26/07/2017 COURSE OUTLINE. The Key Elements of US GAAP session 2. Introduction to gaap, underpinning principles and high-level considerations

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1 The Key Elements of US GAAP session 2 Wayne Bartlett, CPA COURSE OUTLINE SESSION 1: Intro Core principles Overarching standards SESSION 2: Statement of Financial Position Property, Plant and Equipment Other Assets Contingencies and liabilities SESSION 3: Income statement Other comprehensive income Specific types of income and cost SESSION 4: Taxation Leases and special asset situations Special reporting and disclosures SESSION 5: Consolidations and equity accounting Fair value accounting SESSION 6: Accounting for financial instruments Final wrap-up Introduction to gaap, underpinning principles and high-level considerations 1

2 SESSION 2: THE STATEMENT OF FINANCIAL POSITION Property, Plant and Equipment Intangibles Goodwill and Other Inventory Receivables Contingencies Guarantees ASC 360 PROPERTY, PLANT AND EQUIPMENT Contains guidance on accounting for relevant assets including depreciation Also includes guidance on impairment Property, plant and equipment is sometimes referred to as fixed assets or plant assets. They will create a benefit for the entity that lasts beyond one year Also includes guidance on real estate sales ISSUES TO ADDRESS 1. Determination of amounts at which to initially record assets 2. Whether assets are capitalised in groups or as major individual components within individual assets 3. Proper accounting of post-acquisition costs 4. Rate and pattern of allocation of amounts capitalised including what to do with impairment 5. Events that cause assets to be reclassified to/from categories such as held for resale, idle etc. 6. Derecognition: sale, exchange, retirement, disposal 2

3 COST INITIAL ACQUISITION General rule: all costs should be capitalised that are necessary to bring an asset to its intended location and prepare it for productive use This includes any interest cost applicable to the period when the asset is being got ready for use (ASC ) Per IAS 23 Borrowing costs MUST be capitalised except in relation to equity method investments Costs that can be included: Sales and other taxes Import duties Freight and insurance costs Installation and set-up costs Costs of testing OTHER COSTS TO CONSIDER Demolition of pre-existing buildings, excavating or filling the land to get it ready for a new building Contract costs relating to sub-contractors Architects and engineers costs Building permits Renovation of pre-existing buildings COMPOSITE ASSETS GAAP is vague as to whether assets should be grouped or split into individual detailed sub-components when it might be appropriate to do so It has been noted that there might be significant tax benefits in some cases for splitting major assets such as aircraft into sub-components such as engines, fuselage etc. Disclosure of the policy adopted is again important. Policy once applied should then be used consistently in future years. In the unusual event of a change in accounting policy related to composite assets then the rules outlined in ASC 250 must be followed 3

4 POST-ACQUISITION COSTS If the cost adds to the value of the asset a new asset has been created Capitalisation thresholds commonly used in practice as a cost-benefit measure Costs may also increase the future service potential of the asset Some may not extend the useful life of the asset: in theory the cost of the part of the asset being replaced should be removed and treated as a loss in the period in which this takes place does this happen in practice? Probably not! Some may extend the useful life of an asset then there is a case for reviewing the remaining useful life and impacting on the depreciation charge accordingly DEPRECIATION Costs of fixed assets allocated to period based on their useful economic lives Method chosen must result in a systematic and rational allocation of costs of an asset (less residual and scrap value) over that life Useful life needs to consider a range of factors including technological change, normal deterioration, physical usage Method used can be a function of time (e.g. straight line or reducing balance) or of actual physical usage (IFRS: units of production method ) (ASC ) DEPLETION The annual charge for the use of natural resources (note: depletion rate often revised because of uncertainties surrounding the resources that can be utilised) Costs to be treated as depletion can include the following: Acquisition e.g. property rights, royalty payments to property owner Exploration costs often written-off though in some circumstances may be capitalised Development costs drilling, tunnels, shafts, wells etc. Restoration costs restoring property to its natural state once extraction is completed 4

5 IMPAIRMENT AND DISPOSAL GAAP distinguishes between general impairment rules, which apply to a wide range of assets and circumstances, and specialised rules for specific cases (e.g. computer software to be sold, leased etc.) Impairment is only recognised when the carrying amount of the impaired asset is not recoverable. The carrying amount is compared to undiscounted cash flows expected to arise from that asset net of any disposal proceeds Assets carrying amount may exceed its fair value but if its future cash flows exceed the carrying amount then no impairment is necessary. If an impairment takes place it may also be necessary to review the depreciation method and the asset lives INDICATORS OF IMPAIRMENT Significant decline in market price of a long-life asset Adverse change in the way an asset is used or its physical condition Adverse legal ruling that could have an effect on the use of an asset Increase in costs for asset acquired or constructed History/current period losses associated with the asset Expectation that an asset will be sold/disposed of before the end of its previously estimated life DIFFERENCES BETWEEN IFRS AND GAAP PPE Under GAAP, any costs relating to environmental remediation are not capitalised Estimates of useful life, residual value, method of depreciation are only reviewed when there is an indication that they should be: not annually as per IFRS Component accounting is permitted but not required Unlike IFRS, revaluation method for PPE is not permitted 5

6 DIFFERENCES BETWEEN IFRS AND GAAP IMPAIRMENT Unlike IFRS, impairments are always through net income: reversal of revaluation surpluses cannot therefore be put through OCI Unlike IFRS, impairments once recognised cannot be reversed Under US GAAP impairment is a two step test, under IFRS a one step test. US GAAP uses undiscounted cash flows and then compares carrying amount to a fair value based on market value. IFRS compares the carrying amount to the recoverable amount which is the higher of (1) the asset s fair value less costs of disposal or (2) the asset s value in use ASC 350 INTANGIBLES: GOODWILL AND OTHER Main elements: ASC : Goodwill ASC : General intangibles other than goodwill ASC : Internal-Use software ASC : Website development costs NB: excludes financial instruments and deferred tax which is dealt with by separate standards. Recent issue of ASY looks at simplifying the accounting for cloud computing ASC GOODWILL Not considered to be an identifiable intangible asset and therefore must be reported separately Internally-generated goodwill costs are expensed as incurred It has an indefinite life: therefore not amortised but it has its own unique impairment tests Amortisation takes place at the level of what is known as the reporting unit Reporting units are determined as operating segments (NB: it is possible that there is only one such in the entity) Assets and liabilities will be assigned to specific reporting units Assets and liabilities will be considered in calculating the fair value of the reporting unit 6

7 FAIR VALUE OF A REPORTING UNIT Implied fair value is the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date Quoted market values are the best if available: though these may not accurately reflect goodwill opportunities if the reporting unit were to be acquired If not available should use prices for similar assets Can use expected present value techniques, option pricing models Note that if the reporting unit includes any goodwill that relates solely to the parent HOW TO ESTIMATE IMPAIRMENT ON GOODWILL IN A REPORTING UNIT (1) 1 Compare the fair value of the reporting unit to its carrying value 1a If carrying amount greater than zero and exceeded by fair value, no impairment 1b If reporting unit zero or negative then the possibility of an impairment needs to be considered 1c If carrying amount exceeds fair value, then there is an impairment HOW TO ESTIMATE IMPAIRMENT ON GOODWILL IN A REPORTING UNIT (2) 2 Determine impairment as follows 2a Estimate implied fair value of goodwill 2b Compare implied fair value of goodwill to carrying amount 2c If implied fair value exceeds carrying amount, it is impaired and writer down 7

8 ASC 350 GENERAL INTANGIBLES OTHER THAN GOODWILL These can be divided into those with finite lives and those with indefinite lives Assets acquired are initially recognised at fair value A number of factors to take into account when estimating the useful life of an intangible: 1. Expected use of the asset 2. Expected useful life of any asset to which this one is connected 3. Provisions in law, contract etc. that might impact 4. Historical experience with similar assets 5. Effects of obsolescence, demand, competition etc. 6. Level of maintenance required ASC 350 AMORTISATION OF INTANGIBLE ASSETS Identifiable intangibles e.g. franchise rights, patents, trademarks, copyrights, licenses to be amortised over their useful economic lives Lives should be reviewed when events suggest that circumstances have changed No residual value normally assumed unless either there is a 3 rd -party commitment to purchase the asset at the end of its life or a market for the intangible exists and is expected to continue to exist. Residual value should be evaluated every reporting period Interest received and paid plus dividends received must be under operating activities with GAAP, dividends paid must be under financing. IFRS gives a wider range of choice in these areas INDEFINITE-LIVED INTANGIBLE ASSETS These need to be tested for impairment annually Impairment loss recognised if carrying amount exceeds fair value An initial test is allowed: if the asset is less than 50% likely to be impaired then fair value need not be established This general review should include cost factors e.g. increases in costs of raw materials, financial performance e.g. ve/declining cash flows, legal/political/business factors, changes in management/key personnel. Industry/market considerations, macroeconomic conditions 8

9 ASC : SOFTWARE DEVELOPED FOR INTERNAL USE - To qualify, must meet two criteria 1 Specifications must be designed or modified to meet the entity s internal needs 2 During the development period, there must be no plan to market the software externally IMPAIRMENT Subject to impairment reviews in the same way as tangible or many other intangible assets Indications of impairment can include: 1. A realisation that the software is not expected to provide significant service potential 2. A significant change in the way that the software is being used 3. Significant change made or anticipated to the software 4. Costs of developing the software significantly exceed the amount originally expected ASC : WEBSITE DEVELOPMENT COSTS Costs incurred in the planning stage must be written off as incurred Costs incurred to develop graphics are included in software costs Costs of operating website must be treated in the same way as repairs and maintenance 9

10 DIFFERENCES BETWEEN GAAP AND IFRS The revaluation of intangible assets is not permitted in GAAP unlike IFRS except for some financial instruments Both research and development costs of internal software are expensed under GAAP. IFRS allows capitalisation of development expenditure if certain criteria are met. Direct-response advertising expenditure can be capitalised if certain criteria are met. This is not permissible with IFRS where all advertising is expensed as incurred DIFFERENCES BETWEEN GAAP AND IFRS - IMPAIRMENT Under US GAAP, the assessment for impairment is performed at the asset level. Under IFRS, the assessment may be performed at a higher level (i.e., the CGU level). Under US GAAP, an entity may first assess qualitative factors to determine if a quantitative impairment test is necessary. Further testing is only required if the entity determines, based on the qualitative assessment, that it is more likely than not that a indefinite-lived intangible asset s fair value is less than its carrying amount. Otherwise, no further impairment testing is required. Under IFRS no such option exists ASC 330 INVENTORY Looks at the definition, valuation and classification of inventory A major consideration is to determine when title passes between buyer and seller: must be a transfer of the risks and rewards of ownership Goods held may not be owned and goods that are not held may be owned: need to look at substance over form 10

11 GOODS IN TRANSIT AND CONSIGNMENT STOCK At year-end, must be included in someone s financial statements depending on the conditions of sale Free on Board (FOB): FOB destination costs paid by seller and title does not pass until delivery, therefore seller s inventory until then. FOB shipping point means that goods will be handed over at a designated point en route: when the goods are passed over to the agent of the buyer then title also passes. Goods on consignment are included in the inventory of the consignor and not included in the inventory of the consignee ACCOUNTING FOR INVENTORIES The main consideration is to match expenses with the revenue that they earn in order to calculate profit in a logical way. Periodic inventory: inventory values calculated by a physical count. Cost of sales can be calculated by taking opening inventory and purchases and deducting closing inventory. Perpetual inventory keeps a running total of the inventory and maintaining records which record all purchases and sales. This still requires checking of inventory values to confirm that the records are accurate. INITIAL MEASUREMENT RAW MATERIALS AND MERCHANDISE Primary basis is to account for these at cost Cost includes all those costs required to bring the items to the point of sale and converting them to a saleable condition. This includes the purchase price, transportation costs, insurance and handling costs Purchases can be valued at gross amount or net with any discounts deducted. Either is acceptable under GAAP but whatever is used must be consistently applied Selling costs expensed as incurred. 11

12 MANUFACTURING INVENTORY Costs here include both acquisition and production costs often known as full absorption or full costing. This means that costs include materials, labour and appropriately allocated indirect production costs ( indirect overhead ) Indirect overheads include depreciation, repairs, maintenance, factory rent, indirect labour, normal rework labour and scrap, quality control, small tools not capitalised Fixed cost overheads should be allocated based on normal expected capacity of the facility. Variable cost overhead should be allocated based on actual usage VALUATION OF INVENTORY Measured at the lower of cost and current market price The current market price is defined as the current replacement cost of the inventory, as long as the market price does not exceed net realizable value less the normal profit margin. Net realizable value is defined as the estimated selling price, minus estimated costs of completion and disposal. Therefore the ceiling of the cost measured is the NRV, the floor is the NRV less the normal profit margin (or cost, whichever is lower) FIFO, LIFO or weighted-average cost basis are all allowed EXAMPLE OF MARKET PRICE The carrying amount of an item of inventory is 1.65 USD per item and there are 25,000 items altogether. The net realisable value for each item is 1.75 USD per item. The entity normally makes a 20% profit margin on each of these items. What is the market price and how, if at all, does this impact on the valuation of the items held in inventory? 12

13 DIFFERENCES BETWEEN GAAP AND IFRS LIFO, FIFO both allowed by GAAP (as is weighted average costing). LIFO is not allowed by IFRS Inventory is measured at the lower of cost or market, and lower of cost and NRV in IFRS. US GAAP therefore excludes any normal profit Same cost formula need not be applied to all items having similar characteristics unlike IFRS A subsequent reversal in value of inventory valued at market is not subsequently reversed in the financial statements unless it relates to changes in exchange rates ASC RECEIVABLES Covers a number of issues including general guidance on receivables and rebates (ASC ) Also covers non-refundable fees and other costs (ASC ) Sections on troubled debt restructurings by creditors may also have relevance (ASC ) GENERAL RECEIVABLES Includes trade accounts receivable, loans, credit cards, certain types of lease debts GAAP requires that different types of receivables should be separately identified either on the face of the financial statements or in the notes Most assets, including receivables, may be valued at fair value in the financial statements Receivables due within one year are presented at outstanding face value less any write-offs. This covers both potential provisions for bad debts and also any discounts taken by the customer at the time of payment Any items shipped on approval should also be allowed for based on e.g. past experience 13

14 ALLOWANCES FOR UNCOLLECTIBLE AMOUNTS Direct write-off: only write-off debts when it is clear that they cannot be collected: may be the approach for tax purposes but unsatisfactory for accounting it potentially overstates assets and does not match the writeoff with the debt that it relates to Two different types: percentage-of-sales and ageing the accounts method Percentage-of-sales: historical data analysed to try and assess the likely bad debts against credit sales. However this may require some adjustment to reflect current market conditions The ageing of accounts method looks at the age of the debt in days/months. Can then assess the likelihood of payment based on e.g. past experience with particular customers, industry averages ASSIGNING RECEIVABLES Companies may pledge receivables: this means they are used as collateral for loans. The debtor is normally unaware that this has taken place. The debt still ultimately gets paid by the debtor. The only accounting issue here is adequate disclosure of the security given Assignment: more formal transfer of a debt to a lending institution. Again customers are often not aware that the assignment has taken place and the responsibility for payment still rests with them. Because of the risk of non-payment the lending institution will only advance a proportion of the debt (e.g %). Debt remains that of the borrower and stays in their financial statements. Finance charges should be amortised as a prepayment over the period to which the charges apply Factoring: involved the outright sale of a debt to a factor. Future payments by the creditor will be to the factor, who assumes the risk of the inability to collect. The debt ceases to be a concern of the entity who is entering into the factor agreement and the accounting reflects this NON-REFUNDABLE FEES AND OTHER COSTS Loan origination fees should be deferred and recognised over the life of the loan as an adjustment of interest income Commitment fees are received in advance in return for a commitment to originate a loan. These should be deferred and should be included as an adjustment to interest income over the life of the loan But if the loan does not actually happen subsequently the fee should be recognised as income on expiration. If it is deemed from the start that the loan will never be taken up then they should be recognised on a straightline basis as service fee income 14

15 ASC : TROUBLED DEBT RESTRUCTURING BY CREDITORS A TDR loan takes place when the creditor grants a concession that it would not normally consider and the borrower is having financial difficulties. Essentially this is a list of rules that applies to assess whether an impairment of a debt has taken place The lender is required to evaluate modifications that may be necessary because the borrower is having financial difficulties. Indicators of financial difficulties 1. Borrower is in payment default for part or all of its debt 2. Borrower is in the process of declaring bankruptcy 3. Significant doubt as to the entity's going concern basis 4. Borrower has securities that have been de-listed 5. Cash flow estimates suggest difficulties 6. Without the modification the entity would be unable to borrow more funds from elsewhere CONCESSIONS Deemed to have taken place when a lender does not expect to collect all amounts due including any accrued interest Creditor also needs to consider changes to collateral if the principal payment is linked to the value of that collateral ASC 450: CONTINGENCIES Deals with both loss and gain contingencies It is noted in the Standard that not all estimates are covered by contingencies, for example depreciation, estimates used in accruals or changes in tax law. An estimate concerns a known condition but the amount is uncertain, a contingency has uncertainties about the actual events and also the amount Also excluded are uncertainties in income taxes A contingency is an existing condition or situation involving uncertainty as to possible gain or loss. The uncertainty will be resolved when one or more future events occur or fail to occur 15

16 ASC : LOSS CONTINGENCIES These occur when there is a potential impairment of an asset or a probable liability A loss will be recognised only if two conditions are met: 1. It is probable that an asset has been impaired or a liability has been incurred 2. The amount of loss can be reasonably estimated 3. Levels of probability also need to be taken into account: 1 Probable likely to occur 2 Reasonably possible more than remote but less than likely 3 Remote only a slight chance of occurring ESTIMATING LOSSES A range of losses rather than one specific loss is permissible The amount accrued is the loss that appears to be most likely If there is no best estimate, the minimum amount should be used The maximum amount estimated should be disclosed Subsequent years may require a change: this is a change in estimate rather than a prior-year adjustment Probable: accrue Reasonably possible: disclose Not estimable: disclose ASC : GAIN CONTINGENCIES Contingent gains should not be recognised: to do so may be to recognise revenue before its actual realisation But the gain may be disclosed as long as the disclosure is not misleading 16

17 DIFFERENCES BETWEEN GAAP AND IFRS Under GAAP, if there is a range of outcomes the lowest end of the range is used An obligation is measured at the individual most likely outcome even if the possible outcomes are mostly lower or higher than that amount Unlike IFRS, contingencies are not normally discounted No requirement under GAAP to generally recognise a provision for an onerous contract ASC GUARANTEES Two major areas are covered: how to deal with a guarantee in the books of the guarantor and the issue of product warranties Guarantees can be applicable in a range of circumstances e.g. 1. Changes in a specified interest rate, foreign exchange rate, commodity price etc. 2. Another entity s failure to perform under a binding agreement 3. The occurrence of a specified event or circumstance (this is known as an indemnification agreement) e.g. the application of additional taxes or the resolution of a court case 4. The occurrence of specified events which result in creditors being legally entitled to payments BASIC PRINCIPLES Requirement that fair value of guarantees be recognised as a liability The notion that guarantees consist of two elements: A) Non-contingent element unconditional, must be met is certain conditions happen: a stand ready arrangement B) Contingent an obligation to make future payments if those triggering events occur 17

18 HOW IS THIS ACCOUNTED FOR? Initially both non-contingent and contingent elements are recognised However this is not the same as recognising both elements at their full potential value, rather it is recognition of the willingness of the entity to stand ready to make the payments if they are required This makes it similar to the treatment of a provision It would appear that in this case discounting of cash flows is applicable An example may help. EXAMPLE OF ACCOUNTING FOR GUARANTEES A company using GAAP for its accounting provides guarantees for payment of a debt of 2.5 million USD. It assumes the following: 1. A 40% probability of having to pay in Year 1. If this happens there is a 60% chance the payment will be for 40,000 USD and a 40% chance of paying 60,000 USD 2. A 20% probability of paying in Year 2. This is deemed to be 50% probability of paying 20,000 USD and a 50% chance of paying 40,000 USD 3. A 10% probability of paying in Year 3: 70% chance of paying 100,000 USD and 30% chance of paying 250,000 USD The appropriate discount rate to use is 10% GUARANTEES TO BE RECOGNISED HYPOTHETICAL EXAMPLE Year 1: 48,000 USD ((60% x 40,000) + (40% x 60,000)) x 40% = 19,200-19,200 x discount factor of 0.91 = 17,472 USD Year 2: 30,000 USD ((50% x 20,000) + (50% x 40,000)) x 20% = 6,000-6,000 x discount factor of.83 = 4,980 USD Year 3: 125,000 USD ((70% x 100,000) + (30% x 250,000)) x 10% = 12,500-12,500 x discount factor of.75 = 9,375 USD Total 31,827 USD 18

19 PRODUCT WARRANTIES These fall within the definition of a contingency and therefore the main guidance is to be found in ASC 450 (i.e. there is an overlap between the two standards here) They therefore have the two basic tests applied to them as per other contingencies: 1. Is it probable that an obligation has been incurred because of a transaction or event that has already occurred? 2. Can the amount of the obligation be reasonably estimated? Note that if the warranty obligation is deemed to stretch into more than one future period then the obligation must be split into current and long-term obligations in the financial statements NEXT STEPS. Today we have covered some important aspects of the statement of financial position Not possible to cover every dimension in the time available but a number of the most important elements have been covered Tomorrow we will look at some key aspects of the income statement. 19