FINANCIAL REPORTING FLASH REPORT

Transcription

1 FINANCIAL REPORTING FLASH REPORT First Quarter Changes Driven by International Convergence and Transparency March 21, 2006 Recent headlines reported 2005 to be another record breaking year for financial statement restatements many driven by international companies implementing the new International Financial Reporting Standards, but numerous others resulted from issues arising from the application of current standards, rules and guidance. These events make external auditors even more focused on assessing a company s application of accounting principles and its internal control over financial reporting. In preparing for 2006 s first interim reporting period, companies should carefully assess new rules and standards that become effective during 2006 and most importantly, those required to be implemented during this first interim or quarterly report (different effective dates for standards may apply to fiscal year or small business filers). Significant areas of current and future change that may command additional attention and resources for many companies are discussed below. Companies should carefully consider whether each area is applicable to their respective facts and circumstances and whether circumstances have changed that may require current implementation of a previously effective Financial Accounting Standard (FAS). Current Changes (Effective for most companies January 1, 2006) Corrections of Errors and Accounting Changes Consistency of terminology improves a reader s understanding of financial statements when adjustments are presented for errors, changes in estimates and implementing new standards. FAS 154, Accounting Changes and Error Corrections A Replacement of APB Opinion No. 20 and FASB Statement No. 3, establishes and defines such terminology: Retrospective Adjustment In the absence of explicit transition provisions provided for in new or existing pronouncements, changes in accounting principle should be applied retrospectively to prior period financial statements, unless it is impracticable. Gone is the previous approach of recognizing changes in accounting principles by reporting a cumulative effect of the new accounting principle in net income of the period of the change Protiviti Inc. All Rights Reserved.

2 Restatement Correction of an error in previously issued financial statements should be disclosed as a "restatement", with the correction reflected in the period during which it occurred or the cumulative effect of the restatement presented in the earliest period presented in the financial statements. Change in Estimate While changes in estimate continue to be reported prospectively, this standard now defines a change in depreciation method as a change in estimate. Change in Reporting Entity When the financial statements are essentially those of a different entity, the change shall be retrospectively applied to all periods presented. New Leases / Construction Period Rentals Entering into a new ground or building lease can result in recognizing expense even before the stated lease term or any lease payments become due. While allocating lease costs across the life of the lease (including the period prior to the commencement of rent payments) has been the standard for quite sometime, the application in practice of expensing versus capitalization of these costs has been diverse. A new FASB Staff Position (FSP) FAS 13, Accounting for Rental Costs Incurred during a Construction Period, now redefines the life of the lease to include the period in which specified improvements or changes to the leased asset occur prior to occupancy or the contractually stated lease term. If a lessee is granted access or control of the property to enable construction or inspection of constructed improvements managed by the lessor, this construction period can extend the life of the lease requiring rental costs to be allocated and expensed beginning with the commencement of the construction period. This standard is required to be implemented prospectively for leases signed during Inventory A new standard (FAS 151, Inventory Costs an amendment of ARB No. 43, Chapter 4) redefines overhead costs that can be allocated or included in the cost of inventory. Costs including excess freight, spoilage, rehandling costs, idle facility expense, etc., are now defined as "abnormal costs" and are required to be expensed as incurred. Further, the standard specifies that fixed production overheads should be allocated to conversion costs based on "normal capacity" of the production facilities. Care should be taken when implementing the new definitions of "normal capacity" and abnormal costs ; since both impact standard cost systems and the recognition of costs when actual production varies from normal capacity. More specifically, normal production refers to the range of production levels expected to be achieved over a number of periods under normal circumstances, taking into account planned maintenance capacity losses. Non-monetary Asset Exchanges Generally, exchanges of non-monetary, productive assets should be measured based on the fair value of the assets exchanged, unless the exchange lacks commercial substance. New rules set forth by FAS 153, Exchanges of Non-monetary Assets an amendment of APB Opinion No. 29, provide guidance on whether gains or losses should be recognized when companies swap income-producing assets for other incomeproducing assets. Further, a significant change of future cash flows as a result of the - 2

3 exchange provides evidence of commercial substance and triggers the requirement to measure the transaction at fair value. The new standard eliminates the fair value measurement exception for exchanges of similar productive assets and serves to improve international comparability by converging U.S. and International GAAP. The standard does not apply to transfers where the transferor continues to have some risk and/or reward of ownership - such as the forming of a joint venture, or a carried interest in an oil and gas well. Prospective application is required under FAS 153. Investment Impairment Controversial proposed implementation guidance (EITF 03-1) addressing when and why companies should recognize other-than-temporary impairment is now superseded with FSP and 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. These new requirements clarify that: Assessing investment impairment is required each reporting period and at an individual security level. An investment is impaired if its fair value is less than its cost as adjusted for accretion, amortization, previous impairments and hedging. Impairment losses are recognized and written down to fair value when determined to be "other than temporary. An other-than-temporary impairment occurs before an actual sale and must be recognized even if a decision to sell has not been made. Impairment assessment requires consideration of all factors and an investor's intent. This FSP also provides accounting considerations subsequent to recognizing an impairment and disclosures about unrealized losses for temporary impairments. Earnings Per Share The SEC s changes to Topic D-98 states increases or decreases in the carrying amount of a redeemable common stock should not affect income applicable to common shareholders. To the extent a common shareholder has a legal right to redeem a share (other than upon ordinary liquidation) at an amount not equal to the fair value; the SEC has determined the redemption right represents a preferential distribution. When a class of common stock is redeemable at other than fair value, increases or decreases in the carrying amount of that redeemable security should be reflected in earnings per share determinations pursuant to the two-class method addressed in FAS 128 and EITF The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. This guidance should be applied in the first fiscal period after September 15, 2005 with prior period earnings per share amounts retrospectively adjusted for comparative purposes. Convertible Debt Two EITF consensuses provide clarifications related to financial reporting for convertible debt. EITF 05-7 prescribes measuring the change in fair value upon modification of a conversion option considering both the intrinsic and time value components of the option. These components must be considered in determining whether debt extinguishment has occurred. EIFT 05-8 concludes that convertible debt with in-themoney non-detachable conversion features has a temporary basis difference for - 3

4 purposes of reporting income tax consequences. The temporary difference results from financial reporting effectively creating two separate instruments a debt instrument and an equity instrument, while tax reporting accounts for it only as a debt instrument, effectively resulting in different book and tax bases. Planning Ahead (Effective in future periods) When addressing a new standard or rule that requires considerable analysis and effort, management must often pause and consider appropriate strategies and processes. The combination of new standards and proposed rules around executive compensation is one such area. Share-Based Compensation Effective during 2006, many companies have already addressed this complex principlebased standard, but many other companies have yet to begin. This standard is requiring considerably more time and resources to implement than initially thought. Implementation complexities increase due to such factors as: Difficulty in developing adequate historical support of assumptions Stock options and other share-based compensation plans extended to numerous employee groups Business combinations with conversions of predecessor stock compensation programs Activities resulting in capitalized labor Net tax operating loss carry-forwards Loss of control or other cash out and early vesting provisions In summary, this standard requires recognition in the financial statements of compensation costs relating to share-based payment transactions, including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. Cost measurement should be based on the fair value of the equity or liability instruments issued. Fair value requires developing estimates regarding expected volatility of the reporting company's share price and the exercise behavior of its employees. Classification of the instrument issued requires consideration of the requirements of FAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, and FAS 133, Accounting for Derivative Instruments and Hedging Activities. Executive Compensation A recent speech by SEC commissioner Cynthia Glassman recognizes that under our current disclosure rules, it is often difficult for investors to figure out exactly how much company executives are paid. This recognition corresponds to new proposed SEC rules to make disclosure of executive compensation clearer and more comprehensive. Specifically, the rules, if adopted without change, would require detail disclosure of total compensation for the CEO, CFO and three other highest paid executive officers, directors and in certain cases three other highly compensated non-executives. Although these rules are still early in the proposal stage, management should gain familiarity with them and begin to establish a process for gathering and reporting the necessary - 4

5 information. Early preparations would enable easier implementation when the rules become effective. Purchases and Sales of Inventory with the Same Counterparty In the second quarter of 2006, companies need to implement EITF 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty, which addresses two questions involving inventory transactions: When two or more purchase and sale transactions should be viewed as one single transaction, and Whether the exchange should be recognized at fair value. Generally, purchase and sale transactions of raw material or work-in-process inventory entered into and contingent upon, or in contemplation of, one another should be combined and evaluated further as non-monetary exchange transactions. Further, if finished goods are exchanged for raw materials or work-in-process inventory in the same line of business, the company transferring the finished goods should recognize the transaction at fair value if such value is reasonably determinable and the transaction has commercial substance. All other non-monetary exchanges of inventory in the same line of business should be measured at the book value of the inventory transferred. The consensus should be applied to new arrangements entered into, as well as modifications or renewals of existing agreements. Hybrid Financial Instruments Although not required to be implemented until a company s first interim period of its fiscal year beginning after September 15, 2006, FAS 155, Accounting for Certain Hybrid Financial Instruments, provides simplicity for companies previously having to bifurcate and separately account for certain embedded derivatives. To early implement this standard, calendar year filers must implement the standard in their first quarter report. This new standard resolves and simplifies, among others, the following key issues: Permits fair value measurement for hybrid financial instruments containing certain embedded derivatives, eliminating the need for bifurcation; Clarifies that interest-only and principle-only strips are not subject to FAS 133 Accounting for Derivative Instruments and Hedging Activities; and Eliminates the prohibition for holding passive derivative instruments by qualifying special purpose entities. Provisions of this statement may be applied on an instrument-by-instrument basis for instruments held at the date of adoption. On the Radar In February, Robert Herz, Chairman of the FASB, announced renewed affirmation between the FASB and IASB to work together to bring about a common set of accounting standards that will enhance the quality, comparability and consistency of global financial reporting. The following highlights progress on key agenda items: Business Combinations While deliberations continue of the June 2005 Exposure Draft, Business Combinations, FASB decided to explore developing a new definition of a business combination and agreed that the formation of a joint venture should be excluded from the scope of the business combinations final Statement. - 5

6 Uncertain Tax Positions The Board recently decided that the measurement attribute for the amount of recognized tax benefit should be the maximum amount which is more likely than not to be realized. Fair Value Measurement The Board is scheduled to discuss clarifying aspects of the guidance included in its October 21, 2005 working draft of the fair value measurements final statement, as well as the effective date and timing of the final statement later this month. Top Questions to Ask this Reporting Period: Standards often apply across many industries and in ways that are not always initially obvious. Issues can arise from not asking appropriate questions. The following are broad questions to consider related to new standards, rules or guidance for the current reporting period: Were any leases entered into during 2006 for which improvements will be made by or on behalf of the company prior to the inception of occupancy? Do inventory values include any abnormal overhead costs? Have there been any non-monetary exchanges of productive assets? Has there been a change in depreciation or amortization methods? Are there any contractual commitments related to revenue performance, minimum payments or compensation? At the individual security level, is there a potential for impairments when considering the net carrying value? Does the company have any hybrid financial instruments that qualify for simplified reporting under new standards? If the company has debt with conversion features, have there been any modifications to those features? Coming Next Quarter Next quarter we will discuss, among other topics, recent consensuses of the Emerging Issues Task Force related to debt conversion, policy for sales taxes, accounting for sabbatical leave, payments made by service providers, accounting for planned major maintenance, and discussions related to split-dollar life insurance. Summary This quarterly reporting period requires companies to carefully address a number of new accounting and reporting standards and rules. In addition to addressing the reporting aspects of these new standards and rules, companies must also demonstrate controls over such changes. In doing so, companies should address two key points. First, assess the applicability of new principles or rules and the implementation approach. Second, document controls related to key implementation decisions, including estimates. Additional discussion of new financial accounting standards may be found at Protiviti is not a CPA Firm, nor do we provide accounting opinions. - 6