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FASB Update with FASB Update with Comparison to IFRSComparison to IFRS

For Acct 592

Spring 2008

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SFAS No. 151 – Inventory Costs 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.

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Changes in Principles, Changes in Principles, Estimates, Entities & Estimates, Entities & Corrections of ErrorsCorrections of Errors

SFAS No. 154 - Accounting Changes and Error Corrections

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Accounting Changes & CorrectionsAccounting Changes & Corrections

SFAS No. 154 discusses 3 types of accounting changes plus correction of errorsChanges in Accounting PrincipleChanges in Accounting EstimatesChanges in Reporting EntityErrors in Financial Statements

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SFAS No. 154 - Accounting SFAS No. 154 - Accounting Changes and Error CorrectionsChanges and Error Corrections Issued May 2005 – effective for fiscal years

beginning after 12/15/2005 Applies to VOLUNTARY changes in choice of

accounting principle 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 Change previously reported numbers so that they now

represent what the numbers would have been had the new principle been in use during that time period

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Some changes in principle = a Some changes in principle = a change in estimatechange in estimate A change in depreciation method is now

considered a change in estimate and would not require retroactive restatement of prior years We already had the rule that if a change in principle

cannot be distinguished from a change in estimate, it would be treated as a change in estimate

Example: Switch bad debt accounting from percentage of sales method to aging of accounts receivable (allowance) method

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Asset cost $240,000Estimated residual value $40,000Estimated service life 5 years

Depreciation ExampleDepreciation Example

Consider these facts related to an asset acquired January 1, 2010:

The company uses straight-line depreciation Assume that after 2 years, it becomes obvious that the asset

will be used for a total of 8 years At the end of 8 years, it will be worth $10,000 What depreciation expense should be recorded for 2012?

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160,000 -10,000 = 6

$240,000

YearDepreciation

Book value at end of year

2010 40,000$ $200,0002011 40,000$ $160,000

2012 25,000$ $135,000

2013 25,000$ $110,0002014 25,000$ $85,0002015 25,000$ $60,0002016 25,000$ $35,0002017 25,000$ $10,000

$240,000 - 40,000- 40,000 =$160,000

Carrying Value

Solution – Prospective MethodSolution – Prospective Method

8 - 2

new estimate

$ 25,000

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Alternate treatment – IFRS Alternate treatment – IFRS (Cumulative effect method)(Cumulative effect method) If we had originally known new facts:

We would have had $57,500 in accumulated depreciation at end of 2011.

Actually in acc’d depreciation = $80,000 Make adjusting JE and then continue with

$28,750 depreciation for remaining useful life

240,000 -10,000 = $28,750 8

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Alternate treatment – IFRS method?Alternate treatment – IFRS method?

2012Correcting JE:

Acc’d Depr 22,500 Depr Exp 22,500

Record 2012 depreciation:

Depr Exp 28,750

Acc’d Depr 28,750

240,000 -10,000 = $28,750 8

$240,000

YearDepreciation

Book value at end of year

2010 40,000$ $200,0002011 40,000$ $160,000

2012 6,250$ $153,750

2013 28,750$ $125,0002014 28,750$ $96,2502015 28,750$ $67,5002016 28,750$ $38,7502017 28,750$ $10,000

Example - Coal MineExample - Coal Mine

Cost of property $9,000,000 Cost to restore property $1,200,000* Value after restoration $1,000,000 Recoverable resources 4,000,000

tons First year production 150,000 tons Sold for $30 per ton

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* Present value (asset retirement obligation measured in accordance with SFAS No. 143)

Statutory depletion rate for tax purposes = 10%

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Cost basis + cost to restore - residual value after restoration Total estimated recoverable units

$9,000,000 + 1,200,000 - 1,000,000 = 4,000,000 tons $2.30 per ton

Sold 150,000 tons, therefore cost depletion = 150,000 * 2.30 = $345,000

Coal mine example:Coal mine example:

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Coal mine example, continuedCoal mine example, continued

Assume that 250,000 tons of coal were produced and sold during the second year of operation

However, new EPA regulations increased the projected restoration costs to $2,000,000 (asset retirement obligation)

At the beginning of the second year of production, geologist estimate 4,050,000 tons remain

We start over estimating the depletion rate per ton -- using the current BOOK VALUE instead of cost

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Coal Mine ExampleCoal Mine ExampleCost basis + cost to restore - residual value after restoration Remaining recoverable units (estimated)

Cost basis is now $9,000,000 - $345,000 = $8,655,000

The cost to restore is now $2,000,000

The new estimate of recoverable units (including 2nd year’s production) is 4,050,000 tons(3,800K left + 250K mined this year)

$8,655,000 + $2,000,000 - $1,000,000 = $2.38 per ton 4,050,000

250,000 tons * $2.38 = $595,000 depletion expense

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Statutory DepletionStatutory Depletion

Note that the tax deduction would be much higher using statutory depletion allowance (a permanent difference between accounting and tax return)

Year 1 - 150,000 tons * $30 per ton = $4,500,000 revenue * 10% statutory rate = $450,000 on tax deduction vs. $345,000 on income statement

Year 2 - 250,000 tons * $33 per ton = $8,250,000 Revenue * 10% statutory rate = $825,000

tax deduction vs. $595,000 on income statement

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Restatement ExampleRestatement Example

SFAS No. 154, Appendix A Illustration 1 - detailed example of a change

from LIFO to FIFO inventory method Shows extensive disclosures that would be

needed to communicate impact on balance sheet, income statement, and statement of cash flows

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A simplification?A simplification?

Now all types of accounting changes are handled the same way – retroactive restatementOnly exception is when it is not practicable to

determine impact on prior periods

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Fair Value Fair Value MeasurementsMeasurements

SFAS No. 157

Signs of the Future!

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FAS157 Issued Sept. 2006FAS157 Issued Sept. 2006

With a few exceptions, it does not change WHAT is currently measured using fair value

Sets out a framework for measuring fair value

Requires additional disclosures about fair value measurements

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FAS157 – Definition of Fair ValueFAS157 – Definition of Fair Value

Paragraph 5 - Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.This is an exit-price definition of fair value

(see paragraph 7)

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FAS157 – Related definitionsFAS157 – Related definitions

Market Participants (4 criteria) Independent of reporting entityHave knowledge needed for reasonable

understanding about transactionFinancial and legal ability to enter into the

transactionBe willing to enter into transaction without

compulsion

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Accounting Changes & Corrections - Accounting Changes & Corrections - summarysummary SFAS No. 154 discusses 3 types of

accounting changes plus correction of errors

1. Changes in Accounting Principle retroactive

2. Changes in Accounting Estimatesprospective

3. Changes in Reporting Entity retroactive

4. Errors in Financial Statements retroactive

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Fair Value Fair Value MeasurementsMeasurements

SFAS No. 157

Signs of the Future!

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FAS157 – Related definitionsFAS157 – Related definitions

Principal Market Has the greatest volume and level of activity.

If there is no principal market, use the most advantageous market

Most Advantageous Market Most advantageous market has price that maximizes

the net amount that would be received or minimizes the net amount paid

Transactions costs are included in determining which market to use but do NOT become part of the fair value measurement

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Example of which market…Example of which market…

Market A Market B

Selling price $50 $48

Transaction cost $5 $2

Net proceeds $45 $46

Fair value to use $48

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FAS157 – Related definitionsFAS157 – Related definitions

Assumptions about the market The asset or liability is exchanged in an orderly

transaction between market participants An orderly transaction is a transaction that assumes

exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities;

it is not a forced transaction (for example, a forced liquidation or distress sale).

The price is for a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the item

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FAS157 – Related definitionsFAS157 – Related definitions

Valuation premise – the assumption about how market participants would use an assetChoose the premise based on “highest and

best use” In-use premise

Provides maximum value through use in combination with other assets

In-exchange premise Provides maximum value principally on a stand-alone

basis

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Valuation TechniquesValuation Techniques

Market approach Uses observable prices from market transactions for

comparable assets or liabilities

Income approach Analysis of future cash flows using present values

Cost approach Estimates cost to replace an asset’s service capacity

A change in valuation technique is a change in accounting estimate, not a change in accounting principle

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The “Fair Value Hierarchy”The “Fair Value Hierarchy”

Level Inputs to achieve reliability level

1 Quoted prices in active markets for identical assets or liabilities

2

Observable prices in active markets for similar assets or liabilities, or prices from markets that are not active. Market inputs for substantially full term of item (interest rates). Market inputs that are not directly observable but can be derived or corroborated by market data

3Unobservable inputs based on the reporting entity’s own assumptions about assumptions that market participants would use. Cannot be corroborated by observable market data

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Valuing LiabilitiesValuing Liabilities

The valuation technique must consider the reporting entity’s credit standingA reporting entity could record a GAIN for

derivatives at a measurement date because the fair value of the liability decreases in response to a credit downgrade if all other inputs remain unchanged

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Restrictions on AssetsRestrictions on Assets

Restrictions are evaluated to determine whether they are an attribute of the asset or an attribute of the reporting entity If sold, would the restriction transfer to another

holder? If yes, the impact of the restriction would be taken into

consideration (adjust asset fair value downward) If no, the restriction would not reduce the fair value

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Other provisions of FAS157Other provisions of FAS157

It is now possible to recognize a gain on the day recognized (previously prohibited under EITF 02-3)

Blockage adjustments are not permitted in pricing

Bid-ask spreadsUse the price within the bid-ask spread that is

most representative of fair value in the circumstances

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FAS 157 DisclosuresFAS 157 Disclosures

Will be extensive and reported in three sections (see paragraph A33-A36 for examples) Assets and liabilities measured at fair value on a

recurring basis Tabular display reconciles beginning and ending amounts

when significant Level 3 inputs are used Assets and liabilities measured at fair value on a

nonrecurring basis (impairment of assets, etc.) For all fair value measurements, a table showing the

reliance on Level 1, 2 or 3 inputs plus discussion of the valuation techniques used for the measurements

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FAS 157 – effective dateFAS 157 – effective date

Implementation is prospective Required for financial statements issued

for fiscal years beginning AFTER Nov. 15, 2007

A new FSP has delayed the effective date for ‘HIERARCHY LEVEL 3’ measurements like asset retirement obligations

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FAS 159 – The Fair FAS 159 – The Fair Value OptionValue Option

Optional use of fair value for certain assets and liabilities

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Essentially a one-time electionEssentially a one-time election

On a contract by contract basis, company can designate specified financial instrument to be accounted for using fair value instead of the usual measurement technique

Companies may be able to reduce volatility in reported earnings caused by measuring assets and liabilities differently

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Other “benefits”Other “benefits”

Movement toward accounting for all financial instruments at fair value

Brings US GAAP into closer agreement with IASB 39 which already contains a fair value election

However, it is not “perfect agreement”

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Eligible assets & liabilitiesEligible assets & liabilities

Most recognized investments including those currently accounted for using the equity method But cannot be used to recognized investments that

must be consolidated (VIEs, subsidiaries)

Many recognized liabilities Excluding leases, demand deposits of banks,

postretirement plans, etc.

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Eligible assets & liabilitiesEligible assets & liabilities

Firm purchase commitments that would otherwise not be recognized at inception (but only for ones involving financial instruments)

Rights and obligations under warranties that meet certain requirements

Certain host financial instruments that result from separation of embedded nonfinancial hybrid instruments under FAS133

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Irrevocable electionIrrevocable election

Must be applied to contracts as a whole and not to parts of contracts

Changes in fair value will be recognized in earnings during each reporting period

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Election dateElection date

Transition – any eligible item as of the date that FAS159 is initially adopted

Thereafter:The eligible item is first recognized (including

entering into an eligible firm commitment)Occurrence of a short list of other events

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DisclosuresDisclosures

If fair value option is elected, company must disclose separately assets and liabilities measured at fair value from those not measured at fair value Intended to help readers compare companies

that choose the option to those that choose not to elect fair value accounting

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Disclosures – specific (1)Disclosures – specific (1)

Why fair value option was selected for each eligible item

Difference between fair value and aggregate unpaid principal amounts

Relation to other fair value measurements under FAS157

Description of partial applications to groups of similar items and why company chose not to be consistent

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Disclosures – specific (2)Disclosures – specific (2)

Loans carried at assets at fair value that are past due by 90 days or more

APB18 disclosures about investments that would otherwise have been reported using equity method

Description of how interest and dividends are measured and reported for items with fair value election

Quantitative information (line by line) as to where gains and losses related to fair value option have been reported in the income statement

Comparison to IFRSComparison to IFRS IFRS {IAS39} Significant restrictions on

applying FVO Documented strategy required

to support use of FVO FVO must generally be applied

to all eligible financial instruments that are managed and evaluated together

Entities cannot reclassify financial instruments into or out of FVO while held

FVO not available to insurance contracts and warranties

U.S. GAAP {FAS159} Wider scope of application with

fewer restrictions to use FAS159 does not prescribe how

documentation of the FVO should be created and maintained

FVO need not be applied to all instruments issued or acquired in a single transaction

Greater opportunity to elect the FVO

FVO can be applied to insurance contracts and warranties

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What’s Next?What’s Next?

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Exchanges of Exchanges of Nonmonetary AssetsNonmonetary Assets

SFAS No. 153 – Exchanges of Nonmonetary Assets

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Exchanges of nonmonetary assetsExchanges of nonmonetary assets

Formerly had special rules for exchanges of “similar assets”Losses were recognizedGains were not recognized or only partially

recognized (if boot {cash} was received) Those rules are now GONE

Probably a good thing since the new rules are actually less complicated!

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From Kieso Update2 for 11From Kieso Update2 for 11thth ed. ed.

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SFAS No. 153 –Exchanges of SFAS No. 153 –Exchanges of Nonmonetary AssetsNonmonetary Assets Nonmonetary exchanges are recognized at the

fair value of the nonmonetary asset relinquished (unless fair value of asset received is more clearly evident)

EXCEPTIONS1.Fair value is not determinable for either asset2.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.

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Commercial SubstanceCommercial 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

2. The entity-specific value is different

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Examples (from KWW update)Examples (from KWW update)

Two car rental companies swap Fords for Chevys [equivalent models] to increase variety of cars availableLacks commercial substance because the

cash flows generated by rental activities will be substantially the same

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Car Rental Company ExampleCar Rental Company Example

The (loss)/gain will be recognized as the vehicles are used since depreciation expense will be higher (lower)

Here is the JE that the company receiving the Chevy’s will make:

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Car Rental Company ExampleCar Rental Company Example

Make the journal entry on the books of the company that receives the Fords (assume cost is $200,000 and accumulated depreciation is $40,000):

Ford automobiles 150,000Chevy automobiles 200,000Acc’d Depreciation 40,000

Cash 10,000

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Asset Retirement Asset Retirement ObligationsObligations

FIN 47 - Accounting for Conditional Asset Retirement Obligations: an interpretation of FASB Statement No. 143

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Do we need to review FAS 143?Do we need to review FAS 143?

There are lecture notes on the “notes” page at the course web site

I’m not sure if there will be time to fit this topic in this semester but some of you have done a research case on AROs (in Acct 414 or 315) If you know nothing about this topic and want to do

something for extra credit, ask about this case

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Asset retirement obligationsAsset retirement obligations

FIN 47 (March 2005) would clarifies 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.

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ARO ExamplesARO Examples

Telephone company uses wood poles that are chemically treatedNo legal requirement to remove poles from

groundHowever, if and when poles are removed from

the ground, special disposal procedures are mandated by law

An asset retirement obligation should be estimated at date of purchase

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ARO ExampleARO Example

Facility currently owned contains asbestosSince acquisition, regulations are put into

place that require special handling if building is renovated or demolished

ARO should be recognized when regulations go into effect, if entity can reasonably estimate fair value of the liability