Comments on Special Purpose Entities (SPE

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How Might US Adoption of IFRS Affect Quantitative
Models used by Financial Analysts? 2010 CARE
Conference

April 2010 Katherine Schipper, Duke University
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Overview

• Process issues
• Current status of International Financial
  Reporting Standards (IFRS) use in the US and
  elsewhere
• SEC proposals for permitting/requiring the use of
  IFRS by US SEC registrants
• Substantive issues
• Examples of differences between US GAAP and IFRS
  that could affect investment analyses
• Convergence efforts of the IASB and FASB
• Attempts to eliminate differences and improve
  guidance could lead to substantial changes in
  format and content of financial reports
• Summary of several joint IASB/FASB major projects
  
• Financial statement presentation
• Consolidation policy
• Revenue recognition
• Lease accounting
• Financial instruments An example of (likely)
  nonconvergence
• Comment This presentation uses Statement
  numbers not Codification numbers.

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Process issues IFRS use and convergence

• Over 100 jurisdictions use some version of IFRS
  or have announced plans to do so
• In some jurisdictions, phased adoption based in
  part on size of firm
• In some jurisdictions, the standards in use may
  differ from IFRS as promulgated by the IASB
• Differences in the standards themselves and/or
  differences in implementation
• Of large economies, only Japan and the United
  States have not either adopted IFRS (or some
  version of IFRS) or announced a planned
  date/schedule of adoption
• The FASB and IASB are committed to working toward
  convergence to a single set of high quality
  financial reporting standards
• Several major joint projects are underway that
  are intended to replace both US GAAP and IFRS
  standards with converged and improved guidance
• In the US, non-US SEC registrants have a choice
• File with US GAAP
• File with IFRS, as promulgated by the IASB
• File with another set of standards and reconcile
  portions of the balance sheet and income
  statement to US GAAP

Observation This free choice creates explicit
noncomparability
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SEC proposals for IFRS use in the US

• Proposal issued Nov 14, 2008, with comments due
  Feb 19, 2009
• Feb 3, 2009, extended comment deadline to April
  20, 2009
• Feb 24, 2010, the SEC reaffirmed a commitment to
  a single set of high-quality globally accepted
  accounting standards
• Release Nos. 33-9109 34-61578 available on the
  SECs website
• Perhaps of greatest interest is the Appendix that
  describes the Work Plan to be executed by the
  SEC staff
• The Work Plan describes how the SEC staff will
  investigate areas of concern identified in
  comment letters on the Nov 2008 proposal
• Comprehensiveness, auditability and
  enforceability of IFRS comparability of IFRS
  applications within/across jurisdictions
• Governance and oversight of the IFRS Foundation
  and the IASB, including funding, composition of
  the trustees and the board, and IASB processes
• Investor knowledge
• Regulatory considerations
• Impact on US SEC registrants (accounting systems
  and internal controls contractual arrangements
  governance, including audit committee IFRS
  knowledge)
• Human capital readiness

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SEC proposals for IFRS use in the US

• Based on the Feb 2010 decisions
• The SEC will decide in 2011 whether to permit or
  require IFRS for US SEC registrants
• Lengthy transitionno earlier than 2015
• Unclear whether the decision would be wholesale
  adoption or standard-by-standard phase-in
• A key condition Completion of the convergence
  projects
• The FASBs website lists joint IASB-FASB
  standards projects (information in parentheses is
  stated date for a final standard)
• Statement of comprehensive income (3Q 2010)
• Financial statement presentation (2011)
• Consolidation policy and procedures (4Q 2010)
• Revenue recognition (2011)
• Leases (2011)
• Fair value measurement (3Q 2010)
• Financial instruments (4Q 2010)
• Financial instruments with characteristics of
  equity (2011)
• Emissions trading schemes (2011)
• Insurance contracts (2011)
• Discontinued operations (3Q 2010)

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Differences between IFRS and US GAAP with
potential effects on investment analysis

• LIFO inventory accounting IFRS does not permit
  LIFO and the US permits LIFO for tax purposes
  only if it is used for financial reporting
• Observation There are periodic proposals to
  disallow LIFO for tax accounting in the US
• Observation The majority of US firms do not use
  LIFO, but LIFO users tend to be large, with
  substantial LIFO versus FIFO differences (LIFO
  reserves)
• Examples include Exxon Mobil, Chevron, Valero
  Energy, Caterpillar, Dow Chemical, Deere, Alcoa
  and United States Steel
• Asset impairments Nonfinancial assets
• IFRS one-step impairment testing is based on fair
  value-type measurement while US GAAP impairment
  testing is based on the ability to recover
  undiscounted cash flows
• The IFRS approach is believed to result in more
  impairments, compared with US GAAP two-step
  approach
• IFRS permits recovery of certain impairment
  losses US GAAP does not

Observation about impairment recoveries
generally IFRS permits recovery of certain
impairments of financial and nonfinancial assets
US GAAP does not. The FASB has proposed changing
US GAAP to converge with IFRS, at least for
financial assets.
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Differences between IFRS and US GAAP with
potential effects on investment analysis

• Loss contingencies
• IAS 37 defines probable for loss contingencies
  as more likely than not while practice in the US
  (SFAS 5) has applied a higher threshold.
  Measurements of recognized loss contingencies may
  also differ
• Observation The IASB is close to issuing a
  revised standard that would largely remove the
  probable criterion for recognition of
  losses/obligations with uncertain amounts and
  timing and would change the measurement to be
  more like an expected value.
• Possible implication more contingent
  obligations recognized under IFRS than under US
  GAAP
• Covenant violations IFRS does not permit curing
  debt covenant violations after year-end, while US
  GAAP does
• Implication Current liabilities could contain
  long term debt that is not due to be paid
• Convertible debt IFRS requires separate
  accounting for the call option embedded in
  convertible debt in most cases, while US GAAP
  specifies separate accounting for certain
  convertible debt instruments with a
  cash-settlement provision (effective 2009 FSP
  APB 14-1)
• Implication IFRS applied to convertible debt
  usually results in lower debt and larger equity,
  at least at inception

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Differences between IFRS and US GAAP with
potential effects on investment analysis

• Intangible assets IFRS requires capitalization
  of development costs that meet certain criteria.
  US GAAP does not permit capitalization of any
  development costs other than certain costs of
  software development (SFAS 86)
• Implication RD intensive IFRS firms have more
  intangible assets (that are subject to
  amortization and impairment)
• Depreciation IFRS requires that components of
  an asset with differing patterns of benefit
  consumption be depreciated separately (component
  depreciation) US GAAP permits but does not
  require this treatment
• Implication Differing patterns of depreciation
  charges for the same (composite) asset
• Measurement requirements (or choices)
• IFRS permits property, plant and equipment to be
  measured at fair value or historical cost US
  GAAP requires historical cost
• IFRS permits investment property to be measured
  at fair value with changes included in net
  income US GAAP requires historical cost
• IFRS requires that certain agricultural assets
  (crops, livestock, orchards, forests) be measured
  at fair value with changes included in net
  income US GAAP permits fair value only for
  certain agricultural items (e.g., livestock held
  for sale)

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Differences between IFRS and US GAAP with
potential effects on investment analysis

• Classification and displayselected examples
• IFRS permits expenses to be shown by nature
  (e.g., personnel costs, raw materials costs) or
  by function (e.g., selling costs, RD costs)
  while US GAAP requires display by function
• IFRS does not specify where to display an excess
  tax deduction associated with a share based
  payment arrangement while US GAAP requires
  display in Cash from Financing
• IFRS requires all deferred tax assets and
  deferred tax liabilities to be classified as
  noncurrent while US GAAP requires classification
  as current or noncurrent based on the nature of
  the item that underlies the deferred tax item
• IFRS lease classification guidance does not
  contain the numerical thresholds in US GAAP
  (although the qualitative considerations are
  similar)
• IFRS requires that an obligation that is settled
  by issuing a variable number of shares be
  classified as liability US GAAP permits equity
  classification under certain circumstances
• IFRS requires that debt issue costs must be
  expensed US GAAP permits capitalization as an
  asset for debt measured at amortized cost

• Observations
• Existing classification and display differences
  between US GAAP and IFRS suggest that balance
  sheet and income statement analysis may require
  pre-analysis adjustments.
• IFRS contains more guidance for presentation than
  does US GAAP

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Differences between IFRS and US GAAP with
potential effects on investment analysis

• For those who are accustomed to US GAAP detailed
  implementation guidance
• IFRS lacks the level of specificity and detail,
  and the amount of implementation guidance, that
  characterizes US GAAP.
• Example The IFRIC provides limited guidance
  (analogous to the EITF, but less active)
• Example There does not appear to be an IASB
  analog to the FASBs FSPs (although the annual
  improvements project may serve a similar purpose)
• Example IFRS contains two broad revenue
  recognition standards US GAAP contains
  approximately 200 pieces of industry-specific and
  transaction-specific guidance
• Question to consider What should be the source
  of implementation guidance for IFRS, if IFRS is
  required in the US?
• Should the US proceed without this detailed
  guidance?
• Should the FASB remain as a US-implementation-guid
  ance organization?
• What are the implications for comparability, both
  within the US and across jurisdictions, of
  either
• Substantially reduced implementation guidance and
  specificity
• Implementation guidance for US firms that is
  established outside the IASBs organizational
  control

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Joint IASB-FASB projects on financial statement
presentation and comprehensive income

• Objective is to achieve convergence by creating a
  single standard for how to present information on
  the face of financial statements
• US GAAP contains only limited guidance, and that
  is dispersed across standards IFRS contains IAS
  1
• Preparers of financial statements use a variety
  of formats/displays and levels of aggregation,
  which users find confusing
• Displays are not linked across statements. The
  Statement of Cash Flows separates operating,
  investing and financing activities but the other
  statements do not.
• The Boards issued a preliminary views discussion
  paper on financial statement presentation late in
  2008
• Comment period ended April 2009 exposure draft
  expected 2010 final standard 2011
• A related project on presentation of
  Comprehensive Income
• Two-section single statement that contains profit
  or loss (or net income/loss) and other
  comprehensive income (OCI)
• No planned changes in what is included in OCI
• Continue the free choices between net-of-tax and
  pre-tax presentation of OCI and between display
  of tax effects on the statement or in the notes
• Final standard expected Q3 2010

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IASB-FASB project on financial statement
presentation
Discussion paper proposed format for financial
statement presentation
Statement of financial position Statement of comprehensive income Statement of cash flows
Business Operating assets and liabilities Investing assets and liabilities Business Operating income and expense Investing income and expense Business Operating cash flows Investing cash flows
Financing Financing assets Financing liabilities Financing Financing asset income Financing liability expenses Financing Financing asset cash flows Financing liability cash flows
Income taxes Income taxes (continuing operations) Income taxes
Discontinued operations Discontinued operations (net of tax) Discontinued operations
Other comprehensive income
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Joint IASB-FASB project on financial statement
presentation

• Discussion paper proposals are based on a
  management approach
• Management would determine what items belong in
  the Business (that is, the Operating and
  Investing sections) and the Financing section and
  explain the reasons for the classifications
• Management would decide the order of sections and
  categories and use that order consistently
  across statements
• Management would classify income, expenses and
  cash flows in the same section/category as the
  related asset or liability
• Management would be required to relate the
  presentation of assets and liabilities to the
  entitys business

• Observations and questions to consider
• As of Sept 2009 the term management approach
  was abandoned but the idea it represents appears
  to have been retained
• Segment reporting, the accounting for certain
  assets and IFRS 9 (discussed later) are also
  based on approaches that seem similar to the
  management approach described here.
• Accounting is linked to the entitys business
  model, so that the same item could receive
  different accounting treatment if business models
  differ
• How is this idea connected to management intent
  (as, for example, in the HTM classification for
  debt securities in SFAS 115)?
• What are the implications of a management
  approach for decision usefulness of financial
  reports?

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Joint IASB-FASB project on financial statement
presentation

• As of February 2010, the IASB and FASB are also
  proposing
• Required analysis (in the notes) of changes in
  balances of all significant asset and liability
  line items
• Distinctions between remeasurement changes and
  other changes
• Remeasurements arise from a change in current
  prices or values, or transactions at current
  prices or values (except for selling inventory)
  certain changes in estimates
• Creation of a subcategory, financing arising from
  operating activities
• Appears to include long term items with a time
  value of money component that do not qualify as
  financing items
• The proposed guidance also contains a definition
  of financing items, based on (a) assets and
  liabilities that qualify as financial items and
  (b) management views the items as providing
  funding

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Consolidation policy and procedures

• Joint IASB-FASB project in which the IASB has
  taken the lead, with an exposure draft (ED 10)
  issued December 2008, to replace IAS 27 and SIC
  12
• Apply a qualitative definition of control with
  two criteria the ability to direct the
  activities of an entity so as to generate returns
• Direct activities determine strategic operating
  and financing policies
• Recent FASB-IASB decisions, for entities that are
  controlled through voting rights
• Holding more than half the votes meets the
  ability criterion of control, absent other
  arrangements
• Holding less than half the votes also meets the
  ability criterion of control if the investor has
  the ability to direct those activities of the
  entity that significantly affect returns
• Issues to consider
• How to consider options and conversion rights in
  assessing the ability criterion
• How to analyze the ability criterionmust an
  entity demonstrate that it is in control and that
  it can perpetuate that control?

• Observations
• Consolidation policy determines which assets and
  liabilities of entities that are linked by
  ownership or contract are included on the
  consolidated balance sheet
• The qualitative control definition proposed by
  the IASB is similar to definitions proposed in
  1995 and 1999 FASB exposure drafts
• US GAAP currently sharply distinguishes entities
  controlled through voting rights and other
  entities. The proposed guidance does not appear
  to make this same distinction.

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Joint IASB-FASB project on revenue recognition

• Objective is to create a single converged revenue
  recognition standard that would replace the
  voluminous US GAAP guidance and IAS 11/IAS 18
• After several years of effort, the Boards issued
  preliminary views in December 2008
• Comment period ended June 2009
• Focus is on a contract with a customer in which
  the seller obtains a right to payment and incurs
  an obligation to deliver goods/services
• Revenue would be recognized as performance
  obligations are satisfied by delivering goods and
  services
• Observation As written, that rule would
  preclude methods like the percentage-of-completion
  method. The IASB and FASB are currently
  reconsidering the implications of this rule.
• The amount the customer pays (customer
  consideration) would be allocated to each
  performance obligation using a variant of
  relative-fair-value that is based on the
  stand-alone price for each good or service
  (including estimates, if necessary)
• Observation That allocation method is similar
  to practice around EITF 08-1
• After contract inception, a seller would
  remeasure a contract if it became onerous, in the
  sense of incurring a loss

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Joint IASB-FASB project on revenue recognition

• Revenue recognition based on accounting for a
  contract with a customer
• Based on recognition and measurement of contract
  assets and contract liabilities
• Contract asset arises if the entity performs
  before the customer pays
• Contract liability arises if the customer pays
  before the entity performs
• It may be necessary to combine two or more
  contracts, if the arrangements are interdependent
• Seller recognizes revenue only when it has
  satisfied a performance obligation by
  transferring a good or service to the customer
• Transfer occurs when the customer obtains control
  of the good or service

• Observations
• Revenue recognition, as proposed, turns on the
  definition of control. The IASB and FASB have
  proposed several indicators of control, for
  example
• Customer has an unconditional obligation to pay,
  and the payment is nonrefundable
• Customer has legal title, or can sell or exchange
  the asset, or has physical possession (or the
  practical ability to take possession)
• Customer specifies the design of the asset, or
  has continuing managerial involvement with the
  asset or can secure or settle debt with the asset

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Joint IASB-FASB project on lease accounting

• Objective is to create a single converged
  standard that would replace SFAS 13 and IAS 17
  with improved guidance
• The operating lease versus capital/financing
  lease distinction gives rise to substantial
  accounting differences for very small changes in
  lease contracts
• Even though rights and obligations associated
  with operating leases may qualify as assets and
  liabilities, there is no balance sheet
  recognition of these items
• The Boards issued a preliminary views discussion
  paper in March 2009
• Comment period ended July 2009
• Current proposals focus more on lessees than on
  lessors
• Leases give rise to right-to-use assets and
  obligation-to-pay liabilities that should be
  recognized
• Separate recognition would not be required for
  renewal, termination or purchase options.
  Instead, the lessee would be required to
  determine the most likely outcome and incorporate
  that outcome into the lease accounting
• Example A five-year lease has a renewal option
  for an additional five years. If renewal is the
  most likely option, account for the lease as a
  10-year lease
• The measurement of the obligation would include
  contingent rentals and residual value guarantees

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Joint IASB-FASB project on lease accounting

• Other aspects of current proposals
• A lessor would initially recognize a receivable
  from the lessee and a performance obligation and
  it would not derecognize the leased asset (per an
  October 2009 tentative decision)
• The basis for this conclusion is that the lessor
  does not transfer control of the leased item at
  inception of the lease, so it continues to
  recognize the leased item as an asset
• The measurement of the receivable and the
  obligation would be the rentals discounted at the
  implicit rate of the lease
• The lessor would remeasure (reduce) its
  performance obligation as it permitted the lessee
  to use the leased item
• However, the IASB and FASB are considering
  whether some leases are in-substance sales in
  which revenue would be recognized at inception of
  the lease
• However, at a March 23, 2010 meeting, the IASB
  and FASB agreed to continue to consider an
  approach in which lessors would derecognize the
  leased asset and recognize a lease receivable
• A sale-leaseback arrangement would require the
  lessee/seller to analyze the arrangement to
  determine if it should derecognize the leased
  asset.
• If yes, account for the lease (recognize a
  right-to-use asset and an obligation-to-pay
  liability)
• The proposals are not specific as to how to reach
  the derecognition determination
• A lessee would amortize its right-to-use asset
  and also test it for impairment

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Joint IASB-FASB project on financial instruments

• Objective is to replace both FASB and IASB
  guidance for financial instruments with a common
  standard
• Recognition and measurement of financial assets
  and financial liabilities
• Reduce complexity
• Impairment
• Needed only for instruments that are not
  accounted for at fair value with changes included
  in earnings
• Hedge accounting
• Resolve practice issues
• Address differences in the accounting for
  derivatives versus hedged items or hedged
  transactions
• The IASB has promulgated a standard that
  addresses recognition and measurement of
  financial assets
• The FASB has not promulgated a standard as yet
• The scope of the FASB project includes both
  financial assets and financial liabilities

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Joint IASB-FASB project on financial
instrumentsIFRS 9

• The IASB issued IFRS 9 (November 12, 2009),
  effective January 1, 2013, early adoption is
  permitted
• Eventual goal replace IAS 39 in its entirety
  IFRS 9 is just the first step
• Scope gt financial assets (exposure draft
  included financial liabilities)
• Includes certain hybrid instruments (host
  embedded derivative)
• Account for the instrument as a whole (do not
  separate the derivative)
• Decision to eliminate financial liabilities based
  on constituent concerns about recording the
  effects of changes in the issuing entitys credit
  risk
• Both the FASB and the IASB are considering how to
  (re)measure financial liabilities for changes in
  the issuers credit risk
• Credit risk includes the effects of changes in
  the issuers credit quality and changes in the
  price of credit, holding credit quality constant
• IFRS 9 requires Measure financial assets at
  amortized cost or fair value on the balance sheet
  except that the fair value option in IAS 39 is
  retained
• Fair value option designate at initial
  recognition a qualifying financial asset to be
  measured at fair value with changes included in
  profit or loss if doing so eliminates or
  significantly reduces an inconsistency
  (accounting mismatch) that would otherwise arise

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Joint IASB-FASB project on financial
instrumentsIFRS 9

• IFRS 9 Measure financial assets at amortized
  cost or fair value
• Amortized cost items must meet two criteria
• Business model test Asset is held within a
  business model whose objective is to hold the
  assets to collect contractual cash flows
• Reclassification is required if the business
  model changes
• Analysis is neither at the individual instrument
  level nor at the reporting entity level (the
  portfolio level?)
• The entity need not hold the asset to maturity
• Contractual cash flows test Contractual terms
  of the asset specify principal and interest only
• Except that management must look to the assets
  and liabilities of the issuing entity if the
  financial asset is linked to other securities in
  a way that affects the concentration of credit
  risk (for example, arrangements that specify the
  order in which losses are allocated)
• Initial measurement is fair value transaction
  costs
• Assets are subject to impairment (impairments can
  be reversed)
• Application of the classification criteria is
  illustrated by means of examples

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Joint IASB-FASB project on financial
instrumentsIFRS 9

• IFRS 9 Measure financial assets at amortized
  cost or fair value
• Fair value items
• Debt instruments held as assets and not
  classified as being measured at amortized cost
  (either because of not qualifying or because of
  applying the fair value option)
• Equity instruments
• Except, possibly, equity instruments where cost
  might be the best estimate of fair value (refer
  to paragraphs B5.5 to B5.8)
• Fair value changes included in net income
• Except that management can designate an equity
  instrument not held for trading as measured at
  fair value with changes included in OCI, with no
  recycling and with dividends included in profit
  and loss

• Observations
• IFRS 9 eliminates the trading, AFS and HTM
  classifications, impairment testing except for
  items measured at amortized cost and the
  recycling of unrealized gains and losses when
  securities are sold
• The dividend and price change components of
  return on certain equity securities will be
  reported separately (dividends in profit/loss and
  price changes in OCI)

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Joint IASB-FASB project on financial
instrumentsFASB tentative decisions

• The FASB proposed to address all three components
  of the financial instruments project in a single
  standard
• Measure all financial instruments in the scope of
  the standard initially and subsequently at fair
  value with changes in income, except for core
  deposits
• Except that if an entitys business strategy is
  to hold debt instruments to collect (or, if a
  liability, to pay) contractual cash flows rather
  than to sell or settle the instruments with a
  third party, certain changes in fair value of
  those instruments may be recognized in OCI
• Amount that may be recognized in OCI the total
  change in fair value except for interest accruals
  and except for effects of credit losses.
• Realized changes are always in net income
• The business strategy test is based on how the
  instruments are managed, as opposed to
  managements intent for an individual instrument
  and on whether the entity holds a high proportion
  of similar instruments for long periods relative
  to their contractual terms
• Except that equity method investments may not be
  measured at fair value
• An equity method investment is one in which the
  investor has significant influence and the
  investment is considered related to the
  investors consolidated businesses
• Except that the effective date for nonpublic
  entities with lt1 billion in assets would be
  delayed 4 years, during which time the entities
  would measure loans and core deposit liabilities
  at amortized cost

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Joint IASB-FASB project on financial
instrumentsFASB tentative decisions

• Core deposit liabilities
• Measure at the present value of the average
  balance discounted at a rate the difference
  between the alternative funds rate and the
  all-in-cost-to-service rate
• Changes in value except for interest accruals may
  be recognized in OCI
• Credit impairments receive special treatment
• Credit impairment exists when a consideration of
  all past and current events indicates that the
  entity will not be able to collect all the
  contractually promised cash flows
• Entitys own debt
• Measured at amortized cost if the entitys
  business strategy is to owe the instrument to
  maturity and fair value measurement would result
  in a measurement attribute mismatch
• Hybrids (arrangement contains an embedded
  derivative)
• If the derivative does not meet the clearly and
  closely related criterion, and therefore must be
  separated under SFAS 133, measure the entire
  arrangement at fair value with changes in
  earnings
• However, if the derivative need not be separated,
  apply the business strategy test
• Fair value option will be reconsidered in the
  future
• Reclassifications would not be permitted

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Concluding comments

• While the SEC has proposed a timetable for
  considering, and possibly adopting, IFRS for
  registrants domiciled in the US, it is possible
  that the timetable could change
• Comment letters cite the cost of moving to IFRS
  and suggest that the FASB continue its
  convergence activities with the IASB
• It is not clear how many of the existing major
  convergence projects will be completed, or nearly
  completed, by 2011, the proposed date for the SEC
  decision
• The FASB and IASB have undertaken major projects
  to improve and converge guidance in several key
  areas, including lease accounting, revenue
  recognition and financial statement presentation
• Revenue recognition and financial statement
  presentation have been on the FASBs agenda for
  several years. Due process documents have been
  issued, so constituents now have a sense of the
  Boards thinking.
• Proposals to apply fair value measurement to more
  financial assets
• A final process issue As of summer 2009, the
  FASB has replaced the system of numbered
  statements
• US GAAP has been codified into numbered sections,
  by topic, and authoritative guidance is now to be
  referred to by those section numbers
• The IASB has not adopted a similar codification
  approach (it continues the use of
  standard-by-standard numbering)

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