Defining Issues June 2013, No

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fed funds effective swap rate (or overnight index swap rate) as a benchmark interest rate for hedge accounting purposes; and Presentation of an unrecognized tax benefit when a net operating loss

1 Defining Issues June 2013, No EITF Reaches Two Final Consensuses The FASB s Emerging Issues Task Force (EITF) discussed six issues at its June 11, 2013, meeting and reached final Consensuses on two issues: Inclusion of the fed funds effective swap rate (or overnight index swap rate) as a benchmark interest rate for hedge accounting purposes; and Presentation of an unrecognized tax benefit when a net operating loss carryforward or tax credit carryforward exists. Additionally, the EITF reached three Consensuses-for-Exposure: Accounting for the difference between the fair value of the assets and the fair value of the liabilities of a consolidated collateralized financing entity (reexposure); Accounting for service concession arrangements; and Reclassification of collateralized mortgage loans upon a troubled debt restructuring. Contents Final Consensuses 1 Consensuses-for-Exposure 4 Other Issues Discussed and the Future EITF Agenda 7 The EITF also discussed determination of whether a performance condition that is allowed to be met after the requisite service has been provided by the employee is a vesting condition or a condition that affects the grant-date fair value of the award in accounting for share-based compensation. The final Consensuses and Consensuses-for-Exposure must be ratified by the FASB before they are issued or become authoritative. The FASB is scheduled to consider these Consensuses at its June 26, 2013, meeting. Final Consensuses Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes (Issue 13-A). At its June 11, 2013, meeting the EITF reached a final Consensus that the fed funds rate could be used as a benchmark interest rate for hedge accounting purposes. Currently, the only acceptable benchmark rates for hedge accounting

2 purposes under U.S. GAAP are U.S. Treasury rates (UST) and LIBOR. 1 However, because of the 2008 financial crisis, the demand for hedging products incorporating the fed funds rate has increased significantly. Factors driving that demand have been U.S. banks increased focus on their sources of funding, the widening spreads between LIBOR and the overnight index swap (OIS), and the collateralization of derivatives. The effect of this change is not confined to financial institutions. Other entities also are exposed to OIS via the return on collateral and the valuation of collateralized derivatives. Before the credit crisis, U.S. market participants commonly valued their derivative instruments using LIBOR as the discount rate, but now they have begun using OIS to value derivatives. For entities that apply hedge accounting, using OIS to value derivative hedging instruments instead of a benchmark rate can result in accounting ineffectiveness and earnings volatility, even if the terms of the hedging derivative match those of the hedged item. Although an entity uses OIS for valuing hedging derivatives, accounting standards require a benchmark rate to determine the change in value of the items being hedged in a fair value hedge. Advocates of allowing the fed funds rate for hedge accounting believe that it better reflects current hedging strategies. They assert that when the Board decided on UST and LIBOR as the only acceptable benchmarks, the frequency of transactions using the fed funds rate was not as prevalent as in today s environment, and they point to a statement in the accounting literature that indicates that the definition of a benchmark rate that may be hedged should be flexible enough to withstand potential future developments. Advocates also note that the fed funds rate is the most liquid and transparent overnight rate in the United States and that if it were permissible as a benchmark, hedgers would more readily use it, which could reduce the accounting ineffectiveness that currently results. In addition to allowing the fed funds rate to be used as a benchmark rate for hedge accounting purposes, the EITF also decided to remove the scope reference in ASC Topic 815 (ASC paragraph ) that requires the same benchmark interest rate be used for similar hedges and that using different rates 1 The Fed Funds Rate is the negotiated interest rate at which depository institutions actively trade balances held at the Federal Reserve with each other, usually overnight, to meet reserve requirements. The weighted average of this rate is the overnight fed funds effective rate. The related OIS (overnight index swap) rate is the fixed rate swapped in exchange for the overnight fed funds effective rate. A benchmark rate is a widely recognized and quoted rate in an active financial market that is broadly indicative of the overall level of interest rates attributable to high-credit-quality obligors in that market. It is a rate that is widely used in a financial market as an underlying basis for determining the interest rates of individual financial instruments and commonly referenced in interest-rate-related transactions. 2 / Defining Issues / June 2013 / No

3 be rare and justified. However, the guidance in ASC Topic 815 (ASC paragraph ), which indicates that different methods of assessing effectiveness for similar hedges shall be justified, will remain. The final Consensus requires prospective application to new hedge relationships and de-designated and re-designated hedge relationships. The guidance is effective for both public and nonpublic entities upon issuance of the guidance, which is targeted for mid-july. Presentation of an Unrecognized Tax Benefit When a Net Operating Loss or Tax Credit Carryforward Exists (Issue 13-C). When an entity has an unrecognized tax benefit and a net operating loss carryforward (NOL) or similar tax loss or tax credit carryforward in the same jurisdiction as the uncertain tax position, the loss of the tax position may reduce the NOL or tax credit carryforward instead of resulting in a cash payment. The issue of gross versus net presentation of the deferred tax asset for the carryforward and the tax effect of the uncertain tax position is not specifically addressed under U.S. GAAP. The EITF reached a final Consensus that entities should present the unrecognized tax benefit as a reduction of the deferred tax asset for an NOL or similar tax loss or tax credit carryforward rather than as a liability when the uncertain tax position would reduce the NOL or other carryforward under the tax law. The EITF determined that no new disclosures were necessary. Example 1: Presenting Unrecognized Tax Benefit as a Reduction of the Deferred Tax Asset for NOL Rich Industries has taken a position in its U.S. tax return that resulted in a reduction of taxable income of $250, and a reduction of taxes payable of $100 at a 40% tax rate. It has concluded the tax position taken is less than 50% likely of being sustained, resulting in an unrecognized tax position of $100. Rich Industries suffered losses in recent years resulting in an NOL carryforward of $500 that can be used to offset future U.S income taxes. The Company s deferred tax assets are expected to be realized. In calculating deferred taxes, $250 of the NOL carryforward would be used to offset the additional taxable income resulting from the uncertain tax position, thereby reducing the deferred tax asset for the NOL by $ / Defining Issues / June 2013 / No

4 The final Consensus will require prospective application (including accounting for uncertain tax positions that exist upon date of adoption) with optional retrospective application. The final Consensus will be effective for public companies for annual and interim periods beginning after December 15, 2013, and will be effective for nonpublic companies for annual and interim periods beginning after December 15, Early adoption is permitted. Consensuses-for-Exposure Accounting for the Difference between the Fair Value of the Assets and the Fair Value of the Liabilities of a Consolidated Collateralized Financing Entity (12-G). A collateralized financing entity (CFE) is an entity that holds financial assets such as asset-backed securities and issues beneficial interests to investors. These beneficial interests are usually debt instruments that are considered financial liabilities under U.S. GAAP. Because a CFE generally has little or no equity, it is typically a variable interest entity (VIE) under U.S. GAAP and subject to the consolidation requirements that apply to entities not controlled through voting equity interests. Consequently, an entity may be the primary beneficiary of, and therefore required to consolidate, a CFE for which it is the asset manager, even if it owns no equity or beneficial interest in the CFE. An asset manager may be the primary beneficiary of a CFE that is a VIE because it has the power to direct the activities that most significantly affect the CFE s economic performance by making decisions about the CFE s investment portfolio. An asset manager also may have the right to receive benefits that could potentially be significant to the CFE through a subordinated management fee. Many reporting entities that are required to consolidate a CFE elect the fair value option for all of the CFE s eligible financial assets and financial liabilities. Although a CFE s assets are the sole source of repayment for its beneficial interests (i.e., its liabilities) and its beneficial interests are entitled to receive all of the cash flows from the CFE s assets after payment of management fees and other expenses, fair value differences between a CFE s assets and its beneficial interests may arise. Fair value differences may be caused by different liquidity discounts and duration mismatches between the CFE s assets and its beneficial interests. As a result, the fair value of a CFE s assets may exceed the fair value of its beneficial interests. There is diversity in the accounting for differences between the fair value of a consolidated CFE s assets and liabilities. Some primary beneficiaries record the initial difference in fair value as a gain or loss in the consolidated income statement. Other primary beneficiaries do not recognize the gain or loss in the consolidated income statement but instead record it directly to appropriated retained earnings. At its June 11, 2013, meeting the EITF decided to re-expose for comment its revised proposed Consensus. The revised proposed Consensus will propose that a primary beneficiary should initially and subsequently measure the liabilities of a 4 / Defining Issues / June 2013 / No

5 consolidated CFE using the value of the CFE s assets when the fair value option is elected for both the financial assets and liabilities of the CFE. Financial assets would be measured at fair value and any nonfinancial assets that may be held temporarily as a result of foreclosure would be measured initially at fair value and subsequently at their carrying value. The assets and liabilities should be presented on a gross basis. Any portion of the CFE s beneficial interests held directly by the primary beneficiary should be eliminated in consolidation. At previous meetings, the EITF clarified the scope to include CFEs that have nominal equity and CFEs that temporarily hold nonfinancial assets as a result of restructuring (e.g., borrower default). The EITF agreed that the measurement guidance of the final Consensus does not apply to interests that represent compensation for services, such as management fees. The EITF clarified that the fair value hierarchy disclosures apply to the financial assets, with a qualitative disclosure noting that the financial liabilities are measured using the CFE s asset values. Finally, the EITF also agreed to permit entities to elect the fair value option upon adoption if they have not already done so. The effect of initial application of this standard, including entities that have already elected the fair value option prior to adoption, is to be recognized as a cumulative-effect adjustment as of the beginning of the year of adoption. The effective date of the standard is yet to be determined. This issue will be discussed further following the comment period. Accounting for Service Concession Arrangements (Issue 12-H). Service concession arrangements (SCAs) are public-to-private contracts whereby a public sector entity (grantor) grants a non-governmental entity (operator) the right to construct, operate and/or maintain the grantor s infrastructure assets, such as roads, bridges, tunnels, airports, prisons, hospitals, etc. In typical SCAs: The operator provides initial consideration in the form of either constructing or upgrading the infrastructure, making a cash payment, or combination of consideration; The contracted services must meet minimum performance requirements; and At the end of the contract term, the grantor controls the residual interest in the infrastructure or specifies the minimum conditions the infrastructure must be in at the end of the term. U.S. GAAP does not specifically address accounting for public-to-private SCAs; however, International Financial Reporting Standards address these arrangements in IFRIC 12. The EITF discussed whether lease accounting should apply to an SCA that meets the following two criteria: 5 / Defining Issues / June 2013 / No

6 The grantor controls or has the ability to modify or approve the services the operator must provide with the infrastructure, to whom it must provide them, and at what price; and The grantor controls, through ownership, beneficial entitlement or otherwise, any residual interest in the infrastructure at the end of the term of the arrangement. The EITF noted that in these arrangements an operator may not control the infrastructure or receive substantially all of the infrastructure s economic output. Accordingly, the EITF reached a Consensus-for-Exposure that a public-to-private service arrangement that meets the two criteria above should not be accounted for as a lease and that other applicable U.S. GAAP should apply. The EITF decided not to provide additional specific guidance on accounting for these arrangements because of the variety of the types and terms of arrangements. The Consensus-for-Exposure will propose limited retrospective application (cumulative-effect adjustment) for all SCAs existing as of the beginning of the year of adoption and all subsequent SCAs. The effective date is yet to be determined. The issue will be discussed further following the comment period. Reclassification of Collateralized Mortgage Loans upon a Troubled Debt Restructuring (Issue 13-E). A growing number of vacant or abandoned residential properties resulting from the weak housing market and extended foreclosure process has increased the potential for higher levels of other real estate owned (OREO) held by banks and similar institutions (creditors). Questions have arisen in these situations about when creditors should reclassify mortgage loans collateralized by these properties from the loan portfolio to OREO. Under current accounting guidance, loans should be reclassified to OREO upon a troubled debt restructuring that is in-substance a repossession or foreclosure by the creditor. Reclassification occurs when the creditor has physical possession of the debtor s assets, regardless of whether formal foreclosure proceedings have taken place. The terms in-substance a repossession or foreclosure and physical possession, are not defined in the accounting literature, creating diversity in practice about when loans are reclassified as foreclosed assets. The different views are highlighted below: Some believe that loans should be reclassified as foreclosed assets only when a creditor obtains legal title to the real estate, or when the borrower voluntarily conveys to the creditor all interest in the residential property (e.g., by a completed deed in lieu of foreclosure). This view is consistent with prevalent current practice. Others believe that loans should be reclassified as foreclosed assets when the facts and circumstances reflect that the creditor has significant involvement in the collateral and its primary risk is real estate risk (instead of 6 / Defining Issues / June 2013 / No

7 the risk that the borrower will not be able to repay the loan), which may occur prior to obtaining legal title or completing a deed in lieu of foreclosure. At its June 11, 2013, meeting the EITF agreed that reclassifying the loan to OREO upon the transfer of legal title or the conveyance of interest in the residential property by the borrower will promote consistency among creditors and help eliminate current diversity in practice in determining when the creditor has physical possession of the property. The EITF noted that in most cases both foreclosed real estate and collateral dependent delinquent loans are initially measured the same way (i.e., based on the fair value of the real estate minus the cost to sell). The EITF also agreed that, because real estate risk exposure may be of interest to financial statement users, creditors should disclose non-performing loans in the process of foreclosure (consistent with the current bank regulatory reporting guidance) and a rollforward of OREO. The proposed guidance would require prospective application and early adoption would be permitted. The effective date is yet to be determined. This issue will be discussed again following the comment period. Other Issues Discussed and the Future EITF Agenda Determination of Whether a Performance Condition That Is Allowed to Be Met after the Requisite Service Has Been Provided by the Employee Is a Vesting Condition or a Nonvesting Condition (Issue 13-D). Entities may grant a share-based compensation award that includes a performance condition and permits an employee to earn the award even if the performance condition is achieved after the requisite service has been provided. For example, nonpublic companies sometimes issue awards that only transfer upon an initial public offering (IPO). An entity may also offer an award with a performance condition to a retirement-eligible employee who is not required to provide any future service to receive the award. There is diversity in practice in applying U.S. GAAP to these types of sharebased awards. Some believe these awards should be accounted for as awards with a performance condition where compensation expense is only recorded if achievement of the performance condition is probable. Others believe these awards represent a post-vesting restriction (or, in the case of share options, an exercisability restriction) that should be incorporated into the award s grant-date fair value and expensed during the requisite service period, or upon grant if there is no requisite service period. At its June 11, 2013, meeting the EITF discussed three potential views to account for these types of share-based awards: View A The terms of the awards are a performance condition that affects the vesting of the award; 7 / Defining Issues / June 2013 / No

8 View B The terms of the awards are a condition that affects the grant-date fair value of the awards; and View C The awards are classified as a liability. The EITF focused its discussion on the merits of View A and View B and noted that each view could result in material differences for both measurement and timing of compensation expense. Example 2: Evaluating Two Views to Account for Share-based Awards Facts: A nonpublic Technology Company (TC) grants unvested shares to employees that include a 3-year service condition. In addition, the shares will only be transferred if TC completes an IPO within 10 years of the grant date. If there is no IPO by that date, the shares will expire worthless. After three years, employees may terminate employment and still receive the underlying shares if the IPO occurs within the 10- year period. Assume that the awards are equity classified, there are no expected (or actual) forfeitures, and the IPO occurs in Year 4. Under View A, the grant date fair value of the awards is $100 million. Under View B, the grant date fair value of the awards is $70 million (discounted to reflect the uncertainty of the IPO). Analysis: View A Compensation expense ($100 million) is not recognized until the IPO is probable. View B Compensation expense ($70 million) would be recognized ratably over the three-year service period (even if an IPO never occurs). The awards under View A have a higher grant-date fair value relative to View B. A similar distinction in accounting may arise with grants made to retirementeligible employees who may receive their award without providing any future service to the entity if the award s performance target is ultimately achieved. The EITF did not reach a conclusion at its June 11, 2013, meeting. Instead, the EITF requested that the FASB staff conduct further research and outreach to determine, in part, (a) whether the scope of the issue should apply to all 8 / Defining Issues / June 2013 / No. 13-X

9 performance conditions; (b) potential convergence with IFRS; and (c) the preference of financial statement users. This issue will be included on the EITF s agenda for future meetings. Future EITF Agenda. In addition to the issues discussed at the June meeting, the following issues are on the EITF s agenda for discussion at future meetings: Recognition of New Accounting Basis (Pushdown) in Certain Circumstances (Issue12-F); Accounting for Investments in Affordable Housing Tax Credits (Issue 13-B); and Accounting for the Effect of a Federal Housing Administration Guarantee. The next scheduled EITF meeting will be held on September 13, Contact us: This is a publication of KPMG s Department of Professional Practice Contributing authors: Mark M. Bielstein Sam O. Kerlin Natasha V. Boswell Rory S. Doheny Michael A. Gaiso Jeremy R. Peters Earlier editions are available at: The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the proposed standard or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative ( KPMG International ), a Swiss entity.

Defining Issues January 2013, No. 13-5

Defining Issues January 2013, No. 13-5 EITF Reaches Final Consensuses on Cumulative Translation Adjustments and Joint and Several Liability Arrangements The FASB s Emerging Issues Task Force (EITF) discussed