1. A Global Reach with a Local Perspective www.decosimo.com UNIVERSITY OF NORTH ALABAMA 2013 ACCOUNTING SEMINAR WHAT WAS THE FASB THINKING? JENNIFER GOODMAN | July 19, 2013

2. Examples of unusual accounting rules Common sense might not prevail! The Rule with The Kicker An Example Discuss What was the FASB thinking? Dont believe me, I wouldnt either Business card with # of unusual accounting rule and I will email standard OVERVIEW 3. Accrue cost in connection with exit or disposal of operating lease or other contract Recognize cost to officially terminate contact before end of term as a liability at fair value upon termination Recognize continued cost without economic benefit at cease use date as a liability at fair value #1 Contract Termination Costs The Rules 4. Measuring fair value of operating lease FV is based on the remaining lease rentals reduced by actual or estimated sublease rentals The Kicker: Sublease rental income included in the FV determination even if the entity does not intend to enter into a sublease #1 Contract Termination Costs The Rules 5. Operating lease rentals of $100,000 per year for 10 years After six years, the entity commits to an exit plan Remaining lease rentals will be $400,000 Market rentals for similar property, sublease $75,000 per year The entity decides not to sublease the facility (or otherwise terminate the lease) at the cease use date #1 Contract Termination Costs Example 6. Expected net cash flows of $100,000 ($100,000 outflow for 4 years less $75,000 inflow for 4 years) Discount using a credit-adjusted risk-free rate of 8% The fair value is $89,000 using an expected present value technique Explain this to the board of directors! Actual cash outflow over 4 years $400,000 Recorded liability $89,000 #1 Contract Termination Costs Example 7. Entity receives economic benefit not to sublease. The entity will recognize the impact of deciding not to sublease the property over the period the property is not subleased. #1 What was FASB thinking? 8. Other costs associated with exit or disposal should be recognized at fair value in the period the liability is incurred Liabilities - probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services in the future as a result of past transactions or events Generally corresponds to the period in which the goods or services associated with the activity are received The Kicker: Commitment to an exit or disposal plan by management does not, by itself, result in the incurrence of a liability # 2 General Exit or Disposal CostsThe Rule 9. Board approves a plan on 12/1/12 to close Line 5; line 5 moved to line 2 April 2013 Management prepares an estimate of cost that will be incurred with includes: $250k be paid in 2013 to engineering consultants $250k internal wages to shut line down and move to Line 1 $1M relocation cost to be paid to third party to move usable equipment to Line 1 and set-up $2M impairment of unusable equipment Exit cost accrual at 12/31/12 = $0, Impairment of assets held for sale $2M # 2 General Exit or Disposal Cost - Example 10. The Board decided to address the accounting and reporting for costs associated with exit or disposal activities because entities increasingly are engaging in exit and disposal activities and certain costs associated with those activities were recognized as liabilities at a plan (commitment) date that did not meet the definition of a liability. #2 What was FASB thinking? 11. If a period of time is required in order to construct or carry out other activities necessary to bring an asset to usable condition, interest cost incurred during that period shall be capitalized as a part of the historical cost of that asset. The Kicker: Interest cost to be capitalized includes interest on debt that is not related to the project. #3 Capitalizing Interest The Rules 12. Two methods: An overall borrowing rate shall be used based on rates applicable to borrowings outstanding during the period However, if a loan is obtained specifically to fund an entire project, it is usually appropriate to use the interest rate from that loan This is true even if the rate on the specific construction debt is lower than interest rates on other debt Dont capitalize more interest than actually incurred #3 Capitalized Interest The Rules 13. Qualifying assets $1M times 12.3% = Capitalized Interest $123,000 Construction loan 12% 750,000 Unsecured bank note 16% 150,000 Capitalized leases 9% 400,000 Equity 500,000 Rate Calculation: Specific debt 750,000 75% 12%*75%=9% Unsecured bank note 150,000 15% 16%*15%=2.4% Capitalized leases 100,000 10% 9%*10%=.9% Total 1,000,000 100% 12.3% #3 Capitalized Interest - Example 14. Acquisition cost should reflect the total investment in the asset AND should charge a cost that relates to the acquisition to future periods where revenues are generated. #3 What was the FASB thinking? 15. Before ASU 2010-24, health care entities used the following methods to present malpractice claims or similar liabilities and related insurance recoveries: (1) Netted insurance recoveries with the estimated accrual for related claims (allowed by industry guidance), or (2) Presented the claim liability separately from insurance recovery consistent with ASC 210-20 (asset and liability offsetting guidance). FASB now requires health care entities to follow the same rules as other industries for balance sheet offsetting i.e. requirements of ASC 210-20 must be met. #4 Insurance Recoveries The Rules 16. Under ASC 210-20, offsetting of conditional or unconditional liabilities with anticipated insurance recoveries from third parties is generally not permissible. The Kicker - The presentation guidance applies to other similar contingent liabilities such as workers compensation claims, employee health claims and officers and directors claims. #4 Insurance Recoveries The Rules 17. Health Company, Inc. has a gross liability for malpractice claims of $1M of which $700k has been submitted to the insurance carrier. The insurance agent deals with ALL aspects of the claim including paying the settlement. Current practice accrue liability of $300k Revised practice accrue liability of $1M and receivable of $700k #4 Insurance Recoveries Example 18. Do the rules apply when the entitys insurer deals with all aspects of the claims, including settlement? The entity is still the primary obligor for payment of the claim. Unless offsetting is allowed (ASC 210-20-45-2), the entity should record the claims liabilities separately from the receivable for insurance recoveries. #4 Insurance Recoveries Example 19. Gross presentation reflects that the entity remains obligated for the claim and that the entity is exposed to credit risk from the insurer. #4 What was the FASB thinking? 20. Current liabilities: Expected to be paid/liquidated in a short period of time i.e. 12 months Expected to require use of existing current assets or incur other current liabilities Not intended to include long term obligations expected to supplement working capital for long periods of time #5, #6, #7 Debt Classification The Rules 21. Issue An entity has long term debt. A debt covenant has been violated and a waiver has been obtained from the lender. How should the debt be classified on the balance sheet? The Kicker A waiver from the lender may not automatically provide a entity with the ability to classify the debt as noncurrent. #5 Loan Covenant Waivers - The Issue 22. Lender may waive right to call debt for period greater than one year but retain right to act on covenant violations occurring after the waiver Debt should be classified as noncurrent unless: Violation occurred at the balance sheet date or would have without the parties agreeing to modify the loan, AND It is not probable borrower will be able to comply with covenant requirements within next 12 months. #5 Loan Covenant Waivers - The Rules 23. Borrower has long-term debt and must comply with loan covenants quarterly. Incompliance at 12/31/12, however probable not in compliance at 3/31/13. Current or Noncurrent classification at 12/31/12? Noncurrent but disclose in 12/31/12 financials probable 3/31/13 violation. #5 Loan Covenant Waivers Example 1 24. Borrower has long-term debt and must comply with loan covenants quarterly Not in compliance at 12/31/12 however waiver obtained for 12 months and 1 day. Lender retains rights to act on violations after waiver date. Not probable borrower will meet 3/31/13 covenants but probable will meet 6/30/13, 9/30/13 and 12/31/13. Interim financials are not audited and do not contain full disclosures Current or Noncurrent classification at 12/31/12? Current - violation occurred at 12/31/12 AND not probable meet covenants within next 12 months. #5 Loan Covenant Waivers Example 2 25. Issue In poor economic times, the likelihood that a subjective acceleration clause (SAC) will be exercised by a lender is higher. The Kicker Beware if your loan agreements include subjective language such as material adverse change. It could impact the classification of your debt especially if you have a traditional lockbox arrangement. #6 Subjective Acceleration The Issue 26. When a SAC is included in a debt agreement the classification of the liability depends on the likelihood of the lender exercising its rights. Likelihood is remote = noncurrent Likelihood is more than remote = borrower must consider if current classification and/or disclosure is required #6 Subjective Acceleration The Rules 27. Agreement states lender can accelerate payment if 1) borrower fails to maintain satisfactory operations or 2) a material adverse change occurs If acceleration clause is exercised repayment of loan is due in 120 days Borrower provides documentation that asserts likelihood is remote Current or Noncurrent classification at 12/31/12? Noncurrent just because there is an SAC does not mean loan must be classified as current #6 Subjective Acceleration Example 28. Issue Lockbox arrangements, subjective accelerations clauses and springing lockbox arrangements can cause complexity when determining proper classification of liability. The Kicker Borrowings under a line of credit with a lockbox arrangement will be classified as current liabilities regardless of the line of credit due date because borrowings are repaid from current assets (need to meet exception otherwise). #7 Revolving Credit Agreement The Issue 29. If borrowings are due when the underlying short- term notes roll over, determine if short-term notes automatically replace other short-term notes upon maturity and if the rollover extends beyond one year. If so, classify borrowings as noncurrent if agreement meets criteria in ASC 470-10-45-14b These are the criteria used to classify a short-term obligation that the borrower intends to refinance on a long-term basis as noncurrent #7 Revolving Credit Agreement The Rules 30. If the agreement includes a lockbox and it is at the borrowers discretion, the existence of a lockbox does not impact classification. Does the lockbox arrangement require lockbox deposits to be used to repay the loan without another event occurring (happens automatically)? If so, classify as current unless exception in 470-10- 45-14b met. If agreement contains a SAC, it will fail criteria in 470- 10-45-14b automatically regardless if the SAC is exercised. #7 Revolving Credit Agreement The Rules 31. Does the arrangement call for deposits to be automatically applied to loan only if another event occurs? i.e. springing lockbox arrangement If so, existence of lockbox arrangement does not impact classification. Does it also have a SAC? If so, determine if acceleration is remote or more than remote. #7 Revolving Credit Agreement The Rules 32. Lockbox SAC Current or Noncurrent Classification None None Noncurrent None Yes Noncurrent if it is remote lender will exercise its right Traditional None Noncurrent only if 470-10-45-14b exception is met Traditional Yes Current because 470-10-45-14b exception will not be met Springing Yes Noncurrent if remote lender will exercise its right #7 Revolving Credit Agreement The Rules 33. Agreement dated March 1, 2012 for $30M 4-year revolver Agreement permits a series of renews of 90 days each until the end of the 4-year period Lender requires all customer payments to be submitted to lockbox which are used to pay down revolver Current or Noncurrent classification at 12/31/12? Noncurrent - Absent the revolver meeting the conditions of 470-10-45-14b borrower would classify as current because payments are being made from use of current assets. However agreement meets requirement of 470- 10-45-14b for classification as noncurrent because of the intent to refinance on long-term basis. #7 Revolving Credit Agreement Example 34. Agreement dated March 1, 2012 for $30M 4-year revolver Agreement permits a series of renews of 90 days each until the end of the 4-year period Lender requires all customer payments to be submitted to lockbox which are used to pay down revolver Lender can require borrower to pay all outstanding amounts within 30 days if material adverse change. Current or Noncurrent classification at 12/31/12? Current - One of the requirements of 470-10-45-14b is that the agreement may only be cancelable within 1-year of the borrowers balance sheet date if borrower violates an objectively determinable provision. #7 Lockbox Arrangements Example 35. Debt agreements can have terms that can cause surprising classification issues Why do we care so much about debt classification? Debt covenants may contain requirements for working capital therefore debt classification is critical Auditors may consider liquidity in assessment of going concern Potential lenders will assess borrowers liquidity #7 What was the FASB thinking? 36. Should be amortized over the shorter of their economic lives or the term of the lease Lease term includes fixed noncancellable term plus: Periods covered by bargain renewal options Periods where the lessees failure to renew the lease imposes a material penalty whereby renewal is reasonably assured Renewal or extension periods that are at the option of the lessor Periods covered by ordinary renewal options preceding the date in which a BPO can be exercised #8 Amortization of LHI The Rules 37. 10 year Noncancellable lease signed on Sept 1, 2005 with terms beginning Jan 1 2006 One renewal option for additional 5 years Property in desirable location; market for space tight If exercised renewal requires market rate adjustment No cash penalty to lessee if renewal not exercised Lessee invests $3M during remainder of 2005 with useful life of 25 years Leassee occupied space January 3, 2006 #8 Amortization of LHI Example 38. Amortize over the shorter of estimated useful life of assets (25 years) or lease term. Would lessee suffer an economic detriment upon termination at the end of initial term w/o renewal? Lack of alternative space in the market, coupled with the abandoned LHI, would constitute a penalty such that at the inception of the lease, renewal is reasonable assured. Lease term would be 15 years (plus 3 months???). #8 Amortization of LHI Example 39. FTB 85-3, Accounting for Operating Leases with Scheduled Rent Increases, stipulate that rent expense for operating leases with rent-free periods or scheduled increases must be accounted for on a straight-line basis over the lease term, including the related holiday period Unless another systematic and rational method is more representative of the lessees pattern of use over time. Treatment assumes that lessee takes possession of or controls the property at the inception of the lease. #9 Rent Holidays The Rules 40. LHIs made by the tenant but funded by the landlord under an operating lease Should be recorded by lessee as LHI assets and amortized Incentive should be recorded as deferred rent and amortized over straight line basis as a reduction in rent expense The treatment considers the incentive to be inseparable element of overall agreement recognized along with other lease provisions. #10 Landlord/tenant Incentives The Rules 41. January 1, 2006 lessee signed 10 year operating lease Fixed monthly rent of $20k with no renewal or rent holiday Lessee needs to make improvements to space to satisfy business requirements Lessor agrees to reimburse lessee 25% of first $1M of improvements January 1 through June 30 lessee spent $1.5M and received $250k from lessor Lessee occupies space on July 1, 2006 #10 Landloard/tenant Incentives Example 42. LHI $1.5M amortized over 10 years = $150k/year Deferred rent $250k over 10 years = $25k/year Rent expense = $240k/year Therefore Year 2 Rent expense $215k ($240k-$25k) Amortization expense $150k Dont reduce the LHI by the incentive! #10 Landloard/tenant Incentives Example 43. In a February 7, 2005, SEC staff letter to the AICPAs Center for Public Company Audit Firms (CPCAF), clarity on the application of three key issues for lessees: The proper amortization period for leasehold improvements; Accounting for rent holidays; and The treatment of construction incentives received from landlords. The resulting wave of restatements highlighted the diversity in long-standing industry practices and the misapplication of existing GAAP in these areas. #8,9,10 What was the FASB thinking? 44. Questions 45. JENNIFER GOODMAN, CPA Assurance Principal | jennifergoodman@decosimo.com Jennifer Goodman is an assurance principal with more than 15 years experience in public accounting. Jennifer provides audit and assurance services, including audits of internal control over financial reporting, to privately held businesses, public companies, not-for-profit organizations and manufacturing and distribution clients. She contributes to the firms manufacturing and distribution team by providing cost accounting expertise, insights into best practices and specialized advice regarding internal control issues. Her experience also includes financial statement audits, audits of internal control over financial reporting and limited scope consulting engagements for foreign firms performing assurance engagements for foreign SEC filers.