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impairment

The Financial Accounting Standards Board (FASB) Recently Issued New Guidance

The Financial Accounting Standards Board (FASB) recently issued new guidance that makes a paradigm shift in how entities will measure credit losses for most financial assets and certain other instruments that aren’t measured at fair value through net income. The new standard responds to criticism that existing guidance delays recognition of credit losses to point when credit event occurs.

The standard will replace today’s “incurred loss” approach with an “expected loss” model for instruments measured at amortized cost and require entities to record allowances for available-for-sale (AFS) debt securities rather than reduce the carrying amount, as they do today under the other-than-temporary impairment (OTTI) model. It also simplifies the accounting model for purchased credit-impaired debt securities and loans.

The requirements of this standard differ significantly from the three-stage expected credit loss model of IFRS 9, Financial Instruments, which the International Accounting Standards Board issued in July 2014. Under the new model if the credit risk of a financial asset has not increased significantly since its initial recognition, the financial asset will attract a reserve equal to 12-month expected credit losses. However, if its credit risk has increased, significantly, it will attract a reserve equal to lifetime expected credit losses, thereby increasing the amount of impairment recognised.

Key changes

The new standard requires entities to use the following models:

  • The new “expected credit loss” impairment model, which is codified in Accounting Standards Codification (ASC) 326-20 and will apply to most financial assets measured at amortized cost and certain other instruments, including trade and other receivables, loans,held-to-maturity (HTM) debt securities, net investments in leases and off-balance-sheet credit exposures (e.g., loan commitments, standby letters of credit)
  • An AFS debt security impairment model (codified in ASC 326-30) that is a modification of today’s OTTI model.
  • The existing model for beneficial interests that are not of high credit quality (ASC 325-40),amended to conform to the new impairment models for HTM and AFS debt securities The existing loss contingency model in ASC 450-20 will apply to instruments outside the scope of these models, including receivables between entities under common control,participant loans made by a defined contribution plan, pledges receivable of a not-for-profit entity and policy loan receivables of an insurance entity.

The standard also eliminates today’s accounting model for purchased credit impaired loans and debt securities. Instead, entities will gross up the initial amortized cost for so-called purchased financial assets with credit deterioration (PCD assets). Under this approach, an entity will record as the initial amortized cost the sum of (1) the purchase price and (2) the estimate of credit losses as of the date of acquisition. Thereafter, the entity will account for PCD assets using the models listed above.

The new ‘expected credit loss’ model

The standard requires an entity to estimate its lifetime “expected credit loss” and record an allowance that, which when deducted from cost basis of the instruments, presents the net amount expected to be collected on the financial asset. The standard says an expected credit loss estimate should:

  • Be based on an asset’s amortized cost (including premiums or discounts, net deferred fees and costs, foreign exchange and fair value hedge accounting adjustments)
  • Reflect losses expected over the remaining contractual life of an asset, considering the effect of voluntary prepayments
  • Consider available relevant information about the collectibility of cash flows, including information about past events, current conditions, and reasonable and supportable forecasts
  • Reflect the risk of loss, even when that risk is remote, meaning that an estimate of zero credit loss would seldom be appropriate.

How it affects us

Moving from today’s “incurred loss” model to the new “expected credit loss” model will require entities to change their impairment processes, even for simple financial assets such as receivables. These would include (i) Maintaining and using lifetime loss information instead of annual loss data and (ii) forecasting future economic conditions and quantifying the effect of those conditions on expected losses.

AFS debt security liability

The standard amends the impairment model for AFS debt securities and requires entities to determine whether all or a portion of the unrealized loss on an AFS debt security is a credit loss. The standard also indicates that management may not use the length of time a security has been in an unrealized loss position as a factor in concluding whether a credit loss exists,as they are permitted to do today.

Under the new guidance, an entity will recognize an allowance for credit losses on AFS debt securities as a contra-account to the amortized cost basis rather than as a direct reduction of the amortized cost basis of the investment, as is currently required. As a result, entities will recognize improvements to estimated credit losses on AFS debt securities immediately in earnings rather than as interest income over time, as they do today.

Transition 

Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective.

The standard is effective as follows:

  • For public business entities (PBEs) that meet the definition of a Securities and Exchange

Commission (SEC) filer, the standard is effective for annual periods beginning after

15 December 2019, and interim periods therein.

  • For other PBEs, the standard is effective for annual periods beginning after 15 December

2020, and interim periods therein.

  • For all other entities, the standard is effective for annual periods beginning after 15 December

2020, and interim periods within annual periods beginning after 15 December 2021.

Early adoption is permitted for all entities for annual periods beginning after 15 December

2018, and interim periods therein.

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Current GAAP Requires That Goodwill be Tested for Impairment At Least Annually

Background 

Current GAAP requires that goodwill be tested for impairment at least annually using a two-step process as follows:

Step 1: an entity compares the fair value of its reporting units with their carrying value, including goodwill. If the fair value of a reporting unit (including goodwill) exceeds its carrying amount, the goodwill of the reporting unit is not considered impaired and step 2 is not applicable. If, however,the fair value of the reporting unit (including goodwill) is less than its carrying amount,an entity must proceed to step 2 to determine the amount of the impairment loss.

Step 2:If the carrying amount of a reporting unit is greater than its fair value, a reporting entity must calculate the implied fair value of goodwill by performing a hypothetical application of the acquisition method as of the date of the impairment test. In other words an entity assigns the fair value of a reporting unit determined in first step step 1, to all the assets and liabilities of that reporting unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. The goodwill impairment, if any, is equal to the excess of the carrying amount of goodwill over its implied fair value.

Due to concerns about the cost and complexity of the annual goodwill impairment test, the FASB on November 25, 2013, the FASB added a project to its agenda on the accounting for goodwill for public business entities and not-for-profit entities.

Subsequently on October 28, 2015, the FASB decided to proceed with the project under a phased approach. The first phase is to simplify the impairment test. In the second phase of the project, the FASB plans to work concurrently with the IASB to address any additional concerns.

Subsequent Measurement

The Board decided to simplify the impairment test by removing the requirement to perform a hypothetical purchase price allocation when the carrying value of a reporting unit exceeds its fair value (step 2 of the impairment model in current GAAP). The Board considered but decided not to allow entities an option to perform step 2.

The Board decided that entities should apply the same impairment model for a reporting unit with a zero or negative carrying amount as the model for a reporting unit with a positive carrying amount by comparing the fair value of the reporting unit to its carrying amount. This reverses the Board’s previous decision to require the write-off of goodwill allocated to reporting units with zero or negative carrying amounts.

Presentation

The Board decided not to make any changes to the presentation requirements in current GAAP.

Disclosures

The Board decided that in addition to the current disclosure requirements, entities with reporting units with zero or negative carrying amounts should disclose the following:

  • Identification of reporting units with zero or negative carrying amounts
  • The amount of goodwill attributable to each reporting unit with a zero or negative carrying amount.

Transition

The Board decided that entities would be required to adopt the simplified impairment test prospectively.

Transition Disclosures

The Board decided that entities should provide the applicable disclosures described in paragraphs 250-10-50-1(a), which requires disclosure of the nature of and reason for the change in accounting principle, and 250-10-50-2, which states that the required transition disclosures should be included in both interim and annual financial statements in the period of the change.

Source: FASB website

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US GAAP UPDATES

FASB Issues Accounting Standards Update 2016-08—Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)

In March 2016 the FASB issued Accounting Standard Update 2016-08 to address issues related to guidance on principal versus agent arising from the discussion of Transition Resource Group meetings. While the amendments in this Update do not change the core principle of the guidance (i.e. the 5 step revenue recognition model), the amendments clarify the implementation guidance on principal versus agent considerations.

When another party is involved in providing goods or services to a customer, an entity should evaluate whether the nature of its promise is to provide the specified good or service itself (that is, the entity is a principal) or to arrange for that good or service to be provided by the other party (that is, the entity is an agent). When an entity is a principal, the entity recognizes revenue in the gross amount of consideration to which it is entitled in exchange for the specified good or service.Conversely as an agent, the entity recognizes revenue in the amount of any fee or commission to which it expects to be entitled in exchange for arranging for the specified good or service to be provided by the other party.

The amendments in this Update are intended to improve the operability and understandability of the implementation guidance on principal versus agent considerations by clarifying the following:

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Business Transformations: Importance

Business Transformation continues to present challenges and disappointments more often than not.  There have been many books and publications those attempted to provide insight for business leaders (including management accountants) but we still struggle to improve business performance through transformation programs driven by ERP.  It typically isn’t a failure of one functional group rather paths to success have changed quite dramatically over the last decade or so.  There is no single approach to resolving these problems; success requires a coordinated program that involves multiple elements. This means evolving from a world that’s understood and organised by functions to where ERP applications have exposed the logical relationship b/w functions.  Most companies haven’t recognised this revelation, so they continue to attempt to resolve cross functional design issues from a functional mind set.

The Challenge:

Let’s take an example of receiving raw materials. Say, 20 years ago the material would arrive at the loading dock, and clerk would complete a paper form on which receipt will be recorded, showing material, PO number, vendor etc. The supervisor would take the material and take to purchasing department. Next morning clerk would clip the original PO to the pertinent receiver and place them on purchasing manager’s desk. Purchasing manager would check the documents and proceed to accounts department where accounting clerk would look up the standard cost for the material, multiply with the quantity, place the entry in the GL and pass the file to A/P, and so on.  Each department analysed and modified the information so then everyone who needed information received it eventually. Each department adapted the detailed information to its particular processes and procedures. As early IT applications were developed, overnight updates would translate the information from one form to another and update files.  Today when material arrives, operator takes a hand held device, looks up the PO, creates receiver on the device, enters the transaction and everything, which used to take a day or so during manual operating days, happens as a result of one action. What’s the procedure for moving from a manual process (with many opportunities to tailor the information) to one where the company has aligned all functional processes and then designed, implemented and accepted consistent cross functional business processes?

Anything as dramatic as a business transformation must be built into company’s vision, which can take the form of merger/ acquisition strategy, an organic growth approach, or many others.  To ensure an effective business transformation:

  • Vision must define, understand and address the current or potential customer’s needs(i.e., Focus on Customer).
  • Vision must include the concept of business optimization(i.e., addressing internal issues of process competence and performance).

Focus on Customer: The dynamics of moving from one style to the other require redesigning many business processes that have always been part of a logically integrated organism that we managed functionally.  Change requires the ability to see the logic and design for efficiency.  Widespread introduction of ERP applications initiated about 20 years ago. Today we have entire suites of functionality available that provide opportunities to understand cross- functional integration to meet customer’s ever changing needs.  To use the new capabilities we need a different approach to business reengineering, so its necessary to capitalise on new, logical insight into how integrated business process operate.

Business Optimisation: Business optimisation requires companies to:

  • Analyse business fundamentals that affect both cost and revenue
  • Identify areas ripe for improvement;
  • Create a ROI stream;
  • Select IT applications that support process designs and implementations;
  • Create continuous improvement governance programs; and
  • Create and implement optimal business process designs.

The Transformational Organisation

It’s the organisation rather an individual that must be truly transformational for a business to make the most effective use of the capability of IT applications. On the other hand, one key leader who doesn’t see himself or herself as transformational can easily derail the entire process.  There are many examples from both ends of the spectrum that rendered all efforts fruitless.

Example1 :One CEO declared that the business team was too busy with “more important things” to become involved in defining business processes, so the CIO was,  by edict, IT leadership, business leadership and owner of all the solutions. The CFO supported the decision and CIO accepted it.  The result? The technical team and software vendor consultants designed business process and functionality that the functional business executives never accepted. The program failed!

Example 2 :Inanotherbusiness, the CIO, a business leader, drove the transformational program at the direction and with the support of the CEO, only to be derailed by a revolt of functional business leaders who hadn’t bought into the program. Here CEO thought that by assigning a business leader to lead the ERP implementation, he could gain acceptance from the other senior executives. But, now work was done to alter the functional thought process of the other executives, and the CIO was simply written off as a traitor.

Example 3 :Inanotherbusiness,  leaders talked the talk very well, but at the end of the program, they distrusted the ROI, managed costs to the lowest level possible, compressed timelines, marginalised project teams and eliminated critical program elements because they didn’t understand their importance. Here, while individual leaders may have accepted opportunities to transform their parts of the organisation, the organisation remained rooted in past behaviours and resisted changing the business process both within and between their areas of responsibility.

Finally, we need to remember are:

  1. Transformation isn’t for the faint of hearts. It’s difficult and complex business that requires cross functional understanding and focus throughout the executive suites.
  2. Key leaders’ roles are crucial to any organisation trying to become transformational, and not one of the key leaders individually has the ability to perform all the necessary roles.
  3. Selecting key leaders who understand and embrace the transformational process is critical to success.
  4. It’s necessary to train the cross functional leadership team on the role of business process supported by integrated business applications to deliver improved business results.
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New Lease Accounting Model – The Beginning of New Way

On 13 January 2016 the International Accounting Standard Board issued IFRS 16 Leases, the new accounting standard on leasing. The new standard eliminates the distinction between finance and operating leases for lessees and requires recognition of lease liabilities for leasing arrangements.

This contrasts with the existing accounting models for leases require lessees and lessors to classify their leases as either finance leases or operating leases and account for those leases differently and a result lessee in an operating lease is not required to present important information about significant assets and liabilities arising from leases.

The project was few years back the International Accounting Standards Board (‘IASB’) and the Financial Accounting Standards Board (‘FASB’) initiated a joint project to develop a new approach to lease accounting that would require almost all assets and liabilities arising from leases to be recognised in the statement of financial position. While IASB has issued its leasing standard the FASB is expected to issue the new leasing standard under US GAAP in first quarter of 2016.  The new requirements would supersede the present requirements with respect to lease accounting under IFRS and US GAAP respectively.

After the initial Exposure Draft (‘ED’) issued in the year 2010, both FASB and IASB issued a revised ED of the standard in May 2013. They received significant feedback on their proposals and consequently the Boards redeliberated almost all aspects of the revised ED.

IFRS 16 is effective for annual period beginning on or after 1 January 2019.. A company can choose to apply IFRS 16 before that date but only if it also applies IFRS 15 Revenue from Contracts with Customers. It is expected that the new standard will be adopted in India from Financial Year 2019-20

Lessee accounting model

Under the new model the underlying principle reflects that, at the start of a lease, the lessee obtains the right to use an asset for a period of time and has an obligation to pay for that right. Consequently the new standard requires lessees to recognise assets and liabilities arising from all leases on the balance sheet, subject to certain exemptions for short term (leases with a lease term of 12 months or less) and small asset leases (where the underlying asset has a low value when acquired).

As the new standard considers all leases as financing arrangements, a lessee would always recognize and present in the income statement amortisation of lease assets separately from interest on lease liabilities.

Impact on the balance sheet

For companies that currently have significant operating leases, the new lease standard is likely to result in increase in lease assets and corresponding lease liabilities and may have significant impact on key financial ratios derived from recognition of lease assets and liabilities (for example, leverage and performance ratios).

While the proposed guidance is expected to affect lessees across all sector, impact is likely to be higher on “asset-light” business models, particularly in the aviation, retail and logistics sectors.

Impact on the income statement

The impact on income statement of the new model will depend on the significance of leasing to the lessee and the length of its leases. EBITD A is likely to increase compared to the amounts reported today because, a lessee will present the implicit interest component operating lease payments as part of finance costs whereas, today, the entire lease expense is included within operating costs.

The net profit, however, is likely to decrease because interest expense is typically front loaded as the combined effect of amortization of lease asset and interest on lease liability is higher in the earlier years of a lease than in the later years and vice-versa. Over the lease term, the total amount of expense recognised is the same.

Impact on the cash flow statement

Consistent with the balance sheet, the new model reduces operating cash outflows, with a corresponding increase in financing cash outflows for principal repayments, compared to the amounts reported today to reflect the economics of a financing arrangement 

Lessor accounting model

The lessor’s accounting will not change as the difference between finance and an operating lease has been retained. However, it requires a lessor to provide some additional disclosures to enable users of financial statements to better evaluate the uncertainty of cash flows associated with the lessor’s leasing activities. The enhanced lessor disclosure requirements are as listed below:

  • Table of lease income- requires a lessor to disclose the components of lease income recognised in the reporting period.
  • Information about exposure to residual asset risk- requires a lessor to disclose information about how it manages its risk associated with any rights that it retains in leased assets.
  • Information about assets subject to operating leases- IFRS 16 requires a lessor to provide the disclosures required by IAS 16 Property, Plant and Equipment separately for assets subject to operating leases-further distinguished by significant classes of underlying assets from owned assets that are held and used by the lessor for other purposes.

Key differences between IASB and FASB model

Recognition

While both IASB and FASB requires a lessee to recognise lease assets and liabilities on the balance sheet giving an exemption related to short term leases, the IASB model provides an additional exemption for small asset leases (i.e. asset whose underlying value is low at inception) from recognition as assets and liabilities. 

Measurement

Although both Boards require recognition of lease liabilities for all leasing arrangements on the balance sheet, the Boards have diverged on the recognition of leases in the lessee’s income statement. While the IASB’s model requires all leases to be presented in a manner similar to today’s finance leases  (referred to as Type A leases), the FASB has proposed a dual model that, in addition to Type A leases, would permit a straight-line expense recognition pattern similar to today’s operating leases (referred to as “Type B”). This is achieved by measuring the amortisation of the lease asset each period as a balancing amount (i.e., accounting plug), calculated as the periodic straight-line lease expense (calculated in a manner similar to current Type Aoperating leases) minus interest on the leType Base liability for the period. Therefore for the Type B leases the amortisation of leases asset will be inverse of interest on lease liability i.e. it will lower in earlier years and will increase in later years so that the charge on income statements reflect straight-line pattern.  Under the FASB’s dual model approach, determining whether a lease is Type A or Type B would be based on guidance similar to the classification model under current U.S. GAAP but without the bright lines.

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