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An Update on Changes to Financial Statements

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Michael Moran, of Goldman Sachs’s Global Markets Institute, kicked off January’s “Changes to 2009 Financial Statements” (an event sponsored by NYSSA’s Improved Corporate Reporting Committee), and he could not have given us a more timely presentation on accounting for transfers of financial assets if he had read an advance copy of the Valukas Report on Lehman Brothers. 

Using a securitization as an example of a transfer, Moran described gain-on-sale accounting under the former FAS140, by which a company could remove financial assets from its books by relinquishing control of the assets through legal isolation and by giving the receiver the ability to pledge or transfer. Moran explained that the new rules would require most such transfers to be accounted for as secured borrowings rather than sales, eliminating the technical loopholes that existed in the previous standards. Using the securitization example, Moran also addressed additional issues, not applicable in the Repo 195 transactions, such as consolidation of special purpose or variable interest entities (SPE or VIE) created in a securitization. 

Under the new standard, all existing SPEs must be reevaluated under the new consolidation rules, which require a qualitative rather than quantitative assessment of the transferring company’s relationship to the SPE. Additional disclosures about these decisions are also required to improve transparency. Moran cautioned that the FASB and IASB are working on a joint project on consolidation so these rules might change again in the near future. Lehman’s Repo 105 transactions are just another example of the company’s using off-balance-sheet treatment under the previous standards, which will be curtailed going forward.

The new revenue recognition rules for multiple element arrangements or bundled contracts (e.g., equipment, installation, future upgrades) address companies’ concerns that the former requirement to provide vendor specific objective evidence (VSOE) (i.e., market prices) was creating uneconomic results. Chandy Smith, a senior investor liaison at the FASB, explained that the new rule creates a hierarchy, with VSOE as the most preferable, followed by third-party evidence (TPE), but permitting a “best estimate of selling price” when VSOE or TPE is not available. The result is that companies will likely recognize revenue earlier under the new rules with greater management discretion over the timing of recognition. Analysts will need to rely heavily on the associated disclosures to understand and assess how companies are determining their “best estimates.” Smith also discussed a current FASB project to improve disclosures about loan losses including roll-forward schedules of the gross carrying amount of loans (i.e., a reconciliation of the beginning and ending amounts, including additions, disposals, transfers, and other changes), credit quality of loan receivables, and an aging schedule of past due receivables.

Following Smith’s explanation of the new revenue recognition rules, Zhen Deng, a senior analyst of CFRA at RiskMetrics Group, discussed her research into the impact on company’s revenue and gross margin. She expressed several concerns about the effect of the new rule, including the impact on year-over-year growth rates (which may increase over time), changes to business practices (including more bundled contracts to take advantage of the flexibility the new rule provides), and impact on gross margin. She used Apple, a company that has not yet adopted the new rule but has provided disclosure of the deferred revenue under the old rule, as an example to illustrate the likely increase in gross margin. (Apple adopted the new rule retrospectively in fiscal 1Q10.)

“It seemed like a good idea at the time” is how Jack Ciesielski, owner of RG Associates, characterized companies’ pension and other post-employment benefit promises made before the FASB required liability recognition and measurement. However, the required information on these large obligations is still inadequate. For example, all we have now is one net number (over- or underfunding) on the balance sheet that doesn’t give the analyst any context for risk assessment. The new disclosure requirements provide a context and should allow better risk assessment of companies with underfunded plans. Companies now need to provide information about how investment allocation decisions are made, including the factors that are pertinent to an understanding of investment policies and strategies, major classes of plan assets, and inputs and valuation techniques used to measure the fair value of plan assets. Ciesielski finds the most interesting new disclosure to be the effect of fair value measurements using Level 3 inputs on changes in plan asset and significant concentrations of risk within plan assets.

Wallace Enman, vice president and senior accounting analyst at Moody’s Investors Services, followed Ciesielski’s reference to fair value measurements with an update on developments in fair value accounting. The financial crisis created significant concerns about FASB requirements and guidance on fair value measurements, and it remains a controversial issue. These concerns focused on measurements of “other than temporary” impairment changes. FASB guidance was directed toward securities in illiquid markets or those that were distressed. The guidance stressed the objective of fair value measurements. 

Although financial statement users believed the FASB had gone far in identifying distressed securities, companies did not believe there would be a significant impact on financial statements. Enman discussed several specific changes including loosening the “ability and intent” to hold to maturity (HTM). Companies will also be able to split the impairment charge on distressed securities between income (only the credit-related portion of the impairment charge) and other comprehensive income (the noncredit portion). In contrast, a company records the entire impairment charge when the security is reclassified because the asset is reclassified as available for sale through income. 

Enman concluded with a brief discussion of the FASB and IASB project to overhaul accounting for financial instruments in general. IASB issued a new standard, IFRS 9, on classification in November 2009 providing only two categories (fair value and amortized cost), defining fair value as exit prices, and expanding the use of fair values to debt instruments. The European Commission (EC) deferred adoption of IFRS 9 stating that it did not strike the right balance between fair value and amortized cost. However, the boards differ in their thinking on fair values despite the importance of this project to convergence efforts. The FASB leans even more toward requiring fair values than the IASB leaning even further from what is considered desirable by the EC.

The conference concluded with an update and assessment of FASB-IASB convergence efforts by Deng and Ciesielski. Deng began by showing the extent of countries converging or converting to IFRS. Deng noted that there are currently pages of differences between US GAAP and IFRS but that investors should be concerned only if these technical differences result in materially different numbers. Her study found that the differences are not only material, but also difficult for investors to adjust for in making apples-to-apples comparisons because of the wide range of impact. 

She showed that the largest ADR companies reporting under IFRS would lose 14% of earnings on average if they recast their results according to US GAAP (by referencing the US GAAP reconciliation disclosure that is no longer required by the SEC). Seven percent of this 14% difference was caused by differences in accounting for acquisitions (most significant difference by magnitude) and 4% by differences in pension accounting (most significant difference by frequency). Even though a major convergence project on acquisitions has been completed, legacy differences between IFRS and US GAAP will continue to impact financial results for years to come. With respect to pensions, the most significant difference is that IFRS companies can recognize all actuarial gains and losses through equity with no recycling through income, and US GAAP companies do not have this option. Many IFRS companies select this option.

Ciesielski opened his remarks with a short history of the IASB and noted the Memorandum of Understanding with the FASB in 2002, updated in 2008. At the same time, the SEC had issued a proposed roadmap for US adoption of IFRS in 2011. At the time of the conference, the SEC, under a new administration, had delayed confirmation of this proposal. However, the FASB and IASB are working diligently on their convergence projects with a view to the 2011 deadline. In 2009 both boards agreed to work on a complete overhaul of accounting for financial instruments. In late 2009 the IASB, as noted earlier in the conference, issued IFRS on classification and measurement of financial instruments. The IASB’s proposal on impairment was out for comment with a proposal on hedge accounting scheduled for 2010. 

The FASB took a different approach with both fair value and historical cost on the balance sheet. Fair value changes will go through other comprehensive income, rather than income. An exposure draft has not yet been issued. Although investors by and large support reporting fair value information on the balance sheet and performance statements, banks around the world are more concerned about fair values, particularly in light of the recent financial crisis. Therefore, in Ciesielski’s view, the FASB may have a better product by requiring fair values across the board, but it has lost the leader’s advantage. 

Ciesielski commented that, in light of the agreement to converge, it would be interesting to see how this project is resolved. Reconciling these two approaches will not be simple. The other projects still on the 2011 agenda are leases, liabilities, revenue recognition, and financial statement presentation. Ciesielski commented that the SEC had not yet issued an update on the proposed roadmap. (The SEC issued a work plan in February confirming its commitment to convergence, but not identifying what the final outcome would be: convergence, standard-by-standard adoption, or wholesale adoption.)

–Arthur Fliegelman

Listen to a podcast of the entire event at NYSSA OnDemand.

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