Board Meeting Handout Insurance Targeted Improvements to Accounting for Long-Duration Contracts August 27, 2014

Transcription

1 Board Meeting Handout Insurance Targeted Improvements to Accounting for Long-Duration Contracts August 27, 2014 PURPOSE OF THIS MEETING 1. At the April 16, 2014 meeting, the Board decided to consider certain targeted improvements to the accounting for long-duration contracts. The purpose of the August 27, 2014, decision-making meeting is to discuss the following topics related to the liability for future policy benefits: (a) Whether assumptions should be updated periodically (b) If assumptions should be updated, how often they should be updated (c) If assumptions should be updated, how the effects of the changes in assumptions should be recognized in the financial statements (d) If assumptions should be updated, whether the provision for adverse deviation should be included in the calculation of the liability for future policy benefits (e) What discount rate(s) should be used to reflect the time-value of money in the calculation of the liability for future policy benefits (f) Whether clarification is needed about using a yield curve or a single discount rate to discount the liability for future policy benefits (g) If all assumptions are updated periodically, whether the premium deficiency test should be required (h) If the premium deficiency test is required, whether the level of aggregation for performing the premium deficiency test should be clarified (i) If the premium deficiency test is required, whether additional disclosures also should be required, such as the current loss recognition margin, level The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations. Page 1 of 10

2 of aggregation, significant assumptions, and the amount of premium deficiency recognized during the period. ISSUE 1: ASSUMPTIONS 2. For traditional long-duration contracts, limited-payment contracts, and participating life insurance contracts, assumptions for measuring future policy benefit liabilities (such as investment return, mortality, morbidity, termination [lapse], and expense assumptions) are locked in at policy inception and unlocked or reset only if a premium deficiency emerges. Additionally, a provision for adverse deviation is included in the measurement of the liability for future policy benefits, which allows for possible unfavorable deviations from the locked-in assumptions. 3. Because long-duration contracts may remain in force for 30 years or longer, this may result in significant differences between initial assumption estimates and current assumption estimates. 4. For universal life-type contracts with features that provide for potential benefits in addition to the account balance that are payable only upon annuitization (for example, guaranteed minimum income benefits) and that are not accounted for under the provisions of Subtopic , Derivatives and Hedging Overall, or Subtopic , Derivatives and Hedging Embedded Derivatives, an additional liability for the contract feature is established if the present value of expected annuitization payments at the expected annuitization date exceeds the expected account balance at the expected annuitization date. Also, for universal life-type contracts with death or other insurance benefit features (for example, guaranteed minimum death benefits and no-lapse guarantees), if the amounts assessed against the contract holder each period for the insurance benefit feature are assessed in a manner that is expected to result in profits in earlier years and losses in subsequent years from that feature, an additional liability for unearned revenue is recognized in addition to the policyholder account balance. A provision for adverse deviation is not included in the liability for future policy benefits. Insurance entities are required to regularly evaluate estimates used and adjust the Page 2 of 10

3 additional liability balance if actual experience or other evidence suggests that earlier assumptions should be revised. Changes are recorded in the statement of comprehensive income. 5. Consistent with the guidance in the revised 2013 IASB Exposure Draft, Insurance Contracts, the guidance in the proposed FASB Accounting Standards Update, Insurance Contracts (Topic 834), would have required a reporting entity that issues long-duration insurance contracts to update assumptions each reporting period to reflect all available information at the end of the reporting period regarding the amount, timing, and uncertainty of the remaining future cash flows. 6. The guidance in the proposed Update would have required reporting entities to recognize changes in the fulfillment cash flows 1 due to changes in the discount rate in other comprehensive income as well as all other changes in fulfillment cash flows in net income. A. Whether Assumptions Should Be Updated Periodically 7. To potentially address the issue of whether assumptions should be updated for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts, the staff has identified the following three alternatives: (a) Alternative A An insurance entity should update all assumptions and recognize changes in the liability periodically, and disclose information about the liability for future policy benefits and the assumptions used. (b) Alternative B An insurance entity should only update discount rates and recognize changes in the liability periodically, and disclose information about the liability for future policy benefits and the assumptions used. (c) Alternative C An insurance entity should disclose information about the liability for future policy benefits and a comparison of original assumptions with current information. 1 Fulfillment cash flows are defined in the proposed Update as the present value of the unbiased, probability-weighted estimate of the future cash flows that will arise as an entity fulfills the insurance contract. Page 3 of 10

4 Questions for the Board 1. Does the Board believe that assumptions used to calculate the liability for future policy benefits for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts should be updated periodically? B. If Assumptions Should Be Updated, How Often They Should Be Updated 8. If the Board believes that assumptions used to calculate the liability for future policy benefits for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts should be updated periodically, the staff has identified the following three alternatives for the frequency with which insurance entities should update the assumptions: (a) Alternative A An insurance entity should update assumptions each reporting period. (b) Alternative B An insurance entity should update assumptions annually. (c) Alternative C An insurance entity should regularly evaluate and update assumptions if actual experience or other evidence suggests that revisions are necessary. Page 4 of 10

5 Questions for the Board 2. If the Board believes that assumptions used to calculate the liability for future policy benefits for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts should be updated periodically, does the Board believe that these assumptions should be (a) updated each reporting period, (b) updated annually, or (c) regularly evaluated and updated if actual experience or other evidence suggests that revisions are necessary? 3. If the Board believes that assumptions used to calculate the liability for future policy benefits for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts should be updated either at each reporting period or annually, does the Board also believe that the same guidance should apply to assumptions used to calculate the additionally liability for universal life-type contracts? 4. If the Board believes that insurance entities should update assumptions annually, does the Board also believe that insurance entities should update assumptions at the same time every year? 5. If the Board believes that insurance entities should either update assumptions annually or regularly evaluate and update assumptions when revisions are necessary, does the Board also believe that insurance entities should (a) provide disclosures about the accounting policy for when assumptions are reviewed and updated and (b) provide disclosures in the period in which assumptions are updated and at year-end? C. If Assumptions Should Be Updated, How the Effects of the Changes in Assumptions Should Be Recognized in the Financial Statements 9. If the Board believes that assumptions used to calculate the liability for future policy benefits for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts should be updated periodically, the staff has identified the following three potential alternatives for how insurance entities should recognize the effects of changes in assumptions in the financial statements: (a) Alternative A An insurance entity should recognize the effects of changes in assumptions (other than discount rates) in net income. The effects of changes in discount rates should be recognized in other comprehensive income (OCI). Page 5 of 10

6 (b) Alternative B An insurance entity should recognize the effects of changes in assumptions in net income. (c) Alternative C An insurance entity should recognize the effects of changes in assumptions in net income. However, an insurance entity may choose to present the effects of changes in discount rates in OCI as its accounting policy. Question for the Board 6. If the Board believes that assumptions used to calculate the liability for future policy benefits for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts should be updated periodically, how should changes in assumptions be recognized in the financial statements? D. If Assumptions Should Be Updated, Whether the Provision for Adverse Deviation Should Be Included in the Calculation of the Liability for Future Policy Benefits 10. Existing generally accepted accounting principles (GAAP) guidance for longduration contracts prescribes that a provision for adverse deviation is included in the measurement of the liability for future policy benefits for traditional longduration contracts, limited payment contracts, and participating life insurance contracts. This allows for possible unfavorable deviations from assumptions that are locked in at inception of the contracts. A provision for adverse deviation is not included in the measurement of the liability for future policy benefits for universal life-type contracts. Question for the Board 7. Does the Board believe that a provision for adverse deviation should not be included in the calculation of the liability for future policy benefits for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts if assumptions are updated periodically? Page 6 of 10

7 ISSUE 2: DISCOUNT RATE 11. The Long-Duration Subsections in Subtopic , Financial Services Insurance Claim Costs and Liabilities for Future Policy Benefits, require insurance entities to reflect (a) the time value of money in the measurement of the liability for future policy benefits (traditional long-duration contracts and limitedpayment contracts), (b) any additional liability included in the liability for future policy benefits (universal life-type contracts with annuitization benefits, or with death or other insurance benefit features), and (c) any net level premium reserve or terminal dividends included in the liability for future policy benefits (participating life insurance contracts). 12. In general, Subtopic requires that insurance entities use an asset rate when discounting the liability for future policy benefits. For example, the discount rate used to calculate the liability for future policy benefits for traditional longduration contracts and limited payment contracts is the expected investment yield, which is defined in the Master Glossary of the FASB Accounting Standards Codification as the interest rate the entity expects to earn on the assets supporting the policies, net of investment expense. Subtopic does not specify whether the discount rate(s) used should be a single rate or should be calculated using a yield curve. 13. Similar to the revised 2013 IASB Exposure Draft (considering the recent IASB tentative decisions reached during redeliberations), the guidance in the proposed Update would have required reporting entities to reflect the time value of money in the measurement of the fulfillment cash flows using discount rates that reflect the characteristics of the insurance contract liability and that: (a) Are consistent with observable current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability in terms of, for example, timing, currency, and liquidity. (b) Exclude any factors that influence the observed rates but that are not relevant to the insurance contract liability, for example, risks that are not Page 7 of 10

8 present in the liability but that are present in the instrument for which the market prices are observed. 14. Additionally, the guidance in the proposed Update described two approaches for calculating discount rates: the top down approach or the bottom up approach. E. What Discount Rate(s) Should Be Used to Reflect the Time Value of Money in the Calculation of the Liability for Future Policy Benefits 15. To address what discount rates should be used to reflect the time value of money in the liability for future policy benefits, the staff has identified the following alternatives: (a) Alternative A The discount rates should be asset rates, consistent with existing guidance in Topic 944. (b) Alternative B The discount rates should reflect the characteristics of the liability, consistent with the guidance in the proposed Update. (c) Alternative C The discount rates should be an insurance entity s incremental borrowing rate. Questions for the Board 8. What discount rate(s) does the Board think should be used to reflect the time value of money in the liability for future policy benefits? 9. If the Board believes that asset rates should be used to reflect the time value of money in the liability for future policy benefits, does the Board also want to consider what additional implementation guidance should be provided on how to calculate the discount rate(s)? 10. Does the Board believe that insurance entities should disclose (a) the discount rates used to reflect the time value of money in the liability for future policy benefits and (b) qualitative information about the methods used to calculate discount rates? Page 8 of 10

9 F. Whether Clarification Is Needed about Using a Yield Curve or a Single Discount Rate to Discount the Liability for Future Policy Benefits 16. Existing GAAP does not specify that an insurance entity should use a yield curve to reflect the time value of money in the liability for future policy benefits. However, the guidance in the proposed Update specified that a yield curve should be used in the top down approach to discount the cash flows of insurance liabilities. Questions for the Board 11. Does the Board believe that clarification is needed about whether insurance entities should use a yield curve or a single rate to discount the liability for future policy benefits? 12. If so, does the Board believe that a yield curve or a single rate should be used? ISSUE 3: PREMIUM DEFICIENCY AND LOSS RECOGNITION G. If All Assumptions Are Updated Periodically, Whether the Premium Deficiency Test Should Be Required 17. Insurance entities perform the premium deficiency test by calculating the liability for future policy benefits using current assumptions and comparing the result with the liability for future policy benefits and unamortized acquisition costs at the valuation date. The purpose of this test is to determine if the liability for future policy benefits calculated using original assumptions is still sufficient to (a) cover the present value of future benefits to be paid to or on behalf of policyholders and settlement and maintenance costs and (b) recover unamortized acquisition costs. Question for the Board 13. If the Board believes that all assumptions should be updated periodically, does the Board also believe that a premium deficiency test should not be required? H. If the Premium Deficiency Test Is Required, Whether the Level of Aggregation for Performing the Premium Deficiency Test Should Be Clarified 18. Existing GAAP guidance requires insurance entities to group insurance contracts consistent with the entity's manner of acquiring, servicing, and measuring the Page 9 of 10

10 profitability of its insurance contracts to determine if a premium deficiency exists. However, existing GAAP guidance also states that a premium deficiency, at a minimum, shall be recognized if the aggregate liability on an entire line of business is deficient. 19. To potentially address the level of aggregation used to perform the premium deficiency test, the staff has identified the following three alternatives: (a) Alternative A Insurance contracts should be grouped by product type, for each operating segment as defined in Subtopic , Segment Reporting Overall. (b) Alternative B Insurance contracts should be grouped by line of business. (c) Alternative C Insurance contracts should be grouped consistent with the entity's manner of acquiring, servicing, and measuring the profitability of its insurance contracts. Question for the Board 14. If the Board believes that the premium deficiency test should be required, does the Board also believe that the level of aggregation used should be clarified? I. If the Premium Deficiency Test Is Required, Whether Additional Disclosures Also Should Be Required 20. There are no required disclosures about the premium deficiency and loss recognition testing and the amount of premium deficiency recorded. Question for the Board 15. If the Board believes that the premium deficiency test should be required, does the Board also believe that insurance entities that issue long-duration contracts should provide additional disclosures about premium deficiency and loss recognition? If so, what additional disclosures should be required? Page 10 of 10

11 Board Meeting Handout Leases August 27, 2014 PURPOSE OF THIS MEETING 1. The purpose of this meeting is to discuss the following Topics: (a) (b) (c) (d) Nonpublic Business Entity Discount Rate Considerations Related Party Leasing Transactions Accounting for Sale and Leaseback Transactions Leveraged Leases. TOPIC 1: NONPUBLIC BUSINESS ENTITY DISCOUNT RATE CONSIDERATIONS 2. The guidance in the 2013 proposed FASB Accounting Standards Update, Leases (Topic 842), introduced a specified relief for nonpublic business entities lessees that would permit an accounting policy election for the initial and subsequent measurement of all lease liabilities. Under that election, when measuring lease liabilities at present value, those liabilities could be discounted using a risk-free rate. The risk-free rate would be determined by using a period comparable with the lease term, and the lessee would disclose in the footnotes the use of the accounting policy election for all leases. 3. The use of a risk-free rate is a practical expedient that would continue to provide relevant information to users of private company financial statements while addressing the cost and complexity concerns of determining either the rate the lessor charges the lessee or a nonpublic business entity s incremental borrowing rate. The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations. Page 1 of 6

12 4. The staff recommends that the FASB retain the accounting policy election to use the risk-free rate for nonpublic business entities. Questions for the Board 1. Does the FASB want to retain the risk-free rate accounting policy election for entities other than public business enterprises (that is, nonpublic business entities)? 2. If not, does the FASB want to eliminate that election or revise that election (for example, by allowing nonpublic business entities to measure their lease liabilities on an undiscounted basis)? TOPIC 2: RELATED PARTY LEASING TRANSACTIONS 5. The guidance in the 2013 proposed Update stated that the recognition and measurement requirements for all leases should be applied by lessees and lessors that are related parties on the basis of the legally enforceable terms and conditions of the lease, acknowledging that some related party transactions are not documented and/or the terms and conditions are not at arm s length. This eliminates the requirement under current generally accepted accounting principles (GAAP) for lessees to evaluate the economic substance of the lease to determine the appropriate accounting, as addressed in paragraph The proposed guidance also noted that lessees and lessors would be required to apply the disclosure requirements for related party transactions in accordance with Topic 850, Related Party Disclosures. 7. The staff recommends that the FASB retain the related party guidance for all entities as it appeared in the 2013 proposed Update. Page 2 of 6

13 Question for the Board 3. Does the FASB want to retain the related party guidance that was proposed in the 2013 proposed Update? That is, does the FASB agree that related party leases should be accounted for on the basis of legally enforceable terms and conditions (rather than substance) and that the disclosures in Topic 850, Related Party Disclosures, should be applied? TOPIC 3: ACCOUNTING FOR SALE AND LEASEBACK TRANSACTIONS 8. At the July 2014 joint Board meeting on leases, the FASB and the IASB reached a number of tentative decisions regarding accounting for sale and leaseback transactions. 9. The FASB requested that its staff provide further analysis on the topics presented below. Repurchase Options in a Sale and Leaseback Transaction 10. Analysis was completed to clarify the effect of certain repurchase options, specifically those that permit a seller-lessee to repurchase the underlying asset in a sale and leaseback transaction at the fair market value of that asset at the date the repurchase option is exercised. 11. The staff is proposing the following alternatives with respect to this issue: (a) (b) Approach 1: Rely on the recently issued guidance in FASB Accounting Standards Update No , Revenue from Contracts with Customers (Topic 606), regarding repurchase options in a sale and leaseback transaction, with certain clarifications. Approach 2: Provide separate guidance in the final leases standard with respect to seller-lessee repurchase options in a sale and leaseback transaction. 12. The staff recommends Approach 1. Page 3 of 6

14 Application Guidance for Determining Whether a Sale Has Occurred in a Sale and Leaseback Transaction 13. Analysis was completed to determine whether, and if so, what additional application guidance the FASB should include in the final leases standard to assist entities in determining whether a sale has occurred in the context of a sale and leaseback transaction. 14. The staff recommends that additional application guidance should be included in the final leases standard to assist entities in determining whether a sale occurs in the context of a sale and leaseback transaction. Accounting for Failed Sale and Leaseback Transactions 15. Analysis was completed on how to account for a failed sale and leaseback transaction. The guidance in the 2013 proposed Update stated that an entity would account for a sale and leaseback transaction as a sale of the underlying asset and a leaseback of that underlying asset only if that transaction qualifies as a sale in accordance with the guidance in Update on revenue recognition. If the transaction does not qualify as a sale, an entity would account for the entire transaction as a financing transaction. 16. The staff recommends that the FASB reaffirm the proposals in the 2013 proposed Update on leases. In addition, the staff recommends that the FASB provide explicit application guidance consistent with current interpretive guidance that would prevent negative amortization of the financial liability in a failed sale and leaseback transaction. Page 4 of 6

15 Questions for the Board Repurchase Options in a Sale and Leaseback Transaction 4. Does the FASB prefer Approach 1 or Approach 2 with respect to considering repurchase options in the context of a sale and leaseback transaction? 5. If the FASB prefers Approach 2, does the FASB agree with restricting application of Approach 2 (that is, adopting guidance specific to repurchase options in the context of a sale and leaseback transaction) to those circumstances in which the leaseback is substantive? 6. If the FASB prefers Approach 2, which repurchase options (for example, fair market value repurchase options, any nonbargain purchase option, etc.) does the FASB think should not preclude sale accounting in the context of a sale and leaseback transaction? Application Guidance for Determining Whether a Sale Has Occurred in a Sale and Leaseback Transaction 7. Does the FASB want to include additional application guidance with respect to determining whether a sale occurs in the context of a sale and leaseback transaction (for example, additional detail in the sale and leaseback examples, discussion of how to consider the control principle in this context in the basis for conclusions, and/or more explicit application guidance linking back to key parts of the new guidance in Update on revenue recognition) in the final leases standard? Accounting for Failed Sale and Leaseback Transactions 8. Does the FASB want to reaffirm the proposal in the 2013 proposed Update on leases that the seller-lessee and the buyer-lessor should account for a failed sale and leaseback transaction as a financing? If not, what does the FASB prefer? 9. Does the FASB want to add explicit application guidance requiring adjustment of the seller-lessee discount rate to ensure that (a) there is no negative amortization (that is, interest expense increasing the financial liability, which exceeds the payments reducing that liability) and (b) the carrying value of the underlying asset would not exceed the financing obligation at the end of the lease? Page 5 of 6

16 TOPIC 4: LEVERAGED LEASES 17. For a lease to be considered a leveraged lease under existing guidance, it must meet the criteria within paragraph The amendments in the 2013 proposed Update on leases did not retain the existing accounting model for leveraged leases. Furthermore, there was no specific transition guidance that allowed for the grandfathering of the accounting for existing leveraged lease transactions. 18. The staff is proposing the following alternatives for leveraged lease accounting: (a) Approach A: The lessor would continue to apply leveraged lease accounting as described in Topic 840 to existing and/or future leveraged lease transactions. (b) Approach B: The lessor should account for leveraged leases consistent with the new leases guidance (that is, the same as all other leases). Under Approach B, the FASB would need to consider whether to allow existing leveraged leases to be grandfathered or what additional transition guidance for leveraged leases would need to be provided in the new leases guidance. 19. The staff has a split recommendation on retaining leveraged leases. If the FASB decides not to retain leveraged lease accounting, all staff members would recommend allowing existing leveraged leases to be grandfathered in transition. Questions for the Board 10. Does the FASB want to retain leveraged lease accounting in the final leases standard? 11. If not, does the FASB want to grandfather existing leveraged lease transactions? Page 6 of 6

17 Board Meeting Handout Financial Statements of Not-for-Profit Entities August 27, 2014 PURPOSE OF THIS MEETING 1. At this meeting, the Board will discuss potential improvements to not-for-profit (NFP) entity-unique note disclosures. Specifically, the staff will ask the Board to decide on the following issues: (a) (b) (c) Whether salaries and benefits that are directly related to and netted against investment return should be disclosed within the detailed expense information tentatively required for all NFPs Whether additional information should be disclosed about an NFP s cost allocations and, if so, the nature and extent of that information Other potential improvements to notes that, at the June 18, 2014 Board meeting, the staff proposed the Board not address and the Board agreed. However, the Board instructed the staff to make the Not-for-Profit Advisory Committee (NAC) aware of those outcomes and see if there were any objections. The staff will report on additional feedback received from NAC members, Project Resource Group (PRG) members, and others and ask whether the Board now wishes to address any of those potential disclosure improvements. SALARIES AND BENEFITS EXPENSE DISCLOSURE Background Information 2. At its December 18, 2013 meeting, the Board tentatively decided to improve the reporting of expenses by requiring all NFPS to provide an analysis of all expenses by nature and function in one location, which could be provided in several ways, including on the face of the statement of activities, through a separate statement of expenses (currently called a statement of functional expenses), or a schedule in the notes. Based on tentative decisions reached to date, the Board has decided that investment expenses that are netted against The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

18 investment return need not be included and other nonoperating expenses (for example, interest and other financing expenses) need not be functionalized. 3. At its June 18, 2014 meeting, the Board also reaffirmed its tentative decision to (a) require external and direct internal investment expenses to be netted against the investment return and (b) remove the current disclosure requirement of paragraph that states an NFP shall disclose the amount of investment-related expenses netted against investment revenues if that amount is not disclosed on the face of the statement of activities. 4. Based on the tentative decisions reached to date, the staff noted that direct internal salaries and benefits that are netted against investment return are not required to be disclosed with the detailed expenses by function and nature. Consequently, the staff thinks the detailed analysis of expenses described in paragraph 2 would not include direct internal salaries and benefits that an NFP nets against investment return, especially if the entity chooses not to disclose the netted expenses on its activity statement. Therefore, the total salaries and benefits disclosed as part of the details of expenses by their nature would not reflect the full salaries and benefits expense incurred by the entity, which may be information desired by users. Therefore, the Board may wish to specifically require disclosure of this expense, despite previously deciding not to require disclosure of all investment expenses. Question 1 for the Board: Salary and Benefit Expense Disclosure 1. Does the Board believe the amount of direct salaries and benefits expense related to an NFP's investment activities is significant information that should be disclosed as part of the detailed analysis of expenses? Staff Analysis 5. The staff presents the following two alternatives for the Board s consideration: Alternative A: Require additional information to be disclosed (likely with the tentatively required detailed expense analysis) for the amount of internal salaries and benefits that are directly related to and netted with an NFPs investment return. Appendix A provides an illustration of the detailed expense disclosure with the inclusion of salaries and benefits. 2

19 Alternative B: Do not require additional information to be disclosed for the amount of internal salaries and benefits that are directly related to and netted with an NFP s investment return. COST ALLOCATION DISCLOSURE Background Information 6. As discussed above in paragraph 2, the Board tentatively decided to require NFPs to report expenses by nature and by function in one location, stating that the disclosure furthers the relevance and usefulness of the financial statements, while not imposing significant burden on preparers because the information is likely readily available. Related to disclosure of expenses by nature and by function, the staff was made aware that stakeholders are concerned that the lack of specific guidance on cost allocation may create incentive for some NFPs to misallocate expenses across program and support functions. This concern is heightened because functional expense ratios are often used as a benchmarking tool and for comparison purposes across NFPs. One of the most significant ratios used to assess an NFP s performance is often the program expense to total expense ratio, in which there is often an incentive to attribute expenses to program functions. To facilitate valid comparisons and increase the decision-usefulness of financial statements, users of financial statements should be able to understand the discretion NFPs have in cost-allocation decisions, as well as the types of expenses that have been allocated. To address the concern about the lack of cost-allocation disclosure, the staff would like to ask the Board the following: Question 2 for the Board: Cost-Allocation Disclosure 2(i). Does the Board want to require disclosure about cost allocations? If so, does it prefer qualitative disclosure or qualitative and quantitative disclosure? 2(ii). Does the Board want to refine the definition of management and general activities and the illustrative examples in the Codification? 3

20 Staff Analysis 7. To address the concern that users may have about the lack of cost-allocation disclosure, the staff presents three alternatives for the Board s consideration: Alternative A: Choose not to further address cost-allocation disclosure requirements on the basis that the decision to require a detailed functional expense schedule will improve reporting and provide sufficient transparency about expenses. Alternative B: Choose to further address cost-allocation disclosure requirements with the following options: (i) (ii) Require qualitative disclosure about cost allocation if the allocation is between both a program and a support function. Appendix B provides an illustration of a qualitative note disclosure. Require additional quantitative and/or qualitative disclosure on the cost allocation of support and program functions. Although natural expenses are broken out in the functional expense schedule, there is no requirement to show or explain the allocation of costs among the support and program functions. Qualitative disclosure could supplement the numeric information and report the basis for cost allocation. Appendix B provides an illustration of a note disclosure with both additional quantitative and qualitative information. Alternative C: Refine the Codification s definition of management and general activities and/or provide additional implementation guidance to better depict how support costs should be allocated among program functions, which would promote consistency and comparability. 8. The proposed changes to the definition and implementation are below: Management and General Activities Activities that are not identifiable with a single one or more program services, fundraising activity, or membership-development activity but that are indispensable to the conduct of those activities and to an entity s existence. The staff believes the focus on a single program in the definition could be misunderstood, and the latter section of the definition could raise unnecessary questions without providing any additional help. 4

21 9. The examples used in paragraph (with certain proposed amendments that have been underlined, and others to follow during drafting, that are necessary as a result of other tentative decisions) are as follows: Management and general activities include the following: a. Oversight b. Business management c. General recordkeeping d. Budgeting e. Financing, including unallocated interest costs pursuant to paragraph f. Soliciting funds other than contributions and membership dues, for example, the costs associated with: 1. Promoting the sale of goods or services to customers, including advertising costs 2. Responding to government, foundation, and other requests for proposals for customer-sponsored contracts for goods and services 3. Administering government, foundation, and similar customersponsored contracts, including billing and collecting fees and grant and contract financial reporting. g. Disseminating information to inform the public of the NFP s stewardship of contributed funds h. Making announcements concerning appointments i. Producing and disseminating the annual report j. Subparagraph superseded by Accounting Standards Update No jj. Recruiting and employee benefits (human resources) k. All other management and administration except for direct conduct of program services (see paragraphs through 45-5), fundraising activities (see paragraphs through 45-10), membership development activities (see paragraphs through 45-14). Additionally, as part of drafting the staff intends to provide illustrative examples of what is oversight versus what is the direct conduct of program services. 5

22 10. The staff believes the Codification already requires allocation of costs that benefit multiple programs or support functions, as outlined in As part of the aforementioned drafting, the staff plans to provide illustrative examples of what is meant by directly supervising, as discussed in the section below. The costs of oversight and management usually include the salaries and expenses of the governing board, the chief executive officer of the NFP, and the supporting staff. If such staff spend a portion of their time directly supervising [emphasis added] program services or categories of other supporting services, however, their salaries and expenses shall be allocated among those functions. 11. The purpose of the following paragraph is to clarify that the costs are allocable when there is a shared cost between two or more activities. The placement of this paragraph within the Codification will be determined during drafting. Certain costs are shared and identifiable with more than one function and could be allocated. An example of this is information technology, which is generally used in areas such as accounting and financial reporting, human resources, fundraising, and program delivery. Thus, the information technology costs would be allocated among the functional areas with direct benefit. TAX-EXEMPT STATUS DISCLOSURE Background 12. At the June 18, 2014 Board meeting, the staff recommended and the Board agreed not to address several note disclosure topics that were initially identified by the NAC, including whether NFPs should be required to disclose their tax-exempt status under the Internal Revenue Code. However, after soliciting feedback from NAC members, the Board s tentative decision not to address tax status received some pushback from respondents. 13. Some NAC respondents noted that disclosure of the tax-exempt status, including the subsection number, would help users and donors determine the deductibility of their charitable contributions. There presently is no requirement in the Codification applicable to NFPs, other than health care entities following Topic 954, to disclose their tax-exempt statuses. However, doing so has become an accepted practice over time, as observed by the staff in reviewing NFP financial statements. There is nothing in current guidance that would prevent an NFP from making this disclosure if it chose to make it. Because of the 6

23 feedback received, the staff would like the Board to consider the feedback on its decision not to require disclosure of tax-exempt status. Question 3 for the Board: Tax Status Disclosure 3. Does the Board wish to affirm its previous decision not to require disclosure of tax-exempt status? Staff Analysis 14. The staff presents three alternatives for the Board s consideration regarding disclosure of tax-exempt status: Alternative A: Require disclosure of tax-exempt status for all NFPs. Alternative B: Affirm the previous decision not to require the disclosure of the taxexempt status for any NFPs generally, and specifically remove the current requirement to require the disclosure for health care NFPs that follow guidance in Topic 954. Alternative C: Retain current generally accepted accounting principles (thus health care NFPs would be required to disclose their tax-exempt statuses and all other NFPs would not be required to disclose their tax-exempt statuses). NEXT STEPS 15. The August 27, 2014 Board meeting is the next to last scheduled decision-making meeting for the Financial Statements of Not-for-Profit Entities project. At this project s last scheduled Board meeting on September 17, 2014, the staff will present to the Board a discussion of costs, complexities, and benefits of all significant tentative decisions made and will request permission to begin drafting an Exposure Draft of a proposed Accounting Standards Update. Before the cost and complexity meeting, the NAC will meet on September 4 and 5, 2014, to discuss implications of the tentative decisions reached to date. Following the NAC meeting, the staff plans to report back to the Board the comments received from the NAC to further inform the Board of stakeholders feedback on the proposed amendments to the NFP reporting model. 16. Additionally, after the staff begins drafting, the staff expects to come back to the Board with any sweep issues for discussion and resolution, unless the Board prefers that the staff include the anticipated resolution of these issues as part of the ballot draft package. 7

24 Appendix A: Schedule of expenses with additional disclosure on salaries and benefits related to an NFP s investment activities The following is an example of what the detailed expenses disclosure could look like: Functionalization of Expenses The following chart shows Organization A s expenses by both function and nature for the year ended June 30, Investment related expenses that are netted against investment return on the statement of activities are not separately disclosed or included in the schedule below and are $2 for the year then ended. Program Activities Supporting Activities Total Operating Program A Program B Program C M&G Fundraising Expenses Nonoperating Expenses Total Expenses Salaries and benefits $22 $34 $25 $15 $9 $105 $1 $106 Professional service fees Supplies Other Interest 3 3 Total $30 $40 $30 $20 $10 $130 $8 $138 8

25 Appendix B: Cost-Allocation Illustrative Examples Alternative B(i): Require qualitative disclosure on cost allocation of natural expenses to program and support functions Expense Allocation The consolidated financial statements report certain categories of expenses that are attributable to more than one program or supporting function of the Organization. These expenses include depreciation and amortization, president s office, communications department, information technology department, and interest expense. Depreciation and amortization, and interest are allocated based on a square footage basis, the president s office is allocated based on a time and cost study of where efforts are made, certain costs of the communications department are allocated based on the benefit received, and the information technology department is allocated based on a cost study of specific technology utilized. 9

26 Alternative B(ii): Require additional quantitative and/or qualitative disclosure on cost allocation of support functions to program functions Expense Allocation The consolidated financial statements report certain categories of expenses that are attributable to more than one program or supporting function of the Organization. These expenses include depreciation and amortization, president s office, communications department, information technology department, and interest expense. Depreciation and amortization, and interest are allocated based on a square footage basis, the president s office is allocated based on a time and cost study of where efforts are made, certain costs of the communications department are allocated based on the benefit received, and the information technology department is allocated based on a cost study of specific technology utilized. Depreciation, president s office, communications, information technology, and interest that have been accounted for in Management & General have been partially allocated to Programs A, B, and C, and Fundraising and Development. Functional Expenses as Reported Allocations Made Program A $486,780 $95,000 Program B 530,678 50,000 Program C 423,093 60,000 Management and General 591, ,000 Fundraising and Development 320,157 20,000 Total $2,351,771 $ - 10

27 Tentatively Required Statement of Functional Expenses Business and charitable expenses Program A Program B Program C Subtotal Programs Management & General Fundraising & Development Subtotal Supporting Total Salaries and benefits $138,358 $126,379 $78,635 $343,372 $214,789 $34,589 $249,378 $592,750 Rental expense 102, ,974 89, , ,697 47, , ,572 Equipment rental and maintenance 94, , , ,886 95,643 39, , ,478 Depreciation and amortization 35,701 49,731 29, ,867 34, , , ,369 President's office 48,631 32,887 23, ,701 55,125 19,467 74, ,293 Communications 21,813 18,799 45,397 86,009 32,647 12,876 45, ,532 Information Technology 35,697 26,779 21,654 84,130 21,779 15,683 37, ,592 Total business and charitable expenses 477, , ,131 1,418, , , ,581 2,288,586 Nonoperating expenses Interest 9,237 5,347 7,962 22,546 13,254 27,385 40,639 63,185 Total expenses $486,780 $530,678 $423,093 $1,440,551 $591,063 $320,157 $911,220 $2,351,771 11