THE KEY ELEMENTS OF US GAAP SESSION 3 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
THE INCOME STATEMENT SESSION 3
SESSION 3: THE INCOME STATEMENT Revenue Recognition Compensation Other Expenses
ASC 605 REVENUE RECOGNITION: ELEMENTS A number of elements are covered by this Standard, including: Products Services Dealing with milestones Construction contracts Principal and agent considerations Customer payments and incentives
GENERAL CONSIDERATIONS AROUND REVENUE Fairly clear guidelines in this area But in practice an area much susceptible to fraud or at best over-optimistic accounting Shift to service-based economy has perhaps made this area more complex Bonus culture has also created tensions Two major elements to think about: where income is reported in the wrong period ( cut-off ) and where it has never really been earned at all
GENERAL GUIDELINES An entity s revenue-earning activities involve delivering or producing goods, rendering services or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues CON 5 Paragraph 83
REVENUE RECOGNITION Staff Accounting Bulletin (SAB) 104 states that revenue should be recognised when all the following are in place: There is persuasive evidence that an arrangement exists Delivery has occurred or services have been rendered The price is fixed or determinable There is reasonable assurance that the monies due may be collected
LONG-TERM CONSTRUCTION CONTRACTS ASC 605-35 The major issue here is how and when to recognise revenues on contracts which may cross over a number of different accounting periods Complications are the need to use estimates of revenues and of costs that are likely to be incurred as well as the percentage of completion of the contract Percentage of completion method: recognise income based on the progress of the work. Any excess of billings over WIP plus accumulated profit should be recognised as a liability: further work needs to be done to meet the customer s expectations. Income not based on cash billings. Completed contract method: income only recognised when contract is complete or substantially complete (not allowed under IFRS).
SERVICE REVENUES (ASC 605-20 & 605-45) Increasingly significant part of accounting. Estimated that over 50% of all transactions in the US are now service transactions. Revenue from service transactions is to be based on performance which determines whether the earnings process is complete or virtually complete Revenue recognition methods include: 1. Specific performance when the service consists of a single act recognised when the act takes place 2. Proportional recognition when the service consists of a number of similar or related acts: use formula (direct cost of individual act divided into total estimated cost x total revenues from completed transaction) or straight-line method (e.g. health club membership annual fees) 3. Completed performance method: when more than one act must take place but the final act is so significant that the remainder mean very little in comparison 4. Collection method: revenue not recognised until collection takes place usually because there is significant uncertainty over the customer s ability to
TREATMENT OF RELATED EXPENSES Type of Cost Definition Treatment Pre-contract Direct Indirect Out-of-pocket Overhead Incurred before service contract has been executed Directly related to a specific service contract or activity Incurred as a result of all service activities but not linked to specific contract Incidental reimbursables e.g. taxi fares, hotels General costs of running the business Write-off as incurred Linked to type of service recognition Write-off as incurred Write-off as incurred, often with recharge to customer Write-off as incurred
SALES WITH UNCERTAIN COLLECTION Accruing for income brings with it the risk that it is recognised but not subsequently paid Income normally treated as a receivable with a valuation adjustment if there are initial doubts as to how much will subsequently be received But if receivable is so uncertain that it is difficult to be confident as to anything being received then an alternative method is required The Instalment method: recognition linked to payment of instalments. Both revenue and costs linked to point of sales but no profit taken until cash received on instalments. Not strictly speaking in line with accruals accounting but prudent. Cost recovery method: no income until cost of item sold is covered by cash receipts. Revenue and cost of sale both recognised at point of sale but no profit taken. No profit taken at all until all costs of sale are covered. Only allowable if very serious
RIGHT OF RETURN Specific applicability can relate to nature of the industry. Some industries do not recognise revenue at all until the return privilege has substantially expired (e.g. newspapers) Recognition takes place only if all the following conditions are met (ASC 605-15-25): 1. Seller s price is substantially fixed or determinable 2. The buyer has paid the seller or is obligated to do so (and is not linked to any re-sale of that product) 3. The obligation in 2 does not change if the goods are stolen or destroyed 4. The buyer has economic substance separate from the seller 5. The seller has no significant obligation for future performance 6. The amount of future returns can be reasonably estimated Under IFRS, revenue may be recognised earlier on such sales to the extent of recoverable and measurable costs incurred to date
DIFFERENCES FROM IFRS As a general point, there is much more detail on industry-specific issues in GAAP as opposed to IFRS which relies more on general principles Under US GAAP revenue should not be recognized until an exchange transaction has occurred. For example, US GAAP uniquely talks about vendor-specific objective evidence (VSOE) to determine the fair value of revenue to be recognised from the sale of individual components of a multi-item bundle of, for example, software products Percentage of completion method in GAAP allows all costs incurred plus related profit earned in the period to be recognised: using IFRS both contract revenue and costs are based on the stage of completion IFRS requires that contracts with a number of different elements must be segmented i.e. dealt with individually: under GAAP this is not mandatory (though may be used if certain criteria are met)
ASC 835: INTEREST Two major elements covered: the capitalisation of interest and the imputation of interest With respect to capitalisation, the capital cost of an asset should include all costs necessary to get it into useable order This is also important in terms of matching the costs of assets against the revenue which those assets will help to generate Imputation is an issue where the interest rate chargeable is for whatever reason not reasonable and therefore a more representative interest rate needs to be calculated
CAPITALISATION OF INTEREST Inventories and land that is not being prepared for use are not normally allowable as far as capitalisation of interest is concerned But when land is being developed for resale it is regarded as a qualifying asset However if land is being developed for use by the entity for building then the capitalised interest will be added to the cost of the building The amount of interest includes: A) interest on debt having explicit interest rate B) Interest related to capital leases C) Interest imputed on payables due in more than one year
CAPITALISATION INTEREST RATE The most appropriate rate is that which applies to specific new debt relating to the development of the asset but that is not always available If it is not available then use the weighted-average of the other borrowings of the entity Strictly speaking the amount to be capitalised should be the amount avoided if the qualifying asset were not developed If the reporting entity uses derivative financial instruments as hedges, then the rate to use is the effective yield of that derivative instrument (ASC 815-25-35)
BASE FOR CAPITALISATION The base to which the rate should be applied is the average amount of accumulated qualifying asset expenditure during the relevant period Interest may be simple or compound. Simple means that interest is just applied to the opening debt. Compound is both the principal and the unpaid interest. Most fixed assets are based on compound interest The total amount of interest incurred by the entity is the ceiling for the calculation the amount capitalised cannot exceed this figure. On a consolidated basis the total is defined as the interest recognised by the parent and also consolidated subsidiaries
IMPUTATION OF INTEREST If a receivable is due to be paid more than one year from the reporting date then the correct presentation is to calculate the present value of future payments using an interest rate that reflects the risk involved. This may be specifically stated in the agreement but sometimes it may not or the rate used may not appear to be reasonable If either of these two situations pertain then interest should be imputed using the market rate of interest An adjustment is made to change the value of the receivable to the present value at the market rate The adjustment made is amortised as additional interest income so that the income recognised has a constant interest rate over the life of the arrangement (the effective interest method)
SUMMARY OF REQUIREMENTS Qualifying assets When to capitalise Applicable interest Assets constructed for use in operations Assets for sale or lease constructed as unique projects Certain equity method investments Expenditure on assets has been made Activities meant to prepare asset for use are underway Interest cost is being incurred Interest obligations with explicit rates Imputed interest with regarded to specific receivables or payables
DIFFERENCES BETWEEN GAAP AND IFRS GAAP allows an equity-method investee to be a qualifying asset Internally-developed intangible assets are not normally qualifying assets unlike IFRS Foreign currency movements are not allowable as part of the capitalised interest cost unlike IFRS
COMPENSATION There are four specific Standards covering this in GAAP ASC 710 Compensation General ASC 712 Compensation Nonretirement post Employment Benefits ASC 715 Compensation Employment Benefits ASC 718 - Stock Compensation
ASC 710 COMPENSATION GENERAL This has two main areas covered: general guidance on issues like compensated absences (payments for vacation and other holidays and illness), deferred compensation and lump-sum payments under union contracts and Rabbi trusts A Rabbi Trust: trusts generally set up to fund compensation for a group of managers or highly paid executives. To qualify as a Rabbi Trust for income tax purposes, the arrangement must state that the assets of the Trust are available to pay general creditors in the event of a corporate failure It does not cover issues like post-retirement benefits and Stock Compensation plans which have separate Standards to cover them
MANAGEMENT COMPENSATION - Under US GAAP rules disclosure of the compensation of key management personnel is not required within the financial statements. - SEC regulations require key management compensation to be disclosed outside the primary financial statements. - Under IFRS compensation of key management personnel is disclosed within the financial statements in total and by category of compensation.
COMPENSATED ABSENCES A liability must be accrued if all the following conditions are met: 1. The right to receive payment has already been earned by services already performed 2. The right vests or accumulates 3. Payment of the compensation is probable 4. The amount of payment can be reasonably estimated
WHAT IS VESTING? When an employer is required to compensate an employee for unused vacation, holidays or sick days even if employment is terminated then the employee s right is said to vest Accrual depends on whether or not the right expires at year-end or whether it is allowed to be carried forward ( use it or lose it ) If carry forward is allowable to any extent, then the rights earned should be accrued in the financial statements to the extent that they are likely to be redeemable in subsequent years (ASC 710-10-25-2) Sick days carried forward are not normally accrued because it is hard to estimate reliably what future usage of these days is actually going to be Other types of pay for leave of absence such as jury days are
DEFERRED COMPENSATION CONTRACTS Remember that if the payments are equivalent to a pension plan, then ASC 715 applies. All other compensation payments are dealt with by ASC 710 The amount to be accrued for these is not to be less than the present value of the estimated payments to be made. When elements of current and future service are both included, only the current service elements are accrued for If lump sums on payment apply, then the amount to be accrued is based on the estimated life expectancies of the employees concerned
EXAMPLE OF DEFERRED COMPENSATION PAYMENT A senior manager is to be given a lump sum payment of 200,000 USD in five years time. This is on condition that (s)he is still working for the company then. For each year worked, the manager will have earned a payment of 40,000 USD. Each year then an expense and liability of this amount will be set up. When the five years has passed and assuming that the manager has kept his/her part of the bargain then there will be a payment of 200,000 USD made against which this provision can be offset. Note that it is acceptable to use discounted or undiscounted values for this calculation but that the values accrued must be at least equivalent to the net present value of the future payment
ASC 712 NONRETIREMENT POST- EMPLOYMENT BENEFITS This Standard concerns guidance for employers providing services to employees after termination of their employment Nonretirement post-employment benefits are defined as all types of benefit provided to former or inactive employees and their beneficiaries other than those covered by pension arrangements Inactive employee: one who is not currently providing service but who has not been terminated The types of benefit considered would include counselling, pay continuation, continuation of healthcare benefits These should be accrued for if the same four conditions are met: i.e. services have already been performed, the rights accumulate or vest, payment is probable and the amount can be reasonably estimated
ASC 715 COMPENSATION RETIREMENT BENEFITS The Standard applies to all postretirement benefit plans even if not formally described as such. However it does not apply to specific arrangements with individuals. It covers both single or multiple employer plans It is often a complex subject, requiring extensive actuarial involvement and voluminous disclosures It involves a significant degree of accounting for accruals, underpinned by frequent estimation and assumptions. The basis for these must be clearly disclosed for the benefit of the reader Underfunded pension liabilities will impact significantly on the statement of financial position
TYPES OF PENSION FUND DEFINED BENEFIT Provides benefits for each participant The calculation of benefit is based on the level of contribution from both employer and employee, investment results, less any allowable administrative costs Any shortfall is the risk of the employee DEFINED CONTRIBUTION Pays out determinable amounts based on a formula provided for in the plan Can include both lump sums and regular payments Usually linked to factors such as age, years of service, final salary Any shortfalls usually fall to the employer to pick up: the risk is therefore with them
NET PERIODIC PENSION COSTS The basic premise is to measure the compensation cost associated with employee benefits and recognise that cost over the service period The pension creates long term obligations which it is assumed will continue into the future Net periodic pension costs include the following: 1. Service cost 2. Interest cost on projected benefit obligation 3. Actual return on plan assets 4. Gain or loss 5. Amortisation of unrecognised prior service costs 6. Amortisation of unrecognised net assets or net obligation
CALCULATION OF NET PERIODIC PENSION COST Two elements to consider: PROJECTED BENEFIT OBLIGATION future pension payments taking account of future compensation adjustments ACCUMULATED BENEFIT OBLIGATION future pension payments without regard to salary progression Both PBO and ABO are calculated taking account of actuarial present value of benefits that are attributable. PBO normally is the best indicator of the estimated costs of benefits payable on retirement Plans typically take into account service performed to date plus future compensation increases, staff turnover rates etc.
NET PERIODIC PENSION COSTS VESTED BENEFIT OBLIGATIONS: active employees, retirees, leavers who have nevertheless accrued pension rights NON-VESTED BENEFIT OBLIGATIONS: active employees EFFECTS OF PROJECT FUTURE COMPENSATION LEVELS: active employees
COMPUTATION OF AMOUNTS TO BE INCLUDED ON STATEMENT OF FINANCIAL POSITION Contributions made by the sponsoring employee + Net earnings on investment (dividends, interest plus asset value movements) - Benefits paid to retirees
SERVICE COSTS This is the element of net periodic pension costs which equates to the actuarial present value of benefits attributed during the current period Vesting schemes can result in a distorted share of benefits to be attributed to later years. Because of this the actuary usually applies an adjustment to the expected benefits to be paid out on the following basis: NUMBER OF YEARS SERVICE COMPLETED BY THE EMPLOYEE NUMBER OF YEARS OF SERVICE REQUIRED TO BE COMPLETED FOR FULL VESTING Some benefits such as death or disability benefit may not be vested: benefits are calculated in the following way:
GAINS OR LOSSES These result from 1. Changes in plan assumptions 2. Changes in amounts of plan assets 3. Changes in amounts of the projected benefit obligation If any movements are deemed to be short-term fluctuations then smoothing of the net gain/loss is allowed as costs are amortised
TYPES OF GAINS AND LOSS Actuarial gains/losses: arise from issues such as employee compensation, mortality, turnover of staff, earnings of the pension fund. Not considered prior-year adjustments but changes in estimate Plan assets gains/losses are both realised and unrealised. They relate to differences between actual and expected return on assets. Expected return is calculated by multiplying the expected long-term rate of return by the market value of the plan assets Amortisation of unrecognised prior service cost: prior service costs are incurred when there are changes in plan benefits attributable to participants in the past a change in estimate. Remaining service period of every active employee expected to receive future benefits is calculated and an equal amount of prior service cost charge to each future period: the years of service
REPORTING REGARDING PENSION FUNDS ASC 715 requires that entities that have defined benefit schemes should disclose the funded status of those plans on the face of the statement of financial position rather than in disclosures. Actuarial gains/losses and prior-service costs should be reported as items of other comprehensive income The measurement date for plan assets and obligations must be the annual reporting date (a fairly recent change to previous rules which were more flexible) The difference between plan assets and the projected benefit obligations must be used to gauge the extent of the liability: this will result in an increase in the size of that liability when accumulated benefit obligation was previously used
OTHER PENSION ISSUES Defined contribution: the expense to be reported is based on the contributions due from the employer in the year. These may either be discretionary or based on a formula With multi-employer pension plans the account to be included is the contribution required for the period.
SETTLEMENT AND CURTAILMENT OF PLANS Settlement: an irrevocable action that relieves the employer (or the plan) of primary responsibility for an obligation and eliminates significant risks related to the obligation and the assets used to effect the settlement. Curtailment: a significant reduction in, or an elimination of, defined benefit accruals for present employees' future services. ASC 715-30 describes the accounting to be followed when benefit plans have been settled or curtailed. A pension obligation settlement occurs when: 1. The decision is irrevocable 2. Must relieve the obligor of primary responsibility for the obligation 3. Must eliminate significant risks associated with the obligation and the assets used to affect it If settled, then any previously unrecognised gains or losses associated with the plan are immediately recognised
DIFFERENCES BETWEEN GAAP AND IFRS No specific guidance in GAAP on short-term benefits other than compensated absences though general rules of accruals accounting apply No limit to the amount of plan surplus that can be recognised: in IFRS it is limited to the present value of any available benefits in the form of refunds or reductions in future contributions Regarding curtailments even if there is an agreement that describes how surpluses would be distributed or deficits funded, there is no agreement of an asset or liability until the amounts involved are assessed or a refund received. Under IFRS the amounts included would be recognised based on the agreement
ASC 718 STOCK COMPENSATION Has a number of different areas covered within it Awards classified as equity Awards classified as liabilities Employee stock ownership plans Employee share purchase plans Incomes taxes related to share-based payment arrangements
ACCOUNTING FOR SHARE-BASED PAYMENTS Covers plans that convey shares of the employer s stock, derivatives related to the employer s shares and cash in amounts that are tied to the value of shares Equity-classified awards are those that are publicly traded and have readily-available market prices. These should be valued using the market price. More complex when it is a non-listed company. The grant date is used to set the value vis-à-vis the market price. The grant date is the date on which the parties fix their agreement. Vesting can be based on several possible conditions e.g. service, performance Compensation cost is recognised based on the actual number of awards that eventually vest. Estimates are made to make accruals in each period based on current estimates of expected future
ASC 720 OTHER EXPENSES Areas not covered as they are dealt with by other specific Standards: Ongoing customer acquisition costs Loan origination costs Activities related to routine, ongoing efforts to refine, enrich or improve the qualities of an existing product, service, process or facility Activities related to mergers and acquisitions.. And many others such as store advertising, special offer coupons, obtaining licences
VARIOUS TYPES OF COSTS These include organisation costs The general rule is that costs should be written-off as incurred Regarding insurance, the premium paid minus the amount retained by the insurer is accounted for as a deposit by the party which is insured
ADVERTISING COSTS The costs of advertising must be expensed either as they are incurred or the first time that the associated advertising takes place e.g. the first time that a TV advert is aired Depreciation or amortisation on an asset used for advertising is a cost of advertising Advertising costs are sometimes incurred after the revenue to which they relate is received e.g. co-operative advertising with customers. In such cases, costs should be estimated and accrued in line with the revenue to which they are linked