr 2005] would clarify that a legal obligation to perform an asset retirement activity that is conditional on a future event is within the scope of FASB Statement No. 143  Uncertainty surrounding the timing and method of settlement that may be conditional on events occurring in the future would be factored into the measurement of the liability rather than the recognition of the liability.  If there is insufficient information to estimate the fair value, the liability would be initially recognized in the period in which sufficient information is available for an entity to make a reasonable estimate of the liability’s fair value.

51. Longer term projects Fair value measurement Definition of liability vs. equity Revenue recognition  Looking toward an asset/liability approach so it may be quite different than current GAAP Business & not-for-profit combinations  We are still waiting for clear definition of control  Eliminate parent co. method in favor of the economic entity approach