US GAAP Convergence and IFRS

August 2012
October 8, 2012 To our clients and friends: After months of anticipation, the SEC completed its Staff report on the IFRS work plan. The Staff report did not include a recommendation on whether, when, or how IFRS should be i ncluded in the US financi al reporting system, and the Staff noted that a vast majority of participants in the US capital markets do not support outri ght adoption of IFRS by US issuers. However, the report did note that there was subs tantial support for exploring other methods of incorporating IFRS. Next s teps on this front are uncertain, but may lead to change further out i n the future. The FASB and IASB conti nue to work towards finalizing accounting standards on reve nue recognition, leasing and financi al instruments. Much of the focus was on the fi nancial instruments project this quarter, where the FASB changed course from the previous "three-bucket" impai rment model, as a result of i nput from US stakeholders. The FASB is still plans to issue an exposure draft by the end of the year. The boards have substantially completed their redeliberations on the leasing project and the proposals are expected to be reexpos ed in early 2013. Several important issues are still being addressed on the re-exposed revenue standard, with attention now focused on the variability, collectability and time value of money aspects of the new model. Barring any setbacks in these areas, a final standard is expected in the fi rst half of 2013. Companies shoul d remain engaged in the standard -setting process by participating in roundtables and comment letter processes. As standards change, compani es may need new systems that can capture data, track contracts, and s upport processes to develop and assess complex estimates. Inv estor and stakehol der communication and education may be necessary. The new standards will impact some compani es more than others, but all companies will need to thoughtfully consider them. We have been updating our compendium of our current convergence publications designed to provide you with one single reference resource as you manage the potenti al impact of the proposed standards on your company. Included is an overview of the s tandard -setting landscape, our perspective on the transition methods, and technical insights on the standard-setting projects. As developments unfolded and draft standards moved forward, we have pos ted updates for you to print and add to the original compendium on a dedicated website www.pwc.com/us/jointprojects. We will continue to do so, but in the meantime, if you have any questions, please reach out to your PwC engagement team or me directly.
Sincerely,
James G. Kaiser
James G. Kaiser, Partner, US Convergence & I FRS Leader PricewaterhouseCoopers LLP, Two Commerce Square, Suite 1700, 2001 Market Street, Philadelphia, PA 19103 T: (267) 330 2045, F: (813) 741 -7265, www.pwc.com/us/jointprojects
Contents
1. Setting the standard (March 2012) 2. SECTION: Effective dates and transition methods 3. In brief: IFRS Foundation responds to SEC's final report on IFRS "Work Plan" 4. Dataline: SEC Staff releases its final report on its IFRS Work Plan 5. In brief: SEC Staff releases final report on its IFRS Work Plan 6. Point of view: The path forward for international standards in the United States 7. SECTION: Financial
instruments 8. In brief: IASB proposes limited amendments to its financial instruments guidance under IFRS 9 9. In brief: FASB reaches conclusion on impairment model for financial assets measured at FV-OCI 10.In brief: FASB makes key decisions about the revised impairment model for financial assets 11. In brief: FASB decides to explore a revised impairment model for financial assets 12.In brief: FASB announces intent to further discuss key aspects of proposed impairment model 13.In brief: Boards agree on
three-category financial asset classification and measurement approach 14.In brief: FASB and IASB discuss a more converged financial instrument accounting approach 15.In brief: IASB delays IFRS 9 effective date 16.In brief: Let's try again - the impairment model for financial assets refined 17.Dataline: An update on the FASB's financial instruments project redeliberations as of June 30, 2011 18.Dataline: Accounting for hedging activities - A comparison of the proposed models
19.Dataline: Changes to financial instruments accounting impacts for nonfinancial services companies 20. SECTION: Revenue recognition 21.In brief: Boards conclude redeliberations on key revenue measurement and recognition issues 22.In brief: Boards make decisions on several major outstanding revenue issues 23.Dataline: Revenue from contracts with customers: The redeliberations continue 24.In brief: FASB and IASB decide on revenue contract modifications and measures of progress 25.In brief: FASB and IASB make
progress on revenue redeliberations; more to come 26.Dataline: Revenue from contracts with customers Ready, set, redeliberate 27.In brief: FASB and IASB redeliberate to make the proposed revenue standard less "onerous" 28. Dataline: Responses are in on the re-exposed proposed revenue standard 29.Dataline: Revenue from contracts with customers - The proposed revenue standard is re-exposed 30. 10Minutes on the future of revenue recognition 31.Revenue recognition: Aerospace industry supplement
32.Revenue recognition: Asset management industry supplement 33.Revenue recognition: Automotive industry supplement 34.Revenue recognition: Engineering and construction industry supplement 35.Revenue recognition: Entertainment and media industry supplement 36.Revenue recognition: Industrial products and manufacturing industry supplement 37.Revenue recognition: Pharmaceutical and life science industry supplement 38. Revenue recognition: Retail and consumer industry supplement
39.Revenue recognition: Transportation and logistics industry supplement 40. Revenue recognition: Technology industry supplement 41.Revenue recognition: Telecommunications industry supplement 42.SECTION: Leases 43.Dataline: Leases - One size does not fit all: A summary of the boards' redeliberations 44. In brief: Lease accounting deliberations come to an end, but alternative views are upcoming 45.In Brief: A dual model for lease accounting: redrawing the lines
46. In Brief: FASB and IASB deliberate lessee accounting May 2012 47.In brief: Can we talk about lessee accounting - again? 48. In brief: FASB and IASB make significant decisions related to lessor accounting and transition 49. In brief: Transition decision postponed - will this delay re-exposure of the Leases exposure draft? 50. In brief: FASB and IASB agree to re-expose leasing ED and agree on one lessor accounting model 51.Dataline: Redeliberations of the leasing project - Some new twists 52.In brief: Leases: FASB and IASB
change course 53.10Minutes on the future of lessee accounting 54.Dataline: A new approach to lease accounting - Proposed rules would have far reaching implications 55.SECTION: Fair value measurement 56.In brief: FASB clarifies scope of nonpublic entity fair value disclosure exemption 57.Dataline: Adoption of the new guidance: First quarter 2012 measurement and disclosure observations 58.Dataline: "New fair value measurement standard Adoption of the new guidance: First quarter 2012"
59.Dataline: Implementation guidance for new disclosure requirements 60. Dataline: New fair value measurement standard Implementation guidance for key changes 61.Dataline: Fair value measurement - FASB and IASB complete joint project 62.In brief: FASB and IASB issue final fair value guidance 63.SECTION: Statement of comprehensive income 64. In Brief: FASB to issue a revised proposal on reclassifications from other comprehensive income 65.Dataline: Presentation of comprehensive income -
Applying the FASB's final standard 66. SECTION: Balance sheet offsetting 67.In brief: FASB amends and clarifies scope of balance sheet offsetting disclosures 68. In brief: FASB issues final standard on balance sheet offsetting disclosures 69. In brief: FASB and IASB take separate paths on derivatives netting rules 70.SECTION: Pensions and postemployment benefits 71.In brief: FASB issues final standard to enhance disclosures for multiemployer pension plans
72.Dataline: Pension/OPEB accounting - Understanding changes expected from the IASB 73.In brief: IASB issues amendments to IAS 19, Employee benefits 74.SECTION: Insurance contracts 75.In Brief: FASB Chairman provides status update on insurance contracts project 76.Insurance contracts: Summary as of March 7, 2012 77.PwC summary of FASB education session - Insurance contracts (January 18 2012) 78.SECTION: Consolidation 79.In brief: IASB finalizes definition of an "investment entity"
80. In brief: IASB finalizes amendments to transition guidance for new consolidation standards 81.FASB and IASB agree on principles-based definition for investment companies 82. In brief: IASB proposes amending transition guidance for new consolidation standard 83. Dataline: FASB proposes to align investment company definition with IFRS proposal 84. Dataline: A look at the new IFRS consolidation standard and how it compares to US GAAP 85.In brief: IASB proposes accounting guidance for investment entities 86. SECTION: Financial instrument
presentation 87.Dataline: Financial Statement Presentation - A look at the FASB and IASB's Staff draft 88. SECTION: Contingencies 89. In brief: FASB votes to discontinue loss contingencies project 90. Dataline: Disclosure of Certain Loss Contingencies - An analysis of the FASB's proposed changes
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What you need to know about the FASB and IASBs joint projects
Setting the standard

A spotlight on the FASBs and IASBs projects
September 25, 2012
Whats inside
What you need to know. 2 Status of projects ........... 3 FASB/IASB projects: Financial instruments .......... 4 Revenue recognition............. 6 Leases .................................... 8 Insurance contracts ............ 10 Consolidation ....................... 12 Investment companies ........ 13 Other FASB-only projects .................... 15 Appendix: highlights of priority project board decisions .................. 21
What you need to know about the FASBs and IASBs standard setting activities
Welcome to the latest edition of Setting the standard, our publication designed to keep you informed about the standard-setting activities of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).
Progress continues, but is convergence closer?

What a difference a quarter makes. After a relatively slow second quarter, the boards made headway on their joint projects. Although progress has not been even, the boards are poised to issue several exposure drafts and final standards in the upcoming months. The financial instruments project occupied much of the boards' agenda during the quarter. While they were able to achieve greater convergence on classification and measurement, the boards appear to be parting ways on impairment. Both boards had been moving forward on a three bucket impairment model, but the FASB changed course based on input from US stakeholders. The FASB is now considering a different model it believes will be more operational. The FASB still plans to issue an exposure draft by the end of the year. On the other hand, the boards continue to make steady progress on redeliberations of their revenue recognition project. Although several important issues still need to be addressed, it appears we may see a final standard in the first half of 2013. And after many months of debate, the boards substantially completed redeliberations on the leases project. However, some board members have signaled their intent to provide alternative views in the upcoming exposure draft. Whether these views will impact the final standard remains to be seen. The boards plan to re-expose their proposals in early 2013.
FASB projects see continued momentum

As for FASB-only projects, the board had a very productive summer, issuing three exposure drafts and two discussion papers. In addition, the FASB released a final 1 standard to simplify indefinite-lived intangible asset impairment tests. There are plenty of important details and insights on these and other projects in this edition.
SEC staff weighs in on IFRS

In July, the Securities and Exchange Commission (SEC) staff issued its much 2 anticipated final report on its IFRS workplan. The SEC staff gave its commissioners plenty to think about in the 127-page report. Not surprisingly, one of the considerations the staff evaluated was the extent to which the FASB and IASB have achieved convergence on their joint projects. But what the report didnt include was a recommendation about whether, how, or when the US should incorporate IFRS. Those hoping for some direction are left with unanswered questions about the future of IFRS in the US. While timing of the SECs final decision is unknown, it will likely extend beyond 2012.
Refer to Dataline 2012-08, Indefinite-lived intangible asset impairmentFASB issues guidance that simplifies impairment test and allows early adoption. 2 Refer to Dataline 2012-06, SEC Staff releases its final report on its IFRS workplan.
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Status of projects
Below is the FASBs project timeline. Key differences from the IASBs timeline are footnoted. Joint projects:
FI: classification and measurement FI: impairment FI: hedge accounting Revenue recognition Leases Insurance contracts Consolidation Investment companies
Q3 2012 R R R R D R (4) R
Q4 2012 ED (1) ED R (2)
H1 2013
Thereafter
F ED ED (3) F F R
FASB-only projects:
Investment property entities Liquidity and interest rate disclosures Liquidation basis of accounting Going concern Definition of a nonpublic entity Private company framework Disclosure framework Reclassifications out of accumulated OCI Repurchase agreements
C ED D DP (5) DP DP ED D
C ED C C C C ED
Legend:
D = Deliberations C = Comment period ends ED = Exposure draft issued/expected F = Final standard issued/expected R = Redeliberations DP = Discussion paper issued
(1) Although the IASB finalized its classification and measurement standard in October 2010, it is reconsidering certain aspects as it evaluates limited improvements and plans to propose amendments to its existing standard in the fourth quarter of 2012. (2) The FASBs timing for hedge accounting is uncertain. The IASB issued a review draft of its general hedge accounting standard in September, which is scheduled to be finalized in December. The IASB is expected to issue a discussion paper on macro hedging in 2013. (3) The FASB intends to issue an exposure draft in the fourth quarter of 2012. The IASB is considering re-exposure. (4) The timing of the FASB's final or re-exposed standard is uncertain. The IASB issued its consolidation standard in May 2011. (5) Tentative decisions reached about what constitutes a private company were exposed for comment as part of the July 2012 Discussion Paper on the Private Company Decision-Making Framework. The board still needs to address other aspects of this project, including not-for-profit organizations, and expects to issue a complete exposure draft once deliberations are finalized.
Financial instruments
Whats new?
The boards appear to be at a crossroads on an impairment model for financial assets. 3 After previously agreeing on a three bucket impairment model, the FASB decided to abandon that approach in favor of one it believes is more operational. It is unclear whether the IASB will move forward with its exposure draft on the three bucket model or if it will first consider the FASBs revised proposal. Meanwhile, the boards are in synch on much of their classification and measurement guidance, and the FASB anticipates releasing its revised proposal during the fourth quarter.
FASB takes a different direction on impairment

After considering the results of outreach and constituent feedback, the FASB concluded that aspects of the three bucket model are difficult to understand and present operational challenges that cannot be addressed through implementation guidance. As a result, the FASB decided to explore an alternative impairment model. FASBs alternative impairment approach The FASBs alternative approachknown as the current expected credit losses approachwill reflect managements estimate of the future contractual cash flows it does not expect to collect. The model will consider a range of potential outcomes, based on probability, resulting in an estimate of expected credit loss. There is no threshold that needs to be met before recording a credit impairment (for example, losses dont have to be probable), which is a key difference from both the three bucket model and current practice. Purchased credit impaired assets The FASB is attempting to simplify the accounting model for purchased credit impaired assets (that is, acquired assets that have experienced a significant credit deterioration since origination). Under the new model, an initial impairment allowance will be established based on expected losses that will be remeasured each period. Changes in the allowance, positive or negative, will be recognized in income immediately. This is expected to be less complex than existing guidance, where increases in expected cash flows are reflected prospectively through a yield adjustment.
A joint impairment model is proving difficult to achieve.
Boards reach additional classification and measurement decisions

Over the last couple of quarters, the boards reached general agreement on the accounting for debt investments. This was a major step toward convergence, with debt investments being classified in one of the following three categories: 1. Amortized cost 2. Fair value with changes in fair value recognized in other comprehensive income 3. Fair value with changes in fair value recognized in net income The boards tackled additional questions over the summer, including whether classification should be reconsidered if there is a significant change in an entitys business model for its investment portfolio. To demonstrate that a business model change is significant and warrants reclassification, all of the following criteria will need to be met:
3
The "three bucket" approach recognizes impairment in a way that reflects the general pattern of deterioration in the credit quality of financial assets. The level of reserves increases as credit deteriorates. Refer to In brief 2011-52, Let's try againThe impairment model for financial assets refined.
The change is determined by the entitys senior management in response to external or internal changes The change is significant to the entitys operations The change is demonstrable to external parties The boards, however, did not agree on when changes in a business model should be reported in the financial statements. The IASB requires changes to be reported at the beginning of the subsequent period after the change, whereas the FASB requires changes to be reported at the end of the period in which the changes occurred. The boards are not expected to further discuss the issue jointly.
The boards stay on course with classification and measurement decisions.
Classification and measurement The final stretch?

Beyond the joint decisions, the FASB is tying up loose ends on the remaining pieces of its model. While most of the big ticket items have been redeliberated, there are still key areas where differences remain between the FASBs and IASBs models: Accounting for equity investments not under the equity method of accounting Determining when the equity method of accounting can be used Accounting for hybrid instruments and convertible debt by issuers Determining when the fair value option should apply Presentation and disclosure requirements The FASB plans to discuss a number of these and other important issues in the coming months.
Whats next?
The FASB hopes to nail down key elements of its impairment model by the end of September and issue an exposure draft by the end of 2012. The FASB is also projecting an exposure draft on classification and measurement by the end of the year. Following these exposure drafts we expect the FASB to pick up its hedging project.
For more information: See a summary of key board decisions in the Appendix to this publication in addition to the following: In brief 2012-41, FASB reaches conclusion on impairment model for financial assets measured at FV-OCI In brief 2012-37, FASB makes key decisions about the revised impairment model for financial assets In brief 2012-10, FASB and IASB agree on a three-category financial asset classification and measurement approach Dataline 2011-06, Accounting for hedging activitiesA comparison of the FASBs and IASBs proposed models
Revenue recognition
Whats new?
Redeliberations are in full swing. The boards have been meeting to address key areas where stakeholders voiced concerns. Those concerns include how to determine when certain goods or services are distinct, how to apply the transfer of control criteria to service contracts, how to assess onerous contracts, and how to assess variable consideration when applying the reasonably assured constraint. The boards will be revisiting other important topics in the coming months as they move closer to finalizing this far-reaching new standard.
Redeliberations take two

During redeliberations, the boards have conducted extensive outreach, including sector-specific workshops and roundtables. With industry guidance going away, there is no shortage of application issues to address. But, rather than tailoring guidance for specific industries, the boards remain committed to evaluating issues on a broader basis. So far, the boards have: Refined the guidance for identifying separate performance obligations and determining when a performance obligation is distinct Clarified the criteria for performance obligations satisfied over time Eliminated the assessment of onerous performance obligations Agreed to clarify what constitutes variable consideration
License transactionsthe debate continues

Should license revenue be recognized upfront or over time? That has been a lingering question throughout the project. Recent focus on licensor-imposed restrictions (including time-based restrictions and restrictions on the customers use of the underlying intellectual property) has sharpened the debate. The boards expected to resolve this issue in July, but decided more work was needed. The staff will be taking another run at the issue, likely in October. The central question is whether these license restrictions impede transfer of control, and therefore, result in revenue recognition over time. Or, are the restrictions merely a characteristic of the asset being licensed, which should not delay upfront revenue recognition. Throughout this debate, the software and entertainment industries have been particularly engaged. But licenses of intellectual property are common in other industries as well. The boards continue to analyze the guidance in this area, so stay tuned.
Where do redeliberations stand?

The boards upcoming meetings will focus on the treatment of customer credit risk, the time value of money concepts, and other broader issues. Heres a recap of some of the key decisions made so far this year:
Topic Identifying separate performance obligations Key redeliberation decisions Clarified that a promised good or service is a separate performance obligation if it is capable of being distinct (i.e., customers ability to benefit separately from the good or service) and is distinct in the context of the contract (i.e., customers
Topic
Key redeliberation decisions perspective of what they have contracted to receive) Added indicators to assess whether goods and services are distinct in the context of the contract Added an indicator to help determine the performance obligations for repetitive service contracts Considered one performance obligation if it is satisfied over time and the same measure of progress is used to depict transfer to the customer
Performance obligations satisfied over time Onerous contract loss test Reasonably assured constraint
Clarified and refined the criteria to determine recognition over time to better address application to service contracts Clarified the guidance about whether an asset has an alternative use and when an entity has a right to payment for performance to date Removed the requirement to assess onerous performance obligations Retained existing guidance in both US GAAP and IFRS regarding contract losses Removed the term reasonably assured in favor of an objective to include amounts for which the entity has predictive experience Agreed to clarify what constitutes variable consideration
Whats next?
The boards goal is to issue a final standard in the first half of 2013. To do that, they will need to stay on pace with their plans to address a number of significant issues in the coming months. Several of the more hotly contested issues have yet to be addressed including transition, disclosures, and effective date.
For more information: In brief 2012-28, FASB and IASB redeliberate to make the proposed revenue standard less "onerous" Dataline 2012-07, Revenue from contracts with customersReady, set, redeliberate Dataline 2012-04, Responses are in on the re-exposed proposed revenue standardConstituents voice their support and concerns Dataline 2011-35, Revenue from contracts with customersThe proposed revenue standard is re-exposed (includes certain industry supplements) 10Minutes on the future of revenue recognition
Leases
Whats new?
After nearly 18 months of debate, the boards substantially completed leasing redeliberations in July. The boards agreed to a dual approach that both lessees and lessors will apply to determine income statement recognition. Now, the staff is working through the difficult task of writing an exposure draft for another round of public input, expected early next year. The next stage of this project may be interesting to watch as several FASB and IASB members voiced significant concerns about key elements of the revised proposals. These concerns are likely to be discussed further before a final standard is issued.
The dual approach

To recap, the boards voted for a dual approach for lessee accounting, allowing straight-line expense recognition for some leases. Other leases will follow an interest and amortization approach with a front-loaded expense recognition pattern (similar to that proposed in the 2010 exposure draft). Under either model, all leases will be recognized on the balance sheet unless the maximum lease term is 12 months or less. Classification of a lease will be based on a principle of consumption of the underlying asset. That is, a lease will be classified using either the interest and amortization approach or a single lease expense approach, depending on whether the asset is consumed over the lease term. Generally, lessees will recognize expense on a straight-line basis for leases of property (buildings and land). The accounting for other types of leases, such as equipment, generally will follow the interest and amortization approach, resulting in front-loaded expense. These presumptions can be overcome in certain circumstances. Lessor accounting will also incorporate a consumption model depending on whether the lease term is for a major part of the assets economic life or the present value of the fixed lease payments account for substantially all of the leased assets fair value. Its likely that most lessors of property will continue to qualify for an approach similar to todays operating lease accounting , recognizing income on a straight-line basis over the lease term. For leases of assets other than property, lessors will apply the receivable and residual approach if the lessor has sold more than an insignificant portion of the underlying asset. Under this approach, a lessor will recognize upfront profit and a receivable for the portion of the asset sold. For the portion of the asset deemed not sold, a lessor will recognize a residual asset and no upfront profit. Leases of equipment will likely qualify for this approach. The boards decision to incorporate a dual approach overturns the previous scope exclusion for investment property. The scope exclusion is no longer needed because application of the consumption of the underlying asset principle results in most lessors of investment property applying an approach similar to existing operating lease accounting, rather than a receivable and residual approach.
Alternative views may lead to future redeliberations.
Alternative views looming

Redeliberations have been a challenge for the boards, as they try to balance comments from preparers and users. Preparers have concerns about the cost and complexity of applying the requirements, while users continue to challenge the usefulness of information provided by the proposals. Other concerns also surfaced during redeliberations about the conceptual merit and practical application of the proposed model.
In fact, several FASB and IASB members may present alternative views in the revised exposure draft. Some FASB members expressed significant concerns about the overall cost/benefit proposition and questioned whether the proposal will provide users with more useful information. Other concerns raised include the accounting for variable leases payments, the effectiveness of disclosures, and the interaction of lessor accounting with the proposed revenue recognition model. Some IASB members also may present alternative views indicating support for a single, rather than dual, lease accounting model by both lessees and lessors.
Whats next?
The FASB is scheduled to meet soon to discuss potential differences for nonpublic entities. An exposure draft is expected in early 2013, with a 120-day comment period.
For more information: See a summary of key board decisions in the Appendix to this publication. Dataline 2012-11, Leases One size does not fit all: A summary of the boards' redeliberations In brief 2012-26, Lease accounting redeliberations come to an end, but alternative views are on the horizon In brief 2012-15, A dual model for lease accounting: redrawing the lines
Insurance contracts
Whats new?
A converged solution on insurance contracts may not be likely, but the boards are still jointly deliberating some topics. The FASB continues to make progress toward its plan to issue an exposure draft. The board recently decided charitable gift annuities will not be in scope of the project, but title insurance will. The FASB also decided all advertising, including direct response, will be expensed as incurred. In addition, the FASB recently made an important decision on its single margin approach, and the boards made a much awaited joint decision on transition. The weighty topic of income statement presentation still needs to be addressed.
Single margin to lock or unlock?

Under the FASBs building block model, a deferred profit (single margin) is recognized at inception if expected cash inflows exceed expected cash outflows. The margin is then amortized in future periods as the insurer satisfies its obligation to policyholders, based on the insurers release from risk. The FASB decided that the single margin on a portfolio of insurance contracts will not be used as an offset (unlocked) for changes in actual or expected cash flows. Instead, changes in cash flows will be reported in the income statement immediately. The FASB believes this approach most faithfully represents the current value model. The board decided that changes in management expectations of cash flows should be recognized in the income statement when they occur, rather than spreading the impact over future periods. This differs from the IASBs view on its residual margin, which will be adjusted for changes in cash flow estimates. An exception to the FASB's lock-in of margin approach occurs if an insurer determines that a portfolio of contracts is onerous (that is, in an overall loss position). In that case, an additional liability will be recognized with a corresponding offset that eliminates any remaining margin. If that additional liability exceeds the remaining margin, an insurer will recognize an expense for the excess. This is similar to todays treatment for traditional long duration contracts, where the policy benefit liability calculation is locked in unless there is a premium deficiency. Despite the FASBs rationale, some constituents prefer the approach of adjusting the margin for changes in estimates. They argue that if expected cash outflows increase, the contract becomes less profitable. In that case, they believe locking in the single margin amortization amount based on an amount determined at contract inception is inconsistent with a current value model.
Convergence may not be in the cards, but the boards continue to jointly discuss some issues.
Transition boards land on retrospective

In September, the boards decided that their proposals should be retrospectively applied to all prior periods. Such an approach will require a retrospective determination of the residual margin (IASB) or single margin (FASB) back to contract inception, which could be quite a challenge for many life insurance companies. Even if full retrospective application is not practical, other methods of estimation must be employed. A practical expedient is also expected for determining the applicable discount rate.
Exclude investment components from premiums and claims

For the most part, investment components of an insurance contract will not be unbundled and measured as financial instruments. Instead, they will be included in the measurement of the insurance liability. However, the boards decided that the investment component of insurance premiums received, and subsequently, of claims paid, will not be included in premium revenue or claims expense, respectively, in the
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income statement. Next, the FASB plans to discuss how to determine the investment component. We expect the board to debate several alternatives in October.
Income statement presentation still looking for an answer

We expect the boards to continue discussing income statement presentation of key items such as premiums, claims, benefits, and gross underwriting margin in October. The insurance industry and financial statement users overwhelmingly oppose the summarized margin approach originally proposed. Instead, they support presenting theses items individually in the income statement. After much discussion and debate, the issue of presentation remains unresolved. Whether a classic revenue and expense presentation can be created from a balance sheet approach (that focuses on current value measurement) is yet to be determined.
Whats next?
The FASB is still targeting the end of 2012 for an exposure draft, but that could be delayed to 2013 given the significant topics still to be discussed. Additionally, the FASB has yet to decide whether it will target specific changes to existing US GAAP or issue an entirely new standard. The IASB, on the other hand, will ultimately issue a comprehensive insurance standard.
For more information: See a summary of key board decisions in the Appendix to this publication. In brief 2012-14, FASB chairman provides status update on insurance contracts project IASB-FASB insurance contracts project summary (as of April 19, 2012) Dataline 2011-14, (revised March 4, 2011), Insurance contractsComment letter themes being addressed in fast paced redeliberations Dataline 2010-39 (revised February 16, 2011), Insurance contracts Fundamental accounting changes proposed
Setting the standard 11
Consolidation
Whats new?
Keep the consolidation project on your watch list. There may be some news coming later this year as the FASB continues to make decisions that could change which entities are considered variable interest entities, and who, if anyone, should consolidate. After appearing to be on the backburner for several months, this project has recently come back into focus. The FASB listened to feedback and is considering whether to change aspects of the proposal it issued last year. Discussions will likely continue in the fourth quarter as the board works toward issuing a final standard in the first half of 2013.
What did the proposal say?

As a reminder, the proposal introduces a principal versus agent model to determine whether an entity is a variable interest entity and who should consolidate a variable interest entity, and to determine if a general partner should consolidate a limited partnership or similar entity. A decision-maker that is a principal will typically consolidate while an agent will not. Three factors will be weighted in performing this analysis: (1) the rights held by other parties, (2) the decision maker's compensation, and (3) other economic interests held by the decision maker.
Redeliberation decisions reached to date

The FASBs redeliberations are still in the early stages. Perhaps most noteworthy is the boards decision to reaffirm its intent to align the guidance for participating rights across all consolidation models. This will impact entities beyond variable interest entities, and could trigger changes to todays conclusions about whether to consolidate. For example, under the current consolidation approach for voting entities, a noncontrolling shareholders ability to veto decisions about a specific activity could prevent a majority shareholder from consolidating an entity. Under the proposal, a noncontrolling shareholder must be able to veto all of the activities that most significantly impact the entitys economic performance before the majority shareholder will be precluded from consolidating.
Whats next?
The FASB will next discuss important implementation guidance about how to weigh the three factors in a principal vs. agent analysis. The timetable for a final standard has slipped into the first half of next year. Companies will want to stay on top of developments because if this proposal moves forward, it could significantly change current practice. For more information: In brief 2012-20, IASB finalizes amendments to transition guidance for new consolidation standards Dataline 2011-33, Consolidation of VIEs and partnershipsmore changes under considerationFASB proposes to require principal versus agent analysis Dataline 2011-29, (revised November 15, 2011), A look at the new IFRS consolidation standard and how it compares to US GAAPMany aspects of the IASBs consolidation guidance are now converged with US GAAP
Investment companies
Whats new?
The boards have continued redeliberations and are nearing completion of their joint project. In response to feedback, the boards revised their original proposal, which had defined an investment company using six prescriptive criteria. While retaining some of the original requirements, the revised approach will allow for more judgment. The new model defines an investment company using certain criteria, but also incorporates additional, non-determinative characteristics of a typical investment company. These include whether an entity manages its investments on a fair value basis; its number of investments and investors; related party investors; and ownership interests. Interestingly, this means an entity could qualify as an investment company even if one or more of the typical characteristics of an investment company are not present.
FASB sharpens its guidance on investee funds

On the consolidation front, the FASB decided to retain existing guidance for consolidation of investee funds. It also identified certain disclosures that will be required for significant investments in an investee fund. Further, the FASB clarified that any investment that is held by an investee fund that is significant to the reporting entity will need to be disclosed. This will change current practice, which requires disclosure of the underlying investments that exceed 5% of the reporting entitys net assets.
The boards decided to change the proposed definition of an investment company, allowing for more judgment in the evaluation.
The definition of an investment company

The FASB reaffirmed its earlier decision that entities regulated under the SECs Investment Company Act of 1940 will continue to qualify as investment companies for accounting purposes irrespective of whether they meet the investment company definition. As a result, certain entities such as business development corporations that may not qualify based on the proposed criteria will continue to report using an investment company model, consistent with their regulatory reporting requirements.
Convergence differences may remain

Generally, constituents have welcomed the new principles-based approach, although some significant differences remain between the two boards proposals. The IASB continues to view investment company accounting as a narrow exception to consolidation or equity method accounting. However, the FASB believes the definition of an investment company should be applied more broadly. The differing approaches proposed by the boards means that entities with similar activities for example, entities holding debt securities primarily for collection of income streams could reach different conclusions about whether they meet the definition of an investment company under IFRS and US GAAP. Despite these differences, its safe to say that many view the boards new approach as much closer to the existing investment company definition than the rules-based approach previously proposed.
Whats next?
The IASB appears to have finalized its decisions on most matters and is expected to issue a final standard in the upcoming months. While the FASB will continue deliberating some key topics, such as effective date and transition, it still plans to issue a final standard on this project by the end of 2012.
For more information: In brief 2012-12, FASB and IASB agree to principles-based definition for investment companies Dataline 2011-32, Investing in a new investment company definition FASB proposes to align investment company definition with IFRS proposal
Other FASB-only projects

Outside the joint projects, the FASB continues to work on various projects that impact US GAAP. Highlights of these are included here. During the quarter, the FASB discontinued its loss contingencies project and its nonpublic entity fair value measurement disclosures project.
Investment property entities still searching for a solution

Companies holding investment property are following this project closely, as it may impact how their investments are measured. Although the original proposal had centered on an entity-based model, the FASB abandoned that approach and is now considering other options. One of those options may be to simply discontinue the project. Another possibility is to develop asset-based guidance. The prospect of asset-based guidance generated significant discussion at the August board meeting, but concerns emerged about the boards ability to define investment property and whether such guidance should include a requirement, or an option, to measure investment property at fair value. At this point, it is unclear if convergence will be achieved. Under IFRS, entities have the option to measure all investment properties at fair value. At previous meetings, the FASB also considered integrating certain aspects of this project (such as presentation and disclosure matters specific to real estate funds) into the investment companies project. One obstacle to this approach is that the investment companies project is a joint project with the IASB, while the investment property entities project is a FASB-only project. Thus, merging these two projects does not appear likely. For its next steps, the board plans to evaluate the asset-based approach in conjunction with its research project that is focused on when a reporting entity should apply asset- or entity-based guidance to its nonfinancial assets. A preliminary report is expected in the fourth quarter. For more information: In brief 2012-34, FASB debates the path forward for investment property entities Dataline 2011-34, Investment property entitiesThe good, the bad and the ugly
Risk disclosures proposal comment letter period wraps up

In June, the FASB released a proposal that will require new disclosures about liquidity and interest rate risks. The proposal introduces new quantitative and qualitative liquidity risk disclosures for all entities. For financial institutions, the proposal goes further. It requires more extensive liquidity disclosures and interest rate risk disclosures. As defined in the proposal, financial institutions are entities and reportable segments that earn income primarily from managing the difference between interest generated on financial assets and interest paid on financial liabilities, or that provide insurance. Breaking it down, most banking entities or segments will likely fall within the definition, while investment banks, broker-dealers, and investment companies will not.
The FASB did not propose an effective date but would like it to be soon. See the Appendix to this document for additional details on the types of disclosures proposed. The comment period ended September 25, 2012. For more information: Dataline 2012-12, Disclosures about liquidity risk and interest rate risk A closer look at the proposed standard
Liquidation basis of accounting striving for consistency and comparability

The FASB recently issued an exposure draft on the liquidation basis of accounting. Today, there is minimal guidance about when and how an entity should apply the liquidation basis of accounting. IFRS does not provide guidance in this area. The proposal requires an entity to prepare its financial statements using the liquidation basis of accounting when liquidation is imminent. Liquidation is imminent when either: the plan of liquidation has been approved by the entitys governing body that has the power to make such a plan effective and it is remote that the plan will be blocked by other parties, or the plan to liquidate is being imposed by other forces and it is remote that the entity will return from liquidation in the future. Assets and liabilities will be measured at the amounts expected to be collected or paid during the course of liquidation. An entity will accrue and present costs it expects to incur and income it expects to earn during the liquidation period. Statements of net assets in liquidation and of changes in net assets in liquidation will continue to be required, along with disclosures about the liquidation plan and amounts recorded. The board has not yet proposed an effective date. Comments are due by October 1, and a final standard is expected in late 2012 or early 2013. For more information: In brief 2012-22, FASB proposes guidance for applying liquidation basis of accounting
Going concern FASB taking another look

After a few starts and stops, the board is now recommencing deliberations on its going concern project. Some believe management needs to disclose more about the ability of its company to stay in business, but thats a thorny issue. The questions at hand are whether and how an entity should conduct a going concern assessment and if so, what should be disclosed. Expect to see some updates in the fourth quarter.
Private company decision-making framework taking steps forward

With the members of the new Private Company Council (PCC) now appointed and the FASB getting input on a decision-making framework, progress is well underway toward addressing private company financial reporting. In July, the FASB issued a discussion paper on a framework that the FASB and the PCC will use in determining
whether and when to allow exceptions or modifications to US GAAP for private companies. The purpose of the framework is to better address the needs of private company financial statement users and identify opportunities to reduce the complexity and cost of preparing financial statements. The framework asserts that lenders and investors often use private company financial statements differently than public company users, and they sometimes need different information. It also calls for a deeper cost-benefit evaluation, given the typical resource constraints of private companies. In a separate but concurrent project, the board is making important decisions about which types of companies qualify as nonpublic entities and which entities can apply the differences allowed under the framework. The discussion paper includes the boards tentative decisions and the FASB is seeking input about whether there are additional types of entities that should be included in the definition. The paper includes initial FASB staff recommendations but reflects input from the board and a variety of private company stakeholders. The paper identifies the following six significant factors that differentiate private company financial reporting from that of public companies: Types and number of financial statement users Access to management Investment strategies Ownership and capital structures Accounting resources Learning about new financial reporting guidance The paper also provides a look into the factors to consider when allowing differences in recognition and measurement, disclosures, display (presentation), effective dates, and transition methods. The board has not deliberated any of the topics in the staff paper or reached tentative conclusions about the framework. This is because much of its content breaks new ground, so the FASB first wants to hear whether its on the right track. Also, comment letter input should be ready to share with the PCC, which is tasked with jointly approving the framework. The question that remains top of mind for many stakeholders is to what extent the board and PCC should allow differences in recognition and measurement between private and public companies. Those favoring a single or pure set of US GAAP are hopeful differences will be minimal, while others want to see more significant changes. Another key issue the board and PCC will need to tackle is whether a private company that elects to apply any difference in recognition or measurement guidance must apply all differences available, or whether it should be able to pick and choose. While these initiatives are aimed at private companies, we see the benefits of the framework extending beyond private companies. Thats because any cost-effective alternatives identified to benefit private companies might also influence the FASBs public company and not-for-profit organization standard-setting activities.
The comment period ends October 31, 2012 and the FASB is hopeful many stakeholders will weigh in.
Disclosure framework a cure for disclosure overload?

The FASB issued a discussion paper in July seeking stakeholder input on ways to improve disclosure effectiveness. With preparers upset about prescriptive and lengthy disclosure requirements, and users frustrated that notes have become too boilerplate, the board sees the need for change. The FASB is hopeful the project will reduce the volume of disclosures, but says this is not its primary objective. The paper does not propose any specific changes but it does suggest a number of concepts and alternatives that the FASB believes could lead to better disclosures. At the projects core is how to clearly communicate information that users find most important to their decision-making. The paper discusses a decision process that the FASB could use to establish disclosure requirements intended to provide the most relevant information to users. And recognizing that one size doesnt fit all, the FASB suggests that the decision process could also be used by management to decide on the appropriate type and level of disclosures. In doing so, the FASB has introduced an approach that could empower management to exercise judgment in determining the extent of disclosure to provide based on their circumstances. The paper suggests the following four methods to create flexible disclosure requirements designed to focus on information that is relevant: Change disclosure requirements to be less prescriptive Provide one set of disclosures and require preparers to determine which are relevant Provide minimum and expanded disclosures for each topic and require preparers to choose between these two alternatives Provide three or more tiers (instead of just a minimum and a maximum) and require preparers to decide which tier to apply The paper also includes details of the following: A judgment and materiality framework that preparers could use to determine which disclosures are relevant in specific circumstances Organization and formatting techniques that could make the information users need easier to find and understand Disclosure requirement alternatives for interim financial reporting After the framework has been sufficiently developed, the board plans to apply it to both new and existing standards. The comment period ends November 16, 2012. For more information: Dataline 2012-09, FASB solicits feedback on its framework for improving financial statement disclosures
Reclassifications out of accumulated OCI responding to stakeholder concerns

In August, the FASB issued an exposure draft that will require companies to disclose information about reclassifications from accumulated other comprehensive income (OCI) to net income in their interim and annual financial statements. The new guidance responds to concerns raised about the amendments issued in 2011 relating to the presentation of OCI. The 2011 amendments required entities to measure and present the effect, by individual line items within net income, of reclassifications from accumulated OCI on the face of the financial statements. Preparers said it was too difficult to identify the income statement line items affected by reclassifications from accumulated OCI when those amounts are first reclassified to a balance sheet account. On top of that, some stakeholders felt that the original requirement to present reclassifications on the face of the financial statements would cause clutter and distraction. The FASB listened and believes its new proposal strikes the right balance by addressing the concerns of financial statement preparers while still providing the additional transparency sought by financial statement users. Under the proposal, companies must disclose, in a single footnote, a table showing the amount reclassified from each component of accumulated OCI and the income statement line items affected by the reclassification. The income statement line item will only need to be shown for components required to be reclassified to net income in their entirety. This means that for items reclassified from accumulated OCI that are capitalized, such as net periodic pension costs, affected line items will not be disclosed. However, companies will need to cross reference to the footnote where additional information can be found (for example, the pension note). The FASB did not propose an effective date, but the final standard could be effective for public companies as early as 2012, with a one-year deferral for private companies. The comment period ends October 15, 2012. For more information: Dataline 2012-13, Disclosure of items reclassified from accumulated other comprehensive income FASB proposes new disclosures
Repurchase agreements stay tuned for proposal

The FASB recently decided to require certain types of transactions, including certain repurchase agreements, to be accounted for as secured borrowings. As a refresher, repurchase agreements (or repos) involve the transfer of a financial asset and an agreement for the transferor to repurchase the transferred asset or a similar asset from the transferee in the future. Currently, repurchase transactions are accounted for either as: Financing transactions the transferred asset remains on the balance sheet of the transferor and cash received by the transferor is treated as a secured borrowing Sales the transferred asset is derecognized or removed from the balance sheet of the transferor, cash received is treated as sale proceeds, and the obligation to repurchase the transferred asset generally is treated as a derivative
Feedback suggests that constituents generally view repurchase agreements as financing transactions. The FASB decided that specifying the types of transactions to be accounted for as secured borrowings would expeditiously address this feedback and achieve greater consistency. The board decided that a repurchase agreement or similar transaction that meets all of the following six criteria will be accounted for as a secured borrowing: It involves a transfer of existing financial assets at its inception It involves both a right and an obligation to repurchase financial assets The initial transfer and forward repurchase agreement involve the same counterparty The agreement to repurchase the financial assets is entered into contemporaneously, or in contemplation of, the initial transfer The repurchase price is fixed or readily determinable The financial assets specified under the forward repurchase agreement are identical to or substantially the same as the financial assets transferred at inception The FASB decided to utilize the existing criteria defining substantially the same and make minor modifications to reinforce that a company needs to do a full analysis to conclude about the substantially the same criteria. For repurchase agreements that do not meet all of the criteria above, the transaction will be evaluated under the existing derecognition criteria. This includes analysis of legal isolation, the transferees ability to freely pledge or exchange the transferred asset, and whether the transferor maintains effective control. In addition, the FASB decided to require additional quantitative disclosures for both transactions accounted for as secured borrowings and those accounted for as sales. Expect an exposure draft to be issued before the end of the year. For more information: In brief 2012-42, FASB determines additional disclosure requirements for repurchase agreements In brief 2012-33, FASB makes further decisions on repurchase agreement accounting In brief 2012-19, FASB tentatively agrees on approach for repurchase agreement accounting
Appendix: highlights of priority project board decisions

Financial instruments: summary of FASB decisions on classification and measurement to date
Component Current proposal Financial assets will be classified into one of three categories based on: (1) the individual instruments characteristics and (2) an entitys business strategy for the portfolio. The basis for classifying financial liabilities is expected to be discussed further by the board. Classified into one of the following categories: amortized cost, Debt investments fair value with changes in fair value recognized in other comprehensive income, or fair value with changes in fair value recognized in net income. Debt liabilities Classified into one of the following categories: (1) amortized cost; or (2) fair value with changes in fair value recognized in net income. Classified as fair value with changes in fair value recognized in net income. A practicability exception is allowed for measuring nonmarketable equity securities. Applicable if there is significant influence over the investee, but only if the investment is not held for sale. If held for sale, equity investment accounting applies (that is, fair value). Separate accounting for financial asset host contracts and embedded derivatives in hybrid financial assets will be prohibited; instead, the entire hybrid financial asset is accounted for as a single instrument. Hybrid financial liabilities will continue to be bifurcated. Only available for: Fair value option hybrid financial liabilities, to avoid the complexity of separately accounting for embedded derivatives, and groups of assets and liabilities managed and reported on a net exposure basis. Fair value will be presented parenthetically on the face of the balance sheet for financial assets measured at amortized cost. Amortized cost will be presented parenthetically on the face of the balance sheet for financial liabilities recorded at fair value (such as debt), excluding demand deposits.
Principle for classification
Equity investments (not under the equity method of accounting)
Equity method of accounting
Hybrid financial instruments
Presentation
Financial instruments: summary of IASB decisions on impairment to date (see next page for FASB decisions to date)
Component Current IASB proposal Impairment of financial assets will follow a threebucket approach. All assets originated or purchased with no credit deterioration will start in bucket one and move into bucket two or bucket three as credit quality deteriorates. Estimates of lifetime losses must: Estimating expected losses reflect all reasonable and supportable information considered relevant consider a range of possible outcomes consider the time value of money Assets with evidence of credit deterioration at acquisition will begin in either bucket two or bucket three and remain outside of bucket one even if credit subsequently improves. Interest income will be measured based on expected future cash flows, which is continually updated to reflect current estimates. An expected loss impairment model is applied to trade receivables with a significant financing element. Entities can either apply the general approach or a simplified approach in which the allowance is based on lifetime expected losses at initial recognition. An expected loss impairment model will be applied to trade receivables without a significant financing component. Measurement objective is a lifetime of expected losses. For lease receivables, entities can either fully apply the general approach or a simplified approach in which the allowance is based on lifetime expected losses at initial recognition. For debt instruments modified in a troubled debt restructuring, an entity will recognize lifetime expected credit losses.
The general approach
Purchased credit impaired assets
Trade receivables with a significant financing component
Trade receivables without a significant financing component
Lease receivables
Troubled debt restructurings
Financial instruments: summary of FASB decisions on impairment to date

Component Current FASB proposal Impairment of financial assets will follow current expected credit loss (CECL) approach. Expected losses are defined as the estimate of contractual cash flows not expected to be collected. There will be no threshold to meet prior to recording expected credit losses. Estimates of lifetime losses must consider: Estimating expected losses all relevant, reasonable, and supportable information a range of possible outcomes the time value of money These are assets acquired that have experienced significant credit deterioration since origination. Purchased credit impaired assets The initial impairment allowance will be based on the level of expected losses. The impairment allowance is updated each period with changes to be recognized in income immediately. The remaining non-credit purchase discount or premium is recognized in income over the life of the asset.
The general approach
Financial instruments: summary of FASB decisions on liquidity and interest rate disclosures to date
Non-financial institutions Financial institutions
Qualitative disclosures
Additional discussion and numerical information about significant changes in the timing and amounts included in quantitative tables is required where needed to provide users an understanding of the entity's risk exposure. Available liquid funds table: shows unencumbered cash and high-quality liquid assets currently held, and available sources of borrowings (e.g., lines of credit) Expected cash flow obligations table: shows the undiscounted amount and timing for all obligations, including off-balance-sheet items Not applicable Available liquid funds table: same as non-financial institutions
Quantitative liquidity risk disclosures
Expected maturity table: shows amount and timing of expected settlement for all financial assets and liabilities based on contractual terms Repricing analysis table: shows timing of when interest rates will be reset on classes of interest-bearing financial assets and liabilities Interest rate sensitivity table: shows impact on net income and equity of prospective, hypothetical interest rate shifts on an entitys interestsensitive financial assets and liabilities Time deposits table (for depository institutions only): shows total amount, average interest rate, and life for issuances of classes of time deposits for the previous four quarters
Quantitative interest rate risk disclosures
Appendix, continued
Revenue recognition: summary of joint board decisions to date
Component Current proposal Applicable to all industries and entities. Contracts scoped out: Financial instruments Scope Insurance contracts Lease contracts Guarantees (excluding warranties) Certain nonmonetary exchanges Considered a separate contract and accounted for prospectively if the modification results in the addition of a separate performance obligation and price is reflective of stand-alone selling price of the additional obligation. Otherwise accounted for as an adjustment to the original contract either through a cumulative catch-up adjustment or prospective adjustment as future performance obligations are satisfied. Separate performance obligations exist if the goods or services are: Identifying separate performance obligations capable of being distinct because the customer can use the good or service on its own or together with resources readily available to the customer, and distinct in the context of the contract because the good or service is not highly dependent on, or highly interrelated with, other promised goods or services in the contract. An entity will combine a good or service with other goods or services in the contract if they are not individually separable until a separate performance obligation is identified. Includes fixed and variable consideration with variable consideration at a probability-weighted estimate or most likely amount of cash flows, whichever is most predictive. Time value of money will be included when significant and if it exceeds a period greater than one year. Bad debts will not be included; rather, they will be reflected in a line item adjacent to revenue (not as an expense). Allocation of transaction price to multiple performance obligations Based on relative selling price of all performance obligations. Residual technique can be used when the standalone selling price of a good or service is highly variable or uncertain. Variable consideration and discounts can be allocated to one (or more) performance obligations in some cases. Goods and licenses: when control passes. Timing of revenue recognition Services: as the obligation is being satisfied, if specified criteria are met. Otherwise, upon completion of the service. Constrained to amounts for which the entity has predictive experience. Customer options Only considered a separate performance obligation if the option provides the customer a material right (for example, a discount incremental to the range of discounts typically given to similar customers in similar markets).
Contract modifications
Elements of the transaction price
Component
Current proposal Recognize revenue allocated to the option when the option expires or when the additional goods or services are transferred. Accounted for as a separate performance obligation if the customer has the ability to purchase it separately. Considered a cost accrual if not sold separately unless a service is provided in addition to the standard warranty. Generally consistent with existing guidance. Derecognize the full value of inventory, record a liability for the refund obligation, and recognize an asset representing the right to recover goods. Revenue recognition will be precluded when an entity is unable to estimate returns.
Warranties
Rights of return
Onerous contract losses
Retains existing guidance in US GAAP and IFRS to assess whether a contract is onerous. Incremental costs of obtaining a contract will be capitalized if expected to be recovered. Entities can choose not to apply to short-term contracts (12 months or less). Assets will be amortized over the expected period of benefit, which may exceed the contract term. Costs to fulfill a contract will be capitalized based on other applicable guidance (for example, inventory) or if specified criteria are met. Breakage revenue will be recognized in proportion to the pattern of rights exercised by the customer if expected breakage is reasonably assured. If not reasonably assured, revenue will be deferred until it becomes remote the customer will exercise its rights under the contract. Evaluation is similar to existing guidance.
Capitalization of contract costs
Breakage (forfeitures)
Gross versus net presentation
Significant increase in disclosure requirements such as: Disaggregation of revenue into primary categories that depict the nature, amount, timing, and uncertainly of revenue and cash flows Tabular reconciliation of the movements in capitalized costs to obtain or fulfill a contract Disclosure Analysis of remaining performance obligations, including nature of goods and services, timing of satisfaction, and significant payment terms Information on onerous performance obligations and tabular reconciliation of movements in the corresponding liability Significant judgments and changes in judgments that affect the determination of amount and timing of revenue Many of the disclosure requirements will apply to interim periods, if material. Certain exceptions will be available for nonpublic entities. Transition Retrospective application to all periods, with certain relief accommodations.
Appendix, continued
Leases: summary of joint board decisions to date
Component Current proposal Includes contracts in which the right to use a specified asset (explicitly or implicitly identified) is conveyed, for a period of time, in exchange for consideration. Excludes: (1) leases to explore for, or use, minerals, oil, natural gas, and similar non-regenerative resources, and (2) leases of biological assets. Includes the fixed non-cancellable term plus any options to extend or terminate when a significant economic incentive exists (for example, bargain renewal options). Requires reassessment when there is a significant change in one of the indicators (excluding changes in market rates after lease commencement) relating to significant economic incentive. The following variable lease elements will be included in lease payments: Future lease payments based on a rate or index Disguised minimum lease payments Variable lease payments For lessees, residual value guarantees expected to be paid Lease payments based on a rate or index will initially be measured at the spot rate at lease commencement; reassessment will be required as rates or indices change. Contingent rents based on usage or performances will not be included, unless they are disguised minimum lease payments. Lessees will discount lease payments using the rate being charged by the lessor if known; otherwise, the lessees incremental borrowing rate is used. Lessors will discount lease payments using the rate they charge in the lease. Discount rate The discount rate will be reassessed only when there is a change in the lease payment due to: A change in the assessment of whether the lessee has a significant economic incentive to exercise an option to extend the lease or purchase the underlying asset. The exercise of an option that the lessee did not have a significant economic incentive to exercise. At commencement, all lessees will recognize a liability at the present value of the lease payments, and a right-of-use asset equal to the lease liability plus initial direct costs. The pattern of profit and loss recognition will depend on whether the interest and amortization (I&A) approach or the single lease expense (SLE) approach is applied. In determining which approach to use, the lessee evaluates whether they acquire or consume more than an insignificant portion of the underlying asset over the lease term. Lessors will apply either a financing approach (receivable and residual model) or an approach similar to operating lease accounting using the same consumption principle as lessees. Under the receivable and residual model, the lessor will derecognize the leased asset and record a lease receivable and a
Scope
Lease term
Lessee accounting
Lessor accounting
Component
Current proposal residual asset. Day-one profit will be recognized related to the lease receivable, but profit related to the residual asset will be deferred and only recognized after the initial lease ends. Similar to operating lease accounting, the leased asset will remain on the lessors balance sheet and income will be recognized on a straight-line basis over the lease term.
Short term leases
Lessees and lessors can elect to account for leases that have a maximum term of 12 months or less (including any renewal options) in a manner similar to todays accounting for operating leases. Lessees will follow existing guidance on impairment of fixed assets when evaluating the right-of-use asset. Under the IASB's proposal, lessors can apply the three-bucket model or a simplified approach in which lease receivables will have an impairment allowance measurement objective of lifetime expected credit losses at initial recognition and through the lease receivables life. Under the FASB's proposal, lessors will follow the current expected credit loss approach. Lessors follow existing guidance for fixed assets when evaluating the residual asset.
Impairment
Separating lease and non-lease components
Lease and non-lease components (e.g., service elements and executor costs such as real estate taxes, insurance, and utilities) in a multiple element contract will be identified and accounted for separately. Lessees will deduct incentives that meet the definition of initial direct costs from the right-of-use asset. Other upfront payments will be netted against total lease payments when calculating the lease liability. The accounting for amounts paid by lessors to lessees will depend on whether the payment meets the definition of an initial direct cost.
Lease incentives
Sale leaseback
When a sale has occurred, the transaction is accounted for as a sale and then a leaseback. Entities will apply the control criteria in the revenue recognition project, supplemented by additional clarification in the leases project, to determine if a sale occurred. A change in circumstances other than a modification to the terms that affect the assessment of whether a contract is, or contains, a lease will result in reassessment. When there is a contract modification that results in a different determination as to whether the contract is, or contains, a lease, the original contract will be considered terminated and the modified contract accounted for as a new contract. Subleases will be accounted for as two separate transactions. That is, a sublessor will apply lessee accounting on the head lease and lessor accounting on the sublease. Lessees will disclose a reconciliation of the opening and closing balance of lease liabilities for both I&A and SLE leases, a single maturity analysis of the undiscounted cash flows for all lease liabilities, and costs relating to variable lease payments not included in the liability. Lessors will disclose a table of all lease-related income items, a reconciliation of the opening and closing balance of the right to receive lease payments and residual assets, and a maturity
Contract modifications or change in circumstances after the date of inception of the lease Subleases
Disclosure
Component
Current proposal analysis of the undiscounted cash flows that are included in the right to receive lease payments. Note: This summary is not inclusive of all required disclosures. Transition requirements will be applied to all leases existing at the beginning of the earliest comparative period presented. Lessees For leases previously classified as capital/finance leases, a lessee will not be required to make adjustments to the carrying amount of lease assets and lease liabilities and will reclassify them as right of use assets and liabilities to make lease payments. For leases previously classified as operating leases, a lessee will recognize liabilities to make lease payments and right of use assets at transition. Lessees applying the I&A approach can elect a modified retrospective or full retrospective approach. Lessees applying the SLE approach can elect a simplified retrospective or full retrospective approach. Lessors For capital/sales type and direct finance leases a lessor will not be required to make adjustments to the carrying amount of the assets associated with those leases. For operating leases a lessor will recognize the right to receive lease payments and a residual asset, and derecognize the underlying asset. Lessors can apply the full retrospective or modified retrospective approach.
Transition
Appendix, continued
Insurance contracts: summary of joint board decisions to date
Component Current proposal Applies to all entities that issue insurance contracts (as defined), not just insurance entities. Scope Excludes certain contracts that otherwise meet the definition of insurance contracts (e.g., certain warranties and certain fixed fee service contracts). The model is current value (i.e., based on the present value of expected future cash inflows and outflows, updated each period). The IASB model includes an explicit risk adjustment while the FASB model does not. Acquisition costs Cash flows will be reduced by the direct costs associated with selling, underwriting, and initiating contracts, although the FASB will only include costs for successful efforts. This approach is permitted by the IASB when it is a proxy for the current value measurement model. It is required by the FASB when specified criteria are met. It is used for measuring the pre-claim liability for certain short duration contracts; current value measurement model will still apply to incurred claims. The same measurement model used for other contracts will be applied to reinsurance. Reinsurance Gains on ceded reinsurance will be deferred, and losses relating to reinsurance of past events will be recognized immediately. Certain components not closely related to the coverage provided by the contract will be unbundled (e.g., embedded derivatives and certain services) and accounted for under other guidance. Most deposit components will not be unbundled and accounted for under a different model, but will be excluded from premiums and claims in the income statement. Recognize at the start of coverage period unless onerous; derecognize when extinguished. Potentially requires certain line items to be included in the statement of comprehensive income, including premiums, claims, benefits, and underwriting margin. Presentation and disclosure Requires qualitative and quantitative information about amounts recognized in the financial statements and the nature and extent of risks, as well as balance rollforwards. Changes in the liability relating to discount rates will be recorded in other comprehensive income, rather than earnings. Transition Apply full retrospective method, with practical expedients to estimate margin and discount rates.
Measurement model
Simplified measurement model (premium allocation approach)
Unbundling
Recognition and derecognition
Edited by:
Jan Hauser Partner Phone: 1-973-236-7216 Email: jan.hauser@us.pwc.com Kevin Catalano Partner Phone: 1-973-236-5057 Email: kevin.catalano@us.pwc.com Gregory Johnson Director Phone: 1-973-236-7365 Email: gregory.johnson@us.pwc.com Andrew Barclay Senior Manager Phone: 1-973-236-4741 Email: andrew.x.barclay@us.pwc.com
Setting the standard is prepared by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.
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IFRS Foundation responds to SECs final report on IFRS Work Plan
What's new?
On October 23, 2012, the IFRS Foundation (the organization that oversees the IASB) published a response (the Foundation Staff response) to the SECs final report on its 1 IFRS Work Plan (the SEC Staff report) issued in July 2012. The IFRS Work Plan was intended to aid the SEC in evaluating the implications of incorporating IFRS into the US financial reporting system. The IFRS Foundation Trustees had committed to carefully considering the SEC Staffs observations. The Foundation Staff response is an assessment of the matters discussed in the SEC Staff report, including the operations of the IFRS Foundation and the IASB, the use of IFRS as global accounting standards, and issues related to incorporating IFRS into the US financial reporting system. Michel Prada, Chairman of the IFRS Foundation Trustees, summarized the major finding of the Foundation Staff response in comments accompanying its release: While acknowledging the challenges, the analysis conducted by the IFRS Foundation Staff shows that there are no insurmountable obstacles for adoption of IFRSs by the United States, and that the US is well placed to achieve a successful transition to IFRSs, thus completing the objective repeatedly confirmed by the G20 leaders. Refer to the SEC Staff report and the Foundation Staff response for more details.
No. 2012-47 October 29, 2012
What is in the response?

The SEC Staff report identifies potential improvements in areas such as the funding of the IASB, the comprehensiveness of IFRS and the IFRS interpretative process, the enforcement and coordination activities of regulators across territories, and the IASBs coordination with national standard setters. The Foundation Staff response addresses each of these areas and discusses responsive actions that, in many cases, are in progress. In some areas, the Foundation Staff response outlines different conclusions than those reached in the SEC Staff report. The Foundation Staff response also provides certain information that the Foundation Staff believes complements the SEC Staffs analysis.
Refer to Dataline 2012-06, SEC Staff releases its final report on its IFRS Work Plan.
In brief 1
In response to the challenges outlined in the SEC Staff report of a transition to IFRS, the Foundation Staff response discusses lessons learned from the transitions of other territories. Specifically, it notes that issues of sovereignty, endorsement, investor education, human-capital readiness, and transition costs have been successfully addressed by other territories. Other notable observations made by the Foundation Staff in this area include:
If an endorsement process is used to incorporate IFRS, a high threshold is needed for non-endorsement. A gradual incorporation approach through convergence might be an appropriate short-term strategy for transitioning to IFRS, but it cannot be a substitute for IFRS adoption. The viability of a gradual introduction of IFRS on a standard-by-standard basis is questionable. Optional use of IFRS for certain companies could provide the SEC with important data on the practical application of IFRS by US companies, but should only be used as a short-term strategy.
The Foundation Staff response also discusses the benefits of IFRS, including how the US might benefit from adoption, and notes that this was not a focus of the SEC Staff report. An academic analysis on the topic is included as an appendix.
What conclusions are reached?

The Foundation Staff response does not reach any formal conclusions and is not a due process document of the IFRS Foundation. The Foundation Staff response recognizes that the size of the US economy presents significant transitional challenges that are unique to the United States. However, it states that the experience of other territories suggests many of the challenges can be overcome with the appropriate political will to make a commitment to the mission of a single set of global standards. The Foundation Staff also believes that in many areas the United States is better prepared than other territories to consider the adoption of IFRS.
Who's affected?
The Foundation Staff response has no immediate direct impact. However, it provides additional information and perspectives for the SEC to consider in its evaluation of whether, when, and how IFRS might be incorporated into the US financial reporting system.
What's next?
There are no next steps publicly announced by either the IFRS Foundation or the SEC. The SEC Staff report indicates that additional analysis is necessary before any decision is made about incorporating IFRS. The timing of this additional activity is currently unknown, but we expect it to extend beyond 2012.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact David Schmid (1-973236-7247) or Erin Bennett (1-973-236-4623) in the National Professional Services Group.
In brief
Authored by:
David Schmid Partner Phone: 1-973-236-7247 Email: david.schmid@us.pwc.com Erin Bennett Senior Manager Phone: 1-973-236-4623 Email: erin.bennett@us.pwc.com
In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.
Dataline A look at current financial reporting issues

SEC Staff releases its final report on its IFRS Work Plan
Overview
Whats inside: Overview .......................... 1
At a glance ...............................1 The main details ..................... 2
No. 2012-06 August 8, 2012

(Revised September 17, 2012*)
At a glance On July 13, 2012, the SEC Staff published its final Staff Report (the "Staff Report") on the potential impact of incorporating IFRS into the US financial reporting system. The Staff Report summarized the Staff's findings in six key areas introduced in its February 2010 Work Plan, intended to aid the SEC in considering whether, when, and how to incorporate IFRS. The Staff Report did not include a recommendation on whether (or how) IFRS should be incorporated into the US financial reporting system. It also did not indicate when such a decision might be made, provide a timeline of next steps, or address whether US public companies should have the option to adopt IFRS on a voluntary basis. The Staff Report noted that a vast majority of participants in the US capital markets do not support outright adoption of IFRS by US issuers. Other forms of incorporation, such as an endorsement mechanism, are viewed more favorably. It also noted that:
The six key areas studied ...........................3

Sufficient development and application of IFRS for the US domestic reporting system .................. 3 The independence of standard-setting for the benefit of investors ......... 6 Investor understanding and education regarding IFRS ..................................... .8 Regulatory environment ..... .10 Impact on issuers................... 11 Human capital readiness ......14
Next steps ....................... 16 Questions ....................... 16
IFRS is generally perceived to be of high quality, but its interpretations should be timely, education is needed to improve investor understanding, and increased cooperation among regulators would improve application and enforcement. A mechanism to consider the needs of the US capital markets, such as the FASB endorsing IFRS, may be needed. The IASB should also consider expanding reliance on national standard setters for assistance with projects, outreach with local investors, and assistance with post-implementation reviews. The IFRS Foundation strikes a reasonable balance between overseeing the IASB and respecting its independence, but the IASB will need independent sources of sustainable funding.
* This Dataline has been revised to clarify and enhance its text. The substance of the Dataline is unchanged.
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The main details .1 The SEC Staff embarked on a Work Plan in February 2010 to consider specific factors relevant to an SEC decision of whether, when, and how IFRS may be incorporated into the US financial reporting system. The Work Plan called for a study of six key areas: (1) sufficient development and application of IFRS for the US domestic reporting system; (2) the independence of standard setting for the benefit of investors; (3) investor understanding and education regarding IFRS; (4) the effect on the regulatory environment; (5) the impact on issuers; and (6) human capital readiness. .2 In executing the Work Plan, the Staff provided two status updates and issued three separate papers. The first paper, issued in May 2011, explored a possible incorporation method (the "endorsement approach") whereby the FASB would remain the US standard setter. It would endorse new IFRS into the US financial reporting system if it found the guidance acceptable, and would consider how to conform US standards to existing IFRS. In November 2011, the Staff issued two papers, A Comparison of US GAAP and IFRS and 1 An Analysis of IFRS in Practice. .3 The Staff Report did not include a decision on whether, when, and how IFRS may be incorporated into the US financial reporting system. There was significant support from those contacted during the Staff's outreach for some method of incorporation, and for a set of high-quality, globally accepted financial reporting standards. PwC observation: The Staff Report was not intended to answer the threshold question of whether a transition to IFRS is in the best interests of US capital markets and US investors. Instead, its purpose was to consider information relevant to this threshold question. The Staff Report gives no indication of the timing or process for such a determination. We believe several factors may have contributed to the SEC's decision to continue studying the threshold question, including the current status of the IASB and FASB convergence projects, a focus by the SEC on other required rulemaking (e.g., Dodd-Frank), and the uncertainty resulting from the upcoming November presidential and Congressional elections, which could delay a decision on IFRS beyond 2012. .4 The Staff found a lack of support for an outright-adoption approach. US capital market participants were concerned that outright adoption would decrease the US influence on IFRS standard setting. They also believe that the burden of converting to IFRS was too high and that the extensive use of US GAAP terminology in regulations and contracts would make outright adoption challenging. .5 While it is not a surprise that the Staff Report did not include a decision about whether to transition to IFRS, there have been expressions of disappointment from the international standard-setting community. The chairman of the IFRS Foundation made the following comment in response to the release of the Staff Report: "While recognizing the right of the SEC to determine the method and timing for incorporation of IFRSs in the United States, we regret that the Staff paper was not accompanied by a recommended action plan for the SEC."
Refer to Dataline 2011-36, SEC Staff continue progress on IFRS work plan, for further information about these Staff papers.
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com Dataline 2
The six key areas studied

1. Sufficient development and application of IFRS for the US domestic reporting system .6 The Staff evaluated the comprehensiveness, comparability, auditability, and enforceability of IFRS. Comprehensiveness of IFRS .7 The Staff compared US GAAP as of June 30, 2010 to IFRS, as promulgated by the IASB, as of January 1, 2010. The review omitted an in-depth analysis of the standards that are the subject of ongoing joint standard-setting projects between the FASB and IASB, as well as the requirements of SEC interpretations and those of standard-setting and regulatory authorities in other jurisdictions. .8 The differences were categorized into four areas where the impact on the reported information could be significant: Those existing in standards subject to the Boards' joint projects Standards that have similar objectives, or are substantially converged (or both) Standards with fundamental differences Industry guidance .9 Joint Projects: The Staff Report acknowledged that the boards have made progress on a number of convergence projects, such as revenue recognition, leasing, and financial instruments. However, the extent of differences that remain between IFRS and US GAAP is greater than the Staff expected at the time it commenced the Work Plan in 2010. The Staff indicated that the continued ability of the boards to operate together effectively is often cited as an area of concern. PwC observation: The boards continue to make progress on many areas of joint focus. The consolidations and fair value standards have been issued. The proposed revenue standard has been re-exposed, with a final standard targeted for 2013. The proposed leasing standard will be re-exposed in the fourth quarter of 2012, with a final standard expected in late 2013 or early 2014. On the other hand, the boards continue to struggle to find common ground on all of the important aspects of the financial instruments project. Although they have moved closer in some areas (e.g., the threecategory, financial-asset measurement approach), they are not converged in others (e.g., impairment). The timelines for completion of some areas that originally had a joint focus, such as insurance contracts, remain uncertain. While, at times, the convergence process has been difficult and time-consuming, it has improved both IFRS and US GAAP. On balance, the process of bringing the two sets of standards closer together has been worthwhile. .10 Similar or Converged Standards: For standards that are similar or substantially converged, such as for business combinations, basic debt instruments, share-based compensation, and earnings per share, the Staff expects that the reported amounts and disclosures under IFRS would be similar under US GAAP. However, the differences that still exist, such as in scoping, detailed requirements, and illustrative and application guidance, could result in different amounts or disclosures.
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.11 Fundamental Differences: The Staff observed that fundamental differences between IFRS and US GAAP arise when: a) standard-setters are addressing different circumstances, objectives, or perspectives (e.g., how best to report the economics of a transaction); b) there are differing market or regulatory structures; or c) US standard setters establish anti-abuse provisions. The Staff suggested that resolving these differences may prove difficult. .12 Some examples of these differences identified in the Staff Report include: Impairments of property, plant, and equipment, intangible assets, and inventory US GAAP prohibits reversal of impairment losses; IFRS permits reversal in some circumstances. Inventory costing methods US GAAP permits use of the last-in, first-out ("LIFO") method; IFRS does not. Accounting for research and development costs US GAAP requires all research and development costs to be expensed; IFRS requires capitalization of certain development costs. .13 The Staff Report notes that a change from using LIFO inventory valuation under US GAAP may have a significant impact on net income and cash taxes for US issuers. US tax rules have conformity provisions that only permit the use of a method under tax rules if it is used for book-accounting purposes. Accordingly, absent a change in tax legislation, use of a LIFO inventory valuation approach would no longer be permitted for tax-reporting purposes if an issuer applied IFRS. .14 Industry Guidance: US GAAP contains industry-specific guidance, which does not exist in IFRS. The guidance, such as for rate-regulated and oil and gas entities, was specifically tailored to meet the financial reporting needs of entities in certain industries. It also responded to situations where application of more general guidance was unclear or deemed to result in less relevant information. The Staff believes that industry guidance should not be removed from US GAAP until the IASB has had time to perform outreach to investors, assess the effects of removing that guidance, and develop its own guidance, as appropriate, to fill any void in IFRS. Comparability within and across jurisdictions .15 The Staff analyzed the extent to which financial statements prepared under IFRS are comparable within and across jurisdictions. The Staff reviewed a sample of 183 fiscal 2009 annual consolidated financial statements of SEC registrants (foreign private issuers) and non-registrants that were prepared using IFRS. While the financial statements generally appeared to comply with IFRS, two themes emerged: The transparency and clarity of financial statements could be enhanced across all topical areas. For example, the Staff observed instances where preparers omitted accounting policy disclosures, provided insufficient detail in their accounting policy disclosures to support an understanding of the financial statements, and used terms that are inconsistent with terms used in IFRS. The Staff noted that some disclosures referred to local accounting and reporting guidance, the specific requirements of which were unclear. Thus, the disclosures were insufficient to determine whether the preparers had complied with IFRS. Diversity in the application of IFRS presents a challenge to comparability across industries and territories. The Staff observed that this diversity may be the result of options available to preparers under IFRS, a lack of application guidance, and possibly noncompliance. The local diversity in the application of IFRS was sometimes mitigated by local guidance that narrowed the range of acceptable
alternatives under IFRS. A tendency of preparers to use local country GAAP in the absence of IFRS guidance was also a mitigating factor. However, the application of local country GAAP diminishes comparability globally. .16 It is noteworthy that the Staff's November 2011 paper, An Analysis of IFRS in Practice, did not compare the application of IFRS to the application of US GAAP. Similar observations as those above may result from a comparison between financial statements prepared under US GAAP and IFRS. The Staff also indicated that improvements to the IFRS Interpretations Committee's ("IFRS IC") processes for issuing application guidance could enhance financial statement comparability. PwC observation: We believe that an expectation gap exists in the US regarding the amount of IFRS interpretation and application guidance that users expect versus the relatively low volume of guidance that has been provided. This is in contrast to the amount of guidance provided by the FASB. As major new standards are expected to be released beginning in 2013, we expect to see the demand for interpretations increasing further.
Auditability and enforceability .17 Principles versus Rules: IFRS is generally thought to allow for greater flexibility in accounting because it is perceived to be more principles-based and thus less prescriptive than US GAAP. The Staff, however, noted that both US GAAP and IFRS reflect a combination of rules-based and principles-based standards. The Staff referred to FASB Statement No. 167, Consolidation of Variable Interest Entities, as an example of a less prescriptive US GAAP standard, when compared with its predecessor, that requires the application of significant judgment. The Staff observed preparers, auditors, and regulators appear to have been able to apply and enforce its guidance. .18 Audit Firm Structure: The Staff Report recognized that the major accounting firm networks have established infrastructures that can provide IFRS support to preparers. However, the Staff noted that a more top-down IFRS interpretation function at these networks, rather than the current decentralized, voluntary, consensus-building processes of individual member firms in the network, would help to foster comparability in the application of IFRS. The major US accounting firms advised the Staff that they believe the IFRS infrastructures in place are suitable to support an environment in which IFRS is incorporated into the US financial reporting framework. .19 The Staff also performed outreach to a number of smaller accounting firms. It found that many of them had limited exposure to IFRS and limited resources trained to apply IFRS. .20 Enforcement and Compliance: Staff research indicated a less active financial statement review program in the European Union versus in the US. The Staff believes that an active review program can have a greater impact in promoting consistent application than the standard itself. .21 The Staff also reviewed a number of prior enforcement actions involving accounting violations and financial fraud to assess its ability to have brought those actions if IFRS had been used. The Staff believes that a significant majority of the accounting actions still would have been brought. .22 Additionally, the Staff Report noted the efforts of three regulatory bodies to improve the consistency of enforcement of IFRS the International Organization of Securities
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Commissions, the European Securities and Markets authority, and the Asia-Oceanian Standard-Setters Group. PwC observation: The adoption of international standards in all major capital markets will not, by itself, achieve the vision of a single set of consistently applied, high-quality, accounting standards. We believe that, in addition to completion of the convergence projects, greater cooperation is needed from national regulators to promote consistency. In its recent strategy review, the Trustees of the IFRS Foundation acknowledged that the IASB needs to establish formalized cooperation agreements among securities regulators, audit regulators, and national standard setters to receive feedback on how IFRS is being implemented.
2. The independence of standard-setting for the benefit of investors .23 The Staff evaluated the governance structure, composition, and funding of the IFRS Foundation, a non-profit entity charged with oversight of the IASB. It also considered the independence of the IASB from the IFRS Foundation in the standard-setting process. Oversight of the IFRS Foundation, including structure and effectiveness reviews .24 The Staff Report summarized the IASB's three-tier governance structure, whereby the IASB is overseen by the IFRS Foundation. The IFRS Foundation, in turn, is subject to public oversight by the Monitoring Board, which consists of capital market authorities responsible for the form and content of financial reporting in capital markets in their jurisdictions. .25 The Staff Report acknowledged that the recent strategic review conducted by the Trustees of the IFRS Foundation, and the recent governance review conducted by the Monitoring Board, found this structure to be appropriate. The overall design of the governance structure of the IFRS Foundation strikes a reasonable balance of providing oversight of the IASB while recognizing and supporting its independence. However, it may be necessary to put in place mechanisms to consider and protect the US capital markets, for example, by maintaining an active role for the FASB in standard setting. .26 The Staff Report noted the Trustees' recommendation that the roles and responsibilities of each element of the IASB's governance be more clearly defined. The Staff Report also discussed the composition of the Monitoring Board and its role in nominating and appointing Trustees of the IFRS Foundation. PwC observation: The Monitoring Board, which includes the SEC, provides a link between capital market regulators and the IFRS Foundation. Improvements to the Monitoring Board are in process as a result of its recent governance review. They include expanding the size of the Monitoring Board, refining its membership criteria, and increasing the transparency of its activities. The criteria refinements limit membership to countries that allow local use of IFRS ("domestic use" criterion). It is unclear whether this would affect the continued participation of the SEC on the Monitoring Board. For example, is the SEC's prior decision to permit foreign private issuers to file financial statements in accordance with IFRS sufficient to meet this criterion?
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Composition of the IFRS Foundation and the IASB .27 The Staff Report summarized the structure, composition, and selection process for IFRS Foundation Trustees and IASB members, and the involvement of the Trustees in the standard-setting process. The Staff noted that up to three members of the IASB may be part-time members and retain their association with an employer. While this does not appear to have resulted in an issue, it creates a possibility that those individuals will not be viewed as objective. .28 The Staff Report summarized the IASB's post-implementation review process, which consists of a review by the IASB of new IFRS and major amendments to existing IFRS. The Staff Report noted that the IFRS Trustees should consider altering the reporting structure for post-implementation reviews by having IASB staff who conduct the reviews report to the IFRS Foundation Trustees rather than to the IASB. This would be similar to the way the FASB staff who review US standards report directly to the Financial Accounting Foundation ("FAF") Board of Trustees and President/CEO. The Staff believes the public is likely to regard the reviews as more credible if the IASB is not reviewing its own work. Funding of the IFRS Foundation .29 The Staff Report evaluated the IFRS Foundation's desired funding principles, as well as its current sources of funding. The focus was on whether the funding sources and methods are consistent with maintaining the IASB's independence, and whether present sources of funding are sustainable. .30 The Staff identified the following primary concerns: Approximately 25 percent of 2012 funding is expected to come from large accounting firms. Continued reliance on this funding source causes concern about the adequacy and independence of the funding model. While the United States is one of the largest contributors to the IASB, recently the IFRS Foundation Trustees have not been successful in meeting their funding objectives for the United States. A source of continued funding of the US portion of the Foundation's operating budget has yet to be identified. The criteria for membership on the IFRS Foundation Monitoring Board include a requirement for financial contributions by the member's jurisdiction. Neither the SEC nor its Staff can act as a fundraiser and there is a question whether the SEC could contribute its own funds. Thus, the SEC's membership on the Monitoring Board depends on others in the United States funding the Foundation. It appears that less than 25% of countries that have incorporated IFRS in some form contribute to the IFRS Foundation. IASB standard-setting process .31 The Process: The Staff Report reviewed the IASB's standard-setting process and noted that the Staff attends meetings of the IFRS Advisory Council, the IFRS IC, and, occasionally, meetings of project-specific advisory groups, as an observer. The Staff also noted that it reviews IASB standard-setting documents in much the same way it conducts its reviews of FASB standard-setting documents. .32 Focus on Investors: The Staff Report considered the IFRS Foundation and IASB objective to provide standards that communicate a faithful presentation of an entity's financial position and performance. The Staff elaborated on the IASB's efforts to involve investors in the standard-setting process, and concluded that the IASB has made good
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faith efforts to understand and meet investor requests for improvements to financial statements. .33 Timeliness: The Staff acknowledged that the Trustees of the IFRS Foundation have recommended changes to the IFRS IC that have not yet been implemented. Based on its monitoring and outreach activities, the Staff believes enhancements are needed to address emerging issues on a timely basis. .34 Objectivity: The Staff observed that the IASB's standard-setting process is heavily based on consultations, gathering facts, assessing views, and explaining its decisions to the public. The Staff noted that issues are resolved based on their technical merits and a focus on usefulness to investors and is not aware of instances where IASB members failed to exercise independent judgment in setting IFRS. .35 Continuing Role for the FASB: The Staff noted that establishing the FASB as an endorser of IFRS for the US financial reporting system could help to address some of its concerns related to the timeliness of standard setting and the need to maintain focus on the needs of US investors. This might include the FASB assisting the IASB with individual projects for which it has expertise, performing investor outreach, identifying areas in which there is a need to narrow diversity in practice or issue interpretive guidance, and assisting with post-implementation reviews of standards. 3. Investor understanding and education regarding IFRS .36 The Staff considered the impact on investors of incorporating IFRS into the US financial reporting system. This involved assessing how investor understanding of IFRS could be promoted, as well as the robustness of existing mechanisms for educating investors about changes in accounting standards. .37 Investors generally expressed support for a transition to a single set of high-quality, globally accepted accounting standards. But this support is conditional on the quality of IFRS and the approach and timeliness of the IFRS IC in interpreting IFRS. .38 Some investors noted concerns over the quality of IFRS, the perceived lack of independence of the IASB, including regarding its funding and the potential for political interference in its processes, and the lack of investor participation on the IASB and the IFRS Foundation. Investors also stated that the IFRS IC should be more active in interpreting IFRS standards to narrow diversity in practice. PwC observation: The Staff Report indicated that the endorsement approach of incorporating IFRS into the US financial reporting system, together with an active role by the FASB in the standard-setting process, could mitigate many of these concerns.
Current awareness and knowledge .39 The Staff Report noted that US investors' current awareness and knowledge of IFRS varies. Institutional investors are generally aware of the ongoing consideration of IFRS in the US. Many of these investors already use financial information prepared in accordance with IFRS from foreign private issuers registered with the SEC. .40 Some investors are primarily or exclusively focused on domestic companies that report under US GAAP. The Staff observed that these investors are reluctant to commit extensive resources to develop a better understanding of IFRS until the joint projects are completed, and it becomes clear whether and, if so, how the US might incorporate IFRS into the US financial reporting system.
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Investor education regarding accounting standards .41 The Staff learned that many investors obtain information about new accounting standards primarily through a company's disclosures about pending or new standards and the effect of such standards on its financial statements. .42 Secondary sources of investor education about new accounting standards are continuing education programs, publications, and speeches. In some cases, investors obtain their education by following the standard-setting projects directly. Any SEC decision to incorporate IFRS into the US financial reporting system would have to consider the amount of time needed by investors to assimilate new standards. Investor preparedness for incorporation of IFRS .43 The Staff Report noted that many US investors have not yet committed extensive resources to develop IFRS knowledge. Therefore, they may not be prepared for a nearterm transition to IFRS. .44 Many investors, however, indicated that preparedness issues would not be a significant impediment to incorporating IFRS. Since US GAAP is not static, the investors are accustomed to changes in accounting standards. .45 The Staff Report indicated that certain individual investors that focus primarily on domestic companies may not have the same resources as large institutional investors, and may not be as prepared for a change. The initial investment in time by this group to obtain IFRS knowledge would likely be disproportionate to that of the large institutional investors. Accordingly, the individual and smaller investor groups preferred a gradual transition approach to incorporation. .46 Investors believe sufficient time should be provided for any transition and that disclosures during transition will be critical to understand the impact of the change. Investor views on the length of time needed for a transition ranged from a few quarters to several years. The Staff noted that the time period for transition could be significantly reduced if, before any incorporation of IFRS occurs, the joint projects are completed and remaining significant differences between US GAAP and IFRS are narrowed. .47 Investors generally favored a retrospective transition to IFRS, as this would provide more comparable financial information in the periods presented during the transition period. Additionally, some investors believe that companies should not be allowed the option of voluntary early adoption because it would affect comparability between US companies. They also believe this would undermine the objective of convergence and potentially cause companies to selectively choose accounting methods that produce the most favorable outcome. .48 Investors communicated that further action by the boards to harmonize US GAAP and IFRS by eliminating differences would improve investor preparedness. If the boards' joint projects do not result in converged standards, investors are concerned that double the effort and cost would be required to first understand the new US GAAP, and later on, the IFRS standard. Other investor views .49 Most investors commenting to the Staff believe that the FASB should have a significant and active role in the standard-setting process, acting in the interests of US constituents and ensuring a US voice in standard setting. In this role, the FASB could endorse the standards that the IASB promulgates, while retaining its authority to issue new standards and interpretations when necessary to protect US investors. Thus, investors believe the FASB could ensure that standards incorporated into the US financial reporting system are of sufficient quality.
4. Regulatory environment .50 The Staff considered the impact that incorporation of IFRS into the US reporting system would have on the US regulatory environment. .51 In addition to the SEC, various federal, state, and local regulators, such as tax authorities and industry regulators, utilize US GAAP financial information. US GAAP terminology is thus entrenched in laws and regulations, and in a significant number of private contracts. The effort that would be required to change the references from US GAAP to IFRS would be significant. Manner in which the SEC fulfills its role .52 The Staff believes that it is important for the US to continue to have an active role in the development of global accounting standards, and be proactive in identifying and addressing new and emerging financial reporting issues. This was seen as important to help the SEC protect investors, maintain orderly and efficient capital markets, and facilitate capital formation. The Staff believes that the FASB is best equipped and already positioned to fulfill this role. .53 If IFRS is incorporated into the US financial reporting system, the Staff envisions that the FASB would continue to promulgate US GAAP. In the May 2011 Staff paper, it was envisioned that the FASB would be able to endorse the "vast majority" of new IFRS based on its participation in the IASB's standard-setting process, but would retain the authority to modify or add to the requirements of IFRS incorporated into US GAAP. If incorporation occurs through an endorsement process, such that the FASB would have a direct role in issuing standards, the question is how much discretion the FASB should exercise in the endorsement process. PwC observation: An approach of incorporating international standards based on assessing the quality of new and existing international standards would be a fair starting point in achieving the goal of high-quality, globally accepted accounting standards. It would establish a continuing role for the FASB, and maintain the SEC's oversight of accounting standards used by companies that participate in the US capital markets. .54 The number of references to US GAAP in various federal, state, local, and industry rules and regulations is substantial. If a decision is made to incorporate IFRS directly, rather than through an endorsement approach, a comprehensive effort would have to be undertaken to modify each reference to be compatible with IFRS. Regulators indicated that incorporating the content of IFRS into US GAAP, so that US GAAP is effectively the same as IFRS, may address or mitigate this. .55 The SEC has historically recognized standards set by the FASB, and has from time to time published accounting and financial reporting guidance to narrow practice and provide practical implementation guidance. If the SEC were to incorporate IFRS into the US financial reporting system, its ability to perform any of the aforementioned actions, in addition to enforcing against non-compliance, would not change. Industry regulators .56 Various industry regulators, such as those of financial institutions, insurance companies, and public utilities, are responsible for a variety of regulatory functions, including establishing utility rates and approving financial institutions' transactions. These regulators rely heavily on US GAAP financial information. The Staff speculated that this is done in the interests of expedience and because statutes and regulations require the use of US GAAP. Further, some regulators have their own accounting
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requirements that rely on US GAAP-based inputs. Changing US GAAP would thus significantly impact the regulatory regime. .57 An SEC decision to incorporate IFRS directly would only affect public companies. Regulators, however, have the same reporting requirements for public and private companies. Accordingly, the regulators would have to determine whether they would require regulatory reporting to continue under US GAAP, change to IFRS for all companies, or accept both standards. If a regulator chose to accept IFRS, it would need to assess the differences that use of IFRS may generate, and modify the system of regulatory reporting where necessary. .58 The Staff noted that a decision to incorporate IFRS by endorsement would most likely alleviate a number of these concerns. It would enable regulators to monitor the decisions by the FASB to determine whether a new IFRS standard to be endorsed requires a change to their regulatory systems. Regulators indicated that they have mechanisms in place to address accounting changes, although the sophistication and effectiveness of such procedures varies. Federal and state tax impacts .59 The Staff Report addressed potential effects of incorporation of IFRS on federal tax regulations in the following broad categories: Ability to use the LIFO inventory method for tax purposes Changes in US tax accounting methods where a change in accounting policies is considered a change in accounting method Changes in the computation of US earnings and profits Impact on an organization's existing transfer pricing policies .60 The calculation of state taxes could also be affected by a change to IFRS. Two potential areas cited in the Staff Report are the apportionment of income among jurisdictions, and the extent to which taxes based on an entity's equity or net worth will change when those balances are affected by a change to IFRS. Audit regulation and standard setting .61 The Staff evaluated whether accounting firms have limitations on their ability to perform audits and issue audit opinions on foreign private issuers. Accounting firms indicated that they are able to perform audits and issue opinions on these entities currently, and that a transition to IFRS would not affect their ability to issue audit opinions in the future. .62 In considering how a change to IFRS might affect the PCAOB's auditing standards, the PCAOB staff did not think there was a need to change PCAOB auditing standards to accommodate a particular incorporation method. With limited exceptions, PCAOB standards have been written in a neutral manner to accommodate any accounting standards, and a choice of any particular incorporation method would not have a significant impact. 5. Impact on issuers .63 This section of the Staff Report explored how incorporation of IFRS into the US financial reporting system would impact the 10,000 or so US issuers that file reports with the SEC. The Staff included examination of the following areas:
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Accounting systems, controls, and procedures Contractual arrangements Corporate governance Accounting for litigation contingencies Smaller issuers versus larger issuers .64 Issuers generally supported the objective of a single set of high-quality, globally accepted accounting standards. The Staff found that support for a single set of global standards varies based on the size of the issuer. Larger issuers tended to be more supportive than smaller issuers. Additionally, the method of IFRS incorporation in the US affected issuers' views. In light of the convergence projects, many issuers expressed concerns about the amount of significant change to the financial reporting system in a relatively short time frame. PwC observation: Many issuers expressed a need for the SEC to provide as much clarity as possible as to the ultimate approach for the further incorporation of IFRS, in order to conduct effective impact assessments and to plan the transition appropriately. This clarity currently does not exist, even after the issuance of the Staff Report.
Accounting systems, controls and procedures .65 When analyzing the impact of IFRS incorporation into the US financial reporting system, the Staff sought to determine the extent of, logistics for, and time necessary to undertake changes to issuer accounting systems, controls, and procedures to facilitate such an incorporation. .66 The Staff Report explained the significant expected investment in changing systems, controls, and procedures. The Staff noted that the significant changes required to adopt new standards resulting from the joint projects would mitigate, to an extent, the incremental efforts of moving to IFRS. .67 The Staff acknowledged that many issuers will not start any plan of IFRS incorporation until the uncertainty of how and when incorporation will happen is resolved. Further, the Staff Report discussed the various methods of transition and their effect on systems, controls, and procedures. Some issuers expressed a preference for a single transition approach (referred to as the "big bang" approach) to incorporation, because they believe it would minimize costs by transitioning at one point in time. However, most expressed a preference for a more gradual transition. Contractual arrangements .68 The Staff observed that the majority of the contracts of US issuers are based on US GAAP. The Staff assessed the types and pervasiveness of contractual arrangements that would be affected by IFRS incorporation, and how these contracts would be affected. The Staff also attempted to determine the cost and estimated time required to address concerns regarding affected contractual arrangements. .69 Two principal types of contract terms would be affected by outright IFRS adoption: (1) terms requiring delivery of US GAAP financial statements and (2) terms requiring that a company achieve or maintain certain financial targets or ratios that are calculated
Dataline 12
based on US GAAP. The Staff believes that both the scope and volume of affected contracts would be significant. .70 Companies will need to review all of their contracts to identify explicit or implicit references to US GAAP, and to determine how to address provisions that would be affected by incorporation of IFRS. Contracts may need to be renegotiated, which could be complex and time consuming. An appropriate transition period would be necessary to provide issuers enough time to review their contracts and make the appropriate changes. Corporate governance .71 The Staff noted that compliance with corporate governance requirements may be affected by the incorporation of IFRS. For example, existing SEC and stock exchange listing rules require audit committees to include an individual qualified as a financial expert and an individual qualified as financially literate. It is unclear whether such an individual could retain that status after incorporation of IFRS. .72 Some commenters thought that incorporation of IFRS would not call into question the status of audit committee financial experts or individuals qualified as financially literate. Others requested that the SEC or the exchanges (or both) provide a sufficient transition period to address this potential issue. A minority of commenters thought that the Work Plan should address additional issues, such as the accounting knowledge of CEOs and CFOs that is required in order to make the financial statement certifications required under the Sarbanes-Oxley Act. Accounting for litigation contingencies .73 The Staff analyzed the interaction of the accounting and disclosure requirements for litigation contingencies under IFRS with the legal environment in the US, given that IFRS differs from US GAAP in this area. The Staff discussed this with issuers, the legal profession, and investors in order to identify possible approaches to address their concerns. .74 Differences between ASC 450, Contingencies, and IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, include the definition of probable. Under IFRS, probable is defined as more likely than not to occur, which is generally accepted to mean a probability greater than 50 percent (e.g., 51%). Under US GAAP, probable is defined as the future event or events are likely to occur, which generally is interpreted as a percentage much greater than 50 percent. .75 Concerns were expressed about the lower threshold and the different disclosures required by IFRS. The Staff Report noted the controversial nature of recent FASB proposals, which were rejected, to change its loss contingencies disclosure requirements. The IFRS provisions are similar to what the FASB had proposed and thus could be met with similar objections. .76 Other issues include the potential need to revise applicable auditing standards, such as the standard that address inquiry of a client's lawyer. There also may be a need to revise the agreement between the accounting and legal professions regarding lawyers' responses to requests for information from auditors. .77 The Staff observed some inconsistencies in the accounting for litigation contingencies under IFRS. It was unclear whether this was due to preparers relying on an accommodation in IFRS that permits certain disclosures to be omitted if they would seriously prejudice the company's legal position.
Dataline 13
PwC observation: Recently, the FASB decided to discontinue its loss contingencies project. Constituents' unsupportive feedback, amongst other reasons, led to this decision. This leaves in place a significant difference between the disclosure requirements of US GAAP and IFRS. The FASB indicated that it will consider addressing loss contingencies as part of its disclosure framework project.
Smaller issuers versus larger issuers .78 The Staff Report noted that smaller issuers might bear costs to incorporate IFRS differently than large or global companies. The Staff analyzed how the impact of IFRS incorporation would vary based on an issuer's size and determined possible approaches to mitigate concerns regarding any disproportionate effects of IFRS incorporation on smaller issuers. .79 The Staff performed outreach to smaller issuers through comment requests and a roundtable focused on smaller issuers. The Staff Report acknowledged that all issuers would generally have to perform similar activities to transition to IFRS, and that smaller issuers have more limited resources. The feedback included mixed views about the method of incorporation suitable for smaller issuers. Some supported phased adoptions. Others supported a permanent option to use either US GAAP or IFRS. Finally, some expressed significant concerns that the costs of both transitioning to, and subsequently applying, IFRS would outweigh the benefits of using it. 6. Human capital readiness .80 IFRS incorporation would require sufficient readiness of human capital to execute the change. In this section of the Staff Report, the Staff evaluated education and training, auditor capacity, and how the method of incorporation would affect the level of investment required for preparing human capital. .81 The Staff Report noted that human capital preparedness varies according to the type of company and the method of transition. In addition, the extent to which IFRS and US GAAP are aligned as a result of the joint projects will have a significant impact on the level of preparedness. .82 The Staff Report reviewed two alternatives for acquiring the necessary human capital through the training of existing people or through the recruiting of new employees or hiring of outside consultants who have the appropriate expertise. Both of these alternatives are likely to be costly. .83 While the Staff Report did not reach any conclusion regarding human capital readiness, it noted that by extending incorporation of IFRS over a sufficient period of time, the degree of change should not be significantly different from what individuals experience following the existing pace of FASB standard setting. PwC observation: The FASB and the IASB are actively working together on several priority joint projects. These convergence projects will introduce a significant change to US GAAP, regardless of the decision of the SEC concerning incorporation of IFRS. Addressing these changes requires preparers to employ an organized, methodical approach. Adopting the new standards would improve human capital readiness for IFRS incorporation.
Dataline 14
Education and training .84 The Staff evaluated the current level of IFRS expertise and the extent of IFRS training needed. The Staff also considered implementation plans for the future training of constituents. Targeted outreach was conducted among issuers, auditors, and regulators to understand the current level of their training efforts, and to consider whether existing processes of identifying and incorporating changes in accounting standards could be employed. .85 The Staff found that IFRS readiness varied greatly among constituents. Those that have an extensive understanding of IFRS are generally associated with the US practices of large accounting firms or large multinational companies with non-US entities that report in accordance with IFRS. Most constituents, including many smaller accounting firms and regulators, indicated having limited internal IFRS training or experience. Generally, those constituents will not invest more resources in IFRS training until there is greater certainty about the timing and method of IFRS incorporation. .86 The Staff's outreach activities confirmed that for the majority of preparers consulted, their current human capital readiness would not be sufficient to accommodate a "big bang" adoption of IFRS. However, other more gradual transition methods would likely reduce the extent to which existing processes would need to be supplemented by outside resources. Generally, those included in the outreach believed that current processes would be sufficient for an endorsement approach. Auditor capacity .87 The Staff analyzed auditor capacity constraints with respect to IFRS by assessing the population of auditors that would be impacted. It evaluated the implication of alternative transition methods by making inquires of accounting firms, issuers and others. .88 The Staff observed that accounting firms' preparedness for IFRS incorporation varies depending on whether IFRS was incorporated into the firm's auditing infrastructure. The largest international accounting firms have already implemented a sufficient quality control infrastructure to accommodate any form of IFRS incorporation. Smaller and mid-size accounting firms have less extensive, if any, IFRS infrastructures in place and may not currently have the capability to support issuers reporting under IFRS or to perform audits of IFRS financial statements. .89 The impact on auditors' capacity and the cost of qualified auditors will likely be influenced by the method and timing of transition. For example, a shorter transition period to adopt IFRS may lead to a shortage of both qualified IFRS auditors and IFRS consultants. A longer, phased-in transition could provide auditors greater opportunity to make the necessary adjustments needed to be ready to provide audit services to IFRS issuers. .90 Some constituents expressed concerns that IFRS incorporation would lead to a further concentration of public company audits among the largest accounting firms, and would restrict competition. A more gradual transition approach under which US GAAP is conformed to IFRS would give auditors the opportunity to keep abreast of changes in US GAAP related to incorporation of IFRS. The Staff observed that a less gradual approach may lead some firms to exit the audit market rather than make the investments needed to audit companies applying IFRS. On the other hand, the Staff noted that IFRS incorporation may introduce new business opportunities for some of the accounting firms.
Dataline 15
Next steps
.91 The Staff is not requesting comments on the Staff Report, but welcomes any feedback.
Questions
.92 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the Global Accounting Services Group in the National Professional Services Group (1-973-236-4377).
Dataline 16
Authored by:
David Schmid Partner Phone: 1-973-236-7247 Email: david.schmid@us.pwc.com David Humphreys Partner Phone: 1-973-236-4023 Email: david.humphreys@us.pwc.com Dieter Wulff Senior Manager Phone: 1-973-236-4856 Email: dieter.x.wulff@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com
Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

SEC Staff releases final report on its IFRS Work Plan
What's new?
On July 13, 2012, the Staff of the SEC's Office of the Chief Accountant published its final report (the "Staff report") on its Work Plan intended to aid the SEC in evaluating the implications of incorporating IFRS into the US financial reporting system. In early 2010, the SEC published a statement of continued support for a single set of high-quality, global accounting standards, and acknowledged that IFRS is best positioned to serve that role. The SEC initiated the Work Plan at that time to obtain information relevant to the determination of whether, when, and how IFRS might be incorporated into the US financial reporting system. Refer to the Staff report for more details.
No. 2012-25 July 16, 2012
What is in the Staff report?

First, what's not in the Staff report is worth noting. The Staff report does not include a final policy decision as to whether IFRS should be incorporated into the US financial reporting system, or how such incorporation should occur. The Work Plan was not intended to provide an answer to the threshold question of whether a transition to IFRS is in the best interests of US capital markets and US investors. Instead, it is an important step in the SEC's decision-making process. In the Staff report, the Staff indicates that IFRS is generally perceived to be of high quality. However, there are areas where gaps remain (for example, accounting for rateregulated industries and insurance) and inconsistencies exist in the application of IFRS globally. These findings were set forth in two separate Staff papers issued last year, A 1 Comparison of US GAAP and IFRS and An Analysis of IFRS in Practice. The Staff also believes that improvements can be made to the IFRS interpretative process, and the enforcement and coordination activities of regulators across territories. Finally, although it acknowledges progress has been made, the Staff believes enhancements should be made to the IASB's coordination with individual country accounting standard setters and the IASB's funding process.
Refer to Dataline 2011-36, SEC Staff continue progress on IFRS work plan, for further information about these Staff papers.
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1
The Staff report does not address whether US public companies should have the option to adopt IFRS on a voluntary basis. However, the Staff report does state that investors are generally in agreement that companies should not be permitted to adopt IFRS early, because it would compromise comparability with US companies applying US GAAP.
What conclusions are reached?

As noted above, the Staff report does not reach any conclusions about incorporating IFRS. The Staff report does state, however, that adopting IFRS as authoritative guidance in the United States is not supported by the vast majority of participants in the US capital markets and would not be consistent with the methods of incorporation followed by other major capital markets (for example, the endorsement process followed by the European Commission). On the other hand, the Staff found there to be substantial support for exploring other methods of incorporating IFRS that demonstrate the US commitment to the objective of a single set of high-quality, global accounting standards. Last year, the Staff issued a paper on one possible method, involving an active FASB incorporating IFRS into US 2 GAAP over an extended period of time.
Who's affected?
US public companies will be affected by any decision ultimately made about whether, when, and how IFRS might be incorporated into the US financial reporting system.
What's next?
The Staff report indicates that additional analysis is necessary before any SEC decision is made about incorporating IFRS into the US financial reporting system. The timing of this additional activity is currently unknown, but could extend beyond 2012. The Staff has not requested comments, but welcomes feedback on the Staff report. A PwC webcast has been scheduled for Thursday, July 19, 2012, that will provide insights and observations on the Staff report. Also coming soon is a PwC Dataline that will summarize the Staff report and our observations.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact David Schmid (1-973236-7247) or Dieter Wulff (1-973-236-4856) in the National Professional Services Group.
Refer to In brief 2011-23, SEC Staff Paper explores one possible method to incorporate IFRS in the U.S.
In brief 2
Authored by:
David Schmid Partner Phone: 1-973-236-7247 Email: david.schmid@us.pwc.com Dieter Wulff Senior Manager Phone: 1-973-236-4856 Email: dieter.x.wulff@us.pwc.com
view
October 2011
point of
The path forward for international standards in the United States

Considering possible alternatives
Highlights
The SEC has stated it plans to make
a determination on the future use of international standards by US public companies in 2011. rejection of a move to international standards in the US seems increasingly unlikely. A compromise solution will likely be necessary. convergence agenda, enhanced cooperation among key capital market securities regulators and a refocused international interpretations body will provide a more solid foundation for a single set of high-quality global accounting standards.
The international standards' debate continues.

The Securities and Exchange Commission has stated it plans to determine this year whether, when, and possibly how international standards should be incorporated into the US financial reporting system. Those involved in the US financial reporting system seem divided on the best path forward. Our sense is that some of the support is waning for full near-term mandatory adoption of international standards in the US. A May 2011 SEC staff paper describes a slower approach of incorporating international standards into the US financial reporting system, with an objective of US standards being compliant with international standards in perhaps five to seven years. We believe in the vision of a single set of high-quality global accounting standards. Achieving that vision will require more consistent application of international standards across jurisdictions that adopt them. The potential SEC staff approach is a fair starting point and one that can be built upon to make progress towards this ultimate objective.
Full acceptance or complete
Completion of the current
Background
Many possible paths to a common objective
High quality accounting standards The vision is powerful. Few dispute its attainment will have value for investors. A single set of high-quality, transparent, and robust accounting standards, consistently applied by companies in capital markets around the world will enhance the efficient allocation of capital. Worthy companies will find it easier to access low-cost capital to grow. Investor returns will improve. These outcomes are what many envision from a move to a single set of high-quality global standards. For more than ten years, the world's two most significant standard setters, the FASB and IASB - collectively the boards - have brought US and international standards substantially closer together. Throughout the process, the boards have dealt with many thorny, long-standing issues. In some areas of the literature they agreed to remove differences, in other areas they did not. While at times the process has been difficult and time-consuming, it has improved both sets of standards. On balance, most would agree that the process of bringing the two sets of standards closer together has been worthwhile. Approximately 60 countries plus those in the European Union have adopted international standards, in some form, for publicly listed companies. However, adoption of international standards in all major capital markets will not, in and of itself, achieve the vision. This is because the protection of investors and the efficient allocation of capital globally can only be achieved when the common set of highquality global accounting standards is also applied with reasonable consistency. A number of major capital markets have not fully adopted international standards as issued by the IASB. And some believe that the consistency of application of international standards, among those countries that have adopted them, should be improved.
Multiple paths; valid perspectives The alternatives for integrating international standards into the US reporting system are numerous. They range from doing nothing - leaving US accounting unchanged, to abandoning US accounting and adopting international standards all at once, to many possibilities in between. Each has advantages and disadvantages and supporters with strongly-held views. Those advocating leaving US accounting alone assert that it is well established, meets the needs of financial statement users, and has allowed US companies to have the lowest cost of capital. Those advocating changing to international standards cite the benefits of increased global comparability for investors, lower preparation costs (ultimately), and easier cross-border access to capital. Others acknowledge the long-term benefits of international standards, but say that a more gradual implementation process is needed. They believe such an approach could address the lack of a political mandate for change in the US, spread the costs over a longer period, and pragmatically address the multitude of issues that will be encountered. Possible SEC staff approach The SEC staff has been exploring a way to gradually incorporate international standards into the US financial reporting system. Under this scenario, US accounting would continue to exist. The FASB would endorse for use in the US acceptable new international standards resulting from joint or IASB-only projects. The FASB would also evaluate other existing international standards during this time and consider how to conform US standards to them. The ultimate objective would be for US standards to be compliant with international standards in perhaps five to seven years.
Different, but valid and strongly-held, views exist as to whether and how the US should change to international standards.
The SEC staff suggested a possible compromise to start a dialog on potential transition approaches.
PricewaterhouseCoopers LLP 2
Analysis
Compromise, flexibility and a slower transition

No perfect solution We support the thorough way the SEC staff has gathered input, and we are confident thoughtful deliberations will occur among Commission members as they decide the path forward. But based on the political and business landscapes, if an all or nothing decision is to be made, we fear it will be nothing. The US would stay with its own accounting - and in the long run, that would be unfortunate. Though sufficient support for change does not currently exist, in our view, progress toward achieving the vision should not stop. Standard setters and regulators Today, achieving the vision remains a longer-term objective. Though standard setters have worked diligently, and great progress has been made, all major convergence projects are not yet complete. Allowing an option to change to international standards If using international standards were allowed, most US companies would need at least four years to put in place the systems and controls necessary to adopt them. Also, the expected timing for issuance of standards resulting from the major convergence projects will likely be late in 2012. Given this timing, the retrospective adoption provisions, and the effort required of companies to make needed system and control changes, most interested US companies wouldn't adopt the new convergence standards or international standards until 2015. Significant progress can be achieved between now and 2015 in standard setting and regulatory cooperation. For example, completing convergence projects, further improving international standards consistent with the IASB's new agenda, putting a foundation in place to enhance the consistency of application, and resolving numerous US transition issues can be accomplished. We believe that the SEC should monitor progress between now and 2015. If sufficient progress continues, the SEC should target the beginning of 2015 to allow US companies to optionally adopt international standards. In conclusion The potential SEC staff approach of slowly incorporating international standards based on assessing the quality of new and existing international standards is a fair starting point. It establishes a continuing role for the FASB and maintains the SEC's oversight of accounting standards used by companies that participate in the US capital markets. In addition, by addressing the practical consequences of making fundamental changes to US financial reporting, we believe the SEC staff is moving the ball forward. Although the vision is clear, the pathway is not. More consistency, compromise, and a slower transition plan will increase support among US companies to move to international standards. Continued dialog and increased cooperation are needed, but the worthiness of the goal demands that progress continue to be made.
PricewaterhouseCoopers LLP 3
We believe in the vision - a single set of high quality, transparent and robust global accounting standards.
We are convinced that only international standards can be the foundation for this vision.
We believe that the boards should continue working together to finish the current convergence projects. After completing those projects, the boards should continue collaborating to enhance the quality of financial reporting in areas where common needs for improvement exist. We realize that many inside and outside the US tire of convergence. Nevertheless, the benefits for investors of eventually getting to high-quality global accounting standards are worth the price of continued collaboration for a period of time. In addition to improved standards resulting from convergence and collaboration, a key to achieving the vision is establishing an effective foundation to enhance the consistency of application. This would assist investors in attaining maximum benefits from high-quality global standards. The regulatory and standard setting mechanisms to facilitate improved consistency in application are, for the most part, not yet in place or do not yet operate at a sufficiently high level. Enhanced cooperation and coordination is needed among national regulators, the IASB and its interpretive body, auditors, and preparers to facilitate more consistent application of international standards.
The SEC staff's suggested direction is a fair starting point in making progress towards achieving this vision.
Questions and answers
Q: How can increased regulator collaboration facilitate more consistent application of international standards? A: Increased collaboration can be achieved through greater focus on consistent application, improved communication between regulators, and cooperation agreements. One example of a cooperation agreement relates to companies seeking cross-border capital in public markets. Major capital market securities regulators could agree that any company purporting to follow IFRS and seeking public capital in another market, but not following that market's accounting principles, would be required to file periodic financial statements with the securities market regulator in which capital is being raised, using standards issued by the IASB. The financial statements of those companies would be subject to reviews by regulators in the countries where capital is raised. If instances of non conformity with standards issued by the IASB are identified, those matters would be resolved through discussions between the company, their home market securities regulator, and the securities regulator where the filing occurs. In this way, these cooperation agreements would enhance the sharing of information and help to reconcile views. Consistent application of international standards also would be enhanced through regulatory reviews aimed at identifying unacceptable differences in the application of international standards. Agreements among capital market securities regulators to refer interpretation and application differences to a refocused interpretations committee would also assist in achieving a higher degree of reasonable consistency.
Q: Some suggest that companies should be permitted to move to international standards as early as possible. You suggest such an option should be targeted for the beginning of 2015. Why? A: As a practical matter, key convergence standards are not expected to be effective until 2015 at the earliest. Even if early adoption of these new standards were allowed, because of the changes needed to systems and controls to implement them, and the retrospective adoption requirements, we believe many companies would not want to adopt them before 2015. Preparations to use international standards would take at least as long. As a result, we believe the SEC should use the time leading up to 2015 to monitor further development of international standards and the progress toward putting a foundation in place to improve the consistency of application. If sufficient progress is made, the SEC should allow US companies the option to change. Q: The SEC staff paper envisions an endorsement process that allows the FASB to modify international standards as they are incorporated. Will this work against the goal of a single set of global standards? A: The ability to modify standards through endorsement could result in a US "flavor" of international standards. This is why the threshold for making modifications is so important. Careful consideration must be given to the criteria. We believe that the threshold should be set at a level that would result in minimal modifications. The SEC staff's suggestion that the threshold consider "the public interest and the protection of investors" is a good starting point.
Contact Information
To have a deeper discussion about our point of view on international standards in the United States, please contact:
Michael Gallagher Managing Partner, Assurance Quality & Transformation Phone: 646-471-6331 Email: michael.j.gallagher@us.pwc.com James Kaiser U.S. Convergence and IFRS Leader Phone: 267-330-2045 Email: james.kaiser@us.pwc.com
2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.
US GAAP Convergence & IFRS Financial instruments

IASB proposes limited amendments to its financial instruments guidance under IFRS 9
What's new?
This week, the IASB issued its exposure draft proposing limited amendments to IFRS 9 (2010), Financial instruments. The proposed amendments are intended to:
No. 2012-55 November 29, 2012
Address application issues that have arisen since the original issuance of IFRS 9 with regard to financial assets measured at amortized cost Consider the interaction with the IASBs insurance project Reduce differences between IFRS 9 and the FASBs proposed classification and measurement approach
The IASB finalized its guidance on classification and measurement of financial assets in 2009 and financial liabilities in 2010, while the FASB has continued to develop its approach. A year ago, the FASB and IASB agreed to conduct joint discussions on the topic. Those meetings were completed earlier this year. This exposure draft represents the IASB's proposed changes to its existing guidance resulting from the joint discussions. The FASB is currently drafting its exposure draft that it plans to issue for public comment in the first quarter of 2013. A copy of the IASB's exposure draft is available on its website at www.ifrs.org.
What are the key proposals?

The proposal focuses on the accounting for debt investments. IFRS 9 currently requires debt investments to be classified and measured at amortized cost if they meet the contractual cash flows characteristics test and are held in a business model where the primary objective is to hold to collect contractual cash flows. Other debt investments are measured at fair value with changes in fair value recognized in profit or loss. Third measurement category added The proposal adds a third measurement category for debt investments: fair value with changes in fair value recognized in other comprehensive income. A debt investment will fall in this category only if it meets the contractual cash flow characteristics test and is held in a business model that is managed both to collect contractual cash flows and for sale. These instruments will follow the same impairment and interest income recognition
approach as debt investments measured at amortized cost. Amounts recognized in other comprehensive income will be recycled to profit or loss when the investment is derecognized. Clarification of amortized cost measurement category The proposal clarifies the primary objective of "hold to collect." Among other things, it provides additional application guidance on the types of business activities and the frequency and nature of sales that would allow debt investments to qualify for amortized cost. For example, a portfolio of debt investments that an entity would only sell in a "stress case," which is expected to be infrequent, would be consistent with the amortized cost business model. Additional guidance for the contractual cash flow characteristics test Debt investments are eligible to be measured at amortized cost under IFRS 9 if their contractual cash flows represent solely payments of principal and interest. In order to make this determination, the proposal requires an entity to assess contractual terms that could change an instrument's cash flows by reference to a benchmark instrument (i.e., an instrument with cash flows consisting purely of principal payments and compensation for the time value of money and credit risk). If the difference between the cash flows of the benchmark instrument and the instrument under assessment is more than insignificant, the debt investment will be measured at fair value with changes in fair value recognized in profit or loss.
Is convergence achieved?
The proposal focuses only on debt investments and is expected to be broadly consistent with the FASB's proposed approach. While not addressed by this proposal, the FASB and IASB also have broadly consistent approaches for financial liabilities. However, a number of differences still exist in other areas, such as the accounting for equity investments.
Who's affected?
Any entity that holds financial assets is affected by the guidance in IFRS 9. Entities in the financial services sector are likely to be most impacted by the proposal.
What's the effective date?

The proposed changes would be effective at the same time that IFRS 9 is effective, which is January 2015. The proposal would also make some changes to the IFRS 9 transition provisions. One key proposal the FASB is also considering would allow an entity to early adopt only the requirements for the presentation of fair value gains or losses attributable to changes in the issuer's own credit risk.
What's next?
The comment period for the IASBs proposal ends on March 28, 2013. The FASB is expected to issue its proposal in the first quarter of 2013. In the coming weeks we will issue a Dataline summarizing what we expect to see in that FASB proposal.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).
In brief
Authored by:
John Althoff Partner Phone: 1-973-236-7021 Email: john.althoff@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com Elaine O'Keeffe Senior Manager Phone: 1-973-236-4160 Email: elaine.okeeffe@us.pwc.com

FASB reaches conclusion on impairment model for financial assets measured at FV-OCI
What's new?
The FASB (the board) recently began discussing a revised impairment model for financial assets. At its September 7 meeting, the FASB made a key decision with respect to the impairment model by tentatively concluding that the current expected credit loss (CECL) model should apply to financial assets measured at fair value with changes in fair value recorded through other comprehensive income (FV-OCI). However, the FASB also decided to allow a practical expedient in applying the new model. Background Over the past several weeks, the FASB has been developing a revised impairment model for financial assets, known as the CECL model. At each reporting date, the model would require an entity to recognize a credit impairment that reflects its current estimate of credit losses expected to be incurred over the life of the financial asset. One of the remaining key decisions left to be made on the CECL model was whether the model should apply to debt securities and other financial assets measured at FV-OCI. At its most recent meeting, the FASB reached a tentative decision on this issue.
No. 2012-41 September 11, 2012
What are the key decisions?

During the meeting, there was a significant amount of discussion and varying views expressed by the board members. Ultimately, the board voted 4-3 in favor of applying the CECL model to financial assets measured at FV-OCI and establishing a practical expedient for these assets. The practical expedient would allow entities to not perform a detailed impairment analysis if both of the following conditions exist: (i) the fair value of the financial asset is greater than its amortized cost basis and (ii) the expected credit losses on the financial instrument are not significant. If either of these conditions is not present, entities would be required to perform a full impairment assessment and, if appropriate, record a credit impairment to reflect the current estimate of expected credit losses.
In brief
The decisions reached to date on the CECL model do not result in convergence with the IASBs model. At this stage, the IASB has not publicly discussed any of the recent FASB decisions and whether these decisions will affect its current plan to issue an exposure draft on the three bucket impairment model in the fourth quarter of 2012.
What's next?
Over the next several weeks, the FASB plans to further discuss trade receivables, transition, and disclosure requirements. The FASBs goal is to complete all significant discussions about the CECL model by the end of September. The FASB plans to share its revised model with the IASB at that time.
Questions?
In brief
Authored by:
John Althoff Partner Phone: 1-973-236-7021 Email: john.althoff@us.pwc.com Christopher Gerdau Partner Phone: 1-973-236-5010 Email: christopher.gerdau@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-4576 Email: christopher.rickli@us.pwc.com

FASB makes key decisions about the revised impairment model for financial assets
What's new?
Earlier this month, the FASB (the board) directed its staff to explore a revised impairment model for financial instruments. At its August 22 meeting, the board made some key decisions about the revised model. Background Over the past several months, the FASB and IASB have jointly deliberated a three bucket impairment model for financial assets. After considering constituent feedback, the board concluded that aspects of the three bucket impairment model are difficult to understand and present operational challenges that cannot be addressed through implementation guidance. As a result, the board decided not to move forward with an exposure draft on the three bucket approach. Instead , the board is considering a model that incorporates the concept of expected losses, but applies that concept to all financial assets and uses a single measurement approach.
No. 2012-37 August 23, 2012

The board reached the following tentative decisions about key aspects of the revised impairment model. Estimating expected losses The model will focus on the recognition of all expected losses, which will be defined as the estimate of contractual cash flows not expected to be collected. The board decided not to establish a threshold that should be met before an entity recognizes a credit impairment. This decision will result in a change to current practice under which entities recognize all incurred losses for which it is probable that one or more future events will occur confirming the loss. When estimating expected losses, an entity will be required to consider a range of potential outcomes. The information used to develop the estimate will include: (1) a current assessment of credit risk and (2) an estimate of expected credit losses. The estimate of expected credit losses will be based on all relevant internal and external
In brief
information, including past events, current conditions, and reasonable and supportable forecasts. Time value of money The model will incorporate the time value of money into the measurement of expected credit losses. The FASB plans to issue guidance to communicate appropriate methods to accomplish this objective. Purchased credit impaired assets Purchased credit impaired (PCI) assets will be defined as acquired assets or acquired groups of assets with shared risk characteristics that have experienced significant credit deterioration since origination based on an assessment by the buyer. For PCI assets, entities will be required to establish an initial impairment allowance based on the level of expected losses. The impairment allowance will be updated each period with changes recognized in income immediately. The remaining non-credit purchase discount or premium will be accreted over the life of the asset.
The FASBs tentative decisions do not result in convergence with the IASBs model. The IASB has not publicly discussed the recent FASB decisions and whether these decisions will affect its current plan to issue an exposure draft in the fourth quarter of 2012.
What's next?
Over the next several weeks, the FASB will continue to discuss the application of the model to debt securities and assets recorded at fair value with changes in fair value recognized through other comprehensive income. In addition, the board expects to further discuss non-accrual loans, trade receivables, transition, and disclosure requirements. The FASBs goal is to complete all significant discussions about the model by the end of September. The FASB plans to share its revised model with the IASB at that time.
Questions?
In brief
Authored by:
John Althoff Partner Phone: 1-973-236-7021 Email: john.althoff@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-4576 Email: christopher.rickli@us.pwc.com

FASB decides to explore a revised impairment model for financial assets
What's new?
Over the past several months, the FASB and IASB have jointly deliberated a proposed three bucket impairment model for financial assets. After recently announcing its intent to further discuss key aspects of the model, the FASB (the board) met this morning to discuss the next steps for the project. After considering the results of outreach efforts and constituent feedback, the board unanimously agreed with concerns that aspects of the three bucket impairment model are complex and difficult to understand. As a result, the FASB will not move forward with an exposure draft on the three bucket impairment model and will instead explore a revised approach.
No. 2012-32 August 1, 2012
What are the key issues?

Under the three bucket impairment model, financial assets would initially be placed in bucket 1, where credit reserves would be established for only those assets expected to experience a loss event in the next twelve months. As credit risk deteriorates, assets would then move to bucket 2 or bucket 3, where credit reserves would be based on a lifetime of expected losses, irrespective of when the loss event is expected to occur. Key aspects of the three bucket impairment model include determining whether a loss event is expected to occur in the next twelve months, and the level of credit deterioration that requires a transfer of assets between buckets. Clearly defining these concepts proved to be difficult and raised concerns as to the understandability, operability, and auditability of the model. The board considered whether implementation guidance could adequately clarify the objectives of the model. The board concluded that even with improved definitions for the key terms, there would likely still be concern over whether the model results in credit reserves that faithfully represent the credit risk of the portfolio. As a result, the board directed its staff to explore a model that incorporates the concept of expected losses, but applies that concept to all financial assets held and uses a single measurement approach.
In brief
The FASB's decision to explore a revised approach could result in an impairment model that differs from the IASBs model. During today's discussion, certain IASB members indicated that they have heard much less concern about the three bucket impairment model and therefore, plan to move forward with that approach.
What's next?
The board directed its staff to develop the new model and is hopeful that the staff will be able to leverage the discussions held to date in that process. Discussions of the new model are expected to take place over the next several weeks. The FASB plans to share its findings with the IASB in early fall. It is unclear at this time whether the IASB will move forward with an exposure draft in the near term, or whether the IASB will first consider any revised proposals from the FASB.
Questions?
In brief
Authored by:
John Althoff Partner Phone: 1-973-236-7021 Email: john.althoff@us.pwc.com Christopher Gerdau Partner Phone: 1-973-236-5010 Email: christopher.gerdau@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-4576 Email: christopher.rickli@us.pwc.com

No. 2012-27 July 19, 2012
FASB announces intent to further discuss key aspects of proposed impairment model for financial assets
What's new?
On July 18, 2012, the FASB and IASB (the boards) met to discuss the financial instruments project. At the conclusion of the meeting, the FASB announced its intent to continue discussions about several key aspects of the impairment model, as well as consider the results of recent outreach efforts, prior to moving forward with an exposure draft. The exposure draft is currently expected to be released in the fourth quarter of 2012. For the past several months, the FASB and IASB have continued to refine their proposed impairment model for financial assets. At a high level, the boards have agreed on a model that evaluates financial assets for credit impairment under a three bucket approach. The level of certain reserves recorded would be expected to increase as credit deteriorates over time. See In brief 2011-52, Let's try again the impairment model for financial assets refined, for more on the three bucket approach. The FASB staff has conducted outreach with stakeholders, including preparers, users, regulators, and accounting firms, to discuss various aspects of the proposed model. As part of this process, the staff received feedback that certain key aspects of the model remain unclear. Stakeholders indicated that many of their questions might be best addressed through the issuance of additional application guidance.
What's next?
The FASB staff has developed application guidance that it intends to present to the FASB during the month of August. The FASB believes that evaluating this guidance and ensuring that constituent concerns are addressed are key steps that need to be taken prior to moving forward with an exposure draft. In response to the FASBs announcement, members of the IASB expressed concern over the potential impact the FASBs activities could have on the progress made to date on this project.
Questions?
Authored by:
Christopher Gerdau Partner Phone: 1-973-236-5010 Email: christopher.gerdau@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-4576 Email: christopher.rickli@us.pwc.com

FASB and IASB agree on a three-category financial asset classification and measurement approach
What's new?
This week, the FASB and IASB (the boards) continued their joint discussions on classification and measurement of financial assets and agreed on a three-category approach for eligible debt investments. The boards had announced in January 2012 that they would work together in an attempt to achieve a more converged solution on this important part of their broader financial instruments project. These joint discussions are nearing completion and the boards have been successful in agreeing on a substantially converged approach for debt investments. Prior to January, the boards had reached different conclusions on classification and measurement and were at differing stages of finalization. The FASB had completed most redeliberations of its 2010 proposal while the IASB had already issued its final standard (IFRS 9). However, the IASB decided in late 2011 to consider targeted amendments to that standard. All decisions noted in this In brief are tentative and therefore subject to change, as the boards have not yet concluded their deliberations. A complete summary of the FASB's decisions on the financial instruments project is available on its website at www.fasb.org.
No. 2012-10 May 22, 2012

Under their respective approaches, debt investments (e.g., loans and debt securities) would be classified based on an individual instrument's characteristics (as further explained below) and the business strategy for the portfolio. However, before this week's meeting, the IASB had defined two categories whereas the FASB had defined three categories. This week, the IASB agreed to introduce a third category in which debt investments are measured at fair value with changes in fair value recognized through other comprehensive income. The FASB also agreed on a revised definition for this category. As a result, the categories for debt investments would be broadly defined as follows: Amortized cost consists of debt investments where the primary objective is to hold the assets to collect the contractual cash flows.
Fair value with changes in fair value recognized in other comprehensive income consists of debt investments with the primary objective of both holding the assets to collect contractual cash flows and realizing changes in fair value through sale. Interest and impairment would be recognized in net income in a manner consistent with the amortized cost category, and fair value changes would be recycled from other comprehensive income to net income when the asset is sold. Fair value with changes in fair value recognized in net income consists of debt investments that either (1) do not meet the instrument characteristics criterion or (2) meet the instrument characteristics criterion but do not meet one of the other category definitions (i.e., "the residual category"). In addition, the FASB agreed to adopt the IASB requirement for prospective reclassifications between categories when there is a significant change in business strategy, which is expected to be "very infrequent." In previous meetings, the FASB had also agreed to incorporate the following aspects of the IASB's approach: Instrument characteristics criterion. The contractual cash flows of the debt investment must represent solely payments of principal and interest in order to be eligible for the amortized cost or fair value with changes in fair value recognized in other comprehensive income categories. Bifurcation of hybrid financial instruments. Separate accounting for financial asset host contracts and embedded derivatives in hybrid financial assets would be prohibited; instead the entire hybrid financial asset would be accounted for as a single instrument. However, hybrid financial liabilities would continue to be bifurcated.
Most of the areas slated for joint discussion have now been concluded. While the boards have agreed on a substantially converged approach for debt investments, they do not plan on addressing all differences in their respective approaches (e.g., classification and measurement of equity investments that are not under the equity method of accounting).
Who's affected?
The final guidance will likely affect entities across all industries that hold financial instruments.

The FASB must still complete its redeliberations before deciding on an effective date. The IASB had previously decided to extend the effective date for IFRS 9 to annual periods beginning on or after January 1, 2015 (see In brief 2011-55).
What's next?
The boards are still expected to discuss some remaining issues including transition and disclosures. The FASB will also separately address a number of other matters in the coming months before issuing an exposure draft later this year. It is unclear at this time whether the new impairment approach will be included in that document or issued as a separate exposure draft.
Questions?
Authored by:
Greg McGahan Partner Phone: 1-973-236-5250 Email: gregory.mcgahan@us.pwc.com Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com Elaine O'Keeffe Senior Manager Phone: 1-973-236-4160 Email: elaine.okeeffe@us.pwc.com

FASB and IASB discuss the potential for a more converged financial instrument accounting approach
What's new?
This week the FASB and IASB (the 'boards') began joint discussions on classification and measurement of financial assets and financial liabilities. The boards had announced their intent in January 2012 to work towards greater convergence on this important project. This week was the first in a series of meetings that will address a converged solution for classification and measurement. To date, the boards have worked separately on classification and measurement and are at differing stages of finalization. The FASB has completed most of its classification and measurement redeliberations of its 2010 proposal, while the IASB has already issued its final standard (IFRS 9). However, the IASB decided in late 2011 to consider limited amendments to that standard to address: (1) how its approach interacts with the insurance contracts project, (2) implementation questions that had arisen since IFRS 9 was issued, and (3) differences with the FASB's tentative approach. All decisions noted in this In brief are tentative and therefore subject to change, as the boards have not yet concluded their deliberations. A complete summary of the FASB's decisions on the financial instruments project is available on its website at www.fasb.org.
No. 2012-03 March 1, 2012

Classification and measurement The boards' approaches for the classification and measurement of financial assets focus on two criteria, the individual instrument's characteristics and the entity's business model for those instruments. However, these two criteria have been defined differently by the two boards. This week the FASB decided to adopt the IASB's instrument characteristics approach. That approach requires that in order for a financial asset to qualify for measurement at other than fair value through net income (e.g., amortized cost), the contractual cash flows of the asset must represent solely payments of principal and interest. The IASB also decided to make some changes to its application guidance for this criterion.
In brief
Impairment In addition, the boards are continuing their joint discussions to develop a new impairment approach. During this week's joint meetings, the boards discussed the model for trade receivables. Some decisions were reached, but discussions will continue.
The joint discussions on classification and measurement will continue over the next few months. It should be noted, however, that not all the topics where the boards have different approaches are slated for discussion. For example, the boards do not currently plan to revisit their approach to the classification and measurement of equity investments that are not under the equity method of accounting.
Who's affected?
The final guidance will likely affect entities across all industries that hold or issue financial instruments.

The FASB must still complete its redeliberations before deciding on an effective date. The IASB had previously decided to extend the effective date for IFRS 9 to annual periods beginning on or after January 1, 2015 (see In brief 2011-55), and must still decide on the effective date of a final standard on impairment.
What's next?
The boards are expected to discuss the remaining criterion for classification and measurement the business model at their next meeting. This discussion would include a consideration of whether the IASB should add a third category for debt investments measured at fair value through other comprehensive income. Among other items, the boards also plan to discuss interrelated issues for financial liabilities and the need for bifurcation of hybrid financial assets. The FASB retained bifurcation of hybrid financial assets during the redeliberations of its 2010 proposal while IFRS 9 eliminated that requirement. The boards also plan to continue their joint discussions on the impairment model in the coming months, including further developing the approach to trade receivables, purchased loans with existing credit impairment, and debt securities. The IASB plans to issue an exposure draft on its targeted amendments to IFRS 9 in the second half of this year whereas the FASB has not made any formal decisions yet about re-exposure on classification and measurement. Both boards plan to expose the new impairment approach in the second half of this year for public comment.
Questions?
In brief
Authored by:
Greg McGahan Partner Phone: 1-973-236-5250 Email: gregory.mcgahan@us.pwc.com Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com Jivka Batchvarova Senior Manager Phone: 1-973-236-4841 Email: jivka.i.batchvarova@us.pwc.com Guido Tamm Manager Phone: 1-973-236-4171 Email: guido.tamm@us.pwc.com

IASB delays IFRS 9 effective date
What's new?
The IASB has issued an amendment to IFRS 9, Financial instruments, that delays the effective date to annual periods beginning on or after January 1, 2015. The original effective date was for annual periods beginning on or after January 1, 2013. The amendment is a result of the board extending its timeline for completing the remaining phases of its project to replace IAS 39, Financial instruments: Recognition and measurement, (such as impairment and hedge accounting) as well as the delay in the insurance project. In issuing the amendment, the IASB confirmed the importance of applying the requirements of all the phases of the project to replace IAS 39 at the same time. Under the current version of IFRS 9, entities that adopt IFRS 9 for reporting periods beginning before January 1, 2012 are not required to restate prior periods, while entities that adopt the standard on or after January 1, 2012 are required to restate prior periods. The amendment provides further relief from restating prior periods. However, a consequential amendment to IFRS 7, Financial instruments: Disclosures, requires additional transition disclosures when prior periods are not restated. These disclosures focus on the impact that the adoption of IFRS 9 has on the classification of financial assets and liabilities. Under the modified versions of IFRS 9 and IFRS 7, an entity that adopts IFRS 9 for reporting periods: (a) beginning before January 1, 2012 need not restate prior periods and is not required to provide the additional disclosures in IFRS 7; (b) beginning on or after January 1, 2012 and before January 1, 2013 must elect to either restate prior periods or provide the additional disclosures in IFRS 7; and (c) beginning on or after January 1, 2013 need not restate prior periods but are required to provide the additional disclosures in IFRS 7. Early application of IFRS 9 continues to be permitted.
No. 2011-55 December 21, 2011
In brief
While the FASB and IASB have been working together on certain phases of the financial instruments project, the boards have been on different timetables. The effective date of the FASB financial instruments model has not yet been determined as the FASB continues to redeliberate certain aspects of the project. In addition to the delay of the effective date, the IASB has recently decided to consider making further limited amendments to IFRS 9. These amendments are intended to: address specific practical issues raised by those who have already early adopted IFRS 9; consider the interaction between the insurance project and IFRS 9; and achieve greater convergence with the FASB's proposed approach.
Who's affected?
IFRS preparers that hold or issue financial instruments will be required to adopt IFRS 9 no later than January 1, 2015. The amendment allows additional time for these preparers to comply with the new requirements and provides preparers the opportunity to determine the best timing of the adoption in light of the other aspects of the project.
What's next?
IFRS preparers should consider their timing of transition to IFRS 9, taking into consideration the revised guidance on providing comparative information. IFRS preparers should also begin preparations for providing the additional disclosures.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the National Professional Services Group.
In brief
Authored by:
Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Guido Tamm Manager Phone: 1-973-236-4171 Email: guido.tamm@us.pwc.com
In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

Let's try again the impairment model for financial assets refined
What's new?
The FASB and the IASB (the boards) met this week and agreed on the impairment objective and measurement approach for financial assets, including loans and securities. After months of deliberations and discussions, the boards appear to have made progress in achieving convergence in the area of impairment for financial assets. These discussions are part of the boards' redeliberation efforts on the joint impairment project. All decisions noted in this In brief are tentative and therefore subject to change, as the boards have not yet concluded their deliberations or issued a final standard. A complete summary of the boards decisions on the impairment model project is available on the FASB's website at www.fasb.org.
No. 2011-52 December 15, 2011
What are the key provisions?

Overview To quickly recap, portfolios of financial assets will be divided into three buckets for purposes of measuring impairment. Assets will start off in Bucket 1 and the measurement of impairment will be based on twelve months of expected losses. Assets will shift to either the second or third bucket if and when credit deteriorates. The measurement of impairment in Bucket 2 and 3 will be based on lifetime expected losses. Expected losses In previous discussions, which were affirmed during this week's meeting, the boards decided that expected losses should be estimated with the objective of an expected value. Under the expected value concept, entities will need to identify possible outcomes, estimate the likelihood of each outcome, and calculate a probability-weighted amount. The boards also decided that other appropriate methods could be used as a reasonable way to achieve the objective of an expected value. Examples of suitable methods include: (1) the loss rate method, which incorporates the probability of default and loss given default, and (2) the collateral value method. Bucket 1 The objective for the allowance provision in Bucket 1 will be to provide for an adequate reserve at the measurement date for expected losses that are anticipated to occur over the
next twelve months. Financial assets with insignificant deterioration in credit since origination or purchase for which entities expect to recover substantially all contractual cash flows may qualify for Bucket 1 measurement. Assets will need to be grouped in pools with similar risk characteristics or analyzed at the individual level to evaluate if they meet the Bucket 1 criteria. Buckets 2 and 3 The recognition of lifetime expected losses will be based on: (1) the extent of deterioration in credit quality since initial recognition and (2) the resulting risk of not collecting the contractual cash flows. Financial assets will be transferred to Bucket 2 or 3 when entities determine that there has been more than insignificant deterioration of credit quality since the initial recognition and it is at least reasonably possible that the cash flows may not be fully recoverable. The difference between Bucket 2 and Bucket 3 is simply a unit of evaluation difference. Bucket 2 includes financial assets evaluated collectively and Bucket 3 includes financial assets evaluated individually. Transfers between buckets The boards agreed that the impairment model will allow for migration of credit in both directions. For example, assets can transfer from Bucket 1 to Bucket 2 when credit deteriorates or vice versa if credit improves. An entity will need to evaluate and consider various factors when determining whether transfer between impairment buckets needs to occur, such as changes in general economic and industry conditions, changes in underwriting standards, and credit quality of the borrower, among others. In addition, the boards agreed that the probability of default should be the predominant characteristic for determining the collectibility of cash flows. Debt securities model The model will also be applied to debt securities. Debt securities may be evaluated individually or in the aggregate based on similar risk characteristics to determine whether the recognition of lifetime expected losses is required. A predominant indicator for credit deterioration will be changes in the security's fair value. However, the staff will continue to work on specific factors for securities that will help entities make a determination about when to transfer securities to Bucket 2. While the boards conceptually agreed on the proposed approach described above, they will continue to have discussions regarding factors and events that may trigger transfers between buckets as well as yield recognition for financial assets under this model.
Both boards continue to strive to achieve convergence in this area as constituents believe that achieving convergence on the impairment model is critical. The tentative decisions made this week indicate that the boards may be one step closer to achieving this goal.
What's next?
The boards' decisions are tentative and subject to change. Once the boards complete redeliberations, an exposure draft will be issued for public comment. An exposure draft is targeted for the first half of 2012.
Questions?
In brief
Authored by:
Gregory McGahan Partner Phone: 1-973-236-5250 Email: gregory.mcgahan@us.pwc.com Jivka Batchvarova Senior Manager Phone: 1-973-236-4841 Email: jivka.i.batchvarova@us.pwc.com

Financial instruments An update on the FASB's financial instruments project redeliberations as of June 30, 2011
Overview
At a glance The accounting for financial instruments is a priority joint project of the FASB and IASB. Whereas the IASB has finalized its classification and measurement approach, the FASB is in the process of redeliberating its May 2010 proposal. The FASB has made significant changes from that proposal, including requiring loans that are principally held for collection, bank deposits, and most of an entity's own debt to be classified and measured at amortized cost, and retaining the current criteria for the equity method of accounting. The FASB and IASB continue to work on developing a joint approach to the accounting for credit impairments. After considering constituent input on the different impairment approaches in their supplement document, the Boards have decided to develop a variation of the previous impairment proposals. An exposure draft of the revised impairment proposal is expected by the end of third quarter 2011. The FASBs current timeline indicates that it plans to finalize its classification and measurement and impairment approach by the end of 2011, although this may be challenging given the projects current status. The FASB has obtained feedback on the IASB's proposed revisions to hedge accounting and its own May 2010 proposal. The IASBs proposal differs significantly from the FASBs proposal in a number of ways including proposing to extend hedge accounting to components of nonfinancial instruments. The FASB plans to consider the feedback in future redeliberations that will take place later in 2011. Consequently, the FASB is unlikely to finalize its revised hedge accounting guidance by the end of 2011.
No. 2011-26 July 7, 2011 Whats inside: Overview .......................... 1

Scope ................................2 Update on redeliberations..............3

Classification and measurement ....................... 3 Impairment of financial assets ...................................13 Hedge accounting .................. 15 Disclosures ............................. 15
Questions ....................... 15
Dataline
The main details .1 The objective of this joint project is to improve the decision usefulness of financial statements by simplifying and harmonizing the accounting for financial instruments. However, despite being a joint project, the FASB and IASB have reached different conclusions on many aspects of the project to date. Once finalized, the new guidance will replace or amend most of the FASBs and IASBs respective financial instruments guidance. .2 In May 2010, the FASB proposed changes to its standards on financial instruments accounting. That proposal included an entirely new classification and measurement model for all financial instruments, a new credit impairment model for debt instruments, and significant amendments to the guidance on hedge accounting. For a summary of the key elements of that proposal, refer to Dataline 2010-25, FASB Proposes Changes to Financial Instruments Accounting. .3 The FASB is in the process of redeliberating its May 2010 classification and measurement approach and has significantly changed course from that proposal. It has also been jointly redeliberating impairment with the IASB. The FASB aims to finalize most of the guidance by the end of 2011. The FASB must still decide on the effective date for the final standard. It has separately sought input from constituents on the effective dates and transition for all of its priority projects. PwC observation: As discussed in our recent Point of view, Finding the right pace for standard setting, we support the Boards' conclusion that more time is needed to develop final standards on the priority joint projects. We believe that completing these projects by the end of 2011 will be challenging given the amount of work that remains to be done. This is especially true for the financial instruments project, particularly as it relates to impairment. As further noted in our Point of view, we also believe that re-exposure of the FASB proposals would be beneficial and is the best way for the FASB to obtain an appropriate level of constituent input. The FASB has entirely rewritten its classification and measurement approach during redeliberations and has not to date had the benefit of constituent input. The Boards have indicated that they will seek further input through re-exposure of the impairment approach prior to finalizing that approach. .4 All FASB decisions discussed in this Dataline are tentative and therefore subject to change, as it has not yet concluded its deliberations or issued a final standard. A complete summary of the FASBs decisions on the financial instruments project is available on the FASBs website at www.fasb.org.
Scope
.5 The FASB has not redeliberated the scope of instruments to which this guidance would apply. While its May 2010 proposal used the definition of a financial instrument as its starting point, a number of exceptions were provided. PwC observation: The interplay between this guidance and the scope exceptions included in the derivatives guidance (ASC 815) is unclear, including whether an instrument that meets a scope exception under the derivatives guidance would then fall within the
Dataline
scope of this project. In addition, the relationship between this project and the scope of the insurance project has yet to be determined. For example, it is unclear at this stage whether financial guarantees would be subject to the financial instruments project, the insurance project, or existing guidance.
Update on redeliberations
Classification and measurement .6 Whereas the FASB is in the middle of its redeliberations, the IASB has already finalized its classification and measurement guidance in the form of IFRS 9, Financial instruments. While the FASB's tentative approach diverges from the IASB's finalized classification and measurement approach, the IASB has indicated that it will give its constituents the opportunity to comment on the FASB's approach once it is closer to being finalized. PwC observation: Even though the IASB's classification and measurement approach has been finalized and allows for early adoption prior to the mandatory effective date at the start of 2013, the European Union (EU) has not yet endorsed IFRS 9 thereby precluding IFRS-reporting entities within those countries from being able to early adopt that guidance. The EU has indicated that it will only make a decision on endorsement once the entire financial instruments guidance has been finalized. At this stage it would seem that a 2013 effective date would be challenging from an implementation perspective. As a result, the IASB is expected to consider moving the mandatory effective date to the beginning of 2015 at its July 2011 meeting. In addition, some EU constituents have expressed their desire for targeted changes to be made to IFRS 9. These constituents may prefer certain aspects of the FASB's approach and will again have the opportunity to formally express their views when the IASB requests comments on the FASB's revised approach. Two examples of aspects of the FASBs approach that some may view as desirable include: (1) the ability to recognize debt investments held for liquidity or interest rate risk management purposes at fair value with changes recognized in other comprehensive income (OCI), and (2) the requirement to bifurcate embedded derivatives that are not clearly and closely related to the host contract from hybrid financial assets. Other aspects of the FASB approach however may be less appealing such as the inability to classify equity securities in the fair value through OCI category. .7 The FASB has not completed its redeliberations on classification and measurement and among other aspects must still address the scope of the project, instruments that can only be redeemed for a certain amount, the accounting for changes in fair value due to an entity's own credit, presentation, and disclosures. Subcategories for classification and measurement .8 The FASB decided that debt instrument assets are classified and measured in one of three categories: (1) amortized cost, (2) fair value with changes in fair value recognized in OCI, or (3) fair value with changes in fair value recognized in net income. The IASB approach instead requires all debt instrument assets to be classified and measured into one of two categories: (1) amortized cost or (2) fair value with changes in fair value recognized in profit or loss.
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.9 Under both the FASB's tentative approach and IFRS 9, debt instrument liabilities are classified and measured in one of two categories: (1) amortized cost or (2) fair value with changes in fair value recognized in net income (profit or loss). .10 All equity investments not accounted for under the equity method are measured at fair value with changes in fair value recognized in net income under the FASB's approach. Comparison to IFRS 9: This is also the default treatment under IFRS 9 for equity instruments. However, IFRS 9 does allow entities to irrevocably elect on an individual instrument basis to have fair value changes for equity investments not held for trading purposes to be recognized in OCI with no impairment and no subsequent recycling to profit or loss even upon disposal of the instrument. Debt instrument assets .11 Debt instrument assets would be classified and measured into the three categories based on two criteria: (1) the individual instrument's characteristics, and (2) the entitys business activities. Comparison to IFRS 9: IFRS 9 also requires classification and measurement to be based on the business model and certain instrument characteristics. However, the similarity ends there as the IASB has defined both of those criteria very differently from the FASB's proposed model. The IFRS 9 approach for the amortized cost category is focused solely on (1) the business model (i.e., whether the objective is to hold the asset to collect the contractual cash flows) and (2) the instrument's cash flow characteristics approach (i.e., whether the instrument give rises to cash flows that constitute solely payments of interest and principal). As a result the IASB approach is focused on the business purpose for buying or originating a portfolio of assets whereas the FASB approach focuses on an entity's business activities (i.e., customer financing, investing, or trading). .12 The FASB decided to retain the current guidance to identify any embedded derivative and determine whether it should to be accounted for separately from the host contract. Any embedded derivative in a hybrid financial asset that is required to be accounted for separately (because it is not clearly and closely related to the host contract) would continue to be measured at fair value with changes in fair value recognized in net income. The instrument's characteristics and business strategy criteria would then be applied to the remaining host contract to determine its appropriate classification and measurement. Comparison to IFRS 9: IFRS 9 differs from the FASB's tentative approach in that it requires that hybrid financial assets be accounted for as a single instrument. Embedded derivatives in financial assets are no longer bifurcated. The existence of the features that do not represent solely payments of principal and interest will require the entire instrument to be measured at fair value through profit or loss. Some non-U.S. constituents may find the FASB's approach for hybrid financial assets preferable on the basis that it would reduce the earnings volatility that would result from recognizing fair value changes for the entire instrument in earnings and allow institutions to hedge the discrete risk. Criterion 1 the instrument's characteristics .13 To be eligible for classification and measurement at either amortized cost or fair value with changes in fair value recognized in OCI, all of the following criteria would need to apply to the individual debt instrument asset:
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a. It is not a derivative subject to the derivatives guidance in ASC 815 b. It involves an amount transferred to the issuer at inception (principal adjusted for any discount or premium) that will be returned at maturity or settlement Note: The FASB suggested that the amount transferred initially could include goods or services, which means that accounts receivable and accounts payable would meet this test. c. It cannot be contractually settled or prepaid such that the investor would not recover substantially all of its initial investment other that due to its own choice PwC observation: Because most interest-only strips can be contractually prepaid such that the holder would not recover substantially all its recorded investment, few would meet this criterion. Only those that cannot be contractually prepaid (e.g., Treasury strips) could qualify. Residual interests would also fail this test. Bonds purchased at significant premiums may also be ineligible for the amortized cost or fair value with changes in fair value recognized in OCI categories due to criterion (c).
Criterion 2 the entitys business activities .14 The FASB has broadly defined three business activities: customer financing, investing, and trading activities. This differs from current guidance for investments in securities which only defines two of the three categories with the third (available-forsale) being a default category. Under the proposed model, companies would have to classify an instrument at origination or purchase based on its business activity for the portfolio and no default option could be applied. PwC observation: During redeliberations it appeared that the individual FASB members had a view on the appropriate measurement basis for individual instruments in certain circumstances. However, there is a risk that the manner in which the principles are articulated may not always achieve that intended treatment. For example, by not allowing a fair value option or fair value (with changes in fair value recognized in net income) to be the default measurement, there is a risk that certain entities which currently manage all of their financial instruments on a fair value basis and recognize fair value changes in net income would be required to recognize changes in fair value in OCI for debt instruments that are not held for sale. The FASB may still consider requiring fair value measurement in those instances (for further information see paragraph 32). .15 Debt instrument assets are classified based on the business activity used to manage those financial instruments as a portfolio (rather than the entitys intent for an individual instrument), together with the individual instrument's characteristics. An entity can manage the same or similar instruments through different business activities thereby resulting in the same instrument type being classified differently. .16 In contrast with current guidance for the amortized cost (held-to-maturity) category, the FASB decided that subsequent sales of instruments do not taint the existing portfolios classification. However, significant sales may call into question assertions on newly originated or acquired instruments. In addition, the FASB decided that if an entity subsequently decides to sell debt investments that are measured at amortized cost, then the impairment model would change from a credit impairment approach to recognizing
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in net income the entire difference between the amortized cost basis and the fair value of those instruments. .17 The FASB also noted that an entity must classify all investments into one of the three categories even if at inception it cannot specifically identify which debt investments in a portfolio will be sold versus held under the amortized cost business strategy. PwC observation: The FASB struggled to find an approach that was operational to address the classification of portfolios of assets where a portion will be managed for collection of the contractual cash flows while the remainder will be sold or securitized, but the individual assets to be sold or securitized are not specifically identified at inception. This is not a new issue as under current GAAP many have struggled with distinguishing between the held-for-investment and the held-for-sale categories for loans, albeit that current GAAP allows for reclassifications. Ultimately the FASB noted that companies would have some flexibility because this determination would only have to be made by the end of the reporting period, by which time the instruments that will be sold or securitized may have been identified. However, that may not be the case and companies will need to make their best effort considering available information to establish the appropriate classification. Companies are unable to change their initial classification in subsequent periods under the FASB's tentative approach (for further information see paragraph 38).
Amortized cost category .18 All of the following would need to apply to a debt instrument asset classified in this category: The business strategy is to manage through customer financing (lending or borrowing) activities with a primary focus on the collection or payment of substantially all contractual cash flows. The holder of the instrument has the ability to manage the credit risk by negotiating any potential adjustment of contractual cash flows with the counterparty in the event of a potential credit loss. Sales or settlements would be limited to circumstances that would minimize losses due to deteriorating credit. PwC observation: This test is intended to limit the debt instruments classified in the amortized cost category to those that involve a direct relationship between the holder (lender) and the issuer (borrower) of the instrument. In particular, a holder of publicly-issued debt would be less likely able to manage its credit risk exposure through renegotiation than the provider of financing directly to a borrower. Meeting this criterion may also be challenging for participants in loan participation or syndication arrangements as the lead arranger is often the only party that is able to manage the borrower relationship on behalf of the other participants. However, some FASB members have suggested that an entity's participation should be eligible for amortized cost if an agent is managing the credit risk exposure of that instrument on behalf of the entity.
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At a recent joint FASB and IASB education session, some FASB members indicated that they intend this category to capture portfolios where the primary objective is to manage the credit risk and that a secondary objective (e.g., managing interest rate risk and an entity's interest margin) should not preclude amortized cost measurement. In addition, the FASB Chairman acknowledged concerns expressed by some smaller financial institutions that this category was not sufficiently broad and noted that the FASB will continue to work on refining the categories. The instrument is not held for sale Comparison to IFRS 9: The business model for the amortized cost category is defined more broadly under IFRS 9 than the FASB's approach in that it focuses on the business strategy for originating or buying an individual financial asset (i.e., holding for collection of contractual cash flows versus selling). As a result it potentially allows more debt securities to be eligible for amortized cost than under the FASB's approach. However, a debt instrument that is being managed to maximize total return and could therefore either be sold or held for collection of the contractual cash flows would likely have to be measured at fair value with changes in fair value recognized in profit or loss. Fair value with changes in fair value recognized in OCI (fair value through OCI) category .19 All of the following would need to apply to a debt instrument asset classified in this category: The business strategy is to invest the cash of the entity either to: a. Maximize total return by collecting contractual cash flows or selling the asset
b. Manage the interest rate or liquidity risk of the entity by holding or selling the asset The instrument is not held for sale at acquisition Comparison to IFRS 9: Under IFRS 9, no debt investments can be classified and measured at fair value with changes in fair value recognized in OCI. Consequently, all debt investments would be classified into either the amortized cost or fair value with changes recognized in profit or loss categories. PwC observation: While not the FASB's intent, this broad definition could effectively cause this to be the default category for most debt instruments. This definition appears to generally require debt securities that are held in liquidity portfolios and asset liability management portfolios (which are typical in the insurance and banking industries) to be classified and measured at fair value through OCI. Insurance companies are concerned that requiring their debt investments to be classified and measured at fair value with changes recognized in OCI would create an accounting mismatch with the Board's insurance project which would require measurement changes on their insurance obligations to be recognized in net income. The FASB is aware of this concern and may consider this further as it continues to refine these categories. .20 Consistent with current accounting guidance, the FASB decided to require the recycling of gains and losses on instruments from OCI to net income that are realized due
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to the sale or settlement of a financial asset. Also, any impairment charges would continue to be recognized in net income in the period they arise. Fair value with changes in fair value recognized in net income (fair value through net income) category .21 Either of the following would need to apply to a debt instrument asset classified in this category: The instrument is held for sale The instrument is actively managed and monitored internally on a fair value basis but does not qualify for the fair value through OCI category Comparison to IFRS 9: IFRS 9 will likely require more debt instruments to be measured at fair value with changes in fair value recognized in earnings than under the FASB's approach, mainly because it does not provide a middle category for OCI recognition of fair value changes and it may be difficult for instruments to qualify for amortized cost. Debt instrument liabilities .22 Any debt instrument liability that meets the instrument's characteristics criterion (refer to paragraph 13 for more information) would be classified and measured at amortized cost unless either of the following exists in which case it would be classified and measured at fair value with changes in fair value recognized in net income: It is held for transfer and the entity has the ability and means to transact at fair value It is a short sale PwC observation: The FASB was concerned that by applying the amortized cost business strategy tests to financial liabilities there would be unintended consequences. For example, a holder of debt obtained in the public markets is typically unable to manage its credit risk exposure through renegotiation and thus, the issuer would not have been eligible for amortized cost measurement. Therefore, the FASB concluded that it needed a different approach to financial liabilities that would retain amortized cost measurement in most instances. .23 Consistent with its decision for hybrid financial assets, the FASB decided to retain the current guidance for hybrid financial liabilities to identify any embedded derivative and determine whether it should to be accounted for separately from the host contract. Any embedded derivative in a hybrid financial liability that is required to be accounted for separately would continue to be measured at fair value with changes in fair value recognized in net income. The classification and measurement approach for financial liabilities would then be applied to the remaining host contract to determine its appropriate classification and measurement. Comparison to IFRS 9: The IASB also retained a bifurcation approach for financial liabilities. Exception for convertible debt issuances .24 The FASB has decided to provide an exception from its classification and measurement approach for issuers of convertible debt where the conversion feature is not required to be separately accounted for as equity under current guidance (ASC 470-
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20-25-12) or separately accounted for as an embedded derivative because it qualifies for the derivative scope exception under ASC 815-10-15-74(a). The entire convertible debt instrument would then be classified and measured at amortized cost. Comparison to IFRS: Under IFRS, the debt host is eligible for amortized cost treatment after separation of the equity conversion option. The equity conversion option is either classified as equity if the instrument is convertible at a fixed amount of cash for a fixed number of shares (the fixed for fixed requirement) or recognized separately as an embedded derivative if the fixed for fixed requirement is not met. PwC observation: The treatment remains unclear under the FASBs approach for other forms of convertible debt that have an equity conversion feature that is required to be separately accounted for as equity or as a bifurcated derivative under current guidance. Specifically, it is unclear whether the host contract could be eligible for amortized cost measurement. A literal read of the instrument characteristics criterion that requires the amount transferred at inception to be returned at maturity would suggest that only the host contract of instrument C (an instrument where only the conversion spread can be settled in cash or shares while the par amount is settled in cash) would be eligible for amortized cost measurement whereas the host contract of other instrument types would not since shares and not cash could be returned to the issuer. The FASB is aware of this issue and has asked the staff to address this matter while drafting the standard.
Nonrecourse liabilities that can only be settled using specified assets .25 In situations where financial assets can only be used to settle nonrecourse liabilities, the FASB decided that the nonrecourse liabilities should be measured consistently with those financial assets. This may occur in securitization entities that are reflected in the consolidated financial statements due to failed sales or by applying the consolidation guidance for variable interest entities. Consequently, if the financial assets are measured at amortized cost then the nonrecourse liabilities would also be measured at amortized cost and would reflect an adjustment if the financial assets become impaired. Loan commitments, revolving lines of credit, and standby letters of credit .26 The FASB decided that the accounting for loan commitments, revolving lines of credit, and standby letters of credit should generally follow the accounting for the loan when funded. Therefore, they would be evaluated first under the business activities criterion. Consequently, if the loan when funded would be held for sale then the commitment would be measured at fair value with changes in fair value recognized in net income. The instrument characteristics criterion would not be applied to these instruments because the fact that they do not include an amount transferred at inception that will be returned at maturity or settlement would cause them to be measured at fair value with changes in fair value recognized in net income. .27 Instruments that do not fall into the fair value with changes in fair value recognized in net income category would be accounted for under the existing guidance (ASC 310-20), which would remain unchanged. Entities would continue to need to assess the likelihood of the commitment being drawn upon under that guidance. In situations where the likelihood of exercise is determined to be remote, then the commitment fees would be recognized as fee income on a straight-line basis over the commitment period. If the likelihood of exercise if more than remote, then the fees would be deferred and recognized over the life of the funded loan as an adjustment of yield, or if the
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commitment is not drawn upon then the deferred fees would be recognized in net income on expiration of the commitment. Comparison to IFRS 9: Loan commitments are required to be measured at fair value with changes in value recognized in profit or loss if an entity has a past practice of selling the loans once funded. If an entity does not have a past practice of selling the loans, the loan commitments would not be carried at fair value. In these cases, the entity would need to assess if it is probable that the commitment will be exercised. Only if it is probable would the fees be deferred and recognized over the life of the funded loan as an adjustment of yield. Initial measurement .28 The FASB decided that the initial measurement of a financial instrument would follow its subsequent measurement. In other words, an instrument that will subsequently be measured at fair value with changes in fair value recognized in net income would initially be measured at fair value. An instrument that is subsequently measured at amortized cost or fair value with changes in fair value recognized in OCI would initially be recognized at the transaction price. .29 When initial measurement is at transaction price, a company would need to determine if any of the consideration given or received is for elements other than the financial instrument. If consideration relates to other elements (e.g., a credit facility offered at an off-market interest rate that compensates for services provided) then those elements should be separately accounted for under the relevant existing guidance. The FASB will continue to work on defining when an entity would need to look for other elements but has indicated that it is only looking to capture transactions that are clearly not on market terms such as when loans are extended at a zero interest rate. .30 An exception from the initial fair value measurement requirement is provided for investment companies subject to ASC 946. Those entities would continue to account for their financial instruments at transaction price including explicit transaction costs, with subsequent changes in fair value included in the fund's statement of operations as a component of unrealized/realized gains or losses on investments. Comparison to IFRS 9: Under IFRS, all financial assets and liabilities have to be initially measured at fair value. The initial fair value is normally considered to be the transaction price unless part of the consideration is for something other than the financial instrument. However, no day one gain or loss is initially recognized unless fair value is evidenced by a quoted price in an active market for the identical instrument (i.e., Level 1 in the fair value hierarchy) or based on a valuation techniques that only include data from observable markets (this day one gain or loss recognition prohibition is an existing difference between IFRS and U.S. GAAP). The fair value option .31 The FASB decided to eliminate the unrestricted fair value option that exists in U.S. GAAP today on the basis that it undermines the business strategy approach to classification and measurement. Instead, a fair value option is only provided for hybrid financial liabilities that would otherwise have required bifurcation into a host contract and embedded derivative. This option would enable an entity to measure the entire hybrid instrument at fair value and avoid the complexity of having to separately account for and measure the embedded derivative at fair value. The FASB will consider at a later date whether to allow a similar fair value option for hybrid financial assets. .32 At a later date, the FASB will consider whether to provide a fair value option or require fair value measurement for assets and liabilities that are risk managed together and their performance assessed on a fair value basis.
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Practicability exception for nonmarketable equity investments .33 The FASB decided to provide certain nonpublic entities with the ability (an option) to elect a practicability exception to the fair value measurement requirement for their nonmarketable equity investments that are not under the equity method of accounting. The FASB must still decide which nonpublic entities would be eligible for this practical exception. Comparison to IFRS 9: This practicability exception differs from the practical expedient afforded under IFRS 9, which allows measuring nonmarketable equity investments at cost on the basis that cost may approximate fair value, absent any significant changes. The FASB's practicability exception does not purport to represent fair value in any way. PwC observation: The lack of, and/or inability to obtain access to, information in order to determine the fair value of nonmarketable equity instruments that make the FASBs exception necessary would appear to apply equally to all companies, not only nonpublic entities. This challenge is exacerbated for public entities that have to determine fair values on a quarterly basis. The FASB believes that since public companies are already required to disclose these fair values, the necessary valuation processes already exist in those organizations. However, determining fair values in advance of press releases will be more challenging than determining them for disclosure purposes only. .34 Under this exception, the instrument would be measured at amortized cost less impairment but adjusted for any observable prices. The impairment approach would require a qualitative factors-based assessment to determine if it is more likely than not that the fair value is less than the carrying amount. Only if a factor(s) exists indicating that it is more likely than not that the fair value is less than the carrying amount would fair value need to be determined and, if necessary, an impairment charge recorded. The carrying amount would also need to be adjusted either up or down for any observable prices. Observable prices are those prices that represent orderly transactions for the identical or a similar asset from the same issuer. The equity method of accounting .35 The FASB decided to retain the current guidance for determining if an equity investment should be accounted for under the equity method of accounting. In its May 2010 proposal, the FASB had proposed limiting the investments accounted for under the equity method to those where the investor has significant influence over the investee and the operations of the investee are related to the investors consolidated operations. Subsequently, the FASB decided that only significant influence would be needed, consistent with current guidance. In a future meeting, the FASB will consider if additional qualitative disclosures are needed to enable users to better understand the reason for a company's investment in an entity that is accounted for under the equity method. PwC observation: Based on the feedback received on the FASB's May 2010 proposal, most companies are likely to be pleased with this decision. The May 2010 proposal could have significantly restricted the use of the equity method of accounting and required many of these investments to be measured at fair value with changes in fair value recognized in net income. .36 The fair value option would no longer be available for equity investments under the equity method of accounting.
PwC observation: Some companies that utilize the fair value option may be unhappy with the decision to eliminate this alternative. Some have used this option to simplify their accounting where there is a readily obtainable market price or in order to achieve consistent treatment between entities within a consolidated group that invest in the same investee. However, the FASB has indicated that it may consider in a future meeting whether to instead require fair value measurement for equity investments in certain circumstances despite the existence of significant influence. .37 The impairment approach for investments under the equity method of accounting would be similar to that required for nonmarketable equity investments under the practicability exception. It would require a qualitative factors-based assessment to determine if it is more likely than not that the fair value is less than the carrying amount. Only if a factor(s) exists indicating that it is more likely than not that the fair value is less than the carrying amount would fair value need to be determined and, if necessary, an impairment charge recorded. Impairment charges taken could not be reversed at a later stage due to a recovery in value. Comparison to IFRS: IFRS (IAS 28) also requires the equity method of accounting when the investor has significant influence over the investee. However, IAS 28 does exclude venture capital entities and many funds from this requirement where they instead account for those investments at fair value with changes recognized in profit or loss in accordance with IFRS 9. PwC observation: While the FASB preferred to eliminate the need to perform an additional assessment of whether a decline is other-than-temporary, individual FASB members suggested that they would like some consideration of the extent to which fair value is below the carrying amount and how long that situation has existed before recognizing an impairment charge in net income for marketable equity investments under the equity method of accounting. However, it appears that the FASB does not want to retain the current guidance that considers the intent and ability of an entity to hold the investment until recovery. The FASB will continue to refine this impairment approach.
Reclassification .38 The FASB has reaffirmed its May 2010 proposal to prohibit reclassifications between categories after initial recognition. Comparison to IFRS 9: This decision is not convergent with IFRS 9, which does require reclassification when the business model changes. However, under IFRS 9 a change in intent (even in circumstances of significant changes in market conditions) is not a change in business model. PwC observation: The FASB does not believe it is necessary to change the measurement attribute (from amortized cost to fair value or vice versa) when the business activities for the portfolio change. Instead the FASB prefers to address a change from an amortized cost strategy to a fair value strategy through the impairment model by requiring fair value be the basis for any impairment and not only credit risk changes. This change in
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impairment model is intended to ensure that losses are not deferred when an entity's strategy changes from one focused on cash flow collection to one focused on returns through sale.
Impairment of financial assets .39 The FASB and IASB are continuing to work on developing an impairment approach that would be applied to all debt instruments that are not measured at fair value with changes in fair value recognized in net income. Joint discussions to date have focused on debt instruments classified and measured at amortized cost because only the FASB's proposed classification and measurement approach would require certain debt instruments to be classified and measured at fair value with changes in fair value recognized in OCI. As previously discussed, under the FASB's proposed approach, the amortized cost category would consist predominantly of loans whereas the amortized cost category under IFRS 9 could include both loans and debt securities. In addition, the Boards have continued to focus on developing an impairment approach for open portfolios of loans. In the future they will need to consider whether that impairment approach can be applied to debt securities, closed portfolios, and individual assets. .40 The FASB and IASB had originally proposed differing impairment models that they developed separately. Many constituents that commented on those proposals emphasized the need for the Boards to develop a converged impairment approach. In January 2011, the Boards issued a joint supplementary document titled Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging ActivitiesImpairment (the "Supplementary Document") to gather input on new impairment approaches. The Supplementary Document contained three credit impairment approaches a common proposal and two alternative proposals. For a more detailed summary of these approaches, refer to Dataline 2011-09, Impairment redux FASB and IASB are seeking comments on a converged impairment model for financial assets. Respondents were generally not supportive of the Boards common proposal. PwC observation: No obvious solution has emerged from the various rounds of constituent feedback or the Boards' deliberations that balances their differing objectives with the need to have conceptual merit and also be operational. One suggested approachdeveloped by a group of U.S. banksthat has received attention proposes to expand on the current incurred loss accounting model by eliminating the probability threshold, incorporating expected events into the loss forecast, and extending the loss emergence period. Specifically, the allowance would consist of a "base component" for losses inherent in the portfolio that are reasonably predictable, plus a "credit risk adjustment component" for losses that are not yet reflected in the base component but consider macro-level indicators that are expected to emerge as the credit cycle unfolds. Many constituents are very interested in understanding the future impairment model for debt securities. Current guidance requires impairment to be assessed on an individual asset basis for debt securities given their unique nature. If the Boards adopt an approach that requires pooling of these investments in order to determine the allowance, then this would be a new concept and may be counterintuitive to some when no allowance would otherwise have been required if assessed at an individual asset level. In addition, where an entity holds only one or a few investments of the same type, it remains to be seen whether a pooling approach would require a hypothetical pool of securities to be considered in determining the allowance for those individual assets.
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It is also unclear whether the FASB will develop a different impairment model for debt instruments classified and measured at fair value with changes in fair value recognized in OCI. This category is likely to include most debt securities that are not measured at fair value with changes in fair value recognized in net income. .41 Most recently in June 2011, the Boards agreed to pursue a variation of the previous approaches. Instead of splitting the portfolio into two categories as under current practice (performing and nonperforming), the new approach would divide an open portfolio into three categories: Bucket 1: Assets not affected by observable eventsThis category would consist of debt investments that have been unaffected by observable events indicating a direct relationship to a possible future default, although credit loss expectations may have changed due to macroeconomic events that are not specific to an individual asset or group of assets. An allowance for credit impairment would be a minimum of twelve months of expected losses based on initial expectations at acquisition or origination. The allowance would also include any changes in expected credit losses from those expected at acquisition or origination. Bucket 2: Assets affected by observable events (but the specific assets that will default are not identified)This category would consist of debt investments that have been affected by observable events indicating a direct relationship to a possible future default; however, the specific assets in danger of default have not yet been identified. An allowance for credit impairment would be recognized equal to the full expected lifetime losses. Since expected credit losses cannot be specifically identified for individual assets, the allowance amount would be determined at a portfolio level. Bucket 3: Individual assets expected to default or that have defaulted This category would consist of debt investments for which information is available that specifically identifies that credit losses are expected to, or have, occurred on individual assets. No default needs to have occurred for assets to be included in this category. An allowance for credit impairment would be recognized based on the full lifetime expected losses for the individual assets. PwC observation: The FASB and IASB will continue to work on refining this new approach. Some individual Board members have expressed concern that the approach for bucket 1 would be challenging for companies to implement, especially for open portfolios. In addition to determining an allowance at inception for twelve months of expected losses, the approach for bucket 1 would likely require companies to determine the expected losses over the life of the portfolio at inception in order to be able to subsequently quantify the impact of changes from those initial expectations. Constituents are likely to raise similar operational concerns as were noted on the IASB's original impairment proposal, such as how to keep track of initial expectations when loans are continually being added or removed in an open pool, or how to determine whether a subsequent change in expected losses relates to loans previously in the open portfolio or rather are due to a change in the portfolio mix as a result of adding or removing loans. Another challenge the Boards will face is clarifying when assets need to be transferred from bucket 1 to bucket 2, or whether newly originated loans could ever go directly to bucket 2.
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Hedge accounting .42 Based on constituent feedback on its December 2010 hedge accounting proposal, the IASB has begun to redeliberate its approach. The FASB also gathered constituent feedback on the IASB's approach but has deferred redeliberating hedge accounting until later in 2011. For a more detailed analysis of the IASBs hedge accounting proposal and how it compares with the FASBs May 2010 proposal, refer to In Brief 2011-06, FASB seeks comments on IASB hedge accounting proposal, and Dataline 2011-06, Accounting for hedging activities A comparison of the FASBs and IASBs proposed models. PwC observation: The IASB is working toward finalizing its general hedge accounting model in the fourth quarter of 2011. In addition, the IASB has started work on a macro hedging model designed for risk management strategies such as asset and liability management at banking institutions. As a result, similar to classification and measurement, the FASB will lag behind the IASB and may reach different conclusions in its own redeliberations than those contained in the IASB's final standard. This disconnect in timing may make it challenging for the Boards to achieve a converged solution. The Boards' respective proposals differed significantly and if they continue to prefer their respective approaches, the extent of differences between the two sets of standards would increase from what exists today. In addition, while the IASB plans to issue an exposure draft on macro hedging in the fourth quarter of 2011, the FASB currently has no plans to address this concept.
Disclosures .43 The FASB intends to develop standardized tabular disclosures about liquidity and interest rate risks arising from an entity's involvement in financial instruments. While these disclosures will likely apply to banks, insurance companies, and captive finance companies, the FASB has indicated it will need to further consider the application of these disclosures to other types of entities. Other new disclosures will also be considered, for example for situations where an entity has subsequently decided to sell financial assets that are classified and measured at amortized cost.
Questions
.44 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact a member of the Financial Instruments Team in the National Professional Services Group (1-973-2367803).
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Authored by:
Greg McGahan Partner Phone: 1-973-236-5250 Email: gregory.mcgahan@us.pwc.com Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com
Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

Accounting for hedging activities A comparison of the FASBs and IASBs proposed models
Overview
At a glance In December 2010, the IASB released for public comment an exposure draft of proposed changes to the accounting for hedging activities, resulting from the third phase of the IASB's project to revise financial instruments accounting. Comments are due by March 9, 2011. The proposed IFRS model is more principles-based than the current IASB and US GAAP models and the US GAAP proposal, and aims to simplify hedge accounting. It would also align hedge accounting more closely with the risk management activities undertaken by companies and provide decision-useful information regarding an entitys risk management strategies. The IASB plans to issue a final standard by mid-2011, with an effective date of January 1, 2013. However, the IASB recently issued a discussion paper on effective dates and transition for major projects. Its deliberations of the issues raised in the discussion paper could impact the effective date of the proposed hedge accounting guidance. The IASB's exposure draft proposes changes to the general hedge accounting model only. The macro hedge accounting principles will be addressed in a separate exposure draft, which is expected to be released in the second quarter of 2011. The FASB is planning to seek feedback from its constituents on the IASB s exposure draft. In May 2010, the FASB issued an exposure draft that proposed fundamental changes to the accounting for financial instruments, including certain changes to hedge accounting.
No. 2011-06 February 1, 2011 Whats inside: Overview .......................... 1

Key provisions .................3
Qualifying for hedge accounting ............................ 3 Discontinuation of hedging relationships ......... 6 Eligible hedged items.............. 6 Hedging instruments.............13 Presentation ...........................16 Transition and effective date ....................... 17
Questions ....................... 17
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The main details .1 The existing guidance on hedge accounting under IFRS and US GAAP is considered highly rules-based, complex, and inflexible. The detailed rules have, at times, made achieving hedge accounting difficult, even when transactions are entered into in connection with a rational risk management strategy, and costly. Users have also found that the current hedge accounting model does not adequately portray an entity's risk management activities. .2 In the FASB's and IASB's outreach efforts, an overwhelming majority of preparers and users who provided input to the boards requested a more principles-based approach that would promote closer alignment of hedge accounting with an entity's risk management strategies. In addition, users asked for better disclosures regarding an entitys risk management activities and the effectiveness of such strategies. .3 There are currently significant differences between the existing hedge accounting rules under IFRS and US GAAP. One of the objectives of the financial instruments project is to harmonize the accounting for hedging activities under both frameworks. Despite starting as a joint project, the IASB and FASB have taken fundamentally different approaches to address the feedback received during their outreach efforts. Broadly speaking, the FASB focused on selected issues to address the concerns related to complexity and inflexibility of the hedge accounting model, while the IASB undertook a more comprehensive review of its hedge accounting model. PwC observation: The two boards have so far moved in different directions on the hedge accounting project, as they have for the first two phases of the financial instruments project (i.e., classification and measurement and impairment). This may widen the gap between the hedge accounting requirements under the two frameworks. However, given the fact that the broad objective is to reach a converged standard in this area, we expect the boards will be focusing on reconciling their differences as they complete their redeliberations. .4 The FASBs exposure draft includes, but is not limited to, the following major changes: Relaxation of the rules pertaining to the assessment of hedge effectiveness by reducing the effectiveness threshold from highly effective to reasonably effective Elimination of the short-cut method and critical terms match method as techniques to assess effectiveness Recognition of hedge ineffectiveness resulting from under-hedges of cash flows Elimination of the ability to voluntarily de-designate hedging relationships For a detailed discussion of the significant changes proposed by the FASB, refer to Dataline 2010-25 dated June 10, 2010. .5 In contrast, the following fundamental changes are proposed by the IASB: Introduction of concepts of other than accidental offset and neutral and unbiased hedging relationships, which will replace the highly effective (80% to 125%) threshold as the qualifying criteria for hedge accounting Ability to designate risk components of non-financial items as hedged items
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More flexibility in hedging groups of dissimilar items (including net exposures) Accounting for the time value component as a cost of buying the protection when hedging with options in both fair value and cash flow hedges Prohibition of voluntary de-designation of the hedging relationship unless the risk management objective for such relationship changes Changes to the presentation of fair value hedges Introduction of incremental disclosure requirements to provide users with useful information on the entitys risk management practices .6 The IASBs exposure draft primarily provides guidance on the micro (one-to-one) hedging model with some guidance on hedges of groups and hedges of net positions. A separate exposure draft is expected to propose guidance and/or an alternative model for macrohedging strategies. Accordingly, this Dataline does not cover the existing IFRS and US GAAP differences related to macrohedges.
Key provisions
Qualifying for hedge accounting Qualifying for hedge accounting at inception .7 This is an area where both the IASB and FASB are proposing to significantly relax the current rules to allow more hedging relationships to qualify for hedge accounting. Currently, both frameworks require that the hedge must be expected to be highly effective (a prospective test) at inception and on an ongoing basis. Additionally, the relationship must be demonstrated to have actually been highly effective (a retrospective test) at each subsequent reporting date. Highly effective is defined as a bright line quantitative test of 80% to 125%. .8 Under the FASB's proposal, to qualify for hedge accounting, a company will need to demonstrate and document at inception that: An economic relationship exists between the derivative and the hedged item in a fair value hedge (or hedged forecasted transaction in a cash flow hedge) The changes in fair value (or cash flows) of the hedging instrument would be reasonably effective in offsetting changes in the hedged items fair value or variability in cash flows of the hedged transaction. The term reasonably effective is not defined and is open to judgment. Many constituents asked for more guidance on this threshold in their comment letters. The risk management objective of the hedging relationship and how effective the hedging instrument is in managing those risks. While this assessment needs to be performed only qualitatively, the proposal notes that a quantitative assessment may be necessary in certain situations. .9 The IASBs exposure draft also would eliminate the highly effective requirement. However, the IASB concluded that replacing highly effective with reasonably effective (as proposed by the FASB) would still result in the use of a quantitative threshold. Therefore, it introduced a concept of having other than accidental offsetting, neutrality, and an unbiased result as the qualifying criteria for hedge accounting. Hence, the hedge relationship should be such that it minimizes expected ineffectiveness, and should not reflect a deliberate mismatch between the hedged item and the hedging instrument. The
objective of the IASB is to allow greater flexibility in qualifying for hedge accounting but also to ensure that entities do not systematically under-hedge to avoid recording any ineffectiveness. This is important because the IASB has retained the current guidance that only ineffectiveness resulting from over-hedges is recorded in net income. In assessing whether the hedge relationship would minimize expected ineffectiveness, an entitys risk management function would determine the expected sources of ineffectiveness and the optimal hedge ratio. Example An entity wants to hedge a forecast purchase of 100 tons of a commodity in Location A. That commodity for delivery point Location A usually trades at about 90% of the price for the exchange-traded benchmark grade of the same commodity in Location B. If the entity wants to hedge the forecast purchase of 100 tons with exchangetraded forward contracts, then a forward contract to purchase 90 tons of the benchmark grade of the commodity in Location B would be expected to best offset the entitys exposure to changes in the cash flows for the hedged purchase. Hence, a hedge ratio of 1.11:1 would minimize expected hedge effectiveness (assuming a perfect correlation between changes in the hedged item and the changes in the hedging instrument). PwC observation: The new concepts of neutrality and unbiased result may not necessarily be viewed as simplifying the accounting for hedging activities. It may simply result in the replacement of the 80% to 125% threshold with another accounting-only measure. An alternative may be to rely on risk management policies (with a requirement to have an economic relationship between the hedged item and the hedging instrument) or require that all ineffectiveness be recorded in net income (including ineffectiveness arising from underhedging).
Maintaining the hedging relationship on an ongoing basis .10 The IASBs proposal requires an entity to determine and document the optimal hedge ratio that would result in minimizing expected hedge ineffectiveness. However, the board acknowledges that this ratio may change over time due to market conditions and other factors. In such cases, the entity would determine whether the risk management objective remains the same and the hedge relationship still meets the other qualifying criteria for hedge accounting. If so, the entity is required to rebalance the hedging relationship. .11 An entity would be required to monitor the hedging relationship to ensure that the designated hedge ratio remains optimal. If circumstances lead to a change in the optimal hedge ratio, then rebalancing would be required to minimize any expected ineffectiveness. On rebalancing, any ineffectiveness of the hedging relationship is determined and recognized immediately in net income before adjusting the hedge relationship. Fluctuations around an optimal hedge ratio cannot be minimized by adjusting the hedge ratio in response to each particular outcome. Hence, in such circumstances, the change in the extent of offset is a matter of measuring and recognizing hedge ineffectiveness (i.e., it does not result in rebalancing). Example Assume an entitys risk management function has originally determined an optimal hedge ratio of 0.9. In arriving at that ratio, the risk management function performed a regression analysis. Fluctuations in the originally determined optimal hedge ratio do not require rebalancing. However, if it is determined that there is a new trend that
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would lead away from that hedge ratio, then a new ratio would result in minimizing ineffectiveness. In such a case, rebalancing would be required. .12 Rebalancing is a continuation of the hedging relationship. That is, the hedge is not reset by de-designation and re-designation, and hence does not require setting up a new hypothetical derivative or amortization (in the case of an interest rate hedge) of an effective portion of fair value changes to net income. The IASBs proposal permits rebalancing to be effected by increasing or decreasing the volume of the hedged item or hedging instrument in the relationship. PwC observation: The risk management function may not necessarily adapt the hedging relationship to reflect an optimal hedge ratio on a regular basis. Therefore, having a requirement to rebalance will likely add unnecessary burden on the entity. This can be a cumbersome process and may be viewed as negating the objective of simplifying hedge accounting. Frequency and nature of effectiveness tests .13 The FASBs proposal would change the existing requirement to test the effectiveness on a quarterly basis to a requirement to test only if circumstances suggest that the hedging relationship may no longer be effective. The IASB, on the other hand, proposes to retain the periodic assessment criterion (at least at each reporting date or when circumstances change). However, under both proposals, the effectiveness test is only a forward-looking test (i.e., no retrospective test would be required). .14 Like the FASBs proposal, the IASBs exposure draft would allow an entity to demonstrate effectiveness qualitatively or quantitatively, depending on the characteristics of the hedging relationship. For example, in a simple hedge where all the critical terms match, a qualitative test might be sufficient. On the other hand, in highly complex hedging strategies, some type of quantitative analysis may need to be performed. Measuring ineffectiveness .15 Currently, for cash flow hedges, both frameworks require performing a lower-of test to determine the effective portion of the hedge. Only the amount of ineffectiveness related to any over-hedges (i.e., where the cumulative changes in fair value of the hedging instrument over-compensates those of the hedged item) is recorded in net income. The IASBs exposure draft has retained this lower-of test. However, under the FASBs proposal, any ineffectiveness, whether resulting from over- or under-hedges, would be recognized in earnings. A significant number of respondents to the FASB's exposure draft expressed concern over the requirement to record all ineffectiveness, whether resulting from over- or under-hedges. .16 In addition, the IASBs proposal requires that, in measuring ineffectiveness, entities should take into consideration the impact of the time value of money on the hedged item. PwC observation: The IASB staff believes that this is not a change in guidance, and hence should not have any practical implications. However, this may affect hedges involving forward contracts. Currently, in practice, many entities separate the forward points from the forward contract and designate only the spot element as the hedged risk. The spot is not discounted; hence, the impact of the timing of cash flows is ignored, which is a critical factor in rolling strategies and partial-term hedges.
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Discontinuation of hedging relationships Voluntary de-designation .17 Currently, the hedge accounting guidance under both frameworks allows an entity to voluntarily de-designate the hedging relationship. However, the proposed IASB and FASB models restrict entities from voluntarily de-designating the hedging relationships. .18 Under the FASBs proposal, an entity would only be able to discretionarily discontinue hedge accounting by entering into an offsetting derivative instrument or by selling, exercising, or terminating the derivative instrument. If an entity enters into an offsetting derivative instrument for purposes of discontinuing the hedging relationship, the derivative must be expected to fully offset future fair value changes or cash flows. In addition, the entity must concurrently document the effective termination of the hedging relationship. In such an event, neither derivative instrument could be designated as a hedging instrument in a subsequent hedging relationship. .19 In contrast, the IASB's proposal allows termination of the hedging relationship only if it is no longer viable for risk management purposes, or the hedging instrument is sold, expired, exercised, or terminated. PwC observation: This may result in the use of some commonly used strategies being discontinued for example, an entity hedging the foreign currency risk of forecasted foreign currency sales. Once the sale and the related receivable are recognized, the fair value changes of the derivative and the receivable would achieve a natural offset. Thus, it is common to discontinue hedge accounting at that point. However, under the IASB's proposal, this would no longer be possible. The FASBs proposal to remove the ability to voluntarily de-designate a hedging relationship lacked support from those who responded to the exposure draft. Whether the IASB will receive support from its constituents remains to be seen.
Eligible hedged items .20 Overall, the IASBs proposal provides greater flexibility in the designation of exposures as hedged risks. It will allow designating risk components of non-financial items and groups of dissimilar items (including net exposures) as hedged items. The following table provides a summary of the key changes introduced by the IASBs proposal and a comparison with the current and proposed US GAAP:
Hedged item Components of nonfinancial items Current and proposed US GAAP Prohibited Current IFRS Prohibited Proposed IFRS Permitted if the risk component is separately identifiable and reliably measurable Permits hedging a synthetic risk exposure
Derivatives
Derivatives cannot be designated as hedged items
Similar to US GAAP
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Hedged item Groups of similar items
Current and proposed US GAAP Permitted only if fair value change for each individual item is proportional to the overall change in the groups fair value Not permitted, except when hedging with internal derivatives in limited circumstances, as discussed in paragraph 39 below. Layers are permitted for cash flow hedges. Hedges of bottom layers or last of are not allowed.
Current IFRS Similar to US GAAP
Proposed IFRS Designation permitted without regard to the fair value changes of the individual items Permitted with certain restrictions
Groups of dissimilar items (net positions)
Not permitted
Layers, including bottom layers and layers of groups of items
Similar to US GAAP
Permits hedges of layers, including bottom layers for fair value hedges
Hedging risk components of non-financial items .21 Currently, the FASB and IASB allow hedges of components for financial items only. However, the IASB's proposal permits entities to hedge risk components for nonfinancial items, provided such components are separately identifiable and reliably measurable. This is an area of significant interest for risk management functions in nonfinancial service organizations. .22 In assessing whether a risk component of a non-financial item is eligible for designation as a hedged risk, an entity would take into consideration factors such as: The particular market structure to which the risk relates and where the hedging activity takes place Whether the risk component is a contractually specified component (where the contract entails a formula-based pricing structure (e.g., commodity A plus a margin) Example Entity A has a long-term supply contract for natural gas that is priced using a contractually specified formula that references commodities (e.g., gas oil, fuel oil) and other factors such as transportation charges. Entity A can hedge the gas oil component in the natural gas supply contract using a gas oil forward contract. Whether the risk component is implicit in the fair value or cash flows of the item (non-contractually specified risk components, for example, where the contract includes only a single price instead of a pricing formula) Example Entity A buys jet fuel for its consumption and is therefore exposed to changes in the price of jet fuel. Entity A can hedge the crude oil component of its forecast jet fuel purchases with crude oil forward contracts. Even though crude oil is not contractually specified in the pricing of the jet fuel, Entity A concludes that there is a relationship between jet fuel prices and crude oil prices. The relationship results from different refining margins that allow the entity to look at the hedging
relationship as a building block and consider itself exposed to two different risks, the crude oil price and the refining margins. PwC observation: The ability to hedge risk components will be welcomed by many companies that may not have been able to achieve hedge accounting in this area for the reasons discussed above. It will be easy to demonstrate that the risk component is separately identifiable and reliably measurable when it is contractually specified; however, this may prove more challenging outside the contractually specified area. For example, brass comprises copper, zinc, and conversion costs. An entity may wish to hedge the copper component of its fixed-price brass purchases with a copper forward contract. However, the fair value movements of the brass component may be partially offset by the fair value movements of zinc (because copper and zinc are impacted by different demand curves). This may indicate ineffectiveness that will not get measured if an entity concludes that the hedge of the copper risk component with a copper forward was perfectly effective. We believe that is an area where further outreach may be required to ensure that the principles are operational and any ineffectiveness can be appropriately measured and recorded.
Derivatives as hedged items .23 Currently, derivatives are not permitted to be designated as hedged items under both IFRS and US GAAP. The FASB's proposal would not change this. However, the IASB has proposed permitting designation of aggregate exposures resulting from a combination of a derivative and another exposure (a synthetic position). This is generally the case when entities seek to manage risk on a layering basis. Example Entity A has a USD functional currency. It entered into a 10-year fixed-rate financing denominated in EUR. At the inception of the financing, the entitys risk management objective is to have a fixed-rate exposure in its functional currency for the first three years and a floating rate exposure thereafter. Hence, the entity enters into a 10-year fixed-to-floating cross currency interest rate swap ("CCIRS") at the time the debt is issued. This would swap the fixed-rate debt with a variable-rate exposure in the functional currency of the entity. Under the proposal, the entity can hedge the combined exposure (synthetic variable debt exposure created as a combination of the fixed-rate debt with the fixed-to-floating CCIRS) with a three-year floating-to-fixed interest rate swap to have a fixed-rate exposure in USD for the first three years. Groups of items .24 Currently, IFRS and US GAAP allow hedges of groups of items only if all items within the group are subject to similar risks and if changes in the fair value of each individual item are proportional to the overall change in fair value of the group. In addition, IFRS allows a fair value hedge of interest rate risk in a portfolio of dissimilar items. The IASB is proposing significant changes in this area to provide better alignment of the accounting with risk management strategies. The FASB, on the other hand, has not proposed any changes affecting groups of items as eligible hedged items. .25 The IASB's proposal would allow hedges of: (1) groups of similar items without a requirement that the fair value change for each individual item be proportional to the overall group (e.g., hedging a portfolio of S&P 500 shares with an S&P 500 future) as well as (2) groups of offsetting exposures (e.g., exposures resulting from forecast sale and purchase transactions).
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.26 However, the IASBs exposure draft stipulates additional qualifying criteria for such hedges of offsetting exposures. These include: The group should consist of items that are eligible as hedged items on an individual basis. The items in the group are managed together for risk management purposes. In the case of a cash flow hedge of net exposures, any offsetting cash flows within the group should affect net income in the same reporting period (including, any interim reporting periods). Example Assume an entity is forecasting purchases of inventory and sales of GBP150 and GBP100, respectively. The entity will only be allowed to hedge the net exposure of 50 if both the purchases and sales are expected to affect net income in the same reporting period. PwC observation: The ability to hedge net exposures is in line with common risk management practices and would remove the need to identify specific gross cash flows (e.g., a specific amount of sales that matches the net open position), which is currently required under IFRS. However, the requirement for the hedged items in the net position to affect net income in the same period would limit the use of net position hedges. As a result, this change may not provide as much flexibility as many companies expected. .27 Further, for net position hedges the IASBs exposure draft specifies that the impact of the hedge should be reflected as a separate line within the income statement. For example, if an entity is hedging sales and cost of sales, the impact of the hedge would be shown as a separate line after the sales and cost of sales lines. Example Assume an entity with a EUR functional currency has sales of USD 100 and expenses of USD 80 (both forecasted in three months) and wants to hedge against the fluctuations in exchange rates. It hedges USD 20 with a forward contract at a rate of 1.33, accordingly locking its margin at EUR 15. The spot rate on settlement is 1.25, which gives a loss on the forward of EUR 1. The following table depicts how the proposed IFRS presentation would compare with how a similar hedge is reflected under current IFRS:
Existing accounting (Reflect the hedge impact only on the gross identified position) 79 64 15 Proposed IFRS accounting (Reflect hedge impact as a separate line) 80 64 (1) 15
Hedged item Sales Expenses Hedge result Operating profit
The presentation under current and proposed US GAAP would be similar to the existing accounting under IFRS in a hedge of a percentage of gross revenue. However, if internal derivatives are used, then a gross presentation would be allowed and the hedge impact would be reflected in each of the sales and expenses lines.
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PwC observation: Showing the hedge impact separately does not necessarily reflect the risk management strategy for the items that are hedged. Risk managers typically view all items within the net position as hedged, and hence may like to present those items at the hedged rate. However, presentation at the hedged rate would not be permitted by the IASBs proposal.
Hedges of layers .28 Currently, IFRS and US GAAP allow cash flow hedges of a proportion (percentage) or a portion (layer) of a specific item or groups of items. However, in the case of a fair value hedge, this is restricted to a proportion of specific items (including groups). If a layer approach is used, the layer should be identified in the relationship with sufficient specificity so that when the transaction occurs it is clear whether that transaction is or is not the hedged transaction. The FASB has not proposed any changes in this area. .29 The IASB, on the other hand, has proposed to permit more flexibility in this area. Hence, an entity would have the ability to enter into a fair value hedge for a percentage or a portion of the specific item or groups of items without many restrictions, such as, hedges of the bottom layer of a fixed-rate debt. However, if an item includes a prepayment option, a layer of such item is not eligible to be designated as a hedged item in a fair value hedge if the options fair value is affected by changes in the hedged risk. For example, a layer component of a prepayable debt cannot be a hedged item. Other differences .30 In addition, there are numerous other differences between existing IFRS and US GAAP related to the designation of hedged items that have not been addressed by the recent proposals. Some of the key differences are discussed below:
Hedged item Components of financial items Current and proposed US GAAP Permitted for benchmark interest rate, credit risk, and foreign exchange risk. Benchmark is restricted to US government borrowing rates and LIBOR. Not permitted Current and proposed IFRS Permitted; definition of benchmark is not restricted
Partial-term hedging (fair value hedges) Hedging more than one risk with a single derivative Hedges of intragroup royalty
Permitted
Not permitted, except for basis swaps Permitted
Permitted
Permitted only if the royalty payments are linked to an external transaction
Hedging risk components of financial items .31 IFRS permits any risk components of financial instruments to be eligible hedged items, provided the types of risk are separately identifiable and reliably measurable. In contrast, current (and proposed) US GAAP specifies that the designated risk must be the changes in one of the following: (1) overall fair value or cash flows, (2) benchmark interest rates, explicitly limited to specified benchmark interest rates (interest rate on
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treasury obligations of the US federal government or LIBOR in the United States and comparable rates for non-US instruments), (3) foreign currency exchange rates, or (4) credit risk. Additionally, practice has developed in the United States such that measurement of benchmark interest rates is very restrictive. The IFRS model is therefore already more flexible in this area than US GAAP. .32 The calculation of ineffectiveness also differs in this area between IFRS and US GAAP. For example, when hedging a fixed-rate debt for changes in benchmark interest rate, US GAAP (existing and proposed) requires that the fair value of the hedged item be determined using the contractual interest rate. This results in ineffectiveness recorded in income. IFRS, on the other hand, allows using the swap rate for calculating the fair value of the hedged risk. This difference is illustrated in the following example: Example Assume an entity issues a fixed-rate debt instrument at 7%. The swap rate on a receive fix-pay LIBOR swap is 5% at issuance date. The entity designates the swap as a hedging instrument in a fair value hedge of changes in LIBOR in the fixed-rate debt. Under IFRS, the designated hedged risk is the swap rate of 5%; therefore, effectiveness is assessed, and ineffectiveness is measured, with reference to the 5% portion of the total 7% fixed rate. Under US GAAP, the cash flows used to calculate ineffectiveness must be based on the contractual cash flows of the entire hedged item (unless the shortcut method is used). Therefore, while the designated risk is a benchmark interest rate, effectiveness is assessed and ineffectiveness is measured with reference to the contractual 7% fixed rate; as such, ineffectiveness will arise. .33 A significant number of respondents to the FASB's financial instruments exposure draft expressed concern that the definition of "benchmark" is very restrictive. Respondents requested that the FASB expand the definition, especially in light of the fact that the short-cut method would be eliminated. Partial term hedging .34 IFRS is more permissive than US GAAP with respect to a partial-term fair value hedging relationship. It permits designating a derivative as hedging only a portion of the time period to maturity of a hedged item, if effectiveness can be measured reliably and the other hedge accounting criteria are met. Example Entity A acquires a 10%, fixed-rate government bond with a remaining term to maturity of 10 years. Entity A classifies the bond as available for sale. To hedge itself against fair value exposure on the bond associated with the first five years of interest payments, Entity A acquires a five-year, pay-fixed/receive-floating swap. The swap may be designated as hedging: The fair value exposure of the interest rate payments for five years The change in value of the principal payment due at maturity to the extent affected by changes in the yield curve relating to the five years of the swap In other words, IFRS allows imputing a five-year bond from the actual 10-year bond. US GAAP does not permit defining the hedged risk in a similar way.
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Hedging multiple risks with a single hedging instrument .35 IFRS allows a single hedging instrument to be designated as a hedge for more than one type of risk, provided that: The risks hedged can be identified clearly The effectiveness of the hedge can be demonstrated It is possible to ensure that there is specific designation of the hedging instrument and different risk positions Accordingly, under IFRS, a single derivative may be separated into two components by inserting (hypothetical) equal and offsetting legs, provided that they are denominated in the entitys own functional currency. US GAAP, however, does not permit creation of hypothetical components in a hedging instrument, and hence does not allow such a hedging strategy (except in a cash flow hedge using a basis swap). The following example illustrates a situation in which hedge accounting would be permitted under IFRS but not under US GAAP. Example Entity As functional currency is EUR, and it wishes to hedge the following two items with one swap as the hedging instrument: Hedged items: (1) 10-year, 5%, fixed-rate USD borrowing and (2) 10-year, sixmonth LIBOR + 80 bp loan receivable denominated in Swiss francs (CHF). Hedging instrument: 10-year cross-currency interest rate swap (CCIRS) under which Entity A will receive fixed interest in USD and pay variable interest in CHF at six months LIBOR (the rate representing a six-month interbank deposit in CHF). For IFRS, a single swap may be separated by imputing hypothetical equal and offsetting legs. These legs may be fixed or floating, provided either one of the alternatives qualifies for hedge accounting. In addition, IFRS does not necessarily require the two hedge relationships to be of the same type; as such, an entity could have two different hedge relationships (i.e., a cash flow and a fair value hedge). In this example, the original CCIRS may be separated in either of two ways:
Hedging instrument Hedged item Hedge type
ALTERNATIVE A: INSERT EUR FLOATING LEGS TO THE SWAP Receive fixed USD/pay floating EUR Receive floating EUR/pay floating CHF Currency and interest rate risk on USD debt Currency risk of CHF loan receivable Fair value hedge of interest rate and currency risk Cash flow hedge of currency risk
ALTERNATIVE B: INSERT EUR FIXED LEGS TO THE SWAP Receive fixed USD/pay fixed EUR Receive fixed EUR/pay floating CHF Currency risk on USD debt Currency and interest rate risk of CHF receivable Cash flow hedge of currency risk Cash flow hedge of interest and foreign currency risk
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Hedging intragroup royalty .36 Under current US GAAP, forecasted intragroup royalty payments are sometimes hedged in cash flow hedge relationships. While the FASB proposal issued in 2008 had proposed some changes in this area, the financial instruments exposure draft issued in May 2010 did not include any changes. IFRS is currently viewed as more restrictive in allowing such a hedging relationship. Under IFRS, forecasted intragroup royalty payments are not allowed to be designated as hedged items unless there is a related external transaction. The IASBs proposal carries forward this guidance without any changes. .37 This is a significant difference between the proposed IFRS and the practice that has developed in the United States. The FASBs 2008 exposure draft, which was viewed by many as potentially limiting the ability to hedge forecasted intragroup royalties, did not receive support from the respondents. Hedging instruments .38 The IASB's proposal entails allowing cash instruments, which are classified at fair value with changes in fair value recognized in net income (referred to in IFRS as fair value through profit or loss), to be eligible for hedging different types of risks. Currently, under IFRS, cash instruments are restricted to the hedges of foreign exchange exposures only. In addition, the IASB's exposure draft includes significant changes to the accounting for the time value of options. These proposals are discussed in more detail in the following table:
Instrument Cash instruments Current and proposed US GAAP Current IFRS Proposed IFRS Instruments classified at fair value through profit or loss are permitted to be used as hedging instruments for all types of risks. Debt instruments classified at amortized cost can be hedging instruments for foreign exchange risk only. Implications Proposed IFRS allows greater flexibility in designating cash instruments as hedging instruments
Permitted only for Permitted for hedging foreign hedging foreign exchange risk in exchange risk limited circumstances
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Instrument Embedded derivatives
Current and proposed US GAAP Permitted under current US GAAP if embedded derivative is bifurcated Not permitted for hybrid financial instruments under proposed US GAAP (since embedded derivatives are no longer bifurcated from financial hosts)
Current IFRS Similar to current US GAAP
Proposed IFRS Not permitted for embedded derivatives in hybrid financial assets under IFRS 9 (since they are no longer bifurcated)
Implications This change results from the proposed amendments to the classification and measurement of financial instruments. Under current IFRS, embedded derivatives bifurcated from hybrid financial liabilities can still be designated as hedging instruments. Embedded derivatives bifurcated from non-financial hosts would also remain eligible as hedging instruments.
Options
Current US GAAP permits time value for certain qualifying cash flow hedge relationships to be deferred in OCI and subsequently released into net income. Proposed US GAAP is similar to current guidance, except that it requires amortization of the time value component over the life of the hedging relationship.
The time value component of an option is marked to market through net income, resulting in income statement volatility.
Any time value paid is treated similar to an insurance premium for both fair value and cash flow hedges.
Proposed IFRS may yield a comparable result to the current US GAAP treatment for several transactions. However, the Accounting for the proposed IFRS premium depends model would apply on whether the to fair value and hedged item is cash flow hedge transaction or relationships time related. (proposed and current US GAAP Subsequent models are limited changes in time to certain cash flow value are hedge relationships deferred in OCI. only).
Internal derivatives
Permitted for foreign Not permitted exchange risk only in limited circumstances
Not permitted
Current US GAAP is more flexible in this area. The IASBs proposal does not include any changes in this area.
Dataline 14
Accounting for the time value of options .39 Under US GAAP for certain qualifying cash flow hedge relationships, the time value component of a purchased option can be deferred in OCI and subsequently released to net income when the hedged item affects net income. The FASB proposal would require that such changes be taken to income rationally over the term of the hedging relationship. .40 Currently, IFRS allows only the intrinsic value of the option to be designated as the hedging instrument, while the time value is marked to market through net income. The IASBs proposal introduces significant changes to the guidance related to the accounting for the time value of options. It analogizes the time value to an insurance premium. Hence, the time value would be recorded as an asset on Day 1 and then released to net income based on the type of item the option hedges. For example, if the hedge is for a forecasted purchase of inventory (i.e., it is transaction related), the option premium would be recognized in income when the hedged item affects net income. However, if the entity is using options to cap interest payments on a debt instrument, the premium would be recognized in earnings on a time proportion basis (time related). Any changes in the fair value of the option attributable to the time value would be recorded in OCI (along with changes in intrinsic value). The proposed IFRS treatment would also apply to fair value hedges. PwC observation: Overall this will be a welcome change for many IFRS preparers, and may result in an increased usage of purchased options in hedge accounting since the income statement volatility of the time value can now be avoided. However, prescribing two different methods to record the initial option premium may introduce unnecessary complexity. Another approach could be to require recognition of such premium in net income when the hedged item affects net income, rather than based on the type of hedging relationship. This approach would be consistent with the current US GAAP model for cash flow hedges.
Internal derivatives .41 Under current and proposed IFRS, only instruments that involve a party external to the reporting entity can be designated as hedging instruments. As internal derivative contracts are eliminated in consolidation, they do not qualify under IFRS for hedge accounting in the groups consolidated financial statements. The restrictions under IFRS compel entities to either: Enter into separate third-party hedging instruments for the gross amount of foreign currency exposures in a single currency rather than on a net basis (as a typical treasury center would do to hedge group exposure) Enter into hedging instruments with third parties on a net basis and designate such contracts as a hedge of a portion of one of the gross exposures The gross approach may not be desirable given the cost of entering into multiple external derivative contracts. The IASB is not proposing any changes in this area. .42 Similar to IFRS, US GAAP generally permits only those instruments that involve an unrelated external party to be eligible as hedging instruments. However, US GAAP permits internal derivatives in cash flow hedges of foreign currency risk if certain conditions are met. These include: All the criteria for hedge accounting are met by the entity with the hedged exposure
Dataline 15
The treasury center must either: (a) Enter into a derivative contract with an unrelated third party to offset the exposure that results from the internal derivative, or (b) If certain additional conditions are met, enter into derivative contracts with unrelated third parties that would offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivative contracts PwC observation: The issue was discussed by the IASB while developing the exposure draft; however, the board decided not to allow internal derivatives to be used as hedging instruments because these do not mitigate the risks of the consolidated group. Additionally, the board believes that changes in the guidance related to net positions will, in part, help the issues that treasury centers may face from not having the ability to use internal derivatives.
Presentation Fair value hedges .43 Currently, both IFRS and US GAAP require a basis adjustment to the hedged item for changes in fair value attributable to the hedged risk. This results in the measurement of the hedged item on a basis that neither represents fair value nor amortized cost (unless the hedge is designated as hedging the total changes in fair value of the hedged item). The FASB has not proposed any changes to these requirements. However, the IASB proposal would remove the requirement to adjust the basis of the hedged item. Instead, fair value changes attributable to the hedged risk would be presented as a separate line item in the balance sheet. A corresponding entry would be recorded in OCI on a gross basis. Any ineffectiveness in the hedging relationship would then be recycled to net income. Example Assume an entity has a fair value hedge of foreign exchange risk in a firm commitment to purchase machinery from a UK supplier. The fair value change on the forward contract to hedge the purchase is USD 60, whereas the fair value change on the hedged item related to the hedged risk is USD 50. Currently, under both IFRS and US GAAP, the fair value movements on the hedged risk and hedging instrument are reflected in the income statement. Additionally, there is a basis adjustment of 50, which would affect the hedged item. The following presentation would be required under the IASB proposal:
Dataline 16
Balance sheet (extract) Assets Machinery Basis adjustment (separate line) Liabilities Derivative liability Other comprehensive income Changes in fair value of hedging derivative Changes in fair value of hedged item Ineffective portion transferred to net income Income statement Ineffective portion of FV hedge
50
Debit
60
Credit
(60) 50 10
Debit Credit Credit
(10)
Debit
Mandatory basis adjustment Cash flow hedges .44 In addition, for hedges of forecasted purchases of non-financial assets (e.g., a depreciable asset), the IASB has proposed a mandatory basis adjustment of the hedged item once it is recognized. Accordingly, fair value changes of the hedging instrument deferred in OCI would be adjusted against the value of the hedged item on its initial recognition. Currently, IFRS provides a choice to adjust the basis of the hedged item or continue to defer the fair value changes in equity and release them to net income when the hedged item affects net income. Current and proposed US GAAP prohibits adjusting the basis of the hedged item and requires the fair value changes deferred in OCI to be released out of OCI. Example Assume that an entity is hedging the foreign currency risk in the forecasted purchase of machinery using a forward contract. There is a cumulative gain of 100 on the derivative deferred in equity at the date the machinery is purchased. If the price paid for the forecasted purchase of machinery is 500, the initial amount recognized on the balance sheet under current IFRS will be 400 (500 less 100) when the basis adjustment policy is elected. Under the proposed IFRS model, the machinery would be recorded at 400 (mandatory basis adjustment). Under the current and proposed US GAAP, the machinery must be recognized at 500 with the 100 gain deferred in equity and released to net income when the hedged item affects net income. Transition and effective date .45 The IASB has proposed that the new requirements be applied prospectively for accounting periods beginning on or after January 1, 2013, with earlier application permitted. The FASBs proposal also requires prospective application but does not specify an effective date. It is also pertinent to note that both boards have issued discussion papers on effective dates and transition for their major projects. Their deliberations of the issues raised in those discussion papers could impact the effective date of the proposed hedge accounting guidance.
Questions
.46 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).
Dataline 17
Authored by:
Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Naveed Rafique Director Phone: 1-973-236-4019 Email: naveed.rafique@us.pwc.com Steve Halterman Director Phone: 1-973-236-4179 Email: steven.g.halterman@us.pwc.com John Liang Director Phone: 1-973-236-5618 Email: john.liang@us.pwc.com
Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. [FP120610] To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.
DataLine
A look at current financial reporting issues PricewaterhouseCoopers 201034 August 26, 2010
Changes to Financial Instruments Accounting

Impacts for Nonfinancial Services Companies
What's inside:
Overview ............................. 1
At a glance ................................ 1 The main details........................ 1
Overview
At a glance
The FASB's proposal to change the accounting for financial instruments and hedge accounting could have broad implications to companies across all industries, including those in commercial and industrial industries. The proposed changes could result in a significant expansion of the use of fair value. Such changes would require greater valuation expertise and result in increased earnings volatility in many cases. Common instruments including investments in equity and debt instruments, accounts receivable and issuances of convertible debt, among others, would be affected. Companies should consider evaluating the impacts of the proposed changes now and consider responding to the FASB on this very important proposal.
Key provisions ..................... 1

Investments in equity instruments ............................. 1 Equity method of accounting .............................. 2 Investments in debt instruments ............................. 2 Accounts receivable factoring .................................. 3 Issued convertible debt ............. 3 Embedded derivatives............... 3 Hedge accounting ..................... 4
Next steps............................ 4 Questions ............................ 4
The main details

.1 On May 26, 2010, the FASB issued a proposed Accounting Standards Update (ASU), Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, setting out a new comprehensive approach to financial instruments classification, measurement, and impairment and proposing revisions to hedge accounting. .2 While the effects of the proposal on the financial industry are wide-ranging, its impact to the corporate community (i.e., nonfinancial services companies) is broader than the changes to hedge accounting and should not be overlooked.
Key provisions
.3 Following are a few of the more common instruments and transactions that could be affected if the proposed ASU is adopted in its current form.
Investments in equity instruments

.4 Today, investments in equity instruments that do not result in consolidation of the investee can be accounted for under one of four models: Fair value through earnings Fair value through other comprehensive income (OCI)
National Professional Services Group CFOdirect Networkhttp://www.cfodirect.pwc.com
1 PricewaterhouseCoopers LLP
DataLine 2010-34
The cost method The equity method .5 Under the proposed model, companies with investments in equity instruments, including equity investments in private companies, options to purchase private company shares, and mutual funds, will be required to account for such investments at fair value with changes in fair value recorded in current period earnings, unless an investment qualifies for the equity method of accounting (see below). This will result in (1) a greater need for valuation expertise since many of these investments may have previously been carried at cost, (2) timely valuations since fair values will need to be reflected in each interim and annual set of financial statements, and (3) greater earnings volatility since the changes in the fair value of these investments will be recorded in earnings. .6 For companies with equity investments in private companies this may prove to be particularly challenging both from an accounting and operational perspective.
Equity method of accounting

.7 The equity method of accounting is currently appropriate for investments in common stock or in-substance common stock where the investor has significant influence over the investee. It is also applicable to investments in partnerships where the investor's influence is considered more than "minor." .8 The proposed model will limit the use of the equity method to investments over which the investor has significant influence and where operations of the investee are considered related to the investor's consolidated operations. The proposed ASU provides factors to consider in determining whether operations of an investee are considered "related to the investor's consolidated operations." These factors may not capture certain investments considered by preparers of financial statements to be related to the consolidated operations or strategic. The addition of this criterion will reduce the number of investments that currently qualify for equity method treatment. .9 Equity investments no longer qualifying for equity method treatment will be required to be recorded at fair value with changes in fair value recorded in current period earnings. This may be particularly challenging from an operational perspective since the fair value information will need to be available on a quarterly basis (the 90-day lag period currently available for the equity method of accounting will not be available).
Investments in debt instruments

.10 Investments in debt instruments will be required to be recorded at fair value through earnings unless certain criteria are met. One of these criteria requires that an entity's business strategy be to hold the debt instrument for collection of contractual cash flows rather than to sell the instrument to a third party. This would be determined based on how an entity manages its portfolio of debt instruments rather than its intended use of a specific debt instrument. .11 To meet this criterion, an entity's business strategy would need to be to hold instruments within the portfolio for a significant portion of their contractual terms. Companies therefore need to carefully review their debt portfolios to determine whether or not they meet the business strategy criterion. If the business strategy criterion is not met, portfolios of debt instruments currently accounted for as available-for-sale will need to be recorded at fair value through earnings creating additional earnings volatility. Many corporate treasury groups manage portfolios of debt securities representing investments of excess cash. The business
DataLine 2010-34
strategy of these portfolios is to support the general liquidity needs of the company. As a result, purchases and sales of instruments in the portfolio may occur in shorter time frames than the holding periods currently contemplated in the FASB's requirements for OCI treatment. .12 For debt portfolios that do qualify for the fair value through OCI treatment, companies will need to review their current impairment processes, since the proposal also changes the impairment triggers and the measurement of impairment for debt instruments.
Accounts receivable factoring

.13 Many companies choose to factor their receivables for liquidity or other purposes. Under the proposed guidance, in order for accounts receivable to be recorded at the invoiced amount (as opposed to fair value through earnings), they must meet a number of criteria, one of which is that the business strategy be to hold the accounts receivable for collection of the contractual cash flows. .14 If companies plan to factor their receivables, it may not be possible to assert that the business strategy is to hold them for collection. These receivables may therefore have to be fair valued with changes recorded in earnings. Besides increasing the use of fair value measurement, the proposal will also create operational challenges as many companies may not know at inception which portfolios of receivables will be factored.
Issued convertible debt

.15 Under the proposal, many issued convertible debt instruments will need to be recorded at fair value with changes in fair value recorded in earnings. Convertible debt instruments would generally not be eligible for the fair value through OCI treatment because the convertible debt instrument could be settled in a manner where the investor does not simply receive a stated amount upon settlement (i.e., if the investor chooses to convert, the instrument would be settled through the issuance of shares with an uncertain value). This means earnings volatility driven by movements in interest rates, the entity's share price and the entity's own credit. It will also result in a greater need for valuation expertise and the performance of timely valuations since fair values will need to be reflected in each interim and annual set of financial statements. .16 We believe that under the proposed model, only the liability component of a convertible debt instrument known as "Instrument C" could qualify for either the fair value through OCI treatment or amortized cost. Instrument C is an instrument where the par amount is required to be settled in cash, and only the conversion spread is settled in cash or shares. As a result, companies should review the terms and conditions of their convertible debt issuances.
Embedded derivatives
.17 Under the proposed guidance, hybrid financial instruments with embedded derivatives that are bifurcated under current guidance will be required to be recorded at fair value through earnings in their entirety, regardless of the value of the embedded derivative. No longer will the host contract be recorded separately at the value(s) prescribed by other accounting guidance (e.g., at amortized cost). .18 Currently, some companies may not bifurcate certain hybrid financial instruments containing an embedded derivative if the embedded derivative has only nominal value and is considered immaterial to the financial statements. Because the proposal requires fair value through earning treatment regardless of the value of the embedded derivative, companies will
DataLine 2010-34
need to carefully review their financial assets and liabilities to determine whether they contain embedded derivatives, even nominal ones. .19 The presence of embedded derivatives in these hybrid financial instruments will result in (1) a greater need for valuation expertise since the entire hybrid instrument (host plus embedded derivative) will now need to be fair valued, (2) a need for timely valuations since the fair values of these instruments will be reflected in each interim and annual set of financial statements, and (3) greater earnings volatility since the changes in fair value of the entire instrument will now be recorded in earnings. .20 This requirement does not affect non-financial contracts (e.g., executory contracts).
Hedge accounting
.21 Under the proposal, the current requirement to quantitatively assess hedge effectiveness each quarter will be replaced with a qualitative assessment at inception and a limited need for reassessment in subsequent periods. Additionally, the proposed model lowers the threshold to qualify for hedge accounting. The hedging relationship now must be "reasonably effective" instead of "highly effective." The proposed model also (1) eliminates the shortcut and critical-terms match methods for assessing hedge effectiveness, (2) prohibits the discretionary de-designation of hedging relationships (unless the derivative exposure is terminated), (3) requires the recognition of the ineffectiveness associated with both over- and under-hedges for all cash flow hedging relationships, and (4) requires the amortization of the cost of a purchased option used as a hedging instrument. .22 In many circumstances, these changes will make it easier to establish and maintain hedging relationships. The proposal may be an opportunity for companies to revisit hedging strategies since some strategies that may not have been highly effective in the past may now meet the "reasonably effective" threshold. However, the requirement to measure and record all ineffectiveness may be more onerous depending on what method of hedge accounting a company is currently employing. Companies currently using shortcut or critical-terms match will need to establish processes to determine the effectiveness of these relationships and record the ineffectiveness of the relationships in earnings.
Next steps
.23 This DataLine was designed to highlight some, but not all, of the potential impacts of the FASB's financial instrument proposal on non-financial services companies. The proposal is complex and will undoubtedly be subject to interpretation upon issuance. For more information on the proposed ASU see DataLine 2010-25. .24 Companies should read the proposed ASU and become familiar with its requirements. Accounting policy and financial reporting groups should begin discussions with the different business units in the organization to assist with an impact analysis. Based upon the results of this analysis, companies should consider commenting on the proposal to the FASB. The comment letter period ends on September 30, 2010.
Questions
.25 PwC clients who have questions about this DataLine should contact their engagement partner. Engagement teams that have questions should contact a member of the Financial Instruments Team in the National Professional Services Group (1-973-236-7803).
DataLine 2010-34
Authored by:
Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com Mark Solak Senior Manager Phone: 1-973-236-4351 Email: mark.w.solak@us.pwc.com
DataLines address current financial-reporting issues and are prepared by the National Professional Services Group of PricewaterhouseCoopers LLP. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2010 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate legal entity. To access additional content on accounting and reporting issues, register for CFOdirect Network (http://www.cfodirect.pwc.com), PricewaterhouseCoopers' online resource for senior financial executives.
US GAAP Convergence & IFRS Revenue recognition

Boards conclude redeliberations on key revenue measurement and recognition issues
What's new?
The FASB and IASB (the boards) reached decisions at their December meeting on allocating the transaction price to separate performance obligations, applying the proposed model to bundled arrangements, constraining the cumulative amount of revenue recognized on licenses, and accounting for contract acquisition costs. The boards decisions are tentative and subject to change. Other key issues still to be redeliberated include scope, disclosures, transition and certain industry specific matters.
No. 2012-58 December 18, 2012
What were the key decisions?

Allocating the transaction price use of the residual approach The boards decided to retain the proposals in the 2011 exposure draft relating to the use of a residual approach to estimate the standalone selling price of a performance obligation. They clarified that this approach can also be used when two or more performance obligations in a contract have standalone selling prices that are highly variable or uncertain. The boards also clarified that when two or more performance obligations have standalone selling prices that are highly variable or uncertain, the transaction price should first be allocated to the performance obligations for which standalone selling prices are determinable. The remaining (residual) transaction price should be allocated between the other performance obligations using another method of estimation. The 2011 exposure draft includes guidance on when discounts and variable consideration in an arrangement should be allocated to specific performance obligations. The boards clarified that discounts or variable consideration should first be allocated to one or more specific performance obligations using that guidance. The entity would then use a residual approach to estimate the standalone selling price of any other performance obligations. Bundled arrangements The boards retained the proposed guidance in the 2011 exposure draft for allocating the transaction price to distinct performance obligations. They confirmed that the proposed guidance can be applied to a portfolio of contracts or to performance obligations with similar characteristics, if the entity expects that doing so would not result in materially
In brief
different outcomes from applying the guidance to an individual contract or performance obligation. The boards decided not to provide an exception or practical expedient in response to the concerns expressed by the telecommunication industry on the practical challenges of applying the proposed revenue recognition model to a large portfolio of contracts with multiple deliverables. The boards were concerned that doing so would be inconsistent with the objectives of the overall revenue recognition model. Constraining the cumulative amount of revenue recognized licenses The boards decided to remove the specific exception in the 2011 exposure draft that constrained revenue from licenses of intellectual property where payments vary based on the customers subsequent sales (for example, a sales-based royalty). They agreed that when consideration is highly susceptible to factors outside the entity's influence, the entity's experience for determining the transaction price might not be predictive. Highly susceptible factors could include actions of third parties, such as sales by an entity's customers. The boards will enhance the guidance to clarify this point, and that the underlying principle applies to all contracts with customers. Contract acquisition costs The boards decided to retain the guidance in the 2011 exposure draft requiring capitalization of contract acquisition costs if they are incremental and the entity expects to recover the costs. An entity may elect, as a practical expedient, to record these costs as an expense when incurred if the amortization period of the asset is one year or less. The boards considered alternatives, including expensing all contract acquisition costs or allowing a policy choice to expense or recognize contract acquisition costs as an asset. They concluded that the guidance in the 2011 exposure draft is consistent with the decisions reached to date for the leasing, insurance and financial instruments projects, and the practical expedient would minimize implementation issues.
Convergence is expected for revenue recognition, as the same principles will be applied to similar transactions under both U.S. GAAP and IFRS. Differences might continue to exist to the extent that the guidance requires management to refer to other standards before applying the guidance in the revenue standard.
Who's affected?
The proposal will affect most entities that apply U.S. GAAP or IFRS. Entities that currently follow industry-specific guidance should expect the greatest impact.
Whats the proposed effective date?

We anticipate the final standard to have an effective date no earlier than 2015.
What's next?
The boards timeline indicates issuance of a final standard in the first half of 2013. They are expected to finalize their redeliberations over the next few months and perform targeted outreach on some of the more significant changes.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377).
Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com Michelle Mulvey Senior Manager Phone: 1-973-236-7272 Email: michelle.l.mulvey@us.pwc.com

Boards make decisions on several major outstanding revenue issues
What's new?
The FASB and IASB (the boards) reached decisions on when revenue from variable consideration should be recognized, presentation of amounts not expected to be collected and licenses at their November meeting on revenue recognition. The boards decisions are tentative and subject to change. Other key issues still to be redeliberated include allocation of transaction price, contract costs, disclosures, and transition.
No. 2012-54 November 20, 2012

Constraint on recognizing revenue from variable consideration The boards agreed to clarify the objective of the constraint on when revenue from variable consideration should be recognized. An entity should recognize revenue as performance obligations are satisfied only up to the amount that the entity is confident will not be subject to significant reversal in the future. An entity should assess its experience with similar types of performance obligations and determine whether, based on that experience, the entity does not expect a significant reversal in future periods in the cumulative amount of revenue recognized. The boards decided to retain the indicators included in the 2011 exposure draft as to when the constraint should apply. The boards decided to apply the constraint to the measurement of the transaction price, as proposed in the 2010 exposure draft. This will constrain the recognition of revenue from variable consideration through the determination of the transaction price rather than creating a separate constraint on the amount recognized subsequent to allocating the transaction price. The boards expect that the amount and timing of revenue recognized should be the same regardless of where the constraint is applied, but asked the staff to consider any unintended consequences of this change. Collectibility The boards agreed that an entity should present any initial and subsequent impairment of customer receivables, to the extent material, as an expense in a separate line item in the statement of comprehensive income. The line should be presented below gross margin, as opposed to a line item adjacent to revenue as proposed in the 2011 exposure draft. The amount cannot be disclosed in the notes to the financial statements rather than being presented on the face of the statement of comprehensive income. This
In brief
decision would apply to all contracts with customers, whether or not they contain a significant financing component. The boards confirmed the proposals in the 2011 exposure draft that collectibility should not be a threshold for recognition of revenue, as this is not consistent with the controlbased model proposed by the boards. Licenses The boards decided that in some cases a license is a promise to provide a right, which transfers to the customer at a point in time, and in other cases a license is a promise to provide access to an entity's intellectual property, which transfers benefits to the customer over time. Indicators will be provided to help determine the accounting depending on the nature of the license and the commercial substance of the agreement. The boards began with divergent views on whether revenue from the transfer of a license should be recognized at a point in time or over time. The agreed approach outlined above is a compromise by the boards in which they acknowledged there might not be a "one size fits all" approach to accounting for licenses. The boards requested that the indicators provide guidance as to when a license transfers at a point in time or when it provides access. They also commented that the guidance needs to be operational and result in consistent accounting for similar transactions. Board members acknowledged this might be difficult to achieve.
Who's affected?

What's next?
The boards timeline indicates issuance of a final standard in the first half of 2013. They are expected to continue their redeliberations over the next few months and perform targeted outreach on some of the more significant changes.
Questions?
In brief
Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com

No. 2012-15 October 24, 2012 Whats inside: Overview .......................... 1
At a glance ...............................1 Background .............................1
Revenue from contracts with customers The redeliberations continue

Overview
At a glance
Current developments ....2

Constraining revenue recognition for variable consideration ....................... 2 Collectibility ............................ 5 Time value of money .............. 7 Contract combinations for distributor and reseller arrangements ......... 9 Contract modifications......... 10 Measuring progress toward satisfying a performance obligation ...... 11
The FASB and IASB (the boards) met in September and October 2012 to continue redeliberating their joint revenue recognition project. The boards reached tentative decisions on the constraint for recognizing variable consideration, certain issues related to collectibility, time value of money, distributor and reseller arrangements, contract modifications, and measuring progress toward satisfying a performance obligation. The boards asked their staff to perform additional analysis on the constraint on recognizing revenue from variable consideration and on the presentation of impairment losses on receivables, which will be discussed at a future meeting. Other key issues still to be redeliberated include licenses, allocation of transaction price, disclosures, and transition. The boards currently plan to complete all major redeliberations by the end of 2012. A final standard is planned for the first half of 2013 with an effective date no earlier than January 1, 2015. Full retrospective application, with certain reliefs, will be required unless the boards change their current position. The boards plan to redeliberate transition at a future meeting.
Next steps ....................... 14 Questions ....................... 15 Appendix Redeliberation decisions to date ......... 16
Background .1 The boards issued a revised exposure draft on revenue recognition in November 2011 (the 2011 exposure draft). They decided to re-expose the proposed standard to avoid unintended consequences. Refer to Dataline 2011-35, Revenue from contracts with customers: The proposed revenue standard is re-exposed, for a detailed discussion of the proposed guidance, and Dataline 2012-04, Responses are in on the re-exposed proposed revenue standard, for a discussion of the feedback received in comment letters and roundtables.
Dataline
.2 The boards made tentative decisions at their July meeting to refine the criteria for identifying separate performance obligations, clarify the criteria for when a performance obligation is satisfied over time, and eliminate the onerous performance obligation assessment from the proposed revenue standard. The boards also discussed the accounting for licenses, but they did not reach any decisions and plan to revisit the topic at a future meeting. Tentative decisions reached at this meeting are discussed in Dataline 2012-07, Revenue from contracts with customers Ready, set, redeliberate. The Appendix to this Dataline summarizes the boards' tentative decisions to date since July and compares them to the 2011 exposure draft. .3 This Dataline summarizes the boards redeliberations and tentative decisions made at the September and October joint meetings and the potential implications for certain industries. These decisions are tentative and subject to change until a final standard is issued.
Current developments
.4 The boards' redeliberations in September and October focused on enhancing and clarifying the proposed guidance in certain areas and suggesting implementation guidance in others. The following topics were discussed:

The constraint on revenue recognition for variable consideration Guidance on collectibility and presentation of impairment losses Accounting for time value of money Accounting for distributor and reseller arrangements Guidance on contract modifications Measuring progress toward satisfying a performance obligation
Constraining revenue recognition for variable consideration .5 The 2011 exposure draft provides guidance on the accounting for consideration that is variable or contingent on the outcome of future events (for example, discounts, incentives, and royalties). An estimate of variable consideration is included in the transaction price and allocated to separate performance obligations. Variable consideration is recognized as revenue when an entity is reasonably assured to be entitled to that amount. Predictive experience with similar performance obligations is needed for an entity to be reasonably assured that it will be entitled to that consideration. .6 Judgment is needed to assess whether an entity has predictive experience about the outcome of a contract. The following indicators might suggest an entity's experience is not sufficiently predictive of the outcome of a contract:
The amount of consideration is highly susceptible to factors outside the influence of the entity The uncertainty about the amount of consideration is not expected to be resolved for a long period of time The entity's experience with similar types of contracts is limited The contract has a large number and broad range of possible consideration amounts
Dataline
.7 The 2011 exposure draft also includes an exception to this principle for certain transactions. An entity that licenses intellectual property in exchange for royalties based on the customer's subsequent sales of a good or service is not reasonably assured to be entitled to the royalty payment until those future sales occur. .8 Respondents generally support constraining revenue recognition on variable consideration if there is not sufficient evidence to support its recognition. It is unclear to some respondents whether reasonably assured is intended to be a quantitative or a qualitative threshold. Others raised concerns about the level of evidence needed when considering reasonably assured as a threshold. The term reasonably assured is currently used as a quantitative probability threshold under IFRS and U.S. GAAP, but with different meanings, which also caused confusion among respondents. Tentative decisions .9 The boards agreed to clarify the guidance for recognizing revenue on variable consideration. An entity will recognize variable consideration as revenue when it has experience with similar types of performance obligations and this experience is predictive, consistent with the 2011 exposure draft. .10 The boards agreed to clarify when an arrangement contains variable consideration. The revenue recognition constraint applies to contracts with a variable price as well as contracts with a fixed price if it is uncertain whether the entity will be entitled to all of the consideration even after the performance obligation is satisfied (for example, specified performance bonuses that are only paid if certain criteria are met). .11 The boards agreed to remove the term reasonably assured to address the confusion highlighted by constituents. The removal of the term is not expected to affect the constraint on revenue recognition, which will focus on whether the entity has predictive experience to determine the amounts to which it expects to be entitled. .12 The boards discussed potential refinements to the guidance for determining when an entity's experience is predictive. The boards staff proposed three alternatives for discussion, but did not suggest making a decision. The three alternatives were:
2011 exposure draft qualitative assessment: Retain the qualitative assessment in the 2011 exposure draft by retaining the indicators, but reinforce the principle of the constraint. Determinative approach: Eliminate the indicators for when an entity's experience is not predictive and require entities to assess the likely outcome. This assessment would consider whether there are other outcomes that have a reasonable possibility of occurring that could differ significantly from the transaction price and, if so, the entity's experience would not be predictive. Confidence threshold: Eliminate the indicators for when an entity's experience is not predictive and make the determination more prescriptive by specifying a level of confidence (for example, "reasonably confident" for a confidence level of 70% - 80% or "highly confident" for a confidence level of 80% - 90%).
.13 Constituents with construction-type contracts raised significant concerns about certain of these alternatives. They felt that aspects of the proposals fundamentally changed the model in the 2011 exposure draft. .14 Board members generally agreed that refinements were needed in this area, but views differed as to when an entity's experience is predictive. Views expressed include:
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Some board members noted that the objective of the constraint is to limit subsequent revisions to the reported revenue. Those board members tended to believe that contingent amounts should only be recognized when the contingency is resolved. Other board members felt the 2011 exposure draft provided guidance that allowed for reasonable judgment to reflect the economics of the arrangement and only minor clarifications to the guidance is needed. A few board members questioned how entities would assess whether their experience is predictive, and whether an entity could look to a portfolio of contracts to assess its experience. A majority of board members did not support including a specific confidence threshold as it would be arbitrary and it could potentially be difficult to determine whether an entity's experience results in a particular confidence threshold being met.
.15 No decisions were reached regarding when a reporting entity's experience is predictive. The boards asked their staff to perform additional outreach and analysis, including developing specific examples for further discussion at a future meeting. The boards' discussions about variable consideration have not included any discussion about the specific guidance on accounting for sales-based royalties in license arrangements. PwC observation: The boards made decisions on some of the minor issues involving variable consideration, but one of the largest issues remains unresolved: When should revenue related to variable consideration be recorded? Developing a clear position on this issue is critical to consistent application of the model given the pervasiveness of variable consideration arrangements. There are diverse constituent views on the recognition of variable consideration as different models exist today. Entities that currently recognize variable consideration before the contingency is resolved, such as those that follow construction contract accounting, support the approach in the 2011 exposure draft as it allows for judgment to reflect experience with similar transactions. Other entities, particularly those that do not recognize contingent amounts today until the contingency is resolved, have concerns about these judgments in light of investor and regulatory scrutiny. We agree that the revenue an entity recognizes should be limited to the amount the entity expects to be entitled to based on its predictive experience. We believe the qualitative assessment and related indicators included in the 2011 exposure draft achieve this objective and allow for an appropriate level of judgment by reporting entities to reflect the economics of their arrangements.
Industry perspectives Aerospace & defense and Engineering & construction .16 The aerospace and defense and engineering and construction industries generally accepted the proposed guidance in the 2011 exposure draft for constraining revenue recognition for variable consideration. These industries apply construction contract accounting today, which allows for recognition of variable consideration in revenue when a reasonably dependable estimate can be made (U.S. GAAP) or it is probable of economic benefit (IFRS). These industries expressed concerns with the staffs' new proposals, which
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could result in a significant change from today's accounting and from the proposals in the 2011 exposure draft. .17 Many believe more prescriptive criteria, as opposed to indicators, will delay recognition of revenue compared to today when these contracts have not changed. Often contracts include incentive-type payments that are significant to the overall contract price. There is concern that deferring recognition of these amounts when there is a reasonable basis for estimating and recognizing them will not reflect the economics of the contracts with customers. Many are also concerned about the potential interaction of constraining revenue recognition with the loss recognition guidance that will continue to apply to many contracts in these industries. The staff plans to do additional outreach with these industries to better understand their concerns before bringing the topic back for discussion at a future meeting. Collectibility .18 The 2011 exposure draft proposes that an entity present any allowance for receivable impairment losses in a separate line item adjacent to revenue. Both the initial expected impairment and any subsequent changes to that estimate are recorded in this line. The 2011 exposure draft distinguishes between contracts that have a significant financing component and those that do not as follows:
Contracts without a significant financing component: Initial and subsequent impairment of a trade receivable are determined in accordance with ASC 310 or IFRS 9 / IAS 39 and presented in a separate line item adjacent to revenue. Contracts with a significant financing component: The transaction is bifurcated into a revenue component and a loan component. The revenue component is in the scope of the revenue guidance; the loan component is in the scope of the financial instruments standards. Consequently, the impairment of receivables from contracts with a significant financing component will likely be presented differently from those contracts without a significant financing component, and will not be presented adjacent to revenue.
.19 Respondents generally disagree with presenting the effects of credit risk adjacent to revenue and recommend that entities continue to record losses from receivable impairments as an operating expense that does not affect gross profit. Other feedback focuses on whether the effects of credit risk need to be presented on the face of the income statement or whether disclosure would be sufficient. A few respondents raised concerns about collectibility no longer being a hurdle to recognizing revenue, and feel such a threshold should be brought back into the proposed guidance. Tentative decisions .20 The boards confirmed that initial and subsequent impairments of receivables should be presented in the same financial statement line item. The boards did not conclude on where the impairment loss should be presented in the income statement, as they struggled to decide whether presentation should be different when there is a significant financing component in a contract. The discussion focused on the following three options:
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Income statement presentation options Present all impairment losses in operating expenses (similar to presentation under current standards) Present all impairment losses arising from contracts without a significant financing component adjacent to revenue and all impairment losses arising from contracts with a significant financing component in operating or other expenses Present all impairment losses adjacent to revenue
Concerns raised by board members Presenting revenue at the amount which the entity will be entitled could be misleading if an entity does not expect to collect certain amounts and the presentation of those uncollectible amounts is disconnected from the related revenue. This approach might impact comparability, as the presentation of uncollectible amounts related to sales will differ based on the payment terms.
Impairment losses related to transactions for goods or services with significant financing components will be presented differently from impairments of a loan even when the underlying financial instrument is economically the same.
.21 The boards asked their staff to perform further analysis on these alternatives, including what disclosures might be required for each. .22 The debate over presentation of impairment losses reintroduced the question of whether collectibility should be a threshold for recognizing revenue. Some board members suggested the staff consider whether a collectibility threshold might be employed with a principle consistent with that for recognizing revenue from variable consideration. The boards requested their staff evaluate the potential consequences of such a threshold, and whether a threshold would be consistent with the core principles in the model. Further discussion is planned for a future meeting. .23 The boards also considered when revenue should be recognized for contracts that involve financing provided by the seller where the borrower can put the collateral back to the seller in satisfaction of the loan (non-recourse seller financing). They will provide additional implementation guidance about whether a contract with a customer exists based on when the parties are committed to perform their obligations under the contract. They will also clarify the scope of the proposed revenue guidance in this area. Parties might not be committed to perform under the contract if payment terms reflect uncertainty about the customer's intent on following through with its obligations. PwC observation: Presenting impairment losses adjacent to revenue will align revenue recognized with cash ultimately received from the customer if the contract does not have a significant financing component. This presentation will help financial statement users who are interested in reconciling revenue with cash received.
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A collectibility threshold could contradict the control-based revenue recognition model proposed by the boards by delaying revenue recognition until after control of the promised goods or services transfers to the customer. Few respondents raised concerns about collectibility being a hurdle to revenue recognition, with most preparers being in favor of the proposed change from current guidance.
Industry perspectives Real estate .24 Respondents in the real estate industry expressed concern about what they perceive as "inappropriate acceleration" of revenue under the proposed model, particularly for entities following U.S. GAAP who enter into contracts with customers that contain nonrecourse, seller-based financing. Those respondents believe that the collectibility requirements in today's accounting are the best indicators of an entity's commitment to a contract and therefore, the appropriateness of revenue recognition for those transactions. .25 The clarification of when the parties in a contract are committed to perform their respective obligations will help real estate entities assess when a contract exists before applying the rest of the proposed revenue recognition model. Time value of money .26 The 2011 exposure draft proposes that the transaction price should reflect the time value of money when the contract contains a significant financing component. Management should consider the following factors, among others, to determine if there is a significant financing component in a contract:
The length of time between when the entity transfers the goods or services to the customer and when the customer pays for them Whether the amount of consideration would substantially differ if the customer paid cash when the goods or services were transferred The interest rate in the contract and prevailing interest rates in the relevant market
.27 The 2011 exposure draft also includes a practical expedient that allows entities to ignore the time value of money if the time from transfer of the goods or services to payment is less than one year. .28 Many respondents acknowledge the theoretical basis for accounting for the effects of the time value of money but have concerns that the proposal is too broad and would require an adjustment for financing on too many transactions. The majority of respondents argue that the cost of reflecting the time value of money outweighs the benefit to users; they recommend that the boards remove this requirement. Some also suggest removing the practical expedient as it is arbitrary and does not provide adequate relief. Tentative decisions .29 The boards affirmed their decision to require adjustment to the transaction price for the effects of the time value of money when a significant financing component exists in a contract. .30 The staff recommended that the boards narrow the application of the proposals by only requiring entities to adjust for financing on transactions when the primary purpose of the payment terms is to provide financing to either the customer or the entity. The
staff believes this will ease concerns that the guidance is too broad. The boards rejected this recommendation and requested that the staff prepare examples to illustrate when an arrangement includes a significant financing component. .31 The boards clarified that an entity that is paid in advance for goods or services need not reflect the effects of the time value of money when the timing of transfer of those goods or services to the customer is at the customer's discretion. An example of such an arrangement is where a customer purchases a prepaid phone card from a telecom entity and uses the prepaid airtime at his or her discretion. Another example is a customer loyalty program where the customer can redeem the points awarded by the entity at his or her discretion. Those entities will not be required to account for time value of money even though there could be a significant timing difference between payment and performance. .32 The boards retained the practical expedient and clarified that it also applies to contracts where the contract term is greater than one year but the timing difference between payment and performance is one year or less. .33 The boards also clarified that the proposals require interest income to be presented separately from revenue from the sale of goods or services, but do not preclude interest income from being presented as a type of revenue. The proposed guidance suggests that an entity will not be precluded from presenting interest income as revenue if it generates interest income in the ordinary course of business similar to a financial services entity. PwC observation: It might be difficult to determine whether a significant financing component exists in a contract, particularly in long-term or multiple-element arrangements where goods or services are delivered, and cash payments received throughout the arrangement. Management will need to assess the timing of delivery of goods and services in relation to cash payments to determine if there is a gap in excess of one year, which could indicate that a significant financing component exists. This could include transactions where payment is received in advance and services are provided over time. The FASB acknowledged respondents' concerns about the breadth of application. The IASB reiterated that accounting for the time value of money has been a component of various IFRS standards (including IAS 18, Revenue) for years and the proposed guidance should not introduce a significant change for entities applying IFRS, despite constituent concerns. It remains to be seen if the boards will agree on the examples being developed by the staff in this area. The diverse perspectives of board members could affect what they view as a "significant financing component," especially given the differing application of time value of money under current U.S. GAAP and IFRS.
Industry perspectives Entertainment and media .34 Many entities in the entertainment and media industry could be affected by the proposed time value of money guidance. An entity that licenses an episodic television series to a broadcaster where the content is delivered upfront, but payments are received over a contract term greater than one year, might need to account for the effects of the time value of money.
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Telecommunications .35 Those in the telecom industry could be affected by the proposed time value of money guidance in some situations. An entity that sells a handset for a reduced price to secure the customer's obligation to purchase phone service for a set period of time might need to consider the effects of the time value of money. Assuming the amount allocated to the handset is paid throughout the service period, a timing difference arises between the transfer of control of the handset and the payment. The financing component might be difficult to determine in these situations. Financial services .36 Entities in the financial services industry generate interest income in the ordinary course of business. The 2011 exposure draft's requirement to present the interest component of a significant financing separately from revenue concerned entities in this industry, particularly with respect to whether interest income could be presented as revenue. The boards' clarification that the proposal does not preclude presenting interest income as revenue alleviates these concerns. Contract combinations for distributor and reseller arrangements .37 The 2011 exposure draft proposes to combine contracts and account for them as a single contract only if they are entered into at or near the same time and with the same customer (or related parties), and one or more of the following criteria are met:

The contracts are negotiated as a package with a single commercial objective The amount of consideration to be paid in one contract depends on the price or performance of the other contract The goods or services promised in the separate contracts are a single performance obligation
.38 A few respondents have concerns because, in many instances, they offer a good or service to an end customer, but do not directly provide or perform the promised good or service themselves. They asked for clarification of how the boards intend the requirements to be applied in these situations. .39 The boards previously considered whether entities should account for goods or services provided as sales incentives differently from the primary goods or services in a contract; the boards concluded entities should not. Some respondents believe they should account for these incentives differently from the primary goods or services in a contract. .40 Cash consideration paid to a customer or other parties that purchase an entity's goods or services from the customer are accounted for as a reduction in the transaction price under the 2011 exposure draft, unless it was paid for a distinct good or service. Promises to provide goods or services, on the other hand, are accounted for as additional performance obligations. Some respondents believe that promises to provide goods or services to a customer should be accounted for the same as promises to pay cash to the customer when the entity does not directly provide those goods or services. Tentative decisions .41 The boards clarified that all promises in a contract, whether explicit or implicit, to provide goods or services, including offers to provide goods or services that the customer can resell or provide to its customer, are performance obligations, even if they are satisfied by another party. The boards noted that these promises are different from promises to pay cash to the customer. Promises to pay cash to a customer are not
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performance obligations and are accounted for as reductions of the transaction price, unless paid for a distinct good or service. .42 The boards also concluded that the accounting for promises in a contract made at contract inception might differ from the accounting for promises made subsequently if those promises were not anticipated at contract inception. Contract modification guidance should be applied to promises made after contract inception. PwC observation: The boards' clarification to the proposed standard did not change the substance of the 2011 exposure draft. Entities that provide an offer of goods or services to an end customer that will be honored by a third party will need to allocate some of the transaction price to those goods or services and recognize revenue as those goods or services are delivered or performed. Some entities offering these incentives might find the proposed model more complex than current practice.
Industry perspectives Automotive .43 Automotive manufacturers often provide offers such as free maintenance to customers who purchase their vehicles from a branded dealership. Some in the industry believe that an offer of free maintenance is no different from an offer of a cash refund. They believe, therefore, that the accounting should be the same as the accounting for a cash incentive, particularly when the manufacturer does not provide the free services to the end customer. The boards' clarification confirms that these offers are promised services. Manufacturers that offer incentives such as free maintenance through dealership networks will need to account for the offer as a separate performance obligation even though the manufacturer will not perform the maintenance service. Contract modifications .44 A contract modification is treated as a separate contract under the 2011 exposure draft if it results in the addition of a separate performance obligation and the price reflects the stand-alone selling price of that obligation. A modification is otherwise accounted for as an adjustment to the original contract, either prospectively or through a cumulative catch-up adjustment, depending on the facts and circumstances. .45 Respondents expressed concerns about the complexity of the proposed guidance, but generally did not disagree with the conceptual basis of the guidance. Questions were raised about the accounting for changes to scope or price that are not approved or are in dispute. Some believe application guidance would be helpful for situations where the parties to a contract approve a change in scope, but have not agreed on the price (commonly referred to as "unpriced change orders"), and for the accounting for disputes (contract claims). Tentative decisions .46 The boards considered providing additional guidance for modifications from "contract claims" (for example, when an entity seeks additional consideration for customer-caused delays, changes, and errors in specifications and designs). They decided to retain the guidance proposed in the 2011 exposure draft for contract modifications, as they believe it adequately addresses these situations. They will clarify that a contract modification, including a contract claim, is approved when the modification creates or changes the enforceable rights and obligations of the parties to the contract, which could
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be in writing, orally, or implied by customary business practice. The boards will consider including an example that illustrates a modification due to contract claims. .47 The boards also clarified that the accounting for a contract modification that only affects the transaction price should be treated like any other contract modification. The change in price will be either accounted for prospectively or on a cumulative catch-up basis, depending on whether the remaining performance obligations are distinct. PwC observation: The boards' decisions do not change the substance of the guidance in the 2011 exposure draft, but provide clarifications in an area where constituents found the guidance difficult to follow. These clarifications should help entities better understand the proposed guidance; however, determining whether a modification should be accounted for prospectively or as a cumulative catch-up adjustment will still be judgmental.
Industry perspectives Aerospace & defense and Engineering & construction .48 Contract modifications in the aerospace and defense and the engineering and construction industries often include changes to scope or price that might be unapproved or in dispute. These modifications are often agreed to after the contractor provides the related service. Respondents believe the proposed accounting for these modifications is unclear and recommend carrying forward existing guidance. Existing guidance is similar under IFRS and U.S. GAAP and allows for recognition of amounts subject to claims or unapproved change orders in certain circumstances. .49 The boards' decisions in this area are not likely to mitigate the concerns of entities in these industries. Management will need to assess the modification guidance and determine if a modification, such as a claim or unpriced change order, is approved either in writing, orally, or though customary business practice before recognizing the related revenue. Measuring progress toward satisfying a performance obligation customized manufacturing and output methods .50 The 2011 exposure draft states that for a performance obligation satisfied over time, the objective is to depict the transfer of control of the promised goods or services to the customer. Methods for measuring progress include:
Output methods that recognize revenue based on units produced or delivered, contract milestones, or surveys of work performed Input methods that recognize revenue based on costs incurred, labor hours expended, time lapsed, or machine hours used
.51 Some respondents requested that the boards clarify whether "units delivered" can be used to measure progress in manufacturing contracts satisfied over time or in contracts where a vendor manufactures large volumes of homogeneous goods but also meets the requirements for performance obligations satisfied over time. These respondents also requested further guidance on accounting for the related costs of production when this measure is used.
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Tentative decisions .52 The staff proposed a practical expedient to allow the use of a units delivered measure when a vendor manufactures large volumes of homogeneous goods but also meets the requirements for performance obligations satisfied over time. The boards rejected this proposal because they felt it circumvents the guidance on when performance obligations are satisfied over time. Manufacturers of large volumes of homogeneous goods that meet the requirements for performance obligations satisfied over time will therefore need to assess what measure of progress depicts the transfer of goods or services to the customer. Transfer might not be upon delivery of the product in some situations. PwC observation: Entities that manufacture large volumes of homogeneous goods to a customer's specification (for example, contract manufacturers) might be surprised to find that they could meet the criteria for performance obligations satisfied over time. This is due the fact that (1) such goods often have no alternative use to the entity given their customization and (2) the payment terms in these arrangements might include a protective clause that provides for payment for performance to date in the event the contract is cancelled. The boards' decision not to include a practical expedient for these situations could have broad consequences. Entities that manufacture these types of goods could be required to recognize revenue as the goods are produced, rather than when they are delivered to the customer. Different outcomes for economically similar arrangements could result from this proposed guidance. Slight differences in payment terms could result in the goods being treated as a performance obligation satisfied over time in one case and as inventory in another. Take as an example Entity A, which manufactures customized goods with no alternative use. The customized goods have a short manufacturing cycle so any work in process at the end of a period is likely to be immaterial. Entity A's contract terms require its customers to pay cost plus a profit on all finished goods and any work in process if the contract is cancelled. The goods being produced meet the criteria for performance obligations satisfied over time with revenue recognized as control is transferred, which is likely to be as the goods are produced. Compare that situation to Entity B, which also manufactures customized goods with no alternative use. Entity B has structured its contract terms so that its customers will pay cost plus a profit on all finished goods, but Entity B will only be reimbursed for out-of-pocket costs for work in process if the contract is cancelled. The profit on work in process would be immaterial to both Entity B and its customer. The goods being produced do not meet the criteria for performance obligations satisfied over time, resulting in revenue being recognized when control transfers to the customer, which might be on delivery. The proposed definition of when an asset has no alternative use, coupled with right to payment for performance completed to date, might lead to unintended consequences. This is because the proposed definition considers customer protective rights (such as contractual terms that preclude transfer to another customer) as a determining factor of when an asset has no alternative use. The definition is inconsistent with recognizing revenue when control transfers because customer protective rights do not determine control.
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Measuring progress toward satisfying a performance obligation uninstalled materials and input methods .53 The 2011 exposure draft also proposes guidance for situations where an input method is used to measure progress and there are uninstalled materials that a customer controls prior to the performance of the services related to those goods. Revenue should be recognized only to the extent of the cost for those materials if:
the cost of the goods is significant relative to the expected costs to satisfy the performance obligation, and the entity procures the goods from another entity and is not significantly involved in designing and manufacturing the goods.
.54 Respondents generally disagree with the proposed guidance for uninstalled materials, as recognizing a zero profit margin for uninstalled materials might not reflect the economic substance of a contract in many situations. The concern is that different accounting could result if the entity constructs a large component rather than subcontracting the construction of that component. Profit could be recognized on the self-constructed component, but not on the subcontracted one. Tentative decisions .55 The boards also agreed to clarify the guidance for uninstalled materials. The feedback received indicates that this guidance is being interpreted more broadly than the boards intended. The clarifications should more closely align the guidance with the objective of measuring progress by only including in the measure of progress goods or services that depict transfer to the customer. This might result in revenue equal to the cost of the goods being recognized in some situations, but not in others. The boards also agreed to amend the example included in the implementation guidance to be consistent with this clarification. Industry perspectives Aerospace and defense .56 Most respondents agree with the proposals for measuring progress, but request the boards clarify when a units delivered measure is appropriate. They also question the timing of cost recognition when such a method is used to measure progress. Many are concerned that contract costs will be expensed as incurred as fulfillment costs, which could be in advance of revenue recognition when progress is measured based on units delivered or produced. This is a change from today's contract accounting guidance. Many respondents feel it will distort the margin during contract performance and does not therefore reflect the economics of a contract satisfied over time. These respondents recommend that entities be allowed to use a systematic and rational approach for recognizing contract costs to reflect the single overall profit margin of the arrangement. .57 The boards' decisions did not address these concerns as the guidance in the exposure draft was retained. Entities will need to assess contracts where performance obligations are satisfied over time and select a measure of progress that depicts the transfer of goods and services to the customer. Engineering and construction .58 Common in many engineering and construction contracts is the use of third parties, such as sub-contractors, to construct goods specifically for a project. These goods could remain uninstalled for a significant period of time due to long lead times to engineer, fabricate, and construct these items, or other factors. The proposed standard requires
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that an entity only recognize revenue to the extent of the cost of such uninstalled materials. .59 Respondents generally believe profit should be recognized on goods specifically produced for a project consistent with the overall contract profit margin, as contracts are typically bid and negotiated with an overall profit objective. Transfer of materials customized specifically for a project represents progress toward satisfying the performance obligation and should therefore include the recognition of profit on that progress. .60 The boards decision to clarify the guidance for uninstalled materials should help address some of the concerns of entities in this industry. Aligning this guidance with the objective of measuring progress toward satisfying a performance obligation should help avoid uneconomic outcomes. Consumer industrial products and other contract manufacturers .61 Many respondents that manufacture customized products for specific customers are concerned with possible unintended consequences of the guidance on performance obligations satisfied over time. Many contracts for these customized products could meet the criteria for recognition over time because the goods being produced have no alternative use and have contract terms providing for a right to payment for work performed in the event of a cancellation. .62 Entities with contracts that meet the requirements for performance obligations satisfied over time as a result of how "alternative use" is defined will need to select a measure of progress that depicts the transfer of control of the goods or services to the customer, which might not be upon delivery of the product. .63 The pattern of revenue recognition in these cases could shift from recognition upon delivery under today's guidance to recognition as the goods are produced. Contract manufacturers believe they are manufacturing inventory items for a customer and that the customer also views the transaction as the purchase of inventory. They believe the accounting model should reflect this shared understanding. .64 Respondents also disagree with the guidance on uninstalled materials when an entity uses subcontractors that provide as is equipment for installation into a final product or service. The proposed standard requires the revenue recognized for this performance obligation to equal the cost of the equipment acquired from a subcontractor (that is, a zero percent profit margin). Respondents disagree with allocating a zero percent profit margin for goods purchased from a subcontractor contending that the entity is providing the customer a turn-key solution, not just passing through the equipment. .65 The boards' decision to clarify the guidance on uninstalled materials to better align this guidance with the objective of measuring progress toward satisfying a performance obligation should help address the concerns raised by respondents.
Next steps
.66 The boards' redeliberation plan includes several key issues still to be discussed. These include additional discussions about licenses, the constraint on recognition of revenue from variable consideration, and collectibility, as well as discussions about disclosures and transition. .67 A final standard is planned for the first half of 2013. The boards will continue to redeliberate over the next several months and perform targeted outreach on some of the more significant changes.
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Questions
.68 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377 or 1-973-236-7804).
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Appendix Redeliberation decisions to date

The table below summarizes the decisions reached by the boards to date. These decisions are tentative and subject to change until a final standard is issued.
Topic
Identifying the contract
November 2011 Exposure Draft

A contract exists if all of the following criteria are met: The contract has commercial substance The parties to the contract have approved the contract and are committed to perform their respective obligations Management can identify each party's rights and obligations regarding the goods or services to be transferred Management can identify the terms and manner of payment for the goods or services to be transferred
Tentative Decision
The boards decided to include indicators of when parties to the contract are committed to perform their respective obligations. Some of the indicators being considered are: Whether payment terms reflect uncertainty about the customer's intent The reasons for entering into the contract in light of the parties' business models Experience or lack of thereof with the customer for similar transactions
Contract combinations for distributor and reseller arrangements
An entity may need to combine two or more contracts entered into at or near the same time with the same customer if one or more of the following criteria are met: The contracts are negotiated as a package with a single commercial objective The amount of consideration to be paid in one contract depends on the price or performance of the other contract The goods or services promised in the separate contracts are a single performance obligation
The boards clarified that all promises to provide goods or services, including offers to provide goods or services that the customer can resell or provide to its customer, are performance obligations even if they are satisfied by another party. These promises are different from promises to pay cash to the customer, which are accounted for as reductions of the transaction price, unless paid for a distinct good or service.
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Topic

A contract modification is treated as a separate contract only if it results in the addition of a distinct performance obligation and the price is reflective of the stand-alone selling price of that additional performance obligation. The modification is otherwise accounted for as an adjustment to the original contract, either through a cumulative catch-up adjustment to revenue or a prospective adjustment to revenue when future performance obligations are satisfied, depending on the facts and circumstances.
Tentative Decision
The boards decided to retain the guidance proposed in the 2011 exposure draft for contract modifications. The boards also decided to clarify that a contract modification, including a contract claim, is approved when the modification creates or changes the enforceable rights and obligations of the parties to the contract, which could be in writing, orally or implied by customary business practice. The boards will also consider including an example that addresses modifications due to contract claims and/or unpriced change orders. The boards also clarified that the accounting for a contract modification that only affects the transaction price should be treated like any other contract modification. The change in price will be accounted for either prospectively or on a cumulative catch up basis, depending on whether the remaining performance obligations are distinct.
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Topic
Identifying separate performance obligations

A separate performance obligation exists if the goods or services are distinct. Goods or services are distinct if: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with resources readily available to the customer
Tentative Decision
The boards decided that an entity should account for a promised good or service (or a bundle of goods or services) as a separate performance obligation only if both of the following criteria are met: The promised good or service is capable of being distinct because the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer The promised good or service is distinct within the context of the contract because the good or service is not highly dependent on, or highly interrelated with, other promised goods or services in the contract
A bundle of goods or services is accounted for together as one performance obligation if both of the following criteria are met: The goods and services are highly interrelated and the entity provides a significant service of integrating goods and services into the combined item that the customer has contracted for The entity is contracted by the customer to significantly modify or customize the goods or services
The boards agreed that the assessment of whether a promised good or service is distinct in the context of the contract should be supported by indicators, such as: The entity does not provide a significant service of integrating the goods or services The customer was able to purchase or not purchase the good or service without significantly affecting the other promised goods or services in the contract The good or service does not significantly modify or customize another good or service promised in the contract The good or service is not part of a series of consecutively delivered goods or services promised in a contract that meets the following two conditions: 1. The promises to transfer those goods or services to the customer are performance obligations that are satisfied over time The entity uses the same method for measuring progress to depict the transfer of those goods or services to the customer
2.
The boards decided to remove the practical expedient that permitted an entity to account for two or more distinct goods or services as a single performance obligation if those goods or services have the same pattern of transfer to the customer.
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Topic
Collectibility

Collectibility of the transaction price is not a hurdle to revenue recognition. The transaction price is presented without adjustment for credit risk. An allowance for the expected impairment loss on receivables is presented in a separate line item adjacent to revenue. Both the initial impairment assessment and any subsequent changes in the estimate of collectibility are recorded in this line (if the contract does not have a significant financing component).
Tentative Decision
The boards confirmed that initial and subsequent impairments of receivables should be presented in the same financial statement line item. They did not conclude, however, on where the impairment should be presented in the income statement. This debate raised once again the question of whether collectibility should be a threshold for recognizing revenue. The boards asked the staff to perform further analysis including evaluating the potential consequences of a collectibility threshold. Further discussion is planned for a future meeting. The boards clarified that an entity paid in advance for goods or services need not reflect the effects of time value of money when the transfer of those goods or services to the customer is at the discretion of the customer. The boards clarified that the practical expedient may be applied to contracts where the term may be greater than one year, but the timing difference between payment and performance is one year or less. The boards clarified that interest income is not precluded from being presented as a component of revenue.
Time value of money
The transaction price should reflect the time value of money when the contract includes a significant financing component. As a practical expedient, an entity is not required to reflect the effects of the time value of money in the measurement of the transaction price when the period between payment by the customer and the transfer of the goods or services is less than one year.
Dataline 19
Topic
Performance obligations satisfied over time

A performance obligation is satisfied over time if (a) the entity's performance creates or enhances an asset that the customer controls, or (b) the entity's performance does not create an asset with alternative use to the entity and one of the following criteria is met: The customer simultaneously receives and consumes the benefits of the entitys performance as it performs Another entity would not need to substantially reperform the task(s) if that other entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance completed to date and it expects to fulfill the contract
Tentative Decision
The boards decided to make the following refinements to the criteria for determining whether an entity satisfies a performance obligation over time and, hence, recognizes revenue over time: Retain the criterion that considers whether the entitys performance creates or enhances an asset that the customer controls as the asset is created or enhanced Combine the simultaneous receipt and consumption of benefits criterion and the another entity would not need to substantially reperform proposed criterion into a single criterion that would apply to pure service contracts Link more closely the alternative use criterion and the right to payment for performance completed to date criterion by combining them into a single criterion
The boards also decided to clarify aspects of the alternative use and right to payment for performance completed to date criteria. For example: The assessment of alternative use is made at contract inception and that assessment considers whether the entity would have the ability throughout the production process to readily redirect the partially completed asset to another customer. The right to payment should be enforceable and, in assessing the enforceability of that right, an entity should consider the contractual terms as well as any legislation or legal precedent that could override those contractual terms.
Dataline 20
Topic
Measuring progress toward satisfying a performance obligation

The objective is to faithfully depict the pattern of transfer of the goods or services to the customer. Methods for recognizing revenue when control transfers continuously include: Output methods that recognize revenue on the basis of the value of the entity's performance to date (for example, surveys of goods or services transferred to date, appraisals of results achieved) Input methods that recognize revenue on the basis of inputs to the satisfaction of a performance obligation (for example, time lapsed, resources consumed, labor hours expended, costs incurred, and machine hours used)
Tentative Decision
The boards agreed to retain the guidance from the exposure draft for measuring progress toward satisfying a performance obligation over time. The boards tentatively decided that methods such as "units produced" or "units delivered" could provide a reasonable proxy for the entitys performance in satisfying a performance obligation in the following circumstances: A "units produced" method could provide a reasonable proxy for the entitys performance if the value of any work in progress at the end of the reporting period is immaterial A "units delivered" method could provide a reasonable proxy for the entitys performance if: 1. the value of any work in progress at the end of the reporting period is immaterial; and the value of any units produced but not yet delivered to the customer at the end of the reporting period is immaterial.
An entity may select an appropriate input method if an output method is not directly observable or available to an entity without undue cost. The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if the costs of goods are significant and transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials). Constraint on revenue recognition Revenue is recognized when the performance obligation is satisfied and the entity is reasonably assured to be entitled to the transaction price allocated to that performance obligation. An entity is reasonably assured to be entitled to variable consideration if both of the following criteria are met: The entity has experience with similar types of performance obligations The entity's experience is predictive of the amount of consideration to which the entity will be entitled in exchange for satisfying those performance obligations
2.
They also agreed to clarify the accounting for uninstalled materials, wasted materials, and inefficiencies when using an input method to better meet the objective of measuring progress to depict the pattern of transfer of goods or services to the customer.
The boards agreed to clarify that this constraint applies to contracts with a variable price and to contracts with a fixed price where it is uncertain whether the entity will be entitled to that consideration even after the performance obligation is satisfied. The boards also agreed to remove the term reasonably assured to avoid confusion as that term has different meanings under current IFRS and U.S. GAAP guidance. The boards discussed enhancements to the guidance for determining when an entitys experience is predictive of the amount of variable consideration to which it will be entitled. Further discussions are expected at a future meeting after the boards perform additional outreach.
For licenses to use intellectual property in exchange for royalties based on the customer's subsequent sales of a good or service, the related variable consideration only becomes reasonably assured once those future sales occur.
Dataline 21
Topic
Licenses and rights to use

The promised rights are a performance obligation that the entity satisfies when the customer obtains control (that is, the use and benefit) of those rights. An entity should consider whether the rights give rise to a separate performance obligation or whether the rights should be combined with other performance obligations in the contract.
Tentative Decision
The boards discussed possible refinements to the implementation guidance on accounting for licenses. They directed the staff to perform additional analysis and bring the topic back to a future meeting.
Onerous performance obligations
An entity should recognize a liability and corresponding expense if a performance obligation that is satisfied over a period of time is onerous. The performance obligation will not need to be assessed if it is satisfied over a period less than one year. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of transaction price allocated. The lowest cost of settling a performance obligation is the lower of the following: The costs directly related to satisfying the performance obligation The amount the entity would have to pay to exit the performance obligation
The boards decided to remove this guidance from the scope of the revenue standard. As a result, the IASB decided that the requirements for onerous contracts in IAS 37, Provisions, Contingent Liabilities and Contingent Assets, should apply to all contracts with customers in the scope of the revenue standard. The FASB decided to retain existing guidance related to the recognition of losses arising from contracts with customers, including the guidance relating to construction-type and productiontype contracts in Subtopic 605-35, Revenue RecognitionConstruction-Type and Production-Type Contracts. The FASB also indicated it would consider whether to undertake a separate project to develop new guidance for onerous contracts.
Dataline 22
Authored by:
Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Larry Westall Partner Phone: 1-408-817-4284 Email: larry.westall@us.pwc.com Brian Wiegmann Director Phone: 1-973-236-7054 Email: brian.c.wiegmann@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com Michelle Mulvey Senior Manager Phone: 1-973-236-7272 Email: michelle.l.mulvey@us.pwc.com

FASB and IASB decide on revenue contract modifications and measures of progress
What's new?
The FASB and IASB (the boards) met on October 18, 2012 to discuss their joint project on revenue recognition. They reached decisions on contract modifications and measures of progress towards satisfying a performance obligation. The boards decisions are tentative and subject to change. Other key issues still to be redeliberated include collectibility, the constraint on recognizing revenue from variable consideration, licenses, allocation of transaction price, disclosures, and transition.
No. 2012-46 October 19, 2012

Contract modifications Revenue from contract modifications that have not been approved by the parties to the contract should not be recognized until the modification is approved. The boards considered providing additional guidance for modifications resulting from "contract claims." For example, an entity might seek additional consideration for customer-caused delays, changes, errors in specifications and designs, etc. The boards decided to retain the guidance proposed in the 2011 exposure draft for contract modifications, as they believe it adequately addresses these situations. They agreed, however, to consider including an example that addresses modifications due to contract claims. The boards also clarified that the accounting for a contract modification that only affects the transaction price should be assessed like any other contract modification. The change in price will then be either accounted for prospectively or on a cumulative catch-up basis depending on whether the remaining performance obligations are distinct. Measures of progress towards satisfaction of a performance obligation Revenue is recognized for a performance obligation satisfied over time as the entity progresses toward satisfying that performance obligation. Appropriate methods to measure progress include output methods, such as units produced, and input methods, such as costs incurred. The boards considered whether a practical expedient should be introduced to address situations where a vendor manufactures large volumes of homogeneous goods that also meet the requirements to be accounted for as performance obligations satisfied over time. The boards made no changes to the proposed guidance. They confirmed that an entity should select a method that depicts the transfer of control of the goods and services to the customer, which might be during production rather than
upon delivery of the product. This could result in a change in the timing of revenue recognition from today for some entities. The boards agreed to clarify the guidance for situations where an input method is used, and a customer obtains control of goods significantly in advance of when the entity performs the services related to those goods (that is, uninstalled materials). Feedback received by the boards suggests that this guidance is being interpreted more broadly than they intended. The proposed clarifications should more closely align this guidance with the objective of measuring progress by only including in the measure of progress goods or services that depict transfer to the customer. In certain situations, revenue equal to the cost of the goods should be recognized.
Who's affected?

What's next?
The boards timeline indicates issuance of a final standard in the first half of 2013. They are expected to continue their redeliberations over the next few months and perform targeted outreach on some of the more significant changes.
Questions?
In brief
Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com Michelle Mulvey Senior Manager Phone: 1-973-236-7272 Email: michelle.l.mulvey@us.pwc.com

FASB and IASB make progress on revenue redeliberations; more to come
What's new?
The FASB and IASB (the boards) met on September 24 and 27 to discuss their joint project on revenue recognition. They reached decisions on certain topics relating to the constraint on recognizing variable consideration, collectibility, time value of money, and distributor and reseller arrangements. The boards decisions are tentative and subject to change. The boards directed their staff to conduct further analysis on certain items, including aspects of the variable consideration constraint and presentation issues relating to collectibility. Other key issues still to be redeliberated include licenses, contract modifications, allocation of transaction price, disclosures, and transition.
No. 2012-44 September 28, 2012

Constraint on recognizing variable consideration The proposed model requires variable consideration that is recognized as revenue to be constrained to the amount to which the entity is reasonably assured to be entitled. The boards agreed to clarify that this constraint applies to contracts with a variable price and to contracts with a fixed price where it is uncertain whether the entity will be entitled to that consideration even after the performance obligation is satisfied. The boards also agreed to remove the term reasonably assured to avoid confusion as that term has different meanings under current IFRS and U.S. GAAP guidance. The boards discussed enhancements to the guidance for determining when an entity s experience is predictive of the amount of variable consideration to which it will be entitled. Further discussions are expected at a future meeting after the boards perform additional outreach. Collectibility The boards confirmed that initial and subsequent impairments of receivables should be presented in the same financial statement line item. They did not conclude, however, on where the impairment should be presented in the income statement. This debate also raised once again the question of whether collectibility should be a threshold for recognizing revenue. The boards asked their staff to perform further analysis including evaluating the potential consequences of a collectibility threshold, and whether it would be consistent with the core principles of the proposed model. Further discussion is planned for a future meeting.
The boards also considered when revenue should be recognized for contracts with nonrecourse, seller-based financing. They agreed to provide additional implementation guidance about whether a contract with a customer exists based on when the parties may or may not be committed to perform their obligations under the contract. Time value of money The boards agreed to retain the proposed guidance that requires adjustment to the transaction price for the effect of time value of money if the contract has a significant financing component. They will, however, consider providing additional implementation guidance for inclusion in the final standard at a future meeting. They also decided to retain the practical expedient that does not require an adjustment for time value of money if the time difference between performance and payment is one year or less. The boards clarified that an entity does not need to reflect the effect of time value of money for advance payments when the timing of the transfer of goods or services is at the discretion of the customer. Contract combinations for distributor and reseller arrangements The boards clarified that promised goods or services in a contract might include offers to provide goods or services that the customer can resell or provide to its customer. They confirmed that these promises are performance obligations even if they are satisfied by another party, and are different from promises to pay cash to the customer, which are accounted for as a reduction of the transaction price.
Convergence is expected for revenue recognition, as the same principles will be applied to similar transactions under both U.S. GAAP and IFRS. Differences might continue to exist to the extent that the guidance requires reference to other standards before applying the guidance in the revenue standard.
Who's affected?

What's next?
The boards timeline indicates issuance of a final standard in the first half of 2013. The boards will continue to redeliberate over the next several months and perform targeted outreach on some of the more significant changes.
Questions?
In brief
Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com

No. 2012-07 August 9, 2012 Whats inside: Overview .......................... 1
Revenue from contracts with customers Ready, set, redeliberate.

Overview
At a glance The FASB and IASB (the boards) met on July 19, 2012 to begin redeliberating their joint revenue recognition project. The discussions were focused on concerns raised through comment letters and roundtable discussions, and other feedback received. The boards reached tentative decisions at their July meeting on identifying separate performance obligations, performance obligations satisfied over time, and onerous performance obligations. They also discussed the accounting for licenses, but did not reach any decisions and will continue to redeliberate this topic at a future meeting. The boards plan to complete all major redeliberations by the end of 2012. A final standard is expected during the first half of 2013 with an effective date no earlier than January 1, 2015. Full retrospective application, with certain reliefs, will be required unless the boards change their current position. This topic is planned for discussion at a future meeting. Background .1 The boards issued a revised exposure draft on revenue recognition in November 2011 (the 2011 exposure draft). They decided to re-expose the proposed revenue guidance to avoid unintended consequences from applying the final standard. Refer to Dataline 201135, Revenue from contracts with customers: The proposed revenue standard is reexposed, for a detailed discussion of the proposed guidance. .2 The redeliberations will focus on feedback received on the 2011 exposure draft through comment letters and roundtable discussions, and from consultation efforts. Themes from the comment letters and the roundtables are discussed in Dataline 2012-04, Responses are in on the re-exposed proposed revenue standard.
Current developments ....2

Identifying separate performance obligations ..... 2 Performance obligations satisfied over time ................ 5 Licenses ................................... 7 Onerous performance obligations............................ 9
Next steps ....................... 10 Questions ....................... 10 Appendix Redeliberation decisions to date ......... 11
Dataline
PwC observation: Striking the right balance when addressing the concerns raised by various constituents is critical to the success of the project. The boards are not limiting their redeliberations to the specific topics in the 2011 exposure draft on which they sought comments. The redeliberation plan also includes several additional topics raised by constituents. .3 This Dataline summarizes the boards redeliberations and tentative decisions made during the July board meeting, and the potential effects on certain industries. These decisions are tentative and are subject to change until a final standard is issued.
Current developments
.4 The boards' redeliberations in July focused on enhancing and clarifying the proposed guidance in some areas, and resulted in a wholesale change on one topic. The following topics were discussed: Refining the guidance for identifying separate performance obligations and determining when a performance obligation is "distinct" Clarifying the criteria for when a performance obligation is satisfied over time Clarifying the implementation guidance related to licenses Revising or eliminating the assessment of onerous performance obligations Identifying separate performance obligations .5 A performance obligation is a promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. Identifying performance obligations that should be accounted for separately is essential to properly applying the revenue recognition model. Separate performance obligations are the units of account to which the transaction price is allocated, and satisfaction of those separate performance obligations determines the timing of revenue recognition. .6 The 2011 exposure draft would require an entity to account for each promised good or service as a separate performance obligation if: The entity regularly sells the good or service separately The customer could benefit from the good or service either on its own or together with other resources that are readily available to the customer .7 It also proposed that a bundle of distinct goods or services should be accounted for as a single performance obligation if both of the following criteria are met: The goods or services are highly interrelated and require the entity to provide a significant service of integrating the goods or services into a combined item that the customer has contracted for The entity significantly modifies or customizes the goods or services to fulfill the contract .8 Respondents generally support the principle of identifying separate performance obligations on the basis of distinct goods or services. They have expressed concerns,
Dataline
however, that the guidance for bundling promised goods or services might sometimes require companies to combine performance obligations that are actually distinct. .9 Questions have been raised about accounting for goods or services provided at the same time as a single performance obligation. The boards have also received significant feedback about the need to clarify the accounting for repetitive or consecutively transferred goods or services. Tentative decisions .10 The boards agreed to retain, but clarify, the principle for identifying separate performance obligations, and refine the guidance for identifying when goods or services are distinct. Indicators of when a good or service is distinct in the context of the contract will be added to help with this assessment. Distinct in the context of the contract means assessing the contract terms and the intent of the contracting parties to determine the performance obligations that exist. Guidance will also be added to help determine whether a series of promised goods or services delivered consecutively is a single performance obligation or multiple separate performance obligations. .11 An entity will account for a promised good or service (or bundle of goods or services) as a separate performance obligation if it meets the revised criteria below. An entity will combine a good or service with other goods or services in the contract if they are not individually separable until a separate performance obligation is identified.
Identifying separate performance obligations:
The promised good or service is capable of being distinct
The customer can benefit from the good or service either on its own or together with other resources readily available to the customer
f
The promised good or service is distinct in the context of the contract
Not highly dependent on or interrelated with other promised goods or services in the contract
.12 The first requirement introduces a hypothetical test to assess whether a good or service could be distinct. This creates a floor for disaggregating goods or services, because the entity cannot account for goods or services separately if the customer cannot benefit from them separately. Click here for additional discussion on identifying performance obligations. .13 The second requirement is an assessment based on what the customer believes it has contracted to receive. This guidance builds on what was included in the 2011 exposure draft. The boards plan to include indicators of when to separate or bundle performance obligations, rather than criteria. This will allow management to apply judgment and make an assessment that reflects the economics of a transaction.
Dataline
.14 The boards decided to add a new indicator to address concerns about repetitive or consecutively transferred goods or services. The boards also clarified that a series of promised goods or services is one performance obligation if: (a) it is satisfied over time and (b) the same measure of progress is used to depict the transfer of those goods or services to the customer. Click here for additional discussion on repetitive goods or services. .15 This clarification means that management of an entity providing two services to a customer that are both satisfied over time will need to consider whether the measure of progress used to depict the transfer of those services is the same. For example, if labor hours are used to measure progress for one service and cost incurred is used for another service under the same contract, the two services will generally be accounted for as separate performance obligations because different measures of progress are being used. Industry perspectives .16 The majority of comments received in this area were from three industry groups: aerospace and defense; engineering and construction; and technology. Aerospace and defense .17 Many respondents in the aerospace and defense industry believe that the production of each individual unit under a contract is not distinct because the production process is highly interrelated and the items are highly customized to meet the customer's specifications. The 2011 exposure draft could be interpreted to require that each unit produced under a contract is a separate performance obligation because the units are not highly interrelated with each other. .18 The revised guidance allows for judgment and the indicators will help management to make an assessment that reflects the terms and intent of the parties in the contract. Presuming that each unit is capable of being distinct, various conclusions could be reached when considering the indicators and assessing whether each unit is distinct in the context of the contract. An entity will need to weigh all of the indicators to determine whether units should be accounted for as one performance obligation or multiple separate performance obligations. Engineering and construction .19 Many entities in the engineering and construction industry expressed concerns that the 2011 exposure draft does not allow for judgment in determining whether performance obligations should be bundled or accounted for separately. The 2011 exposure draft could be interpreted such that every contract that contains a bundle of highly interrelated and significantly customized performance obligations must be accounted for as a single performance obligation. .20 Performance obligations might be distinct yet also highly interrelated and significantly customized in some situations (for example, a contract with engineering, procurement, and construction services bundled together). Therefore, many in the industry believe that judgment should be allowed to determine whether those performance obligations should be bundled or accounted for separately. The boards' revised guidance will allow for judgment in determining whether to account for performance obligations separately in a way that reflects the terms and intent of the parties in the contract. Technology .21 A number of software entities responded to the 2011 exposure draft raising concerns about the accounting for software deliverables. The principles in the proposed standard could result in virtually all of the deliverables currently included in most software transactions (for example, license, services, post-contract support, etc.) being accounted
Dataline
for separately. Software companies that recognize licenses and post-contract support as a single unit of account ratably over the contract term under existing guidance could be required to separate the deliverables under the proposed guidance. Revenue might be accelerated as a result. .22 Some respondents believe the 2011 exposure draft is too prescriptive in requiring distinct components to be accounted for as a single performance obligation if goods or services are highly interrelated and significantly customized. For example, when an entity sells an enterprise software license, in some cases, the customer can engage either the entity or a third party to provide customization and integration services. Many industry respondents interpret the proposed guidance to require this arrangement to be accounted for as one performance obligation when the entity provides both the license and the services. This would result in revenue for the entire contract being recognized over time as the services are provided. The accounting would be different if a third party is engaged to provide the customization and integration services, as the entity transfers control of the software at the beginning of the arrangement, resulting in revenue recognition when the license is delivered. .23 The boards' decision addresses some of these concerns by refining the bundling guidance, and removing the criteria and replacing them with indicators to make the guidance less prescriptive. However, entities that currently account for a bundle of promised goods or services as a single performance obligation due to specific requirements of the existing guidance are likely to have to separate the deliverables under the proposed guidance. PwC observation: We believe the boards are moving in the right direction by allowing for more judgment in determining separate performance obligations based on the context of the contract. The use of indicators to help management assess when goods or services should be bundled or accounted for separately will help with the assessment and allow management to apply an approach that better reflects the economics of a transaction.
Performance obligations satisfied over time .24 Performance obligations can be satisfied either at a point in time or over time. The boards proposed in the 2011 exposure draft that an entity transfers control of a good or service over time if at least one of the following two criteria is met: The entity's performance creates or enhances an asset that the customer controls The entity's performance does not create an asset with alternative use to the entity and at least one of the following criteria is met:
- The customer simultaneously receives and consumes the benefits of the entitys
performance as it performs
- Another entity would not need to substantially reperform the work the entity has
completed to date if that other entity were required to fulfill the remaining obligation to the customer expects to fulfill the contract
- The entity has a right to payment for performance completed to date and it
Dataline
.25 Respondents generally support the guidance for satisfaction of performance obligations over time, but they have asked the boards to clarify the guidance for service contracts. They have also asked the boards to clarify certain items within the criteria, particularly how to assess when an asset has no alternative use and when the entity has a right to payment for performance completed to date. Tentative decisions .26 The boards decided to clarify the criteria to determine when a performance obligation is satisfied over time and refine the guidance to better address service contracts. The indicators of when an asset has no alternative use and when the entity has a right to payment for performance to date will also be clarified. .27 An entity will recognize revenue over time if any of the following criteria are met.
An entity satisfies a performance obligation over time if:
(a) The customer is receiving and consuming the benefits of the entity's performance as the entity performs;
(b) The entity's performance creates or enhances an asset (a work in progress) that the customer controls as the asset is created or enhanced; or (c) The entity's performance does not create an asset with an alternative use to the entity and the customer does not have control over the asset created, the entity has a right to payment for performance completed to date, and it expects to fulfill the contract.
.28 The first criterion generally addresses service contracts where no asset is created and a customer consumes the services as they are provided. Management should assess if another entity would need to substantially reperform the work completed to date to fulfill the remaining obligation to the customer to determine if the customer obtains the benefits as the entity performs. Contractual or practical limitations that prevent an entity from transferring a remaining performance obligation to another entity are not considered in this evaluation. .29 The second criterion addresses transactions where an asset is created and the customer controls that asset as it is created. Management should apply the guidance on transfer of control to determine whether the customer obtains control of the asset as it is created. .30 The last criterion addresses situations where the customer does not control an asset as it is created. Management will need to consider whether the asset being created has an alternative use to the entity and whether the entity has a right to payment for performance to date. .31 The boards clarified that the assessment of whether an asset has an alternative use should be made at the inception of the contract. Management should consider its ability to redirect a product that is partially completed to another customer, considering both contractual and practical limitations. A substantive contractual restriction that limits
Dataline
managements ability to redirect the asset would indicate the asset has no alternative use. Practical limitations, such as significant costs required to rework the asset so it could be directed to another customer, could also indicate that asset has no alternative use. .32 To conclude it has a right to payment, an entity must be entitled to payment for performance completed to date even if the customer can terminate the contract for reasons other than the entity's non-performance. A specified payment schedule does not by itself indicate the entity has a right to payment for performance to date. The assessment of the enforceability of the right to payment should include consideration of the contract terms and any legal restrictions or requirements that could override the contract terms. The right to payment should compensate the entity at an amount that reflects the selling price of the goods or services provided to date. For example, this might be an amount that covers an entity's cost plus a reasonable profit margin. PwC observation: The boards clarifications did not change the substance of the guidance in the 2011 exposure draft. Management will need to apply judgment when assessing the criteria for performance obligations satisfied over time, especially when assessing whether assets have an alternative use and whether the entity has a right to payment for performance completed to date. Entities that sell highly customized products that can only be used by a single customer and entities that are the only provider of products for a specific customer might conclude that they do not create assets with an alternative use. Where these entities have the right to payment as products are manufactured, they will be required to recognize revenue over time. This might result in recognizing revenue earlier than other entities that sell products with an alternative use.
Licenses .33 A license is the right to use an entity's intellectual property including, among others: software and technology; media and entertainment rights (such as motion pictures and music); franchises; patents; trademarks; and copyrights. .34 The 2011 exposure draft would require an entity to recognize revenue from granting the right to use intellectual property when the customer obtains control of that right. This occurs when control of licensed rights transfers to the customer, but is no earlier than the beginning of the license period. .35 Many respondents have commented that the proposed accounting might not reflect the economics of certain license arrangements. They are also concerned that revenue could be recognized earlier than in current practice. They have asked the boards to reconsider the application of the recognition principles to time-based licenses, licenses containing restrictions on use, and licenses bundled with service contracts. Tentative decisions .36 The boards discussed whether the implementation guidance should be clarified to focus on whether a license is distinct from other promised goods or services in an arrangement. Revenue from a license that is distinct would be recognized when control of the license transfers to the customer. A license that is not distinct from other goods and services in a contract would be bundled with those goods or services, with revenue recognized as those goods and services are transferred to the customer.
Dataline
.37 The boards decided that the implementation guidance should be enhanced, but did not make any decisions. They specifically discussed the accounting for time-based licenses and licenses that contain restrictions on use of the licensed asset. .38 The boards debated whether revenue from time-based licenses should be recognized over time or at a point in time. Some board members felt an entity has an implied obligation in a time-based license that is not separable from the license, such as an obligation to protect its intellectual property or maintain its brand. They argued that, as a result, revenue should be recognized over the license term. The majority of board members, however, felt this implied obligation is not an obligation specific to the customer and therefore, it should not affect whether the license is distinct or the timing of revenue recognition. Click here for additional discussion on licenses. .39 The boards also debated the accounting for licenses that contain restrictions on their use. Some board members felt a restriction on the use of a license means control has not transferred to the customer and therefore, revenue should be recognized over the license term. Most board members viewed these restrictions as a characteristic of the license that should not affect when control of the license transfers to the customer. .40 The boards directed their staff to perform additional analysis on how the guidance would apply to different types of licenses as a result of these debates. Further discussion is expected at a future meeting. Industry perspectives Entertainment and media .41 Many constituents in the entertainment and media industry are concerned that the control-based criteria could result in immediate revenue recognition from the licensing of intellectual property. They believe this approach is inconsistent with the economic substance of certain license arrangements, such as licenses of digital content or a portfolio of content. Constituents believe that the standard should be flexible enough to account for the economic substance of different license arrangements, which in some cases would result in recognizing revenue over the period of benefit to the customer. .42 Some constituents have also raised concerns about applying the same accounting to both perpetual and time-based licenses. They argue that the two types of licenses are economically different and therefore, should be accounted for differently. They believe revenue from perpetual licenses should be recognized when the license transfers to the customer, while revenue from time-based licenses should be recognized over the license period. .43 Many long-term license arrangements for film and television content contain licensor-imposed restrictions. These might include restrictions (time-based or usagebased) on the right to use the license during the license term or constraints on the frequency and timing of the use of the license. For example, it is common for a licensor of an episodic television series to specify how the episodes should be sequenced, the frequency of airing, and over what time frame the episodes may be aired. Many respondents highlighted that significant judgment will be required to determine when control transfers due to these complexities. They believe additional clarity is needed to avoid inconsistent application of the guidance to such arrangements. Technology .44 Some software entities are opposed to recognizing revenue over time as this approach differs from their current practice of recognizing revenue when the license is delivered. Other entities that currently recognize software licenses over time would
Dataline
prefer to retain their current practice. The boards ultimate conclusions about the accounting for licenses will likely change current practice for one of these groups. PwC observation: Accounting for licenses has been an area of debate from the beginning of the project. The original exposure draft issued in 2010 proposed an approach that distinguished between exclusive and non-exclusive licenses. Revenue would have been recognized over time for exclusive licenses and at a point in time for non-exclusive licenses. Constituents raised concerns about this approach, so the boards decided to remove the reference to exclusivity from the proposed guidance and require revenue recognition upon transfer of the licensed rights. There are differing views among board members on the timing of revenue recognition for time-based licenses and licenses containing restrictions on use. Regardless of the direction the boards take, the timing of revenue recognition for licenses of intellectual property is likely to change for some entities as compared to current practice.
Onerous performance obligations .45 The 2011 exposure draft would require an entity to recognize a liability and a corresponding expense if a performance obligation satisfied over more than one year is onerous. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of the transaction price allocated to it. The lowest cost of settling a performance obligation is the lower of: (a) what an entity would pay to exit the performance obligation and (b) the cost of satisfying the performance obligation. .46 Respondents generally disagree with the proposed accounting for various reasons. Some argue that the assessment of onerous obligations relates to cost, not revenue recognition, and therefore, should not be included in a revenue standard. Others suggest that if guidance for recording provisions for onerous obligations is included in the final standard, the assessment should be made at the contract level or a higher level to better reflect how contracts are negotiated with customers. The boards have received comments about whether the scope of the assessment should be limited to only performance obligations satisfied over more than one year and they have also been asked to clarify which costs would be included in the assessment. Tentative decisions .47 The boards decided to remove the requirement to assess onerous performance obligations from the final standard. They will instead retain the existing guidance in U.S. GAAP and IFRS. .48 The FASB will carry forward existing U.S. GAAP guidance, which includes the onerous loss guidance in ASC 605-35, Construction-type and Production-type Contracts, and other industry-specific guidance. The guidance carried forward will be limited to those contracts currently in the scope of existing guidance. The IASB decided that contracts with customers will be subject to IAS 37, Provisions, Contingent Liabilities and Contingent Assets. Industry perspectives .49 The boards decision to remove guidance on onerous performance obligations from the proposed standard addresses concerns raised by constituents across industries. Most industries have voiced concerns about the complexity of accounting for onerous performance obligations, the potential diversity in the application of the guidance, and
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the potential for uneconomic outcomes when a contract is profitable on an overall basis. Removal of this guidance will address these concerns. Aerospace and defense, Engineering and construction .50 The aerospace and defense, and engineering and construction industries apply the onerous loss guidance today. The boards decision will result in these industries continuing to apply current guidance to their contracts under U.S. GAAP. It is unclear whether the entities applying IFRS will continue to follow the guidance in IAS 11, Construction Contracts, or will be subject to the guidance in IAS 37. PwC observation: We support the boards decision to remove the onerous test from the proposed guidance. We believe that the accounting proposed in the 2011 exposure draft might not accurately reflect the economics of certain arrangements. It is unclear, however, how existing guidance, including scope, will be carried forward and retained. Most of the boards' discussions focused on ASC 605-35 and IAS 37. The boards will need to ensure the scope of the retained guidance is clear if they are to capture all contracts currently subject to such guidance. The IASB will also need to consider whether to carry forward the loss-making contracts guidance in IAS 11.
Next steps
.51 The boards' redeliberation plan includes several key issues still to be discussed. These include the "reasonably assured" constraint on recognition of variable consideration, collectibility, time value of money, contract combination and modification, disclosures, and transition. .52 A final standard is expected in the first half of 2013. The boards will continue to redeliberate over the next several months and perform targeted consultation on some of the more significant changes.
Questions
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Appendix Redeliberation decisions to date

The table below summarizes the decisions reached by the boards to date. These decisions are tentative and subject to change until a final standard is issued.
Topic
Identifying separate performance obligations

A separate performance obligation exists if the goods or services are distinct. Goods or services are distinct if: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with resources readily available to the customer A bundle of goods or services is accounted for together as one performance obligation if both of the following criteria are met: The goods and services are highly interrelated and the entity provides a significant service of integrating goods and services into the combined item that the customer has contracted for The entity is contracted by the customer to significantly modify or customize the goods or services
Tentative Decision
The boards decided that an entity should account for a promised good or service (or a bundle of goods or services) as a separate performance obligation only if both of the following criteria are met: The promised good or service is capable of being distinct because the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer The promised good or service is distinct within the context of the contract because the good or service is not highly dependent on, or highly interrelated with, other promised goods or services in the contract The boards agreed that the assessment of whether a promised good or service is distinct in the context of the contract should be supported by indicators, such as: The entity does not provide a significant service of integrating the goods or services The customer was able to purchase or not purchase the good or service without significantly affecting the other promised goods or services in the contract The good or service does not significantly modify or customize another good or service promised in the contract The good or service is not part of a series of consecutively delivered goods or services promised in a contract that meet the following two conditions: 1. The promises to transfer those goods or services to the customer are performance obligations that are satisfied over time 2. The entity uses the same method for measuring progress to depict the transfer of those goods or services to the customer The boards decided to remove the practical expedient that permitted an entity to account for two or more distinct goods or services as a single performance obligation if those goods or services have the same pattern of transfer to the customer.
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Topic
Performance obligations satisfied over time

A performance obligation is satisfied over time if (a) the entity's performance creates or enhances an asset that the customer controls, or (b) the entity's performance does not create an asset with alternative use to the entity and one of the following criteria is met: The customer simultaneously receives and consumes the benefits of the entitys performance as it performs Another entity would not need to substantially reperform the task(s) if that other entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance completed to date and it expects to fulfill the contract
Tentative Decision
The boards decided to make the following refinements to the criteria for determining whether an entity satisfies a performance obligation over time and, hence, recognizes revenue over time: Retain the criterion that considers whether the entitys performance creates or enhances an asset that the customer controls as the asset is created or enhanced Combine the simultaneous receipt and consumption of benefits criterion and the another entity would not need to substantially reperform proposed criterion into a single criterion that would apply to pure service contracts Link more closely the alternative use criterion and the right to payment for performance completed to date criterion by combining them into a single criterion The boards also decided to clarify aspects of the alternative use and right to payment for performance completed to date criteria. For example: The assessment of alternative use is made at contract inception and that assessment considers whether the entity would have the ability throughout the production process to readily redirect the partially completed asset to another customer. The right to payment should be enforceable and, in assessing the enforceability of that right, an entity should consider the contractual terms as well as any legislation or legal precedent that could override those contractual terms.
The boards discussed possible refinements to the implementation guidance on accounting for licenses. They directed the staff to perform additional analysis and bring the topic back to a future meeting.
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Topic

An entity should recognize a liability and corresponding expense if a performance obligation that is satisfied over a period of time is onerous. The performance obligation will not need to be assessed if it is satisfied over a period less than one year. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of transaction price allocated. The lowest cost of settling a performance obligation is the lower of the following: The costs directly related to satisfying the performance obligation The amount the entity would have to pay to exit the performance obligation
Tentative Decision
The boards decided to remove this guidance from the scope of the revenue standard. As a result, the IASB decided that the requirements for onerous contracts in IAS 37, Provisions, Contingent Liabilities and Contingent Assets, should apply to all contracts with customers in the scope of the revenue standard. The FASB decided to retain existing guidance related to the recognition of losses arising from contracts with customers, including the guidance relating to construction-type and productiontype contracts in Subtopic 605-35, Revenue RecognitionConstruction-Type and Production-Type Contracts. The FASB also indicated it would consider whether to undertake a separate project to develop new guidance for onerous contracts.
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Authored by:
Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com Roshini Prasad Senior Manager Phone: 1-973-236-4412 Email: roshini.prasad@us.pwc.com

FASB and IASB redeliberate to make the proposed revenue standard less "onerous"
What's new?
The FASB and IASB (the boards) met on July 19 to discuss their joint project on revenue recognition. They reached decisions on identifying separate performance obligations, performance obligations satisfied over time, and onerous performance obligations. They also discussed the accounting for licenses, but did not reach any decisions. The decisions reached are tentative and subject to change. Other key issues still to be redeliberated include the "reasonably assured" constraint on recognition of variable consideration, collectibility, time value of money, contract combination and modification, disclosures, and transition.
No. 2012-28 July 20, 2012

Identifying separate performance obligations A key step in the revenue recognition model is identifying the separate performance obligations in a contract. The boards agreed to clarify the principle for identifying separate performance obligations and refine the criteria for identifying when goods or services are distinct. An entity will account for a promised good or service (or a bundle of goods or services) as a separate performance obligation if it: (a) could be distinct (the customer can benefit from the good or service either on its own or together with other resources readily available to the customer); and (b) is distinct based on the substance of the contract (not highly dependent on or interrelated with other promised goods or services in the contract). The boards also agreed to include indicators of when a good or service is not distinct to help with this assessment. The indicators include guidance to assist in determining whether a series of promised goods or services in the contract is a single performance obligation or a series of distinct performance obligations. Performance obligations satisfied over time The boards clarified the criteria to determine when a performance obligation is satisfied over time. The guidance was refined to better address service contracts. The indicators of
In brief
when an asset has "no alternative use" and when the entity has a right to payment for performance to date were also refined. The boards agreed that an entity satisfies a performance obligation over time if: (a) the customer is receiving and consuming the benefits of the entity's performance as the entity performs (i.e., another entity would not need to substantially re-perform the work completed to date); (b) the entity's performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or (c) the entity's performance does not create an asset with an alternative use to the entity, the entity has a right to payment for performance completed to date, and it expects to fulfill the contract. Accounting for licenses The boards agreed that the implementation guidance on accounting for licenses should be enhanced, but did not make any decisions on this topic. We expect further discussion at a future meeting. The boards requested their staffs to conduct further analysis on applying the guidance to various types of licenses, including the pattern of revenue recognition (over time or at a point in time) for term-based licenses. The staffs were also asked to consider the effect of contractual restrictions on revenue recognition. It was unclear to the boards how the proposed guidance would apply in these situations. Onerous performance obligations The boards decided to remove the requirement to assess onerous performance obligations from the final standard. This decision was in response to concerns raised by constituents about the difficulties in applying the proposed guidance. The boards decided instead to retain current onerous loss guidance within U.S. GAAP and IFRS.
Convergence is expected for revenue recognition, as the same principles will be applied to similar transactions under both frameworks. Differences might continue to exist to the extent that the guidance requires reference to other standards before applying the guidance in the revenue standard.
Who's affected?

What's next?
The boards' timeline indicates issuance of a final standard in the first half of 2013. The boards will continue to redeliberate over the next several months and perform targeted outreach on some of the more significant changes.
Questions?
Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Steve Mack Senior Manager Phone: 1-973-236-4378 Email: steve.mack@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com

Responses are in on the re-exposed proposed revenue standard Constituents voice their supportand concerns
Overview
At a glance The FASB and IASB (the "boards") released an updated exposure draft, Revenue from Contracts with Customers, on November 14, 2011 (the "2011 Exposure Draft"). The boards received approximately 360 comment letters in response to the updated exposure draft, down significantly from the nearly 1,000 comment letters received on the exposure draft released in June 2010 (the "2010 Exposure Draft"). Since issuing the updated exposure draft, the boards have continued extensive outreach efforts, including four public and numerous private, industry-focused roundtables. Refer to Appendix B for the boards' proposed project timeline, which details the expected timing of discussion of outstanding issues. The boards asked whether the proposed guidance is clear, and specifically requested feedback on: (1) performance obligations satisfied over time; (2) presentation of the effects of credit risk; (3) recognition of variable consideration and the revenue recognition constraint; (4) the scope of the onerous performance obligation test; (5) disclosures in interim financial reports; and (6) transfer of non-financial assets that are outside an entity's ordinary activities (for example, the sale of property, plant and equipment). Respondents have commented on the questions asked by the boards, but also on a number of other areas, including the application of time value of money, transition, and annual disclosures. Industries have also asked the boards to address or clarify the application of the proposals to certain industry-specific issues. The boards have not yet decided on the effective date of the standard, but have said that it will not be effective earlier than January 1, 2015. Early adoption will not be permitted under U.S. GAAP, but will be permitted under IFRS.
No. 2012-04 May 31, 2012 Whats inside: Overview .......................... 1

At a glance ...............................1 Background ............................ 2
Comment letter trends and roundtable discussions ....................3

Performance obligations satisfied over time ................ 4 Presentation of the effects of credit risk ......................... 4 Recognition of variable consideration and the revenue recognition constraint ............................. 5 Scope of onerous performance obligation test ........................................ 6 Disclosures .............................. 7 Transfer of non-financial assets that are outside an entity's ordinary activities ............................... 8 Time value of money .............. 8 Transition ............................... 9
Industry perspectives ... 10 Next steps .......................22 Questions .......................22 Appendix A Summary of significant comment letter topics by industry group ............23 Appendix B Boards' proposed project timeline .......... 24
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Background .1 The boards decided unanimously to re-expose the proposed revenue guidance because of the importance of the revenue number to all entities and to avoid unintended consequences from applying the standard. This decision was made despite the 2011 Exposure Draft not significantly changing the core model proposed in the 2010 Exposure Draft, which requires the following five steps: Identify the contract with the customer Identify the separate performance obligations in the contract Determine the transaction price and amounts not expected to be collected Allocate the transaction price to separate performance obligations Recognize revenue when (or as) each performance obligation is satisfied .2 Several key differences exist between the 2010 and 2011 Exposure Drafts, despite the core model remaining largely unchanged. Changes were made in several areas including identifying separate performance obligations, determining the transaction price, accounting for variable consideration, transfer of control, and accounting for contract costs, among others. Refer to Dataline 2011-35, Revenue from contracts with customers: The proposed revenue standard is re-exposed, for a detailed discussion of the key changes. .3 The boards continue to focus on industry outreach efforts, and have held roundtables to gauge reactions and understand concerns with the 2011 Exposure Draft. Key topics raised in these meetings include identifying separate performance obligations, applying time value of money, practical challenges with applying the onerous performance obligation test, allocation of transaction price, disclosures and transition. PwC observation: Striking the right balance in addressing these concerns is critical to the success of the project given the proposed standard will eliminate industry specific guidance. Respondents appear to believe the boards are heading in the right direction based on the volume and content of comment letters. The remaining concerns with the exposure draft are not insignificant, however, and the boards will likely need to further address certain areas before issuing a final standard. .4 This Dataline addresses the areas of focus in roundtables and in comment letters received by the boards on the proposed standard. References within this Dataline to the "exposure draft" or "proposed standard" refer to the exposure draft issued in November 2011, unless otherwise indicated.
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Comment letter trends and roundtable discussions

.5 The boards revised various aspects of the proposed standard in response to extensive feedback received on the 2010 Exposure Draft. The boards requested comments on those key changes as well as feedback on whether the guidance is clear and if it will result in information that reflects the economic substance of transactions. Respondents were asked to comment on the following topics: Performance obligations satisfied over time Presentation of the effects of credit risk Recognition of variable consideration and the revenue recognition constraint Scope of the onerous performance obligation test Disclosures in interim financial reports Transfer of non-financial assets that are outside an entity's ordinary activities .6 Other topics such as time value of money, disclosures, and transition continue to cause concern. .7 The number of industry-specific comments decreased since the 2010 Exposure Draft, but a number of concerns remain. The chart below depicts the volume of comment letters by industry: Comment letters by industry
180 160 140 120 100 80 60 40 20 0
2010 Exposure Draft 2011 Exposure Draft
.8 Certain industry groups, such as engineering and construction, consumer and industrial products, and technology, sent far fewer letters on the 2011 Exposure Draft compared to the 2010 Exposure Draft. The volume of letters from other industry groups, such as telecommunications, automotive and entertainment and media, remained generally consistent with those received on the 2010 Exposure Draft.
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PwC observation: We believe the number of letters significantly decreased because the boards addressed many of the questions and concerns raised in response to the 2010 Exposure Draft. Areas that caused significant concern in the 2010 Exposure Draft, such as the accounting for services, the identification of a contract, collectibility, warranties, and licenses, are addressed in the 2011 Exposure Draft to the satisfaction of many. Challenges identified by certain industries around separation of performance obligations and allocation of transaction price are also addressed. Proposed guidance that continues to be unpopular across all industry groups includes accounting for the time value of money, the application of the onerous test at the performance obligation level, the level of disclosures required, and retrospective transition.
Performance obligations satisfied over time .9 Guidance was added to the 2011 Exposure Draft on how to determine whether performance obligations are satisfied over time. This was added in response to feedback that the 2010 Exposure Draft lacked guidance in this area, especially for service contracts. .10 The proposed standard is now clear that performance obligations can be satisfied either at a point in time or over time. Control is transferred and revenue is recognized over time if certain criteria are met. .11 Respondents generally agree with the additional guidance, but confusion remains about whether a contract for the delivery of repetitive goods or services is a single performance obligation or multiple performance obligations. For example, a two-year contract for a daily cleaning service could be viewed as a single performance obligation satisfied over time or many daily distinct performance obligations. PwC observation: Support for the additional guidance was not unexpected as it clarified the accounting for most service arrangements. Significant progress has been made on this issue, despite there still being areas where clarity is needed. We agree with the guidance suggested, but further clarification is needed around the delivery of repetitive goods or services. This determination might affect the pattern and timing of revenue recognition, the accounting for contract modifications, and the onerous performance obligation test.
Presentation of the effects of credit risk .12 The presentation of the effects of credit risk, meaning the consideration an entity believes will not be collected, continues to get attention from respondents. The 2011 Exposure Draft proposes that an entity present any allowance for receivable impairment losses in a separate line item adjacent to revenue. Both the initial assessment and any subsequent changes to the estimate are recorded in this line.
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.13 Respondents generally disagree with presenting the effects of credit risk adjacent to revenue and recommend entities continue to record credit risk as an operating expense that does not impact gross profit. Most respondents have indicated that recognizing credit risk adjacent to the revenue line item introduces complexities that do not exist today. Other feedback has focused on whether the effects of credit risk need to be presented on the face of the income statement or whether disclosure would be sufficient. Respondents appear to agree that credit risk should not impact transaction price. PwC observation: Only a few respondents have raised concerns about collectibility no longer being a hurdle to revenue recognition. It appears that most preparers favor such a change in the proposed standard. Investors, on the other hand, are concerned about eliminating the "collectibility is reasonably assured" criteria under U.S. GAAP. They believe the proposed constraints on revenue are not effective enough to prevent entities from recording revenue prematurely. Investors also tend to agree with presenting revenue and any impairment losses (and reversals) as a separate line item adjacent to the revenue line, consistent with that proposed in the exposure draft. This contrasts with the views of preparers, who also suggest that the presentation of credit risk on the face of the income statement might not provide added benefit in all situations. We believe that allowing entities to present this information in the notes to financial statements would be equally useful.
Recognition of variable consideration and the revenue recognition constraint .14 The 2011 Exposure Draft provides guidance on the accounting for consideration that is variable or contingent on the outcome of future events (for example, discounts, incentives, and royalties). An estimate of variable consideration is included in the transaction price and allocated to each separate performance obligation. Variable consideration is only recognized as revenue when the entity is reasonably assured to be entitled to that amount. An entity needs to have predictive experience with similar performance obligations for the entity to be reasonably assured that it will be entitled to that consideration. .15 The proposed standard includes an exception to this principle for certain transactions. An entity that licenses intellectual property in exchange for royalties based on the customer's subsequent sales of a good or service is reasonably assured to be entitled to the royalty payment when those future sales occur. .16 Treatment of variable consideration was different in the 2010 Exposure Draft, as the transaction price was constrained rather than the cumulative revenue recognized. There were a number of unintended consequences of that treatment, which led the boards to propose a different constraint. .17 Some respondents support the exception for sales-based royalties, but many oppose it, particularly those in the technology, and retail and consumer industries. Concerns were raised that it could drive different accounting treatments for economically similar transactions, and should therefore either be eliminated or be expanded to include other arrangements where consideration is based on the customers' sales or where consideration is based on other customer performance measures.
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PwC observation: Feedback from constituents has been consistent--revenue recognition should be constrained if there is not sufficient evidence to support its recognition. Opinions diverge, however, on what constitutes sufficient evidence, with some believing the amounts should be "virtually certain" and others supporting "probable" or "more likely than not" thresholds. The boards have proposed a qualitative threshold, as opposed to a quantitative one, but more clarity might be needed to achieve that objective. We agree with respondents who said an exception is not needed for sales-based royalties. The proposed guidance on whether an entity's experience is predictive should be able to sufficiently address sales-based royalty arrangements without the need for an exception.
Scope of onerous performance obligation test .18 A performance obligation was onerous in the 2010 Exposure Draft if the present value of the costs to satisfy the obligation exceeded the transaction price allocated to it. There was no scope limitation and this test applied to all performance obligations. The boards revised the scope of the test to apply only to performance obligations that an entity satisfies over time and over a period greater than one year in response to concerns raised. .19 The boards now propose that a performance obligation is onerous only if the lowest cost of settling the performance obligation, being either the cost to fulfill or the cost to exit, exceeds the transaction price allocated to that performance obligation. A liability and a corresponding expense are recognized if the performance obligation is onerous. .20 Most respondents continue to disagree with assessing performance obligations to determine whether an obligation exists, citing that the accounting does not reflect the commercial substance in many arrangements. Respondents also believe that recording a loss at the performance obligation level for overall profitable contracts could result in misleading information. They contend that maintaining records at the performance obligation level is impractical and the cost and effort outweigh the benefits. Even those entities that currently apply an onerous test for long-term contracts do so at the contract level, not the performance obligation level. PwC observation: The onerous test continues to be universally disliked by industries that do not apply construction contract accounting today. Assessing performance obligations each reporting period to determine whether they are onerous will be challenging for many entities and it is questionable whether the benefits of making such an assessment will outweigh the cost or effort. We recommend that, if the assessment is retained in the final standard, it should be performed at the contract level or higher. Assessing whether a performance obligation is onerous as currently prescribed might not reflect the underlying economics of an arrangement. An entity might enter into loss-making performance obligations or loss-making contracts because other benefits are received, for example.
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Disclosures .21 The boards believe there is significant improvement to be made to existing revenue disclosures in light of criticism by regulators and users of financial statements. They have therefore proposed a comprehensive list of disclosures, for both annual and interim financial statements. .22 The proposed disclosures are intended to enable users of financial statements to understand the amount, timing, and judgments around revenue and the corresponding cash flows. Required disclosures include qualitative and quantitative information about revenue, such as significant judgments made and changes in those judgments, rollforward of balances, and assets recognized for the costs to obtain or fulfill contracts. .23 The boards have proposed that interim financial statements should include most of the same disclosures required in annual financial statements, if material. .24 Preparers of financial statements acknowledge the efforts made by the boards to enhance disclosures. Most believe, however, that the pendulum has swung too far. Key concerns raised by preparers include: Required disclosures are too extensive and might be based on information not used by management to manage the business The costs of providing the disclosures will exceed perceived benefits The disclosure requirements do not meet the boards' overall objective of increasing transparency and understanding of revenue recognition because they "clutter" the disclosures The extent of the disclosures required appears counterintuitive to the objectives in ongoing discussions at the IASB and FASB to improve disclosure effectiveness .25 Investors support the disclosure requirements, for both interim and annual financial statements. They believe the requirements are comprehensive and will significantly enhance users' understanding of an entity's revenue recognition. Investors acknowledge preparers' concerns around the volume of disclosures required, but believe the requirements are reasonable given the importance of revenue. .26 Investors also recommend that nonpublic companies should not be exempt from certain disclosure requirements and should not be treated differently than public companies, a view not shared by most other respondents. PwC observation: The boards are trying to improve the quality of disclosures, while achieving the right balance between the benefits to users of having that information and the costs to entities to prepare it. This is a fair objective given the limited disclosure requirements today. However, both interim and annual disclosure requirements proposed in the standard continue to be an area of controversy. To find the right balance, the boards have discussed holding a workshop that includes both preparers and users of financial statements to reconcile what is most critical to have in the financial statement disclosures. We agree that revenue disclosures generally need to be enhanced. We agree with preparers, though, that the proposal requires too many disclosures and risks obscuring useful information. Removing certain disclosure requirements will better balance the objectives of the boards, desires of users and the burden on preparers.
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For example, we question the need to disclose items not used by management to manage the business, and wonder whether such disclosures will be meaningful. The proposed interim disclosures appear inconsistent with the principle that interim reporting should reflect only significant changes since the last annual reporting period. A majority of preparers who responded have expressed concerns about both the annual and interim disclosure requirements, despite the boards only asking for input on interim disclosures. We believe the boards should reconsider their position on this issue.
Transfer of non-financial assets that are outside an entity's ordinary activities .27 The boards have proposed that the guidance on transfer of control and recognition of variable consideration in the proposed standard should also be applied to transfers of non-financial assets that are not an output of an entity's ordinary activities such as property, plant and equipment. .28 This guidance would determine when an entity should derecognize an asset and would provide guidance on how to measure any gain or loss on sale. The boards asked for specific feedback in this area as the recognition constraint would have an effect on the gain or loss when the consideration is variable. .29 Most respondents did not comment on this area. Those that did respond generally agree with applying the guidance to non-financial assets. Others disagree, advocating that current guidance be retained. PwC observation: This is an area that might have gone unnoticed by many respondents. We support applying the guidance in the proposed standard to the transfer of non-financial assets that are not part of an entitys ordinary activities. We recommend the scope of the guidance be clear, given there are currently different derecognition models and measurement guidance depending upon the nature of the item sold and whether an entity is applying U.S. GAAP or IFRS.
Time value of money .30 The proposed standard specifies that an entity reflect the time value of money to determine the transaction price if the contract has a significant financing component. .31 An entity that expects, at contract inception, that the period between payment by the customer and the transfer of goods or services to the customer will be one year or less does not need to consider the time value of money. This is a practical expedient introduced to address concerns about the burden and complexity of applying this guidance. .32 Respondents generally understand the conceptual basis for incorporating the time value of money into the transaction price, but continue to express concerns over the complexities and practical challenges associated with it. They are particularly concerned about the need to implement systems and processes to account for the time value of money. The majority of respondents across industries argue that the cost outweighs the benefit to users, and recommend this requirement be removed.
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.33 Some suggest that the practical expedient be removed since it is arbitrary and does not provide adequate relief. PwC observation: The volume of feedback in this area and the general direction of that feedback came as no surprise. Feedback through roundtables and other forums has been consistent with that noted in the comment letters. Generally, respondents (including users) believe that an entity should account for the time value of money when it is apparent that the contract contains a significant financing component; however, respondents are concerned with the complexity of applying this guidance. We understand the conceptual merit of considering the time value of money to determine the transaction price, but we also share constituent's concerns. The practical challenges of applying this guidance could outweigh the benefit to users in some situations. System and process changes will also be needed, at potentially high cost, for preparers to apply the guidance.
Transition .34 It is unclear when a final standard will be issued, but it will likely be early 2013. The boards have not yet decided on the effective date of the standard, but have said that it will not be effective earlier than January 1, 2015. Early adoption will not be permitted under U.S. GAAP, but will be permitted under IFRS. .35 The boards propose that the standard be applied retrospectively, with certain optional reliefs. The boards affirmed that comparability and understandability of revenue recognized before and after adoption of the new standard outweighs concerns raised about costs and efforts of applying the guidance to prior periods. The boards believe entities will have sufficient time between issuance of the standard and the effective date to prepare and compile the necessary information. .36 The boards have provided entities with several practical expedients to ease the burden of transition, as follows: Contracts that begin and end in the same annual reporting period do not need to be restated The transaction price at the date the contract was completed can be used for contracts with variable consideration that were completed on or before the effective date The onerous performance obligation test does not have to be applied to performance obligations in prior periods unless an onerous contract liability was recognized previously Disclosure of the amount of the transaction price allocated to remaining performance obligations and the expected timing of revenue recognition (the ofttermed "maturity analysis") is not required .37 Financial statement preparers acknowledge that retrospective application will provide users valuable information. Their primary concern is the added burden of applying both the proposed standard and current guidance to large and complex multiple-element arrangements and long-term contracts that span multiple periods. Many respondents believe maintaining a dual reporting system for up to three years is not practical or cost effective.
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.38 Other concerns raised by respondents point to potential unintended consequences from retrospective application, including implications on previously filed tax returns or compensation arrangements. .39 An overwhelming number of respondents recommend the boards allow some form of prospective adoption of the final standard or at least allow prospective application when it is not practical for entities to apply the standard retrospectively. Many also support permitting early adoption for all entities, not just those under IFRS. .40 Although users of financial statements acknowledge the burden of retrospective application on preparers, they support the proposed transition method and believe it is necessary for meaningful financial analysis. Instead of providing an option for another transition method, as proposed by preparers, users suggest that a better approach would be to delay the effective date of the proposed standard to give preparers more time to implement. PwC observation: Transition has been and continues to be one of the most loudly voiced concerns. While retrospective application might increase consistency across periods, the effort involved might outweigh the benefits. The practical expedients reduce some challenges, but there could be other implications which need to be considered, including statutory or regulatory requirements.
Industry perspectives
.41 Industry groups have been active in commenting, both verbally and in writing, on the 2011 Exposure Draft. They continue to express concerns with aspects of the proposed standard, some of which are common themes across multiple industries, while others are more specific to one industry. .42 This section summarizes specific issues and concerns raised by industries through the boards' outreach efforts. Some of the concerns raised during this outreach period, while less in volume than heard in relation to the 2010 Exposure Draft, remain significant to specific industries. The boards might need to reconsider certain proposals before issuing a final standard if they are to resolve some of these issues. .43 Certain industry groups are still struggling with aspects of the proposed standard. For example, the telecommunications industry continues to be concerned about the allocation of the transaction price in bundled arrangements and accounting for contract costs. The automotive industry has different views on how to account for non-cash incentives, while the entertainment industry is concerned with revenue recognition for license arrangements. The volume of comment letters remained relatively flat for these industries; however, the content of the comments is more focused on these specific issues. Aerospace and defense .44 The table below captures topics that remain top of mind for this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic.
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Summary of comments
Satisfaction of performance obligations Disclosures Onerous test Contract modifications Separate performance obligations Time value of money Transition 0% 20% 40% 60% 80% 100%
Identification of separate performance obligations .45 A majority of respondents in the aerospace and defense industry believe that a contract for the production of several similar items for a government, such as aircraft, is a single performance obligation since the contract is negotiated and managed on a combined basis. Many in the industry hold the view that the production of each individual unit is not distinct because the production process is highly interrelated and some of the items are highly customized to meet the customer's specifications. Respondents have highlighted that the proposals can be interpreted such that each unit produced under the contract is a separate performance obligation because the units are not highly interrelated with each other. Respondents therefore recommend the boards clarify the guidance. Performance obligations satisfied over time .46 Revenue should be recognized by measuring the progress toward satisfaction of a performance obligation if it is satisfied over time. Most respondents agree with the proposals, but question the timing of cost recognition when an output measure, such as units of delivery, is used to measure progress. Many are concerned that contract costs will be expensed as incurred as a fulfillment cost. This is a change from today's contract accounting guidance, which respondents feel will distort the margin during contract performance and therefore, does not reflect the economics of a contract that is satisfied over time. These respondents recommend that entities be allowed to use a systematic and rational approach for recognizing contract costs to reflect the single overall profit margin of the arrangement. .47 Many aerospace and defense contracts include estimates of rework costs, such as redesign or work-arounds, which are factored into contract estimates as normal costs to deliver highly complex and specialized equipment. The proposed standard requires that costs of wasted materials and inefficiencies be expensed when they are not already factored into the price of the contract. Concerns have been raised that it is difficult to identify when these normal rework costs become incremental to the initial estimate included in the contract. Contract modifications .48 Contract modifications occur frequently in the aerospace and defense industry. These modifications include changes to scope or price, including some that might be unapproved or in dispute (known as "claims"). Generally these modifications are approved after the contractor provides the related service. Respondents believe the proposed standard is unclear on the accounting for such modifications and recommend carrying forward existing guidance on the accounting for contract modification for construction contracts. This existing guidance is similar under IFRS and U.S. GAAP and
allows for recognition of amounts subject to claims or unapproved change orders in certain circumstances. PwC observation: The aerospace and defense industry is generally satisfied with the direction of the 2011 Exposure Draft. This industry was especially active in working with the boards during their redeliberations to share concerns and related business implications. The boards listened, and many of the concerns expressed by this industry on the 2010 Exposure Draft were addressed. Not surprisingly, the main concerns that remain are those that could drive different accounting results than the contract accounting models used today under both U.S. GAAP and IFRS.
Automotive .49 The table below captures significant topics that concern this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments
Transition Warranties Consideration payable to a customer Disclosure Time value of money 0% 10% 20% 30% 40% 50% 60% 70%
Consideration payable to a customer .50 Automotive manufacturers typically sell vehicles through an independent network of authorized dealers, who then sell the vehicles to the retail consumer. At the same time, the manufacturer commonly offers incentives directly to the retail consumer, including promises to provide free goods or services such as maintenance on the vehicle. Respondents are uncertain as to how to account for these non-cash incentives when they are offered directly to their customer's customer (i.e., the retail consumer). .51 Some believe that the cost of non-cash incentives should reduce the transaction price, similar to cash paid to a customer's customer, since the manufacturer does not perform the services promised. Others believe the promised good or service is a separate performance obligation and some revenue should be deferred at the time of sale to the authorized dealer. To the extent the promised good or service is not regularly sold separately by the manufacturer and its cost is incidental to the cost of the vehicle, some have proposed the boards consider allowing the incentives to be accounted for as a costaccrual. Despite the varying perspectives, most agree that additional clarity on the accounting for non-cash incentives promised to the customer's customer is needed.
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Warranties .52 Accounting for warranties continues to be an area of focus for the automotive industry. The industry supports the boards' proposal that assurance-type warranties should be accounted for as a cost accrual similar to today. The industry remains concerned about the requirement to account for a warranty as a separate performance obligation if there is a service component that the entity is unable to separate. Some do not believe that accounting for the service component of the warranty separately is practical. They also do not believe it represents the underlying economics of the arrangement unless that portion of the warranty is more than incidental to the assurance warranty. Respondents also do not agree that the length of the warranty period should determine whether a warranty includes a service element. Repurchase agreements .53 Automobile manufacturers sell vehicles to customers and often include repurchase or reimbursement options as part of the contract. This is common in arrangements with rental car companies, for example. These agreements are commonly structured as either: (1) the buyer has an option to put the vehicles back to the seller, or (2) the seller guarantees the residual value of the vehicle at the end of a specified term, such as 12 months. .54 The proposed standard results in different accounting for these arrangements. An unconditional obligation to repurchase the vehicle is a lease if the customer has a significant economic incentive to put the vehicle back to the manufacturer. The agreement is a sale if the manufacturer must reimburse the customer for any deficiency between the sales proceeds and a minimum resale value. Any expected reimbursements reduce the transaction price at the time of sale. Respondents believe these are economically similar transactions that should be accounted for the same way. Some respondents have also requested the boards define "unconditional obligation" to avoid diversity in practice, as the repurchase agreements are typically conditional on the vehicle being returned in a certain condition and within a certain time period. PwC observation: The automotive industry has generally supported the overall objectives of the proposed guidance. The remaining concerns, particularly around consideration payable to a customer, require the boards to further clarify guidance in the 2011 Exposure Draft as the guidance is not being consistently interpreted by entities within the industry.
Consumer industrial products .55 The consumer industrial products sector comprises a range of entities involved in the production of goods and delivery of services across a diverse industry base. This includes industrial manufacturing, metals, chemicals, forest products, paper and packaging entities. The wide range of entities in this industry voiced concerns on a variety of issues. Uninstalled materials .56 Respondents have raised concerns with the guidance on uninstalled materials when an entity uses subcontractors who provide as is equipment for installation into a final product or service. The proposed standard requires that the revenue recognized for this performance obligation equal the cost of the equipment acquired from a subcontractor (that is, a zero percent profit margin). Respondents disagree with allocating a zero percent profit margin for goods purchased from a subcontractor contending that the entity is providing the customer a turn-key solution not just passing through the equipment.
Licenses .57 Franchisors generally do not agree with the proposed accounting for license arrangements with variable consideration. There is specific concern with recognizing royalty revenue prior to the related sale by the franchisee. They believe these arrangements are economically similar to royalties based on a customer's subsequent sale in a license of intellectual property and that revenue should be recognized over time as the royalties are earned. Engineering and construction .58 The table below captures significant topics commented on by this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments
Onerous test Contract costs / uninstalled materials Disclosures Transition Separate performance obligations Contract modifications 0% 20% 40% 60% 80%
Identification of separate performance obligations .59 The engineering and construction industry is concerned that the proposed definition of a distinct performance obligation in the 2010 Exposure Draft might require contracts to be accounted for as numerous separate performance obligations, which might not reflect the substance of the contract. The 2011 Exposure Draft clarifies that promised goods or services are not distinct if they are highly interrelated and significantly customized. .60 Some concerns around identifying separate performance obligations remain, despite the industry generally being pleased with the clarifications made by the boards. The guidance indicates that every contract that contains a bundle of highly interrelated and significantly customized performance obligations must be a single performance obligation. This might often be the case, but there are situations when performance obligations are distinct yet also highly interrelated and significantly customized (for example, a contract with engineering, procurement, and construction services bundled together). Respondents recommend the boards revise the guidance to allow for the application of reasonable judgment in applying the principle to identify separate performance obligations. Uninstalled materials .61 Common in many engineering and construction contracts is the use of third parties, such as subcontractors to construct goods specifically for a project. These goods could remain uninstalled for a significant period of time, for example, due to long lead times to engineer, fabricate, and construct these items, or other factors. The proposed standard requires that an entity only recognize revenue to the extent of the cost of such uninstalled materials.
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.62 Respondents generally believe the profit recognized on goods specifically produced for the project should be consistent with the contract as a whole since contracts are typically bid with an overall profit margin in mind, not separate, distinct profit margins for different phases of the project. Transfer of materials customized specifically for a project represents progress towards satisfying the performance obligation. Respondents therefore propose that profit consistent with the overall contract be recognized on such uninstalled materials when measuring progress toward satisfying the performance obligation. Contract modifications .63 Contract modifications occur frequently in the engineering and construction industry. These modifications include changes to scope or price, including some that might be unapproved or in dispute (known as "claims"). Generally these modifications are approved after the contractor provides the related services. Respondents believe the proposed standard is unclear on the accounting for such modifications and recommend carrying forward existing guidance on the accounting for contract modifications for construction contracts. This existing guidance is similar under IFRS and U.S. GAAP and allows for recognition of amounts subject to claims or unapproved change orders in certain circumstances. PwC observation: The engineering and construction industry have expressed broad support for the boards' overall objectives; however, many in the industry (both preparers and users) do not believe the proposed model improves existing accounting. That said, the industry is generally satisfied with the direction of the 2011 Exposure Draft. Similar to the aerospace and defense industry, this industry has been active in working with the boards during the redeliberation process and, in fact, many of their concerns were addressed in the 2011 Exposure Draft. There is only a short list of concerns that remain and it is not surprising that these center on the nature of certain business practices in this industry. We believe the proposed revenue guidance could benefit from clarification in these areas.
Entertainment and media .64 The table below captures significant topics that remain top of mind for this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments
Transition Licenses Onerous test Disclosures 0% 20% 40% 60% 80% 100%
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Licenses .65 Some constituents have raised concerns over the accounting for perpetual licenses and time-based licenses, arguing that the two are economically different and therefore, should be accounted for differently. They believe revenue from perpetual licenses should be recognized when the license transfers and revenue from time-based licenses should be recognized over the relevant period. Others question this distinction, and highlight that it might be difficult to determine whether a license is perpetual or time-based if renewal options or cancellation clauses exist. .66 Many long term license arrangements for film and television contain licensorimposed restrictions. These may include interruptions on the right to use the license during the license term or constraints on the frequency and timing of the use of the license. For example, it is common for a licensor of an episodic television series to specify how the episodes should be sequenced, and with what frequency and over what time frame the episodes may be aired. Many respondents highlight that these complexities result in significant judgment to determine when control transfers. They believe additional clarity is needed to avoid inconsistent application of the guidance to such arrangements. .67 Digital distribution of licensed content has become more prevalent in the entertainment and media realm. A library or portfolio of content might be provided under a single arrangement; however, the content may be substituted or refreshed throughout the license term. Respondents question whether arrangements to distribute licensed intellectual property over certain digital platforms should be accounted for as a service arrangement satisfied over time, which many believe better reflects the economics of such transactions rather than a performance obligation satisfied at a point in time when the license is provided. Onerous performance obligations .68 The onerous test is likely to add significant complexity to the accounting within this industry. The boards have been asked to further clarify how to apply the onerous test when an entity pools its related programming costs. Programming assets are often recovered through cash flows from multiple distributor arrangements and advertising revenues. Respondents in the industry believe that when there is a pool of costs shared among several customer contracts, an onerous test applied at a level even higher than the contract would be more practical and better reflect the economic substance of these transactions. Some respondents also feel that the onerous test contradicts existing impairment guidance for these assets since loss recognition could occur even though the underlying program investment is profitable. PwC observation: Many constituents in the entertainment and media industry are concerned that the control-based criteria could result in immediate recognition of revenue from the licensing of intellectual property, which they believe contradicts the economic substance of certain arrangements. There are certain license arrangements, such as licenses of digital content or a portfolio of content, where revenue recognition over time might better reflect the benefit that the customer is receiving. Constituents feel that the standard should be flexible enough to account for the economic substance of different license arrangements, including reflecting revenue in the period of benefit to the customer. This issue is becoming more prevalent with the recent growth in digital distribution of media content. We believe significant judgment will be required in determining the application of the control-based criteria to these arrangements.
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Financial institutions .69 Financial services companies such as banking institutions, insurance companies, real estate, and asset managers commented on a variety of issues. However, the applicability of the reasonably assured constraint on performance fees is one of the main concerns highlighted by asset management entities. The customer loyalty program for credit cards is one of the main concerns highlighted by banks and other financial services entities. Asset management Reasonably assured constraint .70 Common revenue streams in scope of the proposed standard are performance fees, management fees, and upfront fees. Respondents are primarily concerned with the potential impact the proposed standard might have on performance fees. Performance fees are usually based on the value of investments managed by funds, subject to certain thresholds (for example, hurdle rate, high water mark or internal rate of return). Performance fees are often subject to clawback provisions requiring the return of a portion of the fees received if the cumulative performance results of the fund are lower than expected. This raises concerns as to when the fees should be considered reasonably assured. Revenues could be deferred in some cases if the payments are not reasonably assured until there is no risk of return, which could result in revenue being recognized well after the cash has been received. .71 Respondents are concerned that the overall usefulness of their financial statements will decline as a result of deferring revenue in such situations. Respondents believe the treatment of performance fees is well understood in the industry and recommend the boards conduct further industry outreach before issuing a final standard. PwC observation: The proposed standard might impact the timing of the recognition of performance fees as these fees may be highly susceptible to external factors such as market risk. Under current U.S. GAAP, asset managers can apply one of two methods to account for performance fees. We do not expect the proposed standard to significantly affect asset managers that currently recognize performance fees in the periods during which the related services are performed and all the contingencies have been resolved. On the other hand, asset managers that currently recognize performance fees using the hypothetical liquidation method will be impacted since under this approach revenue is typically recognized in advance of the amount becoming reasonably assured as defined under the proposed standard. Asset managers currently under IFRS will generally not be significantly impacted by the proposed standard as the majority of asset managers already recognize performance fees when the fee becomes reliably measurable, which is often at the end of the performance period when the outcome is known.
Financial services Customer loyalty programs .72 The banking and capital markets industry is concerned about whether credit card loyalty programs are in the scope of the proposed standard. A card issuer earns a processing fee from the merchant on the revenue transaction that occurs between the merchant and the cardholder in a typical credit card reward program. The cardholder earns reward points from the card issuer at the same time. Some respondents argue that
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these are two separate arrangements, one with the merchant for the processing fee and another with the cardholder for the reward program. .73 Respondents recommend that the boards clarify how to apply the proposed standard to these multiple party arrangements if they are in the scope of the standard. They also highlight that the example included in the proposed standard on customer loyalty programs is not applicable to credit card reward programs because the awards arise out of a transaction outside the scope of the revenue standard (that is, a financing arrangement). .74 Many respondents interpret the proposed guidance to mean credit card loyalty programs are outside the scope of the proposed guidance since the card issuer, the merchant and the cardholder are unrelated parties and there is no price interdependency among these contracts. .75 Respondents also have noted that the guidance on measuring the transaction price seems to provide an exception to the contract combination guidance. Consideration payable to a customer or to other parties that purchase the entity's goods or services is treated, in either case, as a reduction of the transaction price with the customer. Respondents therefore believe that additional clarity is needed to understand whether credit card reward programs are scoped into the proposed guidance. .76 Some respondents have suggested that accounting for credit card loyalty credits as performance obligations will introduce significant complexity to existing accounting. Many credit card issuers currently recognize the cost of loyalty rewards as an offset to merchant fee income when rewards are earned and record a corresponding liability. Respondents believe that applying the proposed guidance will require cash rewards to be netted against merchant fee income as a reduction of the transaction price, but non-cash rewards will result in only a deferral of recognition as the transaction price would remain the same. Respondents consider cash and non-cash rewards to be economically similar and believe they should not have different accounting treatments. PwC observation: The industry has been vocal both in roundtables and in comment letter responses that they do not believe that the proposed accounting is appropriate for credit card loyalty programs. There are concerns about the accounting for loyalty awards that are provided outside of a revenue transaction, such as upon opening a credit card account. We believe it is also unclear which revenue streams should be considered to determine the amount of revenue to be deferred. That is, whether it is payments made by the card holder to participate in the program, merchant fees, interest charged to the card holder, or some combination of the above. We agree it is unclear and that the boards need to provide greater clarity on the accounting for contracts that involve multiple parties.
Pharmaceutical, life sciences, and health care .77 Respondents from this industry commented on a variety of issues. The key areas focus on the definition of a customer and accounting for collaboration arrangements. Definition of a customer .78 The proposed standard defines a customer as the party contracted to receive output of an entity's ordinary activities. It further states that the counterparty in a contract might or might not be a customer, and lists a collaborator or partner as an example of
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this. Respondents from the industry are concerned that there can be arrangements in which the definition of a customer under the proposed standard is not clear. Respondents are looking for further guidance on how to account for these arrangements. Collaboration arrangements .79 Collaborative arrangements in the industry commonly focus on product development, but also include other activities such as distributing and marketing a product. The proposed standard only makes reference to collaboration agreements focused on product development. Respondents recommend broadening this to include other types of collaboration agreements that should be scoped out of the proposed standard. PwC observation: Certain collaboration arrangements in the biotechnology industry might be with parties that are not customers and therefore appear out of scope. Being a collaborator in an arrangement does not automatically mean the contract is scoped out of the revenue standard, as such contracts can have both revenue and non-revenue elements. Judgment will be needed to determine which elements of such arrangements should be accounted for under the revenue standard and which will be accounted for under other guidance.
Technology .80 The table below captures significant topics that remain a concern for this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments
Transition Disclosures Separate performance obligations Contract costs Onerous test 0% 10% 20% 30% 40% 50% 60% 70%
Identification of separate performance obligations .81 The identification of separate performance obligations continues to be an area of concern for the technology industry. Respondents' interpretation of the proposed standard suggest that even though bundled arrangements have components that meet the distinct criteria, the entity would have to account for the arrangement as a single performance obligation if the bundled goods or services are highly interrelated and customized. .82 It is common in the software industry to sell a license and related implementation and customization services separately. There is concern that the proposed guidance implies that if the entity is awarded the service with the license in the bidding process, this would be accounted for as a single performance obligation. In some situations, this
results in revenue for the license being deferred and recognized in accordance with the transfer of control over time in combination with the implementation and customization services. This is a contrast to when the license and service are not awarded at the same time which would result in revenue for the license recognized upon transfer to the customer. Contract costs .83 A majority of respondents from the technology industry disagree with capitalizing incremental costs of obtaining a contract with a customer, such as sales commissions. Sales commissions are commonly based on a variety of measures such as overall contract performance or customer satisfaction and rarely are based solely on contract acquisitions. Respondents acknowledge the practical expedient, but believe the one year exclusion is arbitrary. They recommend allowing a policy election to avoid the operational burden of this guidance as they feel the benefit to users of financial statements is not significant. PwC observation: There were a number of software companies that responded to the 2011 Exposure Draft that still have concerns about accounting for software deliverables. The principles of the proposed standard will result in virtually all of the deliverables that are currently included in most software transactions (license, PCS, services, etc.) being accounted for separately. Software companies that recognize licenses and postcontract support ratably over the contractual term due to the inability to establish vendor-specific objective evidence will be required to separate the deliverables under the proposed guidance. As a result, revenue may be accelerated and some software companies are reluctant to abandon the ratable revenue recognition model in these cases. The proposed guidance could also require companies to defer more costs. Specifically, those companies that expense sales commissions as paid and set-up costs as incurred could now be required to capitalize and amortize these costs. Respondents believe the proposed guidance could be an operational burden for companies that currently expense all contract costs as incurred, except where the practical expedient applies.
Telecommunications .84 The table below captures significant topics commented on by this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments
Disclosures Allocation of transaction price Contract costs Transition 0% 10% 20% 30% 40% 50% 60% 70%
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.85 Telecom respondents have primarily focused on two key areas of concern: (i) the allocation of transaction price; and (ii) costs to obtain a contract. Allocation of transaction price .86 Wireless service providers typically offer highly subsidized handsets to customers signing up for a service plan. Standalone sales of wireless devices do occur but are typically limited to sales to third party resellers or dealers, or direct sales to customers replacing a lost or broken device. Telecommunication entities view neither instance as indicative of the selling price of devices if sold regularly on a standalone basis to customers. .87 The proposed guidance eliminates the contingent revenue cap that currently exists under U.S. GAAP and is regularly applied by the industry. That is, the amount allocated to a delivered item is limited to the amount that is not contingent upon the delivery of additional items or meeting other specified performance conditions (i.e., the noncontingent amount). Revenue allocated to the subsidized handset would be greater under the proposed standard, resulting in earlier revenue recognition. Respondents do not believe this represents the economic substance of these transactions, as the industry focuses on the service aspect of these transactions as opposed to the sale of the handsets. .88 As proposed in the standard, using the residual approach is limited to situations where the standalone selling price of a good or service is highly variable or uncertain. Some respondents propose to expand the scope of the residual approach to also include goods or services sold infrequently on a standalone basis. Others propose refinements to the guidance on allocating a discount to specific performance obligations, which they believe better reflects the economics of selling deeply discounted handsets to customers. Contract costs .89 Respondents generally oppose the requirement to capitalize incremental costs of obtaining a contract. They note that capitalizing sales commissions will require significant estimation and periodic impairment evaluations that would introduce judgment and variability to an otherwise uncomplicated process. Respondents propose removing the requirement to account for costs to obtain a contract from the proposed standard or allow constituents to have a policy election for immediate recognition of expense. PwC observation: The telecommunications industry has been one of the most vocal in providing feedback to the boards, both in public and private roundtables, comment letters, and other communications. The industry vehemently disagrees with the allocation of revenue to the mobile phone handsets in an amount that exceeds cash received, as they feel this does not represent the economics of their business. They also contend that the costs to change systems and processes will be significant. We understand the concerns of the industry and the practical challenges of implementation, but believe that any proposed solution needs to be consistent with the principles in the model so as to avoid unintended consequences to other industries.
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Next steps
.90 The boards will begin to redeliberate the proposed standard in June 2012. We have included the proposed redeliberation timeline in Appendix B, which details the expected timing of discussion of outstanding issues by the boards.
Questions
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Appendix A Summary of significant comment letter topics by industry group
Topics
Performance obligations satisfied over time Presentation of the effects of credit risk Recognition of variable consideration Onerous test Disclosures Transfer of non-financial assets Time value of money Transition Identification of separate performance obligations Allocation of transaction price Contract costs Consideration payable to a customer Repurchase agreements
Aerospace & defense
Automotive
Consumer industrial products
Engineering & construction
Entertainment & media
Financial institutions
Pharma, life sciences, & health care
Technology
Telecom
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Appendix B Proposed project timeline1
Month June 2012
Topic Identification of separate performance obligations (Step 2) Satisfaction of performance obligations (Step 5) Contract issues (Step 1)
July 2012 Licenses Onerous test Constraint (Step 5) September 2012 Collectibility Time value of money (Step 3) Scope Costs October 2012 Allocation of the transaction price (Step 4) Nonfinancial assets Disclosures November 2012 Transition, effective date & early adoption Sweep issues & consequential amendments December 2012 Cost-benefit analysis Q1 2013 Q2 2013 & Thereafter Publication Post-publication 6 5 4 3 2
Excerpted from page 21 of the Staff Paper, Revenue recognition Project plan for redeliberations, discussed at the May 21-25, 2012 public meeting of the FASB and IASB. The Staff Paper is copyrighted by the Financial Accounting Foundation and the IFRS Foundation, and this excerpt has been reproduced with permission. The Staff Paper was prepared by the staff of the FASB and IFRS Foundation for discussion at the public meeting. It does not purport to represent the views of any individual members of either board. Comments on the application of US GAAP or IFRSs do not purport to set out acceptable or unacceptable application of US GAAP or IFRSs. The FASB and the IASB report their decisions made at public meetings in FASB Action Alert or in IASB Update.
2011 ED Question 1
Authored by:
Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Steve Mack Senior Manager Phone: 1-973-236-4378 Email: steve.mack@us.pwc.com Jennifer Chen Senior Manager Phone: 1-973-236-4735 Email: jennifer.y.chen@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com Craig Robichaud Senior Manager Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com

Revenue from contracts with customers The proposed revenue standard is re-exposed
Overview
At a glance The FASB and IASB (the "boards") released an updated exposure draft, Revenue from Contract with Customers, on November 14, 2011 and are requesting comments by March 13, 2012. The boards have asked whether the proposed guidance is clear, and requested feedback specifically on: performance obligations satisfied over time; presentation of the effects of credit risk; recognition of variable consideration; the scope of the onerous performance obligation test; interim disclosures; and transfer of nonfinancial assets that are outside an entity's ordinary activities (for example, sale of PP&E). The proposed model requires a five-step approach. Management will first identify the contract(s) with the customer and separate performance obligations within the contract(s). Management will then estimate and allocate the transaction price to each separate performance obligation. Revenue is recognized when an entity satisfies its obligations by transferring control of a good or service to a customer. It is unclear when a final standard will be issued; however, the boards have indicated that the final standard will have an effective date no earlier than 2015. Full retrospective application will be required with the option to apply limited transition reliefs. Background .1 The boards initiated this joint project in 2002 to develop a common revenue standard for U.S. GAAP and IFRS. The original exposure draft was issued in June 2010 (the "2010 Exposure Draft"). .2 The boards received nearly 1,000 comment letters on the 2010 Exposure Draft, which highlighted a number of recurring themes that were discussed during re_____________
No. 2011-35 November 22, 2011

(Revised January 3, 2012*)

At a glance ...............................1 Background .............................1 Scope ....................................... 2
The proposed model ........3

Identify the contract with the customer ................ 3 Identify the separate performance obligations ..... 5 Determine the transaction price and amounts not expected to be collected ........ 7 Allocate the transaction price to distinct performance obligations .... 11 Recognize revenue when (or as) each performance obligation is satisfied ............................12
Other considerations..... 17 Disclosures .....................25 Transition ..................... 26 Next steps ....................... 27 Questions ....................... 27 Appendix Key differences between the 2010 and 2011 exposure drafts .......................... 28
* Example 7.1 in the subsection Measurement of progress was revised to correct the calculation of "rev enue
recognized to date" by excluding the correct amount of costs related to uninstalled materials.
deliberations. They addressed several areas including the identification of separate performance obligations, determining the transaction price, accounting for variable consideration, transfer of control, warranties, contract costs, and accounting for licenses to use intellectual property, among others. .3 The boards decided to re-expose the proposed revenue guidance to avoid unintended consequences from the final standard and to increase transparency. The updated exposure draft was issued in November 2011. References within this Dataline to the exposure draft or proposed standard refer to the exposure draft issued in November 2011, unless otherwise indicated. .4 The exposure draft proposes a new revenue recognition model that could significantly change the way entities recognize revenue. The objective is to remove inconsistencies in existing revenue requirements and improve the comparability of revenue recognition across industries and capital markets. .5 The proposed standard employs an asset and liability approachthe cornerstone of the FASBs and IASBs conceptual frameworks. Current revenue guidance under both frameworks focuses on an earnings process, but difficulties often arise in determining when revenue is "earned" and when the earnings process is complete. The boards believe a single, contract-based model that reflects changes in contract assets and liabilities will lead to greater consistency in the recognition and presentation of revenue. PwC observation: The proposed standard will be a significant shift in how revenue is recognized in many circumstances. The effect could be considerable, requiring management to perform a comprehensive review of existing contracts, business models, company practices, and accounting policies. The proposed standard could also have broad implications for an entity's processes and controls. Management might need to change existing IT systems and internal controls in order to capture different information than in the past. The effect could extend to other functions such as treasury, tax, and human resources. For example, changes in the timing or amount of revenue recognized may affect long-term compensation arrangements, debt covenants, and key financial ratios. .6 This Dataline explores key aspects of the proposed standard. The boards' conclusions are tentative and subject to change until they issue the final standard. We have summarized the key changes to the 2010 Exposure Draft in an Appendix to this Dataline. Scope .7 The proposed standard defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied by an entity's customary business practice. A customer is defined as a party that has contracted with an entity to obtain goods or services that are an output of the entity's ordinary activities. .8 The proposed standard applies to an entity's contracts with customers, except for: Lease contracts Insurance contracts Certain contractual rights or obligations within the scope of other standards including financial instruments and extinguishments of liabilities
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Certain guarantees within the scope of other standards (other than product warranties) Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers .9 Some contracts might include components that are in the scope of the proposed standard and other components that are in the scope of other standards (for example, a contract that includes both a lease and maintenance services). In this situation, an entity will apply the other standard to separate and measure that component of the contract if that standard has separation and measurement guidance. Otherwise, the principles of this proposed standard are applied. PwC observation: The proposed standard addresses contracts with customers across all industries and eliminates industry-specific guidance. Most transactions accounted for under existing revenue standards in U.S. GAAP and IFRS will be within the scope of the proposed standard. Certain transactions in industries that recognize revenue from a counterparty that is a collaborator or partner that shares risk in developing a product might not be in the scope of the proposed standard. For example, some collaborative arrangements in the biotechnological industry or entitlement-based arrangements in the oil and gas industry might not be within the scope of the proposed standard.
The proposed model

.10 Entities will perform the following five steps in applying the proposed model: Identify the contract with the customer Identify the separate performance obligations in the contract Determine the transaction price and amounts not expected to be collected Allocate the transaction price to separate performance obligations Recognize revenue when (or as) each performance obligation is satisfied PwC observation: The steps in the proposed standard may appear simple, but significant judgment will be needed to apply the principles. For example, determining whether a good or service is a separate performance obligation, and thus should be accounted for separately, will require judgment. Management will also need to consider a number of factors to estimate the transaction price, including the effects of variable consideration and time value of money.
Identify the contract with the customer .11 A contract exists if all the following criteria are met: The contract has commercial substance
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The parties to the contract have approved the contract and are committed to perform their respective obligations Management can identify each party's rights and obligations regarding the goods or services to be transferred Management can identify the terms and manner of payment for the goods or services to be transferred .12 Two or more contracts entered into at or near the same time with the same customer (or parties related to the customer) may need to be combined if one or more of the following criteria are met: The contracts are negotiated with a single commercial objective The consideration paid in one contract depends on the price or performance under the other contract The goods or services promised under the contracts are a single performance obligation PwC observation: Identifying the contract with the customer will be straightforward in many cases. The approval of a contract might not be as strict as some existing guidance under U.S. GAAP. For example, the software guidance under U.S. GAAP today has strict rules to establish whether or not a contract with the customer meets the evidence of an arrangement requirement. The underlying concepts are otherwise consistent with existing guidance under U.S. GAAP and IFRS. It may be more challenging to identify the contract with the customer in situations where an arrangement involves three or more parties, particularly if there are separate contracts with each of the parties. These types of arrangements might occur in the asset management industry, for example, or when credit card holders buy goods from a retailer but receive reward points from the credit card issuer. The exposure draft does not include specific guidance on how to account for these types of arrangements. .13 A contract modification is treated as a separate contract only if it results in the addition of a separate performance obligation and the price reflects the stand-alone selling price (that is, the price the good or service would be sold for if sold on a standalone basis) of the additional performance obligation. The modification is otherwise accounted for as an adjustment to the original contract either through a cumulative catch-up adjustment to revenue or a prospective adjustment to revenue when future performance obligations are satisfied, depending on the facts and circumstances. Example 1.1 Contract modifications: A manufacturing entity enters into a contract with a customer to deliver 1,000 products over a one year period for $50 per product. The products are distinct performance obligations because the entity regularly sells each product separately (see paragraphs 14-19). The contract is modified six months after inception to include an additional 500 products for $45 per product. The new price reflects the stand-alone selling price of the product at the time of the contract modification.
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The contract modification is a separate contract that should be accounted for prospectively. The additional products are distinct performance obligations and the price reflects the stand-alone selling price of each product at the time of the contract modification. Example 1.2 Contract modifications: A construction entity enters into a contract with a customer to build a customized house. The contract is a single performance obligation given the deliverable promised to the customer (see paragraphs 14-19). Costs incurred to date in relation to total estimated costs to be incurred is the best measure of the pattern of transfer to the customer (see paragraphs 39-40). The original transaction price in the contract was $500,000 with estimated costs of $400,000. The customer requests changes to the design midway through construction ($200,000 of costs have been incurred). The modification increases the transaction price and estimated costs by $100,000 and $50,000, respectively. The entity should account for the contract modification as if it were part of the original contract because the modification does not result in a separate performance obligation. Management should update its measurement of progress on the original contract to reflect the contract modification because the remaining goods and services are part of a single performance obligation that is partially satisfied at the modification date.
Original Transaction price Estimated costs Percent complete Revenue to date Incremental revenue $500,000 $400,000 50% $250,000 Modification $100,000 $50,000 Revised $600,000 $450,000 44% $264,000 $14,000
Identify the separate performance obligations .14 A performance obligation is a promise (whether explicit, implicit or implied) in a contract with a customer to transfer a good or service to the customer. A contract might explicitly state performance obligations, but they could also arise in other ways. Legal or statutory requirements can create performance obligations even though such obligations are not explicit in the contract. Customary business practices, such as an entity's practice of providing customer support, might also create performance obligations. .15 An entity accounts for each promised good or service as a separate performance obligation if the good or service is distinct. A good or service is distinct if either of the following criteria is met: The entity regularly sells the good or service separately The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer
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.16 An entity shall combine a bundle of distinct goods or services into a single performance obligation if both of the following criteria are met: The goods or services are highly interrelated and require the entity to provide a significant service of integrating the goods or services into a combined item that the customer has contracted for The entity significantly modifies or customizes the goods or services to fulfill the contract .17 Readily available resources are goods or services that are sold separately by the entity or another entity, or resources that the customer already has obtained from the entity or from other transactions or events. .18 An entity may account for separate performance obligations satisfied at the same time or over the same period as one performance obligation as a practical expedient. .19 An entity should combine goods or services that are not distinct with other goods or services until there are bundles of goods or services that are distinct. PwC observation: The exposure draft provides criteria for assessing whether a bundle of goods or services should be combined into a single performance obligation, but does not provide detailed guidance on how to assess whether integration services are "significant" or when an entity is "significantly" modifying or customizing a good. We believe management should carefully evaluate the criteria provided to ensure that combining goods and services results in accounting that reflects the underlying economics of the transaction. Example 2.1 Integration services: A construction entity enters into a contract with a customer to build a bridge. The entity is responsible for the overall management of the project including excavation, engineering, procurement, and construction. The entity would account for the bundle of goods and services as a single performance obligation since the goods and services to be delivered under the contract are highly interrelated. There is also a significant integration service to customize and modify the goods and services necessary to construct the bridge. Example 2.2 Separate performance obligations and consideration of timing: A manufacturing entity enters into a contract with a customer to sell a unique tool and replacement parts. The entity always sells the unique tool and replacement parts together, and no other entity sells either product. The customer can use the unique tool without the replacement parts, but the replacement parts have no use without the unique tool. There would be two distinct performance obligations if the manufacturing entity transfers the tool first, because the customer can benefit from the tool on its own and the customer can benefit from the replacement parts using a resource that is readily available (that is, the tool that was transferred first).
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There would only be one performance obligation if the manufacturing entity transfers the replacement parts first, because the customer does not have a readily available resource to benefit from the replacement parts. The entity would account for both products as a single performance obligation in this scenario.
Determine the transaction price and amounts not expected to be collected .20 The transaction price in a contract reflects the amount of consideration that an entity expects to be entitled to in exchange for goods or services delivered. The transaction price is readily determinable in some contracts because the customer promises to pay a fixed amount of consideration in return for the transfer of a fixed number of goods or services in a reasonably short timeframe. In other contracts, management needs to consider the effects of: Variable consideration Time value of money Noncash consideration Consideration paid to a customer Variable consideration .21 The transaction price might include an element of consideration that is variable or contingent on the outcome of future events, including (but not limited to) discounts, rebates, refunds, credits, incentives, performance bonuses, and royalties. Management estimates the total amount of consideration the entity is entitled to as part of the transaction price when a contract includes variable consideration. Management should use one of the following approaches to estimate variable consideration depending on which is the most predictive, and that estimate should be updated at each reporting period: The expected value, being the sum of probability-weighted amounts The most likely outcome, being the most likely amount in a range of possible amounts .22 The amount of variable consideration included in the transaction price and allocated to a satisfied performance obligation should be recognized as revenue only when the entity is reasonably assured to be entitled to that amount. See paragraphs 41-43 for further discussion of this constraint on the recognition of revenue. PwC observation: The proposed guidance requires management to determine the total transaction price, including an estimate of variable consideration, at the outset of the contract and on an ongoing basis. Variable consideration is also referred to as contingent consideration and can come in a variety of forms. Some contingencies may relate to future performance by the seller that is substantially within the seller's control, while other contingencies may depend heavily on the actions of a customer or a third party.
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Revenue will not be recognized for variable consideration if the entity is not reasonably assured to be entitled to that consideration, as discussed further below. However, management may still be required to estimate all forms of variable consideration to measure and allocate the transaction price to each separate performance obligation. In some cases, such as when there is only a single performance obligation that is delivered at a point in time, it may not be necessary to estimate variable consideration until management is reasonably assured to be entitled to the consideration. Example 3.1 Estimating variable consideration: A construction entity enters into a contract with a customer to build an asset for $100,000 with a performance bonus of $50,000 that will be paid based on the timing of completion. The amount of the performance bonus decreases by 10 percent per week for every week beyond the agreed-upon completion date. The contract requirements are similar to contracts the entity has performed previously and management believes that such experience is predictive for this contract. Management estimates that there is a 60% probability that the contract will be completed by the agreed-upon completion date, a 30% probability that it will be completed one week late, and only a 10% possibility that it will be completed two weeks late. The transaction price should include managements estimate of the amount of consideration to which the entity will be entitled. Management has concluded that the probability-weighted method is the most predictive approach for estimating the variable consideration in this situation:
60% chance of $150,000=$90,000 30% chance of $145,000=$43,500 10% chance of $140,000=$14,000
The total transaction price would be $147,500 based on the probability-weighted estimate. Management should update its estimate each reporting date. Using a most likely outcome approach may be more predictive if a performance bonus is binary such that the entity earns either $50,000 for completion on the agreed-upon date, or nothing for completion after the agreed-upon date. In this scenario, if management believes that the entity will meet the deadline and estimates the consideration using the most likely outcome, the total transaction price would be $150,000.
Time value of money .23 The transaction price should reflect the time value of money when the contract contains a significant financing component. When a significant financing component exists, management should use a discount rate that reflects a financing transaction between the entity and its customer that does not involve the provision of other goods or services. The entity presents the effects of financing as interest expense or income. .24 Management should consider the following factors to determine if there is a significant financing component in a contract: The length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services
Whether the amount of consideration would substantially differ if the customer paid in cash at the time of transfer of the goods or services The interest rate in the contract and prevailing interest rates in the relevant market .25 An entity is not required to reflect the time value of money in the measurement of the transaction price when the time from transfer of the goods or services to payment is less than one year, as a practical expedient. PwC observation: Determining whether a significant financing component exists in a contract could be particularly challenging in long-term or multiple-element arrangements where goods or services are delivered and cash payments are made throughout the arrangement. Management will need to assess the timing of delivery of goods and services in relation to cash payments to determine if the length of time is in excess of one year, which could indicate that a significant financing component exists. Accounting for the effects of the time value of money could result in a considerable change in practice for certain entities, particularly when consideration is paid significantly in advance or in arrears. This could result in the recognition of revenue in an amount that is different from the amount of cash received from the customer. If payments are made in arrears, revenue recognized will be less than cash received. If payments are made in advance, revenue recognized will exceed the cash received. An example of how to apply the guidance for the time value of money in a basic transaction is included in the implementation guidance within the proposed standard. The calculations could be significantly more challenging in complex situations or when estimates change throughout the life of an arrangement.
Noncash consideration .26 An entity measures noncash consideration received for satisfying a performance obligation at its fair value. When management cannot estimate fair value reliably, the entity measures the noncash consideration received indirectly by reference to the standalone selling price of the goods or services transferred. Consideration paid to a customer .27 Consideration paid by an entity to its customer might include rebates or upfront payments (for example, slotting fees), and could take the form of cash or credit. Consideration paid to a customer is assessed to determine if the amount should be reflected as a reduction of the transaction price, because it represents a discount on the goods or services delivered or to be delivered. If the consideration represents payment for distinct goods or services received from the customer, it is treated like any other purchase from a vendor. .28 An entity reduces revenue when it pays consideration to a customer that represents a discount at the later of when the entity: (a) transfers the promised goods or services to the customer or (b) promises to pay the consideration (even if the payment is conditional on a future event). That promise may be implied by customary business practice.
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PwC observation: The underlying concepts for both noncash consideration and consideration paid to a customer are consistent with current revenue guidance under both U.S. GAAP and IFRS. We do not anticipate a significant change in practice in these areas on adoption of the proposed standard. The proposed guidance is not as explicit about whether payments paid to customers to enter into a customer-vendor relationship should be capitalized. We believe that in certain situations these amounts should be capitalized and the subsequent amortization of such amounts would reduce revenue.
Collectibility .29 Collectibility refers to the risk that the customer will not pay the promised consideration. An entity recognizes an allowance for any expected impairment loss (determined in accordance with ASC 310, Receivables, or IFRS 9, Financial Instruments) and presents that allowance in a separate line item adjacent to revenue. Both the initial assessment and any subsequent changes in the estimate are recorded in this line item (if the contract does not have a significant financing component). PwC observation: Current guidance requires that revenue cannot be recognized unless collectibility is reasonably assured (under U.S. GAAP) or is probable (under IFRS). Collectibility will no longer be a recognition threshold, so revenue might be recognized earlier under the proposed guidance. Presenting credit risk in this manner will align revenue recognized with cash ultimately received from the customer if the contract does not have a significant financing component. This will help financial statement users who are interested in reconciling revenue with cash ultimately received from the customer. It is not clear where impairment will be classified if the arrangement contains a significant financing component. The proposed guidance requires management to look to ASC 310 or IFRS 9 to measure expected impairment loss. We believe there is a potential conflict with the impairment model in ASC 310 and IFRS 9 in the classification of subsequent changes to the initial assessment. Subsequent impairment of a financial instrument is recognized as other income and expense, while subsequent changes for receivables would be recognized in the line item adjacent to revenue. The boards have acknowledged that this decision could create consequences for the impairment model being developed for financial instruments and it will therefore need to be discussed further at a future date. Example 4.1 Presentation of credit risk: A consumer products entity enters into a contract with a customer to provide goods for $1,000. Payment is due one month after the goods are transferred to the customer. Management assesses that the customer will not pay 10% of the consideration based on its current knowledge of the customer and its financial position. The entity should recognize revenue, which reflects the total transaction price under the contract, when the goods are transferred to the customer. The entity would also
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recognize the estimated amount of consideration that is uncollectible as a separate line item adjacent to the revenue line item. The below table summarizes the presentation under the current and proposed guidance.
Current Revenue $1,000 Proposed Revenue Impairment loss Subtotal COGS GM $ GM % (400) 600 60% COGS GM $ GM % $1,000 (100) 900 (400) 500 56%
Allocate the transaction price to distinct performance obligations .30 The transaction price should be allocated to separate performance obligations in a contract based on the relative stand-alone selling prices of the goods or services. The best evidence of stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately. Management needs to estimate the selling price if a stand-alone selling price is not available, and should maximize the use of observable inputs. Possible estimation methods include (but are not limited to): Expected cost plus reasonable margin Assessment of market prices for similar goods or services Residual approach, in certain circumstances .31 A residual approach may be used to calculate the stand-alone selling price when there is significant variability or uncertainty in one or more performance obligations, regardless of whether that performance obligation is delivered at the beginning or end of the contract. A residual approach involves estimating the stand-alone selling price of a good or service by reference to the total transaction price less the sum of the stand-alone selling prices of other goods or services promised in the contract. .32 A selling price is highly variable when an entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts. A selling price is uncertain when an entity has not yet established a price for a good or service or the good or service has not previously been sold. .33 An entity should allocate a discount entirely to one separate performance obligation in the contract if the price of a good or service is largely independent of the price of other goods or services in the arrangement based on the following criteria: The entity regularly sells each good or service in the contract separately The observable selling prices from those sales provide evidence of the performance obligation to which the entire discount in the contract belongs .34 Changes to the transaction price, including changes in the estimate of variable consideration, might only affect one performance obligation. Such changes would be allocated to that performance obligation rather than all performance obligations in the arrangement if the following criteria are met:
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The contingent payment terms relate to a specific performance obligation or outcome from satisfying that performance obligation Allocating the contingent amount of consideration entirely to the separate performance obligation is consistent with the amount of consideration that the entity expects to be entitled for that performance obligation PwC observation: The residual approach in the proposed guidance should not be confused with the residual method that has historically been used to allocate the transaction price by software companies applying U.S. GAAP and, in some circumstances, by companies under IFRS. First, the proposed guidance states that the residual approach should only be used when the standalone selling price of a good or service is highly variable or uncertain. Second, the residual approach would be used solely to develop an estimate of the stand-alone selling price of the separate good or service and not to determine the allocation of consideration to a specific performance obligation. Example 5.1 Use of residual approach: An entity enters into a contract with a customer to provide a package of products for $1,000. The arrangement includes three separate performance obligations: products A, B, and C. The entity sells products A and B both individually and bundled together in a package. Product C is unique and has never been sold before. Its estimated selling price is therefore unknown. Products A and B sell for $200 and $300, respectively, when sold on a stand-alone basis. However, as a package, products A and B sell for a discounted amount of $400. Management might conclude the estimated stand-alone selling price of product C is $600 ($1,000 less $400). The $1,000 transaction price would be allocated as follows:
Product A = ($200/$500) x ($400/$1,000) or 16% Product B = ($300/$500) x ($400/$1,000) or 24% Product C = $600/$1,000 or 60%
We believe this is one way that a residual approach might be used to estimate the stand-alone selling price. However, this concept is not illustrated in the proposed guidance and it is possible that this topic may be subject to further clarification by the boards.
Recognize revenue when (or as) each performance obligation is satisfied Transfer of control .35 Revenue is recognized when (or as) a promised good or service is transferred to the customer. An entity transfers a promised good or service and satisfies a performance obligation when the customer obtains control of that good or service. A customer obtains control of a good or service if it has the ability to direct the use of and receive the benefit from the good and service. Indicators that the customer has obtained control of the good or service include: The entity has a right to payment for the asset The entity transferred legal title to the asset
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The entity transferred physical possession of the asset The customer has the significant risk and rewards of ownership The customer has accepted the asset PwC observation: The proposed guidance provides indicators to determine the point of time at which a performance obligation is satisfied. The indicators are not a checklist, and no one indicator is determinative. The indicators are factors that are often present when control has transferred to a customer. There may be situations where some indicators are not met, but managements judgment is that control has been transferred. Management will still need to consider all of the facts and circumstances to understand if the customer has the ability to direct the use of and benefit from the goods or services.
Satisfaction of performance obligations over time .36 Performance obligations can be satisfied either at a point in time or over time. An entity transfers control of a good or service over time if at least one of the following two criteria is met: The entity's performance creates or enhances an asset that the customer controls The entity's performance does not create an asset with alternative use to the entity and at least one of the following criteria is met:
The customer simultaneously receives and consumes the benefits of the entitys performance as it performs Another entity would not need to substantially re-perform the work the entity has completed to date if that other entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance completed to date and it expects to fufill the contract
.37 An asset with alternative use is an asset that an entity could readily direct to another customer. For example, a standard inventory item might have an alternative use because it can be used as a substitute across multiple contracts with customers. An asset that is highly customized would be less likely to have an alternative use to the entity because the entity would likely incur significant costs to direct the asset to another customer. .38 Management should consider the effects of contractual limitations when assessing whether an asset has an alternative use. A contract that precludes an entity from redirecting an asset to another customer results in the asset not having an alternative use because the entity is legally obligated to direct the asset to a specific customer. PwC observation: Management will need to apply judgment to assess the criteria for when a performance obligation is satisfied over time to ensure the timing of revenue recognition reflects the transfer of control to the customer based on the economic substance of the arrangement.
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We understand the objective of the right to payment criterion is that the consideration would be intended to compensate the entity for performance to date and not, for example, a stipulated penalty to cover lost profits in the arrangement. Example 6.1 Assessing whether an asset has alternative use: An industrial products entity enters into a contract with a customer to deliver the next piece of specialized equipment produced. The customer paid a deposit that is only refundable if the entity fails to perform. The deposit also requires the entity to procure materials to produce the specialized equipment. The contract precludes the industrial products entity from redirecting the piece of specialized equipment to another customer. The specialized equipment does not have alternative use to the industrial products entity because the contract has substantive terms that preclude the entity from redirecting the specialized equipment to another customer. The industrial products entity would need to assess the rest of the criteria to determine if production of the specialized equipment represents a performance obligation satisfied over time. The performance obligation would be satisfied at a point in time if the criteria are not met. In this example, it is likely that the performance to date would have to be reperformed by another entity and the customer doesnt immediately receive the benefits of the entitys performance. Therefore, management would have to assess whether the deposit is a right to payment that is commensurate with work performed. If not, and assuming the other criteria are not met, the performance obligation would be satisfied at a point in time, not over time.
Measurement of progress .39 An entity recognizes revenue for a performance obligation satisfied over time by measuring the progress toward complete satisfaction of the performance obligation. The objective when measuring progress is to depict the transfer of control of the promised goods or services to the customer. Methods for measuring progress include: Output methods that recognize revenue on the basis of units produced, units delivered, contract milestones, or surveys of work performed Input methods that recognize revenue on the basis of costs incurred, labor hours expended, time lapsed, or machine hours used .40 When applying an input method to a separate performance obligation that includes goods that a customer controls at a point in time significantly prior to the performance of the services related to those goods, revenue may be recognized in an amount equal to the cost for those goods if both conditions are present: The cost of the transferred goods is significant relative to the total expected costs to completely satisfy the performance obligation The entity procures the goods from another entity and is not significantly involved in designing and manufacturing the goods
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PwC observation: The exposure draft allows both input and output methods for measuring progress, but management should select the method that best depicts the transfer of control of goods and services. Output methods directly measure the value of the goods or services transferred to the customer. The use of an input method measures progress toward satisfying a performance obligation indirectly. Management should take care when using an input model that the inputs represent the transfer of control of the asset to the customer and exclude any inputs that do not depict the transfer of control (for example, upfront purchases of significant materials that have not yet been utilized or transferred to the customer, or wasted effort or materials). Example 7.1 Use of an input method to measure progress: A manufacturing entity enters into a contract with a customer to provide specialized equipment and install the equipment into a data center facility. The entity will need to procure the specialized equipment from an independent source. The entity will account for the bundle of goods and services as a single performance obligation since the goods and services provided under the contract are highly interrelated. There is also a significant integration service to customize and modify the specialized equipment for the data center facility. The entity expects to incur the following cost in connection with the project:
Transaction price Cost of specialized equipment Other costs to fulfill Total estimated costs to complete $500,000 150,000 100,000 $250,000
The manufacturing entity concludes that an input method (costs incurred to date in relation to total estimated costs to be incurred) best depicts the pattern of transfer of control to the customer. Since the costs incurred by the entity to procure the specialized equipment are significant to the overall costs of the project and the entity is not involved in the manufacturing of the equipment, the entity excludes the costs of the equipment from its measurement of progress toward satisfaction of the performance obligation. The entity incurs the following costs and estimates progress for revenue recognition excluding the costs to procure the specialized equipment:
Incurred costs to date Cost of specialized equipment Other costs to fulfill Percent complete excluding specialized equipment ($50,000 / ($250,000 - $150,000)) Revenue recognized to date (50% x ($500,000 - $150,000))
150,000 50,000
50% $175,000
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The manufacturing entity estimates that the performance on the project is 50% complete and recognizes revenue of $175,000. The entity will recognize revenue in an amount equal to the costs of $150,000 upon transfer of control of the specialized equipment to the customer.
Constraint on revenue recognition .41 Variable consideration included in the transaction price that is allocated to a satisfied performance obligation is recognized as revenue only when the entity is reasonably assured to be entitled to that amount. An entity is reasonably assured when the entity has experience with similar types of contracts and that experience is predictive of the outcome of the contract. .42 Management needs to apply judgment to assess whether it has predictive experience about the outcome of a contract. The following indicators might suggest the entity's experience is not predictive of the outcome of a contract: The amount of consideration is highly susceptible to factors outside the influence of the entity The uncertainty about the amount of consideration is not expected to be resolved for a long period of time The entity's experience with similar types of contracts is limited The contract has a large number and broad range of possible consideration amounts .43 The proposed guidance includes an exception for intellectual property licensed in exchange for royalties based on the customer's subsequent sales of a good or service. The entity can only become reasonably assured to be entitled to the related variable consideration (the royalty payment) once those future sales occur. PwC observation: The boards included the reasonably assured constraint in response to feedback that revenue could be recognized prematurely for variable consideration. The constraint is not meant to be a specific quantitative threshold but rather a qualitative assessment based on the level of predictive experience held by a particular entity. We expect that some entities will recognize revenue earlier under the proposed guidance because they will be able to recognize amounts before all contingencies are resolved. The constraint on revenue recognition is generally limited to situations where management has no predictive experience. Revenue will be recognized in these circumstances only when the amounts become reasonably assured, which may be closer to the timing of recognition under existing practice. The "bright line" exception included in the proposed guidance for royalties received from licenses to use intellectual property seems to result in divergent outcomes for economically similar transactions in some cases. For example, the exposure draft includes an example (Example 14) that addresses trailing commissions received by an agent of an insurance company. The example concludes that the entity can recognize commissions related to future policy renewals at the outset of the arrangement because management determines such amounts are reasonably assured of being
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received. It is worth noting that like the royalties, the trailing commissions are also dependent on the customer's future sales. Therefore, the exposure draft appears to require that the exception for licenses to use intellectual property should not be applied by analogy to other types of transactions. Example 8.1 Estimating variable consideration based on predictive experience: An entity sells maintenance contracts to customers on behalf of a manufacturer for an upfront commission of $100 and $10 per year for each contract based on how long the customer renews the maintenance contract. Once the initial maintenance contracts have been sold, the entity has no remaining performance obligations. Management has determined that past experience is predictive (for example, experience with similar types of contracts and customers) and that experience indicates that customers typically renew for 2 years. The total transaction price is therefore estimated to be $120 and the entity will recognize that amount of revenue when the maintenance contract is sold to the customer. As renewal experience changes, management will update the transaction price and recognize revenue or a reduction of revenue to reflect the updated renewal experience.
Other considerations
Identify the separate performance obligations .44 The proposed standard includes guidance on the following areas when considering the impact of identifying separate performance obligations in the contract: Principal versus agent Options to acquire additional goods or services Licenses Rights of return Warranties Nonrefundable upfront fees Principal versus agent .45 Entities often involve third parties when providing goods and services to their customers. In these situations, management needs to assess whether the entity is acting as the principal or as an agent. An entity recognizes revenue gross if it is the principal, and net (that is, equal to the commission received) if it is an agent. An entity is the principal if it obtains control of the goods or services of another party in advance of transferring control of those goods or services to the customer. The entity is an agent if its performance obligation is to arrange for another party to provide the goods or services.
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.46 Indicators that the entity is an agent include: The other party has primary responsibility for fulfillment of the contract (that is, the other party is the primary obligor) The entity does not have inventory risk The entity does not have latitude in establishing prices The entity does not have customer credit risk The entity's consideration is in the form of a commission PwC observation: The proposed guidance and list of indicators are similar to the current guidance under U.S. GAAP and IFRS. The proposed guidance does not weigh any of the indicators more heavily than others. The growth in business models that involve the use of the internet to conduct transactions has continued to increase the focus in this area under existing standards. We expect similar issues to arise under the new guidance, but do not expect a significant change in practice in this area.
Options to acquire additional goods or services .47 An entity may grant a customer the option to acquire additional goods or services free of charge or at a discount. These options may include customer award credits or other sales incentives and discounts. That promise gives rise to a separate performance obligation if the option provides a material right to the customer that the customer would not receive without entering into the contract. The entity should recognize revenue allocated to the option when the option expires or when the additional goods or services are transferred to the customer. .48 An example of a material right would be a discount that is incremental to the range of discounts typically given to similar customers in the same market. The customer is effectively paying in advance for future goods or services and therefore, revenue is recognized when those future goods or services are transferred or when the option expires. .49 An option to acquire an additional good or service at a price that is within the range of prices typically charged for those goods or services does not provide a material right to the customer and is a marketing offer. This is the case even if the option can be exercised only because of entering into the previous contract. .50 The estimate of a stand-alone selling price for a customer's option to acquire additional goods or services is the discount the customer will obtain when exercising the option. This estimate is adjusted for any discount the customer would receive without exercising the option and the likelihood that the customer will exercise the option (that is, breakage or forfeiture). PwC observation: Under the proposed standard, the amount allocated to the loyalty rewards is deferred and revenue is recognized when the rewards expire or are redeemed. Under IFRS, an existing interpretation requires companies to account for loyalty programs using a model that is largely consistent with the guidance in the proposed standard. However, under U.S. GAAP, there is divergent practice in the accounting for loyalty
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programs with many entities following the incremental cost accrual model under which revenue is not allocated to the loyalty awards and the cost of fulfilling the awards is accrued. The proposed standard will therefore result in later revenue recognition for these companies. Example 9.1 Loyalty points: An entity grants its customers one point per $10 spent on purchases. Each point earned has a value of $1, which customers may redeem against future purchases. A customer purchases goods for $1,000 and earns 100 points redeemable against future purchases. The entity estimates that the stand-alone selling price of one point is $0.95 based on the redemption value of the points adjusted for the history of redemptions (that is, 5% breakage). The stand-alone selling price of the goods is $1,000. The option (loyalty points) provides a material right to the customer and is a separate performance obligation. The entity will allocate the total transaction price between goods and loyalty points based on their relative stand-alone selling prices. The transaction price allocated to the points will be recognized as revenue when the points are redeemed (and the related goods or services are transferred to the customer), or when they expire unused.
Product Points $913 $87 (1,000 x 1,000/1,095) (95 x 1,000/1,095)
The $913 of revenue allocated to the goods is recognized upon transfer of control of the goods and the $87 allocated to the points is recognized upon the earlier of the redemption or expiration of the points.
Licenses .51 A license is the right to use an entity's intellectual property. Intellectual property includes amongst others: software and technology; media and entertainment rights (for example, motion pictures and music); franchises; patents; trademarks; and copyrights. .52 An entity should recognize revenue from granting the right to use intellectual property when the customer obtains control of the rights. This occurs when control of the right to use the intellectual property transfers, but is no earlier than the beginning of the license period. .53 If there is more than one performance obligation in the arrangement, management will have to first assess whether the promised right to use intellectual property is a separate performance obligation, or if it should be combined with other performance obligations. PwC observation: The guidance in the proposed standard for licenses to use intellectual property could result in earlier revenue recognition than current practice under U.S. GAAP and IFRS. However, revenue might not be recognized immediately upon transfer of the right if the license is not distinct from other performance obligations in the contract. Additionally, there is often variable consideration in a license arrangement, in which case revenue recognition is constrained until the entity is reasonably assured to be entitled to the consideration. Revenue recognition is constrained until the customers future sales occur for sales-based royalty payments.
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Example 10.1 License to use intellectual property: A technology entity enters into a contract with Customer A to license its intellectual property for one year. The technology entity also enters into a contract with Customer B to provide a perpetual license to its intellectual property. Management will need to assess when the customer obtains control of the promised rights, which will determine when revenue should be recognized. Control of the rights to use intellectual property cannot be transferred before the beginning of the period during which the customer can use and benefit from those rights. In this example, the right to use the intellectual property for both Customer A and Customer B would transfer at the same point in time. The customer obtains control of the promised rights when the software license is transferred. If the contract includes other performance obligations in addition to the license, management will need to evaluate whether the right to use the intellectual property is distinct from those other performance obligations. If it is, revenue is recognized when control of the license is transferred (assuming the entity is reasonably assured to be entitled to the consideration). If it is not distinct, the right to use the intellectual property should be combined with other performance obligations until management identifies a bundle of goods or services that is distinct. Revenue is recognized when (or as) the combined performance obligation is satisfied.
Rights of return .54 An entity accounts for the sale of goods with a right of return as follows: Revenue is recognized for the consideration to which the entity is reasonably assured to be entitled (considering the products expected to be returned) and a liability is recognized for the refund expected to be paid to customers. The refund liability is updated for changes in expected refunds at each reporting period. An asset and corresponding adjustment to cost of sales is recognized for the right to recover goods from customers. The asset is initially measured at the original cost of the goods less any expected costs to recover those goods. Impairment is assessed at each reporting date. .55 A contract that provides the customer with the right to exchange one product for another product of the same type, quality, condition, and price (for example, a red shirt for a blue shirt) does not provide a return right accounted for under the proposed standard. PwC observation: Entities will be precluded from recognizing revenue prior to the lapse of the return right when management is unable to estimate returns, similar to current guidance. However, the proposed standard requires an entity to recognize an asset for the right to recover a product and an offsetting liability for the refund, which may be different from current practice. The asset recognized for the right to recover a product is assessed for impairment in accordance with existing standards.
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Warranties .56 An entity accounts for a warranty as a separate performance obligation if the customer has the option to the purchase the warranty separately. An entity accounts for a warranty as a cost accrual if it is not sold separately. However, if a warranty provides a customer with a service in addition to the assurance that the product complies with agreed specifications, that service is a separate performance obligation. .57 An entity that promises both a quality assurance and service-based warranty, but cannot reasonably separate the obligations and account for them separately, accounts for both warranties together as a separate performance obligation. PwC observation: The exposure draft provides a practical expedient to accounting for warranties and is generally consistent with current guidance under U.S. GAAP and IFRS. However, it might sometimes be difficult to separate a single warranty that provides both a standard warranty and a service. Determining the estimated stand-alone selling price for warranty-related services when such services are not sold separately could also be challenging.
Nonrefundable upfront fees .58 Some entities charge a customer a nonrefundable fee at the beginning of an arrangement. Examples may include setup fees, activation fees, or membership fees. Management needs to determine whether a nonrefundable upfront fee relates to the transfer of a promised good or service to a customer. .59 A nonrefundable upfront fee may relate to an activity undertaken at or near contract inception (for example, customer setup activities), but it does not indicate satisfaction of a separate performance obligation if the activity does not result in the transfer of a promised good or service to the customer. The upfront fee is recognized as revenue when goods or services are provided to the customer in the future. .60 If the nonrefundable upfront fee relates to a performance obligation, management needs to assess whether that performance obligation is distinct from the other performance obligations in the contract. Recognize revenue when each performance obligation is satisfied .61 The proposed standard includes guidance on the following areas when considering when each performance obligation is satisfied: Bill-and-hold arrangements Consignment arrangements Sale and repurchase of a product Bill-and-hold arrangements .62 Under a bill-and-hold arrangement, an entity bills a customer for a product but does not ship the product until a later date. Revenue is recognized on transfer of control of the goods to the customer. All of the following requirements must be met to conclude that the customer has obtained control in a bill-and-hold arrangement:
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The reason for the bill-and-hold arrangement must be substantive The product must be identified separately as the customer's The product must be ready for delivery at the time and location specified by the customer The entity cannot have the ability to sell the product to another customer .63 Management also needs to consider whether the custodial services of storing the goods are a material separate performance obligation to which some of the transaction price should be allocated. PwC observation: The proposed guidance and list of indicators for bill-and-hold transactions are generally consistent with the current guidance under IFRS. There may be situations where revenue is recognized earlier compared to current U.S. GAAP for bill-and-hold arrangements because there is no longer a requirement for the vendor to have a fixed delivery schedule from the customer in order to recognize revenue.
Consignment arrangements .64 Certain industries transfer goods to dealers or distributors on a consignment basis. The transferor typically owns the inventory on consignment until a specified event occurs, such as the sale of the product to a customer of the distributor, or until a specified period expires. .65 Management needs to consider the following factors to determine whether revenue should be recognized on transfer to the distributor or on ultimate sale to the customer: Whether the distributor has an unconditional obligation to pay for the goods Whether the entity can require return of the product or transfer to another distributor (which indicates that control has not transferred to the distributor) PwC observation: The proposed standard requires management to determine when control of the product has transferred to the customer. If the customer (including a distributor) has control of the product, including a right of return at its discretion, revenue is recognized when the product is delivered to the customer/distributor. Any amounts related to expected sales returns or price concessions affect the amount of revenue (that is, the estimate of the transaction price), but not when revenue is recognized. An entity that is unable to estimate returns, however, would not recognize revenue until the return right lapses, similar to todays model. The timing of revenue recognition could change for some entities compared to current guidance, which is more focused on the transfer of risks and rewards than the transfer of control. The transfer of risks and rewards is an indicator to assess in determining whether control has transferred under the proposed standard, but additional indicators will also need to be considered to determine whether control has transferred. If the entity is able to require the customer/distributor to return the product (that is, it has a call right), control has not transferred to the customer/distributor; therefore, revenue is only recognized when the products are sold to a third party.
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Example 11.1 Sale of products on consignment: A consumer products entity provides household goods to a retailer on a consignment basis. The retailer does not take title to the products until they are scanned at the register. Any unsold products are returned to the consumer products entity. Once the retailer sells the products to the consumer, the consumer products entity has no further obligations with respect to the products, and the retailer has no further return rights. The consumer products entity will need to assess whether the retailer has obtained control of the products, including whether the retailer has an unconditional obligation to pay the entity, absent a sale to the consumer. Revenue recognition prior to the sale to the consumer might not be appropriate. Additionally, if the consumer products entity retains the right to call back unsold product, control has not transferred and revenue is recognized only when the product is sold to the consumer.
Sale and repurchase of a product .66 When an entity has an unconditional obligation or unconditional right to repurchase an asset (a forward or a call option), the buyer does not obtain control of the asset because the buyer does not have the ability to direct the use of and obtain substantially all of the remaining benefits from the asset. In this situation, an entity accounts for the transaction as follows: A lease, if the entity has the right or obligation to repurchase the asset for less than the original sales price of the asset A financing arrangement, if the entity has the right or obligation to repurchase the asset for an amount that is equal to or more than the original sales price of the asset .67 The entity continues to recognize the asset in a financing arrangement and recognizes a financial liability for any consideration received from the buyer. The difference between the amount of consideration received from the customer and the amount of consideration paid is interest expense. .68 When a customer has the right to require the entity to repurchase an asset (a put option), the arrangement should be accounted for as an operating lease (that is, the income is recorded over time) if the arrangement provides the customer a significant economic incentive to exercise that right, as the customer effectively pays for the right to use the asset over time. An arrangement is a financing if the repurchase price of the asset exceeds the original selling price and is more than the expected market value of the asset. PwC observation: Management needs to assess the nature of a sale and repurchase arrangement to determine whether the arrangement should be accounted for as a lease, as this determination is critical to applying the appropriate accounting model. The boards decided that if an entity enters into a contract with a repurchase agreement at a price less than the original sales price and the customer does not obtain control of the asset, the contract should be accounted for as a lease in accordance with Topic 840 or IAS 17, Leases.
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Contract costs .69 An entity recognizes an asset for the incremental costs to obtain a contract that management expects to recover. Incremental costs of obtaining a contract are costs the entity would not have incurred if the contract had not been obtained (for example, sales commission). An entity is permitted to recognize the incremental cost of obtaining a contract as an expense when incurred if the amortization period would be less than one year, as a practical expedient. .70 An entity recognizes an asset for costs to fulfill a contract when specific criteria are met. Management will first need to evaluate whether the costs incurred to fulfill a contract are in the scope of other standards (for example, inventory, fixed assets, intangibles). Costs that are in the scope of other standards should be either expensed or capitalized as required by the relevant guidance. .71 If fulfillment costs are not in the scope of another standard, an entity recognizes an asset only if the costs relate directly to a contract, will generate or enhance a resource that the entity will use to satisfy future performance obligations, and are expected to be recovered. .72 An asset recognized for the costs to obtain or costs to fulfill a contract should be amortized on a systematic basis as the goods or services to which the assets relate are transferred to the customer. An entity recognizes an impairment loss to the extent that the carrying amounts of an asset recognized exceeds (a) the amount of consideration the entity expects to receive for the goods or services less (b) the remaining costs that relate directly to providing those goods or services. PwC observation: Entities that currently expense all contract fulfillment costs as incurred might be affected by the proposed guidance since costs are required to be capitalized when the criteria are met. Fulfillment costs that are likely to be in the scope of this guidance include, among others, set-up costs for service providers and costs incurred in the design phase of construction projects. The proposed standard requires entities to capitalize incremental costs to obtain a contract that management expects to recover. This may be different from current practice where entities have the option to expense contract acquisition costs as incurred, allowing for diversity in practice.
Onerous performance obligations .73 An entity recognizes a liability and a corresponding expense if a performance obligation that is satisfied over a period of time greater than one year is onerous. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of the transaction price allocated to that performance obligation. The lowest cost of settling a performance obligation is the lower of (a) the amount the entity would pay to exit the performance obligation and (b) the costs that relate directly to satisfying the performance obligation by transferring the goods or services. .74 Performance obligations that are satisfied over a period of time less than a year are excluded from the onerous performance obligation assessment.
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PwC observation: Limiting the need to assess onerous performance obligations to only those obligations satisfied over a period of time greater than one year is narrower in scope than what had been proposed in the 2010 Exposure Draft. However, some additional complexity may have been introduced, for example, in determining whether (a) a contract requires satisfaction of a series of distinct performance obligations or a single performance obligation over time and (b) management expects the contract to exceed one year. There may also be a number of challenges in determining the appropriate costs to consider in the assessment. Processes and controls will need to be updated to closely monitor performance obligations satisfied over time and associated costs remaining to satisfy those obligations. Management will need to pay particular attention to contracts with decreasing revenue streams and flat or increasing costs as performance obligations are satisfied over time. These performance obligations could become onerous even if the contract is profitable overall. The proposed guidance will also accelerate the recognition of losses for "loss leader" contracts if such contracts include performance obligations satisfied over time. Example 12.1 Onerous performance obligations: A transportation entity signs a contract to provide ferry service for a local government. The contract requires the transportation entity to provide daily service for a three-year period at a fixed price per trip. Assume that there has been an unforeseen spike in fuel costs midway through the first year of the contract. Based on the current fuel costs, the contract is no longer profitable and the entity would have to pay a substantial penalty to terminate the contract early. The transportation entity will need to first assess whether the ferry service represents a series of individual distinct performance obligations per trip which are satisfied at a point in time, or whether the contract is one performance obligation that is satisfied over the three-year contract term. If management concludes that the ferry service is one performance obligation satisfied over a period of time beyond a year, it will be required to assess whether the performance obligation is onerous.
Disclosures
.75 The exposure draft includes a number of proposed disclosure requirements intended to enable users of financial statements to understand the amount, timing and judgment around revenue recognition and corresponding cash flows arising from contracts with customers. .76 The required disclosures include qualitative and quantitative information about contracts with customers, such as significant judgments and changes in judgments made in accounting for those contracts, and assets recognized from the costs to obtain or fulfill those contracts. The following are some of the key disclosures from the proposed standard:
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The disaggregation of revenue into primary categories that depict the nature, amount, timing and uncertainty of revenue and cash flows A tabular reconciliation of the movements of the assets recognized from the costs to obtain or fulfill a contract with a customer An analysis of the entity's remaining performance obligations including the nature of the goods and services to be provided, timing of satisfaction, and significant payment terms Information on onerous performance obligations and a tabular reconciliation of the movements in the corresponding liability for the current reporting period Significant judgments and changes in judgments that affect the determination of the amount and timing of revenue from contracts with customers Interim disclosures .77 The boards propose to amend existing interim disclosure guidance to specify the disclosures about revenue from contracts with customers that an entity should provide in interim financial statements. If material, the disclosures that would be required include most of the disclosures required in the annual financial statements. Nonpublic entity disclosures (U.S. GAAP only) .78 A nonpublic entity may elect not to provide any of the following disclosures: A reconciliation of contract balances The amount of the transaction price allocated to remaining performance obligations and when the entity expects to recognize revenue on that amount A reconciliation of liability balances recognized from onerous performance obligations A reconciliation of asset balances recognized from the costs to obtain or fulfill a contract with a customer An explanation of the judgments, and changes in judgments, used in determining the timing of satisfaction of performance obligations, determining the transaction price and allocating it to separate performance obligations
Transition
.79 The boards have not yet decided on the effective date of the proposed standard, except that it will be no sooner than annual periods beginning on or after January 1, 2015. Earlier adoption is not permitted under U.S. GAAP, although it will be permitted under IFRS. .80 The proposed guidance will be applied retrospectively. However, an entity may use one or more of the following practical expedients: An entity can elect not to restate contracts that begin and end within the same annual reporting period An entity may use the transaction price at the date the contract was completed rather than estimating variable consideration for contracts completed on or before the effective date
An entity does not have to apply the onerous performance obligation test to performance obligations in comparative periods unless an onerous contract liability was recognized previously An entity is not required to disclose the amount of the transaction price allocated to remaining performance obligations with an explanation on the timing of revenue recognition (the so-called maturity analysis)
Next steps
.81 The comment period for the exposure draft ends on March 13, 2012. The boards continue to perform targeted consultation with key industries and other interested parties regarding some of the more significant changes. It is unclear when a final standard will be issued; however, the boards have indicated that the final standard will have an effective date no earlier than 2015.
Questions
.82 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group.
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Appendix Key differences between the 2010 and 2011 exposure drafts
(1) Identify the contract(s) with the customer (2) Identify and separate performance obligations (3) Determine the transaction price (4) Allocate the transaction price (5) Recognize revenue when a performance obligation is satisfied
Topic Combining contracts
2010 Exposure Draft
2011 Exposure Draft
An entity should combine two or more contracts if the prices of those contracts are interdependent.
An entity may need to combine two or more contracts entered into at or near the same time with the same customer if one or more of the following criteria are met: The contract is negotiated with a single commercial objective The amount of consideration paid in one contract depends on the other contract The goods or services promised between the contracts are a single performance obligation
Segmenting contracts
A single contract should be segmented into two or more contracts if some goods or services within the contract are independently priced from other goods or services in that contract. A contract modification is combined with the original contract if the prices of the original contract and the modification are interdependent (that is, treat the modification and original contract as one contract).
The contract segmentation guidance has been removed from the proposed standard. An entity should identify separate performance obligations in a contract. A contract modification is treated as a separate contract only if it results in the addition of a separate performance obligation and the price is reflective of the stand-alone selling price of that additional performance obligation.
1 2
Refers to the exposure draft issued on June 24, 2010 Refers to the exposure draft issued on November 14, 2011
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(1) Identify the contract(s) with the customer
(2) Identify and separate performance obligations
(3) Determine the transaction price
(4) Allocate the transaction price
(5) Recognize revenue when a performance obligation is satisfied
Topic Performance obligations
2010 Exposure Draft Performance obligations are enforceable promises (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. An entity recognizes revenue from performance obligations separately if the goods or services are distinct. A good or service is distinct if an entity sells an identical or similar good or service separately. A good or service that has a distinct function and a distinct profit margin from the other goods or services in the contract is also distinct, even if not sold separately.
2011 Exposure Draft Performance obligations are promises in a contract to transfer goods or services to a customer. The term enforceable was removed from the definition in the proposed standard. A separate performance obligation exists if the goods or services are distinct. Goods or services are distinct if: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with resources readily available to the customer. A bundle of goods or services is accounted for together as one performance obligation if both of the following criteria are met: The goods and services are highly interrelated and the entity provides a significant service of integrating goods and services into the combined item that the customer has contracted for The entity is contracted by the customer to significantly modify or customize the goods or services
Identification of separate performance obligations
Warranties
Revenue is deferred for warranties that require replacement or repair of components of an item, but only for the portion of revenue attributable to the components that must be repaired or replaced. Warranties that provide the customer with coverage for faults that arise after the entity transfers control to the customer give rise to a separate performance obligation.
Warranties that the customer has the option to purchase separately are accounted for as a separate performance obligation. An entity should account for a warranty as a cost accrual if it is not sold separately and the warranty does not provide a service in addition to a standard warranty. An entity that promises both a quality assurance and service-based warranty but cannot reasonably separate them, should account for both as separate performance obligations.
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Topic Variable consideration
2010 Exposure Draft The transaction price is the consideration that the entity expects to receive from the customer. The transaction price includes the probability-weighted estimate of variable consideration when management can make a reasonable estimate of the amount to be received. An estimate is reasonable only if an entity: has experience with similar types of contracts, and does not expect circumstances surrounding those types of contracts to change significantly.
2011 Exposure Draft The transaction price is the consideration that the entity is entitled to under the contract, including variable or uncertain consideration. It is based on the probabilityweighted estimate or most likely amount of cash flows entitled from the transaction, depending on which is most predictive of the amount to which the entity is entitled. Revenue on variable consideration is only recognized when the entity is reasonably assured to be entitled to it.
Collectibility
Collectibility is not a hurdle to recognition of revenue. The transaction price is adjusted to reflect the customer's credit risk by recognizing the consideration expected to be received using a probability-weighted approach. Changes in the assessment of consideration to be received due to changes in credit risk are recognized as income or expense, separately from revenue.
Collectibility of the transaction price is not a hurdle to revenue recognition. The transaction price is presented without adjustment for credit risk. An allowance for the expected impairment loss on receivables is presented in a separate line item adjacent to revenue. Both the initial impairment assessment and any subsequent changes in the estimate of collectibility are recorded in this line (if the contract does not have a significant financing component). The transaction price should reflect the time value of money when the contract includes a significant financing component. As a practical expedient, an entity is not required to reflect the effects of the time value of money in the measurement of the transaction price when the period between payment by the customer and the transfer of the goods or services is less than one year.
Time value of money
The transaction price reflects the time value of money whenever the contract includes a material financing component.
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Topic Allocation method
2010 Exposure Draft The transaction price is allocated to separate performance obligations based on the relative stand-alone selling price of the performance obligations in the contract. An entity may not use the residual method to allocate the transaction price.
2011 Exposure Draft The transaction price is allocated to separate performance obligations based on the relative stand-alone selling price of the performance obligations in the contract. A residual value approach may be used as a method to estimate the stand-alone selling price when there is significant variability or uncertainty in the selling price of a good or service, regardless of whether that good or service is delivered at the beginning or end of the contract. Some elements of the transaction price, such as uncertain consideration, discounts or change orders, may be allocated to only one performance obligation rather than all performance obligations in the contract under certain circumstances.
Breakage
An entity should consider the impact of breakage (forfeitures) in determining the transaction price allocated to the performance obligations in the contract.
The entity should recognize the effects of the expected breakage as revenue in proportion to the pattern of rights exercised by the customer if the amount of expected breakage is reasonably assured. The entity should recognize the effects of the expected breakage when the likelihood of the customer exercising its remaining rights becomes remote, if the amount of breakage is not reasonably assured.
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Topic Transfer of goods
2010 Exposure Draft Revenue is recognized when a promised good or service is transferred to the customer. An entity transfers a promised good or service and satisfies a performance obligation when the customer obtains control of that good or service. A customer obtains control of a good or service if it has the ability to direct the use of and receive the benefit from the good or service. Performance obligations can be satisfied at a point in time or continuously over time. Indicators that the customer has obtained control of the good or service may include: The customer has an unconditional obligation to pay The customer has legal title The customer has physical possession The customer specifies the design or function of the good or service
2011 Exposure Draft An entity recognizes revenue for the sale of a good when the customer obtains control of the good. Indicators that the customer has obtained control of the good include: The customer has an unconditional obligation to pay The customer has legal title The customer has physical possession The customer has risks and rewards of ownership The customer provided evidence of acceptance
Continuous transfer of goods and services
The exposure draft had no specific guidance for services. The guidance was the same as the guidance for goods above.
An entity must determine if a performance obligation is satisfied continuously to determine when to recognize revenue for certain performance obligations. The entity should then select a method for measuring progress in satisfying that performance obligation. An entity should recognize revenue for performance obligations satisfied continuously only if the entity can reasonably measure its progress toward completion. A performance obligation is satisfied continuously if (a) the entity's performance creates or enhances an asset that the customer controls, or (b) the entity's performance does not create an asset with alternative use to the entity but one of the following criteria is met:
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Topic
2010 Exposure Draft
2011 Exposure Draft The customer simultaneously receives and consumes the benefits of the entitys performance as it performs Another entity would not need to substantially re-perform the task(s) if that other entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance completed to date and it expects to fulfill the contract
Measuring progress of satisfying a performance obligation
Methods for recognizing revenue when control transfers continuously include: Output methods that recognize revenue on the basis of units produced, units delivered, contract milestones, or surveys of work performed Input methods that recognize revenue on the basis of costs incurred, labor hours expended, or machine hours used Methods based on the passage of time
The objective is to faithfully depict the pattern of transfer of the goods or services to the customer. Methods for recognizing revenue when control transfers continuously include: Output methods that recognize revenue on the basis of the value of the entity's performance to date (for example, surveys of goods or services transferred to date, appraisals of results achieved) Input methods that recognize revenue on the basis of inputs to the satisfaction of a performance obligation (for example, time, units delivered, resources consumed, labor hours expended, costs incurred, and machine hours used) An entity may select an appropriate input method if an output method is not directly observable or available to an entity without undue cost. The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if the costs of goods are significant and transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials).
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Topic Constraint on recognizing revenue
2010 Exposure Draft Amounts are only included in the transaction price allocated to performance obligations if they can be reasonably estimated.
2011 Exposure Draft Revenue is recognized when the performance obligation is satisfied and the entity is reasonably assured to be entitled to the transaction price allocated to that performance obligation. An entity is reasonably assured to be entitled to variable consideration if both of the following criteria are met: The entity has experience with similar types of performance obligations The entity's experience is predictive of the amount of consideration to which the entity will be entitled in exchange for satisfying those performance obligations There is an exception regarding licenses to use intellectual property in exchange for royalties based on the customer's subsequent sales of a good or service. The related variable consideration only becomes reasonably assured once those future sales occur.
The contract is a sale of intellectual property if the customer obtains control of the entire licensed intellectual property (for example, the exclusive right to use the license for its economic life). The performance obligation is satisfied over the term of the license if the customer licenses intellectual property on an exclusive basis but does not obtain control for the entire economic life of the property. A contract that provides a nonexclusive license to use intellectual property (for example, off-the-shelf software) is a single performance obligation. An entity recognizes revenue when the customer is able to use the license and benefit from it.
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Topic Costs of obtaining a contract
2010 Exposure Draft An entity recognizes costs to obtain a contract (for example, costs of selling, marketing, or advertising) as incurred.
2011 Exposure Draft Costs to obtain a contract should be recognized as an asset if they are incremental and expected to be recovered. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained. Costs to fulfill a contract are in the scope of the proposed guidance only if those costs are not addressed by other standards. Costs required to be expensed by other standards cannot be capitalized under the proposed guidance. An entity should recognize an asset for costs that are not within the scope of another standard only if the costs relate directly to a contract, will generate or enhance a resource that the entity will use to satisfy future performance obligations in a contract, and are expected to be recovered under a contract. An entity amortizes an asset recognized for fulfillment costs in accordance with the transfer of goods or services to which the asset relates, which might include goods or services to be provided in future anticipated contracts. An entity should recognize a liability and corresponding expense if a performance obligation that is satisfied over a period of time is onerous. The performance obligation will not need to be assessed if it is satisfied over a period less than one year. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of transaction price allocated. The lowest cost of settling a performance obligation is the lower of the following:
Costs of fulfilling a contract
An entity may capitalize the costs to fulfill a contract in certain circumstances. Management will need to evaluate whether the costs incurred in fulfilling a contract are in the scope of other standards (for example, inventory, fixed assets, intangibles) to determine which costs may be recognized as an asset. An entity should recognize an asset for costs that are not within the scope of another standard only if the costs relate directly to a contract, will generate or enhance a resource that the entity will use to satisfy future performance obligations in a contract, and are expected to be recovered under a contract.
A performance obligation is onerous when the present value of the probabilityweighted direct costs to satisfy the obligation exceed the consideration (that is, the amount of transaction price) allocated to it.
Dataline 35
Topic
2010 Exposure Draft
2011 Exposure Draft The costs directly related to satisfying the performance obligation The amount the entity would have to pay to exit the performance obligation
Sale and repurchase agreements (put options)
An entity should account for the transaction as a sale of a product with a right of return when it sells a product to a customer that includes an unconditional right to require the entity to repurchase that product in the future.
Arrangements where a customer has the right to require the entity to repurchase an asset (a put option) should be accounted for as a lease under the leasing standard if the arrangement represents a right to use the asset over time rather than a sale.
Dataline 36
Authored by:
Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Guilaine Saroul Director Phone: 1-973-236-7138 Email: guilaine.saroul@us.pwc.com Steve Mack Senior Manager Phone: 1-973-236-4378 Email: steve.mack@us.pwc.com Craig Robichaud Senior Manager Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Andrea Allocco Senior Manager Phone: 01144-207-212-3722 Email: a.allocco@uk.pwc.com
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10 Minutes
The far-reaching implications of a new revenue model
Highlights Management should evaluate existing business practices under the new model, including how product or service offerings are bundled and priced, and begin assessing the need to negotiate revised contract terms. Industry-specic accounting guidance will be eliminated under the new model and industry practice will need to be re-evaluated. Estimates that are required to apply the new model will often require the use of greater judgment and may necessitate process or system changes. Companies should begin assessing the impact of the changes and the adequacy of their resources, systems, and processes to address the newrequirements.
on the future of revenue recognition
July 2011
Revenue, or the top line, is one of the most closely-monitored measures in financial statements. However, the accounting rules for revenue can be difficult to decipher. US revenue guidance today is a tangled web of special rules and exceptions created to address unique transactions, industries, and business models. The FASB and IASB are in the process of replacing this labyrinth of revenue guidance with a new global accounting standard that will apply a single set of principles to all revenue transactions, regardless of industry. Their proposed standard, issued in June 2010, received extensive feedback, which the boards have discussed at length during the first half of 2011. Now that theyve completed their initial redeliberations and decided to re-expose their revenue proposal, its time to take stock of the effects. Understanding the impact now will inform your response to the revised proposal and limit surprises down the road. This 10Minutes provides a preview of the proposed changes and their implications. We expect the FASB and IASB to issue a revised exposure draft in August or September 2011 and a final standard in the September 2012 timeframe. Keep in mind that some aspects of the guidance could change before a final standard is issued.
What it means for your company: 1. Revenue is a key metric subject to considerable focus by investors and other stakeholders. The impact of changes to the revenue model will affect key financial measures and ratios. Early communication to stakeholders will becritical. 2. Companies may need to change information technology systems to capture different information and develop new processes for estimates that arent requiredtoday. 3. The resulting need for increased judgment will require thoughtful documentation and dialogue with those charged withgovernance. 4. It may be necessary to modify contract terms to maintain the original intent of arrangements or better align reported revenue with business objectives. 5. Adopting the new guidance will entail adjusting prior period financial statements. Successful implementation of the standard will require upfront planning. 6. The FASB and IASB have decided to reexpose their proposed revenue standard. Companies should take advantage of this opportunity to participate in the standardsetting process and provide input to theboards.
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At a glance
A principles-based approach The proposed model is easy to understand on its surface, but its application could result in significant changes from existing practice. A few highlights of the revenue proposal1 include: Revenue is recognized when control is transferred to the customer, a new model that requires judgment for many transactions.
with potential for big implications The implications will vary by company and by industry. But at a minimum, companies will need to consider the following: Industry practices that have developed over time are now off the table. It may take time for interpretations to develop and practices to evolve for some aspects of the new model.
Revenue reflects a more extensive use of estimates Most companies will see some impact on margins (for example, contingent fees), and bad debt and other key financial measures. Changes estimates offset gross revenue. that affect a broad base of companies include offsetting bad debt expense against revenue and Revenue from licenses of intellectual property is changes in the timing of recognizing certain costs. recognized when the customer obtains control of the rights, which could result in fewer license fees recognized ratably over the license period.
Direct costs of obtaining and fulfilling contracts are capitalized as assets if they meet certain criteria, bringing consistency to an area of mixed practicetoday.
Changes in how contract terms affect reported revenue, such as contingent fees and prepayments or extended payment terms, could influence how companies and their customers negotiate theseterms. Any change to revenue is likely to affect a wide range of arrangements that are linked to financial measures, including compensation and bonus plans, earnout arrangements, and covenants in financial agreements. Changes to revenue might also have tax implications and could affect the timing of cash tax payments if, for example, revenue recognition is accelerated.
1 The discussion of the proposed guidance throughout this document is based on the proposals in the June 2010 exposure draft and tentative decisions reached during redeliberations as of June 30, 2011. Certain provisions may change before the nal standard isissued.
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01
No more special treatment
Industry-specic US revenue guidance will be largely eliminated including:
Financial services Brokers and dealers Depository and lending Investment companies Mortgage banking
A primary goal of the standard setters is to create a single, principles-based approach thats applied across all industries. So, companies that previously followed industry-specific guidance or established industry practices will likely feel the greatest impact. Assessing this impact now may reveal potential longer-term strategic matters to consider even before the standard is finalized. The examples below represent only a small sample of affectedindustries. Software The detailed rules in todays software guidance were designed with an anti-abuse bias and often delay revenue recognition. Software companies have shaped their business models to address the strict requirements; for example, by including renewal rates in contracts, putting limits on discounts offered to customers, and avoiding promises for future technology. The less rigid approach in the new model may eliminate the need for these restrictions and may cause software companies to rethink their current practices. As a result, some may change how they sell their products and services, and how they negotiate with customers. Real estate Industry-specific guidance for real estate includes prescriptive requirements in areas such as the continuing involvement of the seller and evidence of the buyers commitment to pay for a property. The new model takes more of a principles-based approach that eliminates these bright lines. Thus, companies may decide to modify arrangements
that were previously structured to meet brightline requirements to better align with their businessobjectives. Contractors Those in the engineering and construction, and aerospace and defense industries, among others, currently apply specific guidance on longterm contracts. This guidance includes rules for recognizing revenue (usually on a percent-complete basis), recording contract costs, and accounting for change orders. The new model has similar concepts but there are nuances that could catch some by surprise. For example, there could be differences in the costs that are capitalized or how progress to completion is measured. At the extreme, some arrangements might not result in revenue until the project is complete. Each company will have to assess its own specific facts under the new model. Can one size fit all? The standard setters have encountered some bumps in the road over the course of the revenue project. It hasnt been easy to craft a principles-based approach that functions as intended for all industries. The FASB and IASB plan to issue a revised exposure draft in August or September 2011, with a 120-day comment period. Companies with concerns about unintended consequences of the model should take advantage of this opportunity to influence the standard-setting process.
Entertainment Broadcasters Cable television Casinos Films Music
Other industries Airlines Contractors Extractive activities-oil and gas Franchisors Health care entities Real estate Software
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02
Navigating areas ofjudgment
A principles-based approach, by design, requires more judgment than applying a set of rules. While the standard setters have agreed to add more guidelines and indicators in some areas, accounting for revenue will likely require a greater use of estimates and judgment than it does today. We highlight just a few areas requiring estimates or judgments and the related process implicationsbelow. New estimates of variable fees Revenue under the new model is based on the total fees a company expects to receive. This includes estimates of variable fees, such as performance bonuses, royalties, and other contingent fees. Recognition of revenue for fees with these types of uncertainties is often deferred today. Under the new model, there are still some constraints on recording revenue, particularly for contingencies outside the companys control. But some fees might be recognized earlier than today, and potentially adjusted along the way, requiring new processes to estimate these amounts. A new model for credit risk A change affecting almost all companies is the treatment of bad debts. Today, a company defers all of the revenue from a contract when it cant be assured of collecting from the customer at the onset of the arrangement. Under the new model, this hurdle has been removed. Also, estimates of uncollectible amounts will offset gross revenue, instead of being recorded as bad debt expense. In addition to affecting margins, these changes require recording a day one estimate of customer credit losses for all transactions. Loss leaders in service contracts Today, contract losses are generally not recorded until incurred, except when applying certain industry guidance. A loss could be recorded upfront under the new model, however, when estimated costs to fulfill a service obligation exceed remaining revenue. For example, a service provider might sign a one-year contract with a customer that is unprofitable, anticipating that the customer will renew for future years. A loss will likely be recorded at contract inception in this scenario. The new model will require forecasting costs and updating estimates on an ongoing basis to identify potential losses. Because its an ongoing assessment, a loss could be triggered part way through a contract if costs begin to climb. System and process implications Revenue estimates will be based on the probabilityweighted or most likely amount of cash flows. New systems and processes may be needed to collect and analyze data for developing and continuously reassessing these estimates. Companies will also likely need new processes for other areas of judgment, including allocating revenue to performance obligations, tracking customer credit risk, identifying loss contracts, and analyzing capitalized costs. The judgment required when applying a principles-based approach continues to raise concerns. A common concern is that judgments and estimates can be challenged by others in hindsight. Thats why its essential to establish good processes, thoughtfully document estimates on a contemporaneous basis, and ensure they are subject to the appropriate oversight.
Examples of estimates required by the revenue standard
Bad debts/ credit risk
Record estimated bad debts as an offset to gross revenue Updates to estimates also affect net revenue
Performance bonuses
Estimate the amount the company expects to receive Generally recognize if reasonably assured based on experience and other factors
Royalties and other variable fees
Estimate the amount the company expects to receive Generally do not recognize if sales-based royalties or no predictive experience
Time value of money
Only record impact if significant and greater than one year Could affect contracts with prepayments or extended payment terms
Loss contracts
Record upfront loss if remaining costs exceed revenue for service obligations Update assessment throughout the life of the contract
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03
Assessing the impact on the past, present, and future
A fresh look at contract terms Applying the new model is almost like starting with a clean sheet of paper. This fresh look could prompt changes to contract terms or other business strategies. Now that the standard setters are about to release a revised exposure draft, its time to start thinking ahead about potential strategic changes. An important first step is analyzing existing sales transactions and modeling the impact of the proposed guidance. This could reveal areas where changes are warranted. Management should also reassess business practices that have been influenced by the existing revenue rules. For example, some may bundle or price their offerings in a way to achieve, or avoid, deferral of revenue. Similarly, some may structure arrangements to comply with brightline requirements. These strategies might not be necessary under the new model, or consistent with broader business objectives. Because changes to business practices cant be implemented overnight, companies should think through these issues well in advance of adopting the new standard. Other affected arrangements Due to the pervasive impact of revenue on the financial statements, other arrangements linked to financial measures could be affected. These arrangements might include compensation and bonus plans, earnout arrangements, and covenants in financing agreements, among others. Companies should inventory affected arrangements and assess the impact of changes to the relevant financial measures. In some instances, it may be necessary to modify the terms of these arrangements to maintain their original intent. Adopting the new standard Companies will adopt the new standard by adjusting prior period financial statements as if the guidance had always been applied, with a few practical exceptions provided to reduce the burden. Most agree this approach is conceptually superior as it provides consistency across reporting periods. Gathering data on historical transactions, however, could be challenging, particularly for companies with multi-year contracts. Getting an early start will be key to overcoming these challenges. Managing the transition period For a period of time prior to the effective date, most companies will need to implement some form of parallel or dual tracking of transactions under both the current and new guidance. This analysis will be needed to adjust prior periods on the effective date, but it is also important information for communicating the impact of the new standard tostakeholders. Another challenge during the transition period is planning the timing of strategic changes, such as changes to contract terms. Prior to the effective date of the new standard, reported revenue will continue to reflect existing guidance. However, these same transactions will be reported under the new guidance when prior periods are adjusted upon adoption. The contracts terms in a given arrangement will dictate how it is accounted for under both sets of guidance. Some companies may decide to delay changes to contract terms until they have adopted the new guidance. Regardless of the approach taken, communicating these decisions and their implications to stakeholders will be critical to avoid surprises.
Illustrative timeline for implementing the new standard The boards have yet to decide on the effective date of the nal standard; however, the FASB recently announced that the effective date would be no earlier than annual periods beginning on or after January 1, 2015. The below timeline illustrates key timing considerations, including the transition period, if the effective date is January 1, 2015. January 2013: First September reported period 2012: adjusted Final upon standard expected adoption
January 2015: Illustrative effective date
Implement new processes and procedures
Assess transactions under both sets of guidance (dual recordkeeping)
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04
What should your company be doingnow?
While the standards effective date is still a few years away, its successful implementation will require planning ahead and keeping stakeholders well-informed of the changes to come. Key steps in the process include: Rally the people who need to act Assemble a steering committee. Include resources from legal, tax, operations, information technology, human resources, sales and marketing, and investor relations. Educate business leaders in the company about the changes and business implications. Inform the audit committee and others charged with governance and oversight responsibilities. Develop a point of view on the revised exposure draft (when issued) and provide input to the boards during the comment letter period. Assess the potential impact early
Identify gaps in systems and controls
Consider new systems and controls Assess whether current systems can capture and process the data needed to develop and monitor new required estimates, and track potential differences in revenue for book and tax purposes. Develop a plan to implement dual recordkeeping of transactions during the transition period. Consider the need for new systems and the time requirements to implement and test them. Identify processes and controls that need to be designed or modified, documented, and implemented. Conduct strategic reviews Utilize forecasting models to assess expected changes in reported revenue, gross margin, and other key financial measures. Evaluate potential changes to business practices, including whether to modify existing contract terms. Assess when strategic changes should be enacted (i.e., before or after the standards effective date). Educate the sales force about the changes and assess how the changes will affect negotiations with customers; consider whether any controls related to the sales process need to be modified or put in place. Communicate in advance with stakeholders Develop a plan to limit surprises by communicating the expected impact to investors and other stakeholders.
Preparing for the change
Form a cross-functional steering committee
Inventory affected contract provisions
Review existing revenue arrangements and contracts to identify provisions that will beaffected. Model the impact on significant sales transactions or a sample of transaction types. Assess the potential impact on other arrangements linked to key financial measures, such as compensation plans or debt covenants. Assess the potential tax implications, as the timing of cash tax payments could be affected, and consider the need to pursue approval for changes to existing methods of accounting used for tax purposes.
Evaluate potential changes to business practices
Develop a plan to communicate to stakeholders
At a glance
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To have a deeper discussion about the change in revenue accounting standards, please contact: Jim Kaiser Partner, US Convergence & IFRS Leader PwC 267-330-2045 james.kaiser@us.pwc.com Dave Kaplan Partner, Co-Leader National Accounting Services Group PwC 973-236-7219 dave.kaplan@us.pwc.com David Schmid Partner, US Assurance IFRS Leader PwC 312-298-2939 david.schmid@us.pwc.com Dusty Stallings Partner, National Accounting Services Group PwC 973-236-4062 dusty.stallings@us.pwc.com
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US GAAP Convergence & IFRS Revenue recognition: Aerospace and defense supplement

No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Determining the unit of account ............. 2 Determining transfer of control ...................... 5 Contract costs ............... 10 Onerous performance obligations ................... 13 Long-term maintenance contracts ...................... 14 Other considerations ..... 16
Aerospace and defense industry supplement

Overview
The following items common in the Aerospace and Defense (A&D) industry are expected to be significantly impacted by the new revenue recognition standard. Currently, several accounting standards are commonly used to recognize revenue and related costs in the A&D industry. Defense programs and commercial aviation equipment are often complex, expensive programs, and performance under these contracts typically spans multiple years. Construction contract guidance is generally followed for these programs. Long-term maintenance contracts for commercial aviation equipment and performance-based logistics contracts for military equipment are also common. These contracts can extend up to 20 years and require significant estimates of costs to perform under these contracts over the performance period. This paper, the examples, and the related assessments contained herein, are based on the Exposure Draft, Revenue from Contracts with Customers, which was issued on November 14, 2011. These proposals are subject to change until a final standard is issued. The examples reflect the potential effect based on the proposed standard and any conclusions noted are subject to further interpretation and assessment based on the final standard. We have also provided a high-level summary of key changes from the original exposure draft issued on June 24, 2010 (the 2010 Exposure Draft). References to the proposed model or proposed standard refer to the exposure draft issued in November 2011, unless otherwise indicated. For a more comprehensive description of the proposed standard refer to PwC's Dataline 2011-35 or visit www.fasb.org.
Dataline
Determining the unit of account

Current guidance requires that the contract is the unit of account, except in circumstances where the contract meets the criteria for combining contracts or segmenting a contract. The proposed standard requires consideration of the separate performance obligations in a contract. The complexity of A&D contracts might make it challenging to determine the unit of account for applying the new guidance. Contracts commonly contain integrated systems and combinations of products and services. The exposure draft further indicates that a promised bundle of goods or services shall be accounted for as a single performance obligation if the goods or services in the bundle are significantly customized, highly interrelated, and the entity provides a significant service of integrating the goods or services into the combined item(s). Proposed model Performance obligations A performance obligation is a promise to transfer a good or service to a customer. An entity should separately account for performance obligations if the pattern of transfer is different and they are distinct. A good or service is distinct if either of the following criteria are met: The unit of account for measuring contract performance and recognizing revenue is typically the contract. That presumption may be overcome only if a contract or a series of contracts meets the conditions for combining or segmenting contracts. The unit of account for measuring contract performance and recognizing revenue is typically the contract. That presumption is overcome when a contract or a series of contracts meets the conditions described for combining or segmenting contracts. There is no further guidance for separately accounting for more than one deliverable in a construction contract. Current U.S. GAAP Current IFRS
There is no further guidance for separately accounting for more than The entity regularly sells the good or one deliverable in a construction contract under the construction service separately contract guidance. The customer can use the good or service on its own or together with other readily available resources
An entity should account for two or more performance obligations as a single performance obligation when the following criteria are met: The goods or services are highly interrelated and transferring them to the customer requires the entity to provide a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted The bundle of goods or services is significantly modified or customized to fulfill the contract Goods and services that are not distinct and therefore, not separate performance obligations, should be combined with other performance obligations until the entity identifies a bundle of goods or services that is distinct.
Dataline
Proposed model Contract options An option in a contract to acquire additional goods or services is a separate performance obligation if it provides a material right to the customer that the customer would not have received without entering into the contract. An example of a material right is a significant discount on additional goods or services that is not available to similar customers. A portion of the transaction price is allocated to the option based on the estimated standalone selling price of the option. Contract modifications A contract modification is accounted for as a separate contract if: the modification promises distinct goods or services that result in a separate performance obligation; and the entity has a right to consideration that reflects the standalone selling price of the promised goods or services underlying that performance obligation. A modification that is not a separate contract is evaluated and accounted for either as: A termination of the original contract and the creation of a new contract if the goods or services are distinct from those transferred before the modification A cumulative adjustment to contract revenue if the goods and services are not distinct and part of a single performance obligation that is partially satisfied A prospective adjustment to contract revenue when the goods or services are a combination of distinct and non-distinct
Current U.S. GAAP
Current IFRS
Contract options, which are generally an option to purchase additional units of a product at previously agreed upon pricing, might be included in the original contract or accounted for separately, depending on the circumstances.
Contract options, which are generally an option to purchase additional units of a product at previously agreed upon pricing, might be included in the original contract or accounted for separately, depending on the circumstances.
A change order is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured. U.S. GAAP includes detailed revenue and cost guidance on the accounting for unpriced change orders (or those in which the work to be performed is defined, but the price is not).
A change order (known as a variation) is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured. There is no detailed guidance on the accounting for unpriced change orders. A change order is generally included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured.
Dataline
Proposed model Combining contracts Two or more contracts entered into at or near the same time and with the same customer are combined and accounted for as one contract if one of the following conditions is met: The contracts are negotiated as a single package The amount of consideration paid in one contract depends on the other contract The goods or services promised are a single performance obligation Impact:
Current U.S. GAAP
Current IFRS
Combining contracts is permitted provided certain criteria are met. Combining is not required as long as the underlying economics of the transaction are fairly reflected.
Combining contracts is required when certain criteria are met.
The unit of account for recognizing revenue will no longer default to the contract level. Preparers will need to apply and document their judgments regarding the identification of performance obligations within a contract and when performance obligations should be separately accounted for or combined. The proposed guidance introduces the concept of determining whether a good or service is distinct. A&D contracts often involve complex integrated systems, requiring judgment to determine whether aspects of these systems represent a distinct good or service. Another concept introduced in the proposed standard is the concept of accounting for a bundle of goods or services as a single performance obligation if the entity provides significant customization, the goods and/or services are highly interrelated and the entity provides a significant service of integrating goods and/or services into the combined item(s) for which the customer has contracted. Significant judgment may be required to determine if providing a bundle of goods and/or services meets these criteria. A contract option that provides the customer a material right the customer would not have otherwise received results in a separate performance obligation with a portion of the transaction price allocated to the right. An option that provides a right to additional goods or services at a price within the range of prices typically charged does not result in a material right and therefore, does not result in a separate performance obligation. Contract modifications currently require significant judgment to determine when they are combined with the original contract, and we expect that to continue. The criteria used to combine contracts have not changed significantly. Combining is no longer optional if the criteria are met, which is a change from existing U.S. GAAP.
Key changes from the June 2010 Exposure Draft: The basic principle of accounting for performance obligations separately has not changed from the June 2010 exposure draft. The boards have provided additional guidance on when a bundle of goods or services could result in a single performance obligation in an effort to better reflect the economics of certain long-term contracts. The boards also revised the guidance for determining whether a performance obligation is distinct. The concept of a distinct profit margin was removed. The focus is now on whether the good or service is sold separately by the entity or whether the good can be used with other resources readily available to the customer. The guidance on segmenting contracts was removed as it was deemed unnecessary given the requirement to separate contracts into distinct performance obligations.
Dataline
Example #1 Identification of performance obligations

Facts: A contractor enters into a contract to design and build a series of ten identical unmanned aircraft (a "low rate initial production" or "LRIP"). How many distinct performance obligations are there in the contract? Discussion: The identification of performance obligations in a contract might require considerable judgment. The design services and build of the complex systems for this LRIP might be distinct, but the specific facts and circumstances of the contract will need to be assessed. The contractor may be able to account for the bundle of goods and services (design and build) as a single performance obligation if the goods and services are significantly customized, highly interrelated, and the contractor provides a significant service of integrating goods or services into the combined item(s). Full rate production contracts that do not include design services will also require judgment to determine whether the goods and services are significantly customized and highly interrelated based on the contract terms. Each deliverable under the contract might be a separate performance obligation, particularly in the absence of a significant service to integrate the goods and/or services.
Example #2 Unpriced change orders

Facts: A contractor has a history of executing unpriced change orders; that is, those change orders where the price is not defined until after scope changes are in process or completed. When will these change orders be included in contract revenue? Discussion: The contractor might be able to determine that it expects the price of the scope change to be approved based on its historical experience. If so, the contractor would account for the unpriced change order and estimate the transaction price based on a probability-weighted or most likely amount approach (whichever is most predictive). The contractor would need to then determine whether the unpriced change order should be accounted for as a separate contract. This will often not be the case based on the following: Change orders often wont result in a separate performance obligation because the underlying good or service is highly interrelated with the original good or service and part of the contractor's service of integrating goods into a combined item for the customer. Change orders are typically priced based on the contractor's single commercial objective for the overall contract. The pricing of a change order may, as a result, not represent the standalone selling price of the additional good or service. The contractor would update the transaction price and measure of progress towards completion of the contract accordingly when a change order is combined with the original contract and the remaining goods or services are part of a single performance obligation that is partially satisfied.
Determining transfer of control

Many entities in the A&D industry use percentage-of-completion accounting to recognize revenue as activities are performed. The percentage of completion is measured using either output methods, such as units-of-delivery, or input methods, such as cost incurred compared to total estimated cost at completion. The boards have proposed that revenue is recognized upon the satisfaction of a contractor's performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or over time. The change to a control transfer model will require careful assessment of when a contractor can recognize revenue. We expect that many A&D contracts will transfer control of a good or service over time and, therefore, might result in revenue being recognized in a pattern similar to today. This should not be assumed, however. Contractors will not be able to default to the method used today and a careful assessment of when control transfers will need to be performed.
Dataline
Proposed model Transfer of control Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or, perhaps most important for the A&D industry, over time.
Current U.S. GAAP
Current IFRS
Many entities in the A&D industry use percentage-of-completion accounting to recognize revenue when reliable estimates are available.
Many entities in the A&D industry use percentage-of-completion accounting to recognize revenue when reliable estimates are available. When reliable estimates cannot be made, but there is assurance that no loss will be incurred on a contract (for example, when the scope of the contract is ill-defined, but the contractor is protected from an overall loss), the percentage-of-completion method based on a zero-profit margin is used until more precise estimates can be made. The completed-contract method is prohibited. Assessing whether a contract is within the scope of the construction contract standard or the broader revenue standard continues to be an area of focus. A buyers ability to specify the major structural elements of the design is a key indicator (although not determinative in and of itself) of construction contract accounting. Construction accounting guidance is generally not applied to the recurring production of goods.
When reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (for A performance obligation is satisfied example, when the scope of the over time when at least one of the contract is ill-defined, but the following criteria is met: contractor is protected from an overall loss), the percentage-of-completion The entity's performance creates or method based on a zero-profit margin is used until more precise estimates enhances an asset that the can be made. customer controls; or The entity's performance does not create an asset with alternative use to the entity; and at least one of the following: The customer simultaneously receives and consumes the benefits as the entity performs, Another entity would not need to substantially reperform the work performed to date if that other entity were required to fulfill the remaining obligation to the customer, or The entity has a right to payment for performance completed to date. The completed-contract method is required when reliable estimates cannot be made. Assessing whether a contract is within the scope of the construction contract guidance is a key determination. Many A&D contracts are specifically scoped into the U.S. GAAP contract accounting guidance today given the customer specifies the major elements of the design.
An entity should recognize revenue over time only if the entity can reasonably measure its progress towards complete satisfaction of the performance obligation (see further discussion below). A performance obligation that does not meet the criteria above is satisfied at a point in time. Determining when control transfers will require a significant amount of judgment. Indicators that might be considered in determining whether the customer has obtained control of a good include:
Dataline
Proposed model The customer has a present right to payment The customer has legal title The customer has physical possession The customer has the significant risks and rewards of ownership The customer has accepted the asset This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a stand-alone basis. Measuring transfer of control over time A contractor should measure progress toward satisfaction of a performance obligation that is satisfied over time using the method that best depicts the transfer of goods or services to the customer. Methods for recognizing revenue when control transfers over time include: Output methods that recognize revenue on the basis of direct measurement of the value to the customer of the entity's performance to date (for example, units delivered, surveys of goods or services transferred to date, appraisals of results achieved). Input methods that recognize revenue on the basis of the entity's efforts or inputs to the satisfaction of a performance obligation (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities). The method selected should be applied consistently to similar contracts with customers. Once the metric is calculated to measure the extent to which control has transferred, it must be applied to total contract revenue to determine the amount of revenue to be recognized.
Current U.S. GAAP
Current IFRS
A contractor can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. There are two different approaches for determining revenue, cost of revenue, and gross profit, once a "percentage complete" is derived: the Revenue method and the Gross Profit method.
A contractor can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. IFRS requires the use of the Revenue method to determine revenue, cost of revenue, and gross profit once a "percentage complete" is derived. The Gross Profit method is prohibited.
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Proposed model The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if goods are transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials). Estimates to measure the extent to which control has transferred (for example, estimated cost to complete when using a cost-to-cost calculation) should be regularly evaluated and adjusted using a cumulative catch-up method. Impact:
Current U.S. GAAP
Current IFRS
A&D entities will need to assess government and commercial contracts to determine whether control of the asset(s) being constructed transfers over time to the buyer. Government contracts commonly require highly customized engineering and production where the government specifies the design and function of the items being produced. The products and services often have only a single customer (the government) or require government approval to sell to other customers. Government contracts also commonly require progress payments and an unconditional obligation to pay in exchange for the government controlling any work in process. We believe that many A&D contracts with the U.S. Government will meet the criteria for continuous transfer of control due to these factors. Contracts with other government customers will require careful analysis to determine if control transfers over time. Commercial aerospace contracts also commonly include highly customized systems and components that are integrated with the aircraft design and unique to a specific aircraft model. Whether contracts for systems and components provided to commercial aircraft manufacturers result in transfer of the goods or services underlying the contract over time will be a matter of judgment depending on the nature of the product, the contract terms, and related facts and circumstances. The exposure draft allows both input and output methods for recognizing revenue. An entity should select the method that best depicts the transfer of control of goods and services. This requirement might result in a change from the method an entity uses today. Input methods should represent the transfer of control of the asset to the customer and should therefore exclude any activities that do not depict the transfer of control. The Gross Profit method of calculating revenue, costs of revenue, and gross profit based on the percent complete will no longer be acceptable under the proposed standard, which is a change from current U.S. GAAP and might result in a change in the calculation of revenue to recognize.
Key changes from the June 2010 Exposure Draft: The June 2010 exposure draft had limited guidance for determining whether control transferred over time. The boards added the criteria above to determine when a performance obligation is satisfied over time in response to response to feedback that the original guidance was difficult to apply to service transactions.
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The boards also added the indicators of "risk and rewards of ownership" and "evidence of customer acceptance" to provide further guidance on when control transfers at a point in time.
Example #3 Transfer of control over time

Facts: A contractor enters into a contract with a government to build an advanced radar and weapons system. The contract has the following characteristics: The radar and weapons system is designed to the government's specifications that, due to the proprietary technology used, cannot be transferred to any other government or customer without approval Non-refundable, interim progress payments are made by the government to the contractor The government can terminate the contract at any time, but is required to pay for work performed; the government has a lien on work in process Physical possession and title do not pass to the government until completion of the contract The contractor determined that the contract is a single performance obligation as they are providing a service to integrate all elements of the project into a single item for the government. How should the contractor recognize revenue in this example? Discussion: The contractor is providing a service that is satisfied over the contract term. The government controls the work in process as they have the obligation to pay for work performed, and any work performed is controlled by the government in the event of a contract termination. The contractor will therefore recognize revenue as the performance obligation is satisfied over time.
Example #4 Transfer of control at a point in time

Facts: A manufacturer enters into a contract with an airline to build a commercial aircraft. The manufacturer produces several aircraft models and each can be customized based on a customer's needs. The airline orders a standard model and selects certain options to customize the interior for items such as the seating configuration, entertainment system, etc. The customization will be performed by the manufacturer, but could also be performed by other vendors. The contract has the following characteristics: The airline is required to make progress payments over the period of production. These payments are refundable in the event of a cancellation. The airline can cancel the contract at any time and any work in process remains the property of the manufacturer. Title to the "green aircraft" transfers upon completion of the airframe and the manufacturer has a right to payment for the airframe. Physical possession of the aircraft does not pass to the airline until completion of the contract. The completion services are performed by the manufacturer once the airframe is completed. The manufacturer determined that the contract has two performance obligations: the base aircraft (or "green aircraft") and the completion services as the customer can benefit from the good or service on its own or with resources readily available to it (for example, others can perform the completion services). How should the manufacturer recognize revenue in this example?
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Discussion: The manufacturer should recognize revenue for the "green aircraft" when the airline obtains control of the aircraft, which in this case is likely upon transfer of title. The airline can direct the use and further completion of the aircraft, once the title transfers. Revenue would not be recognized as the aircraft is built as the criteria for satisfying a performance obligation over time would not be met because: The airline does not control the asset during construction. The asset does have an alternative use to the manufacturer as the base aircraft model is sold to other customers. Any rework to resell the asset is likely not significant in relation to the overall cost of the aircraft and therefore the aircraft could readily be directed to another customer. If the customer-specific costs are significant such that the manufacturer could support there was no alternative use for the aircraft, the remaining criteria for continuous transfer would still likely not be met as: -
The airline does not simultaneously receive and consume the benefits as the work is performed as the equipment is not usable until complete. Another entity would need to reperform the tasks performed to date as they would not have the benefit of the work in process of the manufacturer due to the nature of the asset and The manufacturer does not have a right to payment commensurate with the work performed. The progress payments received are refundable except for termination penalties that are unlikely to compensate the manufacturer A at an amount commensurate with the work performed on the aircraft.
The manufacturer should recognize revenue for the completion services as the services are performed. This performance obligation is being satisfied over time since the airline controls the work in process as they have title to the airframe being customized. The facts and circumstances of these types of arrangements will need to be carefully assessed and significant judgment could be required to determine the appropriate number of performance obligations and the method of revenue recognition.
Contract costs
Existing construction contract guidance contains a substantial amount of cost capitalization guidance, both related to precontract costs and costs to fulfill a contract. The proposed standard also includes contract cost guidance that could result in a change in the measurement and recognition of contract costs as compared to today (in particular for those contractors that use the gross profit percentage-of-completion method). Proposed model Incremental costs of obtaining a contract should be capitalized if the costs are expected to be recovered. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained (for example, sales commissions). Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained. Current U.S. GAAP There is a significant amount of detailed guidance relating to the accounting for contract costs within the construction contract guidance. This is particularly true with respect to accounting for pre-contract costs. Current IFRS There is a significant amount of detailed guidance relating to the accounting for contract costs.
Costs that relate directly to a contract and are incurred in securing the contract are included as part of Pre-contract costs that are incurred for contract costs if they can be separately a specific anticipated contract generally identified, measured reliably, and it is may be deferred only if their probable that the contract will be recoverability from that contract is obtained. probable. Entities may recognize costs based on the average cost per unit, using estimates of total costs over the life of the contract. The average cost method
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Proposed model Direct costs incurred to fulfill a contract are first assessed to determine if they are within the scope of other standards (for example, inventory, intangibles, fixed assets), in which case the entity should account for such costs in accordance with those standards (either capitalize or expense). Costs that are not in the scope of another standard are evaluated under the revenue standard. An entity recognizes an asset only if the costs relate directly to a contract, relate to future performance, and are expected to be recovered under a contract. Costs that relate directly to a contract include costs that are incurred before the contract is obtained if those costs relate specifically to an anticipated contract. All costs relating to satisfied performance obligations and costs related to inefficiencies (that is, abnormal costs of materials, labor, or other costs to fulfill) should be expensed as incurred. Capitalized costs are amortized as control of the goods or services to which the asset relates is transferred to the customer which may include specific anticipated contracts. Impact:
Current U.S. GAAP often results in the deferral of contract costs that are subsequently recognized as cost of sales as additional performance takes place under the contract.
Current IFRS
A&D entities that use the average cost method or otherwise defer costs under current guidance might be affected by the proposed standard. Entities will need to follow the hierarchy described in the proposed standard when capitalizing costs. Costs within the scope of another asset standard must be accounted for under that standard (which might require capitalization or expensing as incurred). This could result in more items being expensed than under today's guidance or the asset having a different useful life than the contract. Costs attributable to each performance obligation under the contract will generally be expensed as that individual performance obligation is satisfied. Application of the standard to learning curve costs will require significant judgment. Certain learning curve costs might meet the criteria for capitalization in the exposure draft. Demonstrating that learning costs relate to future performance obligations might be difficult and may result in some of those costs being expensed as incurred.
Key changes from the June 2010 Exposure Draft: Costs to obtain a contract were to be expensed as incurred under the June 2010 exposure draft. The boards received feedback that certain costs to obtain a contract may meet the definition of an asset and should be capitalized. The guidance was therefore revised to permit recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered.
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The boards clarified that costs to fulfill are in the scope of the revenue guidance only if they are not addressed by other standards and that the costs of abnormal amounts of wasted materials, labor, or other resources that were not considered in the price of the contract should be recognized as an expense when incurred.
Example #5 Contract costs

Facts: A contractor enters into a contract to design and build a series of ten identical unmanned aircraft (a "low rate initial production" or "LRIP"). At the beginning of the contract, the contractor incurs certain mobilization costs amounting to $1 million to prepare for the production of the unmanned aircraft and $100,000 of costs for standard production parts. The mobilization costs include setting up the factory for production and non-recurring engineering on the production equipment. How should these costs be accounted for? Discussion: The cost of the standard production parts should be capitalized in accordance with existing inventory guidance. The mobilization costs might not be covered by existing asset standards (for example, inventory, fixed assets, or intangible assets), depending on the nature of those costs. Costs that are not covered by other standards are capitalized if they: (a) relate to the contract; (b) relate to future performance; and (c) are probable of recovery. Costs that meet these criteria should be capitalized and amortized over the contract period as control of the goods produced is transferred to the customer. The production set-up and non-recurring engineering costs likely meet these requirements and are capitalized, provided these costs are recoverable.
Example #6 Learning curve costs

Facts: A contractor enters into a contract to manufacture ten tanks for the government. The contractor determines based on the contract terms and nature of production that there is a single performance obligation in the contract due to the significant customization and integration required. The contract terms specify that any work in process is controlled by the government. The contractor estimates each tank will cost $80 million on average to manufacture and prices the contract at $90 million per tank or $900 million. The contractor previously developed the required technology to manufacture the tanks, but this is its first production contract. The first two tanks are expected to cost $95 million to manufacture due to the learning curve involved. How should the contractor record revenue and cost for this contract? Discussion: The terms of the contract result in control transferring over time to the government because the work in process is controlled by the government. Revenue should be recognized using an appropriate input or output measure. The contractor selects an input measure as the most appropriate measure of progress (for example, cost-to-cost) that results in the contractor recognizing more revenue and expense for the first tanks produced relative to the later tanks. This outcome would be appropriate due to the greater value of the entity's performance in the early part of the contract. The contractor would charge a higher price to a customer purchasing only one unit as compared to the average unit price when the customer purchases more than one unit.
Example #7 Learning curve costs

Facts: A contractor A enters into a contract to manufacture ten engines for a commercial aircraft manufacturer. The contractor determines based on the contract terms and nature of production that each engine is a separate performance obligation that is satisfied when each engine is delivered. The contractor estimates each engine will cost $3 million on average to manufacture and prices the contract at $5 million per engine. The contractor has previously developed the required technology to manufacture the engine, but this is its first production contract. The first engine is expected to cost $6 million to manufacture due to the learning curve involved. How should the contractor record revenue and cost for this contract?
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Discussion: The contractor should recognize revenue of $5 million when each engine is delivered and the customer obtains control. The contractor will need to assess whether the incremental $3 million of costs incurred to manufacture the first engine are eligible to be capitalized first under existing guidance (for example, inventory guidance) and then under the revenue guidance. Judgment will be necessary to determine if these incremental costs to produce the first engine relate to the satisfaction of future performance obligations (that is, completion of the remaining engines). Costs eligible to be capitalized under the revenue guidance would then be amortized over the current contract term and the term of specific anticipated future contracts.

Many A&D entities provide multiple services to their customers as part of a single arrangement, and may anticipate having losses on one performance obligation but an overall profitable contract. Existing guidance for construction contracts under both IFRS and U.S. GAAP requires recording anticipated losses when they become evident. This assessment is made at the contract level and measured based on the estimated contract revenue compared with the costs to complete the contract. The proposed standard requires assessing onerous losses at the performance obligation level for performance obligations satisfied over time and over a period of longer than one year. Proposed model Performance obligations satisfied over time (and over a period of greater than one year) are assessed to determine if they are onerous. Performance obligations satisfied at a point in time are not subject to this assessment in the proposed standard. A performance obligation is onerous if the transaction price allocated to the performance obligation is lower than the cost of settling the performance obligation. The cost of settling a performance obligation is the lower of: costs directly related to satisfying the performance obligation, or the amount the entity would pay to exit the performance obligation. The liability for an onerous performance obligation is measured as the excess of the cost to settle the performance obligation over the amount of consideration allocated to the performance obligation. Current U.S. GAAP Contracts within the scope of construction contract guidance are evaluated at the contract level. A loss provision is recorded if a contract is onerous. Current IFRS Contracts are evaluated at the contract level. A loss provision is recorded if a contract is onerous.
There is no specific guidance on how to measure a loss provision for contracts There is no specific guidance on how to which contain construction measure a loss provision for contracts deliverables and non-construction which contain construction deliverables. These contracts follow deliverables and non-construction general multiple-element arrangement deliverables. These contracts follow guidance. general multiple-element arrangement guidance. When there is a loss on the first element of an arrangement, but a profit When there is a loss on the first on the second element (and the overall element of an arrangement but a profit arrangement is profitable), an entity on the second element (and the overall may elect an accounting policy to arrangement is profitable), an entity recognize a loss upon delivery of the may elect an accounting policy to first element. Management should also recognize a loss if performance of the consider whether they have used the undelivered element is both probable most appropriate allocation method in and in the companys control. this situation. Specifically, there are two acceptable ways of treating the loss on the delivered element. The entity may: (a) recognize costs in an amount equal to the revenue allocated to the delivered unit of accounting and defer the remaining costs until delivery of the second element; or (b) recognize all costs associated with the delivered element (that is, recognize the loss) upon delivery of that element.
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Proposed model Impact:
Current U.S. GAAP
Current IFRS
Many contracts in the A&D industry will have a single performance obligation due to the promised bundle of goods or services being significantly customized and highly interrelated and the contractor providing a significant service of integrating the goods or services into the combined item(s). These contracts will likely not be affected by the proposed guidance because the onerous assessment will effectively be done at the contract level, similar to todays assessment, if there is only one performance obligation in the contract. Contracts with multiple performance obligations could be affected as there is a possibility that more onerous losses will be recognized under the proposed standard given that entities will need to make such assessments at the performance obligation level.
Key changes from the June 2010 Exposure Draft: The scope of the onerous test was modified to apply only to performance obligations that are satisfied over time and over a period greater than one year in response to concerns that the onerous test could have unintended consequences.
Long-term maintenance contracts

Long-term maintenance contracts are common within the industry. The accounting for such contracts is similar to extended or separately priced warranties and requires that an estimate be made of the number and nature of maintenance events that will occur over the contract period. Entities will need to consider the terms of the arrangement to determine if the discrete maintenance events are individual performance obligations under the proposed standard or if the arrangement is a single performance obligation satisfied over time. Proposed model Warranties that the customer does not have the option to purchase separately from the entity should be accounted for in accordance with existing guidance on product warranties (that is, as a cost accrual). Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. These types of extended maintenance and warranty contracts can include "power by the hour" contracts, which are common in the industry. A warranty that calls for a service to be provided to the customer (for example, maintenance) in addition to a promise that the entitys past performance was as specified in the contract results in a separate performance obligation for the service element of the warranty. Current U.S. GAAP Entities typically account for warranties that protect against latent defects in accordance with existing loss contingency guidance. A contractor recognizes revenue and concurrently accrues any expected cost for these warranty repairs. Warranties that a customer can purchase separately are similar to many extended warranty contracts. Revenue from extended warranties is deferred and recognized over the expected life of the contract. Entities generally estimate the total expected costs to maintain the product over the performance period, and recognize the related revenue in proportion to the costs incurred to maintain the product. Current IFRS Entities typically account for warranties that protect against latent defects in accordance with existing provisions guidance. A contractor recognizes revenue and concurrently accrues any expected cost for these warranty repairs. Warranties that a customer can purchase separately are similar to many extended warranty contracts. Revenue from extended warranties is deferred and recognized over the period covered by the warranty. Entities recognize revenue using the percentage of completion method. Input methods may be used, such as estimating the total expected costs to maintain the product over the performance period, with revenue recognized in proportion to the costs incurred to maintain the product.
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Current U.S. GAAP
Current IFRS
Similar to existing guidance, extended warranties or maintenance agreements give rise to a separate performance obligation under the proposed standard and therefore, revenue related to that performance obligation is recognized over the warranty period. Product warranties that are not sold separately and provide for defects at the time a product is shipped will result in a cost accrual similar to today under the current contingency or provisions guidance. Judgment will be needed to determine whether a long-term maintenance arrangement represents a single performance obligation satisfied over time or multiple discrete performance obligations, each satisfied when the maintenance event occurs. Contracts to perform an unspecified number of maintenance events over a period of time are likely to result in a single performance obligation satisfied over time. Contracts to perform each maintenance event at a specified price per event are likely to result in separate performance obligations for each maintenance activity.
Key changes from the June 2010 Exposure Draft: The boards revised the guidance from the June 2010 exposure draft on the two types of warranties, and clarified that only those warranties that provide a service or that the customer has the option to purchase separately should be accounted for as separate performance obligations. The boards also provided additional guidance on performance obligations satisfied over time, which will likely apply to many performance obligations for warranties.
Example #8 Long-term maintenance agreement

Facts: A company enters into a contract to sell an aerospace component system to a customer, and agrees to maintain that system for a period of 10 years once the system is placed in operation. These systems are often sold in the market without the extended maintenance contract and the maintenance contract can also typically be purchased for an additional cost. How should the company record revenue for this contract? Discussion: There are likely two performance obligations in this contract: one to deliver the aerospace component system and a separate performance obligation for the extended maintenance. The fact that the maintenance could be purchased separately by the customer would cause the maintenance to be a separate performance obligation. The total contract consideration should be allocated to the two performance obligations based on their relative standalone selling prices. The aerospace component system would likely be a performance obligation for a product satisfied at a point in time, with revenue recognized when control of the product is transferred to the customer. The maintenance performance obligation would likely be satisfied over time, with revenue recognized based on an appropriate measure of progress. <continued on next page>
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Proposed model Award and incentive fees Awards/incentive payments are included in the transaction price using either a probability-weighted approach or an estimate of the most likely amount of expected cash flows approach (whichever is more predictive). These amounts are recognized as revenue as the entity satisfies its related performance obligations, provided the entity is reasonably assured to be entitled to the amount allocated to that performance obligation. An entity is reasonably assured to be entitled to variable consideration when the contractor has experience with similar types of contracts and that experience is predictive (that is, that experience is relevant to the contract). Claims Claims should be included in contract consideration, using either a probability-weighted or most likely amount approach (whichever is more predictive). These amounts are recognized as the entity satisfies its related performance obligations, provided the entity is reasonably assured to be entitled to the amount allocated to that performance obligation (see above). Time value of money Contract revenue should reflect the time value of money whenever the contract includes a significant financing component. Management will use a discount rate that reflects a separate financing transaction between the entity and its customer that also factors in credit risk. An entity is not required to reflect the time value of money in the transaction price when the period between payment by the customer and the transfer of goods and/or services is less than one year, as a practical expedient. Receivables are discounted in limited situations, including receivables with payment terms longer than one year. The interest component is computed based the stated rate in the agreement or on a market rate when discounting is required. Receivables are discounted when the inflow of cash or cash equivalents is deferred. An imputed interest rate is used to determine the amount of revenue recognized as well as the interest income recorded over time. A claim is recorded as contract revenue when it is probable and can be estimated reliably (determined based on specific criteria), but only to the extent of contract costs incurred. Profits on claims are not recorded until they are realized. A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable the customer will accept the claim and the amount can be reliably measured. Awards/incentive payments are included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Awards/incentive payments are included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Current U.S. GAAP Current IFRS
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Current U.S. GAAP
Current IFRS
Use of a most likely or probability-weighted estimate approach to determine the transaction price in arrangements involving bonuses, claims, and award fees may provide results similar to today when estimating the contract price under the construction contract guidance. Variable consideration can only be recognized when an entity is reasonably assured of being entitled to the amount, which is determined based on an entity's experience if that experience is predictive. This guidance could provide results similar to today's accounting, which provides for the estimation of variable amounts in the contract price. The assessment of when a contract has a significant financing component will require judgment. Contract terms often contain provisions for the contractor to receive progress payments as work progresses. Progress payments received that are commensurate with the progress toward completion generally would indicate there is not a significant financing component in the contract.
Key changes from the June 2010 Exposure Draft: There are three key changes impacting the A&D industry from the June 2010 exposure draft. First, in determining the consideration a contractor expects to be entitled to, entities may use a most-likely amount approach if such approach is more predictive than a probability-weighted estimate approach. The boards introduced a constraint on recognition of variable consideration to when the entity is reasonably assured of being entitled to the amount. A practical expedient was also introduced to limit the application of time value of money to situations where a significant financing component exists in the contract and the period between payment and the transfer of the promised goods or services is greater than one year.
Example #9 Award fees

Facts: A contractor enters into a contract for the development and build of a complex satellite system for the government. The contract price is $250 million plus a $25 million award fee if the system is placed into orbit by a specified date. The contract is expected to take three years to complete. The contractor has a long history of developing similar satellite systems. The award fee is binary and payable in full upon successful launch of the satellite. The contractor will receive none of the $25 million fee if the launch is unsuccessful. The contractor believes, based on significant experience with similar programs, that it is 95 percent likely that the contract will be completed successfully and in advance of the target date. How should the contractor account for the award fee? Discussion: The contractor is likely to conclude, given the binary award fee, that it is appropriate to use the most likely amount approach in determining the amount of variable consideration to include in the estimate of the transaction price. The contract's transaction price is therefore $275 million: the fixed contract price of $250 million plus the $25 million award fee (most-likely amount). This estimate is regularly revised and adjusted, as appropriate, using a cumulative catchup approach, which is consistent with current practice. The contractor will then determine when it is reasonably assured of being entitled to the award fee (and therefore, it is eligible to recognize this amount as revenue). Factors to consider include, but are not limited to: The contractor has a long history of performing this type of work on similar programs It is largely within the contractor's control to complete the work before the targeted date
This should not result in a significant change from todays accounting for variable consideration in many A&D contracts. The contractor could likely conclude in these circumstances that it is reasonably assured of being entitled to the award fee based on its history with similar contracts.
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Example #10 Claims

Facts: Assume the same fact pattern as Example 9, except that due to reasons outside of the contractor's control (for example, customer-caused delays and design changes), the cost of the contract far exceeds original estimates (but a profit is still expected). The contractor submits a claim against the government to recover a portion of these costs. The claim process is in its early stages, but the contractor has a long history of successfully negotiating claims with the government. How should the contractor account for the claim? Discussion: Claims are highly susceptible to external factors (such as the judgment of third parties), and the possible outcomes are highly variable. The contractor may have experience in successfully negotiating claims, but it might be challenging to assert that such experience has predictive value in this fact pattern (because of the highly uncertain variables). The contractor might therefore conclude that it is not reasonably assured of being entitled to such a claim in the early stages. The amount of the claim is included in determining the transaction price, but will not be recognized until the contractor is reasonably assured of being entitled to the amount. The effect for performance obligations satisfied over time is that the claim amount is excluded from the calculation of revenue when the measure of progress towards completing the performance obligation is applied. Amounts from claims are likely to be recognized at a date closer to the date the claim is expected to be resolved.
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Authored by:
Scott Thompson U.S. Aerospace & Defense Leader Phone: 1-703-918-1976 Email: scott.thompson@us.pwc.com Daniel Dipillo Senior Manager Phone: 1-703-918-1415 Email: daniel.c.dipillo@us.pwc.com Craig Robichaud Senior Manager Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Asset management industry supplement

No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Variable consideration management and performance fees ......... 2 Upfront fees received by an asset manager .............. 4 Fees paid to third parties ........................... 5 Other considerations .......7
Revenue recognition exposure draft The proposed revenue standard is re-exposed

Asset management industry supplement
Overview
The asset management industry comprises entities involved in management of various investment structures aimed at achieving returns for investors. Currently, under U.S. GAAP and IFRS, asset managers recognize revenue based on the transfer of risks and rewards of their services or based on the stage of completion of services. Under the proposed standard, revenue is recognized when the performance obligation is satisfied and the asset manager is reasonably assured it is entitled to the consideration. The current U.S. GAAP and IFRS guidance on revenue recognition will be withdrawn when the proposed standard becomes effective resulting in changes with respect to how revenue is recognized in the asset management industry. Common revenue streams in scope of the proposed standard are management fees, performance fees and upfront fees. The proposed standard also encompasses guidance relating to expense recognition, such as costs to secure and fulfill an asset management contract and so-called onerous performance obligations. This industry supplement discusses the areas in which the proposed standard is expected to have the greatest impact. The examples and the related assessments contained herein are based on a current interpretation of the exposure draft, Revenue from Contracts with Customers, issued on November 14, 2011. The tentative conclusions set forth below are subject to further interpretation and assessment based on the final standard. The effective date of the final standard has not been determined, but it is expected to be no earlier than January 1, 2015 with retrospective or limited retrospective application required. Early adoption is permitted under IFRS whereas under U.S. GAAP early adoption will not be permitted. For a more comprehensive description of the proposed standard, refer to PwC Dataline 2011-35 (www.cfodirect.pwc.com) or visit www.fasb.org or www.ifrs.org.
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Variable consideration - management and performance fees

The transaction price is the consideration the asset manager expects to receive in exchange for satisfying its contractual performance obligations to the investor. The performance obligation in the asset management industry is the delivery of asset management services to the investor. This performance obligation is satisfied over time, as asset management services are delivered. Management must determine the amount of the transaction price at contract inception and at each reporting date. The entity will recognize revenue as the performance obligation is satisfied. The asset manager is reasonably assured to be entitled to the transaction price when it has experience with similar contracts (either its own experience or that of others, if applicable) and that experience is relevant to the contract because circumstances are not expected to change significantly. Management fees for hedge funds and mutual funds are usually based on net assets under management, while performance fees are usually based on profits generated from the underlying investments held by funds subject to certain thresholds (for example, hurdle rate, high watermark or internal rate of return). As such, management fees and performance fees constitute what is referred to in the proposed standard as variable consideration. The table below summarizes the proposed guidance for variable consideration in comparison to current U.S. GAAP and IFRS guidance. Proposed standard Management and performance fees If the promised amount of consideration in a contract is variable, the asset manager should estimate the total amount to which it will be entitled in exchange for transferring promised services. The estimated transaction price should be updated at each reporting date to represent the circumstances present at the reporting date and the changes in circumstances during the reporting period. Current U.S. GAAP Management fees: A base management fee is earned periodically for providing asset management services, typically based on a fixed percentage of the fair value of the net assets under management. These fees are generally accrued periodically in accordance with the terms of the asset management contract. Current IFRS Management fees: A base management fee is earned periodically for providing asset management services, typically based on a fixed percentage of the fair value of the assets under management. These fees are generally accrued periodically in accordance with the terms of the asset management contract. Performance fees: Two approaches are permitted. Under the first approach, noncontingent and contingent fees are analyzed separately. Performance fees, being contingent amounts of revenue, are recognized as the services are performed but only when the fee becomes reliably measurable, which is often at the end of the performance period when the outcome is known. Under the second approach, an asset manager looks at the contract as a whole and recognizes revenue based on the performance to date, including an estimate of any performance fees due. Estimates are periodically reassessed.
Performance fees: Performance fees can be recognized The transaction price is estimated using one of two methods under the based on a probability-weighted or best current guidance for management fees estimate approach depending on which based on a formula1 due to the fact that is most predictive for the entity based they are based on profits earned on historical, current and forecasted subject to performance targets (for information. example, high watermark or hurdle rate) and may be subject to clawback. The asset manager should recognize as revenue the amount of the transaction Under Method 1, performance fees are price allocated to the performance recognized in the periods during which obligation if it is reasonably assured to the related services are performed and be entitled to that amount. Revenue all the contingencies have been might not be reasonably assured when resolved: the amount of consideration is highly susceptible to factors outside the for hedge fund managers, this influence of the asset manager or the occurs at the end of the year or uncertainty about the amount of upon the occurrence of the consideration is not expected to be crystallization event; resolved in the near future. Another
The guidance for accounting for management fees based on a formula is included in ASC 605-20-S99-1 (formerly EITF D-96).
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Proposed standard indication of revenue not being reasonably assured might be that the asset managers experience with similar types of contracts is limited or the contract has a large number and high variability of possible consideration amounts.
Current U.S. GAAP for private equity fund managers, this occurs upon termination of the fund or when distributions from a fund exceed the point at which the clawback of a portion or all of the historic performance fees distributions could no longer occur. Method 2 requires performance fee revenue to be recorded at the amount that would be due under the contract at any point in time as if the contract was terminated at that date (otherwise known as the hypothetical liquidation method). As a result, there is a possibility that fees earned by exceeding performance targets early in the measurement period could be reversed due to missing performance targets later in the measurement period. The SEC views Method 1 as the preferable accounting policy.
Current IFRS
Management fees
The proposed standard provides an example of a management and performance fee arrangement commonly encountered in the asset management industry. The performance obligation in this example is to provide asset management services and the asset manager will estimate the transaction price to be the sum of the estimated periodic management fees and performance-based fees. That transaction price is allocated to the performance obligation that the entity satisfies over the period specified in the contract. Management should determine the pattern of transfer of the asset management service (using input or output methods), which governs the amount of revenue recognized in each period under the proposed standard. Management should assess the pattern of transfer for performance obligations satisfied over multiple periods (for example, on a quarterly basis). The pattern of transfer might be similar to the amount of consideration otherwise due and receivable each period. This would be the case if the assets under management are representative of the level of asset management service transferred to the investor. The amount of fee that is due and receivable for a period would then also represent the amount to be recognized for the period. We believe that in many circumstances, analysis of the pattern of transfer of asset management services will result in recognition of revenue related to periodic management fees based on assets under management in a manner that is consistent with current practice under both U.S. GAAP and IFRS.
Performance fees
The proposed standard may impact the timing of the recognition of performance fees, as variable consideration is only recognized when the asset manager is reasonably assured of being entitled to the consideration. It may often be the case that asset managers will be unable to conclude that they have met the "reasonably assured" threshold and therefore, will not be able to recognize the variable consideration before the performance period has ended (which may include any subsequent clawback periods). This is because performance-based fees may be highly susceptible to external factors such as market risk.
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The contractual measurement period for performance fees for hedge fund managers and traditional fund managers is usually one year and therefore, no fees will be recognized in the interim periods (for example, at the end of each quarter). The full amount will instead be recognized at the end of the contractual measurement period when the manager becomes reasonably assured to be entitled to that amount. The fees will be recognized upon a crystallization event (for example, redemptions), in certain cases, because the amount becomes fixed and therefore, the entity is reasonably assured to be entitled to the amount. Managers of funds with a finite life (for example, ten years) often receive performance fees subject to clawback on a cumulative basis based on the performance of the fund over its life. Any distributions of performance fees that could potentially be subject to clawback in future periods will be reflected as deferred revenue until the point at which the entity is reasonably assured to be entitled to retain the amount received. Cash receipt of performance fees does not necessarily indicate that the entity is reasonably assured to be entitled to that amount. For example, an entity might not be reasonably assured to be entitled to performance fees that are subject to clawback until a point in time toward the end of the life of the fund. Under current U.S. GAAP, asset managers applying Method 1 are, in light of the above, not expected to be significantly affected by the proposed standard. On the other hand, asset managers that currently recognize performance fees in accordance with Method 2 (hypothetical liquidation method) will be impacted since entities applying this method may be recognizing revenue in advance of the amount becoming reasonably assured as defined under the proposed standard. Under current IFRS, asset managers will generally not be significantly impacted by the proposed standard as the prevalent IFRS practice is to recognize performance fees when the performance fee becomes reliably estimable and the amount is known. However, asset managers currently recognizing performance fees using the second approach will recognize revenue only when the performance fee is reasonably assured, which is likely to result in later revenue recognition.
Upfront fees received by an asset manager

Asset managers may own a broker or distribution entity that distributes the asset managers sponsored products (or, in some cases, the asset manager might distribute the sponsored products directly). When distribution is done by the asset manager directly or through a distribution entity that is consolidated by the asset manager, the issue of revenue recognition for upfront fees becomes relevant. (This section does not address the accounting in the broker or distribution entity's standalone financial statements.) Upfront fees are generally associated with front-end loaded distribution. Front-end loaded distribution means that an initial sales fee is paid by the investor to the distribution entity upon subscription to the fund (that is, the investor bears the fee on the front end"). This fee compensates the distribution entity, with the subscription amount net of such fee being contributed to the fund. Relevant guidance under the proposed standard, current U.S. GAAP and IFRS is summarized below: Proposed Standard Current U.S. GAAP Current IFRS Initial sales fees are generally recognized as revenue when received only to the extent that services have been provided and the fees do not relate to future services. The receipt of the initial sales fee does not by itself provide evidence that all services associated with that fee have been provided or that the fair value of the services provided in respect of any upfront services is equal to the initial sales fee received.
The proposed standard requires the Initial sales fees are generally asset manager to assess whether the fee recognized as revenue upon receipt. relates to a separate performance obligation The proposed standard further recognizes that in many cases, even though a nonrefundable upfront fee relates to an activity that the asset manager is required to undertake at or near contract inception to fulfill the contract, that activity does not result in the transfer of a promised service to the investor. Rather, the upfront fee is viewed as an advance payment for future services and therefore, would be
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Proposed Standard recognized as revenue when those future services are provided.
Current U.S. GAAP
Current IFRS If the fee is linked to other services or obligations (for example, as evidenced by a fee that is not at fair value for those individual services or the pricing is only understood with reference to services to be performed in the future), the revenue that corresponds with this part of the fee is deferred and recognized as those services are performed. Initial sales fees are typically deferred and spread over the period that the investor is expected to remain with the fund being managed.
As stated above, under the proposed standard, initial sales fees can only be recognized upfront if a distinct service has been provided to the investor upon the initial sale of the fund unit. This will be very difficult to demonstrate in most cases. Therefore, asset managers need to consider what other services are being provided to the investor (for example, ongoing management services or brokerage services) in order to identify services that are distinct. The transaction price, including the initial sales fees, is then allocated to each of the distinct services and recognized as each is being provided to the investor. Typically, even though the initial sales fee relates to an activity that the asset manager is required to undertake at the inception of the contract, it does not result in the transfer of a promised service to the investor. As such, there is only one performance obligation in the arrangement, and asset managers reporting under U.S. GAAP will no longer be able to recognize revenue upfront for these fees. The initial sales fee will instead be deferred and recognized over the estimated period the investor is expected to remain with the fund, which conforms to current practice utilized by IFRS preparers. In the brokers standalone financial statements, the broker will recognize an upfront fee when the service is performed. The service is performed at a point in time (that is, upfront) as the service provided is to introduce an investor to the fund.
Fees paid to third parties

Often asset managers pay fees to third parties that distribute the asset managers' products. Various types of fees are paid, and the timing of payment may also vary (that is, the fees may be paid upfront or on an ongoing basis). The third party generally does not provide substantive ongoing services in addition to the initial introduction of the investor to the fund. One example of a fee paid to a third party is deferred sales commissions. Such a fee is paid by the asset manager of certain registered funds to a third-party broker in connection with back-end loaded distribution. Specifically, the asset manager agrees to compensate the broker for the fixed initial sales fee and the investor does not bear cost of any commission initially. The asset manager recovers the initial sales fee through charges levied over the asset management period and may also charge a fee by reference to the initial subscription amount should the investor withdraw from the fund. Another example is third-party marketer fees (sometimes referred to as trailing commissions). Third-party marketers are used by asset managers of hedge funds and registered funds to introduce investors to the fund being managed. The third-party marketer earns a percentage of the upfront fee and the subsequent management fees charged to the investors that it attracted to the fund. This may extend for the period that the investor remains in the fund. Asset managers of private equity funds may also incur placement fees paid upfront to underwriters to secure capital commitments for the fund. Such fees are paid by the asset manager once the contract is obtained and calculated based on the capital commitment from each investor. Third-party fee arrangements such as those described above represent contract costs (that is, costs incurred in conjunction with obtaining the revenue-generating contract). The associated guidance for these costs is as follows:
Proposed Standard An asset manager will recognize as an asset the incremental costs of obtaining a contract with an investor if it expects to recover those costs. The incremental costs of obtaining a contract are those costs that the asset manager would not have incurred if the contract had not been obtained (for example, a sales commission).
Current U.S. GAAP In accordance with industry practice, deferred sales commissions (that is, fixed fees) paid to the third-party distributor are generally recognized as an asset and amortized over the period of contractual redemption, which can range from a few months to several years.
Current IFRS Fixed fees paid that are incremental and directly attributable to securing an investment contract are capitalized if they can be identified separately, measured reliably, and it is probable that they will be recovered.
An incremental cost is one that would not have been incurred if the entity Impairment is recognized if the asset had not secured the investment An asset recognized in accordance is not recoverable, based on a management contract. The asset is with the above is amortized on a determination of the asset's fair value. amortized as the asset manager systematic basis consistent with the recognizes the related revenue. pattern of transfer of the services to Third-party marketer fees (also which the asset relates. The known as "trailing commission") are If the carrying value of the capitalized incremental costs can be recognized expensed as incurred, which mirrors asset exceeds the recoverable amount, as an expense when incurred if the the way the management fee is the asset is impaired and an amortization period is less than a year recognized. impairment loss is recognized. as a practical expedient. Placement fees are expensed as There are currently two permissible An impairment loss is recognized to incurred. approaches to account for ongoing the extent that the carrying amount of third-party fee arrangements such as the capitalized asset exceeds the net third party marketer fees (also known amount of consideration to which the as "trailing commissions") entity expects to be entitled in exchange for the services to which the The first approach treats the asset relates, less the remaining costs arrangement as a financial liability, that relate directly to providing these initially measuring the obligation to services. pay the fees at fair value. Subsequently, the asset manager will account for the financial liability at amortized cost using the effective interest method. Under the second approach, the ongoing third-party fees should be accounted for when the contingent fee payable becomes due to the third party (that is, expensed as incurred). Both approaches are used, although typically the industry practice is to account for trailing commission fees using the second approach. Placement fees are generally capitalized under financial instruments guidance or, if not related to the issuance of securities, capitalized as costs of securing investment contracts.
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In the proposed standard, it is important to clearly distinguish between costs to fulfill a contract and incremental costs to obtain a contract. Whereas the former are first evaluated under other applicable existing guidance such as guidance for intangible assets or property, plant and equipment, the latter are only governed by the proposed standard. If costs are incurred by the asset manager in its efforts to obtain a contract with an investor and such costs would not have been incurred if the asset manager had not obtained the contract, and the costs are expected to be recovered, these costs must be capitalized unless the amortization period is less than a year. If the amortization period is less than a year, the incremental costs can be recognized as an expense when incurred as a practical expedient. Costs do not need to be explicitly reimbursable to be recoverable.
Incremental fixed fees paid upfront (such as deferred sales commissions)

U.S. GAAP preparers will continue to account for deferred sales commissions as assets as such costs would appear to meet the proposed standard's asset recognition criteria. However, the amortization period will change from the contractual redemption period to reflect the pattern of transfer of asset management services (that is, the period that the investor is expected to remain invested in the fund). This would result in costs being amortized over a longer period than under current U.S. GAAP. IFRS preparers will find that the proposed guidance as it relates to deferred sales commissions results in an accounting treatment similar to current practice and therefore, no significant impact is expected from applying the proposed standard. There will, however, be a difference between current practice and the proposed standard with respect to impairment of the capitalized fees. Under current guidance, discounted cash flows are used in the test for impairment whereas under the proposed standard, the same principles that are used to determine the transaction price would be followed, which could result in using undiscounted cash flows.
Third-party marketer fees (known as "trailing commissions")

When no ongoing services are provided after the initial introduction of the investor, third -party marketer fees would appear to meet the definition of costs of obtaining a contract and therefore, need to be capitalized when the service has been received unless the amortization period would have been for less than one year and the practical expedient is elected. This accounting treatment does not conform to current industry practice under either U.S. GAAP or IFRS, as such fees are typically expensed as incurred. A question then arises as to the amount of third-party marketer fees to be capitalized as the fee due to the third-party marketer only becomes known at the point in time when the management fee is contractually due (for example, the beginning or end of a month/quarter). The cost is therefore variable. The proposed standard does not specifically address this issue. Therefore, management will need to develop a reasonable and practical approach as to the capitalization and amortization of these fees.
Placement fees
Placement fees paid by the asset manager upfront to underwriters to secure capital commitments for the fund would meet the definition of costs of obtaining a contract. Therefore, such fees need to be capitalized when the service has been received unless the amortization period would have been for less than one year and the practical expedient is elected. This accounting treatment does not conform to current industry practice under U.S. GAAP, under which placement fees are typically expensed as incurred. Under IFRS, some of these fees might be accounted for under financial instrument guidance (and may therefore not be impacted by the proposed standard) and others might be accounted for as costs to acquire a contract. When accounted as costs to acquire a contract, the treatment should be consistent with current practice. For private equity fund managers, where the fund is limited life, placement fees would be amortized over the life of the fund (for example, ten years) under the proposed guidance. For hedge fund managers, the amortization term is the period the investor is expected to remain in the fund.
This asset management industry supplement discusses the areas in which the proposed standard is expected to have the greatest impact. Other considerations include the following: Onerous performance obligations - Onerous performance obligations guidance was not previously explicitly addressed by U.S. GAAP; however, onerous losses are expected to be uncommon due to the nature of the arrangements that are typical in the asset management industry. It is noteworthy that under the proposed standard, asset managers will be able to include both management fees and estimated performance fees to be received over the
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life of the contract when determining total estimated fees (that is, total transaction price). These amounts would typically be sufficient to cover direct expenses attributable to the asset management contract (for example, incremental cost of labor, upfront placement cost and other incremental operational expenses) and therefore, would not trigger onerous contract accounting. Nevertheless, asset managers will need to consider whether an asset management contract with an investor is onerous, particularly in falling markets when fees may be decreasing but elements of costs may be fixed. Employee "points" compensation - Some asset managers award their key employees with points compensation whereby these employees receive a specified percentage of crystallized performance fees earned by the manager. The compensation expense resulting from such arrangements is currently estimated and accrued under both U.S. GAAP and IFRS. At each reporting date, asset managers that currently apply Method 2 under U.S. GAAP or the second approach under IFRS are therefore able to match the compensation expense with the associated performance fee income. Under the proposed standard, however, a mismatch will arise as the compensation expense will continue to be accrued whereas the performance fee income will be recognized when the manager is reasonably assured to be entitled to the amount (as more fully described above) and therefore may be in a different period. Systems and processes - As the standard is expected to be effective no earlier than 2015 with retrospective application required, asset managers that currently recognize performance fee using Method 2 under U.S. GAAP or the second approach under IFRS as described above should assess process and systems implications as early as the end of 2012 to capture the information needed for retrospective application when the final standard is adopted. Investor relations - Asset managers that recognize performance fees in accordance with Method 2 under U.S. GAAP or the second approach under IFRS may experience significant changes with respect to how they report their results of operations. These changes will need to be communicated to the investor community. Asset managers might also want to consider changes to their non-GAAP metrics to reflect, for example, changes in timing of recognition of performance fees.
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Authored by:
Thomas Romeo Partner Phone: 1-973-236-4460 Email: thomas.romeo@us.pwc.com Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Guilaine Saroul Director Phone: 1-973-236-7138 Email: guilaine.saroul@us.pwc.com Daniel Kramarz Senior Manager Phone: 1-646-471-5678 Email: daniel.x.kramarz@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Automotive industry supplement

No. 2011-35 (supplement) December 16, 2011 Whats inside: Overview .......................... 1 Defining the contract ..... 2 Account for separate performance obligations .................... 4 Determine and allocate the transaction price.......... 6 Recognize revenue when performance obligations are satisfied ...................... 10 Other considerations ..... 13
Revenue recognition exposure draft The proposed revenue standard is re-exposed
Automotive industry supplement

Overview
The automotive industry includes a broad group of participants, including suppliers, original equipment manufacturers (OEMs), and dealers. Entities in the automotive industry will be affected by the proposed revenue standard, which will replace all current U.S. GAAP and IFRS revenue recognition guidance. Key areas of interest to companies in the automotive industry include the accounting for product warranties, pre-production activities (for example, pre-production design and tooling arrangements), marketing incentives (for example, cash rebates), volume rebates, repurchase options, contract costs, and lease financing arrangements. This automotive industry supplement discusses the areas in which the proposed standard is expected to have the greatest impact or be of particular interest. The examples and the related assessments contained herein are based on a current interpretation of the exposure draft, "Revenue from Contracts with Customers," issued on November 14, 2011. All conclusions set forth below are subject to interpretation and assessment of the final standard, which is expected to be issued in the second half of 2012. We have also provided a high-level summary of key changes from the original exposure draft issued on June 24, 2010 (the "2010 Exposure Draft") throughout this industry supplement and in the Appendix of PwC Dataline 2011-35. References to the "proposed model," "proposed guidance," and "proposed standard" throughout this document refer to the exposure draft issued in November 2011, unless otherwise indicated. For a more comprehensive description of the proposed standard, refer to PwC Dataline 2011-35 (www.cfodirect.pwc.com), or visit www.fasb.org or www.ifrs.org.
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Defining the contract

The proposed standard would apply only to contracts with customers. A contract is an agreement between two or more parties that creates enforceable rights and obligations. A contract does not exist if both parties have the unilateral right to terminate a wholly unperformed contract without penalty. Entities will need to determine whether they should account for two or more contracts with the same customer together. Combining contracts when appropriate helps to ensure that the unit of accounting is properly identified, and the model is properly applied. For example, automotive suppliers often incur costs related to tooling prior to production of automotive parts. In some cases, the tooling is built by the supplier for sale to the OEM (that is, the tooling is or will be owned by the OEM). There is often a separate contract for both the construction of the tooling and the follow-on production output. Contract modifications are common in the automotive industry and come in a variety of forms, including changes in the amount of goods to be transferred and changes in previously agreed pricing. Contract modifications might need to be combined and accounted for together with the existing contract under the proposed standard. It is not uncommon, for example, for an entity to receive price concessions on existing contracts in connection with the negotiation of new contracts. The entity will need to evaluate whether a price concession is a modification of a previous contract or if it relates to a new contract. The entity might need to account for the price concession as part of the new contract and recognize the associated revenue as the performance obligations in the new contract are satisfied. Proposed model Combining contracts Two or more contracts (including contracts with parties related to the customer) should be combined and accounted for as one contract if the contracts are entered into at or near the same time and: The contracts are negotiated with a single commercial objective; The amount of consideration in one contract depends on the price or performance of the other contract; or The goods or services promised are a single performance obligation. Contract modifications A contract modification is accounted for as a separate contract if: the modification promises distinct goods or services that result in a separate performance obligation; and the entity has a right to consideration that reflects the standalone selling price of the promised goods or services There is no clear guidance on accounting for contract modifications within the non-industry specific revenue guidance. We believe many entities account for contract modifications prospectively unless the contract modification is explicitly tied to prior performance. Non-refundable payments associated with accommodation arrangements (for example, price concessions) There is no clear guidance on accounting for contract modifications. Many entities account for contract modifications prospectively today unless the contract modification is explicitly tied to prior performance. Non-refundable payments associated with accommodation arrangements (for example, price concessions) might need to be linked to another arrangement in order to understand Combining contracts that are not in the scope of certain industry specific guidance (for example, construction accounting) is required if they are with the same or related entities and are negotiated at the same time. Combining contracts that are not in the scope of certain industry specific guidance (for example, construction accounting) is required when two or more transactions are linked and combination is necessary to reflect the commercial (that is, economic) substance of the transactions. Current U.S. GAAP Current IFRS
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Proposed model underlying that performance obligation.
Current U.S. GAAP
Current IFRS their commercial effects and should generally be deferred similar to the accounting for an upfront fee.
typically do not represent the culmination of a separate earnings process and should generally be A modification that is not a separate deferred similar to the accounting for contract is evaluated and accounted for an upfront fee. either as: A termination of the original contract and the creation of a new contract if the goods or services are distinct from those transferred before the modification A cumulative adjustment to contract revenue if the remaining goods and services are not distinct and are part of a single performance obligation that is partially satisfied A prospective adjustment to contract revenue when the remaining goods or services are a combination of distinct and nondistinct Potential Impact:
Although the identification of contracts is not expected to be particularly difficult, this step in the process could result in changes within the automotive industry. We anticipate that there will be certain contractual arrangements (for example, contracts for pre-production activities related to long-term supply arrangements) that might need to be considered together as a single contract, albeit as separate performance obligations, for accounting purposes (see discussion below regarding separately accounting for two or more performance obligations and allocating the transaction price). This determination could result in a change in the allocation and pattern of revenue recognition under the proposed standard compared to todays accounting. Contract modifications will continue to require judgment to determine when they should be accounted for as a separate contract. We do not expect current practice in this area to be significantly changed by the proposed standard.
Example 1 - Combining contracts (tooling and production contracts)

Facts: In January, a supplier enters into a contract with an OEM to construct a tool for the OEM. Ownership of the tool will transfer from the supplier to the OEM. Also in January, the supplier enters into a contract to provide the OEM with parts, which will be produced using the tool that is being constructed for the OEM. The supplier will recover the sales price for the tool through a separate payment at a contractually stated amount once the tooling is constructed and approved by the OEM. The contractually stated amount is the supplier's cost to provide the tooling. Production of the parts will begin once the tool has been constructed to the specifications agreed between the supplier and the OEM. Should the supplier combine the contract to construct the tool with the contract to produce the parts? Discussion: The supplier will need to consider a number of factors to determine whether these two contracts should be combined. In this example, the contracts were entered into near the same time. It is also likely that the contracts were negotiated with a single commercial objective, because the supplier is both constructing the tool and providing the production parts. Thus, we believe the supplier would likely combine these two contracts based on consideration of these factors.
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Example 2 - Contract modification

Facts: A supplier and an OEM have an existing contract for the sale of 1,000 parts at a price of $10. Total contract revenue under the existing contract would therefore be $10,000. The OEM purchases 500 parts at that price, then negotiates a price change from $10 to $7.50. The price change only relates to the remaining purchases and is based on the OEM's willingness to increase the volume of purchases to 1,500 parts. A similar discount is not offered on other parts manufactured by the supplier and sold to other OEMs. Should this contract modification be combined with the existing contract or accounted for as a separate contract? Discussion: As the remaining parts to be transferred to the OEM are distinct from the 500 transferred on or before the date of the modification, the supplier would account for the modification as a termination of the original contract and the creation of a new contract. The supplier would recognize revenue of $7.50 as control of each of the remaining 1,000 parts is transferred to the OEM.
Example 3 - Accommodation arrangement

Facts: A supplier and an OEM have an existing contract for the sale of parts at a price of $10. While the supplier expected the OEM to purchase 1,000 parts when entering into the contract, the OEM was under no obligation to purchase a minimum number of parts. The OEM only purchased 500 parts over the contract period due to lower than expected demand for its vehicle. At the end of the contract, the OEM agrees to a price concession of $5,000 ((1,000 parts expected 500 parts sold) x $10) in the form of a non-refundable payment to make up for the lower than expected volumes. The OEM was under no previous obligation under the original contract to agree to the price concession. At the same time the supplier negotiates a second contract with the OEM for parts to be delivered in the following year at a price of $10 based on the expectation that the OEM will purchase 1,000 parts over the second contract period. How should the supplier account for the non-refundable payment received? Discussion: The proposed standard is not clear, but we would generally expect the price concession to be treated as part of the consideration of the second contract in most cases and not a modification of the original contract. This is because the OEM had no previous obligation to agree to a price increase on the original contract and the price concession is negotiated at the same time as, and in contemplation of, the second contract. We expect in most cases that the non-refundable payment will be allocated as part of the transaction price under the second contract and revenue of $15 (($5,000 nonrefundable payment + (1,000 parts x $10)) / 1,000 expected parts) recognized as control of each part in the second contract is transferred to the OEM.
Account for separate performance obligations

The objective of identifying and separating performance obligations is to recognize revenue when the performance obligations are satisfied (that is, goods and services are transferred to the customer). An OEMs agreement to transfer a vehicle and to provide free maintenance on the vehicle, for example, would likely require separation. Contracts must be evaluated to ensure that all performance obligations are identified. Proposed model An entity should separately account for performance obligations only if the pattern of transfer is different and the good or service is distinct. A good or service is distinct if either of the following criteria are met: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with other readily available resources. Current U.S. GAAP Arrangements with multiple deliverables that are not in the scope of construction accounting are divided into separate units of accounting if the deliverables in the arrangement meet specific criteria. Separation is appropriate when the delivered item(s) has value to the customer on a standalone basis and the delivery of the undelivered item(s) is probable and substantially within the control of the vendor. Current IFRS For transactions that contain separately identifiable components, it is necessary to apply the revenue recognition criteria to each separately identifiable component of a single transaction in order to reflect the transaction's substance. The customer's perspective is important in determining whether the transaction has a single element or multiple elements.
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Proposed model An entity should account for two or more performance obligations as a single performance obligation when both of the following criteria are met: The goods or services are highly interrelated and the entity provides a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted. The bundle of goods or services is significantly modified or customized to fulfill the contract. Potential Impact:
Current U.S. GAAP
Current IFRS
The indicators for separation generally are expected to result in similar outcomes as under the current guidance in U.S. GAAP and IFRS. However, we expect that entities in the automotive industry might, in certain cases, need to separately account for more performance obligations under the proposed model than today. This may impact the timing of revenue recognition as compared to current accounting. If an entity concludes, for example, that separate contracts for the construction of a tool and for follow-on production parts should be combined, it is likely that the entity will then have to separately account for the obligation to construct the tool and the obligation to produce the parts. Certain warranties containing service elements will also likely result in more performance obligations under the proposed model as compared to today (refer to "Product warranties" section below).
Key change from the 2010 Exposure Draft: The boards have clarified the principle for when to separately account for performance obligations. They are now proposing to provide guidance for situations when it may be necessary to account for a promised bundle of goods or services as a single performance obligation. We believe entities might have to separately account for more obligations within each contract compared to current guidance, notwithstanding the additional guidance.
Example 4 - Identify the performance obligations (tooling and production contracts)

Facts: Assume from example 1 that the contract to construct the tool should be combined with the contract to produce the follow-on production parts. The supplier is one of several suppliers with the ability to construct the tool and subsequently produce the production parts. What are the separately accounted for performance obligations under the combined contract? Discussion: The supplier has promised to transfer both the tool and the subsequent production parts to the OEM. When an entity promises to provide more than one good or service, each promised good or service is a separate performance obligation if it has a different pattern of transfer and is distinct. The tool and subsequent production parts are likely to be separable because the supplier does not provide a significant service of integrating both into a combined item. The tool and the parts are distinct because they are delivered at different times and the OEM could benefit from the tool by taking it to another supplier and having that other supplier produce the subsequent production parts. The tool and the production parts would likely be separate performance obligations based on these considerations. The supplier will therefore recognize revenue for each distinct performance obligation based on its relative standalone selling price (refer to "Determine and allocate the transaction price" section below) when control of each asset is transferred to the OEM.
Example 5 - Identify the performance obligations (free maintenance)

Facts: A dealer offers a customer "free" vehicle maintenance for the first 3 years or 30,000 miles after taking delivery of a new vehicle, whichever comes first. The maintenance services are provided every 6 months or 5,000 miles. The
maintenance is performed by the dealer as an agent on behalf of the OEM and the dealer is subsequently reimbursed by the OEM. Would this service be a separate performance obligation of the dealer or OEM? Discussion: These services could be separate performance obligations of the OEM that require separate accounting. This is because the contract to provide maintenance is legally between the OEM and the end customer. The pattern of transfer between the sale of the car to the dealer and performing the maintenance services is different, and the maintenance services are likely distinct. The OEM likely has six performance obligations for the free maintenance in this example (that is, one performance obligation for each distinct maintenance service that is promised in the contract). The OEM would recognize revenue as the maintenance is performed or when the time period lapses. We do not believe the pattern of revenue recognition will change significantly from current practice for many entities, as revenue is often recognized today based on a systematic and rational method that is aligned with the terms of the maintenance agreement.
Example 6 - Identify the performance obligations (technological amenities)

Facts: It is common for OEMs to sell vehicles equipped with various technological "amenities," such as satellite radio, navigation capabilities, or roadside assistance. These amenities may be provided by third-parties or directly by OEMs. Would these technological amenities be considered separate performance obligations of the OEM? Discussion: These amenities may be considered separate performance obligations of the OEM in certain circumstances under the proposed model. It is important to consider whether the OEM has a performance obligation, either explicit or implicit, to provide the underlying services to the end customer. This will be a matter of judgment and may be different depending on the specific terms of the arrangement. Consider, for example, satellite radio service provided by a third party. OEMs often sell vehicles in which the owner can receive satellite radio service for free for a trial period (for example, three months) when a consumer purchases a new vehicle. Generally OEMs enter into separate contracts with the third party satellite radio provider who is responsible for providing the satellite radio service to the end customer during the trial period. At the end of the trial period, any renewals are separate transactions between the third party satellite provider and the end customer. The OEMs obligation to the end customer is to provide a working radio with the ability to receive satellite radio stations. It is likely that this obligation will be considered part of the OEMs over all performance obligation to deliver a working vehicle, whereas the third party satellite radio service provider will need to separately consider its obligation to provide service to the end customer (that is, the service is likely not a separate performance obligation of the OEM). Determining the appropriate revenue recognition for these amenities will depend on the OEMs performance obligation.
Example 7 - Product liabilities

Facts: Entities in the automotive industry can, at times, be legally obligated to pay consideration to a customer if the entity's product causes harm or damage. Would these product liabilities be considered a performance obligation under the proposed standard? Discussion: Product liability obligations (for example, when an entity is legally obligated to pay consideration if its products cause harm or damage) are not performance obligations as there is no good or service being provided in an exchange transaction. The accounting for product liability claims will continue to be covered by existing guidance for loss contingencies and provisions.
Determine and allocate the transaction price

The transaction price is the consideration the entity expects to be entitled to receive in exchange for satisfying its performance obligations. The transaction price is readily determinable in most contracts because the customer promises to pay a fixed amount of cash that is due when the entity transfers the promised goods or services (for example, when a supplier sells parts to an OEM for a specified price payable when the parts are delivered). Determining the transaction price in other contracts can be more complex, such as contracts with stated price increases or decreases over time or with volume pricing adjustments. The transaction price allocated to performance obligations in an arrangement also includes consideration payable to the customer and the time value of money.
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OEMs and suppliers commonly offer various forms of customer incentives that reduce the transaction price. Two examples of incentives are cash rebates offered by OEMs and volume discounts offered by suppliers. Once the amount of consideration is determined, it must then be allocated to the separate performance obligations in the contract. We expect that entities might have to separately account for more performance obligations than today if the risks of providing two or more goods or services are not largely inseparable (as described above), so the allocation of the transaction price might be new to many automotive companies. Proposed model Variable consideration Variable consideration (for example, volume discounts and other sales incentives) is included in the transaction price using a probabilityweighted estimate or the most likely amount (whichever is more predictive). These amounts are recognized as revenue as the entity satisfies its related performance obligations, provided the entity is reasonably assured of being entitled to the amount allocated to that performance obligation. This is generally when the entity has experience with similar types of contracts and that experience has predictive value (that is, the experience is relevant to the contract). Discounts on future transactions (for example, volume purchase agreements) are recognized as a reduction of revenue at the time of the future transaction if the customer's future purchase is considered a separate purchasing decision (for example, there is no minimum purchase requirement in the arrangement). Revenue is measured at the fair value of the consideration received or receivable. This is normally the price specified in the contract, taking into account the amount of any trade discounts and volume rebates allowed by the entity. For contracts that provide customers with volume discounts, revenue is measured by reference to the estimated volume of sales and the Rebates on volume purchases should corresponding expected discounts. be recognized on a systematic and Revenue recognized should not exceed rational basis. Measurement of the the amount of consideration that would total rebate obligation should be based be received if the maximum discounts on the estimated number of purchases were taken if estimates of expected the customer will ultimately earn under discounts cannot be reliably made. the arrangement. If the discount cannot be reliably estimated, revenue is reduced by the maximum potential rebate. Current U.S. GAAP Current IFRS
Consideration payable to a customer Amounts paid to a customer (for example, cash rebates) are: (a) a reduction of the transaction price; (b) a payment for distinct goods or services that the entity receives from the customer; or (c) a combination of (a) and (b). If consideration paid is a reduction of the transaction price, management reduces the amount of revenue it recognizes at the later of when:
(a) The entity transfers the promised
Cash consideration given by a vendor to a customer is a reduction of revenue earned from the customer, unless the vendor receives an identifiable benefit (goods or services) from the customer and the fair value of such benefit can be reasonably estimated.
Cash consideration given by a vendor to a customer is a reduction of revenue earned from the customer, unless the vendor is purchasing goods or services from the customer.
Sales incentives offered to customers are typically recorded as a reduction of Sales incentives offered to customers revenue at the later of the date at which are typically recorded as a reduction of the related sale is recorded by the revenue at the later of the date at which vendor and the date at which the sales the related sale is recorded by the incentive is offered. vendor and the date at which the sales incentive is offered.
goods or services to the customer; and

(b) The entity incurs the obligation to
pay the consideration to the customer (even if payment is conditional on a future event).
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Proposed model Time value of money The transaction price should reflect the time value of money whenever the contract includes a significant financing component. As a practical expedient, an entity does not need to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less. Allocating the transaction price The transaction price (and any subsequent changes) is allocated to each separate performance obligation based on relative standalone selling price. The best evidence of a standalone selling price is the observable price of a good or service when sold separately. The standalone selling price should be estimated if the actual selling price is not directly observable. An estimation method is not prescribed in the proposed standard. An entity might use, for example, cost plus a reasonable margin in estimating the selling price of a good or service. An entity should maximize the use of observable inputs when estimating the standalone selling price. An entity may also allocate a discount or an amount of contingent consideration entirely to one (or more) performance obligations if certain conditions are met. Potential Impact:
Current U.S. GAAP
Current IFRS
Revenue is discounted in only limited situations, including receivables with payment terms greater than one year. The interest component should be computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable when discounting is required.
Revenue is discounted when the inflow of cash or cash equivalents is deferred. An imputed interest rate should be used to determine the amount of revenue to be recognized as well as the separate interest income to be recorded over time.
There is a hierarchy for determining the standalone selling price of a deliverable. This hierarchy requires selling price to be based on vendorspecific objective evidence (VSOE) if available, third-party evidence (TPE) if VSOE is not available, or estimated selling price if neither VSOE nor TPE is available. An entity must make its best estimate of selling price in a manner consistent with that used to determine the price to sell the deliverable on a standalone basis. No estimation methods are prescribed; however, examples include the use of cost plus a reasonable margin.
The transaction price should be allocated to the separate elements of the arrangement based on relative fair value when elements in a single contract are accounted for separately. The price that is regularly charged when an item is sold separately is the best evidence of the items fair value. At the same time, under certain circumstances, a cost-plus-reasonablemargin approach to estimating fair value would be appropriate. The use of the residual method and, under rare circumstances, the reverse residual method might be acceptable to allocate arrangement consideration.
Variable consideration can take several forms. For example, variable consideration might be created by the introduction of incentives that reduce the transaction price, such as volume discounts. The proposed standard would affect some U.S. GAAP reporting entities, as it will require incentives to be accounted for similar to current IFRS. Volume discounts are often recorded only to the extent of the amount potentially due to the customer under current U.S. GAAP. The proposed standard requires that the discounts expected to be taken by the customer over the contract period be considered in estimating the transaction price. This might result in earlier recognition of discounts as compared to today. The entity estimates the amount of discounts using a probability-weighted or most likely outcome approach, whichever is most predictive of the discounts expected to be taken. Consideration paid to a customer that is a reduction of the transaction price (for example, cash rebates offered to end consumers by an OEM through its distribution network) will continue to be accounted for as a reduction of revenue. The promise to pay consideration might be implied based on an entity's customary business practice. Revenue might be reduced at an earlier point in time compared to current practice based on the proposal's requirement to consider customary business practice.
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Proposed model
Current U.S. GAAP
Current IFRS
Time value of money could also impact the amount of revenue recognized by OEMs as compared to today. Take an example of a vehicle warranty that the customer has the option to purchase separately, or a free maintenance program. The consideration for separately purchased warranties and free maintenance is typically received at the time of the vehicle sale to the end customer, yet the performance obligation is typically satisfied over a number of years. The transaction price allocated to the warranty or the free maintenance performance obligations should reflect the time value of money as interest under the proposed standard in such cases, resulting in less revenue recognized as compared to today. The sale price in a tooling arrangement between a supplier and an OEM is often structured either as separate payments at contractually stated amounts (typically equal to the supplier's cost of providing the tooling) or built into the sales price of the follow-on production parts. The proposed standard requires the transaction price to be allocated to the tooling and parts based on their estimated standalone selling prices (for example, using a cost plus a reasonable margin approach) when the tooling and parts contracts are combined but the performance obligations should be accounted for separately. A portion of the transaction price charged for each follow-on production part will need to be allocated to the tooling under the proposed model regardless of how the tooling arrangement is structured.
Key change from the 2010 Exposure Draft: The original exposure draft required variable consideration to be estimated using the probability-weighted estimate approach. An entity would use a most-likely amount approach in estimating the amount of variable consideration it expects to be entitled to receive under the proposed standard if that is the most predictive approach (for example, in situations where variable consideration is binary). The boards added the constraint on when revenue related to variable consideration can be recognized. Judgment will be necessary to determine when an entity is reasonably assured to be entitled to variable consideration and such amounts should be recognized. We expect automotive entities in many cases will have experience with similar types of contracts that are predictive and provide a basis for estimating and recognizing revenue related to variable consideration. As a practical expedient, an entity does not need to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less. This change from the original exposure draft reduces the potential impact the accounting for the time value of money will have on contract revenues relative to the boards' original proposal. Entities will likely still need to account for the time value of money in more instances under the proposed model as compared to existing practice (for example, certain tooling contracts, free maintenance arrangements, or certain warranty agreements).
Example 8 - Variable consideration (volume discount)

Facts: A supplier sells a component to an OEM for $100. The price for each component purchased in excess of 1,000 is $50 (that is, components 1 through 1,000 are $100; components 1,001 and on are $50). For simplicity, assume the supplier believes there is a 25% probability that the OEM will purchase 1,000 components and a 75% probability that the OEM will purchase 1,500 components. The supplier's assumptions are based on experience with this OEM with similar contracts, as well as its ongoing relationship with the OEM and insight it has regarding the OEM's planned production. The supplier has determined that the probability-weighted estimate is more predictive of the amount it expects to be entitled to receive than an estimate based on the most likely amount. How should the supplier determine the transaction price? Discussion: The supplier should consider the total volume discounts expected to be taken under the contract in determining the transaction price to be allocated to each component sold. The transaction price is $86.36 (probabilityweighted consideration of $118,750/probability-weighted number of parts of 1,375) for each component, determined using the probability weighted average of the expected outcomes.
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Probability-weighted consideration $100,000 (1,000 components x $100) x 25% $125,000 ((1,000 components x $100) + (500 components x $50)) x 75%: Total probability weighted consideration: Probability-weighted number of parts 1,000 components x 25%: 1,500 components x 75%: Total probability-weighted number of parts $ $ $ 250 1,125 1,375 $ 25,000 $ 93,750 $ 118,750
Revenue is recognized based on this estimated transaction price as it is reasonably assured of being received given that the supplier has experience with similar performance obligations and that experience is predictive. Any changes to the probability-weighted amount would be recognized in the period of change using a cumulative catch-up approach.
Example 9 - Allocating the transaction price

Facts: An entity enters into a contract to sell a vehicle and provide maintenance services for a three-year period. The transaction price, at inception, is $40,000. The car and the maintenance services are typically sold separately by the entity for $40,000 and $2,000, respectively. There is therefore a $2,000 inherent discount that the entity is offering to the customer. Discussion: The entity must first assign a standalone selling price to both the car and the maintenance services to allocate the contract consideration. As the car and maintenance services are sold separately, the transaction price of $40,000 would be allocated as follows using a relative allocation model: Car: Maintenance: $38,100 = $40,000 * ($40,000/$42,000) $1,900 = $40,000 * ($2,000 / $42,000)
Recognize revenue when performance obligations are satisfied

Revenue recognition under existing guidance used in the automotive industry is based primarily on the transfer of risks and rewards. Revenue is recognized upon the satisfaction of an entity's performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or continuously over time. The change to a control transfer model will require careful assessment of when an entity can recognize revenue. We expect revenue will be recognized similar to today for many automotive contracts related to the sale of production goods. This should, however, not be assumed; in particular for certain tooling contracts. Contracts between suppliers and OEMs for the sale of tooling (that is, where ownership of the tooling transfers from the supplier to the OEM) are common and can be organized in several different forms. One type of arrangement between suppliers and OEMs is where the supplier receives a lump-sum payment from the OEM or is reimbursed periodically as certain milestones are met in the completion of the pre-production tooling activities. Suppliers will have to assess the terms of the contract, using the indicators described below, to determine if control of the tooling transfers at a point in time or over time as the tooling is being constructed.
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Proposed model Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or over time. A performance obligation is satisfied over time when (a) the entity's performance creates or enhances an asset that the customer controls or (b) the entity's performance does not create an asset with alternative use to the entity and at least one of the following is met: The customer simultaneously receives and consumes the benefits as the entity performs each task. Another entity would not need to substantially reperform the tasks performed to date if it were to fulfill the remaining obligation. The entity has a right to payment for performance to date and expects to fulfill the contract. A performance obligation is satisfied and control is transferred at a point in time when the criteria above are not met. Determining when control transfers could require a significant amount of judgment. Indicators that might be considered in determining whether the customer has obtained control at a point in time include: The entity has a present right to payment The customer has legal title The customer has physical possession The customer has the significant risks and rewards of ownership The customer has accepted the asset This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a stand-alone basis.
Current U.S. GAAP
Current IFRS
Revenue for the sale of goods is Revenue for the sale of goods is generally recognized once the risks and generally recognized once the following rewards of ownership have transferred conditions are satisfied: to the customer. The risks and rewards of ownership have transferred; Revenue for arrangements in the scope of construction accounting is generally The seller does not retain recognized using the percentage-ofmanagerial involvement to the completion method when reliable extent normally associated with estimates are available. ownership nor retain effective control; The amount of revenue can be reliably measured; It is probable that the economic benefit will flow to the entity; and The costs incurred can be measured reliably. Revenue for arrangements in the scope of construction accounting is generally recognized using the percentage-ofcompletion method when reliable estimates are available.
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Proposed model Potential Impact:
Current U.S. GAAP
Current IFRS
The proposed guidance will require suppliers that enter into tooling arrangements to use judgment to determine when it is appropriate to recognize revenue. The overall effect of the proposed standard on a supplier will depend largely on the terms of the arrangements and the existing accounting practices for such arrangements. Revenue for tooling will be recognized as control of the tooling transfers, while revenue for the parts will likely be recognized as those parts are delivered. We expect that some contracts to construct tooling to the specification of the OEM might result in transfer of control over time, thereby permitting revenue to be recognized by the supplier over the period the tooling obligation is satisfied. Tooling arrangements often are priced with the intent to be margin-neutral (that is, the supplier will be reimbursed for actual cost). Such arrangements may provide the OEM with the right to evaluate whether the contract price of the tooling exceeds the supplier's actual cost. If that is the case, consideration received in excess of the amount of costs incurred by the supplier should be treated as variable consideration subject to the reasonably assured constraint described above.
Key change from the 2010 Exposure Draft: The 2010 exposure draft had limited guidance on when control transferred over time. The boards added the criteria above to determine when a performance obligation is satisfied over time in response to comment letters received, which indicated that the guidance in the original exposure draft was difficult to apply in certain situations, such as contracts for pre-production activities related to long-term supply arrangements and services.
Example 10 - Recognize revenue (tooling: satisfied over time)

Facts: Assume the same facts as in Example 1 above, except: The tool must be constructed to the OEM's specifications, which may be changed at the OEM's request during the contract term; Non-refundable, interim progress payments are required to finance the construction of the tool; The OEM can cancel the contract to construct the tool at any time (with a termination penalty); any work in process is the property of the OEM; and Title does not otherwise pass until completion of the contract for the construction of the tool. Discussion: The OEM controls the work in process related to the tool, which suggests that the supplier transfers control of the tool over time because construction of the tool creates an asset that the OEM controls. The supplier will need to select the most appropriate measurement model (either an input or output method) to measure the amount of revenue to recognize over the contract term. The supplier might, for example, elect to use a labor hour input method if it determined that method to be the best measure of progress toward transferring control of the tooling to the OEM. The transaction price allocated to the tool is determined based on its relative estimated standalone selling price and will be recognized as revenue based on the number of labor hours incurred as a percentage of the estimated total labor hours to be incurred.
Example 11 - Recognize revenue (tooling: control transfers when the tool is completed)
Facts: Assume the same facts as in Example 1 above, except: The OEM can cancel the contract at any time (with a termination penalty) and any work is the property of the supplier; and Title of the tool passes upon completion of its construction. How should the supplier recognize revenue in this example?
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Discussion: The OEM does not control the work in process during the construction of the tool. Although the supplier is likely unable to sell the tooling to another customer and has no alternative use for the tooling, the criteria to satisfy a performance obligation over time would likely not be met as: (a) the OEM does not receive a benefit as the tool is constructed, (b) another entity would need to substantially reperform the work that the supplier has performed in order to fulfill the remaining obligation (presuming the other entity does not have the benefit of the work in process controlled by the supplier), and (c) the supplier does not have the right to payment for performance to date. We believe control is likely to transfer when the tool is completed.
Product warranties
Product warranties are commonplace in the automotive industry. Both OEMs and suppliers routinely provide product warranties to their customers. Suppliers, for example, generally provide a standard warranty to all customers that the product complies with agreed-upon specifications for a specified period. OEMs generally provide a standard warranty on vehicles for a certain number of years or a specified mileage. OEMs might also provide an extended warranty or certain services (for example, maintenance, roadside assistance) in addition to the standard warranty coverage. The proposed standard draws a distinction between product warranties that the customer has the option to purchase separately and those that cannot be purchased separately. Companies will need to exercise judgment when assessing a warranty not sold separately to determine if there is a service component inherent in the warranty that needs to be accounted for as a separate performance obligation. Proposed model Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. The warranty should be accounted for as a cost accrual if a customer does not have the option to purchase a warranty separately from the entity. An entity might provide a warranty that calls for a service to be provided to the customer (for example, maintenance) in addition to a promise that the entitys past performance was as specified in the contract. The entity should account for the service component of the warranty as a separate performance obligation in these circumstances. Potential Impact: This revised principle is similar to current accounting in many cases. There might, however, be situations where the accounting for warranties could result in revenue deferral, for example, when the entity's warranty provides a service to the customer (for example, maintenance, roadside assistance) in addition to a promise that the entitys past performance was as specified in the contract. The entity should account for the service component of the warranty as a separate performance obligation in these circumstances, with revenue relating to that service deferred and recognized as the service is provided. If the entity is unable to separate the service component of the warranty from the standard warranty element, then the entire warranty should be accounted for as a service and revenue should be deferred and recognized as the warranty service is provided. Current U.S. GAAP Entities typically account for warranties that cover latent defects in accordance with existing loss contingency guidance. An entity recognizes revenue and concurrently accrues any expected warranty cost when the product is sold. Revenue from separately priced extended warranty contracts is deferred and recognized over the expected life of the contract. Current IFRS Revenue is typically recognized at the time of sale for products that are sold with a standard warranty, and a corresponding provision is recognized for the expected warranty cost. A product sold with an extended warranty is treated as a multiple element arrangement. Revenue from the sale of the extended warranty is deferred and recognized over the period covered by the warranty. No costs are accrued at the inception of the extended warranty agreement.
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Proposed model
Current U.S. GAAP
Current IFRS
Entities that report under U.S. GAAP and offer separately priced warranties might also be affected, as the arrangement consideration will be allocated on a relative standalone selling price basis rather than at the contract price.
Key change from the 2010 Exposure Draft: The proposed guidance on accounting for product warranties is an area that has significantly changed from the original exposure draft. The boards originally proposed that all types of warranties, including those that provide assurances that the goods or services are as specified in the contract, be accounted for as a deferral of revenue. The accounting for warranties as a separate performance obligation will, under the proposal, be based primarily on whether the customer has the option to purchase the warranty separately, and whether it provides a service in addition to providing assurance that the entity's past performance was as specified in the contract, which is more similar to current accounting. We no longer expect there to be a significant change from current accounting for those warranties offered in the automotive industry, except possibly for more complex warranties that involve both a standard warranty and a service element.
Example 12 - Standard warranty (not offered separately)

Facts: A supplier sells parts with a 90-day standard warranty covering latent defects. The supplier will repair or replace defective components of the product under the standard warranty. How does the supplier account for the warranty? Discussion: The standard warranty is not a separate performance obligation because the customer does not have the option to purchase it separately and it does not provide a service in addition to the assurance that the product complies with agreed-upon specifications. The supplier should accrue, similar to current guidance, the cost of the warranty at the time revenue is recognized for the sale of the related product.
Example 13 - Standard warranty (not offered separately but includes a service component)
Facts: An OEM provides a product warranty to its customer with the purchase of a vehicle. The product warranty provides assurance that the vehicle is as specified in the contract and will operate as promised for up to 3 years or 36,000 miles, whichever comes first. The warranty also provides the customer with free oil changes and tire rotations during the warranty period. Customers do not have the option to purchase the warranty (including the services) separately from the vehicle. Discussion: In addition to assurance that the vehicle complies with the agreed-upon specifications in the contract, the warranty provides maintenance services (that is, oil changes and tire rotations). The maintenance services should be accounted for as a separate performance obligation and revenue related to that service should be recognized as the maintenance services are provided. The cost of the standard warranty element should be accrued at the time revenue is recognized for the vehicle. The entire warranty should be accounted for as a separate performance obligation if the OEM is unable to reasonably account for the service and standard assurance components of the warranty separately.
Contract costs
Entities in the automotive industry may incur costs to design and develop products and tooling or to build tooling that is not sold to the OEM (that is, the supplier retains ownership and the tooling is not a performance obligation). Suppliers might incur costs to develop tooling, for example, in anticipation of a long-term supply arrangement. A contract might exist prior to the costs to develop the tooling being incurred in some cases; in others, a contract might not be agreed until after costs have been incurred. These costs may be either expensed as incurred or capitalized and amortized to expense as the related revenue is recognized under current guidance. This current accounting treatment depends on a number of considerations, including the nature of the costs and the tooling being developed, whether the supplier has a noncancellable right to use the tooling, and whether the supplier will be reimbursed for the costs incurred. The proposed standard includes guidance on both costs to obtain and costs to fulfill a contract and may change today's practice.
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Proposed model Incremental costs of obtaining a contract should be recognized as an asset so long as the costs are expected to be recovered. As a practical expedient, such costs may be expensed as incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less. All costs relating to satisfied performance obligations and costs related to inefficiencies (that is, abnormal costs of materials, labor, or other costs to fulfill) should be expensed as incurred.
Current U.S. GAAP
Current IFRS
There is a significant amount of Costs incurred in arrangements not in guidance on the accounting for contract the scope of construction accounting costs. are capitalized if they are within the scope of other asset standards (for Costs that are incurred for an example, inventory, property, plant anticipated contract generally may be and equipment, or intangible assets). deferred only if the costs can be directly associated with a specific contract and There is no specific cost guidance for if their recoverability from that pre-production costs incurred in contract is probable. certain automotive contracts. Pre-production costs incurred in longterm supply arrangements related to design and development of molds, dyes, and other tools that an automotive supplier will own are capitalized as part of property, plant and equipment. If the costs relate to new technology, such costs are expensed as incurred.
Other direct costs incurred in fulfilling a contract should be accounted for in accordance with other standards (for example, inventory, intangibles, or fixed assets) if they are within the scope Pre-production costs incurred related of that guidance. to molds, dyes, and other tools that a supplier will not own may only be Direct costs of fulfilling a contract will capitalized if they meet certain criteria. generally be expensed as incurred Those criteria include the supplier under the proposed standard (if not having a non-cancellable right to use within the scope of other standards), the molds, dyes, and tools during the unless they relate directly to a contract, supply arrangement or a legally relate to future performance, and are enforceable contractual guarantee for expected to be recovered. reimbursement. Otherwise, such costs are expensed as incurred. Capitalized costs are amortized as control of the goods or services to which the asset relates is transferred to the customer, which may include goods or services provided under specific anticipated contracts. Potential Impact: We expect costs associated with pre-production activities, such as those associated with long-term supply arrangements, might be capitalized more often under the proposed standard than under both current U.S. GAAP and current IFRS.
Key change from the 2010 Exposure Draft: Costs to obtain a contract were to be expensed as incurred under the 2010 exposure draft. The boards revised this guidance to require recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered (unless the amortization period of the asset that the entity otherwise would have recognized is one year or less). Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained. The boards clarified that costs to fulfill a contract are in the scope of the revenue guidance only if they are not addressed by other standards and that the costs of abnormal amounts of wasted materials, labor, and other resources that were not considered in the price of the contract should be recognized as an expense when incurred.
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Example 14 - Costs to obtain a contract (sales commissions)

Facts: A salesperson earns a 5% commission on a contract that was signed in January. The products purchased under the contract will be delivered throughout the next year. The contract is not expected to be renewed in the following year. How should the entity account for the commission paid to its employee? Discussion: The commission payment may be recognized as an asset and amortized as control of the products purchased under the contract is transferred in the following year. The commission payment may also be expensed as incurred in this case because of the practical expedient to allow such costs to be expensed if the amortization period of the asset (that is, the commission paid to obtain the contract) is one year or less.
Financing arrangements
Many OEMs have finance arms that serve as a potential finance source for customers that lease or buy vehicles from dealers. When vehicles sold to dealers are financed through the OEM's financing division, the OEM must meet certain conditions under current U.S. GAAP to recognize revenue at the time of vehicle delivery to the dealer. These specific conditions are not included in IFRS; rather, revenue is generally recognized from sales to dealers or distributors when the risks and rewards of ownership have passed. The proposed standard does not contain the same conditions that exist under current guidance. Proposed model The proposed standard requires revenue to be recognized when control transfers to the customer (see above). Current U.S. GAAP When an OEM sells a vehicle to a dealer who in turn leases it to an end customer, and the end customer finances the lease through the OEM (or its finance affiliate), the OEM may recognize revenue upon sale to the dealer if certain conditions are met, including: The dealer is an independent entity; The OEM has delivered the product to the dealer and the risks and rewards of ownership have passed to the dealer; The finance affiliate of the OEM has no legal obligation to provide a lease arrangement to a potential customer of the dealer; and The customer has other financing alternatives available and controls the selection of the financing alternative. Potential Impact: OEMs generally meet the criteria in U.S. GAAP to recognize revenue at the time of sale to the dealer. We do not expect a significant change in the timing of revenue recognition in such cases as a result of the elimination of the criteria in current U.S. GAAP. This is because it is likely that control has transferred if the transaction meets the specific criteria under existing guidance. The proposal may result in earlier revenue recognition for OEMs that did not meet the criteria under current U.S. GAAP. We also do not expect a significant change in the timing of revenue recognition under IFRS. Transfer of control generally occurs when a vehicle is sold from the OEM to the dealer. Current IFRS There are no specific criteria for when an OEM sells a vehicle to a dealer who in turn leases it to an end customer, and the end customer finances the lease through the OEM. Revenue from sales to distributors, dealers, or others for resale is generally recognized when the risks and rewards of ownership have passed. The sale is treated as a consignment sale when the dealer is acting in substance as an agent.
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Example 15 - Lease financing arrangements

Facts: An OEM sells a vehicle to a dealer. The dealer has legal title and an obligation to pay the OEM upon receipt of the vehicle. The dealer intends to sell or lease the vehicle to a third party. The third party may finance the purchase or lease of the vehicle from the dealer through a finance affiliate of the OEM or through an unrelated third party. When should revenue be recognized for the sale of the vehicle to the dealer? Discussion: The dealer has physical possession, legal title, and an obligation to pay the OEM upon receipt of the vehicle. Control transfers and the OEM should recognize revenue when the dealer receives the vehicle. The fact that the OEM might provide financing to the end consumer that ultimately purchases or leases the vehicle from the dealer does not impact the assessment of whether control has transferred.
Repurchase options and residual value guarantees

OEMs sell vehicles to customers and often include various repurchase or reimbursement options as part of the contract, as is common in arrangements with rental car companies. These options generally provide some form of a guaranteed residual value to the customer when the customer sells the vehicle. Two common options are when OEMs either agree to (a) reacquire the vehicle at a guaranteed price or (b) reimburse customers for any deficiency between the sales proceeds received for the vehicle and the guaranteed minimum resale value. There is specific U.S. GAAP that requires these contracts to be treated as lease transactions under today's accounting. IFRS does not contain specific guidance on how to account for such arrangements. Proposed model The proposed standard differentiates the accounting based on whether the OEM has an obligation to reacquire the vehicle or is required to reimburse the customer for any deficiency between the sales proceeds and a minimum resale value. An OEM would account for an agreement that provides the customer with the unconditional right to require the OEM to repurchase the vehicle (that is, a put option) as a lease if, at contract inception, the customer has a significant economic incentive to exercise that right. The OEM would account for the agreement as a sale with a right of return if the customer does not have a significant economic incentive to require the OEM to repurchase the vehicle. The proposed standard applies to agreements to reimburse customers for any deficiency between the sales proceeds received for the vehicle and a guaranteed minimum resale value. We expect that such agreements might result in recognition of revenue when control of the vehicle is transferred, with the estimate of the expected reimbursement to the customer accounted for as variable consideration payable to the customer and a reduction of revenue (see above discussion).
Current U.S. GAAP An entity should account for a transaction in which it has agreed to (a) reacquire the product at a guaranteed price or (b) reimburse the customer for any deficiency between the sales proceeds received for the product and the guaranteed minimum resale value as a lease.
Current IFRS There is no specific guidance on how to account for an arrangement in which the entity has agreed to (a) reacquire the product at a guaranteed price or (b) reimburse the customer for any deficiency between the sales proceeds received for the product and the guaranteed minimum resale value. An entity should evaluate the substance of the transaction to determine whether the arrangement is a lease or sale.
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Current U.S. GAAP
Current IFRS
Contracts containing repurchase options are common for certain OEMs. We believe these contracts will generally be accounted for under the proposed standard, but will be accounted for as a lease when the customer has the unconditional right to require the OEM to repurchase the vehicle and the customer has a significant economic incentive to exercise that right. Agreements to reimburse customers for any deficiency between the sales proceeds received for the vehicle and the guaranteed minimum resale value will be accounted for under the proposed standard as a reduction of the transaction price, not as a lease. The boards have also proposed significant changes to the accounting for leases, which might result in a different pattern of recognition as compared to today's lease accounting.
Key change from the 2010 Exposure Draft: The 2010 exposure draft required an entity to account for all transactions that provide the customer with the right to require the entity to repurchase the product in the future as a sale of a product with a right of return. The boards subsequently concluded that when the customer has a significant economic incentive to require the entity to repurchase the asset, the substance of the transaction is to provide the right to use the asset and should be accounted for as a lease.
Right of return
Return rights in the automotive industry are common and come in a variety of forms. These arrangements will require careful consideration as to the appropriate accounting under the proposed model. Proposed model The sale of goods with a right of return would be recorded as revenue on the date of sale, and the amount of estimated returns should be accounted for similar to today's failed sale model. Revenue should not be recognized for goods expected to be returned, and a liability should be recognized for the expected amount of refunds to customers. The refund liability should be updated for changes in expected refunds. An asset and corresponding adjustment to cost of sales should be recognized for the right to recover goods from customers on settling the refund liability, with the asset initially measured at the original cost of the goods (that is, the former carrying amount in inventory). The asset should be assessed for impairment if indicators of impairment exist. If an entity is not reasonably assured of the quantity of products that will be returned, revenue will not be recognized until the entity is reasonably assured of the quantity of
Current U.S. GAAP Revenue is recognized at the time of sale if the amount of future returns can be reasonably estimated. Returns are estimated based on historical experience with an allowance recorded against sales. Revenue is not recognized until the return right lapses if an entity is unable to estimate potential returns.
Current IFRS Revenue is typically recognized net of a provision for the expected level of returns, provided that the seller can reliably estimate the level of returns based on an established historical record and other relevant evidence.
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Proposed model products that will be returned (which may be when the right of return lapses). Potential Impact:
Current U.S. GAAP
Current IFRS
The affect of product returns under the proposed standard will be largely unchanged from current guidance under U.S. GAAP and IFRS, with the primary change being that the balance sheet will be grossed up to include the refund obligation and the asset for the right to goods to be returned. Companies will use a probability-weighted approach or most likely outcome, whichever is most predictive, to determine the likelihood of a sales return under the proposed standard, which may result in a difference versus current accounting.
Principal versus agent

Entities will need to determine whether they are the principal or the agent when providing goods or services to a customer. For example, the supplier will need to assess whether its performance obligation is to provide the tooling itself (that is, the supplier is a principal and should present revenue from the tooling arrangement on a gross basis), or to arrange for another party to provide the tooling (that is, the supplier is an agent and should present revenue from the tooling arrangement on a net basis) when a supplier outsources the construction of tooling. Proposed model An entity is the principal when it obtains control of the goods or services of another party before it transfers those goods or services to the customer. (Refer to discussion of control transfer in the "recognize revenue when performance obligations are satisfied" section above.) Indicators that the entity is an agent and should recognize revenue net of amounts paid to others for providing their goods or services to the customer include: The other party is primarily responsible for fulfillment of the contract. The entity does not have inventory risk before or after the customer order, during shipping, or on return. The entity does not have latitude in establishing prices for the other party's goods or services; thus, the benefits it can receive from the goods or services are constrained. The entity's consideration is in the form of a commission. The entity does not have customer credit risk for the amount receivable in exchange for the other party's goods or services. Current U.S. GAAP An entity should assess whether it is acting as a principal or an agent in an arrangement. Revenue is the amount of the commission (that is, net presentation) in an agency relationship. Specific indicators are provided for entities to consider when assessing whether the entity is the principal or the agent in an arrangement. Current IFRS An entity should assess whether it is acting as a principal or an agent in an arrangement. Revenue is the amount of the commission (that is, net presentation) in an agency relationship. Specific indicators are provided for entities to consider when assessing whether the entity is the principal or the agent in an arrangement.
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Current U.S. GAAP
Current IFRS
The proposed guidance for determining whether revenue should be presented gross or net is similar to today's guidance and will likely not result in a significant change. This should not, however, be assumed. Entities will have to assess their current accounting for items such as tooling and service warranty contracts, and their allocation of consideration using the principles in the proposed standard to determine that their accounting is appropriate.

The accounting for onerous performance obligations could represent a significant change for automotive companies based on the holistic application of the proposed standard. For example, suppliers might enter into a contract to construct and deliver tooling to an OEM at a loss as part of a contract that includes a supply agreement for the production of the parts the tool was created for (presumably at a price that would result in the overall contract being profitable). A loss may need to be recorded for the tooling depending on the allocation of consideration determined based on the relative standalone selling prices. Proposed model An entity shall recognize a liability and a corresponding expense if a performance obligation that will be satisfied over a period of time greater than one year is onerous. A performance obligation is onerous if the lower of (a) the costs that relate directly to satisfying the performance obligation by transferring the promised goods or services and (b) the amount the entity would pay to exit the performance obligation exceeds the amount of the transaction price allocated to that performance obligation. Potential Impact: The proposal to account for onerous contracts at the performance obligation level will likely result in more liabilities being recognized as compared to current accounting. Management may be reluctant to enter into contracts that include lossmaking performance obligations with the expectation of overall profitability in light of this proposed guidance. Current U.S. GAAP The recognition of onerous provisions for executory contracts generally is not permitted outside of certain specific guidance (for example, construction contract guidance). Current IFRS A loss should be recorded on a contract that is outside of the scope of accounting for construction contracts when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. A loss shall be recognized on a contract within the scope of accounting for construction contracts when it is probable that total contract costs will exceed total contract revenue.
Key change from the 2010 Exposure Draft: Onerous performance obligations were to be evaluated at the performance obligation level for all performance obligations under the 2010 exposure draft. The boards changed this to apply only to performance obligations satisfied over a period of time greater than one year in response to comments about the unintended consequences of the proposed requirement. Performance obligations that are not satisfied over a period of time greater than one year would not be subject to the guidance on onerous performance obligations under the proposed standard.
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Authored by:
Richard Hanna Global Sector & Assurance Leader Phone: 1-313-394-3450 Email: richard.hanna@us.pwc.com Lawrence Dodyk Partner Phone: 1-973-236-7213 Email: lawrence.dodyk@us.pwc.com Michael Sobolewski Senior Manager Phone: 1-313-394-3299 Email: michael.sobolewski@us.pwc.com Jason Aeschliman Senior Manager Phone: 1-973-236-4983 Email: jason.a.aeschliman@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Engineering and construction industry supplement

No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Defining the contract ..... 2 Determining the transaction price.......... 4 Accounting for multiple performance obligations .....................7 Allocating the transaction price.......... 8 Recognize revenue ........ 10 Other considerations ..... 14 Final thoughts ................18
Engineering and construction industry supplement

Overview
Entities in the engineering and construction (E&C) industry applying U.S. GAAP or IFRS 1 have primarily been following industry guidance for construction contracts to account for revenue. These standards were developed to address particular aspects of long-term construction accounting and provide guidance on a wide range of industry specific considerations including: Defining the contract, such as when to combine or segment contracts, and when and how to account for change orders and other modifications Defining the contract price, including variable consideration, customer furnished materials, and claims Recognition methods, such as the percentage-of-completion method (and in the case of U.S. GAAP, the completed contract method) and input/output methods to measure performance Accounting for contract costs, such as pre-contract costs and costs to fulfil a contract Accounting for loss making contracts
This guidance is included in ASC Topic 605-35, Construction-Type and Production-Type Contracts (U.S. GAAP), and International Accounting Standards 11, Construction Contracts (IFRS).
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Once the new revenue recognition standard becomes effective, the construction contract guidance and substantially all existing revenue recognition guidance under U.S. GAAP and IFRS will be replaced. This includes the percentage-ofcompletion method and the related construction cost accounting guidance as a standalone model. This E&C industry supplement discusses the areas in which the proposed standard is expected to have the greatest impact. The examples and the related assessments contained herein are based on a current interpretation of the exposure draft, Revenue from Contacts with Customers , issued on November 14, 2011. Any conclusions set forth below are subject to further interpretation and assessment based on the final standard. We have also provided a high-level summary of key changes from the original exposure draft issued on June 24, 2010 (the "2010 Exposure Draft"). References to the proposed model or proposed standard throughout this document refer to the exposure draft issued in November 2011, unless otherwise indicated. For a more comprehensive description of the proposed standard, refer to PwC Dataline 201135 (www.cfodirect.pwc.com) or visit www.fasb.org or www.ifrs.org.
Defining the contract

Current guidance covers: When two or more contracts should be combined and accounted for together When one contract should be segmented and accounted for separately as two or more contracts When a contract modification should be recognized These situations and, in particular, contract modifications such as change orders, are commonplace in the E&C industry. The proposed standard applies only to contracts with customers when such contracts: Have commercial substance Have been approved by the parties to the contract and such parties are committed to satisfying their respective obligations Have enforceable rights that can be identified regarding the goods or services to be transferred Have terms and manners of payment that can be identified Current practice is not expected to significantly change in the assessment of whether contracts should be combined. The proposed standard does not contain guidance on segmenting contracts; however, construction companies that currently segment contracts under current guidance might not be significantly affected because of the requirement in the proposed standard to account for separate performance obligations (refer to "Accounting for multiple performance obligations" below). Construction companies currently exercise significant judgment to determine when to include change orders and other contract modifications in contract revenue and therefore, there is diversity in practice. We expect that the use of judgment will continue to be needed and do not expect current practice (or existing diversity) in this area to be significantly affected by the proposed standard, including the accounting for unpriced change orders. Proposed model Combining contracts Two or more contracts (including contracts with parties related to the customer) are combined and accounted for as one contract if the contracts are entered into at or near the same time and one or more of the following conditions are met: Combining and segmenting contracts is Combining and segmenting contracts is permitted provided certain criteria are required when certain criteria are met. met, but it is not required so long as the underlying economics of the transaction are fairly reflected. Current U.S. GAAP Current IFRS
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Proposed model The contracts are negotiated with a single commercial objective The amount of consideration in one contract depends on the other contract The goods or services promised are a single performance obligation (refer to "Accounting for multiple performance obligations" below) Contract modifications (for example, change orders) An entity shall account for a modification when the entity has an expectation that the price of the modification will be approved if the parties to a contract have approved a change in the scope of a contract but have not yet determined the corresponding change in price (for example, unpriced change orders). A contract modification is accounted for as a separate contract if: the modification promises distinct goods or services that result in a separate performance obligation; and the entity has a right to consideration that reflects the standalone selling price of the promised goods or services underlying that performance obligation. A modification that is not a separate contract is evaluated and accounted for either as: A termination of the original contract and the creation of a new contract if the goods or services are distinct from those transferred before the modification A cumulative adjustment to contract revenue if the remaining goods and services are not distinct and part of a single performance obligation that is partially satisfied
Current U.S. GAAP
Current IFRS
A change order is generally included in contract revenue when it is probable that the change order will be approved by the customer and the amount of revenue can be reliably measured. U.S. GAAP also includes detailed revenue and cost guidance on the accounting for unpriced change orders (or those in which the work to be performed is defined, but the price is not).
A change order (known as a variation) is generally included in contract revenue when it is probable that the change order will be approved by the customer and the amount of revenue can be reliably measured. There is no detailed guidance on the accounting for unpriced change orders.
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Proposed model A prospective adjustment to contract revenue when the remaining goods or services are a combination of distinct and nondistinct
Current U.S. GAAP
Current IFRS
Example 1 - Unpriced change orders

Facts: A contractor has a single performance obligation to build an office building. The contractor has a history of executing unpriced change orders; that is, those change orders where price is not defined until after scope changes are agreed upon. It is not uncommon for the contractor to commence work once the parties agree to the scope of the change, but before the price is agreed upon. When would these unpriced change orders be included in contract revenue? Discussion: The contractor might be able to determine that it expects the price of the scope change to be approved based on its historical experience. If so, the contractor would account for the unpriced change order and estimate the transaction price based on a probability-weighted or most likely amount approach (whichever is most predictive). The contractor would need to then determine whether the unpriced change order should be accounted for as a separate contract. This will often not be the case based on the following: Change orders often wont result in a distinct performance obligation because the underlying good or service is highly interrelated with the original good or service and part of the contractor's service of integrating goods into a combined item for the customer. Change orders are typically based on the contractor's goal of obtaining one commercial objective on the overall contract. The pricing of a change order may, as a result, not represent the standalone selling price of the additional good or service. The contractor in this case would update the transaction price and measure of progress towards completion of the contract because the remaining goods or services, including the change order, are part of a single performance obligation that is partially satisfied.
Determining the transaction price

The transaction price (or contract revenue as it is called today in the E&C industry) is the consideration the contractor expects to be entitled to in exchange for satisfying its performance obligations. This determination is simple when the contract price is fixed. It is more complex when the contract price is not fixed. Common considerations in this area for the E&C industry include the accounting for awards/incentive payments, customer-furnished materials, claims, liquidated damages, and the time value of money. Revenue related to awards or incentive payments might be recognized earlier under the proposed standard. We do not expect a significant change in practice as it relates to customer furnished materials, claims, liquidated damages, or the time value of money, except as it relates to the impact of the time value of money on retainage receivables. Proposed model Awards/incentive payments Awards/incentive payments are included in contract revenue using a probability-weighted or most likely amount approach (whichever is more predictive). These amounts are Awards/incentive payments should be included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Awards/incentive payments should be included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Current U.S. GAAP Current IFRS
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Proposed model recognized as revenue as the entity satisfies its related performance obligations, provided the entity is reasonably assured of being entitled to the amount allocated to that performance obligation. This is generally when the contractor has experience with similar types of contracts and that experience has predictive value (i.e., the experience is relevant to the contract). Customer furnished materials The value of goods or services contributed by a customer (for example, materials, equipment, or labor) to facilitate the fulfillment of the contract is included in contract revenue if the entity controls these goods or services. Any non-cash consideration is measured at fair value unless fair value cannot be reasonably estimated, in which case it is measured by reference to the selling price of the goods or services transferred. Claims Claims are included in contract revenue using a probability-weighted or most likely amount approach (whichever is more predictive). These amounts are recognized as the entity satisfies its related performance obligations, provided the entity is reasonably assured of being entitled to such payments (see above). Time value of money Contract revenue should reflect the time value of money whenever the contract includes a significant financing component. An entity is not required to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less, as a practical expedient.
Current U.S. GAAP
Current IFRS
The value of customer furnished materials is included in contract revenue when the contractor has the associated risk for these materials.
There is no explicit guidance on the accounting for non-cash consideration in the construction contracts standard. Management would follow general principles on nonmonetary exchanges, which generally require companies to use the fair value of goods or services received in measuring the amount to be included in contract revenue.
A claim is recorded as contract revenue when it is probable and can be estimated reliably (determined based on specific criteria), but only to the extent of contract costs incurred. Profits on claims are not recorded until they are realized.
A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable the customer will accept the claim and the amount can be reliably measured.
Revenue is discounted in only limited situations, including receivables with payment terms greater than one year. The interest component is computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable when discounting is required.
Revenue is discounted when the inflow of cash or cash equivalents is deferred. An imputed interest rate is used to determine the amount of revenue to be recognized as well as the separate interest income to be recorded over time.
Key change from the 2010 Exposure Draft: The original exposure draft required variable consideration to be estimated using the probability-weighted estimate approach. Entities may now use a most-likely amount approach if it is the most predictive (for example, in situations where variable consideration is binary). This might provide results more similar to today's accounting.
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The boards added a constraint on when revenue related to variable consideration (for example, bonus, claims, and awards) can be recognized. Judgment will be necessary to determine when an entity is reasonably assured of being entitled to receive variable consideration based on the conditions described above and thus, when the related revenue should be recognized. As a practical expedient, a contractor does not need to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less. This change from the original exposure draft reduces the potential impact of the accounting for the time value of money on contract revenues. Entities might still need to account for the time value of money in more instances under the proposed model as compared to existing practice (for example, retainage receivables).
Example 2 - Variable consideration

Facts: A contractor enters into a contract for the expansion of an existing two-lane highway to a three-lane highway. The contract price is $65 million plus a $5 million award fee if the expansion is completed before the holiday travel season. The contract is expected to take one year to complete. The contractor has a long history of performing this type of highway work. The award fee is binary; that is, if the job is finished before the holiday travel season, the contractor receives the full award fee. The contractor does not receive any award fee if the highway is not finished before the holiday season. The contractor believes, based on significant past experience, that it is 95 percent likely that the contract will be completed in advance of the holiday travel season. How should the contractor account for the award fee? Discussion: The contractor is likely to conclude, given the binary award fee, that it is appropriate to use the most likely amount approach in determining the amount of variable consideration to include in the estimate of the transaction price. The contract's transaction price is therefore $70 million: the fixed contract price of $65 million plus the $5 million award fee (most-likely amount). This estimate is regularly revised and adjusted, as appropriate, using a cumulative catch-up approach, which is consistent with current practice. The contractor will then determine whether it is reasonably assured of being entitled to the award fee (and therefore, it is eligible to recognize this amount as revenue when the performance obligation is satisfied). The contractor would likely conclude it is reasonably assured of being entitled to the award fee based on its history with similar contracts that provide predictive experience. Factors to consider include, but are not limited to: The contractor has a long history of performing this type of work It is largely within the contractor's control to complete the work before the holiday travel season The uncertainty will be resolved within a relatively short period of time This should not result in a significant change from todays accounting for variable consideration in many E&C contracts.
Example 3 - Claims
Facts: Assume the same fact pattern as Example 2, except that due to reasons outside of the contractor's control (for example, owner-caused delays), the cost of the contract far exceeds original estimates (but a profit is still expected). The contractor submits a claim against the owner to recover a portion of these costs. The claim process is in its early stages, but the contractor has a long history of successfully negotiating claims with owners, albeit sometimes at a discount from the amount sought. How should the contractor account for the claim?
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Discussion: Claims are highly susceptible to external factors (such as the judgment of or negotiations with third parties), and the possible outcomes are highly variable. The contractor may have experience in successfully negotiating claims, but it might be challenging to assert that such experience has predictive value in this fact pattern (because of the highly uncertain variables). The contractor might therefore conclude that it is not reasonably assured of being entitled to receive such a claim in the early stages. The amount of the claim is included in the transaction price when initiated using either a probability-weighted approach or most likely outcome amount (whichever is more predictive), but it cannot be recognized until the contractor is reasonably assured of being entitled to receive the claim. This is likely to occur at a date closer to the date the claim is expected to be resolved.
Accounting for multiple performance obligations

Performance obligations are defined as promises to deliver goods or perform services. Contractors often account for each contract at the contract level today; that is, contractors account for the macro-promise in the contract (for example, to build a road or build a refinery). Current guidance permits this approach, although a contractor effectively promises to provide a number of different goods or perform a number of different services in delivering such macro-promises. Determining when to separately account for these performance obligations under the proposed model is a key determination and will require a significant amount of judgment. It is possible to account for the contract at the contract level (for example, the macro-promise to build a road) under the proposed model when the criteria for combining a bundle of goods or services into one performance obligation. We expect, however, that contractors might have to separately account for more obligations within each contract compared to current guidance. Significant judgment will be needed, for example, in the case of engineering, procurement, and construction (EPC) contracts. Proposed model Performance obligations separation An entity should separately account for performance obligations only if the pattern of transfer is different and they are distinct. A good or service is distinct if either of the following criteria are met: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with other readily available resources An entity should account for two or more performance obligations as a single performance obligation when the following criteria are met: The goods or services are highly interrelated The entity provides a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted The basic presumption is that each contract is the profit center for revenue recognition, cost accumulation, and income measurement. That presumption may be overcome only if a contract or a series of contracts meets the conditions described above for combining or segmenting contracts. There is no further guidance for separately accounting for more than one deliverable in a construction contract under the construction contract guidance. The basic presumption is that each contract is the profit center for revenue recognition, cost accumulation, and income measurement. That presumption is overcome when a contract or a series of contracts meets the conditions described for combining or segmenting contracts. There is no further guidance around separately accounting for more than one deliverable in a construction contract. Current U.S. GAAP Current IFRS
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Proposed model The bundle of goods or services is significantly modified or customized to fulfil the contract Goods and services that are not distinct and therefore, not separate performance obligations, should be combined with other performance obligations until the entity identifies a bundle of goods or services that is distinct.
Current U.S. GAAP
Current IFRS
Key change from the 2010 Exposure Draft: The boards have clarified the principle for when to separately account for performance obligations. They have now provided guidance for situations when it may be necessary to account for a promised bundle of goods or services as a single performance obligation in an effort to better reflect the economics of certain long-term contracts. We believe contractors might have to separately account for more obligations within each contract compared to current guidance notwithstanding this additional guidance.
Example 4 - Construction management contract

Facts: A contractor enters into a construction contract with an owner to provide construction management services, overseeing the construction of a new airport runway. How many performance obligations is the contractor required to separately account for? Discussion: The contractor is only providing the construction management service to supervise and coordinate the construction activity on the project and might only have one performance obligation in this example.
Allocating the transaction price

The transaction price, once determined, is allocated to the performance obligations in a contract that require separate accounting. We expect that contractors might have to separately account for more performance obligations than today if the risks of providing two or more goods or services are not largely inseparable (as described above), so the allocation of the transaction price (i.e., contract revenue) will be new to many E&C companies. Of particular interest will be the allocation of variable consideration (for example, award or incentive payments) associated with only one separate performance obligation, rather than the contract as a whole. The boards have proposed that, when certain conditions are met, an entity can allocate the transaction price entirely to one (or more) performance obligations. This would be relevant, for example, for contracts that have incentive payments wholly tied to only one performance obligation (for example, a bonus award associated with only the build component of a design/build contract). Proposed model Allocating the transaction price The transaction price (and any subsequent changes in estimate) is allocated to each separate performance obligation based on relative standalone selling price. The best evidence of a standalone selling price is the Except for allocation guidance related to contract segmentation, there is no explicit guidance on allocating contract revenue to multiple deliverables in a construction contract, given the presumption that the contract is the Except for allocation guidance related to contract segmentation, there is no explicit guidance on allocating contract revenue to multiple deliverables in a construction contract, given the presumption that the contract is the Current U.S. GAAP Current IFRS
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Proposed model observable price of a good or service when sold separately. The standalone selling price should be estimated if the actual selling price is not directly observable. An estimation method is not prescribed in the proposed guidance. For example, a contractor might use cost plus a reasonable margin in estimating the selling price of a good or service. An entity should maximize the use of observable inputs when estimating the standalone selling price. Entities may use a residual technique to estimate the standalone selling price (i.e., total transaction price less the standalone selling prices, actual or estimated, of other goods or services in the contract) if the standalone selling price of a good or service is highly variable or uncertain. An entity may also allocate a discount or an amount of contingent consideration entirely to one (or more) performance obligations if certain conditions are met.
Current U.S. GAAP profit center for determining revenue recognition.
Current IFRS profit center for determining revenue recognition.
Example 5 - Allocating contract revenue to more than one performance obligation

Facts: A contractor enters into a contract to build both a road and a bridge (assume for this example that there are only two performance obligations: to build the road and to build the bridge). The contractor determines at inception that the contract price is $150 million, which includes a $140 million fixed price and an estimated $10 million of award fees. The amount of the award fee is variable depending on how early the contractor finishes the entire project. The contractor will receive a base award fee if it finishes the entire project 30 days ahead of schedule. The award fee is increased (decreased) by 10% for each day before (after) the 30 days it finishes the project. The contractor has experience with similar contracts and has determined that it is reasonably assured of being entitled to an award fee of $10 million using a probabilityweighted estimate approach. How should the contractor allocate the contract price to the two separate performance obligations? Discussion: A contractor must first assign a standalone selling price to both the road and the bridge in order to allocate the contract price (including both the fixed and variable amounts). The contractor typically constructs both roads and bridges of a similar type and nature to those required by the contract on a stand-alone basis. The stand-alone selling price to build this road, based on prior experience, is $140 million. The stand-alone selling price to build this bridge, based on prior experience, is $30 million. There is an inherent discount of $20 million built into the bundled contract. The $150 million transaction price is allocated as follows using a relative allocation model: Road: Bridge: $124m ($150m * ($140m / $170m)) $ 26m ($150m * ($ 30m / $170m))
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Example 6 - Allocating contract revenue to more than one performance obligation - changes in the transaction price
Facts: Assume the same fact pattern as Example 5 above, except that the amount of variable consideration changes from an expected $10 million to an expected $12 million after contract inception. The amount of the award fee relates to the contractor's ability to finish the contract as a whole ahead of schedule and not specifically to the completion of either the road or bridge ahead of schedule. How should the contractor allocate the change in the estimated contract price? Discussion: The basis for allocating the transaction price to performance obligations (i.e., the percentage used to allocate based on relative standalone selling prices) is not changed after contract inception. The additional $2 million of contract price would be allocated to the road and bridge using the initially developed allocation percentages as follows: Road: Bridge: $1.6m ($2m * ($140m / $170m)) $0.4m ($2m * ($ 30m / $170m))
Such changes are recognized using a cumulative catch-up approach. For example, if the road was 90% complete and work on the bridge had not yet commenced at the time of the change in estimate, the contractor would recognize revenue of $1.44m ($1.6m x 90%) for the portion of the performance obligation already satisfied for the road. The contractor would recognize additional revenue of $0.56m as the remaining performance obligations related to the road ($0.16m = $1.6m x 10%) and bridge ($0.4m = $0.4m x 100%) are satisfied.
Recognize revenue
Revenue recognition under existing guidance is based on the activities of the contractor; that is, provided reasonable estimates are available, revenue can be recognized as the contractor performs (known as the percentage-of-completion method). The boards have proposed that revenue is recognized upon the satisfaction of a contractor's performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or over time. The change to a control transfer model will require careful assessment of when a contractor can recognize revenue. We expect that many construction-type contracts will transfer control of a good or service over time and therefore, might result in a similar pattern of revenue recognition compared to todays guidance . This should not, however, be assumed. Contractors will not be able to default to the method used today and a careful assessment of when control transfers will need to be performed. A cost-to-cost input method may be used today, for example, to measure revenue under an activities-based recognition model. The measure of progress toward satisfaction of a performance obligation under the proposed model should depict the transfer of goods or services to the customer. A cost-to-cost input method might not be the most appropriate measure of the extent to which control has transferred when a performance obligation is satisfied over time under the proposed model. Proposed model Transfer of control Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or, perhaps most important for the E&C industry, over time. A performance obligation is satisfied over time when at least one of the following criteria is met: Revenue is recognized using the percentage-of-completion method when reliable estimates are available. The percentage-of-completion method based on a zero-profit margin is used when reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (for example, when the scope of the contract is ill-defined, but the contractor is protected from an overall Revenue is recognized using the percentage-of-completion method when reliable estimates are available. The percentage-of-completion method based on a zero-profit margin is used when reliable estimates cannot be made, but there is assurance that no loss will be incurred on a contract (for example, when the scope of the contract is ill-defined, but the contractor is protected from an overall Current U.S. GAAP Current IFRS
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Proposed model
Current U.S. GAAP
Current IFRS loss) until more precise estimates can be made. Contract costs that are not probable of being recovered are recognized as an expense immediately. The completedcontract method is prohibited.
The entity's performance creates or loss) until more precise estimates can be made. enhances an asset that the customer controls; or The completed-contract method is The entity's performance does not required when reliable estimates create an asset with alternative use cannot be made. to the entity and at least one of the following:
-
The customer simultaneously receives and consumes the benefits as the entity performs, Another entity would not need to substantially reperform the work performed to date if that other entity were required to fulfil the remaining obligation to the customer, or The entity has a right to payment for performance completed to date.
A performance obligation is satisfied at a point in time if it does not meet the criteria above. Determining when control transfers will require a significant amount of judgment. Indicators that might be considered in determining whether the customer has obtained control of an asset at a point in time include: The entity has a present right to payment The customer has legal title The customer has physical possession The customer has the significant risks and rewards of ownership The customer has accepted the asset This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a stand-alone basis.
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Proposed model Measuring performance obligations satisfied over time A contractor should measure progress towards satisfaction of a performance obligation that is satisfied over time using the method that best depicts the transfer of goods or services to the customer. Methods for recognizing revenue when control transfers over time include: Output methods that recognize revenue on the basis of direct measurement of the value to the customer of the entity's performance to date (for example, surveys of goods or services transferred to date, appraisals of results achieved). Input methods that recognize revenue on the basis of the entity's efforts or inputs to the satisfaction of a performance obligation (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities). The method selected should be applied consistently to similar contracts with customers. Once the metric is calculated to measure the extent to which control has transferred, it must be applied to total contract revenue to determine the amount of revenue to be recognized. The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if goods are transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials). Estimates to measure the extent to which control has transferred (for example, estimated costs to complete
Current U.S. GAAP
Current IFRS
A contractor can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. There are two different approaches for determining revenue, cost of revenue, and gross profit once a "percentage complete" is derived: the Revenue method and the Gross Profit method.
A contractor can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. IFRS requires the use of the Revenue method to determine revenue, cost of revenue, and gross profit once a "percentage complete" is derived. The Gross Profit method is not permitted.
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Proposed model when using a cost-to-cost calculation) should be regularly evaluated and adjusted using a cumulative catch-up method.
Current U.S. GAAP
Current IFRS
Key change from the 2010 Exposure Draft: The 2010 exposure draft had limited guidance on determining when control transfers over time. The boards added the criteria above to determine when a performance obligation is satisfied over time in response to feedback that the original guidance was difficult to apply in certain situations, such as service arrangements.
Example 7 - Recognizing revenue

Facts: A contractor enters into a construction contract with an owner to build an oil refinery. The contract has the following characteristics: The oil refinery is highly customized to the owner's specifications and changes to these specifications by the owner are expected over the contract term. The oil refinery does not have an alternative use to the contractor. Non-refundable, interim progress payments are required as a mechanism to finance the contract. The owner can cancel the contract at any time (with a termination penalty); any work in process is the property of the owner. As a result, another entity would not need to reperform the tasks performed to date. Physical possession and title do not pass until completion of the contract. The contractor determined that the contract is a single performance obligation to build the refinery. How should the contractor recognize revenue? Discussion: The preponderance of evidence suggests that the contractor's performance creates an asset that the customer controls and control is being transferred over time. The contractor will have to select either an input or output method in this case to measure the progress towards satisfying the performance obligation.
Example 8 - Recognizing revenue - use of cost-to-cost

Facts: Assume the same fact pattern as Example 7 above. Additional contract characteristics are: Contract duration is three years Total estimated contract revenue is $300 million Total estimated contract cost is $200 million Year one cost is $120 million (including $20 million related to contractor caused inefficiencies) The contractor has concluded that cost-to-cost is a reasonable method for measuring the progress toward satisfying its performance obligation. How much revenue and cost should the contractor recognize during the first year?
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Discussion: The contractor should exclude any costs that do not depict the transfer of goods or services in determining the amount of revenue to be recognized under a cost-to-cost model. The costs associated with contractor caused inefficiencies would be excluded in this situation. The amounts of contract revenue and cost recognized at the end of year one are: Revenue: Contract cost (excluding inefficiencies): Gross contract margin: Contract inefficiencies: Adjusted contract margin: $150m ($300m * ($100m / $200m)) $100m $ 50m $ 20m $ 30m
Example 9 - Recognizing revenue - use of cost-to-cost with changes in estimates

Facts: Assume the same fact pattern as Examples 7 and 8 above, except that total estimated cost to complete the contract increases at the end of the second year to $250 million due to an increase in the cost of materials. Actual cumulative cost incurred as of the end of the second year (excluding year-one inefficiencies) is $200 million. How much revenue and cost should the contractor recognize during the second year? Discussion: The amount of contract revenue and cost recognized during the second year: Cumulative revenue: Revenue recognized year one: Revenue recognized year two: Cumulative costs (excluding inefficiencies): Costs recognized year one (excluding inefficiencies): Costs recognized year two: (excluding inefficiencies): Gross contract margin year two: Gross contract margin to-date (excluding inefficiencies): Adjusted contract margin to-date: $240m ($300m * ($200m / $250m) $150m $ 90m $200m $100m $100m $ (10m) ($90m - $100m) $ 40m ($240m - $200m) $ 20m ($240m - $200m - $20m)
Warranties
Most warranties in the construction industry provide coverage against latent defects. There is currently diversity in the way E&C companies account for these and other types of warranties. We expect practice to become less diverse and potentially change significantly for some entities in this area, resulting in delayed revenue recognition and complex accounting calculations for certain of these warranties. Proposed model Warranties Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. Contractors typically account for warranties that protect against latent defects outside of contract accounting and in accordance with existing loss contingency guidance. A contractor recognizes revenue and concurrently accrues any expected cost for these Contractors are required to account for the estimated costs of rectification and guarantee work, including expected warranty costs, as contract costs. However, contractors typically (due to materiality considerations) account for standard warranties protecting against Current U.S. GAAP Current IFRS
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Proposed model The warranty is accounted for as a cost accrual if a customer does not have the option to purchase a warranty separately from the entity.
Current U.S. GAAP warranty repairs.
Current IFRS latent defects outside of contract accounting and in accordance with existing provisions guidance. A contractor will recognize revenue and concurrently accrue any expected cost for these warranty repairs. Revenue is deferred for warranties that protect against defects arising through normal usage (that is, extended warranties) and recognized over the expected life of the contract.
Revenue is deferred for warranties that protect against defects arising through normal usage (that is, extended An entity might provide a warranty that warranties) and recognized over the calls for a service to be provided to the expected life of the contract. customer (for example, maintenance) in addition to a promise that the entitys past performance was as specified in the contract. The entity will account for the service component of the warranty as a separate performance obligation in these circumstances.
Key change from the 2010 Exposure Draft: The boards originally proposed that all types of warranties, including those that provide assurance that the good or services is as specified in the contract, be accounted for as a deferral of revenue. The accounting for warranties as a separate performance obligation is now based primarily on whether the customer has the option to purchase the warranty separately and if it provides a service in addition to providing assurance that the entity's past performance was as specified in the contract, which is more aligned with todays accounting.
Example 10 - Accounting for warranties

Facts: Assume the same fact pattern as Example 7 above. The contractor also provides a warranty that covers latent defects for certain components of the oil refinery. This warranty is automatically provided by the contractor and the customer does not have an option to purchase the warranty separately from the contractor. How would the contractor account for such a warranty? Discussion: The contractor would account for this warranty as a cost accrual. Contractors who determine that cost-to-cost is an appropriate method to measure transfer of control over time might therefore have to consider these costs in their cost-to-cost calculation.
Contract costs
Existing construction contract guidance contains a substantial amount of cost capitalization guidance, both related to precontract costs and costs to fulfil a contract. The proposed standard also includes contract cost guidance that could result in a change in the measurement and recognition of contract costs as compared to today (in particular for those contractors that currently use the Gross Profit method for calculating revenue and cost of revenue). Proposed model Contract costs All costs related to satisfied performance obligations and costs related to inefficiencies (i.e., abnormal costs of materials, labor, or other costs to fulfil) are expensed as incurred. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had There is a significant amount of detailed guidance relating to the accounting for contract costs within the construction contract guidance. This is particularly true with respect to accounting for pre-contract costs. There is a significant amount of detailed guidance relating to the accounting for contract costs. Current U.S. GAAP Current IFRS
Costs that relate directly to a contract and are incurred in securing the contract are included as part of Pre-contract costs that are incurred for contract costs if they can be separately a specific anticipated contract generally identified, measured reliably, and it is
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Proposed model not been obtained and are recognized as an asset if they are expected to be recovered. As a practical expedient, such costs may be expensed as incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less. Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained (for example, certain bid costs) shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained. Direct costs of fulfilling a contract are accounted for in accordance with other standards (for example, inventory, intangibles, fixed assets) if they are within the scope of that guidance. Direct costs of fulfilling a contract are capitalized under the proposed standard if not within the scope of other standards if they relate directly to a contract, relate to future performance, and are expected to be recovered under the contract. Capitalized costs are amortized as control of the goods or services to which the asset relates is transferred to the customer, which may include goods or services to be provided under specific anticipated contracts (for example, a contract renewal).
Current U.S. GAAP may be deferred only if their recoverability from that contract is probable. Other detailed guidance on costs to fulfil a contract is also prescribed by current guidance.
Current IFRS probable that the contract will be obtained. Other detailed guidance on costs to fulfil a contract is also prescribed by current guidance.
Key change from the 2010 Exposure Draft: Costs to obtain a contract were to be expensed as incurred under the original exposure draft. The boards received feedback that certain costs to obtain a contract may meet the definition of an asset and should be capitalized. The guidance was therefore revised to require recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered (unless the amortization period of the asset that the entity otherwise would have recognized is one year or less). The boards clarified that costs to fulfil a contract are in the scope of the revenue guidance only if they are not addressed by other standards and that the costs of abnormal amounts of materials, labor, and other resources that were not considered in the price of the contract should be recognized as an expense when incurred.
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Example 11 - Accounting for contract costs

Facts: Assume the same fact pattern as Example 8 above. At the beginning of the contract, the contractor incurs certain mobilization costs amounting to $1 million. The contractor has concluded that such costs should not be accounted for in accordance with existing asset standards (for example, inventory, fixed assets, or intangible assets). How should the mobilization costs be accounted for? Discussion: These costs to fulfil a contract would be capitalized if they: (a) relate directly to the contract; (b) relate to future performance; and (c) are expected to be recovered. Assuming the mobilization costs meet these criteria and are capitalized, $500,000 would be amortized as of the end of year one (coinciding with 50 percent control transfer using a cost-to-cost method) using the fact pattern in Example 8 above.

Existing construction contract guidance requires a loss to be recorded when the expected contract costs exceed the total anticipated contract revenue. E&C entities might be impacted by the proposed guidance in two ways. First, the proposed standard requires entities to assess performance obligations satisfied over a period of time greater than one year to determine whether they are onerous. The determination of anticipated losses will not be assessed at the contract level. E&C entities might need to recognize an onerous loss on an overall profitable contract if that contract contains separate performance obligations (for example, a design / build contract) and one of the performance obligations is determined to be onerous. Second, a performance obligation is onerous under the proposed standard if the lowest cost of settling the performance obligation, including the cost to exit the performance obligation, exceeds the amount of transaction price allocated to that performance obligation. Factoring in the cost to exit the performance obligation if lower than the remaining direct cost to fulfil it might result in fewer loss provisions recorded (or a decrease in the amount of a loss recorded in some cases) as compared to existing practice. Proposed model Onerous performance obligations An entity will recognize a liability and a corresponding expense if a performance obligation that is satisfied over a period of time greater than one year is onerous. A performance obligation is onerous if the lower of (a) the costs that relate directly to satisfying the performance obligation by transferring the promised goods or services, and (b) the amount the entity would pay to exit the performance obligation exceeds the amount of the transaction price allocated to that performance obligation. Contracts within the scope of construction contract accounting are evaluated at the contract level. A provision for a loss on a contract is made when the current estimates of total contract revenue and contract cost indicate a loss. Contracts within the scope of construction contract accounting are assessed at the contract level. The expected loss is recognized when it is probable that total contract costs will exceed total contract revenue. Current U.S. GAAP Current IFRS
Key change from the 2010 Exposure Draft: Onerous performance obligations were to be evaluated at the performance obligation level for all performance obligations under the original exposure draft. The boards changed the guidance in response to concerns about the unintended consequences of this provision so that it only applies to performance obligations satisfied over a period of time greater than one year. Performance obligations satisfied at a point in time are not subject to the onerous test under the revised exposure draft.
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Final thoughts
The above commentary is not all inclusive. Other potential changes include, for example, the accounting for options to obtain additional goods or services and a significant expansion in disclosure requirements (with certain disclosure exceptions for private companies). The effective date of the final standard is likely to be no earlier than 2015 or 2016. The proposed standard requires retrospective application, but allows for certain practical expedients. The practical expedients are intended to reduce the burden on preparers by (a) not requiring the restatement of contracts for comparative periods that began and ended in the same accounting period; (b) allowing the use of hindsight in estimating variable consideration; (c) not requiring the onerous test to be performed in comparative periods unless an onerous contract liability was recognized previously; and (d) not requiring disclosure of the maturity analysis of remaining performance obligations in the first year of application. The FASB has proposed to prohibit early adoption, while the IASB has proposed to permit early adoption. Companies should continue to evaluate how the model might change current business activities, including contract negotiations, key metrics (including debt covenants, surety, and prequalification capacity calculations), budgeting, controls and processes, information technology requirements, and accounting.
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Authored by:
H. Kent Goetjen U.S. Engineering and Construction Leader Phone: +1 (860) 241-7009 Email: h.kent.goetjen@us.pwc.com Jonathan Hook Global Engineering and Construction Leader Phone: +44 (0) 20 780 44753 Email: jonathan.hook@uk.pwc.com Dusty Stallings Partner Phone: +1 (973) 236-4062 Email: dusty.stallings@us.pwc.com Michael Sobolewski Senior Manager Phone: +1 (313) 394-3299 Email: michael.sobolewski@us.pwc.com Jason Aeschliman Senior Manager Phone: +1 (973) 236-4983 Email: jason.a.aeschliman@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Entertainment and media industry supplement

No. 2011-35 (supplement) December 6, 2011 Whats inside: Overview .......................... 1 Licenses and rights to use ............................. 2 Variable consideration... 5 Accounting for multiple performance obligations .....................7 Options to acquire additional goods or services .................... 9 Accounting for return rights ........................... 11 Contract costs ................ 12 Player points / promotion programs .. 15
Entertainment and media industry supplement

Overview
The entertainment and media industry includes various subsectors, such as filmed entertainment, television, music, video games, publishing, radio, internet, and gaming. Each subsector has unique product and service offerings, and, in certain subsectors, industry-specific revenue recognition guidance exists under U.S. GAAP. IFRS does not have industry-specific guidance. The following items common in the entertainment and media industry may be significantly affected by the proposed revenue recognition standard. This paper, the examples, and the related assessments contained herein, are based on the Exposure Draft, Revenue from Contracts with Customers, which was issued on November 14, 2011. These proposals are subject to change until a final standard is issued. The examples reflect the potential effect based on the proposed standard and any conclusions noted are subject to further interpretation and assessment based on the final standard. We have also provided a highlevel summary of key changes from the original exposure draft issued on June 24, 2010 (the 2010 Exposure Draft). References to the proposed model or proposed standard refer to the exposure draft issued in November 2011 unless otherwise indicated. For a more comprehensive description of the proposed standard refer to PwC's Dataline 2011-35 (www.cfodirect.pwc.com) or visit www.fasb.org.
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Many entertainment and media companies license intellectual property to third parties. Such licenses might include the right to exploit a motion picture in various markets and territories or the right to exploit a character to be used in a video game or other consumer product. Under the 2010 Exposure Draft, revenue recognition for the license of intellectual property was dependent on whether the license was exclusive or non-exclusive. Proposed model A license is a right to use, but not own, intellectual property that is granted by an entity to the customer. The recognition of revenue for the license of intellectual property is a performance obligation that is satisfied when the customer obtains control of those rights. Control of rights to use intellectual property cannot be transferred prior to the beginning of the license period. Current U.S. GAAP Sale of episodic television series in syndication Current IFRS
IFRS does not contain any industryspecific accounting for media and entertainment entities. In general, Current guidance requires that the revenue should not be recognized following conditions be met prior to the under licensing agreements until recognition of revenue: performance under the contract has occurred and the revenue has been earned. Persuasive evidence of an arrangement exists The assignment of rights for a nonrefundable amount under a nonThe film is complete, has been cancellable contract permits the delivered, or is available for licensee to use those rights freely. The immediate delivery transaction is in substance a sale when the licensor has no remaining The license period has begun and obligations to perform. the customer can begin its exploitation, exhibition, or sale A fixed license term is an indicator that the revenue should be recognized over The arrangement fee is fixed or the period because the fixed term determinable suggests that the license's risks and Collection of the arrangement fee is rewards have not been transferred to the customer. However, the following reasonably assured indicators should be considered in Delivery may occur on a daily or weekly determining whether a license fee should be recognized over the term or basis, even though all of the episodes are complete and ready for delivery, in upfront: order to allow for the insertion of advertisements into the filmed product. A contractual provision allowing the producer to insert its national advertising spots is not considered a provision that would preclude revenue recognition. The net present value of the entire syndication contract is recognized as revenue upon commencement of the license term if the criteria above are met. Licenses and right to use motion pictures It is common in certain international territories for a producer to license a film to a counterparty in several markets, such as theatrical, home video, and television. Such contracts Fixed fee or non-refundable guarantee The contract is non-cancellable Customer is able to exploit the rights freely Vendor has no remaining performance obligations When receipt of a license fee or royalty is contingent on the occurrence of a future event, revenue is recognized only when it is probable that the fee or royalty will be received, which is normally when the event has occurred.
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Proposed model
Current U.S. GAAP typically have predefined dates when the title can be exploited in each of the markets. Each contract also typically specifies an overall minimum guaranteed payment that may be paid up front or be allocated to the various components by market. For amounts allocated to the various markets, revenue is generally recognized as each market becomes available. Although current practice is mixed, generally the license fee is allocated to the various markets (for example, theatrical, home video, and television) on a relative fair value basis and revenue is recognized when the market is contractually available for exploitation. Licenses to use a record master or music copyright The license of a record master or music copyright may be considered an outright sale if the licensor has signed a non-cancellable contract, has agreed to a fixed fee, has delivered the rights (as well as the recording) to the licensee, and has no remaining significant obligations to furnish music or records (that is, contracted recordings have been transferred). The earnings process is complete and the licensing fee is recorded as revenue if the license is, in substance, an outright sale and if collectibility is reasonably assured. If the licensor is unable to determine the amount of the license fee earned (that is, the license allows for a continued amount of additional music to be provided), the consideration received should be recognized as revenue equally over the remaining performance period, which is generally the period covered by the license agreement.
Current IFRS
Impact: Careful consideration will need to need to be given to what represents the performance obligation (for example, an episode or the series) and when control is transferred for each obligation (that is, at inception or at some later point in the contract term). The timing of revenue recognition for the license of an episodic television series, filmed entertainment, and music is not anticipated to be significantly impacted by the proposed standard. That is, in many cases, revenue for a license of intellectual property (IP) will be recognized when the customer obtains control of the content and is able to exploit the IP.
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Proposed model
Current U.S. GAAP
Current IFRS
The licensor should estimate any variable consideration in determining the transaction price. Revenue would be recognized when the entity is reasonably assured of being entitled to the fee, which could affect the timing of revenue recognition. The licensor is not reasonably assured to be entitled to an amount of consideration from a license arrangement that is dependent on the customer's subsequent sales until those future sales occur.
Key changes from the 2010 Exposure Draft: The distinction made in the 2010 Exposure Draft between nonexclusive and exclusive licenses was eliminated during redeliberations based on feedback received by the boards. Respondents believed that revenue should be recognized when the performance obligation is satisfied regardless of whether the license is exclusive or non-exclusive. Revenue is recognized for a license that is a separate performance obligation when the customer controls and can use the intellectual property of the entity.
Example #1 - Sale of episodic television series in syndication

Facts: Studio XYZ licenses 100 of its completed episodes of an episodic television series to a cable channel for a four-year period commencing January 1, 20XX on an exclusive basis in the U.S. The cable channel pays an annual fee of $4 million in equal monthly installments and is contractually obligated to air this program each weeknight. Additionally, Studio XYZ has the right to insert two 30-second advertising spots into each airing of the show. How should Studio XYZ account for the license fee? Discussion: Today, the net present value of the payment stream is recognized as revenue when the series is available for exploitation by the cable channel. Consistent with current practice, revenue will be recognized under the proposed standard once the licensee obtains control of the property (that is, the content is available for exploitation). The impact of the time value of money will need to be assessed if the contract includes a significant financing component as the content is delivered at the beginning of the license period while the payments are made throughout the contract term.
Example #2 - Licenses and rights to use motion pictures

Facts: Studio Zed licenses certain international windows for Film A to a customer for a ten-year period in return for $10 million to be paid as follows: $4 million on theatrical availability; $4 million on the date six months after the theatrical release date (which is also the home video availability date), and $2 million one year after the theatrical release date (which is also the television availability date). The arrangement prohibits Studio Zed from licensing Film A to other parties in the same markets and territory during the original license term. How should Studio Zed account for the license fee? Discussion: Studio Zed will need to determine if one license (that is, a ten-year license for multiple windows - theatrical, home video, and television) is granted to the customer or if three distinct licenses are granted (that is, a license for each release theatrical, home video, and television). Assuming Studio Zed determines that each release is a distinct license, the transaction price of $10 million would be allocated to each license based on their relative standalone selling prices. Revenue allocated to each distinct license would be recognized once the licensee obtains control of the content and is able to exploit it under the terms of the agreement.
Example #3 - Non-exclusive license of record master or music copyright

Facts: Record Label enters into a non-exclusive license agreement with a retailer. The license allows the retailer to use Song X for two years in commercials produced by the retailer. The terms of the agreement do not require Record Label to provide the retailer with any additional content or deliverables. How should Record Label account for the license agreement? Discussion: Because Record Label has no further performance obligations under the terms of the agreement, revenue would be recognized once control of the license was obtained by the retailer as that is when the retailer can exploit Song X under the agreement.
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Variable consideration
Many arrangements in the entertainment and media industry include minimum guaranteed payments with additional potential variable consideration in the form of royalties or other incremental payments. Management will need to assess variable consideration in determining the transaction price to be allocated to the performance obligations. Proposed model The transaction price is the amount of consideration that an entity expects to be entitled to in exchange for transferring goods or services to the customer, excluding amounts collected on behalf of third parties (for example, sales taxes). Current U.S. GAAP International sales of films for a minimum guarantee and potential variable upside consideration Current IFRS Revenue is recognized for a license fee or royalty that is contingent on the occurrence of a future event only when the revenue is reliably measurable and it is probable that the fee or royalty will be received, which may be when the event has occurred. Revenue would be recognized when the license is available for exploitation if the license fee or royalty is probable of being received and is reliably measurable.
A licensee may commit to pay a minimum non-refundable license fee up front in a licensing arrangement. The licensor may also include a The transaction price, including any provision stipulating that the licensor variable amounts, must be estimated at is entitled to a percentage of the contract inception and at each licensee's revenues once the variable reporting period. Any variable rate exceeds the amount of the fixed consideration should be estimated minimum guarantee. using either the expected value (based on the sum of probability-weighted The revenue associated with a nonamounts) or the most likely amount, refundable fixed minimum guarantee whichever is most predictive of the would be allocated to each market amount to which the entity will be being licensed on a relative selling price entitled. basis, and would generally be recognized once the license for that market is available for the licensee, presuming all of the revenue recognition conditions have been met. Any amounts to be paid by a licensee in excess of a fixed non-refundable minimum guarantee payment would typically be recognized by the licensor once the variable fee exceeds the total minimum guarantee (that is, the contingency is resolved). Minimum guarantees associated with a record master or music copyright Minimum guarantees received in advance by the licensor are initially reported as a liability and are recognized as revenue as the license fee is earned. If the amount of the license fee earned cannot be determined, the guarantee is recognized as revenue on a straight-line basis over the license term. Impact:
The licensor should estimate the amount of consideration it will be entitled to, including any variable consideration, in determining the transaction price. The recognition of consideration that includes variable amounts is recognized when control passes to the customer if the entity is reasonably assured to be entitled to the variable amount. The requirement to estimate variable consideration will require licensors to make subjective estimates of the transaction price that may not have been made in the past.
Dataline
Proposed model
Current U.S. GAAP
Current IFRS
Revenue recognition that is currently restricted to only the non-contingent amount could change significantly under the proposed model, depending on the nature of the contingency. However, the proposed standard is not expected to significantly affect the timing of revenue recognition for licenses that involve variable amounts based on sales-based royalties (for example, revenue based on a percentage of product sold by a digital service provider or another third party). These amounts generally will not be recognized prior to the uncertainty being resolved.
Key changes from the 2010 Exposure Draft: The original exposure draft allowed for revenue recognition of variable amounts without constraint provided "the transaction price can be reasonably estimated." The recognition of variable amounts will now be limited to "the amount to which the entity is reasonably assured to be entitled." The transaction price will still include an estimate of variable consideration for allocation purposes similar to the 2010 Exposure Draft. Previously, this estimate was based on a probability-weighted amount. The boards received feedback that a probability-weighted approach would not be appropriate in some circumstances and as a result, changed the requirement to the more predictive of either a probability-weighted or most likely amount.
Example #4 - Licenses and rights to use motion pictures

Facts: Studio Zed enters into a contract with a customer to license certain international windows for Film A for a ten-year period in return for a minimum guarantee of $10 million plus a royalty of 10% of revenues once total revenues from exploitation of Film A exceed $100 million. The guarantee is to be paid as follows: $4 million on theatrical availability, $4 million on the date six months after the theatrical release date (which is also the home video availability date), and $2 million one year after the theatrical release date (which is also the television availability date). The arrangement prohibits Studio Zed from licensing Film A to other parties in the same markets and territory during the original license term. How should Studio Zed account for the royalty revenue? Discussion: Variable consideration is generally recognized today once the amount is earned. Variable consideration should be included in the transaction price under the proposed standard and be allocated to the separate performance obligations based on the relative estimated selling price approach, but only recognized once the entity is reasonably assured of being entitled to it. Studio Zed would not recognize the revenues associated with the royalty until they are received, as the amount is dependent on sales derived by the customer. That is, Studio Zed is not reasonably assured to be entitled to the royalty revenues until the subsequent sales occur by the licensee.
Example #5 - Non-exclusive license of record master or music copyright

Facts: Record Label enters into an agreement with a digital service provider to license the full catalog of Record Label's music content for five years. Under the terms of the agreement, the digital service provider will be entitled to current content plus any new music content added to the catalog. The terms of the license include a non-refundable minimum guarantee payable at contract inception plus a portion of future sales (that is, downloads) in excess of the minimum guarantee. How should Record Label account for license fees? Discussion: Currently, upfront revenue recognition is precluded as the label is required to provide new content throughout the term of the license agreement. Under the proposed standard, the timing of revenue recognition may change. Record Label will need to identify all performance obligations in the contract and allocate total estimated consideration to the content currently available and the content anticipated to be available during the term. Breakage will need to be considered for revenue allocated to future content. Consideration associated with the sales-based royalty will be recognized once Record Label is reasonably assured of being entitled to the amount, which will be when the future sales occur.
Dataline

Performance obligations are defined as a promise to deliver goods or perform services. Determining when to separately account for these performance obligations under the proposed standard is a key determination and could require a significant amount of judgment. Management will need to determine whether performance obligations in a contract need to be accounted for separately from other performance obligations in the contract. The separation criteria might result in more performance obligations being identified than under current practice. Proposed model The model requires performance obligations that are "distinct" to be accounted for separately (assuming the performance obligations are delivered at different times). A good or service is distinct and should be accounted for separately if the entity regularly sells the good or service separately or the customer can benefit from the good or service either on its own or together with other resources readily available to the customer. A promised bundle of goods or services should be accounted for as one performance obligation if the bundled goods or services are highly interrelated such that integration services are provided and the bundled goods or services are significantly modified or customized. Current U.S. GAAP Additional functionality included in software products, including video games Certain software products (for example, console video games) provide additional functionality (such as online services and multi-player functionality) in addition to the core software. Management must assess whether the services are incidental to the overall product and is therefore an inconsequential deliverable in such arrangements. Current IFRS An entity should apply the revenue recognition criteria to each separately identifiable component of a single transaction if necessary to reflect the transaction's substance. The customer's perspective is important in determining whether the transaction should be accounted for as one element or multiple-elements. The arrangement might be accounted for as one transaction if the customer views the purchase as one element.
When elements in a single contract are accounted for separately, fair value should be used in allocating the transaction price to the separate elements. Entities would not be precluded from separating elements in a single contract if the elements are not Revenue is generally recognized ratably sold separately. over the estimated service period when the functionality is more than Impact: Multiple-element inconsequential. This is because arrangements accounted for under vendor-specific objective evidence IFRS might be affected because the ("VSOE") of fair value typically does performance obligations will need to be not exist for the online functionality, as accounted for separately if they are it is not sold separately from the game. distinct. Further, the relative estimated selling price approach will be applied in Impact: Video game developers will allocating the transaction price to the need to determine whether the video separate performance obligations game and the additional services rather than the relative fair value should be accounted for as separate allocation. performance obligations under the proposed standard. Management will need to determine whether the game and additional services are distinct performance obligations. If they are distinct, the transaction price will be allocated to the separate performance obligations. Because the video game is typically delivered at a single point in time while the services are delivered over a future service period, the timing When the additional functionality is inconsequential, revenue is generally recognized at delivery (that is, upon the transfer of the risk and rewards to the customer).
Dataline
Proposed model
Current U.S. GAAP of revenue recognition might be affected. Software as a service in the video game industry Revenue from sales of software products playable on hosted servers on a subscription-only basis is generally recognized ratably over the estimated service periods, beginning when the software is activated and delivery of the related services begins. Impact: Contracts with only one performance obligation might not be significantly affected by the proposed standard. However, video game publishers will need to determine whether there are multiple performance obligations in a contract that provides for use of games through a hosted subscription model. Advertising arrangements Advertising arrangements often include more than one type of ad placement, ranging from print, to TV, to internet banners and impressions. Current guidance requires deliverables in contracts to be accounted for separately if each deliverable has stand-alone value. Impact: Advertisers will need to assess whether advertising contracts include more than one performance obligation. The separation criteria in the proposed standard might be less restrictive than current U.S. GAAP, which could result in more performance obligations being accounted for separately and affect the timing of revenue recognition. This change in the separation criteria might impact some entities more than others, depending on the approach currently applied.
Current IFRS
Key changes from the 2010 Exposure Draft: The basic principle of accounting for separate performance obligations has not changed from the 2010 Exposure Draft. The boards have provided additional guidance on when a bundle of goods or services could result in a single performance obligation in an effort to better reflect the economics of certain long-term contracts.
Dataline
The boards also revised the guidance for determining whether a performance obligation is distinct. The concept of a distinct profit margin was removed. The focus is now on whether the good or service is sold separately by the entity or whether the good can be used with other resources readily available to the customer.
Example #6 - Online functionality included in software products

Facts: Company A develops and sells video games. The video games include additional services that enhance the user experience by allowing multi-player game formats and other online services. The additional services are not sold on a stand-alone basis by Company A. Company A has historically accounted for the sale of a video game with additional services that enhance the user experience together, recognizing revenue for both the game and the services over the service period. How should Company A account for the sale of the video game and services? Discussion: Company A will need to determine if the video game and the additional services are distinct and thus, should be accounted for separately under the proposed standard. If the game and additional services are not distinct because the game cannot be used without the online services, then the contract should be accounted for as one performance obligation consistent with current practice. Revenue would be recognized over the service period.
Example #7 - Advertising arrangements

Facts: Advertiser A provides multiple forms of internet advertising to customers, including impression-based advertising and activity-based advertising both in stand-alone and in bundled arrangements. Advertiser A enters into a contract with Customer X to provide three advertising campaigns. Advertiser A will provide 100,000 click-throughs, two banners, and 50,000 impressions during the term of the contract. The total arrangement consideration is $100,000. Advertiser A has established a rate card that is to be used as a starting point in negotiating pricing. However, discounts are commonly granted to customers and the range of pricing is not consistent. Advertiser A has historically accounted for the deliverables as one unit of account when sold on a combined basis due to the inconsistency in pricing of the individual elements. How should Advertiser A account for the advertising revenue? Discussion: Advertiser A will need to consider whether the advertising campaigns included in the contract should be accounted for separately. Assuming the campaigns are delivered at different times, Advertiser A will need to assess whether the ad campaigns are distinct performance obligations. Because the ad spots are sold separately and are not dependent on one another, they are distinct and thus, the transaction price is allocated to each of the three campaigns based on their relative estimated selling prices. Revenue is recognized as the ad spots are delivered during the campaign.
Options to acquire additional goods or services

An entity may grant a customer the option to acquire additional goods or services. Often such options provide a discount on subsequent purchases. It is not uncommon in filmed entertainment to include the option to renew a series for incremental seasons. Licensors will need to determine if that promise gives rise to a material right to the customer in order to determine the appropriate accounting for the option. Proposed model An option to acquire additional goods or services gives rise to a separate performance obligation in the contract if the option provides a material right to the customer that the customer would not receive without entering into that contract. Management will need to estimate the transaction price to be allocated to the separate performance obligations based on the estimated Current U.S. GAAP Options to renew a series for incremental seasons Producers of episodic television series often enter into licensing agreements that allow the licensee to license additional seasons. The option to acquire additional seasons is usually considered to be at Current IFRS The recognition criteria are usually applied separately to each transaction (that is, the original purchase and the separate purchase associated with the option). However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction.
Dataline
Proposed model standalone selling price of the option as, in effect, the customer is paying for future goods or services to be received. Revenue is recognized for the option when it expires or when the future goods or services are transferred to the customer. An option to acquire additional goods or services at a price within a range of prices typically charged for those goods or services is not a material right even if the option can only be exercised because of entering into the previous contract. Such an option is considered a marketing offer. Impact:
Current U.S. GAAP fair value and no allocation of consideration is made to the option.
Current IFRS If an entity grants to its customers, as part of a sales transaction, an option to receive a discounted good or service in the future, the entity accounts for that option as a separate component of the arrangement and therefore allocates consideration between the initial good or service provided and the option.
Revenue will need to be allocated to the option and deferred until delivery of the second item or when the right expires if the producer determines that the pricing for the incremental seasons provide a material right to the licensee. Renewal contracts may provide a customer with a material right to acquire future goods or services (based on the terms of the original contract) that are similar to the original goods or services. The transaction price in such options may need to be allocated to the optional goods or services based on the expected goods or services to be provided and the expected consideration to be received.
Key changes from the 2010 Exposure Draft: No significant changes from the 2010 Exposure Draft.
Example #8 - Options to renew a series for incremental seasons

Facts: Studio Star produces an episodic television series and licenses 13 episodes to be produced in season one to Network Alpha for a license fee of $1.5 million per episode. The arrangement also includes an option whereby Network Alpha, at its sole discretion, can require Studio Star to produce seasons two and three for a license fee of $2 million and $2.5 million per episode, respectively. How should Studio Star account for the option? Discussion: Studio Star would recognize revenue of $1.5 million as it delivers each episode to Network Alpha under existing U.S. GAAP. No specific accounting consideration is given to the existence of the option to acquire subsequent seasons. These options will be exercised only if Network Alpha believes that the episodic series has some reasonable level of consumer acceptance. Conversely, under IFRS, Network Alpha would need to allocate a portion of the consideration to the option and defer such amount until the right is exercised or expires. In evaluating these options under the proposed standard, Studio Star determines that the option provides a material right to the licensee because fixed pricing establishes significant upside for Network Alpha if the series becomes a "hit" (that is, if a new license was entered into, the pricing would be materially different). Therefore, the estimated transaction price for the license of the episodic television series would include the amount of consideration Studio Star expects to be entitled to from the exercise of the option to license the two additional seasons. The total transaction price would then be allocated to the performance obligations, including the future obligations related to seasons two and three.
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Accounting for return rights

Return rights are common in sales transactions that include physical goods sold to retailers. Some of these rights may be articulated in contracts with customers or distributors, while some are implied during the sales process. These rights take many forms and are driven generally by the buyer's desire to mitigate technological risk or the risk that the product will not sell, and the seller's desire to promote goodwill with its customers. Proposed model Revenue should not be recognized for goods expected to be returned; rather, a liability should be recognized for the expected amount of refunds to customers. The refund liability should be updated for changes in expected refunds. An asset and corresponding adjustment to cost of sales should be recognized for the right to recover goods from customers on settling the refund liability, with the asset initially measured at the original cost of the goods (that is, the former carrying amount in inventory). Current U.S. GAAP Sales of digital or physical music Revenue is recognized for sales of physical music products (for example, compact discs) once the product is available for release (that is, at the street date), which is typically after the product has been shipped by the producer to the retailer. The amount of revenue recognized is affected by the estimated returns that are expected. Revenue is recognized for the sale of digital music once the consumer downloads the song or album. The sale of digital music does not include the right of return. Current IFRS Revenue is typically recognized at the gross amount (in full) with a provision being recorded against revenue for the expected level of returns, provided that the seller can reliably estimate the level of returns based on an established historical record and other relevant evidence.
Impact: Accounting for returns will be largely unchanged under the proposed standard. However, the balance sheet will be grossed up to include the refund obligation as a liability (not a contra-asset) and to include an asset for the right to the returned goods. The timing of revenue recognition might be affected for the sale of physical product as recognition currently occurs once the retailer has the ability to sell the product to consumers (at the street date). Recognition is predicated on the transfer of control of the performance obligation under the proposed standard. The entity should consider whether the customer has the ability to direct the use of, and benefit from, the merchandise (that is, the customer has an obligation to pay, has physical possession, legal title, the significant risks and rewards of ownership, and evidence of acceptance of the merchandise) in determining whether control has transferred. Revenue recognition could occur earlier than current practice if control transfers once the customer obtains the physical product (rather than at the street date). The accounting for the sale of digital music is not anticipated to change under the proposed standard as revenue recognition will occur once the consumer obtains control of the download.
Key changes from the 2010 Exposure Draft: No significant changes from the 2010 Exposure Draft
Example #9 - Sale of physical product by a publisher

Facts: A publisher sells 100 copies of Book A for $10 each. The books cost $2 to produce and include a return right. The retailer takes physical possession of the books and is contractually obligated to pay for the inventory once the books are received. The publisher determined that the estimated sales returns associated with this transaction are 30% based on historical sales patterns. The publisher estimates that the costs of recovering the products will be immaterial and expects the returned products can be resold at a profit.
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Discussion: Once control transfers to the retailer, $700 of revenue ($10 x 70 products (100 less the 30% expected returns)) and cost of sales of $140 ($2 x 70 products) would be recognized. An asset of $60 (30% of product cost) would be established for the anticipated sales returns while a liability of $300 (30% of product sale price) would be established for the refund obligation (rather than recording an allowance against accounts receivable). The impact of the anticipated returns on royalties and inventory will be presented on a gross basis rather than being offset against accounts receivable. The estimate of returns is re-evaluated at each reporting date. Any changes in the estimated returns would require an adjustment to the corresponding asset and liability.
Contract costs
Existing U.S. GAAP currently includes a substantial amount of guidance related to the capitalization of costs specific to many of the entertainment and media subsectors, both related to pre-contract costs and costs to fulfill a contract. Entities will need to consider whether the accounting for contract costs will be affected by the proposed standard since the proposed standard also includes contract cost guidance. Proposed model Costs incurred in fulfilling a contract that are within the scope of other standards (for example, inventory, intangibles, fixed assets), should be accounted for in accordance with those other standards. If costs incurred in fulfilling a contract are not within the scope of other standards, the entity will recognize an asset only if the costs relate directly to a contract, relate to future activity, and are expected to be recovered. Costs capitalized under the proposed standard will be amortized as control of the goods or services to which the asset relates is transferred to the customer. Current U.S. GAAP Filmed entertainment Current IFRS
IFRS does not include specific guidance for recognizing costs in relation to The production of motion pictures and selling goods or rendering services. episodic television series require a However, for the rendering of services, significant upfront investment. Projects the percentage of completion method to produce content can include generally should be applied to the significant development stage accounting for revenue and associated expenditures, including those to expenses. acquire intellectual property such as film rights to books or original It might be appropriate to capitalize screenplays. Currently, such costs if the entity can recognize an development costs are typically asset under the inventory, fixed asset, capitalized and included in the film or intangible asset standards, and if the asset balance. Such costs would costs meet the definition of an asset. typically be written-off if the project is not green-lit within three years of the Costs such as training costs are date of initial cost capitalization. typically not capitalized because they All costs related to satisfied do not meet the definition of an asset. performance obligations and costs Impact: The accounting for costs to However, certain initiation or prerelated to inefficiencies are expensed as produce an episodic television series contract costs may be capitalized when incurred. and film costs (that is, capitalization such costs can be separately identified, and amortization) including direct reliably measured, and it is probable Incremental costs of obtaining a negatives, overall deal costs, rights to that the contract will be obtained. contract will be capitalized if they are film properties, costs incurred for Further, such costs can only be expected to be recovered. If the significant changes, as well as the capitalized if they meet the definition amortization period of the incremental allocations of production overhead and of inventory, property, plant and costs is less than one year, such costs capitalization of interest is not equipment, intangible assets, or an may be expensed as incurred as a anticipated to be significantly affected asset within the framework. practical expedient. by the proposed standard. Certain costs associated with filmed Video games entertainment could be capitalized and would be accounted for as an intangible Software development costs typically asset. Costs not capitalizable would be include payments made to independent expensed as incurred. Any costs software developers under capitalizable would be subject to the development agreements, as well as existing guidance on impairments. direct costs incurred for internally developed products. Software Impact: The accounting for contract development costs are capitalized once costs is not expected to be significantly technological feasibility of a product is affected.
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Proposed model
Current U.S. GAAP established and such costs are deemed recoverable. Technological feasibility encompasses both technical design and game design documentation, or the completed and tested product design and working model. Costs incurred to establish the technological feasibility of a computer software product to be sold, leased, or otherwise marketed are expensed as incurred as research and development costs. Costs related to support or maintenance are expensed at the earlier of when the related revenue is recognized or when the costs are incurred. Impact: The accounting for software development costs is not anticipated to change under the proposed standard. Music Advance royalties paid to artists are capitalized if the past performance and expected future performance of the artist provide a sound basis for estimating that the amount of the advance that will be recoverable from future royalties earned by the artist. Similarly, the record master costs incurred by the record company are capitalized if the past performance and expected future performance of the artist provide a sound basis for estimating that the cost will be recoverable from future sales. Impact: The accounting for advance royalties and record master costs is not anticipated to change under the proposed standard as existing cost guidance is not expected to be superseded by the proposed standard. Publishing Pre-publication costs represent direct costs incurred in the development of a book or other media, and include costs for the associated delivery method when such media is digital. Costs that are typically capitalized include both
Current IFRS
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Proposed model
Current U.S. GAAP internal and external costs, but are limited to those that are directly attributable to a specific title. Impact: The accounting for many prepublication costs is expected to remain consistent with current practice. Cable television Many costs incurred in the cable television business are capitalized, including franchise application fees, certain direct selling costs, subscriberrelated costs, and costs incurred for the construction of a cable television plant. Direct selling costs include commissions, salaries, and targeted advertising while subscriber-related costs include costs incurred to obtain and retain customers. Construction costs that may be capitalized include: Direct costs incurred during the prematurity period for the construction of the cable television plant, including materials, direct labor, and construction overhead. Programming costs incurred in anticipation of servicing a fully operating system and that will not vary significantly regardless of the number of subscribers are capitalized. Initial subscriber installation costs, including material, labor, and overhead costs related to the hookup of subscribers are capitalized. Impact: The accounting for costs incurred by cable operators are not anticipated to be impacted by the proposed standard.
Current IFRS
Key changes from the 2010 Exposure Draft: Costs to obtain a contract were to be expensed as incurred under the 2010 Exposure Draft. The boards received feedback that certain costs to obtain a contract may meet the definition of an asset and should be capitalized. The guidance was therefore revised to require recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered, and if the contract period is greater than one year.
Dataline 14
The boards clarified that costs to fulfill a contract are in the scope of the revenue guidance only if they are not addressed by other standards. Costs of abnormal amounts of wasted materials, labor, or other resources that were not considered in the price of the contract should be expensed when incurred.
Player points / Promotion programs

Gaming entities provide various forms of incentive programs. Such incentives may be based on past levels of play or to induce future play. They may be discretionary (that is, based on past levels of play or to induce future play) or nondiscretionary (that is, earned by the customer based on past gaming activity). Proposed model An option to acquire additional goods or services gives rise to a separate performance obligation in the contract if the option provides a material right to the customer that the customer would not receive without entering into that contract. Management will need to estimate the transaction price to be allocated to the separate performance obligations based on the estimated standalone selling price of the option. Current U.S. GAAP Non-discretionary incentive programs Current IFRS
Loyalty programs are accounted for as multiple-element arrangements. There are two models used to account Revenue is allocated between the initial for non-discretionary incentive service and the award credits, taking programs in the gaming industry: (i) a into consideration the fair value of the deferred revenue model; or (ii) an award credits to the customer. The immediate revenue/cost accrual model. assessment of fair value includes consideration of discounts available to A portion of the revenue from the the other buyers absent entering into original transaction is allocated to the the initial purchase transaction and incentive based on a relative fair value expected forfeitures. allocation under the deferred revenue The customer is paying for the future model. The amount allocated to the The fair value allocated to the incentive goods or services to be received when incentive is recognized when the is deferred and recognized when the customer award credits (incentives) are incentive is redeemed or expires. awards are redeemed or expire. issued in conjunction with a current sale. Management recognizes revenue Revenue is recognized under the for the option when it expires or when immediate revenue/cost accrual model these future goods or services are at the time of play and an accrual is transferred to the customer. made for the expected costs of satisfying the incentive. Discretionary incentive programs Discretionary incentives are typically considered part of the normal marketing activities of the gaming entity. Discretionary incentives may be offered in advance of the related gaming revenue or after the related gaming revenue. The incentive is recognized as an expense when the related revenue is recognized in either case because either (i) the revenue is recognized after the incentive is offered or (ii) the offer is made immediately after the revenue is recognized by the vendor.
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Proposed model Breakage The expected breakage amount should be recognized as revenue in proportion to the pattern of rights exercised by the customer if the entity is reasonably assured of the breakage amount. If the entity is not reasonably assured of the breakage amount, the expected breakage amount should be recognized as revenue when the likelihood of the customer exercising its remaining rights becomes remote.
Current U.S. GAAP
Current IFRS
There are three accounting models that are generally accepted for the recognition of breakage, depending on the features of the program, legal requirements and the vendor's ability to reliably estimate breakage: Proportional model - recognize as redemptions occur Liability model - recognize when the right expires Remote model - recognize when it becomes remote that the holder of the rights will not demand performance The model that management selects depends on the features of the incentive program and the ability to estimate breakage amounts. Where escheat laws apply, the vendor cannot recognize breakage revenue from escheatable funds since it is required to remit the funds to a third party even if the customer never demands performance.
No specific models are provided for recognizing breakage. The models used under U.S. GAAP are acceptable under IFRS.
Impact: The proposed standard is consistent with the deferred revenue model currently prescribed under U.S. GAAP and the multiple-element model prescribed under IFRS. The transaction price will be allocated between the different performance obligations (for example, gaming revenues, food and beverage, incentives, etc.). The amount allocated to the incentive is deferred and revenue is recognized when the incentive is redeemed or expires. For discretionary incentive programs, the proposed standard will result in a change as revenue will be allocated to the incentive. The accounting for breakage under the proposed standard might also affect the timing of revenue recognition. Management must consider the impact of breakage for incentives in determining the transaction price allocated to the performance obligations in the contract.
Key changes from the 2010 Exposure Draft: The updated exposure draft includes guidance on how to apply the breakage model. An entity should recognize the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer if it is reasonably assured of the amount of breakage. If an entity is not reasonably assured of a breakage amount, the entity should recognize the expected breakage when the possibility of redemption becomes remote.
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Authored by:
Robert Conklin U.S. Entertainment, Media and Communications Leader Phone: 1-646-471-5858 Email: robert.conklin@us.pwc.com Dave Johnson Partner Phone: 1-213-217-3845 Email: dave.johnson@us.pwc.com Jeff Feiereisen Senior Manager Phone: 1-818-553-5005 Email: jeff.p.feiereisen@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Industrial products and manufacturing industry supplement

No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Construction-type accounting .................... 2 Warranties ...................... 5 Contract costs ................. 6 Collectibility .................... 8 Variable consideration... 8 Consignment sales ........ 10 Bill-and-hold arrangements ............. 11
Industrial products and manufacturing industry supplement

Overview
The Industrial Products (IP) sector comprises a range of entities involved in the production of goods and delivery of services across a diverse industry base. This includes industrial manufacturing, metals, chemicals, forest products, paper and packaging entities. Each industry in the IP sector has different product and service offerings, but there are a number of common revenue recognition issues. Management of IP entities must carefully assess the proposed standard to determine the extent of its impact on their businesses. The following items common in the IP sector may be affected by the proposed revenue recognition standard. This paper, examples, and related assessments contained herein are based on the Exposure Draft, Revenue from Contracts with Customers , issued on November 14, 2011. We have also provided a high-level summary of key changes from the original exposure draft issued on June 24, 2010 (the "June 2010 Exposure Draft"). References to the "proposed model" or "proposed standard" throughout this document refer to the exposure draft issued in November 2011, unless otherwise indicated. The proposed standard is subject to change at any time until a final standard is issued. The examples reflect the potential effects of the proposed standard, pending further interpretation and assessment based on the final standard. For a more comprehensive description of the model refer to PwC's Dataline 2011-35 or visit www.fasb.org.
Dataline
Construction-type accounting
Many IP entities have contracts that include long-term manufacturing and may include a service (installation or customization) along with the sale of products. The products and services may be delivered over a period ranging from several months to several years. Proposed model Transfer of control Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or over time. A performance obligation is satisfied over time when at least one of the following criteria is met: Service revenue from transactions not specifically in the scope of contract accounting is recognized by applying either the proportional performance model or the completed contract model, depending on the specific facts. Revenue is recognized for transactions not in the scope of the contract accounting guidance once the following conditions are satisfied: The risk and rewards of ownership have transferred The seller does not retain managerial involvement to the extent normally associated with ownership nor retain effective control The amount of revenue can be reliably measured It is probable that the economic benefit will flow to the entity The costs incurred can be measured reliably Revenue is recognized for transactions in the scope of contract accounting, using the percentage-of-completion method when reliable estimates are available. When reliable estimates cannot be made but it is probable that no loss will be incurred on a contract (for example, when the scope of the contract is illdefined, but the contractor is protected from an overall loss), the percentageof-completion method based on a zero profit margin is used until moreprecise estimates can be made. Current U.S. GAAP Current IFRS
For transactions in the scope of construction-type and production-type contract guidance (ASC 605-35), revenue is recognized using the The entity's performance creates or percentage-of-completion method when reliable estimates are available. enhances an asset that the customer controls; or When reliable estimates cannot be The entity's performance does not made, but there is assurance that no create an asset with alternative use loss will be incurred on a contract (for to the entity; and at least one of example, when the scope of the contract is ill-defined, but the the following is met: contractor is protected from an overall loss), the percentage-of-completion - The customer receives and method based on a zero profit margin consumes the benefits as the is used until more precise estimates entity performs, can be made. - Another entity would not need to substantially reperform the The completed-contract method is required when reliable estimates work performed to date if cannot be made. required to fulfill the remaining obligation to the customer, or The entity has a right to payment for performance to date and expects to fulfill the contract as promised.
A performance obligation is satisfied at a point in time if it does not meet the criteria above.
The completed contract method is not Determining the point in time when permitted. control transfers will require judgment. Indicators that should be considered in Impact: determining whether the customer has The impact of the proposed standard will vary depending on each entitys specific facts and circumstances. Management will need to assess contracts to obtained control of a good include: determine whether control of an asset(s) being constructed transfers over time to the buyer. Control of goods or services might transfer to the customer over time The entity has a right to payment. for contracts that require highly customized engineering and production, where
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Proposed model The customer has legal title. The customer has physical possession. The customer has the significant risks and rewards of ownership. The customer has accepted the asset. Measuring progress for performance obligations satisfied over time Methods for recognizing revenue when control transfers over time include: Output methods that recognize revenue on the basis of direct measurement of the value to the customer of the entity's performance to date (for example, surveys of goods or services transferred to date, appraisals of results achieved). Input methods that recognize revenue on the basis of the entity's efforts or inputs to the satisfaction of a performance obligation (for example, time, units delivered, resources consumed, labor hours expended, costs incurred, or machine hours used). The method that best depicts the transfer of goods or services to the customer should be used and applied consistently to similar contracts with customers.
Current U.S. GAAP
Current IFRS
the customer specifies the design and function of the items being produced, and where the entity is unable, either contractually or practically, to readily direct the asset to another customer.
The use of a proportional performance model based upon cost-to-cost measures is generally not appropriate for transactions outside the scope of contract accounting. Entities applying contract accounting use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (for example, physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a "percentage complete" is determined (using the appropriate measure of progress), there are two different approaches for determining revenue, costs of revenue, and gross profit: the Revenue method or the Gross Profit method.
Service revenue from transactions not in the scope of contract accounting is recognized based on the stage of completion if the transaction's outcome can be estimated reliably. Entities applying contract accounting can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (for example, physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a "percentage complete" is determined (using the appropriate measure of progress), IFRS requires the use of the Revenue method to determine revenue, costs of revenue, and gross profit. The Gross Profit method is not permitted.
The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the The Gross Profit method of calculating revenue, costs of revenue, and gross measurement of progress. profit based on the percent complete will no longer be acceptable under the proposed standard, which is a change from current U.S. GAAP. In certain circumstances, when measuring progress for a performance obligation that includes uninstalled materials that the customer controls, it may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if the goods are transferred at a
Impact: The exposure draft allows both input and output methods for recognizing revenue, but management should select the method that best depicts the transfer of control of goods and services. Input methods should represent the transfer of control of the asset or service to the customer and should therefore exclude any activities that do not depict the transfer of control (for example, abnormal amounts of wasted materials).
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Proposed model significantly different time from the related service. Estimates to measure the extent to which control has transferred (for example, estimated cost to complete when using a cost-to-cost calculation) should be regularly evaluated and adjusted.
Current U.S. GAAP
Current IFRS
Key change from the June 2010 Exposure Draft: The June 2010 exposure draft had limited guidance on when control is transferred continuously over time. The boards added the criteria above to determine when a performance obligation is satisfied over time in response to feedback that the original guidance was difficult to apply to service transactions. The boards also added the indicators of "risk and rewards of ownership" and "evidence of customer acceptance" to provide further guidance on when control transfers at a point in time.
Example #1
Facts: A vendor enters into a contract to significantly customize a product for a customer. Management has determined that the contract is a single performance obligation. The contract has the following characteristics: The customization is significant and to the customer's specifications and may be changed at the customer's request during the contract term Non-refundable, interim progress payments are required to finance the contract The customer can cancel the contract at any time (with a termination penalty) and any work in progress has no alternative use to the vendor Physical possession and title do not pass until completion of the contract How should the vendor recognize revenue? Discussion: The terms of the contract, in particular the customer specifications (and ability to change the specifications) determine that the work in progress has no alternative use to the vendor, and the non-refundable progress payments suggest that control of the product is being transferred over the contract term. Management will need to select the most appropriate measurement model (either an input or output method) to measure the revenue arising from the transfer of control of the product over time.
Example #2
Facts: A vendor enters into a contract to construct several of its products for a customer. Management has determined that the contract is a single performance obligation. The contract has the following characteristics: The majority of the payments are due after the products have been installed The customer can cancel the contract at any time (with a termination penalty) and any work in progress remains the property of the vendor
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The work in progress can be completed and sold to another customer Physical possession and title do not pass until completion of the contract How should the vendor recognize revenue? Discussion: The terms of the contract, in particular payment upon completion and the inability to retain work-in-progress, suggest that control of the products is transferred at a point in time. The vendor will not recognize revenue until control of the product has transferred to the customer (delivery).
Warranties
Many IP entities provide standard warranties with their products. A standard warranty is given to all customers and protects against defects for a specific time period. Many entities also offer extended warranties or sell warranties separately that provide for coverage beyond the standard warranty period. Proposed model An entity will account for a warranty as a separate performance obligation if the customer has the option to purchase the warranty separately or the warranty provides the customer with a service. This is because the entity promises a service to the customer in addition to the product. An example of this may be the sale of a copier with a one-year service contract for ongoing maintenance and repairs. Current U.S. GAAP Entities typically account for standard warranties protecting against latent defects in accordance with existing loss contingency guidance. An entity will recognize revenue and concurrently accrue any expected costs for these warranty repairs. Current IFRS Entities typically account for standard warranties protecting against latent defects in accordance with existing provisions guidance. Management recognizes revenue and concurrently accrues any expected cost for these warranty repairs.
Separately priced extended warranties Warranties that a customer can result in the deferral of revenue based purchase separately are similar to on the contractual price of the many extended warranty contracts. separately priced extended warranty. Revenue from extended warranties is An entity will account for a warranty as The value deferred is amortized to deferred and recognized over the a cost accrual if the customer does not revenue over the extended warranty period covered by the warranty. have the option to purchase the period. warranty separately and the warranty Impact: does not provide the customer with a Extended warranties give rise to a separate performance obligation under the service in addition to assurance that proposed standard and therefore, revenue is recognized over the warranty the product complies with agreed-upon period, similar to the accounting treatment under existing guidance. specifications. Warranties that are separately priced may be impacted as the arrangement consideration will be allocated on a relative standalone selling price basis rather than at the contractual price under U.S. GAAP. The amount of deferred revenue for extended warranties might differ under the proposed standard compared to current guidance as a result. Product warranties that are not sold separately and only provide for defects at the time a product is shipped will result in a cost accrual similar to today's guidance.
Key change from the June 2010 Exposure Draft: The 2010 exposure draft distinguished between two types of warranties: those that provided coverage for latent defects and those that provided coverage for faults after product delivery. Coverage for latent defects did not create a performance obligation, but resulted in a revenue deferral for product expected to be replaced similar to a right of return. The boards revised the guidance in response to feedback provided so that the accounting for these warranties is now similar to current practice and results in a cost accrual provided the warranties are not sold separately by the entity and do not provide a service.
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Example #3
Facts: An entity sells its product, which includes a 90-day standard warranty. The entity will replace defective components of the product under the standard warranty. The warranty does not provide an additional service to the customer. How does the entity account for such a warranty? Discussion: The entity should account for the warranty as a cost accrual, similar to today's guidance.
Example #4
Facts: An entity sells its product, which includes a 90-day standard warranty. The customer also purchases an extended warranty that provides for an additional 18 months of coverage. How does the entity account for the warranties? Discussion: The standard warranty is accounted for in the same manner as the standard warranty offered in Example 3 above because it is not sold separately and does not provide a service. The extended warranty is accounted for as a separate performance obligation. Management would allocate the transaction price (that is, contract revenue) to the product and the extended warranty based on their relative standalone selling prices. Revenue allocated to the extended warranty would be recognized over the warranty coverage period (starting on day 91 for the following 18 months).
Contract costs
IP entities frequently incur costs prior to finalizing a contract. Many of these pre-contract costs are capitalized and recognized over the term of the contract as revenue is recognized. The most significant costs are typically sales commissions. Proposed model Incremental costs to obtain a contract should be recognized as an asset if they are expected to be recovered. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained (for example, sales commissions). Current U.S. GAAP There is a significant amount of detailed guidance on the accounting for contract costs that are under the scope of construction-type and productiontype contract guidance (ASC 605-35). Current IFRS There is a significant amount of detailed guidance on the accounting for contract costs in construction contract accounting.
Costs that relate directly to a contract Pre-contract costs that are incurred for and are incurred in securing that a specific anticipated contract may be contract are included as part of deferred only if the costs can be directly contract costs that can be capitalized if associated with a specific anticipated they can be separately identified, An entity is permitted to recognize contract and if their recoverability from measured reliably, and it is probable contract acquisition costs as an expense that contract is probable. that the contract will be obtained. as incurred as a practical expedient for contracts with a duration of one year or Outside of contract accounting, there is Costs associated with transactions that less. limited guidance on the treatment of are not in the scope of contract costs associated with revenue accounting are capitalized if such costs Direct costs incurred to fulfill a transactions. Certain types of costs are within the scope of other asset contract are first assessed to determine incurred prior to revenue recognition standards (for example, inventory, if they are within the scope of other may be capitalized if they meet the PP&E or intangible assets) or the standards (for example, inventory, definition of an asset. Framework. intangibles, fixed assets), in which case Impact: the entity should account for such costs Costs likely to be in the scope of this guidance include, among others, sales in accordance with those standards commissions, set-up costs for service providers, and costs incurred in the design (either capitalize or expense). phase of construction projects. The impact on entities will vary depending on the Costs that are not in the scope of another standard are evaluated under the revenue standard. An entity recognizes an asset only if the costs guidance and policies followed currently.
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Proposed model relate directly to a contract, generate or enhance resources that relate to future performance, and are expected to be recovered. Costs related to inefficiencies (for example, abnormal costs of materials, labor, or other costs to fulfill) should be expensed as incurred. Costs that relate directly to a contract can include costs that are incurred before the contract is obtained if those costs relate specifically to an anticipated contract. Capitalized costs are then amortized in a manner consistent with the pattern of transfer of the goods or services to which the asset relates.
Current U.S. GAAP
Current IFRS
Key change from the June 2010 Exposure Draft: Costs to obtain a contract were to be expensed as incurred under the original exposure draft. In response to feedback received, the boards revised this guidance to permit recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered. The boards clarified that costs to fulfil are in the scope of the revenue guidance only if they are not addressed by other standards and that the costs of abnormal amounts of wasted materials, labor, or other resources that were not considered in the price of the contract should be recognized as an expense when incurred.
Example #5
Facts: A salesperson earns a 5% commission on a contract that was signed during January 20X1. The products purchased in the contract will be delivered throughout the next year. How should the entity account for the commission paid to its employee? Discussion: The commission payment can be capitalized as it represents a cost of obtaining the contract. The commission can be expensed as incurred since the commission relates to a contract that extends one year or less, as a practical expedient.
Example #6
Facts: A manufacturer incurs certain mobilization costs at the beginning of a long-term production contract. The mobilization costs include training of employees, setting up the factory for production, and non-recurring engineering on the production equipment. How should these costs be accounted for? Discussion: The mobilization costs might not be covered by existing asset standards (with the exception of training costs which are covered under IFRS by the intangible asset guidance). Costs not subject to other guidance are capitalized if they: (a) relate to the contract; (b) generate or enhance resources of the entity that will be used to satisfy future performance obligations; and (c) are probable of recovery. Costs that meet these criteria are capitalized and amortized over the contract period as control of the goods produced is transferred to the customer.
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Collectibility
Collectibility refers to the risk that the customer will not pay the promised consideration. Collectibility will no longer be a hurdle to revenue recognition as it is under today's guidance. Proposed model Any expected impairment loss due to credit risk will be presented in a separate line item adjacent to the revenue line. Current U.S. GAAP Revenue from an arrangement is deferred in its entirety if an entity cannot conclude that collection from the customer is reasonably assured. Current IFRS Entities must establish that it is probable that economic benefits will flow before revenue can be recognized. A provision for bad debts (incurred losses on financial assets including accounts receivable) is recognized in a two-step process: (1) objective evidence of impairment must be present; then (2) the amount of the impairment is measured based on the present value of expected cash flows.
Both the initial assessment and any Credit risk is reflected as a reduction of subsequent changes in the estimate will accounts receivable by recording an be recorded in this line item. increase in the allowance for doubtful accounts and bad debt expense.
Impact: Revenue may be recognized earlier than current practice since collectibility will no longer be a recognition Impact: threshold. Revenue may be recognized earlier than current practice since collectibility will no longer be a recognition threshold.
The transaction price is the consideration the vendor expects to be entitled to in exchange for satisfying its performance obligations in an arrangement. Determining the transaction price is simple when the contract price is fixed and paid at the time services are provided. Determining the transaction price may require more judgment if the consideration contains an element of variable or contingent consideration. Common considerations in this area include the accounting for volume discounts, awards/incentive payments, claims, and time value of money. Proposed model Volume discounts Volume discounts are generally receivable by the customer when specified cumulative levels of purchases are achieved. The transaction price is the consideration that the entity expects to be entitled to receive under the contract, including variable or uncertain consideration. It is based on either the probability-weighted estimate or most likely amount of cash flows expected from the transaction, depending on which is the most predictive of the amount to which the entity would be entitled. Volume discounts are recognized as a reduction to revenue as the customer earns the rebate. The reduction is limited to the estimated amounts potentially due to the customer. If the discount cannot be reliably estimated, revenue is reduced by the maximum potential rebate. Volume discount payments are systematically accrued based on discounts expected to be taken. The discount is then recognized as a reduction of revenue based on the best estimate of the amounts potentially due to the customer. If the discount cannot be reliably estimated, revenue is reduced by the maximum potential rebate. Current U.S. GAAP Current IFRS
Impact: Accounting for volume discounts is unlikely to be significantly different under the proposed standard compared to today's accounting (U.S. GAAP and IFRS). The accounting for contracts with downward tiered pricing based solely on volume, however, may be different than current U.S. GAAP.
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Proposed model If an entity receives consideration from a customer and expects to refund some or all of that consideration, a liability should be recognized for the amount of consideration that the entity expects to refund. Revenue is recognized as a performance obligation is satisfied but only if an entity is reasonably assured to be entitled to the amount allocated to that performance obligation. An entity is reasonably assured to be entitled to an amount when it has experience with similar contracts (or has other persuasive evidence such as access to the experience of other entities with similar contracts) and the entity's experience is predictive. Awards/Incentive payments/Claims Same as for volume rebates above.
Current U.S. GAAP
Current IFRS
Awards/incentive payments are included in contract revenue (under the scope of construction-type and production-type contract accounting) when the specified performance standards are probable of being met and the amount can be reliably measured. A claim is recorded for contracts under the scope of construction-type and production-type contract accounting as contract revenue only if it is probable and can be reliably estimated, which is determined based on specific criteria. Claims meeting these criteria are only recorded to the extent of contract costs incurred. Profits on claims are not recorded until they are realized.
Awards/incentive payments are included in contract revenue when the specified performance standards are probable of being met and the amount can be reliably measured. A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable the customer will accept the claim and the amount can be reliably measured
Impact: Certain awards, incentive payments, or claims may be recognized earlier than under current practice, particularly for U.S. GAAP as the reasonably assured threshold will be met sooner than today's threshold. Time value of money An entity will adjust the amount of promised consideration to reflect the time value of money if the contract includes a significant financing component. The discounting of revenues is required in only limited situations, including receivables with payment terms greater than one year. Discounting of revenues to present value is required in instances where the effect of discounting is material. An imputed interest rate is used in these instances for determining the amount of revenue to be recognized, as well as
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Proposed model An entity need not assess whether a contract has a significant financing component if the entity expects at contract inception that the period between payment by the customer and the transfer of the services to the customer will be one year or less, as a practical expedient. Management uses a discount rate that reflects a separate financing transaction between the entity and its customer, and factors in credit risk.
Current U.S. GAAP When discounting is required, the interest component is computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable.
Current IFRS the separate interest income component to be recorded over time.
Impact: The proposed standard is not significantly different than today's guidance. We do not expect a significant change to current practice for most industrial products and manufacturing entities in connection with the time value of money, because payment terms often do not extend over more than one year from the timing of contract performance.
Key changes from the June 2010 Exposure Draft: The criteria for recognizing revenue for variable consideration was changed from "when the transaction price could be reasonably estimated" to" the entity should be reasonably assured to be entitled to that amount."
Example #7
Facts: A chemical entity has a one-year contract with a car manufacturer to deliver high performance plastics. The contract stipulates that the chemical entity will give the car manufacturer a rebate when certain levels of future sales are reached, according to the following scheme: Rebate 0% 5% 10% Sales Volume 0 10,000,000 lbs 10,000,001 30,000,000 lbs 30,000,001 lbs and above
The rebates are calculated on gross sales in a calendar year and paid at the end of the first quarter of the following year. Based on past experience, management believes that the most likely rebate that it will have to pay is 5%. How does the chemical entity recognize revenue? Discussion: The entity has experience with similar types of contracts and that experience is predictive. Management therefore recognizes revenue, based on the most likely amount of cash flows expected, equal to 95% of the transaction price as goods are provided to the car manufacturer. This estimate is monitored and adjusted, as necessary, using a cumulative catch-up approach.
Consignment sales
Proposed model Management will need to determine when control of goods provided to a dealer or distributor is transferred. Inventory on consignment is typically controlled by the consignor until the consignee sells the product to an end customer, consumes the good in production, or a specified period Current U.S. GAAP Revenue in consignment arrangements can be recognized only when substantial risk of loss, rewards of ownership, and control of the asset have transferred to the consignee (assuming all other criteria for revenue recognition have been satisfied). Other situations may exist where legal title to delivered goods passes to a buyer, but Current IFRS Revenue is recognized by the shipper (consignor) in consignment arrangements when the goods are sold by the recipient (consignee) to a third party, as this is when the risks and rewards of ownership have generally passed.
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Proposed model expires. Only then does the consignee typically have an unconditional obligation to pay for the products, and the consignor can no longer demand return or transfer the goods to another. Control does not therefore transfer until the consignee sells or consumes the product, or a specified period expires.
Current U.S. GAAP the substance of the transaction is that of a consignment. Current revenue guidance includes several indicators that are considered to determine whether substantial risk of loss, rewards of ownership, and control of the asset have transferred.
Current IFRS
Impact: The proposed guidance is similar to existing U.S. GAAP and IFRS. Current There may be situations in which the revenue recognition, however, focuses primarily on the transfer of risks and legal title of the goods has passed to the rewards whereas the proposed standard focuses on transfer of control of the consignee but control has not. A consigned goods. We expect many consignment arrangements will be unaffected consignee might be acting as an agent by the proposed guidance; however, some arrangements might require different in these situations, in which case accounting under the proposed standard. control does not transfer until sale to a third party.
Example #8
Facts: An entity recently developed a new type of cold-rolled steel sheet that is significantly stronger than existing products, providing for increased durability. This product is newly developed and therefore, not yet widely used. Management and a manufacturer of high security steel doors agree to enter into an arrangement whereby the entity will provide 50 rolled coils of the sheet on a consignment basis. The manufacturer is required to pay a deposit upon receipt of the coils. Title transfers to the manufacturer and payment is due only upon consumption of the coils in the manufacturing process. Each month, both parties agree on the amount consumed by the manufacturer. The manufacturer can return, and the entity can demand back, unused products at any time. How does the entity account for revenue? Discussion: Evidence suggests that control transfers and therefore, revenue should be recognized upon consumption of the coils in the manufacturing process, as title transfers and payment is due only at that point. If the entity did not retain the right to demand return of the inventory, that might suggest that control transferred to the manufacturer upon receiving the shipment.
Bill-and-hold arrangements
Proposed model Management will need to determine when control of the goods provided in a bill-and-hold arrangement is transferred. All of the following criteria must be met to conclude that the customer has obtained control in a billand-hold arrangement: The reason for the bill-and-hold arrangement must be substantive The product must be identified separately as the customer's The product must be ready for delivery to the customer Current U.S. GAAP Revenue is recognized in a bill-andhold arrangement prior to the delivery of the goods, only if the following criteria are satisfied: The risk of ownership must have passed to the buyer The customer must have made a fixed commitment to purchase the goods, preferably in writing The buyer, not the seller, must request that the transaction be on a bill and hold basis and have a substantial business purpose for Current IFRS The following conditions should be considered in determining whether revenue is recognized prior to delivery in a bill-and-hold arrangement: The delivery is delayed at the buyer's request The buyer must have taken title to the goods and accepted billing It must be probable that delivery will take place The goods must be on hand, identified, and ready for delivery to
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Proposed model The entity cannot have the ability to use the product or to sell it to another customer Some of the transaction price is allocated to the custodial services of storing the goods if such services are a separate performance obligation.
Current U.S. GAAP ordering the goods on a bill and hold basis There must be a fixed schedule for delivery of the goods The seller must not have retained any specific performance obligations such that the earnings process is not complete The ordered goods must have been segregated from the seller's inventory and not be subject to being used to fill other orders The goods must be complete and ready for shipment There are additional factors in the guidance to consider in determining whether revenue recognition should precede the delivery of the goods to the customer.
Current IFRS the buyer at the time the sale is recognized The buyer must specifically acknowledge the deferred delivery instructions The usual payment terms must apply
Impact: The proposed standard is not as prescriptive as existing literature and it focuses on when control of the goods transfers to the customer. The lack of a fixed delivery schedule often precludes revenue recognition currently under U.S. GAAP. Such a requirement is not included in the proposed standard. Revenue recognition might occur earlier than under current practice for these reasons; however, we expect the timing of revenue recognition for many bill-and-hold arrangements to be unchanged.
Example #9
Facts: A gas entity placed an order for a drilling pipe with a tubular steel producer. The gas entity requested the transaction to be on a bill-and-hold basis because of the frequent changes to the timeline for developing remote gas fields and the long lead times needed for the delivery of drilling equipment and supplies. The steel producer has a long history of bill-and-hold transactions with this customer and has established standard terms for such arrangements. The pipe, which is separately warehoused by the steel producer, is complete and ready for shipment. The standard terms of the arrangement require the gas entity to remit payment within 30 days of the pipe being placed into the steel producer's billand-hold yard. The gas entity will request and take delivery of the pipe on an as-needed basis. How does the steel producer recognize revenue? Discussion: It appears that control of the pipe transfers to the gas entity once the pipe arrives at the steel producers billand-hold yard, at which time the steel producer should recognize the related revenue. All facts and circumstances need to be evaluated for each arrangement. This conclusion is based primarily on the fact that the gas entity requested the transaction to be on a bill-and-hold basis, the steel producer cannot use the pipe to fill orders for other customers, and the pipe is ready for immediate shipment at the request of the gas entity. Some of the transaction price may need to be allocated to the custodial services if such services are determined to be a material separate performance obligation.
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Authored by:
Joe Herron Global Industrial Products Leader Phone: 1-860-241-7007 Email: jherron@us.pwc.com Jonathon Hook Global Industrial Products Assurance Leader Phone: 44 20 780 44753 Email: jonathon.hook@uk.pwc.com Tracey Stover U.S. Industrial Products Leader Phone: 1-720-931-7466 Email: tracey.a.stover@us.pwc.com Barry Misthal Global Industrial Manufacturing Leader Phone: 1-267-330-2146 Email: barry.misthal@us.pwc.com Andrew Reinsel Partner Phone: 1-513-361-8015 Email: andrew.reinsel@us.pwc.com Robert B Bono Partner Phone: 1-704-350-7993 Email: robert.b.bono@us.pwc.com Simone Sherlock Senior Manager Phone: 1-973-236-5536 Email: simone.t.sherlock@us.pwc.com Holger Schreiber Senior Manager Phone: 1-860-241-7473 Email: holger.schreiber@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Pharmaceutical and life sciences industry supplement

No. 2011-35 (supplement) November 30, 2011 Whats inside: Overview .......................... 1 Proposed model .............. 2 Licenses and rights to use ............................. 2 Variable consideration... 4 Collaborations and licensing arrangements .............. 8 Other considerations .... 10 Medical devices .............. 11 Disclosures ..................... 13 Appendix A ..................... 14
Pharmaceutical and life sciences industry supplement

Overview
The pharmaceutical and life sciences industry includes a number of sub-sectors; the largest being mainstream pharmaceuticals, life sciences, bio-technology and medical devices. The common feature is that they develop, produce and market a diverse array of products, technologies and services that relate to human health. The pharmaceutical sub-sector is high risk as most potential drugs never come to market, but those that are successful are often highly profitable. Revenue recognition issues arise not only from the sale of drugs and medical devices but increasingly from the arrangements between entities in the industry to develop and bring to market drugs and other products. Medical devices may be easier products to bring to market, although those involved with the development of success-fee medical technologies, including in vitro diagnostics, have a higher risk profile. Entities in the industry engage in collaborative arrangements to develop drugs, either as a supplier of services, a consumer of those services or on either end of a license arrangement. These transactions are complex and are mostly likely to be impacted by the proposed revenue recognition standard. Additionally, many medical technology entities provide multiple products to their customers as part of a single arrangement. For example, entities may sell a medical device and replacement parts, and provide installation, training and service. Certain complex medical devices may incorporate software, and consequently may be subject to the software revenue recognition guidance under existing US GAAP. These transactions also may be impacted by the proposed revenue recognition standard.
Dataline
The latest proposals on revenue recognition are included in an exposure draft "Revenue from Contracts with Customers" issued on November 14, 2011 (the "2011 ED") by the IASB and FASB (the "boards"). The 2011 ED incorporates a number of changes that were made in response to feedback received on the original proposals issued in June 2010 (the "2010 ED"). This supplement focuses only on those proposals that may have a significant impact on entities in the industry and it contrasts the 2011 ED with current practice under U.S. GAAP and IFRS. References to the "proposed model," the "proposed guidance," and the "proposed standard" throughout this supplement refer to the 2011 ED unless otherwise indicated. Appendix A sets out the key differences between the 2010 ED and the 2011 ED. The examples and related discussions in this document are based on our current understanding of the 2011 ED and are intended to provide areas of focus to assist companies in evaluating its potential implications. Our tentative conclusions and views are subject to change pending further interpretation and assessment based on the final standard. The boards have indicated that the final standard will have an effective date no earlier than 2015. Full retrospective application will be required with the option to apply limited transition relief. For more general information on the revenue proposals, please refer to PwC Dataline 2011-35 or the IFRS Practical Guide (www.cfodirect.pwc.com) or (www.pwcinform.com) or visit www.fasb.org or www.iasb.org.
Proposed model
Pharmaceutical, life sciences, and medical technology entities will need to assess each contract to determine the timing and amount of revenue to recognize under the proposed standard. The proposed model requires a contract-based approach under which the following steps would apply: Identify the contract with the customer Identify the separate performance obligations in the contract Determine the total transaction price Allocate the total transaction price to each performance obligation in the contract Recognize as revenue the amount of the transaction price allocated to each performance obligation as it is satisfied, provided the entity is reasonably assured to be entitled to that amount Performance obligations are satisfied by transferring control of a good or service to a customer, which may either be at a point in time or continuously over time depending on the nature of the arrangement.

Generally a license is granted by an entity (the "licensor") to a customer (the "licensee") and provides the licensee with the right to use, but not own, the intellectual property of the licensor. For example, in the pharmaceutical and life sciences industry, an entity that has developed a pre-regulatory approval drug might license that drug and the underlying intellectual property to another company. Often under the terms of such a license the licensee can further develop the drug, manufacture and sell the resulting commercialized product. The licensor typically receives an upfront fee and a sales-based royalty stream or milestone payments for specific clinical outcomes. Some licensing arrangements also include ongoing involvement of the licensor, who might provide research, development or manufacturing services relating to the licensed technology. In licensing arrangements with multiple goods and services, entities will need to determine if the goods and services are distinct and should be accounted for separately or whether they are part of a bundle and should be combined into one performance obligation. The concept of bundling goods and services was primarily introduced into the 2011 ED to address issues in the construction industry. Licensing arrangements and construction contracts may have similar characteristics due to the long-term nature of the projects. This is an area that entities may need to seek further clarification on as the timing of revenue recognition is likely to be affected by whether there is one or more separate performance obligations.
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Proposed model A license or rights to use intellectual property granted to a customer gives rise to a performance obligation that is satisfied when the customer obtains control of the rights.
Current U.S. GAAP Consideration is allocated to the license; revenue is recognized when earned, typically when the license is transferred if the license has standalone value.
Current IFRS
Fees paid for the use of an entity's assets are normally recognized in accordance with the substance of the agreement. As a practical matter, this may be on a straight-line basis over the life of the agreement, for example, If a licensing arrangement has multiple If the license does not have stand-alone when a licensee has the right to use deliverables (for example, it also value, the license is combined with certain technology for a specified includes ongoing R&D services), an other deliverables, typically the period of time. entity should consider whether the research or manufacturing services. license is a separate performance Revenue R for the single unit of An assignment of rights for a fixed fee obligation or whether it should be account is recognized when earned, that permits the licensee to exploit combined with other performance typically as the research or those rights freely and the licensor has obligations. manufacturing services are performed. no remaining obligations to perform is, in substance, a sale. Determining Where a license is a separate whether a license is in substance a sale performance obligation, revenue requires the use of judgment. should be recognized at the point in time the license is transferred to the When a license is sold with services or customer (that is, the customer can other deliverables, the vendor is benefit from the license) and the required to exercise judgment to consideration is reasonably assured. determine whether the different components of the arrangement should Where a license is not a separate be accounted for separately. performance obligation, it should be combined with another performance obligation(s) and revenue should be recognized upon satisfaction of the related performance obligation(s). Where a licensing arrangement includes an element of variable consideration (for example, royalties), revenue is recognized when reasonably assured. See below for guidance on variable consideration. Furthermore, revenue cannot be recognized before the beginning of the period during which the customer can use and benefit from the licensed intellectual property, notwithstanding when the license is transferred. Impact: For simple licensing arrangements that result only in the transfer of a technology or intellectual property license for the life of the underlying asset in exchange for up-front cash, we do not expect the proposed standard to have a significant impact on revenue recognition. For more complex licensing arrangements, which include other deliverables such as research and development services, the proposed standard could have a significant impact for pharmaceutical and life sciences entities. The proposed standard could result in earlier revenue recognition than under current practice, or revenue might not be recognized immediately upon transfer of the right if the license is not separable from other performance obligations in the contract. The key issue for entities will be to determine whether the granting of the license should be accounted for separately or combined with other goods and services. An entity should account for the license as a separate performance obligation if it is distinct. The granting of a license is distinct if the entity regularly sells the license separately or the customer can benefit
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Proposed model
Current U.S. GAAP
Current IFRS
from the license either on its own or together with other resources that are readily available. However, an entity will also need to consider whether the license and other goods and services constitute a "bundle" and thus are not distinct and be accounted for as one performance obligation. Goods and services in a bundle are not distinct if they are highly interrelated and require significant integration services and the bundle of goods and services is significantly modified or customized. The proposed standard does not provide detailed guidance on how to assess whether integration services are "significant" or when an entity is "significantly" modifying or customizing a good or service. When licenses are sold with research and development services, the stage of the research on the licensed technology may affect the assessment of whether the license is distinct. For example, certain biotech entities may not sell licenses without research services for early-stage products. During the discovery stage, an entity may have specialized know-how and technology making it the only entity able to provide the services for the specific licensed product. The license may not be a separate performance obligation in this case because the customer cannot benefit from the license on its own and in addition the research may be considered a significant modification or customization. Therefore, the license and the research services together are accounted for as a single performance obligation. The consideration is allocated to the single performance obligation, and revenue is recognized as the performance obligation is satisfied over the period research services are performed. Another scenario may be when a license has been granted with research services that comprise clinical development activity or clinical trials. In the industry it would normally be possible for others to perform those clinical trials. This might indicate that the license and the development services are distinct from each other because at this stage the licensee could benefit from the license on its own and could choose to either perform or outsource the performance of clinical trials. In this case, the consideration is allocated between the two performance obligations on a relative standalone selling price basis, and revenue is recognized as each performance obligation is satisfied. Complex arrangements, which include licenses and other performance obligations, will require careful consideration to determine whether they should be accounted for separately. Entities will need to use judgment in evaluating the criteria in the proposed standard to ensure that combining or separating goods and services results in accounting that reflects the underlying economics of the transaction.
The transaction price in a contract reflects the amount of consideration that an entity expects to be entitled to in exchange for goods or services. The transaction price may include an element of consideration that is variable or contingent on the outcome of future events, including (but not limited to) discounts, rebates, refunds, incentives, performance bonuses, price concessions and royalties. Common examples of arrangements with variable consideration in the industry include strategic collaborations and licensing arrangements with milestone payments and sales-based royalties. Milestone payments might be contingent upon the achievement of certain development or sales targets. Royalties are typically based on product sales. Variable consideration is recognized under the proposed standard when the related performance obligation is satisfied and the entity is reasonably assured to be entitled to the amount of consideration allocated to that performance obligation.
Milestone payments
Proposed model If the promised amount of consideration in a contract is variable, the entity should estimate the total amount of the transaction price to which it will be entitled in exchange for transferring promised goods or services. This estimate can be based on either the expected value (probabilityweighted estimate) or the most likely Current U.S. GAAP A substantive milestone is defined in "Revenue Recognition Milestone Method"; it includes milestone payments received upon achievement of certain events, such as the submission of a new drug application to the regulator or approval of a drug by the regulator. Current IFRS Milestones received for a license with no further performance obligations on the part of the licensor are recognized as income when they are receivable under the terms of the contract and their receipt is probable. When development services are being provided (with or without an associated
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Proposed model amount of cash flows expected from the transaction, whichever is most predictive of the amount of consideration received. The estimated transaction price should be updated at each reporting date to reflect the circumstances at the reporting date and the changes in circumstances during the reporting period. 1. Allocating milestone receipts The transaction price should be allocated to separate performance obligations in a contract based on relative standalone selling prices. If the transaction price includes an amount of consideration that is contingent on a future event or circumstance (for example, a specific outcome of the entitys performance, such as the completion of a phase III trial/regulatory approval), the entity should allocate that contingent amount (and subsequent changes to the amount) entirely to the related performance obligation if both of the following criteria are met: (a) the contingent payment terms for the milestone relate specifically to the entitys efforts to satisfy that performance obligation or to a specific outcome from satisfying that separate performance obligation. (b) allocating the contingent amount of consideration entirely to the separate performance obligation reflects the amount of consideration to which the entity expects to be entitled in exchange for satisfying the performance obligation when considering all of the performance obligations and payment terms in the contract. 2. Recognizing milestone income Variable consideration is recognized as revenue when the related performance obligation is satisfied and the entity is reasonably assured to be entitled to the consideration. An entity is reasonably assured to be entitled to the consideration when the entity has
Current U.S. GAAP An entity that uses the milestone method under current guidance recognizes revenue on substantive milestone payments in the period in which the milestone is achieved. Nonsubstantive milestone payments that may be paid to the licensor based on the passage of time or as a result of the licensees performance would be allocated to the units of accounting within the arrangement and recognized as revenue when those deliverables are satisfied. An entity that does not use the milestone method may use another revenue recognition model for recognizing milestone payments (for example, by analogy to the "Revenue Recognition of Long-term Power Sales Contracts" model or the contingency adjusted performance model.)
Current IFRS license) then the vendor/licensor accounts for the milestones using the percentage of completion method. The milestone payment method is often an appropriate method of accounting if it approximates the percentage of completion of the services under the arrangement. The milestone events must have substance, and they must represent achievement of specific defined goals. Management should consider the following factors to determine when milestone payments are recognized as revenue: The reasonableness of the milestone payments compared to the effort, time, and cost to achieve the milestones; Whether a component of the milestone payments relates to other agreements or deliverables, such as a license and royalty; The existence of cancellation clauses requiring the repayment of milestone amounts received under the contract; The risks associated with achievement of the milestones; and Obligations under the contract that must be completed to receive payment or penalty clauses for failure to deliver.
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Proposed model experience with similar types of contracts and the experience is predictive of the outcome of the contract. An entity should consider the following indicators that may suggest the experience may not be predictive of the outcome of a contract: The amount of consideration is highly susceptible to factors outside the influence of the entity The uncertainty about the amount of consideration is not expected to be resolved for a long period of time The entity's experience with similar types of contracts is limited The contract has a large number and high variability of possible consideration amounts. The proposed standard includes an exception related to licenses for intellectual property in exchange for consideration that varies entirely based on the customer's subsequent sales of a good or service. In that case, the entity would not be reasonably assured to be entitled to that variable consideration until the underlying sales are made. Impact:
Current U.S. GAAP
Current IFRS
The proposed standard requires entities to determine the total transaction price, including an estimate of variable consideration, at the inception of the contract and on an ongoing basis. To determine the transaction price, entities may apply either the "expected value" or "most likely amount" approach, whichever is likely to be the most predictive of the amounts to which they will be entitled. The use of a weighted average assessment in arrangements including milestone payments with a binary outcome may not be most predictive of the actual outcome. Therefore the "most likely amount" may be more indicative of the actual amounts expected to be received, either zero or 100 percent of the milestone. As a general principle, consideration should be allocated to separate performance obligations in a contract based on relative standalone selling prices. Under certain circumstances, however, the entity should allocate the entire amount of contingent consideration (for example, a milestone) to the related performance obligation when the milestone satisfies two conditions: (1) it relates specifically to the entitys efforts to satisfy that performance obligation or to a specific outcome from satisfying that separate performance obligation and (2) allocating the contingent amount entirely to the separate performance obligation reflects the amount of consideration to which the entity expects to be entitled in exchange for satisfying the performance obligation when considering all of the other performance obligations and payment terms in the contract. For example, where an entity receives a milestone payment upon regulatory approval of a licensed asset that it continues to develop for its customer, it should consider whether the payment relates only to the license, research and development services, or to both the license and the research and development services. Entities will need to use judgment in applying the guidance for each specific arrangement.
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Proposed model
Current U.S. GAAP
Current IFRS
Revenue is recognized under current U.S. GAAP and IFRS once a certain trigger (that is, meeting a probability threshold or upon the achievement of a certain event) has been met. Under the proposed standard revenue will not be recognized on contingent milestones until the performance obligation is satisfied and the entity is reasonably assured to be entitled to the milestone payment. Entities will need to evaluate whether they have predictive experience with similar contracts in order to recognize revenue before the milestone occurs. For example, an entity may be reasonably assured to be entitled to a variable amount, prior to the completion of a milestone, when the milestone is related to the completion of a specific service and the entity has an established history of providing this service in similar contracts (this might be the case with a contract research organization performing clinical trial related functions, such as enrolling and testing patients). On the other hand, when an arrangement has substantive milestones based on a specific clinical outcome, an entity might not be reasonably assured to be entitled to the milestone payments until the specified event occurs, as the consideration is highly susceptible to factors outside the control of the entity (for example, clinical trial results or regulatory approval). Under the proposed standard, an entity transferring a license would not be reasonably assured to be entitled to the amounts for sales milestones until the underlying sales to which the milestones relate have occurred. This is consistent with current U.S. GAAP and IFRS.
Royalties
Proposed model Royalty revenue represents a form of variable consideration, and therefore the consideration will be estimated and included in the transaction price based on either the expected value (probability-weighted estimate) or most likely amount approach. Royalties are recognized as revenue when the related performance obligation is satisfied and the entity is reasonably assured to be entitled to the consideration associated with the royalty. If an entity licenses intellectual property to a customer and the customer promises to pay an amount of consideration that varies entirely based on the customer's subsequent sales of a good or service that uses the licensed intellectual property (for example, a sales-based royalty), the entity is not reasonably assured to be entitled to the promised amount of consideration until the uncertainty is resolved (that is, when the customer's subsequent sales occur). Impact: The proposed standard introduces an exception to the model for licenses that contain sales-based royalties. An entity is not reasonably assured to be entitled to the amount until the underlying sales of the licensee have actually occurred (regardless of whether they have predictive experience with similar arrangements). The proposed standard might result in similar accounting to current U.S. GAAP and IFRS under which royalty revenue is generally recognized as the underlying sales are made. However, if the technology was sold rather than licensed, earlier revenue recognition could occur if the entity has predictive experience with that type of arrangement. This could result in different accounting for economically similar transactions. Current U.S. GAAP Royalties are recognized as they are earned and when collection is reasonably assured. Royalty revenue is generally recorded in the same period as the sales that generate the royalty payment. Current IFRS Revenue from royalties accrues in accordance with the terms of the relevant agreement and is usually recognized on that basis unless it is more appropriate to recognize revenue on some other systematic basis.
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Collaborations and licensing arrangements

Pharmaceutical and life science entities frequently enter into complex strategic collaborations and licensing arrangements. In determining how to account for such collaborations the key issues include: Identifying whether the agreement falls within the scope of the proposed standard; and Determining what the separate performance obligations are and how to account for them. The proposed standard requires entities to assess whether the counterparty to the arrangement is (a) a customer or (b) a collaborator or a partner sharing in the risk of the arrangement. If such arrangements are outside the scope of the proposed standard, the related income might not meet the definition of revenue but rather might be recorded as a reduction in R&D expenditure or other income. The following example illustrates the principles of the proposed model for a collaboration agreement in the scope of the proposed standard with multiple performance obligations.
Example A collaboration agreement with multiple performance obligations

Facts: A biotech entity ("Biotech") enters into a collaboration arrangement with a pharmaceutical entity ("Pharma") in September 2011. Biotech grants an intellectual property license (License A) to Pharma and will perform research services on the intellectual property. Biotech receives an upfront payment of LC40 million, per-hour payments for research services performed, a milestone payment of LC150 million upon regulatory approval, and a 10% royalty on sales of a commercial product (estimated value of LC300 million). Research services are to be provided at cost. The normal rate at which Biotech provides its services is cost+25%. How does Biotech account for the arrangement? Discussion: Biotech determines the arrangement is in the scope of the proposed standard as it is providing a license and services to Pharma in the normal course of business. Biotech determines there are two performance obligations in the arrangement: (1) transfer of License A and (2) performance of research services. Management should determine whether the license and research services are distinct performance obligations. In this case, the license can be sold separately and can be used by Pharma with its own resources as Pharma could choose to perform the research itself. As such, each performance obligation is distinct and accounted for separately. Biotech estimates the payments to be received for research services will be LC12 million based on their expected effort taking into consideration experience gained while performing research services on other arrangements. Thus, at contract inception, Biotech estimates the total transaction price to be LC52 million, which includes the upfront payment (LC40m) and the payments for research services (LC12m). Management estimates the consideration for the contingent milestone (LC150m) and royalties (LC300m) to be zero using the most likely amount approach at inception. Given that regulatory approval is highly uncertain and susceptible to external factors, management cannot predict the amount to be received for milestones and royalties based on historical experience. Management allocates the estimated transaction price at inception (LC52m) based on relative standalone selling prices to the two performance obligations. Management determines the standalone selling price for License A to be LC45 million and for research services to be LC15m based on its estimate of the amount of hours necessary to perform research services plus a profit margin of 25%. The transaction price at inception is allocated 75% to License A and 25% to research services based on the proportion of standalone selling prices relating to each performance obligation as follows:
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Performance obligation 1. License A 2. Research services
LC'm
Stand alone price 45 15 60
Relative % 75 25 100
Upfront payment 30 10 40
Payments for research 9 3 12
Total 39 13 52
Transfer of the license performance obligation Biotech transfers License A at the inception of the contract. Upon transfer of the license, Biotech recognizes as revenue only the amount to which it is reasonably assured to be entitled allocated to the performance obligation, which is LC39m. Research services performance obligation Biotech recognizes revenue allocated to research services over the estimated research period based on a pattern that reflects the transfer of the services as the performance obligation for these services is satisfied continuously over the research period. In this case, an output model is used that considers estimates of the percentage of total research services that are completed each period. As a result, LC13 million is recognized over the research period. The transaction price should be re-estimated at each reporting date. At the point in time Biotech determines regulatory approval will be achieved, Biotech includes the contingent milestone of LC150m and the related royalties valued at LC300m (time value of money has been excluded) in the total transaction price. Biotech determines that the milestone and royalties should be allocated to both performance obligations rather than a specific performance obligation since management believes the consideration relates to both the license and research services in this arrangement. Therefore, LC450m will be allocated to the two performance obligations on the same basis the transaction price was allocated at the inception of the contract as follows: Stand alone price 45 15 60
Performance obligation 1. License A 2. Research services
LC'm
Relative % 75 25 100
Milestone 112.5 37.5 150
Royalties 225 75 300
Total 337.5 112.5 450
Transfer of the license performance obligation Biotech recognizes revenue of LC112.5m related to the milestone receipt allocated to License A as the performance obligation to transfer the license has been satisfied. Biotech does not recognize the LC225m related to the royalties until the entity is reasonably assured to be entitled to the amount, which is when subsequent customer sales occur. Research services performance obligation Biotech recognizes a portion of LC37.5m related to the milestone receipt allocated to research services based on the portion of the performance obligation that has been completed to date. Biotech does not recognize the LC75m related to the royalties until the entity is reasonably assured to be entitled to the amount, which is when subsequent customer sales occur.
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Government vaccine stockpile programs
Pharmaceutical, life science and medical technology entities may have bill-and-hold arrangements with their customers whereby an entity bills a customer for a product, but does not ship the product until a later date. Entities can currently recognize revenue when product is billed (rather than on delivery) under arrangements that meet certain criteria. The proposed standard focuses on when control of the goods transfers to the customer to determine when revenue is recognized. The requirement to have a fixed delivery schedule often precludes revenue recognition under current U.S. GAAP; however, this requirement is not included in the proposed standard. The proposed standard sets out the following criteria that should be met to conclude control has transferred: the reason for the arrangement is substantive, the product has been identified separately as belonging to the customer, the product is ready for delivery in accordance with the terms of the arrangement, and the entity does not have the ability to use the product or sell the product to another customer. Entities will need to consider the facts and circumstances of their arrangements to determine whether control of the product has transferred to the customer prior to delivery. Vaccine stockpile programs often require an entity to have a certain amount of vaccine inventory on hand for use by a government at a later date. While these arrangements were at the request of the government, the bill-and-hold criteria in U.S. GAAP for revenue recognition were not met. No revenue could be recognized upon transfer of inventory to the stockpile because typically such arrangements did not include a fixed schedule for delivery and the vaccine stockpile inventory may not be segregated from the entity's inventory. The entity rotated the vaccine stockpile in many cases to ensure it remained viable (did not expire). An exception has been provided by the SEC for entities that participate in U.S. government vaccine stockpile programs, which permits them to recognize revenue at the time inventory is added to the stockpile, provided all other revenue recognition criteria have been met. For entities following U.S. GAAP, the exception applies only to U.S. government stockpiles and only to certain vaccines. For entities following IFRS, depending on the substance of the arrangement, revenue might be recognized when the inventory is added to the stockpile if the bill-andhold requirements under IFRS are met. Entities that participate in government vaccine stockpile programs will need to assess whether control of the product has transferred to the government prior to delivery. The proposed standard does not require a fixed delivery schedule, but the requirement for transfer of control of the inventory may not be met if the stockpile inventory is not separately identified as belonging to the customer and is subject to rotation. It is not clear whether the SEC will carry forward its exception if the proposed standard is adopted. Entities will also need to consider their performance obligations under the arrangement if control is deemed to transfer prior to delivery. The storage of stockpile product, the maintenance and rotation of stockpile product and delivery of product may be distinct performance obligations under the arrangement.
Sell-through approach and consignment stock

Pharmaceutical, life science and medical technology entities may currently recognize revenue using a sell-through approach. Revenue is not recognized under this approach until the product is sold to the end customer, either because inventory is on consignment at distributors, hospitals, or others or because the final selling price is not determinable until the product has been sold through to the end customer. The proposed standard requires management to determine when control of the product has transferred to the customer. Entities will need to consider at what point control of consignment stock has passed to the customer based on the indicators provided in the proposed standard, which will impact the timing of revenue recognition. Proposed model Current U.S. GAAP Current IFRS Revenue is recognized once the risks and rewards of ownership have transferred to the end customer.
Revenue is recognized on the Revenue is recognized once the risks satisfaction of performance obligations, and rewards of ownership have which occurs when control of the good transferred to the end customer. or service transfers to the customer. Factors to consider include, but are not limited to, the customer has:
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Proposed model An obligation to pay Legal title Physical possession The risks and rewards of ownership Accepted the asset Impact:
Current U.S. GAAP
Current IFRS
The proposed standard requires an entity that has entered into a consignment stock arrangement with a distributor, hospital, or other customer to assess when control transfers to the customer. If the customer has control of the product, including the right (but not the obligation) to return the product to the seller at its discretion, control transfers when the product is delivered to the customer. This might result in earlier revenue recognition than under current standards, which focus on the transfer of risks and rewards. If the entity has the ability to require the customer to return the product (for example, a call right), control has not transferred to the customer. Revenue is therefore only recognized when products are sold through to an end customer, similar to current accounting.
Right of return
Pharmaceutical, life science, and certain medical technology entities may sell products with a right of return. The right of return often permits customers to return product within a few months prior to and following product expiration. Return rights may also take on various other forms, such as trade-in agreements. These rights generally result from the buyer's desire to mitigate the risk related to the products purchased and the seller's desire to promote goodwill with its customers. The sale of goods with a right of return will be accounted for similar to current guidance, which results in revenue recognition for only those products the entity is reasonably assured will not be returned. Pharmaceutical entities usually destroy returned inventory, but certain medical technology entities can re-sell returned product. The impact of product returns on earnings under the proposed standard will be largely unchanged from current U.S. GAAP and IFRS. However, the balance sheet will be grossed up to include the refund obligation and the asset for the right to the returned goods. The asset is assessed for impairment if indicators of impairment exist.
Medical devices
Medical technology entities face certain issues in addition to those noted above. Accounting for an arrangement with multiple deliverables has historically been a challenging area. Entities may routinely enter into multiple element arrangements, such as selling a device, selling replacement parts, and providing installation, training and service for the device. Medical equipment may incorporate software, subjecting the entity to the software revenue recognition requirements under the existing literature. In addition, medical technology entities may offer return rights and product warranties and may sell through distributors, all of which can result in additional challenges. The following provides a summary of some of the areas within the medical technology sector that may be affected by the proposed standard.
Elimination of software-specific guidance under U.S. GAAP

Certain medical technology entities sell complex medical equipment where software is a critical component of the product. A device with both software and non-software elements that work together to deliver the product's essential functionality are scoped out of the software revenue recognition guidance; however, any incidental software or subsequent sales of essential software are accounted for under the software guidance for U.S. GAAP. The proposed standard would replace all industry-specific guidance, including specific software revenue recognition guidance, under U.S. GAAP.
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Proposed model Products with software components The proposed standard requires separation of distinct performance obligations when they are satisfied at different points in time. Management should estimate the standalone selling price if it does not separately sell an identified performance obligation on a standalone basis.
Current U.S. GAAP
Current IFRS
Contract consideration is allocated to the separate software and nonsoftware deliverables based on the relative selling prices of all deliverables in the arrangement. Entities must follow a hierarchy for estimating the selling price of a deliverable. This hierarchy requires the selling price to be based on vendorspecific objective evidence ("VSOE") if available, third party evidence ("TPE") if VSOE is not available, or estimated selling price if neither VSOE nor TPE is available.
Revenue is allocated to individual elements of a contract, but specific guidance is not provided for software arrangements or on how the consideration should be allocated. Separating the components of a contract might be necessary to reflect the economic substance of an arrangement. Separation is appropriate when the identifiable components are delivered at different times, have standalone value, and their fair value can be measured reliably. The price regularly charged when an item is sold separately is the best evidence of the item's fair value.
Impact: The elimination of the VSOE requirement for software-related transactions might significantly affect the timing of revenue recognition in situations where revenue was previously deferred due to a lack of VSOE of fair value. The proposed standard is similar to current IFRS guidance.
Product warranties
Many pharmaceutical, life science and medical technology products are sold with implicit or explicit product warranties that the product sold to the customer meets an entity's quality standards and other applicable regulatory requirements and that the product is usable and not defective. Some entities also offer extended warranties, which provide for coverage beyond the standard warranty period. The proposed standard draws a distinction between product warranties that the customer has the option to purchase separately (for example, warranties that are negotiated or priced separately) and product warranties that the customer does not have the option to purchase separately. Management will need to exercise judgment when assessing a warranty not sold separately to determine if there is a service component to be accounted for as a separate performance obligation. Proposed model An entity should account for a warranty that the customer has the option to purchase separately as a separate performance obligation. Current U.S. GAAP Current IFRS Products are often sold with a "standard warranty," which protects the customer in the event that an item sold proves to have been defective at the time of sale (usually based on evidence coming to light within a standard period). This is not usually considered separable from the sale of goods. When the warranty is not a separate element and represents an insignificant part of the sale transaction, the full consideration received is recognized as
Warranties that protect against latent defects are accounted for as a loss contingency and do not generally constitute a deliverable. An entity records a liability for a warranty A warranty that the customer does not contingency and related expense when have the option to purchase separately it is probable that a loss covered by the should be accounted for in accordance warranty has been incurred and the with existing guidance on product amount of the loss can be reasonably warranties so long as the warranty only estimated. provides assurance that the product complies with agreed-upon In determining whether the loss can be specifications. reasonably estimated, an entity normally takes into account its own
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Proposed model A warranty, or a part of the warranty, which is not sold separately but provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications, creates a performance obligation for the promised service. An entity that cannot reasonably separate the service component from a standard warranty should account for both together as a separate performance obligation.
Current U.S. GAAP experience or other available information. Warranties that provide protection for defects that arise after the product is transferred are considered separate deliverables for which revenue is deferred and recognized over the expected life of the contract.
Current IFRS revenue on the sale and a provision is recognized for the expected future cost to be incurred relating to the warranty. If an entity sells a product with an extended warranty, it is treated as a multiple element arrangement and the revenue from the sale of the extended warranty is deferred and recognized over the warranty period. A provision is recognized for rectification and/or replacement only as defects arise through the warranty period. This differs from a standard warranty where provision is made at the time the goods are sold. Similar to other contracts, extended warranty contracts should be reviewed to ensure they are not onerous.
Impact: Similar to existing U.S. GAAP and IFRS, extended warranties give rise to a separate performance obligation under the proposed standard and, therefore, revenue is recognized over the warranty period. Warranties that are separately priced under U.S. GAAP may be impacted as the arrangement consideration will be allocated on a relative standalone selling price basis rather than at the contractual price. The amount of deferred revenue for extended warranties might differ under the proposed standard compared to current guidance as a result. Product warranties that are not sold separately and provide for defects that exist when a product is shipped will result in a cost accrual similar to current guidance.
Disclosures
The proposed standard requires disclosures to enable users of financial statements to understand the amount, timing and uncertainty of revenues and cash flows arising from contracts with customers. Required disclosures include qualitative and quantitative information about: Contracts with customers; The significant judgments, and changes in judgments, made in applying the proposed guidance to those contracts; and Assets recognized from the costs to obtain or fulfill contracts with customers. The proposed disclosure requirements are more detailed than currently required under U.S. GAAP or IFRS and focus significantly on the judgments made by management. For example, they include specific disclosures of the estimates used and judgments made in determining the amount and timing of revenue recognition. Pharmaceutical and life sciences entities will face challenges in estimating standalone selling price for certain deliverables (such as licenses), as well as determining the transaction price for variable consideration, and the judgments and methods used to make the estimates will have to be disclosed. The proposed standard also requires an entity to disclose the amount of its remaining performance obligations and the expected timing of the satisfaction of those performance obligations for contracts with durations of greater than one year. This might have a significant impact on the pharmaceutical and life science industry, where long-term collaboration contracts are a significant portion of an entity's business.
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Appendix A
The table below provides an overview of changes in the areas we reported in the September 2010 pharmaceutical and life sciences industry supplement. Topic Identification of separate performance obligations 2010 Exposure Draft An entity recognizes revenue from performance obligations separately if the goods or services are distinct. A good or service is distinct if an entity sells an identical or similar good or service separately. A good or service that has a distinct function and a distinct profit margin from the other goods or services in the contract is also distinct, even if not sold separately. 2011 Exposure Draft Key changes: The proposed model still focuses on separate performance obligations for distinct goods and services; however, it provides additional guidance to consider that may result in otherwise distinct goods or services being bundled together in some cases. Proposed guidance: A separate performance obligation exists if the goods or services are distinct. Goods or services are distinct if: The entity regularly sells the good or service separately; or The customer can use the good or service on its own or together with resources readily available to the customer. A good or service in a bundle is not distinct if the following criteria are met: The goods and services in the bundle are highly interrelated and require the entity to provide a significant service of integrating the goods or services; and The bundle of goods or services is significantly modified or customized to fulfill the contract. Variable consideration
Milestone payments Royalties Sales discounts, contractual allowances, rebates and pay for performance arrangements
The transaction price is the consideration that the entity expects to receive from the customer. The transaction price includes the probability-weighted estimate of variable consideration when management can make a reasonable estimate of the amount to be received. An estimate is reasonable only if an entity: has experience with identical or similar types of contracts; and does not expect circumstances surrounding those types of contracts to change significantly.
Key changes: The proposed guidance focuses on when the entity is "reasonably assured" of being entitled to variable consideration rather than when it can "reasonably estimate" the amount. The proposed standard provides guidance on when variable consideration would not be reasonably assured, which is when the amount of consideration in a license arrangement is based on the customers subsequent sales, such as sales-based royalties or milestones. In addition, the proposed guidance permits the use of the most likely amount, rather than a weighted average assessment when measuring variable consideration, which may simplify
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Topic
2010 Exposure Draft
2011 Exposure Draft the accounting. See further discussion on variable consideration above. Proposed guidance: The transaction price is the consideration that the entity is entitled to under the contract, including variable or uncertain consideration. It is based on the probability-weighted estimate or most likely amount of cash flows from the transaction, whichever is most predictive of the amount to which the entity is entitled. Revenue on variable consideration is only recognized when the entity is reasonably assured to be entitled to it. If an entity licenses intellectual property to a customer and the customer promises to pay an amount of consideration that varies entirely based on the customers subsequent sales of a good or service that uses the licensed IP (for example, sales-based royalty), the entity is not reasonably assured to be entitled to the promised amount of consideration until the uncertainty is resolved (that is, when subsequent sales occur).
The contract is a sale of intellectual property if the customer obtains control of the entire licensed intellectual property (e.g., the exclusive right to use the license for its economic life). The performance obligation is satisfied over the term of the license if the customer licenses intellectual property on an exclusive basis but does not obtain control for the entire economic life of the property. A contract that provides a nonexclusive license for intellectual property (e.g., offthe-shelf software) is a single performance obligation. An entity recognizes revenue when the customer is able to use the license and benefit from it.
Key changes: The concept of exclusivity has been removed from the proposals based on feedback from the industry. See further discussion on licenses above. Proposed guidance: The promised rights are a performance obligation that the entity satisfies when the customer obtains control (that is, the use and benefit) of those rights. An entity should consider whether the rights give rise to a separate performance obligation or whether the rights should be combined with other performance obligations in the contract.
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Topic Transfer of goods

Sell-through approach and consignment stock
2010 Exposure Draft Revenue is recognized on the satisfaction of performance obligations, which can occur at a point in time or continuously over time. Indicators that the customer has obtained control of the good or service may include: The customer has an unconditional obligation to pay The customer has legal title The customer has physical possession The customer specifies the design or function of the good or service
2011 Exposure Draft Key changes: Most of the guidance on transfer of goods has been carried forward from the 2010 ED except that the proposed guidance adds a risk and rewards indicator and eliminates the design or function indicator. Proposed guidance: An entity recognizes revenue for the sale of a good when the customer obtains control of the good. Indicators that the customer has obtained control of the good include: The customer has an obligation to pay The customer has legal title The customer has physical possession The customer has significant risks and rewards of ownership The customer provided evidence of acceptance
Rights of return
Revenue is not recognized for product that is expected to be returned. An entity records a liability for expected refunds to customers using a probability weighted approach. The liability is adjusted as an entitys estimate of expected returns changes.
Key changes: There have been no significant changes from the 2010 ED. We do not expect a significant impact versus current U.S. GAAP or IFRS in this area. Proposed guidance: Revenue is recognized for the consideration to which an entity is reasonably assured to be entitled (considering the products expected to be returned) and a liability is recognized for the refund to be paid to customers. The refund liability is updated for changes in expected refunds at each reporting period. An asset and corresponding adjustment to cost of sales is recognized for the right to recover goods from customers. The asset is initially measured at the original cost of the goods less any expected cost to recover those goods. Impairment is assessed at each reporting date.
Bill-and-hold arrangements
Revenue is recognized when control of the goods provided in a bill-and-hold arrangement is transferred. The following criteria must be satisfied: The customer has requested the contract to be on a bill-and-hold basis;
Key changes: There have been no significant changes from the 2010 ED. The proposed guidance and list of indicators for bill-and-hold transactions are consistent with the current guidance for IFRS. There may be situations where revenue is recognized earlier as compared to current
Dataline 16
Topic
2010 Exposure Draft The product is identified separately as the customers; The product is ready for delivery at the time and location specified by the customer; and The entity does not have the ability to sell the product to another customer.
2011 Exposure Draft U.S. GAAP because there would no longer be a requirement for the vendor to have a fixed delivery schedule from the customer in order to recognize revenue. See further discussion on government vaccine stockpile programs above. Proposed guidance: Revenue is recognized when control of the goods is transferred to the customer. All of the following requirements must be met to conclude that the customer has obtained control: The reason for the bill-and-hold arrangement must be substantive; The product must be identified separately as the customer's; The product must be ready for delivery at the time and location specified by the customer; and The entity cannot have the ability to use the product or sell it to another customer.
Warranties
Revenue is deferred for warranties that require replacement or repair of components of an item (that is, standard warranties), but only for the portion of revenue attributable to the components that must be repaired or replaced. Warranties that provide the customer with coverage for faults (that is, extended warranties) that arise after the entity transfers control to the customer give rise to a separate performance obligation.
Key changes: The distinction between warranties that protect against latent defects (that is, standard warranties) and warranties that cover normal wear and tear (that is, extended warranties) has been removed. The proposed guidance requires an entity to account for some warranties as a cost accrual, which is more consistent with current U.S. GAAP and IFRS. Proposed guidance: Warranties that the customer has the option of purchasing separately are accounted for as a separate performance obligation. Warranties that the customer does not have the option of purchasing are accounted for as a cost accrual so long as the warranty only provides assurance that the product complies with agreed-upon specifications. An entity that promises both a quality assurance and service-based warranty but cannot reasonably separate them, should account for both as a separate performance obligation.
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Authored by:
Denis Naughter Partner Phone: 1-973-236-5030 Email: denis.naughter@us.pwc.com Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Chad Bonn Partner Phone: +1 973 236 5372 Email: chad.bonn@us.pwc.com Guilaine Saroul Director Phone: 1-973-236-7138 Email: guilaine.saroul@us.pwc.com Adrian Bennett Director Phone: +44 (0)1223 552305 Email: adrian.james.bennett@uk.pwc.com Erin Davis Bennett Senior Manager Phone: +44 (0)207 804 5125 Email: erin.bennett@uk.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Retail and consumer industry supplement

No. 2011-35 (supplement) November 30, 2011 Whats inside: Overview .......................... 1 Right of return ................ 2 Sell-through approach ...................... 3 FOB synthetic shipping ........................ 4 Customer incentives ....... 6 Loyalty programs and gift cards ............... 8 Licenses and royalties ...................... 10 Warranties ..................... 12
Retail and consumer industry supplement

Overview
The accounting for revenue recognition in the retail and consumer sectors is governed by multiple pieces of literature under IFRS and U.S. GAAP. The proposed revenue recognition standard is not expected to have a broad impact on the existing accounting models; however, certain areas might be significantly affected. For example, certain aspects of product-based sales transactions that include customer incentives and loyalty programs could be affected. This paper describes some of the areas in the retail and consumer sectors that could be significantly affected by the proposed standard. Arrangements in the retail and consumer sector are often unique and the specific facts and circumstances should be evaluated closely when applying the proposed standard. The paper, its examples, and the related assessments contained herein, are based on our interpretation of the Exposure Draft, Revenue from Contracts with Customers, issued on November 14, 2011. The examples reflect our initial evaluation of the potential impact of the proposed standard and the conclusions are subject to further interpretation and assessment based on the final standard. We have also provided a high-level summary of key changes from the original exposure draft issued on June 24, 2010 (the 2010 Exposure Draft). References to the proposed model or proposed standard refer to the exposure draft issued in November 2011, unless otherwise indicated. For a more comprehensive description of the proposed standard, refer to PwC's Dataline 2011-35 (www.cfodirect.pwc.com) or visit www.fasb.org.
Dataline
Right of return
Return rights are commonly granted in the consumer industry and may take the form of price protection, product obsolescence protection, stock rotation, trade-in agreements, or the right to return all products upon termination of an agreement. Returned purchases from customers are also common in the retail industry. Some of these rights may be articulated in contracts with customers or distributors, while others are implied during the sales process, or based on historical practice. Proposed model Revenue should not be recognized for goods expected to be returned, and a liability should be recognized for the expected amount of refunds to customers. The refund liability should be updated for changes in expected refunds. An asset and corresponding adjustment to cost of sales should be recognized for the right to recover goods from customers on settling the refund liability. The asset will be initially measured at the original cost of the goods (that is, the former carrying amount in inventory). The asset should be assessed for impairment if indicators of impairment exist. Current U.S. GAAP Revenue is recognized at the time of sale if future returns can be reasonably estimated. Returns are estimated based on historical experience with an allowance recorded against sales for the gross value of the original sale. Revenue is not recognized until the return right lapses if an entity is unable to estimate potential returns. Current IFRS Revenue is typically recognized net of a provision for the expected level of returns, provided that the seller can reliably estimate the level of returns based on an established historical record and other relevant evidence.
Potential impact: The accounting for product returns under the proposed standard will be largely unchanged from current guidance under U.S. GAAP and IFRS. There might be some retail and consumer entities that are deferring revenue because they do not meet the restrictive criteria under current guidance to estimate the impact of return rights. The proposed guidance is less restrictive and therefore could result in revenue being recognized earlier than under today's guidance. Management will use a probability-weighted approach or most likely outcome, whichever is most predictive, to determine the likelihood of a sales return under the proposed If an entity is not reasonably assured of standard. the quantity of products that will be returned, revenue will not be The balance sheet will be grossed up to include the refund obligation and the recognized until the entity is asset for the right to the returned goods. reasonably assured of the quantity of products that will be returned (which may be when the right of return lapses).
Key change from the 2010 Exposure Draft: No significant change from the 2010 exposure draft.
Example 1 - Right of return as a separate performance obligation

Facts: A retailer sells 100 mobile phones for $100 each. The mobile phones cost $50 and the sale includes a return right for 180 days. The retailer determined that the probability of returns associated with this transaction is 10%, based on historical sales patterns. In establishing the 10% return rate, the retailer estimated a 32% probability that seven mobile phones will be returned, a 40% probability that nine mobile phones will be returned, and a 28% probability that 15 mobile phones will be returned. How should the retailer record the revenue and expected returns related to this transaction? Discussion: At the point of sale, $9,000 of revenue ($100 x 90 mobile phones) and cost of sales of $4,500 ($50 x 90 mobile phones) is recognized. An asset of $500 (10% of product cost, or $50 x 10 mobile phones) is recognized for the anticipated return of the mobile phones, and a liability of $1,000 (10% of the sale price) is established for the refund obligation. The probability of return is evaluated at each subsequent reporting date. Any changes in estimates are adjusted against the asset and liability, with adjustments to the liability recorded to revenue and adjustments to the asset recorded against cost of sales.
Dataline
Sell-through approach
The sell-through approach is used for some arrangements with distributors where revenue is not recognized until the product is sold to the end customer (that is, the consumer) because the distributor may have the ability to return the unsold product, rotate older stock, or receive pricing concessions so the risks and rewards of ownership have not transferred. Proposed model Revenue should be recognized when a good or service is transferred to the customer. An entity transfers a good or service when the customer obtains control of that good or service. A customer obtains control of a good or service if it has the ability to direct the use of and receive the benefit from the good and service. Indicators that the customer has obtained control of the good or service might include: The entity has a right to payment for the asset The entity transferred legal title to the asset The entity transferred physical possession of the asset The customer has significant risks and rewards of ownership The customer provided evidence of acceptance Current U.S. GAAP The sell-through approach is common in arrangements that include dealers or distributors. Revenue is recognized once the risks and rewards of ownership have transferred to the end consumer under the sell-through approach. Current IFRS A contract for the sale of goods normally gives rise to revenue recognition at the time of delivery, when the following conditions are satisfied: The risks and rewards of ownership have transferred; The seller does not retain managerial involvement to the extent normally associated with ownership nor retain effective control; The amount of revenue can be reliably measured; It is probable that the economic benefit will flow to the customer; and The costs incurred can be measured reliably. Revenue is recognized once the risks and rewards of ownership have transferred to the end consumer under the sell-through approach. Potential impact: The effect of the proposed standard on the sell-through approach will depend on the terms of the arrangement. The proposed standard requires management to determine when control of the product has transferred to the customer. If the customer/distributor has control of the product, including a right of return at its discretion, control transfers when the product is delivered to the customer/distributor. Any amounts related to expected sales returns or price concessions affect the amount of revenue recognized, but not when revenue is recognized. The timing of revenue recognition could change for some entities compared to current guidance, which is more focused on the transfer of risks and rewards than the transfer of control. The transfer of risks and rewards is an indicator of whether control has transferred under the proposed standard, but additional indicators will also need to be considered. If the entity is able to require the customer/distributor to return the product (that is, it has a call right), control has not transferred to the customer/distributor, therefore revenue is only recognized when the products are sold to a third party.
Dataline
Key change from the 2010 Exposure Draft: The 2011 exposure draft adds indicators to help assess when control of a good has transferred to the customer, including the customer having the risks and rewards of ownership and the customer providing evidence of acceptance.
Example 2 - Sale of products to a distributor on sell-through approach

Facts: A consumer products entity uses a distributor network to supply its product to the final customer. The distributor may return unsold product at the end of the contract term. Once the products are sold to the end customer, the consumer products entity has no further obligations for the product and the distributor has no further return rights. When does the consumer products entity recognize revenue? Discussion: Revenue is recognized once control of the product has transferred to the customer. If the distributor controls whether the goods are returned, the distributor is the "customer" and transfer of control occurs when the goods are obtained by the distributor. The distributor would recognize revenue subject to any anticipated returns.
Example 3 - Sale of products on consignment

Facts: A manufacturer provides household goods to a retailer on a consignment basis (for example, scan-based trading). The retailer does not take title to the products until they are scanned at the register. Any unsold products are returned to the manufacturer. Once the retailer sells the products to the consumer, the manufacturer has no further obligations for the products, and the retailer has no further return rights. When does the manufacturer recognize revenue? Discussion: The manufacturer will need to consider whether the retailer has obtained control of the products, including whether the retailer has an unconditional obligation to pay the manufacturer, absent a sale to the consumer. Revenue recognition prior to the sale to the consumer might not be appropriate. If the manufacturer retains the right to call back or transfer to another retailer unsold product, control has not transferred and revenue is recognized only when the product is sold to the third party.
FOB synthetic shipping

Consumer products entities will often replace or credit lost or damaged shipments even when sales contracts contain "free on board" (FOB) shipping point terms, and it is clear that title legally transfers at the time of shipment. Many consumer products entities have a customary business practice of compensating the customer for lost or damaged shipments such that the customer is in the same position as if the shipping terms were FOB destination. Revenue for shipments would likely be deferred until the product has been received by the customer under today's guidance because the risks and rewards of ownership have not been substantively transferred to the customer at the point of shipment. The timing of revenue recognition might change under a control based model. Proposed model Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Factors to consider in assessing control transfer include, but are not limited to: Current U.S. GAAP Revenue from the sale of a good should not be recognized until the seller has substantially accomplished what it must do pursuant to the terms of the arrangement, which usually occurs upon delivery or performance of the services. Current IFRS A contract for the sale of goods normally gives rise to revenue recognition at the time of delivery, when the following conditions are satisfied: The risks and rewards of ownership have transferred The seller does not retain managerial involvement The amount of revenue can be reliably measured
The customer has an unconditional The risks and rewards of ownership in obligation to pay the goods need to substantively transfer to the customer. Revenue is The customer has legal title deferred until the goods have been delivered to the end customer if the The customer has physical vendor has established a practice of possession covering risk of loss in transit.
Dataline
Proposed model The customer has significant risks and rewards of ownership The customer provided evidence of acceptance Situations where an entity transfers a good but retains the risk of loss based on shipping terms could be indicative of an additional performance obligation, since the transfer of risks and rewards to the customer did not occur.
Current U.S. GAAP
Current IFRS It is probable that the economic benefit will flow to the customer The costs incurred can be measured reliably Revenue is typically recognized once the goods reach the buyer when there are FOB synthetic destination terms, as risks and rewards of ownership typically transfer at that time.
Potential impact: The timing of revenue recognition could change significantly under the proposed model, as the focus shifts from transfer of risks and rewards to transfer of control of the goods. Management will need to assess whether FOB synthetic destination terms create an additional performance obligation under the proposed guidance. An example of this could be in-transit risk of loss coverage. Control of the underlying good could be transferred and revenue recognized when the product leaves the seller's location, depending on the contract terms, but there might be a second performance obligation for shipping and in-transit risk of loss. Management will need to allocate the transaction price to each of the performance obligations, and revenue would be recognized when each performance obligation is satisfied, which might be at different times.
Key change from the 2010 Exposure Draft: No significant change from the 2010 exposure draft.
Example 4 - FOB synthetic destination

Facts: An electronics manufacturer enters into a contract to sell flat screen televisions to a retailer. The delivery terms are free on board (FOB) shipping point (the legal title passes to the retailer when the televisions are handed over to the carrier). The manufacturer uses a third-party carrier to deliver the televisions. The manufacturer has a past business practice of providing replacements to the retailer at no additional cost if the televisions are damaged during transit. The retailer does not have physical possession of the televisions during transit, but the retailer has legal title at shipment and therefore can sell the televisions to another party. The manufacturer is also precluded from selling the televisions to another customer at the point of shipment. Does the manufacturer have a separate performance obligation with respect to retaining the risk of loss? Discussion: The manufacturer might conclude that it has two performance obligations: one for the televisions and a second to cover the risk of loss during transit of the televisions based on past business practice. The manufacturer has not satisfied its performance obligation regarding risk of loss at the point of shipment. The transaction price should be allocated to the televisions and to the service that covers the risk of loss. Revenue for the televisions is recognized at the time of shipping, as that is when the retailer gains control of the televisions. Revenue relating to assuming the risk of loss is recognized as the goods are being shipped.
Dataline
Customer incentives
Retail and consumer entities offer a wide array of customer incentives. Retailers commonly offer to their customers coupons, rebates issued at the point of sale, free products ("buy-one-get-one-free"), price protection, or price matching programs. Consumer product entities commonly provide vendor allowances, including volume rebates and cooperative advertising allowances, market development allowances, and mark-down allowances (compensation for poor sales levels of vendor merchandise). Consumer product entities also offer product placement or slotting fees to retailers. There are various accounting standards applicable today and some diversity in practice in accounting for such incentives. Proposed model The proposed standard requires management to identify the distinct performance obligations in an arrangement and allocate the transaction price to each performance obligation. Sales incentives including customer award credits, volume discounts, and coupons that are options to acquire additional goods or services are separate performance obligations if the option provides a material right. The measurement and allocation of the transaction price should consider the affect of customer incentives and other discounts. Current U.S. GAAP Sales incentives offered to customers are typically recorded as a reduction of revenue at the later of the date at which the related sale is recorded by the vendor or the date at which the sales incentive is offered. Volume rebates are recognized as each of the revenue transactions that results in progress by the customer toward earning the rebate occurs. Current IFRS Sales incentives offered to customers are recorded as a reduction of revenue at the time of sale. Management uses its best estimate of expected incentives awarded to estimate the sales price. The potential impact of volume discounts is considered at the time of the original sale. Revenue from contracts that provide customers with volume discounts is measured by reference to the estimated volume of sales and the expected discounts. Revenue should not exceed the amount of consideration that would be received if the maximum discounts were taken if management cannot reliably estimate the expected discounts.
Potential impact: The proposed standard will affect some U.S. GAAP reporting entities if the incentive provides the customer with a material right (for example, a discount on future purchases) that would not have been obtained without entering into the contract. These incentives are separate performance obligations. The transaction price is allocated to those performance obligations, which is recognized as revenue when the performance obligation underlying the incentive is fulfilled or when the right lapses. If the incentive creates variability in the pricing of the goods or services provided in the contract (such as volume discounts), entities will need to determine the probability-weighted estimate or most likely outcome, whichever is most predictive, to determine the transaction price. Revenue could be recognized sooner under this approach, especially for U.S. GAAP reporting entities.
Key change from the 2010 Exposure Draft: The concept of a "distinct profit margin," which was an indicator of whether a performance obligation was distinct, was eliminated. A good or service is distinct under the proposed guidance if either the entity regularly sells the good or service separately or the customer can benefit from the good or service on its own or together with a resource that is readily available.
Example 5 - Retailer issued coupons

Facts: A retailer sells a product and provides the consumer with a coupon for 60% off the future purchase of a second identical product. The retailer typically provides consumers with 10% discounts on future purchases. The selling price of the product is $10. How much revenue is recognized on the first sale?
Dataline
Discussion: The incentive is a separate performance obligation as it provides the consumer with a material right. Management needs to estimate the probability that the coupons will be redeemed. If the probability of redemption is 100%, the value of the option is $5 ($10 x 50% discount [that is, the incremental value to the consumer of the discount considering a 10% discount is typically offered by the retailer] x 100% expected redemption). Management allocates $3.33 ($10 x ($5 / ($5 + $10))) of the $10 transaction price to the coupon. The retailer recognizes revenue of $6.67 when the product is sold, assuming control transfers, and defers the coupon value of $3.33 until the coupon is redeemed or expires unredeemed. When the coupon is redeemed in connection with a future sale, the $3.33 allocated to the coupon is included with the transaction price for the subsequent sale.
Example 6 - Manufacturer issued coupons

Facts: A manufacturer sells 1,000 boxes of laundry detergent to a retailer for $10 per box. The sale from the manufacturer to the retailer is final, and control of the product passes to the retailer. There are no return rights, price protection, or stock rotation rights. The retailer sells the laundry detergent to consumers for $12 per box. The manufacturer simultaneously issues coupons for a $1 discount directly to consumers via newspapers. The coupons are presented by the consumer to the retailer upon purchase of the detergent. The consumer pays $12 if it has no coupon or $11 if it has a coupon. The retailer submits coupons to the manufacturer and is compensated at the face value of the coupons ($1). It is estimated that 400 coupons will be redeemed. How much revenue should the manufacturer and retailer recognize? Discussion: The manufacturer will recognize $9,600 of revenue ($10,000 less estimated coupon redemption of $400) for detergent sold to the retailer. The retailer will recognize revenue of $12 and cost of sales of $10 for each box upon sale to the consumer. This is not specifically addressed by the proposed standard, but we believe the additional consideration paid by the manufacturer represents revenue to the retailer, as the fair value of the total consideration received by the retailer is $12. Cost of sales remains at the original amount paid by the retailer to the manufacturer.
Example 7 - Free product rebate

Facts: A vendor is running a promotion whereby a consumer who purchases three boxes of golf balls at $20 per box in a single transaction receives a mail-in rebate for one free box of golf balls. How is the consideration allocated to the various deliverables in the arrangement? Discussion: The vendor is selling four boxes of golf balls for $60. Each performance obligation (that is, each box) is allocated $15 based on the relative estimated selling price. If the vendor is unable to determine at the date of the sale the number of mail-in rebates that will be used, the transaction price allocated to the undelivered box is deferred until the earlier of redemption or expiration of the rebate.
Example 8 - Slotting fees

Facts: A manufacturer sells product to a retailer for $8 million. The manufacturer also makes a $1 million non-refundable up-front payment to the retailer for product placement services. The retailer's promise to display the manufacturers products includes stocking and favorable placement of the products. How does the manufacturer account for the upfront payment? Discussion: The product placement services are not sold separately, so the service is not distinct because the manufacturer would not receive any benefit from the service without the sale of the product to the retailer. The manufacturer recognizes a reduction in the transaction price of $1 million and recognizes $7 million in revenue when control of the goods transfers to the retailer. The manufacturer does not receive a service from the retailer that provides a separate benefit apart from its sales of product to the retailer. The up-front payment represents a reduction of the transaction price, which results in lower revenue recognized for the product sold to the retailer.
Example 9 - Price protection if retailer subsequently lowers price

Facts: A retailer sells a product to customer A for $100 on January 1 and agrees to reimburse customer A for the difference between the purchase price and any lower price offered by the retailer over the next three months. How does the retailer account for the potential refund? Discussion: The consideration expected to be paid to the customer is recorded as a liability at the time of sale. The transaction price reflects the $100 sales price less the probability-weighted estimate or most likely outcome of the consideration expected to be refunded to customer A.
Dataline
Loyalty programs and gift cards

Retailers often use customer loyalty programs to build brand loyalty and increase sales volume by providing customers with incentives to buy their products. Each time a customer buys goods or services, or performs another qualifying act, the retailer grants the customer award credits. The customer can redeem the credits for awards such as free or discounted goods or services. Credits that are not redeemed are sometimes forfeited. The use of gift certificates and gift cards is common in the retail industry. The gift cards or certificates may be used by customers to obtain products or services in the future up to a specified monetary value. The amount of rights that are forfeited is commonly referred to as breakage. Breakage will typically result in the recognition of income for a retailer, however, the timing of recognition and classification depend on expected customer behavior and the legal restrictions in the respective jurisdiction. Proposed model Loyalty points An option to acquire additional goods or services gives rise to a separate performance obligation in the contract if the option provides a material right to the customer that the customer would not receive without entering into that contract. The proposed standard requires management to estimate the transaction price to be allocated to the separate performance obligations. There is divergence in practice in U.S. GAAP in the accounting for loyalty programs. Two models commonly followed are a multiple-element revenue model and an incremental cost accrual model. Loyalty programs are accounted for as multiple-element arrangements. Some revenue, based on the fair value of award credits, is deferred and recognized when the awards are redeemed or expire. Revenue is allocated between the good or service sold and the award credits, taking into consideration the fair value of the award credits to the customer. The assessment of fair value includes consideration of discounts available to other buyers absent entering into the initial purchase transaction and expected forfeitures. Current U.S. GAAP Current IFRS
Revenue is typically recognized at the time of the initial sale and an accrual is made for the expected costs of satisfying the award credits under the The customer is paying for the future incremental cost model. The multiple goods or services to be received when element model results in the customer award credits are issued in transaction price being allocated to the conjunction with a current sale. The product or service sold and to the entity recognizes revenue for the option award credits, with revenue recognized when it expires or when these future as each element is delivered. The goods or services are transferred to the incremental cost model is more customer. prevalent in practice. Gift cards Revenue is recognized on the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. The transaction price (that is, the amount of revenue to be recognized) is equal to the amount of consideration that an entity expects to receive from a customer in exchange for transferring goods or services (excluding amounts collected on behalf of third parties, such as sales tax). When the gift card is sold to the customer a liability is recognized for the future obligation of the retailer to honor the gift card. The liability is relieved (and revenue recognized) when the gift card is redeemed. The portion of gift cards not redeemed is referred to as breakage (see discussion below).
Payment received in advance of future performance is recognized as revenue only when the future performance to which it relates occurs. That is, revenue from the sale of a gift card or voucher is accounted for when the seller supplies the goods or services on exercise of the gift card. The portion of gift cards not redeemed is referred to as breakage (see discussion below).
Dataline
Proposed model Breakage The expected breakage amount should be recognized as revenue in proportion to the pattern of rights exercised by the customer if the entity is reasonably assured of the breakage amount. If the entity is not reasonably assured of the breakage amount, the expected breakage amount should be recognized as revenue when the likelihood of the customer exercising its remaining rights becomes remote.
Current U.S. GAAP
Current IFRS
There are three accounting models that are generally accepted for the recognition of breakage, depending on the features of the program, legal requirements and the vendor's ability to reliably estimate breakage: Proportional model - recognize as redemptions occur Liability model - recognize when the right expires Remote model - recognize when it becomes remote that the holder of the rights will not demand performance The model that management selects depends on the features of the incentive program and the ability to estimate breakage amounts. Where escheat laws apply, the vendor cannot recognize breakage revenue from escheatable funds since it is required to remit the funds to a third party even if the customer never demands performance. Potential impact:
No specific models are provided for recognizing breakage. The models used under U.S. GAAP are acceptable under IFRS.
Loyalty points The proposed standard is consistent with the multiple element model currently required under IFRS, but may have a greater impact on U.S. GAAP reporters. The transaction price is allocated between the product and the loyalty reward performance obligations. The amount allocated to the loyalty rewards is deferred and revenue is recognized when the rewards expire or are redeemed. This will result in later revenue recognition for a portion of the transaction price for those currently using an incremental cost model. Gift cards Entities will continue to defer revenue for the future obligation to honor gift cards under the proposed standard. Revenue is recognized when the gift card is redeemed or when it expires. Breakage Breakage is considered in the allocation of revenue to the separate performance obligations when the gift card is sold as part of a bundled arrangement. Expected breakage is recognized as revenue in proportion to the pattern of rights exercised by the customer, so current diversity in practice is likely to be eliminated. Breakage may also affect the timing of revenue recognition. Management must consider the impact of breakage for loyalty rewards in determining the transaction price allocated to the performance obligations in the contract.
Dataline
Key change from the 2010 Exposure Draft: The updated exposure draft includes guidance on how to apply the breakage model. An entity should recognize the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer, if it is reasonably assured of the amount of breakage. If an entity is not reasonably assured of a breakage amount, the entity should recognize the expected breakage when the possibility of redemption becomes remote.
Example 10 - Loyalty points

Facts: A retailer has a loyalty program that rewards customers one point per $1 spent. Points are redeemable for $0.10 on future purchases (but not redeemable for cash). A customer purchases $1,000 of product at the normal selling price and earns 1,000 points redeemable for $100 of goods or services in the future. The retailer expects redemption of 950 points (that is, 5% breakage). The retailer therefore estimates a standalone selling price for the incentive of $0.095 per point based on the likelihood of redemption ($0.10 less 5%). How is the consideration allocated between the points and the product? Discussion: The retailer would allocate the transaction price of $1,000 between the product and points based on the relative standalone selling prices of $1,000 for the product and $95 for the loyalty reward as follows: Product Points $913 ($1,000 x $1,000/$1,095) $ 87 ($1,000 x $95/$1,095)
The $913 of revenue allocated to the product is recognized upon transfer of control of the product and the $87 allocated to the points is recognized upon the earlier of the redemption or expiration of the points. The amount of unredeemed points (that is, 5% breakage) will be recognized as products are being delivered.
Example 11 - Gift cards

Facts: A customer buys a $100 gift card from a retailer, which can be used for up to one year from the date of purchase. The retailer estimates that the customer will redeem $90 of the gift card and $10 will expire unused (10% breakage). The entity has no requirement to remit any unused funds to the customer or any third party when the gift card expires. The entity's accounting policy for breakage is to apply the proportional model. Deferred revenue of $100 is recorded upon sale of the gift card. How is revenue recognized when the gift card is redeemed? Discussion: For every $1 of gift card redemptions, the retailer recognizes $1.11 ($1.00 x $100/$90) of revenue with $0.11 of the revenue reflecting breakage. For example, if the customer purchases a $50 product using the gift card, the retailer recognizes $55 of revenue, reflecting the product's selling price and the estimated breakage of $5.
Licenses and royalties

Licenses are common in the retail and consumer sector - both from the licensor and licensee perspective. Many products include a licensed image or name. Accounting for licenses under the proposed standard may be significantly affected. Proposed model Promises to provide licenses of intellectual property (IP) or other rights will give rise to a performance obligation that the entity satisfies at the point in time when the customer obtains control of the rights. An entity should assess whether the rights to use the IP are separate from Current U.S. GAAP Revenue under license arrangements is recognized when earned and realized or realizable. Revenue is generally earned at either the beginning or throughout the license term, depending upon the nature of the license and any other obligations of the licensor. Current IFRS Revenue is not recognized under licensing agreements until performance occurs and the revenue is earned. The assignment of rights for a nonrefundable amount under a noncancellable contract permits the licensee to use those rights freely and
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Proposed model other performance obligations in the contract to determine when revenue should be recognized. Customers do not obtain control of the rights to use IP before the beginning of the period during which the customer(s) can use and benefit from the license to the IP. Revenue recognition related to consideration that is contingent on future events (sales based royalties, for example) may be constrained if the entity is not reasonably assured of being entitled to those amounts. An entity is reasonably assured of being entitled to the contract consideration if it has experience with similar types of contracts and that experience is predictive of the outcome of the contract.
Current U.S. GAAP
Current IFRS
Royalty revenue is generally recognized where the licensor has no remaining obligations to perform is, in substance, when realized or realizable. a sale. A fixed license term is an indicator that the revenue should be recognized over the period because the fixed term suggests that the license's risks and rewards have not been transferred to the customer. However, the following indicators should be considered to determine whether a license fee should be recognized over the term or upfront: Fixed fee or non-refundable guarantee The contract is non-cancellable Customer is able to exploit the rights freely Vendor has no remaining performance obligations Royalties are recognized on an accrual basis in accordance with the relevant agreement's substance. Potential impact: The proposed standard requires revenue to be recognized when the customer obtains control of the rights to use the intellectual property, presuming those rights are separable from other performance obligations in the contract. This will mean that revenue is recognized when the customer receives the right to use the intellectual property in many circumstances. The timing of revenue recognition might therefore change from today's accounting depending on the model currently followed (over time or upfront). License revenue might, however, be constrained if the consideration for the license is variable and is determined by reference to the customers sales. Licensors may have to perform a much more detailed assessment of the legal terms of contracts to determine when control of the associated asset has been transferred. The time value of money might also need to be considered if there is a significant financing component in the contract.
Key changes from the 2010 Exposure Draft: The distinction made in the 2010 exposure draft between nonexclusive and exclusive licenses was eliminated during re-deliberations. Revenue should be recognized when the customer obtains control of the rights to use the intellectual property of the entity (subject to the separation criteria and the requirements for determining and allocating the transaction price). Revenue recognition related to consideration that is contingent on future events (sales based royalties, for example) may be constrained if the entity is not reasonably assured of being entitled to those amounts.
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Example 12 - Licenses
Facts: A designer jeans entity has a worldwide recognized brand. A global manufacturer of dolls often contracts with the designer jeans entity for the rights to use its brand name on the clothes of the dolls. The terms of the agreement provide the doll manufacturer exclusive rights to use the brand name on the clothes of its dolls for two years. The jeans entity will receive $1 million upfront and 12% of all sales of dolls that include garments branded by the jeans entity. The manufacturer will provide updated sales estimates on a quarterly basis and actual sales data on a monthly basis. When does the designer jeans entity recognize revenue? Discussion: The designer jeans entity will recognize revenue when the customer obtains control of the rights to the license and when it is reasonably assured to be entitled to the consideration. Revenue for the upfront payment of $1 million is recognized when the customer obtains control of the rights. The variable consideration to be received by the designer jeans entity depends on the level of sales of dolls. Revenue is not recognized for the variable consideration until the amounts are reasonably assured, which is when the designer jeans entity has obtained sufficient evidence to determine that the sales have occurred.
Warranties
Products are often sold with standard warranties that provide protection to the consumer that the product will work as intended for a fixed period of time. Many entities also offer extended warranties that cover defects that arise after the initial warranty period has expired. Standard warranties have historically been accounted for as a cost accrual while extended warranties result in the deferral of the revenue. The proposed standard draws a distinction between product warranties that the customer has the option to purchase separately (for example, warranties that are negotiated or priced separately) and product warranties that the customer does not have the option to purchase separately. Management will need to exercise judgment when assessing a warranty not sold separately to determine if there is also a service component embedded in the warranty that should be accounted for as a separate performance obligation. Proposed model If a customer has the option to purchase a warranty separately, an entity shall account for the promised warranty as a separate performance obligation because the entity promises a service to the customer in addition to the product. If a customer does not have the option to purchase a warranty separately, the entity shall account for the warranty in accordance with other existing guidance on product warranties. A promised warranty, or a part of the promised warranty, which is not sold separately but provides the customer with a service in addition to the assurance that the product complies with agreed specifications, creates a performance obligation for the promised service. Current U.S. GAAP Warranties are commonly included with product sales. Such warranties may be governed by third-party regulators depending on the nature of the product. Estimates of warranty claims are accrued at the time of sale for the estimated cost to repair or replace covered products for standard warranties. Extended warranties result in the deferral of revenue for the value of the separately priced extended warranty. The amount deferred is amortized to revenue over the extended warranty period. Current IFRS Management must determine if the warranty obligation is a separate element in the contract if the contract includes a warranty provision. When a warranty is not a separate element and it represents an insignificant part of the transaction, the seller has completed substantially all of the required performance and can recognize the consideration received as revenue at the time of sale. The expected future cost relating to the warranty is recorded as a cost of sale, as the warranty does not represent a return of a portion of the sales price. The warranty costs are determined at the time of sale, and a provision is recognized. If the cost of providing the warranty service cannot be measured reliably, no revenue is recognized prior to the expiration of the warranty obligation. The consideration for sale of extended warranties is deferred and recognized over the period covered by the warranty. When the extended warranty
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Proposed model
Current U.S. GAAP
Current IFRS is an integral component of the sale (that is, bundled into a single transaction), management attributes a relative fair value to each component of the bundle.
Potential impact: Extended warranties create separate performance obligations under the proposed standard and therefore revenue is recognized over the warranty period. This is similar to existing guidance. Warranties that are separately priced might be affected as the arrangement consideration will be allocated based on relative standalone selling prices rather than at the contract price. It may be difficult to separate standard warranties from those that also provide a service in some situations. Determining the estimated standalone selling price for the latter category when such warranties are not sold separately could also be challenging. The amount of deferred revenue for extended warranties might vary under the proposed standard compared to current guidance. Product warranties that are not sold separately and that provide for defects at the time a product is shipped will result in a cost accrual similar to current guidance.
Key changes from the 2010 Exposure Draft: The 2010 exposure draft distinguished between two types of warranties - those that provided coverage for latent defects and those that provided coverage for faults after product delivery. Coverage for latent defects did not create a performance obligation, but resulted in a revenue deferral for products expected to be replaced, similar to a right of return. Significant concerns were raised over the complexity in the proposed model, so the boards have made changes to simplify the approach. These warranties will now be accounted for similar to current practice and result in a cost accrual provided they are not sold separately by the entity. A product warranty that provides coverage for faults arising after the product is transferred will give rise to a separate performance obligation if sold separately by the entity or, if not sold separately, if it provides a service in addition to coverage for defects.
Example 13 - Warranty cost accrual

Facts: A manufacturer sells stereo equipment. The manufacturer also provides a 60-day warranty that covers certain components of the stereo equipment. The warranty is not sold separately by the entity. How should the manufacturer account for the warranty? Discussion: The proposed standard requires that the manufacturer treat the warranty as a cost accrual similar to existing contingency (U.S. GAAP) or provisions (IFRS) guidance.
Example 14 - Warranty separate performance obligation

Facts: A manufacturer sells stereo equipment and a 12-month extended warranty that the customer has the option to purchase separately. How should the manufacturer account for the warranty? Discussion: The proposed standard requires that the manufacturer treat the 12-month warranty as a separate performance obligation. A portion of the transaction price is allocated to the warranty based on its relative standalone selling price and is recognized as revenue when the warranty obligation is satisfied. The manufacturer will need to assess the pattern of warranty satisfaction to determine when revenue is recognized (that is, ratably or some other pattern).
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Authored by:
Steven Barr U.S. Retail and Consumer Assurance Leader Phone: 1-415-498-5190 Email: steven.j.barr@us.pwc.com Peter Schlicksup Partner Phone: 1-973-236-5259 Email: peter.j.schlicksup@us.pwc.com Steve Mack Senior Manager Phone: 1-973-236-4378 Email: steve.mack@us.pwc.com Erin Devine Senior Manager Phone: 1-973-236-4133 Email: erin.e.devine@us.pwc.com Patrick Villanova Senior Manager Phone: 1-213-217-3306 Email: patrick.villanova@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Transportation and logistics industry supplement

No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Scope ............................... 2 Transportation revenue and costs ........ 2 Customer loyalty programs frequent flyer programs ...................... 5 Onerous performance obligations .....................7 Change fees ......................7 Collectibility .....................7 Variable consideration... 8
Transportation and logistics industry supplement

Overview
The Transportation and Logistics industry includes entities associated with four primary modes of transportation: shipping, railways, airlines, and trucking and logistics. Customers generally pay a fee for the movement of cargo or passengers between two or more specified points. Customer incentives are primarily in the form of volume discounts, or for airlines, customer loyalty programs where awards are earned based on mileage flown and can be redeemed for a variety of products or services. The accounting for common transactions in the transportation industry may be affected by the proposed revenue recognition standard. This publication, including the examples and related assessments, is based on the Exposure Draft, Revenue from Contracts with Customers, issued on November 14, 2011. The proposed standard is subject to change until a final standard is issued. The examples reflect the potential effects of the proposed standard, pending further interpretation and assessment based on the final standard. For a more comprehensive description of the model, refer to PwC's Dataline 2011-35 or visit www.fasb.org.
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Scope
Some contracts within the transportation industry may include components that are in the scope of the revenue standard and components that are in the scope of other standards (for example, a lease contract that also includes maintenance or other services). The proposed revenue standard applies to all contracts with customers except for: Lease contracts Insurance contracts Certain contractual rights or obligations within the scope of other standards, including financial instrument contracts Certain guarantees (other than product warranties) within the scope of other standards Nonmonetary exchanges (between entities in the same line of business) to facilitate a sale to another party The proposed revenue standard states that if a contract is partially within the scope of another standard, an entity applies the separation and/or measurement requirements of the other standard first if that standard specifies how to separate or measure components of a contract. Otherwise, the principles in the revenue standard are applied to separate and/or initially measure the part(s) of the contract. The determination of whether an arrangement contains a lease might have significant accounting implications. Careful consideration of the appropriate standard to follow is warranted before applying the revenue standard to a contract. Contracts that involve providing or using fixed assets (for example, vessel charters) might contain a lease component. Management will need to assess whether the contract is or contains a lease and then determine whether the lease component should be accounted for separately from any service component. The boards are currently redeliberating a new lease model that we expect will be effective at the same time as the new revenue standard. Refer to Dataline 2011-21, Leasing: Redeliberations of the leasing project Some new twists, for an update on the latest redeliberations of the lease exposure draft. The following discussion relates only to contracts and or components of contracts that are within the scope of the revenue standard.
Transportation revenue and costs

Transportation or freight services are generally provided over a period of time ranging from a day to several months. The proposed standard includes a control transfer model for recognizing revenue. Revenue is recognized as an entity satisfies a performance obligation by transferring control of a good or service. A performance obligation might be satisfied over time or at a point in time. Proposed model Transportation revenue A performance obligation is satisfied over time if the entitys performance creates or enhances an asset the customer controls, or the entity's performance does not create an asset with alternative future use to the entity, and any one of the following apply: The customer simultaneously receives and consumes a benefit as the entity performs There are two predominant methods for recognizing revenue and costs for freight services: (1) recognize both revenue and direct costs when the shipment is completed, or (2) allocate revenue between reporting periods based on relative transit time in each period with costs recognized as incurred (the Revenue is recognized for service transactions, such as freight services, based on the stage of completion of the transaction. Costs are recognized as incurred. Current U.S. GAAP Current IFRS
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Proposed model Another entity would not need to substantially reperform any work completed to date if another entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance to date and expects to fulfill the contract as promised An entity should recognize revenue over time only if the entity can reasonably measure its progress towards satisfaction of the performance obligation. Transportation costs Incremental costs incurred to obtain a contract should be recognized as an asset if they are expected to be recovered. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained (for example, sales commissions). An entity is permitted to recognize contract acquisition costs as an expense as incurred if the amortization period would be a period of one year or less, as a practical expedient. Costs to fulfill a contract are in the scope of the revenue guidance only if they are not addressed by other standards. Costs in the scope of other standards that are required to be expensed by those standards cannot be recognized as an asset under the revenue guidance. An entity should recognize an asset under the revenue guidance only if the costs relate directly to a contract, will generate or enhance a resource that the entity will use to satisfy future performance obligations in a contract, and are expected to be recovered under a contract. The costs that relate directly to a contract include costs that are incurred before the contract is obtained if those
Current U.S. GAAP proportionate performance method).
Current IFRS
Impact: Transportation services will meet the criteria for revenue recognition over time when the work completed to date would not need to be reperformed. It is not necessary that the contract permit an entity to transfer a performance obligation to another entity. Freight fulfillment costs will continue to be expensed as incurred unless (a) they can be capitalized under another standard; or (b) they relate directly to a contract, relate to future performance, and are expected to be recovered. Where revenue is recognized over time, it is unlikely that fulfillment costs will be capitalized under the proposed standard.
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Proposed model costs relate to a specific anticipated contract. The costs of abnormal amounts of wasted materials, labor, or other resources that were not reflected in the price of the contract should be recognized as an expense when incurred. Capitalized costs are then amortized consistently with the pattern of transfer of control of the goods or services to which the asset relates.
Current U.S. GAAP
Current IFRS
Example #1
Facts: A shipping entity enters into a contract with a customer to transport goods from point A to point B. The customer has an unconditional obligation to pay for the service when the service has been performed, which is when the goods reach point B. When should the entity recognize revenue from this contract? Discussion: These types of contracts will typically meet the criteria for revenue recognition over time. If the shipping entity transports the goods halfway to their destination, another transportation entity could fulfill the remaining obligation to the customer without having to reperform the services provided to date (even if the obligation could not be transferred legally or if it would be unlikely because of the cost of changing vendors). The obligation to provide transportation services is therefore satisfied over time, and revenue should be recognized over the period of performance.
Example #2
Facts: A logistics entity enters into a contract to perform inventory management services for its customer over a two-year period. Mobilization costs are incurred in preparing to service the customer in accordance with the contract. These costs include employee training, leasehold improvements on warehouse space, and internally developed software related to software enhancements and customization to perform under the contract. How should these costs be accounted for? Discussion: Management will first need to evaluate if the costs incurred to fulfil the contract are in the scope of other standards to determine if the costs must be expensed or capitalized under the other standard. The accounting for the internally developed software costs is in the scope of the guidance for internally developed software costs and will be evaluated in accordance with that guidance. Leasehold improvement costs fall under PP&E guidance and are evaluated accordingly. The training costs fall under IAS 38, Intangible Assets, for IFRS reporters and would be expensed as costs cannot be capitalized under the revenue standard if they must be expensed under other applicable standards. US GAAP does not have a standard that specifically covers training costs. These costs would be evaluated in accordance with the guidance in the revenue standard. These costs to fulfill a contract would be eligible for capitalization so long as they: (a) relate directly to the contract; (b) generate or enhance resources that will be used to satisfy future performance obligations; and (c) are probable of recovery.
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Customer loyalty programs frequent flyer programs

Transportation and logistics entities such as airlines often grant award credits (often called "points" or "miles") as part of sales transactions, including award credits that can be redeemed for goods and services supplied by other entities. The most common customer loyalty programs in the industry are the frequent flyer programs offered by airlines. Proposed model Credits issued under customer loyalty programs are separate performance obligations if they provide the customer with a material right that the customer would not receive without entering into the transportation contract. The transaction price is allocated between the initial flight and the award credits based on the actual or estimated standalone selling price of each obligation. Current U.S. GAAP There is divergence in practice in the accounting for loyalty programs. Two models commonly followed are the incremental cost model and the multiple-element model. Many entities use the incremental cost model, whereby revenue is recognized for the flight when the flight occurs. The cost of fulfilling award credits is treated as an expense and accrued. Current IFRS Customer loyalty programs are accounted for as multiple-element arrangements. Revenue allocated to the award credits is deferred and recognized when the award credits are redeemed or expire. The fair value of the award credits is adjusted for discounts available to other buyers absent entering into the initial purchase transaction and for expected forfeitures (breakage). Management determines whether the entity is acting as a principal or an agent in the arrangement. An entity may be acting as an agent if it issues award credits that are transferred to and redeemed by other entities. Revenue is recognized net of payments made to others to redeem award credits if the entity is acting as an agent.
Revenue relating to the award credits is deferred until the obligation is satisfied Other entities use the multiple-element (that is, when the award credits are model and allocate revenue to the redeemed or expire). award credits based on relative fair values. Revenue allocated to the award The stand-alone selling price for a credits is deferred and recognized when customer's option to acquire additional the award credits are redeemed or goods or services (loyalty awards) is expire. The fair value of the award not usually directly observable and may credits is not reduced for expected be estimated. That estimate should forfeitures (breakage). reflect the discount the customer would obtain when exercising the option, An entity determines whether it is adjusted for discounts readily available acting as a principal or an agent in the without the option and the likelihood arrangement based on certain criteria. that the option will be forfeited (breakage). Breakage related to award credits expected to be forfeited is accounted The airline recognizes revenue from the for either proportionally as the awards award credits on a gross basis when the are redeemed or when the awards airline redeems the award credits for expire. goods or services that it provides. The Impact: airline recognizes revenue for the net Award credits issued under customer amount retained when the airline loyalty programs will likely be arranges for another party to provide accounted for as separate performance those goods or services. obligations and the incremental cost model will no longer be acceptable. Adjustments for expected forfeitures (breakage) will affect the timing of revenue recognition. The stand-alone selling price of award credits will be reduced to reflect the award credits not expected to be redeemed. The accounting for breakage will result in earlier revenue recognition for entities that apply the multiple-element model today.
Impact: The proposed standard is consistent with the current IFRS guidance and the effect will therefore be limited.
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Proposed model
Current U.S. GAAP Management will need to determine whether the entity is acting as a principal or an agent when delivering the underlying goods or services upon redemption of award credits. An entity might be acting as an agent if it issues award credits that are transferred to and redeemed by other entities. The entity will recognize revenue from the award credits net of payments made to other parties in these situations. These changes will align the accounting for customer loyalty programs under US GAAP with IFRS.
Current IFRS
Example #3
Facts: Airline A has a frequent flyer customer loyalty program that rewards customers with one award credit for each mile flown. A customer purchases a ticket for $500 (the stand-alone selling price) and earns 2,500 award credits based on mileage flown. Award credits are redeemable at a rate of 25,000 award credits for one free travel award, which has an average value of $500 ($0.02 per credit). The award credits may only be redeemed for flights with Airline A. How is the consideration allocated between the award credits and the ticket (ignoring breakage)? Discussion: The transaction price of $500 is allocated between the ticket and award credits based on the relative standalone selling prices of $500 for the ticket and $50 (2,500 points x $0.02) for the award credits as follows: Ticket: Award credits: $455 ($500 x $500/$550) $ 45 ($500 x $50/$550)
Revenue of $455 is recognized when the flight occurs. Revenue of $45 is recognized upon the earlier of the redemption of the travel award or expiration of the award credits.
Example #4
Facts: Assume the same facts as in Example 3 above, except that the airline expects redemption of 80% of award credits earned (that is, 20% breakage) based on the airline's history. The airline estimates a stand-alone selling price for the credits of $0.016 ($0.02 x 80%) based on the likelihood of redemption. How is the consideration allocated between the award credits and the ticket? Discussion: The transaction price of $500 is allocated between the ticket and award credits based on the relative standalone selling prices of $500 for the ticket and $40 (2,500 points x $0.016) for the award credits as follows: Ticket: Award credits: $463 ($500 x $500/$540) $ 37 ($500 x $40/$540)
Revenue of $463 is recognized when the flight occurs. Revenue of $37 is recognized upon the earlier of the redemption of the travel award or expiration of the award credits.
Example #5
Facts: Assume the same facts as in Example 4 above, except that the award credits can be redeemed for services not provided by the airline. The airline pays other participating entities the value of the award credits less a 10% commission
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when the award credits are redeemed for products or services not provided by the airline. How much revenue is recognized upon the redemption of the award credits assuming all credits are redeemed by other entities? Discussion: Revenue of $3.70 (10% of $37) is recognized upon the redemption of the award credits for products not provided by the airline. The entry when the award credits are redeemed is as follows: Dr. Contract Liability Cr. Revenue Cr. Cash $37.00 $ 3.70 33.30

The proposed standard requires that performance obligations satisfied over a period of time greater than one year be assessed to determine whether a loss will be incurred relating to that obligation. Proposed model Management will need to assess whether performance obligations satisfied over a period greater than one year are onerous. A provision for an onerous performance obligation is recorded if the lowest cost of settling the performance obligation exceeds the transaction price allocated to that performance obligation. Current U.S. GAAP Anticipated losses on executory contracts generally should not be recognized. Current IFRS Contracts in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received are onerous; thus, an onerous provision is recognized.
Impact: Management will need to evaluate services performed over a period greater than a year will need to be evaluated to determine if the performance obligation is onerous.
Change fees
Change fees are common in the airline industry. The predominant industry practice under U.S. GAAP and IFRS is to account for change fees as a separate transaction independent of the original ticket sale and recognize revenue when the change occurs. Change fees are viewed as a separate transaction because the fees are charged subsequent to the initial sale, passengers are not required to pay the fee at the time of the original sale, and passengers who pay the fee receive an additional benefit. An alternative view is that the change is not a separate transaction, but the result of the customer paying the lowest cost to obtain the new travel reservation (that is, paying the change fee instead of the price of a new ticket). The change fee is deferred and recognized when the travel occurs when following this view under current guidance. The proposed standard will require management to consider whether the change fee should be accounted for as a separate contract or as a modification of the original contract. Change fees do not appear to meet the criteria to be accounted for as a separate contract as they do not typically result in the delivery of an additional distinct good or service for a standalone selling price. They are likely to be a contract modification that results in a change in transaction price and at times, also a change in the service to be delivered. The change fee would likely not be accounted for as a separate contract and would likely be accounted for as a modification of the original sales transaction and recognized when the travel occurs.
Collectibility
Collectibility refers to the risk that the customer will not pay the promised consideration. Collectibility will no longer be a hurdle to revenue recognition as it is under today's guidance.
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Proposed model Any expected impairment loss due to credit risk will be presented in a separate line item adjacent to the revenue line. Both the initial assessment and any subsequent changes in the estimate of bad debt expense will be recorded in this line.
Current U.S. GAAP Revenue is recognized when payment is reasonably assured (or probable). Credit risk is reflected as a reduction of accounts receivable by recording an increase in the allowance for doubtful accounts and bad debt expense, which is usually recorded as a general and administrative expense.
Current IFRS Management must establish that it is probable that economic benefits will flow before revenue can be recognized. Provision for bad debts (incurred losses on financial assets including accounts receivable) is recognized in a two-step process: (a) objective evidence of impairment must be present; then, (b) the amount of the impairment is measured based on the present value of expected cash flows. The expense is usually recorded as a general and administrative expense.
Impact: Revenue may be recognized earlier than current practice since collectibility will no longer be a recognition threshold. Customers' credit risks will reduce gross profit.
Determining the transaction price is simple when the contract price is fixed and paid at the time services are provided. Determining the transaction price may require more judgment if the consideration contains an element of variable or contingent consideration. Common issues for the transportation and logistics industry include the accounting for volume discounts and performance bonuses. Many transportation and logistics entities offer discounts for shipping a specified cumulative volume or shipping to or from specific locations. Discounts based on volume or other factors are variable consideration under the proposed standard. Proposed model Volume discounts Volume discounts are generally receivable by the customer when specified cumulative levels of revenue are earned. The transaction price is the consideration that the entity expects to be entitled to receive under the contract, including variable or uncertain consideration. It is based on either the probability-weighted estimate or most likely amount of cash flows expected from the transaction, depending on which is the most predictive of the amount to which the entity would be entitled. If an entity receives consideration from a customer and expects to refund some or all of that consideration, a liability should be recognized for the amount of Volume rebates are recognized as a reduction to revenue as the customer earns the rebate. The reduction is limited to the estimated amounts potentially due to the customer. If the discount cannot be reliably estimated, revenue is reduced by the maximum potential rebate. Volume discount payments are systematically accrued based on discounts expected to be taken. The discount is then recognized as a reduction of revenue based on the best estimate of the amounts potentially due to the customer. If the discount cannot be reliably estimated, revenue is reduced by the maximum potential rebate. Current U.S. GAAP Current IFRS
Impact: Accounting for most volume discounts is unlikely to be significantly different under the proposed standard compared to today's accounting (U.S. GAAP and IFRS). The accounting for contracts with downward tiered pricing based solely on volume may, however, be different than current U.S. GAAP.
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Proposed model consideration that the entity expects to refund. Revenue is recognized as a performance obligation is satisfied but only if an entity is reasonably assured to be entitled to the amount allocated to that performance obligation. An entity is reasonably assured to be entitled to an amount when it has experience with similar contracts (or has other persuasive evidence such as access to the experience of other entities with similar contracts) and the entity's experience is predictive. Time value of money An entity will adjust the amount of promised consideration to reflect the time value of money if the contract includes a significant financing component. As a practical expedient, an entity need not assess whether a contract has a significant financing component if the entity expects at contract inception that the period between payment by the customer and the transfer of the services to the customer will be one year or less. Management uses a discount rate that reflects a separate financing transaction between the entity and its customer, and factors in credit risk.
Current U.S. GAAP
Current IFRS
The discounting of revenues is required in only limited situations, including receivables with payment terms greater than one year. When discounting is required, the interest component is computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable.
Discounting of revenues to present value is required where the effect of discounting is material. An imputed interest rate is used to determine the amount of revenue to be recognized, as well as the separate interest income component to be recorded over time.
Impact: The proposed standard is not significantly different than today's guidance. We do not expect a significant change to current practice for most transportation and logistics entities in connection with the time value of money, because payment terms often do not extend over more than one year from the timing of contract performance.
Example # 6
Facts: A railway entity enters into a contract to ship goods from point A to point B for $1,000. The customer earns a discount of $100 per load if the customer ships at least 10,000 loads annually. Based on past experience, management believes that it is probable that the customer will ship 10,000 loads and earn the discount of $100 per load. How should the railway entity record revenue from this contract? Discussion: The railway entity will record revenue of $900 per load based on the most likely amount of consideration it expects to be entitled to. Any excess amounts paid (that is, the additional $100 per load prior to earning the discount) are recorded as a refund liability. This estimate is monitored and adjusted, as necessary, using a cumulative catch-up approach.
Dataline
Authored by:
Klaus-Dieter Ruske Global Transportation and Logistics Leader Phone: 49-211-981-2877 Email: klaus-dieter.ruske@de.pwc.com Ken Evans U.S. Transportation and Logistics Leader Phone: 1-305-375-6307 Email: ken.evans@us.pwc.com David Mandelbaum Senior Manager Phone: 1-646-471-6040 Email: david.n.mandelbaum@us.pwc.com Michael Parsons Senior Manager Phone: 1-305-375-6355 Email: michael.l.parsons@us.pwc.com Simone Sherlock Senior Manager Phone: 1-973-236-5536 Email: simone.t.sherlock@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Technology industry supplement

No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Elimination of software-specific guidance ....................... 2 Intellectual property licenses .......................... 3 Variable consideration... 4 Multiple-element arrangements .............. 6 Allocation of transaction price...........7 Consulting service contract ........................ 8 Rights of return ............ 10 Product warranties ....... 11 Onerous performance obligations ................... 12
Technology industry supplement

Overview
The technology industry is comprised of numerous subsectors, including, but not limited to, computers and networking, semi-conductors, software and internet, and clean technology. Each subsector has diverse product and service offerings and various revenue recognition issues. Determining how to allocate consideration among elements of an arrangement and when to recognize revenue can be extremely complex and, as a result, industry-specific revenue recognition models have developed. The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are working to replace these multiple sets of guidance with a standard that will contain a single recognition model, regardless of industry. We believe this will significantly impact a number of the technology subsectors. The following provides a summary of some of the areas within the technology industry that may be significantly affected by the proposed revenue recognition standard. This paper, the examples, and the related assessments contained herein, are based on an interpretation of the Exposure Draft, Revenue from Contracts with Customers, issued on November 14, T 2011. We have also provided a high-level summary of key changes from the original r exposure draft issued on June 24, 2010 (the 2010 Exposure Draft). References to the a proposed model or proposed standard refer to the exposure draft issued in November n 2011, unless otherwise indicated. The examples reflect the potential impact of the guidance s based on the proposed standard and any conclusions noted are subject to further interpretation and assessment based on the final standard. For a more comprehensive p description of the proposed standard, refer to PwC's Dataline 2011-35 o (www.cfodirect.pwc.com) or visit www.fasb.org.
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Elimination of software-specific guidance

The proposed standard will replace all industry-specific revenue guidance, including specific software revenue recognition guidance under U.S. GAAP. The elimination of the existing guidance will have an especially significant impact on the accounting for software and software-related transactions. Proposed model Software arrangements involving multiple elements The proposed standard requires separation of distinct performance obligations when they are satisfied at different points in time. Management should estimate the standalone selling price if it does not separately sell an identified performance obligation on a standalone basis. Contract consideration is allocated to the various elements of an arrangement based on vendor-specific objective evidence (VSOE) of fair value, if such evidence exists for all elements in the arrangement. Revenue is allocated to individual elements of a contract, but specific guidance is not provided for software arrangements or on how the consideration should be allocated. Separating the components of a contract might be necessary to reflect the economic substance of an arrangement. Separation is appropriate when the identifiable components are delivered at different times, have standalone value, and their fair value can be measured reliably. The price regularly charged when an item is sold separately is the best evidence of the item's fair value. Other approaches to estimating fair value may also be appropriate, including cost plus a reasonable margin, the residual method, and under rare circumstances, the reverse residual method. Potential impact: The proposed separation and allocation methodology is similar to the current IFRS guidance. Current U.S. GAAP Current IFRS
Revenue is deferred when VSOE of fair value does not exist for undelivered The residual approach may be used for elements until the earlier of: (a) when determining the standalone selling VSOE of fair value for the undelivered price of a good or service if the pricing element does exist; or (b) all elements of that good or service is highly variable of the arrangement have been or uncertain. A selling price is highly delivered. variable when an entity sells the same good or service to different customers Potential impact: VSOE of fair value at or near the same time for a broad will no longer be required for range of amounts. A selling price is undelivered items in order to separate uncertain when an entity has not yet and allocate contract consideration to established a price for a good or service the various promises in a contract. The and the good or service has not elimination of the VSOE requirement previously been sold. for software-related transactions might significantly affect the timing of revenue recognition in situations where revenue was previously deferred due to a lack of VSOE of fair value. These changes could also result in the need for significant modifications to the information systems currently used to record revenue. Post-contract customer support (PCS) The proposed standard requires the separation of distinct performance obligations in a contract when they are satisfied at different points in time. Management should estimate the standalone selling price if it does not separately sell an identified performance obligation on a standalone basis. The fair value of PCS is evidenced by the selling price, VSOE, when this element is sold separately. This might include the renewal rate written into the contract, provided the rate and the service term are substantive.
The selling price of a product that includes an identifiable amount of subsequent servicing is deferred and recognized as revenue over the period during which the service is performed. The amount deferred is that which will cover the expected costs of the services The fees for PCS are combined with any under the agreement, together with a license fees and recognized on a reasonable profit on those services. straight-line basis over the PCS term if there is no standalone selling price. Potential impact: The proposed standard is similar to the current IFRS Potential impact: Management will guidance. need to estimate the standalone selling
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Proposed model
Current U.S. GAAP price of PCS when VSOE was not previously available. This could result in a different timing of revenue recognition for license deliverables than under today's guidance.
Current IFRS
Key changes from the 2010 Exposure Draft: The Boards decided that it may be appropriate for an entity to estimate a standalone selling price using a residual approach if the price of a good or service is highly variable or uncertain.
Example #1
Facts: Software Vendor sells Customer a perpetual software license (version 2.0) and post-contract customer support (PCS) services for a period of five years once the software is activated. None of the goods and services are sold on a standalone basis. How should Software Vendor account for the transaction? Discussion: The license and PCS are separate performance obligations under the contract. Management will need to estimate the standalone selling prices under the proposed standard if the license and the PCS are not sold separately. No estimation method is prescribed in the proposed standard. Estimates can be made using any reasonable and reliable method that maximizes observable inputs. Software Vendor will estimate the individual standalone selling prices for the software license and the PCS services. The need to estimate standalone selling prices might create practical challenges for some software companies. A residual approach can be used to estimate the standalone selling price, if the price of one of the performance obligations is highly variable or uncertain.
Intellectual property licenses

A license is a right to use, but not own, intellectual property granted by an entity to a customer. The licensor typically receives upfront fees for licenses, which might be perpetual or time-based. Licenses are generally sold in bundles with post-contract customer support and/or professional services. Management will need to assess when the customer obtains control of the rights to use the license to determine when revenue should be recognized for the license under the proposed standard. Proposed model The license of intellectual property or other rights will give rise to a performance obligation that an entity satisfies when the customer obtains control of those license rights, resulting in revenue recognition at that time. Customers do not obtain control of the rights to use intellectual property before the beginning of the period during which the customer(s) can use and benefit from the license to the intellectual property. Revenue recognition related to consideration that is contingent on future events may be constrained if the entity is not reasonably assured to be Current U.S. GAAP Revenue from licenses of intellectual property is recognized in accordance with the substance of the agreement. Current IFRS
Existing revenue guidance requires that fees and royalties paid for the use of an entity's assets are recognized in accordance with the substance of the Revenue might be recognized on a agreement. This might be on a straightstraight-line basis over the life of the line basis over the life of the agreement, for example, when a agreement, for example, when a licensee has the right to use the licensee has the right to use certain technology for a specified period of technology for a specified period of time. Revenue could also be recognized time. It might also be recognized upfront similar to the model used for upfront if the substance is similar to a software licenses in certain situations. sale. Judgment is required to determine the most appropriate treatment. Potential impact: The proposed standard requires revenue to be An assignment of rights for a fixed fee or a non-refundable guarantee under a non-cancellable contract that permits the licensee to exploit those rights freely when the licensor has no
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Proposed model entitled to that amount (see discussion on variable consideration below). Management will need to assess whether a license of intellectual property is distinct from other performance obligations in an arrangement. A license that is not distinct will be combined with other performance obligations until a distinct bundle of goods or services is identified.
Current U.S. GAAP recognized when the customer obtains control of the rights to use the intellectual property. Earlier revenue recognition might result as compared to today depending on the current accounting (recognition over time or upfront).
Current IFRS remaining obligations to perform is, in substance, a sale. Judgment is required to determine the most appropriate treatment. Potential impact: The proposed standard requires that revenue be recognized when the customer obtains control of the rights to use the intellectual property of the entity. Earlier revenue recognition might result as compared to today depending on the current accounting (recognition over time or upfront).
Key changes from the 2010 Exposure Draft: The distinction made in the 2010 exposure draft between nonexclusive and exclusive licenses was eliminated during redeliberations based on feedback from received by the boards. Respondents believed that revenue should be recognized when the performance obligation is satisfied regardless of whether the license is exclusive or non-exclusive. Revenue is recognized for a license that is a separate performance obligation when the customer controls and can use the intellectual property of the entity.
Example #2
Facts: Technology Company enters into a contract with Customer A to provide a license of its intellectual property for one year. There are no other performance obligations included in the arrangement. How should Technology Company account for this transaction? Discussion: Management will need to assess when the customer obtains control of the promised intellectual property rights in the arrangement. This will dictate when revenue should be recognized. Control of rights to use intellectual property cannot be transferred before the beginning of the period during which the customer can use and benefit from the licensed intellectual property (that is, the beginning of the license period). The customer will typically obtain control over the promised rights when they have the ability to start using the license. Revenue will therefore be recognized upfront on the date control is transferred. Management will need to evaluate whether a license of intellectual property is distinct and therefore separable from any other performance obligations in the contract.
The transaction price is the consideration the vendor expects to be entitled to in exchange for satisfying its performance obligations in an arrangement. Determining the transaction price is straightforward when the contract price is fixed, but it becomes more complex when the arrangement provides for a variable amount of consideration to be paid. Royalties, performance bonuses, penalties, and future discounts are common examples of variable consideration. Management must estimate the consideration it expects to be entitled to in order to determine the transaction price and to allocate consideration to the performance obligations in an arrangement. Recognition of revenue for variable amounts will be recognized only when the entity is reasonably assured to be entitled to that amount. Proposed model Current U.S. GAAP Current IFRS Revenue is measured at the fair value of the consideration received or receivable. Fair value is the amount for which an asset could be exchanged,
The transaction price is the estimated The seller's price must be fixed or consideration that the entity is entitled determinable for revenue to be to receive under the contract, including recognized. variable or uncertain consideration. It
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Proposed model is based on either the probabilityweighted estimate or most likely amount of cash flows expected from the transaction, depending on which is the most predictive of the amount to which the entity would be entitled. The estimated transaction price is allocated among the performance obligations in the contract. Revenue is then recognized as a performance obligation is satisfied but only if an entity is reasonably assured to be entitled to the amount allocated to that performance obligation. An entity is reasonably assured to be entitled to variable consideration when the entity has predictive experience with similar types of contracts. If an entity licenses intellectual property to a customer and the consideration it receives is variable entirely based on the customer's subsequent sales to a good or service that uses the intellectual property, the entity is not reasonably assured of the variable amounts until the subsequent sales occur. Management will need to update the estimated transaction price at each reporting date to reflect any change in circumstances, including changes in the estimate of variable consideration.
Current U.S. GAAP Revenue related to variable consideration generally is not recognized until the uncertainty is resolved. It is not appropriate to recognize revenue based on the probability of an uncertainty being achieved. Potential impact: Variable consideration might impact the timing of recognition under the proposed standard. Technology companies are frequently developing new or enhancing existing products and each entity will need to consider at which point it is reasonably assured to be entitled to variable consideration. Technology companies might recognize revenue earlier than they do currently in many circumstances.
Current IFRS or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Trade discounts, volume rebates, and other incentives (such as cash settlement discounts) are taken into account in measuring the fair value of the consideration to be received. Revenue related to variable consideration is recognized when it is probable that the economic benefits will flow to the entity and the amount is reliably measurable, assuming all other revenue recognition criteria are met. Potential impact: Variable consideration could impact the timing of recognition under the proposed standard. Technology companies are frequently developing new or enhancing existing products and each entity will need to consider at which point it is reasonably assured to be entitled to variable consideration. Technology companies might recognize revenue earlier than they do currently in many circumstances.
Key changes from the 2010 Exposure Draft: The original exposure draft allowed for revenue recognition of variable amounts without constraint provided "the transaction price can be reasonably estimated." The recognition of variable amounts will now be limited to "the amount to which the entity is reasonably assured to be entitled." The transaction price will still include an estimate of variable consideration for allocation purposes similar to the original exposure draft. Previously this estimate was based on a probability-weighted amount. The boards received feedback that a probability-weighted approach would not be appropriate in some circumstances and as a result, changed the requirement to the more predictive of either a probability weighted or most likely amount.
Example #3
Facts: Vendor sells a license to use patented technology in a handheld device for no upfront fee and 1% of future product sales. The license term is equal to the patent term. Technology in this area is changing rapidly so the possible consideration ranges from $0 to $50,000,000 depending on whether new technology is developed. How should Vendor account for the transaction?
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Discussion: Royalty revenue is recognized when Vendor is reasonably assured of being entitled to those amounts, which is when those future product sales occur.
Multiple-element arrangements
Many technology companies provide multiple products or services to their customers as part of a single arrangement. For example, hardware vendors might sell extended maintenance contracts or other service elements along with the hardware and vendors of intellectual property licenses may provide professional services. Management must identify the separate performance obligations based on the terms of the contract and the entitys customary business practices. A bundle of goods and services might be accounted for as a single performance obligation in certain fact patterns. Proposed model A good or service is distinct if either of the following criteria are met: The entity regularly sells the good or service separately The customer can benefit from the good or service on its own or together with resources readily available to the customer A bundle of goods and services is accounted for as a single performance obligation when the following criteria are met: The goods or services are highly interrelated and transferring them to the customer requires the entity to provide a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted The bundle of goods or services is significantly modified or customized to fulfill the contract Current U.S. GAAP The following criteria are applied to transactions other than those involving software (refer above for discussion related to software companies) to determine if elements included in a multiple-element arrangement should be accounted for separately: The delivered item has value to the customer on a standalone basis If a general return right exists for the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the vendor Potential impact: Technology companies will need to assess whether contracts include multiple performance obligations. Management will need to evaluate if a bundle of goods or services meets the criteria to be accounted for as a single performance obligation, which may require judgment. The other separation criteria in the proposed standard are similar to current U.S. GAAP guidance, although more performance obligations might be identified. Current IFRS The revenue recognition criteria are usually applied separately to each transaction. It might be necessary to separate a transaction into identifiable components in order to reflect the substance of the transaction in certain circumstances. Separation is appropriate when identifiable components have standalone value and their fair value can be measured reliably. Two or more transactions might need to be grouped together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. Potential impact: Technology companies will need to assess whether contracts include multiple performance obligations. Management will need to evaluate if a bundle of goods or services meet the criteria to be accounted for as a single performance obligation, which may require judgment The other separation criteria in the proposed standard are similar to the current IFRS guidance, although more performance obligations might be identified.
Key changes from the 2010 Exposure Draft: The basic principle of accounting for performance obligations separately has not changed from the June 2010 exposure draft. The boards have provided additional guidance on when a bundle of goods or services could result in a single performance obligation in an effort to better reflect the economics of certain long-term contracts. The boards also revised the guidance for determining whether a performance obligation is distinct. The concept of a distinct profit margin was removed. The focus is now on whether the good or service is sold separately by the entity or whether the good can be used with other resources readily available to the customer.
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Example #4
Facts: Vendor licenses customer relationship management software to Customer. Vendor also promises to provide services to significantly customize the software to the customers information technology environment . The total consideration for the license and the customization service is $600,000. Only Vendor can provide this customization and integration service. How should Vendor account for the transaction? Discussion: Vendor is providing a significant service of integrating the goods and services (the license and the consulting services) into the combined item for which the customer has contracted, being a customized customer relationship management system. The software is also significantly customized by the vendor in accordance with the specifications negotiated with the customer. Based on these factors, Vendor would account for the license and consulting services together as one performance obligation. The ability for Customer to obtain the customization and integration service from another entity (other than Vendor) might indicate that the customization is not significant and the services not highly interrelated and thus, should be accounted for separately.
Example #5
Facts: Vendor enters into a contract to provide hardware with installation to Customer. Vendor always sells the hardware with the installation service, but Customer can perform the installation on its own or can use other third parties. How should Vendor account for the transaction? Discussion: Vendor should evaluate whether the hardware and installation service are separate performance obligations. The hardware and installation service are not sold separately by Vendor; therefore, management will need to evaluate whether the customer can benefit from the equipment on its own or together with resources readily available to it. Customer can either perform the installation itself or use another third party, thus the customer can benefit from the equipment on its own. The equipment and the installation will be considered distinct performance obligations and accounted for separately.
Allocation of transaction price

Technology companies may provide multiple products or services to their customers as part of a single arrangement. The Company will allocate the transaction price to the separate performance obligations in a contract based on the relative standalone selling price. Proposed model The transaction price is allocated to separate performance obligations based on the relative standalone selling price of the performance obligations in the contract. The standalone selling price for items not sold separately should be estimated. A residual approach may be used as a method to estimate the standalone selling price when the selling price for a good or service is highly variable or uncertain. Some elements of the transaction price, such as variable consideration, discounts or change orders, might affect only one performance obligation rather than all performance obligations in the contract. Those changes can be allocated solely to the specific Current U.S. GAAP The consideration in an arrangement is allocated to the elements of a transaction based on the relative standalone selling price. The residual value method cannot be used (refer above for discussion related to software companies). Allocation to a delivered item is limited to the consideration that is not contingent on providing an undelivered item or meeting future performance obligations. Potential impact: The ability to use a residual value technique could remove some operational difficulties in determining the standalone selling price of performance obligations that have significant variability in their pricing. Current IFRS Consideration is generally allocated to the separate components in the arrangement based on a relative fair value or cost plus a reasonable margin approach. A residual or reverse residual approach could also be used. Potential impact: The basic allocation principle has not changed under the new guidance; however, allocation guidance in the proposed standard could affect the price allocated to the identified performance obligations due to the ability to allocate discounts and variable consideration amounts to specific performance obligations if certain conditions are met.
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Proposed model performance obligation if certain conditions are met.
Current U.S. GAAP Allocation guidance in the proposed standard might affect the price allocated to the identified performance obligations, and thus the timing of revenue recognition, due to the following: There is no limitation for cash contingent on satisfying a future performance obligation An entity can allocate discounts and variable consideration amounts to specific performance obligations if certain conditions are met
Current IFRS
Key changes from the 2010 Exposure Draft: The boards clarified that it might be appropriate to use a residual approach to estimate standalone selling price if the price of a good or service is highly variable or uncertain. The boards also concluded, that, as a consequence of removing the segmentation guidance from the proposed standard, variable amounts and/or discounts may be fully allocated to specific performance obligations provided certain criteria are met.
Consulting service contracts

Many technology companies provide a wide range of consulting services and arrangements, including business strategy services, supply-chain management, system implementation, outsourcing services, and control and system reliance. Technology service contracts are typically customer-specific and revenue recognition is therefore dependent on the facts and circumstances of each arrangement. Accounting for service revenues may change under the proposed standard as management must determine whether the performance obligation is satisfied at a point in time (like the sale of a good) or over time (like a service). Proposed model Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or over time. A performance obligation is satisfied over time when at least one of the following criteria is met: the entity's performance creates or enhances an asset that the customer controls, or the entity's performance does not Current U.S. GAAP U.S. GAAP permits the proportional performance method for recognizing revenue for service arrangements not within the scope of guidance for construction or certain production-type contracts. Input measures, with the exception of cost measures, which approximate progression toward completion, can be used when output measures do not exist or are not available to an entity without undue cost. Revenue is recognized based on a discernible pattern of benefit and, if Current IFRS IFRS requires that service transactions be accounted for by reference to the stage of completion of the transaction. This method is often referred to as the percentage-of-completion method. The stage of completion may be determined by a variety of methods (including the cost-to-cost method). Revenue may be recognized on a straight-line basis if the services are performed by an indeterminate number of acts over a specified period of time and no other method better represents the stage of completion.
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Proposed model create an asset with alternative use to the entity and at least one of the following: the customer simultaneously receives and consumes a benefit as the entity performs, or another entity would not need to substantially reperform the work performed to date if that other entity were required to fulfill the remaining obligation to the customer, or
Current U.S. GAAP none exists, then a straight-line approach may be appropriate. Potential impact: Entities will need to determine whether a performance obligation is satisfied over time, which may require judgment. We do not expect a significant change in practice for those performance obligations satisfied over time.
Current IFRS Revenue could be deferred in instances where a specific act is much more significant than any other acts. Potential impact: Entities will need to determine whether a performance obligation meets the specified criteria to be satisfied over time, which may require judgment. We do not expect a significant change in practice for those performance obligations satisfied over time.
The method to measure progress toward satisfaction of a performance condition is the measure that best depicts transfer of control to the customer, which could include output - the entity has a right to or input methods. Additional payment for work performed to alternatives may be available to date even if the customer could measure progress (such as cost-to cancel the contract for cost) that were previously not convenience. permitted, provided they result in the best depiction of transfer to the Revenue for a performance obligation customer. that does not meet the above criteria is recognized once the customer obtains control of that good or service. Revenue for a performance obligation satisfied over time is recognized based on the measure of progress that best represents transfer of control to the customer. Both input and output measures are permitted.
Key changes from the 2010 Exposure Draft: There was no specific guidance included for performance obligations satisfied over time in the 2010 exposure draft. The above guidance was created in response to feedback that the original criteria were difficult to apply to service transactions.
Example #6
Facts: Computer Consultant enters into a three-month fixed-price contract to track Customer's software usage in order to help Customer decide which software packages it should upgrade to in the future. Computer Consultant will share his findings on a monthly basis, or more frequently if requested by the company. Computer Consultant will provide a summary report of the findings at the end of three months. Customer will pay Computer Consultant $2,000 per month and Customer can direct Computer Consultant to focus on the usage of any systems it wishes to throughout the contract. How should Computer Consultant account for the transaction? Discussion: Customer receives a benefit from the services as they are performed and Computer Consultant has a right to payment for the services provided, as evidenced by the non-refundable progress payments (assuming that the payment received is commensurate with the services provided). Computer Consultant's performance obligation is to provide Customer with services continuously during the three-month contract, and the performance obligation is being satisfied over time.
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Rights of return
Return rights are common in sales involving hardware, software, and various other technology products. Return rights may also take on various other forms such as product obsolescence protection and trade-in agreements. These rights generally result from the buyer's desire to mitigate the risk related to the products purchased and the seller's desire to promote goodwill with its customers. The sale of goods with a right of return will be accounted for similar to today's model which results in revenue recognition for only those products the entity is reasonably assured will not be returned. Proposed model Revenue is only recognized for goods that the entity is reasonably assured will not be returned and a liability is recognized for the expected amount of refunds to customers. The refund liability is updated for changes in expected refunds. An asset and corresponding adjustment to cost of sales is recognized for the right to recover goods from customers on settling the refund liability, with the asset initially measured at the original cost of the goods (that is, the former carrying amount in inventory). The asset is assessed for impairment if indicators of impairment exist. Revenue is not recognized if the entity is not reasonable assured of the quantity of products that will be returned. Revenue is recognized once the entity is reasonably assured of the quantity expected to be returned (which may only be when the right to return lapses). Current U.S. GAAP Returns are estimated based on historical experience with an allowance recorded against sales. Revenue is not recognized until the return rights lapse if the entity is unable to estimate potential returns. Potential impact: The impact of product returns on earnings under the proposed standard will be largely unchanged from current U.S. GAAP. However, the balance sheet will be grossed up to include the refund obligation and the asset for the right to the returned goods. The asset is assessed for impairment if indicators of impairment exist. Current IFRS Returns are estimated based on historical experience with an allowance recorded against sales. Revenue is not recognized until the return rights lapse if the entity is unable to estimate potential returns. Potential impact: The impact of product returns on earnings under the proposed standard will be largely unchanged from current IFRS. However, the balance sheet will be grossed up to include the refund obligation and the asset for the right to the returned goods. The asset is assessed for impairment if indicators of impairment exist.
Key changes from the 2010 Exposure Draft: No change from the 2010 exposure draft
Example #7
Facts: Vendor sells and ships 10,000 gaming systems to Customer, a reseller, on the same day. Customer may return the gaming systems to Vendor within 12 months of purchase. Vendor has historically experienced a 10 percent return rate from Customer. How should Vendor account for the transaction? Discussion: Vendor should account for the gaming systems that are anticipated to be returned (that is, 10 percent) as a reduction of revenue. Vendor should record a contract liability for 1,000 gaming systems and record an asset (an intangible) for the right to the gaming system assets expected to be returned. The asset should be recorded at the original cost of the gaming systems. The refund liability and related asset should not be derecognized until the refund right lapses or until the actual refund occurs. The recorded asset will need to be assessed for impairment until derecognition. The transaction price associated with the 9,000 gaming systems that Vendor is reasonably assured will not be returned is recorded as revenue once control transfers to the customer.
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Product warranties
It is common for technology companies to provide a product warranty in connection with the sale of a product. The nature of a product warranty can vary significantly as some warranties provide a customer with assurance that the related product complies with agreed-upon specifications (assurance-type or "standard" warranties). Other warranties provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications (insurance-type warranties). The proposed standard draws a distinction between product warranties that the customer has the option to purchase separately (for example, warranties that are negotiated or priced separately) and product warranties that the customer does not have the option to purchase separately. Many of the warranties offered by technology companies could fall in either or both categories. Management will need to exercise judgment when assessing a warranty not sold separately to determine if there is a service component to be accounted for as a separate performance obligation. Proposed model An entity should account for a warranty that the customer has the option to purchase separately as a separate performance obligation. A warranty that the customer does not have the option to purchase separately should be accounted for in accordance with existing guidance on product warranties. A warranty, or a part of the warranty, which is not sold separately but provides the customer with a service in addition to the assurance that product complies with agreed-upon specifications, creates a performance obligation for the promised service. An entity that cannot reasonably separate the service component from a standard warranty should account for both together as a separate performance obligation. Current U.S. GAAP Warranties that a customer can purchase separately are similar to many extended warranty contracts. Revenue from extended warranties is deferred and recognized over the expected life of the contract. Extended warranties that a customer can purchase separately are accounted for as a separate deliverable in an arrangement. A warranty that is separately priced in a multiple-element arrangement is allocated consideration based on the contractually stated price. Product warranties that provide coverage for latent defects are typically accounted for in accordance with existing loss contingency guidance, resulting in recognition of an expense and a warranty liability when the good is sold. Current IFRS Warranties that a customer can purchase separately are similar to many extended warranty contracts. Revenue from extended warranties is deferred and recognized over the period covered by the warranty. Warranties that are not sold separately are accounted for in accordance with existing provisions guidance resulting in recognition of an expense and a warranty liability when the good is sold. Potential impact: Similar to existing guidance, extended warranties give rise to a separate performance obligation under the proposed standard, and therefore, revenue is recognized over the warranty period.
We do not expect a significant impact of the proposed guidance; however, the Potential impact: Similar to existing amount of deferred revenue might guidance, extended warranties give rise differ under the proposed standard to a separate performance obligation compared to current guidance when under the proposed standard and there is a service component to a therefore, revenue is recognized over standard warranty. the warranty period. Product warranties that are not sold Warranties that are separately priced separately and that provide for defects may be affected as the arrangement at the time a product is shipped will consideration will be allocated on a result in a cost accrual similar to today relative standalone selling price basis under the current provisions guidance. rather than at the contractual price. The amount of deferred revenue for extended warranties might differ under the proposed standard compared to current guidance as a result. Product warranties that are not sold separately and provide for defects that exist when a product is shipped will
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Proposed model
Current U.S. GAAP result in a cost accrual similar to today under the current contingency guidance.
Current IFRS
Key changes from the 2010 Exposure Draft: The 2010 exposure draft distinguished between two types of warranties: those that provided coverage for latent defects and those that provided coverage for faults after product delivery. Coverage for latent defects did not create a performance obligation, but resulted in a revenue deferral for products expected to be replaced, similar to a right of return. The accounting for these warranties is now similar to current practice and results in a cost accrual provided the warranties are not sold separately by the entity. The change was based on feedback received by the boards that the original proposal was not operational. A product warranty will give rise to a separate performance obligation if it is sold separately by the entity or, if not sold separately, if it provides a service in addition to coverage for latent defects. A warranty that provides a service in addition to coverage for latent defects will need to be bifurcated into the standard warranty and the service warranty resulting in a cost accrual for the standard warranty portion and a separate performance obligation for the service portion.
Example #8
Facts: Vendor sells a hard drive, keyboard, and monitor. Vendor also provides a 60-day warranty that covers certain components of the hard drive and monitor. The warranty is not sold separately by the entity. How should Vendor account for the warranty? Discussion: The proposed standard requires Vendor to account for the warranty as a cost accrual similar to existing contingency (US GAAP) or provisions (IFRS) guidance.
Example #9
Facts: Vendor sells a hard drive, keyboard, monitor, and a 12-month extended warranty that the customer has the option to purchase. How should Vendor account for the warranty? Discussion: The proposed standard requires Vendor to account for the 12-month warranty as a separate performance obligation. A portion of the transaction price is allocated to the warranty based on its relative standalone selling price and is recognized as revenue when the warranty obligation is satisfied. Vendor will need to assess the pattern of warranty satisfaction to determine when revenue is recognized (that is, ratable or some other pattern).

Many technology companies provide multiple products or services to their customers as part of a single arrangement, and they may have anticipated losses on one performance obligation but an overall profitable contract. Anticipated losses on executory contracts are generally not recognized under current U.S. GAAP and are accrued only if the overall contract is onerous under current IFRS. Entities could be significantly affected by the proposed standard because they will need to recognize expected losses for onerous performance obligations in certain situations, even if the overall contract is profitable.
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Proposed model Performance obligations satisfied over time (and over a period of greater than one year) are assessed to determine if they are onerous. Performance obligations satisfied at a point in time are not subject to this assessment in the proposed standard. A performance obligation is onerous if the transaction price allocated to the performance obligation is lower than the cost of settling the performance obligation. The cost of settling a performance obligation is the lower of: costs directly related to satisfying the performance obligation, or the amount the entity would pay to exit the performance obligation. The liability for an onerous performance obligation is measured as the excess of the cost to settle the performance obligation over the amount of consideration allocated to that performance obligation.
Current U.S. GAAP Anticipated losses on executory contracts (onerous contracts) are generally not recognized unless specific authoritative guidance provides for such recognition because those anticipated losses have not yet been incurred. Any expected losses on constructiontype contracts are recognized immediately when it is probable that contract costs will exceed contract revenue. Potential impact: Onerous contracts are rarely recognized under existing U.S. GAAP other than in relation to construction contract accounting. The proposed standard may significantly affect entities not currently within the scope of construction contract accounting that have performance obligations satisfied over time and a period greater than one year. The guidance could affect entities with overall profitable contracts because the onerous test is performed at the performance obligation level as opposed to the contract level.
Current IFRS Contracts in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under such contract are onerous. Any expected losses on constructiontype contracts are recognized immediately when it is probable that contract costs will exceed contract revenue. Potential impact: Current IFRS guidance requires an assessment of onerous provisions at the contract level, not the performance obligation level. Although the proposed guidance is applied only to performance obligations satisfied over time and over a period greater than one year, it may lead to an increase in onerous contract provisions, resulting in losses being recorded even in situations in which the overall contract is profitable.
Key changes from the 2010 Exposure Draft: The scope of the onerous test was modified to apply only to performance obligations that are satisfied over time and over a period greater than one year in response to concerns that the onerous test could have unintended consequences.
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Authored by:
Cory Starr U.S. Technology Leader Phone: 1-408-817-1215 Email: cory.j.starr@us.pwc.com Michael Coleman Partner Phone: 1-973-236-7237 Email: michael.coleman@us.pwc.com Daniel Zwarn Partner Phone: 1-973-236-4571 Email: dan.zwarn@us.pwc.com Craig Robichaud Senior Manager Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com
US GAAP Convergence & IFRS Revenue recognition: Telecommunications industry supplement

No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Accounting for multiple performance obligations .................... 2 Variable consideration / determining the transaction price .......... 5 Collectibility .................... 9 Allocation of the transaction price and establishing standalone selling prices........................... 10 Equipment installation revenues ....................... 15 Recognition of revenue Impact on advertising and phone directory activities ...................... 17 Fulfillment costs .............19 Contract acquisition costs ............................ 20
Telecommunications industry supplement

Overview
The telecom industry comprises several subsectors, including wireless, fixed line, and yellow-page advertising. Wireless telecom entities provide voice and data products and wireless broadband. Fixed line telecom entities provide voice services (local and longdistance), internet access, broadband video, and data and network access together with outsourcing and networked IT services. Service revenues are primarily earned from providing access to, and usage of, the telecom entiti es network and facilities. Access revenues are typically billed one month in advance and recognized when the services are provided under both current U.S. GAAP and IFRS. Usage revenues (services provided in excess of the customer's plan/tariff) are typically billed in arrears and recognized when services are rendered. Telecom entities also provide enhanced services such as caller identification, call waiting, call forwarding, voicemail, text and multimedia messaging, as well as downloadable wireless data applications, including ringtones, music, games and other data content. These enhanced features and data applications generate additional service revenues through monthly subscription fees or increased usage through utilization of the features. Some telecom entities also sell equipment such as handsets, modems, dongles (a wireless broadband service connector), customer premises equipment (CPE) and a variety of accessories. Many telecom entities also publish yellow and white pages directories and sell directory and internet-based advertising. Publishing entities will also sell direct mail advertising services.
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This paper addresses how the revised exposure draft, Revenue from contracts with customers, issued on November 14, 2011 (2011 ED or proposed standard), could affect businesses operating in the telecom industry. The proposed guidance is subject to change until a final standard is issued. The examples included in this paper reflect potential effects based on the proposed standard; any conclusions are subject to further interpretation and assessment based on the final standard. For a more comprehensive description of the proposed standard, refer to PwC Dataline 2011-35 (www.cfodirect.pwc.com) or visit www.fasb.org or www.ifrs.org.

A performance obligation is defined as a promise to transfer goods or services to a customer. Identifying the separate performance obligations within a contract affects both when and how much revenue is recognized. Management will need to determine whether performance obligations within customer contracts should be accounted for separately from other performance obligations within the arrangement. A performance obligation might be explicit in a contract, or implicit, arising from customary business practices. Applying the proposed separation principle might be challenging in some circumstances due to the significant number of customers and multiple offerings included within bundled packages. Telecom entities regularly enter into contracts with customers that bundle the sale of telecom services and equipment (for example, handsets, modems, accessories, etc.) and may include a charge for activation or set-up. Wireless entities give free or significantly discounted handsets to customers in some countries as an incentive for them to enter into longterm telecom service contracts (for example, one and two-year contracts). Giving or selling equipment with the sale of telecom services in a bundled offering is a separate earnings process from the sale of telecom services as the equipment is deemed to have standalone value under current U.S. GAAP. Activation/connection services do not have standalone value and therefore, do not represent the culmination of a separate earnings process. The accounting under IFRS is currently based on a variety of different commercial models operating across the world (for example, telecom services might only be sold bundled with other products or they might only be sold separately). Equipment (including handsets) transferred to customers meets the definition of a performance obligation in most cases under the proposed standard regardless of whether the equipment is given at no cost or at a significantly discounted price when the customer signs a long-term contract. Management will need to assess whether the equipment, including the handset, is a separate performance obligation. The handset is likely to be a separate performance obligation if the entity separately sells equipment or if the customer can benefit from the handset together with other resources (for example, the handset can operate on another telecom entity's network). Management will have to carefully assess their contracts with customers to identify and separate the performance obligations. Proposed standard Performance obligations Current U.S. GAAP Current IFRS The revenue recognition criteria are usually applied separately to each transaction. It might be necessary to separate a transaction into identifiable components to reflect the substance of the transaction in certain circumstances. Separation is appropriate when identifiable components have standalone value and their fair value can be measured reliably. Two or more transactions might need to be grouped together when they are linked in such a way that the
The following criteria are considered to determine whether elements The proposed standard requires included in a multiple-element entities to identify all promised goods arrangement are accounted for or services in a contract and determine separately: whether to account for each promised good or service as a separate The delivered item has value to the performance obligation. A customer on a standalone basis performance obligation is a promise in a contract to transfer a good or service If a general return right exists for to the customer. the delivered item, delivery or performance of the undelivered A promised bundle of goods or services item(s) is considered probable and is combined into one separate substantially in the control of the performance obligation if: vendor
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Proposed standard the goods or services are highly interrelated and providing them requires the entity to also provide a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted; and the entity is contracted by the customer to significantly modify or customize the goods or services. Performance obligations that are delivered at different times are accounted for separately if they are distinct. A good or service is distinct, and is accounted for separately if: the entity regularly sells the good or service separately; or where not sold separately, the customer can benefit from the good or service on its own or together with resources readily available to the customer. Options to acquire additional goods or services An entity may grant a customer the option to acquire additional goods or services free of charge or at a discount. These options may include customer award credits or other sales incentives and discounts. That promise gives rise to a separate performance obligation if the option provides a material right to the customer that the customer would not receive without entering into the contract. The entity should recognize revenue allocated to the option when the option expires or when the additional goods or services are transferred to the customer. An option to acquire an additional good or service at a price that is within the range of prices typically charged for those goods or services does not provide a material right to the customer and would be considered a marketing offer. This is the case even if the option can be exercised only because of entering into the previous contract.
Current U.S. GAAP
Current IFRS
commercial effect cannot be Third-party evidence (TPE) of fair understood without reference to the value is used to separate deliverables series of transactions as a whole. when vendor specific objective evidence (VSOE) of fair value is not available. Best estimate of selling price is used if neither VSOE nor TPE exist.
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Proposed standard The estimate of a standalone selling price for a customer's option to acquire additional goods or services is the discount the customer will obtain when exercising the option. This estimate is adjusted for any discount the customer would receive without exercising the option and the likelihood that the customer will fail to exercise the option (that is, breakage or estimated forfeitures).
Current U.S. GAAP
Current IFRS
Potential impact - both U.S. GAAP and IFRS Management will need financial processes that identify the different performance obligations in each telecom contract and pinpoint when and how those obligations are fulfilled. Telecom entities will have to carefully consider outsourcing and network IT contracts, various types of activation/connection services and other upfront services (for example, connecting customers to their network or laying physical line to the customers premises) to determine if these services meet the definition of a separate performance obligation. The timing of recognition of revenue for telecom entities that currently do not account for equipment (for example, handsets) separately from the telecom services will be significantly affected if the performance obligations in their bundled offerings meet the proposed standard's definition of distinct performance obligations. The proposed standard states that activation services are an example of non-refundable upfront fees that do not result in the transfer of a promised good or service to the customer. The payment for the activation service is an advance payment for future telecom services. The activation fee should be included in the overall transaction price and allocated to the separate performance obligations. This may result a different pattern of revenue recognition in comparison to today's accounting model for activation fees, for telecom entities that currently recognize the activation fee over the contract period under U.S. GAAP and IFRS.
Example 1 Identifying performance obligations

Question: A telecom entity enters into a contract with a customer to provide wireless telecom services (voice, data, etc.) for $50 per month and a handset for $100. It also charges an activation fee of $30. The telecom entity sells handsets separately to customers that need to replace their handsets (for example, when a customer's handset is lost, stolen, or damaged). How many distinct performance obligations are there in this contract? Discussion: Two distinct performance obligations exist in this arrangement: wireless telecom services and the handset. The handset is a separate performance obligation as the entity sells the handset separately. The handset would be a separate performance obligation even if the telecom entity did not sell the handset separately, if the customer could use the handset to receive telecom services from another entity (that is, there are no technological or legal barriers or impediments that prevent customers from using the equipment on another entity's network). Activation/connection fees are not distinct performance obligations but are advance payments for future telecom services.
Example 2 Identifying performance obligations

Question: A telecom entity enters into a two-year contract with a customer to provide wireless telecom services (voice, data, etc.) for $50 per month. The customer receives a free handset from the telecom entity as inducement to sign a twoyear contract. The telecom entity also charges the customer an activation fee of $30. The telecom entity sells handsets separately to customers. How many distinct performance obligations are there in this contract? Discussion: Two distinct performance obligations exist in this arrangement: wireless telecom services and the handset. Free equipment provided with the sale of telecom services is a distinct performance obligation, not a marketing expense, as the equipment is a promised good transferred to the customer. The handset is a separate performance obligation from the telecom services as the telecom entity sells handsets separately.
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Example 3 Options that do not provide a material right

Question: A telecom entity enters into a two-year contract with a customer to provide wireless telecom services (voice, data, etc.) for $50 per month. The contract requires the telecom entity to provide the customer with 800 voice minutes and 100 text messages per month. The contract specifies the customer may purchase additional voice services for $0.10 per minute and text services for $0.20 per message during any month under the contract. These prices are typically charged for those services regardless of the type of contract the customer holds with the entity. Is the customer's option to purchase additional voice minutes and text messages a separate performance obligation? Discussion: The option provided in the contract is not a performance obligation because it does not provide a material right to the customer (that is, the customer under contract pays the same price, or a price within a range, for voice minutes and text messages as other customers). Telecom entities recognize revenue for the additional voice minutes and text messages if and when the customer receives those additional services.
Example 4 Installation fees

Question: A telecom entity enters into a contract to provide telecom services (voice, data, etc.) on a monthly basis, with no contract end date. An upfront, non-refundable installation fee of $50 is charged to recover the cost of laying physical line to the customer's premises. This line can be used by other telecom entities if the customer later changes service providers. Is the installation service a distinct performance obligation? Discussion: Management will need to carefully assess customer arrangements that include upfront, non-refundable installation fees to determine whether the installation services are a separate performance obligation. In this example, management needs to determine whether laying the physical line is a distinct service. The service could be a distinct performance obligation if the entity could lay a physical line without providing telecom services. Management will need to determine whether the line can be used by the customer on its own or with other telecom services readily available from other telecom entities. In this example, other telecom entities can provide services on the same physical line, so the line can be used by the customer without the entity subsequently providing telecom services; the installation service is therefore a distinct performance obligation.
Variable consideration / determining the transaction price

The transaction price in a contract reflects the amount of consideration an entity is entitled to receive in exchange for transferring promised goods or services to customers. Determining the transaction price is straightforward when the contract price is fixed; it becomes more complex when it is not fixed. Discounts, rebates, refunds, credits, incentives and price concessions may cause the amount of consideration to be variable. For example, a telecom entity may offer other telecom entities (customers) volume discounts on usage rates (voice and data access) to access its network. These discounts are provided as minimum purchase commitments. The network provider charges penalties or the customers lose the volume discounts if the customers do not meet specified usage volumes. Mail-in rebates and refunds are another form of variable consideration. Rebates or refunds of the sales price of equipment (for example, handsets) are also common in the telecom industry. Entities that expect to refund some or all of consideration received from a customer will recognize a refund liability, reducing the transaction price. The proposed standard may cause telecom entities offering volume discounts on minimum purchase commitments to recognize revenue earlier than current practice if it is reasonably assured that minimum purchase commitments will not be met. The proposal is likely to have limited impact on the accounting for mail-in rebates and refunds, except the amount deferred for rebates could differ under the proposed standard. Management should, however, assess all contractual arrangements that may require consideration received to be refunded to customers, as amounts expected to be refunded will reduce revenue.
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Proposed standard Variable consideration An entity estimates the total amount of consideration it is entitled to when a contract includes variable consideration. An entity should use one of the following approaches to estimate variable consideration depending on which is the most predictive: The expected value, being the sum of probability-weighted amounts The most likely outcome, being the most likely amount in a range of possible outcomes The estimate should be updated at each reporting period. The amount of variable consideration included in the transaction price and allocated to a satisfied performance obligation should be recognized as revenue only when the entity is reasonably assured to be entitled to that amount. If an entity receives consideration from a customer and expects to refund some or all of that consideration to the customer, the entity recognizes a refund liability. The amount of the refund liability depends on the amount of consideration to which the entity is reasonably assured to be entitled. Customers may not exercise all of their contractual rights related to, for example, mail-in rebates and other incentive offers. If an entity is reasonably assured of a breakage amount, the entity should recognize the effects of the expected breakage as revenue in proportion to the pattern of rights exercised by the customer. If an entity is not reasonably assured of a breakage amount, the entity should recognize the effects of the expected breakage when the likelihood of the customer exercising its remaining rights becomes remote
Current U.S. GAAP The seller's price must be fixed or determinable in order for revenue to be recognized. Revenue related to variable consideration generally is not recognized until the uncertainty is resolved. It is not appropriate to recognize revenue based on the probability of an uncertainty being achieved. Certain sales incentives entitle the customer to receive a cash refund (for example, a rebate) for some of the price charged for a product or service. The vendor recognizes a liability for those sales incentives based on the estimated refunds or rebates that will be claimed by customers. A liability (or deferred revenue) is recognized for the maximum potential amount of the refund or rebate (that is, no reduction is made for expected breakage) if future refunds or rebates cannot be reasonably and reliably estimated.
Current IFRS Revenue is measured at the fair value of the consideration received or receivable. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Trade discounts, volume rebates, and other incentives (such as cash settlement discounts) are taken into account in measuring the fair value of the consideration to be received. Revenue related to variable consideration is recognized when it is probable that the economic benefits will flow to the entity and the amount is reliably measurable, assuming all other revenue recognition criteria are met. A liability is recognized based on the expected levels of rebates and other incentives that will be claimed. The liability should reflect the maximum potential amount if no reliable estimate can be made.
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Proposed standard (that is, a liability is recognized in full for the entire amount of the rebate or other potential refund on the transaction date). The estimate of breakage is updated at each reporting period for changes in circumstances. Management should consider several factors in assessing whether the entity is reasonably assured to be entitled to breakage amounts, including: the impact of external factors; the time until the uncertainty is expected to be resolved; the extent of experience; and the variability in the range of possible outcomes.
Current U.S. GAAP
Current IFRS
Potential impact - both U.S. GAAP and IFRS Some entities will recognize revenue earlier under the proposed guidance because variable consideration is included in the transaction price prior to the date on which all contingencies are resolved. For example, telecom entities that offer discounts under minimum purchase commitment arrangements and determine they are reasonably assured to receive penalties or additional payments because customers will fail to meet the specified usage volumes could recognize revenue earlier than under current guidance. Management will also have to assess whether the entity is reasonably assured of breakage amounts related to incentives. Management should consider its experience with existing incentives, discounts, take-rates, and other external factors when determining when to recognize breakage amounts. The proposed standard requires entities to adjust the promised amount of consideration to reflect the time value of money if the contract has a financing component that is significant to the contract (and not to a portfolio of contracts). Factors to consider when determining whether a contract has a significant financing component include, but are not limited to, the following: (a) the expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services, (b) whether the amount of consideration would differ substantially if the customer paid in cash promptly in accordance with typical credit terms in the industry and jurisdiction, and (c) the interest rate in the contract and prevailing interest rates in the relevant market. The financing impact of transferring the handset to the customer at the initiation of the contract and collecting the customer's monthly payment for the handset over the contract period is likely to be insignificant.
Example 5 Mail-in rebate, breakage is reasonably assured

Question: A telecom entity enters into a contract with a customer to provide telecom services (voice, data, etc.) for $50 per month and Equipment X for $200. The customer receives a mail-in rebate of $100 related to the purchase of Equipment X. Mail-in rebates are funded by the entity. The entity has predictive experience from providing similar mailin rebates to customers (that is, refund amounts for similar equipment with similar sales prices). Management has also concluded there are no external economic factors that affect historical trends. How should management account for this transaction?
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Discussion: The telecom entity should estimate the transaction price based on the amounts it is reasonably assured to be entitled to, including breakage amounts. The most recent history for similar mail-in rebate programs (that is, refund amounts for similar equipment with similar sales prices) means management can determine that the entity is reasonably assured of an estimated breakage amount. The refund liability is estimated using the following probabilities representing the pattern of similar rebates. Probabilityweighted amount $ 0 75 $ 75
Amount $ 0 100
Probability 25% 75%
Management will record a refund liability of $75 and reduce the total contract transaction price by $75. Management will need to update the estimated liability at each reporting period, with any adjustments recorded to revenue.
Example 6 Mail-in rebate, breakage not reasonably assured

Question: A telecom entity enters into a contract with a customer to provide telecom services (voice, data, etc.) for $50 per month and Equipment Y for $350. The customer receives a mail-in rebate of $100 related to the purchase of the equipment. Mail-in rebates are funded by the entity. The entity does not have predictive experience providing similar rebates (that is, refund amounts for similar equipment with similar sales prices). How should management account for this transaction? Discussion: Management will record a full refund liability of $100 and reduce the total contract transaction price by $100 as it is not reasonably assured of a breakage amount. The liability will be recognized as revenue when the likelihood of the customer submitting the rebate becomes remote. Management will update the estimated liability at each reporting period.
Example 7 Minimum purchase contract

Question: A telecom entity enters into a contract with another telecom entity (customer) to provide access to its network over a one-year period. The contract offers a discounted usage rate of $0.05 per voice minute. The discounted rate is contingent upon the customer's minimum monthly purchase commitment of 25 million minutes of network voice usage. If the customer is unable to meet the volume commitments, the usage rate increases to $0.08 per voice minute, applied retroactively. How should the telecom entity providing network access account for this transaction? Discussion: Management should estimate the variable consideration to determine the amount of consideration the entity is entitled to as part of the transaction price. Management determined, based on its facts and circumstance, the expected value approach to be most predictive method for estimating the transaction price. Management considered the customer's expected operations and usage history and estimated that there is a 25% probability the customer will meet the minimum monthly volume commitments for the contract period and a 75% probability the customer will not meet the minimum commitments. The expected value approach resulted in a probability weighted usage rate of $0.07 per voice minute as shown below. Probabilityweighted amount $ 0.01 $ 0.06 $ 0.07
Rate $ 0.05 $ 0.08
Probability 25% 75%
After the first month of the contract, the customers usage was 26 million minutes ; however, management's assessment of the probable usage over the contract term remained unchanged. Management recognized revenue for the first month
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in the amount of $1.82 million (26 million minutes x $0.07). Management will update its estimate of the probability that customer will meet the minimum volume commitment and therefore, the variable consideration, at each reporting period.
Collectibility
Current U.S. GAAP requires payment to be reasonably assured to recognize revenue and IFRS requires that the payment is probable. The proposed standard removes these hurdles for recognition of revenue, which may cause earlier recognition of revenue. For example, some telecom entities do not recognize revenue for contract termination fees when customers terminate their contracts prior to expiration as the collection of these fees is not reasonably assured (U.S. GAAP) or probable (IFRS). These fees will be recognized upon customer termination under the proposed standard and an allowance recognized for expected credit losses. The proposed standard requires recognition of the expected impairment loss on a separate line item adjacent to revenue with any subsequent changes to the expected collectibility recorded in this same line item. Recognizing the expected impairment as a separate line item adjacent to the revenue line item aligns the sum of these two line items with cash ultimately received from the customer (if the contract does not have a significant financing component). The proposal may cause earlier impairment recognition and reclassifies bad debt expense from selling, general, and administrative expense or other expense to a line item adjacent to revenue. Proposed standard Collectibility will no longer be a recognition threshold. An entity will recognize an impairment loss for the customer's credit risk (the customer's ability to pay the amount of promised consideration) on receivables and contract assets, if any, as of the transaction date. The impairment loss will be presented in a separate line item adjacent to revenue. Once the impairment loss has been recorded, the effects of changes in the assessment of credit risk associated with that right to consideration are recognized in the same line. Potential impact - both U.S. GAAP and IFRS Collectibility is no longer a criterion for revenue recognition. Revenue may be recognized earlier than in current practice, which may affect key metrics used by management and investors in the telecom industry (such as average revenue per user (ARPU)). The impairment of receivables will also be recorded earlier than in current practice because an expected loss might be recorded when revenue is recognized under the proposed standard. Telecom entities currently record an impairment loss when receivables either age or become delinquent. Management will have to determine a practical method to measure and update the expected impairment loss amounts when revenue is recognized and, consistent with today's practice, management will need to regularly update its assessments to reflect subsequent changes to customers' credit risk - likely on a portfolio basis. Current U.S. GAAP Revenue is recognized when payment is reasonably assured (or probable). Credit risk is reflected as a reduction of accounts receivable, net, via an increase in the allowance for doubtful accounts and bad debt expense. Current IFRS Entities must establish that it is probable that economic benefits will flow before revenue can be recognized. Provision for bad debts (incurred losses on financial assets including accounts receivable) is recognized in a two-step process: first, objective evidence of impairment must be present; second, the amount of the impairment is measured based on the present value of expected cash flows.
Example 8 Collectibility
Question: A telecom entity enters into a two-year contract with a customer on January 1, 201X to provide telecom services (voice, data, etc.) for $40 per month. The telecom entity gives the customer a free handset with a fair value of $300 as an inducement to sign the two-year contract. It also charges an activation fee of $30. Payment for activation is due at delivery (date of the sale); payment for monthly service of $40 is billed to the customer on the first day of each
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month beginning on the date of the sale. How should the customer's credit risk for this arrangement be accounted for and presented? Discussion: Management uses the customers credit history, if available, and informat ion about other similar customers (for example, consideration of credit history, geography and plans) to estimate expected impairment loss on receivables and contract assets. Management's estimated impairment loss for this customer's receivable and contract asset is $10 as of the date of the sale. The telecom entity would therefore present the impairment loss of $10 in a separate line adjacent to revenue. Management will also need to update this original assessment for any changes to the customer's credit risk, recognizing any changes to the same line item adjacent to revenue. The table below reflects this presentation. January 31, 201X Revenue Impairment loss $236* ($10) $226
* Revenue calculated under the proposed model (see Example 11 under section - Allocation of the transaction price and establishing standalone selling prices section).
Example 9 Collectibility, subsequent measurement

Question: Continuing with the example above, management later determines the customer's outstanding receivable balance is impaired by an estimated $20 due to further deterioration in the customer's credit risk. What is the accounting impact? Discussion: Changes to receivable impairments are recognized by recording an additional allowance against the receivable and an increased charge in the line item adjacent to revenue. The telecom entity recognizes an additional allowance for impairment of $10 with a charge to the amount adjacent to revenue in the first quarter. March 31, 201X (year-to-date) Revenue Impairment loss $329* ($20) $309
* Revenue calculated under the proposed model (see Example 11 under section - Allocation of the transaction price and establishing standalone selling prices section).
Example 10 Collectibility, subsequent measurement

Question: The customer's financial condition improves and the telecom entity collects the entire transaction price at the end of the contract. What is the accounting impact? Discussion: Amounts collected in excess of the net receivable are recognized in the line item adjacent to revenue. The impact is that, on a cumulative basis, the sum of the two line items reflects the amount of consideration actually received from the customer.
Allocation of the transaction price and establishing standalone selling prices

Telecom entities often provide multiple products and services to their customers as part of a bundled offering. These arrangements usually consist of the sale of telecom services over a contracted period and the sale of equipment (wireless handset, modem, etc.). Some telecom entities also charge customers an upfront activation fee. These elements of the arrangement or contract might be combined into a single performance obligation or separated into multiple performance obligations under the existing revenue guidance. Various methods are used to allocate the transaction price to individual performance obligations. For example, telecom entities reporting under U.S. GAAP are required to apply a contingent revenue cash-cap, while most telecom entities reporting under IFRS use either a residual method or apply a
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contingent revenue cash-cap. The contingent revenue cash-cap limits the amount of consideration allocated to the delivered item (for example, a handset) to the amount that is not contingent on the delivery of additional items (for example, the telecom services). The proposed standard's allocation requirements will have significant implications to the telecom industry. It requires the transaction price be allocated to each separate performance obligation in proportion to the standalone selling price of the good or service. The proposal therefore eliminates the contingent revenue cash-cap requirement. The proposal also substantially eliminates the use of a residual method as it requires entities to estimate the standalone selling price for each of its separate performance obligations. This estimate should maximize the use of observable prices (that is, prices the entity sells the good or service separately), but also might involve other estimation methods including a market approach or an expected cost plus a margin approach. The proposed standard does allow for the use of a residual approach when the standalone selling price is highly variable or uncertain. Determining the standalone selling price of equipment (for example, handsets) may be challenging. Telecom entities in some markets only give or sell equipment to customers in a bundled offering (handsets are not sold separately). Telecom entities in other markets may separately sell equipment but only in limited circumstances when customers, while under contract, purchase a handset to replace their lost, stolen, or damaged handset. Management will need to use estimation methods to determine the standalone selling price when a telecom entity does not sell equipment or telecom services separately. Allocating the total transaction price to each performance obligation based on its relative standalone selling price will likely result in more revenues allocated to the equipment than under current practice. Telecom entities will therefore recognize a contract asset (the difference between revenue recognized and consideration received) at the transaction date. There are also challenges in allocating the transaction price for millions of customer contracts with various configurations of equipment and service plans. High-level estimation or a portfolio approach might be needed to determine a telecom entity's reported revenues for services and equipment. This is an area on which we would expect telecom entities to focus when considering the impact of the proposed standard and drafting their comment letters to the FASB and IASB. Proposed standard The transaction price is allocated to separate performance obligations in a contract based on relative standalone selling prices. The standalone selling price is the price at which the entity would sell a good or service separately to the customer. The best evidence of standalone selling price is the observable price of a good or service when the entity sells that good or service separately. Management estimates the selling price if a standalone selling price is not available. In doing so, the use of observable inputs is maximized. Possible estimation methods include: Expected cost plus reasonable margin Assessment of market price for similar goods or services Residual approach, in certain circumstances Current U.S. GAAP Arrangement consideration is allocated to each unit of accounting based on the relative selling price. When performing the allocation using the relative selling price method, the amount of consideration allocated to a delivered item is limited to the consideration received that is not contingent upon the delivery of additional goods or services. This limitation is known as the contingent revenue cash cap. Entities must follow a hierarchy for estimating the selling price of a deliverable. This hierarchy requires the selling price to be based on VSOE if available, TPE if VSOE is not available, or estimated selling price if neither VSOE nor TPE is available. The term "selling price" indicates that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. The residual or reverse residual methods are not allowed. Current IFRS Revenue is measured at the fair value of the consideration received or receivable. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. IFRS does not mandate how consideration is allocated and permits the use of the residual method, where the consideration for the undelivered element of the arrangement (normally service or tariff) is deferred until the service is provided, when this reflects the economics of the transaction. Any revenue allocated to the delivered items is recognized at the point of sale.
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Proposed standard A residual approach may be used as a method to estimate the standalone selling price when the selling price of a good or service is highly variable or uncertain. A selling price is highly variable when an entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts. A selling price is uncertain when an entity has not yet established a price for a good or service and the good or service has not previously been sold.
Current U.S. GAAP Telecom entities typically account for the sale of the equipment and telecom services in a bundled offering as separate units of accounting, with telecom services collectively accounted for as a single unit of account, as they are generally delivered at the same time. The arrangement consideration that can be allocated to the equipment is generally limited to cash received because future cash receipts are contingent on the entity providing telecom services. Therefore, when the handset is transferred, revenue is recognized at the amount that the customer paid for the handset at contract inception. The remaining contractual payments are recognized subsequently as the entity provides network services to the customer.
Current IFRS
Potential impact - both U.S. GAAP and IFRS Management will need to exercise judgment to determine the standalone selling price for each separate performance obligation in a customer contract (the telecom services and equipment).There is good visibility into the pricing of telecom equipment and the associated telecom service in some markets. However, in many markets, telecom entities charge customers little, if anything, for the equipment and only sell equipment bundled with the telecom services. If telecom entities do not separately sell equipment, management may have to use judgment to estimate the standalone selling price by applying various estimation methods, including, but not limited to a market assessment approach or a cost plus margin approach. The proposed standard includes a residual approach as a suitable estimation method; however, overcoming the threshold requirements (that is, the selling price is highly variable or uncertain) to use this approach may be challenging for telecom entities. Some software entities are more likely to meet the threshold requirements to use the residual approach. These entities provide customized contracts that include multiple, separate performance obligations. The customization of customer contracts means pricing of the various performance obligations may differ significantly between contracts, which may allow the software entity to conclude the selling prices for certain performance obligations are highly variable. Software entities that develop new or enhanced products or services (not developed by other entities; for example, intellectual property and other intangible products) may be able to conclude the selling price for the new or enhanced product or service is uncertain. Management considering the use of the residual approach for telecom entities will have to apply judgment to assess whether the selling prices of their goods and services are highly variable or uncertain. The proposal's allocation requirements will likely result in greater portions of the transaction price being allocated to the equipment than under the current guidance, which causes earlier recognition of revenue at the inception of the contract. Recognizing more revenue than consideration received at the inception of a contract also results in the recognition of a contract asset, which will need to be monitored for impairment. Determining the estimated standalone selling prices of each performance obligation and the relative allocation of the transaction price for millions of customer contracts that have variations in telecom service plans/tariffs, customer types, contract lengths, and equipment will be complex and will require management judgment. The large number of customer contracts means the estimated selling prices and allocations may require assessments to be performed on a portfolio basis. A similar approach may be necessary when monitoring contract assets for impairment.
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Proposed standard
Current U.S. GAAP
Current IFRS
Changes to systems may also be required to reflect the obligations arising from contracts and allocate the transaction price. Management should consider whether they need to modify existing systems or develop new systems to gather reliable information on customer contracts and understand the impact on the timing of revenue recognition.
Example 11 Allocation of transaction price

Question: A wireless entity enters into sales arrangements with two different customers: Customer A and Customer B. Each customer purchases or receives the same handset and selects the same monthly telecom service plan. The standalone selling price for both handsets is $300 (it is purchased wholesale by the wireless entity for $290) and the standalone selling price of the telecom service plan is $40 per month. The $300 standalone selling price of the handset is based on the price the telecom entity sells to customers that purchase the handset exclusive of telecom services (for example, customers that purchase the handset to replace a lost, stolen, or uninsured damaged handset). The selling price of the telecom service is always $40 per month, regardless of whether a customer signs a non-cancelable, long-term contract (for example, a two-year contract) or a cancelable contract (that is, a month to month service plan) or renews a contract. Customer A purchases a handset for $300 and enters into a cancelable contract to receive telecom services (voice and data) for $40 per month. Customer A also pays an activation fee of $30 (activation fees are charged on initial contracts only). Customer B enters into a 24-month contract for $40 per month and receives a free wireless handset as an inducement to enter into the two-year contract. Customer B also pays an activation fee of $30. In summary: Fair value of handset Fair value of services Fair value of the bundle Cost of equipment Customer A transaction price Customer B transaction price $ 300 $ 960 ($40 x 24 months)* $1,260 $ 290 $ 370 ($300 handset + $30 activation fee + one month of service) $ 990 ($960 services + $30 activation fee)
* Fair value of the services is determined using the price the telecom entity charges customers on a standalone bases, including consideration of pricing renewals.
How should the transaction price be allocated to the performance obligations in the contracts with Customer A and B? Discussion: Management needs to identify and separate performance obligations within customer contracts. The sales of telecom services and handsets are typically separate performance obligations while the activation services are not separate performance obligations. Revenue is recognized when a promised good or service is transferred to the customer, which is when the customer obtains control of that good or service. Revenue is recognized for the sale of the handset at delivery, when the telecom entity transfers control of the handset to the customer. Service revenue is recognized ratably over the contract service period, as control of the service transfers continuously to the customer over the contract period. Management determined the financing component of the contract to be insignificant. The financing impact of transferring the handset to the customer at the initiation of the contract and collecting the customer's monthly payment over the 24-month contract period is insignificant. The tables below compares the affect of applying the allocation guidance in the proposed standard with that of the current guidance (example excludes the effect of the time value of money).
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Current guidanceexisting U.S. GAAP guidance (contingent revenue cash-cap)

Customer Customer A Customer B Total Day 1 $326* $30*** $356 Month 1 $44** $40 $84 Month 2 $40 $40 $80 Month 3 $40 $40 $80
* Recognize revenue for the sale of the handset ($300) plus a proportionate allocation of the activation fee ($26). ** Stand-alone selling price of the telecom services ($40) plus a proportionate allocation of the activation fee ($4). The payment for the activation service is an advance payment for future telecom services, not a separate performance obligation. The activation fee is included in the overall transaction price and allocated to the separate performance obligations. ***Recognize revenue for the amount of consideration received that is not contingent upon the delivery of additional items (telecom services).
The telecom entity records the following journal entry for sales transaction with Customer B at the transaction date under U.S. GAAP. The journal entry also reflects the monthly invoicing, billed in advance, to Customer B for the monthly service. Dr. Cash Dr. Cost of goods sold Dr. Accounts receivable Cr. Equipment revenue Cr. Inventory Cr. Deferred service revenue $ 30 $290 $ 40
$ 30 $290 $ 40
The entity records the following journal entry for Customer B as of the end of the month for telecom services provided during the month (the telecom entity entered into the contract with the customer on the first day of the month). Dr. Deferred revenue Cr. Service revenue $ 40 $ 40
Current guidanceexisting IFRS guidance (residual method)

Customer Customer A Customer B Total Day 1 $326* $0*** $326 Month 1 $44** $41 $85 Month 2 $40 $41 $82 Month 3 $40 $41 $82
* Recognize revenue for the sale of the handset ($300) plus a proportionate allocation of the activation fee ($26). ** Stand-alone selling price of the telecom services ($40) plus a proportionate allocation of the activation fee ($4). The payment for the activation service is an advance payment for future telecom services, not a separate performance obligation. The activation fee is included in the overall transaction price and allocated to the separate performance obligations. ***Under the residual method, the amount of consideration allocated to the delivered item ($0) equals the total arrangement consideration ($990) less the aggregate fair value of the undelivered item(s) ($990).
The telecom entity records the following journal entry for sales transaction with Customer B as of the transaction date under IFRS. The journal entry also reflects the monthly invoicing, billed in advance, to Customer B for the monthly service. Dr. Cash Dr. Cost of goods sold Dr. Accounts receivable Cr. Inventory Cr. Deferred service revenue $ 30 $290 $ 40
$290 $ 70
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The entity records the following journal entry for Customer B at the end of the month for telecom services provided during the month (the telecom entity entered into the contract with the customer on the first day of the month). Dr. Deferred revenue Cr. Service revenue $ 41 $ 41
New guidancerevenue recognized (excluding collectibility)

Customer Customer A Customer B Total Day 1 $326* $236** $562 Month 1 $44* $31*** $75 Month 2 $40 $31*** $71 Month 3 $40 $31*** $71
* Includes the activation fee allocated in proportion to the relative standalone selling price of the handset and the service. The calculation is the same as the current accounting under U.S. GAAP and IFRS. ** Handset: $236 = ($300 / $1,260) x $990. *** Monthly service revenue: $31 = ($960 / $1,260) x $990 = $754 / 24.
The telecom entity will recognize $206 more in equipment revenue from Customer B than under U.S. GAAP and $236 more than under IFRS. The telecom entity will also recognize a net contract asset of $197 under the proposed standard, which will have to be monitored for impairment (for example, the telecom entity will have to impair the asset if the customer terminates the contract before the end of two years). The telecom entity would record the following journal entry for Customer B at the transaction date under the proposed standard. The journal entry also reflects the monthly invoicing, billed in advance, to Customer B for the monthly service. Dr. Cash $ 30 Dr. Cost of goods sold $290 Dr. Account receivable $ 40 Dr. Contract asset $ 197**** Cr. Equipment revenue $236 Cr. Inventory $290 Cr. Deferred service revenue $ 31
**** $197 is the net contract asset recorded at the transaction date, which is calculated as follows: equipment revenues ($236) less cash received ($30) less the difference between the amounts billed in advance for the monthly service ($40) and the deferred monthly service revenues ($31). The net contract asset is reduced each month by the difference between amounts invoiced and amounts recognized as revenue.
The entity records the following journal entry for Customer B at the end of the month for services provided during the month (the telecom entity entered into the contract with the customer on the first day of the month). Dr. Deferred revenue Cr. Service revenue $ 31 $ 31
Equipment installation revenues

Some telecom entities provide equipment installation services involving installing cable, phone systems, modems, and routers. Revenues for these services are generally recognized, under U.S. GAAP, using either the completed-contract method or the percentage-of-completion method. The percentage-of-completion (stage of completion) method is used under IFRS. Revenue will be recognized under the proposed standard on the satisfaction of performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or over time. Management will have to determine when control of the equipment or service is transferred to customers and determine the most appropriate method to measure progress to contract completion. The notion of transferring control of a service may not be intuitive and the proposed standard contains guidance in this area. It is explained in the table below.
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Proposed standard Transfer at a point in time Revenue is recognized on the satisfaction of a performance obligation, which occurs when the customer obtains control of the good or service. Control can transfer at a point in time or over time. Determining when control transfers might require a significant amount of judgment. Factors to consider include, but are not limited to: The entity has a right to payment The customer has legal title The customer has physical possession The customer has risks and rewards of ownership The customer has accepted the asset Transfer over time An entity must first determine whether a performance obligation is satisfied over time. If so, an entity must select a method for measuring progress in satisfying that performance obligation. An entity should recognize revenue for a service only if the entity can reasonably measure its progress toward completion of the service. A performance obligation is satisfied over time if (a) the entity's performance creates or enhances an asset that the customer controls, or (b) the entity's performance does not create an asset with alternative use to the entity and at least one of the following criteria are met: the customer simultaneously receives and consumes the benefits of the entitys performance as it performs; another entity would not need to substantially re-perform the
Current U.S. GAAP Revenue is recognized for installation contracts within the scope of construction contract accounting using the percentage-of-completion method when reliable estimates are available. For circumstances in which reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (for example, when the scope of the contract is illdefined but the contractor is protected from an overall loss), the percentageof-completion method based on a zero profit margin is used until more precise estimates can be made. Where reliable estimates cannot be made, the completed-contract method is required.
Current IFRS Revenue is recognized for installation contracts using the percentage-ofcompletion (stage of completion) method when reliable estimates are available. Where the outcome of a contract can be reliably estimated, contract costs and revenue are recognized by reference to the percentage-ofcompletion of the contract. Where the outcome of a contract cannot be reliably estimated, contract costs are recognized as an expense when incurred and revenue is recognized only to the extent of the contract costs incurred, provided it is probable the revenue will be recoverable. Any expected contract loss is recognized immediately.
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Proposed standard task(s) if that other entity were required to fulfill the remaining obligation to the customer; or the entity has a right to payment to date and it expects to fulfill the contract. Measurement of progress An entity recognizes revenue by measuring the progress towards complete satisfaction of the performance obligation for a performance obligation satisfied over time. The objective when measuring progress is to depict the transfer of control of the promised goods or services to the customer. Methods for measuring progress include: Output methods that recognize revenue on the basis of units produced, units delivered, contract milestones, or surveys of work performed Input methods that recognize revenue on the basis of costs incurred, labor hours expended, time lapsed, or machine hours used
Current U.S. GAAP
Current IFRS
Potential impact - both U.S. GAAP and IFRS The change to a control transfer model will require careful assessment as to when revenue is recognized, specifically when control of the goods and services transfers. Management will have to carefully consider the contract terms, including the level of customization, payment terms, units produced and costs incurred, units delivered, and the customer's rights to the goods and services over the contract period to determine the method (output method or the input method) that most faithfully depicts the pattern of transfer of the goods or services. The method used under the proposal may cause differences in comparison to current guidance.
Recognition of revenue Impact on advertising and phone directory activities

Some telecom entities have publishing and advertising businesses that publish and distribute a range of periodicals and phone directories in paper (hard copy publication) and internet formats (online publication). Revenue is typically recognized under U.S. GAAP over the life of the directory (usually 12 months) for both hard copy and online publications. Revenue is recognized for hard copy publications under IFRS when delivery has occurred. The recognition of revenue is on a percentage-of-completion basis if there are multiple deliveries for a single publication. Revenue recognition for online publications under IFRS is consistent with U.S. GAAP. The proposed guidance may accelerate revenue recognition to the delivery date or publication date for hard copy publications the date on which the performance obligation is satisfied but is not likely to have a significant impact for entities reporting under IFRS. Revenue recognition associated with online publications is less likely to change, as the publisher has the obligation to continue to display the advertisement over the contractual period. Management will have to carefully assess the
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performance obligations in their advertising contracts and determine which performance obligations are separate performance obligations and when these obligations are settled. Proposed standard Transfer at a point in time Revenue is recognized on the satisfaction of performance obligations, which occurs when the customer obtains control of the good or service. Transfer over time An entity must first determine whether a performance obligation is satisfied over time. If so, an entity must select a method for measuring progress in satisfying that performance obligation. An entity should recognize revenue for a service only if the entity can reasonably measure its progress toward completion of the service. Current U.S. GAAP Revenue allocated to hard copy publications is recognized based on the entitys accounting policy choice, assuming certain conditions are met, using either of the two methods below. The majority of publishing entities apply the deferral method. 1. Delivery method revenue is recognized based on the percentage of publications/books delivered (that is, a proportionate performance model). Current IFRS Revenue on advertising transactions is recognized as the service is performed. For advertisements included within hard copy publications, revenue is recognized when the advertisement appears publicly, which is typically when the directories are delivered. Potential impact: The timing of revenue recognition under the proposed guidance is similar to current practice.
2. Deferral method revenue is recognized ratably over the contractual circulation period. Potential impact: The proposed guidance may eliminate the deferral method and require publishing entities to apply the delivery method, accelerating revenue recognition. Management will need to estimate the total number of publications/books to be delivered, including the number of primary deliveries and secondary deliveries.
Example 12 Recognizing revenue from advertising and phone directory activities

Question: An entity publishes and distributes a wide range of periodicals and phone directories in both paper and online formats. The entity generates all of its fees from selling advertising in such publications to its customers. It is required to deliver these free publications or directories to specified locations. The advertisement is included in both the physical and online publications for a period equal to the circulation period of the hard copy publication, typically one year. The hard copy and online publication advertising are generally sold as a bundled package for one fee. The entity delivers the hard copy directories both through a primary broad distribution and a secondary delivery; for example, to new residents moving to an area. The entity has completed its obligations for hard copy directories after delivery (that is, no other services are required). It has properly separated and allocated the fee between the two performance obligations (hard copy and online publication) based on the relative standalone selling price. How should the entity recognize revenue on each performance obligation? Discussion: Revenue is recognized ratably or on a straight-line basis over the one-year contract period for the online publication services, as the entity is required to display the advertising on the website (that is, the performance obligation is satisfied over time as the customer simultaneously receives and consumes the benefits of the entitys performance as it performs). The entity satisfies the performance obligation related to the hard copy publication upon delivery, rather than over the contract period. Management will, however, need to consider what additional services are required, if any, after primary
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deliveries to residents. Management should allocate a portion of the consideration to secondary deliveries and recognize revenue upon secondary delivery if the entity is required to provide that service.
Fulfillment costs
Telecom
Some telecom entities defer the cost of activating customers to the telecom network (that is, labor and equipment cost) under U.S. GAAP. These costs can be material and are typically deferred up to the amount of related activation revenue and amortized on a straight-line basis consistent with the related revenues. Entities that provide design-and-build arrangements sometimes defer set-up costs under IFRS because they are necessary investments to support the ongoing delivery of the contract. Costs to fulfill contracts are capitalized under the scope of other standards or if they meet specific requirements under the proposed guidance. Management will need to carefully review its cost capitalization and deferral methods in order to understand the potential effect of these changes.
Publishing
Entities involved in advertising and phone directory activities may no longer be able to defer and amortize directory costs relating to hard copy publications over the contract period. The fulfillment costs are likely to be expensed upon delivery of the directories at the same time as the revenue is recognized. Proposed standard Telecom Direct costs incurred to fulfill a contract are first assessed to determine if they are within the scope of other standards (for example, inventory, property, plant and equipment of intangible assets), in which case the entity accounts for such costs in accordance with those standards. Costs that are not in the scope of another standard are evaluated under the revenue standard. An entity recognizes an asset only if the costs: relate directly to a contract; generate or enhance resources that will be used in satisfying future performance obligations (that is, they relate to future performance); and are expected to be recovered. These costs are then amortized, as control of the goods or services to which the asset relates is transferred to the customer. Costs incurred to install services at the origination of a customer contract relating to, for example, nonrefundable, up-front connection fees, may be either expensed as incurred or deferred and charged to expense in proportion to the revenue recognized. Potential impact: Telecom entities that currently expense all contract fulfillment costs as incurred might be affected by the proposed guidance since costs are required to be capitalized when the criteria are met. Fulfillment costs that are likely to be in the scope of this guidance include, among others, setup costs for service providers and costs incurred in the design phase of construction projects. Many of the costs of connecting customers form part of the operators network and the costs are capitalized as property, plant and equipment. Potential impact: Telecom entities that currently expense all contract fulfillment costs as incurred might be affected by the proposed guidance since costs are required to be capitalized when the criteria are met. Fulfillment costs that are likely to be in the scope of this guidance include, among others, setup costs for service providers and costs incurred in the design phase of construction projects. Current U.S. GAAP Current IFRS
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Proposed standard Publishing Direct costs incurred to fulfill a contract are first assessed to determine if they are within the scope of other standards (for example, inventory costs). If not, costs are capitalized if they meet the specific criteria described above.
Current U.S. GAAP
Current IFRS
Costs incurred to create directories (that is, graphics, printing, bindings and direct contract-acquisition costs) are capitalized as deferred publishing cost in inventory. Deferred costs are recognized based on the proportional performance under the delivery methodin line with the percentage of total revenue recognized upon primary delivery. Costs are recognized ratably over the circulation period of the periodical/book under the delivery method. Potential impact: Publishing entities will need to track and differentiate costs to acquire customer contracts (see below for further guidance related to acquisition costs), fulfillment costs, and other costs. Contract acquisition costs and fulfillment costs might be capitalized, while other costs are expensed when incurred. The proposal requires that non-incremental selling costs are expensed as incurred. Under current guidance, selling costs, regardless of whether a contract is acquired are capitalized into directory inventory.
Costs incurred to create directories (that is, graphics, printing, bindings and direct contract-acquisition costs) are capitalized as deferred publishing cost in inventory and recognized at delivery. Potential impact: Publishing entities will need to track and differentiate costs to acquire customer contracts (see below for further guidance related to acquisition costs), fulfillment costs, and other costs. Contract acquisition costs and fulfillment costs might be capitalized, while other costs are expensed when incurred. The proposal requires that non-incremental selling costs are expensed as incurred. Under current guidance, selling costs, regardless of whether a contract is acquired are capitalized into directory inventory.
Contract acquisition costs

Telecom
Telecom entities - predominately wireless entities - pay substantial commissions to internal sales agents and third party dealers for connecting new customers to their networks. Commissions paid to sale agents vary, for example, depending on the length of the service contract and the type of service plan, including any enhanced services sold. The longer the service contract and the greater the monthly proceeds (for example, service plans with relatively high or unlimited minutes of use), the greater the commission costs. Some wireless entities also provide free or heavily discounted handsets in order to attract customers. A handset is a separate performance obligation and the cost of the handset is a fulfillment cost to be recognized as an expense when the performance obligation is satisfied (that is, when the handset is delivered to the customer). Telecom entities, however, offer a wide range of discounts and subsidies, using both their own and third-party dealer networks, and the accounting for each different type of arrangement should be considered separately. Some entities that report under IFRS capitalize customer acquisition costs as an intangible asset, while other telecom entities, including most U.S. telecom entities, expense these costs as incurred. The proposed standard will require telecom entities to capitalize incremental commission costs if the costs are expected to be recovered. Entities are
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permitted to expense these costs when incurred if the amortization period would be less than one year as a practical expedient.
Proposed standard Entities will recognize as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs. The incremental costs of obtaining a contract are those costs that an entity would not have incurred if the contract had not been obtained. All other contract acquisition costs incurred regardless of whether a contract was obtained are recognized as an expense. The proposal permits entities to expense incremental costs of obtaining a contract when incurred if the amortization period would be one year or less, as a practical expedient. Contract costs recognized as an asset are amortized on a systematic basis consistent with the pattern of transfer of the goods or services to which the asset relates. In some cases, the asset might relate to goods or services to be provided in future anticipated contracts (for example, service to be provided to a customer in the future if the customer chooses to renew an existing contract). An impairment loss is recognized to the extent that the carrying amount of an asset exceeds: (a) the amount of consideration to which an entity expects to be entitled in exchange for the goods or services to which the asset relates; less
(b) the remaining costs that relate
Current U.S. GAAP U.S. GAAP allows costs that are directly related to the acquisition of a contract that would not have been incurred but for the acquisition of that contract (incremental direct acquisition costs) to be deferred and charged to expense in proportion to the revenue recognized. Other costs such as advertising expenses and costs associated with the negotiation of a contract that is not consummated are charged to expense as incurred.
Current IFRS Costs of acquiring customer contacts have been capitalized by some telecom entities as intangible assets and amortized over the customer contract period, while other telecom entities expense the costs when incurred.
directly to providing those goods or services. Entities may reverse impairments, under IFRS, when costs become recoverable; however, the reversal is limited to an amount that does not result in the carrying amount of the capitalized acquisition cost exceeding
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Proposed standard the depreciated historical cost. Entities are not permitted to reverse impairments under U.S. GAAP.
Current U.S. GAAP
Current IFRS
Potential impact - both U.S. GAAP and IFRS The proposal will have a significant impact on entities that are not currently capitalizing contract acquisition costs. Management will likely have to develop systems, processes, and controls to identify and track incremental contract acquisition costs and to subsequently monitor the capitalized costs for impairment. Telecom entities will need to capitalize these contract acquisition costs as an asset if they are recoverable and amortize over the expected period consistent with pattern of when telecom services are provided to the customer. Management will need to use judgment to determine the amortization period as the proposed standard requires entities to consider periods beyond the initial contract period; for example, the renewal of existing contracts and anticipated contracts. Management may determine contract acquisition costs are recovered from the initial two-year contract and a two-year contract renewal. Management may therefore amortize the contract acquisition cost over a four-year period if this period is consistent with the pattern of telecom services to which the costs relate. The FASB and IASB have concluded this approach is consistent with the existing requirements for amortizing other assets such as property, plant and equipment, and intangibles. Management will have to develop a systematic and reasonable approach, considering the number of customers and contract offerings, to impair these contractual assets (for example, a portfolio approach) when the estimated amount of consideration to be received from a customer is less than the outstanding contract asset. Spreading these costs over the amortization period will significantly affect operating margins and minimize the seasonal fluctuation in EBITDA. Wireless entities, for example, often incur significant contract acquisition costs in the holiday seasons through promotional offers on handsets.
Example 13 Customer acquisition costs

Question: A telecom entity enters into a contract with a customer to provide telecom services. The entity pays a thirdparty dealer a commission to connect customers to its network. The customer signs an enforceable contract to receive telecom services for a period of one year for a monthly subscription fee of $80. How should the telecom entity account for the third-party dealer commission under the proposed standard? Discussion: Management will be required to identify incremental contract acquisition costs and capitalize those costs that are recoverable. The telecom entity may use the practical expedient and expense contract acquisition costs when incurred if the amortization period would be one year or less. Management determines the amortization period is one year in this case after considering anticipated contracts. The telecom entity may use the practical expedient and expense these costs when incurred.
Example 14 Customer acquisition costs

Question: A telecom entity sells wireless telecom service subscriptions (service plans) from a retail store in a shopping mall. Sales agents employed at the retail store signed 120 customers to two-year telecom service contracts in a particular month. The monthly rent for the store is $5,000. The telecom entity pays the sales agents commissions for the sale of telecom service contracts, in addition to their normal wage. Wages paid to the sales agents during the month were $12,000 and commission paid was $24,000. The telecom entity also gave customers handsets or sold handsets to them at highly discounted prices to create an incentive for them to enter into two-year contracts. The net cost of giving or selling discounted handsets to the 120 customers was $36,000. The retail store also incurred $2,000 in costs during the month to advertize in the local journals. How much should the telecom entity recognize as a contract acquisition asset? Discussion: The telecom entity is required to capitalize incremental costs to acquire contracts, which are those costs the entity would not have incurred unless it acquired the contracts (the practical expedient is not available as the amortization period is greater than a year). All other costs are charged to expenses when incurred. The store rent of
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$5,000, the sales agents' wages of $12,000, and advertising expenses of $2,000 are all expenses the telecom entity would have incurred regardless of acquiring the customer contracts and should be expensed as incurred. The net costs of giving or subsidizing the handsets to attract customers to sign long-term contracts would be accounted for as fulfillment costs and recognized as cost of goods sold upon sale of the handsets to the customers. Management might characterize the handset losses as marketing incentives or incidental goods or services, but they are performance obligations (that is, goods transferred to the customer). Another telecom entity might pay third-party dealers greater commissions to allow those dealers to offer similar incentives (that is, offer significantly discounted handsets at a dealer's discretion) to customers to sign long-term contracts. These commissions would be treated as contract acquisition costs. Subtle differences in arrangements could therefore have a substantial impact on how telecom entities will account for subsidies and discounts under the proposed standard. The only costs that qualify as incremental contract acquisition costs in this example are the commissions paid to the sales agents.
Example 15 Customer acquisition costs - amortization period for prepaid services

Question: A telecom entity sells prepaid wireless services to a customer. The customer purchases up to 1,000 minutes of voice services for $80 and any unused minutes expire at the end of the month. The customer can purchase additional 1,000 minutes of voice services at the end of the month or once all the voice minutes are used. The telecom entity pays commissions to sales agents for sale of prepaid wireless services. The implied contract is a one-month contract and the telecom entity expects the customer, based on the customer's demographics (for example, geography, type of plan, and age), to renew for six additional months. What period should the telecom entity use to amortize the contract acquisition costs (that is, the commission costs)? Discussion: Management will need to use judgment to determine an amortization period that represents the period during which the entity transfers the prepaid telecom services if the telecom entity determines not to use the practical expedient discussed above. Management considered future anticipated contracts and renewals of existing contracts and as a result, determined an amortization period of seven months was appropriate.
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Authored by:
Robert Conklin U.S. Entertainment, Media and Communications Leader Phone: 1-646-471-5858 Email: robert.conklin@us.pwc.com Pierre-Alain Sur U.S. Communications Leader Phone: 1-501-907-8082 Email: pierre-alain.sur@us.pwc.com Rob Glasgow Senior Manager Phone: 1-973-236-4019 Email: rob.glasgow@us.pwc.com Guilaine Saroul Director Phone: 1-973-236-7138 Email: guilaine.saroul@us.pwc.com
US GAAP Convergence & IFRS Leases

Leases One size does not fit all A summary of the boards' redeliberations
Overview
At a glance The FASB and IASB jointly issued the initial leases exposure draft in August 2010 (the "initial ED"). A majority of the over 800 comment letters received raised significant concerns about the proposals. Redeliberations began in January 2011 and were substantially completed in July 2012. A "revised ED" is planned for the end of November 2012 (although this may slip into early 2013), with a 120-day comment period. Three FASB members and two of the IASB members stated they may present alternative views in the revised ED. The revised ED will retain the previously proposed "right of use" concept, and lessees would reflect all leases (except certain short term leases) on the balance sheet. Some lessors will derecognize the underlying leased asset, but others will continue to include it on the balance sheet. The revised ED will also propose a number of other changes to existing recognition, measurement, presentation, and disclosure guidance. The most significant changes to the initial ED will include: a dual model for lessees and lessors; a higher threshold for including extension options when measuring lease assets and liabilities; simplified treatment of many types of variable lease payments; and new guidance on applying the concepts of "specified asset" and "control" when determining whether a contract contains a lease. The revised ED will allow entities to apply a full retrospective approach or to elect certain reliefs to reduce the transition burden. Preparers will need to apply the guidance to all leases existing as of the beginning of the earliest comparative period presented (i.e., no grandfathering). Issuance of a final standard, although targeted for 2013, may slip into 2014. The effective date has yet to be discussed, but will likely not be before 2016.
No. 2012-11 September 17, 2012 Whats inside: Overview .......................... 1

At a glance ...............................1 Overview of changes from existing GAAP ...................... 2 Background of the project ...... 2 The main details of the redeliberations ..................... 5
Summary of the boards' redeliberations.............. 7

Lessee expense recognition pattern .................................. 7 Lessor accounting..................12 Lease term.............................. 15 Variable/uncertain cash flows .................................... 17 Definition of a lease .............. 18 Transition ............................. 20
The path forward ..........23 Questions .......................23 Appendix: Other key areas ......... 24
Dataline
Overview of changes from existing GAAP .1 The revised ED is expected to propose a number of changes from existing GAAP. The most significant changes are included in the following table: Overview of changes in a revised ED from existing GAAP Determination of whether an arrangement is or contains a lease The analysis under existing GAAP to distinguish a service from a lease will be significantly changed as a result of clarification of what is a "specified asset" and alignment of "control" indicators closer to the guidance in the proposed revenue recognition standard and the latest consolidation guidance. All leases (except short term leases) will be recognized on the balance sheet. A dual model for income statement recognition will be retained; which model will apply would be based on whether the lessee "consumes" the underlying asset. Lessor accounting A dual model for balance sheet and income statement recognition will be retained; which model will apply would be based on the same principle of consumption as for lessee accounting. Current operating lease accounting will be retained for some leases; however, the finance lease approach will be replaced with the receivable and residual approach. Lease term, Variable/uncertain cash flows, and Reassessment The revised ED will alter the threshold for including in the measurement extension options and contingencies based on a rate/index. Reassessment will be required throughout the lease term.
Lessee accounting
Background of the project .2 Leasing arrangements satisfy a wide variety of business needs, from short-term asset rentals to long-term asset financing. Leases allow lessees to use a wide range of assets, including office and retail space, equipment, trucks/cars, and aircraft, without having to make large initial cash outlays. Sometimes, leasing is the only option to obtain the use of a physical asset when it is not available for purchase (e.g., it is generally not possible to buy one floor of an office building). .3 Many observers have long believed that the current lease accounting model is not consistent with the FASB and IASB's conceptual frameworks, which provide the underpinnings for their accounting standards. They argue that the model allows lessees to structure lease transactions to result in operating lease classification and therefore receive off-balance sheet treatment. Critics also point out that the current standards permit something as seemingly illogical as a commercial airline not reporting any airplanes on its balance sheet.
Dataline
.4 In June 2005, the Securities and Exchange Commission (SEC) issued its Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Users. One of the significant recommendations in this report was that existing lease standards needed to be rewritten, predominantly to eliminate offbalance sheet accounting by lessees. .5 As part of their global convergence process, the boards added a joint project on leases to their agendas in 2007 and have been working since to create a single, comparable, worldwide leasing standard. The project was intended to build on previous work contained in the 1999/2000 white paper titled G4+1 Special Report, Leases: Implementation of a New Approach. The initial ED published by the boards in August 2010 was a follow up to a discussion paper published in March, 2009. PwC observation: While there are some differences, the core elements of existing U.S. GAAP and IFRS for leases are largely aligned today. Accordingly, while reaching a converged standard is a key consideration, the boards' joint leasing project is more about addressing perceived problems with the existing accounting model than aligning the guidance.
Overview of the initial ED The definition of a lease under current GAAP is retained. Off-balance sheet accounting by lessees for operating leases is eliminated; essentially all assets currently leased would be brought on balance sheet. Rent expense is replaced by interest expense (which would be greater in earlier years, like a mortgage) plus straight-line amortization of the leased asset, such that total expense would be "frontloaded." Traditional financial performance ratios may no longer be useful; other operating metrics may evolve. Lease assets and liabilities would be recognized based on the present value of payments to be made over the term of the lease and subsequently measured at amortized cost. The payments would include contingent amounts, such as rents based on a percentage of a retailers sales and rent increases linked to changes in the Consumer Price Index. The lease term would include optional renewal periods that are "more likely than not" to be exercised (this is substantially different than todays model). Lease renewal periods and variable lease payments would be continually reassessed, and the related estimates trued up as facts and circumstances change (again, substantially different than today's model which is largely "set-it and forget it"). A lessor would apply the "performance obligation" approach if it retains exposure to significant risks or benefits associated with the underlying asset during or after the expected lease term; the "de-recognition" approach would be used otherwise. This is known as the "dual model." Pre-existing leases would not be grandfathered. A "modified retrospective" approach for transition would be required (i.e., treat all leases in effect as if they started at the beginning of the earliest year presented).
Dataline
.6 For more information on the initial ED, refer to Dataline 2010-38, A new approach to lease accounting Proposed rules would have far reaching implications (which provides an overview and various insights into the ED), Dataline 2011-05, Leasing the responses are in . . . (which summarizes comment letters received), and 10Minutes on the future of lessee accounting (which provides insight into how companies will be impacted by the proposals in the ED and next steps to consider). .7 The boards' primary objective with the initial ED was to get all leases onto the balance sheet of lessees. However, the accounting proposed would significantly impact the income statement, and the changes to expense recognition and income statement presentation quickly became a significant area of focus. The graph below illustrates the differences in the expense recognition pattern between existing operating lease accounting, the proposed model in the initial ED, and cash rents for a basic ten-year lease with an initial annual rent of $2,000, a 2% annual escalation rate, and an assumed incremental borrowing rate of 7%. 2,700 2,600 2,500 2,400 2,300 2,200 2,100 2,000 1,900 1,800 1,700 1,600 1,500 1 Initial ED 2 3 4 5 Years Existing operating lease accounting Cash rents 6 7 8 9 10
.8 Over 800 comment letters were received in response to the initial ED. A majority of the letters were supportive of the need for the project in general, especially with respect to the balance sheet issue for lessees. However, most respondents had significant concerns about many aspects of the proposals and strongly encouraged the boards to take the time necessary to produce a standard that is both high quality and operational. Common concerns centered on: Financial statement impact (especially the income/expense recognition patterns) Complexity/operationality Highly subjective estimates and judgments Time to implement Cost vs. benefit
Annual Expense (in $)
Dataline
.9 In early 2011, the boards began redeliberations to address these concerns, the five key areas discussed in paragraph 13 below, and other issues. In discussions over the past 18 months, the boards identified alternative approaches to reduce complexity and address certain application issues. They also conducted extensive outreach with users and preparers to understand the operationality and usefulness of their alternative approaches. .10 At their July 17, 2012 joint meeting, the boards substantially completed their redeliberations and instructed their staffs to begin drafting a revised ED. The boards plan to issue the revised ED by the end of November 2012 with a 120-day comment period. However, the issuance may slip into early 2013. .11 The difficulties encountered during the 18-month-long redeliberation process were highlighted when the board members were asked whether they planned to present an alternative view in the revised ED. Three of the seven FASB members and at least two of the IASB members stated they may present alternative views. However, the stated rationales for their alternative views are very different. The FASB members expressed significant concerns about whether some of the core objectives of the project are met in the revised ED. They question the overall cost/benefit proposition and whether the revised proposals will provide financial statement users with useful information. Other specific concerns include the accounting for variable lease payments, the effectiveness of the proposed disclosures, and the interaction of lessor accounting with the proposed revenue recognition model. .12 In contrast, IASB members contemplating presenting an alternative view primarily expressed concern about the conceptual merits of a dual, rather than single, lease accounting approach being applied by both lessees and lessors. The main details of the redeliberations .13 The boards have reached tentative decisions in each of the five key areas described in the table below. Many of their decisions significantly change the accounting in the initial ED. In addition, the boards reached tentative decisions on other key areas (refer to the appendix of this Dataline for further details).
Topic Lessee expense recognition pattern
Initial ED A lessee should recognize amortization of the right-of-use asset (straight-line), and interest on the liability to make lease payments (effective interest rate). The result is a front loading of expense in the income statement.
Revised ED Some lessees will apply an expense recognition approach similar to that proposed in the initial ED; some will use an approach that results in straight-line lease expense. Which recognition approach to apply will depend on the level of consumption of the underlying asset. A practical expedient will apply based on the nature of the underlying asset (property versus nonproperty, such as equipment).
Dataline
Topic Lessor accounting
Initial ED A lessor should apply the performance obligation approach if the lessor retains significant risks or benefits of the underlying asset during or after the expected lease term; if not, apply the derecognition approach. This was known as the "dual model."
Revised ED A lessor distinguishes between leases to which the "receivable and residual" approach (similar to the derecognition approach) applies and leases to which an approach similar to operating lease accounting applies using the same principle of consumption and related practical expedients as for lessee accounting. The lease term is the noncancellable period for which the lessee has contracted with the lessor to lease the underlying asset. It also includes any options to extend the lease when there is a significant economic incentive to exercise that option (e.g., bargain renewal) or a significant economic disincentive to not exercise the option (e.g., significant termination penalties). The measurement of lease assets and liabilities includes lease payments that are: In-substance fixed lease payments but structured as variable payments. Dependent on an index or rate. Expected to be payable under residual value guarantees. Variable payments based on usage or performance will not be included.
Lease term
A lessee or lessor should determine the lease term as the longest possible term that is more likely than not to occur taking into account the effect of any options to extend or terminate the lease.
Variable/ uncertain cash flows
Contingent rentals and expected payments under term option penalties and residual value guarantees should be included in the measurement of assets and liabilities arising from a lease using an expected outcome technique.
Definition of a lease
Definition substantially carried forward from IAS 17/ASC 840 and defined as "a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration."
The definition is carried forward substantially unchanged. However the "specified asset" and "right to control" principles that an entity would apply to determine whether a contract contains a lease have been revised. This may change some existing conclusions about whether an agreement is or contains a lease.
Dataline 6
.14 Although the project proposes changes to lessor accounting, it is the redeliberations relating to lessee accounting that are expected to have the most far-reaching implications. This Dataline discusses both the lessee and lessor proposed accounting models. .15 All board decisions noted in this Dataline are expected to be included in the revised ED; however, all decisions are tentative and therefore subject to change in conjunction with the drafting of the revised ED. A complete summary of the board's decisions on the leases project is available on the FASB's website at www.fasb.org and the IASB's website at www.ifrs.org. PwC observation: Redeliberations of the initial ED have been challenging for the boards as they seek to balance concerns from preparers about the cost and complexity of applying the proposals and demands from financial statement users to improve the usefulness of financial information on leases. The boards have remained committed to a largely converged solution and to a model under which lessees recognize lease assets and liabilities on their balance sheets one of the core objectives of the project. However, other areas of redeliberations led to a compromise between conceptual purity and practical application. The most significant of these relates to the boards' objective to remove the existing bright-lines in current lease accounting with both boards failing to find a one-size-fits-all solution. The "dual model" approach for both lessees and lessors, while clearly a pragmatic solution, will most certainly attract significant debate in the comment letter process. This debate will include both whether there should be a dividing line and, if so, where it should be drawn.
Summary of the boards' redeliberations

Lessee expense recognition pattern .16 The initial ED implicitly treats all leases as financing transactions with the combination of amortization of the right-of-use asset, typically on a straight-line basis, and interest expense, calculated using the effective interest rate method in the aggregate creating an accelerated expense recognition pattern. Both preparers and users of financial statements across a wide range of industries had significant concerns about this front-loaded expense recognition pattern and the effect on key ratios of separately presenting amortization expense and interest expense, rather than presenting a combined rent expense within operating expense. .17 After much debate the boards tentatively decided there should be a distinction in the expense recognition pattern, with a straight-line pattern (the "single lease expense approach" or "SLE") for some leases, and the initial ED's front-loaded pattern (the "interest and amortization approach" or "I&A") for others. The determination of which approach to apply is based on a "principle" of consumption with a practical expedient based on the nature (property or non-property) of the underlying asset. .18 Although the lease expense recognition patterns would be different, both approaches would require the right-of-use asset and lease liability to be recorded on the balance sheet, except for leases meeting the definition of "short-term" (defined as a maximum possible term of less than 12 months). The liability would be initially measured at the present value of the lease payments and subsequently measured at amortized cost using the effective interest method. The right-of-use asset would initially be measured at an amount equal to the lease liability plus initial direct costs.
Dataline
.19 However, the I&A approach requires interest expense (relating to the lease liability) and amortization expense (relating to the right-of-use asset) to be reported separately in the income statement, consistent with the initial ED. In contrast, the SLE approach requires the lessee to allocate total lease payments, including initial direct costs, evenly over the lease term, irrespective of the timing of lease payments, to calculate the periodic straight-line expense. Interest expense relating to the lease liability would be recognized in the same way as under the I&A approach. However, the right-of-use asset amortization expense would be a balancing figure, calculated as the difference between the periodic straight-line expense and the interest cost on the lease liability. Amortization of the right of use asset and interest relating to the lease liability would be reported in a single item in the income statement "lease expense." .20 It is presumed that leases of property defined as land and/or a building or part of a building should be accounted for using a straight-line expense recognition pattern. This presumption is overcome if: The lease term is for the major part of the underlying assets economic life; or The present value of the fixed lease payments accounts for substantially all of the fair value of the underlying asset. .21 For leases of assets other than property such as equipment it is presumed that lessees should apply the approach proposed in the initial ED, unless: The lease term is an insignificant portion of the underlying assets economic life; or The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset. .22 The following decision tree depicts the emerging lessee accounting model under the revised ED:
Dataline
Potential outcomes for lessees
Start
Is the arrangement a lease, or does the arrangement contain a lease? Yes Is there a purchase option (with significant economic incentive) or obligation to purchase? No
No Apply non-lease accounting guidance.
Yes Accounting similar to purchase of an asset.
Note on lessee decision tree: Under both the SLE approach and the I&A approach, all leases (except for short-term leases) are included on the balance sheet.
Is the lease a "short-term" lease? Is the lease term for a major part of the underlying assets economic life or is the PV of the fixed lease payments substantially all of the fair value of the underlying asset? Yes No No
Apply existing operating lease accounting model. Yes Is the lease term for an insignificant portion of the underlying assets economic life or is the PV of the fixed lease payments insignificant relative to the FV of the underlying asset? Yes No
Yes
Is the leased asset property?
No
Apply I&A approach
Apply SLE approach
Apply SLE approach
Apply I&A approach
Dataline
.23 The following illustration depicts common lease examples and which expense recognition approach will apply to each type of lease. In determining which approach to apply, significant judgment will be required for those property leases that fall on the borderline of significant (e.g., a 30-year lease of commercial real estate) and those equipment leases that fall on the borderline of insignificant (e.g., a 5-year vessel lease).
.24 General concepts Under the revised ED, lessees of property (including land and buildings) would be presumed to be eligible to apply SLE, unless factors suggest otherwise. Lessees of non-property (such as equipment) would be presumed to apply the I&A approach, unless factors suggest otherwise. PwC observation: The decision to introduce a new dividing line into the model is likely to generate significant interest and debate, given that one of the project's objectives was to remove the existing "bright-lines" between operating and capital leases. For lessees of non-property leases, such as equipment, the I&A approach will create the same frontloaded expense and financial ratio concerns that were raised when the initial ED was published for comment. .25 Impacts of different models The proposal in the initial ED for all lessees to apply a financing approach sparked debate among a number of constituents who were concerned with the effect the proposals would have on earnings and key ratios. Users had mixed views about whether the expense recognition pattern would provide a better representation of the effects of leases or create a further divergence between profit and
loss and cash flows. After much back and forth, the boards determined they could support moving away from applying a financing approach to all leases. .26 The diagram below illustrates the changes in a lessee's financial statements from the existing operating lease accounting to the initial ED and the revised ED (assuming no changes in lease assumptions or transition related impacts).
Changes in expense recognition patterns from existing operating lease accounting

Balance Sheet Assets Liabilities Income statement Lease expense Amortization Interest expense EBIT Proposed Model in the Initial ED Single Lease Expense Approach Interest and Amortization Approach
EBITDA
EBITDAR EPS Cash flow statement
Cash from ops

Cash from finance *A smaller arrow indicates that although there is a change from existing operating lease accounting, the change is smaller than under the proposed model in the initial ED.
.27 Application issues Having two models and applying the practical expedient to different fact patterns is also expected to add fuel to the debate. Some of the questions this could generate include: What is meant by "substantially all"? What is meant by "insignificant"? Are they purely quantitative thresholds (e.g., 90%, 10%) or is a qualitative analysis needed? Does this fundamentally create new bright lines? Should one interpret "property" to mean land or a building, or part of a building ("international view") or to include a broader "real estate" definition ("U.S. view") that includes "integral equipment," such as cell towers? Will "fragmentation" between property and non-property items included in the same arrangement be required? For example, if there is a single contract with more than one lease element (such as land, building, and equipment) is there a requirement to break out each respective component and evaluate it separately, potentially with a different expense recognition pattern for each?
Dataline 11
In applying the practical expedient to long-term land leases (e.g., those greater than 25 years), a quantitative analysis would likely indicate the lessee is obtaining "substantially all" of the fair value of the underlying asset and would imply that the I&A model is appropriate. However, wouldn't this be inconsistent with the underlying concept of consumption? How would the practical expedient apply in re-lease situations? For example, how would one account for a 5-year lease granted in year 45 of an asset's 50-year life? Lessor accounting .28 Similar to lessee accounting, the boards are proposing that two types of approaches apply to leases to be accounted for by lessors. The decision is between an approach that is similar to the straight-line operating lease accounting of today, with no derecognition of the underlying asset or gain/loss on lease commencement, and the "receivable and residual approach." After considerable debate, the boards concluded that the dividing line between the two approaches should be the same as for lessees (i.e., it would be based on an underlying consumption concept with practical expedients). The following decision tree depicts the emerging lessor accounting model under the revised ED.
Start
Is the arrangement a lease, or does the arrangement contain, a lease?
No
Apply other accounting guidance (presumably revenue recognition guidance)
Yes
Is there a purchase Yes option (with a significant economic incentive) or obligation to purchase?
Accounting similar to sale of the underlying asset
No
Is the lease term for a major part of the underlying assets economic life or is the PV of the fixed lease payments substantially all of the fair value of the underlying asset?
Yes Is the leased asset property?
No
Is the lease term for an insignificant portion of the underlying assets economic life or is the PV of the fixed lease payments insignificant relative to the FV of the underlying asset?
Yes
No
Yes
Apply approach similar to operating lease accounting
No
Apply R&R approach
Apply approach similar to operating lease accounting
Apply R&R approach
Dataline 12
The revised dual lessor accounting approach .29 When the lessee does not have a right to acquire or consume more than an insignificant portion of the underlying asset (typically presumed for leases of property), the lessor will apply an approach similar to existing operating lease accounting. Under this approach: The underlying leased asset remains on the balance sheet of the lessor. No lease receivable or gain/loss is recorded at lease commencement. Rental revenue is recognized on a straight-line basis over the terms of the respective leases. Unbilled rents receivable represent the cumulative amount by which straight-line rental revenue exceeds rents currently billed in accordance with the lease agreements. .30 When a lease gives a lessee the right to acquire or consume more than an insignificant portion of the underlying asset (typically presumed when the underlying asset is not property), the lessor will apply the receivable and residual approach. Under this approach, the lessor at lease commencement will: Derecognize the entire carrying amount of the leased asset. Recognize a receivable measured at the present value of the remaining lease payments, discounted at the rate the lessor charges the lessee. Recognize a residual asset, measured as an allocation of the carrying amount of the underlying asset. This comprises a gross residual asset and a deferred profit component. .31 Under the receivable and residual approach, day one profit is recognized on the portion of the underlying asset conveyed to the lessee via a right-of-use. This profit would be measured as the difference between the present value of the lease receivable and the cost basis of the underlying asset allocated to the lease receivable. Any profit on the portion of the underlying asset retained by the lessor (related to the lessor's residual interest in the leased asset) would be deferred and only recognized when the residual asset is sold or re-leased. If the underlying asset is re-leased, a new lease calculation for profit to be recognized over the new lease term is performed, with a portion of the remaining profit deferred. If the underlying asset is sold at the end of the lease term, the remaining profit would generally be recognized. .32 The lease receivable is subsequently measured using the effective interest rate method and would be subject to an impairment assessment. Specifically, for lease receivables, lessors could elect to either fully apply the "three-bucket" model proposed in the Financial Instruments project or apply a simplified approach. Under the simplified approach, lease receivables would have an impairment allowance measurement objective of lifetime expected credit losses at initial recognition and through the lease receivables' life. .33 General concepts Many respondents to the revised ED are likely to challenge the boards' decision to apply a lessor model that is symmetrical with lessee accounting. For example, they may question whether:
Dataline 13
Consistency with the revenue recognition proposals (e.g., when license revenue is recognized) would be preferable. A property/non-property distinction is appropriate (e.g., for multi-tenant equipment leases, such as satellites and telecommunication antennas, which have many characteristic in common with property). A dividing line based on the lessor's business model would better reflect the economics. It is intuitive that the leased asset (or at least a portion of it) appears on both the lessee and lessor's balance sheets, when the lessor applies the operating lease accounting approach. .34 Application issues Given that the principle for determining which lessor accounting approach should be used is the same as that used for determining lessee accounting, the application issues for lessors are likely to mirror those for lessees. These include what is significant and insignificant, how broad the term "property" should be defined, application of the guidance to arrangements involving multiple assets, whether a fragmentation approach should be used, and dealing with re-lease situations. .35 Similar questions to those facing lessees also exist in applying the practical expedient to long-term land leases (e.g., those greater than 25 years). The economic result would likely indicate the present value of the lease payments made by the lessee would account for substantially all of the fair value of land and would imply that the "receivable and residual approach" is appropriate and the lessor would recognize day one profit. However, this result appears on its face to be inconsistent with the underlying concept of consumption for land leases. PwC observation: Perspectives on the proposals relating to day one profit recognition are likely to vary between different types of lessors. For example, current finance lessors that recognize their margin over the lease term may question whether up-front revenue best reflects their business model. In contrast, lessors of existing sales-type leases may question the requirement to defer all of the profit relating to the residual asset until the end of the lease. This is because they have in substance sold the entire underlying asset and in many cases priced the majority, if not all, of the residual risk into the existing lease. Further, the deferral of any profit relating to the cost allocated to the residual asset raises the question of whether the deferred profit meets the conceptual definition of a liability. .36 For lessors that have contracts that fall under the receivable and residual approach, there are also some areas of potential concern relating to the accounting for renewal options and variable/uncertain payments. First, the potential inclusion of extension options initially thought to meet the "significant economic incentive" threshold is viewed by some as creating a potential for over recognition of profit by lessors at lease commencement. Second, in cases where the lease entirely or significantly comprises variable lease payments that are not based on a rate or an index, it is not clear how the model would be applied. Derecognition of the asset with no receivable recognized would seem to result in a loss, even when no real economic loss is expected to be realized on the contract. A concept of "in substance fixed lease payments," which may alleviate this scenario, was briefly discussed but has not yet been clearly articulated a matter that will likely be a focus of the staff when drafting the revised ED. .37 The tentative decision reached by the boards is that a lessor can elect to assess a lease receivable for impairment under the "three-bucket" model proposed in the boards'
Dataline 14
Financial Instruments project. However, as part of that project the boards continue to debate the proposal to apply a three-bucket model, which may affect lessor receivable impairment accounting. It is unclear whether the boards will reach a converged solution. See In brief 2012-37, FASB makes key decisions about the revised impairment model for financial assets for additional details. Lessors of investment property .38 The initial ED contained a scope exclusion from the proposed model to allow lessors of investment properties accounted for at fair value to continue to use a model similar to today's accounting for operating leases. In light of significant computational issues with respect to lessor accounting for portions of assets (e.g., one floor in a multi-story office building or one store location in a shopping mall), this scope exclusion was later expanded to lessors of all investment properties, irrespective of whether the leased investment property was accounted for at fair value. PwC observation: The boards' more recent decision overturns this previous scope exclusion for all investment property. Similar results are expected in most cases because most lessors of investment property will not apply the receivable and residual approach. Because of application of the "consumption of the underlying asset" principle, they will account for the leases using an approach similar to existing operating lease accounting. The revised ED is also expected to clarify the interaction between the leases standard and any requirements in IFRS or U.S. GAAP to measure some investment property at fair value. However, certain longer dated land leases or other property leases may qualify for the receivable and residual approach (i.e., derecognition, gain/loss). Today, these property leases may only qualify for sales type lease accounting under U.S. GAAP (e.g., because the leased asset is not carried at fair value due to builder profit or other reasons) if there is an automatic transfer of title. This may represent a change for some property lessors reporting in the U.S. There is no similar preclusion under current IFRS.
Lease term .39 The threshold for inclusion of extension options in the lease term in the initial ED was "more likely than not" (a greater than 50% likelihood of renewal). A common theme in the comment letters was that this threshold was too low and would be highly subjective and potentially volatile in practice. When coupled with the requirement to reassess every reporting period, it would also be very costly to implement and create unnecessary volatility. PwC observation: One of the primary reasons for including extension options, and not limiting the accounting to the non-cancellable lease term, is to avoid the potential for structuring opportunities. For example, one could theoretically structure a 20 year lease as a daily lease with 20 years worth of daily renewals. In practice, such an arrangement is unlikely and potentially costly (as the lessor would want to be compensated for the related uncertainty and would need to recover tenant specific improvements in a real estate lease).
Dataline 15
.40 The revised ED will raise the threshold to include extension options that provide "a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease." PwC observation: In reassessing the threshold, the boards made a practical compromise that is less complex and more operational while still providing reasonable protection against structuring concerns. The higher threshold will generally result in shorter lease terms and lower amounts recognized by lessees on the balance sheet than would have resulted under the initial ED. The revised threshold is also more consistent with today's treatment of including renewal periods in the lease term only when they are "reasonably certain" of being exercised, which is well understood in practice and would be smoother in transition. .41 A list of indicators to help entities assess whether this threshold has been met is expected to be provided in the revised ED. These indicators will likely include the existence of substantive bargain renewal options and economic penalties if the lease is not renewed (e.g., direct penalty payments, tenant improvements with significant value that would be forfeited, or a lessee's guarantee of lessor debt related to the leased property). Management intent and past business practices are not expected to be sufficient to create a significant economic incentive. PwC observation: One question that has arisen is how the practical application of guidance on determining the lease term under the revised ED may differ from current guidance and whether the lease term may actually be longer or shorter. For example, consider a flagship store with a fair value renewal term that is considered a "mission critical asset." The conclusion as to whether the renewal option is "reasonably certain" of being exercised under today's guidance, and whether a significant economic incentive threshold has been met may be different, depending on the indicators ultimately provided in the revised ED. .42 The lease term would be reassessed when there is a significant change in one or more of the indicators such that the lessee would then have, or no longer have, a significant economic incentive to exercise an option or terminate the lease. PwC observation: While changes will likely be less frequent under the revised ED, the requirement to reassess the lease term still is a significant change from the "set it and forget it" model used today. From a practical perspective, changes as a result of a reassessment will likely be more aligned with the timing of actual business decisions. However, the requirement to reassess requires judgment. The ongoing systems and processes that will need to be maintained to produce the data to make those judgments will likely add significantly to the cost of implementation, particularly for those entities with a significant portfolio of lease contracts. .43 The definition of lease term will be consistent for both lessees and lessors. The boards acknowledged that different conclusions could be reached related to the same lease, as lessees and lessors may have different levels of information or make different judgments.
Dataline 16
PwC observation: Judgment will be required to determine whether, and when, a significant economic incentive exists. For example, consider a lease of factory space with a 10 year initial lease term and a five year renewal option. At lease commencement the lease term was determined to be 10 years because no factors indicated that the lessee had a significant economic incentive to exercise the renewal option. In year two of the lease, the lessee makes plans for significant leasehold improvements, such as embedding a piece of unique equipment in the factory space. The lessee includes the expenditure in its capital budget in year two and expects the improvement project to begin in year four and be completed in year five. The entity will need to consider when the lease term would be reassessed would it be when the expenditure is included in the budget, when the first dollar is spent, when the project is completed, or somewhere in between?
Variable/uncertain cash flows .44 The requirement for all variable lease payments to be measured using a probabilityweighted approach would be eliminated. Instead, the following variable lease payments will be included in the measurement of lease obligations and assets: All contingencies that are based on a rate or an index. Payments where the variability lacks economic substance (i.e., an anti-abuse provision designed to include "disguised" or "in-substance" fixed lease payments). For lessees, any portion of residual value guarantees that are expected to be paid, except for amounts payable under guarantees provided by an unrelated third party. Lessors, on the other hand, would not recognize amounts expected to be received relating to residual value guarantees until the end of the lease. PwC observation: The boards' revised proposal would strike a balance between the complexity of including contingent payments and the structuring concerns that arise if all contingent payments were excluded. The elimination of the requirement to use a probability-weighted approach will also improve operationality. When coupled with the revised threshold for inclusion of term extension options, the elimination of usage and performance-based contingencies (discussed below) will greatly reduce complexity as compared to the initial ED. .45 Variable lease payments that are usage or performance-based (e.g., based on the number of miles a leased car is driven or the level of tenant sales) would be excluded in measuring lease assets and lease liabilities, unless the variable lease payments are "disguised" or "in-substance" fixed lease payments (i.e., an anti-abuse provision as described above). PwC observation: Determining whether a contingent payment is a "disguised" or an "in-substance" fixed lease payment will likely require a significant amount of judgment. For example, consider leases that have no, or nominal, fixed payments and require contingent lease payments based on a percentage of sales (e.g., a retail store) or based on output (e.g., wind or solar farms). If such payments are entirely excluded, such contingent payment structures would have no on-balance sheet accounting by the
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lessee. Clearly both parties are entering into the lease with an expectation of payments being made, so should some amount of the contingent payment be considered an "in-substance" fixed lease payment? If so, what amount? Some factors to consider may be whether this arrangement is consistent with usual business terms offered by the lessor, whether a minimum level of sales or output is required under the contract, how the arrangement terms compare with standard industry practice, and why the contract pricing terms have been structured in this manner. It is not clear whether this issue will be addressed in the revised ED or will be discussed as part of redeliberations that take place after comments are received on the revised ED. .46 "Term option penalties" would be included or excluded in the measurement of lease assets and lease liabilities in a manner that is consistent with the accounting for options to extend or terminate a lease. For example, if a lessee would be required to pay a termination penalty if it does not renew the lease and the renewal period is excluded from the lease term, then that penalty should be included in the recognized lease payments. .47 Variable lease payments will require reassessment as rates and indices change, which may be as often as each reporting period. Reassessing lease payments based on a rate or index will require lessees to re-measure their right-of-use asset and lease obligation each time rates and indices change. Lessees would account for this change in the income statement when it relates to a past or current accounting period and as an adjustment to the right-of-use asset when it relates to a future period. Lessors would account for all changes in the right to receive lease payments due to changes in a rate or an index immediately in the income statement. PwC observation: The requirement for lessors to immediately account for in the income statement all changes in the right to receive lease payments due to movements in a rate or an index represents a significant change from the current models irrespective of whether the lessor is using an approach similar to existing operating lease accounting or the receivable and residual approach. For example, in a 20-year real estate lease with rents that increase with changes in the Consumer Price Index annually over the base year, a change in the index after year 1 impacts years 2-20 and the present value of the differential hits the income statement in one lump sum. This is not symmetrical to lessee accounting and could result in significant volatility in, and front loading of, earnings relative to the contract rents.
Definition of a lease .48 The initial ED carried forward the definition of a lease in existing guidance, subject to some relatively minor amendments. Perhaps the most surprising issue to the boards that came out of the comment letters was the level of concern raised about carrying this forward into the proposals and the extent of application issues in applying the current lease definition that respondents identified. .49 The boards acknowledged during redeliberations that there may be many more multiple-element arrangements that contain an embedded lease than originally expected, which could have substantially increased the complexity and cost of applying the initial ED. Some common agreements that may contain an embedded lease are:
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Time-charter contract: A time charterer enters into a contract with a ship owner for the use of a named cargo ship for 5 years. Under the time charter, cleaning services relating to the cargo space or other relevant services, such as overseeing the loading and unloading of cargo and management of cargo at sea, are the responsibility of the ship owner in addition to maintenance and overhaul. Food and water for the captain and crew are also provided by the owner. The charterer may be chartering the ship either to carry its cargo or cargo owned by third-parties. The charterer pays a daily or monthly hire rate, based on the market price at the date of the contract, for the use of the ship (including the captain) and also pays for the costs of all fuel consumed by the ship and all port fees. Additionally, the time charterer pays all cargo loading and unloading charges. Analysis An assessment of whether this arrangement is a contract for transportation services or includes an embedded lease of the cargo ship is required. The conclusion will depend on whether the instructions provided in the time charter contract are deemed to convey the right to control the ship to the time charterer even though the captain and crew are provided by the ship owner. Parts supply contract: Purchaser P and Supplier S enter into a parts supply agreement for the lifetime of the finished product concerned. S uses equipment (that is owned by S) that can only be used to manufacture the parts required by P. The equipment is identified in the agreement and S could not use an alternative asset to manufacture the parts. The estimated capacity of the equipment is 500,000 units, which corresponds to the total estimated production of units over the equipment's life cycle. P takes all of the output produced by S using the equipment. Analysis An assessment of whether this arrangement is a contract for the supply of parts or includes an embedded lease of the equipment used to manufacture the parts is required. The conclusion will depend on whether P has the right to control the equipment based upon the extent of P's involvement in the design of, operation of, and sourcing of the raw materials needed for, the equipment used to manufacture the parts. .50 Under current guidance, a conclusion that a contract for services contains a lease would not have a significant accounting impact for lessees or lessors if the lease is classified as an operating lease. However, this would have changed significantly under the initial ED. The judgment about whether a lease exists and the allocation of contract consideration between the lease and non-lease elements would be much more important for these so-called "embedded leases." PwC observation: Under current guidance, any embedded lease within an arrangement would often be considered an operating lease. However, many lessees do not separate the embedded lease because the accounting for an operating lease and a service/supply arrangement is generally the same (i.e., there is no recognition on the balance sheet and straightline expense is recognized over the contract period). This practice will change with the proposal to recognize leases on the balance sheet. Accordingly, there is likely to be a greater focus on identifying whether a component of an arrangement meets the definition of a lease. .51 During redeliberations, the boards affirmed the proposal in the initial ED to define a lease as a contract in which the right to use a specified asset (the underlying asset) is conveyed, for a period of time, in exchange for consideration.
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PwC observation: The definition of a lease and whether an agreement is or contains a lease will become a significant area of focus for both lessees and lessors. For potential lessees, it will mean the difference between contracts reflected on the balance sheet (other than short-term leases) under the new lease model and contracts accounted for off-balance sheet as executory contracts. This is not an all or nothing evaluation the contract may include both a lease and a service (or non-lease executory cost) component, requiring the apportionment of contract consideration. For potential lessors, it will determine whether income recognition relating to some or all of a contract is governed by the lease model or by the general revenue recognition model and how contract assets should be presented and measured. .52 The boards also reaffirmed the "specified asset" and "right to control" principles that an entity would apply to determine whether a contract contains a lease. This requires assessing whether: a. The fulfillment of the contract depends on the use of a specified asset; and b. The contract conveys the right to control the use of a specified asset for a period of time. .53 However, while the boards reaffirmed these two principles, the revised ED would change the guidance for applying them in determining whether an arrangement contains a lease or is a service contract in its entirety. The changes are expected to address specific problems that exist in applying the current lease definition to certain types of transactions (e.g., power purchase arrangements) and better align the right to control concept with other convergence projects, such as revenue recognition and consolidation. PwC observation: There is an expectation that the boards will continue to revise the wording used to define a lease when drafting the revised ED. Although, the drafting revisions may appear minor, we think that they may change whether certain arrangements with significant service elements are within the scope of lease accounting. In addition, although the boards left the core definition of a lease largely intact, potentially significant interpretive guidance is expected, which may change some of the existing conclusions from those reached under today's guidance.
Transition .54 The revised ED is expected to require either a full retrospective approach or allow both lessees and lessors options to elect certain reliefs and apply alternative transition approaches. The reliefs are intended to alleviate the burden of applying a full retrospective approach (e.g., providing simplifications to transition discount rate assumptions) and, for lessees, mitigate the front-loaded expense recognition pattern that would result from the transition approach proposed in the initial ED. If elected, these reliefs would be applied to all leases that are outstanding as of the beginning of the earliest comparative period presented. .55 All evidence available to the lessees and lessors through the effective date can be used to measure the lease term and variable lease payments at transition. For example, if a lessee exercised a renewal option prior to the effective date of the new guidance, it could reflect that throughout the comparative periods without having to determine whether there was a significant economic incentive to extend the term of the lease in prior periods. For leases with payments based on an index or rate, this would mean using the actual
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index or rate that was applicable for historical periods and the index or rate as of the effective date for future periods when measuring lease assets and lease liabilities at transition. PwC observation: It is unclear how lessors that apply existing operating lease accounting but will not qualify for the receivable and residual approach will account for transition related matters (e.g., changes in the accounting for variable lease payments and estimates of lease term). The boards have not commented if this issue will be addressed in the revised ED or if it will be discussed as part of redeliberations that take place after comments are received on the revised ED. .56 When lessees and lessors elect to apply alternative transition approaches, lease prepayments and lease accruals relating to existing operating leases with uneven lease payments could lead to an adjustment to the right-of-use asset at the transition date (for lessees) and a transition adjustment to the cost basis in the underlying asset that is derecognized (for lessors applying the receivable and residual approach). PwC observation: When a lessee has an existing operating lease that qualifies for the I&A expense recognition approach under the revised ED and the lessee applies the modified retrospective approach to transition, there will be lease expense recorded as an adjustment directly to retained earnings at transition, rather than in the income statement. This is expected to provide entities with higher total profits over the remaining term of the lease than would be the case under the existing operating lease accounting model, under a full retrospective approach at transition, or when the SLE approach is applied under the revised ED. For lessors, adjusting the cost basis of the underlying asset for any prepaid or accrued lease payments will affect both the "deferred" and "day 1" profit recognized upon transition as an adjustment to beginning retained earnings. Conceptual concerns may exist as to why any prepaid or accrued lease payments arising after the inception of the lease should affect the calculation of deferred profit for a lessor applying the receivable and residual approach. .57 Specific transition guidance is also provided for certain lease arrangements. This includes the: Elimination of leverage lease accounting with a leverage lease lessor required to apply the general lessor transition approach. Continuation of existing sale and leaseback accounting for transactions that resulted in capital lease classification. Re-evaluation of the sale conclusions based on the criteria in the proposed revenue standard for sale and leaseback transactions that resulted in operating lease classification or where the sale recognition criteria previously were not met. If the new revenue criteria are met, a seller/lessee would measure lease assets and lease liabilities in accordance with the core guidance in the revised ED and would recognize any deferred gain or loss in opening retained earnings at transition.
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PwC observation: Seller/lessees that consummated a sale and leaseback transaction under existing U.S. GAAP that resulted in an operating lease are likely to be concerned with the proposed transition accounting. This is because any deferred gain on the original sale and leaseback will be reclassified into retained earnings at the transition date and will not provide the lessee with any future income over the remaining term of the lease. Leverage lease lessors are also likely to raise concerns with the proposal to eliminate, rather than grandfather, the accounting for leverage leases that exist at the transition date. .58 All lessees and lessors will need to consider the deferred tax implications that will arise on transition as a result of changes that will be made to both the balance sheet and income statement presentation of existing leases. The effect on retained earnings of these transition related deferred tax adjustments could be significant. .59 The boards decided not to provide relief for leases outstanding at the date of transition that expire prior to the effective date of the new standard or for arrangements that were grandfathered in accordance with the transition requirements in ASC Topic 840. Further, arrangements that meet the definition of a lease today, but do not meet the definition of a lease in the revised ED would cease applying lease accounting on the transition date. The arrangement would be reclassified under other existing guidance (e.g., revenue recognition) and a cumulative catch-up adjustment would be recognized in retained earnings. .60 Notwithstanding the lack of grandfathering for determining whether an arrangement is, or contains, a lease, and consistent with the initial ED, the boards will require a simplified transition for lessees and lessors with capital and finance leases under today's guidance. Lessees and lessors will continue to recognize existing carrying amounts at the beginning of the earliest comparative period presented, even when the lease contract includes terms relating to option periods and variable lease payments. PwC observation: We believe the boards intend for the definition of a lease to be applied retrospectively that is, any contracts in place as of the beginning of the earliest period presented that are determined to be leases under the revised definition at the transition date would follow the new rules. The lack of grandfathering for existing leases will mean that extensive data-gathering will be required to inventory all contracts. For each lease, a process will need to be established to capture information about lease term, renewal options, and fixed and contingent payments. The information that will be required under the revised ED will typically exceed that needed under current GAAP. Depending on the number of leases, the inception dates, and the records available, gathering and analyzing the information could take considerable time and effort. Beginning the process early will help to ensure that implementation of the final standard is orderly and well controlled. Companies should also be cognizant of the proposed model when negotiating lease contracts between now and the effective date of a final standard.
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The path forward

.61 The boards are planning to issue the revised ED at the end of November 2012, however, this may slip into early 2013. Issuance of a final standard, although targeted for 2013, may well slip into 2014. Although the effective date has not yet been discussed, it will likely not be before 2016. Preparers will need to apply the guidance to all leases existing as of the beginning of the earliest comparative period presented.
Questions
.62 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact members of the Leasing team in the National Professional Services Group (1-973-236-7805).
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Appendix: Other key areas of redeliberations

Topic Build-to-suit leasing transactions Initial ED Not covered Revised ED Will not be covered PwC observations When a lessee is involved in a build-to-suit leasing transaction, it would no longer be required to account for that lease during the construction period between the inception and commencement dates of the lease. This is because the revised ED will require accounting for a lease contract from its commencement date, rather than its inception date. This will significantly change current practice on accounting for build-to-suit leases in the United States under ASC 840 as it will imply that the lease accounting guidance would only be applied once the underlying asset is available for use by the lessee. The financial statements would be required to disclose significant build-to-suit lease transactions prior to commencement of the lease. Further, in instances where payments are required prior to lease commencement, the lessee should recognize those amounts as prepayments and add them to the right-of-use asset at lease commencement. Business combinations Not covered Lessees and lessors should account for a lease acquired in a business combination as a new lease on the acquisition date. If the acquiree is a lessee, the acquirer should recognize a liability to make lease payments and a right-of-use asset. The acquirer should measure: The liability as the present value of future lease payments at the acquisition date. The lessee's right-of-use asset recognized at the acquisition date should be adjusted for any off-market terms in the lease contract. As the lease contract acquired would be accounted for as a new lease, we believe that further clarification may be sought on applying the "consumption of the underlying asset" principle at the acquisition date to determine which accounting approach should be followed (e.g., I&A, SLE, etc.). Clarification may also be requested about whether initial assumptions should be updated (such as about extension options) when valuing leases upon acquisition or determining which approach to apply. If initial assumptions are updated at the acquisition date, the approach to apply (e.g., SLE or I&A for lessees) may change from that used on the lease commencement date.
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Topic
Initial ED
Revised ED If the acquiree is a lessor applying the receivable and residual approach, the acquirer should recognize a right to receive lease payments and a residual asset. The acquirer should measure: The right to receive lease payments as the present value of future lease payments at the acquisition date. The residual asset as the difference between the fair value of the underlying asset at the acquisition date and the carrying amount of the right to receive lease payments. If the acquiree has short-term leases, the acquirer should not recognize separate assets or liabilities related to the lease contract at the acquisition date.
PwC observations
Cancellable leases
Not covered
Lease accounting should be applied only to leases for which enforceable rights and obligations arise. Cancellable leases include those that are cancellable by both the lessee and the lessor with minimal termination payments or include renewal options that must be agreed to by both the lessee and lessor.
The intent of this provision is to ease the application burden for certain lessees (e.g., those in the construction industry) where shorter term lease contracts may not define a specific lease term but are structured on more of a "pay as you go" basis. However, one would need to determine whether there was an economic incentive to extend or not extend the term of the lease to evaluate whether the short-term lease exception could apply to these contracts. It is uncertain how many contracts will meet the definition of cancellable leases and be eligible for this relief.
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Topic Contract modifications or changes in circumstances after the date of inception of the lease
Initial ED Not covered
Revised ED A change in circumstances other than a modification to the contractual terms of the contract that would affect the assessment of whether a contract is, or contains, a lease should result in reassessment. When there is a contract modification that results in a different determination as to whether the contract is, or contains, a lease, the original contract would be considered terminated and the modified contract would be accounted for as a new contract.
PwC observations While the need for reassessment upon a contract modification may be evident, changes in circumstances may be more challenging to identify. For example, a contract to use a specified rail car for five years will likely be a lease. However, if the contract is amended to provide a substantive substitution clause allowing the supplier to replace the rail car with a similar rail car at its discretion, the contract would be reassessed and might not be considered a lease. Contrast this with a situation where, at inception, the contract to use a rail car for five years includes a substitution clause. If the substitution clause is not substantive because, for example, the supplier does not have other rail cars on hand to swap out, the contract would likely be considered a lease. If the supplier later procures other rail cars, and thus the substitution clause becomes substantive, the contract would be reassessed and might not be considered a lease. Other changes in circumstances could include: situations where a leased asset becomes less unique such that it is no longer implicitly specified, or when there are changes in the value of the economic benefits provided by a leased asset or changes in other contracts relating to the inputs, processes, and outputs relating to the leased asset that result in a different conclusion as to a customer's ability to control the use of the asset. The reassessment would apply only to whether a contract is, or contains, a lease. Accordingly, if the contract is within the scope of lease accounting, the determination at lease commencement of which lease approach should be applied is not reassessed if there is a change in circumstances. The boards are not expected to provide guidance on how one would account for a modification to the contractual terms of a contract after inception that upon reassessment does not change the initial conclusion of whether an arrangement is, or contains, a lease. Examples of contract modifications are changing lease payments, and adding or removing extension options, purchase options, and residual value guarantees.
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Topic Disclosure
Initial ED Lessees and lessors should disclose qualitative and quantitative information that (a) identifies and explains the amounts recognized in the financial statements arising from leases; and (b) describes how leases may affect the amount, timing and uncertainty of the entitys future cash flows.
Revised ED Lessee's should disclose a reconciliation of the opening and closing balance of lease liabilities for both I&A and SLE leases, a single maturity analysis of the undiscounted cash flows related to all lease liabilities, and costs for the period relating to variable lease payments not included in the lease liability. Lessors should disclose a table of all lease-related income items, a reconciliation of the opening and closing balance of the right to receive lease payments and residual assets, and a maturity analysis of the undiscounted cash flows that are included in the right to receive lease payments. Note: Listing is not inclusive of all required disclosures.
PwC observations Although changes have been made to the disclosures to be required in the revised ED, constituents are likely to make similar comments to those raised on the initial ED. Companies are likely to consider the proposals overly burdensome, specifically the requirements to provide a number of reconciliations of balance sheet, income statement, and cash flow statement activity. Financial statement users may raise concerns about the piecemeal nature of the disclosures, questioning how intuitive it will be for users to put together the various pieces of disclosure to provide them with useful information about an entity's lease activities. These concerns were raised by some of the FASB members who are contemplating providing an alternative view in the revised ED. Finally, some may question how the disclosure proposals align with the FASB's thoughts in its recently issued discussion paper entitled the Disclosure Framework.
Discount rate
A lessee should use the incremental borrowing rate or, if it can be readily determined, the rate the lessor charges the lessee. A lessor should use the rate the lessor charges the lessee
Lessees should discount lease payments using the rate charged by the lessor if known; otherwise, the lessees incremental borrowing rate should be used. Lessors should discount lease payments using the rate they charge in the lease. The discount rate should not be reassessed if there is no change in lease payments.
Lessees would not be obligated to seek out the rate the lessor is charging in the lease. The rate the lessor is charging is more likely to be identifiable in equipment leases, particularly when the equipment may also be purchased outright. For other types of leases, including real estate leases with rents based on cost per square foot, the lessee rarely knows the rate the lessor is charging because it is typically not relevant to negotiations. In determining the incremental borrowing rate, the lessee uses a discount rate commensurate with a secured borrowing that the lessee could obtain to finance the purchase of the specific asset over a borrowing term consistent with the initial expected term of the lease (including any extension options that include a significant economic incentive to exercise). For example, if a company were entering into a lease of a property in Chicago with an assumed term of 10 years, it would use a rate consistent with a 10 year fixed rate secured borrowing for
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Topic
Initial ED
Revised ED The discount rate is reassessed when there is a change in the lease payment due to: A change in the assessment of whether the lessee has a significant economic incentive to exercise an option to extend the lease or purchase the underlying asset. The exercise of an option that the lessee did not have a significant economic incentive to exercise. property located in Chicago.
PwC observations
Private companies with no third party debt and group entities where lease arrangements are held in different subsidiary entities are likely to question what incremental borrowing rate to use if the lessee has no outstanding debt. We have heard from many preparers that they believe more guidance should be provided on how to assess the appropriate discount rate in these and similar circumstances.
Embedded derivatives
Not covered.
A company should assess whether a lease contract includes embedded derivatives that should be separated and accounted for in accordance with applicable derivative guidance. Lessees would follow existing guidance on impairment of long-lived assets when evaluating the right-of-use asset. For lease receivables, lessors could elect to either fully apply the "three-bucket" model or apply a simplified approach in which lease receivables would have an impairment allowance measurement objective of lifetime expected credit losses at
This is not a substantial change from current practice under U.S. GAAP.
Impairment
Not covered.
A right-of-use asset accounted for under the single lease expense model would have a higher risk of impairment due to the fact that the asset balance would be higher than if the lease was accounted for under the I&A approach. This is because under the SLE approach, depreciation of the right-of-use asset is backend loaded to generate a total straight-line lease expense. The boards have yet to clarify if impairment testing can be done at a portfolio level or if it must be done on an individual lease basis. While a portfolio level test for leases with common characteristics (e.g., similar automobiles) may be possible, it may be challenging to apply such an approach to assets with different characteristics (e.g., different retail store locations). For retailers with a significant number of leased stores, performing an impairment test on a lease by lease basis may be a significant undertaking.
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Topic
Initial ED
Revised ED initial recognition and through the lease receivables' life. Lessors would follow existing guidance for fixed assets when evaluating the residual asset.
PwC observations The three bucket impairment model for lease receivables is currently under discussion by the boards. The boards plan to meet in the fall of 2012 to further discuss the proposed model. It remains unclear whether the boards will achieve convergence on the impairment model.
Inception vs. The lease is commencement measured at lease inception (i.e., the earlier of the date of signing the lease agreement or the date of commitment). However, the asset and corresponding liability would not be recorded until the commencement date of the lease, which is the date on which the lessor makes the leased asset available to the lessee. Initial direct costs Initial direct costs are required to be capitalized and added to the lessee's right-of-use asset. Initial direct costs are defined as recoverable costs directly attributable to negotiating and arranging a lease.
The lessee and lessor will initially measure and recognize the lease assets and lease liabilities (derecognize any corresponding assets and liabilities) at the date of commencement of the lease. This is the date on which the lessor makes the underlying asset available to the lessee.
The decision to measure and record the lease asset and liability on the same date would simplify the guidance. However, at lease inception, lessees would still be required to determine if an onerous lease contract exists and account for it in accordance with existing guidance.
Initial direct costs are required to be capitalized and added to the lessee's right-of-use asset and to the amount recognized as the lessors lease receivable. Initial direct costs are defined as costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been entered into.
Although the boards did not revisit this issue after moving to a dual model approach, we understand that this guidance applies to both lessees and lessors irrespective of which model is used.
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Topic
Initial ED
Revised ED No guidance for distinguishing a lease of an underlying asset from an in-substance purchase or sale of that asset has been discussed during redeliberations. Instead, the leases standard will focus on the definition of a lease. If the lease definition is not met, the contract should be accounted for in accordance with other applicable standards, such as revenue recognition by lessors and property, plant and equipment or executory contract accounting by lessees.
PwC observations While the concept of in-substance purchase is not expected to be included in the revised ED, a similar accounting result occurs where there is a purchase option with a significant economic incentive to exercise or a purchase obligation. Further, the elimination of in-substance sales from the leases guidance will reduce some of the inconsistency between the leases and revenue recognition guidance. Lessors will be required to evaluate indicators of continuing involvement (e.g., put/call options, purchase obligations, and lessor guarantees) in accordance with the principles-based approach in the proposed revenue recognition guidance rather than the existing rules-based guidance to determine whether they are in the scope of the revenue or lessor accounting model. This may result in a significant change to the timing of when a lessor would recognize revenue.
In substance An entity would not purchases/sales apply the guidance to contracts that meet the criteria for classification as a purchase or sale of an underlying asset. No guidance for distinguishing a lease of an underlying asset from an insubstance purchase or sale of that asset was provided. A contract represents a purchase or sale if, at the end of the contract, an entity transfers to another entity control of the entire underlying asset and all but a trivial amount of the risks and benefits associated with the entire underlying asset, such as with an automatic transfer or bargain purchase option. Lease incentives Not covered.
Lessees will deduct all lease incentives from the initial measurement of the right-of-use asset.
It is unclear whether the differentiation in the accounting that exists today between incentives that are provided for lessor improvements and incentives that are provided for lessee improvements will be carried forward under the revised ED. The revised ED is expected to provide detailed application guidance on how various lease incentives and other payments between the lessee and lessor that are not scheduled as "lease payments" should be accounted for.
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Topic Leveraged lease (Lessor accounting in U.S.) Non-lease elements (e.g., service elements and "executory costs" such as real estate taxes, insurance and utilities)
Initial ED Not covered.
Revised ED Leveraged lease accounting will be eliminated and a lessor will be required to apply the general lessor approach appropriate for the underlying asset. Lease and non-lease components in a multiple element contract should be identified and accounted for separately.
PwC observations Since pre-existing leases will not be grandfathered, companies with leveraged leases could have significant balance sheet increases as the inherent secured borrowings and deferred taxes in leverage lease transactions presented net today would need to be presented on a gross basis. Further, significant transition adjustments to retained earnings may result as the expense recognition patterns will change. The boards have implied that all lease and non-lease elements for real estate should be separated. This includes segregating from lease payments amounts relating to both services and items that today are considered "executory costs," such as real estate taxes, insurance, and utilities. Judgment may be required to allocate payments due under a lease contract between the various lease and non-lease components. For net leases or modified gross/base year leases, service elements are either separately billed (e.g., net lease) or readily obtainable in the lease contract (e.g., the base year portion of a modified gross lease). For gross leases, based upon the specific facts and circumstances, we would recommend a lessee seek to obtain the amounts being billed for services from the lessor or make estimates of these amounts using market-based information. Questions are likely to arise regarding the application of this allocation guidance when a multiple element contract provides for both fixed and variable payments. We believe that this evaluation will be facts and circumstances driven. The allocation of consideration between lease and non-lease components will become more important because of the requirement to always recognize assets and liabilities for the lease component of the contract.
Lessees and lessors should apply the proposed revenue standard to a distinct service component of a contract that contains both service and lease components. If the service component is not distinct, the FASB proposed that lease accounting should be applied to the combined contract. The IASB proposed that a lessee and a lessor applying the performance obligation approach should apply lease accounting to the combined contract, whereas a lessor applying the derecognition approach should account for the revenue component in accordance with the proposed revenue
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Topic
Initial ED standard even where it is not distinct.
Revised ED
PwC observations
Presentation cash flow
A lessee should classify cash payments for leases as financing activities in the statement of cash flows and present them separately from other financing cash flows. A lessor should classify cash receipts from lease payments as operating activities in the statement of cash flows
Under the SLE approach, the lessee would classify cash paid for all lease payments as operating activities. Under the I&A approach, the lessee would classify cash paid for lease payments relating to the principal as financing activities, and classify or disclose cash paid for lease payments relating to interest in accordance with applicable GAAP on the statement of cash flows. Variable lease payments not included in the measurement of the liability to make lease payments and shortterm lease payments not included in the liability to make lease payments would be classified as operating activities. A lessor should classify the cash inflows from a lease as operating activities in the statement of cash flows.
For lessees under the I&A approach, the statement of cash flows will become more complex than under current operating lease accounting because lease payments will be split between operating and financing cash flows. These changes in classification may require changes to certain compliance ratios included in lessees' bank covenant arrangements. However, the impact to both operating and financing cash flows will be lower than under the initial ED because of the change in classification of the interest element of lease payments. For lessees under the SLE approach and for lessors, the cash flow statement presentation is not expected to be significantly different than under existing practice.
Presentation Balance sheet for lessees
A lessee should present liabilities to make lease payments separately from other financial liabilities and present right-ofuse assets as if they were tangible assets
For leases under the I&A approach and SLE approach: Lease assets and lease liabilities should be separately presented in the statement of financial position or notes to the
Most lessees will present the right-of-use asset within property, plant, and equipment. However, for financial institutions, it is not clear how regulators will view the right-of-use asset for purposes of determining minimum regulatory capital requirements. If regulators view the right-of-use asset as an intangible, it may not be considered an asset included in the denominator of Tier One leverage ratios and would be subject to higher risk weighting for the risk-based capital ratios.
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Topic
Initial ED within PP&E or investment property, as appropriate, but separately from assets that the lessee does not lease.
Revised ED financial statements. The right-of-use asset would be classified in a manner consistent with classification had the entity owned the underlying asset. There will be no clarification of whether the right-of-use asset recognized by the lessee represents a tangible or intangible asset.
PwC observations For lessees, the changed profile of the balance sheet and related income statement effects could have implications for state and local tax apportionment as well as franchise and property taxes. Multi-national companies will also need to evaluate the impact of the changes in rules on their international tax profile.
Presentation Balance sheet for lessors
A lessor applying the derecognition approach should present rights to receive lease payments separately from other financial assets and should present residual assets separately within PP&E.
Under the receivable and residual approach the lessor should either present the lease receivable and the residual asset: Separately in the balance sheet, summing to a total to be called "lease assets," or Together in a single line itemlease assetsin the balance sheet, and separately disclose those two amounts in the notes. Presentation would remain consistent with current practice for leases not classified under the receivable and residual approach.
The revised ED is not expected to require explanation of the underlying nature of the residual asset. The requirement to recognize accretion of the residual asset as interest income is consistent with a view that the residual asset is a financial asset. However, the presentation option and the requirement to apply a long-lived asset impairment, rather than financial asset impairment, model may imply that the residual asset should be viewed as non-financial.
Dataline 33
Topic Presentation Income statement for lessees
Initial ED A lessee should recognize amortization of the right-of-use asset (straight-line), and interest on the liability to make lease payments (effective interest rate). The result is a front loading of expense in the income statement. The boards also proposed that the amounts be broken out on the face of the financial statements.
Revised ED Under the I&A approach, a lessee should recognize interest expense and amortization expense separately in the income statement. Under the SLE approach, a lessee should recognize lease expense as one amount in the income statement.
PwC observations Due to the variety of changes to the income statement (i.e., interest expense, amortization expense, etc.) lessees applying the I&A approach will need to assess the potential impact on covenants, compensation agreements, and other contracts. Such an assessment may require significant time. As such, we suggest companies begin the process well in advance of the effective date.
Presentation Income statement for lessors
Under the derecognition approach, a lessor should present in the income statement interest income from rights to receive lease payments separately from other interest income. Under the performance obligation approach, a lessor should present in the income statement interest income on a right to receive lease
A lessor should present: The accretion of the residual asset as interest income, The amortization of initial direct costs as an offset to interest income, and Lease income and lease expense in the statement of comprehensive income either in separate line items (gross) or in a single line item (net), on the basis of which presentation best reflects the lessors business model.
Similar to lessees, lessors will need to assess the impact on covenants, compensation agreements, and other contracts. Such an assessment may require significant time. As such, we suggest companies begin the process well in advance of the effective date. Presentation of lease income and lease expense gross or net may depend on the lessor's underlying business model. For example, a manufacturer and lessor of equipment may elect to apply the gross method and present significant lease revenue while a financial institution may elect to apply the net method.
Dataline 34
Topic
Initial ED payments, lease income resulting from satisfaction of a lease liability, and depreciation expense on an underlying asset separately, totaling to a net lease income or net lease expense.
Revised ED
PwC observations
Purchase options
Options to purchase the underlying asset in a lease are excluded from the measurement of the liability and the asset. A lease contract should be considered terminated when an option to purchase the underlying asset is recognized. Thus a contract would be accounted for as a purchase and sale by the lessee and lessor, respectively, when the purchase option is exercised.
Lessees and lessors should include the exercise price of a purchase option (including bargain purchase options) in the measurement of the lessees liability to make lease payments and the lessors right to receive lease payments, if the lessee has a significant economic incentive to exercise the purchase option. In other words, purchase options are accounted for in the same manner as the proposed accounting for lease extension options. If a lessee determines it has a significant economic incentive to exercise the purchase option, the right-ofuse asset would be amortized over the economic life of the underlying asset rather than over the lease term. (See discussion of "In-substance Purchase.")
The revised ED aligns the accounting for purchase options with the accounting for renewal options. This reflects the consistency in the economics of the following two transactions where in substance the lessee has the right to use the leased asset for its entire economic life: Six year lease of equipment with a 10 year economic life. The initial lease has a four year renewal option. At lease commencement the lessee has a significant economic incentive to exercise the renewal option. Six year lease of equipment with a 10 year economic life. The initial lease has a purchase option that the lessee can exercise in year four. At lease commencement the lessee has a significant economic incentive to exercise the purchase option. For lessors of real estate this could be a significant change. This is because upfront revenue would be recognized when a purchase option exists in a lease arrangement, even though legal title to the leased property may never pass to the lessee.
Dataline 35
Topic Purchase obligations
Initial ED An entity should not apply lease accounting to contracts that meet the criteria for classification as a purchase or sale of an underlying asset. A contract represents a purchase or sale of an underlying asset if, at the end of the contract, an entity transfers to another entity control of the entire underlying asset and all but a trivial amount of the risks and benefits associated with the entire underlying asset. An entity would meet this condition if it will transfer title to the underlying asset to the transferee at the end of the contract term or if the contract includes a bargain purchase option. The determination is made at inception and is not subsequently reassessed.
Revised ED Guidance on distinguishing between a lease of an underlying asset and the purchase or sale of an underlying asset is not provided. If an arrangement does not contain a lease, it should be accounted for in accordance with other applicable standards (e.g., property plant and equipment or revenue recognition).
PwC observations The existence of a lessee purchase obligation may affect whether a lessee should apply the I&A or SLE approach and whether a lessor should apply the receivable and residual or operating lease approach. If the lessee applies the I&A approach, the accounting is expected to be similar to that for a purchase of the underlying asset. Similarly, a lessor applying a receivable and residual approach would apply accounting that resembles a sale of the entire underlying asset (including any residual), even though legal title to the underlying asset does not transfer to the lessee until a later date.
Dataline 36
Topic Reassessment
Initial ED Lessees and lessors should remeasure assets and liabilities arising under a lease when changes in facts and circumstances indicate there is a significant change in the liability to make payments or right to receive payments.
Revised ED A lessee and lessor should reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease. Lease payments that depend on an index or a rate should be reassessed using the index or rate that exists at the end of each reporting period. Lease payments should include amounts expected to be payable under residual value guarantees, except for those guarantees provided by an unrelated party. For lessees, amounts expected to be payable under residual value guarantees should be amortized consistently with how other lease payments included in the right-of-use asset are amortized. The amounts should be reassessed when events or circumstances indicate that there has been a significant change in the amounts expected to be payable under the residual value guarantee.
PwC observations The requirement to reassess these estimates entails significant incremental effort compared to the current model, under which lease accounting is set at inception and revisited only if there is a modification or extension of the lease. In addition, it may be necessary to invest in information systems that capture relevant information and support the reassessment of lease terms and payment estimates as facts and circumstances change.
Residual value guarantee
For lessees, the rightof-use model would require that the initial measurement of the obligation to pay rentals include residual value guarantees. Lessors would be required to recognize a receivable for residual value guarantees, but only if the receivable could be reliably measured.
The boards' redeliberation of the accounting for residual value guarantees occurred before the decision was reached that the lessee and lessor should apply a dual accounting model. As a result, there is currently no distinction in applying the guidance by lessees that use the SLE rather than I&A approach or by lessors that apply an operating lease, rather than receivable and residual, approach.
Dataline 37
Topic
Initial ED
Revised ED A lessor will not recognize amounts expected to be received under a residual value guarantee until the end of the lease. The lessor will consider guarantees when determining whether the residual asset is impaired.
PwC observations
Sale & leaseback transactions
If the transfer meets the condition of a sale, the transferor accounts for the transaction as a sale in accordance with the proposed revenue standard. When the conditions of a sale are not met, the contract is accounted for as a financing. A transferee will account for the transaction as a purchase if the conditions of a purchase are met. When not met the transferee will not recognize the transferred asset. The amounts recognized should be based on fair values with a gain or loss recognized.
When a sale has occurred, pursuant to the revenue recognition guidance, the transaction would be accounted for as a sale and then a leaseback. Entities would apply the control criteria in the proposed revenue recognition standard to determine whether a sale has occurred.
The boards' decision to align the sale criteria with the proposed revenue recognition standard would significantly change the proposal and may result in more transactions qualifying as a sale than under the initial ED and current GAAP. It may be appropriate to recognize upfront the full amount of the gain on sale. In longer duration leasebacks, some have argued that the seller/lessee retains a significant portion of the right-of-use asset and fundamentally only the residual asset was sold. In these cases, many believe only the portion of the gain relating to the sale of the residual asset should be recognized. There may be more discussion of sales & leasebacks and the interaction with the proposed revenue recognition standard when the revised ED is redeliberated. Seller/lessees that consummated a sale and leaseback transaction under existing U.S. GAAP that resulted in an operating lease are likely to pay particular attention to the proposed transition accounting. This is because any deferred gain on the original sale and leaseback will be reclassified into retained earnings at the transition date and will not provide the seller/lessee with any future income over the remaining term of the lease.
Dataline 38
Topic Scope exclusions
Initial ED Lessees and lessors should apply the proposed guidance to all leases, except leases of intangible assets, leases of biological assets, and leases to explore for or use minerals. Entities that report under IFRS would also have an exemption for investment properties measured at fair value At the date of inception a lessee that has a short-term lease (12 months or less) may elect to ignore discounting when measuring the lease liability and asset. Lease payments would be recognized in the income statement over the lease term. A lessor may elect not to recognize lease assets and liabilities for short-term leases. Instead it would continue to recognize the underlying asset in accordance with
Revised ED Includes contracts in which the right to use a specified asset (explicitly or implicitly identified) is conveyed, for a period of time, in exchange for consideration. Excludes: (1) leases to explore for, or use, minerals, oil, natural gas, and similar nonregenerative resources, (2) leases of biological assets, and (3) short-term leases.
PwC observations The FASB originally said it would provide an exemption for real estate measured at fair value pending completion of its Investment Property Entity project. However, in light of where the boards are with the dual model for lessors under the revised ED, this exclusion does not appear to be necessary.
Short-term leases
Lessees and lessors can elect to account for leases that have a maximum term of 12 months or less (including any renewal options) in a manner similar to todays accounting for operating leases.
This will reduce the burden of identifying and tracking short-term leases at each reporting period, and may alleviate the need to determine if certain short-term contracts include an embedded lease that requires payments to be split between the lease and the non-lease components of a contract. However, it also allows lessees and lessors to forego the election if they prefer to record on the balance sheet short-term lease commitments for asset classes that are deemed to be significant. This exception may result in a fundamental change in the structure of some contracts to meet the definition of "short-term" and allow lessees to avoid recognition of lease assets and lease liabilities.
Dataline 39
Topic
Initial ED other guidance and recognize lease payments in the income statement over the lease term.
Revised ED
PwC observations
Subleases
The accounting for subleases builds on the lessee and lessor accounting models that the boards have proposed. When a leased asset is subleased, the sublessor would account for the head lease (i.e., the lease agreement between the original lessor and the lessee/sublessor) in accordance with the proposed right-of-use lessee model. It would account for the sublease under the appropriate proposed approach for lessor accounting.
Subleases would be accounted for as two separate transactions. That is, a sublessor would utilize lessee accounting on the head lease and lessor accounting on the sublease.
We understand that there could be situations where the head lease and the sublease are accounted for under different models. For example, there may be a situation where a head lease is accounted for based on an I&A approach and the sublease is accounted for using an approach similar to existing operating lease accounting for lessors. Therefore, the sublessor could report lease expense on the head lease that is not completely offset by income on the sublease. Several questions may arise regarding how a sublessor would determine which lessor accounting approach to apply. Would the "consumption of the underlying asset" principle be applied to the actual asset being leased or just the portion of the asset that is leased by the sublessor? For example, how would a 9 year sublease be assessed that relates to a 1o year head lease for property with an economic life of 40 years? Would the sublessor consider the underlying asset to be the 10 year head lease or would the sublessor look to the 40 year economic life of the property? Some may have conceptual concerns over the accounting for a head lease and sublease. For example, the revised ED is likely to imply that a sublessor would initially recognize a right-of-use asset in relation to the head lease. However, if the sublease qualifies for the receivable and residual approach, it would appear that the entire right-of-use asset would be derecognized and replaced with a lease receivable and a residual asset. Application questions are likely to arise about how the lessee presentation and disclosure requirements should be applied to the head lease if the right-of-use asset is derecognized by the sublessor.
Dataline 40
Topic Term option penalties
Initial ED Expected payments of term option penalties should be included in the measurement of assets and liabilities arising from a lease using the expected outcome technique.
Revised ED The accounting for term option penalties should be consistent with the accounting for options to extend or terminate a lease. That is, if a lessee would be required to pay a penalty if it does not renew the lease and the renewal period has not been included in the lease term, that penalty should be included in recognized lease payments.
PwC observations Lessees should consider term options consistently between the lease term and lease liability. For example, if the term option penalty is minimal and the lease will not be extended, as there is no significant economic incentive, the lessee would not include the option in determining the lease term. However, the lessee would be required to include the term option penalty in the calculation of the lease liability.
Dataline 41
Authored by: Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com David Humphreys Partner Phone: 1-973-236-4023 Email: david.humphreys@us.pwc.com Krystyna Niemiec Senior Manager Phone: 1-973-236-5574 Email: krystyna.m.niemiec@us.pwc.com Suzanne Stephani Director Phone: 1-973-236-4386 Email: suzanne.stephani@us.pwc.com

No. 2012-26 July 19, 2012
Lease accounting redeliberations come to an end, but alternative views are on the horizon
What's new?
At their July 17, 2012 joint meeting, the FASB and IASB (the boards) completed their redeliberations of the leases project and instructed their staff to begin drafting the revised exposure draft. The boards expect to issue the revised exposure draft by the end of November 2012 with a 120-day comment period. However, the difficulties encountered during the 18-month-long redeliberation process were highlighted when the board members were asked whether they planned to present an alternative view to the revised proposals. Three of the seven FASB members stated they may present alternative views. These board members have significant concerns about whether some of the core objectives of the project are met in the revised proposal. Other specific concerns include the accounting for variable leases payments, whether the proposed disclosures will provide useful information to financial statement users, and the interaction of lessor accounting with the proposed revenue recognition model. In contrast, IASB members contemplating presenting an alternative view primarily expressed concern about the conceptual merits of a dual, rather than single, lease accounting approach being applied by both lessees and lessors. At the meeting, the boards also discussed the presentation and disclosure implications of the dual lease accounting approach. Refer to In brief 2012-15, A dual model for lease accounting: redrawing the lines, for more information about this approach.
What's next
The FASB plans to meet again in August 2012 to address whether to provide any practical expedients to the revised exposure draft for private companies. The FASB and IASB are also expected to meet prior to release of the revised exposure draft to discuss any issues that might arise during the drafting process.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Leasing team in the National Professional Services Group (1-973-236-7805).
In brief
Authored by:
Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com David Humphreys Partner Phone: 1-973-236-4023 Email: david.humphreys@us.pwc.com Krystyna Niemiec Senior Manager Phone: 1-973-236-5574 Email: krystyna.m.niemiec@us.pwc.com

A dual model for lease accounting: redrawing the lines
What's new?
After more than a year of redeliberations, the FASB and IASB (the boards) took a big step forward this week in finalizing their revised proposals for lease accounting. They made significant decisions about how a lessee should recognize lease expense. In addition, they revisited some previous decisions concerning lessor accounting. All decisions noted in this In brief are tentative and therefore subject to change, as the boards have not yet concluded their deliberations.
No. 2012-15 June 15, 2012
Lessee accounting
The boards reconfirmed that lessees will recognize all leases with a maximum lease term of more than 12 months on balance sheet. Short term leases, with a maximum lease term of less than 12 months, will not be required to be put on balance sheet. There will be two approaches to recognizing lease expense in the income statement: 1. Lessees will apply the approach proposed in the 2010 exposure draft for some leases, which results in a front loading of lease expense. 2. For other leases, lessees will apply a straight-line expense recognition pattern, similar to current operating lease accounting. The boards agreed on a dividing line to determine when each approach should be applied. In principle, the dividing line will depend on whether a lessee acquires or "consumes" more than an insignificant portion of the underlying asset. The boards decided that, as a practical expedient, this principle will be applied based on the nature of underlying asset. It is presumed that leases of property defined as land and/or a building or part of a building should be accounted for using a straight -line expense recognition pattern. This presumption is overcome if: The lease term is for the major part of the underlying assets economic life; or The present value of the fixed lease payments accounts for substantially all of the fair value of the underlying asset.
In brief
These criteria are similar to some of the criteria used today for capital lease classification under U.S. GAAP. For leases of assets other than property such as equipment it is presumed that lessees should apply the approach proposed in the 2010 exposure draft, unless: The lease term is an insignificant portion of the underlying assets economic life ; or The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.
Lessor accounting
The boards decided that there should be symmetry between lessors and lessees in how they determine which approach to apply. They agreed that lessors should use the same dividing line and presumption as lessees (as outlined above). The boards previously decided that lessors of investment property should apply an approach similar to existing operating lease accounting. The boards latest decisions are expected to produce similar results in that most lessors of investment property will not apply the receivable and residual approach. Where a lease gives a lessee the right to acquire or consume more than an insignificant portion of the underlying asset (typically presumed when the underlying asset is not property), the lessor will apply the receivable and residual approach. For a description of this approach, see In brief 2011-44, FASB and IASB make significant decisions related to lessor accounting and transition. Conversely, where a lease gives a lessee the right to acquire or consume more than an insignificant portion of the underlying asset (typically presumed for leases of property), the lessor will apply an approach similar to todays operating lease accounting . The underlying asset will remain on the lessors balance sheet and income will be recogniz ed on a straight-line basis over the term of the lease. While there are similarities in the criteria, there could be differences in the dividing line under the new model and existing U.S. GAAP. For example, real estate lessors may have to apply the receivable and residual approach for certain longer term real estate leases that are considered operating leases under current guidance.
What's next
The boards intend to meet again in July 2012 to address some final remaining issues, such as presentation and disclosure, before they prepare a revised exposure draft. The revised exposure draft is expected towards the end of this year.
Questions?
In brief
Authored by:
Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com David Humphreys Partner Phone: 1-973-236-4023 Email: david.humphreys@us.pwc.com Krystyna Niemiec Senior Manager Phone: 1-973-236-5574 Email: krystyna.m.niemiec@us.pwc.com Lou DeFalco Senior Manager Phone: 1-973-236-4141 Email: louis.defalco@us.pwc.com

FASB and IASB redeliberate lessee accounting May 2012
What's new?
Since the FASB and IASBs (the boards) February meeting, the staff have been consulting with users, preparers, and auditors to hear their views on how a lessee should subsequently measure a right-of-use asset arising under a lease. The boards held an education session this week to discuss the results of this outreach. The key points were as follows: There was almost unanimous support among financial statement users for recognizing all leases on-balance sheet, regardless of the expense recognition pattern, in accordance with the projects primary objective. Most constituents did not support either the underlying asset or the interest-based amortization approach described in our March 2, 2012 In brief. Although some saw conceptual merit in these approaches, most agreed they were too complex and costly. There were mixed views about the preferred alternative approach. Some constituents preferred the simplicity of applying one model to all leases (whether this be the approach proposed in the 2010 exposure draft, which results in expense front-loading, or a straight-line total expense similar to todays operating lease expense recognition) ; others preferred different approaches for different types of leases. After debating the feedback, the boards instructed the staff to explore three different approaches for discussion at next months meeting: 1. Apply the approach proposed in the 2010 exposure draft to all leases, possibly with some exceptions 2. Require a straight-line total expense recognition for all leases 3. A combination of the above two approaches For the third option, the boards made a number of suggestions as to when each approach should be applied. These ranged from using the existing indicators in IAS 17 (retaining the distinction between operating and finance leases while recognizing assets and liabilities for both types on-balance sheet); using a new set of indicators based on a mirror image of IAS 17 (specifically identifying operating leases, with all other leases
No. 2012-13 May 25, 2012
In brief
being finance leases); and differentiating leases based on the nature of the underlying asset (treating equipment and real estate differently).
What's next?
The boards aim to make tentative decisions about which approach they prefer and consider the implications for lessor accounting at the June meeting. If this is achieved, the boards plan to discuss all outstanding issues in July, with the goal of publishing a revised exposure draft by the end of 2012.
Questions?
In brief
Authored by:
Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com David Humphreys Partner Phone: 1-973-236-4023 Email: david.humphreys@us.pwc.com Mark Pollock Senior Manager Phone: 1-973-236-5601 Email: mark.a.pollock@us.pwc.com

No. 2012-04 March 2, 2012
Can we talk about lessee accountingagain?

What's new?
The February 28-29 joint FASB/IASB board meetings on leases focused on the continued objections from constituents to the 2010 exposure drafts proposed "front -loaded" lessee expense recognition pattern. While most of the meeting dealt with the subsequent measurement of the lessees rightof-use asset, there was some discussion of lessor accounting which mainly related to how tentative decisions to date, specifically relating to the scope exemption for all investment properties, would conceptually align with possible paths forward for lessee accounting.
Lessee accounting subsequent measurement

There was general agreement among board members that something should be done to address constituent concerns and that changes should be made to the tentative decision made in May 2011 to carry forward the "front loading" approach. The boards continued to support their previous decision that assets and liabilities relating to lease contracts should be recognized and that the lease liability, being a financial liability, should be measured at amortized cost using an effective interest rate method. So, most of the discussions focused on the subsequent measurement of the right-of-use asset. The boards were unable to reach any tentative decisions and requested that the staff perform further outreach on two possible paths forward. "Two types of leases" approach The FASB expressed tentative support for having two types of leases with two different amortization approaches based on lease type. "Finance" leases would retain the expense profile of the 2010 exposure draft; "operating" leases would either apply the "underlying asset" approach (discussed below) or, if this is proven impracticable, an "interest-based amortization" approach. An interest-based amortization approach views right-of-use assets as a unique class of asset. The point of distinction is that when considering the lease contract as a whole, essentially there is no financing effect because the lessee is paying for, and consuming the benefits from, the right-of-use asset in the same period. A lessee would subsequently measure the right-of-use asset at amortized cost at the present value of the remaining economic benefits, discounted using the discount rate used to initially measure the lease liability. For typical leases in which lease payments are made evenly over the lease term, this approach would result in a straight-line lease expense profile. However, the expense profile would not be straight-lined when a lease contains rent-free periods, pre-paid lease
balances, stepped rent and other similar features, or when consumption of the right-ofuse asset is uneven over the lease term. In these circumstances, the boards believe a financing element exists between the lessee and the lessor. This approach would require criteria for distinguishing between "finance" and "operating" leases. The majority of the FASB members tentatively agreed to use the risk and rewards indicators included in the current IFRS guidance as a starting point for this criteria. "Underlying asset" approach The IASB expressed tentative support for an "underlying asset" approach. This is based on the presumption that lease payments typically cover three components: (a) a payment for the part of the asset the lessee consumes during the lease term; (b) a finance charge on the part of the asset consumed because the lease payments are made over time; and (c) a return on the residual value of the leased asset (the part of the asset the lessee does not consume, because the residual asset cannot be used by the lessor during the lease term). The right-of-use asset is amortized with reference to each of these elements, and the amortization profile varies based on the extent to which the value of the underlying asset changes over the lease term (i.e., how much of the asset the lessee consumes). If management expects the value of the underlying asset to be the same or greater at the end of the lease compared to the start of the lease (for example, in the case of some property leases), there would be no consumption of the underlying asset by the lessee. As a result, the amortization expense represents only the lessors return on the residual asset. When combined with the interest expense on the lease liability, the total lease expense in this fact pattern is recognized straight-line over the lease term. Conversely, if the value of the underlying asset is expected to be zero at the end of the lease (for example, a lease for the entire useful life of an item of equipment) the total expense profile would be similar to that proposed by the boards in the 2010 exposure draft. As the consumption percentage increases from zero, the total expense profile moves from straight-line to front-loading. Similar to the interest-based amortization approach, the expense profile would reflect an additional financing element when lease payments or consumption of the right-of-use asset are uneven over the lease term. The main advantage of the underlying asset approach is that it can be applied to all leases, with no need to distinguish between "operating" and "finance" leases. This was one of the boards original objectives for this project. However, there is a concern that this approach is overly complex and may not be operational in practice, particularly when information such as the fair value of the underlying asset is not known by a lessee (for example, in many property leases). This view will be tested during the staff's outreach over the coming weeks.
What's next?
The staff will undertake further outreach with users and preparers to better understand the operationality and usefulness of the alternative approaches that were discussed. The plan is to discuss the results of this outreach in the April meeting. The continued discussion on how to address the "front loading" of lease expense has introduced a further delay to the project. We do not expect a revised exposure draft to be issued before Q3 2012. The boards have yet to decide on an effective date, but it likely will not be before 2016.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact members of the Leasing team in the National Professional Services Group (1-973-236-7805).
Authored by:
Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com David Humphreys Partner Phone: 1-973-236-4023 Email: david.humphreys@us.pwc.com Mark Pollock Senior Manager Phone: 1-973-236-5601 Email: mark.a.pollock@us.pwc.com

No. 2011-44 October 24, 2011
FASB and IASB make significant decisions related to lessor accounting and transition
What's new?
The FASB and IASB (the "boards") met last week and reached tentative decisions on (1) an expansion of lessor's investment property scope exception, (2) revisions to the "receivable and residual" approach, (3) lessor presentation issues, and (4) lessee and lessor transition. The decision to expand the lessor investment property scope exception to require all lessors of investment property to apply existing operating lease accounting has caused the FASB (but not the IASB) to decide that they may need to revisit whether there is more than one type of lease for lessees. If this issue is reopened, it could further extend the timeframe before a revised exposure draft is published.

Expansion of lessor's investment property scope exception The boards previously decided to retain the scope exception included in the 2010 exposure draft, Leases (the "ED"), for lessors of investment property measured at fair value, which currently exists internationally under IAS 40, Investment Property. Under US GAAP, a similar scope exception is expected for those entities that will be required to apply fair value accounting pursuant to the Investment Property Entity ("IPE") Project (released for exposure last week). However, many lessors applying IAS 40 have elected to account for investment property at historical cost. In addition, many US lessors of real estate may not qualify as IPE's under the new guidance and would continue to use historical cost. These lessors would not have qualified for the original scope exception for lease accounting. The FASB and IASB staff identified significant application issues with applying the new lessor "receivable and residual" approach to leases of physically distinct portions of an underlying asset, such as shopping centers, office buildings or telecommunication towers. In light of these issues, the boards tentatively decided to broaden the scope of the original exception to include all leased assets that meet the definition of "investment property" under the applicable guidance, irrespective of whether they were measured at fair value. Under US guidance this would likely include real estate, improvements and integral equipment. These lessors would continue to apply the current "operating lease" accounting. Revisions to the "receivable and residual" approach The boards decided to amend their July decision on how the components would be measured under the receivable and residual model. The boards tentatively decided to
remove the requirement that a day-one profit should be recognized in the income statement only if it passes a "reasonably assured" test. Instead, while the profit related to the lease receivable would be recognized in income at the commencement of the lease, any profit related to the residual asset would be deferred throughout the lease term and is only recognized in income at the end of the lease term either upon the sale or re-lease of the underlying asset. Consistent with the July decision, the receivable and gross residual asset will be subsequently accreted using the rate the lessor charges the lessee. However, the deferred profit relating to the residual asset will not be re-measured or accreted. It was also decided that when the rate the lessor charges the lessee reflects an expectation of variable lease payments (such as usage based rental of a motor vehicle), the lessor should adjust the residual asset by recognizing a portion of its cost as an expense when the variable lease payments are recognized as income. Lessor presentation issues A number of lessor presentation issues were tentatively decided. Consistent with the ED, income and expense should be presented in the income statement either as separate line items, or net in a single line item based on the lessors business model. Accretion of the gross residual asset should be presented as part of interest income. It was decided that separate presentation of income and expenses from leasing activities can be either in the income statement or disclosed in the notes to the financial statements. Lessee and lessor transition It was tentatively decided that lessees and lessors should have the option of applying either a modified or a full retrospective approach to transition. Under the modified approach, the lessees incremental borrowing rate on the effective date would be used for measuring the lease liability. Acknowledging the expense front-loading issue that many commentators referred to in response to the ED, the boards decided that the right-of-use asset, the lease liability and the transition adjustment should be calculated as the amount that would have arisen if the lessee had always applied the lease term assumptions and discount rate used at transition. For lessors applying the modified approach, the discount rate at transition should be the discount rate charged in the lease, determined at the commencement of the lease. The boards also tentatively decided that for the selection of the discount rate applicable to a portfolio of leases at transition date, a separate discount rate would not be needed for each individual lease; rather a discount rate would be determined based on some stratification within the portfolio. The boards decided to bring this issue back for discussion at a future meeting for consideration on how this might be accomplished and what factors to consider in connection with the stratification. As a further relief, it was decided that, for leases currently classified as finance leases, lessees and lessors should use existing carrying amounts at transition, even for complex leases including options and contingent rentals.
What's next?
The boards' decisions are tentative and subject to change. Once the boards complete redeliberations an exposure draft will be issued for public comment. A final standard is targeted for the second half of 2012. The effective date has not yet been discussed; however, it will likely not be before 2015.
Questions?
Authored by:
Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com David Humphreys Partner Phone: 1-973-236-4023 Email: david.humphreys@us.pwc.com Ashima Jain Director Phone: 1-408-817-5008 Email: ashima.jain@us.pwc.com Erin Devine Senior Manager Phone: 1-973-236-4133 Email: erin.e.devine@us.pwc.com

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No. 2011-40 September 28, 2011*
Transition decision postponedwill this delay re-exposure of the Leases exposure draft?
What's new?
The FASB and IASB (the "boards") met twice last week to discuss several items regarding their joint project on leasing, including the scope of the standard as it relates to inventory, various lessor accounting issues, and lessee transition guidance. Although a number of tentative decisions were made, some key issues such as transition guidance will be discussed at a future meeting. In order to allow adequate time for those discussions, the boards have officially changed the expected timing for publishing their revised exposure draft to the first quarter of 2012 (previously, it was targeted for the fourth quarter of 2011). It is important to note that the boards decisions are tentative and subject to change, as the boards have not yet concluded their redeliberations or issued a final standard. A complete summary of the boards' decisions on the leases project is available on the FASB's website at www.fasb.org or the IASB's website at www.ifrs.org.

Scope - inventory The boards tentatively agreed that no scope exclusion will be provided in the leases standard for assets that are often treated as inventory (such as non-depreciating spare parts, operating materials, and supplies) and that are associated with the leasing of another underlying asset. Lessor accounting Application of financial asset guidance to the lease receivable: The boards tentatively agreed that (a) the lease receivable should be subsequently measured using the effective interest rate method; (b) a lessor should refer to existing financial instruments guidance (FASB Accounting Standards Codification (ASC) Topic 310, Receivables, or IAS 39, Financial Instruments: Recognition and Measurement , as appropriate) to assess impairment of the lease receivable; and (c) the lease standard should not contain an option for fair value measurement of the lease receivable. The boards instructed the staff to conduct further research and outreach to analyze whether there should be a requirement
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The first paragraph of this In brief was updated on September 28, 2011 to reflect that the boards have officially changed their websites to move the expected timing of the revised exposure draft to the first quarter of 2012.
In brief
to measure the lease receivable at fair value where such lease receivables are held for sale such as through a planned securitization. This issue is expected to be revisited at a future meeting. Other subsequent measurement issues: The boards tentatively agreed that a lessor would follow current impairment guidance (ASC Topic 360 Property, Plant and Equipment, or IAS 36, Impairment of assets, as appropriate) to assess impairment of the residual asset. They acknowledged that US GAAP and IFRS are not converged on impairment; however, they decided not to introduce new concepts from IAS 36 into US GAAP. The IASB also tentatively decided that revaluation of the residual asset should be prohibited. Lastly, the boards tentatively decided that any changes in the right to receive lease payments based on reassessments of variable lease payments that depend on an index or rate should be immediately recognized in profit or loss. Residual value guarantees ("RVG"): The boards tentatively agreed that guidance should be included in the lease standard for all RVGs, whether they are provided by the lessee, a related party, or a third party. They also tentatively agreed that a lessor should not recognize amounts expected to be received under a RVG until the end of the lease; however, the lessor should take the RVG into consideration when assessing impairment of the residual asset. Statement of financial position: The boards tentatively agreed that a lessor should either (a) present the lease receivable and residual asset separately in the statement of financial position with a total for "lease assets" or (b) present the combined lease receivable and residual asset on a single line in the statement of financial position as "lease assets" and disclose the two amounts in the notes to the financial statements. Statement of cash flows: The boards tentatively agreed that a lessor should classify cash inflows from a lease as operating activities in the statement of cash flows. Lessee transition The boards discussed transition requirements for lessees. While no decisions were reached, the FASB appeared to have a preliminary leaning towards requiring a full retrospective approach for all lessees, whereas there were mixed views amongst the IASB. The boards decided to defer the decision on lessee transition until guidance for lessor transition had also been drafted due to common issues such as subleases. The boards instructed the staff to bring lessee and lessor transition guidance back for discussion at a future board meeting.
Who's affected?
All companies that enter into leasing arrangements will be affected by these decisions. Some companies will be impacted more than others depending on the number and type of leases. Existing leases will not be grandfathered.

The boards have yet to decide on an effective date, but it will likely not be before 2015.
What's next?
Once the boards complete redeliberations an exposure draft will be issued for public comment. A final standard is targeted for the second half of 2012. We will continue to keep you informed of the significant redeliberation decisions.
Questions?
In brief
Authored by:
Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com Ashima Jain Director Phone: 1-408-817-5008 Email: ashima.jain@us.pwc.com Erin Devine Senior Manager Phone: 1-973-236-4133 Email: erin.e.devine@us.pwc.com

FASB and IASB agree to re-expose leasing ED and agree on one lessor accounting model
What's new?
The FASB and IASB (the "boards") met last week and voted to re-expose the proposed leasing standard. A revised exposure draft (ED) for public comment is expected in the fourth quarter of 2011, with a final standard by mid-2012. The boards also reached decisions on a single lessor accounting model, the accounting for variable lease payments, along with several presentation and disclosure issues. The boards decisions are tentative and subject to change. A complete summary of the boards' decisions is available at the FASB's website at www.fasb.org or the IASB's website at www.ifrs.org. Re-exposure The boards have agreed to formally re-expose their proposals. The boards intend to complete re-deliberations during the third quarter of 2011, with a revised exposure draft published shortly thereafter. Re-exposure will provide interested parties with an opportunity to comment on the revised proposals (including all the changes the boards have made since the publication of their original ED in August 2010).
No. 2011-31 July 26, 2011
What are the other key decisions?

Lessor accounting The boards agreed that lessors should account for leases using a "receivable and residual" approach (previously called the "derecognition" approach). Under this approach, a lessor would derecognize the underlying asset and record a lease receivable and residual asset. The lessor would allocate the carrying value of the underlying asset being leased between the portion related to the lessee's right-of-use asset and the portion retained by the lessor (the residual). The approach allows for a lessor to recognize profit on the leased asset at lease commencement if it is "reasonably assured." Profit would be recognized for the difference between the lease receivable recognized and the portion of the carrying amount of the underlying asset derecognized. When not "reasonably assured," the timing and recognition pattern of profit would extend over the life of the asset. The staff will continue to develop application guidance on this new approach, including the assessment of "reasonably assured."
In brief
The receivable and residual approach will likely be complex, particularly for lessors of multi-tenant properties. The staff had recommended an approach which would allow current operating lease accounting when it is impractical to determine the carrying amount of the leased portion of an asset. However, the boards did not support this recommendation. The boards agreed to retain the EDs proposal to allow lessors to account for short term leases (a maximum lease term of 12 months or less) similar to current operating lease accounting. The boards also agreed to retain the scope exemption for investment property if measured at fair value, which currently only exists internationally under IAS 40, Investment Property. Under US GAAP, a similar exemption is expected for those entities that qualify for fair value accounting pursuant to the Investment Property Company Project, which is expected to be released for exposure in the third quarter of 2011. Accounting for variable lease payments (based on a rate or index) The boards revisited the accounting for variable lease payments that are based on a rate or index and agreed that such payments would initially be measured at the rate that exists at lease commencement. In practice, this means that leases with payments based on LIBOR would use a current spot rate. Leases with payments based on a CPI index would use the absolute index at lease commencement and not the expected rate of change in that index. Thus, a lease with fixed rental increases of 2% per annum as a proxy for inflation will include such adjustments in the initial measurement, while a lease with rental increases based on changes to CPI (which may be expected to increase at the same rate of 2% per annum) will not include these expected rate changes. In addition, variable lease payments will require reassessment as rates and indices change. Lessees would account for this change in profit or loss when it relates to a past or current accounting period and as an adjustment to the right-of-use asset when it relates to a future period.
Who's affected?

The boards have yet to decide on an effective date, but they have said it likely will not be before 2014. The decision to re-expose may further extend out any potential adoption date.
What's next?
The boards will continue redeliberations through the third quarter of 2011 with a revised exposure draft for public comment expected in the fourth quarter of 2011. The boards need to complete discussions on lessor application issues, including how to reflect changes in contingent cash flows based on a rate or index and the interaction with the financial instruments project. The boards also need to complete discussions on changes in lease agreements, residual value guarantees, right-of-use asset impairment, financial statement presentation, disclosure and transition. We will keep you informed of the significant redeliberation decisions.
Questions?
In brief
Authored by:
In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. [FP102710] To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

Leasing Redeliberations of the leasing project Some new twists
Overview
At a glance In August 2010, the FASB and IASB (the "boards") jointly issued an exposure draft of a proposed accounting standard for leases (the "ED"). Their proposals would change the accounting for lease transactions and have significant business implications. The boards have considered the extensive feedback they received that the ED was overly complex and, in some areas, inconsistent with the economics of the underlying transactions. Based on this feedback, the boards identified five key areas for discussion (the definition of a lease, lease term, contingent payments, profit and loss recognition patterns, and lessor accounting) along with additional areas that required redeliberations. Recently, the boards made tentative decisions that would significantly change the proposals included in the ED in four of the five key areas. Decisions on the final key arealessor accountingare expected shortly. Additional tentative decisions have been reached on other aspects of the ED outside the five key areas. Many of the changes made during redeliberations are in direct response to comments made by preparers, investors and others, and will result in a less complexity in its application for preparers and better information for investors. Once the boards complete their redeliberations, they will consider whether to reexpose the proposals. If re-exposure is not considered necessary, draft standards that incorporate the significant decisions made during redeliberations will be made available, likely in the third quarter of 2011. Both boards have indicated that they expect to issue a final standard by the end of 2011.
No. 2011-21 May 6, 2011 Whats inside: Overview .......................... 1

Status of redeliberations..............3
Key decisions reached ............ 3 Status of discussions on lessor accounting ............... 10 Tentative decisions in other areas ...................... 11 Other issues not yet addressed ............................ 15
The path forward .......... 16 Questions ....................... 16 Appendix A .................... 17 Appendix B..................... 21
Dataline
The main details .1 In January 2011, the boards issued a preliminary redeliberation plan that identified five key areas for discussion:
Topic Definition of a lease Profit and loss recognition pattern Variable/uncertain cash flows Definition of lease term Lessor accounting Status Tentative decision reached Tentative decision reached Tentative decision reached Tentative decision reached Pending
.2 Except for lessor accounting, the boards have reached tentative decisions in each of these areas, which would significantly change the accounting from that proposed by the ED. Their tentative decisions were made after additional targeted outreach and analysis. In addition to the topics noted above, the boards also reached preliminary decisions on certain other areas based on the feedback received. The emerging accounting model based on the key tentative decisions made by the boards can be depicted by the following decision tree:
Start
Does the transaction represent a lease or does it contain a lease? (See paragraphs 6-22 of this Dataline)
Apply other accounting guidance No
Yes
Is the Lease a "short-term" lease as defined? (See paragraphs 43-46 of this Dataline)
Yes (Optional)
Apply existing operating lease accounting model
No
Apply finance lease accounting
No
Is the Lease an "other-than-finance" lease? (See paragraphs 23-29 of this Dataline)
Yes
Apply "other-than-finance" lease model: recorded on balance sheet but straightline "rent" in income statement
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.3 In the paragraphs that follow, we further discuss these and the other decisions reached at the joint meetings held during January 2011 through April 2011. We also include PwC observations on the potential implications as well as examples on the application of the boards' decisions. .4 The boards have not yet completed their redeliberations or issued a final standard. All board decisions noted in this Dataline are tentative and therefore subject to change. A complete summary of the boards' decisions on the leases project is available on the FASB's website at www.fasb.org or the IASB's website at www.ifrs.org. .5 For more information on key aspects of the ED, refer to Dataline 2010-38, A new approach to lease accounting Proposed rules would have far reaching implications (provides an overview and various insights into the ED), Dataline 2011-05, Leasing The responses are in (summarizes the comment letters received by the boards), and 10Minutes on the future of lessee accounting (provides insight into how companies will be impacted by the proposals in the ED and next steps to consider). PwC observation: The recent tentative decisions represent significant changes from the guidance in the ED. Many of these decisions are clearly in response to feedback from preparers and financial statement users. The resulting accounting model may provide more useful information than today's accounting with less complexity and less cost than applying the guidance in the original ED. However, while the proposals in the ED effectively called for a single model of accounting by lessees (excluding in-substance purchase and short-term leases), what is emerging now will not accomplish that goal. Based on the tentative decisions reached, some transactions considered to be leases or contain leases today will not be leases under the new definition. Short term leases will have an alternative (optional) accounting model. Further, there will be two patterns for income statement expense recognition depending on the type of lease.
Status of redeliberations
Key decisions reached Definition of a lease .6 The ED predominantly carried forward the definition of a lease contained in existing leasing guidance. Perhaps the most surprising issue to the boards during the comment letter process was the level of concern raised regarding the fundamental question of whether an arrangement contains an embedded lease. .7 The boards acknowledged during the redeliberations that there may be many more multiple-element arrangements that contain an embedded lease than originally expected, which could substantially increase the complexity and costs of applying the proposed standard. Conversely, some respondents indicated that many transactions currently characterized as a lease may not qualify as a lease for accounting purposes under the proposed definition. Consequently, the boards conducted additional outreach in order to determine what, if any, revisions were necessary to help clarify when transactions are leases or service contracts or both. .8 Under current guidance, whether an arrangement contains a lease often does not have a significant accounting impact if the lease is classified as an operating lease. However, this would change under proposals contained in the ED and, as a result, the
judgment about whether or not a lease exists and the allocation between the lease (so called "embedded leases") and non-lease elements would be much more important. .9 The boards affirmed the proposal in the ED to define a lease as a contract in which the right to use a specified asset (the underlying asset) is conveyed, for a period of time, in exchange for consideration. However, the boards tentatively decided to revise the guidance for distinguishing a service from a lease and also address some of the specific problems in applying current lease guidance for certain types of transactions (e.g., power 1 purchase arrangements). .10 In April, the boards tried to better align the concepts in the leasing ED with those contained in other convergence standards currently under development, such as the revenue recognition standard. The boards also considered situations raised during the comment letter and outreach process where the lessee may be contracting for a service or capacity and was largely indifferent to how that service or capacity was delivered by the supplier. .11 Under the boards' tentative decision, a contract is evaluated by assessing whether it meets both of the following criteria: a) Specified asset: The fulfillment of the contract depends on providing a specified (either explicitly or implicitly) asset or assets. b) Control: The contract conveys the right to control the use of a specified asset for a period of time. .12 The boards also discussed how these criteria would be applied in evaluating contracts for a portion of a larger asset. .13 Previously, the boards discussed whether to exclude portions of contracts that may contain embedded leases that are incidental to the delivery of a specified asset. This concept was ultimately not pursued as a separate element in the tentative decision but rather some of its elements were incorporated into the control requirement. PwC observation: The definition of a lease has become a significant area of focus for companies because it will typically represent a dividing line between arrangements reflected on the balance sheet (other than short-term leases) under the new lease model and other executory contracts. In making these decisions, the boards were clearly balancing concerns about practical application issues, potential structuring opportunities, and fundamental issues about whether a particular contract truly represented a lease or merely a service or capacity arrangement. The proposed guidance may reduce the number of arrangements that are leases or contain leases because: 1) The arrangement may not contain a lease even if the customer obtains all the output if they do not control the asset (unless the use of the asset is "separable" from the related services).
Existing guidance in these areas is covered by ASC 840-10-15 (which represents the codification of the guidance formerly included in EITF 01-8, Determining Whether an Arrangement Contains a Lease) and IFRIC 4, Determining Whether an Arrangement Contains a Lease.
2) The arrangement will not contain a lease even if the customer controls the asset if the customer is only obtaining some, but less than "substantially all," of the benefit during the term. 3) The customer may not have a lease even if they obtain all the physical output and controls the asset if someone else receives economic benefits that are more than insignificant (e.g., renewable energy credits).
Specified asset .14 The new guidance defines a specified asset as an asset that is explicitly or implicitly identifiable rather than an asset of a certain type. Implicit identification means that it is not practical or economically feasible for the supplier to substitute the asset at any time during the term of the arrangement without the customer's consent. .15 If the substitution right is not substantive, then the asset would be considered specified and the arrangement could contain a lease. For example, it is not practical to substitute a branded, customized airplane with another airplane (assuming such customization is significant), and therefore such an arrangement would typically contain a specified asset. However, if the right to substitute a specified asset existed only if the asset were not properly operating, this may be more analogous to a warranty and would not change the conclusion that an asset is explicitly or implicitly specified. PwC observation: Some believe that a lease contract must specify a serial or other identifying number of an asset for the asset to be considered a "specified asset" and thus for the contract to meet the definition of a lease. Contracts, such as master lease agreements rarely contain such information. From a practical perspective, however, when the vendor delivers goods or services, a particular asset has often been delivered to and accepted by the customer. At this point, it could be difficult to assert that it does not meet the definition of a "specified asset" unless there was a substantive possibility that the asset may be substituted at any time. Further, in some cases a reassessment of whether a specified asset exists may require reconsideration when facts and circumstances change. For the majority of lease contracts, we do not believe significant judgment will be required to determine whether an asset is a "specified asset."
Control .16 The boards tentatively revised the definition of control to conform to guidance in the proposed revenue recognition standard. A contract conveys the right to control the use of an underlying asset if the customer has the ability to direct the use of, and receive substantially all of the potential economic benefits from, the asset throughout the term of the arrangement. .17 Directing the use of an asset means the customer has the ability to make decisions that significantly affect the benefit received. Some indicators of this ability include the power to determine in what manner and when the asset is used, and how it might be used in connection with other assets to generate benefits. However, if the customer can specify only the output, but has little say in the input or processes involved in creating the output, the customer may not have the ability to direct the use of the asset. The examples provided by the board demonstrate that if the customer has the ability to make decisions about the input and process used to make the output and it is taking substantially all the benefit, it may be deemed to "control" the asset. For example, if the
Dataline
customer is providing the raw materials (e.g., steel, fuel, etc.) it may be deemed to control the asset used to process those materials. .18 The boards agreed to provide indicators in the final standard to assist in the determination of whether the customer has the right to control an asset. These indicators, to be considered together and not in isolation, include: a) Physical access: The customer is able to control physical access to the specified asset. b) Customization: The asset is customer-specific and the customer is involved in its design. c) Controlling benefits: The customer controls the right to obtain substantially all of the benefits from the asset during the contract term. .19 In indicator (c) above, the boards moved away from existing guidance, which considers only the physical output from the asset, to a broader evaluation of the "benefits" from the asset. .20 In some service arrangements, an asset or assets may be implicitly identified. A supplier may direct the use of an asset to perform the services requested by the customer. If the customer controls the right to obtain substantially all the potential economic benefits of an asset during the term of the arrangement, but does not have the ability to direct the use of the asset, an assessment of whether the use of the asset is an inseparable part of the service would be required. .21 If use of the asset cannot be separated from the services performed, the customer has not obtained control over the asset and the contract would be accounted for as a service arrangement. If the asset can be separated from the services, the customer has obtained the right to control the asset and is essentially using the services of the supplier to direct the use of the asset. PwC observation: The concept of control may address some of the complexity concerns raised by respondents to the ED. The revised definition of control may reduce the potential volume of embedded leases and avoid bifurcation of contracts when the lessee is indifferent to the nature and use of the asset. It may also significantly change prevailing accounting practice in certain industries (e.g., certain types of power purchase arrangements and take-or-pay contracts). See practical examples in Appendix A to this Dataline of how the definition of a lease may be applied to certain common types of transactions.
Transactions involving a portion of a larger asset .22 The boards further agreed that a physically distinct portion of a larger asset, for example, a floor of a building, could be a specified asset. However, non-physically distinct portions could not be a specified asset. For example, while partial capacity of a pipeline could not be a specified asset, particular strands within a fiber-optic cable could potentially be a specified asset.
Dataline
Profit and loss recognition pattern .23 The ED implicitly treats all leases as financing transactions with an accelerated profit and loss recognition pattern. Respondents across a wide range of industries had significant concerns about this approach. .24 Many respondents (including both preparers and users) did not believe the proposed recognition pattern was consistent with the economics of many types of lease transactions that are priced in reference to other market transactions (e.g., by reference to market rent rates) rather than priced like financing transactions (e.g., a function of applying interest rates to a principal balance). They also observed that, while many users of financial information (such as analysts and rating agencies) make adjustments to the balance sheets of lessees, no adjustments are typically made to their income statements as users are generally satisfied with the current income statement recognition pattern and characterization of most leases. As a result, concerns were raised about the continued usefulness of the income statement or operating cash flow as measures of performance if all leases were reflected as financings. .25 After much debate, the boards tentatively decided that there should be a fundamental distinction between those leases that are primarily financing transactions in nature and those that are not. The boards agreed to use indicators similar to those in IAS 17, Leases, as the basis for distinguishing between the two categories of leases. .26 The boards decided that all leases (irrespective of whether they are considered finance leases or not) would be recorded on the balance sheet, with the exception of short-term leases. However, they concluded that the expense recognition pattern for leases should differ. .27 Those leases that are primarily financing transactions would have a recognition pattern similar to a financed purchase (i.e., amortization of the right-of-use asset and interest expense on the lease liability), as proposed in the ED. .28 Those that are not primarily financing in nature would have a straight-line recognition pattern, with expense reflected in a single line item in the income statement (e.g., rent expense). The associated liability would subsequently be amortized using the effective interest method proposed in the ED. The asset would be amortized in a pattern such that the sum of the amortization recognized and the interest expense recognized would be constant for each period during the lease term. .29 Examples of each type of lease and its affect on the financial statements are provided in Appendix B to this Dataline. PwC observation: A dual model for finance and other- than-finance leases may alleviate many of the concerns about the project, but it also introduces additional complexity because of the need to distinguish between the two classifications. It also potentially creates additional incentive to structure transactions to achieve a specific accounting result, although the focus now would be to structure for income statement treatment. The principles in IAS 17, Leases, are similar to ASC 840, Leases; however, the boards specifically left out reference to ASC 840 for determining lease classification. Ostensibly they did so in order to exclude the bright-line tests included in the US standard but also to achieve convergence. Although IAS 17 and ASC 840 are similar in concept, there are certain differences in the detailed application of the two standards for both lessees and lessors.
Dataline
The straight-line expense recognition pattern for other-than-finance leases represents a departure from how other assets and liabilities are amortized under both US and international accounting standards. The boards acknowledged the inconsistency but noted that the lessee's asset and liability are inextricably linked. Some board members have indicated that perhaps the alternative depreciation methods described in their discussion should be available for other types of nonleased assets. However, it is unclear what the conceptual and practical differentiating factors might be to ensure that depreciation continues to properly reflect the consumption of those assets' economic benefits.
Variable or uncertain payments .30 Many respondents to the ED believed that certain types of contingencies should be included in the lessee's liability to make lease payments and the lessor's right to receive lease payments. However, they were concerned about the complexity of using a probability-weighted approach and the need to forecast certain types of contingencies such as performance-based contingencies tied to sales. Conversely, if all contingencies were to be excluded, the boards were concerned about potential structuring opportunities whereby lease payments would appear to be entirely contingent, but where both parties expect significant payments to be made. .31 The boards tentatively decided that the following variable lease payments should be included in the measurement of lease obligations and assets: All contingencies that are based on a rate or an index Any contingency that is a "disguised" minimum lease payment (i.e., an anti-abuse provision to include lease payments for which the variability lacks economic substance and the payments are reasonably certain) Any portion of residual value guarantees that are expected to be paid .32 Variable lease payments that are usage or performance-based (e.g., based on tenant sales) would not be included in measuring the lease asset and liability unless the variable lease payments are "disguised" or in-substance fixed lease payments (i.e., an anti-abuse provision as described above). .33 The boards tentatively decided that any contingent amounts would be included using a best estimate approach rather than the probability-weighted approach proposed in the ED. The boards have not yet redeliberated issues on the potential reassessment of contingencies and the impact on the profit and loss recognition pattern. .34 The boards also tentatively concluded that "term option penalties" should be included or excluded in a manner that is consistent with the accounting for options to extend or terminate a lease. For example, if a lessee would be required to pay a penalty if it does not renew the lease and the renewal period has not been included in the lease term, then that penalty should be included in the recognized lease payments. PwC observation: The boards' decision strikes a balance between the complexity of including contingencies and the structuring concerns if all contingencies were excluded. The elimination of the requirements to estimate the amount using a probability-weighted approach will also improve operationality of the standard. When coupled with the
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revised threshold for inclusion of term extension options (discussed below) and the elimination of usage and performance-based contingencies, this approach will greatly reduce complexity as compared to the ED. The boards initially included variable payments based on usage or performance (such as "percentage rents" based on tenant sales) that were probable. However, they subsequently eliminated them from the measurement (unless they were deemed "disguised minimum lease payments" as described). Presumably, those payments would be reflected in the period to which they pertain, similar to the approach under today's guidance.
Lease term .35 The boards have tentatively decided to raise the threshold for inclusion of lessee extension options in the lease term from the "more likely than not" threshold in the ED to those that provide "a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease." Thus, the lease term will be the non-cancellable term plus any options to extend or terminate when a significant economic incentive exists. .36 The boards decided to provide a list of indicators to help entities assess whether this threshold has been met. Indicators will likely include the existence of substantive bargain renewal options or economic penalties if the lease is not renewed (e.g., direct penalty payments, tenant improvements with significant value that would be forfeited, or a lessee's guarantee of lessor debt related to the leased property). Under the revised approach, management's intent and past business practice would not be included as part of the evaluation. Extension options at the discretion of the lessor have not yet been discussed. .37 The boards also decided that reassessment of lease term should be performed when there is a significant change in one or more of the indicators. If the lessee determines that it has, or no longer has, an economic incentive to exercise an option or terminate the lease, a reassessment of the lease term would be necessary. .38 The definition of lease term is expected to be consistent for both lessees and lessors. The boards acknowledged that different conclusions could be reached related to the same lease as lessees and lessors may have differing levels of information or make different judgments. PwC observation: The higher threshold for including lessee extension options would generally result in shorter lease terms and lower amounts recognized on the balance sheet than would have resulted under the ED. The revised threshold for lessee extension options is more consistent with today's treatment of including renewal periods in the lease term only when they are "reasonably assured" of being exercised, which is well understood in practice. It would also mitigate concerns about structuring opportunities, improve operationality of the new standard, reduce volatility and more closely align the inclusion of these additional periods with the actual economic decisions to exercise extension options. It is not yet clear how lessees would consider economic compulsions that are outside the contract; for example should market-priced lease extension options for a "mission critical" asset be included. More discussion on these considerations is likely necessary, including how and when does one reassess these factors and their implications.
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Further, with respect to ongoing reassessment, more discussion on how or when to reconsider extension options based on market conditions is likely to be necessary. Specifically, what do the boards mean by a "significant change" in one or more of the indicators? Consider for example, changing market rental rates. A company originally excludes a fixed price renewal option because it does not represent a bargain renewal. However, due to changing market conditions, the renewal price becomes nominally below market rental rates. Should the lease term be reassessed to include the renewal period as part of the lease term or should reassessment wait until there is a more significant difference in market rates such that it represents a more compelling likelihood of exercise (i.e., how do you define when you have a real bargain)?
Status of discussions on lessor accounting .39 Many respondents to the ED (including many in the user community) did not believe that the proposed lessor model in the ED was a sufficient improvement to warrant the substantial additional costs to implement and apply the new proposals. .40 Similar to the tentative decision made for lessee accounting, the boards have preliminarily decided that two types of leases exist for lessors. Guidance similar to that in IAS 17, Leases, would be used to determine the accounting approach to apply. .41 The boards have also discussed adjusting the existing lessor model to conform with changes in the definition of a lease, lease term and contingent rents to those that are now expected to be used by the lessee based on decisions reached to date. .42 The boards expect to redeliberate lessor accounting in the coming weeks. They have also clearly indicated that they will focus on making sure that the decisions in leases and the other current joint projects, most notably revenue recognition, are based on consistent core principles. PwC observation: The boards appear to be taking heed of the prevalent view of many of the respondents to the ED that lessor accounting is not fundamentally broken and does not need to be fixed. Further, the dual model of finance and other-than-finance leases for lessees tentatively agreed to by the boards is not symmetrical to the dual model of derecognition and performance obligations for lessors contained in the ED. Some observers do not believe the lessor ED approach will survive redeliberation. Specifically, these observers question how it makes sense for lessees with an otherthan-finance lease to have straight-line expense while the lessor on the other side of the transaction would likely have performance obligation accounting, resulting in the acceleration of earnings due to the inherent finance element embedded in that model. The boards also indicated on many occasions that changes to the definition of a lease, lease term and potentially contingent payments for lessees would also be applied to lessors, presumably also with reassessment, where appropriate. This would represent a significant change to today's model even if the rest of the core provisions of current guidance for lessors are largely retained.
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Lastly, the fact that the boards are referencing the IAS 17 criteria over ASC 840 in connection with evaluation of the approach for lessee profit and loss recognition may indicate they are likely to conform to IAS 17 for lessor accounting. This may result in changes in industry practice in some areas, and potentially eliminate leveraged lease accounting under US GAAP. Leveraged lease accounting has no equivalent in IAS 17.
Tentative decisions in other areas Short-term leases .43 The ED provided a simplified method to ease the burden of accounting for shortterm leases. For leases with a maximum possible term (including all extension options, whether or not they are considered to be part of the lease term) of 12 months or less, lessees could use a simplified lease accounting approach on a lease-by-lease basis. For lessees, the simplified approach essentially meant that there was no requirement to discount; thus the assets and liabilities arising from the lease were presented on a gross undiscounted basis. Lessors were provided more latitude and could elect on a lease-bylease basis not to recognize assets or liabilities arising from such short-term leases (and presumably apply a straight-line operating lease type model to the accounting for these arrangements). .44 Most respondents supported the proposed simplifications for short-term leases, but did not believe the proposals for lessees went far enough. These respondents believed that for lessees the cost of identifying and tracking a large number of short-term leases was not commensurate with the value to users of having this information. .45 The boards have responded to constituent concerns regarding the simplification guidance for short-term leases for lessees. They tentatively agreed that a lessee will be permitted to account for short-term leases in a manner consistent with the current requirements for operating leases. This decision will make the accounting for short-term leases by the lessee symmetrical to the proposed accounting for short-term leases by the lessor. .46 The boards confirmed that a short-term lease is defined as a lease that, at the date of commencement of the lease, has a maximum possible term (including any options to renew or extend) of 12 months or less, irrespective of whether options to extend are considered part of the lease term for accounting purposes. Both lessees and lessors would make an accounting policy choice to follow the simplified short-term lease guidance on an asset class basis. PwC observation: This revised simplification for short-term leases will alleviate the burden of identifying and tracking short-term leases at each reporting period, and may alleviate the need to determine if certain short-term arrangements include an embedded lease. However, it also allows lessees and lessors the flexibility of recording on the balance sheet short-term lease commitments for asset classes that are deemed to be significant. It is not clear whether short-term leases not recorded on the balance sheet would require to be disclosed; such disclosures are not required today.
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Scope .47 The boards affirmed the decision in the ED on scope of the leases standard (see Dataline 2010-38 paragraphs 6-7 for a summary of the ED proposal). The boards directed the staff to perform additional research as to whether leases of internal-use software and leases of inventory should be within the scope of the leases standard. Separating lease and non-lease components of a contract .48 For lease contracts that contain both service and lease components, the proposals in the ED would require a determination of whether the service is considered distinct. Total payments would then be allocated between distinct service and lease components using the principles in the proposed revenue recognition standard. .49 Contracts that include a lease and a service arrangement, especially real estate leases, represent a significant concern to many. Many respondents believe the standard should specifically exclude service and executory costs from lease payments rather than try to link to the definition of a distinct service in the proposed revenue recognition standard. .50 The boards decided that in a multiple-element contract that includes both lease and non-lease components (including services and executory costs), non-lease components should be identified and accounted for separately. Lessors should allocate payments between lease and non-lease components based on the allocation method in the proposed revenue recognition standard. .51 Lessees should allocate payments between lease and non-lease components based on their relative standalone purchase prices. If the purchase price of one component is observable, the residual method can be used to allocate a price to components with no observable purchase prices. However, when there are no observable prices for any of the components, the entire contract would be accounted for as a lease. PwC observation: The boards have implied that all lease and non-lease elements for real estate should be separated, although it is unclear whether this would include both service elements and executory costs (e.g., insurance and real estate taxes). Further clarification will likely be forthcoming either in the redeliberations or within the final standard. For net leases or modified gross/base year leases, service elements are either separately billed (e.g., net lease) or readily obtainable in the lease contract (i.e., the base year portion of a modified gross lease). For gross leases, a lessee may need or want to obtain the amounts being billed for services from the landlord or make estimates of these amounts using market-based information.
In-substance sales and purchases .52 The boards recognized that some contracts may be leases in legal form but are, in substance, sales contracts under which the lessor ceded control of the underlying leased asset to the lessee. Guidance was therefore included in the lease ED to distinguish between a sale and a lease of an asset. .53 In redeliberations, the boards tentatively decided to not include guidance for distinguishing a lease of an underlying asset from an in-substance purchase or sale of that asset. Instead, the leasing standard will focus on the definition of a lease. Where the lease definition is not met, the contract should be accounted for in accordance with other applicable standards, such as revenue recognition by lessors and property, plant and equipment by lessees.
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Inception versus commencement .54 The ED proposed measuring the lease at lease inception (i.e., the earlier of the date of signing the lease agreement or the date of commitment). However, the asset and corresponding liability would not be recorded until the commencement date of the lease, which is the date on which the lessor makes the leased asset available to the lessee. The ED could be read literally to indicate that the change in value of the obligation due to passage of time would result in a charge upon commencement. This charge could be significant if there were a significant passage of time between inception and commencement, which is not uncommon for larger assets or certain types of leases (e.g., real estate leases). .55 Many respondents to the ED requested that the boards provide more guidance on how to account for the change in obligation value due solely to the passage of time between lease inception and commencement. .56 In redeliberations, the boards tentatively decided that a lessee and lessor would initially measure both the lease asset and obligation at commencement of the lease, using the discount rate on that date. .57 If a lessee is required to make payments prior to lease commencement, the boards tentatively decided that a lessee should recognize such prepayments and add them to the right-of-use asset at lease commencement. Where the time value of money is material, the lessee should accrete any prepayments to the commencement date using the rate the lessee uses to measure the lease liability. The lessor would treat such payments as prepaid lease payments until the commencement date. PwC observation: The tentative decision to measure and record the lease asset and liability on the same date would simplify the guidance. However, at lease inception lessees would still be required to determine if an onerous contract exists and account for it in accordance 2 with existing guidance . The boards will revisit this issue when impairment is discussed at a future meeting. Their future discussion will need to address how to apply the existing guidance to lease contracts and whether additional accounting is needed when there is a long passage of time between lease inception and commencement.
Discount rate .58 Respondents to the ED requested that the boards provide additional guidance on determining the discount rate used in calculating the lease asset and obligation. Specifically, respondents noted that leases represent a 100% financing option which may not exist in the market nor be consistent with how a lessee would finance asset acquisitions. .59 The boards affirmed the decision in the ED and further clarified that for finance leases, a lessee would use the rate implicit in the lease if known; otherwise, the lessee should use its incremental borrowing rate. For other-than-finance leases, the lessee should use its incremental borrowing rate. .60 The boards confirmed that a lessor would use the rate the lessor charges the lessee in the lease. The boards also clarified that the rate the lessor charges could be the lessee's
IAS 37, Provisions, Contingent Liabilities and Contingent Assets, or ASC 450, Contingencies
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incremental borrowing rate, the rate implicit in the lease or, for leases of property, the yield on the property. Initial direct costs .61 The proposals in the ED required the capitalization of any initial direct costs, which is defined as recoverable costs directly attributable to negotiating and arranging a lease. .62 In subsequent redeliberations, the boards affirmed the decision to capitalize initial direct costs and add them to the lessees right-of-use asset and to the amount recognized in the lessors lease receivable. However, they modified the definition of initial direct costs by removing the term "recoverable" such that the definition would read "costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made." Lease incentives .63 Incentives provided by the lessor to a lessee was not a topic included in the ED. Many commentators requested guidance on the accounting for incentives such as free rental periods, up-front cash payments or reimbursement of lessee costs. .64 The boards tentatively decided that incentives should be accounted for based on the nature of the incentive. Lessees should deduct incentives that meet the definition of initial direct costs from the initial measurement of the right-of-use asset. Any other upfront cash payment is considered to relate to the right-of-use asset and would be netted against total lease payments when calculating the lease liability at the commencement date. .65 From a lessor perspective, amounts paid to lessees that meet the definition of initial direct costs would be accounted for as such and capitalized on the balance sheet. Other upfront payments to the lessee would either reduce the profit recognized by the lessor at the commencement date, if applying the derecognition approach or reduce the lease liability if the performance obligation approach is applied. As noted earlier, the boards have yet to confirm their proposal on the overall lessor approach. As such, this tentative decision may change. Purchase options .66 Options to purchase the underlying asset in a lease transaction would not be included in the measurement of the liability and asset under the ED proposals. Rather, the ED proposed that a contract is accounted for as a purchase (by the lessee) and a sale (by the lessor) when the purchase option is exercised. .67 Many respondents indicated that purchase options should be considered in the measurement of the liability and asset as they represent a way for the lessee to "control" the underlying asset on a long-term basis. .68 The boards tentatively agreed that lessees and lessors should include purchase options in the measurement of the asset and liability when there is a significant economic incentive to exercise the option, such as a bargain purchase option. They have instructed the staff to perform targeted outreach to determine the effect purchase options would have on the reassessment of lease term. .69 The boards also tentatively agreed that if a lessee determines it has a significant economic incentive to exercise the purchase option, the right-of-use asset would be amortized over the economic life of the asset rather than over the lease term.
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Sale and leaseback transactions .70 The ED contained principles of continuing involvement as indicators to determine whether the sale and leaseback transaction meets the definition of a sale. These indicators were adapted from ASC 840-40-25, Continuing Involvement, (which represents the codification of the guidance formerly included in FAS 98, Accounting for Leases). The continuing involvement principles included in ASC 840 currently apply only to real estate transactions under US GAAP. However, under the ED, the principles would be applied to equipment sale and leaseback transactions as well. .71 The boards affirmed the decision that when a sale has occurred, the transaction would be accounted for as a sale and then a leaseback. If a sale has not occurred, the entire transaction would be accounted for as a financing. The boards tentatively decided that an entity should apply the control criteria described in the revenue recognition project to determine whether a sale has occurred, rather than the guidance proposed in the ED for an in-substance sale or purchase. PwC observation: The boards' decision to align the sale criteria with the proposed revenue recognition standard would significantly change the proposal and may result in more transactions qualifying as a sale than otherwise would have under the ED. The tentative decision on how to evaluate sale and leasebacks fundamentally requires a separate evaluation of the sale from the leaseback. It may be appropriate to recognize upfront the full amount of the gain on sale. In longer duration leasebacks, some have argued that the seller/lessee retains a significant portion of the right to use the asset and fundamentally only the residual asset was sold. In these cases, many believe only the portion of the gain relating to the sale of the residual should be recognized. Further, there are transition issues for those applying U.S. guidance related to deferred gains on sale and leasebacks consummated before adopting the new standard that now qualify as sales. Transition guidance contained in the ED would imply that the deferred gain would result in an opening balance adjustment to equity and would never be recognized in earnings.
Other issues not yet addressed .72 The boards have indicated that as part of redeliberation they will also consider the following issues, among others (many of which were not addressed in the ED): Lease modifications and terminations Subleasing Measurement issues relating to foreign exchange Presentation and disclosure Interaction with asset retirement or restoration obligations Impairment Revaluation of asset and liability Transition issues
The path forward

.73 The boards will continue redeliberations in the coming months. Once the boards finalize their redeliberations, they will consider whether to re-expose the proposals. If re-exposure is not considered necessary, the draft standards will be made available via the boards' websites for review and for outreach to parties most affected by the proposals. The draft standards will also be subject to a "fatal flaw" review process. The boards will consider the feedback received from these steps and either finalize the standards or consider whether additional work or re-exposure is necessary. .74 The boards recently revised their target date for release of a final lease standard to the latter half of 2011. We will continue to keep you informed of the significant redeliberation decisions. .75 The boards have yet to decide on an effective date, but it likely will not be before 2014.
Questions
.76 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact members of the Leasing team in the National Professional Services Group (1-973-236-7805).
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Appendix A What is a lease? Practical examples

Application of the new definition of a lease may require a careful consideration of the contract terms as well as consideration of the facts and circumstances relating to use of the underlying asset. In some cases, the conclusion is relatively straight-forward and in others, it may require significant judgment. The following common transactions are discussed in this appendix along with how the definition might be applied in each case. Equipment lease Real estate lease Power purchase contract Captured production line Rail cars Time charter arrangements PwC observation: Care must be taken to evaluate each arrangement's specific facts and avoid generalizations about asset types. Changing facts may result in differing conclusions for similar assets. For example, see the rail car example below.
Example 1 Equipment lease Facts: A supplier and a customer enter into a master lease agreement whereby the customer agrees to lease 50 laptop computers from the supplier for three years. The serial or other identifying number of each laptop computer is not included in the master agreement. Upon delivery, a laptop is delivered and the delivery documents identify the serial number of the unit delivered. The laptops will remain in the customer's possession during the three-year period and the customer can load any operating systems or software it chooses. If a laptop is, or becomes, faulty the supplier will replace the laptop at a time convenient to the customer. The specific laptop is returned upon the expiration of the three-year period. Specified asset: The contract depends upon the use of laptop computers. Though each laptop is not specified in the master agreement, at the time the laptops are provided to the customer, a particular asset has been delivered to and accepted by the customer. Absent a warranty matter, the supplier cannot substitute the laptops. The laptops are therefore specified assets. Control: The customer has the right to control the use of the laptops because (a) it has the right to obtain substantially all the economic benefits of the laptop (i.e., the customer possesses the equipment during the contract term, regardless of whether it is used), and (b) the customer directs the use of the laptop by determining how, when and in what manner the laptops are used. Conclusion: Both the specified asset and the control criteria are met. The master lease agreement is a series of leases with each discrete asset accounted for as a separate lease. Example 2 Real estate lease Facts: A tenant enters into an agreement to lease one floor of a 40-floor building for a period of 10 years. The landlord will provide security, elevators, common area maintenance and pay the property taxes. The tenant will be responsible for maintenance of its floor. The tenant can construct leasehold improvements on the floor; however, the landlord must approve all construction projects. The tenant can access the floor at any time, though it will normally only be used
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between 8 a.m. and 5 p.m. The tenant also has discretion over the activities performed within the building (with certain restrictions). The landlord can enter the floor with the permission of the tenant, usually to do routine maintenance or inspections. Specified asset: One floor of a 40-floor building is a physically distinct portion of a larger asset and would meet the definition of a specified asset. Control: The customer has the right to receive substantially all the benefits of the floor throughout the contact term. It also has the ability to direct the use of the floor. It determines what leasehold improvements to construct, what activities are performed and when to access the floor. Conclusion: Both the specified asset and the control criteria are met. Therefore, the agreement is a lease. Example 3 Power purchase contract Facts: A customer enters into a contract with an electricity provider to purchase all the power produced from a particular wind farm for a period of 10 years. The electricity provider is responsible for daily operations of the wind farm as well as repairs and maintenance. The customer must take the electricity that is produced from the plant and pays a fixed price per unit. The electricity provider earns renewable energy credits as electricity is produced, which the customer will also purchase at a per unit price. Specified asset: The wind farm is explicitly specified in the contract and it is not practical for the electricity provider to use other power generating plants. Therefore the wind farm is a specified asset. Control: The customer has the right to control substantially all the potential economic benefits of the wind farm because the contract allows it to purchase all the output as well as the renewable energy credits over the term of the arrangement. However, the customer does not have the ability to direct the use of the plant. The most significant input, wind, is outside the control of both the customer and the electricity provider. Although the asset requires little intervention or operation after it is built, the supplier makes the decisions about the use of the wind farm (e.g., ongoing maintenance). Conclusion: While the fulfillment of the contract may rely on a specified asset, the control requirement may not be met. Accordingly, the agreement likely does not contain a lease. Based on the examples and the discussion at the meeting, it appears that this contract would not contain a lease. However, discussion of the definition of a lease is ongoing and the final conclusions and wording of the standard may impact this conclusion. PwC observation: Different facts and circumstances could result in a different conclusion. For example, if the customer were providing the fuel for a power plant, the control criteria may be met and the arrangement could contain a lease. Irrespective of whether the contract contains a lease, many of these arrangements contain service elements that may require separation.
Example 4 Captured production line Facts: An automobile manufacturer enters into an agreement with a parts supplier to purchase a certain quantity of parts for use in its production line. The manufacturer provides the specifications for the parts, sets quality control requirements and decides the arrival date and quantity of the parts to be delivered. The manufacturer has little involvement in the process to produce the parts. The supplier must use customized equipment to produce the parts to the manufacturer's specifications. All output from this equipment will be purchased by the manufacturer.
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Specified asset: Fulfillment of the contract relies on the use of a specified asset. The asset is implicitly identified because the supplier is unable to deliver the quantity of parts using other equipment. Control: The manufacturer does not have the right to control the use of the equipment because it does not have the ability to direct the use of that equipment. Although it provides the specifications, quantity and timing of the parts, it has no ability to direct the process used to make the parts. Conclusion: While the fulfillment of the contract may rely on a specified asset, the control requirement is not met. Accordingly, the contract does not contain a lease. PwC observation: Different facts and circumstance could result in different conclusions. If the customer has the ability to make decisions about the input and processes used to make the output, and obtains substantially all the benefit from the assets during the term of the arrangement, the contract may contain a lease. For example, if the customer controls how the supplier obtains the necessary raw materials (e.g., steel or sub-assemblies), they would have some involvement in the input, in addition to obtaining output or benefit.
Example 5 Rail cars Facts: A customer and freight supplier enter into an agreement to allow the customer to use 25 rail cars over a 4-year term for the shipment of goods. The type of rail car needed is specified in the contract; however, no serial or other identifying numbers are provided. The rail cars are generic and are not significantly customized. The customer determines when the rail cars will be used as well as the destination of the cars. The rail supplier provides and operates the engine to transport the cars over its rails. When the rail cars are not in use for transportation, they are kept at the freight supplier's premises. The supplier can use any rail cars of a certain specification to transport goods as long as it provides at least 25 cars for the customer's use. Specified asset: Fulfillment of the contract depends upon the supplier providing 25 rail cars. The rail cars are not explicitly identified in the contract and can be substituted by the supplier without the customer's consent (i.e., supplier could use any 25 rail cars of a particular specification to transport the customer's goods). Therefore, the rail cars are not specified assets. Control: The customer does not have the right to control substantially all the benefits of the rail cars because it cannot direct the use of the rail cars when they are not used in the shipment of the customer's goods. Conclusion: Neither the specified asset nor the control requirements are met; therefore the agreement is not a lease. PwC observation: Facts and circumstances could result in a different conclusion. The arrangement could be a lease if specific cars were identified and those cars were stored at the customer's location when not in use.
Example 6 Time charter arrangements Facts: A time charterer enters into a contract with a ship owner of a named ship for cargo transportation services for a five-year period. The charterer will pay a set weekly rate when the ship is being used. The rate includes use of the ship, crew and equipment. The charterer pays for fuel and port costs. The ship owner is responsible for maintenance of the ship, navigating the vessel and all operating expenses. The ship owner also has the right to protect the vessel: for example, avoiding pending bad weather such as hurricanes. Specified asset: Fulfillment of the contract depends upon the use of a certain named ship, identified in the contract. Substituting a ship of equal size and power is not feasible. Therefore, the ship is a specified asset. Control: The time charterer has the right to control the use of the ship. It has the right to obtain substantially all the economic benefits during the contract term. It also has the ability to direct its use. Although the captain and crew are
employees of the ship owner, the time charterer specifies the timing and destination of the ship. The ship owner maintains a majority of the risks associated with ownership and operations; however, it does not control the most significant decisions on its use during the contract period (i.e., timing and destination). Conclusion: Both the specified asset and the control criteria are met. Therefore, the agreement contains a lease.
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Appendix B Financial statement impact of finance and other-than-finance leases

The example below illustrates the difference between the finance and other-than-finance lease models for a lease of a 100,000 square foot building with a 10year fixed term, and an initial annual rent of $20 per square foot (paid in equal monthly payments) with rent escalating by 2% per year. The lessee's incremental borrowing rate is 7%. The lease has no extension options, residual value guarantees, or contingent rent. The present value of the cash flows of $15.5M (calculated at a discount rate of 7%) would be recorded as the lease obligation and the right-of-use asset. Under the finance model, the asset would then be amortized, most likely on a straight-line basis, while the obligation is decreased using the effective interest rate method. The other-than-finance model would also result in a decrease in the obligation using the effective interest rate. The asset amortization is the difference between straight-line rents and interest expense. The expense is classified as rent expense in the income statement under the other-than-finance method. The classification of total lease expense as "rent expense" for other-than-finance leases will result in net income and EBITDA calculations similar to today's operating lease accounting model. It also results in a similar cash flow statement presentation as cash flows will be included within the operating section.
Balance Sheet Implications (in thousands) Exposure Draft (finance lease): Right to use asset Lease obligation Other-than-finance lease: Right to use asset Lease obligation
Inception Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 $15,540 $13,986 $12,432 $10,878 $ 9,324 $ 7,770 $ 6,216 $ 4,662 $ 3,108 $ 1,554 $ 0 (15,540) (14,598) (13,547) (12,377) (11,080) (9,645) (8,062) (6,318) (4,403) (2,302) 0
$15,540 $14,408 $13,207 $11,928 $ 10,563 $ 9,103 $ 7,538 $ 5,857 $ 4,049 $ 2,101 $ (15,540) (14,598) (13,547) (12,377) (11,080) (9,645) (8,062) (6,318) (4,403) (2,302)
0 0
Difference between finance and other-than-finance: Right to use asset $ Lease obligation $ Income Statement Implications (in thousands) Exposure Draft (finance lease): Amortization of right to use asset Interest expense on lease obligation Total expenses related to lease Other-than-finance lease (straight-line): Amortization of right of use asset Interest expense on lease obligation Total expenses related to lease (rent expense) Difference - current period Difference - cumulative Cash (paid in monthly installments) Cummulative cash B A-B A
$ $
(422) $ $
(775) $ (1,050) $ (1,239) $ (1,333) $ (1,322) $ (1,195) $ $ $ $ $ $ $
(941) $ $
(547) $ $
0 -
Year 1 $ 1,554 1,058 $ 2,612
Year 2 $ 1,554 989 $ 2,543
Year 3 $ 1,554 911 $ 2,465
Year 4 $ 1,554 825 $ 2,379
Year 5 $ 1,554 730 $ 2,284
Year 6 $ 1,554 625 $ 2,179
Year 7 $ 1,554 509 $ 2,063
Year 8 $ 1,554 382 $ 1,936
Year 9 $ 1,554 242 $ 1,796
Year 10 $ 1,554 89 $ 1,643
Total $ 15,540 6,360 $ 21,900 Total $ 15,540 6,360 $ 21,900
$ 1,132 1,058 $ 2,190 $ 422 422 $ 2,000 2,000
$ 1,201 989 $ 2,190 $ 353 775 $ 2,040 4,040
$ 1,279 911 $ 2,190 $ 275 1,050 $ 2,081 6,121
$ 1,365 825 $ 2,190 $ 189 1,239 $ 2,122 8,243
$ 1,460 730 $ 2,190 $ 94 1,333 $ 2,165 10,408
$ 1,565 625 $ 2,190 $
$ 1,681 509 $ 2,190
$ 1,808 382 $ 2,190
$ 1,948 242 $ 2,190
$ 2,101 89 $ 2,190 (547) $ 2,391 21,900
(11) $ 1,322
(127) $ 1,195
(254) $ 941
(394) $ 547
$ 2,208 12,616
$ 2,252 14,869
$ 2,297 17,166
$ 2,343 19,509
Dataline
21
Authored by:
Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com Ashima Jain Director Phone: 1-408-817-5008 Email: ashima.jain@us.pwc.com Dianna Taylor Senior Manager Phone: 1-973-236-7307 Email: dianna.l.taylor@us.pwc.com

No. 2011-21 May 20, 2011
Leases: FASB and IASB change course

What's new?
In joint meetings this week, the FASB and IASB (the "boards") continued their redeliberations on the leasing project. The key areas discussed include (1) profit and loss recognition pattern and (2) lessor accounting. The boards came to agreement related to profit and loss recognition pattern. However, they were not able to reach agreement on lessor accounting. It is important to note that the boards decisions are tentative and subject to change, as the boards have not yet concluded their redeliberations or issued a final standard. A complete summary of the boards' decisions on the leases project is available on the FASB's website at www.fasb.org or the IASB's website at www.ifrs.org.

A summary of this week's discussions in the keys areas are as follows: Profit and loss recognition pattern (a reversal of prior tentative decision) The exposure draft implicitly treated all leases as financing transactions with an accelerated profit and loss recognition pattern. Respondents across a range of industries raised significant concerns about this approach. Many respondents (including preparers and users) believed the proposed recognition pattern was inconsistent with the economics of many types of lease transactions that are priced in reference to other market transactions (e.g., by reference to market rent rates for property leases) rather than priced like financing transactions (e.g., a function of applying interest rates to a principal balance). While many users of financial information (such as analysts and rating agencies) make adjustments to a company's balance sheet to recognize the financial liability associated with a lease, they typically do not make similar adjustments to the income statement. In the comment letters, many users indicated that they are satisfied with the current income statement recognition pattern and characterization of most leases. Concerns were raised during the comment letter process about the continued usefulness of the income statement or operating cash flow as measures of performance if all leases were reflected as financings. In prior redeliberation meetings, the boards had tentatively decided that there should be a fundamental distinction between those leases that are primarily financing transactions in nature and those that are not (i.e., so called "other-than-financing" leases.) While both types of leases would be recognized on the balance sheet, the expense recognition
would differ. A financing lease would have the recognition pattern described in the exposure draft (i.e., separately as amortization and interest expense). An "other than financing" lease would have a straight line expense recognition pattern (similar to today's operating leases) which would be characterized as rent. The mechanics on how to apply the concept of "other-than-financing" leases had not been finalized. However, the boards reversed this prior tentative decision because of both conceptual and practical application concerns. Many board members observed that most leases contain a financing element of some magnitude, which should not be ignored. Further, the boards had concerns regarding the application of a straight line expense pattern while concurrently achieving the appropriate balance sheet recognition. That is, a straight line expense approach would either require an amortization adjustment (for example, through comprehensive income) or, alternatively, a "sinking fund" type amortization approach for the right-to-use asset (which is not typically allowed for other owned assets). The decision to support the single finance model for lessees as proposed in the exposure draft will likely spark further debate by those constituents who opposed the financing model for all leases. Lessor accounting (no decision yet reached) Two main views appear to be emerging from the discussion. One view is that a single derecognition approach should be applied to all leases and not the dual model proposed in the exposure draft. The other view is to retain current lessor guidance (as adjusted for conforming revisions to the definition of a lease, lease term, and treatment of variable payments) potentially with the FASB moving to an IAS 171 approach to achieve full convergence. The boards have agreed to continue to explore whether a converged consensus around a single derecognition model is possible. However, some concerns were expressed that moving to a single derecognition model approach may necessitate reexposure and result in potential delays to the completion of the project.
Who's affected?

The boards have yet to decide on an effective date, but it likely will not be before 2014.
What's next?
The boards will continue redeliberations over the coming months. The boards will continue to discuss lessor accounting and other areas. A final standard is targeted for the latter half of 2011. We will continue to keep you informed of the significant redeliberation decisions.
Questions?
IAS 17, Leases

In brief 2
Authored by:
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10 Minutes
How new lessee accounting changes your companys financial picture
Highlights
on the future of lessee accounting
February 2011
Leasing arrangements satisfy a wide variety of business needs, from short-term asset rentals to long-term asset financing. Leases allow companies to use assetsoffice and retail space, hotel rooms, equipment, cars, and aircraftwithout having to make large initial cash outlays. Leases can affect the amount, timing, and uncertainty of future cash flows. Yet about $1.2 trillion in future cash obligations for lease arrangements arent reported on the balance sheets of US public companies, according to a 2005 report by the SEC. Many analysts have had to make adjustments in their stock price models to factor in their estimates of these future cash flows. But lessee accounting may be about to change. A proposed new global accounting standard would require companies to record the rights and obligations related to all leases on their balance sheets. This 10Minutes provides a preview of the proposed changes and their implications, while the proposals are being re-deliberated in light of extensive comments received. The final rules are expected to be issued in mid-2011. But beware; substantial changes in the proposals could occur before the issuance of a final standard.
Companies should begin preparing 1. The proposed standard may change the scorecard by which investors, lenders, and rating agencies evaluate your companys indebtedness and creditworthiness. It may also change your companys earnings picture. To limit surprises, you should understand the potential impact of the change. 2. Current systems, controls, and resources may be inadequate under the new standard. In fact, while your company tries to understand the impact of the new rules, you may have to consider the following: new data and estimation methods and more skilled personnel may be needed to deal with new accounting rules about renewal options and contingent rents new or upgraded systems may be needed to replace the current lease tracking systems in spreadsheets and accounts payable systems in companies with no formal asset management system additional resources may be needed to apply the new accounting to what, for some, may be thousands of leases already in force, particularly in large companies
Adding leased assets and obligations to balance sheets will affect measures of nancial strength (e.g., debt-to-equity ratios), net income, and other performance metrics. Agreements tied to these measures may be affected, such as performance-based compensation plans and debt covenants. Accounting for contingent rents and renewal options will require signicant judgment and estimates. Proposed continuous reassessment may increase earnings volatility. The proposed standard and its complexity will prompt some companies to reconsider how and why they use leases. Companies should begin to assess the impact of the changes and consider the adequacy of their systems and processes to address the new requirements.
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At a glance
Under current lease accounting standards leases are classified as either capital leases (effectively, financing arrangements), which are recognized on the balance sheet, or operating leases, which remain off the balance sheet. leases only include non-cancellable periods in the lease term, except where there is compelling economic reason to exercise an option (for example, a penalty provision). contingent rents are generally excluded from minimum lease payments and are reflected in earnings in the period they arise. companies recognize the expense for operating leases (excluding contingent rent) on a constant or straight-line basis.
Changes lie ahead. Under the proposed rules1: substantially all leases would be recorded on the balance sheet as financings, with an asset and an obligation, based on the present value of payments over the term of the lease. the lease term would include non-cancellable periods and optional renewal periods that are more likely than not to be exercised.
lease payments used to measure the initial value of the asset and liability would include estimated future contingent rent amounts. amortization and interest expense would replace rent expense, changing income statement geography and frontloading expense in the early years of the lease. companies would need to continually re-assess lease renewals and contingent rents, and adjust the related estimates as facts and circumstances change which would increase earnings volatility.
lease terms are generally not re-assessed, except when there is a change in the terms or a binding exercise of an extension option.
1 Based on the proposals in the exposure draft published in August 2010. Certain provisions may change upon re-deliberation.
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01
How changing financial metrics could impact ability to borrow
Impacts on nancial metrics vary by industry
PwC assessed the impact of the leasing proposals on the nancial statements and key nancial ratios of a sample of approximately 3,000 listed companies across a range of industries worldwide.
The new rules could re-calibrate your companys leverage and earnings, without any change in underlying cash flows or business activity. The changes could be significant. New baselines for financial metrics In a study of 3,000 companies, we found that recording lease rights and obligations on balance sheets as assets and liabilities would result in about a 58% average increase in interest-bearing debt. Nearly a quarter of surveyed companies would experience an increase in debt of over 25%. In some cases, the added leverage could be multiples of total assets. Moreover, the impact on leverage ratios could change often as a result of the required re-assessment of estimates, including both lease term and contingent rents. On the other hand, operating earnings metrics such as EBITDA could increase because rents would no longer show up as a recurring operating expense. Instead, rent is effectively reported as principal and interest payments and the associated leased assets are amortized. Our study found that the average increase in EBITDA would be around 18%. In some cases, earnings could fall as a result of the acceleration of expense recognition in the new model. Stakeholders will need to adjust to the new information. Investors focused on cash operating metrics may have to adjust reported earnings amounts. New metrics of a companys financial health may evolve to ensure earnings and indebtedness are understood by stakeholders.
Likely impacts on financing For some companies, it may be more than just getting used to new baselines. A companys ability to borrow may be affected, as the new rules make existing operating leverage more transparent. Higher leverage ratios could also affect values of acquisitions or other deals. Rating agencies and many stock analysts already reflect leasing activities in their credit and stock analyses. But the new standard may yield measures of leverage that exceed analysts estimates. Any resulting changes in leverage ratios could impact a companys credit ratings, debt covenants, and regulatory compliance. Market reactions could occur. Financial covenants are often based on the accounting principles in force at inception of the agreement. Those that are will require companies to keep track of both modelsa complexity that may lead companies to want to renegotiate terms to simplify the accounting.
Industries
Average percentage** increase

Leverage ** Interestbearing debt EBITDA *
Retail and trade Other services Transportation and warehousing Telecommunications Professional services Amusement Accommodation Wholesale trade Manufacturing Construction Oil, gas, and mining Financial services Utilities All companies
64 34 31 20 19 19 18 17 9 8 7 6 2 13
213 51 95 23 158 25 101 34 50 68 30 27 3 58
55 25 44 16 27 13 30 21 13 14 10 15 6 18
* Earnings Before Interest, Taxes, Depreciation and Amortization ** Increase in leverage (calculated as interest-bearing debt divided by equity) is the average increase in percentage points
Source: PwC, Proposed lease accounting: research of impact on companies, research conducted with the Rotterdam School of Management, 2009.
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02
Where the proposals raised the most concern
The complexity and the inherent subjectivity in applying the proposed rules raised many issues, ranging from the compliance burden to volatility in earnings and financial ratios. Operating leases become financing leases In general, even for basic leases, the proposed rules would treat leasing as a financing. The lease obligation would be treated like a mortgage, which would cause higher interest expense in the earlier years of the lease. The longer the term of the lease, the more expenses are frontloaded. For some businesses, such as new retail or restaurant outlets, the frontloading of expenses could come at a time when earnings may not be sufficient to cover the combined interest and amortization charges. Renewal optionsIncluding renewal options in the estimate of the lease obligation requires difficult judgments about the probability that options will be exercised as well as the related estimates of future rental payments. Contingent rentsIncluding contingent rents means forecasting the likelihood of future events. Next years restaurant sales, for example, are hard enough to predict accurately; estimates for the full 10- or 20-year term of a lease are even more difficult to predict and subject to a wide range of potential estimates. Continuous re-assessmentsThe proposed ongoing re-assessments in lease renewals and contingent rents not only impose compliance burdens, they also introduce volatility in earnings and financial ratios. Alternative approaches may emerge The proposals are still being debated and substantial changes could be incorporated into the final rules that will be issued in mid-2011. The most significant concerns about the proposed rules are the high level of subjectivity involved in estimates and judgments, the frequency of changes in estimates, and the changed expense recognition pattern. But there are alternative approaches that could reduce subjectivity and the need for frequent re-assessments. Weve offered a number of suggestions that do this and also reduce complexity while addressing potential application challenges and costs. For example, on extension options, weve recommended including only those options that are virtually certain to be exercised, that is, where the only reasonable economic choice for the lessee is to renew the lease. The cash flow implications of other kinds of options can be disclosed in footnotes and still meet investors information needs.2
The proposed rules result in frontloading of rent expense

$3300
$2800
$2300
$1800
$1300
9 10 11 12 13 14 15 16 17 18 19 20 Year
Current model
Proposed model assuming 20-year term
Proposed model optional periods subsequently added
This chart compares the expenses recorded under the current model and scenarios for the proposed model, using the example of a 10-year lease with two 5-year renewals, an initial rent of $2,000, annual escalations of 2%, an incremental borrowing rate of 7%, and no contingent rent or residual value guarantees.
2 PwC, Letter to the International Accounting Standards Board and Financial Accounting Standards Board, 30 November 2010.
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03
Considerations for companies that use leases
Basic operating needs often drive leasing decisions. Through leasing, a restaurant chain, bank, or retail chain can quickly add new locations in response to increased demand. By leasing equipment, hospitals can take advantage of the latest technologies without the risks of obsolescence. For a rapidly growing company, it might be faster and more efficient to execute a lease rather than to go through the approvals required for outright purchase. Leasing offers businesses the flexibility to ride out downturns or other disruptions. And in some cases, leasing is the only option because the property, such as retail space in malls, is not available for purchase. Current economic conditions The proposed standard would not change the fundamental decision process, nor would it change the basic economics of lease transactions. But its implementation will come at a time when the economic downturn has significantly changed property values and rents. Previously negotiated rents may be above the current market price. At the same time, assets may be available at favorable purchase prices. Also, some companies may benefit by obtaining financing using their own credit rating versus the lessors, which could be lower as a result of current market difficulties. Of course, the benefit will have to be weighed against the cost of renegotiating a prior lease arrangement. These could become important factors in re-assessing existing contracts, potential re-negotiations, and new lease-versus-buy decisions.
3 PwC, The overhaul of lease accounting: catalyst for change in corporate real estate, November 2010.
Regulatory and contracting factors Regulators havent yet indicated how risk-based capital requirements will be affected by the new standard. Also, there are implications for some cost plus contracts, which may reimburse an entity for the cost of rent, but not for capital-related items, such as interest and amortization. While the economics of lease transactions would not change, with rent expense re-classified as interest and amortization, the economics of cost plus and other contracts could change drastically. Tax considerations Federal and state tax considerations often play a significant role in strategic decisions about corporate real estate. Tax accounting will become more complex, particularly the tracking of temporary differences between the proposed model and the generally cash-based tax models. For state taxes, the proposed standard may affect the amount of business income apportioned to various states, which could cause an increase in state taxes. Considering all factors together As companies revisit past arrangements and consider future leasing decisions for specific locations, they should weigh the host of these economic, operating, regulatory, accounting, and tax factors together.3
Fundamental lease-versus-buy questions:

Why does your company lease or own in particular situations? What are the alternatives to leasing? How do current market opportunities (e.g., lease rates/ purchase prices) affect your strategies? How quickly are conditions changing in your industry? How important is exibility in real estate and equipment procurement? How do federal, state, and local taxes factor into your lease-versus-buy decisions?
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04
What should your company be doing now?
Preparing for the change
ducate key business leaders in the company E about the leasing change Create a cross-functional steering committee to address the proposed standard and transition nventory your leases; understand what assets I are leased and where the data resides Identify contracts likely to include embedded leases onsider modeling the transition impact on certain signicant C leases (or a sample from a variety of lease types) Summarize existing systems, control processes, and potential gaps nalyze potential income and other tax considerations A (including federal, state, and foreign taxes) dentify contracts affected (e.g., nancial covenants, compensation I agreements, and earnout agreements), the potential implications, and how terms should be modied to maintain the original intent dentify regulatory issues such as implications for regulatory I capital and cost plus government contracts onsider potential changes in leasing strategy; for example, lease/ C buy, shorter versus longer terms, options, contingent rents, etc. Consider if terms of existing leases should be renegotiated
If leasing is significant to your business, ultimately, you may need to communicate with banks, rating agencies, and financial analysts about how your companys financial picture may be affected. The idea is to limit surprises. Assess the potential impact early on Catalog existing leases and gather data about lease terms, renewal options, payments, and embedded leases. If your company has international operations, you may need to address leases written in different languages and any impact of local statutes in applying the proposed standards. Model the impact on certain significant leases or a sample from a variety of lease types. Consider the potential income tax and other tax effects and regulatory issues. Based on the information gathered, prepare a preliminary impact study and update it as needed. Monitor changes in the proposed standards. Rally the people who need to act Educate key business leaders in the company about the issue and get the internal support needed for the transition from tax, operations, information technology, human resources, procurement, treasury, and investor relations.
Consider new systems and controls Critical to a smooth and orderly transition is the ability to gather the required information on existing leases, and to be able to capture data on new leases right at the outset, even before the accounting changes take effect. That might mean the need for new systems, which will take time to obtain, implement, and test. Initial recording on the balance sheet and annual re-assessment of lease terms and payments could also require significant and complex changes to existing processes and internal controls. And you might need more personnel resources. Conduct strategic reviews In light of the proposed rules, review strategies and contract terms to make sure the companys operating and financial objectives are met. Where does it make sense to own rather than lease? Which leases warrant longer terms and exercise of renewal options? Where would it make sense to reduce contingency provisions? Review debt agreements with lenders and credit agreements with suppliers. Evaluate employment contracts to assure proper alignment of performance metrics with anticipated financial results. Communicate in advance with your stakeholders Consider when to start the dialog to help your stakeholders understand the potential impact of the new standard, any resulting changes in leasing strategy, and other relevant information ahead of full implementation of the new standard.
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How PwC can help
To have a deeper discussion about how the change in leasing accounting may impact your business, please contact: Jim Kaiser Partner, US Convergence & IFRS leader PwC 267 330 2045 james.kaiser@us.pwc.com Dave Kaplan Partner, Co-Leader National Accounting Services Group PwC 973 236 7219 dave.kaplan@us.pwc.com Tom Wilkin Partner, National Office Real Estate Leader PwC 973 236 4251 tom.wilkin@us.pwc.com
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2011 PwC. All rights reserved. PwC and PwC US refer to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member rm of PricewaterhouseCoopers International Limited, each member rm of which is a separate legal entity. This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 10Minutes is a trademark of PricewaterhouseCoopers LLP US. NY-11-0405
DataLine
A look at current financial reporting issues PricewaterhouseCoopers 201038 September 16, 2010
A New Approach to Lease Accounting

Proposed Rules Would Have Far Reaching Implications
What's inside:
Overview ............................. 1 Scope .................................. 2 Lessee accounting............... 4 Lessor accounting ............... 9 Other topics ....................... 12 Timing for comments ......... 15 Specific insights ................. 15 Where to go for more information ........................ 16 Questions .......................... 16 Appendix ........................... 17
Overview
At a glance
On August 17, 2010, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly released exposure drafts of a proposed accounting model that would significantly change lease accounting. Under the proposed model, a lessee's rights and obligations under all leasesexisting and newwould be recognized on its balance sheet. Lessors would report leases using either a performance-obligation approach or a derecognition approach. The proposal would require lessees and lessors to estimate the lease term and contingent payments at the beginning of the lease and subsequently re-assess the estimates throughout the lease term, entailing more effort than under existing standards. The proposed model would have significant business implications, including an impact on contract negotiations, key metrics, systems, and processes. The boards expect to issue final standards in 2011. The effective date, which has not yet been determined, could be as early as 2013.
The main details

.1 As part of their global convergence process, the boards' objective of a new leasing standard is to ensure that assets and liabilities arising from lease contracts are recognized on the balance sheet. .2 This DataLine updates the discussion in DataLine 2010-09 to reflect the proposals in the FASB and IASB's exposure drafts, Leases, along with examples and our observations. The proposal will significantly change lease accounting. For lessees, the balance sheet will expand with the recognition of a right-of-use asset and lease obligation. In addition, straightline rent expense will generally be replaced by amortization of the right-of-use asset and interest expense on the lease obligation. The interest expense will be front-end loaded, similar to mortgage amortization. .3 The proposal also would require both lessees and lessors to initially estimate and then reassess estimates of the lease term, contingent rent, and other cash flows as facts and circumstances change. As a result, significantly more effort will be required to account for leases both initially and on an on-going basis. Greater investment in (and reliance on) systems and processes would likely be needed to comply with the proposed model.
DataLine 2010-38
.4 The exposure draft does not include any "grandfathering of existing leases. Companies would need to assess and record all existing leases under the proposed model, with the exception of certain "simple" capital leases, at the time of adoption and for comparable periods presented (see transition discussion). Because virtually all companies enter into lease arrangements, the impact of the proposed model will be pervasive. Therefore, companies should begin evaluating the impact the proposal will have on existing and proposed leases, continue to follow the project, and be prepared for implementation if the boards decide to adopt the proposal as a final standard. .5 The boards' conclusions in the exposure draft are tentative and subject to change until a final standard is issued.
Scope
.6 The boards have proposed that the scope of the leasing standard include leases of property, plant, and equipment and exclude leases of intangible assets. Similar to other standards, the proposed standard would not apply to immaterial items. PwC Observation: Although a single item might be immaterial, items of a similar nature might be material in the aggregate (i.e., one computer lease might be immaterial, but 10,000 computer leases might be material). For leases determined to be immaterial to the financial statements in the aggregate, companies may consider developing a policy similar to commonly used property and equipment capitalization policies. .7 The boards also propose to exclude from the scope (1) leases to explore for or use natural resources (such as minerals, oil, and natural gas); (2) leases of biological assets; and (3) leases of investment property measured at fair value under International Accounting Standard 40, Investment Property (IAS 40) PwC Observation: U.S. GAAP does not currently have an investment property accounting model similar to IAS 40. However, at its July 14, 2010 meeting, the FASB tentatively decided to issue a proposed Accounting Standard Update (ASU) that would be similar to IAS 40. The FASB has indicated that the standard would require an investment property to be measured at fair value (fair value is currently optional under IAS 40). An investment property would be defined as real estate (including integral equipment) held by the owner, or held on a finance lease to earn rentals and/or capital appreciation. This would not include owner occupied property, property held for sale in the ordinary course of business (e.g., residential homes), or property constructed on behalf of third parties. An exposure draft on investment property could be issued as early as September 2010 with a comment period ending December 15, 2010. (This period would be concurrent with the comment period on the lease exposure draft). If a new investment property standard is completed, it is expected that the FASB would adopt it concurrently with adopting a final leasing standard.
Short-term leases and non-core assets

.8 The boards considered excluding short-term leases and leases of non-core assets. Factors considered include the cost of applying the model, the difficulty in defining non-core assets, and the potential structuring opportunity that such an exclusion would create. They decided that excluding these leases would run counter to their objective of bringing the rights and obligations of all leases on the balance sheet. .9 Although the boards decided against a short-term lease exclusion, they did propose a simplified method for lessees to ease the burden of accounting for them. For leases with a
DataLine 2010-38
maximum possible term (including all extension options) of twelve months or less, lessees could use a simplified lease accounting approach on a lease-by-lease basis. Under the simplified approach, the lessee would recognize a right-of-use asset and liability equal to the gross payments remaining on each lease. Payments for the lease would be recognized in the income statement over the lease term. PwC Observation: Because of the short duration of leases that would qualify for the simplified approach, the time value of money associated with those short-term leases would be ignored as a practical expedient. The exposure draft does not explicitly state how lease payments for short-term leases under the simplified approach would be reported in the income statement (e.g., as rent expense or amortization expense). However, we expect that if the asset is being recorded and amortized, the amount included in the income statement would represent amortization expense. Any payments to the lessor would reduce the obligation. .10 Lessors may elect on a lease-by-lease basis not to recognize assets or liabilities arising from short-term leases. If this election is made, the lessor would continue to recognize the underlying asset in accordance with other existing guidance. Thus, if this option is elected, lessors with short-term leases would not need to recognize lease assets or liabilities or derecognize any portion of the underlying asset.
Arrangements containing both lease and service components

.11 The scope also includes leases contained within other arrangements, such as service or supply contracts. Existing guidance on when such a contract conveys the right to control the use of the underlying asset is included in ASC 840-10-15 (which represents the codification of the guidance formerly included in EITF 01-8, Determining Whether an Arrangement Contains a Lease) and IFRIC 4, Determining Whether an Arrangement Contains a Lease. Similar guidance is included in the proposed standard. As a result, a right to control the use of an underlying asset would be considered an embedded lease and reflected on the lessee's balance sheet in accordance with the exposure draft. Unlike the limited grandfathering that was provided in EITF 01-8, it appears that this requirement would apply to all existing embedded leases since the exposure draft does not provide for any grandfathering. PwC Observation: Under current guidance, the embedded leases within these arrangements are often classified as operating leases. Because the accounting for a service or supply arrangement and an operating lease is similar, separating the two components in practice has presented few issues. This will change when the embedded lease is brought onto the balance sheet under the right-of-use model. Accordingly, considerably more judgment in separating the components may be required than under current practice. .12 For lease contracts that contain both service and lease components, a determination of whether the service is considered distinct would be required. Total payments under the arrangement would be allocated between distinct service and lease components using the same principle proposed in the recently issued exposure draft, Revenue from Contracts with Customers. If services are not considered distinct or if total payments cannot be allocated among the service and lease component, the entire arrangement would be accounted for as a lease. The proposal reflects the FASB's tentative decisions in the revenue recognition project that a service would be distinct if either (a) the entity, or another entity, sells an identical or similar service separately or (b) the entity could sell the service separately because it has a distinct function and a distinct profit margin.
DataLine 2010-38
PwC Observation: The definition of distinct service components may present difficulties for lessees to separate executory costs/services from the lease component. If not considered distinct, certain components considered to be executory costs or service components (e.g., common area maintenance, common area utilities, security, insurance and property taxes) would be included in the amounts recorded on the balance sheet. This would differ from the accounting treatment if the asset were owned, making it a major issue for many lessees of real estate where the leases are significant to the company.
In-substance sales and purchases

.13 The boards recognize that some contracts may be leases in legal form but are, in substance, sales contracts under which the lessor has ceded control of the underlying leased asset to the lessee. Contracts would be considered a purchase or sale if, at the end of the contract, an entity transfers control of the asset and no more than a trivial amount of the risks and benefits are retained. Indicators of a transfer of control include contracts that automatically transfer title at the end of the lease term and contracts that have a bargain purchase option that is reasonably certain to be exercised. PwC Observation: Agreements meeting these conditions would be considered a sale and a purchase rather than a lease and therefore would not be in the scope of the proposed standard. The determination would be made at the inception of the contract and would not be revisited. For lessors, if the contract is considered a sale, the transaction would follow the revenue recognition guidance under the proposed revenue exposure draft. See DataLine 2010-28, Revenue RecognitionFull Speed Ahead.
Lessee accounting
The basic model
.14 The boards have proposed a right-of-use model for lessee accounting. This model requires the lessee to recognize at the commencement of the lease an asset representing its right to use the leased item for the lease term and a corresponding liability for the obligation to pay rentals. Under this approach, all leases not considered to be purchases would be accounted for in a similar manner; the classifications of capital and operating leases used today would be eliminated. .15 The boards believe that the right-of-use model is consistent with their conceptual frameworks and increases the transparency of lease accounting. Because leases are commonly viewed as a form of financing, the obligations recognized on the balance sheet under the right-of-use model would be consistent with how businesses reflect other financing arrangements. PwC Observation: The right-of-use model might cause companies to change how they negotiate leases. It may also affect lease-versus-buy decisions. However, we believe leasing will continue for a variety of business reasons. Leasing provides more operational flexibility than outright ownership; certain leasing structures are more tax efficient than direct ownership; and leasing often provides effective financing to companies whose financing options are otherwise limited. In addition, for large-ticket items, such as real estate, leasing is expected to continue as a viable option because many companies prefer not to own these types of assets in order to maintain operating flexibility or the specific asset may only be available through leasing (e.g., a specific retail location).
DataLine 2010-38
Initial measurement .16 Lessees would initially measure the obligation to pay rentals at "cost." Cost is defined as the present value of the lease payments. The right-of-use asset would be measured at the amount of the lease obligation plus any initial direct costs incurred by the lessee. The boards have defined initial direct costs as incremental costs directly attributable to negotiating and arranging a lease. For example, initial direct costs may include commissions, legal fees, negotiating lease terms, preparing and processing lease documents, closing the transaction and other internal costs that are incremental and directly attributable to negotiating and arranging the lease. .17 Present values would be determined using the lessee's incremental borrowing rate as the discount rate at the date of inception of the lease. If the rate the lessor is charging in the lease is readily determinable, this rate can be used in lieu of the incremental borrowing rate. PwC Observation: Lessees would not be obligated to seek out the rate the lessor is charging in the lease and most often will not be able to identify that rate. The rate the lessor is charging is more likely to be identifiable in equipment leases, particularly when the equipment also may be purchased outright. For other types of leases, including real estate leases with rents based on cost per square foot, the lessee rarely knows the rate the lessor is charging because it is typically not relevant to negotiations. Nonetheless, the boards have proposed to grant lessees the option to use the rate the lessor is charging, if known. They did so because in certain circumstances it may be more cost effective for the lessee to use the rate the lessor is charging in the lease rather than determine its incremental borrowing rate. The boards proposed that measurement of the lease occur at lease inception (i.e., the earlier of the date of the lease agreement or the date of commitment). However, the asset and corresponding liability are not recorded until the commencement date of the lease (the date on which the lessor makes the leased asset available). The exposure draft does not address the accounting for the change in present value of the obligation when a significant amount of time passes between lease inception and lease commencement. We believe that the asset and liability should be adjusted at commencement to eliminate this differential. Subsequent measurement .18 The boards proposed that the right-of-use asset should be subsequently measured at amortized cost. The expense recorded would be presented as amortization expense rather than rent expense. The lessee's obligation to pay rentals would be subsequently measured at amortized cost using the effective interest rate method under which payments would be allocated between principal and interest over the lease term. Interest expense determined under that method would be higher in the early years of a lease compared to the current straight-line treatment for rent expense under an operating lease. (See example in paragraph 27). PwC Observation: These changes will affect balance sheet ratios and income statement metrics. EBITDA (earnings before interest, taxes, depreciation, and amortization) would increase, perhaps dramatically, with the absence of rent expense. The changes in metrics may also affect loan covenants, credit ratings, and other external measures of financial strength. Internal measures used for budgeting, incentive and compensation plans, and other financial decisions may similarly be affected.
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Lease term
.19 Under existing standards, optional periods are considered part of the lease term if the lessee concludes at lease inception that it is "reasonably assured" (ASC 840, Leases) or "reasonably certain" (IAS 17, Leases) of exercising the option to renew the lease for the additional periods. Under the right-of-use model, lessees would be required to estimate the ultimate expected lease term and periodically reassess that estimate. A detailed examination of every lease at each reporting date would not be required. A lease's term would be reexamined if facts and circumstances indicate that there would be a significant change in the liability since the previous reporting period. .20 The lease term is defined as the longest possible term more likely than not to occur. In estimating the lease term, all relevant factors should be considered, including contractual, non-contractual, and business factors, as well as intentions and past practices. For example, consider a lease with a non-cancellable five-year term and two five-year renewal options. Clearly, the minimum contractual term of five years is more likely than not to occur. (The probability is 100 percent that the lease will cover at least the initial five-year period). The lessee would also need to consider whether the ten or fifteen-year terms available as a result of the renewal options are more likely than not to occur. Once the lessee has determined which lease terms are more likely than not to occur, the longest of those terms would be the lease term used to account for the lease.
Purchase options
.21 The boards proposed that purchase options not be accounted for in the same manner as options to extend a lease. Instead, purchase options would be recognized only upon exercise. At that time, the exercise of a purchase option would result in the lessee recognizing the underlying asset. PwC Observation: This decision reflects the boards' view that a purchase option goes beyond conveying the right to use an asset for a specified period and, therefore, the purchase should be accounted for separately.
Contingent cash flows

.22 Under existing standards, contingent rentals generally are recognized as expenses in the period incurred. The right-of-use model would require that the initial measurement of the obligation to pay rentals include contingent cash flows, such as "percentage rents," increases in rents based on changes in an index (such as CPI), and residual value guarantees. .23 The boards proposed to use an expected outcome technique for measuring contingent cash flows with the clarification that a lessee does not have to consider every possible scenario. This technique requires the calculation of a probability-weighted average of the cash flows for a reasonable number of outcomes. Many respondents to the boards' March 2009 discussion paper on leases disagreed with the inclusion of lease renewal options and contingent rentals in measuring the right-of-use asset and lease liability. They argued that options and contingent payments are not the same as a commitment and therefore do not meet the definition of a liability. In the Basis for Conclusions that accompanies the exposure draft, the boards set forth their belief that contingent rentals and renewal options meet the definition of a liability. The boards indicated that not reflecting contingent rentals and options in the measurement of the lease obligation would result in the non-recognition of payments due the lessor and could result in structuring opportunities to avoid recognizing an obligation.
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Changes in estimates and remeasurements
.24 The boards proposed that lessees would be required to reassess estimates of lease term and contingent cash flows as warranted by changes in facts and circumstances. Subsequent measurement of the lease obligation would reflect all such changes in estimate. Changes in the lessee's obligation due to a reassessment of the lease term would be recognized through an adjustment of the right-of-use asset. .25 The boards have proposed a mixed model to account for changes in estimated contingent cash flows. Where changes in amounts payable under contingent cash flow arrangements are based on current or prior period events or activities, those changes should be recognized in profit or loss. All other changes would be recognized as an adjustment to the lessee's right-of-use asset. For example, consider a lessee that enters into a ten-year lease agreement that includes rental payments based on a percentage of sales. During the second year of the lease, the lessee determines that the original estimated sales figures require updating. Adjustments in the obligation arising from modifying sales for years one and two would be recognized in profit and loss. Changes in the obligation from the updated forecast in sales in years three through ten would be recognized as an adjustment to the right-of-use asset. .26 The boards considered whether the discount rate should be updated when a remeasurement is required due to a change in estimated term or contingent cash flows, but decided the original discount rate should be used throughout the lease term. The only exception would be a lease with rentals contingent on variable reference interest rates; for all other leases, the accounting would be consistent with that of a fixed-rate borrowing. PwC Observation: The requirement to reassess these estimates entails significant incremental effort compared to the current model, under which lease accounting is set at inception and revisited only if there is a modification or extension of the lease. In addition, it may be necessary to invest in information systems that capture and catalog relevant information and support reassessing lease terms and payment estimates as facts and circumstances change.
Lessee Example
.27 Exhibit 1 illustrates the effect of the proposed standard on expense recognition for a fixed 10-year lease with rental payments that increase 2% per year (see also example 1 in the appendix). The current accounting model reflects rent expense for operating leases on a straight-line basis over the non-cancellable lease term. Historically, critics of todays model have observed that this was sufficiently divergent with the cash due under the contract and does not reflect economic reality. The new approach diverges even further from the cash due under the contract. .28 Under the proposed model, rent expense would be replaced with interest and amortization expense. The expense will be front-end loaded with more expense recognized in the beginning of the lease term and less at the end similar to a mortgage. For a lease that includes escalating rents, the cash payments will be directionally the inverse of what the expense will be lower in the earlier years and higher in the later years.
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Exhibit 1: Comparison of the proposed model, current model and cash payments
$2,600 $2,400 $2,200 $2,000 $1,800 $1,600 1 2 3 4 5 6 7 8 9 10 Cash Rent Current Model Proposed Model
.29 When a lease contains optional periods or contingent payments, additional volatility may be introduced into the income statement, as the lessee would be required to revisit the original estimates of lease term and contingent rentals as facts and circumstances change. Using the same lease example as paragraph 27, Exhibit 2 assumes there are two optional five-year renewal periods. The rents during the option periods continue the same pattern, escalating 2% per annum. .30 Exhibit 2 depicts the expense recognition pattern in the following scenarios: The current leasing model (assuming the exercise of the options was not reasonably assured at lease inception) the current model has a stair step type recognition pattern for each non-cancellable term. The proposed model assuming management determined at inception that the longest lease term more likely than not to occur was 20 years results in increased expense at the front-end of the lease that declines over the lease term. The proposed model assuming management initially estimated the longest lease term was 10 years. In year 7, management determined that a 15-year term was likely. Finally, in year 12, management concluded that the estimated lease term was 20 years this results in a saw tooth recognition pattern, thereby adding increased volatility to the income statement.
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Exhibit 2: Comparison of timing recognition of optional renewal periods
$2,900 $2,700 $2,500 $2,300 $2,100 $1,900 $1,700 $1,500 $1,300 1 3 5 7 9 11 13 15 17 19 Proposed Model assuming 20 year term Proposed Model optional periods subsequently added Current Model
.31 The proposed model does not provide a discretionary choice regarding the pattern of expense recognition. The decision regarding inclusion of optional periods in the lease term will depend upon the likelihood of exercising the options throughout the lease term. Management should consider all relevant factors in initially determining the lease term and contingent payments and reassess these factors as facts and circumstances change.
Lessor accounting
The basic models
.32 The boards proposed to use a dual model for lessor accounting. Depending on the economic characteristics of the lease, a lessor would apply either a performance obligation approach or a derecognition approach. .33 The performance obligation approach would be used for leases in which the lessor retains exposure to significant risks or benefits associated with the leased asset either during the term or subsequent to the term of the contract. If significant exposure is not retained by the lessor, the derecognition approach would be followed. .34 Retaining exposure to the risks or benefits of the leased asset at the end of the term could include either having the expectation or ability to generate significant returns by releasing the asset or by selling it. A determination of which approach to use would be made at lease inception and not revisited, absent a lease modification. .35 To determine whether the risks and benefits associated with an underlying asset are retained during the term, lessors would consider (a) the significance of contingent rentals during the expected lease term based on performance or use of the underlying asset, (b) options to extend or terminate the lease, or (c) material non-distinct services provided in the lease contract. For this assessment, credit risk of the lessee during the expected lease term would not be considered. .36 Under the performance obligation approach, the underlying leased asset would continue to be accounted for as an economic resource of the lessor and remain on the lessor's balance sheet. The lessor recognizes a lease receivable, representing the right to receive
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rental payments from the lessee, with a corresponding performance obligation, representing the obligation to permit the lessee to use the leased asset. The performance obligation is satisfied (and revenue recognized) over the lease term. See example 2 in the appendix for an illustration of the accounting under the performance obligation approach. .37 The derecognition approach assumes that the lessor has performed by delivering the leased asset and providing an unconditional right to use it over the lease term. Consequently, the lessor recognizes a receivable representing the right to receive rental payments from the lessee and records revenue. In addition, a portion of the carrying value of the leased asset is viewed as having transferred to the lessee and is derecognized and recorded as cost of sales. See example 3 in the appendix for an illustration of the accounting under the derecognition approach. PwC Observation: The boards recognize that the dual model they are proposing is somewhat similar to existing lessor accounting. Originally, the boards desired a single lessor model, but they realized that this was the only principles-based alternative as certain fact patterns could only be addressed through a dual model. For example, board members who expressed general support for the derecognition approach were concerned about applying the approach to short-term leases of long-lived assets or multi-tenant real estate leases. At the same time, some board members who expressed general support for the performance obligation approach were concerned about the balance sheet grossup in that approach. Others supported up-front recognition of manufacturer and dealer profit.
Symmetrical treatment
.38 Where possible, the boards aim to have symmetrical accounting for the lessee and the lessor in a lease arrangement. This section describes areas where the boards proposed asymmetrical provisions. Initial measurement .39 The lessor's lease receivable would be measured similarly to the lessee's obligation, except that the lessor would be required to use the rate the lessor is charging in the lease as the discount rate. PwC Observation: In certain operating lease transactions today, the lessor does not calculate an implicit rate for the lease. For example, in leases of real estate the rent is based largely upon the market rental rates at inception of the lease rather than the return on investment or lessee credit risk. The proposal would require lessors to calculate a rate of interest, which will entail incremental effort over the current model. .40 Under the performance obligation approach, the lease receivable and a performance obligation are recognized. Under the derecognition approach, entries would be made to recognize revenue and the lease receivable and partially derecognize an allocated amount of the leased asset and record cost of sales for the portion of the asset considered to be sold. The amount derecognized would be based on the relationship between the fair value of the receivable from the lessee and the fair value of the underlying asset. The exposure draft provides guidance on determining the derecognized portion of the underlying asset and the amount retained as the initial carrying value of the residual asset. The amount derecognized by the lessor is calculated as the carrying amount of the underlying asset, multiplied by the fair value of the right to receive lease payments, and divided by the fair value of the underlying asset. The derecognized amount is determined at inception of the lease.
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Subsequent measurement .41 Subsequent measurement of the lessor's receivable would be at amortized cost using the effective interest method, resulting in interest income. .42 The performance obligation would decrease as the lessor permits the lessee to use the leased item over the lease term. The performance obligation is satisfied and revenue is recognized in a systematic and rational manner based on the pattern of use of the underlying asset (i.e., over time, usage, or output). .43 Under the derecognition approach, the lessor would not remeasure the residual asset retained, except for impairment. The value of the residual asset would not be accreted over time. PwC Observation: Similar to the lessee impact, the right-of-use model would affect the timing of income statement recognition for lessors. For the performance obligation approach to lessor accounting, interest income under the effective interest method would be higher in a lease's early years compared to the current straight-line recognition of an operating lease's rental income. For lessors using the derecognition approach, the cost of goods sold would likely be different than under current sales type leases, thereby affecting the margin recorded at lease commencement. Further, lessors who have sales type leases under current standards may not qualify for the derecognition approach under the proposal, which would result in lease income recognized over the term of the lease rather than at commencement of the lease. In addition, some sales-type leases may meet the definition of a sale rather than a lease and would be excluded from the scope of the lease standard.
Lessor consideration of lease term

.44 The boards proposed that accounting by lessors for optional renewal periods would generally be symmetrical with the accounting by lessees for those options. However, the boards acknowledged that, in the same lease transaction, the objective of symmetry might not result in the lessee and lessor determining the same lease term since there could be different judgments made based on different perspectives and different information. The lessee normally has sole control over the decision to extend and more information about the factors that go into that decision. A lessor might not have insight into the business plans and intentions of the lessee and, therefore, may have less insight into whether the lessee will exercise renewal options. Nonetheless, a lessor is required to estimate the renewal options that the lessee will exercise and revisit the estimate if facts or circumstances indicate that there would be a significant change in the right to receive lease payments.
Contingent cash flows

.45 Similar to lessees, lessors would be required to recognize a receivable for contingent rentals and residual value guarantees, but only if the receivable could be reliably measured. This is consistent with the boards' current view in their exposure draft on revenue wherein contingent revenue would be recognized only if the amount can be measured reliably.
Changes in estimate and remeasurement

.46 Under the performance obligation approach, changes in the lessor's lease receivable resulting from a reassessment of the lease term would be recognized as an adjustment to the performance obligation. In the case of contingent cash flows, changes would be recognized in revenue if the performance obligation has already been satisfied. When the performance obligation has yet to be satisfied, changes would be recognized as an adjustment to the performance obligation.
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.47 The derecognition approach differs from the performance obligation approach for changes in estimates. When a reassessment results in a change in term, the change in the lease receivable is allocated to the rights derecognized and the residual asset. For changes in contingent cash flows, changes in the lease receivable are adjusted through revenues.
Other topics
Sale and leaseback transactions
.48 Some linked sale and leaseback transactions would be accounted for using saleleaseback accounting while others would be accounted for as financings. The different accounting would be based on whether the transaction meets the proposed leasing standard's criteria for an in-substance sale/purchase. As discussed previously, when the seller/lessee retains no more than a trivial amount of risks and benefits and control is transferred to the buyer/lessor at the end of the lease, the asset would be considered sold. .49 If the transaction qualifies as a sale, gains or losses would be recognized immediately. The boards have also proposed that, if the sale or leaseback is not established at fair value, then the asset, liability, and gain or loss would be adjusted to reflect current market rentals. .50 If the transaction does not qualify as a sale, it would be accounted for as a financing. The transferred asset would not be derecognized and any amounts received would be recognized as a liability. PwC Observation: This would be a significant change under U.S. GAAP, which currently provides guidance for determining whether transactions involving real estate qualify for sale accounting (ASC 360-20) or sale-leaseback accounting (ASC 840-40). (The Exposure Draft is expected to replace ASC 840, Leases, including the guidance relating to ASC 840-40-55, Criteria for Determining Whether the Lessee Should be Considered the Owner of the Asset Under Construction.) Under the proposal, the determination of whether a sale and linked leaseback qualifies for sale treatment would be less cumbersome. However, for sales and leasebacks of non-real estate assets, some transactions may qualify as a sale under current standards but not under the proposed model. If the transaction qualifies as a sale, any gain or loss would not need to be deferred under the proposal. On the other hand, IAS 17 currently requires any gain in a sale-leaseback transaction to be deferred if the transaction results in a finance lease. If the sale was at fair value, any gain would be taken up front in a sale-leaseback transaction resulting in classification as an operating lease. The determination of operating versus finance lease is based upon whether the seller/lessee transfers substantially all of the risks and rewards incidental to ownership of the underlying asset. Under the proposal, more transactions likely will be treated as financings rather than sales due to the higher hurdle of retaining no more than trivial risks and benefits.
Subleases
.51 As expected, the accounting for subleases builds on the lessee and lessor accounting models that the boards have proposed. When a leased asset is subleased, the sublessor would account for the head lease (i.e., the lease agreement between the original lessor and lessee) in accordance with the proposed right-of-use lessee model and, likewise, would account for the sublease under the appropriate proposed approach for lessor accounting.
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.52 Presentation of the assets and liabilities will differ depending on which of the two lessor models is followed. To avoid the "double gross-up" in the balance sheet that would otherwise result under the performance obligation model, the boards proposed that all assets and liabilities arising from both the head lease and sublease, except for the obligation to pay rentals to the head lessor, would be presented together at gross amounts in the balance sheet with a net subtotal. The obligation to the head lessor would be presented separately in liabilities. When the lessor approach is derecognition, however, all assets and liabilities arising under a sublease would be presented gross in the balance sheet.
Presentation and disclosure

.53 For lessee accounting, the boards proposed that assets, liabilities, amortization, and interest related to leases would be presented in the financial statements based on the nature of the item. The boards also proposed that the amounts be broken out on the face of the financial statements. However, they asked respondents to comment on whether break-out in the footnotes may suffice. Cash payments on leases and interest expense arising from lease contracts will be presented as financing activities in the statement of cash flows, separately from other financing cash flows. .54 Under the performance obligation approach, lessors would present the leased asset, the lease receivable, and the performance obligation gross in the balance sheet, totaling to a net lease asset or net lease liability. For lessors using the derecognition approach, the residual asset would be separately reported in the balance sheet within property, plant, and equipment. .55 The boards differed in their views about the presentation of income under the performance obligation approach. The FASB proposed that interest income, lease income, and depreciation expense be presented separately in the income statement, totaling to net lease income or expense. The IASB proposed that the amounts be presented separately, but does not believe that netting the amounts in the income statement is necessary. .56 Lessors would classify collection of the lease receivable and interest income arising from that receivable as operating activities in the statement of cash flows. .57 Due to the significantly expanded use of estimates and judgments in the proposed lease standard, disclosure requirements will go well beyond those required under current leasing standards. Quantitative and qualitative financial information that identifies and explains the amounts recognized in financial statements arising from lease contracts and a description of how leases may affect the amount, timing, and uncertainty of the entitys future cash flows would be required. .58 Specific disclosures required would include a description of the nature of an entity's leasing arrangements, the existence and terms of optional renewal periods and contingent rentals, and information about assumptions and judgments. In addition, any restrictions imposed by lease arrangements, such as dividends, additional debt, and further leasing should also be disclosed. .59 The following disclosures would also be required: Information about the principal terms of any lease that has not yet commenced if the lease creates significant rights and obligations A reconciliation between the opening and closing balances of right-of-use assets and obligations to pay rentals, disaggregated by class of underlying asset
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A narrative disclosure of significant assumptions and judgments relating to renewal options, contingent cash flows, and the discount rate used A maturity analysis of the gross obligation to pay rentals showing (a) undiscounted cash flows on an annual basis for the first five years and a total of the amounts for the remaining years and (b) amounts attributable to the minimum amounts specified in the lease and the amounts recognized in the balance sheet Additional disclosures would apply if (a) the simplified option for short-term leases is elected, (b) significant subleases exist, or (c) there is a sale-leaseback transaction
Transition and effective date

.60 The proposed standard would be applied by lessees and lessors by recognizing assets and liabilities for all outstanding leases at the transition date. PwC Observation: The boards proposed that the new model be applied as of the date of initial application (the beginning of the earliest period presented). For example, if a company were to adopt the standard on January 1, 2014, and present two comparative years, it would be required to apply the provisions of the standard beginning January 1, 2012. All outstanding leases would be required to be recognized and measured on the date of initial application. As proposed, leases that expired before the adoption date but existed in the earlier periods would also be recast. .61 Lessees would measure the lease obligation at transition at the present value of the lease payments discounted using the lessee's incremental borrowing rate on the transition date. When lease payments are uneven over the term, the accrued or prepaid rent account (used under current standards to provide for straight-line rent expense) would be recharacterized to the right-of-use asset. Uneven lease payments could result from lease incentives, rent-free or reduced rental periods, or rent escalation clauses. Additionally, the right-of-use asset would be reviewed for impairment. .62 Under the performance obligation approach, lessors would measure the lease receivable and performance obligation using the rate the lessor is charging the lessee, determined at inception, as the discount rate. A lessor would reinstate previously derecognized leased assets at depreciated cost, adjusted as necessary for any impairment considerations. .63 Under the derecognition approach, lessors would measure the lease receivable at transition using the rate the lessor is charging the lessee, determined at inception of the lease. This is consistent with measurement under the performance obligation approach. The residual asset would be measured at fair value as of the transition date. .64 The boards have proposed an exception for "simple capital leases," or leases currently classified by lessees as capital leases but do not include options, contingent rents, termination penalties, or residual value guarantees. Capital leases entered into prior to the transition date that meet this exception would continue to follow existing capital lease accounting standards. .65 This simplified transition approach reflects the reality that, for many long-term leases, the information needed to adopt the proposed standard retrospectively may no longer be available. The boards considered providing an option to adopt retrospectively, recognizing that the asset and obligation are equal only at inception, but rejected it in favor of a single transition approach.
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PwC Observation: The lack of grandfathering for existing leases will mean that extensive data-gathering will be required to inventory all contracts and then, for each lease, a process to capture information about lease term, renewal options, and fixed and contingent payments. The information required under the proposed standard will typically exceed that needed under current GAAP. Depending on the number of leases, the inception dates, and the records available, gathering and analyzing the information could take considerable time and effort. Beginning the process early will ensure that implementation of the final standard is orderly and well controlled. Companies should also be cognizant of the proposed model when negotiating lease contracts between now and the effective date of a final standard. .66 The boards expect to issue a final standard in mid-2011. They have not discussed the effective date of the standard. Presumably, it would be no earlier 2013, with 2014 more likely. Given the potential impact of the proposed changes on accounting and operations, and the express purpose of the boards to ensure that assets and liabilities arising from lease contracts are recognized on the balance sheet, management should begin assessing the implications of the proposal on existing contracts and current business practices.
Timing for comments

.67 Comments on the exposure draft are due by December 15, 2010. We encourage management to engage in the comment letter process and suggest that entities respond formally to the questions included in the exposure draft.
Specific insights
.68 Due to the broad range of assets currently being leased, the proposed standard may affect the leasing of certain assets differently than others. Supplements related to corporate real estate and equipment leases will be provided discussing some of the more significant implications to help readers of this DataLine identify and consider the implications of the proposed standard. Additional supplements may follow. .69 The supplements, examples, and related assessments will be based on the Exposure Draft, Leasing, which was issued on August 17, 2010. The provisions of the proposed standard are subject to change at any time until a final standard is issued. The examples included in the supplements reflect the potential affect of the proposed standard and any conclusions noted are subject to further interpretation and assessment based on the final standard. .70 We encourage management to read the topics discussed in the supplements and consider the potential effects that the proposed standard could have on their existing leasing practices and operations. The issues discussed in the supplements are intended to assist companies in formulating feedback to the boards that can help in the development of a highquality final standard. .71 The Appendix to this DataLine includes examples of the lessee and lessor balance sheet and income statement implications under the proposed model. The Appendix includes the following: Lessee simple example Lessor simple example performance obligation approach Lessor simple example derecognition approach
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Where to go for more information

.72 A summary of all tentative decisions reached by the boards relating to this project can be found at: http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBCont ent_C%2FProjectUpdatePage&cid=900000011123.
Questions
.73 PwC clients who have questions about this DataLine should contact their engagement partner. Engagement teams that have questions should contact a member of the leasing team in the National Professional Services Group (1-973-236-7805).
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Appendix: Examples of revised financial statement format

This Appendix includes the following examples:
Example 1: Lessee simple example Example 2: Lessor simple example performance obligation approach Example 3: Lessor simple example derecognition approach
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The following example of a real estate lease is provided to demonstrate how the lessee model would be applied in practice.
Example 1: Lessee simple example

The lease is for a 100,000 square foot building with a 10-year fixed term, an initial annual rent of $20 per square foot (paid in equal monthly payments) with rent escalating by 2% per year. The lessee's incremental borrowing rate is 7%. The lease has no extension options, residual value guarantees, or contingent rent. The present value of the cash flows of $15.5M (calculated at a discount rate of 7%) would be recorded as the lease obligation and the right-to-use asset. The asset would then be amortized, most likely on a straight-line basis, while the obligation is decreased using the effective interest rate method. This results in a total expense of $2.6M in the first year. This is $612K higher than the cash rent and $422K (approximately 20%) higher than expense under the straight-line method used today. This example illustrates that over the lease term, the total amount of expense recognized would be the same under the proposed model as it is under the current operating lease model (straight-line expense recognition) and would be equal to the aggregate cash payments at the end of the lease term.
Balance Sheet Implications (in thousands) Balance at End of Year Initial Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 recognition $ 15,540 $ 13,986 $ 12,432 $ 10,878 $ 9,324 $ 7,770 $ 6,216 $ 4,662 $ 3,108 $ 1,554 $ (15,540) (14,598) (13,547) (12,377) (11,079) (9,644) (8,061) (6,318) (4,403) (2,302) 0
Right to use asset Lease obligation
Income Statement Implications (in thousands) Proposed model: Amortization of right to use asset Interest expense on lease obligation Total expenses related to lease
Year 1 $ 1,554 1,058 $ 2,612
Year 2 $ 1,554 989 $ 2,543
Year 3 $ 1,554 911 $ 2,465
Year 4 $ 1,554 825 $ 2,379
Year 5 $ 1,554 730 $ 2,284
Year 6 $ 1,554 625 $ 2,179
Year 7 $ 1,554 509 $ 2,063
Year 8 $ 1,554 382 $ 1,936
Year 9 $ 1,554 242 $ 1,796
Year 10 $ 1,554 89 $ 1,643
Total $ 15,540 6,360 $ 21,900 Total $ 21,900
Current accounting model (straight line): Difference - current period Difference - cumulative Cash (paid in monthly installments) Cummulative cash
B A-B
$ 2,190 $ 422 422
$ 2,190 $ 353 775
$ 2,190 $ 275 1,050
$ 2,190 $ 189 1,239
$ 2,190 $ 94 1,333
$ 2,190 $
$ 2,190
$ 2,190
$ 2,190
$ 2,190 (547) -
(11) $ (127) $ 1,322 1,195 $ 2,252 14,869
(254) $ 941
(394) $ 547
$ 2,000 2,000
$ 2,040 4,040
$ 2,081 6,121
$ 2,123 8,244
$ 2,165 10,409
$ 2,208 12,617
$ 2,297 17,166
$ 2,343 19,509
$ 2,391 21,900

The following example of a real estate lease demonstrates how the performance obligation under lessor accounting would be applied in practice.
Example 2: Lessor simple example - performance obligation approach

The lease is for a 100,000 square foot building with a 10-year fixed term, an initial annual rent of $25 per square foot (paid in equal monthly payments) with rent escalating by 2% per year. The rate the lessor is charging the lessee is 7%. Of the initial $25 per square foot amount, $5 per square foot is estimated to cover common area maintenance charges, which is also expected to escalate at a rate of 2% per year. The lease has no residual value guarantees or contingent rent. The carrying value of the underlying asset at lease commencement is $20M. The building has a remaining useful life of 40 years. The present value of the cash flows of $15.5M (calculated at a discount rate of 7%) would be recorded as the lease receivable and the performance obligation. The lease asset would then be decreased using the interest method, the performance obligation is decreased based on the pattern of use of the underlying asset, most likely on a straight-line basis, and the underlying asset is depreciated on a straight-line basis using the remaining life of 40 years. This results in net lease income of $2,112K in the first year. This is $422K (20%) higher than lease income under the straight-line method used today.
Balance Sheet Implications (in thousands) At Inception $15,540 $20,000 Year 1 $14,598 19,500 Year 2 $13,547 19,000 Year 3 $12,377 18,500 Year 4 $11,079 18,000 Balance at End of Year Year 5 Year 6 Year 7 $9,644 $8,061 $6,318 17,500 17,000 16,500 ($7,770) ($6,216) ($4,662) Year 8 $4,403 16,000 ($3,108) Year 9 $2,302 15,500 ($1,554) Year 10 $0 15,000 $0
Lease receivable Underlying asset Performance obligation
($15,540) ($13,986) ($12,432) ($10,878)
($9,324)
Income Statement Implications (in thousands) Proposed model: Interest income on lease receivable Lease income on performance obligation Subtotal of lease revenue Depreciation of underlying asset Total net lease income Current accounting model: Lease income (straight-line) Depreciation of asset Total net lease income Difference - current period Difference cumulative Cash (paid in monthly installments) Cummulative cash
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total $ 1,058 $ 989 $ 911 $ 825 $ 730 $ 625 $ 509 $ 382 $ 242 $ 89 $ 6,360 1,554 1,554 1,554 1,554 1,554 1,554 1,554 1,554 1,554 1,554 15,540 2,612 2,543 2,465 2,379 2,284 2,179 2,063 1,936 1,796 1,643 21,900 (500) (500) (500) (500) (500) (500) (500) (500) (500) (500) (5,000) $ 2,112 $ 2,043 $ 1,965 $ 1,879 $ 1,784 $ 1,679 $ 1,563 $ 1,436 $ 1,296 $ 1,143 $ 16,900 Total $ 2,190 $ 2,190 $ 2,190 $ 2,190 $ 2,190 $ 2,190 $ 2,190 $ 2,190 $ 2,190 $ 2,190 $ 21,900 (500) (500) (500) (500) (500) (500) (500) (500) (500) (500) (5,000) $ 1,690 $ 1,690 $ 1,690 $ 1,690 $ 1,690 $ 1,690 $ 1,690 $ 1,690 $ 1,690 $ 1,690 $ 16,900 $ 422 422 $ 353 775 $ 275 1,050 $ 189 1,239 $ 94 1,333 $ (11) $ (127) $ 1,322 1,195 $ 2,252 14,869 (254) $ 941 (394) $ 547 (547) -
B A-B
$ 2,000 2,000
$ 2,040 4,040
$ 2,081 6,121
$ 2,123 8,244
$ 2,165 10,409
$ 2,208 12,617
$ 2,297 17,166
$ 2,343 19,509
$ 2,391 21,900

The following example of an equipment lease demonstrates how the journal entries under the derecognition approach would be calculated for both equipment in inventory (carrying value is not equal to the fair value) and equipment whose carrying value is equal to the fair value.
Example 3: Lessor simple example - derecognition approach

The lease is for a piece of equipment with the following contract terms and assumptions: Lease terms and assumptions Carrying value not equal to fair Value Fair value of asset Cost of asset Monthly lease payments Lease term Rate charged in the lease Estimated residual value at lease end No extension options, residual value guarantees, or contingent rent Based on the terms and assumptions, the lease receivable and corresponding lease revenue of $90,823 is calculated by taking the present value of monthly cash payments of $2,763 discounted at a 6% rate. The amount of the asset derecognized, and corresponding cost of goods sold, of $54,494, and $90,823 is calculated by taking the carrying value of the asset multiplied by the present value of lease payments and then divided by the fair value of the asset ($60,000*$90,823/$100,000) and ($100,000*$90,823/$100,000). Subsequently, the lease receivable would be decreased using the interest method. The portion of the inventory balance not derecognized represents the residual asset. It would not be remeasured during the lease term, unless an impairment adjustment is necessary. Carrying value not equal to fair value Journal Entries at Lease Commencement: Lease receivable Lease revenue/income Lease expense Residual asset Underlying asset $54,494 $5,506 $60,000 Debit $90,823 $90,823 $90,823 $9,177 $100,000 Credit Carrying value equals fair value Debit $90,823 $90,823 Credit $100,000 $60,000 $2,763 3 Years 6.00% $11,000 Carrying value equals fair value $100,000 $100,000 $2,763 3 Years 6.00% $11,000
DataLine 2010-38
Authored by:
Tom Wilkin Partner Phone: 1-973-236-4251 Email: tom.wilkin@us.pwc.com Dianna Taylor Senior Manager Phone: 1-973-236-7307 Email: dianna.l.taylor@us.pwc.com
DataLines address current financial-reporting issues and are prepared by the National Professional Services Group of PricewaterhouseCoopers LLP. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2010 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, or as the context requires, the PricewaterhouseCoopers global network or other member firms of the network each of which is a separate and independent legal entity. To access additional content on accounting and reporting issues, register for CFOdirect Network (http://www.cfodirect.pwc.com), PricewaterhouseCoopers' online resource for senior financial executives.
US GAAP Convergence & IFRS Fair value measurement

FASB clarifies scope of nonpublic entity fair value disclosure exemption
What's new?
On December 19, 2012, the FASB (the board) met to clarify the applicability of an exemption from a specific fair value disclosure for nonpublic entities. The board decided to clarify that all nonpublic entities are exempt from the requirement to disclose the categorization by level of the fair value hierarchy for items disclosed but not measured on the balance sheet at fair value.
No. 2012-59 December 20, 2012

Certain nonpublic entities are excluded from the requirement to disclose the fair value of their financial instruments not measured at fair value on the balance sheet. Questions have arisen during the adoption of ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, regarding which nonpublic entities are excluded from the new requirement to disclose the categorization by level of the fair value hierarchy for items not measured at fair value in the balance sheet but for which fair value is disclosed. Some read the exemption to apply to only those nonpublic entities that are able to apply the general exemption to not disclose the fair value of their financial instruments. The board voted to clarify that all nonpublic entities are exempt from the requirement to disclose the level in the fair value hierarchy for items disclosed but not measured on the balance sheet at fair value. The board noted that this was its intent when it deliberated ASU 2011-04.
Although the issuance of ASU 2011-04 was the result of a joint project on fair value conducted with the IASB, the disclosure exemptions provided to nonpublic entities in ASU 2011-04 and confirmed at this board meeting are only for reporting entities applying U.S. GAAP. A similar scope exemption is not included in the IASBs fair value standard.
Who's affected?
Nonpublic entities are affected by the clarification.
In brief
What's the proposed effective date?

ASU 2011-04 is effective for nonpublic entities for annual periods beginning after December 15, 2011. The clarification described above is not expected to have a different effective date.
What's next?
A proposed ASU with the clarified language is expected in January 2013. The board decided to provide a 15-day comment period.
Questions?
In brief
Authored by:
Jill Butler Partner Phone: 1-973-236-4678 Email: jill.butler@us.pwc.com Mia DeMontigny Managing Director Phone: 1-973-236-4012 Email: mia.demontigny@us.pwc.com Maria Constantinou Director Phone: 1-973-236-4957 Email: maria.constantinou@us.pwc.com

New fair value measurement standard Adoption of the new guidance: First quarter 2012 measurement and disclosure observations
Overview
At a glance In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU). The ASU primarily clarifies existing fair value measurement guidance and is intended to align U.S. GAAP and IFRS. Additionally, the guidance requires several new disclosures. The guidance was effective for interim and annual periods beginning after December 15, 2011 for public companies and for annual periods beginning after 1 December 15, 2011 for nonpublic entities. For most public companies, the quarter ended March 31, 2012 was the first period the guidance in the ASU was effective. This Dataline provides observations on how the guidance was implemented by a sample of 37 companies to identify leading practices and points of interest to assist reporting entities as they develop their future fair value disclosures. The companies we sampled are from a variety of industries, including (1) financial services banking and capital markets, asset management, and insurance, and (2) other industries - utilities, energy, manufacturing, and real estate.
No. 2012-05 June 13, 2012 Whats inside: Overview .......................... 1

Key observations .............4
Overall observations all industries.............................. 4 Financial services industry .... 6 Other industries ..................... 11
Questions ....................... 13
The FASB is currently deliberating fair value disclosure requirements for nonpublic entities as a separate project.
Background .1 The FASB's summary of the ASU states: "the Board does not intend for the amendments in this Update to result in a change in the application of these requirements of Topic 820." As a result, PwC anticipated the changes in practice under U.S. GAAP to be primarily disclosure-related, since the ASU requires expanded disclosures about the fair value of financial instruments, particularly for public companies. .2 Dataline 2012-02, New fair value measurement standard Implementation guidance for new disclosure requirements, includes a series of questions and answers providing implementation guidance on selected new disclosure requirements. Also, PwC's Guide to Accounting for Fair Value Measurements, 2012 edition, includes a chapter dedicated to fair value disclosures (FV 5). For general information about the ASU, see Dataline 2011-31, New fair value measurement standard Implementation guidance for key changes to the measurement of financial instruments at fair value , and Dataline 2011-23, Fair value measurement FASB and IASB complete joint project. Measurement .3 There were certain areas in which the ASU could have resulted in significant measurement changes for financial instruments. These include the application of premiums and discounts, the valuation of financial instruments with offsetting market and credit risks, and potential changes in the determination of the principal markets. However, PwC has observed only limited disclosures about changes in measurement both within our sample and more broadly. .4 For example, in one case, a financial institution discontinued applying a discount due to the size of its position, and as a result, increased the related fair value measurement. In another case, a financial institution changed the principal market for some instruments, which resulted in a valuation difference on those instruments. PwC observation: As expected, we have not observed that the ASU has caused widespread changes in fair value measurements. While there may be other situations besides the two noted above, our analysis suggests that measurement changes are not prevalent. Consequently, this Dataline focuses on companies' application of the new disclosure requirements.
Disclosure .5 The following are the new disclosures required by the ASU, the most significant of which relate to Level 3 fair value measurements (measurements based on significant, unobservable inputs): For all Level 3 fair value measurements (recurring and non-recurring) by class of assets and liabilities: Quantitative information about significant unobservable inputs used. The ASU does not provide specific guidance on what quantitative information is required; however, an example of what a reporting entity may consider disclosing related 2 to assets is included in the ASU .
Refer to ASC 820-10-55-103 through 55-104.

Dataline 2
A qualitative description of the valuation process in place for both recurring and 3 nonrecurring Level 3 fair value measurements. The guidance indicates that this might include the group responsible for valuation, to whom the group reports, the internal reporting procedures in place, as well as the methods to calibrate and test the models and the frequency of testing. Other disclosures could include the process for analyzing changes in fair value from period to period, what methods are used to develop and substantiate unobservable inputs, and what controls are in place over third-party pricing services, particularly if the 4 company avails itself of the third-party pricing exception . Qualitative discussion about the sensitivity of inputs used in recurring Level 3 fair value measurements. Further, to the extent there are interrelationships between the various unobservable inputs used in the fair value measurement, such interrelationships and the potential impact on sensitivity should also be disclosed. Note that the guidance does not require a quantitative disclosure about sensitivity; therefore, entities are not required to provide specific amounts or quantify the potential changes in the inputs or the fair value measurements. For Level 2 recurring and non-recurring fair value measurements, a qualitative 5 description of the valuation technique(s) and inputs used must be provided. Any transfers between Level 1 and Level 2 fair value measurements on a gross basis, by class, including the reasons for those transfers must be disclosed. Previously, companies were required to disclose only significant transfers. All fair value measurements must now be disclosed by fair value hierarchy level. As a result, public companies are now required to determine the level in the fair value hierarchy of financial assets and liabilities that are not recorded at fair value but for which fair value is disclosed (for example, long-term debt recorded at amortized cost). Use of the exception for measuring certain financial instruments with offsetting market and credit risks as a portfolio as described in ASC 820-10-35-18D (the 6 "portfolio exception") must be disclosed. If the highest and best use of a nonfinancial asset differs from its current use by the entity, the entity is now required to disclose the reason(s) the asset is being used differently. .6 PwC analyzed the March 31, 2012 Form 10-Q filings of 37 public companies (30 within financial services industries and 7 within other industries) that adopted the ASU and considered the following questions: How were all of the new disclosures presented? Did preparers follow the examples given in the ASU? Was the information presented in a logical, comprehensible way?
3 4
ASC 820-10-55-105 ASC 820-10-50-2(bbb) allows a reporting entity to omit certain quantitative disclosures about unobservable inputs that are not developed by the reporting entity (e.g., prices from prior transactions or obtained from thirdparty pricing sources). It should be noted that the qualitative sensitivity disclosures for such inputs may still be required by ASC 820-10-50-2(g), even if the exception for the quantitative disclosure is elected. 5 ASC 820-10-50-2(bbb) 6 ASC 820-10-50-2D
Did companies in a particular industry and across all industries address the required disclosures similarly? Were the same instruments disclosed the same way by different companies within an industry and across all industries observed? For example, companies in multiple industries held asset-backed securities of various kinds at March 31, 2012. Were the significant unobservable inputs and valuation methods disclosed in the same way for all companies? Was the level of disaggregation in the quantitative unobservable inputs table consistent within an industry and across all industries? For example, did entities presenting the fair value of corporate bonds disaggregate them similarly? Did companies avail themselves of the exception for valuations provided by thirdparty pricing services? If so, did they increase disclosures of the controls the company has in place over third-party valuations? Did disclosures about financial instruments not measured at fair value, but for which fair value is disclosed change?
Key observations
Overall observations all industries .7 PwC's review resulted in some overall observations, which are discussed in more detail in later sections. Quantitative disclosures .8 PwC observed that most companies included the new quantitative disclosures required by the ASU. However, the information was not always comprehensive and at times, it was somewhat difficult to follow. For many large companies, there was a significant effort involved in gathering information to complete the new disclosures. As a result, initial disclosures were likely focused on substantial compliance, rather than readability. PwC observation: We believe that in subsequent reporting periods, reporting entities will continue to refine their disclosures. With additional time, preparers could make the information more organized and comprehensible to readers, resulting in more effective disclosures. They may adjust the ways in which they present information, including possibly disclosing more information to the extent it provides readers a clearer picture of the company's fair value measurements. Further, companies will likely use comments from the Securities and Exchange Commission (SEC) staff, questions from analysts, as well as their own analyses of others' disclosures, to gain insights about disclosures that are most meaningful for their financial statement users. It is worth noting that ASC 820-10-50-1A directs preparers to present all material information needed to give readers a clear picture of the company's fair value measurements, regardless of the specific requirements of ASC 820. .9 We noted that companies were not always clear in their disclosures about what was excluded from the quantitative tables of significant unobservable inputs for Level 3 assets and liabilities when compared to the fair value hierarchy tables.
Dataline
.10 Another area lacking consistency was the inclusion of ranges and weighted averages of significant unobservable inputs. .11 We expected to see commonality in the significant unobservable inputs disclosures within and across industries for the more common Level 3 instruments. However, we noted only a few common Level 3 instruments (e.g., residential mortgage-backed securities or "RMBS") and even then, there was limited consistency in the inputs disclosed. .12 About half of the companies in our sample elected the third-party pricing exception for all or a part of their Level 3 portfolios. Consequently, they did not provide the quantitative disclosures about unobservable inputs related to the applicable instruments. PwC observation: Some preparers may have applied the third-party pricing exception despite some level of data being provided by their pricing services. This is likely because the information was provided relatively late in the closing process, thereby not providing companies sufficient time to validate the information and implement appropriate controls for inclusion in the footnote disclosure. The use of broker quotes and third-party pricing services for both Level 2 and Level 3 instruments is a particular area of focus for the SEC. The SEC expects management to take responsibility for all fair value measurements even when those measurements are not developed by the entity. During the 2011 AICPA National Conference on Current SEC and PCAOB Developments held in December 2011, both the SEC and Public Company Accounting Oversight Board (PCAOB) reiterated managements responsibilities in this area. Management should consider these expectations when evaluating whether an unobservable input qualifies for the above-mentioned exception. In instances in which the third-party pricing exception is appropriate, preparers should consider disclosing the controls over their review of the third-party 7 valuations. It is possible that as more preparers request more detailed information from their third-party pricing vendors, use of this exception may become more infrequent over time. Already, some pricing services have provided input information and others are expected to soon follow suit. .13 For companies with Level 3 liabilities or equity, we noted diversity in practice regarding whether they included nonperformance risk (i.e., their own credit) as a significant input. .14 With respect to the qualitative disclosures, including descriptions of companies policies for fair value measurements and the sensitivity analyses of Level 3 instruments, we observed limited meaningful disclosure of the interrelationships between and among the significant unobservable inputs. .15 In general, the disclosures were more in-depth for companies in the financial services industry. However, given the focus on financial instruments in the ASU, such entities were more likely to be impacted due to the nature of the instruments they hold.
ASC 820-10-55-105(d)
Dataline 5
Financial services industry .16 For the financial services industry survey, PwC selected 30 public companies with significant Level 3 financial instruments. The sample included ten banking and capital markets companies, eight corporate asset managers, two funds, and ten insurance companies. Within insurance, to ensure that subsectors were represented, we selected 8 three property and casualty, two financial guaranty, and five life insurance companies. Measurement .17 As noted above, very few companies reported that the ASU had an impact on their fair value measurements. Further, only two companies in the sample, both in the banking and capital markets industry, disclosed that they used the portfolio exception. However, only one of those explicitly disclosed that this exception was taken as the result of an accounting policy election, as required by the ASU. PwC observation: For most companies in the sample, it was not evident if they applied the portfolio exception. PwC expected more widespread use of the portfolio exception by financial institutions, particularly those in the banking and capital markets industry, and consequently more disclosure of its use.
Disclosure .18 The examination of Form 10-Q filings for financial institutions revealed different levels of granularity in the new disclosures. Disclosures ranged from minimal discussion without the required tabular presentation of significant unobservable inputs, to more detailed and robust tabular and narrative disclosures. Quantitative disclosures .19 For the new required table of significant unobservable inputs, we observed that most companies in our sample disclosed the inputs in a tabular format that was largely consistent with the example provided in the ASU. However, only a limited number of companies included a reconciliation or a note explaining how the amounts in the significant unobservable input table reconciled to the fair value hierarchy table. Some companies supplemented the example by including totals and/or subtotal balances that could be helpful as users reconcile the quantitative data. Although not required, a reconciliation is useful to financial statement users in determining how all of the instruments in the fair value hierarchy table have been addressed in the significant input table. .20 In our survey, there was also one insurance company that reconciled the significant input totals back to the fair value hierarchy table by providing an additional table with a break out between its internally- and externally-priced Level 3 assets and liabilities, followed by the quantitative input disclosures for material internally-priced items. Other insurers in the survey did not provide a clear reconciliation; however, most included a footnote explaining that the table had excluded fair value measurements obtained from pricing vendors or immaterial items. .21 Other content in the tables varied as well. The majority of companies included all of the elements provided in the ASUs example (i.e., the valuation technique, fair value at measurement date, details of the unobservable inputs, and ranges). However, a couple of
The sample is intended to be representative of the general population. However, the observations related to our sample may not be reflective of other entities within the same industry.
companies excluded certain components, such as the valuation technique or the fair value itself, from the table. These were instead disclosed elsewhere. In cases in which the fair value wasn't included in the significant input table, users had to refer to other footnote tables to determine the size of each balance. Further, we noted that without the benefit of the dollar amounts for each instrument, it would be unclear to users how the entire Level 3 balance had been addressed. .22 Some of the asset management companies excluded from the quantitative unobservable input disclosure investments valued using unadjusted broker quotes, thirdparty pricing, and those for which NAV was a practical expedient. While this resulted in a difference between the total Level 3 investment balance and the balance per the significant input table, noting the exclusions was useful in bridging the gap for the user. .23 One insurance company did not use a table at all. In that instance, the company used the third-party pricing exception for all of its Level 3 instruments; thus, it was not required to provide the unobservable input disclosures. PwC observation: The companies in our sample used a wide range of formats to present the tabular disclosure of significant unobservable inputs. Some companies followed the example provided in the ASU and other companies either supplemented the example or excluded certain items in the example when preparing their disclosures. We believe a leading practice is to provide a reconciliation from the various tables of quantitative data (i.e., from the significant unobservable input table back to the fair value hierarchy table), providing context as to the instruments excluded to help readers evaluate how all of the Level 3 assets and liabilities have been addressed. .24 Although the ASU does not prescribe the level of disaggregation required for the significant unobservable input disclosure, most financial institutions in our sample maintained the same class level of assets and liabilities disclosed in the fair value hierarchy table. The exception to this was real estate investments held by funds, for which a more detailed breakout was provided in the significant input table. Types and ranges of inputs .25 When analyzing the fair value techniques and inputs for similar asset classes among sampled companies, we observed similarities in fair value techniques and type of inputs for some of the most significant asset classes (e.g., RMBS), but that was not always the case. There were also inconsistencies in the range of inputs provided. .26 For example, in insurance, the range of loss severities was as wide as 56 percent for one insurance company, compared to 35 percent for another. Further, the range of prepayment speeds was as wide as 17 percent for one insurance company, compared to 7.5 percent for another. .27 In banking and capital markets, the loss severities input range for RMBS was as wide as about 90 percent for one company, compared to a narrower range of about 10 percent for another. The prepayment rate, another significant unobservable input for RMBS, was as wide as 40 percent for one company, compared to 7 percent for another. However, we did observe some level of consistency when companies provided weighted averages for this specific input. For example, for the two companies in the sample that disclosed the weighted average prepayment rate, they were only about 1 percent apart (around 6 percent versus 7 percent).
Dataline
PwC observation: Weighted average of the ranges of the unobservable inputs was commonly disclosed in the life and financial guaranty insurance sectors. However, it was not consistently disclosed in banking and capital markets, and very few in asset management, and no property and casualty companies in our population disclosed weighted averages. Given the wide ranges of inputs for certain of these companies, we believe it is a best practice to include the weighted average, or some other measure of the distribution, and to disclose the way in which it is calculated because such a measure will deemphasize the impact of outliers. Assuming like portfolios, inclusion of weighted averages will aid comparison among companies. .28 While it was common for life insurance companies to disclose weighted averages, these companies did not disclose weighted averages for the Level 3 embedded derivatives associated with their guaranteed minimum benefit ("GMxB") liabilities and there was no disclosure as to why this information was excluded. .29 Life insurance companies with GMxB liabilities described their valuation techniques as either using the discounted cash flow, option pricing model, or Monte Carlo simulation. The unobservable inputs disclosed in these valuations were similar, but not as consistent as we expected. The most common inputs disclosed were nonperformance risk, lapse, mortality, and volatility, and most disclosed utilization and withdrawal rates. One company also disclosed its dynamic lapse rate adjustment separately from its base lapse rate, and another, the wait period assumption. These two inputs were not disclosed by any of the other companies. PwC observation: Based on our examination of the inputs disclosed, no one input was consistently disclosed by all of the five life insurance companies. We expected all companies to disclose certain significant unobservable inputs for the embedded derivatives related to GMxB liabilities (e.g., volatility and lapse), but this was not the case for the companies in our population. .30 The ranges disclosed by life insurance companies for each of the GMxB inputs also varied. Some were as narrow as less than 1 percent and others as wide as 80 percent. Perhaps to address this, one company disaggregated its mortality and utilization rates by age groups and duration, respectively. To further break down the classes into smaller groups may aid readers with comparison of multiple companies. .31 In asset management too, except for the discount rate and earnings multiples for private equity investments, the unobservable inputs disclosed by companies varied both in type and quantity. .32 The following table shows the number of times certain inputs appeared in the quantitative table of significant unobservable inputs compared to the number of companies that hold selected products. For example, of the 15 companies that hold RMBS, 13 disclosed prepayment speed as a significant unobservable input.
Dataline
Inputs appearing in quantitative table of significant unobservable inputs
Residential mortgage-backed securities (RMBS)

Prepayment speed/rate 13 of 15 Default rates 11 of 15 Loss severities 12 of 15 Spread over the benchmark or discount rate 7 of 15 Other (7 inputs) < 3 of 15
Commercial mortgage-backed securities (CMBS)

Prepayment speed/rate Default rates Loss severities Spread over the benchmark or discount rate 3 of 11 Other (9 inputs)
Volatility
Yield
6 of 11
3 of 11
5 of 11
4 of 11
5 of 11
< 1 of 11
Interest rate derivatives

Correlation 5 of 8 Volatility 7 of 8 Long dated inflation rates 2 of 8 Long dated inflation volatility 2 of 8 Long dated swap rates 2 of 8 Other (10 inputs) 1 of 8
Guaranteed minimum benefit (GMxB)

Base lapse 4 of 5 Mortality 4 of 5 Utilization 3 of 5 Non performance risk 4 of 5 Withdrawal rate 3 of 5 Other (2 inputs) 1 of 5
.33 An area of much disparity in the banking and insurance industries was the disclosure of items measured at fair value on a non-recurring basis. Some banks included a fair value hierarchy for items measured at fair value on a non-recurring basis, which for the most part included loans held for sale and other real estate owned. However, not all included the required tabular disclosure of significant unobservable inputs for such items. For those banks that included the table, there was not a clear and consistent trend on the range or type of inputs. In our insurance sample, most insurers were either silent or disclosed that there were no non- recurring fair value measurements. Those that included the disclosure, which were mainly for their mortgage loans, did so in a narrative format. They did not utilize the table nor disclose ranges of the unobservable inputs. Third-party pricing exception .34 As noted above, the ASU permits companies to not disclose the quantitative information about unobservable inputs for valuations provided by a third party that are unadjusted. While most insurers disclosed some use of the third-party pricing exception, most banking and capital markets companies were silent regarding the exception. In banking and capital markets, only a few companies noted in their disclosures that they had used the third-party exception and quantified the fair value of financial instruments related to it.
.35 There were a few financial institutions that obtained pricing information from thirdparty services but did not use the third-party pricing exception. They disclosed the input information given to them by the third parties, some for the entire Level 3 portfolio priced by the vendors and others for a portion of the portfolio. PwC observation: It was not evident from some of the disclosures if banking and capital markets companies applied the third-party exception. Companies may consider disclosing, along with the significant unobservable input tabular disclosure, their use of the third-party exception, the fair value of financial instruments under this exception, and the controls over third-party pricing information. For broker quotes and third-party valuations, companies should ensure each reporting period that they update their understanding of and evaluate the accessibility of underlying data. .36 We also focused on the internal control disclosures for each company, looking for expanded internal control discussions related to the use of third-party pricing. It appeared that only the insurance company that applied the exception to its entire Level 3 portfolio included significant new expanded disclosure of its procedures and controls. Financial instruments for which fair value is only disclosed .37 For the new fair value hierarchy disclosure requirements for financial instruments for which fair value is only disclosed, we observed consistent trends in fair value hierarchy for significant balances that are typical in banking (e.g., loans and deposits). For example, loans were usually classified as Level 3, although they were sometimes in Level 2. Deposits were primarily classified as Level 2. .38 Most financial institutions in our survey that held debt disclosed their fair values consistently. They were primarily within Level 2, and sometimes in Level 3, of the fair value hierarchy. Other observations .39 With regard to consolidated variable interest entities, the majority of companies in asset management and all in banking and insurance included the applicable instruments held in these vehicles in the overall ASU disclosures. PwC observation: It is not uncommon for the accounting related to consolidated investment vehicles to be performed by departments outside of corporate accounting. Therefore, from an operational perspective, companies should ensure proper awareness of the ASU across the organization. They should also ensure that appropriate controls have been established to address the new reporting, and that adequate time is built into the reporting process to collect, report and review the disclosure and underlying data.
Qualitative disclosures .40 Only a few financial institutions appear to have expanded or added new disclosures on valuation methodologies or techniques as a result of adopting the ASU. There were, however, a few companies in the insurance industry that incorporated some new disclosures about policies, guidelines and additional information on internal reporting procedures, (e.g., audit committee review of the fair value measurement).
Dataline 10
PwC observation: We expected that the ASU might have prompted some companies to increase disclosures about their policies on fair value measurements. As we noted, only a few companies in our sample expanded their disclosures, presumably as a result of the new requirements. Some others, particularly financial guaranty companies, had already been through extensive reviews. Many financial guaranty companies had received SEC comment letters in prior years requesting more robust disclosures about valuation methodologies, inputs, and assumptions used in establishing fair values for certain Level 3 assets and liabilities. The SEC had also asked these registrants to disclose the impact of changes in key assumptions in their valuation models. Thus, most of those companies have already been including many of the new required disclosures. .41 With regards to the qualitative disclosure about sensitivity of significant unobservable inputs, we observed that the level of detail varied. Some companies provided disclosure of sensitivity for each input by instrument and also disclosed interrelationships. However, most followed the example language contained in the ASU, which was not very detailed. Also, most companies did not disclose interrelationships between two or more inputs, although one disclosed that they did not expect there to be any interrelationships. PwC observation: We expected more detailed disclosure of the sensitivities of the significant inputs, along with "description[s] of the interrelationships" between and among the significant unobservable inputs and "how [the interrelationships] might magnify or mitigate the effect of changes in the unobservable inputs on the fair value 9 measurement." This provides useful information to the reader about the types of market movements that would cause the fair value measurements to change significantly and in what direction.
Other disclosures .42 With regard to disclosures of transfers between Level 1 and Level 2, practice was very mixed in the financial services industry. Some disclosed that transfers occurred, the reasons for the transfers, and the dollar amount of instruments transferred by class. Others provided less disclosure, including not disclosing the transfers by class, or were silent on transfers altogether. Other industries .43 This category included a sample of one conglomerate, one manufacturer, two utilities, one energy company, one agricultural retailer, and one real estate investment trust. Based on our analysis, the ASU did not appear to significantly impact other industries, wherein companies often dont hold significant Level 3 assets or liabilities. While the companies selected are from different industries, certain trends were noted in their fair value disclosures.
ASC 820 BC 96
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Disclosure Quantitative disclosures .44 As expected, there was a wide variety of Level 3 investments subject to the new disclosures in these industries. They ranged from properties held for sale to commodity derivatives. As such, the significant unobservable inputs varied, but in many cases, there was only one significant unobservable input disclosed for each product. PwC observation: The fact that many only disclosed one significant unobservable input raises the question of how companies determined which unobservable inputs were "significant." Companies only have to identify one significant unobservable input to conclude the asset or liability should be classified in Level 3. The new disclosure requirements, however, require companies to disclose quantitative information about all significant unobservable inputs. In one instance, a company disclosed that the instrument was classified as Level 3 "due to a significant number of unobservable inputs." Yet, only two unobservable inputs appeared in the quantitative disclosure. .45 Similar to the financial services industry, there was disparity in how these companies disclosed the quantitative information about Level 3 fair value measurements. Most followed the tabular disclosure provided as an example in the ASU, but usually without totals. Furthermore, none of the sampled entities supplemented the example in the ASU with a reconciliation or note explaining how the amounts in the significant unobservable input tabular disclosure reconciled to the fair value hierarchy disclosure. In one case, a company provided some information to get close to the balance in the fair value hierarchy table, but there was no direct reconciliation, requiring readers to "do the math." Sometimes, amounts in the unobservable input table matched those in the fair value hierarchy table so no reconciliation was necessary. Other times, there was only a small amount of Level 3 instruments. Nonetheless, in general, it was difficult to determine whether the entire balances had been addressed. PwC observation: Not all companies in this sample included the significant unobservable inputs in tabular format. While in these cases there were only a small number of instruments categorized as Level 3, a table is still explicitly required by the ASU. .46 In this sample, only two companies, one real estate company and one conglomerate, used the third-party pricing exception. The 10-Q filing of the conglomerate referred the reader to the year-end filing for information regarding the description of the process used to evaluate third-party pricing services. We had expected to see increased discussion of control procedures over the use of third-party vendors, but in this case, the standard disclosures weren't supplemented. PwC observation: The use of the third-party pricing exception for real estate was unexpected, since real estate appraisals from third-party vendors generally provide the information necessary to complete the ASU's required disclosures. ASC 820-10-50-2(bbb) states, in part, "a reporting entity cannot ignore quantitative unobservable inputs that are significant to the fair value measurement and are reasonably available to the reporting entity." One real estate fund did provide the quantitative unobservable input disclosures even though the appraisals had been prepared by third-party pricing services. In fact, that company went further, describing in detail the process by which the company evaluates, and if necessary, corroborates and adjusts the thirdparty information.
As noted in the "Financial services industry" section above, for broker quotes and third-party valuations, companies should ensure each reporting period that they update their understanding of and evaluate the accessibility of underlying data. .47 For the new fair value hierarchy disclosure requirements for financial instruments for which fair value is only disclosed, we observed results consistent with the financial services industry for debt instruments. Most short-term and long-term debt was categorized as Level 2, although certain instruments were categorized as Level 3 and in limited cases, short-term borrowings were categorized as Level 1. Qualitative disclosures .48 There was diversity in the sample in how much detail companies provided in the disclosures of policies related to fair value measurements. In general, we noted that companies included "a description of the valuation processes" in place, as required by ASC 820-10-55-105. However, we noted limited instances in which companies significantly expanded their disclosures of policies, guidelines and additional information on internal reporting procedures, as suggested in ASC 820-10-55-105. .49 Practice was also mixed for the qualitative sensitivity analyses. In most cases, these analyses were not included or provided limited information. Only a few companies disclosed how a change in each significant input would impact the valuation, as required by the guidance. PwC observation: As noted in the Financial services industry section above, companies have an opportunity with these sensitivity disclosures to provide useful information to users about the types of market movements that would cause the fair value measurements to significantly change and in what direction.
Other disclosures .50 Finally, PwC noted no instances in which companies disclosed that the highest and best use of a nonfinancial asset differed from its current use. PwC observation: While this disclosure could be important in certain circumstances, we expect it to be infrequent. The nonfinancial asset would have to be measured at fair value (e.g., if it were held for sale) and the fair value would have to be higher if it were used in a different form than in its current form. Also, the entire difference would have to be material to the financial statement line item. As such, we are not surprised that there were no instances of this disclosure in our sample.
Questions
.51 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact their designated SEC Services consultant (if applicable), any member of the SEC Services group, or a member of the Financial Instruments team in the National Professional Services Group (1-973236-7803).
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Authored by:
Jill Butler Partner Phone: 1-973-236-4678 Email: jill.butler@us.pwc.com Rob Enticott Partner Phone: 1-973-236-4903 Email: rob.enticott@us.pwc.com Christopher Gerdau Partner Phone: 1-973-236-5010 Email: christopher.gerdau@us.pwc.com Mia DeMontigny Managing Director Phone: 1-973-236-4012 Email: mia.demontigny@us.pwc.com Maria Constantinou Director Phone: 1-973-236-4759 Email: maria.constantinou@us.pwc.com Ryan Folscroft Senior Manager (Asset Management) Phone: 1-973-236-5029 Email: ryan.j.folscroft@us.pwc.com Jose Martinez-Godas Senior Manager (Banking & Capital Markets) Phone: 1-973-236-7148 Email: jose.martinez-godas@us.pwc.com Andrea Selvaraja Senior Manager (Insurance) Phone: 1-973-236-4968 Email: andrea.h.selvaraja@us.pwc.com

New fair value measurement standard Adoption of the new guidance: First quarter 2012 measurement and disclosure observations
Overview
At a glance In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU). The ASU primarily clarifies existing fair value measurement guidance and is intended to align U.S. GAAP and IFRS. Additionally, the guidance requires several new disclosures. The guidance was effective for interim and annual periods beginning after December 15, 2011 for public companies and for annual periods beginning after 1 December 15, 2011 for nonpublic entities. For most public companies, the quarter ended March 31, 2012 was the first period the guidance in the ASU was effective. This Dataline provides observations on how the guidance was implemented by a sample of 37 companies to identify leading practices and points of interest to assist reporting entities as they develop their future fair value disclosures. The companies we sampled are from a variety of industries, including (1) financial services banking and capital markets, asset management, and insurance, and (2) other industries - utilities, energy, manufacturing, and real estate.

Key observations .............4
Overall observations all industries.............................. 4 Financial services industry .... 6 Other industries ..................... 11
Questions ....................... 13
The FASB is currently deliberating fair value disclosure requirements for nonpublic entities as a separate project.
Background .1 The FASB's summary of the ASU states: "the Board does not intend for the amendments in this Update to result in a change in the application of these requirements of Topic 820." As a result, PwC anticipated the changes in practice under U.S. GAAP to be primarily disclosure-related, since the ASU requires expanded disclosures about the fair value of financial instruments, particularly for public companies. .2 Dataline 2012-02, New fair value measurement standard Implementation guidance for new disclosure requirements, includes a series of questions and answers providing implementation guidance on selected new disclosure requirements. Also, PwC's Guide to Accounting for Fair Value Measurements, 2012 edition, includes a chapter dedicated to fair value disclosures (FV 5). For general information about the ASU, see Dataline 2011-31, New fair value measurement standard Implementation guidance for key changes to the measurement of financial instruments at fair value , and Dataline 2011-23, Fair value measurement FASB and IASB complete joint project. Measurement .3 There were certain areas in which the ASU could have resulted in significant measurement changes for financial instruments. These include the application of premiums and discounts, the valuation of financial instruments with offsetting market and credit risks, and potential changes in the determination of the principal markets. However, PwC has observed only limited disclosures about changes in measurement both within our sample and more broadly. .4 For example, in one case, a financial institution discontinued applying a discount due to the size of its position, and as a result, increased the related fair value measurement. In another case, a financial institution changed the principal market for some instruments, which resulted in a valuation difference on those instruments. PwC observation: As expected, we have not observed that the ASU has caused widespread changes in fair value measurements. While there may be other situations besides the two noted above, our analysis suggests that measurement changes are not prevalent. Consequently, this Dataline focuses on companies' application of the new disclosure requirements.
Disclosure .5 The following are the new disclosures required by the ASU, the most significant of which relate to Level 3 fair value measurements (measurements based on significant, unobservable inputs): For all Level 3 fair value measurements (recurring and non-recurring) by class of assets and liabilities: Quantitative information about significant unobservable inputs used. The ASU does not provide specific guidance on what quantitative information is required; however, an example of what a reporting entity may consider disclosing related 2 to assets is included in the ASU .
Refer to ASC 820-10-55-103 through 55-104.

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A qualitative description of the valuation process in place for both recurring and 3 nonrecurring Level 3 fair value measurements. The guidance indicates that this might include the group responsible for valuation, to whom the group reports, the internal reporting procedures in place, as well as the methods to calibrate and test the models and the frequency of testing. Other disclosures could include the process for analyzing changes in fair value from period to period, what methods are used to develop and substantiate unobservable inputs, and what controls are in place over third-party pricing services, particularly if the 4 company avails itself of the third-party pricing exception . Qualitative discussion about the sensitivity of inputs used in recurring Level 3 fair value measurements. Further, to the extent there are interrelationships between the various unobservable inputs used in the fair value measurement, such interrelationships and the potential impact on sensitivity should also be disclosed. Note that the guidance does not require a quantitative disclosure about sensitivity; therefore, entities are not required to provide specific amounts or quantify the potential changes in the inputs or the fair value measurements. For Level 2 recurring and non-recurring fair value measurements, a qualitative 5 description of the valuation technique(s) and inputs used must be provided. Any transfers between Level 1 and Level 2 fair value measurements on a gross basis, by class, including the reasons for those transfers must be disclosed. Previously, companies were required to disclose only significant transfers. All fair value measurements must now be disclosed by fair value hierarchy level. As a result, public companies are now required to determine the level in the fair value hierarchy of financial assets and liabilities that are not recorded at fair value but for which fair value is disclosed (for example, long-term debt recorded at amortized cost). Use of the exception for measuring certain financial instruments with offsetting market and credit risks as a portfolio as described in ASC 820-10-35-18D (the 6 "portfolio exception") must be disclosed. If the highest and best use of a nonfinancial asset differs from its current use by the entity, the entity is now required to disclose the reason(s) the asset is being used differently. .6 PwC analyzed the March 31, 2012 Form 10-Q filings of 37 public companies (30 within financial services industries and 7 within other industries) that adopted the ASU and considered the following questions: How were all of the new disclosures presented? Did preparers follow the examples given in the ASU? Was the information presented in a logical, comprehensible way?
3 4
ASC 820-10-55-105 ASC 820-10-50-2(bbb) allows a reporting entity to omit certain quantitative disclosures about unobservable inputs that are not developed by the reporting entity (e.g., prices from prior transactions or obtained from thirdparty pricing sources). It should be noted that the qualitative sensitivity disclosures for such inputs may still be required by ASC 820-10-50-2(g), even if the exception for the quantitative disclosure is elected. 5 ASC 820-10-50-2(bbb) 6 ASC 820-10-50-2D
Did companies in a particular industry and across all industries address the required disclosures similarly? Were the same instruments disclosed the same way by different companies within an industry and across all industries observed? For example, companies in multiple industries held asset-backed securities of various kinds at March 31, 2012. Were the significant unobservable inputs and valuation methods disclosed in the same way for all companies? Was the level of disaggregation in the quantitative unobservable inputs table consistent within an industry and across all industries? For example, did entities presenting the fair value of corporate bonds disaggregate them similarly? Did companies avail themselves of the exception for valuations provided by thirdparty pricing services? If so, did they increase disclosures of the controls the company has in place over third-party valuations? Did disclosures about financial instruments not measured at fair value, but for which fair value is disclosed change?
Key observations
Overall observations all industries .7 PwC's review resulted in some overall observations, which are discussed in more detail in later sections. Quantitative disclosures .8 PwC observed that most companies included the new quantitative disclosures required by the ASU. However, the information was not always comprehensive and at times, it was somewhat difficult to follow. For many large companies, there was a significant effort involved in gathering information to complete the new disclosures. As a result, initial disclosures were likely focused on substantial compliance, rather than readability. PwC observation: We believe that in subsequent reporting periods, reporting entities will continue to refine their disclosures. With additional time, preparers could make the information more organized and comprehensible to readers, resulting in more effective disclosures. They may adjust the ways in which they present information, including possibly disclosing more information to the extent it provides readers a clearer picture of the company's fair value measurements. Further, companies will likely use comments from the Securities and Exchange Commission (SEC) staff, questions from analysts, as well as their own analyses of others' disclosures, to gain insights about disclosures that are most meaningful for their financial statement users. It is worth noting that ASC 820-10-50-1A directs preparers to present all material information needed to give readers a clear picture of the company's fair value measurements, regardless of the specific requirements of ASC 820. .9 We noted that companies were not always clear in their disclosures about what was excluded from the quantitative tables of significant unobservable inputs for Level 3 assets and liabilities when compared to the fair value hierarchy tables.
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.10 Another area lacking consistency was the inclusion of ranges and weighted averages of significant unobservable inputs. .11 We expected to see commonality in the significant unobservable inputs disclosures within and across industries for the more common Level 3 instruments. However, we noted only a few common Level 3 instruments (e.g., residential mortgage-backed securities or "RMBS") and even then, there was limited consistency in the inputs disclosed. .12 About half of the companies in our sample elected the third-party pricing exception for all or a part of their Level 3 portfolios. Consequently, they did not provide the quantitative disclosures about unobservable inputs related to the applicable instruments. PwC observation: Some preparers may have applied the third-party pricing exception despite some level of data being provided by their pricing services. This is likely because the information was provided relatively late in the closing process, thereby not providing companies sufficient time to validate the information and implement appropriate controls for inclusion in the footnote disclosure. The use of broker quotes and third-party pricing services for both Level 2 and Level 3 instruments is a particular area of focus for the SEC. The SEC expects management to take responsibility for all fair value measurements even when those measurements are not developed by the entity. During the 2011 AICPA National Conference on Current SEC and PCAOB Developments held in December 2011, both the SEC and Public Company Accounting Oversight Board (PCAOB) reiterated managements responsibilities in this area. Management should consider these expectations when evaluating whether an unobservable input qualifies for the above-mentioned exception. In instances in which the third-party pricing exception is appropriate, preparers should consider disclosing the controls over their review of the third-party 7 valuations. It is possible that as more preparers request more detailed information from their third-party pricing vendors, use of this exception may become more infrequent over time. Already, some pricing services have provided input information and others are expected to soon follow suit. .13 For companies with Level 3 liabilities or equity, we noted diversity in practice regarding whether they included nonperformance risk (i.e., their own credit) as a significant input. .14 With respect to the qualitative disclosures, including descriptions of companies policies for fair value measurements and the sensitivity analyses of Level 3 instruments, we observed limited meaningful disclosure of the interrelationships between and among the significant unobservable inputs. .15 In general, the disclosures were more in-depth for companies in the financial services industry. However, given the focus on financial instruments in the ASU, such entities were more likely to be impacted due to the nature of the instruments they hold.
ASC 820-10-55-105(d)
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Financial services industry .16 For the financial services industry survey, PwC selected 30 public companies with significant Level 3 financial instruments. The sample included ten banking and capital markets companies, eight corporate asset managers, two funds, and ten insurance companies. Within insurance, to ensure that subsectors were represented, we selected 8 three property and casualty, two financial guaranty, and five life insurance companies. Measurement .17 As noted above, very few companies reported that the ASU had an impact on their fair value measurements. Further, only two companies in the sample, both in the banking and capital markets industry, disclosed that they used the portfolio exception. However, only one of those explicitly disclosed that this exception was taken as the result of an accounting policy election, as required by the ASU. PwC observation: For most companies in the sample, it was not evident if they applied the portfolio exception. PwC expected more widespread use of the portfolio exception by financial institutions, particularly those in the banking and capital markets industry, and consequently more disclosure of its use.
Disclosure .18 The examination of Form 10-Q filings for financial institutions revealed different levels of granularity in the new disclosures. Disclosures ranged from minimal discussion without the required tabular presentation of significant unobservable inputs, to more detailed and robust tabular and narrative disclosures. Quantitative disclosures .19 For the new required table of significant unobservable inputs, we observed that most companies in our sample disclosed the inputs in a tabular format that was largely consistent with the example provided in the ASU. However, only a limited number of companies included a reconciliation or a note explaining how the amounts in the significant unobservable input table reconciled to the fair value hierarchy table. Some companies supplemented the example by including totals and/or subtotal balances that could be helpful as users reconcile the quantitative data. Although not required, a reconciliation is useful to financial statement users in determining how all of the instruments in the fair value hierarchy table have been addressed in the significant input table. .20 In our survey, there was also one insurance company that reconciled the significant input totals back to the fair value hierarchy table by providing an additional table with a break out between its internally- and externally-priced Level 3 assets and liabilities, followed by the quantitative input disclosures for material internally-priced items. Other insurers in the survey did not provide a clear reconciliation; however, most included a footnote explaining that the table had excluded fair value measurements obtained from pricing vendors or immaterial items. .21 Other content in the tables varied as well. The majority of companies included all of the elements provided in the ASUs example (i.e., the valuation technique, fair value at measurement date, details of the unobservable inputs, and ranges). However, a couple of
The sample is intended to be representative of the general population. However, the observations related to our sample may not be reflective of other entities within the same industry.
companies excluded certain components, such as the valuation technique or the fair value itself, from the table. These were instead disclosed elsewhere. In cases in which the fair value wasn't included in the significant input table, users had to refer to other footnote tables to determine the size of each balance. Further, we noted that without the benefit of the dollar amounts for each instrument, it would be unclear to users how the entire Level 3 balance had been addressed. .22 Some of the asset management companies excluded from the quantitative unobservable input disclosure investments valued using unadjusted broker quotes, thirdparty pricing, and those for which NAV was a practical expedient. While this resulted in a difference between the total Level 3 investment balance and the balance per the significant input table, noting the exclusions was useful in bridging the gap for the user. .23 One insurance company did not use a table at all. In that instance, the company used the third-party pricing exception for all of its Level 3 instruments; thus, it was not required to provide the unobservable input disclosures. PwC observation: The companies in our sample used a wide range of formats to present the tabular disclosure of significant unobservable inputs. Some companies followed the example provided in the ASU and other companies either supplemented the example or excluded certain items in the example when preparing their disclosures. We believe a leading practice is to provide a reconciliation from the various tables of quantitative data (i.e., from the significant unobservable input table back to the fair value hierarchy table), providing context as to the instruments excluded to help readers evaluate how all of the Level 3 assets and liabilities have been addressed. .24 Although the ASU does not prescribe the level of disaggregation required for the significant unobservable input disclosure, most financial institutions in our sample maintained the same class level of assets and liabilities disclosed in the fair value hierarchy table. The exception to this was real estate investments held by funds, for which a more detailed breakout was provided in the significant input table. Types and ranges of inputs .25 When analyzing the fair value techniques and inputs for similar asset classes among sampled companies, we observed similarities in fair value techniques and type of inputs for some of the most significant asset classes (e.g., RMBS), but that was not always the case. There were also inconsistencies in the range of inputs provided. .26 For example, in insurance, the range of loss severities was as wide as 56 percent for one insurance company, compared to 35 percent for another. Further, the range of prepayment speeds was as wide as 17 percent for one insurance company, compared to 7.5 percent for another. .27 In banking and capital markets, the loss severities input range for RMBS was as wide as about 90 percent for one company, compared to a narrower range of about 10 percent for another. The prepayment rate, another significant unobservable input for RMBS, was as wide as 40 percent for one company, compared to 7 percent for another. However, we did observe some level of consistency when companies provided weighted averages for this specific input. For example, for the two companies in the sample that disclosed the weighted average prepayment rate, they were only about 1 percent apart (around 6 percent versus 7 percent).
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PwC observation: Weighted average of the ranges of the unobservable inputs was commonly disclosed in the life and financial guaranty insurance sectors. However, it was not consistently disclosed in banking and capital markets, and very few in asset management, and no property and casualty companies in our population disclosed weighted averages. Given the wide ranges of inputs for certain of these companies, we believe it is a best practice to include the weighted average, or some other measure of the distribution, and to disclose the way in which it is calculated because such a measure will deemphasize the impact of outliers. Assuming like portfolios, inclusion of weighted averages will aid comparison among companies. .28 While it was common for life insurance companies to disclose weighted averages, these companies did not disclose weighted averages for the Level 3 embedded derivatives associated with their guaranteed minimum benefit ("GMxB") liabilities and there was no disclosure as to why this information was excluded. .29 Life insurance companies with GMxB liabilities described their valuation techniques as either using the discounted cash flow, option pricing model, or Monte Carlo simulation. The unobservable inputs disclosed in these valuations were similar, but not as consistent as we expected. The most common inputs disclosed were nonperformance risk, lapse, mortality, and volatility, and most disclosed utilization and withdrawal rates. One company also disclosed its dynamic lapse rate adjustment separately from its base lapse rate, and another, the wait period assumption. These two inputs were not disclosed by any of the other companies. PwC observation: Based on our examination of the inputs disclosed, no one input was consistently disclosed by all of the five life insurance companies. We expected all companies to disclose certain significant unobservable inputs for the embedded derivatives related to GMxB liabilities (e.g., volatility and lapse), but this was not the case for the companies in our population. .30 The ranges disclosed by life insurance companies for each of the GMxB inputs also varied. Some were as narrow as less than 1 percent and others as wide as 80 percent. Perhaps to address this, one company disaggregated its mortality and utilization rates by age groups and duration, respectively. To further break down the classes into smaller groups may aid readers with comparison of multiple companies. .31 In asset management too, except for the discount rate and earnings multiples for private equity investments, the unobservable inputs disclosed by companies varied both in type and quantity. .32 The following table shows the number of times certain inputs appeared in the quantitative table of significant unobservable inputs compared to the number of companies that hold selected products. For example, of the 15 companies that hold RMBS, 13 disclosed prepayment speed as a significant unobservable input.
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Inputs appearing in quantitative table of significant unobservable inputs
Residential mortgage-backed securities (RMBS)

Prepayment speed/rate 13 of 15 Default rates 11 of 15 Loss severities 12 of 15 Spread over the benchmark or discount rate 7 of 15 Other (7 inputs) < 3 of 15
Commercial mortgage-backed securities (CMBS)

Prepayment speed/rate Default rates Loss severities Spread over the benchmark or discount rate 3 of 11 Other (9 inputs)
Volatility
Yield
6 of 11
3 of 11
5 of 11
4 of 11
5 of 11
< 1 of 11
Interest rate derivatives

Correlation 5 of 8 Volatility 7 of 8 Long dated inflation rates 2 of 8 Long dated inflation volatility 2 of 8 Long dated swap rates 2 of 8 Other (10 inputs) 1 of 8
Guaranteed minimum benefit (GMxB)

Base lapse 4 of 5 Mortality 4 of 5 Utilization 3 of 5 Non performance risk 4 of 5 Withdrawal rate 3 of 5 Other (2 inputs) 1 of 5
.33 An area of much disparity in the banking and insurance industries was the disclosure of items measured at fair value on a non-recurring basis. Some banks included a fair value hierarchy for items measured at fair value on a non-recurring basis, which for the most part included loans held for sale and other real estate owned. However, not all included the required tabular disclosure of significant unobservable inputs for such items. For those banks that included the table, there was not a clear and consistent trend on the range or type of inputs. In our insurance sample, most insurers were either silent or disclosed that there were no non- recurring fair value measurements. Those that included the disclosure, which were mainly for their mortgage loans, did so in a narrative format. They did not utilize the table nor disclose ranges of the unobservable inputs. Third-party pricing exception .34 As noted above, the ASU permits companies to not disclose the quantitative information about unobservable inputs for valuations provided by a third party that are unadjusted. While most insurers disclosed some use of the third-party pricing exception, most banking and capital markets companies were silent regarding the exception. In banking and capital markets, only a few companies noted in their disclosures that they had used the third-party exception and quantified the fair value of financial instruments related to it.
.35 There were a few financial institutions that obtained pricing information from thirdparty services but did not use the third-party pricing exception. They disclosed the input information given to them by the third parties, some for the entire Level 3 portfolio priced by the vendors and others for a portion of the portfolio. PwC observation: It was not evident from some of the disclosures if banking and capital markets companies applied the third-party exception. Companies may consider disclosing, along with the significant unobservable input tabular disclosure, their use of the third-party exception, the fair value of financial instruments under this exception, and the controls over third-party pricing information. For broker quotes and third-party valuations, companies should ensure each reporting period that they update their understanding of and evaluate the accessibility of underlying data. .36 We also focused on the internal control disclosures for each company, looking for expanded internal control discussions related to the use of third-party pricing. It appeared that only the insurance company that applied the exception to its entire Level 3 portfolio included significant new expanded disclosure of its procedures and controls. Financial instruments for which fair value is only disclosed .37 For the new fair value hierarchy disclosure requirements for financial instruments for which fair value is only disclosed, we observed consistent trends in fair value hierarchy for significant balances that are typical in banking (e.g., loans and deposits). For example, loans were usually classified as Level 3, although they were sometimes in Level 2. Deposits were primarily classified as Level 2. .38 Most financial institutions in our survey that held debt disclosed their fair values consistently. They were primarily within Level 2, and sometimes in Level 3, of the fair value hierarchy. Other observations .39 With regard to consolidated variable interest entities, the majority of companies in asset management and all in banking and insurance included the applicable instruments held in these vehicles in the overall ASU disclosures. PwC observation: It is not uncommon for the accounting related to consolidated investment vehicles to be performed by departments outside of corporate accounting. Therefore, from an operational perspective, companies should ensure proper awareness of the ASU across the organization. They should also ensure that appropriate controls have been established to address the new reporting, and that adequate time is built into the reporting process to collect, report and review the disclosure and underlying data.
Qualitative disclosures .40 Only a few financial institutions appear to have expanded or added new disclosures on valuation methodologies or techniques as a result of adopting the ASU. There were, however, a few companies in the insurance industry that incorporated some new disclosures about policies, guidelines and additional information on internal reporting procedures, (e.g., audit committee review of the fair value measurement).
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PwC observation: We expected that the ASU might have prompted some companies to increase disclosures about their policies on fair value measurements. As we noted, only a few companies in our sample expanded their disclosures, presumably as a result of the new requirements. Some others, particularly financial guaranty companies, had already been through extensive reviews. Many financial guaranty companies had received SEC comment letters in prior years requesting more robust disclosures about valuation methodologies, inputs, and assumptions used in establishing fair values for certain Level 3 assets and liabilities. The SEC had also asked these registrants to disclose the impact of changes in key assumptions in their valuation models. Thus, most of those companies have already been including many of the new required disclosures. .41 With regards to the qualitative disclosure about sensitivity of significant unobservable inputs, we observed that the level of detail varied. Some companies provided disclosure of sensitivity for each input by instrument and also disclosed interrelationships. However, most followed the example language contained in the ASU, which was not very detailed. Also, most companies did not disclose interrelationships between two or more inputs, although one disclosed that they did not expect there to be any interrelationships. PwC observation: We expected more detailed disclosure of the sensitivities of the significant inputs, along with "description[s] of the interrelationships" between and among the significant unobservable inputs and "how [the interrelationships] might magnify or mitigate the effect of changes in the unobservable inputs on the fair value 9 measurement." This provides useful information to the reader about the types of market movements that would cause the fair value measurements to change significantly and in what direction.
Other disclosures .42 With regard to disclosures of transfers between Level 1 and Level 2, practice was very mixed in the financial services industry. Some disclosed that transfers occurred, the reasons for the transfers, and the dollar amount of instruments transferred by class. Others provided less disclosure, including not disclosing the transfers by class, or were silent on transfers altogether. Other industries .43 This category included a sample of one conglomerate, one manufacturer, two utilities, one energy company, one agricultural retailer, and one real estate investment trust. Based on our analysis, the ASU did not appear to significantly impact other industries, wherein companies often dont hold significant Level 3 assets or liabilities. While the companies selected are from different industries, certain trends were noted in their fair value disclosures.
ASC 820 BC 96
Dataline 11
Disclosure Quantitative disclosures .44 As expected, there was a wide variety of Level 3 investments subject to the new disclosures in these industries. They ranged from properties held for sale to commodity derivatives. As such, the significant unobservable inputs varied, but in many cases, there was only one significant unobservable input disclosed for each product. PwC observation: The fact that many only disclosed one significant unobservable input raises the question of how companies determined which unobservable inputs were "significant." Companies only have to identify one significant unobservable input to conclude the asset or liability should be classified in Level 3. The new disclosure requirements, however, require companies to disclose quantitative information about all significant unobservable inputs. In one instance, a company disclosed that the instrument was classified as Level 3 "due to a significant number of unobservable inputs." Yet, only two unobservable inputs appeared in the quantitative disclosure. .45 Similar to the financial services industry, there was disparity in how these companies disclosed the quantitative information about Level 3 fair value measurements. Most followed the tabular disclosure provided as an example in the ASU, but usually without totals. Furthermore, none of the sampled entities supplemented the example in the ASU with a reconciliation or note explaining how the amounts in the significant unobservable input tabular disclosure reconciled to the fair value hierarchy disclosure. In one case, a company provided some information to get close to the balance in the fair value hierarchy table, but there was no direct reconciliation, requiring readers to "do the math." Sometimes, amounts in the unobservable input table matched those in the fair value hierarchy table so no reconciliation was necessary. Other times, there was only a small amount of Level 3 instruments. Nonetheless, in general, it was difficult to determine whether the entire balances had been addressed. PwC observation: Not all companies in this sample included the significant unobservable inputs in tabular format. While in these cases there were only a small number of instruments categorized as Level 3, a table is still explicitly required by the ASU. .46 In this sample, only two companies, one real estate company and one conglomerate, used the third-party pricing exception. The 10-Q filing of the conglomerate referred the reader to the year-end filing for information regarding the description of the process used to evaluate third-party pricing services. We had expected to see increased discussion of control procedures over the use of third-party vendors, but in this case, the standard disclosures weren't supplemented. PwC observation: The use of the third-party pricing exception for real estate was unexpected, since real estate appraisals from third-party vendors generally provide the information necessary to complete the ASU's required disclosures. ASC 820-10-50-2(bbb) states, in part, "a reporting entity cannot ignore quantitative unobservable inputs that are significant to the fair value measurement and are reasonably available to the reporting entity." One real estate fund did provide the quantitative unobservable input disclosures even though the appraisals had been prepared by third-party pricing services. In fact, that company went further, describing in detail the process by which the company evaluates, and if necessary, corroborates and adjusts the thirdparty information.
As noted in the "Financial services industry" section above, for broker quotes and third-party valuations, companies should ensure each reporting period that they update their understanding of and evaluate the accessibility of underlying data. .47 For the new fair value hierarchy disclosure requirements for financial instruments for which fair value is only disclosed, we observed results consistent with the financial services industry for debt instruments. Most short-term and long-term debt was categorized as Level 2, although certain instruments were categorized as Level 3 and in limited cases, short-term borrowings were categorized as Level 1. Qualitative disclosures .48 There was diversity in the sample in how much detail companies provided in the disclosures of policies related to fair value measurements. In general, we noted that companies included "a description of the valuation processes" in place, as required by ASC 820-10-55-105. However, we noted limited instances in which companies significantly expanded their disclosures of policies, guidelines and additional information on internal reporting procedures, as suggested in ASC 820-10-55-105. .49 Practice was also mixed for the qualitative sensitivity analyses. In most cases, these analyses were not included or provided limited information. Only a few companies disclosed how a change in each significant input would impact the valuation, as required by the guidance. PwC observation: As noted in the Financial services industry section above, companies have an opportunity with these sensitivity disclosures to provide useful information to users about the types of market movements that would cause the fair value measurements to significantly change and in what direction.
Other disclosures .50 Finally, PwC noted no instances in which companies disclosed that the highest and best use of a nonfinancial asset differed from its current use. PwC observation: While this disclosure could be important in certain circumstances, we expect it to be infrequent. The nonfinancial asset would have to be measured at fair value (e.g., if it were held for sale) and the fair value would have to be higher if it were used in a different form than in its current form. Also, the entire difference would have to be material to the financial statement line item. As such, we are not surprised that there were no instances of this disclosure in our sample.
Questions
.51 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact their designated SEC Services consultant (if applicable), any member of the SEC Services group, or a member of the Financial Instruments team in the National Professional Services Group (1-973236-7803).
Dataline 13
Authored by:
Jill Butler Partner Phone: 1-973-236-4678 Email: jill.butler@us.pwc.com Rob Enticott Partner Phone: 1-973-236-4903 Email: rob.enticott@us.pwc.com Christopher Gerdau Partner Phone: 1-973-236-5010 Email: christopher.gerdau@us.pwc.com Mia DeMontigny Managing Director Phone: 1-973-236-4012 Email: mia.demontigny@us.pwc.com Maria Constantinou Director Phone: 1-973-236-4759 Email: maria.constantinou@us.pwc.com Ryan Folscroft Senior Manager (Asset Management) Phone: 1-973-236-5029 Email: ryan.j.folscroft@us.pwc.com Jose Martinez-Godas Senior Manager (Banking & Capital Markets) Phone: 1-973-236-7148 Email: jose.martinez-godas@us.pwc.com Andrea Selvaraja Senior Manager (Insurance) Phone: 1-973-236-4968 Email: andrea.h.selvaraja@us.pwc.com

No. 2012-02 February 27, 2012 Whats inside: At a glance ....................... 1 Questions and interpretive responses ...2
Quantitative disclosures......... 2 Qualitative disclosures and other matters ................. 6
New fair value measurement standard Implementation guidance for new disclosure requirements
At a glance
In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU). The ASU results from a joint project with the International Accounting Standards Board (IASB). The IASB also issued IFRS 13, Fair Value Measurement, in May 2011. Many of the changes to existing fair value measurement guidance represent clarifications and are intended to align U.S. GAAP and IFRS. However, certain of the 1 amendments to U.S. GAAP are substantive and several new disclosures are required. The U.S. GAAP amendments are effective for interim and annual periods beginning after December 15, 2011 for public entities and for annual periods beginning after 2 December 15, 2011 for nonpublic entities. Preparation of the new disclosures will require a significant amount of effort in some cases. Companies should assess the information needed to prepare the new disclosures and identify any necessary process changes. This Dataline includes a series of questions and answers providing implementation guidance on selected new disclosure requirements. Details of other key changes resulting from the ASU, including measurement, can be found in Dataline 2011-23, Fair value measurementFASB and IASB complete joint project, and Dataline 201131, New fair value measurement standardImplementation guidance for key changes to the measurement of financial instruments at fair value .
Questions ........................ 8 Appendices .......................9
1 2
The ASU amends FASB Accounting Standards Codification (ASC) 820, Fair Value Measurement. The FASB has added a project to its agenda addressing fair value disclosure requirements for nonpublic entities. Any discussion regarding nonpublic entities within this Dataline may change, depending on the outcome of that project. Note: This publication contains FASB material copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, and is reproduced with permission.
The following questions and interpretive responses are included in this Dataline: Question Number Question 1 Question 2 Question 3 Question 4 Topic Page Number
Quantitative disclosures What level of disaggregation is required for the quantitative disclosures relating to significant unobservable inputs? Are underlying inputs used to develop significant unobservable inputs required to be included in the quantitative disclosures? When can the third-party pricing exception to the quantitative disclosures about significant unobservable inputs be used? How should derivative assets and liabilities and their related unobservable inputs be presented in the quantitative table about unobservable inputs? Is disclosure of the level in the fair value hierarchy required for assets and liabilities for which fair value is only disclosed, when their carrying values approximate fair value? What level of disaggregation is required for the qualitative disclosure about sensitivity of significant unobservable inputs? Do the new fair value disclosures apply to pension plan assets in the financial statements of the plan sponsor? Should the financial statements of pension plans apply the public or nonpublic entity fair value disclosure requirements? Are comparative disclosures required in the first year of adoption of the ASU? 2 3 4 5
Question 5
Qualitative disclosures and other matters Question 6 Question 7 Question 8 Question 9 6 6 7 8
Questions and interpretive responses

Quantitative disclosures The ASU requires, for all Level 3 fair value measurements, quantitative information about significant unobservable inputs used. The amended guidance states, in part, "For fair value measurements categorized within Level 3 of the fair value hierarchy, a reporting entity shall provide quantitative information about the significant 3 unobservable inputs used in the fair value measurement." The ASU does not provide specific guidance on what quantitative information is required; however, an example of 4 what a reporting entity may consider disclosing is included in the standard. Questions 15 address frequently asked questions relating to this new quantitative disclosure requirement. Question 1 What level of disaggregation is required for the quantitative disclosures relating to significant unobservable inputs?
3 4
Refer to ASC 820-10-50-2(bbb) Refer to ASC 820-10-55-103 through 55-104

Dataline 2
Interpretive response It depends. The guidance requires entities to provide, at a minimum, fair value disclosures for each class of assets and liabilities. The ASU does not prescribe the level of disaggregation (below the class level of assets and liabilities) required for the quantitative disclosures relating to significant unobservable inputs. However, the disclosure should contain sufficient detail to allow users to understand the unobservable inputs used and how those inputs vary over time. When considering how detailed the disclosure should be, a reasonable starting point is to evaluate the classes for each of the assets and liabilities being included in other fair value disclosures (e.g., the fair value hierarchy table), followed by consideration of the nature and risk of the types of assets and liabilities and inputs in each class. The objective of this exercise is to determine whether there are reasonable levels of homogenous pools of inputs for the Level 3 assets and liabilities that can be separated out of the related class. The ASU provides guidance on the determination of classes of assets and liabilities, which includes the consideration of the nature, characteristics, and risks of the asset or liability and the level of the fair value hierarchy within which the fair value measurement 5 is categorized. In some cases, it may be appropriate to limit the disaggregation of the disclosure to the class level. However, to meet the objective of the quantitative disclosure, reporting entities may need to further disaggregate to provide more meaningful information about the significant unobservable inputs used and how these inputs vary over time. For example, an entity's derivative assets and liabilities may be disaggregated at the class level (e.g., interest rate instruments, commodity instruments, and foreign exchange rate instruments). However, an entitys commodity instruments may comprise a number of different types of commodities that do not share similar risk characteristics. An entity may conclude that disaggregating its class of commodity derivatives by type of commodity would provide more meaningful information. Similarly, it may be appropriate when considering a product, such as mortgage-backed securities, to further disaggregate the disclosure by residential and commercial securities. For private equity securities held, it may be appropriate to disaggregate by industry. Entities should balance the level of disaggregation against the usefulness of the disclosure. For example, while it may at times be difficult to develop a disaggregated disclosure due to the existence of a number of pools of homogeneous risks, that should not preclude the entity from developing and disclosing such disaggregated information. Conversely, an entity should consider whether it has provided too much disaggregated information such that the disclosure becomes cumbersome and less meaningful. The amended guidance provides an example that entities can consider when developing this 6 quantitative disclosure, which has been reproduced in Appendix A of this Dataline. Question 2 Level 3 fair value measurements may contain a number of unobservable inputs. Such unobservable inputs may be developed using a variety of assumptions and underlying unobservable inputs (e.g., a number of assumptions are used to arrive at a long-term growth rate input). Are underlying inputs used to develop significant unobservable inputs required to be included in the quantitative disclosures?
5 6
Refer to ASC 820-10-50-2B Refer to ASC 820-10-55-103

Dataline 3
Interpretive response Generally no. We would not expect underlying assumptions to the unobservable inputs to be included in this disclosure, but judgment should be used to ensure that the objective of the disclosure has been met. Many inputs include underlying assumptions; the disclosure of these underlying assumptions could result in a significant amount of extraneous information being disclosed, and could add unnecessary complexity to the disclosure. As a result, the overall disclosure could become less understandable. We therefore believe inclusion of such information is beyond the scope of the disclosure requirement. In addition, an example in the amended guidance includes disclosure of inputs such as weighted average cost of capital, long-term revenue growth rate, and long-term pretax operating margin. These unobservable inputs are based on a variety of assumptions that are also by their nature considered inputs. For example, a weighted average cost of capital input may include a number of assumptions such as the risk-free rate, effective tax rate, required equity rate of return, and the proportion of debt versus equity. These underlying inputs are not included in the example disclosure. Question 3 When can the third-party pricing exception to the requirement to provide quantitative disclosures about significant unobservable inputs be used? Interpretive response It depends. This exception applies to unobservable inputs that are not developed by the reporting entity (e.g., prices from prior transactions or obtained from third-party pricing sources), and allows a reporting entity to omit certain quantitative disclosures about the 8 inputs. It should be noted that the qualitative sensitivity disclosures for such inputs must be provided if required by ASC 820-10-50-2(g), even if the exception for the quantitative disclosure is elected. Third-party pricing includes information such as broker quotes, pricing services, and net 9 asset values. To the extent a reporting entity measures fair value using unadjusted inputs from these sources, these inputs may qualify for the exception. However, reporting entities should not ignore quantitative unobservable inputs that are significant to the fair value measurement and that are reasonably available to the entity. Therefore, when a reporting entity is contemplating use of this exception, we would expect it to make a reasonable attempt at obtaining quantitative information from the third party about unobservable inputs being used. If an entity adjusts the price obtained from a prior transaction or a third party in developing its fair value measurement, then this exception should not be used for that input. Consequently, any adjustments to a third-party price would require the entity to provide quantitative information about such adjustments to the extent they are significant. For example, if a reporting entity estimates its fair value measurement based on 50% internally-developed inputs and 50% from unadjusted third-party pricing, the quantitative information would be required for the internally-developed inputs, if significant, as this represents the adjustment to the third-party price. However, if an entity uses an internal model, but adjusts the result to equal the thirdparty price, then the third-party price would qualify for this exception. In that case, the reporting entity is essentially using a third-party price and developing a model only for
7
7 8
Refer to ASC 820-10-55-103 Refer to ASC 820-10-50-2(bbb) 9 Refer to ASC 820-10-55-104(b)

purposes of validating the price. Entities that use third-party pricing for their fair value measurements should also consider whether it is appropriate to disclose how third-party information such as broker quotes, pricing services, net asset values, and relevant market 10 data were considered in the measurement of fair value. Management should be cognizant of the Securities and Exchange Commissions (SEC) ongoing scrutiny of entities use of broker quotes and third-party pricing services when measuring fair value. The SEC expects management to take responsibility for its fair value measurements, even when not developed by the entity. During the 2011 AICPA National Conference on Current SEC and PCAOB Developments held in December 2011, both the SEC and Public Company Accounting Oversight Board reiterated management's 11 responsibilities in this area. Management should consider these expectations when evaluating whether an unobservable input qualifies for the exception described above. Additionally, management should evaluate whether it has performed sufficient diligence over the fair value measurements and inputs obtained externally, including the related fair value hierarchy level determinations. Question 4 How should derivative assets and liabilities and their related unobservable inputs be presented in the quantitative table about unobservable inputs? Interpretive response It depends. We believe, similar to the fair value hierarchy table disclosure, derivative assets and liabilities should be presented on a gross basis in the quantitative disclosure of unobservable inputs. Any unobservable inputs that are applied to the gross positions (e.g., volatility adjustments for options) should be classified with the corresponding derivative asset or liability on a gross basis. Unobservable inputs applied to a net derivative position should be classified and disclosed in the quantitative table with the derivative assets and/or liabilities impacted by the input consistent with how they are classified in other financial statement presentations or disclosures (e.g., balance sheet presentation or fair value hierarchy table). Question 5 Is disclosure of the level in the fair value hierarchy required for assets and liabilities for which fair value is only disclosed, when their carrying values approximate fair value? Interpretive response Generally yes. The amended guidance introduces new disclosures for each class of assets and liabilities that is not measured at fair value in the statement of financial position, but 12 for which fair value is disclosed within the notes to the financial statements. Specifically, disclosure of the level of the fair value hierarchy in which the fair value measurements are categorized (i.e., Level 1, 2, or 3) is now required. This disclosure is required for assets and liabilities that are disclosed at fair value, even if the carrying amount approximates the fair value. In accordance with ASC 825, Financial Instruments, entities are generally required to disclose the fair value of financial assets and liabilities that are not measured at fair value on the balance sheet.
10 11
Refer to ASC 820-10-55-104(b) For additional details, see Dataline 2011-37, Highlights of the 2011 AICPA National Conference on Current SEC and PCAOB Developments (paragraphs 16, 17, and 76). 12 Refer to ASC 820-10-50-2E
However, ASC 825 provides an exception to the fair value disclosures for trade 13 receivables and trade payables with carrying values that approximate fair value. Because these instruments are scoped out of the fair value disclosure requirement, reporting entities would not be required to provide fair value hierarchy information. We do not believe that this exception should be extended to other financial assets or financial liabilities, as this guidance is specific to trade receivables and trade payables. Management should carefully evaluate a conclusion that the fair value of its trade receivables or trade payables approximates carrying value. While that will often be the case, management should consider the nature, risk, and terms of the trade receivable or payable. For example, the fair value of structured or long-term trade receivables and payables may not approximate their carrying amounts. In such cases, a reporting entity would be required to disclose the fair value of the related trade receivable or payable along with the new required disclosures described above. Qualitative disclosures and other matters In addition to the new quantitative disclosures, the ASU requires certain qualitative disclosures relating to fair value measurements. These new disclosure requirements include (1) a description of the valuation process in place for both recurring and nonrecurring Level 3 fair value measurements and (2) a qualitative discussion about sensitive inputs used in recurring Level 3 fair value measurements. Certain of these new fair value disclosures are not required for nonpublic companies and, as a result, questions have also arisen about when the nonpublic entity requirements apply. Question 6 What level of disaggregation is required for the qualitative disclosure about sensitivity of significant unobservable inputs? Interpretive response It depends. The disclosure should include, at a minimum, discussion of the unobservable inputs included in the quantitative table. The ASU requires a narrative disclosure about the sensitivity of recurring Level 3 fair value measurements to certain changes in 14 unobservable inputs. This guidance requires the potential effect of changes in unobservable inputs to be described if such changes might result in a significantly different fair value measurement. Furthermore, to the extent there are interrelationships between those inputs and other unobservable inputs used in the fair value measurement, such interrelationships and the potential impact on sensitivity should also be disclosed. The guidance does not require a quantitative disclosure about sensitivity; therefore, entities are not required to provide specific amounts or quantify the potential changes in the inputs or the fair value measurements in order to comply with the guidance. The amended guidance provides an example disclosure that entities can consider when developing this qualitative disclosure, which has been reproduced in Appendix B of this 15 Dataline. Question 7 Do the new fair value disclosures apply to pension plan assets in the financial statements of the plan sponsor?
13 14
Refer to ASC 825-10-50-14 Refer to ASC 820-10-50-2(g) 15 Refer to ASC 820-10-55-106

Interpretive response No. Plan assets of a defined benefit pension or other postretirement plan that are accounted for in accordance with ASC 715, CompensationRetirement Benefits, are not 16 subject to the disclosure requirements in the amended guidance. However, these assets 17 are subject to the disclosures required by ASC 715. This guidance requires, among other items, disclosures about the level within the fair value hierarchy in which the fair value measurements fall, a reconciliation for fair value measurements of plan assets categorized as Level 3, and information about the valuation techniques and inputs used and any changes in techniques and inputs. The ASU does not substantially amend the disclosure requirements in ASC 715, and does not create any new disclosure requirements for plan assets within the sponsors financial statements. However, the ASU clarifies some aspects of the disclosure requirements in ASC 715 for consistency with ASC 820, such as clarifications about the fair value hierarchy, the Level 3 rollforward, and transfers between Level 1 and Level 2. Question 8 Should the financial statements of pension plans apply the public or nonpublic entity fair value disclosure requirements? Interpretive response It depends. In order to determine which fair value disclosures a pension plan should include in its financial statements, the plan must first determine whether it is a public or nonpublic entity. Certain of the new fair value disclosures are not required for nonpublic entities, including (1) information about transfers between Level 1 and Level 2 of the fair value hierarchy, (2) information about the sensitivity of a fair value measurement categorized within Level 3 to changes in unobservable inputs and any interrelationships between those unobservable inputs, and (3) the categorization by level of the fair value hierarchy for items not measured at fair value in the statement of financial position but for which the fair value is required to be disclosed. The amended guidance refers to the first definition of a "nonpublic entity" within the Master Glossary of the FASB Codification. Under that definition, a nonpublic entity is an entity that does not meet any of the following conditions: (a) Its debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally. (b) It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over the counter market, including local or regional markets). (c) It files with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market.
18
16 17
Refer to ASC 820-10-50-10 Refer to ASC 715-20-50-1(d)(iv) for public entities and ASC 715-20-50-5(c)(iv) for nonpublic entities 18 Refer to ASC 820-10-50-2F
(d) It is required to file or furnish financial statements with the Securities and Exchange Commission. (e) It is controlled by an entity covered by criteria (a) through (d). Based on the nature and activities of pension plans, criteria (a) through (c) will generally not apply to these entities. As it relates to criterion (d), if the financial statements of the pension plan are filed with the SEC in a Form 11-K or similar filing, then the pension plan would not qualify as a nonpublic entity. Such pension plans would be required to provide all the required disclosures in the ASU. If criterion (d) is not met, management would need to evaluate criterion (e) above to determine if the pension fund is controlled by an entity covered by criteria (a) through (d) (essentially, whether it is controlled by a public entity). If management concludes that the pension plan is controlled by a public entity, the pension plan would be required to provide all the disclosures required by the ASU. Question 9 Are comparative disclosures required in the first year of adoption of the ASU? Interpretive response No. Entities will apply the ASU prospectively. Because the new guidance is prospective, we do not believe that comparative disclosures for prior years are required in the year of adoption. While not explicitly stated in the ASU, we believe this is consistent with the FASBs intention. IFRS 13 specifically states that the disclosure requirements of the IFRS are not required to be applied in comparative form for periods prior to the adoption of the standard. Additionally, because application is prospective, any changes in fair value measurements resulting from the application of the new guidance will be recorded as a change in estimate through the income statement in the first period of application. However, in the period of adoption, a reporting entity will have to disclose the change, if any, in the valuation techniques applied and related inputs resulting from the application of the new guidance and quantify the total effect, if practicable. The guidance in the ASU is effective for public entities for interim and annual periods beginning after December 15, 2011 and for nonpublic entities for annual periods beginning after December 15, 2011. Early application is only permitted for nonpublic entities, for interim periods beginning after December 15, 2011.
Questions
PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact their designated SEC Services consultant (if applicable), any member of the SEC Services Group, or a member of the financial instruments team in the National Professional Services Group (1-973236-7803).
Dataline
Appendix AExample: Quantitative disclosure about significant unobservable inputs*

Quantitative Information about Level 3 Fair Value Measurements ($ in millions)
Fair Value at 12/31/X9 Residential mortgage-backed securities 125 Valuation Technique(s) Discounted cash flow Unobservable Input Constant prepayment rate Probability of default Loss severity Constant prepayment rate Probability of default Loss severity Offered quotes Comparability adjustments (%) Weighted average cost of capital Long-term revenue growth rate Long-term pretax operating margin Discount for lack of marketability (a) Control premium (a) EBITDA multiple (b) Revenue multiple (b) Discount for lack of marketability (a) Control premium (a) Weighted average cost of capital Long-term revenue growth rate Long-term pretax operating margin Discount for lack of marketability (a) Control premium (a) EBITDA multiple (b) Revenue multiple (b) Discount for lack of marketability (a) Control premium (a) Annualized volatility of credit (c) Counterparty credit risk (d) Own credit risk (d) Range (Weighted Average) 3.5% 5.5% (4.5%) 5% 50% (10%) 40% 100% (60%) 3.0% 5.0% (4.1%) 2% 25% (5%) 10% 50% (20%) 20 45 -10% +15% (+5%) 7% 16% (12.1%) 2% 5% (4.2%) 3% 20% (10.3%) 5% 20% (17%) 10% 30% (20%) 10 13 (11.3) 1.5 2.0 (1.7) 5% 20% (17%) 10% 30% (20%) 8% 12% (11.1%) 3% 5.5% (4.2%) 7.5% 13% (9.2%) 5% 20% (10%) 10% 20% (12%) 6.5 12 (9.5) 1.0 3.0 (2.0) 5% 20% (10%) 10% 20% (12%) 10% 20% 0.5% 3.5% 0.3% 2.0%
Commercial mortgage-backed securities
50
Discounted cash flow
Collateralized debt obligations Direct venture capital investments: healthcare
35 53
Consensus pricing Discounted cash flow
Market comparable companies
Direct venture capital investments: energy
32
Discounted cash flow
Market comparable companies
Credit contracts
38
Option model
(a) Represents amounts used when the reporting entity has determined that market participants would take into account these premiums and discounts when pricing the investments. (b) Represents amounts used when the reporting entity has determined that market participants would use such multiples when pricing the investments. (c) Represents the range of the volatility curves used in the valuation analysis that the reporting entity has determined market participants would use when pricing the contracts. (d) Represents the range of the credit default swap spread curves used in the valuation analysis that the reporting entity has determined market participants would use when pricing the contracts. (Note: For liabilities, a similar table should be presented.) _______________________________ * Example reproduced from ASC 820-10-55-103.
Appendix BExample: qualitative disclosure about unobservable inputs**

For recurring fair value measurements categorized within Level 3 of the fair value hierarchy, this Topic requires a reporting entity to provide a narrative description of the sensitivity of the fair value measurement to changes in significant unobservable inputs and a description of any interrelationships between those unobservable inputs. A reporting entity might disclose the following about its residential mortgage-backed securities to comply with paragraph 820-10-50-2(g). The significant unobservable inputs used in the fair value measurement of the reporting entitys residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.
______________________
** Example reproduced from ASC 820-10-55-106.
Dataline 10
Authored by:
Jill Butler Partner Phone: 1-973-236-4678 Email: jill.butler@us.pwc.com Mia DeMontigny Managing Director Phone: 1-973-236-4012 Email: mia.l.demontigny@us.pwc.com Sudipta Yancy Senior Manager Phone: 1-973-236-4256 Email: sudipta.yancy@us.pwc.com

New fair value measurement standard Implementation guidance for key changes to the measurement of financial instruments at fair value
Overview
In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU). The ASU results from a joint project with the International Accounting Standards Board, who issued IFRS 13, Fair Value Measurement, in May 2011. Many of the changes to existing fair value measurement guidance represent clarifications and are intended to align U.S. GAAP and IFRS. However, certain of the amendments to U.S. 1 GAAP are substantive and require analysis of current practice. The valuation of certain financial instruments may be significantly affected by the measurement changes in the ASU. Most notably, the ASU increases the emphasis on the unit of account (as defined in other guidance), generally requiring that the fair value of financial instruments be measured based on the level of the unit of account, rather than at an aggregated or disaggregated level. The ASU also introduces more restrictive guidance on the incorporation of premiums and discounts relating to the size of a position of financial instruments held in measuring fair value. Furthermore, a new exception to some of the principles of fair value measurement has been added, which currently permits the fair value measurement of financial assets and financial liabilities with offsetting market or credit risks to be based on their net positions in certain circumstances (see paragraph 18A). Finally, the ASU reinforces existing guidance that assets and liabilities that trade in active markets (i.e., Level 1 fair value measurements) should be measured as price times quantity held, without adjustment.
No. 2011-31 October 27, 2011

(Revised December 22, 2011*)
Whats inside: Overview .......................... 1 Key provisions .................2

Application of premiums and discounts in a fair value measurement.............. 2 Measuring the fair value of financial instruments with offsetting risks ........................ 6 Valuation of a portfolio of mortgage loans held for sale .... .....11
Questions ....................... 12
The ASU amends Accounting Standards Codification (ASC) 820, Fair Value Measurement (ASC 820). * This Dataline was revised to reflect the announcement of an upcoming FASB Technical Correction that will clarify the application of the "portfolio exception." The updates were made to the section titled Measuring the fair value of financial instruments and non-financial derivative instruments with offsetting risks, beginning in paragraph 16. Also, paragraph 13 was revised to include a reference to impairment assessments.
The ASU is effective for public companies in fiscal years beginning after December 15, 2011, including interim periods within those years. Application of the ASU is prospective. Consequently, any changes in fair value measurements resulting from the application of the new guidance should be recorded as a change in estimate through the income statement in the first period of application. However, in the period of adoption, a reporting entity will have to disclose the change, if any, in the valuation techniques applied and related inputs resulting from the application of the new guidance and quantify the total effect, if practicable. This Dataline provides implementation guidance on certain aspects of the ASU, specifically regarding the fair value measurement of financial instruments, including (1) the application of premiums and discounts, (2) measuring the fair value of financial instruments with offsetting market and credit risks, and (3) the valuation of a portfolio of mortgage loans held for sale. Details of other key changes resulting from the ASU, including disclosures, can be found in Dataline 2011-23, Fair Value Measurement FASB and IASB complete joint project. Companies that measure or disclose a significant amount of financial instruments at fair value should closely review and evaluate the impact of the ASU.
Key provisions
Application of premiums and discounts in a fair value measurement .1 One of the most significant amendments to existing guidance is a narrowing of the ability to incorporate certain premiums and discounts in a fair value measurement. Under todays guidance, the application of a premium or discount in a fair value measurement primarily depends on whether a market participant would include one when pricing the asset or liability or groups of assets or liabilities. When an entity held a significant position in a financial instrument, before this ASU, preparers might have included a discount in the valuation. .2 For example, if an entity held an investment in the common stock of another entity for which the size of the position was several times the daily trading volume, the entity might have reflected a blockage factor in that valuation (provided the fair value of the shares was not based on Level 1 inputs). A blockage factor is a discount applied in measuring the value of a security to reflect the impact on its value of selling a large block of the security at one time. Under today's guidance, blockage factors are not permitted when measuring the fair value of an asset or liability with inputs that are observable in an active market (i.e., Level 1 measurements). However, blockage has been, until now, a relevant concept for Level 2 or Level 3 fair value measurements. .3 The ASU introduces a new concept to further clarify the interaction of the unit of account with the application of premiums and discounts. The unit of account is the level at which fair value measurement must be applied. Therefore, the ASU distinguishes between premiums or discounts related to size as a characteristic of the reporting entity's holding (specifically, a blockage factor, which is prohibited) as opposed to premiums or discounts related to a characteristic of the asset or liability (for example, a control premium, which is permitted under certain circumstances). A control premium is applied when the investment's value is enhanced as a result of maintaining a controlling interest in an investee. .4 The new guidance is intended to amend the application of premiums or discounts, including blockage factors, in a fair value measurement. Under the amendment, preparers may no longer apply a blockage factor to any fair value measurement. While this is not a change for Level 1 fair value measurements in which valuation adjustments have not been permitted, it could result in significant change for those who have historically applied blockage factors in Level 2 and Level 3 fair value measurements.
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Adjustments for size may be appropriate in the certain circumstances, including the portfolio exception, which is discussed beginning in paragraph 16. PwC observation: The prohibition on the use of blockage factors will result in changes to current practice in, for example, measuring the fair value of equity securities held in blocks that represent a noncontrolling interest. Fair value measurements of blocks of securities held by companies including private equity or investment companies may be affected. Immediate gain recognition may occur if a block of securities was purchased at a discount because the entity cannot record the fair value inclusive of a blockage factor, even though a discount was reflected in the purchase price. However, such gain may never be realized if the entity sells the block at a similar discount in the future. Results such as these may be counterintuitive since the accounting result may not always reflect the economic outcome. Entities that regularly enter into such transactions or hold large positions of financial instruments should evaluate how they may be affected by the new guidance. .5 Certain premiums or discounts are permitted for instruments that are not classified as Level 1. When determining whether it is appropriate to include a premium or discount in a Level 2 or Level 3 fair value measurement, reporting entities should consider the following: Market participant assumptions The unit of account as defined by other guidance for the asset or liability being measured The unit of measurement (see paragraph 16 below on the exception provided for portfolios of financial instruments with offsetting market and/or credit risks) (the portfolio exception) Whether the premium or discount is related to the size of the entitys holding of the asset or liability or rather reflective of a characteristic of the asset or liability itself Whether the impact of the premium or discount is already contemplated in the valuation. .6 A core principle of the fair value guidance is that a fair value measurement is determined based on the assumptions that market participants would use to price the asset or liability being measured. Market participants are assumed to transact in a manner that is in their economic best interest. Therefore, under the new guidance, an entity would continue to incorporate premiums or discounts (except for discounts or premiums related to size, such as blockage factors) in a Level 2 or Level 3 fair value measurement if market participants would do so. While the determination of fair value is rooted in market participant assumptions, such application cannot contradict the unit of account for the asset or liability being measured under the new guidance. ASC 820 does not define the unit of account for any asset or liability. Rather, unit of account is based on other guidance. ASC 820 does provide guidance on the unit of measurement in the case of the portfolio exception.
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PwC observation: In some cases, the unit of account may not be clear. There are few instances in U.S. GAAP in which the unit of account is explicitly defined. Often, it is inferred from the recognition or measurement guidance in the applicable literature and/or from industry practice. For example, it is clear that the unit of account for evaluating goodwill impairment is the reporting unit. On the other hand, the guidance for accounting for securities by investment companies is not explicit on the unit of account. Also, there are times when the unit of account varies depending on whether one is considering recognition, initial measurement, or subsequent measurement, including impairments. Two examples are loans that are not held for sale and insurance contracts. Both are recorded at the individual loan or contract level, but reserves and impairments related to them are calculated at an aggregated level. Situations in which the unit of account guidance lacks clarity may prove challenging for reporting entities since the new fair value guidance is highly dependent on the unit of account.
Interaction with bid-ask spread guidance .7 The ASU carries forward existing guidance that when entities have access to pricing within a bid-ask spread, the price within the spread that is most representative of fair value should be used. Some may question whether the judgment inherent in determining where in the bid-ask spread the position's fair value resides could provide some flexibility for the application of blockage factors or similar adjustments for the size of the holding. However, as noted above, the ASU explicitly states that adjustments to the fair value of a position related to the size of the holding are not permitted unless such adjustments are consistent with the unit of account or unit of measurement (e.g., in the portfolio exception). Therefore, selecting a price within the bid-ask spread that reflects an adjustment for the size of the holding or asserting that the bid-ask spread is wider for large positions would generally not be appropriate. Control premiums .8 Although adjustments for the size of an asset or liability are no longer permitted in any fair value measurement (other than when using the portfolio exception), control premiums may sometimes be appropriate when measuring the fair value of a block of securities. Control premiums are permitted for Level 2 and Level 3 fair value measurements. .9 The underlying concept in the ASU is that a control premium is an adjustment that relates to a characteristic of the asset being measured. When a controlling interest is held, a control premium reflects the additional value that can be created for each of the securities held because of the controlling interest. In other words, having the ability to control the investee is viewed as changing the characteristic of all of the individual underlying securities held. As a result, when determining the fair value measurement of individual securities classified in Level 2 or Level 3 of the fair value hierarchy held that represent a controlling interest, it would be appropriate to conclude that a market participant would pay a premium to acquire the additional benefits attributable to the controlling interest. While the unit of account remains the individual security, the controlling interest is a "characteristic" of the individual security and therefore, its fair value should be adjusted if market participants would do so. .10 A "day one" gain that may result from purchasing a block of securities at a discount. However, immediate loss recognition would not be expected if a block of securities measured using Level 2 or Level 3 inputs was purchased at a premium resulting in the entity holding a controlling interest. In the case of a controlling interest, a control premium could be reflected in the measurement of fair value for securities that are classified as Level 2 or Level 3.
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PwC observation: As described above, it is assumed that market participants act in their economic best interest. In addition, a fair value measurement should incorporate market participant assumptions, not entity-specific assumptions. This may provide some insight into the boards' distinction between blockage factors and other premiums or discounts. The boards believe blockage factors are conceptually similar to transaction costs, which are not permitted in a fair value measurement since they result from the entity's decisions about how to transact. In contrast, if an entity holds a controlling interest through a block of securities, a market participant would not be expected to sell the securities in smaller units and lose the value attributable to that controlling interest.
Other premiums and discounts .11 The incorporation of other premiums and discounts in a fair value measurement that is not classified in Level 1 may be appropriate, based on how market participants would value a transaction for the related asset or liability. Because the boards did not intend to preclude any specific adjustments other than blockage factors, the ASU does not specify which other premiums or discounts a reporting entity should or could apply in Level 2 or Level 3 fair value measurements. Therefore, the application of premiums or discounts depends on facts and circumstances at the reporting date. .12 Some examples of other premiums and discounts might include adjustments for location, restrictions on sale, or liquidity. However, as previously described, adjustments are not permitted due to the size of the position (unless the unit of account in other guidance is an aggregated position, for example). Therefore, the application of other premiums and discounts must be consistent for each unit of account, regardless of the size of the holding. Said another way, the same adjustment should apply uniformly to each unit of account being measured, and should not expand (or decrease) as the size of a holding changes. .13 Examples of common premiums or discounts that may be permissible in a Level 2 or Level 3 fair value measurement include, but are not limited to, the following: Premiums due to significant influence in an equity method investment accounted for under the fair value option or when assessing an equity method investment for impairment Premiums or discounts for uncertainty in cash flows Premiums or discounts for liquidity (e.g., for location or market) Discounts because the instrument is not marketable Noncontrolling interest discounts Default risk and/or collateral value risk adjustments associated with mortgagebacked securities .14 As noted above, whether these premiums or discounts can be incorporated depends on the facts and circumstances of the particular asset or liability being measured, including consideration of market participant assumptions and the unit of account. They are permissible in a Level 2 or Level 3 fair value measurement and may be applied in addition to other elements required by the fair value guidance, such as adjustments for a company's own credit.
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Premiums and discounts - examples .15 The following table provides some common examples of assets and liabilities and describes whether certain types of premiums or discounts are applicable for Level 2 or Level 3 fair value measurements under the new guidance. This excludes blockage factors, which are not permitted in any fair value measurement. (See discussion of the portfolio exception, beginning in paragraph 16).
Applicability of: Asset or liability Block of securities held by an investment company (accounted for under ASC 946, Financial Services Investment Companies) Control Premium Included if the block was sufficient to provide a controlling interest that a market participant would take into account. Other Premiums or Discounts May apply, depending on facts and circumstances, including market participant assumptions. Examples may include lack of marketability discounts, noncontrolling interest discounts, or contractual restrictions on transfer. Not applicable. In a May apply, depending on facts situation in which a control and circumstances, including premium would apply, market participant assumptions. ASC 320 would not be the Examples may include lack of authoritative guidance. marketability discounts, The entity would noncontrolling interest discounts, consolidate the or contractual restrictions on investment. transfer. Not applicable. Control May apply, depending on facts premiums do not apply and circumstances, including since there is not a market participant assumptions controlling interest. and the unit of account. Examples may include premiums for having a significant influence, lack of marketability discounts, or contractual restrictions on transfer. Not applicable. May apply, depending on facts and circumstances, including market participant assumptions. Example may include adjustments for risk or liquidity.
Block of securities held by a non-investment company (accounted for under ASC 320, Investments - Debt and Equity Securities)
Equity method investment in which the "fair value option" in ASC 825, Financial Instruments, is elected
Derivative (ASC 815, Derivatives and Hedging)
Measuring the fair value of financial instruments with offsetting risks .16 The ASU eliminates the concept of the valuation premise and highest and best use for financial assets. Under existing guidance, financial assets and liabilities that trade in pools of relatively homogeneous assets are commonly grouped when measuring their fair values. This approach is known as the in-use methodology. Under the ASU, the grouping of financial assets under an in-use valuation premise for purposes of determining their fair values is prohibited. Rather, the fair value of financial assets must be measured at the level of the unit of account as specified in other guidance, which in some cases is the individual instrument (e.g., the individual share). .17 The boards acknowledged that this requirement could result in a significant and unintended change in practice for the fair value measurement of certain financial instruments such as derivatives. As a result, the boards decided to provide an exception to the fair value measurement guidance in instances in which an entity manages its market risk(s) and/or counterparty credit risk exposure within a group (portfolio) of financial instruments on a net basis (the portfolio exception). When elected, the
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portfolio exception allows an entity to measure the fair value of those financial assets and financial liabilities based on the net position of the portfolio (i.e., the price that would be received to sell a net long position or transfer a net short position for a particular market or credit risk exposure), rather than the individual positions within the portfolio (i.e., the gross positions). PwC observation: The portfolio exception removes the limitation imposed on reporting entities that requires financial instruments to be measured at the level of the unit of account defined by other guidance. For example, when the unit of account is the individual financial instrument, absent use of the portfolio exception, aggregation or offsetting of instruments to determine fair value would not be permitted. Furthermore, the application of premiums and discounts in the measurement of financial instruments would be more restrictive than under todays guidance. However, when a reporting entity elects the portfolio exception, the unit of measurement becomes the net position of the portfolio. In applying the portfolio exception, valuation should be performed based on the price that a market participant would pay (or be paid) to acquire the entire portfolio in a single transaction. In essence, this valuation would reflect the "net open risk" of the portfolio. Because the unit of measurement is the net position of the portfolio, size is a characteristic of the portfolio being valued, and consequently, an adjustment based on size is appropriate to the extent it would be incorporated by market participants. Therefore, for those portfolios of financial instruments that qualify for the exception, current valuation practices are not expected to significantly change. .18 As written in the ASU, the portfolio exception applies only to financial assets and financial liabilities under the scope of ASC 815, Derivatives and Hedging, and ASC 825, Financial Instruments. Therefore, the portfolio exception is available for financial assets and liabilities that can (pursuant to the fair value option) or must be measured at fair value on a recurring basis in the statement of financial position. It does not apply to assets and liabilities for which fair value is only disclosed or for which fair value is not measured on a recurring basis. Under the language in the ASU, derivatives that do not meet the definition of a financial instrument would not qualify. This would include, for example, physically-settled commodity derivative contracts or combinations of cashsettled and physically-settled commodity derivative contracts. However, because physically-settled commodity derivatives are considered non-financial assets and liabilities, the concepts of the valuation premise and highest and best use would still be available for those assets and those liabilities that are associated with complementary assets. Based on a literal reading of the language in the ASU, groups of physically-settled commodity derivatives and financially-settled derivatives cannot be measured together using the portfolio exception or in combination under the highest and best use guidance. .18A At the 2011 AICPA National Conference on Current SEC and PCAOB Developments, Susan Cosper, FASB Technical Director and EITF Chairman, discussed the exclusion of non-financial derivatives from the portfolio exception. She indicated that the exclusion was not intentional and would be corrected during the normal course of the FASB's annual Technical Corrections process. It is not yet known when the Technical Correction will be issued. PwC observation: The FASB staff has indicated that the guidance, as written, would render an unintended result and thus, requires clarification. We expect that the language in the guidance (ASC 820-10-35-18D through 35-18H) will be revised to include not only
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financial assets and liabilities (as the words say now), but also financial and nonfinancial derivatives subject to ASC 815, Derivatives and Hedging. Non-financial assets and liabilities might continue to be valued on a net basis under an "in-use" valuation premise; however, financial assets and liabilities will only be valued on a net basis if they are eligible for the portfolio exception. The Technical Correction will likely allow entities to measure fair value on a net basis for those portfolios in which financial assets and liabilities and non-financial derivatives are mixed. For example, consider a portfolio of physically-settled commodity contracts (that are derivatives under ASC 815) that are managed in a portfolio with offsetting cash-settled derivatives. The Technical Correction is expected to address this type of mixed portfolio. .19 The portfolio exception applies only to fair value measurement, not to financial statement presentation. Whether the instruments in the portfolio or group can or must be presented on a net or gross basis in the financial statements depends on other guidance. Therefore, while the fair value of financial instruments managed within a group may be determined based on the net position when using the portfolio exception, the entity must allocate the resulting fair value based on the unit of account required by other guidance for those instruments. The ASU does not prescribe any allocation methodology; rather, the allocation should be performed in a reasonable and consistent manner that is appropriate in the circumstances. Refer to chapter FV 10 of the PwC Guide to Fair Value Measurements - 2010 Edition for examples of common allocation methodologies. .20 The entity must apply the portfolio exception consistently from period to period when elected, and must provide evidence that it continues to manage risk exposure(s) on a net basis in order to continue to qualify for the exception. As the entity's risk exposure preferences change, the entity can elect not to use the exception, but instead measure fair value on an individual instrument basis. However, since significant changes in risk management strategies are rare, changes to the use of the portfolio exception are expected to be infrequent. Qualifying for the portfolio exception .21 The new guidance prescribes requirements for use of the portfolio exception based on how the reporting entity manages the portfolio. The portfolio exception is elective, but is only permitted if the reporting entity: a) manages the group of financial assets and liabilities on the basis of the entity's net exposure to a particular market risk (or risks) or to the credit risk of a particular counterparty, and b) reports information to management about the group of financial assets and liabilities on a net basis. .22 Should management make an accounting policy election to use the portfolio exception, it should be able to demonstrate that reasonable evidence exists about its assertion that the portfolio or group in question is managed based on the net exposure to market or credit risk. Examples of such evidence could include robust documentation of the companys risk management or investment policies and strategies, risk committee meeting minutes, and internal management reporting information. In addition, management may want to consider the types and composition of portfolios the company has historically managed when evaluating the reasonableness of its assertions.
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Exposure to market risks .23 In addition to the requirement that the entity manage the portfolio on a net basis, the new guidance requires that the market risks that are being offset be substantially the same in both the type of risk (i.e., basis risk) as well as duration. Degree of offset .24 When considering whether the portfolio exception is available for a group of financial assets and liabilities for a particular market risk, the degree of exposure (or offset) of market risk to arrive at a net long or net short position should be considered. The ASU does not prescribe how much of a long or short position is permitted to qualify for the portfolio exception. For example, assets in a portfolio do not have to be nearly 100% offset by liabilities. Rather, a reporting entity should assess the appropriateness of electing the portfolio exception based on the nature of the portfolio being managed in the context of its risk or investment management strategy. .25 Broad risk management strategies, such as managing on the basis of value-at-risk (VAR), may not be sufficient on their own for a group to be eligible for the portfolio exception because VAR does not necessarily represent managing a business or portfolio to a net position. Further, if the positions in a portfolio do not offset at the measurement date in accordance with expectations the entity would not be precluded from using the portfolio exception at that measurement date, provided the lack of offset is temporary and due to unanticipated market events or operating conditions. PwC observation: We do not believe that bright lines or percentages of the degree of offset of risk positions should be applied in determining whether there is sufficient offset in a group or portfolio. However, we also believe it would be inappropriate to apply the portfolio exception to an aggregated position without any offset or hedging (e.g., an aggregated block of equity shares). Such a position may relate to a trading or investment strategy that is not managed on a net basis. It is important that the application of the portfolio exception be applied based upon the substance of the portfolio and how it is managed. For example, it would be inappropriate to enter into a non-substantive offsetting position in an attempt to qualify for the portfolio exception solely to change the unit of measurement in order to apply adjustments related to size of the holding. .26 In applying the portfolio guidance, valuation of the net open risk position is required. Market participants may value a portfolio with basis risk differently than one that was perfectly hedged. The following are some examples of mismatches in the portfolio that affect the measurement of fair value. Basis differences .27 Portfolios with basis differences may qualify for the portfolio exception. To the extent that there is any basis difference for dissimilar risks, that basis risk should be reflected in the fair value of the net position. For example, an entity may include financial instruments with different (but highly correlated) interest rate bases in one portfolio, provided that the entity manages its interest rate risk on a net basis. However, any difference in the interest rate bases (e.g., LIBOR vs. treasury) must be considered in the fair value measurement. Duration differences .28 Similar to basis differences, portfolios containing offsetting positions with different maturities may qualify for the portfolio exception. Adjustments to the fair value of the net position of a portfolio should also be made for such duration mismatches. Therefore, unmatched (or unhedged) portions of the terms to maturity of the financial assets and
liabilities that form part of the portfolio could result in an adjustment to the net position. For example, in a portfolio of interest rate swaps with long (asset) positions of 30 years to maturity offset with short (liability) positions of 25 years to maturity, the company could avail itself of the portfolio exception for the net position for interest rate risk. However, the five years of unhedged long position would be measured as part of the net position. Exposure to counterparty credit risk .29 When applying the portfolio exception to a portfolio in which specific counterparty credit risk is managed on a net basis, the entity must consider market participants expectations about whether any arrangements in place to mitigate credit risk exposure are legally enforceable in the event of default (for example, through a master netting arrangement). In a portfolio of financial assets and liabilities within a master netting arrangement, the adjustment for credit risk could be applied to the net exposure to the counterparty, rather than to each of the financial assets and liabilities separately. The adjustment will be applied to the net position based on the individual counterparty's credit risk in the case of a net asset position or the reporting entity's own credit risk in the case of a liability position. The portfolio exception does not change the current requirement to incorporate a credit valuation adjustment (CVA) on or debit valuation adjustment (DVA) on a net open asset or liability position, respectively. The portfolio exception application examples Example 1 qualifying for the portfolio exception: portfolio of shares Company A owns 1 million shares representing .05% of the outstanding publicly traded common shares of Entity X and enters into a forward sale agreement for 50,000 shares of Entity X. Company A accounts for the shares at fair value using the fair value option. Company A documents and manages the long position of shares and the forward sale agreement together as a net position according to its investment strategy. Can Company A apply the portfolio exception for offsetting market price risk? Specifically, could Company A value the shares based on the price that is most representative within the bid-ask spread for the net position of 950,000 shares, by incorporating a discount to the shares of Entity X if this is how market participants would price the net risk exposure? PwC interpretive response Maybe. The portfolio exception changes the unit of measurement to the net position (rather than each individual share which may be prescribed as the unit of account and unit of measurement in other guidance absent use of the portfolio exception). Furthermore, the ASU does not prescribe the degree of offset of the position that is required to qualify for the portfolio exception. Management should consider that in this case the degree of offset in the position may not be meaningful and determine whether the particular strategy is consistent with its overall investment policies and strategies. We believe it would be inappropriate to apply the portfolio exception to an aggregated position without any offset or hedging (e.g., an aggregated block of equity shares), and the minimal amount of offset in this fact pattern may be considered non-substantive. However, if management can demonstrate that it qualifies in this fact pattern based on its investment strategy (considering factors discussed in paragraphs 21 through 22 above), fair value could be measured for the shares on a net basis. Example 2 applying the bid-ask spread to a net risk position: interest rate swaps Company B has $500 million in 10-year pay 3-month LIBOR, receive fixed rate interest rate swaps (liability position) and $200 million in 10-year receive 3-month LIBOR, pay fixed rate interest rate swaps (asset position) that Company B manages together and documents as a $300 million net liability position for purposes of managing interest rate risk. Can Company B elect the portfolio exception and adjust the bid-ask spread of the $500 million short position and the $200 million long position to a new bid-ask spread
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for the net short $300 million position based upon how market participants would price the net risk exposure at the measurement date? PwC interpretive response Yes. When elected, the portfolio exception allows an entity to measure the fair value of those financial assets and financial liabilities based on the net positions of the portfolio. Assuming the entity has met the requirements for electing the portfolio exception, the exception permits Company B to determine fair value based on how market participants would price the net risk exposure within the bid-ask spread. Note that the interest rate risk exposure on the long and short positions are identical (i.e., both positions are based on LIBOR) and the terms to maturity are also identical. Therefore, the entity would not need to apply any adjustments for basis or duration mismatches. However, Company B should consider any need for a counterparty credit risk adjustment. Example 3 duration mismatches: interest rate swaps with different maturities Assume the same facts as in Example 2 except that the long position (i.e., the $200 million in swap asset) has a term to maturity of 12 years instead of 10 years. Company B documents its holding as a $300 million net liability position for purposes of managing interest risk. Does the resulting approach to fair value measurement described in Example 2 change? PwC interpretive response Yes. While Company B may elect the portfolio exception for the $300 million net position, it would be required to adjust the fair value on the 10-year net position for the additional two years of net open risk. The fair value for the remaining two-year period on the 12-year swap would impact the valuation of the net position. Valuation of a portfolio of mortgage loans held for sale .30 Industry-specific mortgage banking guidance states that mortgage loans held for sale should be reported at the lower of cost or fair value. Under current guidance, financial institutions typically determine the fair value of loan assets on a portfolio basis under the "in-use" valuation premise. As noted in paragraph 16 of this Dataline, the amendment prohibits that approach when valuing financial assets and liabilities. However, the updated ASU states entities should measure fair value using assumptions that marker participants would use, assuming they act in their economic best interest. .31 The market participant in the context of loans typically would be another bank or insurance company that also has a portfolio of similar loans. The market participant purchasing a loan will act in its economic best interest by considering how the loan will fit into its overall portfolio when determining a price to pay for it. As a result, it is likely that a market participant will value the loan based on portfolio level inputs as opposed to valuing it solely as an individual loan. .32 In addition, financial institutions must consider the unit of account that is specified 3 in other guidance. For loans held for sale, the guidance changes the unit of measurement by specifically allowing the aggregation by type of loan to determine fair value. PwC observation: Based on the above, we believe that entities may continue to measure the fair value of loans held for sale using portfolio-level assumptions. This conclusion would also
2
2 3
Refer to ASC 948-310-35-1 Refer to ASC 948-310-35-3

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apply to determining the fair value of loans not held for sale and to insurance contracts. In those situations, market participants are banks or insurance companies that have portfolios of similar instruments and would only purchase a single loan or insurance contract because it fits in to one of their portfolios. Further, for loans that are not held for sale and insurance contracts, the unit of account varies depending on what is being measured. In both cases, they are recorded at the individual loan or contract level, but reserves and impairments may be calculated at the portfolio level. Because the unit of account varies, we believe it is appropriate to continue to value loans not held for sale and insurance contracts at the individual loan/contract level using portfolio-level assumptions.
Questions
.33 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the financial instruments team in the National Professional Services Group (1-973-236-7803).
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Authored by:
Jill Butler Partner Phone: 1-973-236-4678 Email: jill.butler@us.pwc.com Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com Mia DeMontigny Managing Director Phone: 1-973-236-4012 Email: mia.l.demontigny@us.pwc.com Maria Constantinou Director Phone: 1-973-236-4957 Email: maria.constantinou@us.pwc.com Steven Halterman Director Phone: 1-973-236-4179 Email: steven.g.halterman@us.pwc.com

Fair value measurement FASB and IASB complete joint project
Overview
At a glance In May 2011, the FASB and IASB completed their joint project on fair value measurement and issued their respective final standards. The joint project was part of the Memorandum of Understanding between the FASB and IASB. The objective of the project was to bring together as closely as possible the fair value measurement and disclosure guidance issued by the two boards. The issuance of the final standards results in global fair value measurement and disclosure guidance and minimizes differences between U.S. GAAP and IFRS. Many of the changes in the U.S. final standard represent clarifications to existing guidance. Some changes, however, such as the change in the valuation premise and the application of premiums and discounts, and new required disclosures, could have a significant impact on practice. The U.S. guidance is effective for interim and annual periods beginning after December 15, 2011. For nonpublic companies that apply U.S GAAP, the standard is effective for annual periods beginning after December 15, 2011. The IASBs standard will first be effective for annual periods beginning on or after January 1, 2013. Subsequent to the first year of adoption, the measurement principles and certain disclosures will be applicable in interim and annual periods. The main details .1 Since 2008, entities that report under U.S. generally accepted accounting principles (U.S. GAAP) have been required to apply the guidance in the Financial Accounting Standards Boards (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures, when accounting for fair value measurements. In May 2009, the International Accounting Standards Board (IASB) issued an exposure draft on fair value measurement and disclosure, which proposed guidance similar to that found in U.S. GAAP. Facing potential divergence between International Financial Reporting

At a glance ...............................1 The main details ......................1
Key provisions .................2

Primary changes to U.S. GAAP............................. 2 Other new or clarifying guidance ............................... 6
Effective date and transition ..................... 8 Differences between U.S. GAAP and IFRS .............................. 8
Day one gains and losses ....... 8 Measuring the fair value of certain investments .......................... 9 Certain disclosures ................. 9
Next steps .........................9 Questions .........................9
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Standards (IFRS) and U.S. GAAP, the FASB and the IASB (the boards) in October 2009 agreed to work together to reconcile differences with a goal of reaching a converged standard. This joint project was part of the Memorandum of Understanding between the boards. .2 On May 12, 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU), and the IASB issued International Financial Reporting Standard (IFRS) 13, Fair Value Measurement (together, the new guidance). The new guidance amends U.S. GAAP and is a new standard under IFRS. .3 The boards have converged many aspects of fair value measurement guidance, including principles (such as the definition of fair value and the market participant concept), other specified guidance (such as an exception for the measurement of financial instruments held in a portfolio with certain offsetting risks), and most disclosures. Certain of the amendments in the ASU will result in significant changes in practice. Such changes include how and when the valuation premise of highest and best use applies, the application of premiums and discounts, as well as new required disclosures. Despite the boards alignment on most aspects of the project, certain differences were not resolved. They include the recognition of gains and losses at the inception of a transaction that result from differences between fair value and transaction price (day one gains and losses), the valuation of certain investments that report a net asset value (NAV), and certain disclosure requirements. .4 This Dataline describes the key changes to U.S. GAAP as well as other notable clarifying guidance included in the ASU. It also highlights key differences that will remain between U.S. GAAP and IFRS. PwC observation: One aspect of the fair value measurement project has yet to be resolved. The boards had originally proposed a measurement uncertainty analysis disclosure for unobservable (Level 3) fair value measurements. Constituents suggested the boards clarify and/or reconsider the proposed disclosure, citing cost/benefit concerns and a view that the proposed disclosure would not provide meaningful information. As a result, the boards decided to address the proposed measurement uncertainty analysis disclosure in a separate phase of the project. In its place, quantitative disclosures about unobservable inputs for all Level 3 fair value measurements, as well as qualitative disclosures about the sensitivity inherent in recurring Level 3 fair value measurements will now be required until issues involving the measurement uncertainty disclosure are resolved. Similar to the proposed disclosure, the new quantitative and qualitative Level 3 disclosures may entail significant effort to prepare. It is unclear at this time when the boards will revisit the measurement uncertainty analysis disclosure.
Key provisions
.5 The following key provisions are consistent between U.S. GAAP and IFRS. Primary changes to U.S. GAAP Highest and best use and the valuation premise .6 Under existing U.S. GAAP, the valuation premise incorporates two approaches for determining the highest and best use of an asset: in-use and in-exchange. In-use
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refers to a valuation premise for an asset that provides maximum value to market participants principally through its use with other assets as a group. In-exchange refers to a valuation premise for an asset that provides maximum value to market participants principally on a stand-alone basis. The boards have eliminated the terms in-use and inexchange and instead now describe the objectives of the valuation premise. .7 Under the new guidance, the concepts of the valuation premise and highest and best use are only relevant when measuring the fair value of nonfinancial assets (and therefore will not apply to financial assets and to liabilities except in the limited circumstances described in the paragraph following). This represents a significant amendment to ASC 820, which today provides general guidance on the application of the valuation premise and highest and best use for assets but provides for its application to all assets, as appropriate in the circumstances. Therefore, the grouping of financial instruments for purposes of determining their fair values is prohibited (except as provided for under the exception for portfolios as described in paragraph .11 below). The fair value of financial instruments must be measured at the level of the unit of account as specified in other guidance. .8 For nonfinancial assets, the objectives of the valuation premise are described such that the highest and best use of a nonfinancial asset may provide maximum value either in combination with a group of assets, or a group of assets and liabilities (formerly inuse), or on a standalone basis (formerly in-exchange). An example of a grouping of assets or liabilities may be a business. Liabilities associated with the complementary assets can include liabilities that fund working capital. However, liabilities used to fund assets other than those within the group of assets cannot be included in the valuation. .9 The boards decided to restrict the highest and best use valuation premise based on the view that financial assets do not have alternative uses, that disposing of financial assets in different ways (such as in a group) represents an entity-specific decision, and that the concept of highest and best use was originally developed for valuing nonfinancial assets, such as land. Therefore, under the new guidance, aggregating individual financial assets (such as a block position of a particular equity security) into a pool of securities or block position will no longer be permitted in arriving at a valuation. Rather, measurement will be based on the value of the individual security consistent with the unit of account defined by other guidance. This will apply even though the disposition of the financial assets may be most efficiently and economically achieved by grouping them, and such groupings may be consistent with prior business practices and with managements intent. PwC observation: The current in-use methodology is commonly applied to financial items that trade in pools of relatively homogeneous assets, such as blocks of equity securities. The elimination of the in-use methodology for financial instruments may significantly affect the way that entities such as private equity firms value their financial asset holdings, resulting in values that may be inconsistent with expectations based on business and market practices. However, there may be circumstances where entities can avail themselves of the exception to this principle when valuing groups or portfolios of financial instruments with similar risks as described in paragraph .11 below.
Measuring portfolios of financial instruments .10 The new guidance includes an exception to the valuation premise when an entity manages its market risk(s) and/or counterparty credit risk exposure within a group (portfolio) of financial instruments, on a net basis. This exception includes portfolios of derivatives that meet the definition of a financial instrument that are managed on a net
basis. The exception allows for the fair value of those financial assets and financial liabilities to be measured based on the net positions of the portfolios (i.e., the price that would be received to sell a net long position or transfer a net short position for a particular market or credit risk exposure), rather than the individual values of financial instruments within the portfolio. This represents an exception to how financial assets and financial liabilities will be measured under the new guidance, which requires each unit of account within a portfolio to be measured on its own (that is, on a gross basis). .11 In order to qualify for either the exception related to market risk(s) or credit risk, the reporting entity must meet the following criteria: It manages the group of financial assets and financial liabilities on the basis of its net exposure to a particular market risk (or risks) or to the credit risk of the counterparty, in accordance with the reporting entitys documented risk management or investment strategy. Market risks refer to interest rate risk, currency risk, or other price risk (for example, market price risk). It provides information on that basis about the group of financial assets and financial liabilities to management. It is required to or has elected to measure the financial assets and financial liabilities at fair value in the balance sheet at each reporting date. .12 The reporting entity must make an accounting policy decision to use the exception and apply it consistently from period to period for the portfolio. Offsetting market risks .13 In addition to meeting the criteria outlined in paragraphs .11 and .12 above, the new guidance requires that market risks that are being offset be substantially the same. Entities should apply the bid-ask spread guidance in ASC 820 to the net position (that is, an entity should apply the price within the bid-ask spread that is most representative of the fair value of the entity's net exposure to those market risks). The adjustments applied to the net position will then need to be allocated among the positions in the portfolio to arrive at their individual fair values using a reasonable and consistent methodology that is appropriate in the circumstances. PwC observation: It is important to note that the exception relating to the offsetting of market risks is limited to those risks that are substantially the same, in nature and duration. Therefore, it would be inappropriate to apply the guidance for offsetting risks by offsetting interest rate risk and currency risk, or other price risk. However, the exception can be applied to basis risk, provided that the basis risk is taken into account in the fair value measurement. As a result, provided an entity meets the criteria for applying the exception, it would be appropriate to offset financial instruments with different interest rate bases if the entity manages the associated risk on a net basis (e.g., LIBOR and treasury rates).
Offsetting credit risk .14 In addition to meeting the criteria outlined in paragraphs .11 and .12 above, to apply the exception related to credit risk, the entity must consider market participants expectations about whether any arrangements in place to mitigate credit risk exposure are legally enforceable in the event of default (for example, through a master netting arrangement). In a portfolio of financial assets and liabilities within a master netting arrangement, the adjustment for credit risk could be applied to the net exposure to the
counterparty, rather than to each of the financial assets and liabilities separately. The adjustment will be applied to the net position based on the counterparty's credit risk in the case of a net asset position or the reporting entity's own credit risk in the case of a liability position. Blockage factors and other premiums and discounts .15 A blockage factor is a discount applied in measuring the value of a security to reflect the impact on its value of selling a large block of the security at one time. ASC 820 currently prohibits application of a blockage factor in measuring the fair value of financial instruments that have quoted prices in active markets (that is, Level 1 fair value measurements). However, blockage factors are not currently prohibited for Level 2 and Level 3 fair value measurements under ASC 820. .16 The new guidance is intended to clarify the application of blockage factors and other premiums or discounts in a fair value measurement. The ASU specifies that premiums or discounts that represent an adjustment relating to the size of an entitys holding of the asset or a liability (specifically, blockage factors) are not permitted. While discounts related to size of a holding may not be appropriate, discounts related to other attributes of an asset, such as the absence of liquidity of a particular security, are appropriate in a fair value measurement. Therefore, a fair value measurement that is not a Level 1 measurement may include premiums or discounts when market participants would do so in pricing the asset or liability at the level of its unit of account specified in other guidance. Adjustments to the inputs for assets or liabilities deemed to be within Level 1 of the fair value hierarchy would continue to be precluded (i.e., if a fair value measurement is a Level 1 fair value measurement, the fair value should be measured as the price times the quantity held, without adjustment). .17 The new guidance therefore prohibits the use of blockage factors in all levels in the fair value hierarchy, on the basis that the incurrence of a blockage factor is an entityspecific decision (which does not form part of a fair value measurement). However, it may permit the incorporation of a control or concentration premium in Levels 2 and 3 of the fair value hierarchy. Control premiums are applied in the context of a controlling interest on the basis that the adjustment represents a characteristic of all of the underlying securities held. Under the guidance, reporting entities should assume that market participants transact in their economic best interest. As a result, when determining the fair value of individual securities held that represent a controlling interest, it would be appropriate to conclude that a market participant would pay a premium to acquire the additional benefits attributable to the controlling interest. The incorporation of premiums or discounts would continue to be appropriate in the case of a reporting unit for which fair value is applied in connection with a business combination or goodwill impairment testing. PwC observation: The new guidance regarding premiums and discounts may require changes to current practice for large blocks of securities held by private equity or investment companies. In such cases, immediate gain recognition may occur if a block of securities was purchased at a discount because a blockage factor would not be permitted on the basis of the number of shares held. Conversely, immediate loss recognition would not be expected to occur if a block of securities was purchased at a premium resulting in the entity holding a controlling interest through this block of securities.
Disclosures .18 The new guidance includes some new and revised disclosure requirements. The boards decided to retain most of the proposed disclosures with some clarifications.
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However, the proposed measurement uncertainty disclosure was deferred as a separate phase of the project. Certain additional disclosures regarding Level 3 fair value measurements will be required. The new disclosures are described below. .19 For all Level 3 fair value measurements, quantitative information about significant unobservable inputs used and a description of the valuation processes in place will be required. Furthermore, a qualitative discussion about the sensitivity of recurring Level 3 fair value measurements will be required. These disclosures replace the originallyproposed measurement uncertainty analysis that would have required entities to disclose the effect on a Level 3 fair value measurement when changes from unobservable inputs to other inputs that could reasonably have been substituted result in significant differences in measurement. .20 The new guidance also requires that U.S. public companies, and all companies under IFRS, disclose any transfers between Level 1 and Level 2 fair value measurements on a gross basis, including the reasons for those transfers. The requirement to disclose any such transfers is broader than the current requirement under U.S. GAAP, which focuses on significant transfers, and may be more operationally difficult to apply in practice. .21 Also included in the new guidance is a requirement regarding the disclosure about the highest and best use of a nonfinancial asset. If the highest and best use of a nonfinancial asset differs from its current use by the entity, the entity will now be required to disclose the reason(s) why the asset is being used differently. This is required in the case where the nonfinancial asset is being recorded at fair value on the balance sheet (as well as those only disclosed at fair value, for public companies). For example, if a nonfinancial asset is acquired in a business combination and is recorded at fair value based on its highest and best use, which is different from how the acquiring entity is using the asset in its business, it is required to disclose that fact and the reason(s) why. .22 The new guidance also contains a requirement that all fair value measurements (whether they represent fair value measurements recognized on the balance sheet or, for public companies, are disclosure-only in accordance with ASC 825) be categorized in the fair value hierarchy with disclosure of that categorization. As a result, public companies will now be required to determine the level in the fair value hierarchy of assets and liabilities that are not recorded at fair value (such as the disclosure of the fair value of long-term debt that is recorded at amortized cost on the balance sheet). Disclosure exceptions for nonpublic entities .23 No exceptions to the principles of fair value measurement have been provided to nonpublic entities. However, the FASB decided that nonpublic entities will not be required to disclose: Any of the disclosures above pertaining to fair value measurements if fair values are not reported as the measurement basis on the balance sheet, but are only disclosed. Transfers of fair value measurements between Level 1 and Level 2 of the fair value hierarchy. The qualitative discussion about the sensitivity of recurring Level 3 fair value measurements. Other new or clarifying guidance Principal (or most advantageous) market .24 The new guidance includes a clarification that the principal market is the market with the greatest volume and level of activity for the asset or liability. This represents a
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change from existing U.S. GAAP, which currently indicates that the principal market is the market where the reporting entity transacts with the greatest volume and level of activity for the asset or liability. However, the new guidance also clarifies that the principal market is presumed to be the market in which the reporting entity normally transacts, unless there is evidence to the contrary. Reporting entities do not have to do exhaustive searches for other markets where the asset or liability may have more activity. Practice is not expected to change except where it is evident there is another active market with greater activity for the asset or liability than the one in which the reporting entity transacts. .25 In addition to the clarification of the principal market, the new guidance specifies that in the absence of a principal market for an asset or liability, a reporting entity should determine the most advantageous market and, in doing so, take into account both transaction costs and transportation costs. Further, the measurement of fair value continues to incorporate transportation costs but excludes transaction costs unless specifically required by other U.S.GAAP. This does not represent a difference from how U.S. GAAP is applied today. Application to liabilities .27 Two clarifications relative to the guidance for measuring the fair value of liabilities are introduced by the new guidance. The first requires that transfer restrictions on liabilities be ignored in the valuation because the fair value of the liability is a function of the requirement to fulfill the obligation. This is different from an asset, whereby a restriction on the transfer of the asset affects its marketability. The boards determined that nearly all liabilities include a restriction preventing their transfer. Consequently, the effect of any restrictions preventing the transfer of a liability would be consistent for all liabilities; thus, such restrictions are effectively inherent in other inputs to the valuation. This is consistent with current practice for valuing liabilities based on a hypothetical transfer. .28 The second clarification pertains to the income approach for liabilities. When measuring the fair value of a liability using a present value technique, U.S. GAAP currently requires that a reporting entity include the compensation that a market participant would require for taking on that obligation. The new guidance clarifies that compensation that a market participant would require for taking on the obligation includes the return that the market participant would require for (1) undertaking the activity and (2) assuming the risk associated with the obligation. The return for undertaking the activity represents the value of fulfilling the obligation, for example, by using resources that could be used for another purpose. The return for assuming the risk represents the value associated with the risk that cash flows may ultimately differ from expectations. Because existing U.S. GAAP requires that reporting entities include market participant assumptions in the fair value measurement (including considering compensation for taking on a liability) this clarification, while providing clearer guidance, is not expected to result in a significant change in practice. Instruments classified within shareholders equity .29 While ASC 820 currently does not include guidance on how to measure the fair value of instruments classified within shareholders equity, the principles in ASC 820 must be applied when measuring their fair values. An example where this may apply is when equity interests are issued as consideration in a business combination. Based on the new guidance, the valuation model of instruments classified within shareholders' equity is consistent with the requirements for measuring the fair value of liabilities. The new guidance specifies that an entity should measure the fair value of its own equity instruments from the perspective of a market participant who holds the instrument as an asset. Similar to the application to liabilities, when equity instruments are not held by other parties as assets, an entity should use a valuation technique using market
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participant assumptions. This new guidance is not expected to result in a change in practice under U.S. GAAP. However, some entities could experience a difference if they have historically used another method to value these instruments.
Effective date and transition

.30 For public entities, the ASU is effective for interim and annual periods beginning on or after December 15, 2011, with early adoption prohibited. Nonpublic entities must adopt the new guidance in annual periods beginning on or after December 15, 2011 but may choose to begin applying it in interim periods beginning after December 15, 2011. IFRS 13 is effective for annual periods beginning on or after January 1, 2013, with earlier application permitted. The new guidance requires prospective application. .31 Because application is prospective, any changes in fair value measurements resulting from the application of the new guidance should be recorded as a change in estimate through the income statement in the first period of application. However, in the period of adoption, a reporting entity will have to disclose the change, if any, in the valuation techniques applied and related inputs resulting from the application of the new guidance and quantify the total effect, if practicable.
Differences between U.S. GAAP and IFRS

.32 The impetus for this joint project was convergence of the fair value measurement and disclosure guidance between U.S. GAAP and IFRS. Based on the new guidance, a high degree of convergence should be achieved for the measurement and disclosure of the fair value of assets and liabilities, when fair value is required or permitted to be used. However, certain key differences between the fair value measurement and disclosure guidance under U.S. GAAP and IFRS will continue to exist, as described below. Day one gains and losses .33 The issuance of ASC 820 resulted in a difference between U.S. GAAP and IFRS in the accounting for day one gains and losses. Under ASC 820, the immediate recognition of gains and losses is required even when inputs are unobservable. ASC 820 had the effect of nullifying prior guidance that prohibited immediate recognition of unrealized gains and losses for the difference between transaction price and fair value, when the fair value determination relied significantly on inputs that were not based on observable market data. Furthermore, the ASU confirms that guidance by adding the following in amended ASC 820-10-30-6: If another Topic requires or permits a reporting entity to measure an asset or a liability initially at fair value and the transaction price differs from fair value, the reporting entity shall recognize the resulting gain or loss in earnings unless that Topic specifies otherwise. .34 While IFRS 13 contains similar language, certain IFRS contain guidance disallowing the recognition of day one gains and losses when the fair value measurement is based on inputs that are not observable. For example, such guidance is in IAS 39, Financial Instruments: Recognition and Measurement, and IFRS 9, Financial Instruments. The IASB has not addressed whether it will change that guidance. .35 While this difference pertains to the recognition of gains and losses (rather than to how the fair value of an asset or liability should be measured or disclosed), it is an important difference that arises in the fair value measurement of certain assets and liabilities.
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Measuring the fair value of certain investments .36 In October 2009, the FASB issued ASU 2009-12, Fair Value Measurements and Disclosures (Topic 820): Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent), which amended ASC 820. This guidance provides a practical expedient to reporting entities, allowing them to measure the fair value of investments within the scope of the ASU at NAV, under certain conditions. The scope of the guidance includes investments in entities that are substantially similar to investment companies, as specified in ASC 946, Financial Services - Investment Companies. The guidance was issued due to certain practical difficulties of adjusting NAV to estimate the fair value of certain alternative investments. .37 The FASB retained this guidance in the ASU. However, under IFRS, there currently is no similar definition of or guidance on investment companies. As a result, and because NAV is not defined or calculated in a consistent manner in different parts of the world, the IASB has decided against issuing similar guidance on measuring alternative investments at this time. Certain disclosures .38 IFRS currently requires a quantitative sensitivity analysis for financial instruments that are measured at fair value and categorized within Level 3 of the fair value hierarchy. In accordance with IFRS 7, Financial Instruments: Disclosures, entities should disclose whether changing one or more of the inputs to reasonably possible alternative assumptions would change a Level 3 fair value measurement significantly, and disclose the effect of those changes. Entities should disclose how the effect of a change to reasonably possible alternative assumptions was calculated. This requirement has been carried forward from IFRS 7 into IFRS 13. U.S. GAAP does not contain such a requirement; it requires only the quantitative and qualitative disclosures for Level 3 fair value measurements described above.
Next steps
.39 Companies should evaluate their fair value measurements to determine which, if any, of the measurement techniques they use will have to change as a result of the new guidance, and what additional disclosures will be necessary. .40 PwC will issue a supplementary Dataline in the near future to address specific application issues in more depth. PwC observation: While many of the changes to U.S. GAAP are clarifications to existing guidance, some (such as the change in the valuation premise, the application of premiums and discounts to fair value measurements, and the new required disclosures) could have a significant impact on current practice. Companies are encouraged to begin performing an assessment of the impact of the new guidance on their financial reporting.
Questions
.41 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the financial instruments team in the National Professional Services Group (1-973-236-7803).
Dataline
Authored by:
Tom McGuinness Partner Phone: 1-973-236-4034 Email: thomas.mcguinness@us.pwc.com Jill Butler Partner Phone: 1-973-236-4678 Email: jill.butler@us.pwc.com Mia DeMontigny Managing Director Phone: 1-973-236-4012 Email: mia.l.demontigny@us.pwc.com Laurence Falicon Senior Manager Phone: 1-973-236-7015 Email: laurence.falicon@us.pwc.com
Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. PwC refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

FASB and IASB issue final fair value guidance
Whats new?
On May 12, 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU), and the International Accounting Standards Board (IASB) issued International Financial Reporting Standard (IFRS) 13, Fair Value Measurement (together, the new guidance). The new guidance amends U.S. GAAP and is a new standard under IFRS.
No. 2011-20 May 13, 2011

The new guidance results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. GAAP and IFRS. While many of the amendments to U.S. GAAP are not expected to have a significant effect on practice, the new guidance changes some fair value measurement principles and disclosure requirements. The key changes to U.S. GAAP are described below. Highest and best use and valuation premise The new guidance states that the concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities). The new guidance therefore prohibits the grouping of financial instruments for purposes of determining their fair values when the unit of account is specified in other guidance, unless the exception provided for portfolios described below applies and is used. Blockage factors and other premiums and discounts Current guidance prohibits application of a blockage factor in valuing financial instruments with quoted prices in active markets. The new guidance extends that prohibition to all fair value measurements. Premiums or discounts related to size as a characteristic of the entitys holding (that is, a blockage factor) instead of as a characteristic of the asset or liability (for example, a control premium), are not permitted. A fair value measurement that is not a Level 1 measurement may include premiums or discounts other than blockage factors when market participants would incorporate the premium or discount into the measurement at the level of the unit of account specified in other guidance.
In brief
Measuring the fair value of financial instruments held in a portfolio The new guidance includes an exception to the valuation principle described above. The exception is available to an entity when it manages market risks (that is, interest rate risk, currency risk, or other price risk) and/or counterparty credit risk exposures of a group (portfolio) of financial instruments on the basis of the entitys ne t exposure. The exception allows the entity to measure those financial instruments on the basis of the net position for the risk being managed. Certain criteria must be met in order to apply the exception. Instruments classified within shareholders equ ity The new guidance aligns the fair value measurement of instruments classified within an entitys shareholders equity with the guidance for liabilities. As a result, an entity should measure the fair value of its own equity instruments from the perspective of a market participant that holds the instruments as assets. Disclosures The disclosure requirements have been enhanced, with certain exceptions for U.S. nonpublic companies. The most significant change will require entities, for their recurring Level 3 fair value measurements, to disclose quantitative information about unobservable inputs used, a description of the valuation processes used by the entity, and a qualitative discussion about the sensitivity of the measurements. New disclosures are required about the use of a nonfinancial asset measured or disclosed at fair value if its use differs from its highest and best use. In addition, entities must report the level in the fair value hierarchy of assets and liabilities not recorded at fair value but where fair value is disclosed.
Although the new guidance is substantially converged, there will continue to be some differences. The IASB has not changed its accounting for the recognition of day one gains and losses. Unlike U.S. GAAP, IFRS requires that a fair value measurement be based on observable inputs in order for a gain or loss to be recognized at inception. IFRS also does not provide a practical expedient similar to the one under U.S. GAAP for the measurement of certain investments that report a net asset value.
Whos affected?
The new guidance affects all entities that measure or disclose assets, liabilities, or equity at fair value. The new measurement provisions may have a more significant impact on entities that have a significant amount of financial instruments recorded at fair value.
Whats the effective date?

For public entities, the ASU is effective for interim and annual periods beginning on or after December 15, 2011, with early adoption prohibited. Nonpublic entities must adopt the new guidance in annual periods beginning on or after December 15, 2011 but may choose to apply it in interim periods beginning after December 15, 2011. IFRS 13 is effective for annual periods beginning on or after January 1, 2013, with earlier application permitted. The new guidance will require prospective application.
Whats next?
Companies should evaluate their fair value measurements to determine which, if any, of the measurement techniques they use will have to change as a result of the new guidance, and what additional disclosures will be necessary.
Questions?
Authored by:
Tom McGuinness Partner Phone: 1-973-236-4034 Email: thomas.mcguinness@us.pwc.com Jill Butler Partner Phone: 1-973-236-4678 Email: jill.butler@us.pwc.com Mia DeMontigny Managing Director Phone: 1-973-236-4012 Email: mia.l.demontigny@us.pwc.com Laurence Falicon Senior Manager Phone: 1-973-236-7015 Email: laurence.falicon@us.pwc.com
US GAAP Convergence & IFRS Statement of comprehensive income

FASB to issue a revised proposal on reclassifications from other comprehensive income
What's new?
This week the FASB decided to issue an exposure draft requiring new footnote disclosures for reclassifications from accumulated other comprehensive income to net income. In its 2011 standard on the presentation of comprehensive income, the FASB required reclassification adjustments from accumulated other comprehensive income to be measured and presented by income statement line item in net income and also in other comprehensive income on the face of the financial statement. However, responding to 2 concerns from financial statement preparers, the FASB decided to indefinitely defer that requirement pending further outreach. Refer to In brief 2011-57, FASB finalizes deferral of new presentation requirement for other comprehensive income reclassifications , for further background information. Having completed its outreach, the FASB plans to issue a proposal intended to address preparer concerns while being responsive to financial statement user requests for greater transparency about the impact of reclassification adjustments on net income.
1
No. 2012-16 June 22, 2012

The exposure draft will propose requiring public and nonpublic companies to present additional information about reclassification adjustments in their interim and annual financial statements. Most notably, companies would disclose, in a single footnote, the amount reclassified from each component of accumulated other comprehensive income based on its source (e.g., interest rate contracts included in gains and losses on cash-flow hedges) and the income statement line items affected by the reclassification (e.g., interest income and
1
Accounting Standards Update 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, issued on June 16, 2011 2 Accounting Standards Update No. 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05
In brief
interest expense) using a tabular format. However, companies would not be required to disclose the income statement line items that are affected by pension costs reclassified from accumulated other comprehensive income. The FASB decided to make this exception due to feedback from preparers that they are currently unable to provide this information. Companies would also disclose the total amount reclassified from each component of accumulated other comprehensive income (e.g., the total amount reclassified from unrealized gains and losses on available-for-sale securities).
Who's affected?
All entities that report items of other comprehensive income could be affected.

The exposure draft will not propose an effective date. However, the FASB intends to make these requirements effective as soon as possible, potentially as early as the fourth quarter of 2012 or the first quarter of 2013 for public entities. The FASB plans to ask preparers for input on the time needed to implement these requirements. Nonpublic entities would likely get an additional year to implement these requirements.
What's next?
The exposure draft is expected to be released in July 2012 with a 60-day comment letter period. Thereafter, the FASB will consider constituent input in determining if changes are needed and whether a final standard should be issued.
Questions?
In brief
Authored by:
Donald Doran Partner Phone: 1-973-236-5280 Email: donald.a.doran@us.pwc.com Craig Cooke Director Phone: 1-973-236-4706 Email: craig.cooke@us.pwc.com

Presentation of comprehensive income Applying the FASB's final standard on presenting comprehensive income after deferral of the reclassifications requirement
Overview
At a glance
No. 2012-01 January 19, 2012 Whats inside: Overview ......................... 1

Key provisions of the FASB's requirements ... 3

Scope ....................................... 3 The alternatives ...................... 3 Tax effects ............................... 4 Accumulated balances ............ 4 Example presentation ............ 4
Comparison with the IASB's requirement...... 8 Effective date and transition ..................... 8 Questions ........................ 8
The FASB issued a final standard in June 2011 requiring entities to present net income and other comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity is eliminated. As a result, the presentation of comprehensive income will be broadly aligned with IFRS. In response to concerns from some preparers, the FASB issued an amendment in December 2011 to indefinitely defer one of the requirements contained in its June 2011 final standard. That requirement called for reclassification adjustments from accumulated other comprehensive income to be measured and presented by income statement line item in net income and also in other comprehensive income. In Dataline 2011-24 we discussed the final standard as originally issued. Now that the FASB has amended the standard to defer the reclassification reporting requirement, we have updated the discussion from Dataline 2011-24 in this new Dataline to reflect the amended standard along with our additional insight. The new requirements and the related deferral are generally effective for public entities in fiscal years (including interim periods) beginning after December 15, 2011 whereas nonpublic entities will generally only apply the new requirements for the first time in their 2012 year-end financial statements. Early adoption is permitted. Full retrospective application is required.
Dataline
The main details .1 On June 16, 2011, the FASB issued a new standard 1 requiring most entities to present items of net income and other comprehensive income either in one continuous statement referred to as the statement of comprehensive income or in two separate, but consecutive, statements of net income and other comprehensive income. .2 The FASB and IASB (the "Boards") worked jointly on this project, and at the same time the IASB issued an amendment to IAS 1, Presentation of Financial Statements. As the IASB had eliminated the option to present other comprehensive income within the statement of changes in equity in 2007, the changes under IFRS are more limited. The standards are intended to enhance comparability between entities that report under US GAAP and those that report under IFRS. The standards are also intended to provide a more consistent method of presenting non-owner transactions that affect an entity's equity and increase the prominence of items reported in other comprehensive income. .3 The new requirements do not change, under either accounting framework, which components of comprehensive income are recognized in net income or other comprehensive income, or when an item of other comprehensive income must be reclassified to net income. Also, the earnings-per-share computation does not changeit will continue to be based on net income. Nevertheless, the Boards felt that these presentation changes are needed because of the potential for more or different items to be reflected in other comprehensive income under other proposals. For example, the FASB's tentative proposed classification and measurement approach for financial instruments contemplates changes in the use of other comprehensive income and the IASB's recent amendment to pension accounting requires greater use of other comprehensive income. .4 On December 23, 2011, the FASB issued an amendment to the new standard on 2 comprehensive income to defer the requirement to measure and present reclassification adjustments from accumulated other comprehensive income to net income by income statement line item in net income and also in other comprehensive income. That requirement would have called for the measurement and presentation in net income of items previously recognized in other comprehensive income. For example, pension expense may include amortization of actuarial gains and losses previously recognized in other comprehensive income. The amount of amortization and which line items in the income statement are affected would need to measured and presented on the face of the statement. The requirement also eliminated the option to disclose reclassification adjustments in the footnotes. .5 As a result of the deferral, entities will continue to report reclassifications out of accumulated other comprehensive income consistent with the requirements in effect before adoption of the new standardthat is, by component of other comprehensive income, either by displaying each component on a gross basis on the face of the appropriate financial statement, or by displaying each component net of other changes on the face of the appropriate financial statement with the gross change disclosed in the notes. The deferral is effective at the same time that the new standard is adopted.
1 2
Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income Accounting Standards Update No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive income in Accounting Standards Update No. 2011-05
PwC observation: After the FASB issued its new standard on presenting comprehensive income, a number of constituents highlighted concerns about the new requirement for presenting reclassifications into net income. In particular, when the reclassifications impact multiple line items within net income (e.g., amortization of prior service cost and actuarial gains and losses on pensions could affect cost of goods sold and administrative expenses) or are first capitalized (e.g., to inventory), a number of implementation challenges were noted. In addition, the presentation raised concerns about undue complexity within the statement of net income, potentially compromising clarity. The deferral was intended to allow the FASB time to consider the matter further and conduct additional outreach to financial statement users. While the deferral is for an indefinite period of time, the FASB plans to complete its reconsideration of this matter expeditiously in 2012. Consequently, constituents will not have to wait long before the FASB indicates its likely direction. .6 The new requirements and the related deferral are effective from the beginning of 2012 for calendar year-end public entities with full retrospective application required. Nonpublic entities are only required to apply the new requirements and the related deferral for their 2012 year-end financial statements and their interim and annual periods thereafter. Early adoption is permitted.
Key provisions of the FASB's requirements

Scope .7 The new presentation requirements apply to all entities that provide a full set of financial statements to report financial position, results of operations, and cash flows. The requirements also apply to investment companies, defined benefit pension plans, and other employee benefit plans that are exempt from reporting a statement of cash flows 3. Not-for-profit entities 4 are outside the scope of the requirements. In addition, an entity continues to report only net income in the performance statement if it does not have items of other comprehensive income for any of the periods presented. PwC observation: Although the requirements also apply to investment companies, defined benefit pension plans, and other employee benefit plans, these entities typically do not have items of other comprehensive income. Therefore, we do not expect the new requirements to impact most of these entities. The alternatives .8 An entity can elect to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. An entity is required to display each component of net income and each component of other comprehensive income under either alternative. In addition, under both alternatives, totals need to be displayed for comprehensive income and each of its two parts: net income and other comprehensive income. .9 Under both alternatives, the statement(s) is required to be presented with equal prominence as the other primary financial statements. The previous alternative option to
3 4
Refer to ASC 230, Statement of Cash Flows As defined by ASC 958, Not-for-Profit Entities
Dataline 3
report other comprehensive income and its components in the statement of changes in equity is eliminated. PwC observation: It is unclear whether the elimination of the option to present other comprehensive income within the statement of changes in equity will cause financial statement users to place greater emphasis or importance on other comprehensive income and/or comprehensive income. However, the increased prominence of other comprehensive income and comprehensive income could lead to an increase in questions from financial statement users. Consequently, entities should be prepared to proactively address or respond to these questions. .10 If an entity elects the two statement approach, the second statement the statement of other comprehensive income may begin with net income. The FASB decided not to require an entity to begin with net income in that second statement because that total could be carried over from the statement of net income on the previous page, thereby emphasizing the interdependence between the two statements. .11 If applicable, an entity will continue to separately present items of net income and comprehensive income attributable to its parent and any non-controlling interest. In addition, the requirement does not change:

The items that constitute net income and other comprehensive income When an item of other comprehensive income must be reclassified to net income The earnings-per-share calculation
Tax effects .12 The requirements continue to provide an option to present components of other comprehensive income either (a) net of the related tax effects or (b) before the related tax effects with one amount reported for the tax effects of all other comprehensive income items. Entities are still required to present parenthetically on the face of the statement or disclose in the footnotes the tax allocated to each component of other comprehensive income, including reclassification adjustments. Accumulated balances .13 The total for accumulated other comprehensive income will continue to be presented separately from retained earnings and additional paid-in capital on the statement of financial position. Changes in the components of accumulated other comprehensive income for the period will need to be displayed separately either on the statement of changes in equity or in the footnotes. Example presentation .14 The examples on pages 5-7 illustrate some of the alternative presentation requirements (after considering the related deferral of the new requirement to present reclassifications into net income):
Dataline
Example 1: Single statement

Consolidated Statement of Comprehensive Income
For years ended December 31 2012 2011 $ 3,300,000 (1,950,000) (250,000) 1,100,000 (250,000) 850,000 850,000 (170,000) 680,000
Revenues Expenses Gains (losses) on sales of securities Income from operations before tax Income tax expense Income before extraordinary item Extraordinary item, net of tax Net income Less: net income attributable to noncontrolling interest Net income attributable to the company Earnings per share Basic and diluted
5
$ 3,550,000 (2,100,000) 600,000 2,050,000 (600,000) 1,450,000 (50,000) 1,400,000 (280,000) 1,120,000
0.25
0.15
Other comprehensive income, before tax : Foreign currency translation adjustments Unrealized gains for the period Less: reclassification adjustment for gains included in net income Unrealized gains on available-for-sale securities Prior service cost for the period Net loss for the period Less: amortization of prior service cost included in net income Defined benefit pension plan Other comprehensive income (loss) before tax Income tax (expense) benefit related to items of other comprehensive income Other comprehensive income (loss), net of tax Comprehensive income Less: comprehensive income attributable to the noncontrolling interest Comprehensive income attributable to the company 5,000 450,000 (150,000) 300,000 (10,000) (60,000) 5,000 (65,000) 240,000 (70,000) 170,000 1,570,000 (314,000) $ 1,256,000 (20,000) 60,000 (50,000) 10,000 (5,000) (120,000) 5,000 (120,000) (130,000) 30,000 (100,000) 750,000 (150,000) $ 600,000
Alternative presentation is to show net of tax.

Dataline 5
Example 2: Two separate, but consecutive, statements

Consolidated Statement of Net Income For years ended December 31 2012 Revenues Expenses Gains (losses) on sales of securities Income from operations before tax Income tax expense Income before extraordinary item Extraordinary item, net of tax Net income Less: net income attributable to noncontrolling interest Net income attributable to the company Earnings per share Basic and diluted $ 3,550,000 (2,100,000) 600,000 2,050,000 (600,000) 1,450,000 (50,000) 1,400,000 (280,000) $ 1,120,000 2011 $ 3,300,000 (1,950,000) (250,000) 1,100,000 (250,000) 850,000 850,000 (170,000) $ 680,000
0.25
0.15
Dataline
After page break: Consolidated Statement of Comprehensive Income For years ended December 31 2012 Net income Other comprehensive income, before tax : Foreign currency translation adjustments Unrealized gains for the period Less: reclassification adjustment for gains included in net income Unrealized gains on available-for-sale securities Prior service cost for the period Net loss for the period Less: amortization of prior service cost included in net income Defined benefit pension plan Other comprehensive income (loss), before tax Income tax (expense) benefit related to items of other comprehensive income Other comprehensive income (loss), net of tax Comprehensive income Less: comprehensive income attributable to the noncontrolling interest Comprehensive income attributable to the company 5,000 450,000 (150,000) 300,000 (10,000) (60,000) 5,000 (65,000) 240,000 (70,000) 170,000 1,570,000 (314,000) $ 1,256,000 (20,000) 60,000 (50,000) 10,000 (5,000) (120,000) 5,000 (120,000) (130,000) 30,000 (100,000) 750,000 (150,000) $ 600,000
6
2011 $ 850,000
$ 1,400,000
Alternative presentation is to show net of tax.

Dataline 7
Comparison with the IASB's requirement

.15 The IASB's amendment to IAS 1 is similar to the FASB's final standard. However, some terminology and other differences exist between the two final standards. .16 IFRS currently allows comprehensive income to be presented in two statements: a statement displaying components of profit or loss and a second statement beginning with profit or loss and displaying components of other comprehensive income. Therefore, the new standard has a limited impact on current IFRS. The IASB had eliminated the option to present other comprehensive income within the statement of changes in equity in 2007. .17 Consistent with the FASB's final standard, the IASB standard does not change the items that constitute net profit or loss or other comprehensive income. Earnings-pershare continues to be based on net profit or loss. Also, entities continue to have the option to present items of other comprehensive income either gross or net of tax. .18 The IASB requires that items included in other comprehensive income that might be reclassified subsequently to profit or loss (for example, cash flow hedges and the cumulative translation adjustment) be presented separately from those that will not be reclassified (for example, revaluations of property, plant, and equipment, and actuarial gains and losses). This distinction does not exist under U.S. GAAP, where all items included in other comprehensive income might subsequently be reclassified into net income. .19 An entity that elects to show items in other comprehensive income before tax is required to allocate the tax between the tax on items that might be reclassified subsequently to profit or loss and tax on items that will not be reclassified subsequently. .20 The IASB has retained the option to disclose reclassification adjustments in the notes to the financial statements. As noted above, the FASB decided to eliminate that option, but subsequently deferred that change. The difference in the approaches by the two boards is due, at least in part, to the fact that fewer items are reclassified from other comprehensive income into net income under IASB standards. Therefore, the IASB did not deem it necessary to require reclassification adjustments to be presented on the face of the income statement. .21 The one continuous performance statement alternative is referred to by the IASB as the statement of profit or loss and other comprehensive income. Both the FASB and the IASB, however, continue to allow entities to use other titles for the primary financial statements.

.22 The new U.S. GAAP requirements and the related deferral are effective for public entities as of the beginning of a fiscal year that begins after December 15, 2011 (including interim periods) and for nonpublic entities for fiscal years ending after December 15, 2012 and interim and annual periods thereafter. The new IFRS requirements are effective for fiscal years that begin on or after July 1, 2012. Early adoption is permitted. .23 Full retrospective application is required under both accounting standards.
Questions
.24 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact a member of the Financial Instruments Team in the National Professional Services Group (1-973-2367803).
Authored by:
Donald Doran Partner Phone: 1-973-236-5280 Email: donald.a.doran@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com
US GAAP Convergence & IFRS Balance sheet offsetting

FASB amends and clarifies scope of balance sheet offsetting disclosures
What's new?
Over the past several months, issuers and other constituents in a variety of industries have raised concerns to the FASB staff and board regarding the scope of the new balance sheet offsetting disclosure requirements. In response to these concerns, at its October 31 meeting the FASB decided to amend and clarify the scope of the balance sheet offsetting disclosures. These disclosures are effective in Q1 2013 for calendar year-end companies. Background In December 2011, the FASB issued Accounting Standards Update No. 2011-11, Disclosures about Offsetting Assets and Liabilities (the "ASU"). The new disclosures require that entities disclose both gross and net information about recognized financial instruments and derivative instruments that are:
No. 2012-48 November 1, 2012
offset in the statement of financial position (in accordance with either ASC 210-2045 or ASC 815-10-45), or subject to an enforceable master netting arrangement or similar agreement irrespective of whether they are offset in the statement of financial position.
During the deliberations of the ASU, board discussions were focused primarily on instruments that are traditionally offset in the financial statements or subject to master netting agreements such as derivatives and repurchase agreements. However, the scope of the ASU includes all transactions governed by master netting agreements or similar agreements regardless of whether the transactions are offset or are eligible for offset in the balance sheet. As a result, the new guidance also includes arrangements that may exist outside the financial services industry.

In response to the concerns raised, the FASB decided to amend and clarify the scope of the disclosures to include only derivatives, repurchase agreements and securities lending transactions. The board plans to release an exposure draft with the revised scope language in the coming weeks. During the comment period for the exposure draft, the FASB staff may perform additional outreach to gain a better understanding of the extent of those transactions that would be excluded from the disclosure as a result of the revised scope language. Such outreach may include obtaining information regarding balances
that are being offset on the balance sheet, but would not be included in the new disclosures.
In the ASU, the FASB and IASB did achieve convergence on the disclosure requirements, but did not converge on the requirements to offset balances in the statement in financial statements. The proposed change in the scope language for U.S. GAAP reporting could create differences between the disclosures reported under U.S. GAAP and IFRS. However, the transactions that result in the most significant differences in the presentation under U.S. GAAP and IFRS, namely derivatives, repurchase agreements, and securities lending agreements will be addressed in these disclosure requirements. These transactions were the drivers behind the respective boards' offsetting projects.
Who's affected?
The ASU will impact entities with agreements that would have otherwise required disclosure in accordance with the ASU. However, entities with derivative assets and derivative liabilities, repurchase agreements, and securities lending arrangements will require additional disclosures as originally provided for.

An entity is required to apply the disclosures for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods.
What's next?
An exposure draft is expected during November 2012.
Questions?
In brief
Authored by:
Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com Kristin Derington-Ruiz Senior Manager Phone: 1-973-236-7093 Email: kristin.derington-ruiz@us.pwc.com

FASB issues final standard on balance sheet offsetting disclosures
J What's new? u n On December 16, 2011, the FASB issued Accounting Standards Update No. 2011-11, e Disclosures about Offsetting Assets and Liabilities. The standard requires disclosures to
No. 2011-53 December 20, 2011
provide information to help reconcile differences in the offsetting requirements under U.S. GAAP and IFRS. The differences in the offsetting requirements account for a x significant difference in the amounts presented in statements of financial position x prepared in accordance with U.S. GAAP and IFRS for certain entities. ,
Background 2 0 This project began as an attempt to converge the offsetting requirements under U.S. 1 GAAP and IFRS. In January 2011, the FASB issued proposed guidance that would have 1 established a common approach to offsetting with IFRS. The proposed approach would
have required an entity to offset a recognized financial asset and a recognized financial liability and to present the net amount in the statement of financial position if, and only if, it has an unconditional and legally enforceable right of set off and intends either to settle the asset and liability on a net basis or to realize the asset and settle the liability simultaneously. Subsequently, the FASB decided (by a narrow margin) to allow an exception that would permit netting of derivatives, repurchase agreements, and related collateral subject to master netting agreements under U.S. GAAP, provided certain conditions are met. The IASB, however, unanimously decided not to permit a similar exception under IFRS. The FASB decision leaves the current offsetting guidance under U.S. GAAP unchanged. As the boards were unable to reach a converged solution, they developed convergent disclosure requirements, noting that financial statement users have consistently asked that information be provided to help reconcile any differences in the offsetting requirements under U.S. GAAP and IFRS. Users have also asked for both gross and net information about transactions eligible for offset.
New disclosure requirements

The new disclosure requirements mandate that entities disclose both gross and net information about instruments and transactions eligible for offset in the statement of financial position as well as instruments and transactions subject to an agreement
In brief
similar to a master netting arrangement. In addition, the standard requires disclosure of collateral received and posted in connection with master netting agreements or similar arrangements. Examples of financial instruments that are not within the scope of the disclosure requirements include the following: Loans and customer deposits at the same institution (unless they are offset in the statement of financial position) Financial instruments that are only subject to a collateral agreement An entity will be required to disclose the following information for assets and liabilities within the scope of the new standard: a) The gross amounts of those recognized assets and those recognized liabilities b) The amounts offset to determine the net amounts presented in the statement of financial position c) The net amounts presented in the statement of financial position d) The amounts subject to an enforceable master netting arrangement or similar agreement not otherwise included in (b) e) The net amount after deducting the amounts in (d) from the amounts in (c) The standard permits flexibility with respect to how certain items are disclosed. For example, companies can choose to disclose items (c) through (e) above either by class of financial instrument or by counterparty. The standard also contains several examples intended to illustrate its application.
The boards were unable to reach a converged solution on the requirements for offsetting. The boards did, however, achieve convergence on disclosure requirements, which will help users to reconcile any differences in the offsetting requirements under U.S. GAAP and IFRS. In addition, the boards were able to respond to requests from financial statement users to provide both gross and net information.1
Who's affected?
The standard affects all entities with balances presented on a net basis in the financial statements, derivative assets and derivative liabilities, repurchase agreements, and financial assets and financial liabilities executed under a master netting or similar arrangement.

An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods.
Questions?
Note: On December 16, 2011, the IASB issued its disclosure guidance as well as guidance clarifying the offsetting requirements under IFRS.
Authored by:
Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com John F. Horan Director Phone: 1-973-236-4072 Email: john.f.horan.iii@us.pwc.com

FASB and IASB take separate paths on derivatives netting rules
J What's new? u n At the June 14, 2011 FASB/IASB joint board meeting, the boards discussed their project e on offsetting financial assets and financial liabilities, specifically considering whether to
No. 2011-28 June 17, 2011
permit netting of derivatives and related collateral subject to master netting agreements. The FASB supported (by a narrow margin) an exception that would permit netting of x these items under U.S. GAAP. The IASB, however, unanimously decided not to permit a x similar exception under IFRS. ,
What did each board decide? 2 0 FASB vote 1 1 In a 4-to-3 vote, the FASB supported a derivatives exception to the new balance sheet
offsetting requirements set forth in the boards January 2011 exposure drafts (the 1 January 2011 joint proposal ). The exception permits offsetting of fair value amounts recognized for derivatives and the related right to reclaim cash collateral (or the obligation to return cash collateral arising from derivatives) with the same counterparty if they are governed by a master netting agreement. The January 2011 joint proposal would have precluded offsetting derivative assets and liabilities and the related collateral recorded on the balance sheet even if the underlying transactions were executed under a single master netting agreement, unless the criteria for unconditional offsetting were met. Master netting agreements provide for netting of amounts owed against amounts due in the event of bankruptcy or default of one of the counterparties. Under current U.S. GAAP, an entity has the ability to elect gross or net presentation for derivatives and collateral subject to master netting agreements. Thus, the requirements of the January 2011 joint proposal would have significantly impacted the balance sheets of many reporting entities that currently apply an accounting policy election to net these amounts.
FASB Proposed Accounting Standards Update, Balance SheetOffsetting, and IASB Exposure Draft, Offsetting financial assets and liabilities.
In brief
IASB vote The IASB unanimously supported a different approach, based predominantly on the requirements for unconditional offsetting in the January 2011 joint proposal, with some modifications based on user comments. The IASB decided to move ahead with an approach in which netting requires an unconditional right of setoff. The IASB is likely to discuss some modifications to the requirements at future meetings. Under current IFRS, derivative assets and liabilities are generally not presented on a net basis unless very specific criterion is met as there is no "exception" to the existing offsetting criteria. So, the IASBs decision is more in line with current IFRS requirements.
The existing differences in offsetting requirements under U.S. GAAP and IFRS account for the single largest quantitative difference in a balance sheet under U.S. GAAP vs. under IFRS. Nonetheless, the boards were unable to reach a converged solution. The boards did, however, decide to work on converging disclosure requirements, noting that users have consistently asked that information be provided to help reconcile any differences in the offsetting requirements under U.S. GAAP and IFRS.
Who's affected?
The requirements of the January 2011 joint proposal would have significantly changed the U.S. GAAP accounting for counterparties to derivatives who execute master netting agreements. The FASBs vote to provide the derivates exception primarily affects them insofar as they will not be required to gross up their balance sheets as was previously proposed.

The January 2011 joint proposal did not specify a target effective date.
What's next?
The FASB and IASB are expected to work together on new disclosures. It is not yet clear when final standards will be issued.
Questions?
In brief
Authored by:
Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com Maria Constantinou Director Phone: 1-973-236-4957 Email:maria.constantinou@us.pwc.com
US GAAP Convergence & IFRS Pensions and postemployment benefits

FASB issues final standard to enhance disclosures for multiemployer pension plans; effective for public companies in 2011
What's new?
On September 21, 2011, the FASB (the "Board") issued Accounting Standards Update No. 2011-09, Compensation - Retirement Benefits - Multiemployer Plans (Subtopic 715-80). The revised standard is intended to provide more information about an employers financial obligations to a multiemployer pension plan and, therefore, help financial statement users better understand the financial health of all of the significant plans in which the employer participates. All entities that participate in multiemployer pension plans will be affected. The revisions do not change the current recognition and measurement guidance for an employer's participation in a multiemployer plan. Multiemployer pension plans allow for two or more unrelated employers to make contributions to one plan. The assets of the plan are commingled and can be used to provide benefits to employees of other participating employers. Multiemployer pension plans are commonly used by employers in unionized industries. Currently, employers are only required to disclose their total contributions to all multiemployer plans in which they participate and certain year-to-year changes in circumstances.
No. 2011-39 September 22, 2011
When is the revised standard effective?

The revised standard is effective for public entities for fiscal years ending after December 15, 2011, with a one year deferral for non-public entities. Early adoption will be permitted and retrospective application will be required.

Employers will be required to disclose on an annual basis for all individually significant multiemployer plans: Legal name of the plan Employer Identification Number of the plan The amount of employer contributions made to each significant plan and to all plans in the aggregate
In brief
An indication of whether the employers contributions represent more than 5% of t otal contributions to the plan The expiration date(s) of collective bargaining agreement(s) and any minimum funding arrangements The most recent certified zone status (a color-coded designation based on the funded status of the plan) as defined by the Pension Protection Act of 2006 ("PPA") If the zone status is not available, an employer will be required to disclose whether the plan is less than 65 percent funded, between 65 percent and 80 percent funded, or greater than 80 percent funded An indication of which plans, if any, are subject to a funding improvement plan (as required under the PPA when a plan is in critical or endangered status) A description of the nature and effect of any changes affecting comparability for each period in which a statement of income is presented To the extent the information required under the revised standard is not available in the public domain, as may be the case for some foreign plans, employers shall include more qualitative information about the plan, including a description of the plan and risks associated with the plan. The revised standard does not require certain of the quantitative disclosures that were originally proposed in its September 2010 exposure draft, including the estimated withdrawal liability, the total assets and the accumulated benefit obligation of the plan, and the employer's contribution to a plan as a percentage of total contributions.
The IASB amended IAS 19, Employee benefits, in June 2011, which included incremental disclosure requirements for multiemployer pension plans. While disclosures will be more closely aligned, certain differences will remain, such as the requirement in IAS 19 to disclose expected contributions for the next annual period. Further, the FASBs standard addresses disclosures only and will not eliminate differences between US GAAP and IFRS accounting for multiemployer pension plans.
Questions?
PwC clients that have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Compensation team in the National Professional Services Group (1-973-236-7802).
In brief
Authored by:
Jay Seliber Partner Phone: 1-973-236-7277 Email: jay.seliber@us.pwc.com Nicole Berman Director Phone: 1-973-236-4202 Email: nicole.s.berman@us.pwc.com

Pension/OPEB accounting Understanding changes expected from the IASB
Overview
At a glance The IASB is nearing completion of various amendments to its standard on accounting for defined benefit pensions and other postretirement benefits (OPEB). The amendments are not the result of joint deliberations with the FASB. However, the objective of the IASB and FASB is to adopt a converged standard on this topic and both boards have stated their intent to make further changes to their respective standards to achieve this. Thus, the changes the IASB is expected to adopt shortly will be considered by the FASB for purposes of achieving convergence. The IASB has concluded that fluctuations in the value of the benefit obligations and plan assets (i.e., gains and losses) should be recognized in the balance sheet in full. This would be accomplished through a charge or credit to other comprehensive income (OCI) in the periods in which the gain or loss occurs. Those amounts would not be subject to subsequent amortization into net income, as currently required under U.S. GAAP. We expect the final amendments to be issued in April 2011, with an effective date no earlier than January 1, 2013. Adoption will be retrospective with early adoption allowed. The summary in this Dataline is based on our understanding of the decisions made by the IASB to date and may change based on our review of the final amendments. Background .1 For many years, the accounting for pensions and OPEB has been criticized by preparers, auditors, and financial statement users. Preparers and auditors have found the strict rules-based guidance on this subject difficult to understand and apply. Investors and other financial statement users have found the information disclosed about retirement benefits difficult to interpret and correlate to the economics of the benefit arrangements.
No. 2011-15 February 28, 2011 Whats inside: Overview .......................... 1

Key provisions .................2
The elimination of deferred recognition ............ 2 Presentation ............................ 4 Disclosure................................ 6 Multi-employer plans ............. 6 Other amendments ................. 7 Items not addressed ............... 7 Transition and effective date ....................................... 7
Questions ........................ 8
Dataline
.2 One of the primary causes of complexity in the accounting has been the deferred recognition techniques that enabled changes in the value of the benefit obligation and 1 2 plan assets to be recognized on a delayed basis under both IFRS and U.S. GAAP . Under that approach, and prior to 2006, the amount reported on the employer's balance sheet did not represent the full amount of the benefit obligation less plan assets. For income statement purposes, deferred recognition results in benefit expense that is significantly less volatile from period to period, since the impact of changes in the value of obligations and plan assets is typically recognized over several subsequent periods. .3 In 2006, the FASB began requiring the funded status of a plan (i.e., the current value 3 of benefit obligations less plan assets) to be reported on the balance sheet . However, deferred recognition of changes in those amounts continued for income statement purposes. Since 2005, the IASB has allowed an alternative approach under which actuarial gains and losses can be recognized immediately on the balance sheet through OCI with no income statement effect.
Key provisions
The elimination of deferred recognition .4 As the IASB debated this project, board members agreed that deferred recognition should be eliminated. That is, any changes in the value of the benefit obligation and plan assets should be immediately recognized in the period in which they occur. The IASB published a discussion paper sharing its preliminary thinking in late 2008. In subsequent deliberations, the board reached a preliminary view that all changes in the obligations and assets, including the effects of plan amendments (i.e., changes to the plan that grant additional benefits attributable to employees' prior service) and gains and losses, should be recognized currently in determining an employer's net income. .5 As the debate continued into 2009, the IASB received feedback from preparers and various stakeholders opposing this treatment. The IASB was told that the deferral mechanisms are needed to reduce the impact of gains and losses on current period earnings. Those who advocated the continued use of deferral mechanisms were troubled by the volatility of net income and earnings per share that could result if the full amount of changes in the obligation and plan assets were recognized in the income statement each period. There was also concern about the understandability of the impact of benefit expense on net income and earnings per share if gains and losses were included in determining those amounts, because gains and losses have less predictive value than other components of benefit expense. .6 The IASBs April 2010 exposure draft (ED) proposed a compromise . Instead of recognizing gains and losses in net income in the period in which they occur, the IASB proposed that they be recognized through a charge or credit to a category called remeasurement costs in OCI. This approach is equivalent to the current U.S. GAAP treatment of such amounts. However, unlike U.S. GAAP, where such amounts are subsequently amortized from accumulated other comprehensive income (AOCI) into benefit expense, the IASB proposed no such "recycling" of these amounts. .7 The majority of comment letters received by the IASB expressed support for the 2010 proposal. However, a number of respondents expressed concern that where assets held to satisfy pension obligations did not meet the definition of plan assets, gain and loss
1 2
International Accounting Standard 19, Employee Benefits. FASB Statements No. 87, 88, 106, and 132(R) (codified in ASC 715). 3 Under Statement of Financial Accounting Standards No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plansan amendment of FASB Statements No. 87, 88, 106, and 132(R) (now ASC 715).
recognition in OCI could lead to an accounting mismatch (i.e., the gains and losses on the assets may be reflected in net income while the gains and losses on the obligation will be reflected in OCI). Other comment letters also pointed out that the IASB (and FASB) had not set out clearly the purpose of OCI and why items recognized in OCI should, or should not, be recycled through net income. Those respondents argued that it is premature to reach a conclusion on the use of OCI in pension accounting before establishing general guidance related to OCI. PwC observation: In a separate joint project, the FASB and IASB had proposed that a continuous statement of comprehensive income be required, with subtotals for net income and OCI. However, in subsequent redeliberations the boards decided not to adopt this approach. Instead, they decided to maintain the current IFRS position, which gives entities two presentation choices: (1) a continuous statement of comprehensive income or (2) two separate statementsa statement of net income (profit or loss) and a statement of comprehensive income that immediately follows the statement of net income. The third alternative currently used by most U.S. GAAP entities but not permitted under IFRSpresenting OCI within the statement of changes in stockholders' equitywould no longer be permitted under US GAAP. Pension/OPEB gains and losses may receive greater attention when they are presented as part of a comprehensive income statement rather than within the statement of changes in stockholders' equity. .8 These comments were debated at great length and several Board members preferred to allow at least some choice between recognition in net income or OCI. However, the IASB concluded that it would be better to require recognition of actuarial gains and losses only in OCI with no recycling to net income. Currently, IAS 19 permits employers to make an accounting policy election, applied consistently to all of its plans, to reflect gains and losses in either OCI or net income. Under the planned amendments, the alternative of recognizing gains and losses in net income will be removed. .9 The IASB has also decided to eliminate deferred recognition of prior service costs. Prior service costs related to benefits that have not yet vested will no longer be amortized (prior service costs related to vested benefits are immediately expensed under existing IAS 19 requirements). Instead, at the date a plan amendment is adopted, the benefit obligation will be remeasured to reflect the new plan provision, and any increase or decrease in the obligation will be immediately recognized in determining net income. PwC observation: Under IAS 19 today, operating income increases or decreases as a result of the requirement to immediately recognize prior service costs arising from plan amendments that relate to vested benefits. Prior service costs arising from plan amendments involving benefits that have not yet vested are currently recognized over the average period until the benefits become vested. Whether requiring all prior service costs to be recognized immediately, regardless of whether the related benefits are vested, will be a significant change will depend on the significance of the unvested benefits and the length of the period over which the costs would have been recognized under the current guidance. The IASB requirement will continue to be significantly different from US GAAP, which requires prior service costs to be initially recognized in OCI and then amortized through net income. .10 Thus, under the IASBs planned amendments, employers will recognize all changes in the benefit obligation and the fair value of plan assets in the period that the changes occur in both the balance sheet and either a single statement of total comprehensive income, or split between two statementsa statement of income and a statement of
comprehensive income. All deferred recognition approaches for actuarial gains and losses (e.g., the "corridor approach," under which amortization is required only if the net gain or loss is outside a prescribed range) will be eliminated. .11 The IASB's rationale for eliminating deferred recognition is based on the following: Immediately recognizing the effect of remeasurements of benefit obligations and plan assets is conceptually appropriate and will more faithfully present the employer's financial position and comprehensive income. Deferred recognition is inconsistent with accounting principles for changes in estimates applied to other financial transactions, and fails to present obligations and asset values in a transparent manner in the financial statements. Prior service costs associated with a plan amendment arise from the employee's past service, and therefore should be recognized in full when the plan is amended. PwC observation: Total comprehensive income will be subject to volatility from period to period under the IASB's planned amendments. For many companies, a majority of the volatility would come from remeasurements of plan assets, which typically include significant amounts of equity securities, private equity, and other alternative investments, whose values fluctuate. Because the IASB is not expected to amend its interim reporting requirements, if a company reports earnings on an interim basis, the immediate recognition of gains and losses and prior service costs will likely require remeasurement of obligations and plan assets at each interim reporting period. Accordingly, companies will need to ensure that necessary information is obtained on a timely basis in order to meet interim reporting deadlines. Unlike U.S. GAAP, IFRS does not restrict remeasurements during a year to specific circumstances, such as curtailments, settlements and significant plan amendments. .12 The IASB has rejected any approach that would include recycling gains and losses reflected in OCI and recognizing those amounts in determining net income. This differs from U.S. GAAP, where recycling of OCI amounts into net income is required. The IASB believes that once a transaction is recognized in comprehensive income, there is no conceptual basis to shift that amount from AOCI into net income. Instead, those amounts are immediately reflected in equity. PwC observation: The FASB also has a project on its agenda to comprehensively reconsider employers' accounting for pensions and OPEB. That project will reconsider the deferred recognition techniques allowed under U.S. GAAP. The FASB has acknowledged that its ultimate goal is convergence with the IASB's standard and appears to be waiting for the outcome of the IASB's project. Accordingly, U.S. employers and other U.S. stakeholders may wish to consider what impact the IASB's planned amendments could have if they are incorporated into U.S. GAAP.
Presentation .13 The ED proposed requiring employers to display separately the components of pension and OPEB cost (service cost, finance cost, and remeasurement) in the statement of comprehensive income. However, some respondents expressed a view that separate display could distort performance metrics for companies in some industries. The IASB therefore concluded that it would only require disaggregation in the footnotes. In the
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statement of comprehensive income, the IASB will give the employer flexibility to either (1) present all components recognized in determining net income (i.e., service and finance costs but not actuarial gains and losses) as a single net amount (similar to U.S. GAAP) or (2) separately display those components. Service cost component .14 The IASB concluded that both current and prior service costs directly relate to employment costs and thus both should be included in employee costs. The IASB decided that the effects of curtailments and "non-routine" settlements should also be included in employee costs. Finance cost component .15 The ED proposed that interest cost be based on the net defined benefit liability or asset reported on the balance sheet multiplied by the discount rate. Interest cost would be recognized as a finance cost in the statement of comprehensive income. This reflects the IASB's view that since the net defined benefit liability or asset is a present value amount, interest should be accreted on that net amount based on the passage of time. During redeliberations, the IASB reaffirmed its decision to move to a net interest cost model. The IASBs planned amendments will require separate disclosure of that interest cost in the footnotes. However, as noted above, separate or aggregate presentation of service plus finance cost components will be permitted in the financial statements. .16 The net interest cost model replaces the "expected return on plan assets" method currently used in IAS 19 (as well as U.S. GAAP). In essence, the expected long-term rate of return assumption will be replaced by the discount rate assumption for purposes of determining a return on plan assets, and the expected return on plan assets will be effectively treated as interest income when measuring the net interest cost presented in the financing cost component. For many employers, that amount will be less than the expected return on plan assets that is currently calculated under U.S. GAAP and IFRS, as many employers use an expected rate of return that is higher than the discount rate. PwC observation: Under current IAS 19, a company can present the expected return on plan assets and interest cost amounts before or after operating income, based on a policy election. Companies will have the same choice for the new measure of finance cost under the IASBs planned amendments. Accordingly, for companies that report under IFRS, reporting interest income calculated using the discount rate versus a larger expected rate of return on plan assets could affect operating income, or only net income, depending on their policy.
Remeasurement component .17 Under the IASBs planned amendments, the remeasurement component will consist of actuarial gains and losses on the defined benefit obligation, and actual return on plan assets (excluding interest income on plan assets included in the finance cost component). The remeasurement component will be presented on a net-of-tax basis in OCI. .18 Adjustments under IAS 19 relating to the asset ceiling (i.e., the limit on any balance sheet asset for an overfunded plan) will also be included in the remeasurement component since the effect of the limit arises from a remeasurement.
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Disclosure .19 The ED proposed several new required disclosures, which were generally consistent with disclosures already required under U.S. GAAP. Many of the comment letters expressed the view that the IASB had proposed too many required disclosures. In considering the comments received, the IASB moved to an approach that specifies objectives that the disclosures should achieve rather than a checklist of required disclosures. Although that change should make the disclosure requirements more manageable, the proposed disclosures still represent a significant increase over current IAS 19 disclosure requirements. In particular, the IASBs planned amendments are expected to require significantly more disclosures about plan assets. .20 The following are some of the expected disclosures: Characteristics of the defined benefit plan the nature of the benefits to be provided by the plan, any minimum funding requirements, a narrative description of unusual risks or concentration of risks that are specific to the plan or the entity, and any plan amendments, curtailments, or non-routine settlements Explanation of amounts in the financial statements disaggregation of the fair values of plan assets and the defined benefit obligation into categories that separate the risk and liquidity characteristics of those assets and obligations (e.g., types of investments included in plan assets) Amount, timing, and uncertainty of future cash flows a sensitivity analysis of the significant actuarial assumptions used to determine the benefit obligation, as well as the methods and assumptions used in creating the sensitivity analysis, details of any asset-liability matching strategies to manage risk, a narrative description of any funding arrangements and policy, and details regarding the maturity profile of the benefit obligation Multi-employer plans .21 The IASBs planned amendments will not change the accounting requirements for employers that participate in a multi-employer benefit plan. However, there will be new disclosure requirements for those employers, such as: A description of the funding arrangements, including how the funding requirements are determined The extent to which the employer can be liable for other employers' obligations The employer's level of participation in the plan by disclosing its proportion of total plan members or total contributions If the employer accounts for its proportionate share of the plan, all information required for a traditional single-employer plan If the employer accounts for the plan as if it were a defined contribution plan, the fact that the plan is a defined benefit plan, the reason sufficient information is not available to account for it as a defined benefit plan, expected contributions for the next year, how those contributions are determined, and any deficit/surplus in the plan that may affect those contributions Qualitative disclosures of any withdrawal obligation, unless it is probable that the withdrawal obligation will be triggered (in which case the amount would be reported in the balance sheet along with sufficient disclosure in the footnotes to explain the relevant facts and circumstances)
Other amendments .22 The IASB is also making other changes to IAS 19. For instance, the definition of termination benefits will be narrowed so that, for example, stay bonuses will be classified as post-employment benefits and not termination benefits. Additionally, the difference between a short-term employee benefit and a long-term employee benefit will be clarified. A long-term benefit will be a benefit the employer does not expect to settle within twelve months of the reporting date, while a short-term benefit will be a benefit expected to wholly settle in less than twelve months. In addition, the IASB changed the timing of recognition of certain plan amendments, curtailments, and termination benefits to require recognition of the gain or loss related to such events that occur in connection with a restructuring when the related restructuring cost is recognized. .23 The ED also addressed the accounting for administration costs. IAS 19 currently permits administration costs to be included in the return on plan assets or considered in developing actuarial assumptions used to estimate the defined benefit obligation. The ED would have required these costs to be included in the defined benefit obligation unless they relate to the management of plan assets and the benefit promise does not depend on the return on those assets. .24 Comments received by the IASB indicated a widespread concern that requiring administration costs to be included in the benefit obligation would mean allocating costs, such as costs related to actuarial valuations and plan recordkeeping, between past and future service, and that such an allocation would be arbitrary. Based on these comments, the planned amendments will require that expenses related to investment management, including taxes payable on the investments, be reflected in the actual return on plan assets. Other taxes payable by the plan would be reflected in the measurement of the defined benefit obligation, and all other expenses would be recognized as incurred. Items not addressed .25 Other aspects of accounting for pensions and OPEB will not be addressed by the planned amendments. For example, contribution-based promises, which were a significant focus in the IASB's 2008 discussion paper, are not addressed. IFRIC 14, the interpretation regarding application of the asset ceiling test in IAS 19, has not been incorporated into the standard because of the wide variation in its application. Some of the areas that are expected to be addressed in future phases of the IASB's (and FASB's) project include: Measurement how the measurement of the retirement benefit obligation should be performed (which likely would resolve key questions related to contribution-based promises, including cash balance plans) Assumptions how key assumptions, such as the discount rate, should be determined Multi-employer plans how to account for participation in multi-employer plans Transition and effective date .26 The amendments are not expected to be accompanied by any special transition rules, other than a practical exception for the potential affect on past capitalized costs. Therefore, employers will apply the general IFRS transition requirements to the amendments. These requirements call for accounting changes to be applied retrospectively to all years presented. The IASB believes that retrospective adoption is consistent with its general requirements for adoption of changes in accounting principles and that the information necessary to apply the new requirements should generally be available.
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PwC observation: While the information may be available, companies should consider the effort required for compliance, particularly if they have (1) numerous plans, (2) special events, such as curtailments and settlements, and (3) complicated tax allocations. .27 The effective date for the amendments will not be before January 1, 2013 with early application allowed.
Questions
.28 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact a member of the Compensation team in the National Professional Services Group at 1-973-236-7802. Human Resource Services specialists are available to assist engagement teams and clients with benefits and compensation issues. Contact Murray Akresh (1-646-471-2362) or Ken Stoler (1-646-471-5745) in Human Resource Services.
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Authored by:
Kenneth E. Dakdduk Partner - National Professional Services Group Phone: 1-973-236-7239 Email: kenneth.e.dakdduk@us.pwc.com Richard Davis Director - National Professional Services Group Phone: 1-973-236-5520 Email: richard.x.davis@us.pwc.com Murray S. Akresh Partner - Human Resource Services Phone: 1-646-471-2362 Email: murray.s.akresh@us.pwc.com Kenneth M. Stoler Partner - Human Resource Services Phone: 1-646-471-5745 Email: ken.stoler@us.pwc.com

IASB issues amendments to IAS 19, Employee benefits
What's new?
The IASB has amended IAS 19, Employee benefits, making significant changes to the recognition and measurement of post employment defined benefit expense and termination benefits, and to the disclosures for all employee benefits. The changes will affect most entities that apply IAS 19, and may significantly change a number of performance indicators and significantly increase the volume of disclosures.
No. 2011-27 June 17, 2011
Recognition of actuarial gains and losses (remeasurements): Actuarial gains and losses are renamed remeasurements and will be recognized immediately in other comprehensive income (OCI). Actuarial gains and losses will no longer be deferred using the corridor approach or recognized in income; this is likely to increase balance sheet and OCI volatility. Remeasurements recognized in OCI will not be recycled through profit or loss in subsequent periods. Recognition of past service cost/curtailment: Past-service costs will be recognized when a plan is amended; unvested benefits will no longer be spread over the vesting period. Curtailments now only occur when an entity reduces significantly the number of employees. Curtailment gains/losses are accounted for as past-service costs. Measurement of benefit expense: Annual expense for a funded benefit plan will include net interest expense or income, calculated by applying the discount rate to the net defined benefit asset or liability. This will replace the finance charge and expected return on plan assets, and will increase benefit expense for most entities. There will be no change in the discount rate, which is a high-quality corporate bond rate where there is a deep market in such bonds, and a government bond rate in other markets. Presentation in income statement: There will be less flexibility in income statement presentation. Benefit cost will be split, either in the income statement or in the notes, between (1) the cost of benefits accrued in the current period (service cost) and benefit changes (past-service cost, settlement and curtailment) and (2) finance cost/income. Disclosure requirements: Additional disclosures are required to present the characteristics of benefit plans, the amounts recognized in the financial statements, and the risks arising from defined benefit plans and multi-employer plans. The objectives and principles underlying disclosures are provided; these are likely to require more extensive disclosures and more judgment to determine what is required.
In brief 1
Distinction between short-term and other long-term benefits: The distinction between short- and long-term benefits is based on when payment is expected, not when payment can be demanded. A long-term benefit liability could therefore be presented as current if the entity expects to settle it after more than one year, but does not have the unconditional ability to defer settlement for more than one year. Treatment of expenses and taxes relating to employee benefit plans: Taxes related to benefit plans should be included either in the return on assets or the calculation of the benefit obligation, depending on their nature. Investment management costs should reduce the actual return on assets. Other expenses should be recognized as incurred. This should improve comparability but might complicate the actuarial calculations. Termination benefits: Any benefit that requires future-service is not a termination benefit. This will reduce the number of arrangements classified as termination benefits. A liability for a termination benefit is recognized when the entity can no longer withdraw the offer of the termination benefit or recognizes any related restructuring costs. This might delay the recognition of voluntary termination benefits. Risk or cost sharing features: The measurement of obligations should reflect the substance of arrangements where the employers exposure is limited or where the employer can use contributions from employees to meet a deficit. This might reduce the defined benefit obligation in some situations. Determining the substance of such arrangements will require judgment and significant disclosure.
The immediate recognition of remeasurements and past service costs will bring IFRS and US GAAP balance sheets closer. However, the new interest cost calculation and the fact that amounts recognized in OCI will never impact income moves the income statements further apart. Termination benefit accounting is brought into line with "one-time benefits" guidance under US GAAP.
Who's affected?
These changes will affect most entities that apply IAS 19. They could significantly impact a number of performance indicators and significantly increase the volume of disclosures.

The amendment is effective for periods beginning on or after January 1, 2013. Early application is permitted. Application should be retrospective, except for changes to the carrying value of assets that include capitalized employee benefit costs.
What's next?
Management should determine the effect of the revised standard and, in particular, any changes in benefit classification and presentation, the effect of the changes on any existing employee benefit arrangements, and whether additional processes are needed to compile the information required to comply with the new disclosure requirements. Management should also consider the choices that remain within IAS 19, including the possibility of early adoption, the possible effect of the changes on key performance ratios, and how to communicate the effects to analysts and other users of the financial statements.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Compensation team in the National Professional Services Group (1-973-236-7802).
In brief
Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Richard Davis Director Phone: 1-973-236-5520 Email: richard.x.davis@us.pwc.com
US GAAP Convergence & IFRS Insurance

No. 2012-14 June 7, 2012
FASB Chairman provides status update on insurance contracts project

What's new?
At the June 5 meeting of the Financial Accounting Standards Advisory Council (FASAC), as clarified at a subsequent FASB education session, FASB Chairman Leslie Seidman provided an update on the status of the insurance contracts project. She indicated that based on the nature and totality of differences between the FASB s and IASBs (the boards) views, it is not likely that the two boards will achieve convergence on this project. She further noted that the FASB and IASB have very different perspectives on the project, given that the US has existing guidance on insurance contracts whereas there is currently no comprehensive IFRS insurance standard. The FASB Chairman acknowledged that despite a strong desire to reach convergence and several attempts to resolve key differences, the boards could not reach agreement on fundamental aspects of the proposal. Those aspects include whether to include a risk adjustment in addition to the present value of expected cash flows estimate, the timing and classification of changes in assumptions (the unlocking of margin issue), and the treatment of acquisition costs relating to unsuccessful efforts.
What's next?
The FASB Chairman stated that given it is unlikely the two boards will have converged standards, and given that the FASB has existing standards to start from, the FASB is planning to take a step back to rethink the method under which they might incorporate their decisions into a final product. For example, the FASB will explore whether it should make targeted improvements (through amendments) to existing US GAAP, rather than issuing an entirely new insurance standard. The FASB Chairman noted that they still plan to work through remaining open topics on the project with the IASB in the upcoming months, which include determining an approach for measuring earned premiums and transition. Although the FASB's technical plan currently targets issuance of an exposure draft by the end of 2012, given the FASB Chairman's comments, this plan may change.
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Insurance team in the National Professional Services Group (1-973-236-7803).
In brief
Authored by:
Mary Saslow Managing Director Phone: 1-860-241-7013 Email: mary.saslow@us.pwc.com Jennifer Englert Senior Manager Phone: 1-973-236-4099 Email: jennifer.m.englert@us.pwc.com
IASB/FASB Insurance Contracts Project

PwC Summary as of March 7 7, 2012
Note: The following summary was developed using the IASB Exposure Draft, Insurance Contracts, issued on July 30, 2010, FASB Discussion Paper, Preliminary Views on Insurance Contracts, issued September 17, 201o as well as PwC knowledge gained from attendance at IASB and FASB meetings through March 7, 2012.
Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB Status FASB Discussion paper (DP) issued September 2010. FASB exposure draft targeted for second half 2012.
Boards redeliberation edeliberation status
Exposure draft (ED) issued July 2010. Joint redeliberations began January 2011. Boards plan to complete redeliberations by mid-2012 2012. Revised exposure draft or final review draft targeted for second half 2012.
Boards will evaluate and attempt reconciliation of key differences at end of redeliberations.
Definition of insurance contract
Retain IFRS 4 definition of insurance contract: "A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the po policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder."
Reaffirmed ED/DP position. position
Significant insurance risk
Retains IFRS 4 requirements with additional clarification that evaluation of insurance risk should be done using present values rather than absolute amounts. As a result, contractual provisions that delay timely reimbursement to policyholder can eliminate significant insurance risk. Risk transfer analysis should focus on the v variability of outcomes (i.e., is the range of outcomes significant to the mean?), ), consistent with IFRS 4, but amended to require that there be at least one possible outcome with commercial substance in which the present value of net cash outflows paid by insurer can exceed the present value of premiums. Financial guarantee contracts meeting the definition of an insurance contract are included in the scope of the insurance contracts standard. Exclusions from Insurance Contracts scope include: - Residual value contracts offered by a manufacturer, dealer, or retailer and lessee guarantees of resid residual value (but stand-alone alone residual value guarantees not addressed by other projects are in Insurance Contracts scope). - Manufacturer, dealer, and retailer warranty contracts (but unrelated third party warranties are in Insurance Contracts scope). - Fixed-fee service contracts that have as their primary purpose the provision of services, for example maintenance contracts in which the service provider agrees to repair specified equipment after a malfunction. - Contingent consideration payable or receivable in a business usiness combination combination. - Employer's assets and liabilities under employee benefit plans and retirement benefit obligations reported by defined benefit plans. - License fees, royalties, contingent lease payments and similar items.
Some constituents (principally IFRS) commented that present value clarification and requirement for at least one possible loss outcome not necessary. necessary Reaffirmed ED/DP position. position
Scope
IASB changed position from ED for financial guarantee contracts; will retain existing IFRS 4/IAS 39 scope guidance in the short term. FASB will deliberate whether financial f guarantee contracts (including mortgage guarantee) should be included in scope in conjunction with financial instruments project. Both Boards reaffirmed scope exclusions. Boards' reaffirmation of scope exclusions includes FASB decision that employers employ account for employer-provided employer healthcare benefits to their employees under employee compensation compensati guidance rather than impute a premium and account for them as issued insurance contracts. contracts To clarify fixed-fee fee service contract exclusion, added 3 required qualifying criteria: (a) not priced based on an assessment of the risk associated with an individual customer; (b) contracts compensate customers by providing prov a service, rather than cash payment; and
Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB FASB Direct insurance contracts an entity holds as policyholder (except for cedant accounting).
Boards redeliberation status
Unbundling
(c) type of risk transferred primarily related to use (or frequency) of services relative to overall risk transferred. Reaffirmed ED/DP position to separate embedded derivatives as defined in IFRS and US GAAP, respectively, and account for as derivatives at fair value. Unbundle goods and services based on criteria developed for identifying and separating distinct performance obligations in the revenue recognition project. Potential issue is the allocation of transaction price and acquisition cost between insurance and goods/services components due to measurement differences between the two models (e.g., contingent consideration, discounting, and acquisition costs). Still discussing separation of deposit elements; diversity of views expressed on (1) criteria for determining investment components to be separated (i.e., explicit account balances only or beyond, such as cash surrender values and payout annuities) (2) whether to merely "disaggregate" such amounts for presentation only or to "unbundle" them for measurement purposes as well and (3) impact on income statement presentation of deposit components. Changed position from ED/DP to require initial recognition at start of coverage period, or in pre-coverage period if contract is onerous. Decision based on cost/benefit and practical considerations. An insurance contract accounted for under the building block approach is onerous prior to start of coverage period if expected present value of future cash outflows (plus risk adjustment in IASB approach) exceeds expected present value of future cash inflows from that contract; measurement of existing onerous contract is updated at end of each reporting period. Onerous contract test applied when facts and circumstances indicate the contract "might" be onerous; application guidance will be provided. Open issue on treatment of acquisition costs in pre-coverage period. Not expected to be redeliberated
Issue is whether and how to unbundle the components of an insurance contract (e.g., insurance, deposit, embedded derivative, service components) for recognition and/or measurement purposes. Insurer required to unbundle components of a contract that are not closely related to the insurance coverage specified in the contract. Examples included in ED are: - Policyholder account balances that bear an explicitly credited return rate and meet specified criteria. - Embedded derivatives that are separated under existing bifurcation requirements. - Contractual terms relating to goods and services provided under the contract that are not closely related to insurance coverage but have been combined in a contract with that coverage for reasons that have no commercial substance. Where unbundling is not required it is prohibited IFRS and US GAAP have different requirements for separation of certain embedded derivatives associated with insurance contracts (e.g., GMABs and GMWBs) which could lead to different results.
Recognition of rights and obligations arising under insurance contracts
An insurer should recognize the rights and obligations arising from an insurance contract on the earlier of the following two dates: - When the insurer is bound by the terms of the contract. - When the insurer is first exposed to risk under the contract (i.e., when insurer can no longer withdraw from its obligation to provide coverage and no longer has right to reassess risk of particular policyholder, and as a result cannot set a price that fully reflects that risk). This can occur prior to coverage period.
De recognition of insurance liabilities Insurer should derecognize an insurance liability (or part of an insurance liability) when it is extinguished, i.e., when the obligation is discharged or cancelled or expires, consistent with the derecognition principle in IAS 39, Financial Instruments: Recognition and Measurement. This represents the point at which the insurer is no longer at risk and no longer required to transfer any economic resources
Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB for that obligation. Measurement approach: "Building Block Approach" or "BBA" Measurement approach should portray a current assessment of the contract, using the following building blocks: - Explicit, unbiased, probability-weighted average (expected value) of future cash outflows less future cash inflows that will arise as insurer fulfills the insurance contract - A discount rate to incorporate of time value of money - A margin* These building blocks should be used to measure the combination of rights and obligations arising from an insurance contract rather than to measure the rights separately from the obligations. That combination of rights and obligations should be presented on a net basis. FASB
* Two different margin approaches proposed are explicit risk adjustment approach and composite margin approach. Both approaches eliminate any gain at inception. The IASB ED includes the explicit risk adjustment approach, while the FASB narrowly favors the composite margin approach. Note: The Boards were asked during deliberations to consider the detailed application of each approach. As a result, the discussion below on measurement of margins at inception and subsequently reflects the Boards' views under each approach. Risk adjustment: Explicit risk adjustment approach This approach includes two separate parts: 1. An explicit risk adjustment for the effect of uncertainty about the amount and timing of future cash flows from the perspective of insurer rather than from the perspective of a market participant 2. An amount that eliminates any gain at inception of the contract (residual margin) Risk adjustment: Explicit risk adjustment is the maximum amount insurer would rationally pay to be relieved of the risk that the ultimate fulfillment cash flows exceed those expected. Explicit risk adjustment would be updated (remeasured) each reporting period. Under the explicit risk adjustment approach, the range of permitted techniques that can be used is limited to the following three: the confidence level technique (Value at Risk), the Conditional Tail Expectation technique (Tail Value at Risk), and the Cost of Capital technique (using economic rather than regulatory capital). Although the risk adjustment is included in the measurement as conceptually separate from other building blocks (cash flows and discount rate), this is not intended to preclude "replicating portfolio approaches." To avoid double counting, the risk adjustment does not include any risk captured in the replicating portfolio. Residual margin: In principle the initial recognition of an insurance contract should not result in the recognition of an accounting profit, resulting in the recording of a residual margin. A loss arises at inception if the expected present value of cash outflows, plus explicit risk adjustment, exceeds the expected present value of cash inflows. An entity should recognize that loss in profit or loss at
Reaffirmed the concept of a building block model using expected value and a discount rate to incorporate the time value of money. Clarified that measurement objective of expected value refers to the mean. Clarified that not all possible scenarios need to be identified and quantified provided the estimate is consistent with the mean measurement objective. Reaffirmed no gain at inception, but immediate recognition of any day one loss. Reaffirmed ED approach to measuring expected cash flows for impending infrequent high severity events, both in BBA approach and for onerous test in PAA approach: measure using estimates of expected cash flows at balance sheet date; do not adjust for the actual occurrence or non-occurrence of the insured event after reporting period end.
Clear majority of IASB in favor of explicit risk adjustment approach; FASB rejected it. Risk adjustment objective changed to: the compensation the insurer requires for bearing the uncertainty inherent in the cash flows of a portfolio that arise as the insurer fulfills the insurance contract. IASB tentatively decided that it would not specify further guidance on the unit of account for the risk adjustment. Reflects the point at which insurer is indifferent between holding the insurance liability and a similar liability not subject to uncertainty. Largely consistent with risk premium in IFRS 13 and ASC 820 fair value guidance except that it reflects risk aversion of insurer rather than market participant. Eliminated the limitation that existed in ED of 3 permitted techniques. The 3 techniques retained as examples in application guidance.
Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB inception. FASB
Composite Composite margin approach: margin In principle the initial recognition of an insurance contract approach should not result in the recognition of an accounting profit, (Alternative resulting in the recording of a composite margin. view in IASB Composite margin at initial recognition is the difference Basis of between the present value of expected value of cash inflows Conclusions) and the present value of expected cash outflows. Under composite margin approach, there is no explicit risk adjustment, as objective is not sufficiently robust to promote rigorous application. In composite margin approach, a loss arises at inception if the expected present value of cash outflows exceeds the expected present value of cash inflows, i.e., any Day 1 loss would not include a risk adjustment. An entity should recognize that loss in profit or loss at inception. Level of measurement The current definition of a portfolio of insurance contracts in IFRS 4 will be retained (insurance contracts that are subject to broadly similar risks and managed together as a single pool). Estimate future cash flows at portfolio level (except for incremental acquisition costs), recognizing that in principle, the expected cash flows from a portfolio equal the sum of expected cash flow of individual contracts. If the measurement approach includes an explicit risk adjustment, that adjustment should be determined for a portfolio of insurance contracts rather than individually. The explicit risk adjustment would not reflect the effects of diversification between portfolios. Residual and composite margins would be determined initially and subsequently at a cohort level that groups insurance contracts (a) by portfolio, (b) within the same portfolio by similar date of inception of the contract, and (c) by similar length of the contract (coverage period for residual margin; coverage and settlement period for composite margin). Consider all current available information that represents fulfillment of the insurance contract from perspective of the entity, but for market variables, be consistent with observable market prices. Types of data that may be useful include, but are not limited to, industry data, historical data of an entitys costs, and market inputs. Existing guidance on inventory costing and proposed guidance on revenue recognition noted as potential principles for types of costs (e.g., direct, incremental, allocated) to be included in the building block approach. Examples of costs included in the building block approach include claims and benefit payments, claims handling costs, policy administration and maintenance costs, initial and recurring incremental contract acquisition costs such as commissions, surrender benefits, participating benefits, transaction based taxes such as premium taxes, and certain directly allocable costs that are incremental at the portfolio level , but not general overhead.
FASB supports this approach; IASB rejected it. Renamed "the single margin" to better reflect the FASB's view that it represents the amount of profit at risk.
Reaffirmed that in general measurement will be done at the portfolio level (e.g., estimate of cash flows and risk adjustment). Have not yet decided level of measurement for other components such as residual margin and onerous contract test under modified (premium allocation) approach.
Use of inputs
Reaffirmed that costs directly attributable to contract activity as part of fulfilling portfolio of contracts that can be allocated to portfolio should be included in cash flows. Reaffirmed that inventory costing guidance in IAS 2 should be used as basis for types of costs to be included in cash flows (except for acquisition costs, for which only direct costs would be included). Appear to include certain costs thought by some to be overhead (such as rent for claims handling department and software to run claims processing system), but not general overhead, except for acquisition costs, for which only direct costs would be included.
Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB Definition of contract boundary FASB
Insurer should include premiums and other cash flows resulting from those premiums only if the insurer can compel the policyholder to pay premiums, or the premiums are within the boundary of the contract. Contract boundary is the point at which the insurer: (1) is no longer required to provide coverage OR (2) has the right or practical ability to reassess the risk of the particular policyholder and, as a result, can set a price that fully reflects that risk. In making this assessment, insurer should ignore restrictions that have no commercial substance (i.e., no discernible effect on economics of contract) If insurer is constrained in the pricing to below market levels, this would be within the contract boundary.
Policyholder behavior and contract boundaries Policyholder options, forwards, and guarantees related to existing coverage (other than those required to be unbundled), should be included in the measurement of the insurance contract on a look through basis using the expected value of future cash flows (to the extent that those options are within the boundary of the existing contract). Options, forwards, and guarantees that do not relate to the existing insurance contract coverage would be excluded from the measurement of that contract. Those features should be recognized and measured as new insurance contracts or other stand-alone instruments, according to their nature. Discount rates should adjust future cash inflows and outflows that arise as insurer fulfills its obligation for time value of money. Discount rates should be consistent with observable current market prices for instruments with cash flows whose characteristics reflect those of insurance contract liability in terms of, for example, timing, currency, and liquidity. Discount rates should exclude any factors that influence the observed rates but are not relevant to the insurance contract liability (e.g., differences in liquidity between government bonds and certain insurance contracts). Present value of cash flows should not reflect risk of nonperformance by insurer Discount rates based on expected returns on actual assets backing those liabilities used only when amount, timing or uncertainty of cash flows of contract depend wholly or partly on performance of specific assets (in which case a replicating portfolio technique may be appropriate). Based on principle noted above, discount rates will reflect yield curve for instruments that expose holder to no or negligible credit risk, with adjustment for liquidity (except of contracts whose cash flows depend on performance of specific assets).
Tentatively changed position such that contract boundary is point when insurer is no longer required to provide coverage or when the existing contract does not confer any substantive rights to policyholder. Not a substantive right when insurer has right or practical ability to reassess risk of particular policyholder and as result can set a price that fully reflects that risk. For contract where pricing of premium does not include risks relating to future periods (i.e., financing element), not a substantive right when insurer can reassess risk of the portfolio the contract belongs to, and as a result can set a price that fully reflects risk of that portfolio. Revision expected to result in certain health contracts priced at portfolio level to be short duration. Consideration being given to potential unintended consequences. Reaffirmed ED/DP position.
Discount rates
Reaffirmed objective to adjust cash flows for the time value of money and reflect characteristics of the insurance contract liability and not the expected return on assets. Tentatively decided not to prescribe a method for determining the rate (i.e. may use bottom-up or top-down approach as long as objective achieved). Top-down approach may start with yield curve based on actual or reference asset portfolio. Types of adjustments expected in topdown approach include asset credit risk (both expected defaults and credit risk premium). Insurer using top-down approach need not make adjustments for remaining differences including liquidity, market sentiment, and market inefficiencies. Reaffirmed that measurement of the liability should not reflect changes in the insurer's own credit standing. Tentatively decided not to allow lock in of discount rate.
Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB FASB
Tentatively decided not to provide a practical expedient for determining the discount rate. Expected to explore OCI treatment for changes in discount rate. Tentatively decided all liabilities (including all short tail and long tail claims) should be discounted unless impact of discounting is immaterial. Not yet specifically discussed.
Accretion of interest on residual margin or composite margin
Subsequent treatment of residual margins under explicit risk adjustment approach
Accrete interest on the residual margin (under the explicit risk adjustment approach) and on the composite margin (under the composite margin approach). Interest rate should be locked in at inception.
Do not accrete interest on the residual margin (under the explicit risk adjustment approach) or on the composite margin (under the composite margin approach).
Insurer should not adjust the residual margin in subsequent reporting periods for changes in estimates. Insurer should release residual margin over coverage period in a systematic way that best reflects exposure from providing insurance coverage on the basis of passage of time; but if the insurer expects to incur benefits and claims in a pattern that differs significantly from passage of time, the residual margin should be released on the basis of the expected timing of incurred benefits and claims over the coverage period. Residual margin would be included as part of insurance liability.
IASB tentatively changed position from ED and decided in close vote that the residual margin should not be locked in at inception. If unlocked, IASB would adjust residual margin prospectively, up and down to reflect favorable and unfavorable changes in future estimated cash flows, and tentatively decided not to adjust it for changes in experience or changes in risk adjustment. Residual margin cannot be negative. IASB still discussing whether changes in discount rate should adjust residual margin or potentially be taken through OCI along with fair value changes in related assets. FASB would not unlock the residual margin after inception (if they were to adopt a risk adjustment approach). Insurer should release residual margin over coverage period in a systematic way that is consistent with pattern of transfer of services under contract (a change from ED position). FASB revised amortization approach would be based on release from risk rather than premiums and claims formula. In some types of business, such as life insurance, this could occur through the passage of time. In others, where variability in cash flows could be due to frequency and severity of an event, release could occur as insurer is released from variability in cash flows determined using an adjusted baseline ratio of actual claims reported to total expected cash outflows each period. No remeasurement or recalibration of margin to recapture previously recognized
Subsequent treatment of composite margin under composite margin approach (now referred to as single margin) (Alternative view in IASB Basis of Conclusions)
Composite margin is "released" or "allocated" over both the coverage and claims handling periods. Amortize composite margin based on a combination of two drivers, the provision of insurance coverage and the uncertainty in future cash flows. Approach specifies a formula that calculates a ratio of current period allocated premiums plus claims and benefits cash flows to the expected value of total premiums plus claims and benefits and then applies this ratio to the composite margin. Composite margin to which ratio is applied would not be "remeasured" (no change to initial inception amount). Composite margin would not be adjusted directly for changes in cash flow estimates, i.e., not a "shock absorber." But allocation pattern/term could change based on components of ratio in formula changing.
Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB Unearned premium approach for certain shortduration insurance contracts (now referred to as the premium allocation approach, or "PAA") FASB
Composite margin would be included as part of the insurance liability. An unearned premium measurement approach (simplified/modified measurement approach) for pre-claim liabilities for certain short-duration contracts would be required rather than permitted. Criteria for applying simplified approach include coverage period of approximately one year or less and no embedded options or guarantees (such as extension of coverage) that significantly affect variability of cash flows. Building block approach for claim liabilities, including an explicit risk adjustment, but excluding a residual margin. Interest accreted at current rate on unearned premium liability. Incremental acquisition costs associated with contracts using the simplified approach are netted against the unearned premium liability and recognized over coverage period. Liability adequacy test (onerous contract test) required. Income statement presentation permits gross revenue, claims, and expenses. FASB did not address in DP the "modified" measurement and presentation approach and which insurance contracts should apply that approach rather than the building block approach.
margin. Constituents commented that approach is not simplified and that one year criterion is too restrictive. Many US constituents believe non-life requires a separate model and existing US GAAP model should be retained. Both Boards agree that contracts with coverage period of one year or less can use the PAA. However, IASB views PAA as proxy for BBA; PAA would be permitted (but not required) for contracts with coverage period longer than a year only where it is reasonable approximation of BBA. FASB sees PAA as separate model , (similar to revenue recognition model) required to be used in place of BBA where specified criteria are met; these criteria are such that existing US GAAP short duration contracts likely to meet PAA criteria under FASB approach. IASB would use FASB PAA criteria as secondary application guidance only. Boards have reaffirmed revenue recognition pattern over coverage period. Discount and interest accretion required in measuring liability for remaining coverage where significant financing component exists. As practical expedient, discounting and accretion not required where insurer expects at contract inception that period of time between payment by policyholder of all or substantially all premium and satisfaction of insurer's obligation to provide insurance coverage will be one year or less. FASB: liability for incurred claims (formerly the post claims liability) should be measured as the present value of expected cash flows (mean) without a single margin. Discounting not required when the effect of discounting is immaterial. A practical expedient would permit insurers not to discount incurred claims where incurred claims are expected to be paid within 12 months of the insured event. An insurance contract is onerous if the expected present value of future cash outflows (plus risk adjustment in IASB approach) exceeds the carrying amount of the liability for remaining coverage; measurement of existing onerous contract is updated at end of each reporting period.
Onerous contract test applied when facts and circumstances indicate the contract "might" be onerous; application guidance will be provided. For PAA contracts for which undiscounted incurred claims practical expedient has been elected, onerous test would be on undiscounted basis (i.e., discounting would not be applied to expected cash flows for onerous contract test trigger or measurement). Changed position from ED and DP and tentatively decided that contract cash flows should include those direct acquisition costs that relate to a portfolio of insurance contracts. Direct costs would include commissions, and direct costs at portfolio level including sales force contract selling, underwriting, medical and inspection, and policy issuance and processing functions as well as direct response advertising. FASB would include only those direct costs relating to successful acquisition efforts. IASB would include direct costs for both successful and unsuccessful efforts. Indirect costs such as the following would be excluded: software dedicated to contract acquisition, equipment maintenance and depreciation, agent and sales staff recruiting and training, administration, rent and occupancy, utilities, general overhead, advertising. Definition of types of acquisition costs is the same under PAA as under the BBA approach, but under PAA approach, insurers are permitted to recognize all acquisition costs as immediate expense if coverage period is 1 year or less. Not yet discussed.
Acquisition costs
Acquisition costs that are "incremental at the contract level," such as initial and recurring commissions, would be included as cash flows in the building block approach. All other acquisition costs are expensed as incurred. "Incremental at the contract level" means those acquisition costs that would not have been incurred absent the contract sale.
Business combinations and nonbusiness combination portfolio transfers
In non-business combinations assumption transactions (portfolio transfers), any positive difference between consideration received and insurance liability calculated using building block approach recorded as residual (or composite) margin. Any negative difference recognized as an immediate loss. In a business combination, any positive difference between fair value and insurance liability calculated using building block approach recorded as residual (or composite) margin. In a business combination, if the amount calculated under the building block approach exceeds the fair value, the building block amount rather than the fair value is used to measure the liability. Any negative difference would increase the initial carrying amount of goodwill recognized.
Reinsurance
Assuming reinsurer accounting: A reinsurer should use the same recognition and measurement approach for reinsurance contracts that it issues as direct insurers use for the insurance contracts that they have issued.
Changed position from ED and DP to recognize losses (net negative fulfillment cash flows) immediately relating to reinsurance of past events and to defer any day 1 gains as residual/single margin.
Cedant accounting: A cedant should apply the same principles as the building block approach in measuring a reinsurance contract, using the same recognition and measurement approach that it uses for the reinsured portion of the underlying insurance contracts that it has issued. Reinsurance contract is measured by cedant as the sum of: - Expected present value of future cash inflows plus the risk adjustment (in explicit risk adjustment approach), less the expected present value of cash outflows; and - A residual margin (cannot be negative) In addition, the cedant should consider the risk of nonperformance by the reinsurer on an expected value basis when estimating the present value of cash flows. Ceding commission is treated by cedant as a reduction in premium ceded to reinsurer. If expected present value of future cash inflows plus the risk adjustment (in explicit risk adjustment approach) exceed the expected present value of cash outflows, the excess is recorded as a gain at initial recognition of reinsurance contract. No offsetting of reinsurance assets against insurance contract liabilities.
Only net negative fulfillment cash flows relating to reinsurance coverage for future events should be deferred as prepaid premium and expensed over coverage period. As another change from ED and DP, a cedant should not recognize a reinsurance contract until the underlying direct contract is recognized unless the reinsurance is based on aggregate losses. If based on aggregate losses, a cedant should recognize the reinsurance contract when the reinsurance coverage period begins. IASB tentatively decided that the ceded portion of the risk adjustment should represent the risk being removed from the reinsurance contract without specifying whether the ceded risk adjustment should be calculated on a gross basis or arrived at by performing a "with and without" reinsurance calculation of the net exposure. A cedant should estimate the present value of fulfillment cash flows without reference to the residual margin/ single margin on the underlying contracts. A cedant should apply the financial instruments impairment model when assessing recoverability of the reinsurance asset, and should consider collateral in the analysis. Losses from disputes should be reflected in the measurement of the recoverable asset when current information and events suggest the cedant may be unable to collect amounts due under contractual terms of the contract. If the reinsurer is not exposed to a loss, the reinsurance contract is nevertheless deemed to transfer significant insurance risk if substantially all of insurance risk relating to the reinsured portions of the underlying insurance contracts has been assumed by the reinsurer. "Substantially all" means the economic benefit to the reinsurer for its respective portion of the underlying policies must be virtually the same as the cedant's economic benefit. Not yet discussed.
Insurance contracts denominated in a foreign currency
An insurance contract is treated as a monetary item, including all of the components of the contract (expected present value of cash flows, risk adjustment, residual margin or composite margin). Conclusion also applicable to simplified unearned premium approach pre-claims liability (as a proxy for the building block approach). Include all cash flows that arise from a participating feature in an insurance contract in the measurement of the
Participating features in insurance
Applies to contracts where performance depends wholly or partly on performance of specified assets and liabilities of the
Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB contracts FASB
insurance liability on an expected present value basis. Cash flows include payments that will be generated by existing contracts but are expected to be paid to future p0licyholders.
insurer. Measure on same basis as underlying items in which policyholder participates are measured for US GAAP/IFRS. Measure any embedded options and guarantees not separately accounted for as derivatives using a current marketconsistent expected value approach. Examples include interest rate guarantees, surrender options, and minimum death benefit guarantees. Present changes in insurance contract liability in statement of comprehensive income consistent with presentation of linked items (i.e., in profit or loss or OCI). Measurement of the liability should include all amounts expected to be paid to current or future policyholders, which implies no equity for mutual insurers. IASB: Proceed with ED proposal to allow fair value for treasury shares and owner occupied property to eliminate accounting mismatch. Participating contracts include unitlinked and variable contracts. Boards still to address how decisions apply to contracts with non-guaranteed features that are not specifically performance-linked, e.g., universal life contracts and non-US contracts where amount to be credited is discretionary. IASB: Include in scope of insurance contracts standard if issued by insurers. FASB: Do not explicitly scope in; these contracts do not meet the definition of an insurance contract and should not be in scope.
Participating investment contracts
Include in scope of insurance contracts standard if they participate in the same pool of assets as insurance contracts, or same profit or loss of same company, fund, or other entity. Other participating investment contracts included in scope of financial instruments standard. Amortize residual margin based on passage of time, or on basis of the fair value of assets under management if that differs significantly from passage of time.
Include in scope of financial instruments standard
Statement of Comprehensive Income
Summarized margin approach considered most consistent with the liability measurement model and is similar in many respects to previously considered expanded margin approach. Summarized margin approach shows the following on the face of statement of profit and loss (amounts in brackets may be shown on face or in notes): - Underwriting margin (change in risk adjustment, release of residual margin) - Gains/losses at initial recognition (loss at inception, loss
Comments from almost all preparers and users that volume information such as premiums and claims considered a key performance metric. Some users appear to want performance reporting of insurers on a basis that is comparable to other industries (i.e., classic revenues earned and expenses incurred). Tentative decision that an insurer should present premiums, claims, benefits, and
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on portfolio transfer, cedant gain at inception) Non-incremental acquisition costs. Experience adjustments and changes in estimate (actual versus expected, changes in cash flows and discount rates, impairments on reinsurance assets). - Interest on insurance contract liabilities. Summarized margin approach would be supplemented by additional information including a reconciliation of changes in the liability and volume of business written. In simplified unearned premium approach only: - Underwriting margin (premium revenue, gross of incremental acquisition cost amortization, claims incurred, expenses incurred, amortization of incremental acquisition costs). - Changes in additional liabilities for onerous contracts. No offsetting of income and expense from reinsurance contracts against expense or income from insurance contracts.
the gross underwriting margin in the statement of comprehensive income. However, key matters to be resolved include definition of premiums for inclusion in the performance statement and whether deposits should be included in premiums. Boards still to consider whether contracts measured using the building-block approach and the premium allocation approach should be separately presented. Boards to consider whether an insurer should be permitted to present in OCI the difference between the insurance contract liability determined using the current discount rate and the liability determined using the original discount rate at inception. IASB to consider targeted improvements to IFRS 9, particularly the interaction between accounting for financial assets and insurance contracts, with potential remeasurement of some financial assets through OCI. Apply same measurement approach as participating insurance contracts. IASB: Proceed with ED proposal to allow fair value for treasury shares and owner occupied property to eliminate accounting mismatch.
Unit-linked (variable) contracts presentation
Defined as contracts for which some or all benefits are determined by the price of units in an internal or external investment fund (i.e., a specified pool of assets held by the insurer or a third party and operated in a manner similar to a mutual fund). Assets and related liabilities associated with such contracts should be reported as the insurer's assets and liabilities in the statement of financial position. Pool of assets underlying unit-linked contracts should be reported as a single line item, not commingled with insurer's other assets. Portion of liabilities from unit-linked contracts linked to pool of assets should be reported as a single line item, not commingled with insurer's other insurance contract liabilities. Unbundling provisions apply to unit-linked contracts. Income and expense from unit-linked contracts presented as a single line item, not commingled with income and expense from insurer's other insurance contract liabilities. Income and expense from pool of assets underlying unitlinked contracts presented as a single line item, not commingled with income or expense from insurer's other assets. Require fair value measurement through profit or loss of own shares (treasury shares) and owner occupied property to eliminate accounting mismatch with liability to the extent those changes relate to the interest of unit-linked contract holders in the pool of assets.
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Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB Statement of Financial Position FASB
Present each portfolio of insurance contracts as a single item within insurance contract assets or insurance contract liabilities. Do not offset reinsurance assets against insurance contract liabilities.
Separate liabilities (or assets) for insurance contracts measured using the building block approach from those using the premium allocation approach. Separate premium allocation approach liability for remaining coverage from liability for incurred claims. For building block approach, present contract rights and obligations on net basis, except for unconditional rights to premium or other consideration, which should be presented as a receivable. For premium allocation approach, present all insurance contract rights and obligations on a gross basis (including asset for conditional receivable). Portfolios in an asset position should not be aggregated with portfolios in a liability position. Boards exploring balance sheet presentation of netting acquisition costs against residual/single margin in BBA or liability for remaining coverage in PAA and presenting this net amount separately from PV of expected cash flows (and risk adjustment in IASB). Retain disclosures in the proposal, with the following changes: Eliminate minimum reportable segment disaggregation requirement, and use disclosure principles, but retain reportable segments as one example of disaggregation. Level of aggregation could vary for different types of qualitative and quantitative disclosures. Disaggregate the following components, in the statement of financial position or the notes, in a way that reconciles to amounts included in the statement of financial position: expected future cash flows, risk adjustment (IASB), residual margin (IASB), single margin (FASB), and effect of discounting. Disclose separately the effect of each change in inputs and methods, reason for change, types of contracts impacted. Disclose yield curve or range of yield curves for non-participating contracts. IASB deleted the proposed requirement to disclose a measurement uncertainty analysis; FASB retained it. Require maturity analysis based on expected maturity (as opposed to an option to use contractual maturities). IASB to require expected maturities on annual basis for first 5 years and in aggregate thereafter as minimum. FASB to rely on financial institutions risk disclosure project decisions.
Disclosures
Extensive disclosure requirements based on IFRS 4 and IFRS 7 existing disclosure requirements, with some enhancements, including: Insurer shall not aggregate information relating to different reportable segments. Reconciliation from opening to closing balance of each major component of contract balances, including insurance contract liabilities, insurance contract assets, and the risk adjustment and residual margin included in each; similar information for reinsurance contracts. Methods and inputs used to develop the measurements that have the most material effect, and when practicable, quantitative information about those inputs. This includes methods and inputs used to measure the risk adjustment, and the confidence level used. Confidence level to which the risk adjustment corresponds if CTE or cost of capital method is used to measure risk adjustment rather than confidence level method. Measurement uncertainty analysis of inputs that have a material effect on the measurement. Nature and extent of risk arising from insurance contracts, including insurance risk, market risk, liquidity risk, and credit risk. Maturity analysis showing remaining contractual maturities or expected maturities. Effect of the regulatory framework in which the insurer operates.
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Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB Effective date and transition FASB
Proposed effective date not included in IASB ED. Transition adjustment calculated and recognized as adjustment to opening balance of retained earnings in earliest year presented. Transition impact measured using insurance contract portfolio as unit of account. Each portfolio measured using building block approach, including both expected (probability weighted) present value of cash flows and an explicit risk adjustment. Difference between this amount for each portfolio and the existing net insurance liability recorded under the previous GAAP (i.e., the liability net of any unamortized deferred acquisition costs and present value of in-force intangible) for that same portfolio would be charged or credited to opening retained earnings. Under explicit risk adjustment approach, risk adjustment calculated at transition would be re-measured each period subsequent to transition. Alternatively, under composite margin approach, risk adjustment calculated at transition would be treated as if it were a composite margin in subsequent periods; amortized over remaining coverage and claim settlement periods but not re-measured. At the beginning of earliest year presented, an entity is permitted, but not required, to re-designate financial assets to be measured at fair value through profit and loss (FVTPL) if doing so would eliminate or significantly reduce an inconsistency in measurement or recognition. Entity not required to publish previously unpublished claims development information earlier than first five years before end of first year it applies the standard.
Effective date will be determined taking into account the significance of the changes required and methods of transition. IASB: Noted earlier in redeliberations that effective date likely to be 3 years from issuance date of final standard.
www.pwc.com 2012 All rights reserved. PwC and PwC US refer to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication.
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Insurance alert
FASB Education Session Insuran nsurance Contracts January 18, 2012
Since a variety of viewpoints are discussed at FASB and IASB meetings, and it is often difficult to characterize the FASB and IASB's tentative conclusions, these minutes may differ in some respects from the actions published in the FASB's Action Alert and IASB Observer notes. In addition, tentative conclusions may be changed or modified at future FASB and IASB meetings. Decisions of the FASB and IASB become final only after completion of a formal ballot to issue a final standard.
Highlights hts
PwC summary of meeting Premium allocation approach: eligibility criteria Premium allocation approach: mechanics
The topics discussed at the FASB only education session included the eligibility criteria for the premium allocation approach, the IASB exposure draft (ED) proposed requirement to discount the liability for remaini remaining coverage and accrete interest on it, and the treatment of acquisition costs. As this was an education session, no decisions were reached; the meeting was in preparation for an upcoming joint meeting with the IASB where these issues are expected to be deliberated. That meeting was originally scheduled for January 25, but the most recent board agendas now show the January 25 meeting as being an IASB only meeting. FASB discussion paper (DP) did not address this issue. Some respondents to the ED suggested making the criteria more principles based, and some suggested it be based on the company's business model (e.g., apply a the PAA approach where the profitability of the contract is primarily driven by underwriting results rather than investment income). In prior redeliberations, the IASB and FASB boards could not agree on the objective of the PAA approach, with the IASB ASB generally viewing it as a proxy for the building block approach (BBA), while the FASB saw it more as a separate model and similar to a revenue recognition approach. Although the boards could not agree on the objective of the PAA, the staff was nevertheless neverth tasked with developing criteria for applying the PAA, in the hopes that while the objectives of the two boards might be different, criteria could be developed that would satisfy both objectives.
Premium allocation approach: Eligibility criteria

The staff noted that the boards had discussed eligibility criteria for the premium allocation approach (PAA) in April, July and October. Respondents to the ED in general generally believed that the criterion in the ED that the contract coverage period be approxim approximately one year or less was too restrictive. The
Several attempts were made by the staff to develop less restrictive criteria than those noted in the ED, with the latest criteria presented in October having two main components, each of which indirectly attempted to deal with the leanings of each board. The criteria were also "flipped" to start with an assumption that the PAA was the appropriate model, unless either of the two specified criteria were met, which would then require application of the BBA. The first main component, which seemed to reflect the IASB leaning that PAA be used as a proxy, included two sub-criteria: the BBA rather than the PAA should be applied to contracts where (1) the expected cash flows before the claim is incurred are expected to vary significantly over the coverage period and such variance is not expected to result in the recognition of an onerous contract adjustment and (2) the risk in the contract associated with the liability for remaining coverage had the potential to vary significantly. The second main component, implicitly addressing the FASB view that the PAA approach is more of a revenue recognition approach and that the BBA approach should be reserved for life and annuity contracts, was a requirement to use the BBA if it would be difficult to allocate the premium for the contract in a reliable and rational manner. This might be the case, for example, if significant deposit elements existed that are not unbundled or if there is significant uncertainty about the length of the coverage period, for example due to options for renewal. While the boards indicated a general agreement with the direction the staff was headed in October, individual board members came up with differing conclusions on how various contracts would be categorized under the criteria. For example, some thought certain life contracts did not typically have significant changes in cash flows and that premium could be allocated, resulting in PAA classification, while others thought BBA was appropriate. Some thought that certain property/casualty contracts such as catastrophe covers could end up under the BBA due to the chance that expected cash flows could change drastically without necessarily triggering an onerous contract result at a portfolio level, while others thought PAA classification was appropriate. The boards thus asked the staff to revise the language to address this disparity and to test the application of the criteria against different types of contracts to determine if the criteria were clear and operational and the results reasonable.
The revised criteria drafted by the staff after the October meeting (but similar to that noted above) and thirteen different contract types were provided both to board members and constituents (including preparers, auditors, and actuaries) for testing. The results of the survey yielded questions and some inconsistencies in how various contracts would be classified depending on one's interpretation of the unit of account to be used in making the assessment and other subjective judgments such as the meaning of "expected to vary significantly." The staff revised the criteria further in an attempt to make them more operational, with the latest staff paper (IASB/FASB staff paper 2A/78A) providing the following criteria: "Insurers should apply the building block approach rather than the premium allocation approach if, at the contract inception date, either of the following conditions is met: (a) It is likely that, during the period before a claim is incurred, there will be a significant change in the expectations of net cash flows required to fulfill the contract that would not be captured by the onerous contract test (expected cash flows criterion). (b) Significant judgment is required to determine the amount of premium to be recognized in each reporting period, for example if there is significant uncertainty about the length of the coverage period (allocation of premium criterion)." The staff believe the above proposed criteria would result in the following measurement models for example contract types (details of which are provided in the staff paper): 1. Traditional whole life BBA 2. Term life (1 year) PAA 3. Term life (5 years, with additional renewal rights) BBA 4. Universal life BBA 5. Annuity BBA 6. Personal auto PAA 7. Construction surety bond PAA* 8. Catastrophe insurance PAA 9. Workers' compensation PAA 10. Long term disability BBA 11. Directors and officers insurance PAA* 12. Health insurance PAA 13. Japanese fire (30 year) BBA
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*The staff paper notes that these contracts are particularly impacted by the macro-economic environment but that the impact of any significant changes in that environment on a contract would be covered by the onerous contract test and thus would qualify for PAA. The staff noted that the criteria would be assessed and classification determined only at contract inception (which could proceed the contract coverage period), as this would allow companies to make their determination based on pricing and underwriting information readily available. Questions arose in the testing as to what the appropriate unit of account should be. Some suggested that application at the individual contract level would result in all contracts that meet the definition of insurance being classified under the BBA approach, as the definition of insurance necessitates the potential for a significant loss. Others noted that if the portfolio were used as the unit of account, certain life insurance contracts would not be expected to have significant changes in cash flows. The staff paper explains that they did not intend for either unit of account to be used, but instead that the criteria be applied to "the characteristics of a representative contract or average contract." The staff described this as a level higher than the individual contract level, given that it considered the grouping of similar contracts. This explanation seemed unclear to some board members, and a few commented that it would be difficult to conclude on this issue without a better understanding of the unit of account. The staff acknowledged that the boards had not yet concluded on a number of unit of account issues, which would be addressed at a future meeting. With regard to criterion (a), the staff noted that the reference to onerous contracts was added after the survey was completed to deal with contracts such as catastrophe covers, surety, and director and officer coverages that were in the "gray" area when tested. The staff felt that by adding the onerous contract test wording, such covers would more likely meet the PAA approach. That is, some of those surveyed thought that these three types of contracts might be expected to have significant changes in cash flows, and yet thought that consistent with current practice, they should apply the unearned revenue approach (PAA) to such contracts. The staff reasoned that for these contracts, significant changes in cash flows would most likely be the result of expected adverse experience, and in those
situations, if the additional phrase on onerous contracts were added, the contracts would be onerous, leading to PAA classification. This and similar responses throughout the discussion implied that, as suggested by some participants in the study, the staff appeared to be trying to backward engineer a set of criteria in order for contracts to end up with a classification of either BBA or PAA consistent with current accounting as either a long duration or short duration contract. For that reason, some participants suggested that existing criteria for contract classification, such as the US GAAP definitions of long and short duration, be used instead. With regard to criterion (b), the staff noted that significant uncertainty about the length of the coverage period could arise in life and annuity insurance contracts due to the uncertainty in terms of how long a policyholder would live, what renewal options might be elected, and whether or not he/she would surrender. For such contracts, allocation of premium would in the staff's view be subjective and complex. The board discussion on eligibility criteria centered mostly on two items: the operationality of the criteria given the lack of an explicitly stated unit of account, and the application of the "onerous contract test" within the expected cash flows criterion (a). With regard to the onerous test, one board member questioned how an insurer would know, at the inception of a contract whether or not an expected significant change in net cash flows would be so large (and negative as opposed to positive) so as to cause an onerous contract situation. The staff responded that typically, changes in certain property/casualty lines of business were adverse, and once they occurred, would bring a contract into a loss position. Several board members questioned this logic, noting that changes could potentially be positive (depending on how the contract was originally priced), and more importantly, even if negative at the individual contract level, might very well not be negative at the level that an onerous contract test would be performed. Holding the three "gray area" contracts aside, a board member questioned why, in the other examples, it seemed that the conclusion was that whenever an insurer writes a life insurance contract, it is expected that cash flows could change significantly, but when a property/casualty contract is written, such as an auto policy, the insurer would assume cash flows would not change significantly. The staff responded that what is
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really driving this criterion is the difference between a life and P/C contract in terms of the length of the contract period. The longer the contract term, the more likely net cash flow estimates will change over time. For this reason, the one year term life contract would be accounted for as PAA, while the longer term life contract would be BBA. In a one year auto policy, the insurer's expectations as to whether the insured will have an adverse event are typically the same throughout the contract based on the insured's risk profile, whereas in a longer term life insurance contract, the insurer's expectations about mortality would be expected to change over this longer time period. Another board member questioned what the staff meant by "during the period." Is this an annual period? Or is it a quarterly period for a US public company? For example, if a 4 year term life contract were accounted for as PAA when viewed from an annual perspective, could it potentially be BBA if viewed as having 16 individual periods for which the criteria needed to be satisfied (e.g., the allocation of premium to each of these 16 periods). The staff noted that they hadn't considered this issue, but thought that the analysis would not change for that example, whether viewed from an annual period or quarterly reporting period perspective. After a lengthy discussion of the eligibility criteria, the general leaning of the board seemed to be to potentially remove the reference to the onerous contract test in criterion (a) based on the flaws noted above. In addition, it seemed that the board was suggesting that the unit of account would need to be clarified in describing the eligibility criteria, as board members were unclear what the staff meant that the criteria should be assessed by "type of contract."
Discounting and interest accretion on the liability for remaining coverage The staff are split on this issue, with some staff recommending that, consistent with the proposals in the revenue recognition exposure draft, discounting and interest accretion be required in the measurement of the liability for remaining coverage for contracts that have a significant financing component. These staff also recommend that, as a practical expedient (and consistent with the revenue recognition ED), insurers need not apply discounting or interest accretion if the coverage period of the contracts is less than one year. However, other staff recommend that the liability for remaining coverage should not be discounted and interest should not be accreted on the liability, regardless of the coverage period of the insurance contracts. The staff noted that consistent with the revenue recognition proposal, in considering whether a significant financing component is present, an insurer should consider the expected length of time between receipt of initial premium and the coverage period, whether the amount of consideration would differ substantially if the customer paid in cash upfront or over the coverage period, and whether the interest rate in the contract is at the prevailing market interest rate. The staff clarified that for a contract for which the entire premium is received upfront, a discounting and accretion model would result in accreting interest expense on the liability for remaining coverage, and then recording as premium revenue over the coverage period this accreted amount, which would be in excess of the premium actually received. Most board members seemed to have an aversion to recording as premium revenue an amount greater than the amount received in cash from the policyholder, which they referred to as an "inflated" revenue amount. However, one board member argued strongly for the discounting and interest accretion approach, saying that it best reflected the economics of the transaction, where "float" is an important component of the contract. Another board member stated that there hadn't been an outcry from users for this change from the current model, to which the first board member responded that people have a tendency to keep status quo rather than go through the trouble of changing their metrics. He also said that the current ambivalence was due in part to the low interest rate environment.
Premium allocation approach: Mechanics

The board discussed the three issues within staff paper 2B/78B dealing with the PAA: the ED requirement to discount the liability for remaining coverage and accrete interest, the types of costs to include in acquisition costs for contracts subject to the PAA, and the balance sheet presentation for acquisition costs relating to PAA contracts.
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The staff pointed out some of the operational complexities associated with having to accrete interest on the liability, as detailed in the staff paper. A board member noted that he also had some concerns with the wording of the practical expedient, which was linked to the coverage period. Instead, he believed the practical expedient should be based on the length of time between when the service is performed and the premium payment is made. For example, the practical expedient should apply to an eighteen month contract where the premium is paid monthly, because in that situation, there would be no significant timing difference between when the cash is received and the service is provided. Premium allocation approach: Treatment of acquisition costs The staff are also split on the types of acquisition costs that should be included in the measurement of the PAA. Some staff recommend that the measurement be consistent with the BBA, i.e., include directly attributable costs (limited to successful acquisition efforts only in the FASB model), In addition, they believe insurers should be permitted to expense directly attributable costs that are not incremental. Other staff recommend that the measurement of acquisition costs in the PAA should be consistent with the proposals in the revenue recognition exposure draft. Under this approach, the measurement of acquisition costs would include only incremental costs at the contract level, and insurers would be permitted to expense all acquisition costs if the coverage period is one year or less. While a couple of board members suggested that the categories of costs included in the BBA and PAA models should be consistent with each other, another board member said he didn't see the need to require additional work for shorter duration contracts, and thus would permit expensing as incurred in the PAA approach. The final issue discussed with the FASB board was the staff recommendation that, consistent with the model proposed in the revenue recognition project, acquisition costs for PAA contracts should be recognized as an asset, with the liability for remaining coverage thus presented gross of acquisition costs, a change from the ED requirement to net such costs against the liability. Under this approach, acquisition
costs would be amortized in a manner consistent with the recognition of premium (i.e., over the coverage period on the basis of time, but on the basis of the expected timing of incurred claims and benefits if that pattern differs significantly from the passage of time). Board members seemed to think the staff approach was reasonable, and that direct acquisition costs should be recorded separately as an asset rather than netted against the liability. Some suggested that they would like the boards to reconsider classification of qualifying acquisition costs as an asset under the BBA as well, but the staff reminded them that the decision had already been made to include qualifying acquisition costs as part of net cash flow in the building block approach.
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Additional information
Questions on this summary and the FASB/IASB joint project can be directed to: Mary Saslow (860-693-4407) a Managing Director in the National Professional Services Group, who is part of both the U.S. and Global Accounting Consulting Services groups
2012 PricewaterhouseCoopers LLP. a Delaware limited liability partnership. All rights reserved. PwC refers to the US member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
US GAAP Convergence & IFRS Consolidation

IASB finalizes definition of an investment entity
What's new?
On October 31, 2012, the IASB issued amendments to existing guidance to define an investment entity. The purpose of the amendments is to provide an exception for such entities from the existing requirement to consolidate certain subsidiaries. Investment entities will instead report all investments at fair value through profit or loss. The amendments also introduce new disclosure requirements for an investment entity's unconsolidated interest in a subsidiary.
No. 2012-49 November 2, 2012

Definition of an investment entity The IASB originally proposed a set of prescribed criteria to qualify as an investment entity, but ultimately decided to provide a principles-based definition. An investment entity is an entity that:
Obtains funds from one or more investors for the purpose of providing those investor(s) with investment management services Commits to its investor(s) that its business purpose is to invest funds solely for returns from capital appreciation, investment income, or both Measures and evaluates the performance of substantially all of its investments on a fair value basis
In addition, entities are required to consider whether they have the typical characteristics of an investment entity, such as multiple investments and investors, non-related party investors, and ownership in the form of equity or similar interests. While these additional characteristics are not determinative to the conclusion, an investment entity that lacks these typical characteristics is required to disclose the reasons it concluded it is nevertheless an investment entity. Consolidation Investment entities will account for their portfolio investments at fair value, even where they have a significant influence or a controlling financial interest in the investee. However, the final amendments do not allow such exception to consolidation for a nonNational Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1
investment entity parent with a controlling interest in an investment company. Rather, a non-investment entity parent of an investment entity must consolidate all entities it controls, including those controlled through an investment entity.
Both the IASB and FASB have agreed on a principles-based approach to defining investment entities, but there remain significant differences between the final IFRS guidance and the FASBs tentative decisions to date. The differences largely stem from the IASB's view that the investment entity guidance is a narrow exception to consolidation. Key differences include:
The FASB has reaffirmed its earlier decision that entities regulated under the SEC's Investment Company Act of 1940 will continue to qualify as investment companies irrespective of whether they meet the investment company definition. The IASB did not reference existing regulatory guidance given concerns that there could be different conclusions across jurisdictions, and the possibility that regulations could change. The IASB concluded that an entity is not an investment entity if it has more than an insignificant amount of investments that are not measured and evaluated on a fair value basis. The FASBs definition does not have the same requirement, although it is a factor to consider in the assessment. The FASB tentatively decided that a parent entity will retain the specialized accounting used by an investment company subsidiary in consolidation, consistent with current US GAAP. The IASBs guidance requires a non-investment entity parent to consolidate all controlled investees, including those that are held through an investment entity subsidiary. The IASBs guidance requires investment entities to carry all of their investments at fair value, including investee funds. Current US GAAP permits, but does not require, consolidation of controlled investee funds by an investment company parent. The FASB has tentatively decided to leave this guidance unchanged.

The IASBs amendments are effective January 1, 2014, with early adoption permitted. Entities are required to apply the amendments retrospectively, subject to certain transition reliefs.
What's next?
The FASB plans to continue redeliberations of its investment entity project over the next few months. Future topics for discussion include fund of fund disclosures for significant investments, changes to the current scope exception for REITs, transition guidance, and effective date. We expect the FASB to issue a final standard in the first half of 2013.
Questions?
In brief
Authored by:
Annette Spicker Partner Phone: 1-973-236-4088 Email: annette.p.spicker@us.pwc.com Luke Wilson Senior Manager Phone: 1-973-236-7046 Email: luke.a.wilson@us.pwc.com

IASB finalizes amendments to transition guidance for new consolidation standards
What's new?
This week, the International Accounting Standards Board (IASB) issued a final standard that amends the transition guidance for three standards. The three affected standards are: IFRS 10, Consolidated Financial Statements, IFRS 11, Joint Arrangements, and IFRS 12, Disclosure of Interests in Other Entities. The amendments primarily address the initial application of IFRS 10; however, they also require additional disclosures under IFRS 12. IFRS 10, which was issued in May 2011, replaces all of the consolidation guidance in IAS 27, Consolidated and Separate Financial Statements , and SIC-12, Consolidation Special Purpose Entities, with the exception of the portion of IAS 27 that deals with separate financial statements.
No. 2012-20 June 29, 2012

The amendments are responsive to requests from some preparers to clarify whether the date of initial application of IFRS 10 is the beginning of the annual reporting period in which IFRS 10 is applied for the first time or the beginning of the earliest period presented in the financial statements (i.e., the beginning of the comparative period). The amendments clarify the following: The date of initial application is the beginning of the annual reporting period in which IFRS 10 is first applied. For example, this would be January 1, 2013 for a calendar year entity that adopts IFRS 10 in 2013. No retrospective adjustments to the previous accounting are required if the consolidation conclusion is unaffected by the adoption of IFRS 10 at the date of initial application. Therefore, no adjustments are required for investees that would be consolidated under both IFRS 10 and the previous guidance as of the date of initial application. Similarly, no adjustments are required for investees that would not be consolidated under either model. For example, comparatives would not need to be restated if an investor disposes of an interest during the comparative period and neither IFRS 10 nor the previous consolidation guidance would require consolidation as of the date of initial application.
Retrospective adjustments to the previous accounting are required if the consolidation conclusion is affected by the adoption of IFRS 10 at the date of initial application. For example, if a previously acquired investee would be consolidated under IFRS 10 as of the date of initial application, the assets, liabilities, and non-controlling interest are measured as of the date the investor obtained control. Any difference between the IFRS 10 carrying amounts and previous carrying amounts at the beginning of the annual period immediately preceding the date the initial application is recorded in equity. On the other hand, if, for example, an investee is deemed to not be controlled under IFRS 10 as of the date of initial application, the investee is deconsolidated with the comparative period restated and the transaction measured as of the date the investor became involved with the entity or lost control over it. IFRS 12 disclosures related to subsidiaries, associates, and joint arrangements are required for the comparative periods. However, this requirement is limited to the period that immediately precedes the first annual period of IFRS 12 application. Comparative disclosures are not required for interests in unconsolidated structured entities.
The FASB issued a proposal in November 2011 to amend its consolidation guidance by incorporating the agent versus principal analysis contained in IFRS 10. The FASB's proposal allows the guidance to be applied retrospectively to the earliest period presented or as of the beginning of the year of adoption with a cumulative effect adjustment to retained earnings. There are also other existing differences between the IFRS 10 and U.S. GAAP consolidation models. The FASB is in the process of redeliberating its proposal.
Who's affected?
The amendments will affect all reporting entities that need to adopt the affected standards.

The amendments are effective for annual periods beginning on or after January 1, 2013, consistent with the effective dates for IFRS 10, 11, and 12. While earlier application is permitted, the amendments, together with the entire package of related standards, are required to be adopted at the same time.
What's next?
IFRS preparers should start considering the transition amendments, and how they can use the exemptions granted to minimize implementation costs. IFRS preparers should also start collating the comparative disclosure information required by the amendments.
Questions?
In brief
Authored by:
Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com

FASB and IASB agree to principles-based definition for investment companies
What's new?
The FASB and IASB (the boards) met on May 21, 2012 to redeliberate the investment company definition project for the first time. The boards considered two items: (1) whether the IASB will continue with an entity-based approach or apply an asset-based approach and (2) the approach to apply the definition and any changes that need to be made to the related criteria and implementation guidance. As anticipated, the IASB decided to continue an entity-based approach to the project. The boards also agreed to move from a series of fixed criteria to qualify as an investment company and instead are proposing a principles-based definition with additional implementation guidance.
No. 2012-12 May 24, 2012

The boards considered several potential methodologies, but in the end supported an approach that establishes a principles-based definition of an investment company. However, there are some differences between the boards on the specific wording of the definition and the application of additional factors in concluding whether the entity meets the definition. The IASB noted that their goal is to provide a narrow exception to consolidation or equity method accounting of investees where fair value reporting was ultimately viewed as the appropriate method of reporting for the entity. Consequently, the IASB will require fair value management be included in its definition of an investment company and will require that capital appreciation (and accordingly an exit strategy) be one of the drivers of investment returns. Conversely, the FASBs definition will not include the requirement for fair value management but instead will retain that criterion as a factor to be considered in its implementation guidance, including the consideration of how an entity transacts with its investors and how the asset-based fees are calculated. Further, the FASB will also allow both capital appreciation and/or investment income as a means of achieving returns. The boards also considered additional factors to be provided as implementation guidance, including number of investments and investors, related party investors, and ownership interests. No final decisions were made at the meeting. The boards have asked their staff
to prepare additional research, including examples that are intended to illustrate how to weigh these factors for the entities that fall into a gray area of the definition . Highlights of other areas of the implementation guidance that the boards elected to modify include: Joint decisions Transactions between controlled entities will not be prohibited. (Nature of investment activities) An entity does not need to be a separate legal entity. (Reporting entity) The phrase in conjunction, which is a concept used in the implementation guid ance, is not intended to mean funds must be set up simultaneously in order to apply this guidance. An entity may be set up as a single investor or single investment fund in conjunction with another fund for business purposes other than legal, regulatory or tax reasons, as long as both funds otherwise meet the definition of an investment company. IASB only Entities will be allowed to provide investment-related services to third parties, provided it is not substantive. (Nature of investment activities) Day-to-day management of investees will not disqualify an entity. (Nature of investment activities) An entity is required to have an exit strategy for all its investments, but may perform this assessment at the portfolio level and not at the individual investment level. (Express business purpose)
In addition to the areas of divergence discussed above regarding scope, there remain several areas of divergence that have not yet been addressed. We expect the boards to discuss these issues at future meetings, including whether the IASB will provide an accommodation for regulated funds, how to account for controlling financial interests in other investment companies, and retention of specialized investment company accounting by a non-investment company parent.

An effective date has not yet been determined. As currently proposed, early adoption would not be allowed.
What's next?
We expect the boards to continue their redeliberations on the project over the coming months, with a goal of issuing a final standard by the end of 2012. In particular, the IASB has indicated a final standard is necessary this year given the 2013 effective date of several related standards, such as IFRS 9 and 10.
Questions?
In brief
Authored by:
Annette Spicker Partner Phone: 1-973-236-4088 Email: annette.p.spicker@us.pwc.com John McCardell Senior Manager Phone: 1-973-236-7408 Email: john.n.mccardell@us.pwc.com

IASB proposes amending transition guidance for new consolidation standard
What's new?
This week, the International Accounting Standards Board (IASB) issued a proposal to make amendments to the transition guidance contained in IFRS 10, Consolidated Financial Statements. IFRS 10, which was issued in May 2011, replaces all of the consolidation guidance in IAS 27, Consolidated and Separate Financial Statements, and SIC-12, Consolidation Special Purpose Entities, with the exception of the portion of IAS 27 that deals with separate financial statements.
No. 2011-56 December 22, 2011

Currently, IFRS 10 requires retrospective application but does not require an entity to make adjustments to its previous accounting if its consolidation conclusions are unchanged when IFRS 10 is applied. The proposal is intended to be responsive to requests from some preparers to clarify whether the date of initial application of IFRS 10 is the beginning of the annual reporting period in which IFRS 10 is applied for the first time or the beginning of the earliest period presented in the financial statement (i.e., the comparative period). The proposal would amend IFRS 10 by clarifying the following: The date of initial application is the beginning of the annual reporting period in which IFRS 10 is first applied. For example, this would be January 1, 2013 for a calendar year entity that adopts IFRS 10 in 2013. Retrospective application does not require adjustment of the previous accounting if the consolidation conclusion is unaffected by the adoption of IFRS 10 at the date of initial application. Therefore, no adjustments are required for investees that will be consolidated under both IFRS 10 and the previous consolidation guidance as of the date of initial application, or investees that will be unconsolidated under both IFRS and the previous consolidation guidance as of the date of initial application. For example, comparatives would not need to be restated if an investor disposes of an interest during the comparative period and neither IFRS 10 nor the previous consolidation guidance require consolidation at the date of initial application.
In brief
The comparative period is required to be restated to be consistent with IFRS 10 if the consolidation conclusion is affected by the adoption of IFRS 10 at the date of initial application. For example, if a previously acquired business is newly consolidated under IFRS 10 as of the date of initial application, the assets, liabilities, and noncontrolling interest are measured as of the date of the business combination. A business that is deemed to be not controlled under IFRS 10 as of the date of initial application is deconsolidated with the comparative period restated and the transaction measured as of the date of the disposal. Retrospective adjustments are required unless impracticable, in which case retrospective adjustment from the earliest practicable date is required.
The FASB issued a proposal in November 2011 to amend its consolidation guidance by incorporating the agent versus principal analysis contained in IFRS 10. The FASB's proposal allows the guidance to be applied retrospectively to the earliest period presented or as of the beginning of the year of adoption with a cumulative effect adjustment to retained earnings. Other existing differences between the IFRS 10 and U.S. GAAP consolidation models remain divergent at this stage.
Who's affected?
IFRS 10 could affect IFRS reporting entities that expect changes in the consolidation conclusion for one or more investees under the revised definition of control.

The effective date of IFRS 10 is not affected by the proposal. IFRS 10 is effective for annual periods beginning on or after January 1, 2013. While earlier application is permitted, an entire package of related standards is required to be adopted at the same time.
What's next?
Comments on the IASB's proposal are due on March 21, 2012. A final standard is planned for issuance in the second quarter of 2012.
Questions?
In brief
Authored by:
Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com

Investing in a new investment company definition FASB proposes to align investment company definition with IFRS proposal
Overview
At a glance On October 21, 2011, the FASB issued a proposal to (1) amend the criteria for determining whether an entity is an investment company and (2) address when an investment company should apply consolidation accounting. Investment companies would continue to measure their investments at fair value, including any investments in which they have a controlling financial interest. However, investment companies would be required to consolidate any other investment companies or investment property entities in which they have a controlling financial interest. Under the proposal, six criteria would have to be met in order for an entity to be an investment company. In addition to amending the current four criteria, two new criteria would be added. Entities that do not hold multiple investments or only have a single investor would not qualify. However, entities that are registered under the Investment Company Act of 1940 would qualify as investment companies regardless of whether they meet all of the six criteria in the revised definition. Concurrently, the FASB issued a proposal to define an investment property entity. The criteria to qualify as an investment property entity are similar to those for an investment company, but with some notable differences. Entities would need to determine if they are an investment property entity before determining whether they meet the criteria to be an investment company. Refer to our forthcoming Dataline on the investment property entity proposal for details. The new definition of an investment company was developed jointly with the IASB. The IASB issued its proposal in August 2011. While the criteria to qualify as an investment company are substantially similar, some key differences exist between the boards' respective proposals. Most notably, the IASB would not retain investment
No. 2011-32 November 8, 2011 Whats inside: Overview .......................... 1

Key provisions .................3

Definition of an investment company............ 3 Examples ................................. 7 Accounting for an investment company's investments ........................ 10 Presentation and disclosure ............................ 11 Reassessment of entity status ...................................12 Differences with the IASB's investment entity proposal .....................12 Interaction with investment property entity definition...................13
Effective date and transition .................... 13 Questions ....................... 14 Appendix ........................ 15
company accounting in consolidation by a non-investment company parent, and all investments would be measured at fair value even if they represent a controlling financial interest in another investment company. In addition, the IASB has not issued a corresponding proposal to define an investment property entity. The proposed amendments would apply to an entity's interim and annual reporting periods in fiscal years that begin after the effective date, which has not been determined. Comments on both the FASB and IASB's proposals are due January 5, 2012. The main details .1 The AICPAs Audit and Accounting Guide, Investment Companies, (the Guide) originally defined an investment company. Under the Guide, investment companies were required to measure their financial assets at fair value and were precluded from consolidating non-investment company investees. These aspects of the Guide were subsequently codified in Topic 946, Financial ServicesInvestment Companies, of the Accounting Standards Codification. .2 In 2007 the AICPA undertook a project to amend the definition of an investment company and determine when a parent or equity method investor should retain the specialized accounting in Topic 946 to account for their interest in an investment 1 company. That project resulted in the issuance of SOP 07-1 . However, a number of 2 implementation issues arose with the SOP and the FASB deferred it indefinitely so that it could consider whether any changes were needed. .3 Around the same time, the IASB was developing a new consolidation standard, which ultimately became IFRS 10. As part of that project the IASB began to explore establishing a definition of an investment company based on feedback it gathered from preparers and users. Specialized accounting for investment companies did not previously exist in IFRS. Consequently these types of entities were required to account for their investments, and apply consolidation and equity method guidance to their investee portfolios, consistent with all other entities. .4 Since both boards were considering the investment company definition, they decided to add the project to their convergence agendas. Rather than starting with a new model, the boards agreed to utilize the criteria developed in SOP 07-1 as the starting point for identifying investment companies. .5 While the boards are aligned on the six criteria to be used to define an investment company, their proposals reflect some differences. The most notable differences include: (1) an exception under the FASB's proposal that allows entities that are registered under the Investment Company Act of 1940 to qualify as investment companies even if they do not meet all of the other criteria, (2) the FASBs proposal requires investment companies to consolidate other investment companies and investment property entities in which they have a controlling financial interest whereas the IASB's proposal would require all investees to be measured at fair value, and (3) the FASB's proposal would retain investment company accounting in consolidation by a non-investment company parent, whereas the IASB's proposal would not allow that parent to retain the specialized investment company accounting.
1 2
AICPA Statement of Position 07-1 FASB Staff Position SOP 07-1-1, Effective Date of AICPA Statement of Position 07-1
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Key provisions
Definition of an investment company .6 In order to be considered an investment company, the proposal requires an entity to meet the guidance that accompanies all six of the following criteria: Nature of the investment activity Express business purpose Unit ownership Pooling of funds Fair value management Reporting entity However, entities that are registered under the Investment Company Act of 1940 would qualify as investment companies regardless of whether they meet all six criteria. .7 The current prohibitions for Real Estate Investment Trusts (REITs) from qualifying for investment company accounting under Topic 946 would be rescinded. As the REIT designation is elective under the tax code, the FASB felt that such an election should not affect whether an entity is an investment company under GAAP. Criterion 1: Nature of investment activity .8 The entity cannot have any substantive activities other than its investing activities. As a result, the entity cannot have any significant non-investing assets or liabilities. .9 An exception is provided for non-investment services that support the entity's own investment activities. Examples of these services include investment advisory and transfer agent activities. Therefore, an entity can still meet this criterion even if these service activities are substantive. However, if the entity provides the same services to other entities, then it can only meet this criterion if those services are not substantive. PwC observation: Many asset managers, particularly for private equity funds, were concerned that the FASB would retain the notion in SOP 07-1 that ongoing involvement in the day-today management of an investee would preclude an entity from being an investment company. However, the FASB (and IASB) did not think involvement in day-to-day management was inconsistent with the characteristics of an investment company and also felt that precluding such activity would be inconsistent with the idea of having a controlling financial interest.
Multiple investments .10 The entity is required to hold multiple investments at the same time. The proposal does not define how many investments must be held but the FASB notes in its basis for conclusions that it should be more than one investment. The multiple investments may be held directly or indirectly through another investment company, such as in the case of a feeder fund's interest in a master fund. A fund-of-funds structure would also qualify as long as the underlying fund holds multiple investments. Said differently, one must look-
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through the entity to the underlying investment company's investments in order to determine whether this requirement is met. .11 An entity may, for legitimate reasons, not hold multiple investments at all times during its life. An exception to the multiple investments requirement is made to accommodate the following stages in an entity's lifecycle: The entity's initial offering period. Suitable investments have not yet been identified and the entity has not fully executed its investment strategy to acquire multiple investments. Replacement investments have not yet been made. The entity is liquidating. .12 Many times investment companies may form other entities that hold only a single investment. These entities may be formed for regulatory, legal, tax, or other reasons and are often referred to as blocker entities. These types of entities would still be eligible to be investment companies provided they were created in conjunction with the parent investment company and meet all the other criteria to qualify. PwC observation: Some may interpret the "in conjunction with" requirement to mean that the entity would need to be formed at the same time as its parent. We believe that this is not the intent but rather that the entity is formed, for example, as part of the investment company making an investment in a specific investee, which can occur at a later date.
Returns .13 There are limitations on the extent of the interactions that the entity and its affiliates can have with the entity's investees. These limitations were carried forward from SOP 07-1 and are designed to limit relationships that were viewed as being outside the investment company model. The proposal provides the following examples of relationships and activities between the entity and its investees that would indicate that the entity is aiming to generate returns that are not focused on capital appreciation or investment income: The entity (or its affiliates) is acquiring, using, exchanging, or exploiting the technology, processes, or assets of the underlying investee. There are joint product or service arrangements between the entity (or its affiliates) and its investee. There are transactions with terms exclusive to the entity (or its affiliates) that represent a significant portion of the investee or entity's activities (or that of their affiliates). The entity (or its affiliates) has disproportionate or exclusive rights to acquire assets, technology, products, or services from the investee. The investee (or its affiliates) provides financing guarantees or collateral to the entity. The entity's affiliate has an option to purchase an interest in the investee from the entity at an amount other than fair value.
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PwC observation: This new requirement may be challenging to implement for complex groups where the underlying entities are consolidated by a common parent. All relationships between the entities within the group and individual investees will need to be identified and analyzed for the purposes of determining if these are inconsistent with the notion of investing for capital appreciation and/or investment income. Note that affiliates are defined as entities under common control, which would include a family of funds with a common parent.
Criterion 2: Express business purpose .14 A commitment must be made to investors that the entity's purpose is to invest for returns from capital appreciation, investment income, or both. Investment income typically consists of dividends and interest. This commitment can take different forms including an explicit commitment, such as in an offering document, or be implied by the manner in which it is represented to investors. The proposal also clarifies that this is the only business purpose the entity may have and that it cannot be linked to any other objectives, such as jointly developing a product with an investee. .15 The proposal also requires that the entity have an exit strategy that sets out its plans to realize capital appreciation on its investments if that is part of its express business purpose. The entity is only required to identify potential exit strategies, which may vary by the type of investment. Realizing investment returns only through redemption or liquidation of the entity is not viewed as a valid exit strategy. The FASB noted that an entity that has a stated purpose of only investing for returns from investment income, such as a fixed income fund, does not require an exit strategy for its investments, and therefore, would not be precluded from being an investment company if it meets the other criteria. Criterion 3: Unit ownership .16 Investors in the entity are required to obtain ownership units that entitle the investors to an identifiable, but not necessarily proportionate, share of the net assets of the entity. The ownership units are required to be in the form of equity or partnership interests. Multiple classes of equity instruments with distinct rights are not precluded from being considered ownership units under this criterion. PwC observation: SOP 07-1 provided an example of a collateralized loan obligation that would be considered an investment company based on a pooling of funds from numerous investors, even though most of those investments were in the form of debt. The requirement that investors obtain ownership interests under the proposal may therefore represent a significant change in practice for collateralized debt obligations (CDOs) that currently employ investment company reporting. While those CDOs could avail themselves of the fair value option to account for their investments, they would nonetheless not qualify for the specialized financial statement presentation of an investment company.
Criterion 4: Pooling of funds .17 An entity is required to have multiple investors that are not related to the parent of the entity (if a parent exists), and those unrelated investors must, in the aggregate, have a significant ownership interest in the entity. For this analysis, any investors that are
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related to the parent would be combined with the parent and collectively they would be considered a single investor. .18 The FASB was concerned that the parent could have arrangements with other investors that could expose the parent to the underlying investee. Therefore, this criterion requires that if the parent has an arrangement that would require it to acquire another investor's ownership interest at an amount other than fair value, those investments would have to be combined with that of the parent. For example, it (1) has a put option to acquire another investors ownership interest or (2) financed an investors ownership interest with that interest serving as collateral. .19 An exception to the requirement to have more than one unrelated investor is provided where an entity is formed in conjunction with an investment company parent. However, the parent itself would need to have third party investors that, in the aggregate, hold a significant unrelated interest in the parent. This exception should enable master funds with a single investor (i.e., the feeder fund) and other entities that are set up for tax or legal reasons, such as blocker entities, to meet the requirements of this criterion. .20 Similar to the nature of investment activity criterion, this criterion also contains an accommodation for periods in an entity's lifecycle when it may not meet the requirement to have more than one unrelated investor. In particular, not having multiple investors would not preclude eligibility in the following situations: The entity's initial offering period has not expired and it is actively seeking investors. Suitable replacement investors are being sought after an ownership interest has been redeemed. The entity is liquidating. PwC observation: Certain entities that have a single investor will not qualify as investment companies under the proposal. For example, pension funds, sovereign wealth funds, and funds with a single nominee investor that holds investments on behalf of multiple beneficiaries. This criterion will also require funds to determine if there is a parent entity and, if there is, to identify any related parties of the parent. The Topic 850 definition of related parties would be incorporated by the ED into Topic 946. That definition includes, among others, affiliates, trusts for the benefit of employees, principal owners and management and their immediate families, and equity method investees. In determining if an entity has a parent, the FASB's forthcoming proposal on consolidation (principal versus agent) may contain relevant guidance (see In brief 2011-47).
Criterion 5: Fair value management .21 The entity must be managed and its performance evaluated on a fair value basis. Fair value should provide the basis for the investment decisions. For these types of entities, fair value is the key measurement basis that investors would likely use to evaluate the entity's investment results. It is also the value at which investors typically acquire and redeem their ownership interests in such entities. The FASB considered this in relation to money market funds, which report on an amortized cost basis. In its basis for conclusions, the FASB concluded that, as these funds manage the difference between the amortized cost and fair values of their investments in order to achieve a consistent net asset value, they would be considered to be managed on a fair value basis and would therefore meet this criterion.
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.22 An exception to the fair value management requirement is provided for assets that relate to the servicing of the entity's own investments. Criterion 6: Reporting entity .23 The entity does not need to be a legal entity, but it must provide its investors with periodic financial results. The substance of the entity would need to be assessed to determine if it is a reporting entity. Not requiring the entity to be a legal entity provides an accommodation for certain industries, such as insurance company separate accounts where the activities of a portion of the entity can be distinguished from the rest of the entity and the operating results of those accounts serve as the basis for investment decisions by investors. The FASB also was concerned that a requirement based on the legal status of an entity could lead to inconsistent conclusions in different jurisdictions. PwC observation: Limited guidance is provided in the proposal on how to assess the substance of an entity to determine if it meets this criterion. It is unclear what form the periodic financial results must take and whether these need to be in the form of financial statements; however, the basis for conclusions indicates that an entity whose performance is only evaluated by internal parties (i.e., management) on a standalone basis would not meet the criterion.
Examples .24 The proposal includes some examples on applying the new investment company definition to certain fact patterns. These examples are summarized below: Example 1: Private equity partnership
Entity GP
3rd-Party Investors
Criteria
Nature of investment activity Express business purpose Unit ownership
Entity LP
1%
99%
Entity LP
Controlling interest Noncontrolling interest
Pooling of funds Fair value management Reporting entity
Entity ABC
Other investments
Additional facts: The offering memorandum states the purpose of Entity LP is to invest in entities with rapid growth potential and realize capital appreciation.
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Investments will be sold during the life of the entity either by sale or distributing equity in investees to investors on completion of a public offering. Formed in 20x1, Entity LP acquires its first investment, in Entity ABC, in 20x2 but is unable to find other suitable investments until 20x3 when it acquires five new investments. Conclusion: Entity LP is an investment company. Example 2: High technology fund
Investor
Investor
Investor
Investor
Investor
Investor
Criteria
Nature of investment activity
Entity HTF
Entity HTF
Express business purpose Unit ownership Pooling of funds
Startup company
Startup company
Startup company
Fair value management Reporting entity
Additional facts: Entity HTF is managed by an investment advisor that is unrelated to the investors; however, the investors (themselves also high technology companies) provide advice to the advisor about potential investments. Three of the high technology investors have options to acquire investments at fair value. No exit strategy exists. Conclusion: Entity HTF is not an investment company.
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Example 3: Retail property partnership
Entity GP
3rd-Party Investors
48%
Criteria
Nature of investment activity Express business purpose Unit ownership
Entity LP
X X
52% Controlling interest
Entity LP
Pooling of funds Fair value management Reporting entity
Property
Property
Property
Additional facts: The 3rd party investors cannot remove or replace Entity GP without cause. Entity GP's interest increases based on value of contributed property. Entity GP is an affiliate of Entity LP (has a controlling financial interest). The properties are developed into retail centers and managed by Entity GP. At end of Entity LP's life, the properties may be sold or Entity GP may acquire them based on independent appraisal. Conclusion: Entity LP is not an investment company because (1) its business purpose is other than investing for capital appreciation or investment income and (2) its activities which are conducted by the affiliate (Entity GP) are not related to the business activities of capital appreciation or investment income.
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Example 4: Master-feeder fund structure
GP
3rd party Investors
Sponsor
3rd party Investors
Criteria
Entity MF (and feeder funds)
1%
99%
1%
99%
Nature of investment activity

Domestic feeder Offshore feeder
Express business purpose Unit ownership Pooling of funds
Entity MF
Investment
Investment
Investment
Fair value management Reporting entity
Additional facts: The GP of the domestic feeder and sponsor of the offshore feeder are the same entity. The purpose of Entity MF is to hold multiple investments for capital appreciation and investment income. This objective was also communicated to investors in the feeder funds. Conclusion: Entity MF and the Domestic and Offshore feeder funds are investment companies. Despite only having one investment in Entity MF, the feeder funds were formed in conjunction with Entity MF which has multiple investments. In addition, despite Entity MF not having unrelated investors with significant investment, it was formed in conjunction with the feeder funds, which themselves have unrelated investors with significant investment. Accounting for an investment company's investments .25 The proposal would make significant changes to how investment companies account for their investments in other investment companies. The proposal would require an investment company to apply the guidance in ASC 810 to an investee that is itself an investment company or an investment property entity. Therefore, if the investment company has a controlling financial interest in another investment company or an investment property entity, it would have to consolidate that investee. All other investments would be measured at fair value, including any investees in which the investment company has significant influence (i.e., an investment company would not apply the equity method of accounting to its investments). The proposal also allows an exception from the consolidation guidance for master-feeder structures, provided they follow all other requirements in the proposal. .26 An investment company would also have to consolidate any investees in which it has a controlling financial interest and that provide services to the investment company, such as investment advisory or transfer agency services. If the investment company only has significant influence over such an investee, it would apply the equity method of accounting. This is the only instance where an investment company would apply the equity method to its investees.
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PwC observation: The requirement to consolidate other investment companies and investment property entities in which the entity has a controlling financial interest would represent a potentially significant change in practice. Today, Topic 946 only permits an investment company to consolidate another investment company investee, and in practice this is typically only applied to wholly-owned entities. As a result, instead of reflecting investments in other funds as one line item in the portfolio presented at fair value, the investment company would consolidate those entities and show all of the entities' assets and liabilities and the related non-controlling interests on its balance sheet. Fund-of-funds entities are an example of the types of entities that would likely be impacted by this change. ASC 946-210-45-7 (not proposed to be amended) states, "Fund management shall consider if an investment in a single underlying fund is so significant to the fund of funds as to make the presentation of the financial statements in a manner similar to a master-feeder fund more appropriate." Given the significant differences under this proposal between fund of funds and master-feeder presentations, applying the proposed guidance to a fund of funds may require substantial judgment. .27 All investments are to be recorded at their transaction price, which includes any commissions or other charges that are part of the purchase transaction. For real estate transactions the transaction price includes any professional fees, property transfer fees, or other costs that are part of the property purchase. PwC observation: In its redeliberations on the broader financial instruments project, the FASB reached the same conclusion about the treatment of transaction costs for investment companies. .28 If an investment company is the lessor of real estate properties, rental revenue is recognized when the lease payments are due or received based on the contractual terms of the lease agreement. This was required to prevent double counting, as future cash flows are generally included in the fair value measurements of property. Presentation and disclosure .29 Investment companies will be required to comply with the presentation requirements for non-controlling interests in ASC 810 for consolidated investees. Illustrative disclosures of a non-controlling interest in an investment company's financial statements are included in the proposal. .30 The following additional requirements would apply: The extent of non-controlling interest, due to consolidating investment companies and investment property entities, that is attributable to investees will need to be disclosed in the schedule of investments. The financial highlights would be calculated excluding any amounts attributable to the non-controlling interest. For investment companies that consolidate investment property entities, an expense ratio must be shown excluding all expenses of the consolidated investment property entity.
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A reconciliation of the amounts used in calculating the financial highlights back to the financial statements must be included. .31 The proposal calls for two additional disclosures by investment companies: Any financial support provided to any investees during the period and situations where the investment company intends to provide support. The type of support provided, including any assistance in obtaining the support, and also the primary reasons for the providing the support must be disclosed. This applies only to support that the entity was not previously required to provide. Any restrictions on the ability of an investee to pay dividends, interest, or repayments of loans to the investment company. .32 The proposal requires investments in real estate property, along with any associated debt, to be shown separately in the statement of assets and liabilities. Rental income and operating expenses related to the properties must also be presented separately in the statement of changes in net assets. Any restrictions on the ability to increase rent, receive rent, collect proceeds from the sale of a property, or any contractual obligations associated with the property would also require disclosure. Reassessment of entity status .33 Determination of whether an entity meets the definition of an investment company is made at the formation of the entity. Reassessment of an entity's status is not required at each reporting period, but rather whenever there is a change in the purpose and design of the entity. .34 If an entity no longer meets the investment company criteria, the change in status is applied prospectively from that date and other existing GAAP would provide the basis for its accounting. The fair value of the investments on the date of the change in status would be each investment's initial carrying amount. .35 An entity that subsequently meets the investment company criteria will also account for the change from the date it occurred. The difference between the carrying amount and the fair value of the investments would be recognized as a cumulative-effect adjustment to net assets on that date. Any unrealized gain or loss in accumulated other comprehensive income would also be part of the adjustment. The cumulative-effect adjustment would be included in beginning net assets and included in the beginning per share information of the financial highlights. .36 The reasons for a change in status would need to be disclosed, and an entity that becomes an investment company would disclose the effect of the change in status on its investments. Differences with the IASB's investment entity proposal .37 While the FASB and the IASB proposals would be substantially converged in most areas, there are several key differences: The IASB's proposal prohibits a non-investment company parent from retaining the specialized investment company accounting in consolidation. All portfolio investments will be accounted for at fair value under the IASB's proposal, including investments in other investment companies in which the entity has a controlling financial interest.
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Unlike the FASB proposal, which specifies that all entities subject to the Investment Company Act of 1940 are investment companies, the IASB's proposal does not provide for funds subject to certain regulatory requirements to qualify for investment entity status without meeting all of the stated criteria. The IASB proposal contains only a disclosure principle to enable investors to evaluate the nature and results of an entitys investment activities. The proposal does provide recommendations that mirror US GAAP requirements. Specifically, the IASB proposal recommends disclosures similar to a statement of investments and financial highlights; however, final disclosures under IFRS may ultimately differ from those recommended. In addition, IFRS requires comparative statements. The IASB proposal does not provide an exception to the requirement for an exit strategy for an entity that has a stated purpose of only investing for returns from investment income, such as a fixed income fund. Interaction with investment property entity definition .38 The definition of an investment property entity has similar criteria to that used to define an investment company. Notable differences in the criteria include (1) the investment property entity definition does not include criterion 5 requiring fair value management and (2) criterion 1 (nature of the business activity) instead requires that substantially all of the entity's business activities are investing in real estate property. Also, the "pooling of funds and unit-ownership criteria for an investment property entity provide specific exclusions for an entity that is wholly owned by a pension plan or not-for-profit entity. .39 An entity would first apply the investment property entity definition and if it meets that definition it would apply that guidance. Only if it does not meet the definition of an investment property entity would it then assess whether it is an investment company. PwC observation: The criteria to qualify as an investment company differ in certain respects from those currently used in US GAAP. Consequently, some entities that are currently considered to be investment companies will no longer qualify while others may (e.g., certain REITs). However, a REIT investing in physical properties will first be required to determine if it meets the definition of an investment property entity and apply that guidance if it meets that standard's criteria. See the Appendix to this Dataline for a summary comparison between the current US GAAP definition and the one being proposed by the FASB.

.40 The proposal does not include an effective date and prohibits early adoption. The FASB has indicated that it will decide on the effective date and whether to allow early adoption based on feedback it gathers on the proposal. .41 An entity that was previously not an investment company but qualifies as such under the new criteria would apply the new guidance as of the date of adoption with any effects recorded as an adjustment to opening net assets. .42 If an entity no longer meets the definition of an investment company, then it would apply the relevant guidance as of the beginning of the period of adoption, with any differences recognized as a cumulative-effect adjustment to beginning retained earnings. For investments where the entity has a controlling financial interest, it would need to
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determine the carrying amounts of the assets, liabilities, and non-controlling interests as if the entity had applied this guidance when it obtained the controlling financial interest. The same would apply to any investments in which it has significant influence. If it is not practical to go back to the beginning of the year of adoption, then it would use the fair value of an investment on the date of adoption. For all other investments, initial measurement of investments shall be the fair value on the date of adoption.
Questions
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Appendix Comparison of current investment company definition to the FASB's proposal

Criterion Nature of the investment activity Topic 946 Proposed
o The entity's primary business activity

involves investing for current income, appreciation, or both.
o No substantive activities other than

investing - exception for services relating to entity's own investing activities. o Entity holds multiple investments - some accommodation for certain stages in entity's life and exception if formed in conjunction with another entity that has multiple investments. o Returns are for capital appreciation, investment income, or both.
Express business purpose
o No specific criterion.
o Commitment made to investors to invest for

capital appreciation, investment income, or both. o Investment plans include exit strategies for investments unless only held for investment income.
Unit ownership
o Ownership represented by units of

investments to which a proportionate share of net assets can be attributed.
o Investors obtain ownership units in the form

of equity or partnership units that are entitled to an identifiable portion of net assets.
Pooling of funds
o The funds of the owners are pooled to

avail them to professional investment management.
o Has unrelated investors that in the

aggregate hold a significant ownership interest in the entity; some accommodation for certain stages in entity's life and exception if formed in conjunction with another entity that has unrelated investors that hold a significant interest in the entity.
Fair value management
o No specific criterion.
o Substantially all investments are managed

and their performance evaluated on a fair value basis; exception for assets used to service the entity's investments.
Reporting entity
o Entity must be a legal entity - exception

for separate insurance accounts. o The entity is the primary reporting entity.
o Need not be a legal entity but provides

(external) investors with periodic fair-value based financial results about investment activities.
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Authored by:
Annette Spicker Partner Phone: 1-973-236-4088 Email: annette.p.spicker@us.pwc.com John McCardell Senior Manager Phone: 1-973-236-7408 Email: john.n.mccardell@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com

No. 2011-29 October 27, 2011
(Revised November 15, 2011*)

A look at the new IFRS consolidation standard and how it compares to US GAAP Many aspects of the IASBs consolidation guidance are now converged with US GAAP
Overview
At a glance The IASB released IFRS 10, Consolidated Financial Statements, in May 2011, introducing new guidance on when investors will have to consolidate investees. Many aspects of the new guidance are now converged with U.S. GAAP. The new approach combines the concepts of power to control and exposure to variable returns in the determination of whether control exists, and whether consolidation is required. Control only exists when the investor has power, exposure to variable returns, and the ability to use that power to affect the investors returns from the investee. The new standard is available for early adoption, with mandatory application required from January 1, 2013. Retrospective application is required with certain practicability exceptions. The effective date for IFRS 12, Disclosure of Interests in Other Entities, which deals with the related disclosures, coincides with that of IFRS 10. The FASB is expected to issue a proposal in the fourth quarter of 2011 to amend its consolidation guidance for variable interest entities and limited partnerships by incorporating a principal versus agent assessment that is broadly consistent with that contained in IFRS 10. Management will need to evaluate the impact of IFRS 10 on their assessment of the entities that they are required to consolidate. Changes to the constitution of the consolidated group could result in a fundamental change to key investor metrics (including debt covenants) such as leverage, liquidity, and profitability ratios.
Key provisions .................3

Scope ....................................... 3 Control .................................... 3 Framework for assessment of control .............................. 4 Purpose and design of the investee ........................... 5 Power ...................................... 5 Variable returns ................... 28 Link between power and returns principal vs. agent ............................. 29
Other issues ...................36

De facto agent ....................... 36 Silos ....................................... 37 Frequency of reassessment .. 38 Accounting requirements ..... 38
Disclosures .................... 38
General objective of IFRS 12 ............................... 38 Scope of disclosures .............. 38 Aggregation of disclosures .......................... 40 Significant judgments and assumptions .................41
Transition ...................... 41 Potential business implications ................43 Questions ...................... 44 Appendix A ....................45 Appendix B.................... 48 Appendix C .................... 49
*A footnote was added to Illustration 20 to clarify that the more rights held by a decision maker as compared to
other parties, the more likely the decision maker is a principal.
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The main details .1 The IASB issued IFRS 10 in May 2011 to revise the control definition and enhance related disclosures. IFRS 10 addresses the redefinition of control, while IFRS 12 addresses the related disclosures. PwC observation: The consolidations project that led to IFRS 10 has been on the IASBs agenda since June 2003. The objective was to develop a standard that replaces IAS 27, Consolidated and Separate Financial Statements, and SIC 12, Consolidation Special Purpose Entities. IAS 27 focused more on the power to control while SIC 12 focused on exposure to variable returns. The interaction between these two approaches is not always clear. IFRS 10 aims to revise the definition of control and provide detailed application guidance so that a single control model can be applied to all entities. The project was accelerated in 2008 upon the recommendation of the Financial Stability Forum as a result of the global financial crisis, and a resulting exposure draft was published in December 2008. .2 The FASB is shortly expected to propose amendments to its variable interest entity (VIE) and limited partnership consolidation guidance by incorporating a principal versus agent assessment that is broadly consistent with that contained in IFRS 10. Separately, the FASB and IASB are proposing a definition for investment entities that, if met, would exclude such entities from the consolidation requirements. An exposure draft of the investment entities definition was issued by the IASB in August 2011 and the FASB issued its proposal in October 2011 for public comment. .3 The key principle in the IASBs new consolidation standard is that control exists, and consolidation is required, only if the investor possesses power over the investee, has exposure to variable returns from its involvement with the investee, and has the ability to use its power over the investee to affect its returns. PwC observation: The new standard will affect some entities more than others. Entities that are most likely to be affected include investors in the following entities: (1) entities where the distribution of returns is not commensurate with the distribution of power; (2) entities with a dominant investor that does not possess a majority voting interest, where the remaining votes are held by widely-dispersed shareholders; (3) structured entities which were designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements; (4) entities that have issued significant potential voting rights, which, when exercised, can result in a change of control; and (5) asset management entities. In difficult cases, the precise facts and circumstances will affect the analysis under IFRS 10. IFRS 10 does not provide bright lines and requires consideration of many factors. .4 The new standard also sets out consolidation principles and guidance for measuring non-controlling interests, potential voting rights, and accounting for loss of control.
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Key provisions
Scope .5 IFRS 10 is to be applied by all parent entities that need to present consolidated financial statements, except for post-employment benefit plans or other long-term employee benefit plans subject to the guidance for employee benefits. .6 Parent entities are exempted from having to consolidate if: (a) the parent is a wholly or partially owned subsidiary in which all owners do not object to non-consolidation; (b) the parents debt or equity securities are not publicly traded; (c) the parent did not file, and is not filing, its financial statements to issue publicly traded instruments; and (d) the ultimate or any intermediate parent of the parent entity produces IFRS consolidated financial statements that are available for public use. The exception from consolidation is similar to the existing exemption in IAS 27. Comparison to US GAAP: Two broad models exist under US GAAP: one for assessing certain interests in VIEs and another for assessing interests in voting interest entities. One first applies the VIE model and then the voting interest entity model is only applied if a scope exception from the VIE model is met or the entity is determined to not be a VIE. In contrast, IFRS 10 has one single definition of control for all entities.
Control
Control
Power
Ability to use power to affect returns
Variable returns
Illustration 1: The elements of control
.7
Control exists when an investor has all three of the following elements: (a) Power over the investee (b) Exposure, or rights, to variable returns from its involvement with the investee (c) The ability to use its power over the investee to affect the amount of the investors returns. PwC observation: Previously, control through voting rights was addressed by IAS 27, while exposure to variable returns was an important consideration within the SIC 12 framework. However, the relationship between these two approaches to control was not clear. IFRS 10 links the two models by introducing an additional requirement that the investor is capable of wielding that power to influence its returns.
Dataline
Comparison to US GAAP: The definition of control under IFRS 10 is similar to that for VIEs under US GAAP which is based on having both (1) power to direct activities of the VIE that most significantly impact its economic performance, and (2) the obligation to absorb losses or the right to receive benefits that could potentially be significant to VIE.
Framework for assessment of control The chart below illustrates the framework for assessment of control and includes references to the relevant paragraphs and illustrations within this Dataline.
Assess purpose and design (para. 9-10)
Assess power (illustration 3)
What activities signif icantly af fect the investees returns (relevant activities)?
How are decisions about relevant activities made?
Do investors rights provide ability to direct relevant activities?
Assess exposure to variable returns (para. 47-49)
Assess ability to use power to influence variable returns
Principal/agent assessment (illustration 20)
De f acto agent assessment (para. 54-56)
Illustration 2: Conceptual framework for assessment of control
.8 Reassessment of control is required if facts and circumstances indicate that any of the above three elements have changed. Comparison to US GAAP: A continuous reassessment of which party has control based on changes in facts and circumstances is also required under the US GAAP consolidation model for both voting interest entities and VIEs. However, the reassessment of whether an entity is a VIE is only performed on the occurrence of a specified triggering event.
Dataline
Purpose and design of the investee .9 The purpose and design of an investee could impact the assessment of what the relevant activities, how those activities are decided, and who can direct those activities. The consideration of purpose and design may make it clear that the company is controlled by voting rights or potential voting rights. .10 Voting rights in some cases may not significantly impact an investees return. The investee may be on auto-pilot through contractual arrangements. In those cases, the following should be considered in assessing the purpose and design of an entity: (a) Downside risks and upside potential that the investee was designed to create (b) Downside risks and upside potential that investee was designed to pass on to other parties in the transaction (c) Whether the investor is exposed to those downside risks and upside potential Comparison to US GAAP: The need to assess the purpose and design of an entity is also required under the VIE model in order to determine if the reporting entity has a variable interest in the entity and if the entity is a VIE, and in identifying the significant activities of the entity.
Power .11 An investor has power over an investee when the investor has existing substantive rights that give it the current ability to direct the relevant activities of the investee. Relevant activities are the activities that significantly affect the investees returns. Comparison to US GAAP: US GAAP has considerable guidance for determining if a reporting entity has a variable interest which is a prerequisite for assessing consolidation under the VIE model. Although there is no definition per se of the term investor in IFRS 10, the basis for conclusions in IFRS 10 suggests that an investor is similar to a holder of a variable interest under US GAAP in that it absorbs variability. The basis for conclusions (paragraph BC 67) states that "the Board decided that it was not necessary to refer specifically to instruments that absorb variability, although it expects that an investor will typically have rights, or be exposed, to variability of returns through such instruments." Consistent with that theme, paragraph BC 66 includes an example of a credit default swap that creates variability for the entity and therefore, does not expose the swap counterparty to variability of returns. Under US GAAP, a variable interest results from an economic arrangement that gives a reporting entity the right to the economic risks and/or rewards of the entity. The guidance1 states that "variable interests in a VIE are contractual, ownership, or other pecuniary interests in a VIE that change with changes in the fair value of the VIE's net assets exclusive of variable interests." Potential variable interests may include, but are not limited to: equity securities, beneficial interests, debt instruments, guarantees, service contracts, derivatives, purchase options, and collaborative R&D arrangements. To determine if an instrument is a variable interest, the
ASC 810-10-20 (Consolidation Glossary)

Dataline 5
purpose and design of the entity needs to be considered, including the risks the entity was designed to create and pass on to its investors. Certain derivative instruments may be considered creators of variability (and not absorbers of variability) and thus, not a variable interest if the underlying is a market observable variable and the counterparty is senior in priority relative to other interest holders in the entity. .12 In assessing whether an investor has power over an investee, the investor has to consider: (a) What the relevant activities of the investee are and how those activities are directed (b) Whether an investors rights provide the ability to direct relevant activities (c) Whether an investors rights are substantive or merely protective in nature (d) Whether an investors voting rights and potential voting rights enable it to direct relevant activities (e) Whether an investor has power when voting or similar rights do not have a significant effect on the investees returns .13 Due to the large number of considerations in the determination of power, applying the guidance in IFRS 10 can be complex. The following flowchart provides an overview of the various decisions involved in the assessment of power, with references to the applicable paragraphs and illustrations within this Dataline. <continued on next page>
Dataline
Assess purpose and design of entity (para. 9-10) af f ects Determine relevant activities (para. 15-16)
af f ects
Determine how relevant activities are directed
Determine whether investors rights provide ability to direct relevant activities Does entity own >50% of substantive* voting rights (illustration 9)? Does entity have power over structured entity (illustration 18)?
no
Is there de f acto control (illustration 10)? no Do substantive* potential voting rights give controlling power (illustration 14)? no Do other contractual agreements, or some combination of contracts, voting rights, and potential voting rights provide controlling power (para. 31)?
directed by voting rights
directed by contracts
No power
Power
yes
unclear
Consider f actors in IFRS 10.B18-B20 (illustration 6).
no
No power Power
* Whether rights are substantive or protective is dealt with in illustration 7.
Illustration 3: Conceptual flowchart for assessment of power
.14 IFRS 10 provides the following additional guidance in relation to determining control: (a) Where equity instruments clearly determine voting rights and powers to control, the majority shareholder has control in the absence of other factors. (b) When two or more investors must act together to direct activities that affect returns, neither investor has control.
Dataline
Comparison to US GAAP: The consolidation model for VIEs provides similar 2 guidance for shared power. The guidance states that if "power is, in fact, shared among multiple unrelated parties such that no one party has the power to direct the activities of a VIE that most significantly impact the VIE's economic performance, then no party is the primary beneficiary." Unlike IFRS 10, US GAAP also provides for a concept of "majority power" when the most significant activities are directed by multiple unrelated parties and the nature of the activities is the same. In this scenario, the party who has power over the majority of the most significant activities would be deemed to have the power over the entity. While this guidance exists, it does not have broad applicability and is generally limited to certain securitization or structured entities. PwC observation: Control is determined by voting rights in the majority of cases. When control is established through voting rights, and no other relevant contractual rights exist, no further assessment is required to determine control under IFRS 10.
Relevant activities .15 Appendix A of IFRS 10 defines relevant activities as "activities of the investee that significantly affect the investees returns." IFRS 10 offers a wide range of possible relevant activities including, but not limited to: sales and purchases of goods and services; management of financial assets before and after default; selection, acquisition, and disposal of assets; research and development; and funding activities. .16 Decisions over relevant activities include operating, capital, and budgetary decisions; or the appointment, remuneration, and termination of service providers or key management. Comparison to US GAAP: The consolidation model for VIEs is similar in that it focuses on the most significant activities that impact the entity's economic performance, which can be wide-ranging. .17 The following examples are summarized from Examples 1 and 2 of IFRS 10. Example 1 Two investors form an investee to develop and market a medical product. One investor has the responsibility and the unilateral ability to make all the decisions relating to product development and to obtaining regulatory approval. Once the regulator has approved the product, the other investor has the responsibility and the unilateral ability to make all manufacturing and marketing decisions.
ASC 810-10-25-38D (Consolidation - Recognition)

Dataline 8
Regulatory approval
Activity 1: Product development
Activity 2: Manuf acturing/ Marketing
Investor A decides
Investor B decides
Illustration 4(a): Relevant activities directed by different parties example 1
Which investor has power over the investee? Solution: The considerations are summarized in flowchart below:
Do both activities significantly affect investees returns?
No
Consider only the activity that significantly affects returns.
Yes
Which activity most significantly affect returns?
General considerations: A. The purpose and design of the investee; B. The f actors that determine the prof it margin, revenue and value of the investee as well as the value of the medical product; C. The ef f ect on the investees returns resulting f rom each investors decision -making authority with respect to the f actors in (b); and D. The investors exposure to variability of returns. Considerations specific to this example: E. The uncertainty of , and ef f ort required in, obtaining regulatory approval (considering the investors record of successfully developing and obtaining regulatory approval of medical products); and F. Which investor controls the medical product once the development phase is successf ul.
Illustration 4(b): Relevant activities directed by different parties example 1
PwC observation: This type of decision will be highly judgmental in practice. For example, when one investor is responsible for manufacturing and another investor is responsible for marketing, it can be difficult to identify which activity has more effect on returns. The answer could be affected by the investee's strategy. For example, consider a lowcost manufacturer of a commoditized product and a manufacturer of a high-end branded product. Low-cost manufacturing could be the critical process for the first manufacturer, while effective marketing could be the critical process in the second manufacturer.
Dataline
Comparison to US GAAP: The conclusion under the VIE consolidation model is expected to be broadly consistent. In situations where there are two or more distinct phases in an entity's life cycle, one needs to assess whether all phases should be considered in the consolidation analysis or if each phase should be considered separately. For example, when there is significant uncertainty that the next phase will occur, it may be appropriate to only assess power for the phase(s) that is certain to occur. In some circumstances, the party that meets the power criterion may change over time. For example, the decisions that impact the economic performance of the entity may be consistent throughout an entity's life, but when certain contingencies are met, power may shift from one party to another.
Example 2 An investment vehicle (the investee) is created with debt and equity instruments.
Asset manager 30% equity Investee Other equity investors 70% equity Debt investor Debt instrument
Equity absorbs f irst losses and receives residual returns

Markets debt instrument as having minimal credit risk due to existence of equity Purchases portf olio of financial assets with debt and equity proceeds
Returns af f ected by
Management of asset portf olio Management of def aulted assets
Illustration 5(a): Relevant activities directed by different parties example 2
The asset manager manages all activities until defaults reach a specified threshold (i.e., when the equity tranche of the investee has been consumed). Thereafter, a third-party trustee manages the assets according to the instructions of the debt investor. The sequence of decision powers can be illustrated as follows:
Def ault passes threshold
Activity 1: Asset portf olio management
Activity 2: Def aulted asset management
Asset manager decides
Debt investor decides
Illustration 5(b): Relevant activities directed by different parties example 2
Dataline 10
Who controls the investment vehicle? Solution: The asset manager and the debt investor each need to determine whether they are able to direct the activities that most significantly affect the investee's returns, including considering the purpose and design of the investee as well as each party's exposure to variability of returns. Comparison to US GAAP: The consolidation model for VIEs requires a similar assessment. Sometimes one party is deemed to have the power until a contingent event occurs, such as when losses reach a predetermined level or activities change based on reaching a milestone (e.g. see Example 1), at which point power may shift to another party. This differs from situations where the only relevant activities are performed when contingent events occur (e.g., an event of default).
Power over relevant activities .18 An investor must have rights that provide the current ability to direct relevant activities to have power. This ability can stem from a wide variety of rights including voting rights or potential voting rights, rights to appoint or remove decision makers including key management, veto rights, and contractual rights. Comparison to US GAAP: The consolidation model for VIEs is similar in that it does not require the reporting entity to act on its power in order to have power, but rather only have the current ability. Oftentimes, the significant decisions are only made on the occurrence of contingent events, such as in the event of default of an asset within a securitization structure, but that does not preclude the holder of those decision-making rights from having power currently. .19 Generally, when the investee has a range of relevant activities that require continuous substantive decisions, voting or similar rights will provide power. In other cases, voting rights do not have a significant effect on returns, and these are dealt with in paragraphs 38 to 46 below. .20 When it is difficult to determine whether an investors rights are sufficient to provide power over an investee, the factors to be considered are shown in the following diagram (with references to the applicable paragraphs of IFRS 10). The priority indicators should be given more weight than the other indicators because the priority indicators evidence the practical ability to direct the investee. <continued on next page>
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Priority indicators (IFRS 10.B18) Evidence the Practical Ability to Direct the Investee Non-contractual ability to appoint investees key management personnel (KMP)
Non-contractual ability to direct investee to enter into signif icant transactions, or veto such transactions Ability to dominate the nomination of members to the investees governing body or obtain proxies f rom other vote-holders Investees KMP, or majority of governing body, are related parties of the investor (e.g. investee and investor share the same CEO)
Other indicators
Special relationship indicators (IFRS 10.B19) Exposure to variability (IFRS 10.B20) Greater exposure, or rights, to variability of returns provides greater incentive to obtain power. Extent of exposure, in itself , is not determinative.
Investees KMP are current or ex-employees of the investor.

Economic dependence on investor Funding
Key management personnel

Specialised knowledge Other critical assets
Guarantees Critical services

Technology Supplies or raw materials
Licences or trademarks
Economic dependence alone does not lead to power (IFRS 10.B40).
Investees activities either involve or are conducted on behalf of investor.

Disproportionate exposure
Exposure, or rights, to returns f rom involvement with investee is disproportionately greater than voting or similar rights. E.g. >50% exposure but <50% votes.
Illustration 6: Factors to consider when assessment of control remains uncertain
PwC observation: Economic dependence is not uncommon. For example, mid-stream processing companies for rare minerals or resources could be dependent on its resource suppliers. However, the priority indicators in the above illustration take precedence over economic dependence indicators. Therefore, if the resource supplier has little or no influence over the mid-stream processors key management personnel, governing bodies, proxy process, and decision making processes, the processors dependence on the resource supplier for raw materials will be insufficient to constitute power.
Substantive or protective rights .21 IFRS 10 requires only substantive rights to be considered in the assessment of power. Protective rights are not considered. .22 Substantive rights exercisable by other parties can prevent an investor from obtaining control, even if those right-holders are not able to initiate decisions.
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.23 The following flowchart summarizes the criteria for differentiating substantive and protective rights (with references to the applicable paragraphs of this Dataline). It applies to all types of rights, including current voting rights and potential voting rights.
Is there the practical ability to exercise? Are there barriers to exercise of those rights by holder? Examples: Financial penalties or incentives;
Exercise/Conversion prices that deter exercise/conversion; Terms and conditions that prevent exercise of rights (e.g. conditions that narrowly limit timing of exercise); The lack of an explicit, reasonable mechanism through which holders can exercise their rights; Inability to obtain information needed to exercise rights;
Operational barriers such as lack of expertise to replace existing management after gaining control; and
Legal/Regulatory requirements that prevent exercise. No
Do practical mechanisms exist f or collective exercise of rights? The more parties that need to agree, the less likely that the rights are substantive. Independent board of directors may provide the required mechanism.
Yes
Will the holder benef it f rom the exercise of those rights? Potential voting rights are more likely to be substantive if: They are in the money; or Investor will benefit for other reasons from exercise (e.g. realize synergies). Yes Practical ability to exercise
Yes
Is the right exercisable when decisions about the direction of relevant activities need to be made (para.25)? Yes
Substantive rights
Illustration 7: Flowchart for determining whether rights are substantive
Comparison to US GAAP: These considerations for determining whether rights are substantive are similar to those for assessing the substance of removal, liquidation, and participating rights in US GAAP. .24 Potential voting rights that are deeply out of the money can results in those rights being regarded as non-substantive, as examples 9 and 10 in IFRS 10 illustrate. These are summarized below.
Dataline 13
Fact pattern
Financial position of potential voting rights Deeply out of the money and expected to remain so over option life
Other facts
Conclusion
30% investor with call option exercisable over next 2 years for a further 50%
The other investor (holding 70%) has been exercising its votes and actively directing the investee's activities
Option is not substantive
Three investors Out of the money but each hold 1/3 of not deeply out of the votes in an money investee. One investor (A) holds convertible debt with a fixed strike price. If converted, A will own 60% of votes. PwC observation:
Option is Investee's substantive business activity is closely related to A A benefits from synergies if the conversion option is exercised
An important change introduced by IFRS 10 is its articulation of the financial position of potential voting rights (that is, whether in or out of the money) as a factor to consider in assessing control. IAS 27 provided very little guidance on this factor. .25 Substantive rights that provide the holder with the current ability to direct relevant activities are usually currently exercisable, but not always so. IFRS 10 provides the examples below of non-currently exercisable rights that are nevertheless substantive. Refer to paragraphs 35 to 36 of this Dataline for a discussion on potential voting rights. Example 3 The investee makes decisions about relevant activities at special meetings and annual general meetings. The next annual general meeting is in eight months. Shareholders that individually or collectively hold at least 5% of the voting rights can call a special meeting within 30 days.
Example B: Forward exercise date Example C: Option exercise date
Example A: Earliest decision date of majority shareholder
Example D: Forward exercise date
25 days
6 months
30 days
8 months
Special meeting
AGM
Illustration 8: Whether rights are exercisable when decisions need to be made example 3
Dataline 14
This scenario applies to Examples A to D below. Each example is considered in isolation. Rights held by investor Example A Majority of voting rights Are rights substantive? Voting rights are substantive. Investor can make decisions about relevant activities when they need to be made. 30-day delay before the exercise does not preclude existence of power from moment that shares are acquired. The forward contract is substantive. Existing shareholders are unable to change existing policies within the next 30 days. The forward contract will have settled by that time. The investor's rights are essentially equivalent to the majority shareholder in example A. The forward contract gives the investor power even though settlement has not yet occurred. The same conclusion would be reached as in example B.
Example B 25-day forward to acquire majority voting rights
Example C Deeply in-the-money 25-day option to acquire majority voting rights
Example D The forward contract is not substantive. Six-month forward to Existing shareholders can change existing policies over the acquire majority relevant activities before the forward contract is settled. voting rights; no other Therefore, investor does not have the current ability to direct related rights the relevant activities.
Comparison to US GAAP: Potential voting rights are generally not considered in the analysis for voting interest entities. Instead, current voting rights have priority. Therefore, the conclusions would differ under US GAAP and IFRS 10 in Examples B and C for these entities. Potential voting rights may need to be considered under the VIE consolidation model depending on the relevant facts and circumstances, including (1) what are the significant activities that will drive economic performance of the entity in future, (2) when and who will make decisions about those activities, and (3) what is the likelihood that the potential voting rights will be exercised, including any barriers to those rights being exercised. Generally, potential voting rights would only impact the analysis if they are likely to be exercised (e.g., deep in-the-money). Therefore, the conclusion for VIEs in Examples B and C will likely be consistent with IFRS 10.
Protective rights .26 Protective rights apply only in exceptional circumstances or relate to fundamental changes in the investee. Rights are not protective simply because they are contingent on events or circumstances or because they apply in exceptional circumstances.
Dataline 15
.27 Protective rights include: (a) Lenders rights to restrict borrowers activities that adversely affect its credit risk to the lenders detriment (b) Rights of a non-controlling shareholder to approve exceptional capital expenditure or debt/equity issues (c) Rights of a lender to seize assets upon default Comparison to US GAAP: US GAAP indicates that protective rights are designed to protect the interests of the party holding those rights without giving that party a controlling financial interest in the entity to which they relate. Protective rights do not preclude an investor from having power when such rights are held by other parties.
Franchises .28 Judgment is required to determine whether a franchisors rights over a franchisee ar e substantive or protective in nature. IFRS 10 distinguishes decision rights that protect the franchise brand from decision rights that significantly affect the franchisees returns (e.g. , legal form and funding structure). The franchisor does not have power over the franchisee if other parties have the current ability to direct the fr anchisees relevant activities. .29 The less financial support provided by the franchisor and the lower the franchisors exposure to variability of returns from the franchisee, the more likely it is that the franchisor only holds protective rights. PwC observation: The introduction of explicit guidance on franchises is new in IFRS 10 and is expected to provide much greater clarity to decisions by franchisors on whether they should consolidate franchisees. Comparison to US GAAP: The consolidation model for VIEs contains similar guidance for assessing franchise arrangements.
Voting and potential voting rights Power with a majority of the voting rights .30 An investor with more than half of the voting rights has power when the conditions illustrated in the following flowchart (with references to the applicable paragraphs of IFRS 10) are fulfilled.
Dataline 16
Does investor hold majority of voting rights? Yes
Either
Relevant activities are directed by majority vote (IFRS 10.B35a); Majority of governing body that directs relevant activities are appointed by majority vote (IFRS 10.B35b)?
Yes
Or
Are voting rights substantive (IFRS 10.B36)? Voting rights may not be substantive if the investee is subject to direction by a government, court, administrator, receiver, liquidator, or regulator (IFRS 10.B37).
Yes
Do voting rights provide current ability to direct relevant activities (IFRS 10.B36)? An investor does not have power if another entity, acting as principal, can direct the relevant activities (IFRS 10.B36). Yes Power
Illustration 9: Flowchart for assessing whether voting rights provide power
Power without a majority of the voting rights .31 An investor with less than a majority of voting rights can also gain power through:
Contractual arrangements with other vote holders Rights arising from other contractual arrangements For example, such a contract may enable the investor to control sufficient votes held by other investors to provide itself with power over the investee. For example, such a contractual arrangement may allow the investor to directly control certain of the investees activities (e.g., manufacturing). If these are relevant activities, this may result in control by the investor.
Ownership of the largest block of This is discussed in detail in the section De facto control. voting rights in a situation where the remaining rights are widely dispersed (de facto control) Potential voting rights A combination of the above This is discussed in detail in the section Potential voting rights. For example, a combination of 40% voting rights and 20% potential voting rights may provide power.
De facto control .32 An investor with less than a majority of the voting rights may hold the largest block of voting rights with the remaining voting rights widely-dispersed. The investor may have the power to unilaterally direct the investee unless a sufficient number of the
remaining dispersed investors act in concert to oppose the influential investor. However, such concerted action may be hard to organize if it requires the collective action of a large number of unrelated investors. PwC observation: One of the significant changes introduced by IFRS 10 is the introduction of guidance on de facto control for the first time. Comparison to US GAAP: The consolidation model for voting interest entities does not contain a de facto control concept. However, the SEC, in Rule 1-02 of Regulation S-X, extended the definition of control to "the possession, direct or indirect, of the power to direct or cause the direction of management and policies of a person, whether through the ownership of voting shares, by contract, or otherwise." The SEC emphasizes the need to consider substance over form to determine an appropriate consolidation policy. This concept is limited in application and rarely seen in practice. .33 The following diagram summarizes the considerations for assessment of de facto control, with references to the applicable paragraphs of IFRS 10 and Illustration 6 within this Dataline.
Primary considerations (IFRS 10.B42)
Other investors shares

Amount of shares held by reporter* Size Dispersion
Conclusive
af f ects
af f ects
Number of other investors that must act together to outvote reporter*
Conclude
Potential voting rights held by reporter* and other investors
Rights arising f rom other contractual arrangements
Inconclusive
Secondary considerations (IFRS 10.B45) Voting patterns at previous shareholder meetings Factors to consider when control is unclear (illustration 6) Inconclusive
Conclusive
No de facto control (IFRS 10.B46)
Illustration 10: Assessment of de facto control
Dataline 18
PwC observation: De facto control judgments are difficult in practice because of the many qualitative factors that must be considered. .34 The examples below illustrate the application of the above principles. Appendix B to this Dataline summarizes the examples that can be found in IFRS 10 on the de facto control concept. Example 4
Entity P Nominates majority of directors that are approved due to Ps presence at general meetings. Other investors Other investors Other investors Other investors Other investors Many shareholders, each with < 5% of votes. No arrangements to vote collectively. General representation at general meetings <30% f or many years.
48% Entity Q Listed. No history of shareholder activism in listing country. Hostile takeovers unusual.
52%
Illustration 11: De facto control example 4
Does P control Q? Solution: Applying the de facto control guidance, (a) Relative size P holds 48% as compared to other shareholders individually owning less than 5% each. (b) Dispersion of other shareholdings The other shareholders each own less than 5% so there would be at least 11 shareholders. The examples in IFRS 10 concluded that: (a) An investor with 48% voting rights and remaining shareholders holding less than 1% was sufficient to constitute power. (b) An investor with 45% voting rights as compared to 11 other investors each holding (exactly) 5% was insufficient to constitute power. Ps case lies in between the two examples and further analysis is required.
Dataline 19
Looking at the additional factors (see Illustration 10 above), (a) The remaining shareholders have not formed any group to vote collectively, they have not been well-represented in past general meetings, and there is no history of shareholder activism. (b) Entity P dominates the nominations process for electing Qs governing body. The additional factors may suggest that P controls Q. Example 5 Parent L has a 51% interest in listed entity, M. L consolidated M. M is highly leveraged and started making losses. L decides to sell a 2% to an investment bank. The post sale structure, and additional information, is as follows:
Entity L Can easily re-acquire controlling interest in M by buying shares in market. Otherinvestors investors Other Other investors Other investors Many shareholders other than the investment bank, each with < 1% of votes.
Expects to continue managing M, controlling Ms policies and appointing Ms directors.

Casts the majority of votes in general meetings. 49%
Investment Bank
No arrangements to vote collectively.

Usually not represented at meetings.
2%
49%
Entity M Listed with deep and liquid market f or shares. No history of shareholder activism in country where listed.
Solution: L owns 49% as compared to other shareholders with holdings that are dispersed. It expects to go on appointing management and directing activities. L has the practical ability to direct the activities of M. The de facto control guidance, together with the factors in IFRS 10, indicates that L controls M. <continued on next page>
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Example 6
Entity T
30% Investor 1 14%
Investor 2
14% Entity V
Investor 3
14%
Investor 4
14%
Investor 5
14%
Investors 1 to 5: Are venture capital companies or institutional investors Do not participate at general meetings Are known to meet with representatives of entity V and with each other Solution: Applying IFRS 10 principles: (a) Relative size - T holds 30%, which is not much higher than the other shareholders. (b) Dispersion of other shareholdings Remaining shareholdings are concentrated in five shareholders which do meet with each other. Arguably, it may not be too difficult for the remaining five shareholders to act together. Example 6 in IFRS 10 concluded that an investor does not have control as only two other investors would need to co-operate to prevent an investor from directing the investees activities. Only three investors need to co-operate to exceed Ts voting power in the above example. In this case, T does not control V. Potential voting rights .35 Potential voting rights are defined in paragraph B47 of IFRS 10 as rights to obtain voting rights of an investee, such as those arising from convertible instruments or options, including forward contracts. .36 IFRS 10 specifies three considerations in dealing with potential voting rights: (a) Substantive or protective? Only substantive voting rights are considered in assessing power. Accordingly, voting rights should be assessed against the criteria for substantive rights specified by IFRS 10 (see paragraphs 21-23 of this Dataline). (b) Purpose and design of instrument and other involvement. The purpose and design of the potential voting right instrument and the purpose and design of any other involvement the investor has with the investee should be assessed. This involves an assessment of terms and conditions, as well as the investors
Dataline 21
apparent expectations, motives, and reasons for agreeing to those terms and conditions. (c) Other voting or decision rights held by the investor. For example, ownership of a 20% option that is accompanied by a 40% shareholding may result in control.
Substantive rights
Potential voting rights
Purpose and design of instrument and involvement
Other voting or decision rights
Illustration 14: Potential voting rights
Comparison to US GAAP: There is no specific guidance on how potential voting rights should be considered in the VIE consolidation model. Nevertheless, potential voting rights need to be considered in assessing power under the VIE consolidation model (see further discussion in Comparison to US GAAP in paragraph 25). .37 The following examples illustrate the application of the above principles. The analysis based on the existing IAS 27/SIC 12 guidance has been included for comparison purposes. Example 7 A and B own 80% and 20% respectively of the voting shares of C. A sells 50% interest to D and buys call options from D that are exercisable at any time at a premium to the market price on issue. The exercise price has economic substance and is not set deliberately high The option is slightly out of the money at the reporting date <continued on next page>
Dataline 22
The resulting structure is as follows:

50% call
30% 50% C 20%
Illustration 15 (Example 7)
Additional information about the call option: If exercised, A would recover its original 80% interest and voting rights The exercise price has economic substance and is not set deliberately high. The option is slightly out of the money at the reporting date. Is the call option substantive? IFRS 10 analysis The options held by A are at a premium to the market price upon issue and are slightly out of the money at the reporting date. However, it is necessary to consider whether A benefits for other reasons from the exercise of the options (for example, protection of interests and acquisition of assets). If that is the case, the options may be substantive, and A should consolidate C. IAS 27/ SIC 12 analysis The options are out of the money when issued, but they are exercisable immediately. Hence, A has the power to govern the financial and operating policies of C and, as a consequence, C is determined to be a subsidiary of A.
Example 8 A, B and C own 40%, 30%, and 30% respectively of D's voting shares. A also owns call options that: o Are exercisable at any time at the fair value of the underlying shares. o If exercised would give it an additional 20% of the D's voting shares reduce B and C's interests to 20% each. The following diagram illustrates this arrangement:
10% call 10% call
30% 40% D 30%
Dataline 23
Is the call option substantive? IFRS 10 analysis The call options are exercisable at fair value. As such, they are neither in nor out of the money. A would have to consider the other factors in Illustration 7 of this Dataline in order to determine whether the options are substantive. If the options are substantive, A would have to consider the factors in illustration 14 of this Dataline (for example, purpose and design of the option instrument) to assess whether the options provide A with power over D. IAS 27/ SIC 12 analysis The existence of the potential voting rights that can be exercised at any time gives A the power to govern the financial and operating policies of D. Hence, D is a subsidiary of A.
Example 9 A, B, and C each own 33% of D's voting shares. A, B, and C each have the right to appoint two directors to the board of D. A owns call options that are exercisable at a fixed price at any time and if exercised would give it all the voting rights in D. A's management does not intend to exercise the call options even if B and C do not vote in the same manner as A. The options are in the money at both the issuance and reporting date.
33% call
33% call
33% 33% D 33%
Are the call options substantive? IFRS 10 analysis The call options appear to be substantive as they are in the money and there are no other countervailing factors. Managements intent does not affect the assessment of whether the options are substantive unless this intention is caused by barriers or other practical difficulties (see Illustration 7 of this Dataline). IAS 27/ SIC 12 analysis The intention of A's management should not be taken into account in assessing whether A has control of D. The existence of the potential voting shares and entity A's ability to exercise the options and thereby gain control of D indicate that D is a subsidiary of A.
Dataline 24
IFRS 10 analysis If the options are substantive, A would have to consider the factors in Illustration 14 of this Dataline (for example, purpose and design of the option instrument) to assess whether the options provide A with power over D.
IAS 27/ SIC 12 analysis
Comparison to US GAAP: As previously discussed, potential voting rights would not be considered under the consolidation model for voting interest entities, but would be considered under the VIE consolidation model. The options in Examples 7 - 9 would likely not be considered substantive in the VIE consolidation analysis because, among other reasons, they are not deeply in-the-money.
Structured entities .38 Voting rights may not have a significant effect on an investees returns. This could be the case, for example, when voting rights relate to administrative tasks only and contractual arrangements dictate how the investee should carry out its activities. These entities are termed as structured entities." PwC observation: Previously, SIC 12 used the term Special Purpose Entities (SPEs) to mean those entities that are created to accomplish a narrow and well-defined objective, and stipulated separate consolidation criteria for these entities. This term is no longer used under IFRS 10, so as to meet the objective of a unified consolidation framework for both SPEs and non-SPEs. However, IFRS 12 defines a structured entity (used for disclosure purposes) and indicates that a narrow and well-defined objective may be a characteristic of a structured entity. This suggests that a subset of former SPEs will likely fall under the new category of structured entities . In particular, the auto-pilot entities under SIC 12 are likely to be a key candidate for classification as structured entities. Comparison to US GAAP: The concept of a VIE is defined in US GAAP for the purposes of establishing when control should be assessed more broadly than focusing solely on voting rights. Similar to the definition of a "structured entity" under IFRS 12, the VIE definition includes entities that are thinly capitalized (i.e., the equity is not sufficient to fund the entity's activities without additional subordinated financial support) and entities where equity holders as a group lack the power to direct the activities that most significantly impact the entity's economic performance, or possess nonsubstantive voting rights. However, the concept of a VIE is broader than that of a "structured entity" and would generally capture more types of entities such as certain operating entities and joint ventures. The VIE definition under US GAAP also includes entities where the equity holders as a group lack the obligation to absorb the entity's expected losses or lack the right to receive the entity's expected returns, and where voting rights are disproportional to the equity holders' expected returns and substantially all of the entity's activities involve or are conducted on behalf of an investor with disproportionately few voting rights.
Dataline 25
.39 All substantive powers in structured entities may appear to have been surrendered to contracts that impose rigid control over the entities activities. As a result, none of the parties may appear to have power. However, entities may be indirectly controlled by one of the parties involved. Further analysis is required to determine if there is a party with control. .40 An investor should consider the following factors (with references to the relevant guidance in IFRS 10 or paragraphs and illustrations within this Dataline) when determining whether it has power:
a. Is investor exposed to downside risks and upside potential that investee was designed to create or pass on (IFRS 10.B8)? b. Is investor involved in the design of the investee at inception (IFRS 10.B51) (para. 41)? D o the terms of decisions made at investees inception provide the investor with rights that provide power (IFRS 10.B51)? c. Do contractual arrangements established at inception provide investor with rights over closely-related activities (IFRS 10.B52) (para. 43- 44)?
Yes
Indicator of investor power
d.
Does investor hold rights over relevant activities that arise only upon the occurrence of contingent events (IFRS 10.B53) (para. 45)? Does investor have a commitment to ensure that investee operates as designed (IFRS 10.B54) (para. 46)? Do other f actors (illustration 6) indicate that investor has power (IFRS 10.B17)?
e.
f.
Illustration 18: Structured entity considerations
Items (b) - (e) are discussed further below. Comparison to US GAAP: As previously discussed, under US GAAP a reporting entity must first determine if it holds a variable interest in a VIE under the VIE consolidation model. For a reporting entity to determine whether it has power to direct the activities of the VIE that most significantly impact the VIE's economic performance, it must (1) identify which activities most significantly impact the entity's economic performance, and then (2) identify who has power over those activities. The ability to exercise power over these activities must be considered even if an investor does not exercise its power.
Involvement and decisions made at the investees inception as part of its design .41 IFRS 10 requires a consideration of the involvement of various participants in the design of the investee at inception. Such involvement, by itself, would not be sufficient to provide control; however, participants who were involved in the design would have the opportunity to obtain powerful rights. .42 Consideration should be given to the decisions made at the investees inception and evaluate whether the transaction terms provide any such participant with rights that are sufficient to constitute power.
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Comparison to US GAAP: The VIE consolidation model similarly requires a consideration of involvement in the design of an entity. For certain entities that require no significant ongoing decision-making, the only relevant decision-making activities are considered to occur during their design under US GAAP. Said differently, under US GAAP, all entities are considered to have relevant activities.
Contractual arrangements established at investees inception .43 The structured entity is often governed not only by its constitution documents but by contracts that bind the structured entity to its original purpose. These include call rights, put rights, liquidation rights, or other contractual arrangements that may provide investors with power. For example, the put right in Example 10 within this Dataline ensures that the structured entity only needs to collect and pass on principal and interest, and provides investor X with the power to manage defaulted receivables. .44 When these contractual arrangements involve activities that are closely related to the investee, these activities should be considered as relevant activities. This is true even if the activities do not occur within the structured entity itself, but in another entity. Example 10 in this Dataline illustrates this concept. Rights to direct relevant activities that activate only upon the occurrence of certain events .45 IFRS 10 requires the consideration of decision rights that take effect only when particular circumstances arise or events occur. An investor with these rights can have power even if those events have not occurred. Comparison to US GAAP: The VIE consolidation model includes a similar concept.
Commitment to ensure the investee operates as designed .46 An explicit or implicit commitment by an investor may increase exposure to variability of returns and heighten the likelihood of control. However, on its own, this factor is insufficient to demonstrate power or prevent other parties from having power. Comparison to US GAAP: The VIE consolidation model includes the concept of an implicit variable interest, which considers whether a reporting entity may be absorbing losses of the entity indirectly. For example, an implicit variable interest exists when a reporting entity may be required to protect other variable interest holders from absorbing losses from the entity. The following example from IFRS 10 illustrates the above principles. Example 10 An investees only business activity is to purchase receivables and service them on a day-to-day basis. Servicing involves the collection and passing on of principal and interest payments. Upon default, the investee automatically puts the receivable to investor X as agreed separately in a put agreement with investor X.
Dataline 27
Default of receivable Receivables owned by investee. Receivables owned by X.
Activity 1: Servicing receivables - collect and pass on principal and interest
Activity 2: Collecting on def aulted receivables
Investees responsibility
Investor Xs responsibility
Illustration 19: Structured entities example 10
Does investor X have power over the investee? Solution: Yes, for the following reasons: The only relevant activity is managing the receivables upon default. Servicing the receivables before default is not a relevant activity. The actions are predetermined and do not require substantive decisions that affect returns. Investor X controls the only relevant activity and therefore it has power over the investee. This example demonstrates three additional points. For structured entities, the consolidation analysis is not affected by the following: (a) X can only exercise its power upon a contingent event (that is, default). This is because a default is the only time when decisions are required. X can decide when decisions are needed, and therefore it has power, even though it may not be able to make decisions immediately. (b) Xs power arises only from a side contract (the put agreement) rather than the incorporation documents of the investee. The put agreement is integral to the overall transaction and the establishment of the investee, and as such, should be considered. (c) Management of defaulted receivables takes place within X and not the investee that is, X owns the defaulted receivables that it manages, not the investee. Comparison to US GAAP: This conclusion is expected to be broadly consistent with the conclusion that would be reached under US GAAP.
Variable returns .47 IFRS 10 defines variable returns as returns that are not fixed and have the potential to vary as a result of the performance of an investee. Variable returns can be positive, negative, or both. .48 A wide variety of possible returns are identified in IFRS 10, including traditional dividends and interest, servicing fees, changes in fair value of investment, exposures arising from credit or liquidity support, tax benefits, access to liquidity, economies of scale, cost savings, and gaining proprietary knowledge.
Dataline 28
.49 Variability is assessed based on the substance of the arrangement regardless of legal form. For example, contractually fixed interest payments could be subject to high variability if credit risk is high. Similarly, asset management fees that are contractually fixed could nevertheless be subject to high variability if the investee has a high risk of non-performance. Comparison to US GAAP: The VIE consolidation model has a similar second test in determining if a reporting entity is the primary beneficiary (consolidator) of the VIE. Specifically, the guidance indicates that a reporting entity must have the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. This assessment is intended to be a qualitative judgment-based analysis that considers all of the facts and circumstances about the terms and characteristics of the variable interest(s), the design and characteristics of the VIE, and the other involvement that the reporting entity may have with the VIE.
Link between power and returns principal vs. agent .50 An agent is a party engaged to act on behalf of another party (the principal). A principal may delegate some of its decision authority over the investee to the agent, but the agent does not control the investee when it exercises such powers on behalf of the principal. In assessing control, the decision-making rights of the agent should be treated as being held by the principal directly. Power resides with the principal rather than the agent. Comparison to US GAAP: No explicit guidance currently exists in US GAAP regarding the linkage between power and returns, but this concept may be incorporated in the principal versus agent guidance that is expected to be exposed shortly by the FASB. .51 The overall relationship between the decision maker and other parties involved with the investee must be assessed to determine whether the decision maker acts as an agent. The standard sets out a number of specific factors to consider. Some of the factors are determinative, but the majority are judgmental and need to be considered together in assessing the overall relationship. In assessing the judgmental considerations, different weightings of factors may be appropriate based on an entitys specific facts and circumstances. These definitive and judgmental considerations are summarized in the following illustration. <continued on next page>
Dataline 29
Definitive considerations
Does any single party have the ability to remove the decision maker without cause (IFRS 10.B65)? No
Is the decision makers remuneration commensurate with his skill level (IFRS 10.B69-B70)? Yes
Yes
Agent
No
Does the remuneration agreement include only terms, conditions and amounts that are customarily present in arms -length contracts f or similar services (IFRS 10.B69B70)?
Yes
Principal No
Judgemental Considerations
Scope of decision makers authority over investee Consider:
Decision makers discretion over activities permitted by contracts/law (IFRS 10.B62)

Purpose and design of investee (IFRS 10.B63) Decision-makers involvement in design of investee (IFRS 10.B63)
Greater scope
More likely to be principal
Rights held by other parties (IFRS 10.B64-B67) Consider: Number of parties required to act together to remove decision maker
Greater rights*
Remuneration of decision maker Consider: Magnitude/variability of decision makers remuneration (IFRS 10.B68)
Larger/more variable remuneration
Decision makers exposure to variability of returns from other interests in the investee (IFRS 10.B71-B72) Consider:
Magnitude/variability of decision makers total economic interests Whether decision makers exposure dif f ers f rom other investors (e.g. subordinated interests)
Larger exposure
* The more rights held by a decision maker as compared to other parties, the more likely the decision maker is a principal.
Illustration 20: Assessment of whether decision maker is principal or agent
Comparison to US GAAP: The existence of a single party kick-out (removal) right is also determinative under the current VIE model. However, in contrast with IFRS 10, if kick-out rights require the action of two or more parties, such rights would not be considered in the analysis. Removal and certain liquidation rights are assessed similarly for limited partnerships that are voting interest entities. In practice, under US GAAP, in order for liquidation rights to be viewed similarly to removal rights, they have been interpreted to only include only those rights that enable the holders to liquidate the entity and establish a new entity with a new manager to own the same assets and pursue the same objectives of the previous entity. IFRS 10 does not explicitly address liquidation rights and whether those would be viewed similarly to removal rights.
Dataline 30
The FASB is expected to issue a proposal to amend the VIE and limited partnership consolidation models to incorporate principal versus agent guidance that is broadly consistent with that contained in IFRS 10. That proposal would allow kick-out (removal and liquidation) rights without cause that are held by more than one party to be considered in determining if a decision maker is acting as an agent or a principal, provided they are substantive. Consistent with IFRS 10, the existence of a board of directors holding such rights should be considered in the analysis. However, rights held by a board of directors would not be considered to be determinative of an agent relationship since they are not viewed as held by one party. One difference that is anticipated between IFRS 10 and the FASB's proposal is that the FASB proposal would not indicate that a decision maker cannot be an agent if its remuneration is not commensurate with the services provided and the terms of the remuneration are not market based. While not determinative under the FASB's expected proposal, the FASB would likely indicate that if one of these circumstances exists, it would be a strong indicator of a principal relationship. Consequently, this difference, by itself, is unlikely to result in divergent consolidation conclusions under IFRS and US GAAP. .52 IFRS 10 illustrates the above principles with the examples below. Also refer to the Appendix C of this Dataline for a summary of the IFRS 10 principal vs. agent examples. Example 11 A decision maker (fund manager) establishes, markets, and manages a publicly traded, regulated fund. The fund was marketed to investors as an investment in a diversified portfolio of equity securities of publicly traded entities. IFRS 10 criteria Scope of decision maker's authority Additional facts relevant to assessment of IFRS 10 criteria Fund manager is subject to narrowly defined parameters set out in the investment mandate. Within the defined parameters, the fund manager has discretion about the assets in which to invest. Investors do not hold any substantive rights that would affect the decision-making authority of the fund manager, but can redeem their interests within particular limits set by the fund. The fund is not required to establish, and has not established, an independent board of directors. Remuneration consists of a market-based fee equal to 1 per cent of the funds net asset value. The fees are commensurate with the services provided. Fund manager has a 10% pro rata investment in the fund. Fund manager does not have any obligation to fund losses beyond its 10% investment. It has been assessed that the fund managers remuneration and investment does not create exposure that is of such significance that it indicates that the fund manager is a principal.
Rights held by other parties
Remuneration of decision maker Decision maker's exposure to variability from other interests
Dataline 31
Is the fund manager a principal? Solution: Consideration of the fund managers exposure to variability of returns together with its restricted decision-making authority indicates that the fund manager is an agent. Example 12 A fund manager establishes, markets, and manages a fund that provides investment opportunities to a number of investors. Is the fund manager principal or agent in examples A-C? These examples are considered in isolation. IFRS 10 criteria Scope of decision maker's authority Additional facts relevant to assessment of IFRS 10 criteria Examples A-C The fund manager must make decisions in the best interests of all investors and in accordance with the funds governing agreements. Despite this, the fund manager has extensive decisionmaking authority to direct the relevant activities of the fund. Example A The investors can remove the fund manager by a simple majority vote, but only for breach of contract. Example B Same as example A. Example C The fund has a board of directors comprised entirely of directors that are independent of the fund manager. The board appoints the fund manager annually. The services performed by the fund manager could be performed by other fund managers. Remuneration of decision maker Examples A-C Remuneration consists of a market-based fee of 1% of assets under management; and 20% of profits if a specified profit level is achieved. Fees are commensurate with services provided. The remuneration is intended to align the interests of the fund manager with those of the other investors. It is assessed that the remuneration, on its own, does not create sufficient exposure to variability of returns for the fund manager to be a principal.
Rights held by other parties
Dataline 32
IFRS 10 criteria Decision maker's exposure to variability from other interests
Additional facts relevant to assessment of IFRS 10 criteria Example A The fund manager also has a 2% investment in the fund that aligns its interests with those of the other investors. The fund manager does not have any obligation to fund losses beyond its 2% investment. Example B The fund manager has a more substantial pro rata investment in the fund than in Example A. The fund manager does not have any obligation to fund losses beyond that investment. Example C The fund manager has a 20% pro rata investment in the fund. The fund manager does not have any obligation to fund losses beyond its 20% investment.
Solution: Example A The fund manager is an agent. The market-based fee of 1% of assets and 20% of profits, as well as the 2% investment does not create sufficient exposure for the fund manager to be a principal. The other investors rights to remove the fund manager are protective as they are exercisable only for breach of contract. Example B It depends on the amount of the fund managers investment in the fund. For example, a 20% investment may be sufficient to conclude that the fund manager is principal. The amount of exposure that will result in principal classification will change in different circumstances (for example, if the remuneration is different). The other investors rights to remove the fund manager are protective, as in example A. Example C The fund manager is an agent. The investors have substantive rights to remove the fund manager, and the board of directors provides a mechanism to exercise these rights.
Dataline 33
Example 13
Asset manager
Otherinvestors investors Other Widely-dispersed equity Other investors investors
Otherinvestors investors Other Widely-dispersed debt Other investors investors
35% equity
Investee
65% equity
Fixed-rate debt
Created to purchase a portf olio of f ixed rate asset-backed securities (ABS).
Equity instruments absorb losses and are entitled to residual returns.

Equity instruments represent 10% of asset value at f ormation. Debt was marketed as an investment in ABS with interest rate and credit risk.
Illustration 21: Principal-agent analysis example 13
IFRS 10 criteria Scope of decision maker's authority Rights held by other parties
Additional facts relevant to assessment of IFRS 10 criteria The asset manager manages the active asset portfolio by making investment decisions within the parameters set out in the investees prospectus. The asset manager can be removed, without cause, by a simple majority decision of the other investors. The other equity and debt investors comprise of a large number of widely-dispersed, unrelated third party investors. The asset manager receives fees of: 1% of assets under management; and 10% of profits if profits exceed a specified level. The fees are market-based and are commensurate with services provided. The remuneration aligns the interests of the fund manager with those of other investors. The asset manager holds 35% equity in the investee.
Remuneration of decision maker
Decision maker's exposure to variability from other interests
Is the asset manager a principal? Solution: The asset manager is a principal and thus, has control. Holding 35% of the equity, in addition to the exposure provided by the fees, provides sufficient variability for the asset manager to be classified as a principal. The right to remove the asset manager without cause receives lower emphasis in this example, as this right is not easily-exercisable, requiring the concerted effort of a large number of widely-dispersed investors.
Dataline 34
Example 14
Otherinvestors investors Other Other investors Transferors
Sponsor
Otherinvestors investors Other Unrelated third party Other investors investors
Sell high-quality medium-term assets Manage defaulted receivables for marketbased fee Provide first loss protection against credit losses through overcollateralisation of transferred assets
See additional information below.
Invest in short-term debt, which has been marketed as having minimal credit risk
Multi-seller conduit (MSC)
Illustration 22: Principal-agent analysis example 14
IFRS 10 criteria Scope of decision maker's authority
Additional facts relevant to assessment of IFRS 10 criteria The sponsor establishes the terms of the MSC. The sponsor: manages the operations of the MSC; approves the transferors permitted to sell to the MSC; approves the assets to be purchased by the MSC; and makes decisions about the funding of the MSC. The sponsor must act in the best interest of all investors. The investors do not hold substantive rights that could affect the decision-making authority of the sponsor. Sponsor receives a market-based fee that is commensurate with the services provided. Sponsor is entitled to residual return of the MSC. Sponsor provides credit enhancement, which absorbs losses of up to 5% of all of the MSCs assets, after losses are absorbed by the transferors. Sponsor provides liquidity facilities to the MSC. Liquidity facilities are not advanced against defaulted assets.
Rights held by other parties Remuneration of decision maker Decision maker's exposure to variability from other interests
Is the asset manager a principal? Solution: The sponsor appears to be a principal and thus, has control.
Dataline 35
Sponsors exposure to variability of returns is significant, arising from both the sponsors entitlement to residual returns and the credit enhancement and liquidity facilities it provides. The exposure to liquidity risk is exacerbated by the fact that MSC uses short-term debt to fund medium-term assets. Sponsor has extensive authority over those decisions such as transferor selection, asset selection, and funding, which are likely to be the activities that most significantly affect the MSCs returns. The obligation to act in the best interest of all investors does not prevent the sponsor from being a principal. Comparison to US GAAP: Similar, if not identical, examples (Examples 11, 12, 13 and 14 of this Dataline) are expected to be included in the FASB's proposal to amend the VIE consolidation model. The FASB is also expected to update the existing examples for VIEs contained in ASC 810 to incorporate the proposed principal versus agent analysis in the assessment of which party should consolidate (i.e., which party is the primary beneficiary).
Other issues
.53 Three further issues are addressed by IFRS 10: (a) Determining whether the investor is a de facto agent (b) Determining whether an investor who has power over specified assets of an investee can regard those assets as a separate entity; IFRS 10 uses the term silo to denote such an entity that has been ring-fenced for accounting purposes (c) Frequency of reassessment with regards to whether an investor has control over an investee; however, a change in market conditions on its own will not result in a reassessment of control unless it changes one of the three elements of control De facto agent .54 An agent need not be bound to the principal by a contract. IFRS 10 uses the term de facto agents to describe agents who may be acting on behalf of principals even when there is no contractual arrangement in place. Identification of such relationships is highly judgmental. Consideration should be given to the nature of relationships between the investor and various parties and how they interact with each other. .55 IFRS 10 lists a wide range of parties who may be de facto agents for the true principal including: (a) Related parties of the principal as defined in IAS 24, Related Party Disclosures (b) Parties that received interests in the investee as a contribution or loan from the principal (c) Parties that agreed not to sell, transfer, or encumber their interests in the investee without the principals approval (d) Parties that cannot finance operations without subordinated financial support from the principal (e) Parties that have largely similar governing body members or key management personnel as the principal (f) Parties that have close business relationships with the principal
Dataline 36
.56 When a party acts as a de facto agent for another investor, that principal investor should consider the de facto agents decision-making rights, as well as its indirect exposure to variable returns through the de facto agent when assessing whether the principal investor itself controls the investee. Comparison to US GAAP: Interests held by related parties and de facto agents must be considered in the consolidation analysis for VIEs. A "related party tie breaker" is required to be applied when no party alone has control over a VIE but rather the related party group has control. The party that is most closely associated with the VIE would be deemed to control the VIE (be the primary beneficiary) under the "related party tiebreaker" requirement. IFRS 10 requires the application of judgment when assessing related parties and de facto agents, and does not include the "related party tiebreaker" guidance. Consequently, the party that consolidates within a related party group could differ between US GAAP and IFRS. US GAAP, however, does not have specific guidance for how to consider related parties in the consolidation model for voting interest entities.
Silos .57 When an investor has power over specified assets of an investee, IFRS 10 allows those assets to be regarded as a separate entity for accounting purposes (a silo) only when the following conditions exist: (a) Those specified assets and related credit enhancements, if any, are the only source of payment for the investors interest in the investee. (b) Parties other than the investor do not have rights or obligations over those specified assets and the cash flows from those assets. .58 If assets can be regarded as a separate silo, the investor must then determine whether it can control the silo based on IFRS 10 criteria. .59 If an investee contains silos that meet the above conditions, an investor that controls the rest of the investee but does not control the silos should exclude the silos when it assesses control of the investee, as well as when it consolidates the investee. Comparison to US GAAP: While the concept of silos could exist for all entities under IFRS 10, this concept only exists for entities deemed a VIE under US GAAP. Therefore, a silo can only exist within a VIE, in which a party holds a variable interest in selected assets and liabilities of a VIE. In addition, a silo can only exist if there is a primary beneficiary of that silo. US GAAP also includes the concept of having an interest in specified assets, while IFRS 10 does not have any explicit guidance. The holder of a variable interest in specified assets would not be subject to the VIE consolidation model and therefore, would not consolidate the entity. A variable interest in specified assets of a VIE exists when the variable interest relates to specified assets that comprise less than a majority of the total value of the entity's assets (on a fair value basis) and the holder of the variable interest does not have another variable interest in the entity as a whole (except interests that are insignificant or have little or no variability).
Dataline 37
Frequency of reassessment .60 Reassessment of control is required if facts and circumstances indicate there have been changes to the elements of control in IFRS 10. These elements include the investors power over the investee, exposure to variable returns from the investee, and the investors ability to use its power over the investee to affect returns. .61 IFRS 10 highlights that control can change when: (a) Decision-making mechanisms change (e.g., change from a substantive voting system to an auto-pilot mechanism) (b) Events occur, even if they do not involve the investor (e.g., a lapse of decisionmaking rights by another party); however, changes in a market condition on its own does not necessitate a reassessment of control (c) An investors exposure to variable returns changes (d) The relationship between an agent and a principal changes Accounting requirements .62 The accounting for consolidation has remained largely consistent with the existing IAS 27 guidance. .63 Additional guidance has been provided for potential voting rights. IFRS 10 specifies that the allocation of profits and assets to the parent company and non-controlling interests for consolidation purposes is usually based on current ownership interests. However, where potential voting rights or other derivatives, in substance, give access to the economic benefits associated with an ownership interest, the allocation of profits and assets is determined by taking into account the eventual exercise of those potential voting rights and derivatives. Such potential voting rights and derivatives are not accounted for under the guidance for accounting for financial instruments.
Disclosures
.64 The disclosure requirements for subsidiaries are not spelled out in IFRS 10 itself but are instead included in another standard, IFRS 12. General objective of IFRS 12 .65 The objective of IFRS 12 is to disclose information that helps financial statement readers to evaluate the nature, risks, and financial effects associated with the entitys interests in subsidiaries, associates, joint arrangements, and unconsolidated structured entities. Reporting entities should disclose any additional information that is necessary to meet this objective. Scope of disclosures .66 IFRS 12 applies to interests in subsidiaries, joint arrangements, associates, and unconsolidated structured entities. This Dataline only addresses disclosures in subsidiaries and unconsolidated structured entities. Comparison to US GAAP: Disclosures for VIEs are broadly aligned with the new disclosures required under IFRS 12 for interests in structured entities. This is largely because the IASB used those US GAAP disclosures as a starting point based on positive user feedback. .67 IFRS 12 disclosures only apply to involvements that meet the definition of interests in another entity. IFRS 12 provides detailed guidance on what is meant by interests in
Dataline 38
another entity. This question takes on particular relevance with regards to disclosures for unconsolidated structured entities as it determines the scope of such disclosures. .68 IFRS 12 defines interest in another entity as an involvement that: Can be contractual or non-contractual Exposes an entity to variability of returns from the performance of the other entity Could include equity or debt instruments, provision of funding, liquidity support, credit enhancement, or guarantees Includes control or joint control, or significant influence Does not arise solely because of a typical customer-supplier relationship .69 The purpose and design of a structured entity should be considered in making a judgment as to when a relationship represents an "interest." .70 Only instruments that absorb variability of returns from the investee qualify as interests in the investee. Instruments that transfer risk to the investee create variability of returns for the investee, but do not typically expose the reporting entity to variability of returns from the performance of the other entity. Such interests do not qualify as interests. The following examples are summarized from IFRS 12. Example 15 A structured entity holds a loan portfolio. The structured entity obtains a credit default swap (CDS) from the reporting entity to protect itself from default risk. Does the reporting entity have an "interest" in the structured entity? Solution: Yes. The reporting entity has involvement that exposes it to variability of returns from the performance of the structured entity because the credit default swap absorbs variability of returns of the structured entity. Example 16 The following structured entity was set up to provide investment opportunities to investors.
Swap counterparty
Credit def ault swap to transf er Zs credit risk to structured entity
Fee
Cash
Cash Risk-f ree notes Risk-free debtors
Investors
Notes linked to credit risk of third party (Z)
Structured entity
Illustration 23: Identifying interest in an entity example 16
Dataline 39
Does the swap counterparty have an "interest" in the structured entity? Solution: The swap counterparty does not have an "interest" in the structured entity because the CDS transfers variability to the structured entity, rather than absorbing variability of returns of the structured entity. Comparison to US GAAP: IFRS 10 uses the concept of an "investor" for consolidation purposes while IFRS 12 uses the concept of an "interest" for disclosure purposes. As discussed earlier in this Dataline, the term investor used in IFRS 10 is not explicitly defined but appears to have a similar meaning to the term interest. US GAAP, however, uses the variable interest definition consistently for both consolidation and disclosure purposesbut only as it relates to VIEs. Additional indicators are provided within US GAAP to assist in determining whether a variable interest exists for assessing certain risks and derivatives (refer to Comparison to US GAAP in paragraph 11 for further information). .71 IFRS 12 does not apply to the following: (a) Post-employment benefit plans or other long-term employee benefit plans to which IAS 19, Employee Benefits, applies (b) Separate financial statements to which IAS 27, Consolidated and Separate Financial Statements, applies; however, disclosures on unconsolidated structured entities are required if the entity only prepares separate financial statements (c) An interest held by an entity that participates in, but does not have joint control of, a joint arrangement unless that interest results in significant influence over the arrangement or is an interest in a structured entity (d) An interest that is accounted for under IFRS 9, Financial Instruments, unless that is an interest in an associate, joint venture, or unconsolidated structured entity Aggregation of disclosures .72 IFRS 12 allows reporting entities to judge the level of detail required in the disclosures and the emphasis of the disclosures. Disclosures should be aggregated or disaggregated as appropriate to avoid either obscuring useful information or including voluminous insignificant details. IFRS 12 provides that: (a) Aggregation should be consistent with the disclosure objective (b) Interests in subsidiaries, joint ventures, joint operations, associates, and unconsolidated structured entities should be presented separately and not aggregated (c) Quantitative and qualitative information about different risks and return characteristics of various entities and the significance of each such entity should be considered (d) Possible aggregation criteria include aggregation based on nature of activities, industry classification, and geography
Dataline 40
Significant judgments and assumptions .73 IFRS 10 requires a reporting entity to disclose significant judgments and assumptions made in determining whether the entity controls, jointly controls, significantly influences, or has some other interests in other entities including: (a) Judgments and assumptions related to reassessment of control due to changes in facts and circumstances (b) Any override of presumptions of control (or non-control) when voting rights exceed (or fall below) 50% (c) An assessment of principal-agent relationships in consolidation .74 The group should also disclose how it aggregates interests in similar entities for disclosure purposes.
Transition
.75 IFRS 10 is applicable for annual periods commencing on or after January 1, 2013. It generally requires full retrospective application in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, except for the impracticability exemptions discussed below. Early application is permitted, but early adopters should disclose this fact and are required to adopt the standard simultaneously with certain 3 other new standards . <continued on next page>
IFRS 11 - Joint Arrangements, IFRS 12, IAS 27 (Revised) - Separate Financial Statements, and IAS 28 (Revised) - Investments in Associates and Joint Ventures
.76 The following flowchart illustrates the transition requirements:
Change in consolidation status of investee?
No No adjustments
Yes
Determine the change in consolidation status
Consolidating a previouslyunconsolidated investee
De-consolidating a previouslyconsolidated subsidiary
Is investee a business?
Measure investment as if IFRS 10 effective all along (i.e. retrospective).
Yes
No
Consolidate from date that control is acquired.
Consolidate using IFRS 3 principles from date that control is acquired, but without recognising goodwill.
Difference from previous carrying amount adjusted to opening equity.
Impracticable
Impracticable
Impracticable
Apply from earliest practicable date.
Illustration 24: IFRS 10 transition flowchart
Comparison to US GAAP: The transition provisions that are expected to be included in the FASB's proposed principal versus agent guidance for VIEs and limited partnerships is likely to be broadly consistent with FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R) (FAS 167), which was issued in 2009 to amend the consolidation guidance for VIEs. That standard also required retrospective application unless not practicable, in which case the reporting entity would apply the practicability exception on the date of adoption. This is in contrast with IFRS 10, which requires the practicability exception be applied from the earliest practicable year presented, although it acknowledges that this may be the current year.
Dataline 42
.77 IFRS 12 is also effective for annual periods beginning on or after January 1, 2013 with early application permitted. An entity can choose to provide any of the disclosures in IFRS 12 early without having to adopt the other standards referenced in paragraph 75 above.
Potential business implications

.78 Changes to the consolidated entities of a group may result in significant financial changes for the group. This could impact both the amounts recognized in profit and loss (e.g. revenues and expenses) as well as the balance sheet presentation. PwC observation: Leverage, capital ratios, covenants, and financing agreements may be affected as a result of changes to the balance sheet. In particular, structuring efforts to unburden the balance sheet by offloading assets to special-purpose entities may no longer work under the new requirements. Such impacts should be reviewed in advance to understand how a reporting entitys balance sheet may be affected. Impacts on performance measures, such as interest cover, EBIT or EBITDA, should also be considered. .79 IFRS 10 introduces certain judgmental and variable considerations, such as de facto control and principal-agent relationships. As a result, the application of IFRS 10 may result in more frequent consolidation and de-consolidation in the future. Entities that anticipate this outcome should consider the availability of resources, and plan for the increased capacity that would be required to handle the additional volume of work (e.g., purchase price allocations). .80 The initial application of IFRS 10 may coincide with a significant volume of purchase price allocations if the application of this standard requires the group to consolidate a significant number of previously unconsolidated investees. This could be true, in particular, for entities that are associated with large numbers of previously unconsolidated special-purpose entities. Management of such entities should review the requirements of this standard early to anticipate and prepare for such scenarios. .81 Initial transition requirements and annual reassessment of controls may require changes to existing processes and internal controls. Gathering and analyzing the information could take considerable time and effort depending on the number of investees that may require consolidation, the inception dates, and the records available. PwC observation: Where significant changes to financial results and financial position arise, entities should clearly communicate these impacts to stakeholders as soon as possible. Timely assessment and management of all of the potential implementation and ongoing business implications of IFRS 10 will help reduce unexpected business and reporting risks. Beginning this process early will allow entities enough time to consider potential adoption strategies or to renegotiate agreements in order to reduce the impact of adoption and to achieve preferred classification outcomes for future arrangements. .82 IFRS 12 has greatly increased the amount of disclosures required. Reporting entities should plan for, and implement, the processes and controls that will be required to gather the additional information. This may involve a preliminary consideration of IFRS 12 issues such as the level of disaggregation required.
Dataline 43
.83 The IASB staff recently issued an Effect Analysis on both IFRS 10 and IFRS 12 which highlights certain areas where the IASB expects the most significant effects from applying these new standards. This analysis includes comparative examples to previous guidance to highlight some of the changes.
Questions
Dataline 44
Appendix A - Summary comparison between IFRS and US GAAP consolidation guidance

Current IFRS (IAS 27 and SIC 12) Single definition for all entities but SIC 12 contains specific indicators of control for SPEs Ability to govern financial and operating policies so as to obtain benefits Presumption of control when investor owns more than 50% of voting power unless exceptional circumstances. Control could also exist with less than 50%. For SPEs, other indicators of control are considered. Effective date N/A Annual periods beginning on or after Jan 1, 2013 - can early adopt together with other new standards Retrospective (with practicability exception) US GAAP to be proposed No change
Topic Definition of control
IFRS 10 Single definition for all entities
US GAAP No single definition - 2 models (voting interest entities and variable interest entities)
Comparison of definition of control
1. Power through rights that give an investor the current ability to direct activities that significantly affect the entitys returns 2. Exposure or rights to variable returns 3. Ability to use its power to affect its returns
Criteria for consolidation of a No change VIE: 1. Power to direct activities of VIE that most significantly impact economic performance 2. Obligation to absorb losses/ right to receive benefits that could potentially be significant to VIE For voting interest entities, the usual condition for control is ownership of a majority interest but other contractual rights are also considered and could overcome that presumption. N/A TBD
Transition
N/A
N/A
Retrospective (with practicability exception) No change
Accounting policies for consolidated group Reporting periods
Use consistent policies for Use consistent policies for all 4 all entities in group entities in group
Use consistent policies some exceptions for industry-specific accounting (e.g. , investment companies) Parent and subsidiary usually the same reporting date, but can differ up to 3 months. Recognition is given, by disclosure or adjustment, to the effects of intervening events that would materially affect consolidated financial statements. Exemption for investment companies and broker-dealers
Parent and subsidiary usually the same reporting date, but can differ up to 3 months however, adjustments for significant transaction in the gap period
Parent and subsidiary usually the same reporting date, but can differ up to 3 months however, adjustments for significant transaction in the gap period
No change
Consolidation of controlled investments
Always applies (exemptions exist to the requirement to present consolidated financial statements) Included only if currently exercisable - all facts and circumstances must be considered to determine if substantive (but not for determining share of profits)
Always applies (exemptions exist to the requirement to present consolidated financial statements) No longer need to be currently exercisable or convertible all facts and circumstances must be considered to determine if substantive (but generally not for determining profit share)
No change
Potential voting rights (e.g., options, convertibles, warrants, forward contracts)
No specific guidance on how to consider, but the concept may apply in limited fact patterns for VIEs
No change
Based on the IASBs Investment Entity Exposure Draft, a parent of an investment entity would not retain the fair value accoun ting that is applied by its investment entity subsidiary to controlled entities, unless the parent qualifies as an investment entity itself.
Topic De facto control (no other contractual arrangements) Scope of the standard
Current IFRS (IAS 27 and SIC 12)
IFRS 10
US GAAP No such concept for voting interest entities; per SEC guidance, there may be very limited instances where control exists with less than 50% of vote For VIEs, must hold a variable interest in a VIE (significant guidance on what is a variable interest)
US GAAP to be proposed No change
Existed in practice but not Explicit guidance provided explicit in IAS 27
Focus on voting power; An investor must determine for SPEs, indicators of if it controls the investee (i.e., control are majority risks/ it is the parent) benefits, having (or delegating) decisionmaking to obtain majority, and if activities are conducted on behalf of entity No such concept
No change to the characteristics of a VIE and scope 5 exceptions
Variable interest
An investor must determine Significant guidance on how to if it controls the investee (i.e., determine whether an investor it is the parent) - an investor holds a variable interest is typically exposed to variability of returns Consider in identifying relevant activities, how decisions are made, who has current ability and returns, principal versus agent analysis, and potential voting rights Must consider, but judgment needs to be applied. No explicit related party tiebreaker rule exists. Concept exists No explicit guidance Determinative if held by one party, the more parties that have to agree the less likely the removal rights are substantive; board provides a mechanism Consider in determining if a VIE exists and whether there are variable interests
No change
Purpose and design
No explicit guidance. For SPEs, consider specific business needs and decision-making powers
No change (unclear if will be considered in principal versus agent analysis)
Related party and de facto agents consideration Silos Interests in specified assets Removal rights
No explicit guidance
For VIEs, specific guidance exists to consider related party interests as your own and related party tiebreaker if group controls Concept exists for VIEs Concept exists for VIEs VIEs: only considered/ determinative if held by single party VOEs: substantive removal rights are considered
How to consider related parties in the principal versus agent analysis may change No change No change Still only determinative if held by a single party but rights held by more than one party would be considered in the principal versus agent analysis - the fewer the parties that hold the rights, the more weight Change - same as for removal rights
No explicit guidance No explicit guidance No explicit guidance
Liquidation rights
No explicit guidance on how to consider
VIEs: Not considered VOEs: Same as for removal 6 rights
Investment companies are currently excluded from the VIE consolidation model. However, the FASB and IASB are revising the definition of an investment company and consequentially, some entities may no longer qualify and would potentially be subject to the VIE consolidation model. 6 Currently interpreted to include only liquidation rights that enable the holders to liquidate the entity and establish a new entity with a new manager to own the same assets and pursue the same objectives of the previous entity
Topic Participating rights Protective rights Shared power (when multiple parties do same activities) Majority power (when multiple parties do same activities and power is not shared) Principal versus agent guidance
Current IFRS (IAS 27 and SIC 12) No explicit guidance
IFRS 10 Substantive rights may prevent control Do not provide power to holder
US GAAP Same as for removal rights
US GAAP to be proposed Change - similar in same manner as removal rights No change No change
Do not provide power to holder
Does not overcome control presumption Concept exists. When power is shared among multiple unrelated parties, no party is the primary beneficiary.
No such concept but only Concept exists. When two or one party can have control more parties must act together, no investor has control. No such concept but only No such concept one party can have control
Concept exists. Party with power No change over majority of most significant activities has power.
Four factors to be considered: (1) scope of decision making; (2) rights held by other parties; (3) remuneration; (4) other interests. Market based fees (including performance fees) alone do not result in a principal relationship. Follow agent versus principal guidance
Guidance for determining if a fee is a variable interest focuses on a number of criteria, including if economics are more than insignificant (fees and other interests). Guidance also requires fees to be senior or equal in priority of payment to operating liabilities. Presumption of control for general partner; can be overcome for example, due to majority kick out rights
Expected to be broadly consistent with IFRS10 approach; Not expected to change whether an investor holds a variable interest Presumption of power for general partner; requires principal versus agent analysis consistent with VIEs
Limited No specific guidance partnerships (or similar entities) that are not VIEs
Dataline 47
Appendix B - Summary of IFRS 10 de facto control examples

Note that the following summarize IFRS 10 examples and may not contain all of the facts and circumstances set out in the standard.
Holdings of next largest investors Holdings of remaining investors Thousands with less than 1% each
IFRS 10 example number 4
Largest investor's holdings 48%
Other facts and circumstances None of the largest investors have arrangements to consult each other or make collective decisions.
Control by largest investor Yes
40%
12 investors A shareholder agreement grants the largest with 5% each investor the right to appoint, remove, and set the compensation of, management responsible for directing the relevant activities. A two-thirds majority vote is required to change this agreement. 3 other investors with 1% -
Yes, because of the agreement. Not conclusive if only consider voting rights.
45%
Next 2 investors each hold 26% Next 3 investors hold 5% each
No
7 8
45% 35%
11 investors None of the largest investors have arrangements with 5% each to consult each other or make collective decisions. Numerous investors with less than 1% each None of the largest investors have arrangements to consult each other or make collective decisions. Decisions made based on majority vote. 75% of votes have been cast at recent meetings.
Not conclusive if only consider voting rights. No
Dataline 48
Appendix C - Summary of IFRS 10 agent versus principal examples

Note that the following summarize IFRS 10 examples and may not contain all of the facts and circumstances set out in the standard.
IFRS 10 example number Description 1. Scope of decisionmaking 2. Rights held by other parties Removal or participating rights? None 3. Fixed fee Remuneration Performance fee Commen -surate with level of effort? Yes 10% of equity 11% Agent 4. Other interest Total interests Conclusion
Independent board?
13
Investment fund publicly traded, regulated fund
Manages investments under investment mandate and regulatory requirements, full discretion within these parameters Manages investments with wide discretion over invested capital Manages investments with wide discretion over invested capital Manages investments with wide discretion over invested capital Manages investments; has discretion to select assets subject to parameters or prospectus 3rd parties' service assets; Sponsor establishes terms; approves sellers and assets; decides on funding and provides liquidity facility
No
1% of NAV
None
14A
Investment fund performance -based fees Investment fund performance -based fees and other interests Investment fund performance -based fees and other interests CDO structure: Fixed rate ABS Funded by - Equity 10% - Debt 90%
No
No (only for breach of contract) No (only for breach of contract)
1% of AUM
20% of fund profits above target 20% of fund profits above target 20% of fund profits above target 10% of fund profits above target
Yes
2%
Up to 23%, minimum 3% Up to 41%, minimum 21%
Agent
14B
No
1% of AUM
Yes
More substantial (e.g., 20%)
Principal
14C
Yes
Yes, by board
1% of AUM
Yes
20%
Up to 41%, minimum 21%
Agent
15
No
Yes (widely dispersed among equity and debt holders) None
1% of AUM
Yes
35% of equity
Up to at least 35%
Principal
16
Multi-seller conduit: Medium term assets Funded by: - Short term debt - Residual interest
No
Yes not specified
None
Yes
100% of residual interest, credit enhanceme nt up to 5% losses (after overcollater alization by transferors) and liquidity facilities
Up to 5% of losses; fees not noted
Principal
Dataline 49
Key U.S. contacts:

Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com Mary Perrotta Director Phone: 1-973-236-7575 Email: mary.b.perrotta@us.pwc.com

*
No. 2011-37 August 26, 2011*
IASB proposes accounting guidance for investment entities

What's new?
On August 25, 2011, the IASB proposed new guidance to define an investment entity. The IASB's proposal would require investment entities to account for their portfolio investments at fair value. In addition, investment entities would have several new disclosure requirements centered on investment performance.

Consolidation Under the proposal, all portfolio investments held by an investment entity would be accounted for at fair value. IFRS does not currently define an investment entity or provide a broad exception from its normal consolidation rules for such entities. Thus, in contrast to current IFRS guidance, an investment entity would not consolidate any portfolio investment in which it has a controlling financial interest nor would it account for investments under the equity method where it has significant influence. However, the parent of an investment entity will be required to apply normal consolidation guidance to the underlying investment entitys portfolio, if the parent is no t itself an investment entity. Definition of an investment entity The IASB's proposal requires an entity to meet all of the following criteria to qualify as an investment entity: Nature of the investment activity. The entitys substantial activities are to invest in multiple investments for purposes of generating investment income, capital appreciation or both. Business purpose. The express business purpose of an investment entity is to invest for investment income, capital appreciation or both. Unit ownership. Ownership in the entity is represented by units of investments proportionate to their share of net assets. Pooling of funds. The funds of the entitys owners are pooled so that the owners can collectively access professional investment management. There must be multiple investors who hold significant ownership interests that are unrel ated to the entitys parent (if any).
*
The text under the subheading Consolidation was revised on October 27, 2011 to ref lect a technical correction regarding the guidance applicable to the parent of an investment entity.
Fair value management. Substantially all of the investments are managed, and their performance evaluated, on a fair value basis. Reporting entity. The entity must provide financial information to its owners about its investment activities. The entity itself does not have to be a legal entity. The proposal would require a reassessment if facts and circumstances indicate that there have been changes in the characteristics of the entity. Disclosures The proposal would require several new disclosures by the investment entity, including information intended to enable investors to evaluate the nature and financial effects of the investment activities undertaken by the entity.
The FASB is expected to issue a similar proposal in the third quarter of this year. While the criteria to qualify as an investment entity are expected to be substantially converged, there would be several significant financial reporting differences. In particular, US GAAP would differ from IFRS by requiring that: Entities regulated under the Investment Company Act of 1940 would be subject to the investment entity guidance, even if they do not otherwise meet all the criteria of an investment entity. An investment entity would account for a controlling financial interest in another investment entity or an investment property entity in accordance with Topic 810, Consolidation, rather than measure that investment at fair value. A non-investment entity that has a controlling financial interest in an investment entity would be required to retain the investment entity's accounting in consolidation. Investment transactions will initially be recorded at transaction price, in contrast with the IASBs requirement to record all transactions at fair value.
Who's affected?
Entities reporting under IFRS that would be impacted by this proposal are those that have been established for investment purposes and meet the definition of an investment entity. Some entities reporting under US GAAP that are currently considered to be investment companies may no longer qualify under the FASB's proposal that is expected to be issued soon. In addition, the FASB's proposal would result in a change in practice by requiring an investment entity to consolidate another investment entity (or investment property entity) in which it has a controlling financial interest. Today, this typically only occurs when an investment entity is wholly-owned.

An effective date has not been included the IASB's proposal. Early adoption would be allowed provided the package of recently issued IFRS consolidation and joint venture standards are adopted at the same time.
What's next?
Comments on the IASB's proposal are due January 5, 2012. The FASB is expected to issue its proposal in the third quarter of this year with a comment letter deadline that will likely coincide with IASB proposals comment letter deadline.
Questions?
In brief
Authored by:
Annette Spicker Partner Phone: 1-973-236-4088 Email: annette.p.spicker@us.pwc.com John McCardell Senior Manager Phone: 1-973-236-7408 Email: john.n.mccardell@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com
US GAAP Convergence & IFRS Financial instruments
DataLine
A look at current financial reporting issues PricewaterhouseCoopers 2010-35 August 26, 2010
(Revised February 3, 2011*)
Financial Statement Presentation

A Look at the FASB and IASB's Staff Draft
What's inside:
Overview ............................. 1
At a glance ................................ 1 Background............................... 1
Overview
At a glance
The FASB and IASB (the "boards") have completed their initial redeliberation of the key issues from their 2008 Discussion Paper and issued a Staff Draft of the Exposure Draft on Financial Statement Presentation ("staff draft"). The staff draft is intended to facilitate additional outreach efforts. The boards are not formally inviting comments on the staff draft but would welcome any input provided. The staff draft contains significant changes from the Discussion Paper and incorporates much of the feedback from comment letters and field tests Key changes being proposed are: assets, liabilities, revenues, and expenses would be categorized as operating, investing, and financing, with a separate section for taxes and discontinued operations, the direct method would be used for the Statement of Cash Flows, with certain indirect information also presented, a "roll forward" would be presented in the notes of significant Statement of Financial Position line items, information would be disaggregated by function (e.g., cost of sales, selling, and marketing) on the face of the Statement of Comprehensive Income and by nature (e.g., bad debt, advertising) in the notes, and expansive segment disclosures would be required (FASB only).
Key provisions ..................... 2

Scope ....................................... 2 Core principles of financial statement presentation ............................ 2 Statement of Financial Position ................................... 3 Statement of Comprehensive Income .......... 4 Statement of Cash Flows .......... 5 Roll-forward analysis ................. 6 Segments.................................. 7
Comment letters, field tests, and research study .................................. 8 Differences between FASB and IASB staff drafts .......................... 9 Next steps............................ 9 Business implications......... 10 Where to go for more information......................... 10 Questions .......................... 10 Appendix: Examples of revised financial statement format............... 11
This project was re-prioritized under the modified convergence strategy in June 2010 with an expectation to release an exposure draft in the first quarter of 2011. However, the boards acknowledged in October that they do not currently have the capacity necessary to address the issues raised on this project. At their October joint meeting, the boards decided to delay activities on this project until after June 2011.
Background
.1 The boards' objective for the Financial Statement Presentation project is to address investor and other financial statement users' concerns that the existing requirements permit too many alternative presentations and that the information in financial statements is highly aggregated and inconsistently presented, making it difficult to fully understand the
*
The At a glance (third bullet),Background (paragraph 2),and Next steps (paragraph 16) sections of this DataLine were revised to reflect the Boards' decision at their October joint meeting to delay activities on the project until after June 2011.
National Professional Services Group CFOdirect Networkhttp://www.cfodirect.pwc.com 1 PricewaterhouseCoopers LLP
DataLine 2010-35
relationship between an entitys financial statements and its financial results. The project was added to the FASB/IASB Memorandum of Understanding as a joint project in 2006. The boards issued a Discussion Paper in 2008 setting out their preliminary views on financial statement presentation. The FASB and IASB have concluded their initial redeliberations on the Discussion Paper. The boards have issued the staff draft to allow for additional outreach efforts and evaluate concerns about (1) the costs versus benefits of the proposals and (2) the implications for financial institutions. .2 The staff asked users and preparers of financial statements how the proposed changes would benefit them, and is evaluating the effort and cost involved in adopting the proposed changes in their circumstances. The boards have performed the following types of outreach: General - to ensure that participants have a clear understanding of the draft proposals, particularly the changes that have been made to the proposed presentation model since the 2008 Discussion Paper (see discussion in PwC Observation in "Comment letters, field tests and research study" section for significant modifications to the proposals outlined in that paper), Investors - the boards have asked users (from various countries) to evaluate how the proposed changes would benefit their analysis and resource allocation decisions, and Field test - the boards have asked preparers of financial statements to evaluate the effort and cost involved in adopting the proposals. The staff expects to complete the outreach activities by the end of January and plans to present its findings to the boards in March 2011. .3 The staff draft reflects the boards collective tentative decisions through April 2010 and includes other disclosures and matters that were not part of the original Discussion Paper (e.g., segments, roll-forward analysis, transition). These tentative decisions are subject to change until the boards issue a final standard. This DataLine summarizes the key tentative decisions reached by the boards and reflected in the staff draft, together with information we have obtained through our observations of board meetings and project updates published by the boards.
Key provisions
Scope
.4 The boards intend the proposal to apply to all entities except: Not-for-profit entities, Entities within the scope of the IASBs SME standard, and Benefit plans within the scope of IAS 26, Accounting and Reporting by Retirement Benefit Plans, or ASC Topics 960, 962, and 965.
Core principles of financial statement presentation

.5 An entity shall present information in its financial statements in a manner that: Disaggregates information to explain the components of its financial position and financial performance, and Portrays a cohesive financial picture of the entity's activities.
DataLine 2010-35
The boards believe that the revised format will allow users of the financial statements to better understand an entity's performance by separating its financial position, changes in financial position, and cash flows between core operations and other activities. The proposed new financial statement categories would be as follows: Statement of Financial Position Statement of Comprehensive Income Cohesiveness Business section Operating category Operating finance subcategory Investing category Financing section Debt category Equity category Business section Operating category Operating finance subcategory Investing category Business section Operating category Investing category Statement of Cash Flows
D i s a g g r e g a t i o n
Financing section Debt category
Financing section
Income tax section Income tax section Discontinued operations section Discontinued operations section Other Comprehensive Income section
Income tax section Discontinued operations section
Statement of Financial Position

.6 The boards are proposing the following changes to the Statement of Financial Position: Assets and liabilities are to be classified as arising from business or financing activities. Assets and liabilities arising from business activities are to be segregated between operating, investing, and financing arising from operating activities. The operating category reflects the entitys business activities that relate to the generation of revenues (e.g., accounts receivable, inventory, accounts payable). The investing category reflects the entitys activities that generate non-revenue income (e.g., purchase and sale of investments, dividends received on equity investments, equity method investments). The financing arising from operating activities (operating finance subcategory) reflects activities that (a) do not meet the definition of financing activities, (b) are initially long term, and (c) have a time value of money component that is reflected by either interest or an accretion of the liability due to the passage of time (e.g., accrued pension liability, lease liability).
DataLine 2010-35
Financing activities include items that relate to an entity obtaining (or repaying) capital and consist of two categories: debt (e.g., issuing loans, notes, obtaining a mortgage on a building, interest payable on a note) and equity (e.g., issuing shares or other equity instruments, common, preferred, and treasury shares, distribution to owner). Income taxes and discontinued operations are to be displayed separately from business and financing activities. The income tax section should include all current and deferred income tax assets and liabilities. Entities are to display subtotals for total assets, total liabilities, short-term assets, short-term liabilities, long-term assets, and long-term liabilities. Information is to be presented in a manner that best reflects the way the assets or liabilities are used by the entity in operating the business. An entity may use an asset or liability for more than one function. For example, a building may be used as part of an entity's operations but may also be used partly as an investment property. The building is classified in the section or category of predominant use. An entity with multiple reportable segments classifies its assets and liabilities at the reportable segment level. For example, an entity may have two reportable segments, manufacturing and retail, each with a portfolio of financial instruments. In the manufacturing segment, financial liabilities may be used to fund ongoing operations and therefore are classified in the financing debt category. In the retail segment, financial instruments may provide a return to an entity but will not be used to fund the activities of the retail business and therefore will be classified in the investing category. Thus, similar assets and liabilities may appear in multiple sections of the statement of financial position. PwC Observation: We expect the Exposure Draft to contain additional guidance to help determine which items should be included in the operating versus investing categories or financing section. The boards will also require entities to explain in the notes to the financial statements the basis for classifying items within the sections, categories, and subcategories, and how classification relates to the entity's activities.
Statement of Comprehensive Income

.7 As with the Statement of Financial Position, income and expenses are to be classified as business or financing activities. Business activity is to be segregated between operating, investing, and financing arising from operating activities. Financing activity includes items that relate to an entity obtaining (or repaying) capital and consists of debt. Income taxes and discontinued operations are to be displayed separately from business and financing activities. Entities are to display net income, other comprehensive income, total comprehensive income, and earnings per share. The boards have published separate proposals to require entities to prepare a single statement of comprehensive income. The boards are proceeding with these proposals as a separate project and the staff draft has
DataLine 2010-35
been prepared on the basis that a single statement of comprehensive income has been adopted. The proposal does not change how EPS is calculated or what constitutes other comprehensive income. Entities are to present separately, in the appropriate section, category, or subcategory in the Statement of Comprehensive Income, material events or transactions that are unusual or occur infrequently, along with a narrative describing each event and its financial effects. Entities are not to describe any item of income or expense as an extraordinary item either in the Statement of Comprehensive Income or in the notes. This is consistent with IAS 1, which prohibits the presentation of items of income and expense as extraordinary items. All entities are to disaggregate their income and expense items by function on the Statement of Comprehensive Income and provide information disaggregated by nature in the notes. Entities will also disaggregate items according to the measurement basis. When disaggregation by nature is useful in understanding the amount, timing, and uncertainty of future cash flows, the entity would present its income and expenses by nature in the Statement of Comprehensive Income. The FASB also requires that multi-segment entities present information by nature in the segment note, and single segment entities in a separate note. Function refers to the primary activity in which an entity is engaged, such as selling goods, providing services, etc. Nature refers to the economic characteristics or attributes that distinguish assets, liabilities, and income and expense items (e.g., disaggregating total revenues into wholesale revenues and retail revenues, or disaggregating total cost of sales into materials, labor, transport, and energy costs). Measurement basis refers to the method or basis used to measure an asset or a liability, such as fair value or historical cost. PwC Observation: Most respondents to the boards Discussion Paper indicated that a financial statement user's ability to assess future earnings and cash flows would be enhanced by presenting information by both function and nature. Providing the by-nature information is a change from current practice, and when presented at the segment level will result in incremental work.
Statement of Cash Flows

.8 The boards have tentatively concluded that all entities, including financial service entities, will be required to present cash flows using the direct method and that a reconciliation from operating income to net cash from operating activities (i.e., an indirect reconciliation) should also be presented on the face of the financial statements. PwC Observation: The boards rationale for requiring a direct method cash flow statement is that this would make the information more intuitive and understandable to a broad range of users, improve the ability to predict future cash flows, and provide insight into an entity's cash conversion cycle. The staff draft suggests that direct method cash flow information could be prepared either (1) directly through the accounting records of the company or (2) indirectly by identifying the activities that make up the changes in asset and liability balances. This is a modification from the boards' 2008 Discussion Paper.
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PwC Observation: This is a significant change from what was proposed in the Discussion Paper and is the direct result of feedback received, mainly from preparers, on the difficulty of preparing a direct method cash flow statement. This gives preparers a choice of how to gather the information needed for a direct method cash flow statement. Although a system change may not be necessary if an entity chose the "indirect" option of preparing the direct method cash flow statement, the entity would need to develop a policy, document and implement a process, and test the estimates used for accuracy. Entities will be required to disaggregate cash flows in the Statement of Cash Flows by classes of cash receipts and payments so that the statement of cash flows shows how the entity generates and uses cash and should reflect the nature of the income or expense to which the cash flow is related. Examples of cash receipts and payments that reflect the nature of the income or expense include: Operating activities: cash received from customers, cash paid for labor, and cash paid for advertising Investing activities: cash received from dividends, interest, and rents Financing activities: cash paid for interest
The staff draft proposes a revision to the cash flow netting guidance in both IFRS and U.S. GAAP to prohibit an entity from reporting loan originations and repayments net unless the loan meets the criteria set out for netting cash flows (that is, turnover is quick, the amounts are large, and the maturities are short). Entities with funds held on deposit are to present cash inflows and outflows so that the Statement of Cash Flows reflects transactions between the entity and its depositors as if they were settled by external funds. Non-cash transactions (e.g., share-based payments, acquisition of assets under a finance lease, or the conversion of debt to equity) are to be presented as a supplement to the statement of cash flows. The staff draft proposes that information about limitation and restrictions on the availability of cash and short-term investments should be disclosed in the notes to the financial statements. PwC Observation: Financial services entities, specifically banks, raised concerns that the direct method of presenting cash flows is not meaningful for financial institutions and impractical to do. At this juncture, the boards' decision is to require all entities to use the direct method of presenting cash flows. However, the boards are seeking input from financial services entities to understand the implications for financial institutions in using the direct method.
Roll-forward analysis
.9 All entities (except nonpublic entities) will be required to provide a "roll-forward" presentation of changes in assets and liabilities that management regards as important for understanding the current period change in the entity's financial position. This presentation would include an analysis and explanation of the nature of transactions and other events that gave rise to changes in the account balances. Each roll-forward should separately distinguish:
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Cash inflows and cash outflows Non-cash (accrual) transactions that are repetitive and routine in nature (e.g., credit sales, wages, material purchases) Non-cash transactions or events that are nonroutine or nonrepetitive in nature (e.g., acquisition or disposition of a business) Accounting allocations (e.g., depreciation) Accounting provisions and reserves (e.g., bad debts, obsolete inventory) Remeasurements -- which are amounts recognized in comprehensive income that reflect the effects of a change in the net carrying amount of an asset or liability, and result from: (a) a change in (or transacting at) a current price or value; (b) a change in an estimate of a current price or value; or (c) a change in any estimate or method used to measure the carrying amount of an asset or liability. Examples are fair value changes, foreign currency translations, and impairment losses. PwC Observation: The preparer community has voiced concerns that the roll-forward analysis will be difficult to prepare due to all the categories that would need to be separately displayed, especially due to the overlap between the categories. .10 The staff draft also proposes that entities disclose information about remeasurements in a single note. This note would present separately the remeasurement component of items of income and expense recognized in the Statement of Comprehensive Income, with the intent to show significant remeasurements. Remeasurements should be disclosed by section, category, and subcategory and for other comprehensive income. The information would be comparative, and a narrative would also be required. PwC Observation: The boards believe that the disclosure of remeasurements will provide users with information they currently do not have that will help them assess the amount, timing, and uncertainty of future cash flows.
Segments
.11 The FASB will also propose that entities disclose the following for segments: Operating cash flows by segment Income and expense information by nature for each reportable segment. This income and expense information by nature will be disclosed regardless of whether it is regularly reviewed by or provided to the chief operating decision maker. A measure of each of the following for each reportable segment regardless of whether that measure is regularly reviewed by or otherwise provided to the chief operating decision maker: Operating profit or loss Operating assets Operating liabilities Operating cash flows
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The total of the reportable segments' operating profit or loss, operating asset, operating liabilities, and operating cash flows must be reconciled to the entity's corresponding consolidated totals. The activities of all operating segments that are not reportable segments separately from all other information in the segment note. PwC Observation: We expect the segment disclosures to be proposed by the FASB to result in a substantive difference in the volume of disclosures between IFRS and U.S. GAAP. The IASB is requiring disaggregated information at the entity level (not by reportable segment).
Comment letters, field tests, and research study

.12 The boards received over 200 comment letters (mainly from preparers) on the Discussion Paper in 2008, conducted two separate field tests (a preparer field test with 31 companies, and an analyst field test with 43 analysts), and conducted a research study with 60 experienced credit analysts. .13 The majority of the respondents supported the project's principles and overall objectives, but most preparers did not support the direct method of presenting cash flows (except for respondents from Australia where the direct method is currently required). Most financial statement users supported the direct method, as they believe it would make the quality of earnings more transparent. In response to comment letters, field tests, and research, the boards have, in addition to the foregoing: Modified certain aspects of the proposed model to reduce the costs of implementation (e.g., replacing the line-by-line reconciliation with the roll-forward analysis), Will require a reconciliation of operating income to operating cash flows in the Statement of Cash flows to provide users with a measure similar to indirect cash flow information that will accompany the direct cash flow information, and Concluded that requiring all disaggregated information to be presented on the face of the financial statements would be too costly and potentially confusing. (The staff draft proposes the presentation of information by function on the face of the statements, and by nature in the notes.) 14 The Appendix to this DataLine includes examples of the expected form and content of the financial statements under the proposed model. The Appendix includes the following: Statement of Comprehensive Income Statement of Financial Position Statement of Cash Flows A note disclosure of expenses disaggregated by nature Analysis of changes in selected significant line items on the Statement of Financial Position
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Differences between FASB and IASB staff drafts

.15 While the Financial Statement Presentation project is a joint project, the FASB and IASB tentative decisions differ in the following significant ways: Minimum line item requirements - the IASB will require minimum line items on the Statement of Financial Position. The FASB believes the disaggregation principles proposed in the staff draft provide enough guidance on which line items should be presented. Net debt reconciliation - users of financial statements usually refer to an analysis of changes in specific line items (all the line items in the debt category, cash, any shortterm investments, and finance leases) as a net debt reconciliation. The IASB will require this reconciliation to be included in a single note. The FASB will not propose a similar disclosure because users of financial statements in the United States have not requested that information. Segments - the FASB will propose that an entity with more than one reportable segment should be required to present by-nature income and expense information for each reportable segment in its segment note. As a result, the FASB is proposing changes to segment reporting requirements. The IASB did not want to amend IFRS 8 at this time and will only require disaggregated information on an entity basis either in the Statement of Comprehensive Income or in a separate note. Overall disclosures - the FASB and IASB differ slightly on what disclosures they will require in the notes related to various items.
Next steps
.16 The boards have not formally invited comments on the staff draft, but would welcome input. The boards' outreach efforts extended through the end of 2010. As part of those efforts, they asked financial statement users to evaluate the benefits of the proposals and asked financial statement preparers to evaluate the cost of adopting the proposals. They also conducted additional field tests and research, as well as met with financial institutions to discuss the proposals. At their October 2010 joint meeting, the boards discussed some of the significant concerns raised through these ongoing outreach activities and acknowledged that they would need to dedicate resources to appropriately address them. Given the higher priority of several other major projects (such as the projects on financial instruments, revenue recognition, and leasing), the boards concluded that the financial statement presentation project should be delayed. The boards plan to revisit this project in March 2011 in order to consider next steps but at the present time do not expect to fully return to the project until after June 2011. .17 The Exposure Draft is expected to propose full retrospective application and will require one comparative period for a complete set of financial statements. In the first year of adoption, however, three Statements of Financial Position would be required. PwC Observation: The requirement to present only one comparative period would conflict with current SEC guidance, which requires two comparative periods for the Statement of Comprehensive Income, Statement of Cash Flows, and Changes in Stockholders Equity. The boards have yet to discuss this matter with the SEC. .18 The Exposure Draft is not expected to include an effective date. Rather, the Exposure Draft will include a question soliciting information about the amount of time needed to implement the proposed changes. Both boards, however, have indicated that the effective
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date for the final standard would provide sufficient time for reporting entities to prepare for and implement the proposed changes.
Business implications
.19 Although this project deals with the presentation of financial data, the magnitude of the changes being proposed are significant and preparers should consider the following potential business implications: System Changes - entities will need to assess the adequacy of existing systems to determine the extent to which those systems are capable of gathering the necessary data (i.e., direct method information, the nature and function information, etc.). Processes and Controls - entities may have to update processes and controls over financial reporting to address the changes required to comply with new financial statement presentation guidance. Disaggregation - the proposal would require more expansive disclosures (e.g., segments, by nature, roll-forward analysis, remeasurements) in the notes. Entities will need to identify where potential data gaps exist and the disclosures will likely result in incremental work. Overall cost of implementing the proposal - the proposed changes could result in incremental costs to preparers.
Where to go for more information

.20 The letters written to the boards in response to the discussion paper (including PwC's response letter) are available on the FASB's website: http://www.fasb.org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid=1218220137090 &project_id=1630-100 .21 A copy of the staff draft is available on the FASB's website: http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blo bwhere=1175820952978&blobheader=application%2Fpdf
Questions
.22 PwC clients who have questions about this DataLine should contact their engagement partner. Engagement teams that have questions should contact Timothy Corrigan (973-2365302), Larry Dodyk (973-236-7213), Saira Gilani (973-236-5335), or Douglas Kangos (617530-5044) in the National Professional Services Group.
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Appendix: Examples of revised financial statement format

This Appendix includes the following examples:
Example 1: Statement of Comprehensive Income (Manufacturing Entity) Example 2: Statement of Financial Position (Manufacturing Entity) Example 3: Direct Method Statement of Cash Flows (Manufacturing Entity) Example 4: Statement of Comprehensive Income (Financial Services Entity) Example 5: Statement of Financial Position (Financial Services Entity) Example 6: Direct Method Statement of Cash Flows (Financial Services Entity) Example 7: Disaggregation of Expenses by Nature This is an example of the disaggregated disclosure of expenses by nature that would be required in the Notes to the financial statements. Example 8: Disaggregation of a Multisegment Entity This is an example of the disaggregated by-nature operating income and expense information Entity Z discloses in its segment note. Example 9: Analysis of Changes in Select Significant Line Items This is an example of the "roll-forward" of significant Statement of Financial Position line items. The required narratives are not included in this example.
Note: This Appendix includes material reproduced from the FASB Staff Draft of an Exposure Draft on Financial Statement Presentation. The FASB material, copyright by Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, is reproduced by permission.

Example 1: Statement of Comprehensive Income (Manufacturing Entity)1
For the Years Ended December 31, 20X1 20X0 BUSINESS Operating Revenue Cost of goods sold Gross profit Selling expenses General and administrative expenses Other operating income (expense) Impairment loss on goodwill Operating income before operating finance costs Operating finance costs Total operating income Investing Dividend and interest income Earnings in Company A (equity method) Realized gain on securities Fair value change in investment in Company B Total investing income TOTAL BUSINESS INCOME FINANCING Debt Interest expense TOTAL FINANCING EXPENSE Income from continuing operations before taxes INCOME TAX Total Income tax expense Income from continuing operations DISCONTINUED OPERATION Loss on discontinued operation Income tax benefit NET LOSS ON DISCONTINUED OPERATION NET INCOME OTHER COMPREHENSIVE INCOME (net of tax) Gains on available-for-sale securities arising during the year Amounts reclassified into earnings Unrealized gain on securities (investing) Gains on futures contracts arising during the year Amounts reclassified into earnings Unrealized gain on futures contracts (operating) Foreign currency translation adjustment on equity method investee (investing) TOTAL OTHER COMPREHENSIVE INCOME TOTAL COMPREHENSIVE INCOME Net income per share - basic Net income per share - diluted
3,487,600 (1,956,629) 1,530,971 (153,268) (469,754) 17,663 952,612 (33,235) 892,377
3,239,250 (1,816,903) 1,422,347 (130,034) (433,950) (2,025) (35,033) 821,305 (33,250) 788,055
62,619 23,760 18,250 7,500 112,129 1,004,506
55,500 22,000 7,500 3,250 88,250 876,305
(111,352) (111,352) 893,154 (333,625) 599,529
(110,250) (110,250) 766,055 (295,266) 470,789
(32,400) 11,340 (21,060) 538,469
(35,000) 12,250 (22,750) 448,039
29,056 (11,863) 17,193 3,784 (1,959) 1,825
20,150 (4,875) 15,275 3,503 (1,813) 1,690
(1,404) 2,094 19,708 558,177 7.07 6.85
(1,300) (1,492) 14,173 462,212 6.14 5.90
Reproduced from FASB staff draft issued July 1, 2010.

Example 2: Statement of Financial Position (Manufacturing Entity)2
As of December 31, 20X1 20X0 BUSINESS Operating Cash (see Note 6) Accounts receivable, trade (net of allowance) Inventory Prepaid advertising and other Total short-term operating assets Property, plant, and equipment (net of accumulated depreciation) Goodwill and other intangible assets Total long-term operating assets Advances from customers Accounts payable trade Wages, salaries, and benefits payable, and share-based compensation liability Total short-term operating liabilities Total long-term liabilities Net operating assets before operating finance Operating finance Short-term portion of lease liability and interest payable on lease liability (see Note 6) Total short-term operating finance liabilities Accrued pension liability Long-term portion of lease liability (see Note 6) Decommissioning liability Total long-term operating finance liabilities Total operating finance liabilities Net operating assets Investing Short-term investments (see Note 6) Available-for-sale securities (see Note 6) Total short-term investing assets Equity method investment in Company A Investment in Company B at fair value Total long-term investing assets Total investing assets NET BUSINESS ASSETS
74,102 922,036 679,474 86,552 1,762,164 2,838,660 189,967 3,028,627 (182,000) (612,556) (212,586) (1,007,142) (3,848) 3,779,801
61,941 527,841 767,102 78,150 1,435,034 3,064,200 189,967 3,254,167 (425,000) (505,000) (221,165) (1,151,165) (1,850) 3,536,186
(50,000) (50,000) (293,250) (261,325) (29,640) (584,215) (634,215) 3,145,586
(50,000) (50,000) (529,500) (296,500) (14,250) (840,250) (890,250) 2,645,936
1,100,000 473,600 1,573,600 261,600 46,750 308,350 1,881,950 5,027,536
800,000 485,000 1,285,000 240,000 39,250 279,250 1,564,250 4,210,186

Example 2 (continued)
As of December 31, 20X1 20X2 FINANCING Debt Short-term debt and interest payable (see Note 6) Dividends payable Total short-term debt Total long-term debt (see Note 6) Total debt EQUITY Common stock (par .01, 100,000 shares authorized and issued both years; 76,149 and 73,000 shares outstanding December 31, 20X1 and 20X0, respectively) Additional paid-in capital Treasury stock Retained earnings Accumulated other comprehensive income Total equity TOTAL FINANCING INCOME TAX Income taxes payable Deferred tax asset NET INCOME TAX (LIABILITY ASSET) DISCONTINUED OPERATION Assets of discontinued operation Liabilities of discontinued operation NET ASSETS OF DISCONTINUED OPERATION Total short-term assets Total long-term assets TOTAL ASSETS Total short-term liabilities Total long-term liabilities TOTAL LIABILITIES
(702,401) (20,000) (722,401) (2,050,000) (2,772,401)
(512,563) (20,000) (532,563) (2,050,000) (2,582,563)
(761) (1,514,839) 88,360 (1,100,358) (158,081) (2,685,679) (5,458,080) (72,514) 46,226 (26,288) 856,832 (400,000) 456,832 4,192,596 3,383,203 7,575,799 (2,252,057) (2,638,063) (4,890,120)
(730) (1,506,770) 164,500 (648,289) (138,373) (2,129,662) (4,712,225) (63,678) 89,067 25,389 876,650 (400,000) 476,650 3,596,684 3,622,484 7,219,168 (2,197,406) (2,892,100) (5,089,506)

Example 3: Direct Method Statement of Cash Flows (Manufacturing Entity)3
For the Years Ended December 31 20X1 20X0 BUSINESS Operating Cash collected from customers Cash paid for labor Cash paid for materials Cash contribution to pension plan Other operating cash outflows Cash paid for lease Capital expenditures Disposal of property, plant, and equipment Sale of receivables Net cash flows from operating activities Investing Net change in short-term investments Investment in Company A Dividends and interest received Purchase of equity securities Sale of equity securities Net cash flows from investing activities NET CASH FLOWS FROM BUSINESS ACTIVITIES FINANCING Dividends paid Interest paid Proceeds from reissuance of treasury stock Proceeds from issuance of treasury stock Proceeds from issuance of long-term debt NET CASH FLOWS FROM FINANCING ACTIVITIES Net cash flows from continuing operations before taxes INCOME TAX Total cash paid for income tax Change in cash before discontinued operation and effect of foreign exchange DISCONTINUED OPERATION Net cash outflows from discontinued operation Effect of foreign exchange Change in cash Beginning cash Ending cash
2,812,741 (810,000) (935,554) (340,200) (260,928) (50,000) (54,000) 37,650 8,000 407,709
2,572,073 (845,000) (785,000) (315,000) (242,535) (50,000) 10,000 344,538
(300,000) 62,619 56,100 (181,281) 226,428
(800,000) (120,000) 55,500 (130,000) 51,000 (943,500) 598,962
(86,400) (83,514) 84,240 162,000 76,326 302,754 (281,221)
(80,000) (82,688) 78,000 150,000 250,000 315,312 (283,650) (193,786)
21,533
(477,436)
(12,582) 3,210 12,161 61,941 74,102
(11,650) 1,027 (488,059) 550,000 61,941

Example 3 (continued) Supplemental Cash Flow Information (Manufacturing Entity)4
For the Years Ended December 31 20X1 20X0 Operating income Adjustment to reconcile operating income to net cash flows from operating activities: Gain on disposal of property, plant, and equipment Depreciation and amortization Loss on sale of receivable Bad debt expense Loss on obsolete and damaged inventory Share-based compensation Impairment loss on goodwill Other noncash items Net change in asset and liability accounts Accounts receivable, trade Inventory Advances from customers Accounts, salaries, and share-based compensation payable Other assets and liabilities Net pension liability Cash inflows and outflows from other operating activities Sale of property, plant, and equipment Capital expenditure Cash paid on lease liability Net cash flows from operating activities Supplemental information about non-cash activities Capitalization of equipment in exchange for lease 892,377 788,055
(22,650) 279,120 4,987 23,068 29,000 22,023 1,189 (422,250) 58,628 (243,000) 76,954 3,259 (236,250)
273,500 2,025 15,034 9,500 17,000 35,033 1,100 (431,663) 48,398 (225,000) 91,665 (7,409) (220,500)
37,650 (54,000) (33,500) 407,709
(50,000) 344,538
330,000

Example 4: Statement of Comprehensive Income (Financial Services Entity) 5
For the Years Ended December 31 20X1 20X0 BUSINESS Operating Interest income Loans and leases, including fees Trading securities Securities available-for-sale Federal funds sold Interest expense Interest checking deposits Savings deposits Federal funds purchased Time deposits Net interest income Provision for credit losses Net interest income after provision for credit losses Non-interest operating income (expense) Mortgage banking revenue Service charges on deposits Wages, salaries, and benefits expense Occupancy expense Share-based compensation expense Depreciation expense Realized losses and gains Impairment loss on goodwill Amortization of core deposit intangibles Transaction processing expense and other Total operating income Investing Earnings in Company S (equity method) Fair value change in investment in Company R Dividend income from Company R Total investing income TOTAL BUSINESS INCOME FINANCING Debt Interest expense on debt TOTAL FINANCING EXPENSE Income before income tax INCOME TAX Total income tax expense NET INCOME OTHER COMPREHENSIVE INCOME, NET OF TAX (Loss) gain on available-for-sale securities arising during the year Amounts reclassified into earnings Unrealized gain (loss) on available-for-sale securities (operating) Gains on futures contracts arising during the year Amounts reclassified into earnings Unrealized gain on futures contract (operating) Foreign currency translation adjustment on equity method investee (investing) TOTAL OTHER COMPREHENSIVE (LOSS) INCOME TOTAL COMPREHENSIVE (LOSS) INCOME, NET Net income per share-basic Net income per share-diluted
220,320 1,399 23,539 3,672 (564) (21,644) (19,224) (46,296) 161,202 (12,853) 148,349 7,907 32,079 (38,000) (6,860) (36,172) (6,400) (87) (2,658) (23,298) 74,860 3,780 (7,500) 2,700 (1,020) 73,840
204,000 1,295 54,795 3,400 (414) (20,290) (17,800) (41,170) 150,816 (11,922) 138,894 8,931 31,033 (35,000) (7,000) (17,000) (5,850) 4,260 (9,000) (3,544) (25,049) 80,675 3,500 3,250 2,500 9,250 89,925
(47,127) (47,127) 26,713
(44,457) (44,457) 45,468
31,044 (1,404) (32,448) 583 (400) 183 (540) (32,805) (15,366) 0.17 0.16
29,250 (1,300) 27,950 539 (370) 169 (500) 27,619 53,950 0.26 0.24

Example 5: Statement of Financial Position (Financial Services Entity) 6
As of December 31 20X1 20X0 BUSINESS Operating Assets Cash Federal funds sold Advances and loans to banks Trading securities at fair value Securities available-for-sale at fair value Derivatives at fair value Interest receivables on loans and leases (see Note 3) Loans and leases, net (see Note 3) Premises and equipment, net Goodwill, core deposit, and other intangible assets Total operating assets Liabilities Noninterest bearing deposits Interest checking deposits Savings deposits Time deposits Total deposits Federal funds purchased Wages payable and share-based compensation liability Litigation provision Total operating liabilities Net operating assets Investing Equity method investment in Company S Investment at fair value in Company R Total investing assets NET BUSINESS ASSETS INCOME TAX Deferred tax asset Income taxes payable NET INCOME TAX ASSET FINANCING Debt Interest payable Dividends payable Long-term debt Total debt Equity Common stock (25 par, 500,000 shares authorized, 100,000 issued and outstanding in both years) Additional paid-in capital Treasury stock Retained earnings Accumulated other comprehensive income Total equity TOTAL FINANCING Total assets Total liabilities
22,871 45,800 15,203 34,022 653,636 655 180,570 3,836,442 195,250 84,165 5,068,614 (607,717) (78,846) (1,352,372) (1,236,335) (3,338,270) (404,704) (106,172) (3,846) (3,852,992) 1,215,622
25,993 35,000 10,279 32,685 744,812 315 79,000 3,844,975 176,650 86,824 5,036,533 (646,217) (72,156) (1,292,728) (1,154,039) (3,165,140) (376,300) (67,000) (1,850) (3,610,290) 1,426,243
53,240 31,750 84,990 1,300,612
50,000 39,250 89,250 1,515,493
34,391 (2,087) 32,304
17,945 (4,306) 13,639
(93,360) (20,000) (727,313) (840,673)
(89,446) (20,000) (832,101) (943,547)
(25,000) (105,642) 55,918 (347,005) (70,514) (492,243) (1,332,916) 5,187,995 (4,695,752)
(25,000) (101,025) 59,725 (415,966) (103,319) (585,585) (1,529,132) 5,143,728 (4,558,143)

Example 6: Statement of Cash Flows (Financial Services Entity) 7
As of December 31, 20X1 20X0 BUSINESS Operating Interest received from loans Cash interest received from available-for-sale securities Cash interest received from federal funds sold Cash interest paid from federal funds purchased Interest paid--interest checking deposits Total interest collected, net of interest paid Mortgage banking revenue Service charges on deposits Wages, salaries, and benefits Other net cash outflows Cash received for interest and fees, net of cash paid for expenses Cash flows related to operating assets and liabilities Principal collected on loans Cash paid for loan originations Cash received from trading securities Cash received from deposits, net Interest checking deposits Savings deposits Time deposits Noninterest-bearing deposits Cash from federal funds purchased, net of federal funds sold Cash paid for advances and loans to banks, net Purchase of equipment Sale of loans Purchase of available-for-sale securities Sale of available-for-sale securities Received from settlement of derivatives Net cash flows from operating activities Investing Investment in Company S (equity method) Dividends received from Company R Net cash from investing activities NET CASH FROM BUSINESS ACTIVITIES INCOME TAX Total cash paid for income taxes FINANCING Cash dividends paid Proceeds from issuance of long-term debt Debt repayments Interest paid Proceeds from reissuance of treasury stock NET CASH USED IN FINANCING ACTIVITIES Change in cash Beginning cash Ending cash
118,750 11,875 3,672 (19,224) (61,220) 53,853 7,907 32,079 (35,000) (28,159) 30,680 86,400 (103,680) 2,375
125,000 12,500 3,400 (17,800) (68,150) 54,950 8,931 31,033 (30,000) (30,200) 34,714 80,000 (96,000) 2,500
6,545 58,300 76,500 24,500 17,604 (4,924) (25,000) 8,000 55,080 340 232,720
6,170 61,500 76,100 25,000 16,300 (406) (25,000) 10,000 (130,000) 51,000 315 112,193
2,700 2,700 235,420
(12,000) 2,500 (9,500) 102,693
(10,566)
(15,667)
(86,400) (109,989) (40,011) 8,424 (227,976) (3,122) 25,993 22,871
(80,000) 135,780 (106,788) (43,212) 7,800 (86,420) 606 25,387 25,993

Example 6 (continued) Supplemental Cash Flow Information (Financial Services Entity) 8
As of December 31, 20X1 20X0 Operating income Adjustments to reconcile operating income to cash flow from operating activities Provision for credit losses Share-based compensation Depreciation and amortization Realized losses (gains) Impairment loss on goodwill Other non-cash items Change in operating assets and liabilities Change in interest receivable Change in advances and loans to banks Net increase in deposits Cash received from federal funds purchased, net Other Sale (purchase) of operating assets and liabilities Purchase of available-for-sale securities Sale of available-for-sale securities Sale of loans Loan repayment Loan origination Purchase of equipment Proceeds from settlement of derivatives Net cash flows from operating activities 74,860 80,675
12,853 36,172 9,058 87 1,997 (112,257) (4,924) 173,130 17,604 3,000
11,922 17,000 9,394 (4,260) 9,000 1,850 (87,090) (406) 162,493 16,300 5,000
55,080 8,000 86,400 (103,680) (25,000) 340 232,720
(130,000) 51,000 10,000 80,000 (96,000) (25,000) 315 112,193

Example 7: Disaggregation of Expenses by Nature9
For the Year Ended December 31 20X1 2,790,080 697,520 3,487,600 (1,039,104) (405,000) (43,175) (219,300) (160,800) (60,250) (29,000) (1,956,629) (60,000) (56,700) (23,068) (13,500) (153,268) (321,300) (43,175) (59,820) (22,023) (23,436) (469,754) For the Year Ended December 31 20X0 2,591,400 647,850 3,239,250 (921,300) (450,000) (39,250) (215,000) (135,000) (46,853) (9,500) (1,816,903) (50,000) (52,500) (15,034) (12,500) (130,034) (297,500) (39,250) (58,500) (17,000) (21,700) (433,950)
Wholesale sales Retail sales Total revenue Cost of goods sold Materials Compensation expense Pension expense Overhead-depreciation Transportation and other Change in inventory Loss on obsolete and damaged inventory Total cost of goods sold Selling expenses Advertising Compensation Bad debt Other selling Total selling expenses General and administrative expenses Compensation Pension Depreciation Share-based compensation Other general and administrative Total general and administrative expenses Other operating Gain on disposal of property, plant, and equipment Loss on sale of receivables Impairment loss on goodwill Total other operating income (expenses) Operating income before operating finance costs Operating finance costs Interest cost-pension Expected return on pension plan assets Interest expense on lease liability Accretion expense on decommissioning liability Total operating finance costs Total operating income
22,650 (4,987) 17,663 925,612 (30,800) 13200 (14,825) (810) (33,235) 892,377
(2,025) (35,033) (37,058) 821305 (2,800) 12000 (16,500) (750) (33,250) 788,055

Example 8: Disaggregation of a Multisegment Entity10
Retail BUSINESS Operating Revenue Cost of goods sold (a) Materials Labor Rent Depreciation Other Total cost of goods sold Selling Labor Advertising Other expense Total selling Research and development Labor Rent Other Total research and development Administration Labor Audit Legal Other Total administration Operating finance Expected return on plan assets Interest on lease expense Other interest costs Pension interest costs Total operating finance costs (a) Total operating income Total operating cash flow by segment Capital expenditures Non-operating interest expense As of December 31, 20X1 Total assets Total operating assets Total operating liabilities For the Year Ended December 31, 20X1 Fabrication Corporate Total
2,545,400
650,000
3,195,400
(1,167,000) (130,000) (62,000) (67,500) (23,000) (1,449,500)
(181,000) (50,000) (25,000) (14,000) (8,230) (278,230)
(1,348,000) (180,000) (87,000) (81,500) (31,230) (1,727,730)
(86,500) (75,000) (36,500) (198,000)
(6,900) (6,900)
(86,500) (81,900) (36,500) (204,900)
(143,200) (53,000) (36,000) (232,000)
(143,200) (53,000) (36,000) (232,200)
(114,000) (39,900) (153,900)
(10,000) (5,900) (15,900)
(60,000) (30,000) (35,000) (30,000) (155,000)
(184,000) (30,000) (35,000) (75,800) (324,800)
511,800
348,970
650 (2,500) (3,000) (18,200) (23,050) (178,050)
650 (2,500) (3,000) (18,200) (23,050) 682,720
(3,000) 50,000 -
142,202 -
(135,000) (93,450)
4,202 50,000 (93,450)
4,772,852 3,958,160 (1,109,130)
1,906,434 1,744,784 (612,859)
6,679,286 5,702,944 (1,721,989)
(a) Differences between segment information presented and consolidated statements are the result of internal accounting for inventory on a FIFO basis that amounts to lower materials cost of 180,000 for the year ended December 31, 20X1.
10


Example 9: Analysis of Changes in Select Significant Line Items (Rollforward Analysis)11
Long-Term Debt (1,950,000) (250,000) 150,000 (2,050,000) (2,050,000) Short-term Debt (250,000) (a) (150,000) (400,000) (a) (162,000) (562,000) Interest Payable (85,001) 82,688 (110,250) (112,563) 83,514 (111,352) (140,401)
Beginning balance, January 1, 20X0 Cash received from issuance of debt Cash paid for interest Accrual-interest Amounts reclassified to discontinued operations Ending balance, December 31, 20X0 Cash received from issuance of debt Cash paid for interest Accrual-interest Ending balance, December 31, 20X1
(a) Increases in short-term debt consist of amounts drawn on a short-term credit facility.
Beginning balance, January 1, 20X0 (a) Cash collections Revenue accrual Remeasurement-loss on sale of receivables Amounts allocated for bad debts (b) Remeasurement-change in estimate for bad debts Amounts reclassified to discontinued operations Remeasurement-foreign exchange adjustment Ending balance, December 31,20X0 (a) Cash collections Revenue accrual Remeasurement-loss on sale of receivables Amounts allocated for bad debts Remeasurement-foreign exchange adjustment Ending balance, December 31, 20X1
Accounts Receivable, Net 339,500 (2,282,073) 2,714,250 (2,025) (17,741) 2,707 (225,000) (1,777) 527,841 (2,496,741) 2,920,600 (4,987) (23,068) (1,609) 922,036
Customer Advances (650,000) (300,000) 525,000 (425,000) (324,000) 567,000 (182,000)
(a) Cash collections include both amounts collected from customers as well as cash collected from the sale of receivable balances. (b) Assumptions related to the allowance for bad debt were changed during the period resulting in an additional bad debt expense in 20X0.
Note: The above examples illustrate analysis of changes from a Statement of Financial Position (SFP) perspective. Such disclosures would be combined with or replace disclosures currently required by IFRS or US GAAP.
11
Reproduced from FASB staff draft issued on July 1, 2010.
DataLine 2010-35
Authored by:
Timothy Corrigan Partner Phone: 1-973-236-5302 Email: timothy.corrigan@us.pwc.com Larry Dodyk Partner Phone: 1-973-236-7213 Email: lawrence.dodyk@us.pwc.com Douglas Kangos Partner Phone: 1-617-530-5044 Email: douglas.j.kangos@us.pwc.com Saira Gilani Senior Manager Phone: 1-973-236-5335 Email: saira.s.gilani@us.pwc.com
DataLines address current financial-reporting issues and are prepared by the National Professional Services Group of PricewaterhouseCoopers LLP. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2010-2011 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate legal entity. To access additional content on accounting and reporting issues, register for CFOdirect Network (http://www.cfodirect.pwc.com), PricewaterhouseCoopers' online resource for senior financial executives.
US GAAP Convergence & IFRS Contingencies

FASB votes to discontinue loss contingencies project
What's new?
After a long hiatus on its loss contingencies project, the FASB voted today to remove the controversial project from its agenda. Some of the reasons cited by board members for discontinuing the project were: Improved compliance with existing disclosure requirements as a result of increased SEC focus on loss contingencies Constituent feedback opposing the changes proposed in the Exposure Drafts issued by the FASB in 2008 and 2010 The FASB's disclosure framework project, in which the FASB will take a broad look at all disclosures. The board may decide to consider improvements to loss contingency disclosures within the scope of that project. Feedback from FASB Advisory Committees that the project on loss contingencies is a low priority
No. 2012-23 July 9, 2012
Project history
In 2007, the FASB added a project to its agenda to address concerns expressed by the users of financial statements that disclosures about loss contingencies, particularly litigation contingencies, do not provide adequate and timely information to assist them in assessing the likelihood, timing, and amount of future cash outflows associated with loss contingencies. The FASB issued two Exposure Drafts, the first in 2008 and the second in 2010, proposing changes to the required disclosures of loss contingencies. The changes proposed in both Exposure Drafts were strongly opposed by non-user constituents. The opposition was due, in large part, to the belief that the imposition of additional disclosures regarding litigation contingencies could be prejudicial to the reporting entity. In late 2010, the SEC gave a series of speeches and issued a "Dear CFO" letter, which put constituents on notice that the SEC would be focusing on the disclosure of loss contingencies.
In brief
Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the National Professional Services Group (1-973-236-7804).
In brief
Authored by:
John R. Formica, Jr. Partner Phone: 1-973-236-4152 Email: john.r.formica@us.pwc.com Nora Joyce Managing Director Phone: 1-973-236-4771 Email: nora.d.joyce@us.pwc.com
DataLine
A look at current financial reporting issues PricewaterhouseCoopers 2010-32 August 3, 2010
(Revised February 1, 20111)
Disclosure of Certain Loss Contingencies

An Analysis of the FASB's Proposed Changes
What's inside
Overview ............................. 1
At a glance ................................ 1 Background............................... 1
Overview
At a glance
In July 2010, the Financial Accounting Standards Board (FASB or the "Board") issued an exposure draft of a proposed Accounting Standards Update, Contingencies Disclosure of Certain Loss Contingencies (the proposal). The objective of the Board is to require enhanced disclosure of certain loss contingencies, including litigation, environmental remediation, and product warranty liabilities. The proposed disclosures consist of qualitative and quantitative information about loss contingencies that will enable financial statement users to understand their nature, potential magnitude, and potential timing (if known). The disclosures would include publicly available quantitative information, such as the claim amount for asserted litigation contingencies, other relevant nonprivileged information about the contingency, and, in some cases, information about possible recoveries from insurance and other sources. Public companies would be required to provide a tabular reconciliation (i.e., a rollforward) of recognized loss contingencies from the beginning to the end of the reporting period. In November 2010, the Board discussed its redeliberation plan, including whether investor concerns about the current disclosures reflect a compliance issue with existing guidance or a need for more guidance. The Board also acknowledged the recent initiatives by the SEC staff to improve compliance with the guidance in this area through emphasis in comment letters, speeches, a "Dear CFO" letter, and other means. The Board will evaluate whether disclosures in 2010 year-end financial reports improve as a result of the SEC staff's emphasis prior to deciding whether an amendment of the existing standard is still needed. At that time, the Board will decide whether any future redeliberations are needed or whether additional outreach should be conducted. This decision delays the project until the second quarter of 2011 at the earliest.
Key provisions .................... 2

Scope ....................................... 2 Disclosure principles ................. 3 Disclosure threshold.................. 3 Disclosure requirements ........... 4 Tabular reconciliation ................ 6 Transition and effective date.......................... .7
SEC staff views ................... 7 IASB loss contingencies project ................................ 8 Questions ............................ 9
Background
.1 In 2007, the Board added a project to its agenda to address constituents' concerns that disclosures about loss contingencies under existing guidance do not provide adequate and timely information to assist them in assessing the likelihood, timing, and amount of future cash outflows associated with loss contingencies.
1
Sections entitled At a glance (third and fourth bullets), Background (paragraphs 4 and 5),Transition and effective date (paragraphs 17-19), and IASB loss contingencies project (paragraph 26) have been revised and a new section entitled SEC staff views (paragraphs 20-25) has been added to reflect the delayed timing of this project and incorporate relevant views expressed by the SEC staff.
DataLine 2010-32
.2 To address these concerns, the Board issued an exposure draft in June 2008 (the original proposal) seeking comments on proposed disclosures of certain loss contingencies. The comment period ended in August 2008. At its August 2009 meeting, the Board began to consider the feedback that it had received on its original proposal. That feedback came from over 240 comment letters on the exposure draft, a limited field test, and two roundtable discussions, in addition to other feedback from the marketplace. The Board resumed its redeliberations on this project in April 2010, which resulted in the issuance of the July 2010 proposal. .3 The requirements in the July 2010 proposal represent a significant departure from the original proposal and are intended to address certain of the concerns raised by constituents. However, like the original proposal, the July 2010 proposal will require more disclosure of publicly available, factual information pertaining to loss contingencies than current GAAP requires. The Board believes that this proposal will not require disclosures that will prejudice a company's case in legal proceedings. The comment period for the proposal ended in September 2010, and the Board received approximately 380 comment letters. .4 In October 2010, the Board ruled out the 2010 year-end effective date included in the proposal. In November 2010, the Board discussed its plan for redeliberations. At that time, the Board acknowledged the concerns of some constituents that insufficient loss contingency disclosures may indicate a compliance issue with the existing guidance rather than a need for a new standard. The Board also acknowledged the recent initiatives by the SEC staff to improve compliance with the guidance in this area through emphasis in comment letters, speeches, a "Dear CFO" letter, and other means. In light of the SEC staff's emphasis, the Board decided to evaluate whether there is improved disclosure of loss contingencies during the 2010 year-end financial reporting cycle. At that time, the Board will decide whether any future redeliberations are needed or whether additional outreach should be conducted. .5 This DataLine provides a summary of specific aspects of the proposal, recent views expressed by the SEC staff in this area, and our insights on selected matters. It updates the discussions set out in DataLines 2009-44 and 2010-22. The proposal is tentative and subject to change until a final standard is issued. PwC Observation: In our comment letter on the original proposal, we stated that an important first step is for the Board to demonstrate that the current disclosures on loss contingencies warrant change. Although the current proposal addresses certain of the other points that we raised in our comment letter, it provides no additional justification as to why the Board believes that a change is warranted. While we believe the July 2010 proposal is an improvement over the original proposal, in certain areas the changes may not be sufficient to address the concerns raised by many preparers and members of the legal community, especially those related to legal contingencies. Accordingly, the comment letters on the July 2010 proposal submitted by those groups express concerns that are similar to the concerns they expressed to the Board about its original proposal.
Key provisions
Scope
.6 The Board affirmed that the scope of the new standard would include all loss contingencies that are within the scope of either the existing contingencies standard or business combinations standard, except for the following:
DataLine 2010-32
Guarantees (other than product warranties) Liabilities of insurance entities covered by specialized industry guidance Certain liabilities for employment-related costs, including stock issued to employees, pensions and other postemployment benefits Income tax uncertainties PwC Observation: We believe that the most common types of contingencies that would be within the scope of the proposed standard are litigation, environmental remediation, withdrawal obligations related to a multi-employer pension plan, certain non-incomebased tax uncertainties, and product warranties.
Disclosure principles
.7 The Board decided on two overall disclosure principles, summarized below: During early stages of a contingency's life cycle, a company should disclose information (quantitative and qualitative) that allows users of its financial statements to better understand the nature, potential magnitude, and potential timing (if known) of a loss contingency. This disclosure should be more extensive in subsequent reporting periods as more information becomes available. A company may aggregate disclosures about similar contingencies (for example, by class or type). Judgment will be required to determine the basis for aggregation; that basis also should be disclosed. The Board has provided implementation guidance to assist in making these judgments. It may not be appropriate, for example, to aggregate disclosures related to environmental contingencies with contingencies related to product liability claims, or disclosures related to individual litigations with those related to class-action lawsuits. PwC Observation: The Board believes that by limiting disclosure requirements to publicly available, factual information and allowing the disclosures of similar contingencies to be aggregated, the disclosures should not impact the outcome of the contingency. Accordingly, the proposal does not include a prejudicial exemption. Judgment will be required to determine the most appropriate basis for aggregation. A company will need to consider whether the nature, risk profiles, and time horizons of contingencies are similar enough to permit aggregated disclosures. For example, a lawsuit in the U.S. may not have the same risk profile as a lawsuit involving similar claims in a non-U.S. jurisdiction. Aggregation of disclosures is intended to help mitigate prejudicial concerns, although that may not be possible where a company has only one significant contingency or only one contingency of a specific type that the company concludes cannot be aggregated with other types of contingencies.
Disclosure threshold
.8 The Board maintained the existing disclosure threshold requirements for both asserted and unasserted claims and assessments, except that asserted remote contingencies may require disclosure under the proposed standard. Disclosure of asserted remote contingencies may be necessary to alert users about a company's vulnerability to a potential "severe impact" due to the contingency's nature, potential magnitude, or potential timing (if known). A company will need to exercise judgment in assessing the facts and circumstances pertaining to the contingency to determine whether the threshold has been met. In making this judgment, a company may consider the potential effect on operations, expected costs, and the amount of effort management may need to devote to resolve the contingency.
DataLine 2010-32
.9 The threshold for determining that an impact may be "severe" is higher than the threshold for determining that an impact is "material." "Severe" is a significant financially disruptive effect on the normal functioning of an entity. The Board selected this terminology in an attempt to avoid inundating financial statement users with disclosures of frivolous claims or information that may be of questionable value when making investment decisions. The Board affirmed that the amount of damages claimed by the plaintiff, by itself, does not necessarily create the need to disclose a remote contingency (although it could be one of the factors to consider). PwC Observation: It may be challenging for management and legal counsel to make judgments as to which remote contingencies meet the threshold for disclosure, as there is no specific guidance or triggering mechanism for this determination in the proposal. For example, uncertainty may arise when determining the appropriate time horizon to use in evaluating whether a remote contingency meets the disclosure threshold. The 2008 exposure draft proposed that a contingency have a severe "near-term" (i.e., within the next year) impact to be considered for disclosure. The July 2010 proposal does not contain similar language, which may make determining the threshold challenging. Further, once management decides which contingencies meet the disclosure threshold, sharing the supporting documentation that was considered in making those judgments with auditors could expose a company to claims that it has waived the attorney-client privilege or other legal protections. In addition, some believe that providing these disclosures could increase the risk of copy-cat claims against the company. .10 The proposal also provides additional guidance for determining whether an unasserted claim meets the threshold for disclosure. Specifically, the proposal states that, among other things, a company should consider the existence of reputable scientific or industry publications that it is aware of that indicate potential significant hazards related to the company's products or services. .11 The proposal also affirms that potential loss recoveries from insurance or other indemnification arrangements should not be considered when assessing materiality in determining if a contingency should be disclosed. However, if a contingency is disclosed, a company will be required to disclose information about possible recoveries in certain circumstances, as discussed in paragraph .13 below.
Disclosure requirements
.12 The proposal would require that a company provide the following qualitative disclosures about a loss contingency (including remote contingencies) or classes of similar contingencies that meet the threshold for disclosure: Qualitative information to enable users to understand their nature and risks During early stages of asserted litigation contingencies, the contentions of the parties, for example, the basis for the claim, amount of damages claimed by the plaintiff, and the basis for the company's defense (or a statement that the company has not yet formulated its defense) would be disclosed. In subsequent periods, as more information about a potentially unfavorable outcome becomes available (e.g., as the litigation gets closer to resolution), the disclosure should be more extensive. Additionally, if known, the anticipated timing of, or the next steps in, the resolution of individually material asserted litigation contingencies should be disclosed.
DataLine 2010-32
For individually material contingencies, disclosures should be detailed enough to enable readers to obtain additional information from publicly available sources (e.g., court records). For example, for a litigation contingency, a company should disclose the name of the court/agency in which the proceedings are pending, the date the claim was instituted, the principal parties to the suit, a description of the alleged underlying facts, and the current status of the litigation contingency. As noted in paragraph .7 above, when disclosure is provided on an aggregated basis, a company should disclose the basis for aggregation and information that would enable financial statement users to understand the nature, potential magnitude, and potential timing (if known) of loss. For example, a company may have aggregated claims based on its different segments or product lines, or by similar types of contingencies. The proposal provides an example that if a company has a large number of similar claims outstanding, the company should consider disclosing the activity in that population of claims, such as the total number of claims outstanding, the average amount claimed, and the average settlement amount. PwC Observation: Certain disclosures are required for those contingencies that are individually material. There may be different views on the most appropriate basis for determining the materiality of a contingency, for example, whether materiality should be assessed based on the claim amount, management's best estimate of loss, or some other measure. Management will need to exercise judgment and be able to support its position in making these assessments. .13 The proposal would require that a company provide the following quantitative disclosures about a loss contingency (including remote contingencies, except as noted below) or classes of similar contingencies that meet the threshold for disclosure: Publicly available quantitative information; this might include the amount claimed by the plaintiff or, in the absence of a claim amount, the amount of damages indicated in the testimony of expert witnesses in the case of a litigation contingency. An estimate of the possible loss or range of loss and the amount accrued, if any; if the possible loss or range of loss cannot be estimated, the company should make a statement that an estimate cannot be made and the reason why that is the case. However, these disclosures are not required for remote contingencies that meet the threshold for disclosure. Other nonprivileged information that would be relevant to users of financial statements to enable them to understand and/or assess the possible loss. Possible recoveries from insurance arrangements if this information has been provided to the plaintiff, is discoverable by the plaintiff or a regulatory agency, or relates to a recognized receivable. However, for financial statement presentation purposes, accrued contingent liabilities and potential recovery amounts from insurance arrangements or other sources that have been recognized should not be netted or offset. A company should also describe whether a claim for coverage under an insurance or indemnification arrangement has been contested or denied. PwC Observation: Disclosing the amount accrued may raise prejudicial concerns, especially if a company is unable to aggregate such disclosure with others of a similar type or class. Disclosing insurance or indemnification recovery information may also raise prejudicial concerns, particularly in those situations in which such information had not been provided previously to a plaintiff.
DataLine 2010-32
Tabular reconciliation
.14 For each annual and interim reporting period for which an income statement is presented, public companies would be required to disclose a tabular reconciliation (i.e., a rollforward) of loss contingencies (by class) for which an accrual has been recorded in the financial statements. PwC Observation: Nonpublic companies will be exempt from the requirement to present the rollfoward. The Board believes that this exemption is consistent with the tentative decisions on its joint project with the International Accounting Standards Board on financial statement presentation to exempt nonpublic companies from certain requirements to present a reconciliation of significant balance sheet accounts in the notes to the financial statements. .15 Companies would describe significant activity in the reconciliation and the line items in the balance sheet and income statement where loss contingencies are included. The disclosure would include the following information: The carrying amounts of the accruals at the beginning and end of the period Increases (i.e., amounts accrued during the period) for new loss contingencies recognized during the period Increases for changes in estimates for loss contingencies recognized in prior periods Decreases for changes in estimates for loss contingencies recognized in prior periods Decreases for cash payments or other forms of settlements during the period The Board decided that loss contingencies for which the underlying cause and ultimate settlement occur in the same period should be excluded from the tabular reconciliation. PwC Observation: Some constituents have raised concerns that presenting the changes, and related descriptions of the changes, in a contingency accrual from period to period may be prejudicial. They contend that changes in the accrual could be associated with specific developments in the case during that reporting period, which could provide plaintiffs with information that could be detrimental to a company's legal defense. .16 All loss contingencies recognized in a business combination should also be included in the rollforward but presented separately if they have a different measurement attribute. For example, acquired warranty contingencies measured at fair value in a business combination would be presented separately from warranty contingencies that originated in the normal course of business and were recorded at management's best estimate. PwC Observation: Generally, the proposal would require companies to capture data at a more detailed level than under current practice. Companies will need to consistently evaluate more information and make more judgments on a greater population of contingencies, and establish reporting protocols, frameworks for making consistent judgments, bases for aggregation, and appropriate internal controls. Companies may also require more frequent and detailed communications with outside counsel to meet the disclosure requirements in the proposal.
DataLine 2010-32
Transition and effective date
.17 The proposal includes an effective date of 2010 for calendar year-end public companies, with a one-year deferral for nonpublic companies. However, with the delay of the project (discussed in paragraph .19), those effective dates were ruled out. If and when a final standard is issued, the Board will determine new effective dates. The definitions of public and nonpublic companies for purposes of applying the proposed requirements would be the same as the definitions used in applying the guidance for disclosures of uncertain income tax positions. .18 The proposed disclosures would only be a current-year requirement in the year of adoption. Companies presenting comparative financial statements in the year of adoption would not be required to revise disclosures for previous periods that are presented for comparative purposes. .19 As discussed in paragraph 4, the Board has decided to evaluate whether the disclosure of loss contingencies in 2010 year-end financial reports improves before it decides whether an amendment to the existing standard is still needed. This decision delays the project until the second quarter of 2011 at the earliest, and most likely until the second half of 2011. PwC Observation: In light of the enhanced focus on 2010 loss contingency disclosures by the SEC staff and the FASB, companies may find it beneficial to refresh their understanding of the requirements in the existing standard and ensure that the disclosures being made in 2010 year-end financial statements are robust.
SEC staff views

.20 The SEC staff over the course of 2010 emphasized in comment letters, speeches, and a "Dear CFO letter" issued in October 2010, the required disclosures under the existing standard for loss contingencies. When an accrual has been made, disclosure of the nature of the accrual, and in some circumstances the amount accrued, may be necessary for the financial statements not to be misleading. .21 The staff has also cautioned in comment letters and speeches that, in general, the first disclosure regarding a contingency should not be in the same reporting period when an accrual for the contingency is recognized. This applies to annual and quarterly reporting, as SEC regulations require the disclosure of material contingencies in interim financial statements (and that would be the case regardless of whether there have been any changes from the most recent year-end). Further, the staff generally expects that disclosures related to a particular case will become more robust as the life cycle of the case progresses and the matter moves closer to resolution or settlement. .22 For a contingency with a reasonably possible likelihood of loss, the required disclosures include the nature of the contingency and an estimate of the possible loss or range of loss amounts, or a statement that such an estimate cannot be made. The staff has highlighted three possible ways in which to comply with this requirement: (i) provide an estimate of the possible loss or range of loss, (ii) disclose that the possible loss or range of loss above the amount accrued is not material to the financial statements as a whole, or (iii) disclose that an estimate cannot be made. Management should be prepared to support its position with contemporaneous documentation. If management discloses that an estimate cannot be made, the documentation should evidence the process followed and the analysis performed in reaching that conclusion. .23 The staff would likely consider it unusual that a company could not reasonably estimate a range of loss for at least some of the cases in its portfolio of contingencies. The staff has
DataLine 2010-32
suggested that when the possible loss or range of loss for certain contingencies can be estimated, aggregated disclosure of the possible loss or range of loss for these items is permissible. The staff has cautioned that it would not be acceptable to justify the lack of a required disclosure by stating that a high level of confidence or certainty cannot be assured in attempting to estimate the possible loss or range of loss. .24 When evaluating the materiality of a particular matter for disclosure, the staff has indicated that it is not appropriate to offset the potential loss with potential recoveries from insurance arrangements, as the possible cash outflows and inflows are each subject to an independent set of risks. Inappropriately offsetting such amounts could understate the volume and magnitude of potential losses. .25 Regarding other reporting requirements outside of the financial statements, the staff would expect discussion of material contingencies and uncertainties in the Management Discussion and Analysis section of a filing if such matters had a significant impact on the results of operations or are indicative of trends that could impact the business in the future. Additionally, the disclosures made about a particular matter in the "Legal Proceedings" section of the filing and the disclosures related to that matter in the footnotes to the financial statements may be different, as those disclosures have different objectives. The legal proceeding disclosure is more prescriptive in nature and triggered by a specific quantitative threshold (claim amounts greater than 10% of current assets), whereas the GAAP disclosures are intended to be more of an analysis regarding the likelihood of loss, the nature of the case, and a quantification of possible losses. PwC Observation: The SEC staff's views that the disclosures should become more robust as the life cycle of a case progresses, the ability to aggregate disclosures, and the prohibition on offsetting contingent losses with potential insurance recoveries, are all consistent with the guidance included in the FASB's proposal.
IASB loss contingencies project

.26 While the scope of the Board's proposal is limited to disclosures of loss contingencies, the International Accounting Standards Board (IASB) has an active project to reassess the recognition, measurement, and disclosure aspects of its standard on loss contingencies. Despite the similar timing, the Board's project and the IASB's project are not being conducted jointly. The IASB issued an exposure draft with its proposal in January 2010, with a comment period that ended in May 2010. The IASB began the process of evaluating the comment letters received and redeliberating certain aspects of the proposal in October 2010, but has postponed further redeliberations until the second half of 2011. Based on its published timeline, the IASB plans to expose a revised proposal during the second half of 2011. PwC Observation: Companies reporting under U.S. standards may have an interest in the IASB's proposal even though it is not part of a joint project with the FASB. With the trend towards having converged U.S. and international standards, the decisions made by the IASB could influence any future project to reassess the accounting for loss contingencies under U.S. standards.
Questions
.27 PwC clients that have questions about this DataLine should contact their engagement partners. Engagement teams that have questions should contact the National Professional Services Group (1-973-236-7804).
DataLine 2010-32
Authored by:
John R. Formica, Jr. Partner Phone: 1-973-236-4152 Email: john.r.formica@us.pwc.com Kevin McManus Senior Manager Phone: 1-973-236-5573 Email: kevin.m.mcmanus@us.pwc.com
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US GAAP Convergence and IFRS

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US GAAP Convergence and IFRS

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August 2012

Setting the standard

September 25, 2012

Progress continues, but is convergence closer?

FASB projects see continued momentum

SEC staff weighs in on IFRS

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Setting the standard

Q4 2012 ED (1) ED R (2)

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Setting the standard

FASB takes a different direction on impairment

A joint impairment model is proving difficult to achieve.

Boards reach additional classification and measurement decisions

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Setting the standard

The boards stay on course with classification and measurement decisions.

Classification and measurement The final stretch?

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Setting the standard

Redeliberations take two

License transactionsthe debate continues

Where do redeliberations stand?

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Setting the standard

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Setting the standard

The dual approach

Alternative views may lead to future redeliberations.

Alternative views looming

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Setting the standard

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Setting the standard

Single margin to lock or unlock?

Transition boards land on retrospective

Exclude investment components from premiums and claims

Income statement presentation still looking for an answer

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Setting the standard 11

What did the proposal say?

Redeliberation decisions reached to date

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Setting the standard 12

FASB sharpens its guidance on investee funds

The definition of an investment company

Convergence differences may remain

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Setting the standard 13

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Setting the standard 14

Other FASB-only projects

Investment property entities still searching for a solution

Risk disclosures proposal comment letter period wraps up

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Setting the standard 15

Liquidation basis of accounting striving for consistency and comparability

Going concern FASB taking another look

Private company decision-making framework taking steps forward

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Setting the standard 16

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Setting the standard 17

Disclosure framework a cure for disclosure overload?