US GAAP Convergence and IFRS (1) .PDF - Adobe Reader

US GAAP Convergence & IFRS What you need to know about the FASB and IASBs joint projects
March 2011
Contents
1. Summary Document 2. Update (November 15, 2011) 3. Effective dates and transition methods 4. Update (November 30, 2011) 5. Financial instruments 6. Update (July 31, 2011) 7. Revenue recognition 8. Update (November 30, 2011) 9. Automotive 10.Engineering and construction 11. Entertainment and media
12.Healthcare 13.Industrial products and mfg 14.Pharmaceutical and life sciences 15.Retail and consumer 16.Technology 17.Telecommunications 18.Transportation and logistics 19.Leases 20. pdate (October 31, 2011) U 21.Fair value measurement 22.Update (July 31, 2011) 23.Statement of comprehensive income
24.Update (November 30, 2011) 25.Balance sheet offsetting 26.Update (June 30, 2011) 27.Pensions and postemployment benefits 28. Update (October 15, 2011) 29.Insurance contracts 30. pdate (August 15, 2011) U 31.Consolidation 32.Update (May 15, 2011) 33.Financial statement presentation 34.Contingencies
March 7, 2011
To our clients and friends: Memorandum of Understanding. Accounting convergence. Joint projects. These are the buzz words of today relating to the future of accounting and financial reporting. What do they mean to you? Changeand a lot of it! The Financial Accounting Standards Board and International Accounting Standards Board are currently working on roughly a dozen joint projects designed to improve both US and international accounting standards. The scale of the proposed changes and their potential impact on US companies are unparalleled. As standards change, companies may need new systems that can capture data, track contracts, and support processes to develop and assess complex estimates. Changes in balance sheet ratios and operating results may lead to renegotiating contracts such as debt agreements, royalty agreements and compensation agreements. Companies may want to reassess lease or buy decisions. Investor and stakeholder communication and education will be necessary, as the timing and pattern of revenue and expense recognition will change. The new standards will impact some companies more than others, but all companies will need to thoughtfully consider them. Enclosed is a compendium of our current convergence publications designed to provide you with one single reference resource as you manage the potential impact of the proposed standards on your company. Included are an overview of the standard-setting landscape, our point of view on effective dates and transition methods, technical insights on the standard setting projects, and discussions of what you can be doing now to prepare for these changes. While all of the joint projects as well as certain other projects are addressed, our primary focus is currently on the big threeleasing, revenue recognition and financial instruments. These are closest to completion and will impact a broad spectrum of companies in the nearer term. As developments unfold and standards move forward, we will post updates for you to print and add to this compendium on a dedicated websitewww.pwc.com/us/jointprojects. 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 & IFRS 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
Table of contents
The heart of the matter
US financial reporting is poised to undergo an unprecedented level of change
An in-depth discussion
Setting the standard: A spotlight on the FASB and IASBs joint projects
What this means for your business
30
A measured approach
March 2011
US financial reporting will undergo an unprecedented level of change within the next several years. The Financial Accounting Standards Board and International Accounting Standards Board are currently working on roughly a dozen joint projects with the goal of converging and improving both US and international standards. The boards strategy centers around a targeted completion date of June 2011 for the highest priority projects, including revenue recognition, leases, and financial instruments. The impacts will be broad and deepwell beyond financial reporting. The proposed standards have the potential to significantly impact revenue and expense recognition patterns as well as a companys reported assets and liabilities. Under the proposed revenue standard, the recognition of some revenue streams will accelerate while others will decelerate. Irrespective of the timing of revenue recognition, gross margin erosion will occur, as a result of the proposed incorporation of credit risk into the measurement of revenue.
Under the proposed leasing standard, all leases will result in the recognition of lease assets. At the same time, increased volatility and changes in expense and revenue recognition patterns may significantly impact a number of ratios (e.g., leverage ratios) and measures (e.g., EBITDA) used by companies for a variety of purposes, ranging from determining compensation for employees to valuing a business in a structured transaction. Contracts, such as debt and compensation agreements, may require adjustment as a result of changes in financial ratios and reported results. In addition, companies will need to ensure their systems, processes and controls can accommodate the proposed accounting models. The proposed leasing standards will require companies to capture and update detailed data for all of their leases. Many companies do not currently have a systematic method in place. The proposed revenue standard is expected to require a considerable amount of estimation, specifically related to the recognition of variable or uncertain consideration (e.g., royalty revenue, usage based fees, and trade discounts). Effective processes and controls will need to be in place around these estimates. Companies may need entirely new systems or modifications to existing systems to ensure they can capture data, track contracts and support processes to develop and assess complex estimates.
Other important stakeholders will also feel an impact. The increased level of judgment inherent in the proposed standards will make it more challenging for companies to provide guidance to analysts. Rating agencies have already started to estimate how much debt will be added to a companys balance sheet as a result of the proposed leasing standard. Communication with these stakeholders is essential, to help them understand the business implications and other effects of the changes. Not all companies will be equally impacted by these proposed standards. Companies with less flexible systems may have a more difficult time. Complex multinational companies will have more challenges obtaining all required data than less complex or predominantly domestic companies. That being said, the adoption of these standards will take a considerable amount of time and effort for all companies. It will be important to investors that companies implement the proposed standards properly and cost effectivelythe first time. This publication is designed to help readers develop an understanding of the major convergence projects and provide a perspective on what companies can and should be doing now in relation thereto. The projects are ongoing; as new details emerge, we will post updates at www.pwc.com/ us/jointprojects.
Setting the standard: A spotlight on the FASB and IASBs joint projects*
* Reprinted from the March 4, 2011, edition of Setting the standard
What you need to know about the FASB and IASBs joint projects
Welcome to the current edition of Setting the standard, our publication designed to keep you informed about the most recent developments on the joint standard-setting activities of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). In our December 2010 edition, we reported that the boards had recalibrated their work plan to focus on the priority projects. Two of those projects, fair value measurement and statement of other comprehensive income, are poised for release. Now, the big three remainfinancial instruments, revenue recognition, and leases. The IASB is also working to slay its monster project on insurance contracts, with the FASB closely engaged in the discussion. Whether you are a silent spectator or a vocal participant, the intensity is palpable. The boards continue their sprint toward the targeted June 30, 2011 finish line, carefully navigating the hurdles along the way. Developing high quality standards is a time-consuming task and unexpected bumps in the road can slow progress. Will the boards beat the clock, or will overtime be needed? Only time will tell, but the action has been fast and furious.
Whats inside: What you need to know . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Joint projects timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Balance sheet offsetting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Revenue recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Insurance contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Fair value measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Financial statement presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Investment properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Pensions and postemployment benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Other projects on the horizon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Priority joint projects

Financial instruments Leases Revenue recognition Statement of comprehensive income Fair value measurement Insurance (IASB)
Timeline for completion

June 2011 June 2011 June 2011 March 2011 March 2011 June 2011
The boards are listening Recent activity has demonstrated the boards willingness to listen to constituent input and change their course. For example, the FASB has softened its controversial proposal to report all financial instruments at fair value. In addition, both the IASB and the FASB went back to the drawing board to design a new impairment model for financial assets in the hopes of reaching a converged approach. Likewise, the boards appear to be making changes that will ease complexity as they work on the revenue and leasing projects. As the boards revise their proposals, the question on the minds of many remains: will the revisions require re-exposure? Surely, the prospect is there, as we have seen with the financial asset impairment proposal. If so, the June 30, 2011 targeted completion dates could be in jeopardy.
Striving to reach converged solutions Constituents have expressed that converged solutions will best serve the capital markets. Are the boards achieving this mission? Well, progress is being made on some fronts, with the boards reaching substantial agreement on several projects including revenue recognition, leases, and fair value measurement. They are continuing their quest to reconcile fundamental differences in other projects, such as insurance and financial instruments. Will they claim victory? Too early to say, but their recent actions give hope that their differences will be limited. With all of these moving parts, the standard-setting pace can be overwhelming and difficult to follow. In this edition of Setting the standard, we bring you up to speed on the most significant areas of debate and latest developments on the boards projects. Keeping in mind the fast pace, readers should stay tuned for ongoing updates as the boards proceed.
US GAAP Convergence & IFRS
Joint projects timeline

No big changes on the joint projects timelineat least for now. A lot depends on the magnitude of changes in the redeliberation process and the boards appetite for re-exposure. The following chart reflects the most recent FASB timetable and includes certain IASB-only projects that are being monitored by the FASB.1 Effective dates and transition As the boards approach the finish line, they will be turning their attention to effective dates and transition methodologies. So far, no consensus has emerged
from the recent comment letter process. Many respondents preferred tackling implementation all at once to minimize the disruptive effect on financial statements. Others desired a staggered approach due to resource constraints. How much time is needed? Thats in the eye of the beholder. Responses ranged from 18 months to three years from the date that standards are finalized. Add one to two years if retrospective adoption is required. Some recommended establishing a mandatory effective date but providing flexibility by allowing for early adoption of the standards. Based
on the feedback, mandatory effective dates prior to 2015 appear unlikely for most projects. Finally, what should transition look like? While most acknowledge the benefits of retrospective application, the boards were urged to consider other practical alternatives to alleviate costs and implementation challenges. For additional discussion of these issues, refer to PwCs Point of view: Managing accounting change promoting quality implementations (within the Effective dates and transition methods volume).
Financial instruments Balance sheet offsetting Revenue recognition Leases Fair value measurement Statement of comprehensive income IASBinsurance contracts Financial statement presentation FASBconsolidation (limited) IASBconsolidation (comprehensive) Consolidationinvestment companies Investment properties IASBpostemployment benefits Loss contingencies Discontinued operations Fin. instr. with characteristics of equity Emissions trading schemes Q1 2011 Pre-exposure draft deliberations Comment period and/or redeliberations Q2 2011 Q3 2011 Q4 2011
Exposure draft issued or expected Final standard expected
1 The timing of finalizing hedge accounting by the FASB is uncertain; however, it will likely extend beyond June 2011.
Financial instruments
Whats new? Lots. Here the FASB made headlinesliterallywhen it backed away from the requirement to measure substantially all financial instruments at fair value. This news was applauded as a major step forward in the measurement phase of the project. On the impairment phase, the boards are demonstrating a willingness to explore alternative approaches to achieve convergence. Is hedging next? The FASB recently issued a discussion paper seeking comments from its constituents on the IASBs hedging proposal, so well have to wait and see. Clearly, the boards have picked up the pace, but still face a number of obstacles.
A new approach for measuring financial assets and liabilities Yielding to significant opposition to its original proposal to require that most financial instruments be recognized at fair value, the FASB has been making changes. The result? A new model that would require financial assets and liabilities to be classified into one of three categories: (1) amortized cost; (2) fair value with changes in fair value recognized in other comprehensive income; or (3) fair value with changes in fair value recognized in net income. These categories may sound familiar. However, this new approach may result in a different outcome because it is based on the entitys business strategy and instruments characteristics. While the FASB is refining the criteria for these categories, amortized cost will likely be limited to instruments that are within an entitys lending or financing activities where the strategy is to collect (for assets) or pay (for liabilities) cash flows. Examples of
assets that may qualify include loans held for investment and accounts receivable. Other debt investments (for example, debt securities) would likely be measured at fair value each period. Debt securities held for investment and managed to meet cash flow needs or interest rate risk exposures would possibly qualify for fair value with changes recognized in other comprehensive income. Otherwise, the changes in fair value for debt instruments would be recognized in net income. No relief has been provided however for equity securities. The FASB has decided that all equities not qualifying for the equity method of accounting be measured at fair value with changes in fair value recognized in net income, irrespective of whether or not the securities are marketable. However, the FASB is exploring whether a practical accommodation should be provided to nonpublic entities for measuring nonmarketable equity securities. How about liabilities? Many companies are likely doing high fives, as their plain-vanilla debt would likely qualify for amortized cost treatment. Overall, many details need to be ironed out. In addition, a number of other classification and measurement
The FASB yields on its controversial proposal to require fair value reporting for all financial assets and liabilities.
While not the preferred model of either board, the new proposed impairment approach is a compromise, combining the elements that each of the boards believe are essential.
issues are waiting in the wings such as the equity method of accounting, the fair value option, and the accounting for hybrid financial instruments. You may also be wondering whether these changes align with the IASBs model. Although this new approach is a step toward convergence, differences remain. For example, the IASBs model contains two measurement categories: (1) amortized cost; and (2) fair value with changes in fair value recognized in net income. It is not clear where instruments within the FASBs fair value through other comprehensive income category would fall under IFRS. Impairmentround two Achieving convergence on the impairment model is viewed as critically important by constituents. In a positive development, the boards have crafted a compromise. The revised proposal aims to address the Achilles heel of todays modelthat is, too little, too late when reserving for impaired loans. The boards are working to strike the right balance between reflecting economics and reducing operational complexity. Heres the new lingo: the good book/ bad book approach. What does it mean? Expected losses on assets that are not performing (the bad book) should be fully reservedwhich both boards endorse. The challenge is dealing with impairment for assets that are performing (the good book). The FASB prefers that entities recognize, in the period that the loan is originated or acquired, the full credit impairment for losses expected in the foreseeable future. The IASB, on the other hand, prefers that entities calculate expected losses for the entire remaining life of the asset, and then recognize these losses over that remaining life. Whats the compromise? Entities would be required to recognize the higher of these two impairment calculations. Companies would have flexibility in defining the foreseeable future, although the presumption is that at least 12 months of expected losses can be estimated.
The new approach is focused on open loan portfoliosportfolios that continuously change over time. The reason? Most of the angst over the previous proposal was centered on these types of asset pools. The boards have yet to consider whether the model can be applied to closed portfolios, purchased loans, and individual instruments (including securities). The boards have requested feedback on this question in their proposal. FASB seeks input on the IASBs hedge accounting proposal The hedging element of the project will likely heat up soon, particularly given the FASBs request for input on the recently-released IASB hedging proposal. If youll recall, the FASB included a relatively narrow reconsideration of hedging in its financial instruments exposure draft, largely aimed at simplification. Since that time, the IASB has issued a separate exposure draft solely focused on hedging, which is far broader in scope than the FASBs proposal. The FASB plans to consider the feedback on both its original proposal and the IASBs proposal when its redeliberations resume in second quarter 2011.
While the boards appear aligned on the goal of simplifying hedge accounting, there are numerous differences in the proposed models. The IASB has focused on aligning hedge accounting requirements with a companys risk management strategies and adding more flexibility. One such example is the IASBs proposal to allow companies to hedge component risks that reside within nonfinancial items. The FASB has proposed more targeted changes, such as making it easier to qualify for and maintain hedge accounting. Some believe the FASBs proposals dont go far enough. Whatever your view, now is the time to weigh in. Whats next? Comments are due on the joint impairment proposal by April 1, 2011 and on the FASBs discussion paper on hedge accounting by April 25, 2011. In the meantime, the boards will continue to debate the other aspects of the project.
For more information : In brief 201109, FASB decides on classification and measurement for financial liabilities and equity investments Dataline 201113, FASB redeliberates its financial instruments proposalAn update on significant changes as of February 24, 2011 Dataline 201109, Impairment reduxFASB and IASB are seeking comments on a converged impairment model for financial assets In brief 201106, FASB seeks comments on IASB hedge accounting proposal Dataline 201106, Accounting for hedging activitiesA comparison of the FASBs and IASBs proposed models. All publications listed above can be found within the Financial instruments volume.
10
Balance sheet offsetting

Whats new? In January 2011, the boards jointly issued their proposal on balance sheet offsetting. The proposal defines when it is appropriate to offset financial assets and financial liabilities, including derivatives. The exposure draft effectively eliminates a current exception within USGAAP that allows derivatives subject to master netting agreements to be presented on a net basisa highly controversial outcome that promises to spark considerable debate. A recap on the proposal The exposure draft would require a company to offset a recognized financial asset and a recognized financial liability only if a company (1) has the unconditional right of offset and (2) intends to either settle the asset and liability on a net basis or realize the asset and settle the liability simultaneously. Furthermore, the right of offset must be legally enforceable in all circumstances (including default by or bankruptcy of a counterparty). Because derivatives are often governed by master netting agreements that provide for the netting of amounts only in the event of default or bankruptcy of one
This project is intended to address the largest quantitative difference between IFRS and USGAAP balance sheets.
of the counterparties, the conditions for offsetting typically would not be met. Such rights would be considered conditional rights of offset. Even when an unconditional right of offset exists, there are questions about whether companies can operationally settle financial assets and liabilities simultaneously. The settlement of two amounts is only considered simultaneous if settlement occurs at the same moment. This could prove difficult to demonstrate for repurchase and reverse repurchase agreements. If the transactions are executed through a clearinghouse that settles transactions in batches, they may not be considered simultaneously settled. Get ready for more disclosures, as the proposals go well beyond what is required today under USGAAP. Required disclosures include information about the nature of the agreements and rights to set-off, related cash and other collateral arrangements, and gross and net amounts. Why gross presentation? Most seem to agree that both gross and net information is needed. The tougher question is whether the information should be presented gross in the balance sheet. The current USGAAP presentation that allows for netting of derivatives in certain circumstances was developed to better portray an entitys exposure to credit risk. However, the boards have struggled to reconcile why derivative transactions should be eligible for different treatment than other types of transactions. Ultimately, the boards determined that gross presentation provides more relevant information about liquidity and market risks. Whats next? The comment period ends April 28, 2011 and a roundtable discussion is expected in the second quarter of 2011. The boards currently plan to issue the final standard in the second quarter of 2011.
For more information: Dataline 201110, Balance sheet offsettingThe FASB and IASB proposal The publication listed above can be found within the Balance sheet offsetting volume.
11
The boards are making progress working through the numerous revenue recognition issuesbut many hurdles still lie ahead.
Revenue recognition
Whats new? In recent redeliberations, the boards have advanced a number of bigticket items, including separation of performance obligations, revenue recognition for services, warranties, contract costs, and onerous contracts. The boards have shown real fortitude in muscling through these issues, but there are still many more on the docket. Can they get it all done by June 30, 2011? Stay tuned because its going to be a close race. Boards grapple with two threshold issues The boards have spent considerable effort on two fundamental topics: (1) when to separately account for performance obligations within a contract and (2) revenue recognition for services. Constituents raised concerns in the comment letter process that the proposed guidance was unclear and could lead to diversity in practice or have unintended consequences. As a result, the boards are attempting to develop workable solutions in these areas. Performance obligationsboards address separation criteria So where do the boards stand? They tentatively decided that one
performance obligation exists when goods or services are integrated into a single item provided to a customer. The boards believe this modification alleviates a concern that contracts that are in substance one performance obligation would have to be separated. This concern was particularly prevalent from those in the construction industry. When would separation of performance obligations be required? Fine tuning their approach, the boards would now require separation when a good or service has a distinct function and is transferred at a different time from other goods or services in the contract. Although this may sound similar to the proposal in the exposure draft, the concept of distinct has been narrowed. A distinct function exists if (1) the entity regularly sells the good or service separately or (2) the customer can use the good or service either on its own or together with resources readily available to the customer. In a change from the exposure draft, whether a good or service is offered by another entity or has a distinct profit margin would no longer affect the criteria for separation. Servicesa new paradigm emerges While transfer of control remains the key driver of revenue recognition
for goods, the concept didnt play as well for many service arrangements. Consequently, the boards decided to create separate criteria for determining when service revenue should be recognized continuously. The criteria differ depending on whether or not an asset is being created or enhanced. If the service creates or enhances an asset that the customer controls, then continuous revenue recognition would be appropriate. For example, this concept would apply to construction contracts. For service arrangements that do not create or enhance an asset, the boards decided that continuous revenue recognition is still appropriate if any one of the following criteria is met: The customer receives a benefit as the vendor performs the task (for example, payroll processing services) Another entity would not need to re-perform the task if that other entity were to fulfill the remaining obligation (for example, transportation services) The vendor has a right to payment for performance to-date even if the contract could be cancelled (for example, consulting services) What is meant by continuous recognition? The boards do not seem inclined to mandate a recognition method. Rather, they intend to emphasize that approaches based on output measures generally best reflect performance.
12
The boards have agreed to expand contract cost capitalization to align with other projects.
Warrantieswhats old is new again Many respondents were concerned that the boards proposal on accounting for warranty obligations was too complex and would be difficult to apply. To address those concerns, the boards looked to existing guidance. Heres the current track. If a customer can separately purchase the warranty from the entity, that warranty should be accounted for as a separate performance obligation. Otherwise, the warranty should be accrued as a cost of the contract, unless it provides an additional service to the customer (other than quality assurance). Although this new approach may alleviate some concerns, the treatment of certain warranties (such as long-term automobile warranties) may still be in question. Will sales commissions be capitalized? It looks that way. In a surprising move, the boards tentatively decided that the incremental costs of obtaining a contract should be capitalized and amortized over the period the goods or services are transferred. Why allow more costs to be capitalized than under todays
practice? Simply put: alignment with other projects. The boards were having difficulty justifying different treatment for contract acquisition costs solely based on the nature of the contract (for example, financial instruments, leases, revenue, or insurance). Still to comethe boards have yet to hash out the definition of incremental cost. Will the onerous test be less onerous? Perhaps. Some constituents were concerned that the boards proposal could result in a day one loss on an overall profitable contract. To address this concern, the boards decided to focus the test at the contract level instead of the individual performance obligation level. However, loss leader contracts would not be exempt from the test. Accordingly, losses on unprofitable contracts would be recognized at contract inception. Companies would not be able to consider future potential contracts or sales when performing this test. Lastly, the boards decided to stay the course on its proposal that all costs directly related to satisfying a performance obligation should be included in the onerous test.
Whats next? The project plan calls for continued redeliberations through May 2011 with the goal of completion by June 2011. Up next in March 2011: determining and allocating the transaction price (that is, variable consideration, time value of money, and collectability), and fulfillment costs. We also expect that the boards will begin field testing any significant changes to the exposed model to ensure the guidance is operational.
For more information: Dataline 201116, Revenue from contracts with customersThe constituents have been heard Dataline 201045, Revenue from contracts with customersThe responses are in Dataline 201028, Revenue recognition . . . Full speed ahead: Latest installment A joint FASB/IASB exposure draft All publications listed above can be found within the Revenue recognition volume.
13
Leases
Whats new? The boards are tackling the tough issues head-on: lease term, variable lease payments, income and expense recognition pattern, the definition of a lease, and lessor accounting. Early decisions suggest considerable progress. However, many of the application details have yet to be worked out, which could impact completion of the project by mid-2011.
has a significant economic incentive to extend the lease. Management intent or past business practice would not affect the evaluation. The lease term would not be reassessed unless there is a significant change in the economic incentive assessment. These revisions are likely to be viewed favorably as they should improve operability, reduce volatility, and more closely align accounting recognition with the timing of the business decision to extend a lease.
contingent payments in the lease measurement: Those based on an index or rate (initially based on the spot rate) Those that are disguised minimum lease payments or that lack commercial substance (effectively, an anti-abuse provision) Those usage-based (e.g., mileage) or performance-based (e.g., lessee sales) contingencies that meet a high recognition threshold (probable under USGAAP) Portions of residual value guarantees expected to be paid Ongoing reassessment of contingent rents and the impact on income and expense recognition patterns are up next for discussion. Is straight-line rent expense back in vogue? Possibly, for some leases. The boards proposal results in the front-loading of expense, based on the boards view that a lease transaction is fundamentally a financing. Some respondents challenged this assertion and thought the resulting expense pattern did not reflect the underlying economics. The boards appear to be reconsidering their proposal and are evaluating whether there are two types of leases: financing and other-than-financing. The boards may decide that expense recognition on other-than-financing leases should be straight-line, similar to existing operating lease treatment. Before getting too excited, however, dont forget that all leases would still
The boards have dialed back in two key areas of constituent concern: lease term and variable lease payments.
Lease termfocusing on economic incentives The proposal to define the lease term as the longest possible term that is more likely than not to occur was not well received. Many believed that the proposal would result in the premature recognition of liabilities for option periods. In response, the boards have agreed to raise the threshold for including optional extensions in the lease term. Option periods would now be included in the lease term only when the lessee Variable lease paymentswill you need a crystal ball? Some estimates will still be required under the boards new approach, but the probability-weighted approach looks destined for the cutting room floor. Constituents thought a best estimate approach is more consistent with how companies would perform their assessmentand the boards conceded. In addition, feedback in the comment letters highlighted the complexity of having to consider all types of contingent lease payments in the calculation of the lease asset and liability. Varying views emerged on what types of contingent payments should be included in the measurement. Here, the boards made some progress by tentatively deciding to include only the following types of
14
Momentum seems to be gaining to postpone major changes to lessor accounting. Conforming changes to align with the lessee model may be more likely.
be recognized on the balance sheet regardless of income statement recognition. Although further analysis and targeted outreach is expected, signs point to some relief in this area. Defining a leasetougher than it may seem Many comment letters asked for clarity on the fundamental question of how to define a lease. The reason? For some types of service arrangements (such as those that contain embedded leases), the answer could significantly change current practice. Under todays guidance, identifying embedded leases in some service arrangements has not been critical. Many embedded leases are classified as operating leases and therefore, separation of the lease component from the service component does not significantly alter the balance sheet presentation or expense pattern. However, the proposed right-of-use conceptwhich results in lease assets and obligationshas heightened sensitivity about how to interpret the definition of a lease. The boards have started wrestling with this issue, but progress has been slow. Some have also observed that this issue may be less of a concern if relief is provided on the expense recognition pattern issue. Expect more analysis and outreach on this topic in the months to come. Lessor accountingno wholesale changes for now? Almost all constituents expressed concern over the proposed lessor accounting model, with many suggesting that the boards hold off on these changes. Simply put, many do not believe it is an improvement over todays guidance. The proposed dual-approach model (that is, a derecognition or performance obligation approach) was viewed as unwieldy. Will the boards scale back on the scope? Based on initial redeliberations, it appears they are leaning toward abandoning the wholesale proposals for now. Instead, near-term changes to existing lessor accounting may be limited to those needed to conform to decisions on the lessee side of the project. For instance, the definition of a lease, aligning the criteria for determining the lease term, and treatment of variable lease payments could be likely candidates. Whats next? The boards redeliberations are expected to continue in earnest over the next few months. The focus will continue to be on the priority areas followed by the granular issues thereafter. At this point, a final standard remains targeted for mid-2011.
For more information: 10Minutes on the future of lessee accounting Dataline 2011-11, Leasing FASB and IASB agree on changes that will reduce complexity of the proposed leasing standard Dataline 2011-05, Leasing The responses are in . . . Dataline 2010-38, A new approach to lease accountingProposed rules would have far-reaching implications All publications listed above can be found within the Leases volume.
15
Insurance contracts
Whats new? Mindful of the IASBs June 2011 timeline for completion, the boards have stepped-up activity on the project. As a reminder, the IASB issued an exposure draft proposing an insurance contract standard in July 2010. Separately, the FASB issued a discussion paper in September 2010 seeking views on the IASBs approach. While the boards continue to seek the development of a converged standard, common ground remains elusive on several key areas of the project. Progress in some areas The sheer volume and complexity of the issues in this project is daunting. However, progress has been made on the topics of discount rate, cash flows, and acquisition costs. In addition, clarity has been provided on employee insurance programs. Discount rateno one-size-fits-all answer One critical issue embedded in the current debate is the discount rate that should be applied to a contracts cash flows. The boards starting point: a risk free rate adjusted for contract illiquidity. Respondents raised several concerns about this proposal. Some, particularly in the United States, did not believe this rate reflects how insurers price their products. Others noted that risk free rates do not exist in many countries, raising the question of whether reliable, comparable estimates can be achieved.
The boards have decided to steer away from prescribing a specific discount rate or method while retaining their basic objective: consider the time value of money and the characteristics of the contract liability. Could a practical expedient, such as a high quality corporate bond rate, be used as an acceptable alternative? Perhaps for smaller insurers. The boards plan to discuss this topic in the near future. Some companies asked for the ability to lock in the discount rate at contract inception, which the boards rejected. Thus, the discount rate will need to be updated each reporting period. The boards also decided that long-tail claims that are not associated with life insurance should be discounted. Long-tail claims are those for which the period between the incurrence and settlement of a claim is more than 12 months. Examples include general liability and environmental liability insurance. The boards also continue to explore whether to allow a practical exception to discounting for certain shorttail claims (for example, automobile damage claims).
What expectations should be included in cash flows? The exposure draft required that the measurement of insurance contracts be based on an explicit, unbiased, and probability-weighted estimate of future cash flows from fulfilling the contract (that is expected value). Hmmgot that? Judging from comment letters, maybe not. Many respondents sought clarification on the expected value concept, including which costs should be included in that measurement. You may need to dust off your statistics textbook to keep up on this debate. In simplified terms, expected value is supposed to be the mean or the probability-weighted sum of possible outcomes. However, not all possible outcomes may need to be considered. The boards also tentatively decided that the costs to be included in the cash flows should be those directly related to the fulfillment of the contract, at a portfolio level. Direct overhead costs appear to qualify based on this characterization.
With only four months to go until the IASBs targeted completion date, the boards are feverishly attacking the issues.
16
Welcome news to non-insurers, employerprovided health insurance is no longer within the scope of the insurance contracts project.
Acquisition coststhe saga continues The boards tentatively decided that direct and incremental costs at the portfolio level would not require immediate expense recognition for certain activities. This goes beyond the boards proposals, which assessed acquisition costs at the contract level. Qualifying costs would stem from the following types of activities: sales force contract selling, underwriting, medical and inspection, policy issuance, and processing functions. However, the FASB is standing firm on limiting such costs to those that relate to successful efforts. The FASB also does not support including allocations of overhead costs (such as sales office rent and depreciation). These views are in line with conclusions recently reached by the Emerging Issues Task Force on insurance acquisition costs. The IASB, on the other hand, prefers to include both unsuccessful efforts and overhead costs. Why? Because the IASB thinks it is more consistent with fulfillment cash flows at a portfolio level. Whether the boards can reconcile these differences is unclear as they appear to be at different ends of the spectrum. Employee insurance no longer in scope A sigh of relief. The health insurance coverage provided by employers to their employees will not be in scope. Under the original proposals, insurance contract accounting would have applied to such coverage. However, the boards agreed that such coverage is better presented as an employee benefit.
Continued discussion in other areas The boards have continued to seek common ground on the following critical aspects of the model: risk adjustment (composite versus explicit) and income statement presentation. Should cash flows be explicitly adjusted for risk? Opinions differ among constituents on whether an explicit risk adjustment should be included in the determination of the amount and timing of future cash flows. US constituents tended to support the FASBs composite margin approach (in the event of a converged standard), and a clear majority of non-US constituents supported the IASBs explicit risk adjustment approach. At a conceptual level, the boards appear to agree that an explicit risk adjustment makes sense and could provide useful information to users (either in the measurement, or possibly in the disclosures). Whether the approach is operational and cost effective remains under debate. Income statement presentation constituents give a thumbs down The boards are grappling with the negative feedback on the proposed summarized margin presentation in the income statement. Under this approach, premium revenue would no longer be presented. Instead, the income statement would show margin, changes in estimate, and experience adjustments. However,
users are not enamored with this approach, as gross premium revenue and contract expense information is important. The boards have struggled to develop an approach that is consistent with the model while satisfying users needs. Whats next? The IASB continues to target a final standard by June 2011. The FASB has not announced an official timetable. One potential outcome is the release of an exposure draft simultaneous with the IASBs issuance of its final standard.
For more information: Dataline 201114 (revised March 4, 2011), Insurance contractsComment letter themes being addressed in fast paced redeliberations Dataline 201039 (revised February 16, 2011), Insurance contracts Fundamental accounting changes proposed All publications listed above can be found within the Insurance contracts volume.
17
Fair value measurement

Whats new? Coming soon: final fair value measurement standards. Except for discussing effective dates and transition, the boards have completed their redeliberations and expect to finalize their respective standards in March 2011. Whats changing and whos impacted? The new guidance provides a consistent framework for measuring and disclosing fair value when other accounting guidance requires or permits the use of fair value. This framework will be brand new for entities that report under IFRS. For USGAAP reporters, the new standard will pack a much lesser impact. However, before breathing a sigh of relief, US companies should take stock of a few new provisions. Companies that report a substantial number of financial instruments at fair value may feel the effects of the measurement-related amendments the most. Why? The ability to measure financial assets based on their highest and best use has
been removed and the inclusion of premiums and discounts in a fair value measurement is narrowed. Practically speaking, there are questions about what these changes mean. For example, should the fair value of an investment in common shares be based on the individual share or the block holding (that is, the aggregated group of shares held)? Can a premium or discount be applied to the block holding? The answer is more straightforward when the unit of account is defined within GAAP. For an investment in common shares, fair value will often need to be determined based on each individual share, consistent with the unit of account prescribed within the guidance on accounting for equity investments. Determining the fair value based on the block holding may only be appropriate when the unit of account is defined at that level, such as when measuring the fair value of a reporting unit. How about disclosures? Good question. Preparers have been concerned about the cost and effort that would be involved with the boards proposal to disclose measurement uncertainty
for Level 3 fair value measurements. Because of those concerns, the boards agreed to perform more work before requiring the disclosure. In the interim, the boards added some incremental disclosures to fill the gap. These include quantitative information about unobservable inputs and assumptions used, along with a narrative disclosure about the sensitivity of the measurements. However, it is unclear what the final required disclosures will look like. As a result, questions are percolating about what exactly will be required to be disclosed. Some of these questions may get answered once the boards issue their standards. However, like any new guidance, there are sure to be some areas that require interpretation. Companies should begin understanding how they may be impacted and developing plans for implementation. Whats next? The boards are expected to discuss effective dates and transition soon, and finalize their respective final standards in March 2011.
Fair value is one priority project nearing completion that will be substantially converged.
For more information: Dataline 201112, Fair value measurementFASB and IASB joint project near completion The publication listed above can be found within the Fair value measurement volume.
18
Financial statement presentation

Whats new? Its back. Despite rumors of its demise, the financial statement presentation project appears to have been resuscitated. Following overwhelmingly negative sentiment from the preparer community and mounting pressure on the standard setting agenda, the boards decided in November 2010 to put a hold on this project until after
refresher on the project. The overarching principle in the proposed redesign of the financial statements was to enhance the cohesiveness of the primary financial statements and to provide disaggregated information to users. What does cohesiveness mean? The idea is that the financial statements should report a companys operating, financing, and investing activities consistently in each of the statements.
administration). Nature refers to the economic characteristics or attributes that distinguish assets, liabilities, income, and expense items (for example, disaggregating cost of goods sold into materials, labor, transportation costs, and energy costs). And lets not forget some of the other big-ticket items in the projectthe direct-method statement of cash flows, more segment information, and roll-forward schedules for significant asset and liability balances. Some of these have been lightening rod issues in the preparer community. It will be interesting to see what unfolds when the project resumes. Disaggregationhow much is enough? Preparers told the staff that disaggregating income and expense items by nature (both generally and in the segment footnote) would be costly because their systems are not currently structured to capture that information. Many also believe that this information does not align with how management evaluates the companys performance. Competitive harm was also a concern when it comes to disaggregation in the segment footnote, particularly when gross margin information is provided at a granular level (such as by segment). Users, however, are at the other end of the spectrum. They told the boards that disaggregation was one of the most useful aspects of the project, especially with respect to margins and segments.
The staff appears amenable to scaling back proposals to address cost and operational concerns.
June 2011. Meanwhile, the FASB and IASB staff has been working behind the scenes. Their objective: better understand (1) preparer concerns with their proposals and how costs could be mitigated and (2) how financial statement users can get the biggest bang for their buck. The staff recently met with the boards to report their outreach findings. No decisions were made at this meeting, although the boards confirmed their commitment to the project. The staff also provided a glimpse of the options that may be considered once the project resumes. A recap Since its been awhile since our last update, it might be good to have a To achieve this objective, the new format for financial statements would separate the companys financial position, performance, and cash flows by operating, financing, and investing activities. What about disaggregation? A company would be required to disaggregate information to explain the components of its financial position and financial performance. The terminology used in the project is disaggregation by function and by nature. These are not exactly intuitive terms, so heres the explanation. Function refers to the primary activities in which an entity is engaged (for example, selling goods, manufacturing, advertising, and
19
Users told the staff a direct-method statement of cash flows and full account balance rollforwards may not be necessary.
Statement of cash flowsis direct the only answer? One of the more hotly debated aspects of this project is the requirement for a direct-method statement of cash flows. Cost/benefit continues to be the largest concern among preparers. Why? Todays general ledgers are typically not organized to capture the transactional-level information needed for a direct presentation. Preparers were also wary about using the boards proposed derived approach to estimate the transactional-level detail. But how do users feel? Interestingly, some users did not express a strong sentiment that a direct-method cash flow statement is necessary. However, users did emphasize the importance of retaining the indirect reconciliation of operating cash flows and other direct information (for example, investment in fixed assets) that is provided today. As a result, the staff is looking for ways to improve cash flow information without requiring a direct-method presentation. Stay tuned, as there will be more to come on this topic. Will roll-forward analyses remain on the table? The proposal would require rollforwards in the footnotes of changes in significant assets and liabilities. These would require detailed analysis and explanation of what is driving the changes in account balances. The staff outreach revealed that preparers are not fans of having to track and compile the movements within the balance sheet line items. Furthermore, many questioned
whether such granular information is really useful. Definitely a quandary here for the boards since users expressed that this was one of the more useful aspects of the proposals. However, there may be some prospect for middle ground, perhaps stopping short of a full roll-forward analysis. Will changes be made for financial services companies? The staff also targeted the financial services industry in its outreach efforts. Users generally questioned whether the proposed presentation changes to the balance sheet and income statement would be beneficial. Other feedback stressed the fact that the industry is different from others, so additional guidance would be helpful. It remains unclear whether any accommodations will be provided, but one possibility is to provide some additional industryspecific implementation guidance. The ongoing debate about other comprehensive income Will the meaning of other comprehensive income ever be wrestled to the ground? Some constituents have expressed that it is time to address this issue head-on. When should items be reported in other comprehensive income, and when should amounts be recycled into net income, if at all? Today, differences exist for both questions between IFRS and USGAAP. Recently, some board members expressed a view that resolving this issue is essential for success on convergence. However, other board members believe that while
important, the conceptual questions about other comprehensive income may best be addressed as a separate project. Whats next? The boards are not expected to resume deliberations until they start knocking some of the priority projects off their list. However, their desire to continue this project appears to remain high, so stay tuned in the second half of 2011 for an update.
For more information: Dataline 201035 (revised February 3, 2011), Financial statement presentationA look at the FASB and IASBs Staff Draft The publication listed above can be found within the Financial statement presentation volume.
20
Consolidation
Whats new? Following a few twists and turns, the road map on this project is coming into focus. After closely monitoring the IASBs comprehensive consolidation project, the FASB has decided to take the exit ramp on pursuing wholesale changes to its existing consolidation model. Whats the current route? For variable interest entities: a new approach for determining if a party is acting as a principal or an agent. For voting interest entities: potential changes to kick-out rights.
The FASB decides not to pursue wholesale changes to its consolidation guidance, choosing targeted amendments instead.
Consolidation, investment companies, investment property? Help! With similar terms and overlapping parts to the project, it can be hard to keep it all straight. So, heres a glossary to keep handy:
What it is
Broad-based project to include structured entities and voting interest entities. Targeted scope amendments for variable interest entities and voting interest entities. Will eliminate deferral of variable interest entity guidance for investment entities. Narrow project that revisits the definition of an investment company, which impacts whether normal consolidation rules apply. Not a consolidation project. Impacts which entities should report real estate at fair value.
Project
Consolidation
Board
IASB
Status
Final standard expected March 2011
Consolidation
FASB
Exposure draft expected March 2011
Investment companies
Joint
Exposure draft expected second quarter 2011
Investment properties (see separate section)
FASB
Exposure draft expected second quarter 2011
21
Kick-out rights guidance for limited partnerships may be changing.

FASB decides: targeted changes in lieu of convergencefor now The FASB decided not to join the IASBs broad consolidation project at this time, as it was not convinced that it represented an improvement. The FASB was concerned about a model that places equal weight on potential voting rights versus current voting rights. The FASB also did not like the prospect for consolidation based on historical voting patterns and shareholder dispersion when an entity holds less than a majority of the voting rights (de facto control). For now, the FASB is seeking narrow improvements to its existing guidance. Whats in play? In early 2010, the FASB decided to defer the application of its new variable interest entity consolidation guidance for certain types of investment entities. The deferral applied to entities such as mutual funds, hedge funds, and private-equity funds, to name a few. As the FASB and IASB began to deliberate the broader consolidation project, it became apparent that principal versus agency and kick-out rights were important threshold questions when analyzing consolidation for investment entities. A central issue is whether an asset manager is a principal of the fund (due to its decision-making capabilities) or simply acting as an agent of the funds investors. Those that are deemed to be principals would consolidate the funds. By resolving these issues, the FASB expects to eliminate the deferral. Principal versus agency The boards appear to be aligned on this topic, tentatively deciding that the assessment should be based on the overall relationship between the decision maker, the entity being managed, and any other interest holders. An entity would consider the following factors in making this assessment: The scope of decision-making authority of the decision maker, considering the design of the entity and who would benefit from that design
The rights held by others, including kick-out and liquidation rights The decision makers compensation, with an emphasis on whether such compensation is market-based Other interests held by the decision maker in the entity Kick-out rights To improve consistency, the FASB plans to align the guidance for kickout rights for voting and variable interest entities. What is the effect? Today, under the variable interest entity model, kick-out rights are only considered in the analysis when held by a single party. However, under the voting interest entity model, kickout rights held by a simple majority are relevant to the consolidation conclusion. The new proposal will require an entity to evaluate kick-out rights more broadly in general. If kick-out rights are held by more than one party, judgment will be required to evaluate whether they are substantive. Generally, the larger the group that holds the rights, the less likely they would factor into the analysis. These changes could impact the evaluation for entities such as limited
22
partnerships. Today, simple majority kick-out rights may preclude consolidation by the general partnerthis may no longer be the case under the proposal. Waiting for exposure investment company guidance The boards are planning to issue their proposal to redefine investment companies in the second quarter of 2011. Investment companies generally do not consolidate ownership interests in underlying investment portfolio companies. Instead, they are recorded as investments at fair value. However, if an entity does not meet the criteria to be considered an investment company, traditional consolidation guidance would apply. What aspect of the proposed definition is under debate? Simply stated, the FASB is evaluating what level of third-party investment is necessary for an entity to qualify as an investment company. Currently, this area is not well-defined and has led to some funds with little third-party investment to qualify as an investment
company. If the FASB raises the bar on the required level of third-party investment, this will precipitate a fundamental change in status for some companies. Another important aspect of this project is whether an entity that consolidates an investment company should retain fair value accounting in consolidation. The FASB tentatively decided to retain current practice, which carries the investment companys fair value accounting up to the consolidated level. The FASB expects further discussion on this topic with the IASB, as it has yet to reconsider this matter. Whats next? The IASBs final consolidation standard is expected in March 2011. The FASBs exposure draft on targeted amendments is also scheduled for March 2011 with a final standard in third quarter 2011. Look for the exposure draft on investment companies in the second quarter 2011 and a final standard in the fourth quarter of 2011.
23
Investment properties
Whats new? The scoping of this project has proven to be elusive. Recently, the FASB took another shot at an approach that captures those entities it believes should be reporting investment properties at fair value. The primary targetsreal estate investment trusts, funds, and operating companies. However, its unclear whether the FASB hit the mark with its latest attempt. Why a project on accounting for investment properties? With everything on its plate, some may wonder why the FASB is developing guidance for investment properties. As background, this issue surfaced during debates on the joint leasing project when the boards proposed to scope out leases of investment property carried at fair value. Except for investment companies, a US accounting standard that permits its investment property to be measured at fair value does not exist. As a result, the FASB undertook this project to address the issue.
So, whats the scoop on scope? The FASBs approach would require that entities within the scope of the guidance report all their real estate at fair value on a recurring basis. An entity would need to meet defined criteria related to its business purpose, activities, and capital structure to be within scope of the guidance. Principally, a companys substantive activities must relate to investing in real estate for total return (including realizing capital appreciation). Entities that hold real estate for purposes other than investing would not be in scope. Examples of other purposes are to produce or supply goods and services, hold property for only rental income, or hold property for sale in the ordinary course of business. An entity would also need to have multiple investors with significant ownership interests in order to qualify. The term real estate in the United States has a broad reach. In addition to traditional real estate such as office buildings and malls, this term also encompasses non-traditional real estate such as power plants and integral equipment such as
pipelines and cellular towers. The FASBs primary focus has been on entities that hold traditional real estate. However, based on its recent scope revision, those entities that hold non-traditional real estate or integral equipment would also appear to be within scope if the property is being held for investing purposes. Convergencesolving the simultaneous equation While solving for one problem, the FASBs proposal may create a further imbalance for convergence. IFRS contains guidance for investment properties that is based on the nature of the property, not the entity. In addition, the guidance allows an option to measure the investment property at cost or fair value. This differs from the FASBs entity-based approach and requirement to measure at fair value. The boards may seek to reconcile their models in the coming months, but until then, convergence remains in question. Whats next? The FASB expects to address remaining issues in the near term including whether a pension fund that wholly-owns an entity holding real estate should be within the scope of the guidance. An exposure draft is expected in the second quarter of 2011 with a final standard by the fourth quarter of 2011. However, the genesis for this project was changes to lessor accounting. If the boards decide not to broadly tackle lessor accounting, the momentum for this project could also potentially wane.
Based on the FASBs current approach, it appears that REITs, real estate funds, and real estate operating companies would be required to report their investment properties at fair value.
24
Pensions and postemployment benefits

Whats new? The IASB is finalizing its redeliberations on pensions and postemployment benefits. In a surprising move, it has reversed course yet again on whether actuarial gains and losses should be reported in net income or other comprehensive income. The IASB has also clarified the accounting for plan settlements and curtailments. Actuarial gains and losses now in other comprehensive income In our December 2010 edition of Setting the standard, we reported that the IASB had decided to allow companies the choice of whether to record actuarial gains and losses in net income or other comprehensive income. We had also reported that the IASB was somewhat divided on allowing this election. Upon further reflection, the IASB has now decided to require that actuarial gains and losses be reported in other comprehensive
income. Why the change? In the interest of comparability, some board members wanted to limit the circumstances in which entities would be allowed to record gains and losses in net income. However, the IASB was unable to develop a workable principle to achieve that objective. Settlements and curtailments net income approach confirmed The IASB confirmed that settlement and curtailment gains and losses will be recognized in net income when the event occurswith one notable exception. If the settlement or curtailment relates to a restructuring, any gain or loss would be recognized when the corresponding cost of the restructuring is recognized. This exception was provided to remove the complexity of recognizing compensation costs related to a restructuring over multiple periods. Where does convergence stand? From a balance sheet perspective, the FASB and IASB guidance will be converged. The income statement
is another matter. Under USGAAP, actuarial gains and losses are often recorded in other comprehensive income but subsequently amortized in determining net income. Because IFRS does not permit the recycling of actuarial gains and losses recognized in other comprehensive income, these amounts will never affect net income. The FASB plans to reconsider its guidance once the IASB project is complete. Whether conforming changes will be made is anybodys guess. However, the IASBs decisions may motivate the boards to tackle the broader conceptual questions related to other comprehensive income. Whats next? The IASB still needs to finalize an effective date for its final standard, but has indicated it will not be sooner than January 1, 2013. The standard is scheduled to be issued by the end of March 2011. However, given the recent changes and pending discussion on effective dates, some slippage in that timetable could occur.
Recognition of pension expense components under the IASB model
For more information:

Net income
Net interest cost Curtailment and settlement gains Past and current service cost Plan administration expenses
Other comprehensive income

Actuarial gains and losses Actual return on assets (excluding the component within net interest cost) Changes in asset ceiling Asset related expenses
Dataline 201115, Pension/ OPEB accounting Understanding changes expected from the IASB The publication listed above can be found within the Pensions and postemployment benefits volume.
25
Other projects on the horizon

Whats new? With the boards focused on the priority projects, there is little to report about several other projects on the agenda. For some, work continues behind the scenes with no visible board activity. Thats the story for the statement of other comprehensive income and discontinued
operations projects, where the boards are drafting a final standard and an exposure draft, respectively. Limited activity is expected on a number of other projects until the intensity surrounding the high priority projects begins to subside. This holds true for contingencies, financial instruments with characteristics of equity, and emissions trading schemes. Below is a snapshot of the timing of the boards next steps on these projects.
Project
Statement of comprehensive income Discontinued operations Disclosure of certain loss contingencies
Board
Joint FASB FASB
Next steps and timing

Final standard March 2011 Exposure draft in second quarter 2011 Review of companies 2010 year-end disclosures by FASB post-June 2011 Staff draft of updated decisions to be released and redeliberations to follow post June 2011 Deliberations to resume post June 2011
Contingencies
IASB
Financial instruments with characteristics of equity Emissions trading schemes
Joint
Joint
Exposure draft Q4 2011
26
Below, we have briefly summarized the status of these projects. If you wish to take a deeper dive into the boards prior decisions, please refer to the October 2010 and December 2010 editions of Setting the standard, and the other publications noted below. Statement of other comprehensive income The boards are planning to issue their final standard in March 2011. Some might view this new guidance as a non-event, as the change is limited to presentation. Companies will be permitted to present net income and other comprehensive income either in a single continuous statement or in two separate, but consecutive, statements. However, presentation of other comprehensive income within the statement of equity will no longer be permitted.
Companies that report under USGAAP should plan to apply the new presentation beginning in 2012. Under IFRS, the standard is expected to be effective for fiscal years that begin on or after January 1, 2012. Early adoption would be permitted.
For more information: Dataline 201108, Statement of comprehensive incomeThe FASB is expected to allow one continuous statement, or separate continuous statements of net income and other comprehensive income The publication listed above can be found within the Statement of comprehensive income volume.
Discontinued operations Companies that are planning to dispose of a significant operation should pay close attention to the FASBs project on discontinued operations. A subset of the financial statement presentation project, this project is intended to converge discontinued operations guidance between USGAAP and IFRS. The FASB plans to adopt a definition that is similar to the current IFRS definition. That guidance focuses on whether the operation is a separate major line of business or geographical area of operation. The FASB, however, will also go a step further on disclosure by requiring information for disposals of components that do not qualify as discontinued operations. The FASB is expected to release an exposure draft in the second quarter of 2011, with a final standard in the fourth quarter of 2011.
27
Contingencies Although this project is on hold at the moment, there continues to be great interest in the reporting community about contingency disclosures. Clearly, the SEC has picked up the pace in its recent comment letters on this topic. Likewise, the FASB plans to scrutinize these disclosures as part of its plan to assess compliance with the existing disclosure requirements. To refresh, the FASB issued a proposal in 2010 to make improvements to loss contingency disclosures. Constituents were concerned that the suggested disclosures would potentially jeopardize legal positions by requiring too much information. Some also questioned whether the perceived shortcomings in todays disclosure practices result from deficiencies in the current standard or rather inconsistent application of current guidance. As a result, the FASB yielded and will decide on how to proceed with the project after its evaluation of 2010 year-end reporting disclosures.
Similarly, the IASB has also been seeking improvements to its contingency guidance, but has gone further by proposing changes to the accounting model. The IASB issued an exposure draft during 2010 which would have, among other things, removed the more-likelythan-not threshold for determining when contingent liabilities should be recognized. This proposal was not supported by constituents. In response, the IASB has softened its stance on some of the more controversial aspects of its proposal. For example, the IASB appears amenable to eliminating its original proposal to remove the more-likely-than-not threshold for determining when contingent liabilities should be recognized. The IASB intends to post a staff draft to its website reflecting its updated decisions for purposes of further consideration when it revisits the project after June 2011. While this is an IASB-only project, USGAAP reporting entities may want to pay close attention considering the boards overarching convergence goal.
Financial instruments with characteristics of equity This project has been in development for a number of years, in an attempt to improve the patchwork of complex guidance that exists today for liabilities and equity. Although an exposure draft was to be released in the summer of 2010, substantial concerns were raised on the draft proposals about the meaning, enforceability, and internal consistency of some of the proposed requirements. Essentially, the boards joint deliberations had considered a variety of approaches that attempted to leverage current IFRS guidance as a starting point, and addressing known practice issues with the IFRS model. However, constituents review of the draft proposals pointed to flaws in the proposed model. The boards considered the feedback and discussed several alternatives on how to best proceed, without any final decision. As a result, the boards may need to find a fresh approach for tackling the age-old question of when a financial instrument is a liability and when it is equity.
For more information: Dataline 201032 (revised February 1, 2011), Disclosure of certain loss contingenciesAn analysis of the FASBs proposed changes The publication listed above can be found within the Contingencies volume.
28
Emissions trading schemes During the fall of 2010, the emissions trading schemes project was injected with new energy, as the boards held three substantive meetings and began to make some progress. Given the lack of authoritative guidance on accounting for emission allowances under both USGAAP and IFRS, this was a welcome step forward, particularly for companies in emissionsheavy industries. However, this project experienced a slowdown when the boards decided to table their debate until the second half of 2011. Although many questions remain unanswered, companies involved in emissions trading programs might find it helpful to gain an understanding of the boards direction. As reported in our December 2010 edition of Setting the standard, the boards had tentatively decided that allocated and purchased emission allowances are assets, and the receipt of allowances under an emissions trading program creates an obligation that should be recognized as a liability. Furthermore, the boards
focused on measurement and tentatively decided that assets and liabilities recognized under an emissions trading scheme should be measured initially, and on an ongoing basis, at fair value. The liability would be capped at the amount of emission allowances the company receives. The more difficult question, which has not yet been answered, is whether and when a company should recognize a liability when it emits more than its allocation under the emissions program. Significant debate has surrounded the issue and there is no clear direction at this time. In addition, the FASB and IASB have discussed gross versus net reporting of the asset and related liability on the balance sheet without achieving clear resolution. At the last meeting in November 2010, the boards instructed their staff to perform additional research and outreach on a number of areas. However, given the boards focus on priority projects, we do not expect any significant developments in the near term.
29
A measured approach
The timing and prioritization of convergence projects continues to evolve, but the most significant elements could be effective as early as 2014 or 2015. While this seems like a ways off, there is work to be done in advance of the effective dates given the level of change as well as the impact on comparative reporting periods. Most companies need not embark upon a full-blown adoption project right away, but there are steps that companies can take in the near term that will serve as strong building blocks for future adoption of the standards. Each company is different, and therefore the impact of the proposed standards will differ from one company to another. Industry segment and business complexity will both play a role in determining the level of impact. As a baseline, companies should remain aware of the changes that result from the joint projects and should stay close to developments in these standards as the FASB and IASB continue their deliberations. Certainly, should your company have strong views on a topic, you might consider getting involved with the standard-setting process by responding to requests for comments or taking part in roundtable discussions and other standard setter outreach activities. Companies should also start to assess, at least at a high level, how the proposed changes will impact their company and form a point of view on the level of impact. Those that are impacted more heavily by the proposed changes should also consider taking further steps to
better understand the requirements and effectively begin to manage the change process. In the near term, such companies may consider taking the following steps: Develop an initial project plan . First, identify those who will own the project and empower them to act. These individuals should perform a more in-depth analysis of the impacts of the proposed standards and develop an initial project plan. The project plan may contain tailored immediate next steps, key project milestones to completion, and areas of significant time or financial investment. Understand the accounting impact . Begin to gather and analyze the necessary data. For example, with respect to the proposed leasing standard, a company may consider inventorying its existing leases, identifying arrangements within the scope of the standard, and beginning to determine the impact on the balance sheet (creation of the right of use asset and the lease liability) and income statement (potential acceleration of expense recognition). Identify the current technology and system landscape . Understand and determine the manner of collecting data, and develop a technology plan, taking into account system changes already contemplated. For example, determine whether your current systems have the ability to
appropriately track a large number of leases, regularly update leaserelated estimates, or allocate and account for revenue with more separate performance obligations. Identify the broader business impacts . Ascertain in what other areas the proposed standards may affect your business. For example, determine what impact the proposed revenue standard will have on your companys sales strategy, resulting from potential changes in sales contracts, multiple element offerings, warranty programs, and construction contracts. Establish a communications strategy . Begin to craft a communications plan for educating key stakeholders about the accounting and business impacts of the proposed standards. Internally, senior management and audit committees should be kept informed about current assessments. Externally, companies would be well-served, at the appropriate time, to brief ratings agencies and analysts with respect to the anticipated impacts. Collectively, these steps form the basis of a comprehensive assessment whereby companies can deepen their understanding of the impact of US GAAP convergence with IFRS. By staying focused on aspects that have a long lead time, companies can stay ahead of the game while also pursuing small one-off projects and easy wins where desirable.
31
www.pwc.com/us/jointprojects
To have a deeper conversation about how this subject may affect your business, please contact: James G. Kaiser US Convergence & IFRS Leader PricewaterhouseCoopers LLP 267 330 2045 james.kaiser@us.pwc.com
This publication is printed on Mohawk Options PC. It is a Forest Stewardship Council (FSC) certified stock using 100% post consumer waste (PCW) fiber and manufactured with renewable, non-polluting, wind-generated electricity.
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. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2011 PwC. 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. NY-11-0522
US GAAP Convergence & IFRS What you need to know about the FASB and IASBs joint projects
November 2011
November 11, 2011
To our clients and friends: The journey towards convergence continues. Standard setters are re-exposing key projects, and the SEC is evaluating whether, when and how IFRS might be incorporated into the US financial reporting system. The standard setting process is slowing in response to concerns raised by constituents, but progress on key standards continues. The priority projects - revenue, leasing and financial instruments - are being re-deliberated and exposure drafts for leasing and revenue are expected later in 2011 and 2012. Following this, valuable additional input from constituents will be needed to ensure the development of high quality standards. This additional time will allow constituents to trial test the proposed standards and provide feedback on whether the words will be interpreted as intended. Obtaining that input now, before the final standards are issued, will reduce potential implementation issues. As standards change, companies may need new systems that can capture data, track contracts, and support processes to develop and assess complex estimates. Changes in balance sheet ratios and operating results may lead to renegotiating contracts such as debt agreements, royalty agreements and compensation agreements. Companies may want to reassess lease or buy decisions. Investor and stakeholder communication and education will be necessary, as the timing and pattern of revenue and expense recognition will change. The new standards will impact some companies 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 potential impact of the proposed standards on your company. Included is an overview of the standard-setting landscape, our point of view on effective dates and transition methods, technical insights on the standard setting projects, and discussions of what you can be doing now to prepare for these changes. While all of the joint projects as well as certain other projects are addressed, our primary focus is currently on the priority projects - leasing, revenue recognition and financial instruments. As developments unfolded and standards moved forward we have posted updates for you to print and add to the original compendium on a dedicated websitewww.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 & IFRS 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
Table of contents
28
A measured approach
November 2011
US financial reporting will undergo an unprecedented level of change within the next several years. Approximately a dozen new accounting standards are under development that will advance the convergence of US GAAP and IFRS. Convergence will affect topical areas such as financial instruments, revenue and leasing. The timing of the convergence projects continues to evolve as the FASB and the IASB respond to constituent requests by taking the time necessary to develop high-quality standards. In this light, the FASB and IASB plan to re-expose the revenue and leasing projects. The impacts will be broad and deep well beyond financial reporting. The proposed standards have the potential to significantly impact revenue and expense recognition patterns as well as a companys reported assets and liabilities. Under the proposed revenue standard, the recognition of some revenue streams will accelerate while others will decelerate. Irrespective of the timing of revenue recognition, gross margin erosion will occur, as a result of the proposed incorporation of credit risk into the measurement of revenue.
Under the proposed leasing standard, all leases, with the exception of short term leases, will result in the recognition of lease assets. At the same time, increased volatility and changes in expense and revenue recognition patterns may significantly impact a number of ratios (e.g., leverage ratios) and measures (e.g., EBITDA) used by companies for a variety of purposes, ranging from determining compensation for employees to valuing a business in a structured transaction. Contracts, such as debt and compensation agreements, may require adjustment as a result of changes in financial ratios and reported results. In addition, companies will need to ensure their systems, processes and controls can accommodate the proposed accounting models. The proposed leasing standards will require companies to capture and update detailed data for all of their leases. Many companies do not currently have a systematic method in place. The proposed revenue standard is expected to require a considerable amount of estimation, specifically related to the recognition of variable or uncertain consideration (e.g., trade discounts). Effective processes and controls will need to be in place around these estimates. Companies may need new systems or modifications to existing systems to ensure they can capture data, track contracts and support processes to develop and assess complex estimates.
Other important stakeholders will also feel an impact. The increased level of judgment inherent in the proposed standards will make it more challenging for companies to provide guidance to analysts. Rating agencies have already started to estimate how much debt will be added to a companys balance sheet as a result of the proposed leasing standard. Communication with these stakeholders is essential, to help them understand the business implications and other effects of the changes. Not all companies will be equally impacted by these proposed standards. Companies with less flexible systems may have a more difficult time. Complex multinational companies will have more challenges obtaining all required data than less complex or predominantly domestic companies. That being said, the adoption of these standards will take a considerable amount of time and effort for all companies. It will be important to investors that companies implement the proposed standards properly and cost effectivelythe first time. This publication is designed to help readers develop an understanding of the major convergence projects and provide a perspective on what companies can and should be doing now in relation thereto. The projects are ongoing; as new details emerge, we will post updates at www.pwc. com/us/jointprojects.
What you need to know about the FASB and IASBs joint projects
Welcome to the September 2011 edition of Setting the standard, our publication designed to keep you informed about the most recent developments on the joint standardsetting activities of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). Take twotimes three? It looks likely. Each of the big three joint projects are poised for a second showing. Revenue recognition will be re-exposed shortly. Leases will follow once the boards finalize their discussions. And, the financial instruments project seems destined for the same path. Not surprisingly, constituents have applauded the re-exposure decisions, which they view as a necessary step to ensure the final products are high quality. So, whats new? During their September 2011 joint board meetings, the FASB and IASB debated key open issues in the priority projects. Impairment is the current focus of the financial instruments project as the boards continue to seek a common solution. For leases, lessor accounting is once again at the forefront with the boards recently agreeing on a new approach. As for revenue recognition,
Whats inside: What you need to know . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Joint projects status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 New releases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Balance sheet offsetting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Revenue recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Insurance contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Consolidation and investment companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Investment property entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Other projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
the boards are wrapping up their discussions and have been putting the finishing touches on the upcoming exposure draft. Given the decisions on re-exposure, what does the timing of completion of these projects look like? At best, look for final guidance sometime in 2012. Effective dates are likely to be extended, meaning it will be a few years before the new standards affect the financial statements. Although that may seem like a long time from now, it may be necessary to start thinking about adoption sooner rather than later. This is because the boards have proposed retrospective application for some of the standards, most notably revenue recognition. Assuming the new standards become effective in 2015, companies would need to start capturing data under the new guidance as early as 2013.
What role will the SEC play on the international accountingscene? Will the Securities and Exchange Commission (SEC) take center stage later this year with its much anticipated announcement about whether International Financial Reporting Standards (IFRS) will be incorporated into the US financial reporting system? Or, will there be a cliffhanger? Only time will tell. Feedback on the SECs suggested endorsement approach, including the views expressed at the July 2011 IFRS roundtable, has generally been positive. The prospect of lower costs associated with a strategy that would bring in IFRSs at a measured pace over a five to seven year transition period was favorably received. However, respondents pointed out the need to address issues related to the consistency of application
of IFRS globally, the status of the boards convergence projects, and oversight of the IASB. Stay tuned for two upcoming documents from the SEC that are expected to address the differences between IFRS and U.S.GAAP, as well as the consistency of application of IFRS. Are you interested in sharing your point of view on the incorporation of IFRS in the United States? Weigh in on the debate by completing our 2011 IFRS outlook survey. We will share survey results with the standard setters, regulators, and with you through a future webcast andpublication.
Project Classification and measurement
Board FASB IASB
Current status Redeliberations ongoing Complete Redeliberations ongoing Constituent feedback has been discussed Redeliberations complete on general model; macro hedging deliberations have started Redeliberations complete Redeliberations complete Redeliberations ongoing Deliberations ongoing Redeliberations ongoing Deliberations complete Final standards issued Deliberations complete; IASBs exposure draft issued Deliberations ongoing No activity currently
Whats next? Re-exposure is an open question Evaluate FASBs final guidance New exposure draft expected in first quarter 2012 Outreach and redeliberations General hedging: final standard in first half of 2012 Macro hedging: exposure draft first quarter 2012 Final amendments expected in fourth quarter 2011 New exposure draft expected in fourth quarter 2011 New exposure draft expected in first quarter 2012 Exposure draft: first half of 2012 Re-exposure is an open question Exposure draft expected in fourth quarter 2011 N/A FASB exposure draft expected in fourth quarter 2011 Exposure draft expected in fourth quarter 2011 To be determined. Further action not expected before end of 2011.
Financial instruments:
Impairment
Both
Hedging
FASB IASB
Balance sheet offsetting Revenue recognition Leases
Both Both
Joint projects status

For the last couple of years, the boards have focused on a long list of joint standard-setting projects with a goal of completing them within a short timeframe. As the boards priorities have narrowed and timing has been extended, we have also sharpened our focus in this document on the active projects. Below, we provide a snapshot of the current status of the joint projectswhere they stand now and what to expect next.
Both
Insurance contracts
FASB IASB
Consolidation
FASB IASB
Investment companies Investment property entities Lower priority projects1

1
Both
FASB Both
Lower priority projects include: Financial statement presentation (including aemissions trading schemes, and contingencies.
Companies may apply the FASBs new goodwill impairment guidance as early as 2011.
New releases
Several new standards were published over the last few months. Heres a quick summary of the new standards, with references on where to find moreinformation. Statement of comprehensiveincome The boards new standard brings a greater focus to other comprehensive income. Net income and other comprehensive income now have to be presented in either a single continuous statement or in two separate, but consecutive, statements. The new requirements are effective for US companies beginning in 2012 (including interim periods) for calendar year-end public entities, on a retrospective basis. Nonpublic entities are required to apply the new guidance for their 2012 year-end financial statements and their interim and annual periods thereafter, with early adoption permitted. The new IFRS requirements are effective for fiscal years that begin on or after July 1, 2012 with early adoption permitted. On the surface, the guidance appears straightforward; however, certain aspects of the standard may require more effort than it appears at first blush. In fact, some constituents have asked the boards to consider deferring the new standards to address implementation concerns. Refer to Dataline 2011-24, Presentation of comprehensive incomeThe FASB
issues final standard on presenting other comprehensive income, for moreinformation. Pensions and other postemploymentbenefits In June 2011, the IASB issued amendments to its pension and postemployment benefit guidance. In some areas, it is a step closer to converged employee benefit accounting guidance. For example, the amendments require actuarial gains and losses to be included in other comprehensive income similar to U.S. GAAP, and will enhance disclosure requirements for defined benefit plans. However, other aspects are not converged. Probably the most notable difference is that amounts classified within other comprehensive income are never reclassified to net income under IFRS whereas U.S.GAAP requires reclassification of those amounts. The new standard will be applicable for fiscal years that begin on or after January 1, 2013, with earlier application permitted. Refer to In brief 2011-27, IASB issues amendments to IAS 19, Employee benefits, for more information. Goodwill impairment In September 2011, the FASB issued a new standard on goodwill impairment. Many preparers are likely appreciative of the change, which is intended to reduce the cost and complexity of the annual goodwill impairment test. Companies may now opt to perform a
qualitative assessment to determine whether further impairment testing is necessary. The standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. However, a company can adopt the standard early as long as it has not yet performed its 2011 annual impairment test or issued its 2011 financial statements. Refer to Dataline 2011-28, Goodwill impairmentFASB issues guidance that simplifies goodwill impairment test and allows early adoption, for more information. Disclosures about multiemployer plans The FASB also released in September 2011 a new standard that requires employers to provide additional disclosures about their financial obligations to multiemployer pension plans. These planswhich allow unrelated employers to contribute to a single pension plan and commingle the related assetsare commonly used by employers in unionized industries. The new guidance is intended to enhance users understanding about the financial health of all of the significant plans in which an employer participates. Current recognition and measurement guidance for an employers participation in a multiemployer plan is not affected. Refer to In brief 2011-39, FASB issues final standard to enhance disclosures for multiemployer pension plans; effective for public companies in 2011, along with our upcoming Dataline, for more information.
Whats new? The boards have been steadily chipping away at the to-do list on this three-legged project. The FASB is close to completing its redeliberations of its new classification and measurement approach. Although a formal decision by the FASB to re-expose its latest model on classification and measurement has not yet been made, most constituents expect they will have another opportunity to comment. The IASB has also said it will seek feedback on the FASBs new approach and recently proposed a delay in the effective date of its classification and measurement guidance from 2013 to 2015. Impairment also continues to evolve, with the boards expected to re-expose a newly developed impairment approach. On the hedging front, the IASB is nearing completion of its new standard on general hedge accounting, while the FASB has yet to redeliberate that piece of the project. FASBs classification and measurement model in the final stretch With the tough accounting-related issues wrapped up, the FASB has turned its attention to presentation and disclosure. Before diving into whats new in that area, a summary of where the FASB has landed on key parts of the model may be helpful:
Component Principle for classification
Tentative decision Financial assets are classified into one of three categories based on (1) the individual instruments characteristics and (2) an entitys business strategy for the portfolio. A limited business strategy applies for liabilities. Classified into one of the following categories: (1) amortized cost; (2) fair value with changes in fair value recognized in other comprehensive income; or (3) fair value with changes in fair value recognized in net income. 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. Nonpublic entities are provided a practicability exception for the measurement of nonmarketable equity securities. Applicable if significant influence over the investee exists, but only if the investment is not held for sale. If held for sale, equity investment accounting applies (that is, fair value). Embedded derivatives that are not clearly and closely related to the host contract in a hybrid instrument are separately accounted for at fair value with changes in fair value recognized in net income. Only available in limited circumstances, such as for hybrid financial instruments, in order to avoid the complexity of separately accounting for embedded derivatives.
Debt investments
Debt liabilities
Equity investments (not under equity method of accounting)
Equity method of accounting
Hybrid instruments
Hybrid instruments
Presentation requirements to give users the best of both worlds While it may not be the predominant measure on the financial statements, fair value will still get its fair share of attention. How is that? The fair value of certain financial instruments measured at amortized cost (such as debt investments) will be presented parenthetically on the face of the balance sheet. Similarly, certain financial instruments measured at fair value (such as debt) will have their amortized cost amount presented on the balance sheet. The income statement will also have new, specified line items for certain financial instruments. For example, interest income along with realized gains and losses will be separately presented for some instruments such as debt investments. Risk disclosures move to the financialstatements From a disclosure standpoint, one theme has surfaced loud and clear from investors: improvements are needed. In response, the FASB will require expanded disclosures that focus on the risks that entities assume as either issuers or holders of financial instruments. Many of these disclosures are currently in management discussion and analysis in public filings, which are not part of the primary financial statements. That will change. Standardized quantitative information about the risks associated with the liquidity of financial instruments will be
required in the financial statement disclosures. Financial institutions and reportable segments of other companies that engage in lending or financing activities will also have to provide information about interestrate related risks. Will the latest impairment approach make the cut? Determined to get it right, the boards have developed yet another approach to the impairment of portfolios of loans. The last model they proposed (the so-called good book/bad book approach) was not embraced by constituents, so the boards went back to re-think the issues. Their latest proposal is intended to recognize impairment in a way that reflects the general pattern of deterioration of the credit quality of the loans. That is, the lower the credit quality of the loan, the higher the related impairmentreserve.
Under the new approach, portfolios of loans would be divided into three categories for purposes of measuring the impairment reserve: (1) assets not affected by observable events (that is, negative credit events); (2) assets affected by observable events at a general economic level; and (3) individual assets expected to default or that have defaulted. Those assets in Category (1) would be reserved using expected losses for the foreseeable future (expected to be 12 months), based on initial expectations at acquisition or origination of the loans. Expected losses for assets in Categories (2) and (3) would be fully reserved based on the lifetime of expected losses for the portfolio and for individual loans, respectively. When would loans be transferred among categories? The boards have been grappling with this question. They first considered a relative
The boards latest impairment approach

Category 1
Asset not affected by observable events
Category 2
Asset affected by observable events
Category 3
Specific assets defaulted or expected to default
Reserve expected losses for the forseeable future
Reserve full lifetime expected losses (portfolio level)
Reserve full lifetime expected losses (individual asset level)
Credit deterioration
The boards continue down their separate paths on hedge accounting.
credit model. Under this approach, generally loans would be initially placed into Category (1). The theory is that credit risk has appropriately been priced into the loan at inception and the lender is being compensated for that risk through the loans yield. Transfers to a lower category would subsequently occur if credit quality of the loan deteriorated compared to the credit risk existing at loan inception. Although appealing conceptually, the operational complexities of this approach caused the boards to seek an alternative solution. Now the boards are evaluating an absolute credit model. That model looks at the credit quality of the loans at each reporting date in isolation (rather than how credit quality compares to an earlier period). While this approach is more consistent with how entities track and monitor their credit exposures, it also has its shortcomingsnamely an increased likelihood for day one impairments. This situation could arise if an entity purchases loans with existing credit problems or originates loans to borrowers with low credit quality. Concerns have been raised that this accounting does not adequately consider that the lender is being compensated for the increased credit risk through a higher future yield. After the boards solve the impairment model for loans, they will need to turn their attention to debt securities. In addition, the FASB also needs to determine how the model will apply to investments measured at fair value
with changes in fair value recognized through other comprehensive income. FASB gets ready to tackle hedging while IASB nearscompletion Back in February 2011, the FASB requested feedback from its constituents on the IASBs hedge accounting proposals. What was the response? A thumbs up on many aspects of the IASBs proposed model. This is not surprising considering the flexibility being introduced by the IASB compared to existing guidance and the FASBs proposal. Constituents also urged the boards to work together on a converged standard. Although that goal would be ideal, it has proven to be elusive as the boards continue to progress at a different pace. Right now, the FASB has yet to engage in redeliberations on its hedging proposalsalthough they are gearing up to perform outreach to users and redeliberations are expected shortly. The IASB, on the other hand, has completed its redeliberations. It plans to issue a staff draft of the final standard in November 2011, with a final standard expected in the first half of 2012. Further, the IASB has begun its deliberations on the second phase of its hedging project: macro hedging. Macro hedging relates to hedging risks in open portfolios portfolios where the population can continue to change over time (for example, a portfolio of loans that carry interest rate risk). Currently, the ability to qualify for hedge accounting
for open portfolios is limited under IFRS. Many companiesparticularly financial institutionsare interested in the ability to apply macro hedging strategies because they manage risk at the portfolio level. Whats next? The FASB should wrap up its redeliberations on classification and measurement shortly. Whether it will re-expose that portion of the project remains unknown, but that course of action seems likely. Clearly, the boards will be seeking input on their latest impairment model, which will likely be in the first quarter of 2012. And, it looks like hedging will continue to move forward for both boards, albeit on separate tracks for now. Look for a final standard on general hedge accounting from the IASB in the first half of 2012. For more information: Dataline 2011-26, Financial instrumentsAn update on the FASBs financial instruments project redeliberations as of June 30, 2011 Dataline 2011-06, Accounting for hedging activitiesA comparison of the FASBs and IASBs proposed models. In brief 2011-34, IASB proposes to delay IFRS 9 effective date
10
U.S. GAAP exception for net presentation of derivatives is retained by the FASB, but disclosure requirements expanded.

In a surprising move, the FASB and IASB have decided to go their separate ways on this project. The FASB decided to retain its existing balance sheet offsetting criteria for both derivatives and non-derivative financial instruments while the IASB decided to retain the proposals from the joint exposure draft. As a result, one of the largest differences between U.S. GAAP and IFRS balance sheets will remain. However, the boards did agree to enhance disclosures to bridge the accounting gap. Agreeing to disagree Under existing U.S. GAAP, derivatives and collateral subject to master netting agreements can be presented either gross or net on the balance sheet at a companys election. The joint proposal would have precluded net presentation, unless the criteria for unconditional offsetting (that is, where amounts could be offset in all cases) were met. This would be the case even if the underlying financial instruments were executed under a master netting agreement. Master netting agreements provide for netting of amounts owed against amounts due in the event of bankruptcy or default of one of the counterparties. This is considered a conditional right of offset. While most stakeholders agreed that both gross and net information is important, divergent views emerged on what is the most meaningful balance sheet presentation. The
boards similarly could not come to agreement and finally decided to go their separate ways. In a close vote, the FASB decided to allow for the continued balance sheet offsetting of derivatives and related collateral amounts subject to a master netting agreement. In contrast, the IASB did not believe that derivatives warranted special treatment. The practical effect of this decision is that the balance sheets of companies that report under IFRSparticularly financial institutionsmay appear significantly larger than those of their US peers. Disclosurethe common thread Although they could not harmonize on presentation, the boards united on enhanced disclosures. The additional information that will be required is intended to enable users to understand an entitys right of setoff and other arrangements relating to its financial assets and liabilities. Such disclosures include the following: Gross amounts of financial assets and liabilities The amounts of financial assets and liabilities offset on the balance sheet, including the net amountspresented The impact of rights of setoff that are only conditionally enforceable (for example, in the event of default or bankruptcy of one of theparties) The net exposure after consideration of the rights of setoff
Whats next? The FASBs redeliberations are complete and final amendments to its guidance to incorporate the new disclosures are expected in fourth quarter 2011. The IASB is also planning to issue the amendments to its guidance in fourth quarter 2011. The boards have tentatively decided on an effective date for the new disclosures of interim and annual periods beginning on or after January 1, 2013. For more information: In brief 2011-28, FASB and IASB take separate paths on derivatives netting rules
11
Revenue recognition
Whats new? After redeliberations concluded in July 2011, the boards decided to re-expose their revenue recognition proposal. Thats a favorable outcome since constituents want to weigh in on any decisions that could affect their revenue-related metrics. We expect the new exposure draft in fourth quarter 2011. What did the boards decide on key concepts? After months of redeliberations, its sometimes hard to keep track of the many board decisions. To refresh your memory, here is a summary of the more significant decisions:
Concept What is included in the transaction price?
Tentative decision
Fixed consideration. Variable consideration at a probability-weighted estimate or most likely amount of cash flows, whichever is most predictive. Time value of money, when significant, and if it exceeds a period greater than one year. Bad debts are not included. Rather, they are reflected in a line item adjacent to revenue (not as an expense).
How is the transaction price allocated to multiple performance obligations?
Based upon the relative selling prices of all performance obligations. Residual technique may be used to estimate standalone selling price when there is significant variability or pricing uncertainty in one or more performance obligations. Variable consideration and discounts can be allocated to one (or more) performance obligations in some cases.
When is revenue recognized?
Goods and licenses: when control passes. Services: as the obligation is being satisfied, if specified criteria are met. Otherwise, upon completion of the service. Constrained to the amount that is reasonably assured.
Are losses accrued for onerous performance obligations?
Yes, but only for performance obligations satisfied over a period of time longer than one year. Loss equals (1) lower of direct costs to satisfy the obligation or to cancel the contract, less (2) consideration allocated to that performance obligation. Incremental costs of obtaining a contract are capitalized if expected to be recovered. Entities may choose not to apply to short-term contracts (12 months or less). Assets are amortized over the expected period of benefit, which may exceed the contract term. Costs to fulfill a contract are capitalized based on other applicable guidance (for example, inventory) or if specified criteria are met.
Can contract-related costs be capitalized?
12
The boards generally stayed the course on not including industry exceptions intheirproposal.
New exposure draft to targetareas of change Although the entire standard is being re-exposed, the boards are seeking feedback in specific areas including the following: The guidance for recognizing revenue when performance obligations are satisfied over time (for example, service obligations). The requirement to present the effects of credit risk (for example, bad debt expense) adjacent to revenue rather than as an expense. The decision to constrain recognition of revenue in some situations involving variable consideration. The decision to limit the onerous test to performance obligations that are satisfied over a period of time greater than one year. Of course, anything is fair game when submitting comments on the proposals. Companies may want to test run their key transactions through the whole model to see whether the accounting results fairly portray their business and the economic substance of theirtransactions.
Transitionsome relief on retrospective application The previous exposure draft required retrospective application of the new guidance to all prior periods. Despite concerns raised about cost and complexity, the boards decided to retain retrospective application. However, to address the concerns, the boards are incorporating provisions that are designed to provide some relief. Companies can choose to apply one or more of the following accommodations in the first year ofapplication: Contracts that begin and end within the same prior annual accounting period do not need to be restated. Rather than estimating variable consideration in prior periods, the actual amounts received upon completion of the contract can be used in determining the transaction price. The onerous test does not need to be performed in comparative periods unless an onerous contract obligation was previouslyrecognized.
The maturity analysis of remaining performance obligations and the expected timing of revenue recognition for those obligations do not need to be disclosed for comparative periods. These transition provisions should help with retrospective application, although it remains to be seen whether constituents believe the boards went far enough to alleviate the cost and complexity concerns. Boards stay true to no industryspecific guidance Many industry-specific issues were raised to the FASB and IASB for their consideration. The boards generally decided not to provide exceptions to the overall guidance. This was consistent with one of the objectives of the projectto reduce industryspecific revenue recognition practices. Instead, industry-related issues were typically addressed by modifying or enhancing the relevant core principles of the guidance. For example, many construction companies asked the boards to retain their existing industry revenue guidance. Rather than carry forward a separate model, the boards modified the proposed guidance about the transfer of control of a good or service and when it is appropriate to recognize revenue continuously. However, that guidance applies to all industries, not justconstruction.
13
Will private companies have different rules? Except for certain disclosures, no. The FASB considered the needs of private companies during its redeliberations, but decided that the broad principles were equally appropriate for non-public companies. However, the FASB performed additional outreach to private company financial statement users, preparers, and auditors to determine whether the proposed extensive disclosure requirements were useful in a private company setting. As a result of that outreach, the FASB has scaled back many of the proposed disclosures for private companies, a decision well received by the private sector. Many public companies have expressed the same cost/benefit concerns, which may resurface during the second comment period. Whats next? The exposure draft is expected in fourth quarter 2011 and will have a 120-day comment period. As a result of the re-exposure, the target date for issuing a final standard has been extended from December 2011 to September 2012. The effective date is expected to be no earlier than annual periods beginning on or after January 1, 2015. The FASB will not allow for early adoption, although it is expected that the IASB will permit early adoption for IFRS preparers.
For more information: 10Minutes on the future ofrevenue recognition In brief 2011-24, The next chapter: FASB and IASB decide to re-expose the proposed revenue standard In brief 2011-22, FASB and IASB on track with deliberation plan for revenueproject Dataline 2011-19, Revenue from contracts with customersKey decisions propel the project forward
Leases
Whats new? The boards will be re-exposing the leases proposal, giving constituents another chance to voice their opinion. The new exposure draft is expected in first quarter 2012, after the boards tie up the loose ends on theirredeliberations. Re-exposuregetting ready forround two The decision to re-expose the leases proposal was not unexpected. Fundamental aspects of the original exposure draft changed, including the definition of a lease, the lessor model, accounting for variable rents, and lease incentives, as well as renewal and purchase options. The boards will be interested in learning whether these changes are improvements and whether preparers believe they are operational. With the boards decision to seek feedback again, a new standard is unlikely until later in 2012 at the earliest. So, what should you expect to see in the next proposal? The basic model for lessees hasnt changed (that is, lessees will record a right-of-use asset and a lease liability on the balance sheet). However, many aspects of the original proposals have changed. To level set, we have included a summary of the boards key decisions reached during redeliberations so far:
14
Component Definition of a lease
Tentative decision
A contract in which the right to use a specified asset (explicitly or implicitly identified) is conveyed, for a period of time, in exchange for consideration. Requires the lessee to have 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.
Lease term
Includes the fixed non-cancellable term plus any options to extend or terminate when a significant economic incentive exists (for example, bargain renewal options). Reassessment is required when there is a significant change in one of the indicators relating to significant economic incentive.
Variable payments for lessees
The following variable lease payments are included in the lease obligation: - Future lease payments based on a rate or index - Disguised minimum lease payments - Residual value guarantees expected to be paid Lease payments based on a rate or index would initially be measured at the spot rate that exists at lease commencement; reassessment is required as rates or indices change. Contingent rents based on usage or performance are not included, unless they are considered disguised minimum lease payments.
Discount rate
Lessees should discount lease payments using the rate being 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.
Income statement recognition
Leases (other than some short-term leases) are treated as financing transactions. This means that for a given lease, amortization and interest expense, rather than rent expense, will be reflected in the income statement. This will result in an accelerated income statement recognition pattern for the lease. The lessor derecognizes the leased asset and records a lease receivable and residual asset. If reasonably assured, profit is recognized at lease commencement; otherwise, it is recognized over the lease term. Lessees and lessors can elect to account for leases that have a maximum term of 12 months or less (including any renewal options) similar to the income statement recognition pattern for todays operating leases.
Lessor accounting
Short-term leases
15
After much debate, the boards have landed on an approach for lessor accounting.
Lessor accounting to change with a new approach For a while, it looked as though the boards might abandon efforts to significantly change existing lessor accounting. Now, they appear to have agreed on a single receivable and residual model (previously known as the derecognition approach). Apart from short-term leases described above, this latest proposal would require a lessor to remove the leased asset from its balance sheet and recognize: (1) a receivable related to the lessees right-of-use asset and (2) the portion of the asset retained by the lessor (the residual). Companies would be required to separately disclose these amounts, either on the face of the balance sheet or in the notes. Immediate profit recognition may be permitted when the underlying assets fair value exceeds its carrying value. The boards are expected to develop application guidance in this area. Putting mechanics aside, how do preparers feel about the latest lessor approach? It depends on who you ask. Equipment lessors may find the new model appealing as it provides results expected to be similar to todays direct financing or sales type lease accounting. On the other hand, lessors of real estate arent quite as enthusiastic. The approach will require lessors to recognize interest income using the effective interest method and to recognize accretion related to the residual asset. The result is lower overall revenue compared to operating lease treatment, as
well as a downward sloping pattern of revenue recognition for a given lease. Preparers pressed the boards to retain a straight-line recognition pattern in the income statement for certain other-than-financing leases. While the boards considered such an approach, ultimately, they could not reconcile it with their fundamental belief that all lease arrangements contain at least some financing element. Surely, the debate over lessor accounting will continue through the re-exposurephase. The impact of the boards tentative decisions on lessors reporting may have re-ignited interest in the FASBs investment property entities project. Those proposals would require entities that qualify as investment property entities to record their real estate at fair value. In turn, such entities, as lessors of real estate, would be outside the scope of the leases standard. For more information, refer to the Investment property entities section in this edition of Setting thestandard. Variable rentsa recurringtopic In July 2011, the boards revisited the accounting for variable lease paymentsagain. This time, they tackled the question of what rate should be used for variable payments that are based on a rate or index. The answer? At lease commencement, use the rate that exists at that time. For example, leases with payments based on the consumer price index would be measured using the current
index. Variable lease payments should be reassessed as rates and indices change. Lessees would account for these changes in the income statement when they relate to a prior or current accounting period. To the extent changes relate to future periods, the lessee will adjust the right-of-use asset. Lessors would recognize any changes immediately in the income statement. Whats next? The boards are scheduled to issue the new exposure draft in first quarter 2012. Key issues, such as transition, remain open for discussion. As a result of the re-exposure, the target date for issuing a final standard has been extended from December 2011 to the second half of 2012. The boards have yet to decide on an effective date, but it will likely not be before2015. For more information: In brief 2011-40, Transition decision postponedwill this delay re-exposure of the Leases exposure draft? 10Minutes on the future oflessee accounting In brief 2011-31, FASB and IASB agree to re-expose leasing ED and agree on one lessor accounting model In brief 2011-21, FASB and IASB change course on leases Dataline 2011-21, Leasing Redeliberations of the leasing projectSome new twists
16
The boards cant seem to reach agreement on the approach for short duration contracts.
Insurance contracts
Whats new? Progress on the insurance project seemed to wilt under the summer heat. Despite the fast pace of board discussions in spring 2011, the timeline for this project has now been extended to 2012. Why the delay? Likely a combination of personnel changes at the IASB, enhanced user outreach, and the biggest culpritthe complexity of insurance accounting. Short duration contractsno short discussion here In July 2011, the boards discussed the simplified approach for short duration contracts (now termed the premium allocation approach). So why isnt it simple? The IASB sees the approach as an approximation of applying the full insurance contract model. On the other hand, the FASB and many US users believe there should be a separate model for property and casualty insurance contracts that is consistent with the revenue recognition proposal. They view property and casualty contracts as economically different from long-term life insurance contracts and, as a result, believe different accounting makes sense. Because their views differ, the boards have struggled to agree on what makes a contract eligible for the premium allocation approach. Despite the differences, there may be some hope for agreement. Both boards believe that premium revenues should be recognized as earned, and claims
should be recorded as expenses when incurred. The crux of the difference lies in the measurement of incurred claims. The IASB likes the full insurance contract model approach, inclusive of a risk adjustment. The FASB would record the incurred claims based upon discounted expected cash flows, with no risk adjustment or margin. The result: the IASBs approach provides a higher liability at inception and a different income statement recognition pattern. FASBs take on profit recognition: the single marginapproach The boards continue to have different views on profit recognition. The IASB supports a risk adjustment and a residual margin for the difference between expected cash inflows and outflows, while the FASB prefers a single margin approach. The two approaches result in the same total, but the IASBs model separates out an explicit risk margin to provide for the uncertainty of the amount and timing of cash flows. The FASB would require the single margin to be brought into income over time, as the insurer is released from risk. Most recently, the FASB debated the mechanics for the following two broad categories of contracts: (1) those where the variability in cash flows is primarily due to the timing of an insured event (for example, a whole life insurance contract) and (2) those where the variability is primarily due to the frequency and severity of the insured event (for example, a property and casualty contract that does not
qualify for the short duration contract exception). And the conclusion? The FASB believes that the amortization pattern should be principles-based and decided not to dictate any specific requirement. Depending on how insurers interpret their release from risk, this could lead to less comparability among companies than under current U.S. GAAP. Whats next? The boards are still working to reach agreement on certain critical aspects of the model such as income statement presentation, disclosure, and transition. Expect to see an exposure draft from the FASB in the first half of 2012. At this point, it is unclear whether the IASB will decide to re-expose its proposal, so stay tuned for developments on that front. For more information: IASB-FASB insurance contracts project summary (as of June 15, 2011) Dataline 2010-39 (revised February 16, 2011), Insurance contracts Fundamental accounting changes proposed
17
Consolidation and investment companies

Whats new? The FASB will soon release two exposure drafts related to consolidation: one on the consolidation model itself and one on investment companies. Although an exposure draft on consolidation had been anticipated in summer 2011, it has been delayed as the FASB has continued to refine its proposals. The IASB issued its final consolidation guidance in May 2011. More recently, board activity has been focused on guidance for investment companies. The IASB issued its exposure draft on investment entities in August 2011, while the FASB is putting the finishing touches on its proposal. Exposure draft to target principal versus agent considerations Not much has happened with the FASBs consolidation project in recent months. However, here is a refresher of the changes in store. In short, the consolidation challenges faced by the asset management industry sparked the need for this project. Specifically, the core issue is whether an asset manager is a principal of a fund (due to its decision-making capabilities) or is an agent of the funds investors. The revised variable interest entity guidance (which became effective in 2010) would often lead to a conclusion that the asset manager is acting as a principal, requiring consolidation of the fund. Many asset
managers believe this conclusion is inconsistent with the nature of their role. Recognizing that concern, the FASB deferred application of the new guidance for certain funds until it had the chance to study the question. The new proposals will now include a required qualitative assessment to determine whether a decision maker is acting as a principal or agent based on a new set of factors. However, consolidation rules can be complex. So, those not in the asset management industry should also review the exposure draft. While the proposals are intended to resolve issues primarily affecting the asset management industry, they may contain changes that could potentially affect the analysis for other types of structures. Some examples of transactions that may be impacted include collateralized debt obligation and collateralized loan obligationstructures. More clarity for investment companies and their investments In a separate work stream, the boards have been developing comprehensive and converged guidance for determining: (1) whether an entity is an investment company and (2) how those entities should measure their investments. The standard will establish a new definition of an investment company, something that currently does not exist under IFRS. As a result, investment companytype entities applying IFRSs today must apply the general consolidation
model and cannot present their subsidiaries at fair value. That differs from U.S.GAAP, where portfolio investments are reported at fair value. Today, U.S. GAAP also provides an option that allows investment companies to consolidate their interests in investment companies that are whollyowned. Defining an investment company How does an entity qualify as an investment company? It will need to meet all of the following criteria: 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 company is to invest for investment income, capital appreciation, orboth. Unit ownership: Ownership in the company is represented by units of investments, such as stock shares or partnership interests, proportionate to an owners 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, unrelated to the entitys parent (if any), who hold a significant ownership interest in the aggregate.
18
FASB retains specialized accounting by parents of investment company subsidiaries.
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 FASB provided one exception to the above criteria. Investment companies under the Investment Act of 1940 would also be considered investment companies under the proposed standard even if they do not meet all of the factors above. Consolidation or fair value? Defining an investment company is important. However, the focal point of this project is how investment companies and other entities should account for portfolio investments as well as interests in other investment companies. Should those portfolio investments and investment companies be consolidated, or should they be recorded at fair value? Lets start with portfolio investments. Under both boards proposals, portfolio investments heldby an investment company would be recorded at fair value. This is the case even when the investment company has a controlling interest in, or significant influence over, the investments. Sound familiar? Thats because this guidance is consistent
with existing U.S. GAAP. However, it will be new for IFRS. What about interests in other investment companies? The FASBs proposal would require investment companies to consolidate an investment company or investment property entity (see the Investment property entities section of this edition of Setting the standard for more information) in which it has a controlling interest. This is a change from current U.S. GAAP whereby a controlling interest would generally only be consolidated if the investment company subsidiary is wholly owned. There is an important accommodation, however, that the FASB has decided to preserve. A parent of an investment company will be required to retain, in consolidation, the specialized accounting followed by the investment company. This guidance is important since, without it, non-investment companies would have to apply consolidation or equity method guidance to the portfolio investments held by the investment company subsidiary. It is often operationally difficult to obtain the data needed to account for the investments on a consolidated basis. This accommodation, however, wont extend to those applying IFRS. The IFRS exposure draft proposes that non-investment company parents of investment companies would continue to apply normal consolidation guidance to the subsidiary investment companys underlying portfolio investments.
Whats next? The FASB is expected to issue both its consolidation and investment companies proposals in fourth quarter 2011 with a comment deadline expected to coincide with the IASBs investment companies proposal comment deadline of January 5, 2012. For more information: In brief 2011-27, IASB proposes accounting guidance for investment entities In brief 2011-19, IASB issues package of standards covering consolidation and joint venture accounting
19
It is still unclear whether the scope definition will achieve the outcome the FASB desires on this project.
Investment property entities

Whats new? The FASB is getting closer to issuing an exposure draft that would require certain types of entities to record their real estate at fair value. Recently, the FASB has continued to refine the scope of the guidance and has addressed other related accounting issues. Why the need for an investment properties project? With all the FASB has on its plate, you may be wondering why investment properties is on the short-term agenda. One reason: leases. Under existing lessor guidance, investment property (for example, real estate) is recorded at cost on the lessors books, with rental income recognizedon a straight-line basis (assuming it is an operating lease). However, the boards lessor accounting proposal fundamentally changes that accounting. Real estate lessors will be required to derecognize some or all of the leased real estate potentially with gains or losses upon lease commencementand will generally recognize rental income in a downward sloping pattern. Many in the real estate industry do not believe this accounting reflects the economics of their business. Why?
This revenue recognition pattern would vary significantly from the related cashflows. To address this issue, the IASB scoped out entities that measure their real estate investment properties at fair value from its new lease proposal. This is a great solution under IFRS, since it has specific guidance allowing companies the option to record investment properties at fair value. Problem is, there is no similar existing guidance under U.S. GAAPthus, the FASBs project. What is the FASBs proposal? Entities that fall within the scope of the investment property entities standard would be required to measure the real estate they hold at fair value, on a recurring basis. The FASBs model differs from IFRS in two key aspects: (1) the scope of the IFRS guidance focuses on the type of property rather than the nature of the entity holding the property and (2) measuring property at fair value under IFRS is optional. Progress made on scope however, issues remain Throughout the FASBs deliberations, the key issue has been scope. The FASB has continued to make scope adjustments in an attempt to capture those entities it believes should be reporting real estate at fair value. Whether an entity is currently in the scope of the guidance depends
on whether it meets defined criteria related to its business purpose and activities, and capital structure. While the FASB has made progress on narrowing in on the scope of the project, practical issues still remain in determining who will qualify as an investment property entity. One requirement is that a companys substantive activities must relate to investing in real estate for total return (including an objective to realize capital appreciation). Critical to this analysis is the company having a defined strategy to exit its real estate investment(s). Crafting these criteria will be a significant issue. Entities holding substantive amounts of real estate for purposes other than investing would not be within the projects scope. Some wonder whether the board will need to further tinker with the proposal. Why? Because certain real estate investment trusts (REITs) (presumably the prime targets for reporting real estate at fair value) may not qualify as an investment property entity due to their lack of a sufficiently defined exit strategy for their investments. Relative to capital structure, an entity needs to have multiple investors that pool their investments together to achieve a significant aggregate ownership interest. That requirement had caused concern for certain
20
single investors such as pension funds that wholly own entities holding real estate, and insurance company separate accounts that hold single investment properties. These entities are required to report their underlying investments (including real estate) at fair value. Recognizing the importance of fair value information for these types of investors, the FASB plans to provide an exception to the unit of ownership and pooling criteria to deal with thesecircumstances. Real estate is also expected to be broadly defined to include not only traditional rental real estate such as office buildings or retail, but also non-traditional real estate and integral equipment attached to real estate. Items such as power plants, pipelines, or cellular towers could potentiallyqualify. Investment property entities versus investment companies The characteristics of an investment property entity may not seem that different from those of an investment company 1. In fact, many investment property entities (such as real estate funds) will often meet the definition of an investment company. However, there could be a number of investment property entities (such
as REITs) that would not meet the definition of an investment company due to the existence of operating activities. Wondering which one you will be scoped in to and whether it matters? It may very well matter since the accounting, presentation, and disclosure requirements will likely bedifferent. Other issues also discussed The FASB has also tentatively concluded on certain recognition and measurement issues. Although specific guidance does not exist today, some real estate funds report their real estate investments at fair value. Over the years, industry practices have developed for reporting fair values of these investments. The FASB has considered these reporting practices and has tentatively decided to incorporate many of them into the investment property entities standard, thus preserving some of todays practices for those already reporting on a fair value basis. Forexample: Transaction costs would be included in the initial measurement of real estate (whether acquired in a business combination or as an asset purchase) rather than being immediately expensed. While consistent with practice today for
entities reporting on a fair value basis, this will be a significant change for those not reporting today at fair value (such as REITs). Other aspects of business combination accounting (such as the allocation of purchase price to lease intangibles for leased real estate purchases) would no longer apply. Rather, real estate and related lease intangibles would be accounted for as one asset. Revenue recognition from leases would be based on contractual revenues rather than recognized on a straight-line basis over the term of the lease. The FASB believes such pattern of recognition is more consistent with a fair value model, since the fair value of the real estate incorporates future rentadjustments. Use of the net asset value practical expedient would be permitted for the fair value of investments in other funds or entities that report a net asset value, as long as investors in such funds or entities would transact at net asset value. Whats next? An exposure draft is expected in fourth quarter 2011, concurrently with the issuance of the FASBs proposal on investment companies. A final standard is scheduled for 2012.
1 The definition of an investment company is currently being revised. For more information, including related consolidation issues, refer to the Consolidation and investment companies section in this edition of Setting the Standard.
21
Contingencies disclosures continue to receive plenty of attention from the SEC.
Other projects
Whats new? Lower priority projects continue to wait for their turn. This is not surprising since the boards have said that further activity is not expected on these projects until they call it a wrap on the priority projects. Because these projects stand to introduce significant changes to financial reporting, we continue to report a brief summary of their current status in this section. If you wish to take a deeper dive into the boards prior decisions, refer to the October 2010 and December 2010 editions of Setting the standard, and the other publications referenced below. Contingencies The SEC has taken the lead on evaluating compliance with loss contingencies disclosures under existing guidance. Based on the comment level activity in this area, its clear that the SEC staff believes existing disclosures could be
enhanced. For example, the SEC staff has challenged companies that failed to disclose possible loss or range of loss estimates for at least some of their contingencies. Reviews are ongoing and additional comments could surface from the SECs review of 2011 filings. Where does the FASB stand? In 2010, it issued a proposal intended to improve loss contingency disclosures. Many constituents were concerned that the suggested disclosures would potentially jeopardize legal positions by requiring too much information. Others said that the perceived shortcomings in todays disclosure practices are caused by inconsistent application of the current guidance, rather than the guidance itself. As a result, the FASB decided to hold off on further deliberations until it had the opportunity to evaluate 2010 year-end reporting disclosures. The FASB has not indicated when the proposal would be back on its agenda, but we believe it is unlikely there will be further movement on this project in2011.
The IASB also issued a proposal in 2010, but went further by proposing changes to the recognition and measurement for contingencies as well as disclosures. This proposal was also not favored by many constituents. Similar to the FASB, the IASB has put its proposal on hold. In fact, the contingencies project is not listed on the possible future agenda that the IASB has recently released for publiccomment. For more information: Dataline 2010-32 (revised February 1, 2011), Disclosure of certain loss contingencies An analysis of the FASBs proposed changes
22
Financial statement presentation In first quarter 2011, the boards gave a sneak preview into the possible direction of this project. If youll recall, the boards had been ready to release their proposal for public comment in July 2010. At that time, the boards published a staff draft of an exposure draft outlining their tentative decisions. The exposure draft would propose sweeping changes to the way that financial statements are presented today. Subsequently, the staff met with constituents to better understand the perceived benefits and costs of the proposed changes as well as the implications for financial institutions. In March 2011, the staff of the FASB and IASB presented the results of their outreach to the boards and suggested potential solutions for addressing concerns when the project re-energizes. Although the boards did not make any decisions at the March 2011 meeting, it was clear they expect the project to continueit just may take awhile. We dont expect any significant activity until at least the end of 2011.
For more information: Dataline 2010-35 (revised February 3, 2011), Financial statement presentationA look at the FASB and IASBs staff draft
constitute a separate major line of business or major geographical area of operation. The proposal is also expected to remove todays threshold requirements that operations and cash flows of the disposed component be eliminated from the ongoing operations of the entity. The proposal may reduce the number of discontinued operations, but it is expected to ratchet up the disclosure requirements. Companies will have to disclose information about disposals that qualify and those that do not qualify as discontinued operations. The disclosures for qualifying disposals will be expanded to require information about: (1) the major classes of cash flows; (2) the major income and expense items constituting the profit or loss from a discontinued operation in current and prior periods; and (3) the nature of any continuing involvement by the disposing entity. The proposal will also require a reconciliation in the footnotes of the major classes of assets and liabilities underlying the amount presented as discontinued operations on the face of the balance sheet.
Discontinued operations An exposure draft was expected on this project in second quarter 2011 even though it had been quiet for some time. However, as a result of the boards focus on the priority projects, the timing for this project is nowuncertain. What is the discontinued operations project? The FASB is seeking to converge its discontinued operations guidance with IFRS in this subset of the financial statement presentation project. The proposal will present a new definition of discontinued operation, consistent with the existing international guidance. To qualify as a discontinued operation, the operation must: (1) have been disposed of or meet all the criteria to be classified as held for sale and (2)
23
Similar to the overall financial statement presentation project, further action is not expected before December 2011. Financial instruments with characteristics of equity This project has been in development for a number of years, in an attempt to improve the patchwork of complex guidance that exists today for liabilities and equity. Although an exposure draft was to be released in the summer of 2010, substantial concerns were raised on the draft proposals about the meaning, enforceability, and internal consistency of some of the proposed requirements. Essentially, the boards joint deliberations had considered a variety of approaches that attempted to leverage current IFRS guidance as a starting point, while addressing known practice issues with that model. However, constituents review of the draft proposals pointed to flaws in the proposed model. The boards considered the feedback and discussed several alternatives, without any final decisions. When the boards are ready to re-engage on this project, they may need to find a fresh approach for
tackling the age-old question of when a financial instrument is a liability and when it is equity. Emissions trading schemes Emissions trading schemes is another project that has been deemed a lower priority by the boards. While this project is not an official joint project, the boards began to deliberate in earnest together during the fall of 2010. At that time, they had started to make good progress, defining emission allowances as assets and determining that receipt of allowances under an emissions trading program creates a liability. For companies in emissions-intensive industries, the activity was an important step, given the current lack of authoritative guidance on accounting for emission allowances under both U.S. GAAP and IFRS. Despite the progress, many aspects of the project remain to be deliberated, such as measurement of the liabilities and financial statement presentation. However, because of the boards focus on the priority projects, we do not expect any significant developments in the near term.
24
Edited by:
Jan Hauser
Partner Phone: 1-973-236-7216 Email: jan.hauser@us.pwc.com

Chad Bonn
Partner Phone: 1-973-236-5372 Email: chad.bonn@us.pwc.com

Mia DeMontigny
Managing Director Phone: 1-973-236-4012 Email: mia.l.demontigny@us.pwc.com

Steve Krump
Senior Manager Phone: 1-973-236-5234 Email: steven.krump@us.pwc.com
25
A measured approach
The timing and prioritization of convergence projects continues to evolve, but the most significant elements could be effective as early as 2015 or 2016. While this seems like a ways off, there is work to be done in advance of the effective dates given the level of change as well as the impact on comparative reporting periods. Most companies need not embark upon a full-blown adoption project right away, but there are steps that companies can take in the near term that will serve as strong building blocks for future adoption of the standards. Each company is different, and therefore the impact of the proposed standards will differ from one company to another. Industry segment and business complexity will both play a role in determining the level of impact. As a baseline, companies should remain aware of the changes that result from the joint projects and should stay close to developments in these standards as the FASB and IASB continue their deliberations. Certainly, should your company have strong views on a topic, you might consider getting involved with the standard-setting process by responding to requests for comments or taking part in roundtable discussions and other standard setter outreach activities. Companies should also start to assess, at least at a high level, how the proposed changes will impact their company and form a point of view on the level of impact. Those that are impacted more heavily by the proposed changes should also
consider taking further steps to better understand the requirements and effectively begin to manage the change process. In the near term, such companies may consider taking the following steps: Develop an initial project plan . First, identify those who will own the project and empower them to act. These individuals should perform a more in-depth analysis of the impacts of the proposed standards and develop an initial project plan. The project plan may contain tailored immediate next steps, key project milestones to completion, and areas of significant time or financial investment. Understand the accounting impact . Begin to gather and analyze the necessary data. For example, with respect to the proposed leasing standard, a company may consider inventorying its existing leases, identifying arrangements within the scope of the standard, and beginning to determine the impact on the balance sheet (creation of the right of use asset and the lease liability) and income statement (potential acceleration of expense recognition). Identify the current technology and system landscape . Understand and determine the manner of collecting data, and develop a technology plan, taking into account system changes already contemplated. For example, determine whether your
current systems have the ability to appropriately track a large number of leases, regularly update leaserelated estimates, or allocate and account for revenue with more separate performance obligations. Identify the broader business impacts . Ascertain in what other areas the proposed standards may affect your business. For example, determine what impact the proposed revenue standard will have on your companys sales strategy, resulting from potential changes in sales contracts, multiple element offerings, warranty programs, and construction contracts. Establish a communications strategy . Begin to craft a communications plan for educating key stakeholders about the accounting and business impacts of the proposed standards. Internally, senior management and audit committees should be kept informed about current assessments. Externally, companies would be well-served, at the appropriate time, to brief ratings agencies and analysts with respect to the anticipated impacts. Collectively, these steps form the basis of a comprehensive assessment whereby companies can deepen their understanding of the impact of USGAAP convergence with IFRS. By staying focused on aspects that have a long lead time, companies can stay ahead of the game while also pursuing small one-off projects and easy wins where desirable.
What this means for your business 27
US GAAP Convergence & IFRS Effective dates and transition methods

March 2011
Managing accounting change Promoting quality implementations

Whats inside: Overview Time, flexibility and good disclosures are key to quality Adoption requirements must be made operational for all companies Allowing companies to manage their own pace of change will enhance quality Questions and answers
Overview At a glance
New accounting standards that are expected to be issued in 2011 will have far reaching financial and business impacts. The proposed changes are so fundamental and pervasive that companies will need several years to develop the systems and processes necessary for implementation. There are no ideal solutions for transitioning to these new standards considering the varying impacts they will have on different companies. Companies should be able to decide what is in the best interest of their investors by being given the flexibility to manage their own pace and cost of change.
Reprinted from: Point of view February 2011 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
Time, flexibility and good disclosures are key to quality

New accounting standards will be issued this year that will fundamentally change how companies account for revenue, leases, and financial instruments. Changes of this magnitudecombined with the complexity of the accountingwill require companies to devote significant time and resources to prepare for and implement the new standards. The minimum time required to implement the proposed changes will differ for each company. In most cases, companies will need several years to develop the necessary systems and processes. To give companies sufficient time, we believe that the standards mandatory adoption dates should be no earlier than 2015. No single adoption date for all of the new standards or staggered approach will work for all companies. Since the
proposed changes will affect every company and industry differently, we believe that companies should have the flexibility to adopt any or all of the standards before their mandatory adoption dates. The costs to implement each new standard will depend on a companys industry, financing, sales strategies, and information technology systems. A companys operating practices and existing agreements may also be impacted by the new standards. Setting a mandatory adoption date of 2015assuming new standards are issued by June 2011and giving companies the flexibility to adopt standards early yields adoption sequences that are cost effective, while providing sufficient time for quality implementations. This approach is also beneficial for investors. Transitions that are tailored by each company will be most cost effective and the resulting implementations will be of higher quality.
Effective dates and transition methods
To facilitate investor understanding and comparability between companies during the transition period, disclosure of the financial statement impacts caused by the changes is critical. The boards should ensure required disclosures are up to the task.
whether they should be implemented retrospectively or prospectively. The boards intend to use the feedback to decide on implementation requirements and timing, and consider the cost to companies and the needs of investors. We applaud the boards additional efforts to seek the views of their constituents.
Adoption requirements must be made operational for all companies

The Financial Accounting Standards Board and the International Accounting Standards Board (the boards) are working on about a dozen joint projects designed to improve both US and international accounting standards. The scale of the proposed changes and their potential impact on companies are unprecedented.
Impact on companies
The new standards will fundamentally change how companies account for financial instruments, lease contracts and revenue transactions. Companies may need new systems that can capture data, track contracts, and support processes to develop and reassess complex estimates. Also tax compliance systems and processes may need changes due to the new accounting. In many cases, systems that can support these changes are yet to be developed. The proposed changes may also necessitate renegotiation of contracts, such as credit and compensation agreements, due to changes in financial ratios and reported results arising from the new accounting. Further, some companies may revise leasing, hedging, and sales strategies as a result of the new standards.
Comparability and understanding the impact of the changes on each company will also be important to investors, analysts, and other users. Although some believe it may be ideal to have all companies change at once, the key to investor understanding will be clear disclosures of the changes as they occur and differentiation of the accounting effects from the performance of the business. The boards should ensure that required financial statement disclosures are up to the task.
Retrospective or prospective transition method

Often it is desirable that standards be retrospectively implemented to provide comparable information across periods. However, each company's transition situation will be different. Factors such as the existence of long-term contracts, agreements with multiple performance obligations, or matters that require significant estimation may make retrospective application difficult or impossible. In these instances, retrospective application may require companies to make overly subjective estimates based on information that is no longer available. We believe that the final standards should provide impracticability exceptions in a range of situations, including when the use of hindsight would require information that is unavailable or too difficult to obtain. Conversely, for the lease standard for which limited retrospective application is currently proposed, we believe full retrospective application should be available to those companies willing to undertake the exercise.
Reprioritization of projects
Recently, the boards decided to delay certain projects and to retain the target completion date of June 2011 for projects they consider most significant. These include accounting for revenue, leases, and financial instruments. Two other projects are expected to be finalized in 2011, but will have less impact. Our views in this paper focus on the three significant projects.
Impact on users
Its important to investors that companies implement the new standards cost effectively and correctly the first time. The reduced cost and risk of error can only be good for shareholder value. Giving companies ample time and flexibility will contribute to this goal.
The boards seek input

In October 2010, the boards issued consultation papers seeking input on when the proposed changes should be effective and
Allowing companies to manage their own pace of change will enhance quality
The core of accounting is changing
Each company is different and the impact on their financial reporting and business will also be different. Companies with older systems may choose to implement completely new reporting systems. A retailer will likely see significant changes as all leases move on to the balance sheet, while a less complex company that owns most of its fixed assets may see less change. Companies with complex longterm sales contracts will be impacted more than those that sell basic products or services. Multinational companies subject to foreign currency movements will be impacted more because of changing hedging requirements and other complexities inherent in operating in diverse environments.
implement the standards. This includes processing data, testing systems, and implementing internal controls. Contract renegotiations may also be prudent. During this period, many companies will account for transactions in parallel under existing and new standards for comparative reporting purposes. Assuming the new standards on financial instruments, leases, and revenue are issued by June 2011, to give companies sufficient time for quality implementations, we believe that the mandatory adoption date for those three standards should be no earlier than January 1, 2015.
more extensive ones. First time adopters of International Financial Reporting Standards may also want to early adopt, rather than transition to current standards; only to change again for new standards shortly thereafter. In our view, a forced single transition date or sequence will not be best for all companies. Allowing flexibility is the key.
Concerns over comparability

We acknowledge that our approach may make comparability between companies more difficult during the transition period. However, the impact on comparability can be reduced by providing disclosures for investors and clear corporate communications on the effects of the changes. More importantly, because of the scale of these changes, we believe the benefits of allowing early adoption outweigh the short-term impact on comparability. This is because companies are best positioned to determine transition plans that are most appropriate and cost effective for their particular situations. The resulting higher quality implementations combined with reduced costs will benefit investors.
Early adoption considerations

Some believe implementing all of the proposed changes on a single date is preferable, because it eliminates multiple retrospective changes to comparative information over an extended period. They believe avoiding these changes to prior year presentations is more cost effective and less confusing to investors. While there are benefits to a single effective date for all, we dont believe that companies should be required to wait. This is because it may be more cost effective for some to adopt any or all of the proposed changes early. For example, companies that can develop necessary systems quickly may want to early adopt to minimize the cost of running under old and new systems in parallel for comparative reporting purposes. Others, for which certain of the changes will have only a limited impact, may wish to put those changes behind them to focus on the
Required effective dates

Because of the pervasive changes, most companies will need significant lead time. Companies have told us that implementation could take up to three and a half years after standards are issued. During the first 12 to 18 months, companies will be interpreting the new standards, working with software developers, setting accounting policies, training staff, and developing technology and operational systems. After systems have been developed, companies may need up to an additional 2 years to
In conclusion
Companies should be given sufficient time to prepare for the proposed changes and the option to manage their own pace of change. Otherwise, companies may be forced into more costly implementations that risk failing to achieve high quality financial reporting. This would not be beneficial for companies or investors.
Effective dates and transition methods
Questions and answers

Q: Should the boards consider alternative transition options such as prospective transition?
A: The boards have proposed retrospective transition methods for the proposed standards with some exceptions. In addition, the boards provided a simplified retrospective approach for transitioning to the leases standard. While prospective adoption is the easiest way to adopt new standards, it reduces comparability between periods. Where practical, we accept retrospective transition because it provides the highest degree of comparability. However, where not practical or operational, we believe some form of prospective or modified retrospective approach makes more sense.
Q: Are there standards that should be adopted at an earlier or later date?

A: If the boards do not address many of the operational issues constituents have raised in the comment letter process on the three major proposed standards, an additional year beyond 2015 may be needed to give companies sufficient time to address the complexities. Further, the financial statement presentation project, which would significantly change how the balance sheet, income statement, and cash flows of a company are presented, has been delayed. Accordingly, depending on when a final standard is issued, a delayed mandatory adoption date may also be appropriate for that project. Two additional joint projects on the presentation of comprehensive income and changes to fair value measurements are also expected to be finalized before June 2011. For consistency and simplicity, the effective dates of those standards should be aligned with the other standards issued in 2011.
Q: Should private companies be allowed additional flexibility in timing and transition methods?
A: Yes. Some believe that private companies should not be given any additional flexibility as they will be impacted no more by the proposed changes than public companies. We believe that the boards should allow private companies an additional year (2016). Implementation by private companies may have additional challenges because they may not have the same depth of resources. This means it may take longer to renegotiate contracts and implement the necessary systems and accounting policy changes. Private companies can also benefit by learning from public companies that adopt first.
Q: Should the boards require the same effective dates and transition methods under US and international reporting standards?
A: Consistent transition methods would enhance comparability for investors. Using the same required effective date would set a consistent mandatory adoption date by which changes are adopted by all companies. Additionally, both boards should allow companies the same flexibility to choose which standards to adopt early for the reasons previously discussed in this paper.
US GAAP Convergence & IFRS Effective dates and transition methods: Updated November 30, 2011
November 2011
Table of contents
SEC Staff compares US GAAP and IFRS frameworks and analyzes IFRS in practice The path forward for international standards in the United States
Considering possible alternatives
Finding the right pace for standard setting

Priority project timelines extended quality cited
SEC Staff compares US GAAP and IFRS frameworks and analyzes IFRS inpractice
Whats inside: Whats new? What are the findings? Whos affected? Whats next? Questions?
Whats new?
On November 16, 2011, the SECs Office of the Chief Accountant published two staff papers. The first summarizes differences between the US GAAP and IFRS frameworks, and the second analyzes IFRS as applied in practice. The papers were published pursuant to the SEC Staffs workplan to analyze considerations relevant to the Commissions decision on whether, when, and how IFRS might be incorporated into the US financial reporting system. To be clear, the Commission has not reached a decision on the use of IFRS by US issuers.
Reprinted from: In brief 2011-50 November 2011
What are the findings?

Comparison of US GAAP and IFRS
The Staff compared existing US GAAP treatments to the accounting required by IFRS as promulgated by the IASB. In comparing each topic included in the USGAAP codification as of June 30, 2010 to the international standards in place as of January 1, 2010, the Staff intentionally excluded SEC interpretations and those of other jurisdictional authorities. As a result, the comparison focused on current, enacted authoritative guidance. The ongoing joint standard-setting projects were also not included in the analysis but are being evaluated separately by the Staff. The timing of these projects is uncertain, but the Staff noted that progress on these joint projects is important regardless of the Commissions ultimate decision on IFRS. In summary, the staff paper reaffirmed that US GAAP contains more detailed guidance as a result of industry or transaction specific standards that are absent in IFRS. On the other hand, IFRS is based
on broad principles which apply regardless of industry. As a result, US GAAP promotes consistency within an industry; whereas IFRS should promote consistency acrossindustries. The staff paper also highlighted differences between the US GAAP and IFRS conceptual frameworks. These conceptual differences in recognition and measurement guidance may contribute to additional differences as new standards are issued. However, the differences may not necessarily have a direct or consistent correlation to the quality of IFRS.
Analysis of IFRS in practice

To better understand the application of IFRS in practice, the Staff analyzed IFRS financial statements prepared by companies included in the 2009 Fortune Global 500, which ranks companies by revenue. The companies represented a diverse range of industries, and approximately 80% of the 183 companies were domiciled in the European Union. Among the financial statements analyzed were those of 76 companies that are currently or had previously been SEC registrants.
While the Staff found that financial statements generally appeared to comply with IFRS requirements, certain differences were noted. Lacking the ability to obtain clarifying information, the Staff was unable to determine whether such differences were material departures from IFRS. The overall analysis suggests a level of diversity in applying IFRS across various territories. This diversity may result from options contained in IFRS or the practice of utilizing previous home country or regulatory guidance. Such practices increase comparability within a territory, but decrease consistency on a global level. The analysis also identified the need for additional transparency and clarity within financial statement disclosures. Enhancing accounting disclosures about significant estimates, key assumptions, and fair value information may better support an investors overall understanding of the financialstatements. The Staff noted fewer observations for those companies that are or previously had been SEC registrants. The Staff acknowledged that this may have been a result of its disclosure review program where financial statements of certain companies may already reflect comments provided by or anticipated from the Staff.
Whos affected?
US public companies may be affected to the extent that these papers influence any Commission decision on whether, when, and how to incorporate IFRS into the US.
Whats next?
The Staff is not requesting comments from stakeholders as these papers are primarily designed to provide the Commission with information that will facilitate its consideration of whether, when, and how IFRS might be incorporated into the US financial reporting system. Any incorporation of IFRS into the US financial reporting system will be complex. These staff papers provide new perspectives that will add to the debate. As a result, further discussion is likely, and a final SEC decision may not be reached in 2011.
Effective dates and transition methods: Updated November 30, 2011
The path forward for international standards in the United States Considering possible alternatives
Whats inside: Highlights The international standards debate continues Questions and answers
Highlights
The SEC has stated it plans to make a determination on the future use of international standards by US public companies in 2011. Full acceptance or complete rejection of a move to international standards in the US seems increasingly unlikely. A compromise solution will likely benecessary. Completion of the current 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.
Reprinted from: Point of view October 2011
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 pointand one that can be built upon to make progress towards this ultimateobjective.
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 globalstandards. For more than ten years, the worlds two most significant standard setters, the FASB and IASBcollectively the boardshave 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 high-quality 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.
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 beencountered.
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. 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.
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.
Multiple paths; valid perspective

The alternatives for integrating international standards into the US reporting system are numerous. They range from doing nothingleaving 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.
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 accountingand in the long run, that would be unfortunate. Though sufficient
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 wouldnt 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 IASBs 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.
point. It establishes a continuing role for the FASB and maintains the SECs 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.
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: 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 markets 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.
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
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
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 staffs suggestion that the threshold consider the public interest and the protection of investors is a good startingpoint.
Finding the right pace for standard setting Priority project timelines extended quality cited
Whats inside: Highlights We applaud the boards focus on quality Standard setters have been working at a breackneck speed Take the time needed to achieve high-quality standards Questions and answers
Highlights
The FASB and IASB recently reset their target for completion of their priority projectsrevenue, leasing, and financial instrumentsfrom June to December 2011. The boards emphasized that they are focused on taking the time necessary to develop high quality standards. The boards have substantially stepped-up their outreach efforts and significant changes have been made to prior proposals. We agree that issuing high quality accounting standards is paramount. The boards should take whatever time is needed to accomplish this goal.
Reprinted from: Point of view May 2011
We applaud the boards focus on quality

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the boards) are re-deliberating their priority projectsrevenue, leasing, and financial instruments and addressing many complex issues. The final standards will have broad implications for many industries. Sufficient development time is needed to ensure that the final standards will be of high quality and will stand the test of time. We commend the boards for the recent increased outreach they have engaged in and their acknowledgment that more time is needed to develop these standards. Because of significant changes, we agree that more constituent input is needed on recent decisions and believe re-exposure of these proposed standards would be beneficial. Such input is essential for the boards to achieve their goal of issuing high quality standards. We continue to support attaining a single set of high quality global accounting standards. Reaching quality,
converged solutions on joint projects will further that goal and best serve the long-term interests of investors and the capital markets. While we believe standard setters need to establish targeted timelines to create discipline in their processes, the issuance of high quality accounting standards is far more important than issuing standards by an arbitrary date. Our bottom line is that getting these standards right is just too important. We encourage the boards to continue taking the necessary time to get to the best answers on these standardseven if that means completion extends beyond 2011.
Standard setters have been working at a breakneck pace

For some time, the boards have been working on about a dozen projects designed to improve both US and international accounting standards. A number of the projects on the original convergence agenda have been completed. Nevertheless, the expected changes resulting from the
remaining projects may dramatically affect companies financial reporting.
Extending the timeline

In late 2010 and early 2011, the boards narrowed their focus and concentrated their resources on completing certain priority convergence projects remaining on the agenda. These projects include revenue, leasing, and financial instruments.1 At the time, the boards target completion date for the projects was June 30, 2011. Since then, the boards have significantly increased the frequency of their meetings. Over the past few months, the volume of issues being debated and speed of decision making has truly been remarkable as the boards worked toward the June target date. Recently, the boards acknowledged the need to extend their target completion date for the priority convergence projects to the end of this year. In making this decision, the boards emphasized that developing high quality standards is their priority. They said that additional time was needed to complete development of the standards and check their conclusions.
To us, it is also apparent that the boards are listening to the feedback. In response to constituent requests, the boards are seeking ways to reduce the complexity of the proposals. For example, they have scaled back certain aspects of their proposals where changes to existing guidance are not critical. This should reduce costs associated with implementing the new standards and help mitigate the risk of unintended consequences.
Take the time needed to achieve high-quality standards

High quality is key
We believe the key objective of standard setting is to develop high quality standards. To us, high quality accounting standards provide decision-useful information for investors, reflect the economics of transactions, and are sustainable. High quality standards contain clear principles, are understandable, and can be implemented at reasonable cost. We continue to support the boards working toward attaining a single set of high quality global accounting standards. Some have suggested that issuing timely new standards is also important in todays ever-changing environment. We agree. However, in our view, the key goal of standard setting remains: to issue high quality accounting standards.
Moving in the right direction

We commend the boards for their steppedup outreach. Obtaining feedback is a critical part of the process necessary to develop high quality accounting standards. Just as important, we are pleased to see that the boards are making practical changes to reduce the complexity of the proposed standards while still providing quality, decision-useful information to investors. We are also pleased that the boards have reconsidered their target completion date. In our view, more time is needed to finalize their decisions and issue these standards. This is because the boards are still re-deliberating key issues raised by constituents. Those re-deliberations will take time as they work together to try to achieve high quality, converged standards. Once re-deliberations are complete, the boards and their staff need to carefully and thoughtfully draft amendments to the original proposals and related existing standards. Additional valuable constituent input on the revised proposals and amendments is then needed. All this takes time. Given the amount of work that remains to be done, even meeting the boards revised timetable will be challenging.
The wisdom in re-exposure

Obtaining robust constituent feedback is a critical part of developing high quality standards. The boards and their staffs have been working hard and have accomplished a lot in a short period. Substantial changes have been made to the original proposals. These standards will have a fundamental impact on the financial reporting of many companies. This leads us to conclude that re-exposing the standards and allowing ample time for constituents to formally comment is the best way for the boards to obtain the right level of input. While informal feedback is good, a formal process is more likely to result in standards that meet investors informational, and preparers operational, needs while avoiding unintended consequences. Providing a
Increased board outreach

The boards also announced late last year that they would increase investor and preparer outreach. Since then, the boards have been true to their words. They have conducted public roundtables, issued additional requests for comment on certain aspects of the proposed standards, posted drafts on their websites for comment, and held informal meetings with investor groups and companies.
1 The IASB considers insurance a priority project.
broad range of constituents with an opportunity to trial test the revised proposed standards and comment on the actual words and associated amendments will better inform the boards about whether the actual words will be interpreted in the manner intended. Obtaining that input now, before the final standards are issued, will reduce potential implementation issues. The boards should also consider providing ample time for preparers and investors to respond to re-exposure drafts issued in similar timeframes.
converged standards and to issue their exposure drafts and final standards on these priority projects at similar times. We realize the process requires challenging discussions and carefully considered compromises that dont adversely affect quality. In our view, though, it would be unfortunate if the good progress to date resulted in final standards that differed because the boards could not agree or because one board issued a standard before the other had completed its work.
occur quickly; and that should mark the end of convergence efforts. Still others believe that meeting the targeted timeline is important because completion of these projects could impact any SEC decision regarding the use of IFRS in the US We understand and respect these views. Nevertheless, we stand by our view that the boards should take the time needed to achieve their primary 0bjective of developing and issuing high quality accounting standards.
Working together
Achieving convergence in these priority standards is part of the critical pathway toward a single set of global standards. Converged solutions best serve investors and the capital markets by creating a level playing field for reporting financial results. Companies around the world deserve that level playing field. We commend the boards for their convergence efforts to date. Converged standards are emerging in revenue and leasing. The financial instruments proposal has been more of a struggle. We admit the path toward convergence is not easy. At times the boards have worked at a different pace, which has resulted in one board issuing a new standard or proposal before the other. In our view, this leapfrogging often impedes the achievement of converged, high quality standards. For example, the board that is still deliberating may be forced to choose between reaching a better solution or settling for convergence because the other board has already moved forward. We encourage the boards to continue to work together to achieve high quality,
In conclusion
So our views are clearquality standards trump speed of issuance. Investors and preparers are asking for high quality, converged standards that result in comparable, decision-useful information. Having a target and a plan is good, but recognize that if it takes additional time beyond 2011 to ensure the appropriate level of input is obtained and the standards are of high quality, we say continue taking the necessary time. Its the right thing to do.
Q: Will a delay in issuing the standards affect the SECs decision on incorporation of IFRS in the US?
A: This is difficult to predict. While the SEC is expected in 2011 to make their decision whether, when or how to incorporate IFRS into the US reporting system, we believe it is more important that they are comfortable with the quality of the IASB standard-setting process than completion of any one standard or group of standards. For example, the SEC Chairman and senior SEC officials have commented that developing high quality, sustainable standards should remain the key focus of standard setters and that delays should not affect the SECs ability to make a determination in 2011. That said, some believe that completion of certain key standards currently under development should be an important consideration for the SEC as it makes its determination. The SEC staff has also focused their attention on understanding the consistency of application of IFRS across the globe and the transition challenges that may exist because of numerous existing US regulations. We believe the outcome of the SECs determination is still uncertain.

Q: Is there any magic to the December target completion date?
A: Pressure to complete these projects surely exists. For example, the Group of Twenty Nations (G20) has said that convergence efforts should be completed by 2011, although they have also stressed the importance of reaching high quality solutions. Also, some constituents feel that international and US convergence efforts should not go on indefinitely; that completion of the joint projects should
10
This page intentionally left blank.
11
12
US GAAP Convergence & IFRS Financial instruments

March 2011
Table of contents
FASB decides on classification and measurement for financial liabilities and equity investments FASB redeliberates its financial instruments proposal
An update on significant changes as of February 24, 2011
2 4 20
Impairment redux
FASB and IASB are seeking comments on a converged impairment model for financial assets
FASB seeks comments on IASB hedge accounting proposal Accounting for hedging activities
A comparison of the FASBs and IASBs proposed models
31 33
FASB decides on classification and measurement for financial liabilities and equity investments
Whats inside: Whats new? What are the key decisions? Is convergence achieved? Whos affected? Whats the effective date? Whats next?
Whats new?
This week the Financial Accounting Standards Board (FASB or the Board) continued its redeliberations on the classification and measurement of financial instruments and made a number of significant decisions related to financial liabilities and equity investments not accounted for under the equity-method. These discussions are part of the FASBs redeliberation efforts on the joint project with the IASB on financial instrument accounting. All FASB decisions noted in this In brief are tentative and therefore subject to change, as the Board has not yet concluded its deliberations or issued a final standard. A complete summary of the Boards decisions on the financial instruments project is available on the FASBs website at www.fasb.org.
Reprinted from: In brief 201109 March 3, 2011 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
What are the key decisions?

Consistent with its recent decision on financial assets, the Board decided to allow financial liabilities to be measured at amortized cost depending on an entitys business strategy for the portfolio and the individual instruments characteristics. Therefore, financial assets and financial liabilities would be classified into one of three categories(1) amortized cost, (2) fair value with changes in fair value recognized in other comprehensive income (it is unclear if any liabilities would qualify for this category), or (3) fair value with changes in fair value recognized in net income. Refer to Dataline 201113 for the Boards previous decisions on financial assets and a description of the three classification and measurement categories.
This decision is responsive to the comment letters received on the FASBs May 2010 proposal by allowing more financial liabilities to be measured as amortized cost. In addition, the Board affirmed its prior decision that all equity investments not accounted for under the equity method should be measured at fair value with changes in fair value recognized in net income. However, the Board is now considering the possibility of providing a practicability exception for certain nonpublic entities for their nonmarketable equity investments. This exception would allow these investments to be measured at amortized cost less any impairment. However, if observable prices are available, then the carrying amount would be adjusted to reflect those prices. The FASB will further develop this approach in future meetings.
Is convergence achieved?
The FASBs decision to allow amortized cost may be viewed as a step closer to convergence with the IASBs approach for financial liabilities. However, they are not converged at this stage, particularly since the FASB has yet to decide whether to allow a fair value option and whether embedded derivatives in hybrid financial instruments should be accounted for separately from the host contract. The FASB approach to accounting for equity investments is similar to the IASB since these investments are measured at fair value with changes in fair value recognized in net income. However, the IASB also allows entities to irrevocably elect to have changes in fair value recognized in other comprehensive income without any subsequent recycling to net income. This option is not available in the FASB model. In addition, the IASB provides a practical expedient to determining fair value for unquoted equity investments in certain situations. The FASB, on the other hand, is considering a practicability exception for nonmarketable equity investments held by certain nonpublic entities.
Whos affected?
The final guidance will likely affect entities across all industries that hold or issue financial instruments.
Whats the effective date?

The FASB must still decide on the effective date, although they have decided that early application would be prohibited.
Whats next?
The FASB is continuing to refine the definition of the three classification and measurement categories and plans to test those definitions with constituents. It is unclear at this stage whether the FASB will re-expose its revised classification and measurement approach. We will continue to keep you informed of the significant redeliberation decisions. We recently issued Dataline 201113 that provided a summary of all the FASBs decisions as of February 24, 2011.
FASB redeliberates its financial instruments proposal An update on significant changes as of February 24, 2011
Whats inside: Overview Update on redeliberations Other proposals to be reconsidered Appendix: Other proposals contained in the FASBs May 2010 exposure draft
The accounting for financial instruments is a priority convergence project for the FASB and IASB. The Boards are aiming to finalize most of their respective guidance in 2011. The FASB received a significant amount of input from financial statement users, preparers, and accounting firms on its May 2010 proposal. The tentative decisions the FASB has made in its redeliberations point to significant changes from the proposal. One significant change involves classification and measurement. The FASB tentatively decided to require that debt instrument assets be classified and measured according to three categories(1) amortized cost, (2) fair value with changes in fair value recognized in net income, and (3) fair value with changes in fair value recognized in OCIdepending on an entitys business strategy for each portfolio and the characteristics of the individual instrument. In contrast, the IASBs finalized guidance classifies and measures debt instruments according to two categories: (1) amortized cost and (2) fair value with changes in fair value recognized in net income, and allows certain investments in equity instruments to be carried, on an elective basis, at fair with changes in fair value recognized in OCI. The FASB and IASB have been jointly redeliberating the accounting for credit impairments. The Boards recently issued a supplementary document in connection with their original proposals on impairment. The supplementary document proposes a common approach to recognizing credit losses on financial assets managed in an open portfolio. The supplement also affords constituents the opportunity to provide feedback on alternative approaches (comments due April 1, 2011). The FASB recently issued a discussion paper to seek feedback on the IASBs proposed revisions to hedge accounting (comments are due April 25, 2011). The IASBs proposal differs significantly from the FASBs proposal, in particular by proposing to extend hedge accounting to components of nonfinancial instruments. The FASB plans to consider the feedback in its redeliberations aimed at improving and simplifying hedge accounting. Those redeliberations will take place later in 2011. Consequently, the FASB will not finalize its revised hedge accounting guidance by June 2011.
Reprinted from: Dataline 201113 February 24, 2011 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
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 thus far. Once finalized, the new guidance will replace or amend most of the FASBs and IASBs respective financial instruments guidance.
input from constituents on the effective dates and transition for all of its priority projects.
5. All FASB decisions noted in this

Dataline are tentative and therefore subject to change, as the Board has not yet concluded its deliberations or issued a final standard. A complete summary of the Boards decisions on the financial instruments project is available on the FASBs website at www.fasb.org.
and payables, certain instruments redeemable for a specified amount, and an amortized cost option for an entitys own debt under certain circumstances. Constituent feedback: Many respondents supported two measurement categories. However, a significant number of the preparers preferred amortized cost rather than fair value with changes in fair value recognized in OCI for debt instruments for which the business strategy was to hold the assets and collect contractual cash flows. User views were more mixed, with some users, including one prominent user group, preferring fair value measurement for all financial instruments. In addition, some large financial institutions preferred three measurement categories: amortized cost, fair value with changes in fair value recognized in OCI, and fair value with changes in fair value recognized in net income. Those preparers believed that amortized cost was needed for portfolios of assets managed for the collection of contractual cash flows and that fair value with changes in fair value recognized in OCI was needed to more closely reflect their asset-liability or liquidity management strategy for holding certain debt instruments.
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. The comment period ended on September 30, 2010. For a summary of the key elements of that proposal, refer to Dataline 201025, FASB proposes changes to financial instruments accounting.
Update on redeliberations
Classification and measurement
Three categories
6. In late January 2011, the FASB

decided to allow certain financial assets to be measured at amortized cost. Debt instruments would be classified and measured in one of three categories: (1) amortized cost, (2) fair value with changes in fair value recognized in other comprehensive income (OCI), and (3) fair value with changes in fair value recognized in net income.
3. The FASB received over 2,800

comment letters on its May 2010 proposal. It also hosted five roundtables in October 2010 and conducted extensive user outreach to gather further input. The FASB has posted on its website a summary of the feedback it received on classification and measurement and on impairment.
7. This represents a significant change

from the FASBs May 2010 proposal in which it called for two principal measurement categories, namely (1) fair value with changes in fair value recognized in net income and (2) fair value with changes in fair value recognized in OCI. Some exceptions to these two broad measurement categories were proposed for core deposits, certain trade receivables
4. The FASB began redeliberating its

May 2010 proposal in late 2010 and aims to finalize most of the guidance in 2011. The FASB must still decide on the effective date for the final standard. It has separately sought
Criteria for classification and measurement
8. The Board also decided in late

January 2011, that debt instrument assets should be classified and
measured in the three categories according to an entitys business strategy for the portfolio and the individual instruments characteristics.
9. The Board described the three broadbased business strategies and how they line up with the proposed categories as follows: Amortized costwould consist of assets pertaining to the advancement of funds (i.e., customer financing or lending) that are managed for the collection of the contractual cash flows Fair value with changes in fair value recognized in OCIwould consist of assets managed for an entitys investing activity in order to maximize the total return and manage the entitys risk exposures Fair value with changes in fair value recognized in net incomewould consist of assets held as part of an entitys trading activities and loans held for sale Consistent with current accounting, the FASB decided to require the recycling of gains and losses on instruments from OCI to net income that are realized due to the sale or settlement of a financial asset. PwC observation: The FASB is continuing to work on refining these definitions of the potential business strategies. The Board indicated its intention to test these definitions with constituents by considering the application to different types of asset portfolios. The FASBs revised business strategy definitions no longer
specifically focus on how the returns of the asset will be realized and the period for which the asset will be held. Instead the focus has shifted to the nature of an entitys activities. The FASB believes that this new focus on why a portfolio is originated or acquired as opposed to how it will be exited better reflects how entities manage their asset portfolios over the asset lives.
interpretation of the proposed criteria to qualify for fair value changes to be recognized in OCI, and called for an expansion of items that would be eligible for changes in fair value to be recognized in OCI and for more implementation guidance to be provided. PwC observation: In their dissenting opinions on the May 2010 proposal, two FASB board members preferred adding a third criterion that would be based on whether an observable market exists for an instrument. If an instrument met both the business strategy and instrument characteristics criteria but had an observable market price, it would be classified and measured at fair value with changes in value recognized in OCI. If an observable market price did not exist for that instrument, it would be classified and measured at amortized cost. While some financial institutions agreed with the need for three classification and measurement categories, many constituents were concerned that considering marketability may result in changes in the measurement basis when an observable market ceases to exist.
10. The FASBs May 2010 proposal

included a requirement that financial instruments be classified and measured based on an entitys business strategy for the portfolio and the instruments characteristics. In general, all financial instruments were to be classified at fair value with fair value changes recorded in net income unless the instrument had certain characteristics and the entity elected to recognize changes in fair value in OCI. An entity could qualify for this irrevocable election if its business strategy was to hold the financial instrument for collection or payment of contractual cash flows rather than to sell the instrument or settle it with a third party. To meet this condition, an entity would need to hold instruments within the portfolio for a significant portion of their contractual terms. Constituent feedback: Most preparers commented that the entitys business strategy should be the primary driver of an instruments classification. However, some expressed concern with the potential for a narrow
11. The Board must still redeliberate the

instrument characteristics criterion. In its May 2010 proposal, a debt instrument was required to meet the following criteria in order to be eligible for fair value changes to be recognized in OCI:
It involves an amount transferred to the issuer at inception that will be returned at maturity or settlement (the principal amount adjusted for any premium or discount on issuance) The contractual terms of the instrument identified any additional cash flows to be paid periodically or at the end of the instruments term The instrument cannot be prepaid or settled in such a way that the investor would not recover substantially all of its recorded investment, other than through its own choice The instrument is not a hybrid instrument with a financial host and does not contain an embedded derivative requiring bifurcation under ASC 815 Constituent feedback: Some expressed concern with certain of these criteria and the potential to require more fair value changes to affect net income. Their concerns centered on some of the FASBs criteria that did not seem consistent with a business strategy approach. For example, the existence of any embedded derivativeno matter how insignificantthat would otherwise have required bifurcation, would cause fair value changes to be recognized in net income. PwC observation: IFRS 9 also requires an instrument to meet certain characteristics to be eligible for amortized cost measurement.
However, the characteristics under IFRS 9 differ in that they focus on the cash flow characteristics of an instrument (i.e., whether it constitutes solely payments of interest and principal), and not specifically on the existence of an embedded derivative.
volatility for equity investments that are viewed as more strategic. PwC observation: The FASB began to discuss the classification and measurement of equity investments in February 2011. At this stage it appears that the Board will reconfirm its proposal to require all marketable equity investments that are not accounted for under the equity method to be measured at fair value with changes in fair value recognized in net income. For nonmarketable equity investments, there appears to be some support for allowing a practicability exception from the fair value measurement requirement. A practicability exception would allow these investments to be measured at cost less impairment. However, the resulting carrying value could be required to be adjusted when an observable price becomes available. This practicability exception would differ from the practical expedient afforded under IFRS 9, which allows amortized cost on the basis that it may approximate fair value measurement absent any significant changes. In addition, while IFRS 9 requires fair value measurement for all equity securities not under the equity method, it diverges from the FASBs proposal by allowing entities to irrevocably elect on an individual instrument basis to have fair value changes for non-trading investments recognized in OCI with no subsequent recycling to profit or loss even upon disposal of the instrument.
12. Consistent with the May 2010

proposal, the Board continues to believe that an entitys business strategy should be determined based on how the entity manages its business and portfolio of instruments rather than its intended use of a specific instrument.
Equity investments
13. Under the May 2010 proposal, all

equity investments that are not accounted for under the equitymethod of accounting would be measured at fair value with changes in fair value recognized in net income (i.e., the option to recognize fair value changes in OCI was unavailable for equity securities). The Board has begun to discuss whether to reaffirm its May 2010 proposal for equity investments; however, no tentative decisions have been reached yet. Constituent feedback: Some preparers were concerned with requiring all equity investments to be measured at fair value, particularly due to the operational challenges of determining fair value for nonmarketable equity investments and the resulting net income
Exhibit A: Comparison between todays financial assets classification and measurement approach and the FASBs tentative decisions*
Fair value through net income Lower of cost or market value Fair value through other comprehensive income Amortized cost
Today: Trading securities and derivatives
Today: Loans held-for-sale
Today: Available-for-sale securities
Today: Held-to-maturity securities, cost-method investments, and loans held-forinvestment
Tentative new approach: Trading activities, derivatives, and loans held-for-sale
Tentative new approach: Investments intended to maximize return and manage risk
Tentative new approach: Lending or customer financing managed to collect cash flows
* Note that the FASB must still decide on its tentative new approach for marketable and non-marketable equity instruments not accounted for under the equity-method.
Financial liabilities
14. The FASB began to discuss the

classification and measurement of financial liabilities in February 2011. Initial indications are that the Board will allow certain financial liabilities that are not held as part of an entitys trading activities and are not derivatives to be measured at amortized cost. However, no tentative decisions have been reached yet. Constituent feedback: There was little support for the FASBs May 2010 proposal to require most financial liabilities to be measured at fair value, with many respondents concerned about the effect that an entitys own credit could have on its results. PwC observation: If the board allows some financial liabilities to be measured at amortized cost, it will need to consider whether to allow a fair value option and if it would only apply in certain situations, for example, one limitation suggested by respondents was to only permit the fair value option if amortized cost would create a
8
measurement mismatch with the assets being funded. The Board may then need to consider the accounting for an entitys own credit and whether, similar to IFRS 9, changes in the fair value due to changes in an entitys own credit would need to be reflected outside of net income if the fair value option is elected. The FASB must still address the accounting for hybrid financial liabilities and, among other alternatives, could decide to require (1) the entire hybrid instrument to be measured at fair value with changes in fair value recognized in net income (consistent with its May 2010 proposal) or (2) bifurcation of the hybrid instrument into an embedded derivative (measured at fair value with changes in fair value recognized in net income) and a host contract that would be eligible for amortized cost measurement. Among other hybrid instruments, the accounting for convertible debt will be dependent on this decision.
Reclassification and tainting
15. The Board has reaffirmed its May

2010 proposal to prohibit reclassifications between categories after initial recognition. Some Board members were concerned that allowing reclassifications between categories would enable entities to cherry pick when gains or losses should be recognized. In addition, some believe that allowing reclassifications would increase the need for some tainting notion, discussed in the next paragraph, to be incorporated in the final guidance.
16. The Board also reaffirmed its May

2010 proposal to not include a tainting concept whereby subsequent sales or settlements of financial assets could impact the classification and measurement of the assets remaining in the portfolio. While subsequent sales or settlements of instruments would not taint the existing portfolio, entities would need to consider the impact of those sales or settlements on the classification of future originated or purchased assets.
Constituent feedback: Most preparers that supported the entitys business strategy as the primary driver of an instruments classification also felt that reclassifications should be required when the business strategy changes, albeit subject to enhanced disclosures. PwC observation: The Board acknowledged that a business strategy for a portfolio of financial assets may change, although it should be rare. However, the Board does not believe it is necessary to change the measurement attribute for that portfolio in such circumstances. Instead, the Board indicated that it may consider requiring separate presentation and additional disclosures, particularly when the strategy changes for a portfolio that was initially classified and measured at amortized cost. This decision would not be convergent with IFRS 9, which does require reclassification when the business strategy changes. IFRS 9 also does not include a tainting concept.
losses. In contrast, the IASBs original proposal resulted in building an allowance over the life of the financial asset. Both Boards received a significant amount of feedback from constituents on their original proposals.
18. The Boards began joint redeliberations of their respective impairment proposals in November 2010. These joint redeliberations considered the input they gathered through their respective comment letter processes, input from the Expert Advisory Panela group formed to advise the Boards on the operational aspects of their original proposalsand their user outreach.
Common approachThe objective of the common approach is to recognize an amount of allowance that reflects all expected losses (on the bad book) in addition to an allowance that reflects a portion of losses that are expected to occur in the future (on the good book). The portion of the allowance required for the good book is the higher of a time-proportional amount of expected losses and losses expected to occur in the foreseeable future, which would be subject to a 12-month floor. FASB alternative approach The FASBs alternative approach requires that the allowance be based solely on the losses expected to occur in the foreseeable future (which should not be less than 12 months) and does not incorporate a time-proportionate amount of expected losses. IASB alternative approach The IASBs alternative approach retains all the elements of the common approach, except that the allowance on the good book is calculated solely based on the time-proportional amount of expected losses over the remaining life of the assets. The objective of this portion of the allowance is to approximate how loans are priced and to reflect a credit-adjusted yield in earnings each period.
19. As a result of these redeliberations,

the IASB and FASB issued a joint supplementary document titled Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging ActivitiesImpairment (the Supplementary Document) on January 31, 2011 to gather input on new impairment approaches. The comment letter period ends April 1, 2011. For a more detailed summary of these approaches, see Dataline 2011 09, Impairment reduxFASB and IASB are seeking comments on a converged impairment model for financial assets.
Impairment of financial assets

17. The FASB and IASB are working 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. In its original proposal, issued in May 2010, the FASB had set forth an impairment model that resulted in upfront recognition of full lifetime expected
20. The Supplementary Document

contains three credit impairment approachesa common proposal and two alternative proposals. All the approaches have been developed with an open portfolio of similar financial assets in mind. The Boards must still consider whether these approaches can also be applied to closed portfolios, individual instruments, and to other assets (e.g., securities).
21. While these three credit impairment

approaches contain some elements of the FASBs and IASBs original proposals, other aspects have been modified to be responsive to the input the Boards received. The original
proposals can be summarized as follows: FASBs May 2010 proposal Credit impairment would be recognized in net income when an entity does not expect to collect all of the contractually promised cash flows (including both principal and interest). An entity no longer would wait until an event suggests it is probable that a loss had been incurred. Instead, an entity would consider the impact of past events and existing conditions on the collectability of contractual cash flows over the remaining life of the asset(s) without regard to the probability threshold. Constituent feedback: Most users and preparers supported the elimination of the probability threshold. Some preferred the retention of an incurred-loss approach, but one that would be based on a lower recognition threshold. Most preparers supported the development of a single impairment model for all financial assets. In addition, most preparers felt that impairment should only include loss of principal consistent with current historical loss rates. Further: In evaluating whether a credit impairment exists, the information an entity could use was limited to past events and existing conditions. As such, management would assume that economic conditions existing at the end of the reporting period will remain
unchanged over the remaining life of the financial asset. Constituent feedback: Preparers and users generally felt that an entity should be able to forecast economic conditions beyond the balance sheet date. Most felt that some parameters were needed on how far out to forecast. Some suggested that the forecast period should be for the foreseeable future and based on supportable data rather than being a bright line. The common and alternative approaches contained in the Supplementary Document are responsive to these views. The credit impairment for the full life of the financial asset would be recognized in the period in which they are estimated, rather than being allocated and recognized at a constant rate over the life of the asset. Constituent feedback: Views were mixed on whether the impairment amount should be calculated based on the remaining life of the asset or a shorter period, or whether it should be recognized immediately or over a period. Those who supported recognizing the allowance over a period reasoned that this approach better matches the pattern over which interest income is recognized that is intended -
to compensate the entity for those losses. The timeproportional amount for the good book used in the common approach and under the IASBs alternative approach is intended to reflect this view. Those who preferred immediate recognition of an amount for a foreseeable period that may be shorter than the remaining life of the asset reasoned that this approach would achieve the objective of increasing reserves while being the easiest to make operational. The common approach and the FASBs alternative approach aim to accommodate this view. A methodology for measuring impairments and determining inputs into the calculations was not prescribed. For pooled assets, entities would apply an appropriate loss rate, which considers historical experience adjusted for current information, to the outstanding balance. For individual assets, the present-value technique would be used, and a decrease in the net present value of managements expectations of cash flows to be collected from one reporting date to the next would be recognized as an impairment in net income (an increase would be recognized as a recovery). The Supplementary Document is similarly not prescriptive in defining calculation methodologies.
10
The option to use the practical expedient in ASC 310-10-35 to measure the impairment based on the value of the collateral after considering costs to sell for collateral-dependent assets was retained. However, the FASB proposed broadening the definition of collateraldependent assets. This issue is not explicitly addressed in the Supplementary Document. Interest income would be determined by multiplying the amortized cost less cumulative allowance for credit impairments by the financial assets effective interest rate (EIR). Contractual amounts due in excess of accrued interest served to increase the allowance; however, if the allowance account exceeds the entitys loss estimates, the difference should be recognized in net income as a recovery (not as interest income). Specific guidance was proposed on the EIR to be used for originated financial assets versus financial assets purchased at a discount due to credit impairment. Constituent feedback: All preparers and most users opposed the proposal to reduce the interest income recognized for the credit impairment and preferred decoupling interest income recognition and impairment. Their rationale was that users prefer to be able to analyze the net interest
margin based on contractual interest rates separately from the credit losses. IASBs November 2009 proposalThe EIR would be calculated upon initial recognition of the assets based on expected cash flows, including credit losses, over the life of the assets. This would result in a lower EIR compared with the contractual rate. By recognizing lower interest income, an allowance would be created by the difference between cash collected and the accrued interest income. The allowance is released as losses occur and loans are written off. Cash flows would need to be continually re-estimated, with changes in cash flow expectations recognized immediately in earnings. Constituent feedback: The IASB proposal also received significant opposition. Constituents raised a number of conceptual concerns, including the potential for an entity to be under reserved on assets where losses tend to occur during the earlier years, and the need to recognize immediately in earnings all changes in expectations, including for future periods while recognizing over time the original estimate of losses. The approaches contained in the Supplementary Document seek to address this concern
by requiring a full reserve to be established on nonperforming assets (on the bad book), with a minimum reserve level required for the good book. Constituents were also concerned with the operational challenges this model presented, including the need to integrate credit and interest computation systems and continually update cash flows expectations. The common and alternative approaches contained in the Supplementary Document would decouple the credit and interest computations. Further, the time-proportional amount calculated for the good book seeks to address the operational complexity associated with determining expected cash flows for the asset in each period by requiring a timeproportional calculation of the reserve.
Other proposals to be reconsidered

22. The FASB decided in October 2010
that, based on input it had received from constituents, it would also redeliberate a number of other significant aspects of its May 2010 proposal as it relates to classification
11
and measurement. Redeliberations on these topics have not yet begun. These include:
Initial measurement
a. Dealing with differences between the transaction price and fair value In the FASBs May 2010 proposal, initial measurement would differ depending on the instruments subsequent measurement. For instruments subsequently measured at fair with changes in fair value recognized in net income, the initial measurement would be fair value with any difference between fair value and transaction price recognized in net income. For instruments subsequently measured at fair value with changes in fair value recognized in OCI, the initial measurement would be the transaction price. However, if an entity has reason to believe that the fair value differs significantly from the transaction price, it would be required to determine if reliable evidence shows that a significant difference does in fact exist. If a significant difference exists due to the existence of other elements, the entity is required to identify and separately account for those other elements in the transaction and measure the remaining financial instrument at fair value. If no other elements can be identified or valued, the entity is required to recognize the entire difference between the transaction price and the fair value in net income. For instruments subsequently measured at amortized cost, the initial measurement would be transaction price. Constituent feedback: Most respondents agreed that significant
12
differences between the fair value and transaction price should be examined to determine if there are other elements that should be separately accounted for. However, most found the proposed guidance for determining whether the transaction price differs significantly from the fair value confusing. Many also disagreed with the default notion that the entire difference between the transaction price and fair value should be recognized in net income if no other elements that need to be separately accounted for could be identified. b. The treatment of transaction costs In its May 2010 proposal, the FASB required that for instruments measured at fair value with changes in fair value recognized in net income, transaction costs and fees associated with purchases or sales be recognized in net income (as an operating expense) immediately. For instruments measured at fair value with changes in fair value recognized in OCI, transaction costs and fees would be deferred in OCI and recognized in net income as a yield adjustment over the life of the instrument. Constituent feedback: In their comment letters, investment managers all opposed the proposal to recognize transaction costs as operating expenses. Current practice for investment funds is to recognize explicit transaction costs, such as brokerage commissions, as part of the original cost of the investments, with all subsequent changes in fair value included in the funds statement
of operations as a component of unrealized/realized gains or losses on investments. Consequently, expense ratiosa key performance metric for investment entitieswould be impacted by the proposal. Those respondents believe that transaction costs associated with a funds investment strategies are more appropriately captured as part of investment gains/losses rather than in recurring operating expenses of the fund. In addition, some respondents also requested further guidance on how to measure transaction costs and noted a number of challenges, such as in determining the transaction costs when it is not explicitly identified as part of the transaction (e.g., implicit in the bid-offer spread).
Enhanced risk disclosures, particularly on interest rate, prepayment, and liquidity risks
Constituent feedback: There was a recurring and consistent comment letter theme among users for financial reporting to include enhanced disclosures on risks relating to financial instruments. PwC observation: It is unclear whether the FASB will work with the SEC to improve the existing risk disclosures contained in managements discussion and analysis (MD&A) or prefer footnote disclosure of risks, requiring them to be provided by both public and nonpublic entities and be subject to audit. Note that credit risk disclosures have already been addressed in ASU 2010-20 (see Dataline
201031, New disclosure requirements for finance receivables and allowance for credit losses, for further details).
Hedge accounting
23. The IASB issued its hedge accounting
proposal on December 9, 2010 for public comment. Comments are due March 9, 2011. The FASB issued a discussion paper titled Selected Issues about Hedge Accounting on February 9, 2011 to seek feedback from US constituents on the IASBs proposal. The comment letter period ends April 25, 2011. As a result, the FASB has deferred redeliberating hedge accounting until later in 2011 when it has gathered that input. For a more detailed analysis of the IASBs hedge accounting proposal and how it compares with the FASBs May 2010 proposal, see In brief 201106, FASB seeks comments on IASB hedge accounting proposal, and Dataline 201106, Accounting for hedging activitiesA comparison of the FASBs and IASBs proposed models. PwC observation: The FASBs May 2010 hedge accounting proposal was predicated on its classification and measurement proposal, which would require most financial instruments to be measured at fair value. It remains to be seen whether the FASB will change course on hedge accounting given its recent decision to allow certain financial instruments to be measured at amortized cost. In its 2008 exposure draft, which was based on the current mixed-measurement model for financial instruments, the FASB had proposed eliminating the ability to hedge by component risk for financial instruments, other than interest rate risk on an entitys own debt at issuance and foreign currency risk. Under that approach, the entire fair
value change on the hedged item and hedging instrument would be recognized in net income.
Equity-method of accounting
The FASB 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. The proposal included factors to be considered in determining whether an investee is related to an entitys consolidated operations. These factors included the line of business in which they both operate, the level of transactions between the investee and entity, and the extent to which management are common to both parties. Additional disclosures would also be required about how management has reached its conclusion on investments in which the entity has significant influence. The fair value option would no longer be available for such investments. Currently, the existence of significant influence alone requires equitymethod accounting by the investor. Constituent feedback: Most users who commented on this aspect of the proposal were supportive of this change. However, many preparers opposed this change on the basis that their equity-method investments are generally strategic in nature and the factors provided by the FASB to identify strategic investments were too limiting. In addition, many preparers did not support the proposal to eliminate the fair value option for these investments.
24. The FASBs May 2010 proposal

supported lowering the threshold to qualify for hedge accounting. The hedging relationship would only need to be reasonably effective instead of highly effective. It also proposed replacing the current requirement to quantitatively assess hedge effectiveness each quarter with a qualitative assessment at inception and would have limited the need to reassess in subsequent periods. 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, (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.
25. The IASBs December 2010 proposal

also changes the threshold to qualify for hedge accounting. However, unlike the FASBs proposal, it introduces a concept of having other than accidental offsetting, neutrality, and an unbiased result as the qualifying criteria for hedge accounting. In contrast to the FASBs proposal, the IASB retained the need to assess hedge effectiveness at each reporting date or when circumstances change, but this assessment can be performed qualitatively. However, under both the IASB and FASB proposals, the effectiveness test is only a forward-looking
13
Appendix Other proposals contained in the FASBs May 2010 exposure draft
test (i.e., no retrospective test would be required). The IASBs proposal also limits the ability to voluntarily de-designate a hedging relationship. The FASB has not decided on the full extent of its redeliberations. The following content reflects the proposals not already addressed in this Dataline and is carried forward from Dataline 201025, FASB proposes changes to financial instruments accounting. Note, however, that the Board may still redeliberate these proposals. Therefore, they are subject to change as the Board has not yet issued a final standard. The following financial guarantees or indemnifications: Contracts that prevent the guarantor from achieving sale accounting for an asset transfer or recognizing profit from a sale transaction Guarantees or indemnifications of an entitys own future performance Product warranties or other guarantees related to the functional performance (not the price) of nonfinancial assets owned by the guaranteed party Guarantees issued between a parent and its subsidiary or between entities under common control Guarantees issued by a parent to a third party for a subsidiarys debt, or guarantees issued by a subsidiary to a third party for its parent or another subsidiarys debt Contracts that provide for payments that constitute vendor rebates
26. The IASBs proposal provides greater

flexibility in the designation of exposures as hedged risks, including by allowing the designation of risk components of nonfinancial items and groups of dissimilar items (including net exposures) as hedged items. The proposal would also change the presentation of fair value hedges by removing the requirement to adjust the basis of the hedged item and instead require fair value changes attributable to the hedged risk to 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.
Scope
The scope of the project is limited to financial instruments, as defined in the master glossary of the FASB Accounting Standards Codification. However, the following are excluded: Employers and plans obligations and the related assets within the scope of: ASC 710, Compensation ASC 712, Compensation Nonretirement Postemployment Benefits ASC 715, Compensation Retirement Benefits ASC 718, Compensation Stock Compensation ASC 960, Plan Accounting Defined Benefit Pension Plans ASC 962, Plan Accounting Defined Contribution Pension Plans ASC 965, Plan Accounting Health and Welfare Benefit Plans -
Transition and effective date

27. The Board has not decided on the
effective date of these changes or the method of adoption. However, the May 2010 proposal called for entities to adopt the standard by making a cumulative-effect adjustment, calculated in accordance with ASC 250, Accounting Changes and Error Corrections, to the last balance sheet before the effective date. The prior-period balance sheet would be restated in the first financial statements (interim or annual) issued after the effective date to provide some comparability. Early adoption was prohibited under that proposal.
Noncontrolling interests in consolidated subsidiaries Equity investments in consolidated subsidiaries Equity instruments issued and classified entirely in stockholders equity. (Note that financial instruments with equity-like features that are classified as liabilities would be subject to the Boards proposal.) The scope also would not apply to equity components of hybrid financial instruments that require bifurcation. An interest in a variable-interest entity that the reporting entity is required to consolidate
Contracts within the scope of ASC 944, Financial ServicesInsurance, except for investment contracts issued by insurance entities and contracts that do not transfer insurance risk and are within the scope of the deposit method of accounting as defined in ASC 944
14
Forward contracts that require physical settlement by repurchase of a fixed number of the issuers equity shares in exchange for cash accounted for under ASC 480, Distinguishing Liabilities from Equity Leased assets and liabilities accounted for under ASC 840, Leases The conditional obligation under a registration payment arrangement that is accounted for separately from the debt or equity instrument Receivables and payables of not-forprofit entities relating to pledges arising from voluntary nonreciprocal transfers Investments accounted for under the equity method (ASC 323, InvestmentsEquity Method and Joint Ventures)
Derivatives that preclude sale accounting under ASC 860, Transfers and Servicing (e.g., call option to repurchase the transferred assets) Policyholders investments in life insurance contracts Investment contracts included in the scope of ASC 960, Plan AccountingDefined Benefit Plans Contracts to enter into a business combination at a future date
Application to certain industries

Broker-dealers would recognize all financial assets at fair value with changes in fair value recognized in net income. However, the proposed guidance would apply to a broker-dealers financial liabilities. Therefore, its financial liabilities could qualify for fair value measurement with changes in fair value recognized in OCI, or qualify for amortized cost measurement. Investment companies would recognize all financial assets and liabilities at fair value with changes in fair value recognized in the net increase or decrease in net assets resulting from operations. Entities within the scope of ASC 958, Not-for-Profit Entities, would be required to classify and measure financial assets and financial liabilities according to the proposed model even if they do not report net income or comprehensive income. Those entities that report a performance indicator similar to net income would need to report fair value changes in that performance indicator unless they are eligible and elect to have fair value changes recognized in OCI, in which case they would report those fair value changes outside of the performance indicator. Entities that do not report a performance indicator would need to report all changes in fair value as a change in the net asset class in the statement of activities. Further, all not-for-profit entities would need to initially measure all financial instruments at transaction price.
To include within the scope of the proposal: Life settlement contracts, which are contracts that do not have a direct insurance element (the investor does not have an insured interest) would be measured at fair value
The board also proposed the following scope clarifications for financial instruments currently excluded from ASC 815, Derivatives and Hedging: To exclude the following from the scope of the proposal: Forward contracts to purchase or sell securities that are deemed regular way Contracts that are not exchange traded, where the underlying is (1) a climatic or geological variable (e.g., weather derivatives), (2) the price or value of a nonfinancial asset or liability of a contract party that is not readily convertible into cash, or (3) specified volumes of sales or service revenues of a contract party
The Board also proposed to require that: Contingent consideration arrangements that are based on an observable market or index be measured at fair value with changes in fair value recognized in net income. Contingent consideration arrangements that are not based on an observable market or index would be excluded from the scope. All loan commitments and standby letters of credit would be recognized and accounted for by the issuers in accordance with the proposal. However, loan commitments in connection with revolving lines of credit issued under credit card arrangements would be excluded from the scope. Potential borrowers under loan commitments and standby letters of credit would be excluded from the scope.
15
Temporary deferral for certain nonpublic entities

The Board decided to provide nonpublic entities with less than $1 billion in total assets with an additional four years after the effective date that would apply to other companies to recognize at fair value on the balance sheet loans that are eligible for the recognition of fair value changes in OCI and core deposit liabilities. These entities would continue to recognize those loans and core deposits at amortized cost. They would also continue to account for any loan commitments under the current accounting guidance. While the fair value disclosures would still be required for these loans based on the exit price definition of fair value contained in ASC 820, Fair Value Measurements and Disclosures, core deposits would not be subject to the new measurement methodology for the purpose of these disclosures. Issuers of conduit debt securities that are traded in a public market are considered public entities.
must be repaid upon disposal of an asset is considered contractually linked to the asset. Or Issued by and reported in, or evaluated by the chief operating decision maker as part of, an operating segment with less than 50% of that segments assets measured at fair value on a recurring basis Or A liability of a consolidated entity with less than 50% of the consolidated assets measured at fair value on a recurring basis
with changes in fair value recognized in net income, although the demand amount will likely approximate fair value since the holding period is typically short. Time deposits would be measured at fair value and may be eligible for recognizing fair value changes in OCI. Constituent feedback: There was no support from respondents for the proposed measurement attribute for core deposits. PwC observation: Given the Boards recent decision that likely would allow most held-forinvestment loans to continue to be measured at amortized cost, it would seem unlikely that the Board will retain this element of its original proposal.
Amortized cost option for own debt

An entity could irrevocably elect at issuance to measure certain types of its own debt at amortized cost if (1) the debt would otherwise qualify to have changes in fair value recognized in OCI and (2) measuring the debt at fair value would create or exacerbate a measurement attribute mismatch between recognized assets and liabilities. A measurement mismatch exists when the liability is: Contractually linked to an asset that is measured at amortized cost (e.g., a mortgage loan). A financial liability that is collateralized by an asset or
The assessment of whether a measurement mismatch exists is made based on the balances of recognized assets at the end of the last reporting period adjusted by (1) removing any assets that are contractually linked to liabilities and (2) including assets acquired due to the issuance of the liability. For the purposes of this calculation, cash is excluded (not considered to be measured at fair value) but cash equivalents are not.
Loan commitments and standby letters of credit

Loan commitments and standby letters of credit issued by potential lenders would be recognized at fair value and classified in a manner that is consistent with how the loan would be classified if and when it is funded. For example, if the potential lender plans to hold the loan for the receipt of its contractual cash flows and intends to elect that the fair value changes be recognized in OCI, then the fair value changes on the loan commitment or standby letter of credit would be recognized in OCI. If the commitment is exercised and an entity decided to recognize fair value changes in OCI for the loan, the commitment fees would adjust the amortized cost, which would be used to calculate interest income, and be recognized as a yield adjustment over the term of the funded loan.
Core deposits
Core deposits would be measured based on the present value of the average core deposit balances discounted over the implied maturity at a rate equal to the difference between the alternative funding rate and the costs of providing services to the deposit holders (the all-in-cost-toservice rate). Core deposits are likely to be eligible for recognizing remeasurement changes in OCI. Core deposits are defined as deposits that do not have a contractual maturity but that management identifies as a stable source of funds. Noncore deposits would be carried at fair value
16
PwC observation: The FASBs recent decision to allow certain loans to be measured at amortized cost would likely trigger a reconsideration of the appropriate measurement attribute for loan commitments that, when funded, would result in loans that are measured at amortized cost.
Investments redeemable for a specified amount

An exception from fair value measurement is also provided for certain investments that can only be redeemed with the issuer for a specified amount. If the investment meets the following criteria, it would be required to be subsequently measured at the redemption amount: It does not have a readily determinable fair value It cannot be redeemed for an amount greater than the holders initial investment It is not held for capital appreciation It is required to enable the holder to enter into a transaction with or participate in the issuers activities
Presentation
Financial instruments for which changes in fair value are recognized in net income would be presented on the balance sheet separate from financial instruments for which fair value changes are recognized in OCI. The table on the following page summarizes the other FASB proposals on financial statement presentation:
Short-term receivables and payables

Entities can elect to measure receivables and payables at amortized cost if they (1) are eligible for fair value changes to be recognized in OCI and (2) arose in the normal course of business and are due in customary terms of up to one year. However, this amortized cost exception is not available to lending arrangements not associated with the delivery of goods and services, such as credit card receivables and short-term debt securities. PwC observation: Note that the FASBs recently revised business strategies guidance should allow most receivables to be classified and measured at amortized cost. Consequently, this exception may no longer be necessary. As previously noted, the Board recently began to reconsider the classification and measurement of financial liabilities but has not made any tentative decisions yet.
17
Classification Financial instruments for which changes in fair value are recognized in net income
Balance sheets Present fair value on the balance sheet, except for an entitys own debt where amortized cost also would be presented on the balance sheet.
Statements of comprehensive income Present separately in net income an aggregate amount for realized and unrealized gains and losses.
An entity may elect to present interest An entity may elect to present, either on income/expense accruals, dividend the balance sheet or in the footnotes, the income/expense accruals, and credit amortized cost and a reconciliation to losses as separate line items. fair value. Present significant fair value changes in an entitys own credit standing in net income separately. Financial instruments for which changes in fair value are recognized in OCI Present as separate line items on the balance sheet: Amortized cost (reduced for any write-offs*) Allowance for credit losses (for assets) Adjustment to arrive at fair value Fair value Present the fair value/ remeasurement changes separately from other accumulated OCI items and also the portion thereof allocated to noncontrolling interests.
* A write-off is a reduction in the carrying amount due to uncollectability.
Present separately in net income: Interest income Interest expense Credit losses or recoveries (for assets) Realized gains and losses Foreign currency gains or losses would continue to be reported in OCI along with other changes in fair value recognized in OCI. Present significant fair value changes in an entitys own credit standing separately.
Core deposits
Present as separate line items on the balance sheet: Face amount (amortized cost) Adjustment to arrive at remeasurement value Remeasurement value
Present interest expense separately in net income if remeasurement changes are recognized in OCI. However, if remeasurement changes are recognized in net income, then, at a minimum, present aggregate unrealized gains or losses. If an entity elects OCI treatment, foreign currency gains or losses would continue to be reported in OCI along with other changes in fair value recognized in OCI.
Financial instruments (own debt) for which the amortized cost option is elected
Present amortized cost on the face of the balance sheet.
Present separately in net income: Interest expense Realized gains or losses
18
Disclosures
The FASB proposed numerous additional disclosures for inclusion in annual and interim reports. The disclosures are required to be disaggregated based on the nature, characteristics, and risks of the financial instruments. The disclosures include requiring information about: The reasons for significant changes in fair value due to the entitys own credit standing, and how the resulting gains or losses were determined The contractual maturities of instruments measured at fair value with changes recognized in OCI Information about financial assets purchased and measured at fair value with changes recognized in OCI The entitys assessment of the credit impairment and the discount/ premium associated with purchased financial assets A roll forward (in the aggregate and by portfolio segment) of the allowance for credit losses
How an entity determines whether a credit impairment exists, and the significant inputs and assumptions used to measure the impairment The average carrying amount, unpaid principal balance, fair value, amortized cost, allowance for credit losses, and interest recognized on individually impaired financial assets The reasons, together with cost basis, fair value, and gain/loss information, that instruments were sold or settled before contractual maturity date if measured at fair value with changes recognized in OCI The method(s) used to determine interest income for pools of financial assets if impairment is determined on a pool basis, and quantitative information about these pools The carrying amount and amortized cost for financial assets that have a negative yield (and are therefore not accruing interest)
The key inputs and assumptions used to measure core deposit liabilities and an analysis of the uncertainty of the measurement (the effect of a 10% change in the discount rate) Why measuring a financial liability at fair value would create or exacerbate a measurement mismatch and the fair value of the liability if the amortized cost option is elected
Entities would need to disaggregate all the recurring fair value disclosures required under ASC 820 between those instruments where fair value changes are recognized in net income and those where fair value changes are recognized in OCI. Entities would also have to provide additional disclosures about significant inputs and the information on measurement uncertainty (proposed in the joint fair value measurement project) for all measurements classified as Level 3 in the fair value hierarchy, with the exception of unquoted equity instruments.
19
Impairment redux FASB and IASB are seeking comments on a converged impairment model for financial assets
Whats inside: Overview Key provisions
On January 31, 2011, the FASB and IASB (the boards) published a supplementary document, titled by the FASB Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities: Impairment1 (the supplement), to solicit views on a converged model to account for impairments of certain financial assets managed in an open portfolio. The supplement is a likely precursor to an exposure draft of a proposed accounting standard. It reflects the boards consideration of feedback received on impairment models included in exposure drafts on financial instruments accounting issued by the IASB in November 2009 and by the FASB in May 2010. Through the boards outreach on the financial instruments project, as well as feedback from groups such as the G-20 and the boards Financial Crisis Advisory Group, impairment has been cited as the area in financial instruments accounting that is most in need of repair and where convergence is essential. The consensus among the boards constituents is that the current impairment model under USGAAP and IAS 392 did not result in the timely recognition of losses (too little, too late) and did not adequately incorporate forward looking information. The supplement acknowledges the importance of reaching a common solution to accounting for impairment of financial assets and at least partly satisfying each boards original objectives for impairment accounting set out in their exposure drafts. The supplement incorporates the IASBs objective to reflect the relationship between the pricing of financial assets and expected credit losses through a loss allocation method. It also addresses the FASBs objective related to the adequacy of the allowance by establishing a minimum allowance or floor. The boards plan to jointly redeliberate the proposals in the supplement based on the feedback received on it and will consider the need for public roundtables, although there is a sense that roundtables are not well suited to address the operational issues. The IASB expects to issue a final impairment standard by June 2011, and the FASB expects to issue a final ASC update that includes the credit impairment model in 2011.
1 The IASBs version of the supplement is titled Financial Instruments: Impairment. 2 IAS 39, Financial Instruments: Recognition and Measurement.
20
The main details

1. The supplement proposes an impairment model with two distinct methodologies for certain financial assets managed in an open portfolio, with credit losses determined based on the credit characteristics of such financial assets (the common proposal). The common proposal is limited to an open portfolio of assets because the boards consider the application of an impairment model to be most operationally challenging for open portfolios. This model is consistent with how many financial institutions manage credit risk. The two methodologies are referred to herein and in the supplement as a good book and bad book approach. The distinction between the categories depends on the degree of uncertainty about collectability. When collectability becomes uncertain and the entitys credit risk management objective changes from receipt of regular payments to recovery, the allowance for the financial asset would be evaluated in the bad book. Thus, financial assets could move between two portfolios, the good book (where the higher of (i) a timeproportional allowance or (ii) the losses expected in the foreseeable future (no less than 12 months) that can be reasonably estimated would be recognized) and the bad book (where the entire amount of expected credit losses would be recognized immediately) according to the entitys internal risk management policies.
the models that each board had been separately developing. Accordingly, the supplement also affords constituents the opportunity to provide feedback on the FASB and IASB alternative approaches. Under the IASB alternative approach, an entity recognizes the time-proportionate remaining lifetime-expected credit losses on the good book with no floor and the full amount of lifetime-expected losses on the bad book. Under the FASB alternative approach, an entity immediately recognizes all credit losses expected to occur in the foreseeable future, with no minimum period specified.
Recap of the original proposals and feedback received3

5. The models originally proposed in
exposure drafts on financial instruments accounting issued by the FASB and IASB are very different. The FASB model was based on upfront recognition of credit losses that are expected over the life of the asset, while the IASB model recognized expected credit losses via an adjustment to the effective interest ratethereby recording losses over the life of the loanwith changes in cash flow expectations resulting in a catch-up adjustment recognized in net income. The information used to forecast expected losses was also not aligned in the proposals because the FASB limited information to past events and current conditions while the IASB required use of forecasts in projecting cash flows. Both proposals required interest income recognition to be affected by credit losses.
3. The comment period for the supplement is short at 60 days with comments due April 1, 2011. The supplement seeks comments on the common approach, and on each boards independently developed alternative approach. The scope of the proposals is limited to financial assets in open portfolios. However, the boards are also inviting comments as to whether the proposed approach is suitable for closed portfolios, individual instruments, and any other types of instruments. At this time, the boards are not re-exposing other aspects of the impairment model, such as the methods for measuring credit losses. They will continue redeliberating these issues based on the feedback received on their original exposure drafts while the supplement is open for comment.
6. Constituents criticized both models

through comment letters and roundtables. The FASB proposal was mainly criticized for (i) requiring too much too soon and (ii) not permitting forecasts to be used in developing expectations. The IASB proposal was mainly criticized for (i) creating operational complexity in requiring explicit cash flow forecasting based on probability-weighted expectations and (ii) potentially resulting in the loss being recorded after it was
2. The common proposal outlined in the

supplement is the result of joint discussions on an impairment model that addresses the primary objectives of the individual boards. However, some members of the FASB and IASB prefer
4. Effective dates and transition provisions are not proposed in the supplement. The boards acknowledge, however, that even if the impairment standard is finalized in 2011, implementing the new model might require substantial lead time.
For further details on the original proposals, refer to PwC Dataline 201025, FASB proposes changes to financial instruments accounting.
21
incurred, thus giving rise to a negative allowance (due to the fact that the charge-off would be debited to the allowance account before all the expected losses were credited to that account). Both models were criticized for requiring interest income to be commingled with credit losses. Users that responded to the boards proposals generally preferred to retain the current method for establishing net interest margin on the basis that it was well-established and understood. They also objected to the subjectivity associated with determining the allowance balance affecting both the interest and provision lines in the performance statement.
impairment model for open portfolios, one of the most operationally complex areas of impairment. The supplement defines a portfolio as a grouping of financial assets with similar characteristics that are managed by a reporting entity on a collective basis. An open portfolio is further described as a portfolio where assets are added to the portfolio through its life by origination or purchase and removed through its life by write-offs, transfers to other portfolios, sales, and repayment. PwC observation: Current US GAAP and IFRS do not include specific guidance on how an entity should group financial assets for the purpose of building up the allowance levels. In addition, although the discussion in the supplement focuses on loan portfolios, portfolios of debt securities may also be considered open portfolios.
some board members raised concerns about the interaction between the impairment model and proposed classification and measurement of the financial instruments. One significant issue still to be discussed is how and when to measure the impairment of instruments measured at fair value with changes in fair value recognized in other comprehensive income. The issue is whether measurement should be based on the fair value or should be based on credit losses, similar to the current US GAAP other-than-temporary impairment model for debt instruments.
7. The IASB sponsored the formation

of an Expert Advisory Panel (EAP) comprising credit risk experts to consult on the operational issues of both models. Although the EAP was set up to provide feedback on the operational aspects of each boards approach, the panel also explored alternative models and provided feedback to the boards that helped establish the groundwork for the common approach in the supplement.
11. The supplement further clarifies that:

Equity investments are excluded from the supplement. Part of the simplification effort in the financial instruments project is to eliminate the need to assess impairment of equities. The FASB originally proposed in the May 2010 exposure draft that all equity investments be recognized at FV-NI. Although the FASB has not finalized that model, if the FASB chooses to move away from FV-NI for equities, then a different impairment model will likely be required for equity investments. Short-term trade receivables are excluded from the IASBs but not the FASBs supplement. Given the complexities of the interaction with the revenue recognition project, the IASB decided that it would discuss impairment of short-term trade receivables at the beginning of its redeliberations on the revenue recognition project. The FASB has not yet discussed this issue.
10. The scope of the common proposal

covers financial assets measured at amortized cost under IFRS 9 and, for the FASB, financial assets that are not measured at fair value with changes in fair value recognized in net income (FV-NI).4 Thus, for the FASB, the model in the supplement would apply to financial assets measured at fair value with changes in fair value recognized in other comprehensive income (FV-OCI) and financial assets measured at amortized cost. PwC observation: During the FASBs redeliberations of its exposure draft on financial instruments,
Key provisions
8. This section highlights the key provisions of the common proposal in the supplement. All decisions noted in this Dataline are tentative and therefore subject to change, as the boards have not yet concluded their deliberations or issued a final standard.
Scope
9. The objective of issuing the supplement is to obtain feedback on an
22
4 Refer to PwC In brief 201102, FASB changes course on financial asset classification and measurement.
Exhibit A: Distinction between good book and bad book

Transfers to other portfolios; sales; repayment
Assets going out
Assets going in*
Good book (open portfolio) Bad book (open portfolio)
Although the closed portfolios are excluded from the supplement, the boards are seeking feedback on whether the proposed model can be applied to such portfolios. Run-off loan books are typically evaluated for impairment on a portfolio basis; therefore, the open portfolio model could apply. Debt securities currently subject to impairment under ASC 32010 may be within the scope of the supplement if credit risk is managed in a portfolio, i.e., grouped based on similar characteristics, although this may be rare. Individual debt securities and loans not evaluated for impairment in a portfolio or group are excluded from the supplement. The boards are asking for feedback on whether and how the proposed model can be applied to assets evaluated for impairment on an individual basis. PwC observation: It may not be intuitive to apply a statistical method that is generally used for portfolios (e.g., based on loss rates) to an individual asset, such as a large, unique loan or a debt security. However, if pooling is applied to such assets, then a good book allowance would need to be recognized. Whether recognition of a good book allowance for an individual asset provides decisionuseful information is to be debated. It may be more intuitive to apply only the bad book approach to an individual debt investment, such as a corporate bond where collectability is uncertain. A bad bookonly approach would be similar to the FASBs current model for
Origination of purchase
* Purchased assets with credit deterioration are yet to be discussed.
Collectability so uncertain that risk management objective changes from receipt of cash flows to recovery; based on internal risk management policies with minimum thresholds for entities that do not manage separately
recognizing impairment on debt securities under ASC 32010, where the entity has the intent and ability to hold the investment. Loan commitments and financial guarantees not accounted for at FV-NI are excluded from the supplement. The IASB is asking for feedback on whether the proposed model (i) should be applied to loan commitments and (ii) will be operational if applied to financial guarantee contracts. PwC observation: The boards prefer to develop a single impairment model that would apply to all financial assets. However, the accounting for impairment of the financial instruments discussed above has not been addressed. Furthermore, the supplement does not address purchased credit impaired assets subject to ASC 31030 (formerly SOP 03-3) and troubled debt restructurings in ASC 31040 (formerly FAS 15)two operationally complex areas that respondents to the FASBs exposure draft recommended it address. Also not addressed in the supplement is the impairment of certain
redeemable instruments that the holder is required to own to benefit from the investees operations, e.g., FHLB stock and an interest in cooperatives.
The common proposal

12. The common proposal should achieve
a total amount of allowance that reflects an entitys expectations for credit losses based on managements credit risk strategy. The remainder of this subsection describes the elements of and some additional considerations related to the proposed model: the distinction between good book and bad book, the information set, the bad book allowance, the good book allowance, transfers between good and bad books, and interest income recognition.
Distinction between good book and bad book
13. Although the supplement does

not define bad book and good book portfolios, the terms are used in the supplements introduction and basis for conclusions and have been used extensively in the boards
23
redeliberations of their exposure drafts on financial instruments accounting. Accordingly, this Dataline distinguishes between the two portfolios using those shorthand terms. Exhibit A on the previous page illustrates the distinction between good book and bad book and the interaction with an open portfolio.
For entities that do not differentiate credit risk based on uncertainty of collectability, a process will need to be developedfor example, based on days past due.
require forecasting, most notably in accounting for non-financial asset impairment, fair value, and pensions.
Information set
Bad book allowance
16. The proposed model retains one

key element from the initial models exposed by the boards: the elimination of a recognition threshold (probable under USGAAP and objective evidence under IFRS). The information used to determine expected losses (for both good book and bad book allowances) should be forward-looking. All information, based on both internal and external data, should be considered, including historical data, current economic conditions, and forecasts of future conditions. The latter should be based on reasonable and supportable information that is consistent with currently available information that management uses for internal purposes. PwC observation: Regarding its original proposed impairment model, the FASB received strong negative feedbackfrom users, preparers, and the EAPon limiting the information that can be used in projecting expected losses. Those who commented supported the element of the IASB exposure draft, which required expected losses to be based on expectations. The FASBs original objective was to limit the information set to exclude unobservable future economic conditions. However, as noted in the basis for conclusions, many other areas of accounting
17. Once an asset is determined to be

in the bad book (as described above in the section Distinction between good book and bad book), the proposed model for the bad book allowance requires recognition of the entire amount of remaining lifetime expected losses. The common proposal does not permit recognition of losses over time when management believes that there is uncertainty regarding collectability of such assets. The supplement does not provide additional guidance on the measurement of the bad book allowance. For example, it is unclear whether the entire amount of remaining lifetime expected losses is discounted or undiscounted, and if discounted, at what discount rate. Also, the consideration of collateral values is not specifically addressed in the supplement. PwC observation: The bad book was introduced into the IASBs original proposal by the EAP (i) to address the problem of deferring actual losses while recording a negative allowance and (ii) to reflect that entities manage those assets differently than performing assets. Relative to the current impairment guidance, the introduction of a bad book is not new; US GAAP addresses specific impairment in ASC 31010 (formerly FAS 114), and IAS 39 makes a distinction between specific and collective provisioning.
14. The total allowance is built up by

computing two separate components: an allowance for the bad book and an allowance for the good book, with each component measured differently. Whether an asset is in a good book or bad book depends on the degree of uncertainty about its collectability. When collectability becomes so uncertain that the entitys credit risk management objective changes from receiving regular payments to recovering the financial asset, an allowance is created for the entire amount of expected losses over the remaining life of the asset; this is referred to as the bad book allowance. For the remaining assets in the portfolio where management of the assets is not focused on recovery, an allowance is created using a calculation methodology described below under the heading good book allowance.
15. Whether an asset belongs in the bad

book or good book for accounting purposes should reflect how the entity manages the credit risk of the asset. For example, a bank typically uses internal credit ratings to monitor credit risk. When a debtors rating falls below a certain threshold, such action may trigger additional credit risk management procedures and also trigger movement into the bad book for purposes of the common proposal.
24
Good book allowance
18. The proposed model requires an

allowance for the good book to be based on the higher of (i) a timeproportional allowance or (ii) the losses expected in the foreseeable future, which should not be less than 12 months. For financial assets with an expected life that is less than 12 months, the foreseeable future timeline should be the remaining average life of the portfolio. Each calculation is described below, along with a discussion of the loss estimation process for the good book allowances.
or use an annuity method (which inherently uses a discounted estimate). While, it appears to be a policy choice under the IASB proposal, both boards are seeking comments on the flexibility provided. This issue is also discussed in the section titled Interest income recognition. PwC observation: The EAP developed the time-proportional allowance method as an operational simplification of the IASBs original proposed impairment model. This approach assumes an entity can calculate an ELL with sufficient accuracy. Some preparers believe the ELL will require a significant effort to calculate. The IASBs decision not to require discounting of the time-proportional allowance provides some operational relief and is consistent with current US GAAP under ASC 450.
to the higher of test, the amount will be recognized immediately, typically in the reporting period when the allowance is updated. The supplement does not address discounting.
22. The allowance calculated pursuant to

this method represents a floor on the good book allowance. In addition, the common proposal states that the foreseeable future time period should not be less than 12 months. PwC observation: The floor serves the purpose of addressing the concerns expressed by FASB members during redeliberations of its exposure draft that the timeproportional allowance may be lagging when there is an adverse change in expectations. For example, when economic conditions worsen, losses in the good book likely will occur sooner, but a time-proportionate method continues to spread the higher losses. As part of the boards outreach, the boards understood that constituents were generally supportive of a floor on the good book allowance.
Time-proportional expected credit loss
19. The IASB alternative approach

of a time-proportional allowance is calculated by multiplying the expected losses over the remaining life of the portfolio (expected lifetime losses, herein referred to as ELL) by a ratio, the numerator of which is the weighted average age of the portfolio (WAA) and the denominator is the weighted average life of the portfolio (WAL). As ELL, WAA or WAL changes, the time-proportional allowance will also change, resulting in a catch-up for the past and spreading for the future, similar to the reassessment approach in the revenue recognition project.
Losses expected in the foreseeable future
21. Losses expected in the foreseeable

future are losses expected based on a time period that management can reasonably estimatealthough reasonably estimate is not defined in the supplement. While the supplement does not propose a bright line time period, the period should not be longer than and does not need to coincide with the expected life of the asset. Whether such a time period should be stable or change based on other factorssuch as macroeconomic conditions or availability of data is an issue on which the boards are asking for comment. If the foreseeable future loss is applicable pursuant
23. During redeliberations of their exposure drafts on financial instruments accounting, the boards discussed an earlier version of the common approach that included a bright line 12-month period for calculating the floor. This amount would be consistent with the allowance for loan losses related to loan portfolios (excluding credit card portfolios) that would be provided under the Basel II framework (a set of international standards and best practices that define the minimum capital requirements for
20. The above description of the timeproportional allowance assumes that an entity chooses to calculate the allowance using an undiscounted, straight-line method. The supplement provides entities the flexibility to use either a discounted or undiscounted estimate on a straight-line method
25
international active banks), as well as the amount provided for by US banks for regulatory capital purposes and financial reporting today (at a minimum). As such, concern was expressed by the FASB staff that a 12-month floor may not address the too little, too late problem. PwC observation: In the basis for conclusions, the boards state
that they were concerned that a 12-month bright line would prevent entities from considering events beyond the 12-month period and therefore delay recognition of expected losses. For example, the interest rate in a hybrid adjustable rate mortgage may reset in three years. Therefore, using a foreseeable future period would require an entity to consider the borrowers
ability to repay when the interest rate resets. However, if the foreseeable future is defined by management as a 12-month period, limiting the loss to a 12-month time horizon may not consider the effect of a known future event.
24. An example of the good book allowance is provided below.
Example: Good book allowance under the common proposal The following assumptions are used in this example: Principal amount in the pool Weighted average life (WAL) Weighted average age (WAA) ELL, at the end of year one Foreseeable future lossesExpected losses in the next two years, at the end of year one $10,000 5 1 $1,200 $900
The target allowance for the good book at the end of year one is based on the higher of the time-proportional allowance or expected losses in the foreseeable future that is not less than 12 months. (A) Time-proportionate allowance ELL WAA / WAL Target time-proportionate allowance (B) Foreseeable future losses Expected losses in the next two years Higher of (A) or (B) is the target good book allowance $900 $900 $1,200 1/5 $240
Note that the foreseeable future losses estimated using a two-year time period is 75% of the ELL in this example. This percentage will vary by asset type, but such a high concentration of losses in the earlier life of the asset is typical for many loan products.
26
Exhibit B: Forecasting expected losses

Loss
Short-term estimates (Discrete estimates with more reliance on internal data)
Medium-term estimates (Discrete estimates based on forecast visibility)
Long-term estimates (More data from external sources with reversion to long-term average loss rates)
PwC observation: During redeliberations, the US banking regulators presented loss data for various loan asset types, e.g., auto, consumer mortgages, and commercial real estate. For many types, losses tend to occur during the earlier part of the life of the asset. Based on these empirical findings, a question arises as to whether the good book allowance will effectively default to the foreseeable future losses calculation for many portfolios because it would produce a higher loss. However, many variables will impact the shape of a loss curve, including the WAL and WAA of the portfolio, economic conditions, and loan origination and mitigation activities. Because of these variables it is possible that the allowance levels will be based on either the time-proportional approach or foreseeable future approach from period to period rather than always the foreseeable future approach.
Time Expected credit losses over remaining life (for good book TPA and bad book) Foreseeable future losses (for good book floor)
forecasts when developing estimates. However, the supplement does not mandate a specific approach for developing loss estimates. For assets with longer expected lives, the supplement suggests an entity may make discrete forecasts of expected losses over the short and medium term and then revert to a long-term average loss rate. Exhibit B illustrates how the foreseeable future loss may interact with the ELL. PwC observation: In the supplement, the loss expected in the foreseeable future is not described explicitly as a subset of the ELL. However, in other areas of forecasting, e.g., forecasting cash flows for calculating the fair value of equities under the income approach, valuation professionals start with a discrete forecasting period for the near term, trend the forecast in the medium term, and use a long-term growth rate for the terminal value. A similar process may be considered for calculating the two loss estimates for the good book under the common approach, absent current clarification from the boards.
Summary of the allowance calculation for the common proposal
26. Exhibit C on the next page illustrates

the buildup of the total allowance and summarizes the approach in the common proposal.
Transfers between good book and bad book
27. The IASB appendix to the supplement

prescribes a method for transferring the allowance from the good book to the bad book when an asset or group of assets has been identified as impaired; these amounts would be disclosed as part of the proposed disclosures of allowance roll-forwards. An example of how this calculation is performed is provided in the IASB supplement. Furthermore, the IASB supplement specifies that transfers can be made from the bad book to the good book. The FASB has not yet addressed this issue. PwC observation: The requirement in the IASB supplement to identify the amount of allowance
Loss estimates
25. The supplement acknowledges

that the common proposal requires entities to make two loss estimates for the good bookfor the timeproportional allowance, the losses expected over the remaining life of the portfolio (the ELL); and for the floor, the losses expected in the foreseeable future. As discussed under the section Information set (paragraph 16 above) the common proposal requires entities to use
27
Exhibit C: Summary of common proposal
Bad book allowance
Good book allowance
Total allowance
Information for loss estimate Consider all available information, including internal and external data and expectations of future conditions based on reasonable and observable information that is consistent with currently available information Life of loan expected loss is a reference point (foreseeable future could be a subset)
Timing of loss Bad book: entire amount of expected credit loss Good book: higher of (i) time-proportional expected credit loss (ii) losses expect to occur within the foreseeable future, but no less than 12 months
Objective The time-proportional allocation is intended to approximate the IASB ED but with two floors: (i) bad bookto prevent negative allowance (ii) losses expected in foreseeable future no less than 12 monthto build allowance for losses before they develop rather than as they develop decoupling. However, to preserve an objective of the original IASB proposal, i.e., to reflect a creditadjusted yield, the supplement permits the allocation of ELL for the time-proportional allowance to be based on (i) an undiscounted straightline approach, (ii) a discounted straight-line approach, or (ii) an annuity approach, which is inherently discounted. If discounting is elected, the discount rate may be a rate between (and including) the riskfree rate and the ASC 31020/IAS 39 effective interest rate. The proposed policy choice described above reflects a decision reached by the IASB; the FASB has not deliberated this issue. PwC observation: It appears that by requiring decoupling of interest income and impairment, the boards have conceded on one of their objectives in creating a new impairment model. However, it is unclear to what extent interest income recognition will be redeliberated and whether any current practice issues will be addressed. Separately, the boards are asking for feedback on the policy choices in calculating the time-proportional allowance. Moving away from an undiscounted straight-line approach will introduce operational complexity.
transferred from good book to bad book could be operationally challenging. Current methods do not specifically identify allowances that should be transferred once an asset is individually identified as impaired. The ability to transfer from the bad book to the good book may be welcomed by US GAAP reporting entities that have assets in the scope of ASC 31040 (troubled debt restructuring); however, the FASB likely will be addressing the effect of a new impairment model on TDRs separately.
Interest income recognition
28. Although not specifically addressed in

the supplement, both boards original impairment models required commingling of interest income and impairment. The IASB did so to reflect a credit-adjusted yield, while the FASB did so to prevent interest income from being recognized on cash flows not expected to be collected. Feedback from comment letters, roundtables,
and the EAP roundly objected to commingling interest income and impairment. The reason for the strong objection is that the collective provision determined under current accounting frameworks is calculated independently from interest income, with the loan subledger tracking interest income on a contractual basis and credit risk systems calculating the appropriate allowance for portfolios. The operational complexity is significant in getting the systems to interact (e.g., accounting for purchased credit impaired assets under ASC 31030.). Moreover, users strongly objected to commingling because net interest margin is a key performance indicator and commingling would introduce uncertainty from impairment into interest recognition; users would prefer uncertainty be limited to the allowance and provision for credit losses.
The alternative approaches

IASB alternative approach
29. As a result of this feedback, the boards

agreed that the proposed model will not commingle interest income and impairment, which is referred to as
30. The IASB alternative approach

incorporates all of the elements of the common proposal, except it does not incorporate the foreseeable future or
28
Exhibit D: Reconciling the common proposal to the IASB alternative approach Information for loss estimate Consider all available information, including internal and external data and expectations of future conditions based on reasonable and observable information that is consistent with currently available information Life of loan expected loss is a reference point (foreseeable future could be a subset) Timing of loss Bad book: entire amount of expected credit loss Good book: higher of (i) time-proportional expected credit loss (ii) losses expect to occur within the foreseeable future, but no less than 12 months Objective The time-proportional allocation is intended to approximate the IASB ED but with two a floors: (i) bad bookto prevent negative allowance (ii) losses expected in foreseeable future no less than 12 monthto build allowance for losses before they develop rather than as they develop
FASB alternative approach
32. The alternative model retains some

elements of the common proposal. There is no good book-bad book distinction and losses are based solely on those losses expected to occur in the foreseeable future without a 12-month minimum period. Exhibit E illustrates the modifications to the common proposal to arrive at the FASB alternative approach.
IASB alternative model
12 month floor concept for the good book allowance. Exhibit D illustrates the modifications to the common proposal to arrive at the IASB alternative approach.
31. During the redeliberations, some

IASB members voiced support for the good book-bad book distinction and the time-proportional allowance for the good book but objected to a floor on the good book allowance. Some
of these board members questioned whether the floor reflects prudence, which is not an objective of financial reporting in the Conceptual Framework. Also, these IASB members did not believe a loss should be recognized immediately when an asset is originated.
33. During redeliberations of the

FASBs exposure draft on financial instruments accounting, some FASB members did not support the common proposal because they believe expected losses over the life of the asset should be recognized immediately. The FASB alternative approach is closer to the originally proposed FASB impairment model with a few changes: (i) the information set includes forecasts using future expectations and (ii) the expected loss is not required to be recognized based on the life of the asset but rather the losses expected in the foreseeable future (which can be shorter than the assets expected life). The FASB alternative approach does not address the distinction between good book and bad book because board members do not believe the FASB has sufficiently deliberated the distinction and the implication of the distinction. PwC observation: The common proposal comprises elements of both alternative approaches. Although a majority of board members of both boards supported the common proposal, there were strong dissenting views. In a comparison of the three potential models, the highest allowance is
Exhibit E: Reconciling the common proposal to the FASB alternative approach Information for loss estimate Consider all available information, including internal and external data and expectations of future conditions based on reasonable and observable information that is consistent with currently available information Life of loan Foreseeable future expected loss is a reference point (foreseeable future could be a subset) Timing of loss Bad book: entire amount of expected credit loss Good book: higher of (i) time-proportional expected credit loss (ii) losses expect to occur within the foreseeable future, but no less than 12 months Objective The time-proportional allocation is intended to approximate the IASB ED but with two floors: (i) bad bookto prevent negative allowance (ii) losses expected in foreseeable future no less than 12 monthto build allowance for losses before they develop rather than as they develop
FASB alternative model

Financial instruments 29
expected to be achieved under the common proposal because the allowance is effectively based on the higher of the allowance calculated pursuant to the IASB and FASB alternatives. The FASB alternative approach may represent a less operationally complex change compared with the changes required for the good books time-proportional allowance in both the common proposal and the IASB alternative approach. However, a concern that will likely be raised for both the common proposal and the FASBs alternative approach is the comparability of foreseeable future expected losses; such concerns may be mitigated with robust disclosures.
Presentation and disclosure

34. The IASB included presentation and
disclosure requirements as part of its supplement, while the FASB did not. The most significant disclosures proposed include the ELL and foreseeable future expected losses and their respective changes during the reporting period, including detail on the inputs, assumptions,
and methodologies used to arrive at those amounts. Also, significant changes in allowance from a particular portfolio or geographic area would be disclosed. The disclosures do not include a sensitivity analysis or a requirement to present losses by vintage as proposed in the original IASB exposure draft. However, quantitative information regarding back-testing is required if performed internally; otherwise, a qualitative discussion is required to be disclosed of expected losses versus actual outcomes. Current USGAAP (as amended by ASU 2010-205), requires comprehensive disclosures by portfolio segment and asset classes; disclosures are required of activities and changes in the allowance between reporting periods and would include robust discussions regarding accounting policy, methodology, and assumptions used by the entity to develop the allowance.
proposals that have not yet been redeliberated. The following list highlights some of those issues: Scopefinancial assets that are not part of open portfolios or are evaluated individually, other problem loans, purchased loans with credit deterioration, short-term trade receivables, and any issues specific to investments in debt securities. Scopeloan commitments and financial guarantees. Methods of measuring credit losses, including discounting. Interaction with classification and measurement (particularly, application to amortized cost, FV-OCI, and held for sale). Interest income recognition, e.g., revisit ASC 31020/IAS 39, application issues for floating rate instruments. Definitions, including write-off and nonaccrual. Presentation and disclosure requirements, e.g., stress testing, by vintage.
Proposals yet to be redeliberated

35. The supplement lists many issues that
the boards will redeliberate in connection with finalizing the impairment model. Also, issues were addressed in the comment letters on the original
36. The list above is not intended to be

exclusive, and the boards believe that comments received on the original exposure drafts will be a starting point to address these issues as part of the redeliberation efforts.
5 Refer to PwC Dataline 201031, New disclosure requirements for finance receivables and allowance for credit losses.
30
FASB seeks comments on IASB hedge accounting proposal
Whats inside: Whats new? What are the key provisions? Is convergence achieved? Whos affected Whats next?
Whats new?
On February 9, 2011, the Financial Accounting Standards Board (FASB) issued a Discussion Paper seeking feedback from its constituents on the International Accounting Standards Boards (IASB) proposed revisions to hedge accounting. The IASB issued its exposure draft on revisions to hedge accounting on December 9, 2010. The FASB had previously issued its own proposals on changes to hedge accounting as part of its overall exposure draft on the accounting for financial instruments, in May 2010. The FASB plans to use the feedback it receives on the Discussion Paper to help it in its own deliberations about how to improve and simplify hedge accounting under US generally accepted accounting principles (USGAAP).
Reprinted from: In brief 201106 February 11, 2011 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
What are the key provisions?

The Discussion Paper outlines the FASBs purpose for inviting comments and includes a copy of the IASBs hedge accounting exposure draft with a summary comparison to current and proposed USGAAP. More importantly, the FASB has directed several questions at its constituents. These questions supplement those within the IASBs exposure draft and touch on the key areas for which the IASB is proposing changes to hedge accounting. The questions are intended to draw feedback on aspects of the IASBs proposal that would represent changes to USGAAP. At a high level, the questions focus on whether respondents believe that the following key changes are understandable, operable, and have conceptual merit: The linkage of hedge accounting to an entitys risk management strategies The broadening of what qualifies as a hedging instrument and hedged item or risk, including the ability to hedge
nonfinancial risk components that are separately identifiable and reasonably measurable The removal of the highly effective threshold for determining hedge effectiveness and the shift to a method that requires an unbiased result that is expected to achieve other-thanaccidental offset The requirement to rebalance hedge relationships over time Accounting for the time value of options New financial statement presentation requirements for fair value hedges Additional disclosures, including disclosures about risks that an entity decides to hedge
The FASB has also asked whether the changes proposed by the IASB would be a better starting point for any changes to hedge accounting in USGAAP than what the FASB had proposed. In addition, the FASB is interested in understanding views on whether it should focus on targeted improvements or convergence of hedge accounting.
31
Despite being part of an overall joint project on the accounting for financial instruments, there are many differences between the IASBs proposed hedge accounting standard and hedge accounting guidance under current and proposed USGAAP. Whether the boards converge on hedge accounting depends on the results of their redeliberations.
Whos affected?
All entities that prepare their financial statements in accordance with USGAAP and engage in risk management activities regardless of whether they use hedge accounting today could potentially be affected. The FASB intends to use the feedback from the Discussion Paper to help it in its redeliberations of its own hedge accounting proposal.
Whats next?
The comment deadline for the Discussion Paper is April 25, 2011. The deadline for responding on the IASBs exposure draft is March 9, 2011. The IASB will begin its redeliberations after its comment period ends. The FASB plans to participate with the IASB in its discussions and to consider the feedback it has received, beginning in the second quarter of 2011. Therefore, entities should consider responding to the FASB, even if they are planning to separately send a comment letter to the IASB on its proposal. For further details on the IASBs hedge accounting proposal, including a comparison to current and proposed USGAAP, refer to Dataline 201106, Accounting for hedging activitiesA comparison of the FASBs and IASBs proposed models.
32
Accounting for hedging activities A comparison of the FASBs and IASBs proposed models
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 IASBs 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 USGAAP models and the USGAAP 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 IASBs 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 IASBs 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.
33
The main details

1. The existing guidance on hedge
accounting under IFRS and USGAAP 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 entitys risk management activities.
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.
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 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
2. In the FASBs and IASBs 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 entitys risk management strategies. In addition, users asked for better disclosures regarding an entitys risk management activities and the effectiveness of such strategies.
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 201025 dated June 10, 2010.
3. There are currently significant differences between the existing hedge accounting rules under IFRS and USGAAP. 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
6. The IASBs exposure draft primarily

provides guidance on the micro (oneto-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 USGAAP differences related to macrohedges.
34
Key provisions
Qualifying for hedge accounting
Qualifying for hedge accounting at inception
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.
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%.
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.
Location A usually trades at about 90% of the price for the exchangetraded benchmark grade of the same commodity in Location B. If the entity wants to hedge the forecast purchase of 100 tons with exchange-traded 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).
8. Under the FASBs 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
Maintaining the hedging relationship on an ongoing basis
Example
An entity wants to hedge a forecast purchase of 100 tons of a commodity in Location A. That commodity for delivery point
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
35
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.
ineffectiveness. In such a case, rebalancing 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.
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.
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).
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 FASBs exposure draft expressed concern over the requirement to record all ineffectiveness, whether resulting from overor under-hedges.
Frequency and nature of effectiveness tests
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 would lead away from that hedge ratio, then a new ratio would result in minimizing
36
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 forwardlooking test (i.e., no retrospective test would be required).
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.
Discontinuation of hedging relationships

Voluntary de-designation
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.
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 IASBs 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.
19. In contrast, the IASBs 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 discontinuedfor 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
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.
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 USGAAP:
18. Under the FASBs proposal, an entity

would only be able to discretionarily discontinue hedge accounting by entering into an offsetting derivative
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
37
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 nonfinancial items
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)
21. Currently, the FASB and IASB allow

hedges of components for financial items only. However, the IASBs proposal permits entities to hedge risk components for non-financial items, provided such components are separately identifiable and reliably measurable. This is an area of significant interest for risk management functions in non-financial service organizations.
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
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 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
38
copper, zinc, and conversion costs. An entity may wish to hedge the copper component of its fixedprice 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.
functional currency for the first three years and a floating rate exposure thereafter. Hence, the entity enters into a 10-year fixedto-floating cross currency interest rate swap (CCIRS) at the time the debt is issued. This would swap the fixed-rate debt with a variablerate 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 fixedrate exposure in USD for the first three years.
as well as (2) groups of offsetting exposures (e.g., exposures resulting from forecast sale and purchase transactions).
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).
Groups of items
24. Currently, IFRS and USGAAP allow

Derivatives as hedged items
23. Currently, derivatives are not

permitted to be designated as hedged items under both IFRS and USGAAP. The FASBs 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
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.
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
39
25. The IASBs 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)
change may not provide as much flexibility as many companies expected.
sales, the impact of the hedge would be shown as a separate line after the sales and cost of sales lines.
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
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 Existing accounting (Reflect the hedge impact only on the gross identified position) 79 64 15
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:
Hedged item
Proposed IFRS accounting (Reflect hedge impact as a separate line) 80 64 (1) 15
Sales Expenses Hedge result Operating profit
The presentation under current and proposed USGAAP 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. 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 USGAAP 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.
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 USGAAP related to the designation of hedged items that have not been addressed by the recent proposals. Some of the key differences are discussed on the next page:
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
40
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 Not permitted, except for basis swaps 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 Permitted Permitted only if the royalty payments are linked to an external transaction 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.
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) USGAAP 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 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 USGAAP.
(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:
33. A significant number of respondents

to the FASBs 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.
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 USGAAP, 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
Partial term hedging
34. IFRS is more permissive than

USGAAP with respect to a partialterm 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.
32. The calculation of ineffectiveness

also differs in this area between IFRS and USGAAP. For example, when hedging a fixed-rate debt for changes in benchmark interest rate, USGAAP
Example
Entity A acquires a 10%, fixed-rate government bond with a remaining
41
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/receivefloating 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
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. USGAAP, 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 USGAAP.
Hedged items: (1) 10-year, 5%, fixed-rate USD borrowing and (2) 10-year, six-month 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).
In other words, IFRS allows imputing a five-year bond from the actual 10-year bond. USGAAP does not permit defining the hedged risk in a similar way.
Hedging multiple risks with a single hedging instrument
Example
Entity As functional currency is EUR, and it wishes to hedge the following two items with one swap as the hedging instrument:
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:
35. IFRS allows a single hedging instrument to be designated as a hedge for more than one type of risk,
Hedging instrument
Hedged item
Hedge type
ALTERNATIVE A: INSERT EUR FLOATING LEGS TO THE SWAP
Receive fixed USD/pay floating EUR
Currency and interest rate risk on USD debt
Fair value hedge of interest rate and currency risk Cash flow hedge of currency risk
Receive floating EUR/pay floating CHF Currency risk of CHF loan receivable
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
42
Hedging intragroup royalty
36. Under current USGAAP, 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.
Hedging instruments
38. The IASBs 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 IASBs 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:
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.
Instrument Cash instruments
Current and proposed US GAAP Permitted only for hedging foreign exchange risk in limited circumstances
Current IFRS Permitted for hedging foreign exchange risk
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
43
Instrument Embedded derivatives
Current and proposed US GAAP
Current IFRS
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 nonfinancial hosts would also remain eligible as hedging instruments.
Permitted under current Similar to current US GAAP if embedded US GAAP derivative is bifurcated
Not permitted for hybrid financial instruments under proposed US GAAP (since embedded derivatives are no longer bifurcated from financial hosts)
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. Accounting for the premium depends on whether the hedged item is transaction or time related. Subsequent changes in time value are deferred in OCI.
Proposed IFRS may yield a comparable result to the current US GAAP treatment for several transactions. However, the proposed IFRS model would apply to fair value and cash flow hedge relationships (proposed and current US GAAP models are limited to certain cash flow hedge relationships only).
Internal derivatives
Permitted for foreign exchange risk only in limited circumstances
Not permitted
Not permitted
Current US GAAP is more flexible in this area. The IASBs proposal does not include any changes in this area.
44
Accounting for the time value of options
39. Under USGAAP 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.
into multiple external derivative contracts. The IASB is not proposing any changes in this area.
42. Similar to IFRS, USGAAP generally

permits only those instruments that involve an unrelated external party to be eligible as hedging instruments. However, USGAAP 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 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.
45
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
Presentation
Fair value hedges
The following presentation would be required under the IASB proposal:
43. Currently, both IFRS and USGAAP

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.
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 (10) Debit (60) 50 10 Debit Credit Credit 60 Credit 50 Debit
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 USGAAP, 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.
46
Mandatory basis adjustment Cash flow hedges
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 USGAAP, 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.

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.
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 USGAAP prohibits adjusting the basis of the hedged item and requires the fair value changes deferred in OCI to be released out of OCI.
47
US GAAP Convergence & IFRS Financial instruments: Updated July 31, 2011
July 2011
Table of contents
An update on the FASBs financial instruments project redeliberations as of June 30, 2011 Impairment model for financial assets takes a new course
14
An update on the FASBs financial instruments project redeliberations as of June 30, 2011
Whats inside: Overview Scope Update on redeliberations
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 entitys 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 IASBs 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.
Reprinted from: Dataline 201126 July 7, 2011
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 instrumentsguidance.
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 InstrumentsAccounting.
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.
Update on redeliberations
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 FASBs tentative approach diverges from the IASBs finalized classification and measurement approach, the IASB has indicated that it will give its constituents the opportunity to comment on the FASBs approach once it is closer to beingfinalized. PwC observation: Even though the IASBs 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 IFRSreporting 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.
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 wereprovided. 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 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.
Financial instruments: Updated July 31, 2011
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 FASBs approach and will again have the opportunity to formally express their views when the IASB requests comments on the FASBs 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.
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.
9. Under both the FASBs 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 FASBs 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.
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 FASBs 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 instruments 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 entitys 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 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 instruments 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 FASBs tentative approach in that it requires
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 entitys own credit, presentation, and disclosures.
Debt instrument assets
11. Debt instrument assets would be

classified and measured into the three categories based on two criteria: (1) the individual instruments characteristics, and (2) the entitys businessactivities. Comparison to IFRS 9: IFRS 9 also requires classification and
Subcategories for classification andmeasurement
8. The FASB decided that debt instrument assets are classified and measured in one of three categories: (1) amortized cost, (2) fair value with
4
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-US constituents may find the FASBs 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.
all of its initial investment other than due to its ownchoice. 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).
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).
Criterion 1the instruments characteristics
Criterion 2the entitys business activities
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 instruments characteristics. An entity can manage the same or similar instruments through different business activities thereby resulting in the same instrument type being classifieddifferently.
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: 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 orsettlement. 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. It cannot be contractually settled or prepaid such that the investor would not recover substantially
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-for-sale) 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
16. In contrast with current guidance

for the amortized cost (held-tomaturity) 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
5
c.
from a credit impairment approach to recognizing in net income the entire difference between the amortized cost basis and the fair value of thoseinstruments.
classification in subsequent periods under the FASBs tentative approach (for further information see paragraph 38).
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
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 publiclyissued 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 entitys participation should be eligible for amortized cost if an agent is managing the credit risk exposure of that instrument on behalf of the entity. 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 entitys 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 FASBs 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 FASBs 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 IFRS9, 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 losscategories. PwC observation: While not the FASBs 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 Boards 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.
with changes in fair value recognized in earnings than under the FASBs 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 instruments 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.
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 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
23. Consistent with its decision for hybrid

financial assets, the FASB decided to
7
retain the current guidance for hybrid financial liabilities to identify any embedded derivative and determine whether it should 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 andmeasurement. Comparison to IFRS 9: The IASB also retained a bifurcation approach for financial liabilities.
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.
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 ofcredit
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.
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 470-20-25-12) 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 amortizedcost. 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
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
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 is 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 commitment is not drawn upon then the deferred fees would be recognized in net income on expiration of thecommitment. 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.
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.
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 US GAAP).
The fair value option
31. The FASB decided to eliminate the

unrestricted fair value option that exists in US 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.
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 funds statement of operations as a component of unrealized/realized gains or losses oninvestments. Comparison to IFRS 9: Under IFRS, all financial assets and liabilities have to be initially measured at fair value. The initial fair value
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
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.
Practicability exception for nonmarketable equity investments
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.
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 FASBs 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.
PwC observation: Based on the feedback received on the FASBs 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 ofaccounting. 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.
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 companys investment in an entity that is accounted for under the equity method.
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
10
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, IAS28 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 otherthan-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 initialrecognition. 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 impairment model is intended to ensure that losses are not deferred when an entitys strategy changes from one focused on cash flow collection to one focused on returns through sale.
on debt instruments classified and measured at amortized cost because only the FASBs 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 FASBs 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, andindividualassets.
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 Activities Impairment (the Supplementary Document) to gather input on new impairment approaches. The Supplementary Document contained three credit impairment approachesa 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
11
Impairment of financialassets
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 a converged impairment model for financial assets. Respondents were generally not supportive of the Boards commonproposal. 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 US 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. 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.
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 defaultedThis 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
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
12
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 IASBs 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.
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 activitiesA 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 IASBs 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 entitys 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.
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 IASBs approach but has deferred redeliberating hedge
13
Impairment model for financial assets takes a new course

Whats inside: Whats new? What are the key provisions? Is convergence achieved? Whos affected? Whats the effective date? Whats next?
Whats new?
In a joint meeting this week, the FASB and IASB (the boards) decided to change course on their proposed model for impairment of financial assets. The new approach attempts to address constituents feedback on previous proposals. Instead of splitting the debt investment portfolio into two categories (the good book and the bad book) as proposed earlier this year, the new approach would divide a portfolio into three categories, which will ultimately determine the timing and amount of the credit losses to be recognized. The assets allocated to each category will be based on their credit risk and any credit deterioration since theirorigination. 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 financial instruments project is available on the FASBs website at www.fasb.org or the IASBs website at www.ifrs.org.
Reprinted from: In brief 201125 June 16, 2011

The intent of the new model is to reflect the general pattern of credit quality deterioration of debt investments. As the credit quality of the debt investment deteriorates over its life cycle, the proposed accounting model is intended to capture this change. The new approach would segregate the portfolio into three categories (referred to as buckets by the Boards). Bucket #1: Assets not affected by observable eventsThis category would consist of debt investments that have been unaffected by observable events that provide direct evidence of a possible future default. It is possible that credit loss expectations of instruments in this bucket may have changed due to macroeconomic events that are not specific to an individual or group of assets. The allowance at each period for this category will be equal to 12 months worth of expected losses.
Bucket #2: Assets affected by observable events (but credit issues are not evident on specific assets)This category would consist of portfolios of debt investments that have been affected by observable events that provide direct evidence of a possible future default, however, there is no evidence that is attributable directly to individual assets in the portfolio. An allowance for credit impairment would be recognized immediately in current earnings 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 defaultedThis category would consist of debt investments where 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
14
in this category. An allowance for credit impairment would be recognized based on the full lifetime expected losses for the individual assets. While the Boards conceptually agreed on the proposed approach described above, they will continue to address and deliberate key points regarding factors and events that may trigger reclassifications between buckets as well as whether the proposed model is operational.
Whats the effectivedate?

The boards have yet to decide on an effective date, but it likely will not be before2014.
Whats next?
The boards will continue to develop the revised impairment model over the next few months. An exposure draft with a new proposed model is targeted to be issued in September of 2011. We will continue to keep you informed of the significant redeliberation decisions.
Both boards continue to strive to achieve convergence in this area as constituents believe that achieving convergence on the impairment model is critical.
Whos affected?
All companies that have debt investments that are not classified and measured at fair value with fair value changes recognized in net income could be impacted.
15
US GAAP Convergence & IFRS Revenue recognition

March 2011
Table of contents
Revenue from contracts with customers

The constituents have been heard . . .
2 9 18

The responses are in . . .
Revenue recognition . . . full speed ahead

Latest installment: A joint FASB/IASB exposure draft
Revenue from contracts with customers The constituents have been heard . . .
Whats inside: Overview Key provisions Current developments Next steps Reprinted from: Dataline 201116 March 1, 2011 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
The FASB and IASB (the boards) received over 960 comment letters in response to their June 24, 2010 exposure draft, Revenue from Contracts with Customers. The comment period closed on October 22, 2010. A number of recurring themes were noted in the comment letters, even across industries. Areas of focus included transfer of control, identification of performance obligations, determining the transaction price, transition, segmentation, accounting for warranties, licenses of intellectual property, and disclosures. At the January and February 2011 meetings, the boards began redeliberating their proposals, focusing on the common themes in the comment letters, and reached a number of tentative decisions. The boards expect to issue the final standard in 2011, with a likely effective date no earlier than 2014. Full retrospective application will be required unless the boards change their current position.
Background
1. The exposure draft proposes a new
revenue recognition standard that could significantly change the way entities recognize revenue.
2. 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 an entity earns revenue. 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. It moves away from specific measurement and recognition thresholds and removes industry-specific guidance. 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 may also have broad implications for an entitys processes and controls. Management may 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.
be required to apply the principles. Determining whether a good or service is distinct, and should be accounted for separately, will require judgment. Management will need to consider a number of variables to estimate the transaction price, including the effects of variable consideration, collectability, and time value of money. Revenue is recognized when control of the good or service is obtained by the customer. Management will need to assess whether the customer has the ability to direct the use of and receive the benefit from the good or service to determine when revenue should be recognized. This might be difficult in some circumstances, such as service arrangements.
Segmentation Contract combination Warranties Onerous performance obligations Contract costs Breakage
3. The proposed standard takes a

contract-based asset and liability approach, applicable to almost all industries. Revenue is recognized when an entity satisfies its obligations to its customers, which occurs when control of an asset (a good or service) transfers to the customer.
Transfer of control
8. The exposure draft stated that
revenue should be 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 when it has the ability to direct the use of and receive the benefit from the good or service.
4. This Dataline summarizes key aspects

of the proposed standard, certain themes identified in the comment letters, and decisions made during recent board meetings. The boards conclusions are tentative and subject to change until a final standard is issued.
9. Respondents generally agreed with

recognizing revenue when control transfers. However, many requested clarification to help assess when control transfers continuously, especially in service contracts.
6. Refer to Dataline 201028 and the

related industry supplements for a detailed discussion of the key aspects of the proposed model, as well as PwCs response letter submitted to the boards on October 20, 2010.
Key provisions
5. Entities will perform the following
five steps in recognizing revenue: Identify the contract with the customer Identify the separate performance obligations in the contract Determine the transaction price Allocate the transaction price to distinct performance obligations Recognize revenue when each performance obligation is satisfied PwC observation: The steps in the proposed standard may appear simple, but significant judgment will
Tentative decisions
10. The boards reaffirmed the core prin-
Current developments
7. The boards have considered many of
the concerns raised by constituents as part of the comment letter process in their redeliberations. The boards recently reached a number of key decisions regarding the proposed revenue recognition model. Areas of focus so far include the following: Transfer of control Performance obligations
ciple that an entity should recognize revenue to depict the transfer of goods and services to a customer, but modified the guidance as follows: Added risks and rewards of ownership as an indicator of control Eliminated the design or function of the good or service is customerspecific as an indicator of control
11. The boards reaffirmed that an entity

should recognize revenue for the sale
Revenue recognition
of a good when the customer obtains control of the good.
obligations) if more than one good or service is promised in the contract.
12. The boards decided that an entity

should recognize revenue for the performance of a service if: The entitys performance creates or enhances an asset that the customer controls, or The entitys performance does not create an asset with alternative use to the entity, and at least one of the following: The customer immediately receives a benefit from each task performed, Another entity would not need to reperform the 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 even if the customer could cancel the contract for convenience.
15. Distinct goods and services would

be accounted for as separate performance obligations. The entity would account for the bundle of goods and services as a service if they are not distinct. PwC observation: We agree that an entity should distinguish between situations when an asset is being created and when one is not, to determine how revenue is recognized. This will make the accounting for services easier to apply and potentially more consistent with existing guidance than the model outlined in the exposure draft. It is unclear whether the performance obligation should be viewed from the perspective of the vendor or the customer, which could create diversity in practice. This could be clarified by adding that a performance obligation represents the good or service that the customer reasonably expects to receive when entering into the contract based on the contract terms and the vendors customary business practices. There may still be arrangements that are not clearly the sale of a good or a service that will require judgment to determine the appropriate recognition model.
transfer a good or service to the customer. Performance obligations may be explicit in contracts, but they may also arise in other ways. Legal or statutory requirements may create performance obligations even though such obligations are not explicit in the contract. Customary business practices, such as a practice of providing customer support, might also create a performance obligation.
17. Many respondents objected to the

subjectivity in identifying performance obligations and the potential for similar transactions to be accounted for differently. Most agreed with the principle, but wanted further clarification on how to identify a performance obligation. There were mixed responses regarding the concept of distinct performance obligations and many respondents disagreed that profit margin is relevant in assessing separation of performance obligations.
13. The boards concluded that an entity

should recognize revenue for a service only if the entity can reasonably measure its progress toward completion of the service. Further discussions are expected regarding which method an entity should use to measure its progress (e.g., an output method, an input method, or a method based on the passage of time), but the boards continue to indicate that output measures might be the most representative of transfer of control in many situations.
Tentative decisions
18. The boards did not fundamentally

change the definition of a performance obligation, but they did delete enforceable from the definition. They also clarified that promises implied by an entitys business practices are performance obligations if they create expectations of performance.
19. The boards concluded that the objec-
Performance obligations
16. The exposure draft defined a performance obligation as an enforceable promise (whether explicit or implicit) in a contract with a customer to
14. An entity first determines whether

the goods and services are distinct (in accordance with the guidance on identifying separate performance
tive of separating distinct performance obligations is to depict the transfer of goods or services and the profit margin attributable to them. The boards retained the principle of distinct goods or services as the
basis for identifying separate performance obligations, but revised the criteria for determining if a good or service is distinct.
20. A performance obligation is distinct if

the entity regularly sells the good or service separately. A good or service might be distinct if not sold separately if the customer can use the good or service on its own or together with resources readily available to the customer.
in the contract. Bundling distinct goods and services together when the integration service is not significant might result in the accounting not reflecting the underlying economics.
services in the contract is independent of the price of other goods or services in the contract. The boards will discuss further the implications of this decision on allocating the transaction price. PwC observation: Eliminating the contract segmentation guidance from the final standard will simplify the model. We believe it is not necessary to segment a single contract into two or more contracts, and note that the proposed accounting for segmentation was difficult to understand and apply. Clear and well understood guidance for the separation of distinct performance obligations, treatment of contract modifications and adjustments to variable consideration should be sufficient.
Segmentation
23. The exposure draft required a single
contract 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. Goods or services are priced independently if: The entity, or another entity, regularly sells the goods or services on a standalone basis, and The price for all goods or services in the contract approximate the sum of the standalone selling price for each good or service (i.e., there is not an inherent discount for the purchase of bundled goods and services).

should account for a bundle of goods or services as one performance obligation if the entity provides a significant integration service. The entity should consider whether the goods or services are sold separately if an integration service is not included. Otherwise, an entity should assess whether the good or services have a distinct function.
22. The boards also decided that it is

not necessary to include additional requirements on accounting for perfunctory, incidental, or other similar obligations. PwC observation: We agree that distinct performance obligations should be identified and accounted for separately and support the boards decision to eliminate the requirement that a performance obligation have a distinct profit margin in order to be considered distinct when not sold on a standalone basis. We are concerned, however, that contracts that include bundled goods or services may be inappropriately accounted for as a single performance obligation when an integration service is included
Contract combination
26. The exposure draft proposed that
two or more contracts would be combined into one if the prices of those contracts are interdependent. The following characteristics were identified to support interdependent pricing: Entered into at or near the same time Negotiated as a package with a single commercial objective Performed concurrently or consecutively
24. Some constituents recommended that

current segmentation guidance be retained for long-term contracts, but many respondents noted that segmentation guidance is not needed if the principle for identifying performance obligations is clear.
Tentative decisions

separates a contract only if separate performance obligations are identified in the contract. The boards eliminated the proposed requirement to account for one contract as two or more contracts if the price of some goods or
27. The price of a contract would not

be interdependent with the price of another contract solely because the customer receives a discount on goods or services in the contract as a result
Revenue recognition
of an existing customer relationship arising from previous contracts.
Tentative decisions
28. The boards decided that interrelated

contracts should be combined. To be interrelated, the contracts should be entered into at or near the same time with the same counterparty. The boards also decided that the following indicators should be considered to determine if contracts are interrelated: Whether the contracts are negotiated as a package with a single commercial objective Whether the amount of consideration received in one contract depends on the performance of the other contract Whether the goods and services in the contracts are closely interrelated or interdependent in terms of design, technology, or function PwC observation: Combining two or more contracts as a single contract if they are interrelated should promote accounting that reflects the economics of the entire arrangement. The criteria identified by the boards for combining contracts is consistent with todays guidance and should be well understood in practice.
customer with coverage for defects that exist when the asset is transferred to the customer, but that are not yet apparent. This warranty would not give rise to a separate performance obligation but recognizes the possibility that the entity did not satisfy its performance obligation. In other words, the entity did not provide an asset that operated as intended at the time of delivery. An entity would not recognize revenue at the time of sale for a defective product that it would subsequently replace in its entirety. Revenue would be 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.
Tentative decisions

should account for some warranties as a warranty obligation (that is, a cost accrual) in accordance with the guidance on provisions and contingencies (IAS 37 and ASC 450). The following criteria should be considered to determine whether a warranty should be accounted for as a cost accrual: If a customer has the option to purchase a warranty separately from the entity, the entity should account for the warranty as a separate performance obligation. The entity would allocate revenue to the warranty service. If a customer does not have the option to purchase a warranty separately from the entity, the entity should account for the warranty as a cost accrual unless the warranty provides a service to the customer in addition to assurance that the entitys past performance was as specified in the contract (in which case the entity would account for the warranty service as a separate performance obligation).
30. The proposals also required that a

warranty that provides the customer with coverage for faults that arise after the entity transfers control to the customer (e.g., normal wear and tear) gives rise to a separate performance obligation. The entity would allocate a portion of the transaction price to the warranty obligation at contract inception.
31. Many respondents disagreed with

the distinction between a warranty for latent defects and a warranty that provides coverage for faults that arise after transfer of control, noting the operational difficulties in distinguishing between the different types of warranties. Some also suggested that the current warranty models should be retained (both for standard and extended warranties) as they are understood in practice and reflect the substance of the warranty obligations.
33. The boards will develop implementation guidance to help an entity determine when a warranty provides a service to the customer in addition to assurance that the entitys past performance was as specified in the contract. PwC observation: The revised proposal provides a practical expedient to accounting for warranties which is consistent with current guidance. However, operational
Warranties
29. The proposals distinguished between
a warranty for latent defects and a warranty for post-transfer defects. A latent defect warranty provides a
difficulties may be encountered in separating warranties that cover latent defects from those that cover both latent defects and future defects. Determining the estimated stand-alone selling price for the latter category when such warranty service is not sold separately could also be challenging.
Tentative decisions
36. The boards proposed to change the

unit of account to the contract level for onerous contract provisions.
(e.g., costs of selling, marketing, or advertising) as incurred.

the proposed accounting for contract costs, but were concerned about expensing all contract acquisition costs.
37. The boards also determined that

direct costs should be used to perform the onerous test. If a contract is subsequently cancelled, the entity would account for the cancellation based on the terms of the contract or in accordance with IAS 37 or ASC 450. PwC observation: We continue to believe that provisions for onerous contracts are cost accruals, not an issue in the recognition or measurement of revenue, and should be addressed in the relevant liability or contingency standards. Measuring provisions for onerous contracts using all of the direct costs that relate to satisfying that contract will result in more onerous loss provisions being recorded than using only the direct incremental costs of fulfilling the obligation. There are a number of operational challenges beyond determining the appropriate costs to consider in the assessment, such as the effect of accelerating losses for lossleader contracts.
Tentative decisions
40. The boards tentatively decided that

an entity should recognize an asset for the incremental costs of obtaining a contract that the entity expects to recover. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained.
Onerous performance obligations

34. The exposure draft required assessment of performance obligations at contract inception and at each reporting date to determine whether the obligation was onerous. A performance obligation was onerous if the present value of the probabilityweighted direct costs to satisfy the obligation exceeded the transaction price allocated to it. The assessment would be updated each reporting period using current estimates. Any changes in the measurement of the liability would be recorded as an expense or a reduction of an expense.
41. An asset recognized for the costs

of obtaining a contract should be presented separately on the statement of financial position and subsequently amortized on a systematic basis consistent with the pattern of transfer of the goods or services to which the asset relates.
42. The boards will discuss the accounting

for the costs of fulfilling a contract at a future meeting. PwC observation: We agree with the tentative decisions made by the board regarding contract acquisition costs. We believe certain costs of obtaining a contract, whether paid to a third party or directly to the customer, should be capitalized if such costs are incremental and will be recovered under the contract. The boards have not determined which contract
35. Respondents generally disagreed

with the proposed accounting for onerous performance obligations, and commented specifically that the proposed guidance may not reflect the underlying economics of the transaction. Respondents also suggested that if an onerous provision is included in the final standard, such assessment should be performed at the contract level as opposed to the performance obligation level.
Contract costs
38. The exposure draft included specific
guidance for accounting for costs associated with fulfilling contracts with customers. An entity would recognize costs to obtain a contract
Revenue recognition
acquisition costs may be considered for capitalization or whether there should be a probability threshold for determining whether costs are recoverable. We expect further discussion on these topics at future meetings. While not specifically addressed in the boards redeliberations, we believe this guidance would also apply to payments made to a customer in order to enter into a customer-vendor relationship.
proportional model, an entity recognizes expected breakage as revenue in proportion to the pattern of transfer of the goods or services to the customer.
46. An entity should apply the remote

model when it is unable to reasonably estimate breakage. This model precludes an entity from recognizing the breakage as revenue until the likelihood of the customer exercising their right under the contract becomes remote. PwC observation: We agree with the boards proposed accounting for breakage, and expect practice to generally remain consistent with todays application.
Breakage
43. The accounting for breakage (forfeitures) under the proposed standard may impact the timing of revenue recognition. Entities would consider the impact of breakage in determining the transaction price allocated to the performance obligations in the contract.
Next steps
47. The boards timeline indicates a final
standard in June 2011. The boards will continue to redeliberate over the next few months and perform targeted consultation with key industries and other interested parties for some of the more significant changes.
Tentative decisions
44. The boards agreed that two models

may be applied when considering breakage in a contracta proportional model and a remote model.
48. Several issues remain to be redeliberated, including allocation of transaction price, measurement of consideration, accounting for licenses, disclosure and transition.
45. The proportional model should be

applied when an entity can reasonably estimate breakage. Under the
Theresponses are in . . .
Whats inside: Overview Key provisions Comment letters Industry themes
The FASB and IASB (the boards) received over 960 comment letters in response to their June 24, 2010 exposure draft, Revenue from Contracts with Customers. The comment period closed on October 22, 2010. A number of recurring themes were noted in the comment letters, even across industries. Areas of focus included transfer of control, identification of performance obligations, determining the transaction price, transition, segmentation, accounting for warranties, licenses of intellectual property, and disclosure requirements. The boards expect to issue the final standard in 2011, with a likely effective date no earlier than 2014. Full retrospective application will be required. 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 an entity earns revenue. The boards believe a single, contract-based model reflecting changes in contract assets and liabilities will lead to greater consistency in the recognition and presentation ofrevenue. PwC observation: In many circumstances, the proposed standard will be a significant shift in how revenue is recognized. It moves away from specific measurement and recognition thresholds and removes industry specific guidance. The effect could be considerable, requiring management to perform a comprehensive review of their existing contracts, business models, company practices and accounting policies. The proposed standard may also have broad implications for an entitys processes and controls.
9
Reprinted from: Dataline 201045 December 20, 2010 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
Background
2. The proposed standard takes a

contract-based asset and liability approach, applicable to almost all industries, in which revenue is recognized when an entity satisfies its obligations to its customers, which occurs when control of an asset (a good or service) transfers to the customer.

of the proposed standard as well as the themes in comment letters received by the boards.
4. The boards conclusions are tentative

and subject to change until a final standard is issued.
Key provisions
Asset and liability model
5. The proposed standard employs
an asset and liability approach, the
Revenue recognition
Management may need to change existing IT systems and internal controls in order to capture information to comply with the proposed guidance. The effect may also extend to other functions such as treasury, income 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. The proposed standard may also affect mergers and acquisitions in a number of ways, including deal models (e.g., amount and timing of revenue recognition may be different) and how earn-out payments are triggered if determined based on revenue.
distinct, and should be accounted for separately, will require management judgment and an understanding of how other goods or services sold in the market interact with the entitys products. Management will need to consider a number of variables to determine whether the transaction price can be reasonably estimated, specifically when considering the effect of variable consideration, collectability, and time value of money. Revenue is recognized when control of the good or service is obtained by the customer. Although the boards have identified indicators to consider, management will need to assess whether the customer has the ability to direct the use of and receive the benefit from the good or service in determining when revenue should be recognized. This might be difficult in some circumstances, such as service arrangements.
a number of concerns over some of the key provisions, including: Transfer of control Performance obligations Transaction price variable consideration time value of money
Transition Segmentation Warranties Licenses Onerous performance obligations Credit risk Contract costs Disclosure
Transfer of control
10. Revenue should be 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 when it has the ability to direct the use and receive the benefit from the good or service.
Applying the model

five steps in applying the proposed standard: Identify the contract with thecustomer Identify the separate performance obligations in the contract Determine the transaction price Allocate the transaction price to distinct performance obligations Recognize revenue when each performance obligation issatisfied PwC observation: Although the steps included in the proposed standard may appear to be simple, significant judgment will be required to appropriately apply the principles. The determination of whether a good or service is
10
7. Refer to Dataline 201028 for a

detailed discussion of the key aspects of the proposed model as well as PwCs response letter submitted to the boards on October 20, 2010.

recognizing revenue when control transfers. However, many requested additional clarification in assessing whether control transfers continuously, especially in service contracts. PwC observation: We agree that revenue from goods and services should be recognized when control transfers. However, further clarification is needed to determine when control transfers in service
Comment letters
8. The boards received over 960
comment letters (mainly from corporations but covering a wide range of constituents) from respondents in 35 differentcountries.
9. The majority of respondents supported

the projects overall objectives, but had
arrangements. We recommend that the proposed standard include indicators that clarify when control transfers for services such as: (1) when the customer obtains the benefit, (2) whether tasks performed represent progress towards completion and do not need to be repeated, and (3) whether the customers obligation to pay is unconditional once services are performed.
of a performance obligation, but, it is unclear whether the existence of a performance obligation should be determined based on the perspective of the vendor or the customer or both. We believe the definition of a performance obligation could be clarified by adding that: A performance obligation represents the good or service that the customer reasonably expects to receive when entering into a contract based on the contract terms and customary business practices. We recommend that separate performance obligations be identified by disaggregating the contract into distinct performance obligations rather than aggregating all individual performance obligations into distinct performance obligations. We also recommend that distinct profit margin be omitted from the list of indicators for both practical and conceptual reasons.
of variable consideration receivable. This estimate requires management to assess the probability of each possible outcome.
16. There was some concern about recognizing revenue prior to a contingency being resolved, but many respondents agreed that variable consideration should be included in the transaction price. However, a significant number of respondents noted that a probability-weighted approach is not practical and may not be appropriate in certain circumstances (e.g., binary outcomes). They suggested that a best estimate approach be permitted in addition to the probability-weighted approach. PwC observation: We agree that revenue should be recognized using an estimated transaction price. Although it may be difficult to estimate variable consideration in some circumstances, we expect vendors may often have a reasonable estimate of the amount of consideration expected to be received. We suggest emphasizing that variable consideration can be reasonably estimated unless insufficient history exists to make a reasonable estimate. We understand the theoretical merits of the probability-weighted approach, but recommend that a best estimate approach be permitted in addition to a probability-weighted approach.
12. A performance obligation is an
enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. Performance obligations may be explicit in contracts, but they may also arise in other ways. Legal or statutory requirements may create performance obligations even though such obligations are not explicit in the contract. Customary business practices, such as an entitys practice of providing customer support, might also create a performance obligation.
Transaction price
14. The transaction price in a contract
reflects the consideration the customer promises to pay in exchange for goods or services.

subjectivity in the proposed guidance and the potential for similar transactions to be accounted for differently. Most agreed with the principle, but requested further clarification in identifying the performance obligations. There were mixed responses regarding the concept of distinct performance obligations and many respondents disagreed with the distinct profit margin concept. PwC observation: We generally agree with the proposed definition
15. 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, credits, incentives, and performance bonuses. When a contract includes variable consideration, the transaction price includes the probability-weighted estimate
17. The transaction price should reflect

the time value of money whenever the effect is material. Management should use a discount rate that reflects a financing transaction between the entity and its customer that does not
Revenue recognition
11
involve the provision of other goods or services.
18. Many respondents agree with the

principle but noted that the operational difficulties of applying it in practice will outweigh the benefits. Many also struggled with applying the principle to prepayments when a material financing component exists for a number of reasons, including the inconsistency it creates between the consideration received and the revenue recognized (i.e., revenue recognized will exceed consideration received). Constituents overwhelmingly suggested that time value of money should only be considered in contracts that clearly include a financing component. Those that agree with the concept asked for further clarification of key inputs into the calculation, including the discount rate. PwC observation: We understand the conceptual merits of adjusting the transaction price to reflect the time value of money if the contract includes a material financing component, but the practical challenges will likely outweigh the benefit to users. The transaction price should not be adjusted for the time value of money in most circumstances. The transaction price should only reflect the time value of money when payment of cash is significantly delayed after control of the good or service transfers.
do not affect current or future periods, but affected previously reportedperiods.
20. In October 2010, the boards issued

Discussion Papers seeking feedback from stakeholders about the time and effort involved in adopting a number of proposed accounting standards, including revenue recognition. As part of this outreach effort, the boards are particularly interested in obtaining views on effective dates and transition methods. The boards intend to use the feedback received to develop implementation plans to help entities manage the pace and cost of change. Although the boards have not yet decided on the effective date for the proposed standard, they have discussed possible effective dates no earlier than 2014.
application may be difficult to apply. Furthermore, it may not be cost beneficial. Companies will need to closely monitor this requirement as it could result in significant incremental efforts in restating historic information.
Segmentation
23. 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. Goods or services are priced independently if: The entity, or another entity, regularly sells the goods or services on a standalone basis,and The price for all goods or services in the contract approximate the sum of the standalone selling price for each good or service (i.e., there is not an inherent discount for the purchase of bundled goods/ services).
21. Most respondents expressed concerns

with full retrospective application, suggesting prospective application might be a better alternative in cases where full retrospective application is impractical.
22. Those respondents that agreed with

full retrospective application noted that implementing the standard would require significant management resources. They requested an extended lead time between the issue of the final standard and the effective date to allow adequate time to implement the standard. PwC observation: We understand the theoretical merit of applying the proposed requirements retrospectively to achieve consistency and comparability across periods presented, but there are a number of situations where retrospective
24. Some constituents recommended

that current segmentation guidance should be retained for long-term contracts. However, respondents consistently noted that segmentation guidance is not needed, so long as the principle for identifying performance obligations is clarified. Most comment letters also noted that the segmentation guidance is too prescriptive and not principles based. PwC observation: We believe it is not necessary to segment a single contract into two or more contracts, and find the proposed accounting for segmentation
Transition
19. The proposed standard requires full
retrospective application, including application to those contracts that
12
difficult to understand and apply. The proposed standard is based on recognizing revenue when separate performance obligations are satisfied. There would be no need to segment contracts if distinct performance obligations are accounted for separately and there is clear and well understood guidance for the treatment of contract modifications and adjustments to variable consideration.
performance obligation. The entity allocates a portion of the transaction price to the warranty obligation at contractinception.

the distinction between a warranty for latent defects and a warranty that provides coverage for faults that arise after transfer of control noting the operational difficulties in distinguishing between the different type of warranties. Some also suggested that the current warranty models should be retained (both for standard warranties and extended warranties) as they are understood in practice and reflect the substance of the warranty obligations. PwC observation: We agree with the concept that a warranty for latent defects is, in substance, a failed sale while a warranty for post transfer defects is a separate performance obligation, but we believe it may be impractical to determine whether defects are latent or the result of wear and tear. The proposed accounting would be more operational if all warranties are accounted for as a distinct performance obligation, with revenue recognized as the warranty obligation is satisfied. As a practical alternative, current guidance could be retained (i.e., account for standard warranties as a cost accrual and extended warranties as a separate performance obligation).
control of the asset. The contract is a sale (rather than a license or a lease) of intellectual property if the customer obtains control of the entire licensed intellectual property (e.g., the exclusive right to use the intellectual property for its economic life). The entity recognizes revenue when control of the intellectual property transfers if the transaction isa sale.
29. 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. The entity generally recognizes revenue over the term of the license in this situation.
Warranties
25. The proposed standard distinguishes
between a warranty for latent defects and a warranty for post transfer defects. A latent defect warranty provides a customer with coverage for defects that exist when the asset is transferred to the customer but that are not yet apparent. This warranty does not give rise to a separate performance obligation but recognizes the possibility that the entity has not satisfied its performance obligation. In other words, the entity has not provided an asset that operates as intended at the time of delivery. An entity does not recognize revenue at the time of sale for a defective product that it will subsequently replace in its entirety. Revenue will be 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.
30. A contract that provides a non-exclusive license for intellectual property (e.g., 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 (i.e., when control transfers but no earlier than the beginning of the license period).
31. Respondents generally disagree with

the proposed guidance, specifically the fact that exclusivity determines the timing of revenue recognition. Comment letters also focused on the need for further clarification around the identification of the performance obligation in a license of intellectual property. Many respondents noted that revenue should be recognized once the performance obligation has been satisfied, regardless of whether the license is exclusive or non-exclusive. PwC observation: The accounting for licenses of intangible assets
26. A warranty that provides the customer

with coverage for faults that arise after the entity transfers control to the customer (e.g., normal wear and tear) give rise to a separate
Licenses
28. The recognition of revenue for the
license of intellectual property depends on whether the customer obtains
Revenue recognition
13
and leases of tangible assets should be consistent, as these arrangements are economically similar. The proposed standard is inconsistent with the proposals for lease accounting and also appears inconsistent with the performance obligation concept underpinning the revenue exposure draft. We recommend the boards describe the performance obligation that exists when an exclusive license has been transferred. There is currently diversity in practice in accounting for licenses, and we accept the proposal as a pragmatic interim solution that should achieve greater consistency. However, a more comprehensive solution that can be applied to both tangible and intangible assets should be developed.
33. Respondents noted general disagreement with the proposed accounting for onerous performance obligations, specifically, that the proposed guidance may not reflect the underlying economics of the transaction. It was also noted that if an onerous provision is included in the final standard, such assessment should be performed at the contract level as opposed to the performance obligation level. PwC observation: We do not agree with the inclusion of onerous performance obligation guidance in the revenue standard. Provisions for onerous performance obligations are cost accruals, not an issue in the recognition of revenue or measurement of revenue, and thus should be addressed in the relevant liability or contingency standards. We strongly disagree with the boards statement that the proposed standard will not result in significant change to existing practice for most entities. The proposals will have a significant effect on current practice and will likely be impractical to apply in many circumstances. We are concerned that the proposed guidance might not reflect the underlying economics of transactions in a number of situations, particularly when an individual performance obligation is not profitable but the overall contract is profitable. If the boards decide to retain this guidance in the final standard, we recommend that the assessment of whether an onerous provision
exists be performed at the contract level or higher. The requirement to consider or remeasure onerous performance obligations each reporting period will likely be impractical for many entities and we believe the benefits of doing so will not outweigh the costs or efforts. The boards should also consider whether measuring provisions for onerous performance obligations using all of the direct costs that relate to satisfying that performance obligation reflects the economics of these arrangements, or whether provisions for onerous performance obligations should be measured using only the directly incremental costs of fulfilling the obligation.

32. Performance obligations are assessed
at contract inception and at each reporting date to determine whether the obligation has become onerous. A performance obligation is onerous when the present value of the probability-weighted direct costs to satisfy the obligation exceed the consideration (i.e., the transaction price) allocated to it. The assessment of onerous performance obligations should be updated each reporting period using current estimates. Any changes in the measurement of the liability would be recorded as an expense or a reduction of an expense. The entity reduces the expense previously recorded on satisfaction of the onerous performance obligation.
Credit risk
34. Credit risk refers to the customers
ability to pay the consideration agreed in the contract. The transaction price is adjusted to reflect the customers credit risk by recognizing the consideration expected to be received on a probability-weighted basis. Changes in assessment of consideration to be received due to changes in credit risk are recognized as income or expense, separately from revenue.
35. Many respondents disagreed that

credit risk should be recorded as a reduction of revenue with subsequent changes in the assessment included in other income or expense. Rather, subsequent changes in the amount of consideration to be received should be recorded in revenue, consistent with other changes in the transaction price.
14
PwC observation: We agree conceptually that a customers credit risk should affect the measurement of revenue rather than the recognition of revenue. We disagree, however, with the proposal to require subsequent changes in the assessment of credit risk in other income or expense. Subsequent adjustments should be recorded in revenue. This will align the revenue recognized with cash ultimately received from the customer, consistent with other areas of the model, such as changes in variable consideration. This information is beneficial for financial statement users who are interested in reconciling revenue with net cash ultimately received from the customer and would be more operational. It might be difficult, however, for some entities to implement the proposed guidance because it will require changes to systems and processes, and the benefit might not outweigh the cost. We suggest the boards consider a simpler solution that allows entities to continue to record bad debt expense separately from revenue. This would avoid the need to make changes to systems and other processes for what will primarily be a change in the geography of where bad debt expense is recorded.
recognizes costs to obtain a contract (e.g., costs of selling, marketing, or advertising) as incurred.
revenue and cash flows arising from contracts with customers. Required disclosures include: Qualitative and quantitative information about performance obligations, rights to consideration, and onerous performance obligations to help users understand the characteristics of the entitys contracts with customers. The significant judgments and changes in judgments that will explain the effect on the timing and amount of revenue recognized in the financial statements. These disclosures should include (a) the effect on the amount of revenue recognized in the current period, and (b) an indication of the expected effect on the timing and amount of revenue that will be recognized in future periods.

the proposed accounting for contract costs. However, concerns were raised regarding the expensing of all contract acquisition costs. PwC observation: We believe cost guidance ideally should not be included in a revenue standard. It should be included in other standards containing asset or cost guidance. We understand, however, the effect the proposed standard will have on existing cost guidance, particularly under US GAAP. We therefore accept the inclusion of cost guidance in the revenue standard as a pragmatic interim measure. The proposed standard requires that costs of obtaining a contract be expensed as incurred. This might contradict existing guidance for intangible assets in some situations. We do not believe costs of obtaining a contract, whether paid to a third party or directly to the customer, should be expensed as incurred in all situations. We recommend that the boards consider all relevant guidance to determine whether consideration paid to acquire a customer creates an intangible asset.
39. There were mixed views from respondents on whether the proposed disclosures achieved the boards stated objectives. A majority of respondents viewed the proposed disclosures as excessive and not decision useful for users of financial statements. Respondents also noted that the time and cost necessary to prepare the proposed disclosures would be a major obstacle. There was also some concern over duplication with segment reporting disclosures. PwC observation: We understand the boards objectives of improving disclosures. However, the proposed disclosure requirements will not meet the boards objectives and will not improve existing disclosures. The volume of detailed disclosures required by the
Contract costs
36. The proposed standard includes
specific guidance for accounting for costs associated with fulfilling contracts with customers. An entity
Disclosure
38. The boards believe that the proposed
disclosures will assist users of financial statements in understanding the amount, timing and uncertainty of
Revenue recognition
15
proposed standard may obscure useful information. We suggest that appropriate disclosures might include: the principle sources of revenue and the accounting policies applied to each; significant estimates, judgments made in the recognition, measurement of revenue, and the extent to which revenue is affected by changes in estimates; and a quantitative analysis of the revenue derived from each principal source.
and segmenting contracts, and contract modifications; (v) variable consideration; and (vi) transitionprovisions.
and time value of money); (iii) distinguishing between a quality assurance and insurance warranty; (iv) presentation and disclosure requirements; and (v) transition provisions.
Engineering and construction

42. There was broad support for the
boards objectives, however, both preparers and users do not believe that the proposed model improves existing accounting under USGAAP or IFRS. Responses centered around (i) retention of percentage-ofcompletion accounting; (ii) the importance of achieving comparability among industries rather than across industries; and (iii) operational difficulties in applying many aspects of the proposed standard including identification of performance obligations, continuous transfer of control, determination of the transaction price, contract costs and onerous performance obligations, disclosure requirements, and transition provisions.
Retail and consumer

44. Most retail and consumer companies
strongly opposed classifying certain payments to customers as an expense, rather than a reduction of revenue, as they do not agree that the payments are for distinct services and would not be made without the related product sale. Franchisors generally did not agree with the proposed accounting for license arrangements and variable consideration. There was specific concern with recognizing royalty revenue prior to the related sale by the franchisee. Further clarification was requested regarding how to apply the proposed license model to franchise rights.
Industry themes
40. In addition to the general themes
noted above, we have summarized the responses by key industries. The summaries below explain industry specific themes in the comment letters submitted to the boards.
Entertainment andmedia
45. Most respondents noted that revenue
for licenses of intellectual property should not be based on exclusivity but on transfer of control of the intellectual property. Many respondents strongly suggested that variable consideration be included in the transaction price only once the related contingencies have been resolved and that a best estimate should be used, not the probability-weighted amount. Comment letters also noted concern with (i) the proposed accounting for collectability; (ii) transition provisions; and (iii) disclosure requirements.
Aerospace and defense

41. Respondents noted the need for
additional guidance, including indicators for when performance obligations are satisfied on a continuous basis. Cost guidance, consistent with todays guidance, was also requested. Key themes in responses from the industry focused on (i) satisfaction of performance obligations for continuous transfer of control; (ii) contract costs and onerous performance obligations; (iii) identification of performance obligations including contract management services; (iv) combining
Technology
43. Technology companies agreed with
the boards efforts to create a consistent standard on a global basis that will enhance comparability in the financial statements, and generally support the proposed standard. However, there were concerns with some of the concepts in the exposure draft including (i) identification of distinct performance obligations; (ii) measurement of transaction price (i.e., probability-weighted amounts, variable consideration, collectability,
16
Pharmaceutical and lifesciences

46. Constituents were primarily
concerned with the recognition of revenue that is contingent upon a future event. This may result in significant income statement volatility, systems costs to calculate probabilityweighted estimates, and may result in less transparent financial statements. Other concerns included (i) consideration of credit risk in determining the amount of revenue to recognize; (ii) presentation and disclosure; (iii) transition provisions; and (iv) the need for additional implementation guidance.
Telecommunications
48. Telecom respondents noted that
existing guidance regarding contingent consideration should be retained (i.e., use of the cash cap). That is, the amount recognized as revenue for the delivered performance obligation should be limited to the amount that is not contingent upon the future satisfaction of additional or undelivered performance obligations. Comment letters also focused on concerns with (i) the identification of performance obligations; (ii) collectability; (iii) contract modifications; (iv) time value of money; (v) transition requirements; (vi) variable consideration; (vii) accounting for licenses; and (viii) accounting forwarranties.
Transportation and logistics

50. Key areas of concern included
(i) more indicators are needed for the satisfaction of performance obligations for service transactions; (ii) onerous performance obligations; (iii) accounting for customer credit risk; (iv) disclosures; and (v) transitionprovisions.
Financial services
51. Respondents noted that loyalty
programs provided by financial institutions (credit card companies) should not be within the scope of the exposure draft.
Industrial products
47. Two areas of focus were noteddetermination of the transaction price and accounting for warranties. There was a general preference that managements best estimate should be used to determine the transaction price as the probability-weighted estimate may result in a transaction price that is not indicative of the amounts expected to be received, and could result in significant volatility. There was also concern with recording subsequent changes in credit risk outside of revenue. Most respondents noted that it is impractical to determine whether defects are latent or the result of wear and tear and recommended that current guidance be retained (i.e., account for standard warranties as a cost accrual and extended warranties as a separate performance obligation).
Asset management
49. Respondents supported a standardized revenue recognition model but suggested several changes to the model to better reflect the economics of their contracts. Further clarification was requested regarding identification of performance obligations and variable consideration to allow earlier recognition of revenue for performance fees. Asset managers were generally opposed to accounting for onerous performance obligations as well as the proposed transitionrequirements.
Automotive
52. Three areas of focus were noted
implementation guidance, transition, and accounting for warranties. Respondents requested additional implementation guidance specific to the industry and noted that retrospective adoption would not be operational. Respondents noted that determining whether defects are latent or the result of wear and tear is not practical. They recommended that current guidance be retained (i.e., account for standard warranties as a cost accrual and extended warranties as a separate performance obligation).
Revenue recognition
17
Revenue recognition . . . full speed ahead

Latest installment: A joint FASB/IASB exposure draft
Whats inside: Overview Key provisions Other considerations Timing for comments Industry insights
The FASB and IASB (the boards) released an exposure draft on June 24, 2010 proposing a new revenue recognition standard that could significantly change the way entities recognize revenue. The proposed standard is a single, contract-based asset and liability approach in which revenue is recognized when an entity satisfies its obligations to its customers, which occurs when control of an asset (whether a good or service) transfers to the customer. The boards expect to issue the final standard in 2011, with a likely effective date no earlier than 2014. Full retrospective application will be required. Management will need to evaluate how the proposed standard might change current business activities beyond accounting, including contract negotiations, key metrics (including debt covenants), budgeting, controls and processes, and information technology requirements.
Reprinted from: Dataline 201028 July 9, 2010 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates. The above-referenced webpage also includes several industry-specific supplements to Dataline 201028.
The main details

1. The boards objective in issuing a
converged standard is to increase the consistency of revenue recognition for similar contracts, regardless of industry. The boards noted that existing guidance under US generally accepted accounting principles (USGAAP) may, in some cases, provide different revenue recognition models for contracts with similar economic characteristics. Existing International Financial Reporting Standards (IFRS) contain less guidance than USGAAP on revenue recognition and the boards noted it is sometimes difficult to apply beyond simple transactions, leading to diversity in practice. PwC observation: The proposed guidance will affect some companies more than others, although all
companies should expect some level of change. The boards have identified the following areas which may be significantly affected: Recognition of revenue based solely on the transfer of goods or services Identification of separate performance obligations Licensing and rights to use Effect of credit risk Increased use of estimates Accounting for contract related costs
2. This Dataline explores the proposed

standard. The comment period ends on October 22, 2010.
3. The boards conclusions are tentative

and subject to change until they issue a final standard.
18
PwC observation: Since the discussion paper comment period ended in June 2009, the boards have continued to seek feedback through forums and direct interaction with constituents. The boards plan to hold public roundtable meetings once the comment period ends to solicit views and obtain additional information from interested parties. We encourage management to engage with the boards, comment on the exposure draft, and continue to monitor the boards progress toward a final standard.
their existing contracts, business models, company practices and accounting policies. The proposed standard may also have broad implications for an entitys processes and controls. Management may need to change their existing IT systems and internal controls in order to capture information to comply with the proposed guidance. The effect may also extend to other functions such as treasury, income tax, and human resources. For example, changes in the timing or amount of revenue recognized may affect long-term compensation arrangements, debt covenants, and other key ratios. The proposed standard may also affect mergers and acquisitions in a number of ways, including deal models (e.g., amount and timing of revenue recognition may be different) and how earn-outs are triggered if determined based on revenue.
consideration prior to transferring goods or services to the customer. PwC observation: A contract asset or contract liability is recorded when consideration is received or performance obligations are satisfied. A contract asset exists when an entity satisfies a performance obligation, even though it might not have an unconditional right to receive the consideration. The contract asset is transferred to receivables when the right to receive consideration is dependent only on the passage of time.
Key provisions
Asset and liability model
4. The proposed standard employs
an asset and liability approach, the 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 an entity earns revenue. The boards believe a single, contract-based model based on changes in contract assets and liabilities will lead to greater consistency in the recognition and presentation ofrevenue. PwC observation: The proposed standard will represent a significant shift in how revenue is recognized in certain circumstances. It moves away from specific measurement and recognition thresholds and removes industry specific guidance. The effect could be significant, requiring management to perform a comprehensive review of
Scope
7. The proposed standard focuses on an
entitys contracts with customers. It defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. A customer is a party that has contracted with an entity to obtain goods or services that are an output of the entitys ordinary activities. A contract can be written, verbal, orimplied.
5. A contract with a customer includes

a right to receive consideration and an obligation to provide goods or perform services. The entity has a contract asset when the rights exceed the obligations and a contract liability when the obligations exceed the rights. If an entity receives no consideration at inception of the contract, the contract position is zero and no entries are recorded.
8. The proposed standard applies to an

entitys 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 whose purpose is to facilitate a sale to another party
6. An entity records a contract asset

when it has a right to consideration from a customer due to the transfer of goods or services. A contract liability is recorded when the entity has received
Revenue recognition
19
9. Some contracts include components

that are in the scope of the revenue standard and other components that are in the scope of other standards (e.g., a lease contract that also includes maintenance services). An entity applies 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. PwC observation: The proposed standard addresses contracts with customers across all industries rather than focusing on specific industries. Industry-specific guidance will be replaced by the proposed standard. As part of the comment letter process, the boards are requesting feedback on whether any aspects of the proposed standard should be different for nonpublic companies, including private companies and not-for-profit organizations. Most transactions accounted for under existing revenue standards will be within the scope of the proposed standard. Transactions in industries that recognize revenue without a contract with a customer (e.g., certain biological, agricultural, or extractive industries) are not in the scope.
selling price for allocation of consideration to performance obligations, while other standards may require use of fair value or other measures. This difference will affect the consideration allocated to a performance obligation at inception of a contract.
Applying the model

five steps in applying the proposed standard: Identify the contract with the customer Identify the separate performance obligations in the contract Determine the transaction price Allocate the transaction price to the separate performance obligations Recognize revenue when each performance obligation is satisfied PwC observation: A performance obligation is similar to what is known today as a deliverable, element, or component of an arrangement. See further discussion of performance obligations at paragraph 19 below. The transaction price is the consideration the seller expects to receive from the buyer in exchange for providing goods or services. See further discussion of measuring the transaction price in an arrangement at paragraph 26 below.
written, verbal or implied. There is a wide array of common business practices and legal requirements associated with customer contracts, across geographical and business boundaries. Management will need to consider not only written contracts, but also customary practices to determine whether a contract exists.
13. A contract exists only if:

The contract has commercial substance The parties to the contract have approved the contract and are committed to satisfying their respective obligations The entity can identify each partys enforceable rights regarding the goods or services to be transferred (i.e., determine the performance obligations) The entity can identify the terms and manner of consideration to be paid by the customer
14. An entity may need to combine two

or more contracts, or segment (i.e., divide) one contract into two or more contracts, to properly reflect the economics of the underlying transaction.
15. An entity should combine two or

more contracts into one if the prices of those contracts are interdependent. Contracts generally have interdependent pricing if they are: Entered into at or near the sametime Negotiated as a package with a single commercial objective Performed concurrently or consecutively
10. Management will need to carefully

assess performance obligations in contracts to ensure they have identified the appropriate standard to follow for separation of performance obligations and the measurement of consideration allocated to those obligations. For example, the proposed standard requires use of relative
20
Identify the contract with the customer

12. The proposed standard applies to
contracts with customers, whether
16. The price of a contract is not interdependent with the price of another contract solely because the customer receives a discount on goods or services in the contract as a result of an existing customer relationship arising from previous contracts.
transaction price to performance obligations at inception.
Identify and separate performance obligations in the contract

19. A performance obligation is an
enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. A contract may explicitly state performance obligations, but they may also arise in other ways. Legal or statutory requirements may create performance obligations even though such obligations are not explicit in the contract. Customary business practices, such as an entitys practice of providing customer support, might also create a performance obligation. PwC observation: Identifying the performance obligations in a contract is critical in applying the proposed standard, as the identification of performance obligations affects: How the transaction price is allocated The timing of revenue recognition, which is based on satisfaction of performance obligations The recognition of onerous performance obligations (see paragraphs 4344 below for further discussion of onerous performance obligations)
18. A contract modification is combined

with the original contract if the prices of the original contract and the modification are interdependent (i.e., treat the modification and original contract as one contract). Management first considers the factors in paragraph 13 above to determine whether a contract modification exists. Management then considers the factors in paragraphs 15 and 17 above to determine whether a modification is priced interdependently or independently of the originalcontract. PwC observation: Contract modifications come in a variety of forms. A modification can be a change in the scope of work, a change in pricing, or both. It is unclear how the proposed standard applies to some modifications. For example, it is common in some industries (such as aerospace and defense, and engineering and construction) for the parties to agree on a modification to the scope of the work, but agree subsequently on pricing (i.e., unpriced change orders). Significant judgment has been and will continue to be required to determine whether a change order, particularly an unpriced change order, is interdependent or independent of the original contract. Modifications that are priced interdependently with the original contract may result in a cumulative catch up adjustment to revenue at the time of the modification.
17. Management should segment one

contract into two or more contracts if some goods or services priced within the contract are independently priced from other goods or services in that contract. Contracts have goods or services with independent pricing if: The entity, or another entity, regularly sells the goods or services on a standalone basis,and The price for all goods or services in the contract approximate the sum of the standalone selling price for each good or service (i.e., there is not an inherent discount for the purchase of bundled goods/ services). PwC observation: The boards believe that contract segmentation ensures that the accounting reflects the economics of the underlying transaction. For example, the segmentation of a contract may be important when variable consideration included in the transaction price relates to only one obligation in a contract (see further discussion in paragraphs 2830 below). Changes in variable consideration for separate contracts are allocated only to the contract to which the variable consideration relates. Changes in variable consideration in a single contract are allocated to all performance obligations based on the ratio used to allocate the
20. The objective of identifying and

separating performance obligations is to ensure that revenue is recognized when such obligations are satisfied (i.e., when goods and services are transferred to the customer). Careful evaluation is required to identify all performance obligations in a contract.
Revenue recognition
21
21. It is not generally necessary to

account for performance obligations separately if they are satisfied at the same time or over the same period of time. An entity might need to account for performance obligations separately if it transfers the promised goods or services at different times (orcontinuously). PwC observation: Separation of performance obligations may be necessary in other situations, even if not required for revenue recognition purposes. For example, management may need to separate a contract that provides for the concurrent transfer of goods or provision of services for income statement presentation or segment disclosures.
resources needed to provide the good or service. PwC observation: The determination of whether a good or service is distinct will require judgment on the part of management and an understanding of how other goods or services sold in the market may interact with the entitys products. Each performance obligation does not have to have a different profit margin (i.e., a different amount or percentage) to be distinct. Rather, a profit margin must be identifiable for each performance obligation in order for them to be distinct. The proposed standard does not specify how to determine whether a good or service is subject to distinct risks or how this determination relates to a good or service having a distinct margin. Consider an example where an entity sells specialized electronic equipment. The entitys contract price for the equipment includes delivery and installation at the customers site. The equipment does not require any modifications or enhancements (other than installation) in order to be used by the customer. The entity typically installs the electronic equipment, although other entities could install the equipment. The entity has two separate performance obligations if control of the equipment transfers upon delivery and the equipment is distinct from the installation. The entity would not account for the two performance obligations separately if
control of the equipment transfers only upon successful installation. The equipment has a distinct function because it has utility together with installation services that are available from other entities. Assuming the entity can separate the costs of the electronic equipment from the costs of installation, the profit margin on the equipment is also distinct from the margin on the installation. The equipment and the installation are distinct in this example.
25. Management combines goods or

services that are not distinct with other goods or services until there are bundles of goods or services that are distinct. The combination of goods or services that are not distinct on their own may result in an entity accounting for all the goods and services promised in the contract as a single performance obligation. PwC observation: Management will need to consider carefully which performance obligations are combined to create a distinct performance obligation and should not default to combining all performance obligations in a contract. Each contract must be assessed to determine the risks, margins, and the timing of the transfer of control of individual performance obligations. Performance obligations that have different risks or margins and for which control transfers at different times should not be combined.
22. An entity recognizes revenue from

performance obligations separately if they are distinct from other goods or services promised in the contract and are delivered separately.
23. A good or service is distinct and

accounted for separately if the entity or another 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.
24. A good or service has a distinct function if it provides utility either on its own or together with other goods or services available in the marketplace. A good or service has a distinct margin if it is subject to distinct risks and the entity can identify the
22
Determine the transactionprice

reflects the consideration the customer promises to pay in exchange for goods or services.
price includes the probability-weighted estimate of variable consideration receivable. This estimate requires management to assess the probability of each possible outcome. PwC observation: Variable consideration, also commonly referred to as contingent consideration, can come in a variety of forms. Some contingencies may relate to future performance by the seller that is fully within the sellers control, while other contingencies may only be resolved by the actions of the buyer or other third parties. The amount of judgment needed to estimate variable consideration will depend on the nature and terms of the contingency.
The extent of the experience The number of possible consideration amounts PwC observation: Some industries and entities may experience a significant change in the timing of revenue recognition due to the proposed treatment of variable consideration. Variable consideration that management can estimate reasonably is included in the transaction price at the probabilityweighted amount. The proposed standard requires an assessment of variable consideration at contract inception and at each reporting period. Entities might recognize revenue earlier than under existing guidance when management can reasonably estimate variable consideration. Significant change may also arise in industries where revenue is currently restricted to the cash received because revenue is contingent on a future event. Throughout the contract life management will assess variable consideration that cannot be reasonably estimated at contract inception. Revenue is recorded when a reasonable estimate can be made. An entity might recognize revenue before the contingency is resolved in most cases, which may increase the volatility of reported results. The boards have included factors to consider in determining whether management can make a reasonable estimate of variable consideration. Entities with similar transactions may recognize revenue at different times if one entity determines that it can reasonably
23
27. The transaction price is readily determinable in some contracts because the customer promises to pay a fixed amount of cash due when the entity transfers the promised goods or services. In other contracts, management will need to consider a number of variables when determining the transaction price, such as: Variable consideration Collectability Time value of money Noncash consideration Consideration paid to a customer PwC observation: Companies will need to apply significant judgment to determine the transaction price when it is subject to the variables noted above. Amounts collected on behalf of third parties (e.g., sales taxes) will not be presented in revenue under the proposed standard. Such amounts are excluded from the transaction price.
29. An estimate of variable consideration is included in the transaction price when management can make a reasonable estimate of the amount to be received. The proposed standard states that an estimate is reasonable only if an entity: Has experience with similar types of contracts (or can refer to the experience of other entities if it has no experience of its own);and Does not expect circumstances surrounding those types of contracts to change significantly (i.e., experience is relevant to the contract)
Variable consideration
28. 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, credits, incentives, and performance bonuses. When a contract includes variable consideration, the transaction
Revenue recognition
30. Management should assess whether

circumstances may reduce the relevance of an entitys experience, including: The impact of external factors The length of time until the uncertainty is expected to be resolved
estimate variable consideration while another entity concludes it cannot. These differences may be the result of entities having different levels of experience or operating in different markets.
a financing transaction between the entity and its customer that does not involve the provision of other goods orservices. PwC observation: Management will need to consider the time value of money for a contract that includes a material financing component. However, the proposed standard does not specify the length of time to consider when determining whether a financing component is material. Management should consider the credit characteristics of the customer to determine the discount rate used. The following example illustrates the accounting for a customer payment made in arrears when a material financing component exists: An entity sells a product for $50,000 with payment due two years after delivery of the product. The entity determines that an 8 percent discount rate is appropriate based on the two year term and the credit characteristics of the customer. Revenue of $42,867 ($50,000 / (1.08 x 1.08)) is recognized when the entity transfers the product to the customer. The entity has an unconditional right to consideration upon transfer of the product and records a receivable, rather than a contract asset. The following example illustrates the accounting for customer payment made in advance when a material financing component exists: An entity sells a product to a customer for 10,000 with payment due one year before the delivery of the product. The entity recognizes
Collectability
31. Collectability refers to the customers

ability to pay the consideration agreed in the contract. The transaction price is adjusted to reflect the customers credit risk by recognizing the consideration expected to be received on a probability-weighted basis.
32. Changes in the assessment of consideration to be received due to changes in credit risk are recognized as income or expense, separately from revenue. PwC observation: Current guidance requires that revenue is recognized when payment is reasonably assured (or probable). As collectability is no longer a recognition threshold, revenue may be recognized earlier than current practice. Collectability affects the measurement of revenue under the proposed standard, as credit risk is reflected as a reduction of the transaction price at contract inception rather than as bad debt expense. Subsequent changes to the assessment of collectability will be recognized as income or expense, rather than as revenue.
a contract liability of 10,000 when the customer pays the consideration. The entity determines that a 5 percent discount rate is appropriate based on the one year term and the credit characteristics of the entity. The entity recognizes interest expense of, and increases the measurement of the performance obligation by, 500 ((10,000 x 1.05)10,000) during the year before it transfers the product. The carrying amount of the contract liability is 10,500 (10,000 + 500) immediately before the performance obligation is satisfied. The entity records revenue of 10,500 when the product is transferred to the customer. This is a significant change from current practice. The accounting for the time value of money may result in a significant change for certain entities, particularly in situations where consideration is paid in advance as the amount of revenue to be recognized could be greater than the amount of consideration ultimately received. Determining whether the time value element in a contract is material could be particularly challenging in long-term or multipleelement arrangements where product/service delivery and cash payments may occur throughout the arrangement.
Time value of money
Noncash consideration

the time value of money whenever the effect is material. Management should use a discount rate that reflects
34. An entity measures noncash consideration received for satisfying a performance obligation at its fair value. When management cannot estimate fair value reliably, the entity
24
measures the noncash consideration received indirectly by reference to the standalone selling price of the goods or services transferred in exchange for the consideration.
contract based on relative standalone selling prices. PwC observation: The proposed standard will significantly affect entities that currently use the residual method to allocate arrangement consideration. The proposed standard does not permit this method. Management will need to make an estimate of selling price for each separate performance obligation when the standalone selling price is not available. Use of estimated selling prices will often result in earlier revenue recognition for entities currently applying the residual method. The residual method allocates the discount inherent in an arrangement to the first performance obligation satisfied rather than spreading the discount ratably over all performance obligations. The proposed standard requires the discount to be spread ratably.
Consideration paid to a customer
35. Consideration paid to a customer (e.g.,

cash or credit) is assessed to determine if the amount should be reflected as a reduction of the transaction price or as a payment for discrete goods or services received from thecustomer.
36. An entity reduces revenue when it

pays consideration to a customer at the later of when: The entity transfers the promised goods or services to the customer; or The entity promises to pay the consideration (even if the payment is conditional on a future event). That promise may be implied by customary businesspractice. PwC observation: The underlying concepts for both noncash consideration and consideration paid to a customer (e.g., rebates expected to be paid to customers) are consistent with current revenue guidance under US GAAP and IFRS. We do not anticipate a significant change in these areas upon adoption of the proposed standard.
PwC observation: Estimating the standalone selling price of performance obligations is a key aspect of applying the proposed standard. Management should not presume that a contractual price (i.e., list price) reflects the standalone selling price of a good or service. The proposed standard should result in a better reflection of the economics of the transaction, but it may create challenges in developing, documenting, and supporting the estimated standalone selling price. It is important that management consider whether new internal systems and processes (and related internal controls) are required to support the process of developing estimates and allocating transaction price.
Recognize revenue when performance obligations are satisfied

39. Revenue should be 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.
Estimating standalone selling prices
38. 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 will need to estimate the selling price if a standalone selling price is not available. In doing so, management should maximize the use of observable inputs. Possible estimation methods include: Cost plus a reasonable margin Standalone sales prices of the same or similar products, if available Cash flow models or other valuation techniques
Allocate the transaction price to the separate performance obligations

37. Consideration should be allocated to
separate performance obligations in a
40. Performance obligations can be

satisfied at a point in time or continuously over time. Management should use judgment to assess the transfer of control for each separately identified performance obligation in a
Revenue recognition
25
contract. 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 PwC observation: These indicators are not a checklist nor are they exhaustive. Management should consider all relevant facts and circumstances to determine whether the customer has obtained control of the good or service. Other potential indicators that control may be transferring continuously might include: (1) whether the customer has the unilateral ability to sell or pledge the asset, for example, as collateral; or (2) whether the customer has custodial risk of loss associated with the asset.
Management should apply the same method to similar contracts. PwC observation: Management that currently use the percentage of completion method should review their contracts to determine whether control transfers continuously during construction. The percentage of completion method, as a standalone model, will no longer exist. Entities that transfer control of the asset under construction continuously will recognize revenue as control transfers, not using a completed contract method. The resulting revenue recognition may be similar to todays accounting if an entity currently recognizes revenue based on the transfer of assets to the customer.
appropriately reflects transfers of goods or services to the customer. In particular, use of input methods or recognition based on the passage of time need to reflect the transfer of control of the good or service to the customer, rather than simply reflecting the activities of the entity. A consistent measurement method might not be applicable for all types of contracts an entity enters into if the contracts differ.
Subsequent measurement
43. Performance obligations are
assessed at contract inception and at each reporting date to determine whether the obligation has become onerous. A performance obligation is onerous when the present value of the probability-weighted direct costs to satisfy the obligation exceed the consideration (i.e., the amount of transaction price) allocated to it. Prior to recognizing a liability for an onerous performance obligation, the entity should recognize any impairment loss on assets directly related to the contract.
42. 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 PwC observation: Management will need to consider the relevant facts and circumstances to determine whether there is continuous transfer of control. Careful consideration is also needed to determine which measurement method most
Continuous transfer of goods andservices
41. An entity may transfer control of

a good or service to the customer continuously as it manufactures the goods or performs the services. Management should consistently apply the method that best depicts the transfer of goods or services to determine how much revenue to recognize when control is transferred continuously. This may be a straight-line basis if the entity transfers goods or services continuously and evenly over time to the customer throughout the contract.
44. Onerous performance obligations

should be updated each reporting period using current estimates. Any changes in the measurement of the liability would be recorded as an expense or a reduction of an expense. The entity reduces the expense previously recorded on satisfaction of the onerous performance obligation. PwC observation: Direct costs include direct materials, direct labor, indirect costs that are either specifically attributable to
26
the contract or specifically reimbursable under the terms of the contract, and those costs that are incurred only because the entity entered into the contract. The proposed standard may represent a significant change for US GAAP and IFRS. US GAAP does not permit accounting for onerous contracts outside of certain specific guidance (e.g., construction contract guidance). IFRS guidance generally requires an assessment of onerous contracts at the contract level, not the performance obligation level. An assessment at the performance obligation level may lead to an entity recognizing a liability for performance obligations that are onerous even though the overall contract is profitable. Management may be reluctant to enter into contracts that include loss-making performance obligations with the expectation of overall profitability in light of this proposed guidance. It is not necessary to account for performance obligations separately if they are satisfied at the same time. However, it is unclear how a contract to provide services concurrently would be accounted for if one of the obligations is onerous. The proposed standard does not address whether the entity would be required to separate concurrent services to account for one performance obligation that was onerous.
changes in the transaction price. An entity should allocate these changes to separate performance obligations on the same basis as at contract inception (i.e., using the same allocation percentages) and recognize those changes in the revenue allocated to satisfied performance obligations as revenue in the period of change.
significantly on the judgments made by management. Management should carefully consider how much information should be disclosed about the anticipated impact of the proposed standard on the entitys financial statements before the effective date. Management may need to include increasing disclosure about the impact of adoption as the adoption date approaches.
Disclosure
46. The boards believe that the proposed
disclosures will assist users of financial statements in understanding the amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.
Transition
48. The proposed standard requires full
retrospective application, including application to those contracts that do not affect current or future periods, but affect reported historical periods. PwC observation: The boards have not decided on the effective date for the proposed standard, but they have discussed possible effective dates no earlier than 2014 to provide management adequate time to prepare for and implement the proposed standard. The boards plan to seek separate feedback on the effective date because of the volume of proposed standards expected in 2011. The boards intend that retrospective application will drive consistency in reporting among periods presented as well as among entities. The transition requirements may affect some entities more than others, depending on the number of reporting periods included in an entitys financial statements as well as the number and nature of contracts outstanding at adoption of
47. Disclosures will focus on:

Qualitative and quantitative information about performance obligations, rights to consideration, and onerous performance obligations to help users understand the characteristics of the entitys contracts with customers. The significant judgments and changes in judgments that will explain the effect of those judgments on the timing and amount of revenue recognized in the financial statements. These disclosures should include (a) the effect on the amount of revenue recognized in the current period, and (b) an indication of the expected effect on the timing and amount of revenue that will be recognized in future periods. PwC observation: The disclosure requirements are more detailed than currently required under US GAAP or IFRS and focus
45. Management must remeasure the

contract asset each reporting period, or as circumstances change, to reflect
Revenue recognition
27
the proposed standard. We expect the effort and cost required for full retrospective application will have a significant impact on some entities. Although the proposed standard does not address early adoption, the FASB prefers to prohibit early adoption while the IASB proposes that first time adopters of IFRS be allowed to adopt early.
51. The entity acting as the principal

should recognize revenue gross when it obtains control of the goods or services of another party in advance of transferring those goods or services to the customer.
transfers additional goods or services to thecustomer.
54. The estimate of a standalone selling

price for a customers option to acquire additional goods or services will reflect the discount the customer obtains when exercising the option. The estimated selling price is adjustedfor: The discount that the customer would receive without exercising the option The likelihood that the option will be exercised (i.e., breakage/ forfeiture)
52. An entity that does not obtain control

of the goods or services should consider whether it is acting as an agent. Indicators that the company is acting as an agent include: The other party has primary responsibility for fulfillment of the contract (i.e., primary obligor) The entity does not have inventory risk The entity does not have discretion in establishing prices The entity does not have customer credit risk The entitys consideration is a commission PwC observation: This proposed principle and list of indicators is consistent with current guidance under US GAAP and IFRS. We do not anticipate significant change in this area.
Other considerations
Identification of performance obligations
49. The boards considered the impact of
the following items on the identification of performance obligations in a contract: Principal versus agent Options to acquire additional goods or services Licenses and rights to use Rights of return Product warranties and product liabilities Nonrefundable upfront fees
55. A contract may include renewal

options (i.e., an option for goods or services similar to the original goods or services) or cancellation clauses. An entity may allocate the transaction price to the optional goods or services by reference to the goods or services it expects to provide and the expected consideration.
56. An option to acquire additional goods

or services at their standalone selling price does not provide the customer with a material right, even if it arises only because the customer entered into the previous contract. Such an option is a marketing offer, which does not provide the customer with a material right. PwC observation: Options come in a variety of forms including sales incentives, customer award credits (or loyalty points), contract renewal options, volume discounts, and other discounts on future goods or services. The accounting for these options as separate performance obligations may be a significant change from existing guidance.
Principal versus agent
50. Management will need to consider

whether the entity is acting as a principal or an agent in a contract. An entity would recognize revenue gross if it is the principal, and net if it is acting as an agent. The entity is acting as a principal if its performance obligation is to provide the goods or services. It is acting as an agent if it is arranging for another party to provide those goods or services.
Options to acquire additional goods or services
53. An entity may grant a customer the

option to acquire additional goods or services. That promise gives rise to a 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 it
28
The following example illustrates the accounting for a customer loyalty program. An entity provides a customer loyalty program to its customers. The program grants customers one point per 10 spent on purchases. Each point earned has a cash value of 1, which the customer may redeem against future purchases. Customers purchase products for 1,000 and earn 100 points redeemable against future purchases. Management expects that customers will redeem 95 of the 100 points earned. Management also estimates that the standalone selling price of one point is 0.95 based on the history of redemption. The standalone selling price of the products to customers without the points is 1,000. The option (i.e., the points) provides a material right to the customer, so the entity will allocate the transaction price between the product and the points on a relative estimated selling price basis as follows: Product 913 Points 87 (1,000 x 1,000 1,095) (95 x 1,000 1,095)
95 points to 98 points. Cumulative revenue for the option is 75 (85 98) x 87). Because the entity previously recognized option revenue of 60 in year one, it recognizes 15 (7560) of incremental revenue in year two for the option. Customers have redeemed 98 points at the end of the third year. Management continues to expect that customers will redeem only 98 points. Cumulative revenue at the end of the third year is 87. The entity recognizes an additional 12 (8775) for the option in year three.
entity recognizes revenue when the customer is able to use the license and benefit from it (i.e., when control transfers but no earlier than the beginning of the license period). PwC observation: A license is accounted for as a sale if it is for substantially all of the intellectual propertys economic useful life or if the license of the intellectual property is granted on a non-exclusive basis. A license is accounted for over the term of the license only when it is provided on an exclusive basis for less than the assets economic life. Entities may grant exclusive rights by reference to time, geography, or distribution channel or medium. The proposed standard clarifies when a license is exclusive, but it is unclear how an entity should determine the economic life of the asset when it can re-license the intellectual property subsequently in the same window or territory once the existing license expires. Determination of the licensed asset (i.e., the unit of account) and the related economic life will be crucial in determining when revenue is recognized.
Licenses and rights to use
57. The recognition of revenue for the

license of intellectual property depends on whether the customer obtains control of the asset. The contract is a sale (rather than a license or a lease) 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 entity recognizes revenue when control of the intellectual property transfers if the transaction is a sale.
Customers redeem 65 points at the end of the first year and management continues to expect that customers will ultimately redeem 95 points. The entity therefore recognizes revenue of 60 (65 95 points) x (87) related to the option. Customers redeem an additional 20 points in the second year (cumulative points redeemed are 85). Management has revised its estimate of total redemptions from
58. 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. The entity generally recognizes revenue over the term of the license in this situation.
Rights of return
60. An entity will account for the sale

of goods with a right of return as follows: Revenue is not recognized for goods expected to be returned and a liability is recognized for the refund to be paid to customers, using a probability-weighted approach
59. A contract that provides a nonexclusive license for intellectual property (e.g., off-the-shelf software) is a single performance obligation. An
Revenue recognition
29
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 when the entity settles the refund liability. The asset is initially measured at the original cost of the goods less any expected costs to recover those goods (that is, the former carrying amount in inventory less costs to recover theproducts)
61. A contract that provides the customer

with the right to exchange one product for another product of the same type, quality, condition, and price (e.g., a red shirt for a blue shirt), does not provide the customer with a return right. PwC observation: The accounting for return rights is similar to todays failed sale model (i.e., an entity does not recognize revenue for goods it expects customers to return). Entities that are unable to estimate returns will be precluded from recognizing revenue prior to the lapse of the return right. The proposed standard will require full derecognition of inventory that an entity has sold and recognition of an asset for the entitys right to recover goods from the customer. The return right (i.e., the asset) is assessed for impairment in accordance with existing standards.
A quality assurance warranty provides a customer with coverage for latent defects (i.e., those that exist when the asset is transferred to the customer but that are not yet apparent). This warranty does not give rise to a separate performance obligation but recognizes the possibility that the entity has not satisfied its performance obligation. In other words, the entity has not provided an asset that operates as intended at the time of delivery. Management will need to determine the likelihood and extent of defects in the products it has sold to customers at each reporting period to determine the extent of unsatisfied performance obligations. An entity does not recognize revenue at the time of sale for defective products that it will subsequently replace in their entirety. Management will defer revenue for warranties that require replacement or repair of components of an item, but only for the portion of revenue attributable to the components that it must repair or replace.
Whether the product could have been sold without the warranty The length of the warranty coverage period
65. A warranty required by law to

protect the customer from the risk of purchasing defective products is not a performance obligation. A warranty sold on a standalone basis or as an optional extra (e.g., an extended warranty) is a performance obligation. Products that cannot be sold without a warranty suggest that the warranty is not a performance obligation. A longer coverage period suggests that the warranty or part of the warranty is a performance obligation.
66. Product liability obligations (e.g.,

when an entity is legally obligated to pay consideration if its products cause harm or damage), are not performance obligations. An entity accounts for these liabilities in accordance with ASC 450-20, Loss Contingencies, or IAS 37, Provisions, Contingent Liabilities and Contingent Assets. PwC observation: Management will need to use significant judgment to determine whether a defect is latent or has arisen subsequent to a sale. It may also be difficult to apply the guidance for quality assurance warranties when the entity is required to repair or replace only a component of the asset sold. For example, the contract may have only one performance obligation (e.g., the sale of a car) but the entity may be required to determine the amount of consideration associated with individual components of the car
63. An insurance warranty provides a

customer with coverage for faults that arise after the entity transfers control to the customer (e.g., normal wear and tear). Insurance warranties give rise to a separate performance obligation. The entity allocates a portion of the transaction price to insurance warranties at contract inception.

the following factors to determine whether a warranty provides coverage for latent defects or for faults that arise subsequent to the transfer of the product to the customer: Whether the warranty is required by law
Product warranties and productliabilities
62. The proposed standard draws a

distinction between quality assurance warranties and insurance warranties.
30
(e.g., the seats or the brakes) that are expected to be defective and subsequently repaired. An insurance warranty includes standard and extended warranties that the entity uses to provide the customer with coverage for faults that arise after control of the product has transferred. Management will be required to allocate a portion of the transaction price to the insurance warranty at the inception of the contract regardless of whether the insurance warranty is standard with the sale of a product or an extended warranty. The accounting for warranties is a significant change from current practice under both frameworks. Entities currently account for standard warranties as a liability for the expected costs to repair defective products based on experience with similar contracts. Entities will not recognize revenue for defects that exist at the time of the original sale under the proposed standard. It may be necessary to separate a warranty between a quality assurance warranty and an insurance warranty when an entity provides coverage for defects that may exist when the product is transferred to the customer as well as for defects that arise after control of the asset has transferred. This may require a significant amount of estimation and judgment. Entities may be required to allocate revenue to the portion of the standard warranty that provides coverage for defects arising after sale (i.e., insurance warranties), which will alter the
timing of revenue recognition for certain product sales. It is unclear how an entity would account for situations in which a customer can receive either cash or require specific performance in the satisfaction of an obligation (e.g., a cash settled warranty).
the separately identified performance obligations.
Satisfaction of performance obligations

70. The boards also considered the impact
of the following items on the satisfaction of performance obligations in acontract: Determining whether a good or service is transferred continuously Bill-and-hold arrangements Consignment arrangements Sale and repurchase of a product Customer acceptance
Nonrefundable upfront fees
67. Management will need to determine

whether a nonrefundable upfront fee relates to a separate performance obligation.
68. A nonrefundable upfront fee may

relate to an activity undertaken at or near contract inception, 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.
Determining whether a good or service is transferred continuously
71. Many contracts clearly identify when

a good or service is transferred to the customer. It may, however, be difficult to determine when a good or a service is transferred to the customer in contracts that include the production, manufacture, or construction of anasset.
69. If the nonrefundable upfront fee

relates to a performance obligation, management will need to determine whether that performance obligation is distinct from the other performance obligations in the contract. PwC observation: Entities currently account for nonrefundable upfront fees separately when they result in the culmination of a separate earnings process. The terminology has changed under the proposed standard, but we expect the accounting for nonrefundable upfront fees to be consistent with current practice. A nonrefundable upfront fee that is not related to a separate performance obligation is included in the transaction price and allocated to
72. If the customer has the ability to direct

the use of and receive the benefit from the work in process (rather than the completed asset), control of the good or service may transfer continuously and revenue is recognized as the services are performed.
73. If the customer does not control

the asset as it is produced, manufactured, or constructed, control of the completed asset transfers and thus revenue is recognized when the customer obtains control of the completed asset.
Revenue recognition
31
PwC observation: Revenue is recognized when control transfers to the customer. Management should carefully consider how and when control transfers. The point at which control transfers will be clear in many contracts, however, it may be difficult to determine when control transfers in certain contracts. For example, a contract may require an entity to issue a report at the end of a consultation or investigative period. Does control transfer as the services are being performed or when the report is issued? This will depend on the facts and circumstances of the arrangement and the nature of the services. Management will need to consider if the services have utility to the customer without the report. Consider, for example, a consulting services agreement in which a final report will be issued at the end of the contract period. The consulting services are intended to identify efficiencies in the accounting and financial reporting function and will be performed over a one year period. The scope of services is determined by the customer and may be changed at any time during the contract term. The customer will pay the consultant $25,000 per month for services provided and is entitled to any analysis or insight developed by the consultant throughout the contract period. The customer has the ability to specify the scope of work performed, change the scope at any point, access information obtained, and is required to pay for services performed, so the customer has the ability to direct the use of, and benefit from, the consulting
32
services as they are performed. Therefore, the consultants performance obligation is to provide consulting services over a one year period on a continuous basis.
77. If an entity recognizes revenue on a

bill-and-hold transaction, management will need to consider whether the custodial services are a material separate performance obligation to which it should allocate some of the transaction price. PwC observation: This proposed principle and list of indicators is consistent with current revenue guidance under US GAAP and IFRS, but management will need to consider all relevant facts and circumstances and use significant judgment to determine whether control has transferred in a billand-hold arrangement. We do not anticipate a significant change in this area upon adoption of the proposed standard.
Bill-and-hold arrangements
74. In some contracts, an entity bills a

customer for a product but does not ship the product until a later date (a bill-and-hold arrangement).
75. Revenue is recognized under the

proposed standard on transfer of control of the asset to the customer, so management will therefore need to consider the following factors in determining whether the customer has obtained control in a bill-and-hold arrangement: The customer must have requested the contract be on a bill-and-hold basis; The product must be identified separately as the customers; The product must be ready for delivery at the time and location specified by the customer; and The entity cannot have the ability to sell the product to another customer.
Consignment arrangements
78. Certain industries transfer goods to

dealers or distributors on a consignment basis. The transferor typically owns 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.
76. Management should also consider the

following indicators in determining whether the customer has obtained control in a bill-and-hold arrangement: Whether the entitys usual payment terms have been modified; The possibility that the customer may cancel the contract before delivery occurs; and Whether the arrangement meets the definition of a contract explained in paragraph 12 above.

the following factors to determine whether revenue should be recognized on transfer to the distributor or on ultimate sale to the customer: Whether the dealer is obligated to pay for the goods only if the dealer sells them Whether the dealer can return the products Whether the dealer obtains a commission for selling the products to the end customer
PwC observation: This proposed principle and list of indicators is consistent with current revenue guidance under US GAAP and IFRS. We do not anticipate a significant change in this area on adoption of the proposed standard. However, the proposed standard focuses on transfer of control rather than the transfer of risks and rewards, so some entities may experience a change in their accounting.
PwC observation: An entity may enter into an agreement to repurchase goods sold to a customer. Management will need to consider whether control of the goods transferred to the customer in the intervening period to assess whether a sale has occurred or whether the arrangement is in substance a lease.
good or service meets the contractual terms in order to support that control has transferred prior to customer acceptance. Factors that may support managements ability to determine objectively that it has met the contract specifications include: The entitys historical experience with meeting specified terms Whether outside factors could affect acceptance The entitys history regarding acceptance clauses
Customer acceptance
83. Management will need to determine

whether the customer has obtained control of the good or service prior to acceptance if the contract includes a customer acceptance provision.
Sale and repurchase of a product
80. When an entity sells a product to a

customer that includes an unconditional right to require the entity to repurchase that product in the future, the entity should account for the transaction as a sale of a product with a right of return (see paragraphs 6061 above).
84. Customer acceptance may be a

formality if the entity can objectively determine that the good or service has been transferred to the customer in accordance with the specifications in the contract.
Contract costs

specific guidance for accounting for costs associated with contracts with customers. An entity recognizes costs to obtain a contract (e.g., costs of selling, marketing, or advertising) asincurred. PwC observation: Expensing costs to obtain a contract as they are incurred may significantly affect entities that previously capitalized certain pre-contract costs (e.g., acquisition costs or legal costs). Management should carefully review its cost capitalization methods in order to understand the potential effects of these changes.
81. When the entity has an unconditional

obligation or unconditional right to repurchase the asset (a forward or a call option), the buyer does not obtain control of the asset and the entity accounts for the transaction asfollows: A lease, if the entity repurchases the asset for less than the original sales price of the asset; or A financing arrangement, if the entity repurchases the asset for an amount that is equal to or more than the original sales price of the asset.
85. The entity does not recognize revenue

prior to acceptance if it is unable to objectively determine that the good or service transferred to the customer meets the contract specifications. This is because management cannot determine whether it has satisfied the performance obligation.
86. When a contract allows the customer

a trial or evaluation period, control transfers either upon customer acceptance of the good or at the end of the trial or evaluation period. PwC observation: The proposed principle for accounting for contracts that include customer acceptance clauses is similar to current revenue guidance. Management will need to carefully consider the terms of the contract and whether they have the ability to objectively determine whether the
88. 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 (i.e., inventory, fixed assets, intangibles) to determine which costs may be recognized as an asset. These costs will be accounted for in accordance with the relevant standards.
33
82. The entity continues to recognize the

asset, together with a financial liability, for any consideration received from the buyer in a financing transaction. It records the difference between the amount of consideration received from the customer and the amount of consideration paid as interest expense.
Revenue recognition
US GAAP Convergence & IFRS Revenue recognition: Updated November 30, 2011
November 2011
Table of contents
Revenue from contracts with customers Take twoFASB and IASB issue new revenue recognition exposure draft 10 Minutes on the future of revenue recognition The next chapter: FASB and IASB decide to re-expose the proposed revenue standard FASB and IASB on track with deliberation plan for revenue project Revenue from contracts with customers Key decisions propel the joint revenue project forward FASB and IASB march closer to completion on key revenue recognition issues
2 30 32 38 40 42 62 64
Revenue from contracts with customers The proposed revenue standard is re-exposed
Whats inside: Overview The proposed model Other considerations Disclosures Transitions Next steps Appendix
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 entitys 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.
Reprinted from: Dataline 201135 November 22, 2011
Background
1. The boards initiated this joint project
in 2002 to develop a common revenue standard for US GAAP and IFRS. The original exposure draft was issued in June 2010 (the 2010 Exposure Draft).
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.
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-deliberations. They addressed several areas including the identification of separate performance obligations, determining the transaction price, accounting for variable
2

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.
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.

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 entitys 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
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 US 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.
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 entitys 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 entitys ordinary activities.
8. The proposed standard applies to an

entitys 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 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
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
9. Some contracts might include

components that are in the scope of the proposed standard and other
Revenue recognition: Updated November 30, 2011
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.
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 US GAAP. For example, the software guidance under US 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 US 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 stand-alone 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 standalone selling price of the product at the time of the contract modification. 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.
Identify the contract with the customer

11. A contract exists if all 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 partys 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
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
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
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 entitys 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
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.
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.
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
Determine the transaction price and amounts not expected to be collected

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
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 sellers control, while other contingencies may depend heavily on the actions of a customer or a third party. 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,
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).
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
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.
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 probabilityweighted 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.
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
7
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:
Time value of money

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
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.
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. PwC observation: The underlying concepts for both noncash consideration and consideration paid to a customer are consistent with current revenue guidance under both US 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.
PwC observation: Current guidance requires that revenue cannot be recognized unless collectibility is reasonably assured (under US 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.
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 stand-alone 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.
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).
28. An entity reduces revenue when it

pays consideration to a customer
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 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%
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
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 standalone 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
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: 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
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.
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 US 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 standalone 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
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
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
10
the use of and benefit from the goods or services.
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. 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.
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 entitys performance creates or enhances an asset that the customer controls The entitys 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
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 re-performed 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
11
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
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.
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 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 - $250,000)) $125,000 50% $150,000 50,000
The manufacturing entity estimates that the performance on the project is 50% complete and recognizes revenue of $125,000. 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.
12
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.
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 received. It is worth noting that like the royalties, the trailing commissions are also dependent on the customers 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.
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 entitys 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 entitys experience with similar types of contracts is limited The contract has a large number and broad range of possible consideration amounts
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.
43. The proposed guidance includes an

exception for intellectual property licensed in exchange for royalties based on the customers 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.
13
Identify the separate performance obligations
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
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 entitys consideration is in the form of a commission PwC observation: The proposed guidance and list of indicators are similar to the current guidance under US 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.
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.
Principal versus agent
50. The estimate of a stand-alone selling

price for a customers 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 US GAAP, there is divergent practice in the accounting for loyalty programs with many entities
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.
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.
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)
14
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.
Licenses
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.
51. A license is the right to use an entitys

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.
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 standalone 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)
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 US 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.
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.
15
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.
recognized for the right to recover a product is assessed for impairment in accordance with existing standards.
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.
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.
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 US 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 standalone selling price for warrantyrelated services when such services are not sold separately could also be challenging.
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.
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
Recognize revenue when each performance obligation is satisfied

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
Nonrefundable upfront fees
58. Some entities charge a customer a

nonrefundable fee at the beginning
62. Under a bill-and-hold arrangement,

an entity bills a customer for a product but does not ship the product until a
16
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: The reason for the bill-and-hold arrangement must be substantive The product must be identified separately as the customers 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
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.
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 US 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.
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.
Consignment arrangements
64. Certain industries transfer goods to

dealers or distributors on a consignment basis. The transferor typically owns the inventory on consignment
17
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
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.
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.
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.
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.
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.
18

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.
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.
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: 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 entitys 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
19
74. Performance obligations that are

satisfied over a period of time less than a year are excluded from the onerous performance obligation assessment. 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
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
Significant judgments and changes in judgments that affect the determination of the amount and timing of revenue from contracts with customers
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 US GAAP, although it will be permitted under IFRS.
Next steps
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.
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.
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)
Nonpublic entity disclosures (US 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
20
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 An entity may need to combine two or more the prices of those contracts are interdependent. 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.
Contract modifications
1 Refers to the exposure draft issued on June 24, 2010 2 Refers to the exposure draft issued on November 14, 2011
21
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.
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:
Identification of separate performance obligations
The entity regularly sells the good or service A good or service is distinct if an entity sells an separately identical or similar good or service separately. A The customer can use the good or service good or service that has a distinct function and on its own or together with resources readily a distinct profit margin from the other goods or available to the customer. services in the contract is also distinct, even if not sold separately. 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 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.
22
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 probabilityweighted 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 probability-weighted 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 customers 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.
23
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.
24
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
25
Topic Continuous transfer of goods and services
2010 Exposure Draft The exposure draft had no specific guidance for services. The guidance was the same as the guidance for goods above.
2011 Exposure Draft 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 entitys performance creates or enhances an asset that the customer controls, or (b) the entitys performance does not create an asset with alternative use to the entity but 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 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
26
Topic
2010 Exposure Draft
2011 Exposure Draft 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 entitys 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).
Measuring progress Methods for recognizing revenue when control of satisfying a transfers continuously include: performance obligation 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
27
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 entitys 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 customers 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-theshelf software) is a single performance obligation. An entity recognizes revenue when the customer is able to use the license and benefit from it.
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.
28
Other consideratinos
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.
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 An entity should recognize an asset for costs that are not within the scope of another standard generate or enhance a resource that the entity will use to satisfy future performance obligations only if the costs relate directly to a contract, will generate or enhance a resource that the entity will in a contract, and are expected to be recovered use to satisfy future performance obligations in a under a contract. contract, and are expected to be recovered under An entity amortizes an asset recognized for a contract. 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. Onerous performance obligations A performance obligation is onerous when the present value of the probability-weighted direct costs to satisfy the obligation exceed the consideration (that is, the amount of transaction price) allocated to it. 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 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.
29
Take two FASB and IASB issue new revenue recognition exposure draft
Whats inside: Whats new The proposed model Is convergence achieved? Whos affected? Whats the effective date? Whats next?
Whats new?
On November 14, 2011, the FASB and IASB (the boards) issued a new exposure draft (ED) on revenue from contracts with customers. The core revenue recognition model and scope have not changed from that proposed in the June 2010 exposure draft. However, the boards have revised various proposals on how to apply that core principle. Consequently, the boards agreed that re-exposure would increase transparency and minimize unintended consequences. The comment period ends on March 13, 2012. The ED requests feedback on the most significant changes from the previous proposal, which are summarized below.
Reprinted from: In brief 201149 November 14, 2011
The proposed model

The proposed model requires a contractbased approach. An entity should first identify separate performance obligations and 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. There are a number of changes from the June 2010 exposure draft. Most of the changes were made in response to concerns raised during the comment letter process and industry consultation.
the following criteria is met: (a) the customer simultaneously receives and consumes the benefit as the entity performs; (b) another entity would not need to substantially reperform tasks already performed; or (c) the entity has a right to payment for work performed.
Presentation of the effects of credit risk

Impairment as a result of credit risk is presented as a separate line item adjacent to revenue. Both the initial impairment assessment and any subsequent changes in the estimate will be recorded in this line item such that the cash ultimately received from the customer equals the sum of the two line items (if the contract does not have a significant financing component).
Performance obligations satisfied over time

The ED provides new guidance on determining when a performance obligation is satisfied over time, rather than at a point in time. A performance obligation is satisfied over time if the entitys performance: creates or enhances an asset that the customer controls, or does not create an asset or creates an asset but the asset has no alternative use to the vendor and one of
Reasonably assured constraint

Revenue is only recognized to the extent that the entity is reasonably assured to be entitled to the consideration. An entity is reasonably assured when it has experience with similar types of performance obligations and that experience is predictive of
30
the amount of consideration to which the entity will be entitled. The ED includes an exception for licenses of intellectual property such that consideration based on the customers subsequent sales using that intellectual property cannot be recognized as revenue until those subsequent sales occur.
Convergence is expected for revenue recognition, since the same principles should 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.

An entity will recognize a loss for a performance obligation that is satisfied over a period greater than one year if the performance obligation is onerous. A performance obligation is onerous if the lower of the cost to settle or fulfil the performance obligation exceeds the transaction price allocated to that performance obligation. The ED removes the requirement from the previous proposal to assess and measure a liability for a performance obligation satisfied at a point in time or within a year.
Whos 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.

The final standard will have an effective date no earlier than 2015. Full retrospective application will be required with the option to apply some transition reliefs.
Interim disclosures
Several new disclosures will be required not only in an entitys annual financial statements, but also in its interim financial statements.
Whats next?
The 120-day comment letter period ends on March 13, 2012, and we understand the boards anticipate issuing the final standard by the end of 2012. We will issue a Dataline shortly to provide a more comprehensive analysis of the ED.
Application to nonfinancial assets

The ED will result in entities recognizing the sale of a non-financial asset when control is transferred to the buyer even if the sale is outside of the scope of the ED (i.e., not a contract with a customer).
31
10 Minutes on the future of revenue recognition
Whats inside: Highlights The far-reaching implications of anew revenue model No more special treatment Navigating areas of judgment Assessing the impact on the past, present, and future What should your company be doing now?
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-specific 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 new requirements.
Reprinted from: 10 Minutes on the future ofrevenuerecognition August 2011
The far-reaching implications of a newrevenue model

1. 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.
inform your response to the revised proposal and limit surprises down theroad.
4. 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.
2. 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.
5. What it means for yourcompany:

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 be critical. 2. Companies may need to change information technology systems to capture different information and develop new processes for estimates that arent required today. 3. The resulting need for increased judgment will require thoughtful
3. 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
32
documentation and dialogue with those charged with governance. 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 re-expose their proposed revenue standard. Companies should take advantage of this opportunity to participate in the standard-setting process and provide input to the boards.
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. Revenue reflects a more extensive use of estimates (for example, contingent fees), and bad debt estimates offset gross revenue. Revenue from licenses of intellectual property is 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 practice today.
...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. Most companies will see some impact on margins and other key financial measures. Changes that affect a broad base of companies include offsetting bad debt expense against revenue and changes in the timing of recognizing certaincosts. 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 these terms. 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 final standardisissued.
33
Industry-specific US revenue guidance will be largely eliminated including: Financial services Brokers and dealers Depository and lending Investment companies Mortgage banking Entertainment Broadcasters Cable television Casinos Films Music Other industries Airlines Contractors Extractive activities-oil and gas Franchisors Health care entities Real estate Software
No more special treatment

6. 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 affected industries.
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
8. 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 bright-line requirements to better align with their business objectives.
(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?
Software
10. 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-settingprocess.
7. The detailed rules in todays software

guidance were designed with an antiabuse 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
Contractors
9. Those in the engineering and

construction, and aerospace and defense industries, among others, currently apply specific guidance on long-term contracts. This guidance includes rules for recognizing revenue
34
Examples of estimates required by the revenue standard Bad debts/ credit risk Performance bonuses Royalties and other variable fees Time value of money Loss contracts Record estimated bad debts as an offset to gross revenue Updates to estimates also affect net revenue Estimate the amount the company expects to receive Generally recognize if reasonably assured based on experience and other factors Estimate the amount the company expects to receive Generally do not recognize if sales-based royalties or no predictive experience Only record impact if significant and greater than one year Could affect contracts with prepayments or extended payment terms Record upfront loss if remaining costs exceed revenue for service obligations Update assessment throughout the life of the contract
Navigating areas ofjudgment

11. 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.
A new model for credit risk
13. 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.
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
15. Revenue estimates will be based

on the probability-weighted 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.
New estimates of variable fees
12. 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.
Loss leaders in service contracts
14. 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
16. 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.
35
Illustrative timeline for implementing the new standard The boards have yet to decide on the effective date of the final 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.
September 2012: Final standard expected January 2013: First reported period adjusted upon adoption January 2015: Illustrative effective date
Implement new processes and procedures
Assess transactions under both sets of guidance (dual recordkeeping)
Assessing the impact on the past, present, andfuture

A fresh look at contract terms
companies should think through these issues well in advance of adopting the newstandard.
early start will be key to overcoming these challenges.
Other affected arrangements
Managing the transition period
19. 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.
21. 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 to stakeholders.
17. 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.
22. 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.
18. 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 bright-line 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,
Adopting the new standard
20. 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
36
Preparing for the change
Form a cross-functional steering committee Inventory affected contract provisions Identify gaps in systems and controls Evaluate potential changes to business practices Develop a plan to communicate to stakeholders
What should your company be doing now?

23. While the standards effective date is
still a few years away, its successful implementation will require planning ahead and keeping stakeholders wellinformed of the changes to come. Key steps in the process include:
Assess the potential impact early

Review existing revenue arrangements and contracts to identify provisions that will be affected. Model the impact on significant sales transactions or a sample of transactiontypes. 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 taxpurposes.
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 financialmeasures. 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.
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.
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.
Communicate in advance with stakeholders

Develop a plan to limit surprises by communicating the expected impact to investors and other stakeholders.
37
The next chapter: FASB and IASB decide to re-expose the proposed revenue standard
Whats new?
The FASB and IASB (the boards) met in May and June to discuss their joint project on revenue recognition. They decided to re-expose the proposed revenue standard, pushing the expected timeline for issuing a final standard into 2012. The boards also reaffirmed that a retrospective application transition method will be required, but provided certain transition reliefs to reduce the burden on preparers. The boards also discussed the effect of the proposed model on the telecommunications industry, and the FASB separately deliberated whether to retain certain revenue guidance for rate-regulated entities and whether to exempt nonpublic entities from certain disclosure requirements. These decisions are tentative and subject to change.
Reprinted from: In brief 2011-24 June 15, 2011

Re-exposure
The boards agreed that formal re-exposure will ensure a transparent process for this key project. The revised exposure draft will include questions that request feedback on the more significant changes from the June 2010 exposure draft. These questions are expected to address the following: (1) performance obligations satisfied over time (i.e., service arrangements), (2) presentation of the effects of credit risk adjacent to revenue, (3) the reasonably assured constraint on revenue recognition, and (4) applying the onerous test. The boards will also ask whether the standard is presented clearly and whether it is operational. The exposure draft is expected to be released in August or September 2011 and will have a 120-day comment period.
Transition requirements
The boards tentatively decided that an entity could transition to the new standard using either full or limited retrospective application, which would reduce the burden on preparers by: not requiring the restatement of contracts that begin and end within the same prior accounting period; allowing the use of hindsight in estimating variable consideration; not requiring the onerous test to be performed in comparative periods unless an onerous contract liability was recognized previously; and not requiring disclosure of the maturity analysis of remaining performance obligations in the first year ofapplication. Disclosure of a qualitative assessment of the likely effect of applying the reliefs isrequired.
38
Telecommunications industry
The boards discussed whether to modify the proposed standard for concerns raised by the telecommunications industry. These concerns related to allocating the total transaction price between handsets and network services based on standalone selling price. The boards concluded that the revenue model should be applied consistently by all industries and did not revise their decisions for the concerns raised by the telecommunications industry.
Disclosure requirements for nonpublic entities (FASB only)

The FASB decided that nonpublic entities will be exempt from many of the proposed disclosure requirements. However, these entities will be required to disclose: (1) disaggregated revenue, (2) certain qualitative information, and (3) information about judgments and the methods, inputs, and assumptions used by the entity.
Whos affected?
The proposal will affect most entities that apply US GAAP or IFRS. Entities that currently follow industry-specific guidance should expect the greatest impact.

We anticipate the final standard to have an effective date no earlier than 2015.
Rate-regulated entities (FASB only)

The FASB decided that existing guidance in ASC 980, Regulated Operations, will be retained for the recognition of regulatory assets and liabilities from alternative revenue programs.
Whats next?
The target date for issuing a final standard has been extended from December 2011 to September 2012. The exposure draft is expected in August or September 2011 and will have a 120-day comment period.
39
FASB and IASB on track with deliberation plan for revenue project
Whats new?
The FASB and IASB (the boards) met in May to discuss their joint project on revenue recognition. They reached decisions on amortization and impairment of capitalized costs, and disclosures. The boards also revisited their previous conclusions on onerous contracts. These decisions are tentative and subject to change. The transition requirements remain to be deliberated. Additionally, the boards have not yet concluded whether they will re-expose the proposal. Targeted consultation is ongoing, including a public session with the telecommunications industry held earlier this month. Issues raised during this process might be discussed further before the standard is finalized.
Reprinted from: In brief 201122 May 23, 2011

Amortization of capitalized contract costs
Costs to obtain and fulfill a contract are capitalized if they are incremental and expected to be recovered, and are not addressed by other guidance (for example, guidance for inventory or property, plant and equipment). Capitalized contract costs are amortized on a basis consistent with the pattern of transfer of the related good or service to the customer. The boards clarified that the amortization period may extend beyond the length of the contract when the economic benefit will be received over a longer period. An example might include set-up costs related to contracts likely to berenewed.
The boards also concluded that costs to obtain a contract are not required to be capitalized if the contract period is expected to be less than one year.
Impairment of capitalized contract costs

Impairment of capitalized contract costs is recognized if the carrying amount is greater than the consideration management expects to receive under the contract. This should include consideration expected to be received under anticipatedcontracts. The boards diverged on the day 2 accounting for impairments. Impairment reversals will be required under IFRS, but not allowed under US GAAP, if circumstances change and previously impaired amounts are expected to be recovered.
40
Onerous contracts
Onerous contract accounting was revisited in response to concerns about unintended consequences raised during the consultation process. The boards tentatively decided that the onerous contract test would only be applied to performance obligations that are satisfied continuously. The assessment is still performed at the contract level. While the boards continue to narrow the circumstances under which onerous contract accounting might occur, a number of questions and operational challenges remain. Not-for-profit entities under US GAAP are exempt from performing the onerous contact test. This exemption is not relevant for IFRS preparers.
will include additions, amortization andimpairments. Contract assets and liabilities may be labeled differently in the balance sheet (for example, unbilled receivables). They may also be combined with other balances and disclosed separately in the footnotes if not material for separate presentation. The maturity analysis for remaining performance obligations has been retained, but the boards are still considering whether to limit the scope to certain types of contracts.
Whos affected?

Whats next? Is convergence achieved?

Convergence is expected for revenue recognition, since the same principles should 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. One difference between IFRS and US GAAP related to the reversal of capitalized contract cost impairments, as discussed above, has been proposed. The target date for issuance of a final standard has been extended from June 2011 to the end of 2011.
Presentation and disclosures

The disclosure requirements have changed little from the exposure draft. The boards confirmed the requirements in the exposure draft and tentatively decided: A rollforward of assets arising from the capitalization of costs to obtain and fulfill a contract is required. It
41
Revenue from contracts with customers Key decisions propel the project forward
Whats inside: Overview Key provisions Current developments Next steps Appendix: Redeliberation decisions
Redeliberations by the FASB and IASB (the boards) began in January 2011 and have continued through April. The boards have focused their discussions on common themes in the comment letters, and have reached several tentative decisions. Some decisions confirm conclusions in the exposure draft and others significantly change direction from what was proposed previously. Tentative decisions made during redeliberations address several key areas, including transfer of control, identification of performance obligations, determining the transaction price, accounting for warranties, and accounting for licenses of intellectual property, among others. The key revenue issues yet to be redeliberated include amortization and impairment of capitalized costs, disclosure and transition. The boards recently announced that they plan to issue a final standard by the end of 2011. We expect a likely effective date no earlier than 2015. Full retrospective application will be required unless the boards change their current position.
Reprinted from: Dataline 201119 April 21, 2011
Background
1. The exposure draft proposed a new

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 an entity earns revenue. 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. It moves away from specific measurement and recognition thresholds and removes industry-specific guidance. 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 entitys processes and controls. Management might need to change existing IT systems and internal controls in order to capture
42
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.
be accounted for separately, will require judgment. Management will need to consider a number of variables to estimate the transaction price, including the effects of variable consideration and time value of money. Revenue is recognized when a promised good or service is transferred to the customer. Management will need to assess whether the customer has the ability to direct the use of and receive the benefit from the good or service to determine when revenue should be recognized.
Sale and repurchase arrangements Contract fulfillment costs
7. Areas of focus in January and

February included the following (previously discussed in Dataline 2011-16): Contract acquisition costs Transfer of control Performance obligations Contract segmentation and combination Warranties Onerous performance obligations Breakage

of the proposed standard, certain themes identified in the comment letters, and decisions made during recent board meetings. This Dataline includes all decisions made to date including those discussed in Dataline 201116, Revenue from contracts with customersThe constituents have been heard... The boards conclusions are tentative and subject to change until a final standard is issued.
5. Refer to Dataline 201028, Revenue

RecognitionFull Speed Ahead, and the related industry supplements for a detailed discussion of the key aspects of the proposed model, as well as PwCs response letter submitted to the boards on October 20, 2010.
Collectibility
8. Collectibility refers to the risk that the
customer will not pay the promised consideration. The exposure draft proposed that entities would assess collectibility as part of determining the transaction price.
Key provisions
five steps in recognizing revenue: Identify the contract with the customer Identify the separate performance obligations in the contract Determine the transaction price Allocate the transaction price to distinct performance obligations Recognize revenue when each performance obligation is satisfied PwC observation: The steps in the proposed standard may appear simple, but significant judgment will be required to apply the principles. Determining whether a good or service is distinct, and should
9. The transaction price would be
Current developments
6. The boards have considered many of
the concerns raised by constituents in the comment letter process in their redeliberations. The boards have reached a number of key tentative decisions regarding the proposed revenue recognition model. The most recent discussions in March and April addressed the following issues: Collectibility Time value of money Variable consideration Allocating the transaction price Licenses
adjusted to reflect the customers credit risk by recognizing the consideration expected to be received on a probability-weighted basis. Changes in the consideration expected to be received due to changes in credit risk would be recognized as income or expense, separately from revenue.

the proposal that revenue should be adjusted for credit risk with subsequent changes in other income or expense. They suggested that subsequent changes in the amount of consideration to be received should be recorded in revenue, consistent with other changes in the transaction price.
43
Tentative decisions
11. The boards affirmed that collectibility

of the transaction price will no longer be a hurdle to revenue recognition as it is under todays guidance.
12. The boards decided that the transaction price will not be adjusted to reflect credit risk. Any expected impairment loss will be presented in a separate line item adjacent to revenue to reduce gross revenue to a net amount. Both the initial impairment assessment and any subsequent changes in the estimate will be recorded in this line item. PwC observation: Current guidance requires that revenue cannot be recognized unless collectibility is reasonably assured (under US GAAP) or is probable (under IFRS). Revenue may be recognized earlier than current practice since collectibility will no longer be a recognition threshold. Presenting credit risk as an adjustment to revenue will align net revenue recognized with cash ultimately received from the customer, consistent with other areas of the model. This will help financial statement users who are interested in reconciling revenue with net cash ultimately received from the customer. Amounts shown as bad debt expense will now be presented as a separate line item adjacent to revenue, reducing gross margin. Impairment of receivables could in some situations be recorded earlier than in current practice. The boards have acknowledged
that this decision could create consequences for the impairment model being developed for financial instruments and will therefore need to be discussed further at a future date.
of money when the contract includes a significant financing component.
16. The boards intend to provide factors

to help identify when a significant financing component exists, such as: Whether the consideration would be substantially different if the customer paid in cash when the goods or services transfer to the customer Whether there is a significant timing difference between when the entity transfers the promised goods or services to the customer and when the customer pays for them Whether the interest rate that is explicit or implicit within the contract is significant
Time value of money

13. The boards proposed that the transaction price would reflect the time value of money whenever the effect is material. Management would 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.
14. Many respondents agreed with the

principle but noted that the operational difficulties of applying it in practice would outweigh the benefits. Many also struggled with applying the principle to prepayments when a material financing component exists for a number of reasons, including the inconsistency it creates between the consideration received and the revenue recognized (i.e., revenue recognized will exceed consideration received). Constituents overwhelmingly suggested that time value of money should only be considered in contracts that clearly include a financing component. Those that agreed with the concept asked for further clarification of key inputs into the calculation, including the discount rate.
17. An entity will not reflect the time

value of money in the measurement of the transaction price when the time from transfer of the goods or services to the customer to the payment by the customer is less than one year. PwC observation: We agree with the boards efforts to limit the circumstances where the effects of time value of money should be considered. The twelve-month window provided by the boards is a practical expedient that should benefit entities. Determining whether a significant financing component exists in a contract could be particularly challenging in long-term or multipleelement arrangements where product or service delivery and cash payments occur throughout the arrangement.
Tentative decisions
15. The boards affirmed that the transaction price should reflect the time value
44
Accounting for the effect of the time value of money could result in a considerable change for certain entities, particularly when consideration is paid significantly in advance or in arrears.
18. 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 and performance bonuses. The exposure draft required that the transaction price include the probability-weighted estimate of variable consideration.
that the entity is entitled to under the contract, including variable or uncertain consideration. It should be based on the probability-weighted estimate or most likely amount of cash flows expected from the transaction, whichever best predicts the amount to which the entity is entitled.
amount at inception, and is reassessed at each reporting date. Reasonably assured appears to be a higher hurdle than that proposed in the exposure draft, but a lower hurdle than current practice in some industries. Entities might recognize revenue earlier than under existing guidance if the variable consideration is reasonably assured. Significant change could also occur in industries where revenue is currently restricted to the cash received because revenue is contingent on a future event, especially when the future event is within the entitys control, such as its own performance. Revenue recognition will be constrained in certain situations if the amounts are not reasonably assured. It is unclear whether the three circumstances described by the boards are the only three situations when revenue is not reasonably assured, or if there could be others. The inclusion of a reasonably assured threshold is an exception to the underlying model and inconsistent with the principle of recognizing revenue when control transfers. Often the entity has no further obligation once the rights are transferred to the customer. Transactions that include salesbased royalties or performance bonuses will also require careful assessment to determine when revenue should be recognized. Management will need to evaluate when sales-based royalties and performance bonuses are
23. Revenue is only recognized when

it is reasonably assured, rather than when it can be reasonably estimated.
24. The boards identified three specific

circumstances when revenue would not be reasonably assured: The customer can avoid paying additional consideration, such as when consideration is based on the customers sales, without breaching the contract (e.g., some sales-based royalties). The entity has no experience with similar contracts or no other persuasive evidence. The entity has experience, but the experience is not predictive.

an entity recognize revenue from satisfying a performance obligation only if the transaction price could be reasonably estimated.
20. Some respondents were concerned

about recognizing revenue prior to a contingency being resolved, but many agreed that variable consideration should be included in the transaction price. A significant number of respondents noted that a probabilityweighted approach is not practical and may not be appropriate in certain circumstances, such as when an arrangement has binary outcomes.
25. The entitys experience will be important in assessing whether variable consideration is reasonably assured. Factors such as the number and variability of possible outcomes and the susceptibility of those outcomes to factors outside the entitys influence will need to be evaluated. PwC observation: Entities in some industries may experience a change in the timing of revenue recognition due to the proposed treatment of variable consideration. Variable consideration is included in the transaction price at the probability-weighted or most likely
Tentative decisions
21. Decisions were reached on both

determining the transaction price and recognizing revenue when an arrangement includes variable consideration.
22. The boards affirmed that the transaction price is the consideration
45
reasonably assured, and whether the outcome of the contingency is within the control of the entity before recognizing revenue.
affect one performance obligation. Such changes would be allocated to that performance obligation rather than all performance obligations in the arrangement. PwC observation: We agree with using a relative standalone selling price method for allocating the transaction price. This method is largely consistent with todays guidance. The residual technique proposed by the boards should not be confused with the residual method that has historically been used to allocate the transaction price. The technique proposed should only be used when the standalone selling price of a performance obligation is not known or is highly variable, and the standalone selling prices of the other performance obligations in the arrangement are known. We agree with the boards decisions on allocating changes in the transaction price to the relevant performance obligation. Allowing changes in the transaction price to be allocated to a specific performance obligation should result in a better reflection of the economics of a transaction. Determining when a change in transaction price relates to a specific performance obligation will require judgment and may affect the timing of revenue recognition.
Allocating the transaction price

26. The exposure draft stated that the
transaction price should be allocated to separate performance obligations in a contract based on relative standalone selling prices.
of intellectual property based on whether the customer obtained control of the asset. The contract would be a sale, rather than a license or a lease, if the customer obtained the exclusive right to use the intellectual property for its entire economic life. The entity would recognize revenue when control of the intellectual property transferred to the customer if the transaction was a sale.
32. The performance obligation relating

to the license would be satisfied over the term of the license period if the license was exclusive but the customer did not obtain control of the intellectual property for its entire economic life. The entity would recognize revenue over the term of the license in this situation.
27. Some respondents noted that in

certain circumstances this might not reflect the economics of the transaction such that alternative methods should be considered.
Tentative decisions
33. A contract for a non-exclusive license

for intellectual property (e.g., offthe-shelf software) would be a single performance obligation. An entity would recognize revenue when the customer is able to use the license and benefit from it, which is when control transfers to the customer, but no earlier than the beginning of the license period.
28. The boards concluded that the

principle of allocation based on the relative standalone selling price of separate performance obligations in the contract should be retained.
29. A residual technique may be used to

calculate the standalone selling price when there is significant variability in one or more performance obligations (regardless of whether that performance obligation is delivered at the beginning or end of the contract).
34. Respondents generally disagreed with

the proposed guidance, particularly with exclusivity driving the timing of revenue recognition. Comments suggested that further clarification of the identification of the performance obligation in a license of intellectual property was needed. Many noted that revenue should be recognized once the performance obligation has been satisfied, regardless of whether the license is exclusive or non-exclusive.
30. Pricing of individual performance

obligations, including any inherent discount in the arrangement, should be considered when allocating the initial transaction price and when assessing subsequent changes. Changes to the transaction price, including changes in the estimate of variable consideration, might only
Licenses
31. The exposure draft required recognition of revenue for the license
46
Tentative decisions
35. The boards decided to remove the

requirement to distinguish between exclusive and non-exclusive licenses in response to feedback from respondents.
36. A license will be evaluated under the

same principles as other goods and services in the model. A license is a single performance obligation that may be satisfied at a point in time or continuously depending on when the customer obtains the rights associated with the license. PwC observation: We believe that the removal of the distinction between exclusive and non-exclusive licenses should more closely align the accounting for licenses with the performance obligation concept underpinning the revenue exposure draft. Determining when the performance obligation relating to a license is satisfied will require judgment and could result in earlier revenue recognition than current practice. Revenue might not be recognized immediately if the license is not separable from other goods or services in the contract, or if there is an element of variable consideration that is not reasonably assured.
financing arrangements or leases depending on the repurchase price, and puts would be classified as rights of return. Only puts transferred control of the good to the customer and thus resulted in revenue being recognized.
of other standards (e.g., inventory, fixed assets, intangibles) to determine which costs may be recognized as an asset. These costs would be accounted for in accordance with the relevant standards.
41. An entity would recognize an asset

for costs that are not in 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. Entities might capitalize the following costs under the proposed standard: Direct labor, including salaries and wages Direct materials, including inventory Allocations of costs, including contract management and depreciation Costs that are explicitly chargeable to the customer under the contract Other costs incurred only as a result of entering into the contract
Tentative decisions
38. The boards concluded that arrangements where a customer has the right to require the entity to repurchase an asset (a put option) should be accounted for as an operating lease (i.e., 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. PwC observation: Management will need to assess the nature of put arrangements to determine whether the arrangement should be accounted for as a lease, as this determination is critical to applying the accounting model.
Contract costs
39. The exposure draft included specific
guidance for accounting for costs associated with obtaining and fulfilling contracts with customers. An entity would expense costs to obtain a contract (e.g., costs of selling, marketing, or advertising) as incurred.
42. Capitalized costs should be amortized

and recognized as cost of sales as the entity transfers the underlying goods or services that relate to the asset.

the proposed accounting for contract costs, but were concerned about expensing all contract acquisition costs.
Sale and repurchase agreements

37. The exposure draft addressed three
types of sale and repurchase arrangements: options, calls and puts. The exposure draft proposed that options and calls would be classified as
40. An entity would capitalize the costs

to fulfill a contract in certain circumstances. Management would need to evaluate whether the costs incurred to fulfill a contract are in the scope
Tentative decisions

should recognize an asset for the incremental costs to obtain a contract
47
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.
to payments made to a customer to enter into a customer-vendor relationship. The guidance on fulfillment costs is largely unchanged from the exposure draft. Entities that currently expense all contract costs as incurred might be affected since assets are required to be recorded when the criteria are met. Costs likely to be in the scope of this guidance include set up costs for service providers, and costs incurred in the design phase of construction projects, amongst others.
and services to a customer, but modified the guidance as follows: Added risks and rewards of ownership as an indicator of control Eliminated the design or function of the good or service is customerspecific as an indicator of control
45. An asset recognized for the costs

of obtaining a contract should be presented separately in the statement of financial position and amortized on a systematic basis as the goods or services to which the asset relates are transferred to the customer.
52. The boards affirmed that an entity

should recognize revenue for the sale of a good when the customer obtains control of the good.
46. The boards confirmed that fulfillment

costs are in the scope of the revenue standard only if they are not covered by other standards. Costs cannot be capitalized under the revenue standard if they must be expensed under other applicable standards.

should recognize revenue as a service if the performance obligation is satisfied continuously. Management should select a method for measuring progress in satisfying the performance obligation that depicts the transfer of benefit to the customer.
Transfer of control
49. The exposure draft stated that
revenue should be 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 when it has the ability to direct the use of and receive the benefit from the good or service.
47. Costs should be capitalized if they

are directly related to the contract, generate or enhance resources of the entity, and will be used to satisfy performance obligations in the future, and are expected to be recovered.
54. A performance obligation is satisfied

continuously if: the entitys performance creates or enhances an asset that the customer controls, or the entity's performance does not create an asset with alternative use to the entity, and: the customer immediately receives a benefit from each task performed, another entity would not need to reperform the task(s) if that other entity were required to fulfill the remaining obligation to the customer, or the entity has a right to payment for services performed to date even if the customer could cancel the contract for convenience.
48. The guidance on abnormal costs will

be clarified to be consistent with the guidance on inventory. Abnormal costs are costs that were not considered in the price of the contract and will not be reimbursed. These costs should be expensed as incurred. PwC observation: We agree with the tentative decisions regarding contract acquisition costs. Certain costs of obtaining a contract should be capitalized if they are incremental and will be recovered under the contract. We believe this guidance should also apply

recognizing revenue when control transfers. However, many requested clarification to help assess when control transfers continuously, especially in service contracts. -
Tentative decisions
51. The boards confirmed the core principle that an entity should recognize revenue to depict the transfer of goods
48

should recognize revenue for a service only if the entity can reasonably measure its progress toward completion of the service. They also clarified that the objective is to faithfully depict the pattern of transfer of the goods or services to the customer. The boards did not prescribe a method to use, but continue to emphasize that output measures might best reflect the transfer in many situations.
There may still be arrangements that are not clearly the sale of a good or a service that will require judgment to determine the appropriate recognition model. The manufacture or construction of a good might meet the criteria for continuous transfer of control and thus be accounted for as a manufacturing service or a construction service with revenue recognized on a continuous basis.
Tentative decisions
60. The boards did not fundamentally

change the definition of a performance obligation, but they did delete enforceable from the definition. They also clarified that promises implied by an entitys business practices are performance obligations if they create expectations of performance.
61. The boards concluded that the objective of separating distinct performance obligations is to depict the transfer of goods or services and the profit margin attributable to them. The boards retained the principle of distinct goods or services as the basis for identifying separate performance obligations, but revised the criteria for determining if a good or service is distinct.
56. An entity first determines whether

the goods and services are distinct (in accordance with the guidance on identifying separate performance obligations) if more than one good or service is promised in the contract.
58. The exposure draft defined a performance obligation as an enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. Performance obligations may be explicit in contracts, but they may also arise in other ways. Legal or statutory requirements may create performance obligations even though such obligations are not explicit in the contract. Customary business practices, such as a practice of providing customer support, might also create a performance obligation.
57. Distinct goods and services would be

accounted for as separate performance obligations. The entity would account for the bundle of goods and services as a service if they are not distinct. PwC observation: We agree that an entity should distinguish between situations where an asset is and is not being created to determine how revenue is recognized. This will make the accounting for services easier to apply and potentially more consistent with existing guidance. It is unclear whether the performance obligation should be viewed from the perspective of the vendor or the customer, which could create diversity in practice. This could be clarified by adding that a performance obligation represents the good or service that the customer reasonably expects to receive when entering into the contract based on the contract terms and the vendors customary business practices.
62. A performance obligation is distinct if

the entity regularly sells the good or service separately. A good or service might be distinct if not sold separately if the customer can use the good or service on its own or together with resources readily available to the customer.

subjectivity in identifying performance obligations and the potential for similar transactions to be accounted for differently. Most agreed with the principle, but wanted further clarification on how to identify a performance obligation. There were mixed responses regarding the concept of distinct performance obligations and many respondents disagreed that profit margin is relevant in assessing separation of performance obligations.

should account for a bundle of goods or services as one performance obligation if the entity provides an integration service.
64. The boards also decided that it is

not necessary to include additional requirements on accounting for perfunctory, incidental or other similar obligations. PwC observation: We agree that distinct performance obligations should be identified and accounted
49
for separately, and support the boards decision to eliminate the requirement that a performance obligation have a distinct profit margin in order to be considered distinct when not sold on a standalone basis. We are concerned, however, that the guidance is not clear how significant an integration service needs to be to result in accounting for a bundle of goods or services as a single performance obligation. Bundling distinct goods and services together when the integration service is insignificant might not reflect the underlying economics of the arrangement.
guidance from the final standard will simplify the model. We believe it is not necessary to segment a single contract into two or more contracts, and note that the proposed accounting for segmentation was difficult to understand and apply. Clear and well-understood guidance for the separation of distinct performance obligations, treatment of contract modifications and adjustments to variable consideration should be sufficient.
depends on the performance of the other contract Whether the goods and services in the contracts are closely interrelated or interdependent in terms of design, technology, or function PwC observation: Combining two or more contracts as a single contract if they are interrelated should promote accounting that reflects the economics of the entire arrangement. The criteria identified by the boards for combining contracts is consistent with todays guidance and should be wellunderstood in practice.
Contract combination
two or more contracts would be combined into one if the prices of those contracts are interdependent. The price of a contract would not be interdependent with the price of another contract solely because the customer receives a discount on goods or services in the contract as a result of an existing customer relationship arising from previous contracts.
Warranties
70. The proposed model distinguished
between a warranty for latent defects and a warranty for post-transfer defects. A latent defect warranty provides a customer with coverage for defects that exist when the asset is transferred to the customer, but that are not yet apparent. This warranty would not give rise to a separate performance obligation but recognizes the possibility that the entity did not satisfy its performance obligation. In other words, the entity did not provide an asset that operated as intended at the time of delivery. An entity would not recognize revenue at the time of sale for a defective product that it would subsequently replace in its entirety. Revenue would be 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 will be repaired or replaced.
Segmentation
65. The exposure draft required a single
contract be segmented into two or more contracts if some goods or services within the contract are priced independently from other goods or services in that contract.
66. Some constituents recommended that

current segmentation guidance be retained for long-term contracts, but many respondents noted that segmentation guidance is not needed if the principle for identifying separate performance obligations is clear.
Tentative decisions
69. The boards decided that interrelated

contracts should be combined. To be interrelated, the contracts should be entered into at or near the same time with the same counterparty. The boards also decided that the following indicators should be considered to determine if contracts are interrelated: Whether the contracts are negotiated as a package with a single commercial objective Whether the amount of consideration received in one contract
Tentative decisions
67. The boards concluded that a contract

should not be segmented into two or more contracts. An entity will identify separate performance obligations in a contract. PwC observation: Eliminating the contract segmentation
50
71. The proposals also required that a

warranty that provides the customer with coverage for faults that arise after the entity transfers control to the customer (e.g., normal wear and tear) gives rise to a separate performance obligation. The entity would allocate a portion of the transaction price to the warranty obligation at contract inception.
The entity should account for the warranty as a cost accrual if it is not sold separately, unless the warranty provides a service in addition to a standard warranty.
76. Respondents generally disagreed

with the proposed accounting for onerous performance obligations, and commented specifically that the proposed guidance may not reflect the underlying economics of the transaction. Respondents also suggested that if guidance for recording onerous obligations is included in the final standard, the assessment should be performed at the contract level rather than the performance obligation level.
74. The boards will develop implementation guidance to help an entity determine when a warranty provides a service in addition to a standard warranty. PwC observation: The revised proposal provides a practical expedient to accounting for warranties and is generally consistent with current guidance. However, operational difficulties may be encountered in separating standard warranties from those that also provide a service. Determining the estimated standalone selling price for the latter category when such warranty service is not sold separately could also be challenging.

the distinction between a warranty for latent defects and a warranty that provides coverage for faults that arise after transfer of control, noting the operational difficulties in distinguishing between the different types of warranties. Some also suggested that the current warranty models should be retained (both for standard and extended warranties) as they are understood in practice and reflect the substance of the warranty obligations.
Tentative decisions
77. The boards changed the unit of

account for onerous contract provisions from the performance obligation level to the contract level. A provision for an onerous contract is recorded if the remaining costs to satisfy the performance obligations in the contract exceed the remaining revenue to be recognized. This guidance also applies to contracts that are intentionally priced at a loss with the expectation of profits on subsequent contracts with the customer (for example, loss leaders).
Tentative decisions

should account for some warranties as a warranty obligation (that is, a cost accrual) in accordance with the guidance on provisions and contingencies (IAS 37 and ASC 450) and others as performance obligations with revenue allocated to the warranty service. The following criteria should be considered to determine whether a warranty should be accounted for as a cost accrual or as a separate performance obligation: The entity should account for the warranty as a separate performance obligation if the customer has the option to purchase the warranty separately from the entity.

75. The exposure draft required assessment of each performance obligation at contract inception and at each reporting date to determine whether the obligation was onerous. A performance obligation would be onerous if the present value of the probabilityweighted direct costs to satisfy the obligation exceeded the transaction price allocated to it. The assessment would be updated each reporting date using current estimates. Any changes in the measurement of the liability would be recorded as an expense or a reduction of an expense.
78. The boards decided that direct

costs should be used in the onerous contract test. If a contract is subsequently cancelled, the entity would account for the cancellation based on the terms of the contract or in accordance with IAS 37 or ASC 450. PwC observation: We continue to believe that provisions for onerous contracts are cost accruals, not an issue in the recognition or measurement of revenue, and should be addressed in the relevant liability or contingency standards. Measuring provisions for onerous contracts
51
using all of the direct costs that relate to satisfying that contract will result in more onerous contract provisions being recorded than using only the direct incremental costs of fulfilling the obligation. There are a number of operational challenges beyond determining the appropriate costs to consider in the assessment. Management will need to pay particular attention to contracts with decreasing revenue streams and flat or increasing costs as performance obligations are satisfied. These contracts could become onerous even if the contract is profitable overall. The proposed guidance will also have the effect of accelerating losses for loss leader contracts.
recognition. Entities would consider the impact of breakage in determining the transaction price allocated to the performance obligations in the contract.
Tentative decisions
80. The boards agreed that two models may

be applied when recording revenue from breakage in a contract, depending on the circumstancesa proportional model and a remote model.
PwC observation: We agree with the boards proposed accounting for breakage, and expect practice to generally remain consistent with todays application. Allocation of the transaction price can be affected depending on the model applied for breakage.
Next steps
83. The boards will continue to redeliberate the remaining issues in the coming months, and perform targeted outreach to key industries and other interested parties regarding some of the more significant changes. The boards timeline indicates voting on a final standard in June 2011 and issuing the standard in the second half of 2011.
81. The proportional model should be

applied when an entity can reasonably estimate breakage. Revenue related to expected breakage is recognized in proportion to the pattern of transfer of goods or services to the customer.
82. An entity should apply the remote

model when it is unable to reasonably estimate breakage. This model precludes recognizing revenue from breakage until the likelihood of the customer exercising their rights under the contract becomes remote.
Breakage
79. The accounting for breakage (forfeitures) under the proposed standard may affect the timing of revenue
84. A few key issues remain to be redeliberated, including amortization and impairment of capitalized costs, disclosure and transition.
52
Appendix Redeliberation decisions
Topic Combining contracts
Exposure draft An entity should combine two or more contracts if the prices of those contracts are interdependent.
Tentative decision An entity should combine two or more contracts if they are interrelated. Contracts entered into at or near the same time with the same counterparty that meet one or more of the following criteria are interrelated: The contracts are negotiated as a package with a single commercial objective The amount of consideration in one contract depends on the other contract The goods and services in the contracts are interrelated in terms of design, technology and function
Segmenting contracts
An entity does not need to segment a contract. A single contract should be segmented into two It should account for separate performance or more contracts if some goods or services within the contract are independently priced from obligations that are identified in the contract. 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 (i.e., treat the modification and original contract as one 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 commensurate with that additional performance obligation.
53
Topic Performance obligations
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 the 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.
Tentative decision Performance obligations are promises in a contract to transfer goods or services to a customer. Promises implied by an entitys business practices are performance obligations if they create expectations of performance. A distinct performance obligation exists 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 bundle of goods or services is accounted for together if the entity integrates those goods or services into a single item provided to the customer. Warranties that the customer has the option of purchasing separately are accounted for as a separate performance obligation. The entity should account for the warranty as a cost accrual if not sold separately unless the warranty provides a service in addition to a standard warranty.
Identification of separate performance obligations
Warranties
Warranties for latent defects are treated as a failed sale. 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 (e.g., normal wear and tear) give rise to a separate performance obligation.
54
Topic Variable consideration
Exposure draft The transaction price is the amount of 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:
Tentative decision 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 expected from the transaction, depending on which is most predictive of the amount to which the entity is entitled.
Has experience with similar types of contracts, Revenue is only recognized when it is reasonably assured. and Does not expect circumstances surrounding those types of contracts to change significantly Collectibility Collectibility is not a hurdle to recognition of revenue. The transaction price is adjusted to reflect the customers 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. Time value of money The transaction price reflects the time value of money whenever the contract includes a material financing component. 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 to reduce revenue to a net amount. Both the initial impairment assessment and any subsequent changes in the estimate of collectibility are recorded in this line. The transaction price should reflect the time value of money when the contract includes a significant financing component. Additional factors for when a significant financing component exists will be provided to address practical issues. An entity will not reflect 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.
55
Topic Allocation method
Exposure draft The transaction price is allocated to separate performance obligations based on the relative standalone selling price of the performance obligations in the contract. An entity may not use the residual method to allocate the transaction price.
Tentative decision The transaction price is allocated to separate performance obligations based on the relative standalone selling price of the performance obligations in the contract. A residual value technique may be used as a method to estimate the standalone 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. Pricing of individual performance obligations, including any inherent discount in the arrangement, should be considered when allocating the transaction price and when assessing subsequent changes. Some elements of the transaction price, such as uncertain consideration, discounts or change orders, might affect only one performance obligation rather than all performance obligations in the contract.
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 it can reasonably estimate the amount of expected breakage. The entity should recognize the effects of the expected breakage when the likelihood of the customer exercising its remaining rights becomes remote if it cannot reasonably estimate the amount of expected breakage.
56
Topic Transfer of control goods
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.
Tentative decision 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 Performance obligations can be satisfied at a point in time or continuously over time. Indicators The customer has risks and rewards of ownership 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 Continued
57
Topic Continued from previous page Satisfying a performance obligationservices
Exposure draft
Tentative decision
The exposure draft had no specific guidance for services. The guidance was the same as for goods above.
An entity must determine that a performance obligation is satisfied continuously to recognize revenue for a service, then 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 continuously if (a) the entitys performance creates or enhances an asset that the customer controls, or (b) the entitys performance does not create an asset with alternative use to the entity but: the customer immediately receives a benefit from each task performed, another entity would not need to re-perform the 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 even if the customer could cancel the contract for convenience. Distinct goods and services are accounted for as separate performance obligations. The entity accounts for the bundle of goods and services as a service if the performance obligations are not distinct. Continued
58
Topic Continued from previous page
Exposure draft
Tentative decision
Methods for recognizing revenue when control Measuring progress transfers continuously include: of satisfying a performance obligation 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 entitys performance to date (e.g., surveys of goods or services transferred to date, appraisals of results achieved). Input methods recognize revenue on the basis of inputs to the satisfaction of a performance obligation (e.g., time, units delivered, resources consumed, labor hours expended, costs incurred, and machine hours used). The entity should select an appropriate input method if an output method is not directly observable or available to an entity at a reasonable 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 goods are transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials). Continued
59
Topic Continued from previous page Constraint on recognizing revenue
Exposure draft
Tentative decision
Amounts are only included in the transaction price allocated to performance obligations if they can be reasonably estimated.
Revenue is recognized when the performance obligation is satisfied and the transaction price to which the entity is entitled is reasonably assured. Revenue is not reasonably assured when: (1) the customer can avoid paying additional consideration, such as with some sales-based royalties; (2) the entity has no experience with similar contracts or other persuasive evidence; or (3) the entity has experience, but that experience is not predictive.
The recognition of revenue for the license of intellectual property depends on whether the customer obtains control of the asset. 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., 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.
The promised rights give rise to a performance obligation that the entity satisfies at the point in time when the customer obtains control (that is, the use and benefit) of the 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 if there are others in the contract.
60
Other consideratinos
Topic Costs of obtaining a contract
Exposure draft An entity recognizes costs to obtain a contract (e.g., costs of selling, marketing, or advertising) as incurred.
Tentative decision 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 revenue guidance only if they are not addressed by other standards. Costs required to be expensed by other 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 costs relate specifically to an anticipated contract. 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.
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 (e.g., 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 probability-weighted direct costs to satisfy the obligation exceed the consideration (i.e., the amount of transaction price) allocated to it.
Onerous contract losses should be assessed at the contract level, considering the remaining performance obligations in a contract and the revenue remaining to be recognized. The remaining performance obligations in a contract are onerous if the direct costs associated with satisfying them exceed the consideration (i.e., the amount of transaction price) allocated to them. Costs to terminate a contract will not be reflected until the entity is committed to cancelling the contract and has the right to do so.
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 an operating lease under the leasing standard if the arrangement represents a right to use the asset over time rather than a sale.
61
Key decisions propel the joint revenue project forward
Whats new?
The FASB and IASB (the boards) met in April to discuss their joint project on revenue recognition. They reached tentative decisions on transaction price, variable consideration, contract fulfillment costs, licenses and customer put options. These decisions are tentative and subject to change. The boards extended the target date for issuance of a final standard from June 2011 to the end of 2011. The boards emphasized their focus on producing highquality standards and evaluating stakeholder feedback.
Reprinted from: In brief 201114 April 15, 2011

Determining the transaction price
The transaction price is the consideration that the entity is entitled to under the contract, including variable or uncertain consideration. It should be based on the probability-weighted estimate or most likely amount of cash flows expected from the transaction, depending on which is most predictive of the amount to which the entity is entitled.
Pricing of individual performance obligations, including any inherent discount in the arrangement, should be considered when allocating the transaction price and when assessing subsequent changes. Some elements of the transaction price, such as uncertain consideration, discounts or change orders, might affect only one performance obligation rather than all performance obligations in the contract.
Recognizing revenue from variable or uncertain consideration

Revenue is only recognized when the transaction price is reasonably assured of being received. Revenue is not reasonably assured when: (1) the customer can avoid paying additional consideration, such as when consideration is based on the customers sales (e.g., some sales-based royalties); (2) the entity has no experience with similar contracts or other persuasive evidence; or (3) the entity has experience, but that experience is not predictive.

The transaction price is allocated to separate performance obligations based on the relative standalone selling price of the performance obligations in the contract. A residual value technique may be used to estimate the standalone selling price when there is significant variability or uncertainty in the standalone selling price of one or more performance obligations, regardless of whether that performance obligation is delivered at the beginning or end of the contract.
62
Contract costs
Costs to fulfill a contract are in the scope of the revenue guidance only if they are not addressed by other standards. Costs required to be expensed by other standards cannot be capitalized under the revenue guidance. Costs likely to be in the scope of the revenue guidance include set-up costs for service providers and costs incurred in the design phase of construction projects. Fulfillment costs are capitalized if they are directly related to a contract (or anticipated contract), generate or enhance the entitys resources and are expected to be recovered. Asset recognition is required when the criteria are met.
Whos affected?
Licenses
The distinction between exclusive and nonexclusive licenses in the exposure draft has been removed. Licenses should be evaluated under the same principles as other goods or services, with revenue recognized when the performance obligation is satisfied, which is when the customer obtains control of the rights.

Customer put options

Arrangements where a customer has the right to require the entity to repurchase an asset (a put option) should be accounted for as an operating lease under the leasing standard if the arrangement represents a right to use the asset over time rather than a sale.
Whats next?
The target date for issuance of a final standard has been extended from June 2011 to the end of 2011. The key revenue issues yet to be redeliberated include amortization and impairment of capitalized costs, disclosure and transition.
63
FASB and IASB march closer to completion on key revenue recognition issues
Whats inside: Whats new? What are the key decisions and developments? Is convergence achieved? Whos affected? Whats the effective date? Whats next?
Whats new?
The FASB and IASB (the boards) met three times in March to discuss their joint project on revenue recognition. The boards reached tentative decisions on the impact of collectibility and the time value of money on the transaction price, and the accounting for onerous contracts. These decisions are tentative and subject to change. The boards also discussed the impact of variable consideration on the transaction price and will continue debating the issue in April. A number of other key issues remain to be redeliberated, including allocation of transaction price, contract costs, accounting for licenses, disclosure and transition.
Reprinted from: In brief 201111 March 25, 2011
What are the key decisions and developments?

Collectibility
Collectibility refers to risk that the customer will not pay the promised consideration. Many respondents disagreed with the proposal that revenue should be adjusted for credit risk, with subsequent changes in other income or expense. The boards affirmed that collectibility of the transaction price will no longer be a hurdle to revenue recognition as it is under todays guidance. However, in a change to the proposal in the exposure draft, the boards agreed that the transaction price will be presented without adjustment for credit risk. An allowance for the expected impairment loss on receivables will be presented in a separate line item adjacent to revenue. Both the initial impairment assessment and any subsequent changes in the estimate of collectibility will be recorded in this line.
Time value of money

The boards affirmed the proposal in the exposure draft that the transaction price should reflect the time value of money when the contract includes a significant financing component. The boards intend to provide additional factors for when a significant financing component exists to address respondents concerns about practical issues. The boards have also tentatively decided that, as a practical expedient, an entity will not need to reflect 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.
Onerous contracts
Onerous contract losses will be assessed at the contract level, rather than the performance obligation level. This includes contracts that are intentionally priced at a loss with the expectation of profits on
64
subsequent contracts with the customer (for example, loss leaders). The boards also concluded that direct costs should be used to determine whether a contract is onerous. Costs to terminate a contract will not be reflected until the entity is committed to cancelling it and has the contractual right to do so. Cancelling the contract may also give rise to other obligations to be accounted for in accordance with provisions and contingencies guidance. The onerous contract guidance will generally result in earlier recognition of losses compared to todays accounting.
Convergence is expected for revenue recognition, since the same principles should be applied to similar transactions under both frameworks.
Whos affected?
The transaction price is the consideration the customer promises to pay in exchange for goods or services. It may include an element that is variable or contingent on the outcome of future events. Some respondents were concerned about recognizing revenue before a contingency is resolved. The boards have extensively discussed alternative approaches, but have not reached a conclusion. The boards did not conclude on how to address situations where consideration is based on future sales of the customers products to another party (for example, sales-based royalties) or on an index value in the future (for example, performance-based fees for assets under management). These arrangements are common in certain industries, including pharmaceutical, entertainment and media, and asset management. The boards will continue redeliberations on variable consideration in April.

Whats next?
The boards timeline indicates a final standard in June 2011. The boards will continue to redeliberate over the next few months and perform targeted consultation with key industries and other interested parties for some of the more significant changes.
65
USGAAP Convergence & IFRS Revenue recognition: Automotive industry supplement

March 2011
Revenue recognition . . . full speed ahead Automotive industry supplement

Whats inside: Overview Product warranties Revenue from tooling arrangements Customer incentives Contract costs Financing arrangements Contract modifications Repurchase options
Overview
The automotive sector includes a broad group of participants, including suppliers, original equipment manufacturers (OEMs), and dealers. Entities in the automotive sector will likely be affected by the proposed revenue recognition guidance, which will replace current USGAAP and IFRS guidance on revenue recognition. Key areas that may be affected by the proposed guidance include the accounting for product warranties, pre-production activities (e.g., pre-production tooling arrangements), marketing incentives (e.g., cash rebates), volume rebates, repurchase options, contract costs, and lease financing arrangements. This paper, examples, and related assessments are based on the Exposure Draft, Revenue from Contracts with Customers, issued in June 2010. The examples reflect the potential impact of the proposed standard. The conclusions are subject to further interpretation and assessment based on the final standard. For a more comprehensive description of the proposed standard, refer to PwCs Dataline 201028 or visit www.fasb.org.
Reprinted from: Dataline 201028 (Supplement) November 22, 2010
Revenue recognition: Automotive industry supplement
Product warranties
Product warranties are commonplace in the automotive industry. Both OEMs and suppliers routinely provide product warranties to their customers. For example, suppliers generally provide a standard warranty to all customers that
the product is free of latent defects (that is, those that exist when the product is transferred to the customer but not yet apparent) for a specified, usually short, period. OEMs provide a standard warranty on vehicles for a certain number of years or a specified mileage. OEMs might provide an extended warranty in addition to the standard warranty coverage. Current US 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.
The proposed standard draws a distinction between warranties that protect against latent defects and warranties that provide coverage for faults that arise after the product is transferred to the customer (e.g., normal wear and tear).
Proposed standard A product warranty that provides coverage for latent defects does not give rise to a separate performance obligation but may indicate that the entity has not satisfied its performance obligation to transfer the product to the customer. Management will need to determine the likelihood and extent of defects in products sold to customers at each reporting date to determine the extent of unsatisfied performance obligations. Revenue is not recognized at the time of sale for defective products that will be replaced in their entirety. Revenue is not recognized for components of a product that will have to be replaced. Revenue for these products is recognized when control transfers, which is generally the earlier of when the products are replaced or repaired or when the warranty period expires. A product warranty that provides coverage for faults arising after the product is transferred is a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. Revenue is recognized as the warranty services are provided.
Current IFRS IFRS addresses two types of warranties: standard warranties; and extended warranties. Revenue is typically recognized at the time of sale for a standard warranty, with a corresponding provision 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.
Potential impact: The proposal will have a substantial impact for OEMs and suppliers that provide warranties. Accounting for warranty costs has historically required estimates, but the proposed standard may increase the subjectivity by requiring management to determine the objective of product warranties and allocate a portion of the transaction price to those warranties. A standard warranty provided by an OEM today might have the objective of covering both latent defects and faults arising after the product is transferred, for example. Revenue associated with products with latent defects will be deferred under the proposed standard. A liability is recorded for the deferred revenue and an asset is recorded for the cost of the inventory that has not yet transferred to the customer in the condition promised. Management will need to consider the value of the defective products when measuring and recording the asset. For example, if the defective product would be scrapped and has little or no value, the asset would be impaired. There is generally a matching between the recognition of revenue and the accrual of warranty expense under existing guidance. The proposed guidance requires the deferral of the margin on products with latent defects until the earlier of when the warranty obligation is fulfilled (that is, the products are replaced or repaired) and when the warranty period expires.
Example 1Accounting for warranties intended to cover latent defects

Facts: An entity sells its product with a 90-day standard warranty covering latent defects. The entity will repair or replace defective components of the product under the standard warranty. How does the entity account for the warranty? Discussion: The standard warranty is not a separate performance obligation because it is intended to cover latent defects. The entity will need to estimate at contract inception the selling price of the product components that will require repair or replacement based on available information and the entitys experience. The warranty provides for repair or replacement of the components that are defective (rather than complete product replacement). Contract revenue is therefore allocated to the components expected to be defective on a relative selling price basis. Revenue is deferred for the components expected to be defective until the customer receives control of those components without defects, which is generally the earlier of when the defects are repaired or replaced or when the warranty period expires.
Example 2Accounting for warranties intended to cover normal wear and tear
Facts: An entity sells its product with a 90-day standard warranty covering latent defects. The customer also purchases an extended warranty that provides for an additional 18 months of coverage. The extended warranty is intended to cover normal wear and tear. How does the entity account for the extended warranty? Discussion: The standard warranty is accounted for consistent with the standard warranty described in Example 1 above because it covers latent defects. The extended warranty is a separate performance obligation because it covers faults that arise after the product is transferred to the customer. The entity will allocate the transaction price (that is, contract revenue) on a relative estimated selling price basis to the product and the extended warranty. Revenue allocated to the extended warranty is recognized over the expected term of the extended warranty contract.
Revenue from tooling arrangements

Tooling arrangements are common between OEMs and suppliers. A supplier may construct a tool for sale to the OEM and also enter into a supply arrangement to sell the output from the tool to the OEM, for example. Consideration for the tooling
might be received through an increase in the sales price of the output from the tool in this situation. Revenue is generally recognized today as the parts are delivered by the supplier to the OEM when tooling is recovered through an increase in the sales price of the output from the tool. Revenue might also be recognized following the percentage-of-completion or completedcontract method. Current US GAAP For arrangements in the scope of contract accounting, combining contracts is permitted provided certain criteria are met, but it is not required as long as the underlying economics of the transaction are fairly reflected. Arrangements with multiple deliverables that are not in the scope of contract accounting are required to be combined if they are with same or related entities and are negotiated at the same time. Arrangements with multiple deliverables that are not in the scope of contract 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 stand-alone basis, there is objective and reliable evidence of the fair value of the undelivered item(s) and the delivery of the undelivered item(s) is probable and substantially within the control of the vendor.1
The proposed standard includes criteria that should be considered to determine whether two or more contracts should be combined and accounted for as one. The proposed standard also requires the identification of the distinct performance obligations in the contract, which is important to determine when revenue is recognized.
Proposed standard Combining/segmenting contracts Two or more contracts are combined and accounted for as one contract if their prices are interdependent. A contract is segmented into more than one contract and accounted for separately if prices for goods and services within that contract are independent.
Current IFRS For arrangements in the scope of contract accounting, combining contracts is required where two or more transactions are linked and combination is necessary to reflect the commercial (that is, economic) substance of the transactions. Separating the components in a contract may be necessary to reflect the economic substance of a transaction. Separation is appropriate when the identifiable components have standalone value and their fair value can be measured reliably.
Potential impact: We anticipate that the proposed guidance related to combining contracts will not result in a substantial change in practice.
1 New multiple element guidance (required to be adopted for calendar year-end companies effective January 1, 2011) eliminates the requirement for objective and reliable evidence of the fair value of the undelivered item(s).
Proposed standard Identifying performance obligations and recognizing revenue The proposed standard requires entities to identify the distinct performance obligations in an arrangement and allocate the transaction price to each performance obligation. An entity recognizes revenue from performance obligations separately if they are distinct from other goods or services promised in the contract and are delivered separately. A good or service is distinct if the entity or another 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. A good or service has a distinct function if it provides utility either on its own or together with other goods or services available in the marketplace. A good or service has a distinct margin if it is subject to distinct risks and the entity can identify the resources needed to provide the good or service. 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 continuously over the contract period. Factors to consider in assessing control transfer include, but are not limited to: 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 The ability to borrow against the asset, for example, may be another control transfer factor to consider. No one factor is individually determinative.
Current US GAAP
Current IFRS
For arrangements in the scope of contract accounting, revenue is recognized using the percentage-of-completion method when reliable estimates are available. When reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (e.g., when the scope of the contract is ill-defined 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. The completed-contract method is required when reliable estimates cannot be made. For arrangements not in the scope of the contract accounting guidance, revenue is generally recognized once the risks and rewards of ownership have transferred to the customer. For arrangements with multiple deliverables (not in the scope of contract accounting), consideration is allocated among the separate units of accounting based on their estimated stand-alone selling prices. The applicable revenue recognition criteria are considered separately for separate units of accounting.
For arrangements in the scope of contract accounting, revenue is recognized using the percentage-of-completion method when reliable estimates are available. When reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (e.g., 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. The completed contract method is not permitted. For arrangements not in the scope of the contract accounting guidance, revenue is recognized once 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 entity. The costs incurred can be measured reliably. For arrangements with multiple deliverables, revenue is allocated to individual deliverables of a contract, but specific guidance is not provided on how the consideration should be allocated. The applicable revenue recognition criteria are considered separately for the separate deliverables.
Potential impact: The proposed guidance will require suppliers that enter into tooling arrangements to use judgment to determine when it is appropriate to recognize revenue. This will include identifying the performance obligations, determining the transaction price, and allocating the transaction price to the performance obligations. The overall effect of the proposed standard to a supplier will depend largely on the terms of the arrangements and the existing accounting practices for such arrangements. For example, when the price of tooling constructed by a supplier for an OEM is recovered through the sales price of parts supplied to the OEM, there are likely to be two performance obligations. We expect that identifying separate performance obligations for tooling and for the production of parts may result in revenue recognition earlier than under existing guidance. Today, revenue is generally recognized under these arrangements as the parts are delivered by the supplier. Revenue for the tooling is likely to be recognized before the transfer of parts under the proposed standard if control of the tooling transfers to the OEM.
Example 3Combining contracts

Facts: On January 1, 200X, Supplier enters into a contract with OEM to construct tool Y. Ownership of tool Y will transfer from Supplier to OEM. Separately, on January 23, 200X, Supplier enters into a contract to provide OEM with part Z, which is produced using tool Y. Supplier will recover the sales price for tool Y though the sales price for part Z. Production of part Z will begin once tool Y has been constructed to the specifications agreed between Supplier and OEM. Should Supplier combine the contract to construct tool Y with the contract to produce part Z? Discussion: Supplier will need to consider a number of factors to determine whether the contracts are price interdependent and need to be combined. The contracts were entered into near the same time. It is likely that the contracts were negotiated with a single commercial objective, because Supplier is both constructing tool Y and providing part Z. The two contracts cannot be performed concurrently, but the production of part Z begins as soon as tool Y has been constructed. We believe Supplier would likely combine the contracts for tool Y and part Z based on consideration of these factors. The next step is to identify the separate performance obligations in the contract(s).
than one good or service, each promised good or service is a separate performance obligation if it is distinct. A good or service is distinct and should be accounted for separately if the entity, or another entity, sells (or could sell) an identical or similar good or service separately. Tool Y and part Z are distinct because there are four suppliers in addition to Supplier that could separately construct the tool and produce the part. Supplier will recognize revenue for each distinct performance obligation when control of the good is transferred to the OEM and the performance obligation is satisfied.
of the tool is being transferred and the performance obligation is being satisfied continuously over the term of the contract for construction of the tool. Supplier will need to select the most appropriate measurement model (either an input or output method) to measure continuous transfer of control. Supplier might elect to follow a labor hours input method, for example. The transaction price allocated to tool Y will be recognized as revenue based upon the number of labor hours incurred as a percentage of the estimated total to be incurred over the life of the contract.
Example 5Recognizing revenue control of the tool transfers during the contract term
Facts: Assume the same facts as in Example 3 above, except: Tool Y must be constructed to OEMs specifications, which may be changed at OEMs request during the term of the contract; Non-refundable, interim progress payments are required to finance the contract to construct tool Y; OEM can cancel the contract to construct tool Y at any time (with a termination penalty); any work in process is the property of OEM; and Title does not pass until completion of the contract for the construction of tool Y and physical possession does not pass until completion of the contract for the production of part Z.
Example 6Recognizing revenue control of the tool transfers after completion of the contract term
Facts: Assume the same facts as in Example 3 above, except: The majority of the payments are due after tool Y has been constructed; OEM can cancel the contract at any time (with a termination penalty) and any work is the property of Supplier; and Title of tool Y passes upon completion of its construction. Physical possession of tool Y does not pass until completion of the contract for construction of part Z.
Example 4Identify the performance obligationscombined contracts

Facts: Assume the contract to construct tool Y should be combined with the contract to produce part Z. Supplier is one of five suppliers with the ability to construct tool Y and subsequently produce part Z. What are the performance obligations under the combined contract? Discussion: Supplier has promised to transfer both tool Y and part Z to OEM. When an entity promises to provide more
6
How should Supplier recognize revenue in this example? Discussion: The payment upon completion and the inability to retain workin-process suggest control of the tool is transferred when construction of the tool is complete. Supplier recognizes revenue when control has transferred to the customer. Control is likely to transfer when title to the tool transfers from Supplier to OEM, which is likely to be before physical possession of the tool passes from Supplier to OEM because the tool will be used to construct part Z.
How should Supplier recognize revenue in this example? Discussion: The customer specifications (and ability to change those specifications), non-refundable progress payments, termination penalty, and ability to retain work-in-process suggest that control
Customer incentives
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. There are various accounting standards applicable currently that provide guidance on accounting for customer incentives and, as a result, there is likely diversity in practice in accounting for such incentives.
The proposed standard requires management to identify the distinct performance obligations in an arrangement and allocate the transaction price to each performance obligation. The allocation should reflect the impact of customer incentives and other discounts, which may be a separate performance obligation or may affect the total transaction price.
Proposed standard An entity recognizes revenue from satisfying a performance obligation only if the transaction price can be reasonably estimated. The transaction price can be reasonably estimated if both of the following criteria are met: The entity has experience with similar types of contracts; and The entitys experience is relevant to the contract because the entity does not expect significant changes in circumstances. When a contract includes variable consideration, the transaction price includes the probability-weighted estimate of variable consideration receivable. Amounts paid to a customer are: (a) a reduction to 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).
Current US 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 and the date at which the sales incentive is offered. Volume rebates are recognized as each of the required revenue transactions that results in progress by the customer toward earning the rebate occurs. 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.
Current IFRS 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 corresponding expected discounts. If estimates of the expected discounts cannot be reliably made, revenue recognized should not exceed the amount of consideration that would be received if the maximum discounts were taken. 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.
continued
Proposed standard continued from previous page 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 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). That promise might be implied by the entitys customary business practice.
Current US GAAP
Current IFRS
Potential impact: The proposed standard will affect some US GAAP reporting entities, as it will require incentives to be accounted for similar to current IFRS. The proposed standard will require an entity to assess the transaction price including the impact of the incentive program. Incentives that provide the customer with a material right (e.g., a discount on future purchases) that would not have been obtained without entering into the contract are separate performance obligations. The transaction price allocated to the option (that is, the future discount) is deferred and recognized as revenue when the obligation is fulfilled or the right lapses. Incentives that create variability in the pricing of the goods or services provided in the contract (as with volume discounts) require management to determine the probability weighted estimate of possible outcomes to determine the transaction price. Variable consideration is included in the transaction price if the entity can reasonably estimate the amount of consideration to be received. Consideration paid to a supplier that is a reduction of the transaction price (e.g., cash rebates offered to end consumers by an OEM through their distribution network) is likely to continue to be accounted for as a reduction of revenue. The promise to pay consideration might be implied based on an entitys customary business practice. Compared to current practice, revenue may be reduced at an earlier point in time based on the proposals requirement to consider customary business practice.
Example 7Variable consideration

Facts: A supplier sells a component to an OEM for C100 for each component. The price for each component purchased in excess of 1,000 is C50 (that is, components 1 through 1,000 are C100; components 1,001 and on are C50). The supplier believes there is a 25% probability that the OEM will purchase 1,000 components; a 50% probability that the OEM will purchase 1,500 components; and a 25% probability that the OEM will purchase 2,000 components. The suppliers assumptions are based on experience with this OEM with similar contracts, as well as their ongoing relationship with the OEM and insight they have to the OEMs planned production. There is no customer credit risk. How should the supplier determine the transaction price and recognize revenue?
Discussion: The supplier has the ability to reasonably estimate the transaction price. The supplier will recognize revenue for the sale of components to the OEM when control of each component transfers to the OEM. The supplier should consider the volume discount in determining the transaction price to be allocated to each component sold. The transaction price is C83.33 for each component, determined using the probability weighted average of the expected outcomes. Revenue is recognized based on this estimated transaction price, which will be monitored and adjusted, as necessary, using a cumulative catch-up approach.
Contract costs
Entities in the automotive industry may incur costs to design and develop products and tooling. 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 may not be agreed to 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. The accounting treatment depends on a number of considerations including the nature of the costs and the tooling
being developed, whether the supplier has a non-cancellable 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 fulfil a contract and may change todays practice.
Proposed standard All costs of obtaining a contract, costs relating to satisfied performance obligations, and costs related to inefficiencies (that is, abnormal costs of materials, labor, or other costs to fulfil) are expensed as incurred.
Current US GAAP
Current IFRS
There is a significant amount of guidance There is some guidance for contract on the accounting for contract costs. costs in construction contract accounting. Costs that relate directly to a Costs that are incurred for an anticipated contract and are incurred in securing the contract generally may be deferred contract are included as part of contract only if the costs can be directly assocosts if they can be separately identified ciated with a specific contract and if and measured reliably and it is probable Other direct costs incurred in fulfilling a their recoverability from that contract is that the contract will be obtained. contract are expensed as incurred unless probable. they are within the scope of other stanCosts incurred on arrangements not in Pre-production costs incurred in longdards (e.g., inventory, intangibles, fixed the scope of contract accounting are term supply arrangements related to assets). If so, the entity should account capitalized if they are within the scope design and development of molds, for such costs in accordance with those of other asset standards (e.g., inventory, dyes, and other tools that an automostandards. If not, the entity should recogproperty, plant and equipment, or intantive supplier will own are capitalized as nize an asset only if the costs relate gible assets). part of property, plant and equipment. If directly to a contract, relate to future the costs relate to new technology, such activity and are probable of recovery costs are expensed as incurred. under a contract. These costs are then amortized as control of the goods or Pre-production costs incurred related services to which the asset relates is to molds, dyes, and other tools that a transferred to the customer. supplier will not own but that will be used in producing products for its customer may only be capitalized if they meet certain criteria. Those criteria include the supplier having a non-cancellable right to use the molds, dyes, and tools during the supply arrangement or a legally enforceable contractual guarantee for reimbursement. Otherwise, such costs are required to be expensed as incurred. Potential impact: We do not expect a significant change in the accounting for contract costs associated with tooling. Entities that currently capitalize and amortize contract acquisition costs will experience a change because all costs of obtaining a contract will be expensed as incurred under the proposed guidance.
Example 8Accounting for costs to obtain a contract

Facts: A salesperson earns a 5% commission on a contract that was signed in January 20X1. The product(s) purchased under 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 is expensed as incurred (i.e., at inception of the contract if the commission is owed to the salesperson upon signing), as it represents a cost of obtaining the contract.
Example 9Accounting for costs to fulfil a contract

Facts: A supplier incurs C1,000,000 in costs to design and develop tooling, which will be used to produce part Z. There is not a separate contract for the tooling, but the costs were incurred related to a supply contract with the OEM. The title for the tooling will transfer from the supplier to the OEM and the supplier does not have a non-cancellable right to use the tooling. How should the costs incurred for tooling be accounted for? Discussion: The tooling is necessary to construct the parts and to fulfil the performance obligation that exists under the supply contract. For this reason, we believe the costs would likely be considered costs to fulfil a contract. Under the proposal, the supplier should first consider whether the costs give rise to an asset in accordance with other applicable guidance (for example, ASC 340, Other assets and deferred costs, or IAS 16, Property, plant and equipment). If not, an asset may be still be recognized if the costs (1) directly relate to the contract, (2) generate or enhance resources that will be used to satisfy performance obligations, and (3) are expected to be recovered. If the determination was made that the costs could not be capitalized in accordance with another standard, it is likely that the costs would be capitalized under the proposal unless the determination was made that such amounts were not recoverable under the contract. The capitalized costs would then be amortized as the parts were supplied to the OEM.
10
Financing arrangements
Many OEMs have finance arms that serve as a potential finance source for customers that lease or buy vehicles from dealers. Where vehicles sold to dealers are financed Proposed standard The proposed standard requires revenue to be recognized when control transfers to the customer. Refer to the discussion of Revenue from tooling arrangements for details on the proposed model and factors to consider in assessing control transfer.
through the OEMs financing division, the OEM must meet certain conditions under current USGAAP to recognize revenue at the time of vehicle delivery to the dealer. These specific conditions are not included within IFRS; rather revenue is generally recognized from sales to dealers or Current US 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:
distributors when the risks and rewards of ownership have passed. The proposed standard does not contain the same conditions that exist under current guidance.
Current IFRS
IFRS does not contain the same specific criteria as US GAAP to be considered 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. Under IFRS, revenue from sales to distributors, dealers or others for resale is generally recognized The dealer is an independent entity; when the risks and rewards of ownership The OEM has delivered the product to have passed. However, when the dealer the dealer and the risks and rewards is acting, in substance, as an agent, the of ownership have passed to the sale is treated as a consignment sale. 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 US 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 as a result of the elimination of the criteria in current US GAAP. The proposal may result in earlier revenue recognition for OEMs that do not meet the criteria under current US GAAP. Potential impact: We do not expect a significant change in the timing of revenue recognition. Transfer of control and risks and rewards generally occurs when a vehicle is sold from the OEM to the dealer.
11
Example 10Lease 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 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.
12
Contract modifications are common in the automotive industry, particularly changes
in pricing. Contract modifications may need to be combined and accounted for together with the existing contract under the proposed standard.
Proposed standard A contract modification is any change in the scope or price of a contract. Examples include changes in the nature or amount of the goods or services to be transferred, changes in the method or timing of performance and changes in the previously agreed pricing in the contract. An entity may be required to account for a contract modification together with the existing contract if the prices of the modification and the existing contract are interdependent. In making this determination, the entity should consider when the contracts were entered into, whether the objective of the contracts is related, and whether performance under the contracts occurs at the same time or successively. If the prices of the contract modification and the existing contract are not interdependent, the entity accounts for the contract modification as a separate contract.
Current US GAAP There is no clear guidance on accounting for contract modifications. In practice, we believe many entities account for contract modifications prospectively unless the contract modification is explicitly tied to prior performance.
Current IFRS There is no clear guidance on accounting for contract modifications. In practice, we believe many entities account for contract modifications prospectively unless the contract modification is explicitly tied to prior performance.
Potential impact: Contract modifications will continue to require judgment to determine when they are combined with the original contract. We do not expect current practice in this area to be significantly changed by the proposed standard.
Example 11Contract modification

Facts: Supplier and OEM have an existing contract for the sale and purchase of 1,000 parts at a price of C10. Total contract revenue under the existing contract would be C10,000. OEM purchases 500 parts at that price, then negotiates a price change from C10 to C7.50. The price change only relates to the remaining purchases, is based on the OEMs willingness to increase the volume of purchases to 1,500 and is
not available to any other OEM. Should the contract modification to reduce the price from C10 to C7.50 and increase the volume be combined with the existing contract? Discussion: Determining whether the contract modification should be combined with the existing contract will require judgment. Supplier will account for the contract modification as a separate contract if it determines that the prices of the contract modification and the existing
contract are not interdependent. However, if Supplier determines that the contract modification and the existing contract are price interdependent, it would combine the contract modification and the existing contract and recognize the cumulative effect of the contract modification as a reduction to revenue of C833 [((C12,500 total consideration/1,500 goods) * 500 goods provided already)C5,000 revenue recognized to date].
13
Repurchase options
OEMs sell vehicles to customers (e.g., rental car entities) and often provide residual value guarantees to the purchaser as part of the contract. Under these contracts, the OEM contractually guarantees that the purchaser will receive a minimum resale amount at the time the vehicle is disposed of, contingent on certain requirements. This guarantee is provided by agreeing to (1) reacquire the vehicle at a guaranteed price at specified time periods as a means to facilitate its resale or (2) pay the purchaser for the deficiency, if any, between the sales proceeds received for the vehicle and the guaranteed minimum resale value. There is specific USGAAP guidance that requires these contracts to be treated as lease transactions. The boards have issued an exposure draft on lease accounting that will substantially change the accounting for lease transactions. As a result, a question arises as to whether the contracts described above are in the scope of the revenue recognition guidance or the leasing guidance. We believe that, as currently drafted, the exposure drafts
suggest that these contracts are in the scope of the revenue recognition guidance. This view is based on the following considerations: (a) the transaction results in an outright sale, not a lease; (b) the current leasing guidance that provided for these contracts to be accounted for as leases is being superseded; and (c) the leasing exposure draft does not provide guidance on accounting for these contracts that is comparable to the guidance that will be superseded. The economics of these contracts could be approximated by a structured lease arrangement that would be in the scope of the proposed lease guidance. As a result, some might argue that these arrangements should be accounted for under the proposed lease model. Additional guidance may be necessary to conclude whether these contracts will be accounted for in accordance with the revenue recognition or leasing guidance.
14
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. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2011 PwC. 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. NY-11-0522
USGAAP Convergence & IFRS Revenue recognition: Engineering and construction industry supplement (Updated November 30, 2011)
November 2011
Table of contents
Revenue from contracts with customers Revenue recognition... full speed ahead
2 20
Revenue from contracts with customers The proposed revenue standard isre-exposed
Whats inside: Overview Defining the contract Determining the transaction price Accounting for multiple performance obligations Allocating the transaction price Recognize revenue Other considerations Final thoughts
Overview
Entities in the engineering and construction (E&C) industry applying USGAAP or IFRS have primarily been following industry guidance for construction contracts1 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 USGAAP, the completed contract method) and input/output methods to measure performance Accounting for contract costs, such as pre-contract costs and costs to fulfil acontract Accounting for loss making contracts
Reprinted from: No. 201135 (supplement) November 22, 2011
Once the new revenue recognition standard becomes effective, the construction contract guidance and substantially all existing revenue recognition guidance under USGAAP 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 2011-35 (www.cfodirect.pwc.com) or visit www.fasb.org orwww.ifrs.org.
1 This guidance is included in ASC Topic 605-35, Construction-Type and Production-Type Contracts (USGAAP), and International Accounting Standards 11, Construction Contracts (IFRS).
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
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
These situations and, in particular, contract modifications such as change orders, are commonplace in the E&Cindustry. The proposed standard applies only tocontracts with customers when suchcontracts: 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: 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)
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.
Current US GAAP Combining and segmenting contracts is permitted provided certain criteria are met, but it is not required so long as the underlying economics of the transaction are fairly reflected.
Current IFRS Combining and segmenting contracts is required when certain criteria are met.
Revenue recognition: Engineering and construction industry supplement (Updated November 30, 2011)
Proposed model 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 A prospective adjustment to contract revenue when the remaining goods or services are a combination of distinct and non-distinct
Current US 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. US 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.
Example 1Unpriced 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
4
would account for the unpriced change order and estimate the transaction price based on a probability-weighted or most likely amount approach (whichever is mostpredictive). 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 contractors service of integrating goods into a combined item for thecustomer.
Change orders are typically based on the contractors 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.

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 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.
Current US GAAP 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 IFRS 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.
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.
Proposed model 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 US GAAP 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.
Current IFRS 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 when the inflow of cash or cash equivalents is deferred. An imputed interest rate is used to determine the amount of revenue to be recogThe interest component is computed nized as well as the separate interest based on the stated rate of interest in the income to be recorded over time. instrument or a market rate of interest if the stated rate is considered unreasonable when discounting is required. Revenue is discounted in only limited situations, including receivables with payment terms greater than one year.
Key change from the 2010 ExposureDraft

The original exposure draft required variable consideration to be estimated using the probability-weighted estimate approach. Entities may now use a mostlikely amount approach if it is the most predictive (for example, in situations where variable consideration is binary). This might provide results more similar to todays accounting. 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 berecognized. 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).

Facts: A contractor enters into a contract for the expansion of an existing twolane 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 travelseason. 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 contracts 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 catchup approach, which is consistent with currentpractice. 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 contractors control to complete the work before the holiday travel season The uncertainty will be resolved within a relatively short period of time
Example 3Claims
Facts: Assume the same fact pattern as Example 2, except that due to reasons outside of the contractors 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 theclaim? 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 probabilityweighted 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.
This should not result in a significant change from todays accounting for variable consideration in many E&C contracts.
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 Proposed model Performance obligationsseparation 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 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.
8
approach, although a contractor effectively promises to provide a number of different goods or perform a number of different services in delivering such macropromises. 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 Current US GAAP 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 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.
Current IFRS 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.

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 4Design/build 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.

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 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 US GAAP 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 profit center for determining revenue recognition.
Current IFRS 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 profit center for determining revenue recognition.
10
Example 5Allocating 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 probability-weighted 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))
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)) $.4m ($2m * ($ 30m/$170m))
Example 6Allocating contract revenue to more than one performance obligationchanges 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 contractors 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.
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.
11
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. 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: The entitys performance creates or enhances an asset that the customer controls; or The entitys 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 fulfil the remaining obligation to the customer, or The entity has a right to payment for performance completed to date.
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 Current US GAAP 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 illdefined, but the contractor is protected from an overall loss) until more precise estimates can be made. The completed-contract method is required when reliable estimates cannot be made.
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. Current IFRS 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 illdefined, but the contractor is protected from an overall 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.
12
Proposed model 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. 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 entitys 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 entitys 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 US 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.
continued
13
Proposed model continued from previous page 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 when using a cost-to-cost calculation) should be regularly evaluated and adjusted using a cumulative catch-up method.
Current US GAAP
Current IFRS

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.
by the owner are expected over the contractterm. 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 todate. Physical possession and title do not pass until completion of the contract.
Discussion: The preponderance of evidence suggests that the contractors 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 performanceobligation.
Example 7Recognizing revenue

Facts: A contractor enters into a construction contract with an owner to build an oilrefinery. The contract has the followingcharacteristics: The oil refinery is highly customized to the owners specifications and changes to these specifications
The contractor determined that the contract is a single performance obligation to build the refinery. How should the contractor recognize revenue?
14
Example 8Recognizing 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 $200million Year one cost is $120 million (including $20 million related to contractor caused inefficiencies)
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:
The contractor has concluded that cost-tocost 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?
Revenue: Contract cost (excluding inefficiencies): Gross contract margin: Contract inefficiencies: Adjusted contract margin:
$150m ($300m * ($100m/$200m)) $100m $ 50m $ 20m $ 30m
Example 9Recognizing 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)
15
Warranties
Most warranties in the construction industry provide coverage against latent 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. 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. 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 will account for the service component of the warranty as a separate performance obligation in these circumstances.
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 Current US GAAP 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 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.
in this area, resulting in delayed revenue recognition and complex accounting calculations for certain of these warranties.
Current IFRS 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 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.

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 entitys past performance was as specified in the contract, which is more aligned with todays accounting.
Example 10Accounting forwarranties

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 ofrevenue).
16
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 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 US 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 precontract costs. Pre-contract costs that are incurred for a specific anticipated contract generally 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 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 contract costs if they can be separately identified, measured reliably, and it is probable that the contract will be obtained. Other detailed guidance on costs to fulfil a contract is also prescribed by current guidance.
17

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.
Example 11Accounting 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-tocost 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.
18
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.
Current US GAAP 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.
Current IFRS 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.

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.
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.
19
Revenue recognition... full speed ahead Engineering and construction industry supplement
Whats inside: Overview Defining the contract Determining the transaction price Accounting for multiple performance obligations Allocating the transaction price to multiple performance obligations Recognize revenue Other considerations
Overview
Entities in the engineering and construction (E&C) industry applying USGAAP or IFRS have primarily been following either Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1, as codified in Topic 605-35), or International Accounting Standards 11, Construction Contracts (IAS 11), 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 USGAAP, the completed contract method) and input/output methods to measure performance Accounting for contract costs, such as pre-contract costs and costs to fulfill acontract Accounting for loss making contracts
Reprinted from: Dataline 201028 (Supplement) July 9, 2010 (Revised September 3, 2010*)
Once the new revenue recognition standard becomes effective, SOP 81-1 and IAS 11 and all existing revenue recognition guidance under USGAAP and IFRS will be replaced. This includes the percentage-of-completion method and the related construction cost accounting guidance as a standalone model. The following items common in the E&C industry may be significantly affected by the new 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 June 24, 2010. These proposals are subject to change at any time until a final standard is issued. For a more comprehensive description of the model, refer to PwC Dataline 201028 or visit www.fasb.org.
* This Dataline Supplement was revised on September 3, 2010 to reflect certain editorial revisions. None of the revisions resulted in substantive changes to the assessments of the proposed model contained herein.
20
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
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
These situations and, in particular, contract modifications such as change orders, are commonplace in the E&Cindustry.
We do not expect current practice in the area of contract combinations and segmentation to be significantly affected by the proposed standard. Construction companies currently exercise significant judgment to determine when to include change orders and other contract modifications in contract revenue and, there is diversity in practice. We expect that the use of judgment will continue to be required 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 standard Combining and segmenting contracts Two or more contracts should be combined and accounted for as one contract if their prices are interdependent. A contract should be segmented into more than one contract and accounted for separately if prices for goods and services within that contract are independent. Contracts with interdependent prices are typically: Entered into at or near the same time Negotiated as a package with a single commercial objective Performed either concurrently or continuously Prices for goods and services within a contract are independent if: The entity (or another entity) sells an identical or similar good or service separately; and The customer does not receive a significant discount for buying a bundle of goods and services.
Current US GAAP Combining and segmenting contracts is permitted provided certain criteria are met, but it is not required so long as the underlying economics of the transaction are fairly reflected.
Current IFRS Combining and segmenting contracts is required when certain criteria are met.
21
Proposed standard Contract (modifications (for example, change orders) Consistent with the contract combination and segmentation principle above, a contract modification is combined with the original contract, recognizing the cumulative effect of the contract modification in the period in which the modification occurs, if the prices are interdependent. A contract modification is accounted for as a separate contract if it is priced independently of the original contract (consider the factors above).
Current US 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. US 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.
Example 1Unpriced change orders

Facts: A 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. When would these change orders be included in contract revenue? Discussion: An entity would first assess whether the change order meets the definition of a contract as defined above, and next assess whether such change order is
priced interdependently with the original contract. Many unpriced change orders do not specify the consideration to be exchanged for goods or services at the time of execution, making it difficult to assess whether the change order is priced interdependently with the original contract. This might result in delayed recognition compared to todays model under both US GAAP and IFRS. There are situations, however, where contractors may be able to identify the amount of consideration to be received using various estimation
methods based on historical experience. We believe it is possible in these situations for a contractor to include unpriced change orders in contract revenue, as such modifications would (a) typically meet the definition of a contract and (b) are likely to be priced interdependently, as the modifications are often negotiated considering the original contract, with a single commercial objective, and relate to activities that are performed either concurrently orcontinuously.
22

The transaction price (or contract revenue, as it is called today in the E&C industry) is the amount of consideration the contractor expects to receive in exchange for satisfying its performance obligations. When
the contract price is fixed, this determination is simple. When the contract price is not fixed, however, the determination is more complex. Common considerations in this area for the E&C industry include the accounting for awards/incentive payments, customer-furnished materials, claims, and time value of money. Revenue
related to awards/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, or time value of money (except for contracts where payment terms materially vary fromperformance).
Proposed standard Awards/incentive payments Awards/incentive payments are included in contract revenue using a probabilityweighted approach when such payments can be reasonably estimated. Such amounts can be reasonably estimated when the contractor has experience with similar types of contracts and that experience has predictive value (i.e., experience is relevant to the contract because the entity does not expect significant changes in circumstances). Customer furnished materials If a customer contributes goods or services (for example, materials, equipment, or labor) to facilitate the fulfillment of the contract, the value 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 should be included in contract revenue, using a probability-weighted approach, only when such revenue can be reasonably estimated.
Current US GAAP 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 IFRS 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.
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 (to the extent of contract costs incurred) only if it is probable and reliably estimable (determined based on specific criteria). 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.
23
Proposed standard Time value of money Contract revenue should reflect the time value of money whenever the effect is material. Management should use a discount rate that reflects a separate financing transaction between the entity and its customer and factors in credit risk.
Current US GAAP Revenue is discounted in only limited situations, including receivables with payment terms greater than one year. When discounting is required, 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.
Current IFRS 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.

Facts: A contractor enters into a contract for the expansion of an existing two-lane highway to a three-lane highway in a heavily congested area. The contract price is $65 million plus a $5 million award fee if 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. If it is not finished before the holiday travel season, the contractor does not receive any award fee. 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 travelseason.
Discussion: The contractor is likely to conclude that it can reasonably estimate the amount of expected award fee. This isbecause: The contractor has a long history of performing this type of work; It is largely within the contractors control to complete the work before the holiday travel season; The uncertainty will be resolved within a relatively short period of time; and The possible outcomes are not highly variable.
Example 3Claims
Facts: Assume the same fact pattern as Example 2, except that due to reasons outside of the contractors control (e.g., 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 withowners. 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 that warrant consideration). The contractor might therefore conclude that such a claim, in the early stages, cannot be reasonably estimated. The claim is excluded from the transaction price until it can be reasonably estimated (this is likely to be closer to the date when the claim is expected to be resolved).
The contracts transaction price is therefore $69.75 million; the fixed contract price of $65 million, plus $4.75 million award fee (probability-weighted amount of $5 million). This estimate is continuously revised and adjusted, as appropriate, using a cumulative catch-up approach, which is consistent with currentpractice.
24

Performance obligations are defined as promises to deliver goods or perform services. Today, contractors often account for each contract at the contract level; that is, contractors account for the macropromise in the contractto build a road or build a bridge, etc. Current guidance permits this, although a contractor effectively promises to provide a number of different goods or perform a number of different services in delivering such macro-promises. Clearing, grading and paving, for example, may qualify as separate performance obligations within Proposed standard Performance obligationsseparation An entity should separately account for performance obligations only if they are transferred at different times and are distinct. An entity will otherwise combine goods or services with other promised goods or services until it identifies a bundle of goods or services that are distinct. A good or service is distinct if either: The entity or another entity sells an identical or similar good or service separately. The entity could sell the good or service separately because it: (a) has a distinct function (utility on its own or together with other goods or services); and (b) has a distinct profit margin (subject to distinct risks and the resources needed can be separately identified).
the macro-promise to build a road. Determining when to separately account for these performance obligations under the proposed model is, therefore, a key determination and will require a significant amount of judgment. Under the proposed model, it is possible to account for the contract at the contract level (e.g., macro-promise to build a road), but we expect that contractors might have to separately account for more obligations within each contract compared to current guidance. This is an area that we expect will continue to evolve and that contractors should pay particular attention to. Applying the proposed separation principle will be challenging for many Current US GAAP 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.
construction companies. We believe the final standard should be clear about how to apply this principle to long-term contracts to ensure it meets the proposed standards objectives of providing consistent, decision-useful information for economically similar contracts.
Current IFRS 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.
25
Example 4Design/build contract

Facts: A contractor enters into a construction contract with an owner to design and build a new runway at a small airport. The build stage primarily includes clearing, excavation, grading and paving activities. The contractor often sells similar design and build services together but also sells them separately. How many performance obligations is the contractor required to account for separately? Discussion: We believe that application of the proposed separation principle remains unclear for many long-term contracts. However, based on the principles described above, it is likely that this design/build contract has at least two performance obligations; that of providing design services and that of building the runway. This is because they are transferred at different times and are distinct, as the contractor has a history of selling similar design services separate from the build. The build aspect of the contract, however, may require further separation. In making this determination, the contractor may have to assess whether the clearing, excavation, grading, and paving activities (or activities at an even lower level than these) are sold (or could be sold) by the contractor or others, such as subcontractors. For example, identical or similar activities that are sold separately by subcontractors may be considered distinct and require separation. Construction contracts to deliver a good often also include a significant construction management service. Assessing whether such management services are distinct from other aspects of the contract (i.e., the design service and construction of the good) will require significant judgment.
Example 5Construction management contract

Facts: A contractor enters into a construction contract with an owner to provide construction management services, overseeing the construction of a new runway at a small airport. How many performance obligations is the contractor required to separately account for? Discussion: The contractor might only have one performance obligation in this example; that of providing the construction management service to supervise and coordinate the construction activity on the project.
26
Allocating the transaction price to multiple performance obligations

Performance obligations are measured at the amount of consideration the contractor expects to receive (i.e., the transaction Proposed standard Allocating the transaction price For performance obligations that require separate accounting, contract revenue is allocated to each performance obligation based on relative actual or estimated selling prices. An estimation method will not be prescribed nor will any method be precluded. For example, a contractor might use cost plus a reasonable margin in estimating selling price of a good or service. This initial measurement is not revisited unless performance obligations become onerous.
price as described above). This consideration must then be allocated to the performance obligations in a contract that require separate accounting. We expect that contractors will have to separately account for more performance obligations than today, so the allocation of the transaction price (i.e., contract revenue) will be new to many E&C companies. Of Current US GAAP 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 profit center for determining revenue recognition.
particular interest will be the allocation of variable consideration (e.g., award/ incentive payments) associated with only one separately accounted for performance obligation, rather than the contract as a whole. This is an area that is currently unclear in the proposed standard and we believe is an important area that requires further consideration. Current IFRS 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 profit center for determining revenue recognition.
27
Example 6Allocating 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 if the contact as a whole is finished 30 days ahead ofschedule. Discussion: In allocating the contract consideration (including both the fixed and variable amounts), a contractor must first assign a selling price to both the road
and the bridge. 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, therefore, an inherent discount of $20 million built into the bundled contract. Using a relative allocation model, the $150 million transaction price is allocated asfollows: Road: Bridge:
$124m ($150m * ($140m/$170m)) $26m ($150m * ($30m/$170m))
Example 7Allocating contract revenue to more than one performance obligationchanges in the transaction price
Facts: After contract inception, the amount of variable consideration changes from an expected $10 million to an expected $12 million. Performance obligations are not remeasured after contract inception, so the additional $2 million would be allocated to the road and bridge using the initially developed allocation percentages as follows: Road: Bridge:
$1.6m ($2m * ($140m/$170m)) $.4m ($2m * ($ 30m/$170m))
Discussion: Such changes are recognized using a cumulative catch-up approach. For example, if the road was completed before the change in estimated variable consideration, the full amount of $1.6m would be recognized as revenue when the estimate was revised.
28
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 contractors performance obligations,
which occurs when control of an asset (good or service) transfers to the customer. Control can transfer either at a point in time or continuously over the contract period. 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 continuously to the owner over the contract term and therefore, might
produce similar results compared to today. This should not, however, be assumed. Contractors will not be able to default to the method used today. Cost-to-cost may be used today, for example, to measure revenue under an activities based recognition model. It may not be appropriate for measuring the extent to which control has transferred under a continuous transfermodel.
Proposed standard Recognize revenue 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, continuously over the contract period. Factors to consider in assessing control transfer include, but are not limited to: 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 This list is not intended to be a checklist or all-inclusive. The ability to borrow against the asset, for example, may be another control transfer factor to consider. No one factor is determinative on a stand-alone basis.
Current US GAAP Revenue is recognized using the percentage-of-completion method when reliable estimates are available. In circumstances in which reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (e.g., 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. Where reliable estimates cannot be made, the completed-contract method is required.
Current IFRS Revenue is recognized using the percentage-of-completion method when reliable estimates are available. In circumstances in which reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (e.g., 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.
29
Proposed standard Measuring continuous transfer of control For contracts where control transfers continuously, a contractor can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones) or the passage of time to measure the extent to which control has transferred. The method that best depicts the transfer of goods or services to the customer should be applied consistently throughout the contract and 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. This is currently referred to as the Revenue method. The use of the Gross Profit method is prohibited. Estimates to measure the extent to which control has transferred (e.g., estimated cost to complete when using a cost-to-cost calculation) should be continually evaluated and adjusted using a cumulative catch-up method.
Current US GAAP
Current IFRS
A contractor can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a percentage-complete is derived, there are two different approaches for determining revenue, cost of revenue and gross profit; the Revenue method and the Gross Profit method.
A contractor can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a percentage-complete is derived, IFRS requires the use of the Revenue method. The Gross Profit method is prohibited.
Example 8Recognizing 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 owners specifications and owner changes to these specifications are expected over the contract term 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 Physical possession and title do not pass until completion of the contract
How would a contractor recognize revenue in this example (assume only for these examples that there is one performance obligationthat of building the refinery)?
Discussion: The preponderance of evidence suggests control of the oil refinery is being transferred continuously over the contract term. In such cases, the contractor will have to select either an input or output method (or, less likely, passage of time) to measure the extent to which control has transferred.
30
Example 9Recognizing revenue use of cost-to-cost

Facts: Assume the same fact pattern and assumptions as 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)
How much revenue and cost does the contractor recognize at the end of year one? Discussion: In determining the amount of revenue to be recognized under a cost-tocost model, the contractor would have to exclude any costs that do not depict the transfer of goods or services; in this case, the costs associated with contractor caused inefficiencies. The amount of contract revenue and cost recognized at the end of year one is: Revenue: Contract cost: Gross contract margin: Contract inefficiencies: Net contract margin: $150m ($300m * ($100m/$200m) $100m $ 50m $ 20m $ 30m
The contractor has concluded that cost-tocost is a reasonable proxy for measuring the extent to which control has transferred.
Example 10Recognizing revenueuse of cost-to-cost with changes in estimates

Facts: Assume the same fact pattern and assumptions as above, except that total estimated cost to complete increases at the end of year two to $250 million due to an unexpected increase in the cost of materials. Actual cumulative cost incurred at the end of year two (excluding year-one inefficiencies) is $200 million.
The contractor has concluded that cost-to-cost is a reasonable proxy for measuring the extent to which control has transferred. How much revenue and cost does the contractor recognize at the end of year two?
Discussion: The amount of contract revenue and cost recognized at the end of year two is: 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: Net contract margin to-date: $240m ($300m * ($200m/$250m) $150m $ 90m $200m $100m $100m $(10m) $40m ($240m - $200m) $20m ($240m - $200m - $20m)
31
Warranties
The proposed standard draws a distinction between warranties that protect against latent defects and warranties that protect Proposed standard Warranties Warranties that protect against latent defects do not give rise to a separate performance obligation. They acknowledge the possibility that the contractor has not satisfied its performance obligation. Management will need to determine the likelihood and extent of defects in the products it has sold to customers at each reporting period to determine the extent of unsatisfied performance obligations. A portion of the contract revenue should be deferred at the time of sale for defective products that will be replaced either in part or in their entirety. A warranty that protects against defects that arise after the product is transferred gives rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception.
against defects that arise after the product is transferred to the customer, such as normal wear and tear. Many warranties in the E&C industry protect against latent defects. We therefore expect practice could significantly change in this area, Current US GAAP Contractors typically account for warranties that protect against latent defects outside of the contract and in accordance with existing loss contingency guidance. A contractor recognizes revenue and concurrently accrues any expected cost for these warranty repairs. Revenue is deferred for warranties that protect against defects arising through normal usage and recognized over the expected life of the contract.
resulting in delayed revenue recognition and complex accounting calculations. However, contractors will need to use significant judgment to determine whether a defect is latent, or has arisen subsequent to the sale. Current IFRS 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 latent defects outside of the contract 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 and recognized over the expected life of the contract.
Example 11Accounting for warranties

Facts: Assume the same fact pattern and assumptions as Example 8. The contractor also provides a 60-day warranty that covers latent defects for certain components of the oil refinery. How would the contractor account for such awarranty?
Discussion: The contractor would have to estimate, at contract inception using all available information such as historical experience, the selling price of each of the oil refinery components that will require repair or replacement. Once determined, contract revenue would be allocated at inception on a relative selling price basis to those components and revenue deferred until the owner received control of those components without defects (i.e., generally the earlier of when the defects are repaired/replaced or when the warranty period expires).
32
Contract costs
Existing construction literature contains a substantial amount of cost capitalization guidance, both related to pre-contract costs and costs to fulfill a contract. The proposed model includes contract cost guidance, but we expect a significant change from todays practice, in particular around the accounting for pre-contractcosts. Proposed standard Contract costs All costs of obtaining a contract, costs relating to satisfied performance obligations, and costs related to inefficiencies (i.e., abnormal costs of materials, labor, or other costs to fulfill) should be expensed as incurred. Other direct costs incurred in fulfilling a contract are expensed as incurred unless they are within the scope of other standards (e.g., inventory, intangibles, fixed assets), in which case the entity should account for such costs in accordance with those standards. If the costs are not within the scope of other standards, the entity should recognize an asset only if the costs relate directly to a contract, relate to future performance, and are probable of recovery under a contract. These costs would then be amortized as control of the goods or services to which the asset relates is transferred to the customer. Current US GAAP There is a significant amount of detailed guidance relating to the accounting for contract costs. This is particularly true with respect to accounting for precontract costs. Pre-contract costs that are incurred for a specific anticipated contract generally may be deferred only if their recoverability from that contract is probable. 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 contract costs if they can be separately identified and measured reliably and it is probable that the contract will be obtained.
Other detailed guidance is also Other detailed guidance is also prescribed in the standard and should be prescribed in the standard and should be appropriately considered. appropriately considered.
Example 12Accounting for contract costs

Facts: Assume the same fact pattern and assumptions as Example 9. 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 (e.g., inventory, fixed assets, or intangible assets). How should these costs be accounted for? Discussion: These costs to fulfill a contract would be eligible for capitalization so long as they: (a) relate to the contract;
(b) relate to future performance; and (c) are probable of recovery. Using the fact pattern in Example 9 above, $500,000 would be amortized at the end of year one (coinciding with 50 percent control transfer using a cost-to-cost method).
33
USGAAP Convergence & IFRS Revenue recognition: Entertainment and media industry supplement
March 2011
Revenue recognition . . . full speed ahead Entertainment and media industry supplement
Whats inside: Overview Licenses and rights to use Variable consideration Accounting for multiple performance obligations Options to acquire additional good or services Accounting for return rights Contract costs
Overview
The entertainment and media sector is comprised of various subsectors, such as filmed entertainment, television, music, video games, publishing, radio, and internet. Each subsector has unique product and service offerings and, in certain subsectors, industry specific revenue recognition guidance exists under USGAAP. 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, examples, and related assessments contained herein are based on the Exposure Draft, Revenue from Contracts with Customers, which was issued on June 24, 2010. These proposals are subject to change at any time until a final standard is issued. The examples reflect potential effects based on the proposed standard and any conclusions are subject to further interpretation and assessment based on the final standard. For a more comprehensive description of the model refer to PwCs Dataline 201028 or visit www.fasb.org.
* This Dataline Supplement was revised on September 3, 2010 to reflect certain editorial revisions. None of the revisions resulted in substantive changes to the assessments of the proposed model contained herein.
Revenue recognition: Entertainment and media industry supplement
Licenses and rights touse

Many entertainment and media companies license intellectual property to third parties. Such licenses may include the right to exploit a motion picture in various markets and territories or the rights to exploit a character to be used in a video game or other consumer product. Proposed standard The recognition of revenue for the license of intellectual property depends on whether the customer obtains control of the asset. The contract is considered a sale (rather than a license or a lease) 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). If the transaction is a sale, revenue is recognized when control transfers. Current US GAAP Sale of episodic television series in syndication Current guidance requires that the following conditions be met prior to the recognition of revenue: Persuasive evidence of an arrangement exists The film is complete, has been delivered or is available for immediate delivery Current IFRS IFRS does not contain any industry specific accounting for media and entertainment entities. Revenue is not generally recognized under licensing agreements until performance under the contract has occurred and the revenue has been earned. The assignment of rights for a nonrefundable amount under a non-cancellable contract permits the licensee to use those rights freely. Where the licensor has no remaining obligations to perform, the transaction is in substance 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 licenses risks and rewards have not been transferred to the customer. However, the following indicators should be considered in determining whether a license fee is recognized over the term or upfront: There is a fixed fee or non-refundable guarantee The contract is non-cancellable The customer is able to exploit the rights freely The vendor has no remaining performance obligations
The license period has begun and the If the customer licenses intellectual propcustomer can begin its exploitation, erty on an exclusive basis but does not exhibition, or sale obtain control for the entire economic The arrangement fee is fixed or life of the property, the performance determinable obligation is satisfied over the term of the license. Revenue will be recognized over Collection of the arrangement fee is reasonably assured the term of the license. A contract that provides a nonexclusive license for intellectual property contains a single performance obligation. Revenue is recognized when the customer is able to use the license and benefit from it (i.e., when control transfers). Delivery may occur on a daily or weekly basis, even though all of the episodes are complete and ready for delivery, in 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. If the criteria noted above are met, the net present value of the entire syndication contract is recognized as revenue upon commencement of the license term.
continued
Proposed standard continued from previous page
Current US GAAP Licenses and right to use motion pictures It is common in certain territories for a producer to license a film to a counterparty in several markets, such as theatrical, home video, and television. Such contracts typically have predefined dates when the title can be exploited in each of the markets. Each contract also typically specifies an overall minimum guarantee (e.g., 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 (e.g., theatrical, home video, and television) on a relative fair value basis and revenue is recognized when each window is available for exploitation. Licensor accounting of a record master or music copyright Under todays accounting, 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 (i.e., the 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 collectability is reasonably assured. If the licensor is unable to determine the amount of the license fee earned (i.e., 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 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.
continued
Current US GAAP
Current IFRS
Impact: The timing of revenue recognition for the license of an episodic television series, filmed entertainment and music may be affected by the proposed standard. If the licensee obtains an exclusive license for less than the economic life of the intellectual property, revenue is recognized over the contractual term (i.e., license term) rather than upfront as currently allowed. If the licensee obtains a non-exclusive license to the intellectual property, revenue is recognized once control of the licensed content is transferred, which is expected to be upon delivery. The timing of revenue recognition may be affected if the licensor is able to reasonably estimate the amount of consideration to be received for licensing content when some or all of the consideration is variable. If the fee to be received can be reasonably estimated, variable consideration is included in the transaction price. If variable consideration cannot be reasonably estimated at contract inception, revenue is not recognized until such amounts can be reasonably estimated. The timing of recognition of revenue depends on whether the license is exclusive or non-exclusive. Based on the numerous markets and territories in which content is licensed, the application of the terms exclusive and non-exclusive in this industry may be challenging to apply under the proposed standard. It is unclear why exclusivity should determine whether revenue is recognized at a point in time or over a period of time if the performance obligation is the same. That is, if the performance obligation is the license of intellectual property (IP) and the licensor has no further obligations, its unclear why the pattern of revenue recognition would be different. The determination of the unit of account (i.e., the asset being licensed) will also be a key factor in determining the appropriate license model to apply under the proposed standard. The underlying IP (e.g., a motion picture) will exist in perpetuity, so it is unclear if many exclusive licenses in the entertainment and media industry will be recognized over the license term, as the term will normally be less than the economic life of the IP, or if the IP may be divided into distinct assets (e.g., theatrical window for a motion picture).
Example 1Sale 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 fouryear period commencing January 1, 20XX on an exclusive basis. The cable channel pays an annual fee of $4,000,000 in equal monthly installments and is contractually obligated to broadcast this program each
weeknight. Studio XYZ also has the right to insert two 30-second advertising spots into each broadcast of the show. How is revenue recognized by Studio XYZ? Discussion: The net present value of the payment stream is currently recognized as revenue when the series is available for exploitation by the cable channel. If the license is exclusive and the term is for a period less than the economic life of the
property (i.e., the completed episodes may be re-licensed once the current license expires), the proposed standard requires that the revenue be recognized as the licensee obtains control of the property during the license term. Straight-line recognition is appropriate if the license is transferred continuously and evenly overtime.
Example 2Licenses and rights to use motion pictures

Facts: Studio Z 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 on the date one year after the theatrical release date (which is also the television availability date). The contractual arrangement prohibits the licensing of Film A in the same markets and territory during the original license term. How is revenue recognized by Studio Z? Discussion: Studio Z will need to determine if one license (i.e., a ten-year license for multiple windowstheatrical, home video, and television) is granted to the customer or if three distinct licenses are granted (i.e., theatrical, home video, and television). Assuming Studio Z determines that each release coincides with a distinct license (i.e., a license for theatrical, home video, and television), the transaction price of 10 million is allocated to each license based on the relative standalone selling price. The contractual arrangement prohibits the licensing of Film A in the same markets and windows during the ten-year contractual term, so each license is exclusive. Studio Z therefore determines the economic life of the underlying asset being licensed in each window. If it determines that the term of the license in a window (e.g., the home video window) is for a period less than the economic life of the asset, revenue is recognized over the license term as control of the performance obligations aretransferred.
Example 3Non-exclusive license of record master or music copyright

Facts: Record Label enters into a nonexclusive license agreement with a retailer. Under the terms of the license, the retailer may use Song X for a period of two years in advertisements 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 does Record Label recognize revenue? Discussion: Record Label has licensed Song X on a non-exclusive basis and there are no further performance obligations. Revenue is therefore recognized once control of the license is obtained by the retailer. That is, revenue is recognized once the retailer could exploit Song X under the terms of the license agreement.
Example 4Exclusive license of record master or music copyright

Facts: Record Label enters into an exclusive license agreement with a retailer. Under the terms of the license, the retailer may use Superstars Song X for a period of two years in advertisements 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 does Record Label recognize revenue? Discussion: Record Label has licensed Song X on an exclusive basis for a period that is expected to be less than the economic life of Song X due to Superstars continuing popularity. Revenue is therefore recognized over the term of the license agreement rather than upfront, as control transfers throughout the licenseterm.
Many arrangements in the entertainment and media industry include minimum guarantees 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. When consideration is not fixed, the transaction price is the probability-weighted estimate of consideration to be received. Inclusion of
variable consideration in the transaction price requires management to assess the probability of each possible outcome. An estimate of variable consideration is only included in the transaction price if it can be reasonablyestimated.
Proposed standard The transaction price is the amount of consideration that an entity receives, or expects to receive, from the customer in exchange for transferring goods or services. For contracts that include variable consideration, the transaction price is estimated at contract inception and at each reporting period. Variable consideration is included in the transaction price if the entity can identify the potential outcomes of a contract. If the entity has experience with similar types of contracts and does not expect significant changes in circumstances, variable consideration is included in the transaction price.
Current US GAAP International sales of films for a minimum guarantee and potential variable upside consideration In a licensing arrangement, a licensee may commit to pay a minimum nonrefundable license fee up front. The licensor may also include a provision stipulating that the licensor is entitled to a percentage of the licensees revenues once the variable rate exceeds the amount of the fixed minimum guarantee. The consideration from the nonrefundable fixed minimum guarantee is allocated to each market being licensed on a relative selling price basis and is generally recognized once that market is available for the licensee, presuming all of the revenue recognition conditions have been met. Revenue to be paid by a licensee in excess of any fixed nonrefundable minimum guarantee is typically recognized by the licensor once the variable fee exceeds the total minimum guarantee.
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. However, if the license fee or royalty is probable of being received and is reliably measurable, revenue is recorded when the license is available for exploitation.
Impact: The proposed standard may significantly affect the timing of revenue recognition, as variable consideration will need to be assessed for inclusion in the transaction price if it can be reasonably estimated. The licensor may be able to reasonably estimate the possible outcomes, including the impact of the variable consideration, if it has historical experience with similar contracts. Significant judgment will be required to determine whether variable consideration can be reasonably estimated and to determine the amount of variable consideration to be included in the transaction price. Entities that currently restrict revenue recognition to the non-contingent amount may experience significant change, depending on the nature of the contingency. An entity might recognize revenue under the proposed standard before the contingency is resolved in some cases, which might be earlier than under todays models.
6 US GAAP Convergence & IFRS
Example 5
Facts: Studio Z enters into a single 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 exceeds $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 on the date one year after the theatrical release date (which is also the television availability date). The contractual arrangement prohibits the licensing of Film A in the same markets and territory during the original license term. How does Studio Z recognizerevenue?
Discussion: Currently, variable consideration is generally recognized once the amount is earned and known. Variable consideration is included in the transaction price under the proposed standard if it can be reasonably estimated and is allocated to the separate performance obligations based on the relative estimated selling price. Studio Z will need to consider if there is experience with similar types of contracts and whether the studio expects significant changes in possible outcomes in considering whether the potential upside can be reasonably estimated.

Performance obligations are defined as an enforceable promise to deliver goods or perform services. Determining when to separately account for these performance obligations under the proposed standard is key and will require a significant amount ofjudgment.
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 may result in more performance obligations being identified than under current practice. This is an area that we expect will continue to evolve and that management should pay particular attention to. Applying the separation principle in the proposed standard may be challenging in some circumstances.
Proposed standard 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 or another entity sells an identical or similar good or service separately. Performance obligations could be distinct if not sold separately if the good or service has a distinct margin and a distinct function.
Current US GAAP Additional functionality included in software products, including video games Certain software and video game arrangements may include software deliverables, non-software deliverables, accessories, and related services (including online services and multiplayer functionality). Management must identify the deliverables that are within the scope of the software literature in such arrangements as well as those accounted for following non-software revenue literature. Management must determine if the deliverables are essential to the functionality of the more than incidental software. Deliverables essential to the software are within the scope of the software literature. Deliverables not essential to the functionality of the more than incidental software are accounted for in accordance with other, non-software revenue literature. For non-software deliverables, management may need to consider whether the deliverables are inconsequential and perfunctory, thus permitting no accounting for such items.
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 transactions substance. The customers perspective is key in determining whether the transaction should be accounted for as one element or multiple-elements. If the customer views the purchase as one element, the arrangement may be accounted for as one transaction. When elements in a single contract are separated, fair value is used to allocate the transaction price to the separate elements. Entities are not precluded from separating elements in a single contract if the elements are not sold separately.
continued
Current US GAAP Impact: Video game developers will need to determine whether the video game and the additional services should be accounted for as separate performance obligations under the proposed standard. Management will need to determine whether the game and additional services are distinct from one another. The transaction price is allocated to the separate performance obligations if they are distinct. The video game is typically delivered at a single point in time while the services are delivered over a future service period, so the timing of revenue recognition may be impacted. Software as a service in the video game industry Revenue for 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 may 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 advertisement 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 and there is objective and reliable evidence of fair value of the undelivered element. Determining whether objective and reliable evidence of fair value of the undelivered element exists is currently restrictive and often limits the separation of deliverables in a multipleelement arrangement.
Current IFRS Impact: Multiple-element arrangements may be affected because the performance obligations will need to be accounted for separately if they are distinct from other performance obligations in the contract. Relative estimated selling prices are used to allocate the transaction price to the separate performance obligations rather than the relative fair values.
continued
Current US GAAP Impact: Advertisers will need to assess whether advertising contracts include more than one performance obligation. The separation criteria in the proposed standard is less restrictive than current GAAP, which may result in more performance obligations being accounted for separately, affecting the timing of revenue recognition. This change in the separation criteria may impact some entities more than others, depending on the guidance currently applied to the entity under US GAAP.
Current IFRS
Example 6Online 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 therefore has historically accounted for the sale of a video game together with additional services that enhance the user experience, recognizing revenue over the service period. How will Entity A account for revenue under the proposed standard?
provide the video game and the additional services). The transaction price is allocated to the separate performance obligations if the game and the services are distinct and revenue is recognized for the video game once control transfers (presumably upon delivery) and for the services over the service period.
Example 7Advertising arrangements

Facts: Advertiser A provides multiple forms of internet advertising to customers, including impression-based advertising and activity-based advertising in standalone arrangements and in bundled arrangements. Advertiser A enters into a single 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, which 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 accounting when sold on a combined basis as there was no objective and reliable evidence of the fair value of the undelivered advertising spots due to the inconsistency in pricing. How does Advertiser A account for revenue under the proposed standard? 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 campaigns are distinct from one another. The advertising spots are distinct, as they are sold separately, so the transaction price is allocated to each of the three campaigns based on a relative estimated selling price allocation. Revenue is recognized as the advertising spots are delivered during the campaign.
Discussion: Company A will need to

determine if the video game and the additional services are distinct and therefore should be accounted for separately. They are separate performance obligations if the game and the services each have a distinct function and if the margins are also distinct (i.e., Company A can separately identify the resources needed to
10
Options to acquire additional good or services

An entity may grant a customer the option Proposed standard If a contract includes an option to acquire additional goods or services, such an option is a separate performance obligation if the option provides a material right to the customer that the customer would not have received without entering into the contract. The transaction price is allocated to the option based on the estimated standalone selling price of 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 Current US GAAP Options to renew a series for incremental seasons Producers of episodic television series often enter into licensing agreements that allow the licensee the ability to license additional seasons. The option to acquire additional seasons is usually considered to be at fair value and no allocation of consideration is made to the option.
seasons. Licensors will need to determine if that promise gives rise to a material right to the customer to determine the appropriate accounting for the option.
Current IFRS The recognition criteria are usually applied separately to each transaction (i.e., the original purchase and the separate purchase associated with the option). However, it is necessary in certain circumstances to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction. 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. It therefore allocates consideration between the initial good or service provided and the option.
Impact: Options to renew a series for incremental seasons may impact the original transaction price if the option provides a material right to the customer that the customer would not have received without entering into the contract. The producer will need to consider factors such as the pricing for the incremental seasons in determining whether a material right has been granted to the licensee. If a material right was granted, revenue will need to be allocated to the option and deferred until delivery of the second item or when the right expires.
Example 8Options to renew a series for incremental seasons

Facts: Studio X produces an episodic television series and licenses the 13 episodes to be produced in season one to Network Y for a license fee of 1.5 million per episode. The contractual arrangement also includes an option that allows Network Y, at its sole discretion, to require Studio X to produce seasons two and three for a license fee of 2 million and 2.5 million
per episode, respectively. How does Studio X account for its revenue? Discussion: Studio X currently recognizes revenue under USGAAP of 1.5 million as it delivers each episode to Network Y. No specific accounting consideration is given to the existence of the option to acquire subsequent seasons. These options will be exercised only if Network Y believes that the series has some reasonable level of consumer acceptance. In evaluating
these options under the proposed standard, Studio X determines that the option provides a material right to the licensee, as fixed pricing establishes significant upside for Network Y if the series becomes a hit (that is, if a new license was entered into, the pricing would be materially different). The estimated transaction price for the license of the television series therefore includes the probability weighted amount of consideration expected to be received from the exercise of the option to license the two additional seasons.
11
Accounting for returnrights

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 Proposed standard The sale of goods with a right of return is accounted for similarly to todays failed sale model. That is, revenue is not recognized for goods expected to be returned; rather, a liability is recognized for the expected amount of refunds to customers using a probability-weighted approach. 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).
or distributors, while some are implied during the sales process. These rights take many forms and are driven generally by the buyers desire to mitigate technological risk or the risk that the product will not sell, and the sellers desire to promote goodwill with its customers. Current US GAAP Sales of digital or physical music Revenue is recognized for sales of physical music products (e.g., compact discs, etc.) once the product is available for release (i.e., 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. 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 and the asset for the right to the returned goods. The timing of revenue recognition may be affected for the sale of a physical product as recognition currently occurs once the retailer has the ability to sell the product to consumers (at the street date). Under the proposed standard, recognition is predicated on the transfer of control of the good and satisfaction of the performance obligation. The record label should consider whether the customer has the ability to direct the use of, and benefit from, the merchandise in determining whether control has transferred. Revenue recognition may 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 expected to change under the proposed standard as revenue recognition will occur once the consumer obtains control of the download. Current IFRS Currently, revenue is typically recognized net of a provision 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.
12
Example 9Sale of physical product by music producer

Facts: A record label sells 100 compact discs for $10 each. The products cost $2 to produce and the sale includes a return right. The retailer takes physical possession of the compact discs and is contractually obligated to pay for the inventory once the discs are received. Based upon historical sales patterns, the record label determined that the estimated sales returns associated with this transaction is 10%. In establishing the 10% return rate, the company estimated a 32% probability that seven discs would be returned, a 40% probability that nine discs would be returned, and a 28% probability that 15 discs would be returned. The record label estimates that the costs of recovering the products will be immaterial and expects the returned products can be resold at a profit. How does the record label account for this transaction?
Discussion: Once control transfers to the retailer, $900 of revenue ($10 x 90 products (100 less the 10% expected returns)) and cost of sales of $180 ($2 x 90 products) is recognized. An asset of $20 (10% of product cost) is recognized for the anticipated sales returns while a liability of $100 (10% of product sale price) is recognized for the refund obligation (rather than recording an allowance against accounts receivable). The estimate of returns is re-evaluated at each reporting date. Any changes in the probability require an adjustment to the asset and liability. Adjustments to the liability recorded to revenue and adjustments to the asset recorded against cost of sales.
13
Contract costs
Existing USGAAP literature 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. No industryspecific information is provided under IFRS. The proposed standard includes contract cost guidance, and management will need to consider whether the accounting for contract costs will be affected by the proposed standard.
Proposed standard All costs of obtaining a contract, costs relating to satisfied performance obligations and costs related to inefficiencies are expensed as incurred. Other direct costs incurred in fulfilling a contract are expensed as incurred unless they are within the scope of other standards (e.g., inventory, intangibles, fixed assets). Costs in the scope of other standards are accounted for in accordance with those standards. If they are not, the entity recognizes an asset only if the costs relate directly to a contract, relate to future activity and are probable of recovery under a contract. These costs are then amortized as control of the goods or services to which the asset relates is transferred to the customer.
Current US GAAP Filmed entertainment The production of motion pictures and episodic television series require significant upfront investment. Projects to produce content can include significant development stage expenditures, including those to acquire intellectual property such as film rights to books or original screenplays. Currently, such development costs are typically capitalized and included in the film asset balance. Such costs would typically be written-off if the project is not green-lit within three years of the date of initial cost capitalization. Impact: The accounting for costs to produce an episodic television series and film costs (i.e., capitalization and amortization) including direct negatives, overall deal costs, rights to film properties, costs incurred for significant changes, as well as the allocations of production overhead and capitalization of interest is not anticipated to be affected by the proposed standard.
Current IFRS There is no specific guidance for recognizing costs in relation to selling goods or rendering services. However, for the rendering of services, construction accounting guidance generally is applied to the accounting for revenue and associated expenses. It may be appropriate to capitalize costs if the entity can recognize an asset under the inventory, fixed asset, or intangible asset standards, or if the costs otherwise meet the definition of an asset. Costs such as training costs are typically not capitalized because they do not meet the definition of an asset. However, certain initiation or pre-contract costs may be capitalized when they can be separately identified, reliably measured and it is probable that the contract will be obtained. Such costs can only be capitalized if they meet the definition of inventory, property, plant and equipment, intangible assets, or an asset within the IFRS Framework. Certain costs associated with filmed entertainment may be capitalized. They are accounted for as intangible assets. Costs that are not capitalized are expensed as incurred. Any capitalized costs are subject to the impairment requirements. continued
14
Current US GAAP Video games Software development costs typically include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products. Software development costs are capitalized once technological feasibility of a product is established and such costs are 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 will be recoverable from future royalties earned by the artist. The portion of the record master costs incurred by the record company is 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.
Current IFRS Impact: The accounting for some contract costs might not be significantly affected. However, the accounting for other costs (e.g., commissions) may be affected, as such costs are expensed as incurred under the proposed standard.
continued
15
Current US GAAP 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 internal and external costs, but are limited to those that are directly attributable to a specific title. Impact: The accounting for many pre-publication costs is expected to remain consistent with current practice. There may be some exceptions such as sales commissions, which will be expensed as incurred. Cable television Many costs incurred in the cable television business are capitalized including franchise application fees, certain direct selling, subscriber related 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 subscriber are capitalized. Impact: The accounting for certain cable television costs may be affected under the proposed standard as franchise application costs and commissions will likely be expensed as incurred. However, costs incurred during the prematurity period are not anticipated to be impacted by the proposed standard.
Current IFRS
16
USGAAP Convergence & IFRS Revenue recognition: Healthcare industry supplement

March 2011
Revenue recognition . . . full speed ahead Healthcare industry supplement

Whats inside: Overview Uncollectable accounts Third-party settlement estimates Loss contracts
Overview
In certain countries, healthcare is a service that is government-operated and government-funded. In contrast, the US healthcare system resides primarily within the private sector, with government serving as the largest purchaser of healthcare services. As a result, USGAAP contains specific guidance and information relating to industry-specific revenue recognition principles for hospitals and other healthcare provider organizations, as well as for health plans such as health maintenance organizations (HMOs) that arrange for healthcare services to be provided to their members. Outside of the US, healthcare industry-specific guidance generally resides within public sector (i.e., governmental) GAAP and is therefore not addressed here. In the US, a major difference between healthcare organizations and other types of service operations is that, in most cases, the recipient of healthcare services the patientdoes not pay directly for the services. Instead, payment is made by some other organization, referred to as a third-party payer. The third party may be Medicare, Medicaid, an insurance company, or an HMO. The actual amount received by the hospital will vary depending on the contractual arrangements between the hospital and the third-party payer, and such contracts typically do not provide for payment at the hospitals established charges. The patient is responsible for paying his or her own bill if the patient does not have insurance or is not covered by a government program. The following items common in the healthcare industry may be significantly impacted by the proposed revenue recognition standard. The impact of the proposed standard on the revenue recognition of continuing-care retirement communities is expected to be similar to the impact on other organizations whose contracts involve multiple-element arrangements and are not discussed within this supplement. This paper, examples, and related assessments contained herein, are based on the Exposure Draft, Revenue from Contracts with Customers, which was issued on June 24, 2010. These proposals are subject to change at any time until a final standard is issued. The examples reflect potential impacts based on the proposed standard reflected in the exposure draft and any conclusions noted are subject to further interpretation and assessment based on the final standard. For a more comprehensive description of the model refer to PwCs Dataline 201028 or visit www.fasb.org.
Reprinted from: Dataline 201028 (Supplement) July 9, 2010
Revenue recognition: Healthcare industry supplement
Uncollectable Accounts
The most significant implications of the proposed standard for healthcare organizations will likely be associated with uncollectable patient accounts. Under both existing USGAAP and IFRS, uncertainties associated with the collectability of receivables are viewed as day 2 loss contingencies associated with a recognized asset (accounts receivable). Under the proposed standard, the potential that an account will not be collected is dealt with in measuring the amount of revenue and contract asset
or receivables initially recorded. Bad debt expense would no longer be recognized for those accounts not expected to be fully collected at the time services are rendered. Instead, the type of analysis historically employed in establishing an allowance for uncollectable accounts will be used as a tool in evaluating the amount of revenue to initially recognize. Any changes in the amount of consideration expected to be received are reflected as income or expense, rather than as an adjustment to revenue. The proposed standard does not specify where subsequent changes should
reside on the face of the income statement or whether they should be reflected separately in operations. The vast majority of uncollectable accounts and bad debt expense are usually associated with services provided to uninsured patients who do not qualify for charity care (self-pay patients). Thus, the most significant of the measurement difference will be encountered in dealing with this category of patients.
Proposed standard Incorporating collectability into initial measurement The transaction price should be adjusted to reflect the customers credit risk (the ability to pay the consideration) by recognizing the consideration expected to be collected on a probability-weighted basis, if it can be reasonably estimated.
Current US GAAP
Current IFRS
Revenue associated with services provided to all non-charity patients is recognized in the financial statements, regardless of whether the organization has an expectation of collectability. Revenue and receivables are recorded at the organizations established rates. If a receivable subsequently proves to be uncollectable, the account is written-off to bad debt expense. Impact: By assessing the expectation of collectability in connection with initial measurement of self-pay revenue, the historical gross-up of revenue and bad debt expense associated with accounts with a high degree of uncertainty of collectability would be eliminated.
No healthcare industry-specific guidance currently exists. Existing revenue guidance requires that an entity determine whether it is probable that the economic benefit associated with the transaction will flow to the entity. If it is not probable, revenue is not recognized until it is probable of being received. Impact: For those accounts not probable of being paid, but for which there is a possibility of receipt of some consideration, more revenue may be recognized than under existing guidance given the requirement to follow a probabilityweighted approach.
Example 1
Facts: Hospital Y has $10,000 in gross charges related to self-pay patients during the month of October. Hospital Y has a demonstrated history of collecting approximately 7% of overall charges associated with self-pay patients (that is, collections from the self-pay group as a whole); however, the hospital cannot predict the specific individuals that will ultimately remit payment.
Discussion: Historically, Hospital Y would have recorded $10,000 in revenues and, over time, written off $9,300 to the provision for bad debts. The proposed standard requires Hospital Y to make a probabilityweighted assessment of expected collections that will be received from this group of patients if such amounts are reasonably estimable. Such an estimate requires management to assess the probability of each possible outcome. Based on Hospital Ys historical experience with self-pay patients, the following outcomes have been identified: Possible collection amounts $0 $250 $500 $750 $1,000 $2,000 Probabilityweighted Probability amounts 1% 16% 25% 45% 13% 0% $0 40 125 338 130 0 $633
Based on the probability-weighted estimation process, Hospital Y would expect to collect $633 from the group of self-pay patients treated in October. Therefore, Hospital Ys financial statements would reflect $633 in revenues and a contract asset of $633 for the month of October. If Hospital Y ultimately collects only $600, the $33 of additional write-off would be reflected as an other expense, rather than reducing revenue previouslyrecognized.
Third-party settlement estimates

The largest purchasers of healthcare services in the US are the federal and state governments, which purchase services through programs such as Medicare and Medicaid. Revenue earned by healthcare
providers under annual contracts with these programs is determined under complex government rules and regulations that subject the healthcare organization to the potential for retrospective adjustments in future years. Because several years may elapse before all potential government adjustments related to a particular
contract year are known, management must estimate the effects of future program audits, administrative reviews and billing reviews in the year that the services are provided. Uncertain amounts to be earned from government contracts would be viewed as variable consideration under the proposed standard.
Proposed standard Variable consideration When the amount of consideration that a customer pays is variable (rather than fixed) due to contingencies, the transaction price is the probability-weighted estimate of consideration to be received, assuming that it can be reasonably estimated.
Current US GAAP Because the amount to be earned under contracts with government payers will not be known with certainty for several years, providers must estimate the cash flows ultimately expected to be received for services provided during a contract period and report that amount as revenue. Impact: Currently, management makes its best estimate of the third-party settlement adjustment required based on its knowledge and experience about past and current events. Under the proposed standard, that process will be modified to incorporate probability-weighting techniques. Single best estimates of amounts to be received will not be acceptable.
Current IFRS No healthcare industry-specific guidance currently exists. Entities follow existing revenue recognition guidance which requires that revenue be measured at the fair value of amounts received or receivable. To the extent that management has reliable settlement history and experience, management recognizes revenue based on its best estimate of consideration to be received. Impact: A change to a probability-weighted approach will likely impact the amount of revenue entities record, particularly if management currently uses a single best estimate approach.
Example 2
Facts: Hospital X participates in the Medicare program. Medicare pays Hospital X at rates it establishes for services rendered to Medicare beneficiaries during a contract year that coincides with the hospitals fiscal year. Typically, it takes three years from the year that services were rendered for Medicare to validate the claims and to issue the notice of final program settlement which will close out that contract year. Each year, management estimates the impact of program adjustments based on its knowledge and experience about past adjustments and its assumptions about adjustments that are required based on current conditions. It accrues a third-party settlement asset or liability to adjust the revenue estimate for that contract year.
During the contract year 20X1, Hospital X tentatively earned $50 million of net patient service revenue associated with Medicare patients; however, it has not yet made a provision for estimated future program adjustments. Discussion: Historically management has made a single best estimate of the adjustment required, which typically has been a recoupment (i.e., additional amounts were owed to Medicare). Under the proposed standard, management must make a probability-weighted estimate of the adjustment required, assessing the probability of each possible outcome. Based on Hospital Xs experience with Medicare, the following possible outcomes have been identified: Possible Probabilityrecoupment weighted amounts Probability amounts $0 million $5 million $10 million $12 million 1% 45% 30% 24% $0 million 2.3 million 3.0 million 2.9 million $8.2 million Based on the results of the probabilityweighted assessment, management would record an estimated third-party settlement liability of $8.2 million to reduce the estimated revenue earned for the contract year to $41.8 million.
Loss contracts
The primary source of income for HMOs is premium payments. In exchange for premiums, HMOs agree to provide (or arrange for provider organizations to supply) healthcare services to the covered individuals. If its premiums are set too low or if utilization by plan members is higher than expected, an HMO may sustain an economic loss in fulfilling a particular contract. Proposed standard Measuring contract losses A performance obligation is considered onerous (and therefore, a loss contract exists) when the direct costs to satisfy a performance obligation exceeds the consideration allocated to it. The onerous test should be applied at the level of the individual performance obligation rather than at the contract level. Only direct costs are considered in measuring contract losses. Direct costs may include: Direct labor Direct materials Current US GAAP To determine whether a loss accrual is necessary, contracts are grouped in the same manner used by the HMO for establishing its premium rates, and the aggregate costs and revenues are projected for each group. The costs considered include all direct costs of the contracts along with any indirect costs identifiable with or allocable to the contracts. If the aggregate group expenses for the contract period are expected to exceed the aggregate group revenues, the excess is accrued as a loss. Only when the group as a whole is unprofitable would a loss be recognized. Current IFRS No healthcare industry-specific guidance currently exists. Existing provisions guidance addresses the accounting for onerous losses. Onerous losses are assessed at the contract level, and are measured by comparing the economic benefits under the contract to the least net costs to exit it. Least net costs may be either the costs to fulfill the contract or the cost of cancelling or breaching the contract. Impact: Existing guidance does not permit the inclusion of indirect costs that are not directly attributable to the contract in the measurement of an onerous contract, therefore the impact will be less significant under IFRS than US GAAP.
Allocations of costs that relate directly Impact: HMOs will no longer include indirect to the contract or contract activities costs when evaluating whether a loss Costs explicitly chargeable to the accrual is required, thus reducing the customer under the contract likelihood of recognizing a loss. However, Other costs incurred only because the HMOs may be negatively impacted by entity entered into the contract the requirement that the onerous test be performed at the level of the individual performance obligation (that is, the individual contract). Thus, a loss could be recognized at the individual performance obligation level, even if the group as a whole is profitable.
Example 3
Facts: HMO Z establishes its rates using the community rating method. Thus, rates to be charged to the entire population are based on the experience of the entire population, rather than on the experience of an individual employer group. HMO Zs enrolled population and its projection of the related revenues and costs associated with that population are as follows: Members Employer A Employer B Employer C Estimated revenue $10 million 10 million 10 million $30 million Discussion: Under existing USGAAP, HMO Z would not recognize a loss because the estimated revenues exceed the projected expenses for the group of contracts. Under the proposed standard, it may at first appear that HMO Z would be required to recognize a loss on its contracts with Employers A and C. However, because the proposed standard considers only direct costs, none of the employer contracts individually would represent an onerous performance obligation. Current IFRS specifies that the unit of account for which an onerous loss should be calculated is the contract level. If the contracts with Employers A, B and C are unrelated, the onerous contract analysis is performed at the individual contract level. Even so, as only the direct costs will be considered relative to the revenue, no loss would be recognized. A similar result is expected under the proposed standard, and as a result, entities currently following IFRS may not see a significant change in this area. Projected expenses $11.00 million 7.75 million 10.25 million $29.00 million Direct costs $9.50 million 6.50 million 9.25 million $25.25 million Indirect costs $1.50 million 1.25 million 1.00 million $3.75 million
USGAAP Convergence & IFRS Revenue recognition: Industrial products and manufacturing industry supplement (Updated November 30, 2011)
November 2011
Table of contents
Revenue from contracts with customers Revenue recognition . . . full speed ahead
2 17
Revenue from contracts with customers The proposed revenue standard isre-exposed
Whats inside: Overview Construction-type accounting Warranties Contract costs Collectibility Variable consideration Consignment sales Bill and hold arrangements
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 PwCs Dataline 2011-35 or visit www.fasb.org.
Reprinted from: No. 201135 (supplement) November 22, 2011
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: The entitys performance creates or enhances an asset that the customer controls; or The entitys performance does not create an asset with alternative use to the entity; and at least one of the following is met: - The customer receives and consumes the benefits as the entity performs, - Another entity would not need to substantially reperform the work performed to date if 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. Current US GAAP 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. Current IFRS 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 For transactions in the scope of involvement to the extent normally construction-type and production-type associated with ownership nor retain contract guidance (ASC 605-35), revenue effective control is recognized using the percentageof-completion method when reliable The amount of revenue can be reliably estimates are available. measured 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 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. The completed-contract method is required when reliable estimates cannot be made. 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 more-precise estimates can be made. The completed contract method is not permitted. continued
Revenue recognition: Industrial products and manufacturing industry supplement (Updated November 30, 2011)
Proposed model continued from previous page A performance obligation is satisfied at a point in time if it does not meet the criteria above. Determining the point in time when control transfers will require judgment. Indicators that should be considered in determining whether the customer has obtained control of a good include: The entity has a 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. 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 entitys 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 entitys 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. 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.
Current US GAAP
Current IFRS
Impact: The impact of the proposed standard will vary depending on each entitys specific facts and circumstances. Management will need to assess contracts to 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 for contracts that require highly customized engineering and production, where 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 transactions 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.
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). 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 US GAAP. continued
Proposed model continued from previous page 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 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 US GAAP
Current IFRS
Key change from the June 2010 ExposureDraft

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.
Non-refundable, interim progress payments are required to finance thecontract 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
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 followingcharacteristics: 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 The work in progress can be completed and sold to anothercustomer Physical possession and title do not pass until completion of the contract
How should the vendor recognizerevenue? 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 nonrefundable 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 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 followingcharacteristics: The customization is significant and to the customers specifications and may be changed at the customers request during the contract term
How should the vendor recognizerevenue? 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. An entity will account for a warranty as a cost accrual if the customer does not have the option to purchase the warranty separately and the warranty does not provide the customer with a service in addition to assurance that the product complies with agreed-upon specifications.
Current US 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. Separately priced extended warranties result in the deferral of revenue based on the contractual price of the separately priced extended warranty. The value deferred is amortized to revenue over the extended warranty period.
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. 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.
Impact: Extended warranties give rise to a separate performance obligation under the proposed standard and therefore, revenue is recognized over the warranty period, similar to the accounting treatment under existing guidance. 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 US 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 todays guidance.
Key change from the June 2010 ExposureDraft:

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.
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 todays 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). An entity is permitted to recognize contract acquisition costs as an expense as incurred as a practical expedient for contracts with a duration of one year or less. 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). Current US GAAP There is a significant amount of detailed guidance on the accounting for contract costs that are under the scope of construction-type and production-type contract guidance (ASC 605-35). Pre-contract costs that are incurred for a specific anticipated contract may be deferred only if the costs can be directly associated with a specific anticipated contract and if their recoverability from that contract is probable. Outside of contract accounting, there is limited guidance on the treatment of costs associated with revenue transactions. Certain types of costs incurred prior to revenue recognition may be capitalized if they meet the definition of an asset. 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 and are incurred in securing that contract are included as part of contract costs that can be capitalized if they can be separately identified, measured reliably, and it is probable that the contract will be obtained. Costs associated with transactions that are not in the scope of contract accounting are capitalized if such costs are within the scope of other asset standards (for example, inventory, PP&E or intangible assets) or the Framework.
Impact: Costs likely to be in the scope of this guidance include, among others, sales Costs that are not in the scope of commissions, set-up costs for service providers, and costs incurred in the design another standard are evaluated under the phase of construction projects. The impact on entities will vary depending on the revenue standard. An entity recognizes guidance and policies followed currently. an asset only if the costs 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 continued expensed as incurred.
Proposed model continued from previous page 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 US GAAP
Current IFRS
Key change from the June 2010 ExposureDraft

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 itsemployee? 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 practicalexpedient.
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.
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. Both the initial assessment and any subsequent changes in the estimate will be recorded in this line item. Current US GAAP Revenue from an arrangement is deferred in its entirety if an entity cannot conclude that collection from the customer is reasonably assured. Credit risk is reflected as a reduction of accounts receivable by recording an 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 threshold. 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. Impact: Revenue may be recognized earlier than current practice since collectibility will no longer be a recognition threshold.
10
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.
Current US GAAP
Current IFRS
Volume discount payments are systemVolume discounts are recognized as a atically accrued based on discounts reduction to revenue as the customer earns the rebate. The reduction is limited expected to be taken. The discount to the estimated amounts potentially due is then recognized as a reduction of revenue based on the best estimate to the customer. If the discount cannot be reliably estimated, revenue is reduced of the amounts potentially due to the The transaction price is the consideration customer. If the discount cannot be reliby the maximum potential rebate. that the entity expects to be entitled to ably estimated, revenue is reduced by receive under the contract, including the maximum potential rebate. 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 predicImpact: tive of the amount to which the entity Accounting for volume discounts is unlikely to be significantly different under the would be entitled. proposed standard compared to todays accounting (US GAAP and IFRS). The If an entity receives consideration from a accounting for contracts with downward tiered pricing based solely on volume, customer and expects to refund some or however, may be different than current US GAAP. 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 entitys experience is predictive. continued
11
Proposed model continued from previous page Awards/Incentive payments/Claims Same as for volume rebates above.
Current US 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. Impact:
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.
Certain awards, incentive payments, or claims may be recognized earlier than under current practice, particularly for US GAAP as the reasonably assured threshold will be met sooner than todays 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. 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. 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 When discounting is required, the to be recognized, as well as the sepainterest component is computed based rate interest income component to be on the stated rate of interest in the instrurecorded over time. ment or a market rate of interest if the stated rate is considered unreasonable. The discounting of revenues is required in only limited situations, including receivables with payment terms greater than one year. Impact: The proposed standard is not significantly different than todays 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.
12
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 thatamount.
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 010,000,000 lbs 10,000,00130,000,000 lbs 30,000,001 lbs and above
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.
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?
13
Consignment sales
Proposed model Management will need to determine when control of goods provided to a dealer or distributor is transferred. Current US GAAP 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. Revenue in consignment arrangements can be recognized only when substantial risk of loss, rewards of ownership, and control of the asset have transferred to Inventory on consignment is typically the consignee (assuming all other criteria controlled by the consignor until the for revenue recognition have been satisconsignee sells the product to an end fied). Other situations may exist where customer, consumes the good in produclegal title to delivered goods passes to a tion, or a specified period expires. Only buyer, but the substance of the transacthen does the consignee typically have tion is that of a consignment. an unconditional obligation to pay for Current revenue guidance includes the products, and the consignor can several indicators that are considered no longer demand return or transfer to determine whether substantial risk of the goods to another. Control does not loss, rewards of ownership, and control therefore transfer until the consignee of the asset have transferred. sells or consumes the product, or a specified period expires. There may be situations in which the legal title of the goods has passed to the consignee but control has not. A consignee might be acting as an agent in these situations, in which case control does not transfer until sale to a third party.
Impact: The proposed guidance is similar to existing US GAAP and IFRS. Current revenue recognition, however, focuses primarily on the transfer of risks and rewards whereas the proposed standard focuses on transfer of control of the consigned goods. We expect many consignment arrangements will be unaffected by the proposed guidance; however, some arrangements might require different accounting under the proposed standard.
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 theshipment.
14
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 bill-and-hold arrangement: The reason for the bill-and-hold arrangement must be substantive The product must be identified separately as the customers The product must be ready for delivery to the customer 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 US GAAP Revenue is recognized in a bill-and-hold 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 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 buyers request
The customer must have made a fixed The buyer must have taken title to the goods and accepted billing commitment to purchase the goods, preferably in writing It must be probable that delivery will take place The buyer, not the seller, must request that the transaction be on a bill and The goods must be on hand, idenhold basis and have a substantial tified, and ready for delivery to business purpose for ordering the the buyer at the time the sale is goods on a bill and hold basis recognized 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 sellers 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. 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 US 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. The buyer must specifically acknowledge the deferred delivery instructions The usual payment terms must apply
15
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-andhold 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 producers bill-and-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 bill-and-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.
16
Revenue recognition . . . full speed ahead Industrial products and manufacturing industry supplement
Whats inside: Overview Contract accounting Warranties Contract costs Variable consideration Consignment sales Bill and hold arrangements
Overview
The Industrial Products (IP) sector comprises a range of companies involved in the production of goods and delivery of services across a diverse industry base. This includes industrial manufacturing, metals, chemicals, and forest, paper and packaging companies. IP companies typically recognize revenue based on the transfer of risks and rewards. Current USGAAP and IFRS guidance on revenue recognition will be withdrawn when the proposed standard becomes effective. Each industry in the IP sector has different product and service offerings, but there are a number of common revenue recognition issues. These include the accounting for long-term construction-type contracts, warranties, bill and hold arrangements, consignment transactions, incentives, and contract costs. IP companies will need to carefully assess the proposed standard to determine the extent of its impact on their business. The following items common in the IP industry may be significantly 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, which was issued on June 24, 2010. These proposals are subject to change at any time until a final standard is issued. The examples reflect potential impacts based on the proposed standard reflected in the exposure draft and any conclusions noted are subject to further interpretation and assessment based on the final standard. For a more comprehensive description of the model refer to PwCs Dataline 201028 or visit www.fasb.org.
*This Dataline Supplement was revised on September 3, 2010 to reflect certain editorial revisions. None of the revisions resulted in substantive changes to the assessments of the proposed model contained herein.
17
Contract accounting
Many IP companies have contracts where they provide a service (installation or customization) along with their products. The products and services are delivered over a period ranging from several months to several years. Revenue is currently recognized based on the activities of the vendor; that is, revenue is recognized as
the vendor performs, provided reasonable estimates are available. The change to a control transfer model will require careful consideration to determine when a vendor can recognize revenue. We expect that, in many contracts, control will transfer continuously to the owner over the contract term and might, therefore, produce results similar to today. This should not, however, be assumed.
Management will not be able to default to the method used today but will need to evaluate their arrangements under the proposed standard. For example, the use of the cost-to-cost method to measure revenue under an activities based recognition model might not be an appropriate measure for revenue arising from the continuous transfer of control.
Proposed standard 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 continuously over the contract period. Factors to consider in assessing control transfer include, but are not limited to: Factors to consider in assessing control transfer include, but are not limited to: 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 This list is not intended to be a checklist or all-inclusive. The ability to borrow against the asset, for example, may be another control transfer factor to consider. No one factor is conclusive on a stand-alone basis.
Current US GAAP For transactions in the scope of contract accounting, revenue is recognized using the percentage-of-completion method when reliable estimates are available. When reliable estimates cannot be made but there is an assurance that no loss will be incurred on a contract (e.g., when the scope of the contract is ill defined, 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. The completed-contract method is required when reliable estimates cannot be made. For transactions not in the scope of the contract accounting guidance, revenue is recognized once the risks and rewards of ownership have transferred to the customer.
Current IFRS For transactions in the scope of contract accounting, revenue is recognized using the percentage-of-completion method when reliable estimates are available. When reliable estimates cannot be made but there is an assurance that no loss will be incurred on a contract (e.g., when the scope of the contract is ill defined, 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. The completed contract method is not permitted. For transactions not in the scope of the contract accounting guidance, revenue is recognized 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
18
Proposed standard Measuring continuous transfer of control For contracts where control continuously transfers, a contractor can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones), or the passage of time to measure such continuous transfer. The method that best depicts the transfer of goods or services to the customer should be applied consistently throughout the contract and to similar contracts with customers. Once the measurement is determined, it is applied against total contract revenue to determine the amount of revenue to be recognized. This is currently referred to as the Revenue method. The use of the Gross Profit method is prohibited. Estimates used in measuring continuous transfer of control (e.g., estimated cost to complete when using a cost-to-cost calculation) are continually evaluated and adjusted using a cumulative catch-up method.
Current US GAAP
Current IFRS
Entities applying contract accounting can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a percentage-complete is derived, there are two different approaches for determining revenue, costs of revenue and gross profit; the Revenue method or the Gross Profit method.
Entities applying contract accounting can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones) or the passage of time to measure progress towards completion. Once a percentage-complete is derived, IFRS requires the use of the Revenue method. The Gross Profit method is not permitted.
Service revenue from transactions not in the scope of contract accounting Service revenue from transactions not in is recognized based on the stage of the scope of contract accounting may be completion if the transactions outcome can be estimated reliably. recognized by applying the proportional performance method.
Example 1Recognizing revenue control transfers during the contract term

Facts: A vendor enters into a contract to customize several of its products and install those products at the customers location. The installation service is available in the marketplace. The contract has the following characteristics: The customization is specific to customer specifications and may be changed at the customers 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 is the property of the customer; and Physical possession and title do not pass until completion of the contract.
Discussion: The terms of the contract, in particular the customer specifications (and ability to change the specifications), non-refundable progress payments, termination penalty, and ability to retain work-in-progress, suggest that control of the products is being transferred continuously over the contract term. The vendor determines if the product and the installation are distinct performance obligations, which are accounted for separately. Assuming the installation is a distinct performance obligation (because it has utility on its own), the vendor will need to select the most appropriate measurement model (either an input or output method or, less likely, passage of time) to measure the revenue arising from the continuous transfer of control of the products. The transaction price allocated to the installation performance obligation is recognized upon completion of the installation service.
How should the vendor recognize revenue?
19
Example 2Recognizing revenue control transfers after completion of the contract term
Facts: A vendor enters into a contract to construct several of its products and install those products at the customers location. The installation is not available from other vendors. 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; and Physical possession and title do not pass until completion of the contract.
Discussion: The terms of the contract, in particular payment upon completion, cancellation with penalty, and the inability to retain work-in-progress, suggest control of the products is transferred at the time of installation at the customer location. The vendor will need to determine if the product and the installation are distinct performance obligations, which are accounted for separately. Assuming the product and installation are accounted for together, the vendor will not recognize revenue until the products have been installed at the customer site and control has transferred to the customer.
How does the vendor recognize revenue?
20
Warranties
Many IP companies provide standard warranties with their products. The standard warranty is given to all customers and protects against latent defects for a specific time period. Many companies also offer extended warranties, which provide for coverage beyond the standard warranty period. An extended warranty is sometimes offered to the customer for an incremental fee.
The proposed standard draws a distinction between warranties that protect against latent defects and warranties that provide protection for defects that arise after the product is transferred to the customer, such as normal wear and tear. The accounting for extended warranties is similar to existing practice, but standard warranty accounting could be significantly different in that it may delay revenue recognition and require complex accounting calculations.
Proposed standard Warranties Warranties whose objective is to protect against latent defects do not give rise to a separate performance obligation but acknowledge the possibility that the contractor has not satisfied its performance obligation. Management will need to determine the likelihood and extent of defects in the products sold to customers at each reporting period to determine the extent of unsatisfied performance obligations. A portion of the contract revenue is deferred at the time of sale for defective products that will be replaced either in part or in their entirety. A warranty that protects against faults that arise after purchase (i.e., normal wear-and-tear) gives rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception.
Current US GAAP Companies typically account for standard warranties protecting against latent defects outside of the contract and in accordance with existing loss contingency guidance. A company will recognize revenue and concurrently accrue any expected cost for these warranty repairs. Warranties that protect against defects arising through normal usage are separate deliverables for which revenue is deferred and recognized over the expected life of the contract.
Current IFRS Companies typically account for certain standard warranties protecting against latent defects outside of the contract and in accordance with existing provisions guidance. Management recognizes revenue and concurrently accrues any expected cost for these warranty repairs. Revenue is deferred for warranties that protect against defects arising through normal usage and recognized over the expected life of the contract.
21
Example 3Accounting for standard warranties

Facts: A company sells its product, which includes a 90-day standard warranty that covers latent defects (e.g., defects that exist at the time of sale) in the product. The company will replace defective components of the product under the standard warranty. How does management account for such a warranty? Discussion: Management will need to estimate the selling price of the product components that will require repair or replacement at contract inception based on available information and the entitys experience. Contract revenue is allocated at inception on a relative selling price basis and revenue is deferred until the customer receives control of those components without defects (i.e., generally the earlier of when the defects are repaired/replaced or when the warranty period expires) because the warranty provides for repair or replacement of the components that are defective (rather than complete product replacement).
Example 4Accounting for extended warranties

Facts: A company sells its product, which includes a 90-day standard warranty that covers latent defects in the product. The customer also purchases an extended warranty that provides for an additional 18 months of coverage. How does management account for the extendedwarranty? Discussion: The standard warranty is accounted for consistently with the standard warranty offered in Example 3 above because it covers latent defects. The extended warranty is a separate performance obligation. Management allocates the transaction price (i.e., contract revenue) on a relative-estimated selling price basis to the product and the extended warranty. Revenue allocated to the extended warranty is recognized over the warranty coverage period (starting on day 91 for the following 18 months).
22
Contract costs
IP entities frequently incur costs prior to finalizing a contract or at the time the contract is finalized. 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 or other marketing costs. We expect a significant change from todays practice around the accounting for pre-contractcosts. Proposed standard Contract costs All costs of obtaining a contract, costs relating to satisfied performance obligations and costs related to inefficiencies (i.e., abnormal costs of materials, labor or other costs to fulfill) are expensed as incurred. Other direct costs incurred in fulfilling a contract are expensed as incurred unless they are within the scope of other standards (e.g., inventory, intangibles, fixed assets) or if other specified criteria are met. Costs that are in the scope of other standards are accounted for in accordance with those standards. An asset is recognized for costs outside the scope of other standards when the costs relate directly to a contract, relate to future performance and are probable of recovery under a contract. These costs are then amortized as control of the goods or services to which the asset relates is transferred to the customer. Current US GAAP There is a significant amount of detailed guidance on the accounting for contract costs, particularly for pre-contract costs. Pre-contract costs that are incurred for a specific anticipated contract may be deferred only if the costs can be directly associated with a specific anticipated contract and if their recoverability from that contract is probable. Current IFRS There is a significant amount of detailed guidance around accounting for contract costs in construction contract accounting. Costs that relate directly to a contract and are incurred in securing that contract are included as part of contract costs that can be capitalized if they can be separately identified, measured reliably and it is probable that the contract will be obtained. Costs associated with transactions that are not in the scope of contract accounting are capitalized if such costs are within the scope of other asset standards (e.g., inventory, PP&E or intangible assets) or the Framework.
Example 5Accounting for sales commissions

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 management account for the commission paid to its employee? Discussion: The commission payment is expensed as incurred (i.e. at inception of the contract if the commission is owed to the salesperson upon signing), as it represents a cost of obtaining the contract.
23
The transaction price (or contract revenue) is the amount of consideration the manufacturer or service provider receives, or expects to receive, in exchange for satisfying its performance obligations (i.e., delivery of goods/services). Determining the transaction price is simple when the contract price is fixed and paid at the time goods are provided or services delivered. Determining the transaction price may be more complex if the consideration contains an element of variable or contingent consideration.
Common considerations in this area for the IP industry include the accounting for awards/incentive payments, volume rebates, claims and time value of money. Manufacturers today generally take a conservative approach in making the determination of when awards/incentive payments are included in contract revenue. We expect such consideration may be recognized earlier under the proposed standard. Otherwise, we do not expect a significant difference from currentpractice.
Proposed standard Volume rebates Volume rebates are generally receivable by the customer when specified cumulative levels of revenue are earned during a defined period. Volume rebates may be considered performance obligations under the proposed standard, as the customer has an option to access discounts on future sales. Hence, a portion of the transaction price is allocated to the obligation to provide discounts or issue price reductions on future orders. Revenue is measured using a probability-weighted approach when payments can be reasonably estimated. The amounts can be reasonably estimated when the seller has experience with such volume rebates and the experience is relevant to the contract. Otherwise, revenue is limited to the amount of consideration that management can reasonably estimate.
Current US GAAP Volume rebate payments are recognized as the customer earns the rebate. The accrued cost is limited to the estimated rebates potentially due. If the rebate cannot be reliably estimated, revenue is reduced by the maximum rebate.
Current IFRS Volume rebate payments are systematically accrued based on discounts expected to be taken. The rebate is then recognized as a reduction of revenue at the best estimate of the rebate. If the rebate cannot be reliably estimated, revenue is reduced by the maximum rebate.
24
Proposed standard Awards/Incentive payments Awards/incentive payments are included in contract revenue using a probabilityweighted approach when such payments can be reasonably estimated. Such amounts can be reasonably estimated when the contractor has experience with similar types of contracts and that experience is relevant to the contract because the entity does not expect significant changes in circumstances. Claims As with awards/incentive payments, claims are included in contract revenue, using a probability-weighted approach, only when such revenue can be reasonably estimated.
Current US GAAP 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.
Current IFRS 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 recorded (only to the extent of contract costs incurred) as contract revenue only if it is probable and can be reliably estimated (determined based on specific criteria). 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.
Time value of money Contract revenue reflects the time value of money whenever the effect is material. Management uses a discount rate that reflects a separate financing transaction between the entity and its customer, and factors in credit risk.
Discounting of revenues to present value is required in instances where the effect of discounting is material. In such instances, an imputed interest rate is used for determining the amount of When discounting is required, the revenue to be recognized, as well as the interest component is computed based separate interest income component to on the stated rate of interest in the instrube recorded over time. ment or a market rate of interest if the stated rate is considered unreasonable. The discounting of revenues is required in only limited situations, including receivables with payment terms greater than one year.
Example 6Accounting for variableconsideration

Facts: A chemical company has a oneyear contract with an car manufacturer to deliver high performance plastics. The contract stipulates that the chemical company will give the car manufacturer a rebate when certain levels of future sales are reached, according to the followingscheme: Rebate 0% 5% 10% Sales volume 010,000,000 lbs 10,000,00130,000,000 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, the chemical company expects that: the likelihood that it would not have to pay a rebate is 20%; the likelihood that it will have to pay a 5% rebate is 50%; and the likelihood that it will have to pay a 10% rebate is 30%. How does the chemical entity recognizerevenue?
Discussion: Management is able to reasonably estimate the amount of expected rebates to be provided to the car manufacturer. The company also has a history of performing this type of work, the uncertainty will be resolved within a relatively short period of time and the possible outcomes are not highly variable. Management therefore recognizes revenue, based on a probability-weighted approach, of 94.5% of the contract value as goods are provided to the car manufacturer (assuming no customer credit risk). This estimate is monitored and adjusted, as necessary, using a cumulative catch-up approach, consistent with currentpractice.
25
Consignment sales
When goods are shipped under a consignment arrangement, title typically passes and payment is expected only when the purchaser (e.g., distributor) resells the inventory to a customer or uses it in production. It is common for IP companies to deliver products on a consignment basis. The proposed guidance is similar to existing USGAAP and IFRS. Current Proposed standard Consignment sales Management will need to determine when control of the goods provided under a consignment arrangement is transferred.
revenue recognition, however, focuses primarily on the transfer of risks and rewards whereas the proposed standard focuses on control transfer. Although we expect many consignment arrangements will be unaffected by the proposed guidance, some arrangements might require different accounting under the proposed standard. Analysis of the facts and circumstances surrounding each consignment arrangement will be necessary. Current US GAAP 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.
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 Inventory on consignment is typifor revenue recognition have been satiscally owned by the consignor until the fied). Other situations may exist where consignee sells the product to an end legal title to delivered goods passes to a customer, consumes the good in producbuyer, but the substance of the transaction, or a specified period expires. Only tion is that of a consignment. then does the consignee have an unconCurrent revenue guidance includes ditional obligation to pay for the prodseveral indicators that are considered ucts, and the consignor can no longer to determine whether substantial risk of demand return or transfer the goods loss, rewards of ownership, and control to another. Control does not therefore of the asset have transferred. transfer until the consignee sells or consumes the product, or a specified period expires. There may be situations, however, in which the legal title of the goods has passed to the consignee but control has not. In these situations, a consignee might be acting as an agent, in which case control does not transfer until sale to a third party. Factors to consider in making this determination are whether the consignee: Is obliged to pay for the goods only if sold Can return the products Obtains a return for selling the products that is in the form of a commission
26
Example 7Accounting for consignment sales

Facts: A company 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 company 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 company 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 company did not retain the right to demand return of the inventory, that might suggest that control transferred to the customer upon receiving the shipment.
27
Bill and hold arrangements

Under bill and hold arrangements, the customer agrees to purchase and pay for goods prior to their shipment and the seller retains possession of the goods for some period of time prior to delivery to the customer. Bill and hold transactions are common in certain industries (e.g., oil and gas) where the nature of the customers operations require this type of arrangement. Proposed standard Bill and hold arrangements Management will need to determine when control of the goods provided in a bill and hold arrangement is transferred. For a customer to have obtained control of a product in a bill and hold arrangement, the following criteria should be satisfied: The customer must have requested the contract be on a bill and hold basis; The product must be identified separately as the customers; The product must be ready for delivery at the time and location specified by the customer; and The entity cannot have the ability to sell the product to another customer. Some of the transaction price is allocated to the custodial services if they are a material separate performance obligation.
Current USGAAP and IFRS are similar to the proposed standard. However, the proposed standard is not as prescriptive as existing literature and it focuses on when control of the goods transfer to the customer in determining the point of revenue recognition. The exclusion of a fixed delivery schedule often precludes revenue recognition currently; however, such a requirement is not included in the
proposed standard. Entities will need to consider the facts and circumstances of its arrangements to determine whether control of the product has transferred to the customer prior to the delivery. Revenue recognition may occur earlier than under current practice in certain circumstances, however, we expect the timing of revenue recognition for many bill and hold arrangements to be unchanged.
Current US GAAP Revenue is recognized once the following criteria have been met: Persuasive evidence of an arrangement exists; Delivery has occurred; The price is fixed or determinable; and Collectability is reasonably assured. If delivery has not occurred, revenue recognition may precede delivery in certain circumstances. In order to recognize revenue in a bill and hold arrangement prior to the delivery of the goods, the following criteria must be satisfied: The risk of ownership must have passed to the buyer;
Current IFRS Revenue recognition generally occurs when the following criteria have been met: The entity has transferred to the buyer the significant risks and rewards of ownership; The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control; The revenue is reliably measurable; It is probable that the economic benefits of the transaction will flow to the entity; and The costs incurred or to be incurred can be measured reliably.
The customer must have made a fixed These criteria are usually satisfied when the goods are delivered. The following commitment to purchase the goods, conditions should be considered in preferably in writing; determining whether revenue is recog The buyer, not the seller, must request nized prior to delivery in a bill and hold that the transaction be on a bill and arrangement: hold basis and have a substantial The delivery is delayed at the buyers business purpose for ordering the request; 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 buyer must have taken title to the goods and accepted billing; It must be probable that delivery will take place; continued
28
Current US GAAP The ordered goods must have been segregated from the sellers inventory and not be subject to being used to fill other orders; and The goods must be complete and ready for shipment. The following factors should also be considered in determining whether revenue recognition should precede the delivery of the goods to the customer: The date by which the seller expects payment, and whether the seller has modified its normal billing and credit terms for the buyer; The sellers past experiences with and pattern of bill and hold transactions; Whether the buyer has the expected risk of loss in the event of a decline in the market value of goods; Whether the sellers custodial risks are insurable and insured; and Whether extended procedures are necessary in order to assure that there are no exceptions to the buyers commitment to accept and pay for the goods. If the criteria noted above are not satisfied, revenue recognition is typically deferred until delivery of the goods.
Current IFRS The goods must be on hand, identified and ready for delivery to the buyer at the time the sale is recognized; The buyer must specifically acknowledge the deferred delivery instructions; and The usual payment terms must apply.
Example 8Accounting for bill and hold arrangements

Facts: A gas company placed an order for a drilling pipe with a tubular steel producer. The gas company 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 manufacturer 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 manufacturer, is complete and ready for shipment. The standard terms of the arrangement require the gas company to remit payment within 30 days of the pipe being placed into the steel companys bill and hold yard. The gas company will request and take delivery of the pipe on an as needed basis. How does the steel manufacturer recognize revenue?
Discussion: It appears that control of the pipe transfers to the gas company once the pipe arrives at the steel manufacturers bill and hold yard, at which time the steel manufacturer should recognize the related revenue. Although all facts and circumstances need to be evaluated, this conclusion is based primarily on the fact that the gas company requested the transaction to be on a bill and hold basis, the steel manufacturer cannot use the pipe to fill orders for other customers, and the pipe is ready for immediate shipment at the request of the gas company. Note that a fixed delivery schedule is not necessary to achieve revenue recognition in this fact pattern. If the custodial services are determined to be a material separate performance obligation, some of the transaction price may need to be allocated to such services.
29
USGAAP Convergence & IFRS Revenue recognition: Pharmaceutical and life sciences industry supplement
March 2011
Revenue recognition . . . full speed ahead Pharmaceutical and life sciences industry supplement
Whats inside: Overview Variable consideration Licenses and rights to use Collaborations and licensing arrangements Sell-through approach and consignment stock Right of return Bill-and-hold arrangements Warranties
Overview
The pharmaceutical and life sciences industry has diverse products and services, as the industry comprises subsectors including pharmaceutical, biotech, and medical technology entities. Revenue recognition issues are common to the industry as a result of the variety of products and services and the complexity of many arrangements. The proposed revenue recognition standard may significantly affect certain aspects of revenue recognition by entities in the industry, while having a lesser affect in other areas. Entities will also continue to face some of the same challenges under the proposed standard that they face under the current guidance. One of the more significant aspects of the proposed standard is the change in the recognition and measurement of royalties and milestone payments under licensing and collaboration arrangements. Revenue is recognized when payment is reasonably assured (i.e., no longer contingent) today, which usually is close to when cash is received. Revenue is recognized under the proposed standard when the related performance obligation has been satisfied and the consideration can be reasonably estimated. Royalties and milestone payments are included in the transaction price when a reasonable estimate can be made and recognized when the related performance obligations are satisfied. The fact that receipt of the consideration may be contingent upon a future event (e.g., achievement of milestones, or specified sales levels) will not necessarily preclude recognition. For example, a biotech entity that has sold or licensed its intellectual property and is entitled to receive a royalty upon commercialization of a product will need to consider whether it has any performance obligations remaining with respect to that royalty stream. The biotech entity will record royalty revenue when it is able to reasonably estimate the stream of royalty revenue if no performance obligations remain. When an entity can reasonably estimate the stream of royalty revenue will require judgment; however, in many cases revenue may be recognized earlier than under current guidance.
Reprinted from: Dataline 201028 (Supplement) September 24, 2010
Revenue recognition: Pharmaceutical and life sciences industry supplement
Overview (continued)
The proposed standard also distinguishes between licenses that constitute an in substance sale and those that are a license (either exclusive or non-exclusive) for a specified period of time. This guidance will affect pharmaceutical, life science, and medical technology entities that enter into licensing arrangements or collaborations. Revenue for a license that is in substance a sale of technology or intellectual property or is a non-exclusive license is recognized when the license is delivered to the customer under the proposed standard. Revenue for exclusive licenses that are for less than the entire economic life of the underlying asset is recognized over the period of the license. When a license has been granted with research services, entities will need to assess whether the license is a separate performance obligation distinct from other goods or services and, thus, accounted for separately, or whether the license and research services together are a single performance obligation and accounted for as a single unit of accounting. The proposed guidance for product warranties that cover latent defects may affect medical technology manufacturers that sell products with standard warranties for repair or replacement of product. An entity will defer a portion of revenue based on estimated product replacements and/or repairs rather than recognize an expense and a liability for estimated warrantycosts. We discuss these and other issues in this paper. The paper, and the examples and related assessments contained herein, are based on the exposure draft, Revenue from Contracts with Customers, issued on June 24, 2010. The proposal is subject to change until a final standard is issued. Comments on the exposure draft are due by October 22, 2010. In light of the significant impact that the proposed standard may have on certain areas of revenue recognition for the industry, we encourage management to engage in the comment letter process and respond to the questions included in the exposure draft. For a more comprehensive description of the proposed standard refer to PwCs Dataline 201028 or visit www.fasb.org.
Variable consideration is recognized under the proposed standard when the related performance obligation is satisfied and consideration can be reasonably estimated. Common examples of variable consideration recorded by entities in the industry include strategic collaborations and licensing arrangements that include milestone payments and royalties. Milestone payments might be contingent on the achievement of certain development or sales targets. Royalties are typically based on product sales.
Entities also provide discounts, contractual allowances, and rebates on sales to their direct customers (e.g., wholesalers, distributors, etc.) and indirect customers (e.g., government, managed care organizations, group purchasing organizations (GPO), etc.). Examples of discounts and rebates are prompt pay discounts, Medicaid and state supplemental rebates, managed care rebates, GPO volume discounts, and payfor-performance rebates.
Proposed standard A performance obligation is an enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. Variable consideration is included in the transaction price based on a probabilityweighted estimate of consideration to be received if the variable consideration can be reasonably estimated. An estimate is reasonable, and is recorded, only if an entity: Has experience with identical or similar types of contracts. An entity can refer to the experience of other entities if it has no experience of its own. Does not expect circumstances surrounding those types of contracts to change significantly. In assessing whether circumstances may change significantly, management considers the impact of external factors, time until the uncertainty is expected to be resolved, the extent of experience, and the variability in the range of possible outcomes.
Current US GAAP Milestone payments A substantive milestone is defined in Revenue RecognitionMilestone Method and includes milestone payments received upon achievement of certain events, such as the submission of a new drug application (NDA) to the FDA or approval of a drug by the FDA. An entity that uses the milestone method under current guidance recognizes revenue on substantive milestone payments in the period the milestone is achieved. Non-substantive milestone payments that might be paid to the licensor based on the passage of time or as a result of the licensees performance are allocated to the units of accounting within the arrangement and recognized as revenue in a manner similar to those units of accounting. An entity that does not use the milestone method may use another revenue recognition model for recognizing milestone payments (e.g., analogy to the Revenue Recognition of Long-Term Power Sales Contracts model or the contingency adjusted performance model).
Current IFRS Milestone payments Milestone payments 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 receipt is probable. When development services are provided (with or without an associated license), the vendor/licensor accounts for the milestone payments 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.
continued
Current US GAAP Royalties 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
Management should consider the following factors to determine when milestone payments are recognized as revenue: (1) the reasonableness of the milestone payments compared to the effort, time and cost to achieve the milestones; (2) whether a component of Sales discounts, contractual the milestone payments relates to other allowances and rebates and pay-foragreements or deliverables, such as a performance arrangements license and royalty; (3) the existence of One of the criteria for revenue recognicancellation clauses requiring the repaytion in current guidance is that the selling ment of milestone amounts received price is fixed or determinable. under the contract; (4) the risks associated with achievement of milestones; The net selling price is determinable and (5) obligations under the contract, if management can reliably estimate including obligations that must be discounts, contractual allowances, completed to receive payment or penalty rebates, and performance outcomes for pay-for-performance arrangements upon clauses for failure to deliver. sale of the product. An entitys ability to The milestone events must have estimate selling price adjustments gener- substance, and they must represent ally requires some historical experience achievement of specific defined goals. as a basis for the estimates. Revenue (net of adjustments) is recognized upon Royalties delivery of the product when the adjustRevenue from royalties accrues in accorments can be reliably estimated. dance 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. Sales discounts, contractual allowances and rebates and pay-forperformance arrangements Revenue is recognized when it can be measured reliably. Experience is needed for arrangements with discounts, contractual allowances, rebates, or pay-for-performance criteria in order to have a reasonable basis for estimating revenue and the required adjustments. Revenue (net of adjustments) is recognized upon delivery of the product if the adjustments can be reliably estimated.
Proposed standard
Current US GAAP
Current IFRS
Impact: The proposal will fundamentally change the way many pharmaceutical, life sciences, and medical technology entities account for variable consideration. Revenue is recognized today only once a certain trigger (i.e., meeting a probability threshold or upon the achievement of a certain event) has been met. Revenue is recognized when variable consideration can be reasonably estimated under the proposed standard. The variable consideration is measured at the probability weighted expected outcome of the contingency, with the estimate updated at each reporting date. This may increase income statement volatility. There are two main issues for pharmaceutical, life sciences, and medical technology entities: What is (are) the performance obligation(s) related to the milestone payments and royalties? Can the amount of revenue be reasonably estimated? Milestone payments Performance obligation Entities will need to identify at inception the performance obligations under the arrangement and allocate the transaction price, which includes milestone payments (refer to the discussion of reliable measurement below), to the performance obligations based on their relative stand-alone selling prices. Entities will need to consider any contingent milestone events and whether there are separate performance obligations associated with them. For example, a biotech entity grants a license to technology to a pharmaceutical entity and agrees to perform research services on the technology. The biotech entity also receives a milestone payment upon submission of an application for approval to the regulatory authority. It will need to determine whether both the performance of research services leading up to the submission and the submission are performance obligations to which the transaction price is allocated. In this case, the transaction price includes consideration received for research services and the contingent milestone payments once such payments could be reasonably estimated (see discussion of reliable measurement below). The transaction price allocated to the research services performance obligation is recognized as revenue when the research services are performed. If the submission of an application for approval is a performance obligation, the transaction price allocated to that performance obligation is recognized when the application is submitted. Reliable measurement Variable consideration is measured on a probability-weighted basis. Reliable measurement does not imply that the entity knows the outcome of the contingency. Management uses its experience with similar contracts, where relevant, to estimate the probabilities of different outcomes. Entities in the industry must determine whether arrangements involving milestones are considered sufficiently similar to determine a reasonable estimate of outcomes. Research and development (R&D) services have highly uncertain outcomes and other R&D contracts may not be a guide to the potential outcomes of the contract in question, in which case no revenue is recognized until one or more potential outcomes can be estimated. However, an entity might be able to estimate potential outcomes prior to the milestone event and therefore recognize revenue before the milestone event is achieved. An entity might be able to more easily estimate a sales-based milestone for a currently marketed product. In this case, milestone revenue is recognized when the related performance obligation is satisfied (e.g., when a license is granted) rather than when the milestone is achieved. Revenue might be recognized prior to the removal of a contingency under the proposed standard if a reasonable estimate can be made. Outcomes are re-estimated at each period-end and revenue adjusted as necessary. Revenue is not limited to the amount of cash payments received or due and payable at the reporting date, as with current US GAAP. This might result in income statement volatility, including negative revenue in certain reporting periods, compared to current practice. continued
Proposed standard continued from previous page Royalties
Current US GAAP
Current IFRS
Performance obligation Entities will need to determine the performance obligation associated with a contractual royalty stream. Royalty revenue is recognized as the performance obligation is satisfied, as long as the revenue can be reasonably estimated. When the royalty is the consideration under a licensing arrangement, the performance obligation may be the transfer of the license. Royalty revenue is therefore recognized when the license is transferred (refer to discussion of licenses below) and the stream of royalty revenue can be reasonably estimated. The proposed standard is a significant change from the current guidance and in many cases may result in earlier recognition of royalties. Royalties are currently recognized as the underlying sales are made, on an accrual basis, provided collectibility is reasonably assured. Reliable estimate Entities will need to consider when they have the ability to reasonably estimate future sales to determine a probabilityweighted estimate of royalty revenue under the proposed standard. This could be at the inception of the arrangement, at some point prior to receipt of the royalty, or upon receipt of the royalty, depending on the licensors ability to estimate future variable consideration. An entity should consider the data used to determine the stand-alone selling price of performance obligations and whether that data can be used to make a reasonable estimate of the stream of royalty revenue. For example, an entity enters into a licensing arrangement under which it transfers the license to certain technology and receives an upfront payment and a royalty upon commercialization of a product. The entity will need to consider what data (e.g., projected cash flows) is available at the inception of the arrangement and at each reporting period to determine whether it can reasonably estimate the stream of royalty revenue. Whether available data is sufficient for an entity to conclude that it can reasonably estimate the contingent consideration is a matter of judgment. Once an entity has recorded the probability-weighted estimate of royalty revenue, it should re-evaluate the estimate at each period-end and adjust revenue as necessary. This might result in income statement volatility compared to current practice, including negative revenue in certain reporting periods. Contract asset A contract asset is recorded when royalty revenue or milestone revenue is recognized prior to the receipt of the royalty or milestone payments. The contract asset is discounted to reflect the time value of money, if the effect of discounting is material. The receivable is measured using a discount rate that reflects a separate financing transaction between the licensor and licensee and is adjusted each reporting period as circumstances change to reflect changes in estimates (with adjustments recorded in revenue). Any discount recorded on the receivable is amortized to interest income. Sales discounts, contractual allowances and rebates We believe that the proposed standard will not significantly change the accounting for sales discounts, contractual allowances, and rebates. An entity records a liability for estimated discounts, contractual allowances, and rebates with a corresponding reduction to revenue. The liability is assessed each reporting period and adjustments are recorded for changes in estimates or for actual payment data. Pay-for-performance arrangements Arrangements where an entity either receives additional amounts or pays rebates based on outcomes of its products in the patients who use the products are pay-for-performance arrangements. The performance obligation is the good or service provided, not the clinical outcome. Entities will use a probability-weighted approach to determine the revenue to recognize as opposed to the fixed or determinable selling price requirement under US GAAP or the requirement for it to be probable that the economic benefits associated with the transaction will flow to the entity under IFRS. However, we do not expect the proposed standard to have a significant impact on pay-for-performance arrangements. The probability-weighted approach to determining a reasonable estimate of variable consideration may align well with the determination of the transaction price under arrangements in which the consideration received is dependent upon various outcomes.
Example 1Royalties
Facts: A biotech entity enters into a licensing agreement in June 2010 that grants a license to certain intellectual property to a pharmaceutical entity. The biotech entity receives an upfront payment and is entitled to a 10% royalty on product sales. The biotech entity treats the transfer of the license to the pharmaceutical entity as a sale as the license is exclusive and covers the entire patent life of the underlying intellectual property (see discussion of licenses below). The biotech entity has no further performance obligations. How does the biotech entity recognize revenue? Discussion: Upon transfer of the license to the pharmaceutical entity, the biotech entity recognizes revenue for the upfront payment. Once the biotech entity transfers the license, it has no further performance obligations to satisfy in order to receive the future royalty revenue. The biotech entity recognizes royalty revenue for the entire period under which the technology was licensed once it can form a reasonable estimate of the future royalty revenues to be received. In cases where the biotech entity is unable to reasonably estimate royalty revenue at the inception of the agreement, it will need to re-assess each subsequent period whether it is able to reasonably estimate royalty revenue. The biotech entity will recognize the royalty revenue when it can be reasonably estimated.
The pharmaceutical entity receives approval in June 2014 for a commercialized product that was developed using the licensed technology. If the biotech entity has sufficient data to make a reasonable estimate of future royalties, it recognizes revenue for the total amount of royalties to be received over the term of the agreement. Assume the biotech entity expects the product to generate $4 billion of gross revenue over the term of the agreement (based on a probability-weighted approach). The biotech entity records revenue and a contract asset of $400 million ($4 billion x 10% royalty rate) in June 2014. The contract asset is discounted if the time value of money is material. Each subsequent period the biotech entity will re-assess the total royalty revenue expected to be recognized and record adjustments to revenue as appropriate for changes in its estimates.
Example 2Milestone payment

Facts: A biotech entity enters into a licensing agreement with a pharmaceutical entity in June 2010. The biotech entity grants a license to certain intellectual property to the pharmaceutical entity and will perform research services on the intellectual property. The biotech entity receives an upfront payment of $70 million, payments for research services performed, and a $150 million milestone payment upon FDA approval of a commercialized product. The biotech entity treats the transfer of the license to the pharmaceutical entity as a sale as the license is exclusive and covers the entire patent life of the underlying intellectual property (see discussion of licenses below). How does the biotech entity recognize revenue? Discussion: There are three performance obligations in this arrangement: (1) transfer of the license; (2) performance of research services; and (3) preparation and submission of information to the FDA to receive product approval. The biotech entity allocates the contract consideration, which includes the upfront payment, the payments for research services, and the contingent milestone payment, to the performance obligations based upon their relative standalone selling prices.
At the inception of the agreement, the biotech entity cannot determine a reasonable estimate of the milestone payment (based on a probability weighted approach) due to the early stage of development of the technology. No revenue is therefore recognized for the milestone payment at inception even though the performance obligation for the license has been satisfied. Following seven years of research and submission of an application for approval, in June 2017 the biotech entity can reasonably estimate the probability of receiving the milestone payment. Management estimates a 60% probability that the product will receive FDA approval. The biotech entity allocates the $90 million (($150 million x 60%) + ($0 x 40%)) of transaction price to the performance obligations as follows: Performance obligation License Research services Preparation and submission for FDA approval Total The license was transferred at the inception of the agreement, so the biotech entity will recognize revenue of $68 million in June 2017. The amounts allocated to research services and the preparation and submission of information to the FDA performance obligations are recognized to the extent these performance obligations have been completed. Refer to discussion of research services and continuous transfer in the collaborations section below. Fair value $75 million $20 million $5 million Relative % 75% 20% 5% Milestone payment $68 million $18 million $4 million $90 million
Example 3Sales rebates

Facts: A pharmaceutical entity sells its cholesterol drug to various distributors (direct customers) at list price. The distributors sell the drug to pharmacies, clinics, and others, which sell the product as prescribed by doctors. The entity has an agreement with a managed care organization (MCO) whereby the entity pays rebates to the MCO based on the relative share of the entitys drug prescribed to MCO members as compared to competitor drugs. The rebates are asfollows: Relative share of prescriptions as compared to competitor drugs +05% +510% +10%
Rebate 10% 15% 20%
The rebates are calculated on gross sales in a calendar quarter and paid once the MCO submits a rebate claim and the entity has validated the claim amount. How does the pharmaceutical entity account forrevenue? Discussion: The entity has a history of indirect sales to the MCO (prescriptions to MCO members). It estimates that approximately 12% of its sales through distributors are sold to pharmacies and prescribed to MCO members.
The entity calculates a probabilityweighted estimate of rebates to be paid to the MCO of 14.5% using the following data, which is based on the historical market share achieved by the MCO. Rebate amount 0% 10% 15% 20% Likelihood 0% 15% 80% 5%
Example 4Pay for performancearrangement

Facts: A pharmaceutical entity manufactures and sells an osteoporosis drug to a hospital, which administers the drug to its patients. The hospital is obliged to pay the entity for product purchased by the hospital under normal, 30-day payment terms. The hospital is eligible for a full refund if the patients test results do not meet pre-determined criteria after three months of treatment. The hospital has two months after the treatment period to request a refund (i.e., a total of five months after the initial treatment). The pharmaceutical entity received regulatory approval for the osteoporosis drug two years ago, and began selling the drug immediately to the hospital. Over the past two years, the entity and the hospital have been tracking the number of patients whose post-treatment test results did not meet the pre-determined criteria, and it has consistently ranged from 6-7% on a monthly and annual basis. The entity
expects future refunds to be consistent with historical results based on the nature of this drug and the relatively consistent patient results over the past two years. On a probability-weighted basis, the entity determines the refund rate to be 6.25%. How does the pharmaceutical entity account for revenue? Discussion: The pharmaceutical entity has sufficient historical data to calculate a reasonable estimate of consideration to be received for sales under the pay-forperformance arrangement. If the entity sells a unit of the osteoporosis drug to the hospital at a price of $5,000, the entity recognizes revenue of $4,700 ($5,000 x (16.25%)) upon delivery of the drug to the hospital. The entity will re-assess its estimate of variable consideration on sales to the hospital each subsequent period and record adjustments to revenue as needed.
The entity recognizes revenue when the product is delivered to the distributor. The entity expects 12% of its sales to the distributor to be sold through the MCO (i.e., prescribed to a member of the MCO), so it records variable consideration equal to the list price (price of the product sold to the distributor) less the rebate of 14.5% on the gross sales amount. The entity re-assesses its estimate of variable consideration on these MCO sales in each subsequent period and records adjustments to revenue as needed.

An entity that has developed a pre-regulatory approved technology may license that technology (intellectual property) to a pharmaceutical, life science, or medical technology entity. The license provides the licensee with rights to develop the technology and sell the resulting commercialized product. The licensor typically receives an upfront fee and a royalty stream for the license. Certain licensing arrangements may also include performance of research services on the licensed technology by the licensor. Proposed standard The transaction price allocated to the license is recognized when the performance obligation is satisfied. An entity will need to determine whether the license is in substance a sale or a license to determine when the performance obligation is satisfied. SaleThe contract is a sale, rather than a license or lease of intellectual property, if the licensee obtains control of the entire licensed intellectual property. This is the case if the entity grants a licensee an exclusive right to use its intellectual property for its entire economic life. Exclusive licenseThe licensor has a performance obligation that is satisfied over time as it permits the licensee to use its intellectual property if the licensee does not obtain control of substantially all of the rights to the licensed intellectual property and the licensor has promised to grant exclusive rights to the licensee. This is the case if the entity grants a licensee an exclusive right to use its intellectual property for a period less than its economic life.
Management will need to consider whether licenses granted qualify as a sale of technology or as exclusive or non-exclusive licenses. When a license is granted with a commitment to perform research services, management will also need to determine whether the license and research services are distinct performance obligations or are one combined performance obligation. This distinction will affect the timing of revenue recognition with respect to the license.
Current US GAAP Consideration is allocated to the license and revenue is recognized when earned, typically when the license is transferred if the license has standalone value. The license is combined with other deliverable(s), typically the research services, and revenue for the single unit of account is recognized when earned, typically as the research services are performed, if the license does not have standalone value.
Current IFRS Fees paid for the use of an entitys assets are normally recognized in accordance with the substance of the agreement. This may be on a straight-line basis over the life of the agreement, for example, when a licensee has the right to use certain technology for a specified period of time. An assignment of rights for a fixed fee or non-refundable guarantee under a non-cancellable contract that permits the licensee to exploit those rights freely and the licensor has no remaining obligations to perform is, in substance, a sale. Determining whether a license is in substance a sale requires the use of judgment. A license sold with services or other deliverables requires the vendor to exercise judgment to determine whether the different components of the arrangement should be accounted for separately.
continued
10
Proposed standard continued from previous page Non-exclusive licenseA nonexclusive license is a single performance obligation. The entity satisfies that obligation when the licensee is able to use and benefit from the license, which is no sooner than the beginning of the license period.
Current US GAAP
Current IFRS
Impact: Two main issues arise for pharmaceutical, life sciences and medical technology entities: When is the performance obligation satisfied? When license arrangements include a license and contract for performance of research services, is the provision of the license itself a distinct performance obligation? Performance obligation A license where the licensee gains control of the intellectual property for substantially all of its economic life (e.g., for the period to patent expiry) is a sale and may be relatively easy to identify. Most licenses in this sector will be for the entire patent life; however, there may be circumstances where determining whether a license is a sale of technology or an exclusive license requires further consideration. For example, is there a sale if a biotech entity grants a perpetual, exclusive license to a compound to a pharmaceutical entity but places certain restrictions on its usage? Does a license that does not provide the pharmaceutical entity with the right to sublicense the compound indicate that the pharmaceutical entity does not have control? What if the pharmaceutical entity has the right to sell a commercialized product, but the biotech entity has retained the right to manufacture products? Is that an indication that the pharmaceutical entity does not have control? The proposed standard is not clear in this area. It might be difficult for entities to determine whether a license is exclusive. Explicit non-exclusive licenses are rare in the industry. It is more likely that a license will be granted to develop and commercialize technology in particular territories or for particular indications. The proposed standard acknowledges that an entity may grant rights to use the same intellectual property to more than one customer, but the rights granted to one customer might differ substantially from the rights granted to another customer. For example, a licensor may grant rights to develop intellectual property in one territory to Entity A and grant the rights to develop the same intellectual property in a different territory to Entity B. These rights are likely to be substantially different for each customer and each will therefore represent an exclusive license. The timing of revenue recognition will depend on whether the license is for substantially all of the useful economic life of the asset (for example, the term of the patent to the underlying intellectual property). Revenue is recognized over the license term if the term is not for substantially all of the economic life of the asset. Entities should consider the time period and distribution channel associated with the rights granted, as well as geography to determine whether licenses are exclusive. License arrangements with research services An entity will need to consider whether the provision of the license is a distinct performance obligation for which revenue is recognized when the obligation is satisfied. The license may be a separate performance obligation if the entity itself or another entity sells licenses separately or the license could be sold separately because it has a distinct function and a distinct profit margin. Entities will need to consider what is meant in the proposed standard by a similar good to determine whether similar licenses are sold separately. For example, is a license considered a similar good if it is sold separately by a university, or if others sell licenses targeted at the same therapeutic area or if there are similar targeted technologies? Most biotech entities grant licenses to technology that will likely qualify as exclusive licenses. So, if an entity grants an exclusive license to technology A and an exclusive license to technology B, the question is whether these exclusive licenses are similar goods only if the technology is targeted in the same therapeutic area or whether they are similar even if targeted in different therapeutic areas. If the license cannot be sold separately, management will need to consider whether the license has a distinct function and a distinct profit margin. This analysis may be challenging, similar to the challenges that US GAAP companies have in determining standalone value. Revenue may only be recognized on the satisfaction of distinct performance obligations. continued
11
Current US GAAP
Current IFRS
When licenses are sold with research services, the stage of the research on the licensed technology may affect the determination of whether the license has a distinct function (apart from the research services). 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 provision of the license may not be a distinct performance obligation in this situation, and the license and the research services together are a single performance obligation. The consideration is allocated to the single performance obligation and revenue is recognized as the performance obligation is satisfied. When a license has been granted with research services that comprise clinical trials, other entities might be able to perform the clinical trials. This might indicate that the license and research services can be separated. Consideration is allocated between the two performance obligations on a relative standalone selling price basis and revenue is recognized as the performance obligations are satisfied. For example, a biotech entity licenses technology to a pharmaceutical entity and will perform research services on the technology. The license provides the pharmaceutical entity with control of the technology for its entire economic life and the transaction is therefore a sale. If the license is a distinct performance obligation, consideration is allocated to the license based on its relative selling price and revenue is recognized on the transfer of the license to the pharmaceutical entity. If the license is not a separate performance obligation, but the license and research services are together a single performance obligation, consideration is allocated to the license and research services and revenue is recognized as the research services are performed. Refer to discussion of research services below. These issues will require careful consideration by management.
Example 5License is a sale of technology

Facts: A biotech entity enters into a collaboration agreement with a pharmaceutical entity. The biotech entity grants an exclusive license to its early stage compound for the treatment of obesity to the pharmaceutical entity. The pharmaceutical entity has the right to develop, distribute, and market a commercialized product that is developed using the licensed technology and has the right to sublicense the technology. The term of the agreement is through the end of commercially reasonable development of the licensed product. For any marketed product, the term is twelve years from commercial launch or expiry of the licensed patents relevant to each licensed product. The biotech entity will also perform research services on the compound. The biotech entity has determined that the license is a distinct performance obligation that should be accounted for separately from the research services performance obligation. How does the biotech company recognize revenue?
Discussion: The license is exclusive and the pharmaceutical entity has control of the license for the economic life of the technology, so transfer of the license to the pharmaceutical entity is a sale. The consideration that has been allocated to the license performance obligation is recognized when the license is transferred to the pharmaceutical entity and a reasonable estimate of the consideration can be made.
license period (10 years) does not represent the economic life of the technology. The biotech entity will also perform research services on the compound. The biotech entity has determined that the license is a distinct performance obligation that should be accounted for separately from the research services performance obligation. How does the biotech company recognize revenue? Discussion: The license is exclusive, but does not cover the entire economic life of the technology. The license to the pharmaceutical entity is therefore an exclusive license for less than the economic life of the technology. The consideration allocated to the license performance obligation is recognized over the 10 year license period.
Example 6License is an exclusivelicense

Facts: A biotech entity enters into a collaboration agreement with a pharmaceutical entity. The biotech entity grants an exclusive license to its early stage compound for the treatment of obesity to the pharmaceutical entity. The pharmaceutical entity has the right to develop, distribute, and market a commercialized product that is developed using the licensed technology for 10 years. The technology reverts to the biotech entity if a commercialized product has not been developed after 10 years. The biotech entity has determined that the
12
Identify the contract with Collaborations and licensing arrangements the customer
Pharmaceutical, life science, and medical technology entities frequently enter into strategic collaborations and licensing arrangements. The parties to these arrangements gain access to emerging technologies and funding for development of technologies. These arrangements typically include multiple elements that must be evaluated to determine the amount and timing of revenue recognition. A typical multiple element arrangement might include some or all of the following components: (1) license to use technology; (2) research services; (3) joint steering committee (JSC) participation; (4) performance based milestone payments (e.g., upon filing of an NDA, or approval by the FDA or another regulator); (5) royalties on sales of a commercialized product; and (6) a manufacturing agreement. The multiple element arrangement guidance in the proposed standard is similar but not identical to the current standards. This will continue to be a complex area that involves judgment. The following are relevant considerations for management in reviewing collaborations and licensing agreements:
Entities will need to consider whether the collaboration and licensing agreements should be segmented into two or more contracts based on specific facts and circumstances. For example, there could be separate contracts for the license, research services, and manufacturing of the compound. A contract should be segmented if the prices of the goods and services are independent of each other. If an entity sells a license with research services that have been independently priced, the entity will need to consider whether it regularly sells licenses and research services separately and if the contract should be segmented. This could affect how the transaction price (including variable consideration) is allocated amongst performance obligations and recognized when performance obligations are satisfied. We expect that the license and research services will not typically be priced independently of one another and therefore will not be accounted for as separate contracts. Manufacturing services provided under the arrangement might qualify as a separate contract with revenue recognized as manufacturing is performed.
Identify and separate performance obligations in the contract

Entities will need to identify distinct performance obligations within a contract and determine when the performance obligations are satisfied in order to recognize revenue. They will need to consider if the components in the contract, such as a license to use technology, research services, JSC participation, and milestones are each distinct performance obligations. An entity will need to consider whether the entity itself or another entity sells each individual component separately or if the different components could be sold separately because they have distinct functions and distinct profit margins. Whether research and development services performance obligations are distinct may depend on the stage of the project. For example, many biotech companies do not sell licenses separately without research services for early stage products. During the discovery stage, biotech companies have specialized know-how and technology for which only they can provide the related R&D services. Research services that comprise clinical trials may be performed by other companies, and this may indicate that research services can be separated and are a distinct performance obligation.
13
JSC participation is often included in collaboration or licensing arrangements that include research services to be performed by an entity on licensed technology. The JSC, which is often comprised of representatives of the licensee and licensor, typically monitors and directs the research and development performed on the licensed technology. The key issue is whether participation on a JSC represents a performance obligation for the licensor. We would not expect this determination to be different under the proposed standard. Entities will continue to assess whether their participation on JSCs is required by the counterparty to determine whether their JSC participation is a performance obligation. A licensors JSC involvement that is participatory often represents an enforceable obligation of the licensor. In that case, it is a performance obligation whereas a licensors JSC involvement that is protective may be a right rather than an obligation of the licensor. When a licensors JSC involvement is a performance obligation, the licensor will need to determine whether the JSC obligation has a distinct function by itself or should be combined with other performance obligations to determine whether revenue is separately allocated to the JSC involvement and when revenue is recognized.
Determine and allocate the transaction price

Entities will need to determine and allocate the transaction price to the performance obligations based on standalone selling prices. Determination of the transaction price will be significantly affected by the proposed standard due to the proposed changes in recognition and measurement of milestone and royalty payments. Variable or contingent consideration is included in the transaction price based on a probabilityweighted estimate of consideration to be received if the variable consideration can be reasonably estimated. Specific considerations with respect to licenses and variable consideration in the form of royalties and milestone payments are discussed above. Once the transaction price is determined, consideration is allocated to separate performance obligations based on relative stand-alone selling prices. This might be difficult in practice because (a) observable transactions for individual elements may not be common and (b) pharmaceutical products and intellectual property are often unique and difficult to value. The relative stand-alone selling prices are determined at the inception of the arrangement and are not re-assessed in future periods. When there are changes to the transaction price, for example, when there is a change in the estimate of variable consideration, such changes are allocated to each of the performance obligations based on the relative stand-alone selling prices determined at the inception of the arrangement.
Recognize revenue when each performance obligation is satisfied

A performance obligation is satisfied when the customer obtains control of the good or service. Performance obligations can be satisfied at a point in time or continuously over time. The main area that pharmaceutical entities will need to consider within collaboration and licensing arrangements is determining when the performance obligations are satisfied in respect of licenses and researchservices. Revenue is recognized when the license is delivered to the customer if the license is in substance a sale of technology or intellectual property or it is a sale of a nonexclusive license. Revenue for exclusive licenses is recognized over the period of the license. Licenses are discussed above. Revenue for research services that are typically performed continuously over a period of time is recognized using a method that best reflects the transfer of services. It may be challenging to determine whether services are transferred continuously as they are performed or whether control of the results of the research activity is transferred only on completion or achievement of a successful milestone event. This will affect the point at which revenue is recognized. Where control is transferred continuously, management will need to determine how revenue is calculated. The proposed standard provides examples of suitable methods, including output methods, input methods, and methods based on the passage of time. We would not expect a significant change under the proposed standard for entities that currently use these methods to recognize revenue for research services (e.g., proportional performance model, such as the contingency adjusted performance model).
Specific considerations with respect to licenses, milestones, and royalties provided under collaboration and licensing arrangements are discussed above.
14
Example 7Collaboration arrangement

Facts: A biotech entity enters into a collaboration arrangement with a pharmaceutical entity in June 2010. The biotech entity grants a license to certain intellectual property to the pharmaceutical entity and will perform research services on the intellectual property. The biotech entity receives an upfront payment of $40 million, payments for research services performed, a milestone payment upon FDA approval of a commercialized product of $150 million, and a 10% royalty on sales of a commercial product. The biotech entity treats the transfer of the license to the pharmaceutical entity as a sale since the license is exclusive and covers the entire patent life of the underlying intellectual property (see discussion of licenses above). How does the biotech company account for the revenue for services?
Discussion: There are three performance obligations in this arrangement: (1) transfer of the license; (2) performance of research services; and (3) preparation and submission of information to the FDA to receive product approval. The biotech entity allocates total contract consideration, which includes the upfront payment, the payments for research services, the contingent milestone payment, and royalties to the performance obligations based upon their relative standalone selling prices. Management determines that it can reasonably estimate the payments to be received for research services at the inception of the arrangement based on expected effort (hours to be incurred) using its experience performing research services on other technologies. Management estimates that total payments to be received for research services will be $25 million. However, at inception the entity cannot determine reasonable estimates of the milestone payment and royalties (based on a probability weighted approach) due to the early stage of development of the technology. No revenue is therefore recognized for the milestone payment and royalties at inception. Total arrangement consideration is allocated as follows: Relative % 75% 20% 5% Upfront payment $30 million $8 million $2 million $40 million Payments for research $19 million $5 million $1 million $25 million
Performance obligation License Research services FDA approval Totals
Fair value $75 million $20 million $5 million
15
Performance obligationtransfer of thelicense

Management considers the license to be a sale of intellectual property. Therefore, $49 million of consideration allocated to the license is recognized once control of the license has transferred. The biotech entity records revenue of $49 million, comprised of the cash received of $40 million and a contract asset established of $9 million. The contract asset is adjusted as payments are received on the other performance obligations.
Performance obligationFDA submissionprocess

The biotech entity recognizes consideration allocated to the FDA submission process once that performance obligation has been satisfied. If the biotech entity determines after seven years of research and the submission of a new drug application to the FDA in June 2017 that it can reasonably estimate the milestone payment and royalties, the biotech entity will allocate the milestone payment and royalties to the performance obligations and recognize revenue for performance obligations satisfied to date. The biotech entity estimates a 60% probability that the product will receive FDA approval. It therefore allocates $90 million (($150 million x 60%) + ($0 x 40%)) of consideration to the performance obligations. The entity estimates royalties will be $400 million (calculated estimated sales of $4 billion using a probability weighted approach x 10%) over the term of the arrangement. The milestone and royalty consideration is allocated asfollows:
As the performance obligation to transfer the license has been satisfied, the entity recognizes revenue of $368 million in June 2017. The entity recognizes a portion of the $98 million allocated to research services based on the portion of the performance obligation that has been completed to date. The entity does not recognize the $24 million of consideration allocated to the FDA submission process until the entity receives FDA approval. Each subsequent period the biotech entity re-assesses the milestone payment revenue and total royalty revenue recognized and records adjustments to revenue for changes in its estimates.
Performance obligationresearch services

The biotech entity recognizes consideration allocated to research services over the estimated research period using an appropriate model. In this case an output model is used that considers estimates of the percentage of total research services that will be completed each period, as the performance obligation to perform these services is satisfied continuously over the research period.
Performance obligation License Research services FDA approval Total
Fair value $75 million $20 million $5 million
Relative % 75% 20% 5%
Milestone payment $68 million $18 million $4 million $90 million
Royalties $300 million $80 million $20 million $400 million
16
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 Proposed standard Revenue is recognized on the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Factors to consider include, but are not limited to: The customer has an unconditional obligation to pay The customer has physical possession The customer has legal title The customer specifies the design or function of the good or service.
distributors, hospitals, or others or because the final selling price is not determinable until the product has been sold through to an indirect customer (e.g., government, managed care organizations, GPOs, etc.). When the final selling price is not determinable until the product has been sold
through to an indirect customer, revenue recognition is deferred until the consideration can be reliably estimated. Refer to discussion of variable consideration above. Entities will need to consider at what point control of consignment stock has passed to the distributor. The proposed standard may result in earlier revenue recognition under these arrangements. Current IFRS Revenue is recognized once the risks and rewards of ownership have transferred to the end consumer.
Current US GAAP Revenue is recognized once the risks and rewards of ownership have transferred to the end customer.
Impact: The proposed standard requires an entity that has entered into a consignment stock arrangement with a distributor, hospital or other customer under which the customer can return unsold product or rotate older stock to determine when transfer of control to the customer has occurred. 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. Managements estimate of expected returns, price concessions, etc., affects the amount of revenue recorded. The proposed standard might result in earlier revenue recognition than 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 (i.e., a call right), the entity may control the goods and revenue is therefore only recognized when products are sold through to an end customer, similar to current accounting.
Example 8Sale of products onconsignment

Facts: A medical technology entity ships stents to hospitals on a consignment basis. A hospital places orders for stents based on its expected need and can return unused stents to the entity. Once the hospital uses a stent (surgically implanted into a patient), the hospital takes title to the
stent. The entity has no further obligations with respect to the stent once it has been used by the hospital. How does the entity account for revenue? Discussion: The entity will need to consider whether the hospital has obtained control of the stents. For example, the entity will need to consider whether it has retained the right to demand the return
of the stents, which would indicate that control did not transfer to the hospital on receipt of the stents. If control of the stents transfers upon delivery to the hospital and a reasonable estimate of stents to be returned by the hospital can be made, the entity recognizes revenue upon delivery of the stents.
17
Right of return
Pharmaceutical, life science, and certain medical technology entities 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. Proposed standard 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. An asset and a corresponding adjustment to cost of sales are 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 sold. An impairment might need to be recognized for product expected to be returned that cannot be resold, which is the case for pharmaceutical and many medical technology products. Entities that are unable to calculate a reasonable estimate of returns might not be able to assert that their performance obligation related to the return provision in their sales terms had been completed with respect to all sales. Impact: We believe that the proposed standard will not affect the timing of revenue recognition when a right of return exists. Entities currently base their returns estimates on an expected return rate that considers return history and other factors (e.g., shelf lives, product in the channel, changes in product demand, launch of competitor product, etc.) to determine the probability that product will be returned within the return period. Management considers these factors in developing its estimate of returns and records a liability and a corresponding reduction to sales for estimated returns each period. If management cannot estimate sales returns, revenue is deferred until the return period expires or management is able to make a reasonable estimate of returns. Pharmaceutical entities usually destroy returned inventory, but certain medical technology entities can re-sell returned product. Where this is the case, the entity would record an asset for the right to recover goods from customers and an offsetting refund obligation. The gross presentation of the refund obligation and the right to recover the inventory is a change from current practice where the obligation and right are typically recorded net, but it is unlikely to have a significant effect. If indicators of impairment exist, the right to recover the inventory should be assessed for impairment.
Current US GAAP Revenue is recognized on sales with a right of return when an entity meets the conditions in ASC 605-15-25 (Revenue Recognition). These conditions include that the amount of future returns can be reasonably estimated. If an entity cannot reasonably estimate sales returns, usually due to a lack of history, the entity is precluded from recognizing revenue and cost of sales until either the return privilege has substantially expired or the entity is able to estimate returns, whichever occurs first. Entities must therefore assess whether they have the return history to be able to reliably estimate returns on product sales in order to recognize revenue.
Current IFRS Revenue from the sale of goods is recognized when the amount of revenue and associated costs can be measured reliably. In the case of returns, this means that revenue is recognized when returns can be estimated reliably. Whether the level of returns is capable of being measured reliably is a matter of judgment and usually relies on having some historical basis from which to draw a meaningful comparison. A liability is recorded and revenue is not recognized for expected returns.
Pharmaceutical, life science, and medical technology entities may have bill-andhold arrangements with their customers whereby the entity bills a customer for product, but does not ship the product until a later date. Entities can currently recognize revenue when product is sold (rather than on delivery) under arrangements that meet certain criteria. Proposed standard An entity will need to determine when control of the goods provided in a bill and hold arrangement is transferred. A customer will have obtained control of a product in a bill and hold arrangement when the following criteria are satisfied: Current US GAAP Revenue is recognized in a bill and hold arrangement prior to the delivery of the goods when the following criteria are met: The risk of ownership has passed to the buyer; Current IFRS Revenue is recognized in a bill and hold arrangement prior to the delivery of the goods when the following criteria are met: The buyer has taken title to the goods and accepted billing;
The customer has requested the The customer has made a fixed It is probable that delivery will take contract to be on a bill and hold basis; commitment to purchase the goods, place; The product is indentified separately preferably in writing; The goods are on hand, identified and as the customers; The buyer, not the seller, requests that ready for delivery to the buyer at the The product is ready for delivery at the transaction be on a bill and hold time the sale is recognized; the time and location specified by the basis and has a substantial business The buyer specifically acknowledges customer; and purpose for ordering the goods on a the deferred delivery instructions; and bill and hold basis; The entity does not have the ability to The usual payment terms apply. sell the product to another customer. There is a fixed schedule for delivery of the goods; Some of the transaction price is The seller does not retain any specific allocated to the custodial services performance obligations such that the if they are a material separate earnings process is not complete; performance obligation. The ordered goods have been segregated from the sellers inventory and not be subject to being used to fill other orders; and The goods are complete and ready for shipment. continued
19
Current US GAAP The following factors should also be considered in determining whether revenue recognition should precede the delivery of goods to the customer: The date by which the seller expects payment, and whether the seller has modified its normal billing and credit terms for the buyer; The sellers past experiences with and pattern of bill and hold transactions; Whether the buyer has the expected risk of loss in the event of a decline in the market value of goods; Whether the sellers custodial risks are insurable and insured; and Whether extended procedures are necessary in order to assure that there are no exceptions to the buyers commitment to accept and pay for the goods. If the above criteria are not satisfied, revenue recognition is typically deferred until delivery of the goods.
Current IFRS
The proposed standard is not as proscriptive as existing USGAAP. It 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 USGAAP; however, this requirement is not included in the proposed standard. 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. Some indicators that control has transferred include the product has been identified separately as the customers, the product is ready for delivery in accordance with the terms of the arrangement, and the entity does not have the ability to sell the product to another customer. Generally, we expect the timing of revenue recognition for bill and hold arrangements to be unchanged. Pharmaceutical entities that participate in vaccine stockpile programs should continue to apply the bill and hold
guidance in assessing when to recognize revenue. A vaccine stockpile program requires an entity to have a certain amount of vaccine inventory on hand for use by the government. The criteria in USGAAP for revenue recognition have not previously been met upon transfer of inventory to the stockpile because typically such arrangements do not include a fixed schedule for delivery and the vaccine stockpile inventory may not be segregated from the entitys inventory. The entity rotates the vaccine stockpile in many cases to ensure it is viable (does not expire). An exception has been provided by the SEC for entities that participate in US 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. This exception is very narrow in scope. For entities following USGAAP, the exception applies only to US government stockpiles and only to certain vaccines. It is not clear whether the SEC will carry forward the exception if the proposed
standard is adopted. For entities following IFRS, depending on the substance of the arrangements, revenue might be recognized when the inventory is added to the stockpile if the bill and hold 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 has not been segregated from an entitys inventory and is subject to rotation. Entities will also need to consider their performance obligations under the arrangement. The storage of stockpile product, the maintenance and rotation of stockpile product, and delivery of product may be distinct performance obligations under the arrangement to which consideration is allocated and revenue recognized as performance obligations aresatisfied.
20
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 entitys quality standards and other applicable regulatory requirements and that the product is usable and not defective. Some medical technology entities also offer extended warranties, which provide for coverage beyond the standard warranty period. The proposed standard draws a distinction between warranties that protect against Proposed standard Warranties that protect against latent defects do not give rise to a separate performance obligation, but acknowledge the possibility that the vendor has not satisfied its performance obligation. At the reporting date, the vendor determines the likelihood and extent of defective products that it has sold to customers. If the vendor is required to replace defective products, it does not recognize any revenue for those defective products when it transfers them to customers. If the vendor is required to repair defective products, it does not recognize revenue for the portion of the transaction price attributed to the products components expected to be replaced in the repair process.
latent defects (e.g., standard warranties) and warranties that provide protection for defects that arise after the product is transferred to the customer, such as normal wear and tear (e.g., extended warranties). The accounting for extended warranties under the proposed standard is similar to existing practice, but the accounting for standard warranties is likely to affect the timing of revenue recognition for certain medical technology products that are sold with a standard warranty and for which the entity has a history of replacing or repairing defective products. Such medical technology products may include capital equipment and instruments. Current US GAAP 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 contingency and related expense when it is probable that a loss covered by the warranty had been incurred and the amount of the loss can be reasonably estimated. In determining whether the loss can be reasonably estimated, an entity normally takes into account its own 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.
We do not expect the proposed standard to affect revenue recognition for products subject to stringent quality standards and applicable regulatory requirements, including pharmaceutical, life science, and other medical technology products, that do not have a history of being replaced or repaired under a standard warranty. These products may be sold with implicit or explicit standard warranties, but in practice, it is unlikely that they have any latent defects at the time of sale due to the stringent quality standards to which they are subject.
Current IFRS When an entity sells a product subject to warranty, it first determines whether the warranty represents a separable component of the transaction. 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 revenue on the sale and a provision is recognized for the expected future cost to be incurred relating to the warranty. continued
21
Proposed standard continued from previous page Warranties that provide protection for defects that arise after the product is transferred give rise to a separate performance obligation. A portion of the transaction price should be allocated to the warranty. Once the warranty obligation has been satisfied, revenue is recognized.
Current US GAAP
Current IFRS
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: Standard warranties The proposed standard may affect the timing of revenue recognition for certain medical technology products that are sold with a standard warranty that provides for replacement or repair of defective products by an entity that has a history of defective product being replaced or repaired under the warranty. The entity defers revenue recognition under the proposed standard if the defective product is expected to be replaced. Delivery of a defective product does not result in satisfaction of the performance obligation and represents a failed sale. The result is similar to the accounting for expected product returns. If the defective product is repaired under the warranty, the entity defers revenue for the portion of the price attributed to the components expected to be replaced. This is different from the current guidance, which requires the entity to record a liability and expense for the estimated probable loss related to the warranty. This liability is generally measured at the cost to replace or repair the product rather than at its sales value. Extended warranties The proposed standard does not significantly change the current accounting models for extended warranties. However, the amount of deferred revenue could be different under the proposed standard depending on the distinct performance obligations identified and the consideration allocated to each performance obligation. An entity allocates a portion of the transaction price, which may include consideration for both the product and the extended warranty (if priced separately), to the extended warranty and defers the portion of the revenue related to the extended warranty until the performance obligation is satisfied or the warranty period has lapsed. Product recalls and product liability claims Pharmaceutical, life science, and medical technology entities experience both product liability claims and product recalls. Product liability claims are scoped out of the proposed standard and are instead subject to the loss contingencies guidance in Contingencies (US GAAP) or Provisions, Contingent Liabilities and Contingent Assets (IFRS). Product recalls occur when a concern is raised regarding the safety of a product and may be either voluntary or involuntary. Recalls are generally not due to known manufacturing defects in a product at the time of sale. In fact, the recalled product was likely subject to stringent quality controls prior to sale. While not specifically addressed in the proposal, it is possible that a distinction may be drawn between defects that are known at the date of sale that require deferral of revenue and clinical safety issues that are not known or are not detected through manufacturing quality controls at the date of sale. If so, a product recall associated with clinical safety issues that are not known at the date of sale are not subject to the standard warranty guidance under the proposed standard. Recall related liabilities and product liabilities are not performance obligations under the proposed standard. Such recalls will continue to be subject to the loss contingencies guidance similar to a product liability
Example 9Standard warranty

Facts: A medical technology entity sells diabetes monitoring devices that come with a standard product warranty that allows the customer to return the device within one year if the customer has any performance issues with the device. If
a device is returned under the standard warranty, the entity ships the customer a replacement device. Based on experience, the probability of a device having a performance failure is 5%. How does the medical technology entity recognizerevenue?
Discussion: The entity will defer 5% of total sales when the devices are delivered. The entity re-assesses the probability of the device operating as intended and recognizes revenue as the warranty obligation is either satisfied or expires at each reporting date.
22
USGAAP Convergence & IFRS Revenue recognition: Retail and consumer industry supplement
March 2011
Revenue recognition . . . full speed ahead Retail and consumer industry supplement
Whats inside: Overview Right of return Sell-through approach Customer incentives Loyalty programs Gift cards Licenses and royalties Warranties
Overview
The accounting for revenue recognition in the retail and consumer (R&C) sector is covered by multiple pieces of literature under IFRS and USGAAP. The existing general revenue recognition model for product sales in the R&C sector is not expected to change broadly under the proposed standard, but where there is a change, it may have a significant impact. For example, certain aspects of product sales transactions in the R&C sector may be affected by the proposed standard such as return rights, sell-through versus sell-to revenue recognition, customer incentives including loyalty programs and gift cards, the licensing of intellectual property and warranties. This paper, examples, and the related assessments contained herein are based on the Exposure Draft, Revenue from Contracts with Customers, which was issued on June 24, 2010. These proposals are subject to change at any time until a final standard is issued. The examples reflect the potential impacts of the proposed standard and any conclusions noted are subject to further interpretation and assessment based on the final standard. For a more comprehensive description of the proposed standard refer to PwCs Dataline 201028 or visit www.fasb.org.
*This Dataline Supplement was revised on September 3, 2010 to reflect certain editorial revisions. None of the revisions resulted in substantive changes to the assessments of the proposed model contained herein.
Revenue recognition: Retail and consumer industry supplement
Right of return
Return rights are commonly granted in the R&C sector 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 the agreement. Some of these rights may be articulated in contracts Proposed standard The sale of goods with a right of return is accounted for similarly to the current failed sale model. That is, revenue is not recognized for goods expected to be returned, rather a liability is recognized for the expected amount of refunds to customers using a probability-weighted approach. The refund liability is periodically 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 subsequently adjusted for any impairment.
with customers or distributors, while some are implied during the sales process. These rights take many forms and are driven generally by the buyers desire to mitigate risk related to the products purchased and the sellers desire to promote goodwill with its customers and ensure customer satisfaction.
Current US GAAP Currently, returns are estimated based on historical experience with an allowance recorded against sales. If an entity is unable to estimate the potential returns, revenue is not recognized until the return right lapses.
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.
Impact: The impact of product returns on earnings under the proposed standard will be largely unchanged from current US GAAP and IFRS accounting. However, the balance sheet will be grossed up to include the refund obligation and the asset for the right to the returned goods. If indicators of impairment exist, the asset is assessed for impairment. Management will use a probability-weighted approach to determine the likelihood of a sales return under the proposed standard.
Example 1Right of return as a separate performance obligation

Facts: A retailer sells 100 mobile phones for 100 each. The mobile phones cost 50 and include a return right for 180 days. The retailer determined that the probability of a sales return 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.
2
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 sales return, and a liability of 1,000 (10% of the sale price) would be 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.
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 (i.e., the consumer) because the distributor may have the ability to return the unsold product, rotate older stock or receive pricing concessions.
Proposed standard Revenue is recognized on 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 continuously over the contract period. Factors to consider include, but are not limited to: 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
Current US GAAP The sell-through approach is common in arrangements that include dealers or distributors. Revenue is recognized once the risk 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 risk and rewards of ownership have transferred the seller does not retain managerial involvement the amount of revenue can be reliably measured it is probable that the economic benefit will flow to the customer the costs incurred can be measured reliably
Impact: The impact of the proposed standard on current accounting under both US GAAP and IFRS will depend on the terms of the arrangement. The proposed standard requires the seller to determine when transfer of control to the customer has occurred. If the customer has control of the product, including the right (but not the obligation) to put the product back to the seller at its discretion, control transfers when the product is delivered to the dealer or distributor. Expected returns, price concessions, etc. affect the amount of revenue recorded. This will change the timing of revenue recognition compared to todays model, which focuses on the transfer of risks and rewards. If the seller is able to require the distributor or dealer to return the product (that is, a call right), the seller controls the goods, and revenue is only recognized when products are sold to a third party, similar to todays model.
Example 2Sale of products to a distributor using the sell-through approach

Facts: A consumer products company 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 company has no further obligations with respect to 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 or not, the distributor is considered the "customer", and transfer of control occurs when the goods are obtained by the distributor.
Example 3Sale of products on consignment

Facts: A manufacturer provides household goods to a retailer on a consignment basis (e.g., 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 with respect to 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 for the products, absent a sale to the consumer. Revenue recognition prior to the transfer of control of the product to the consumer (i.e., at the time of purchase by the consumer) might not be appropriate.
Customer incentives
R&C companies offer a wide array of customer incentives. Retailers commonly offer to their customers coupons, rebates issued at point of sale, free products (buy-one-get-one-free), price protection or price matching programs. Consumer product companies commonly provide vendor allowances including volume Proposed standard The proposed standard requires companies to identify the distinct performance obligations in an arrangement and allocate the transaction price to each performance obligation. The allocation should consider the impact of customer incentives and other discounts, which may be a separate performance obligation or may affect the total transaction price.
rebates and cooperative advertising allowances, market development allowances and mark-down allowances (compensation for poor sales levels of vendor merchandise). Consumer product companies also offer product placement or slotting fees to retailers. There are various accounting standards that are applicable today and some diversity in practice in accounting for such incentives. Current US 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. Current IFRS
Sales incentives offered to customers are recorded as a reduction of revenue at the time of sale. Management uses their 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. For Volume rebates are recognized as each contracts that provide customers with of the revenue transactions that results in volume discounts, revenue is measured progress by the customer toward earning by reference to the estimated volume of the rebate occurs. sales and the corresponding expected discounts. If estimates of the expected discounts cannot be reliably made, revenue recognized should not exceed the amount of consideration that would be received if the maximum discounts were taken. Impact: The proposed standard will affect some US GAAP reporting companies as it will require incentives to be accounted for similar to current IFRS standards. The proposed standard will require a company to assess the transaction price including the impact of the incentive program. If the incentive provides the customer with a material right (e.g., a discount on future purchases) that would not have been obtained without entering into the contract, the incentive is a separate performance obligation. The transaction price is allocated to the separate performance obligations and the amount allocated to the option (i.e., the future discount) would be deferred and recognized as revenue when the obligation is fulfilled or the right lapses. If the incentive creates variability in the pricing of the goods or services provided in the contract (as with volume discounts), management will need to determine the probability-weighted estimate of possible outcomes to determine the transaction price. Variable consideration is only included in the transaction price if management can reasonably estimate the amount of consideration to be received. Revenue may be recognized sooner than currently allowed if the consideration can be estimated reasonably.
Example 4Retailer issued coupons

Facts: A retailer sells a product and provides the customer with a coupon for 60% off the future purchase of a second, identical product. The retailer typically provides customers with 10% discounts on future purchases. The selling price of the product is $10. How much revenue is recognized on the first sale? Discussion: The retailer estimates 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 [i.e., the incremental value to the customer of the discount considering a 10% discount is typically offered by the retailer] x 100% expected redemption). The company 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. If the coupon is redeemed in connection with a future sale, the $3.33 allocated to the coupon is included with the transaction price associated with the subsequent sale.
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 customer. While not specifically addressed by the proposed standard, we believe the additional consideration paid by the manufacturer represents revenue to the retailer, as the fair value of total consideration received is 12. Cost of sales remains at the original amount paid by the retailer to the manufacturer.
product to a retailer. The manufacturer also makes a $1 million non-refundable up-front payment to the retailer for product placement services. The retailers promise to display the manufacturers products includes stocking and favorable placement of the products. The fair value of the product placement service is $875,000, based on similar transactions. How does the manufacturer account for the upfront payment? Discussion: Although the product placement services are not sold separately, under the proposed standard the service is distinct because it has a distinct function and distinct margin. The manufacturer recognizes an expense of $875,000 (the estimated standalone selling price of the product placement services) when control of the goods transfers to the retailer. The remaining amount of consideration paid for the product placement services of $125,000 is reflected as a reduction of the transaction price. The manufacturer recognizes $7,875,000 in revenue when control of the products transfers to theretailer.
Example 6Free product rebate

Facts: A vendor is running a promotion whereby a customer 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 (i.e., each box) is allocated 15 based on the relative estimated selling price. Assuming the vendor is unable to determine if the mail-in rebate will be used on the date of sale, the transaction price allocated to the undelivered box is deferred until the earlier of redemption or expiration of therebate.
Example 5Manufacturer 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 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 customer pays 12 if
Example 8Price protection if retailer subsequently lowers price

Facts: On January 1, a retailer sells a product to customer A for 100 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 reflected as a liability at the time of the sale. The transaction price reflects the 100 sales price less the probability-weighted estimate of the consideration expected to be refunded to customer A.
Example 7Slotting fees

Facts: A manufacturer sells $8 million in
Loyalty programs
Retailers often use customer loyalty programs to build brand loyalty and increase sales volume by providing Proposed standard 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. The customer is paying for the future goods or services to be received when customer award credits are issued in conjunction with a current sale. Management recognizes revenue for the option when it expires or when these future goods or services are transferred to the customer.
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 Current US GAAP There is divergence in practice in US GAAP in the accounting for loyalty programs. Two models commonly followed are a multiple-element revenue model and an incremental cost accrual model. Typically, revenue is recognized at the time of the initial sale and an accrual is made for the expected costs of satisfying the award credits under the incremental cost model. The incremental cost model is more prevalent in practice. Breakage related to award credits expected to be forfeited is accounted for either proportionally as the awards are redeemed or when the awards expire.
the credits for awards such as free or discounted goods or services. Credits that are not ultimately redeemed are forfeited. Forfeitures are often termed breakage.
Current IFRS Loyalty programs are accounted for as multiple-element arrangements. The fair value of award credits is deferred and recognized when the awards are redeemed or expire. Revenue is allocated between the initial 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.
Impact: The proposed standard is consistent with the multiple element model currently required under IFRS and thus it may have more impact on US 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. The accounting for breakage under the proposed standard may also impact 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.
Example 9Loyalty 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 (i.e., 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 asfollows: Product 913 (1,000 x 1,000/1,095) Points 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.
Gift cards
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 monetaryvalue. Proposed standard 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 (i.e., the amount of revenue recognized) is equal to the amount of consideration that a company receives, or expects to receive, from a customer in exchange for transferring goods or services. Current US GAAP A liability is recognized when the gift card is sold to the customer 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. 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 vendors ability to reliably estimate breakage: Proportional model (i.e., revenue for breakage is recognized ratably as redemptions occur) Liability (or expiration) model (i.e., de-recognize an unredeemed incentive obligation and record revenue when the right expires) Remote model (i.e., if the vendor can reliably estimate the pattern of redemption over time, recognize breakage revenue as the possibility of redemptions become remote) Where escheatment 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. Impact: Companies will continue to defer revenue for the future obligation to honor the gift card under the proposed standard. Revenue is recognized when the gift card is redeemed or when it expires. 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, thus the current diversity in practice is likely to be eliminated.
Current IFRS 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. No specific models are provided for recognizing breakage. The models used under US GAAP are acceptable under IFRS.
Example 10Gift 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). Based on all applicable laws (i.e., unclaimed property laws), when the gift card expires the company has no requirement to remit any unused funds to the customer or any third party. The companys 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. To illustrate, if the customer purchases a $50 product using the gift card, the retailer recognizes $55 of revenue, reflecting the products selling price and the estimated breakage of $5.
Licenses and royalties

Licenses are common in the retail and consumer sectorboth from the licensor and licensee perspective. Many of the products that are sold today include a licensed image or name. The accounting for licenses under the proposed standard may be significantly affected. Proposed standard The recognition of revenue for the license of intellectual property will depend on whether the customer obtains control of the underlying asset. The contract is considered a sale (rather than a license or a lease) of intellectual property if the customer obtains control of the entire licensed intellectual property (e.g., the exclusive right to use the property for its economic life). Revenue is recognized when control transfers if it is a sale. If the customer licenses intellectual property on an exclusive basis but does not obtain control for the entire economic life of the property, the performance obligation is satisfied over the term of the license. In this case, revenue is recognized over the term of the license. A contract that provides a nonexclusive license for intellectual property contains a single performance obligation. Revenue is recognized when the customer is able to use the license and benefit from it (i.e., when control transfers). Current US 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. Royalty revenue is generally recognized when realized or realizable. 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 non-cancellable contract permits the licensee to use those rights freely and where the licensor has no remaining obligations to perform is, in substance, 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 licenses risk and rewards have not been transferred to the customer. However, the following indicators should be considered in determining 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 IFRS requires royalties to be recognized on an accrual basis in accordance with the relevant agreements substance.
10
Proposed standard
Current US GAAP
Current IFRS
Impact: The accounting for licenses and royalties may be significantly impacted under both US GAAP and IFRS. An estimate of royalties to be received is included in the transaction price at the probability-weighted amount if an entity can reasonably estimate the amount expected to be received, and recognized as revenue when control of the intellectual property is transferred. This may result in revenue being recognized earlier under the proposed standard than under current practice. Licensors may have to perform a much more in depth assessment of the legal terms of contracts to determine when control of the associated asset has been transferred. Licensors will need to focus on whether the asset is being licensed on an exclusive or non-exclusive basis as well as compare the term of the license to the underlying assets economic life to determine whether the transaction is in substance a sale.
Example 11Exclusive licenses

Facts: A designer jeans company has a worldwide recognized brand. A global manufacturer of dolls often contracts with the designer jeans company 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 a period of two years. During the contractual term, the jeans company will receive 12% of all sales of dolls that include garments branded by the jeans company. The manufacturer will provide updated sales estimates on a quarterly basis and actual sales data on a monthly basis. When does the designer jeans company recognize revenue?
Discussion: The designer jeans company has provided the manufacturer with an exclusive license. If the term of the license is for less than the economic life of the underlying brand name, revenue is recognized over the term of the license. The economic life of the brand name is longer than two years, therefore the transaction is not a sale. Revenue is recognized over the term of the license arrangement. The consideration to be received by the designer jeans company depends on the level of sales of dolls, so the transaction price is the probability-weighted estimate of consideration to be received from the manufacturer, presuming the consideration can be reasonably estimated. Assuming the doll maker expects doll sales of $100 million during the term, the transaction price is $12 million.
11
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 companies 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 Proposed standard A warranty may provide a customer with coverage for latent defects (i.e., those that exist when the asset is transferred to the customer but that are not yet apparent). This warranty does not give rise to a separate performance obligation but acknowledges the possibility that the entity has not satisfied its performance obligation. No revenue is recognized at the time of sale for defective products that will be replaced in their entirety. However, warranties that require replacement or repair of components of an item result in revenue being deferred for only the portion of revenue attributable to the components that will be repaired or replaced. A warranty may provide a customer with coverage for faults that arise after the product is transferred to the customer (e.g., normal wear and tear). These warranties give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. Revenue is recognized over the warranty period.
extended warranties result in the deferral of the revenue. The model for accounting for warranties will be significantly affected by the proposals, as warranties for defects that arise subsequent to the original sale (both standard and extended warranties) will result in the deferral of revenue for the value of the related warranties. Management will need to closely consider the impact that accounting for warranties may have on its operations. Current US GAAP Warranties are commonly included with product sales. Such warranties may be governed by third-party regulators depending on the nature of the product. For standard warranties, estimates of warranty claims are accrued at the time of sale for the estimated cost to repair or replace covered products. Current IFRS In contracts that include a warranty provision, management must determine if the warranty obligation is a separate element in the contract.
When a warranty is not a separate element and represents an insignificant part of the transaction, the seller has completed substantially all of the Extended warranties result in the deferral required performance and can recogof revenue for the value of the separately nize the full consideration received priced extended warranty. The value as revenue on the sale. The expected deferred is amortized to revenue over the future cost to be incurred relating to the extended warranty period. warranty is not recorded as a reduction of revenue but rather as a cost of sale, as the warranty does not represent a return of a portion of the purchasers sales price. The costs of warranties are determined at the time of the sale, and a provision for warranty costs 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. In instances where the extended warranty is an integral component of the sale (i.e., bundled into a single transaction), management attributes a relative fair value to each component of the bundle.
12
Proposed standard
Current US GAAP
Current IFRS
Impact: The proposed accounting for warranties is a significant change for both US GAAP and IFRS, as it will no longer be acceptable for an entity to fully recognize revenue upon sale and accrue the expected cost of the warranty. The warranty obligation is treated as a failed sale, for which revenue will be deferred, when the asset must be replaced or repaired. Management will need to carefully assess whether products are defective at the time control transfers to the customer. If defective products are delivered to the customer, management will need to defer the entire transaction price if the product must be replaced as the entity has not satisfied its performance obligation to provide a good that operates as intended at the time of transfer. A portion of the revenue equal to the standalone selling price of the component is deferred if only the defective component of a product must be replaced.
Example 12Warranties
Facts: A manufacturer sells a radio for 100, which comes with a warranty that ensures the quality of the product during its life cycle. Historically, the manufacturer has experienced a 5% warranty claim rate. How much revenue is deferred? Discussion: The probability of a product failing to meet its specifications is 5%. The manufacturer defers 5 of revenue each time a product is sold. At each reporting date leading up to the expiration of the warranty, the manufacturer reassesses the probability of the product operating as intended and recognizes revenue as the warranty obligation expires.
13
USGAAP Convergence & IFRS Revenue recognition: Technology industry supplement

March 2011
Revenue recognition . . . full speed ahead Technology industry supplement

Whats inside: Overview Product warranties Elimination of software specific guidance Uncertain consideration Multiple-element arrangements Consulting service contracts Rights of return Onerous performance obligations
Overview
The technology industry includes numerous subsectors, including but not limited to computer networking, semi-conductors, software, and clean technology. Each subsector has diverse product and service offerings and various revenue recognition issues common to the industry. 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 proposed standard will contain a single recognition model, so we believe it will significantly affect a number of the technologysubsectors. The following are some of the areas within the technology industry that may be significantly affected by the proposed revenue recognition standard. This paper, examples, and the related assessments contained herein, are based on an interpretation of the Exposure Draft, Revenue from Contracts with Customers, issued on June 24, 2010. The examples reflect the potential impact 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 description of the proposed standard, refer to PwCs Dataline 201028 (www.cfodirect.pwc.com) or visit www.fasb.org.
Reprinted from: Dataline 201028 (Supplement) August 5, 2010
Revenue recognition: Technology industry supplement
Product warranties
The proposed standard draws a distinction between product warranties that provide coverage for latent defects and warranties that provide coverage for
faults arising after the product is transferred. Many of the warranties offered by technology companies are product warranties that provide coverage for latent defects, however, management will need to use significant judgment to determine
whether a defect is latent or has arisen subsequent to the sale. Practice could change significantly under the proposed standard, resulting in a greater deferral of revenue than under existing guidance in manysituations.
Proposed standard Warranties A product warranty that provides coverage for latent defects does not give rise to a separate performance obligation but may indicate that the entity has not fully satisfied its initial performance obligation to transfer the product specified in the contract. Management will need to determine the likelihood and extent of defects in the products it has sold to customers at each reporting date to determine the extent of unsatisfied performance obligations. Revenue is not recognized at the time of sale for defective products that will be replaced in their entirety. Revenue is also not recognized for components of a product that will have to be replaced. A product warranty that provides coverage for faults arising after the product is transferred gives rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. Revenue is recognized as the warranty services are provided.
Current US GAAP Product warranties that provide coverage for latent defects are typically accounted for in accordance with existing loss contingency guidance, resulting in an expense and a warranty liability being recognized when the good is sold. Potential impact: Entities will defer revenue instead of recording an expense and warranty liability. Product warranties that provide coverage for faults arising after the product is transferred are similar to many extended warranty contracts that protect against defects arising through normal usage. Revenue is deferred for these warranties and recognized over the expected life of the contract. Potential impact: The amount of deferred revenue might vary under the proposed standard compared to current guidance, depending on whether the extended warranty is separately priced and substantive. Extended warranties give rise to a separate performance obligation under the proposed standard and therefore revenue is recognized over the warranty period. This may affect the accounting for extended warranties not separately priced because under current guidance, the warranty is recognized with other elements of the arrangements.
Current IFRS Product warranties that provide coverage for latent defects are typically accounted for in accordance with existing provisions guidance resulting in recognition of an expense and a warranty liability. Potential impact: Entities will defer revenue instead of recording an expense and warranty liability. Product warranties that provide coverage for faults arising after the product is transferred are similar to many extended warranty contracts that protect against defects arising through normal usage. Revenue is deferred for these warranties and recognized over the period covered by the warranty. Potential impact: We do not expect a significant impact, however the amount of deferred revenue might vary under the proposed standard compared to current guidance.
Example 1
Facts: A hardware vendor sells a hard drive, keyboard and monitor, and also provides a 60-day warranty that covers latent defects for certain components of the hard drive and monitor. Assume that the performance obligations (i.e., the hard drive, keyboard, monitor and warranty) qualify as distinct performance obligations under the proposed standard. How should the vendor account for the warranty? Discussion: The proposed standard requires that the selling price of the hard drive and monitor components that will require repair or replacement would be estimated at contract inception. Revenue relating to those components is deferred until the customer receives those components without defects or when the warranty period expires.
Example 2
Facts: A vendor sells a hard drive, keyboard, monitor, and a 12-month warranty (i.e., not a coverage for latent defects but for future defects) to a customer. Assume that the performance obligations (i.e., the hard drive, keyboard, monitor and 12-month warranty) qualify as distinct performance obligations under the proposed standard. How should the vendor account for the warranty? Discussion: The proposed standard requires that the vendor will recognize revenue as the performance obligations are satisfied. A portion of the transaction price is allocated to the warranty and recognized as revenue when the warranty obligation is satisfied since the insurance warranty represents a separate performance obligation. The vendor will need to assess the pattern of warranty satisfaction to determine when revenue is recognized (i.e., ratable or some otherpattern).
Elimination of software specific guidance

The proposed standard will replace all industry specific guidance. Specific software revenue recognition guidance, which is applied to certain Proposed standard Software arrangements involving multiple elements The proposed standard requires separation of distinct performance obligations when they are satisfied at different times. Companies will no longer require VSOE of fair value for undelivered items in order to separate and allocate contract consideration. If an entity does not separately sell a good or service on a standalone basis, the entity should estimate the standalone selling price The residual method is not permitted.
transactions that include the sale of software under USGAAP, will be superseded. The elimination of the existing guidance will have a significant impact on the accounting for software and software-relatedtransactions.
Current US GAAP
Current IFRS
Contract consideration is allocated to the various elements based on vendorspecific objective evidence (VSOE) of fair value, if such evidence exists for all elements in the arrangement. When VSOE of fair value does not exist for undelivered elements, revenue is deferred until the earlier of 1) when sufficient VSOE of fair value for the undelivered element does exist or 2) all elements of the arrangement have been delivered. Potential impact: Both the elimination of the residual method and the elimination of the VSOE requirement for software related transactions will significantly affect the consideration allocated to the various deliverables. The timing of revenue recognition will therefore be affected. These changes will also result in the need for significant modifications to the information systems currently used to record revenue.
Revenue is allocated to individual elements of a contract, but specific guidance is not provided on how the consideration should be allocated. Separating the components in a contract may be necessary in order to reflect the economic substance of a transaction. Separation is appropriate when the identifiable components 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 items fair value. Other approaches to estimating fair value may also be appropriate, including cost plus 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, except for the elimination of the residual and reverse residual methods, which may have a broad impact in the industry. The differences in the separation of performance obligations and allocation of consideration will significantly affect revenue recognition and may create greater complexity. It will also result in the need for significant changes to the information systems used to record revenue.
Proposed standard Post-contract customer support (PCS) Post-contract customer support (or maintenance) generally has two elements: telephone support and the supply of new versions (bug fixes, updates and upgrades). The proposed standard requires the separation of distinct performance obligations when they are satisfied at different times using the estimated standalone selling price. If an entity does not separately sell a good or service on a standalone basis, management should estimate the standalone selling price in order to allocate the transaction price.
Current US GAAP The fair value of PCS is evidenced by the selling price when this element is sold separately. This includes the renewal rate written into the contract provided it is substantive. Revenue for PCS is combined with the license revenue and recognized on a straight-line basis over the PCS term if the only undelivered element is PCS. Potential impact: Management will be required to estimate the standalone selling price of PCS when VSOE may not have previously been available. This might result in a different timing of revenue recognition for PCS and the contract consideration allocated to the delivered items (i.e., the license).
Current IFRS When the selling price of a product includes an identifiable amount of subsequent servicing, that amount 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 under the agreement, together with a reasonable profit on those services. Potential impact: The proposed standard is similar to the current IFRS guidance, however the residual method is permitted under current guidance and will no longer be permitted under the proposed standard. This may result in a different timing of revenue recognition for PCS and the contract consideration allocated to the delivered items (i.e., the license). be made using any reasonable and reliable method that maximizes observable inputs. Software Vendor will estimate the standalone selling prices for the software license, the PCS services and telephone support services. The need to estimate stand-alone selling prices may create practical challenges for some softwarecompanies. Current IFRS Existing revenue guidance requires that fees and royalties paid for the use of an entitys assets are normally recognized in accordance with the substance of the agreement. This may be on a straightline basis over the life of the agreement, for example, when a licensee has the right to use certain technology for a specified period of time. An assignment of rights for a fixed fee or non-refundable guarantee under a noncancellable contract which permits the licensee to exploit those rights freely and the licensor has no remaining obligations to perform is, in substance, a sale. Judgment should be applied to determine the most appropriate treatment.
Example 3
Facts: Software Vendor sells Customer a perpetual software license (version 2.0) and post-contract customer support (PCS) services consisting of telephone support for a period of five years once the software is activated. None of the goods and services are sold on a stand-alone basis. Proposed standard Intellectual property licenses Revenue recognition for licenses of intellectual property will depend on whether the customer obtains control of the asset and whether the license is exclusive or non-exclusive.
How should Software Vendor account for the transaction? Discussion: If the license and the PCS are not sold separately, management will need to estimate the stand-alone selling prices under the proposed standard. An estimation method is not prescribed nor is any method precluded. Estimates can Current US GAAP
Perpetual software license fees are recognized at the beginning of the license term (for software that does not require significant production, modification or customization) assuming: (a) persuasive evidence an arrangeFor outright sales of intangibles, ment exists, (b) delivery has occurred, perpetual licenses, and time-based (c) the fee is fixed or determinable, (d) licenses with a term greater than the collectability is probable, and (e) VSOE useful life of the underlying asset; exists for the undelivered elements in revenue should be recognized like a sale, the contract. once the license is delivered/enabled. For time-based licenses, the portion of For exclusive time-based licenses that revenue attributable to the license must are shorter than the useful life of the be recognized on delivery to the client underlying asset; revenue should be rather than over time in some circumrecognized over the term of the license. stances. The treatment of revenue might vary depending on whether a substanFor non-exclusive time-based licenses tive renewal rate for the PCS element that are shorter than the useful life of allows it to be separated from the license the underlying asset; revenue should be recognized like a sale once the license is based on the fair value of the PCS. In the absence of VSOE of fair value of the PCS delivered/enabled. element, all the revenue (license and PCS) must be deferred and recognized on a straight-line basis over the estimated PCS term.
continued
5
Current US GAAP Extended payment terms in software licensing arrangements preclude revenue recognition unless the vendor has a standard business practice of using long-term or installment contracts and a history of successfully collecting under the original payment terms without making concessions. Potential impact: The proposed standard distinguishes between exclusive and non-exclusive licenses. Entities that sell time-based non-exclusive licenses might be affected by recognizing revenue upfront for a non-exclusive license versus over time under current US GAAP when the PCS is not substantive. Extended payment terms will affect the amount of revenue being recognized when the performance obligation is satisfied (see below for further discussion on variable consideration). Time value of money might also be considered if the effect is material.
Current IFRS Potential impact: The proposed standard distinguishes between exclusive and non-exclusive licenses. Revenue recognition may change depending on the current accounting (over time or upfront) and whether the license is exclusive. For example, revenue for the sale of a nonexclusive time-based license with no future obligation other than a standard PCS package currently might be recognized over the life of the license versus upfront under the proposed standard.
Example 4
Facts: Software Vendor enters into a contract with a customer for an exclusive license to its software product for one year. The expected economic life of the software is two years. How should Software Vendor account for the transaction? Discussion: Management will need to assess whether control of the underlying asset transfers to the customer or merely gives the customer the right to use the asset. This will dictate whether revenue should be recognized under a sale model (i.e., at a point in time) or continuously over the license term. As the license is exclusive and is for a period less than the economic life of software, under the proposed standard the performance obligation is satisfied over the term of the license. The economic life in this example is stated as being for a duration of two years, but we believe that determining the economic life of the software will require significant judgment and may depend on how the vendor intends to offer the intellectual property in the market.
Example 5
Facts: Software Vendor enters into a contract with a customer for a nonexclusive license to its software product (e.g., off-the-shelf software). Discussion: The proposed standard states that the performance obligation is satisfied when control of the license transfers to the customer, which will generally be at the beginning of the license period for a nonexclusive license. The timing of revenue recognition under the proposed standard may be similar to current accounting, which allows revenue to be recognized at the time of delivery (assuming all other revenue recognition criteria are met).
Uncertain consideration
The transaction price is the consideration the vendor expects to receive in exchange for satisfying its contractual performance obligations. Determining the transaction price is straightforward when the contract price is fixed but it becomes more complex when it is not fixed. Royalties and discounts are common sources of Proposed standard Uncertain consideration Variable consideration is included in contract revenue using a probabilityweighted approach when such payments can be reasonably estimated. Variable consideration can be reasonably estimated when the entity can identify the potential outcomes of a contract. If management has experience with similar types of contracts and the entity does not expect significant changes in circumstances, variable consideration should be included in the transaction price. Management should consider several factors in assessing whether or not the circumstances may change significantly, 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.
uncertain consideration for the technology industry. Management must determine if they can reasonably estimate the consideration to be received at contract inception and at each reporting date. This may result in earlier revenue recognition and more income statement volatility for royalty arrangements. Discounts will be estimated in the transaction price. Current US GAAP The sellers price must be fixed or determinable in order for revenue to be recognized. Revenue related to contingent consideration generally is not recognized until the contingency is resolved. It is not appropriate to recognize revenue based on the probability of a contingency being achieved. Potential impact: Variable consideration affects the measurement of consideration as opposed to timing of recognition under the proposed standard. Technology companies are consistently developing new or enhancing existing products and each company will need to consider at which point they are able to reasonably estimate any amount of variable consideration. Technology companies may recognize revenue earlier than they do currently in many circumstances. 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 arms 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 relating to contingent 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 affects timing of revenue recognition. Revenue might be recognized earlier than currently as the probability of receipt of consideration affects the measurement of revenue not the timing of recognition.
Example 6
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? Discussion: Vendor will need to assess whether it can reasonably estimate the royalties to be received. Vendor will need to consider its experience and the experience of others in making this
determination. Royalty revenue is recognized when control of the license transfers if Vendor can reasonably estimate the consideration to be received. If Vendor cannot make a reasonable estimate of the royalties at contract inception, Vendor will need to reassess whether the consideration has become reasonably estimable at each reporting date. Once Vendor has better information and can make a reasonable estimate it will need to record the expected royalties. Assume that, after three months, Vendor concludes it can reliably estimate the expected royalties. It will estimate the variable consideration based on a probabilityweighted method. Forexample, Possible royalties (1% of product sales) $0 million $2 million $10 million $50 million Probability-weighted amount 1% 50% 25% 24% $$1.0 million $2.5 million $12.0 million $15.5 million Based on the results of the probabilityweighted assessment, management would record revenue of $15.5 million when the license is transferred. Subsequent changes in the estimate of total consideration are adjusted against revenue.
Probability
Multiple-element arrangements
Many technology companies provide multiple products or services to their customers as part of a single arrangement. For example, hardware vendors Proposed standard Separation criteria for multipleelement arrangements The proposed standard requires separation of performance obligations when they are satisfied at different times provided such performance obligations are distinct. Management should estimate the standalone selling price if the entity does not separately sell the good or service in order to allocate the transaction price to all performance obligations. The residual method is not permitted under the proposed standard.
may sell extended maintenance contracts or other service elements along with the hardware. Elements included in a contract may either be combined as a single unit of accounting or separated into multiple units of accounting under the existing revenue recognition guidance. Current US GAAP Current IFRS
The following criteria are applied to transactions other than those involving software 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 Objective and reliable evidence of fair value of the undelivered item exists (either VSOE of fair value or relevant third-party evidence of fair value)
The revenue recognition criteria are usually applied separately to each transaction. In certain circumstances, however, it is necessary to separate a transaction into identifiable components in order to reflect the substance of the transaction. When identifiable components have stand-alone value and their fair value can be measured reliably, separation is appropriate.
Two or more transactions may need to be grouped together when they are linked in such a way that the commercial If a general return right exists for the effect cannot be understood without delivered item, delivery or perforreference to the series of transactions as mance of the undelivered item(s) is considered probable and substantially a whole. in the control of the vendor. The price that is regularly charged A vendor may use third-party evidence (TPE) of fair value to separate deliverables when VSOE of fair value is not available. Potential impact: Technology companies will need to assess whether technology contracts include multiple performance obligations. The separation criteria in the proposed standard is less restrictive than current guidance, which may result in more performance obligations being accounted for separately thereby impacting the timing of revenue recognition. This change in separation criteria may affect some entities more than others, depending on the guidance currently applied to the entity under US GAAP. when an item is sold separately is the best evidence of the items fair value. A cost-plus-reasonable-margin approach to estimating fair value is also acceptable under IFRS. The use of the residual method and, under rare circumstances, the reverse residual method, may be acceptable to allocate arrangement consideration. Potential impact: The new separation and allocation methodology is similar to the current IFRS guidance, although more performance obligations might be identified and the residual and reverse residual methods will no longer be acceptable. continued
9
Current US GAAP Hierarchy under current guidance 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, third-party evidence (TPE) if VSOE is not available, or estimated selling price if neither VSOE or 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. Potential impact: The proposed standard is similar to current guidance for estimating selling prices. No hierarchy is prescribed but we expect this difference will have a limited affect as an entity will need to maximize the use of observable inputs in estimating selling prices.
Current IFRS
Example 7
Facts: Vendor sells a hard drive, keyboard, and monitor to a customer. The monitor is frequently sold on a standalone basis; the hard drive and keyboard are typically not sold on a standalone basis. Assume the performance obligations (i.e., the hard drive, keyboard, and monitor) are distinct and will be delivered at different times. How should Vendor account for thetransaction?
Discussion: Vendor will need to consider the observable prices of goods or services, when available, to determine standalone selling prices and allocate the contract consideration. The standalone selling price of the monitor will be used in allocating the consideration to the monitor. The selling prices of the hard drive and the keyboard will need to be estimated since they are not sold separately. Vendor can use cost-plus-reasonable-margin or any other reasonable and reliable method that is consistent with standalone selling prices and that maximizes observable inputs. Once the selling prices are estimated, the transaction price should be allocated based on the relative stand alone selling price of each performance obligation. Revenue is recognized once control of each performance obligation transfers.
10
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. Because technology service contracts are typically customer-specific, revenue
recognition is dependent on the facts and circumstances of each arrangement. Accounting for service revenues may change significantly under the proposed standard as companies must determine whether the arrangement is more like the sale of a good or the provision of a service (i.e., whether the performance obligation is satisfied and control of the underlying asset transferred to the customer at a point in time or continuously over a period).
Many technology arrangements include customer acceptance provisions. For arrangements that only involve the delivery of services, the determination of when control of the services transfers may be affected by the presence of customer acceptance provisions.
Proposed standard Consulting service contracts 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 continuously over the contract period. Determining when control transfers will require a significant amount of judgment. Factors to consider include, but are not limited to: 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 This list is not intended to be a checklist or all-inclusive; these are only factors and no one factor is determinative on a stand-alone basis.
Current US GAAP US 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-to-cost measures, which approximate progression toward completion, may be used when output measures do not exist. Revenue is recognized based on a discernible pattern and if none exists, then a straight-line approach may be appropriate. Revenue is deferred where the outcome of a service transaction cannot be measured reliably. Potential impact: Entities will need to determine whether the performance obligation is the service provided to achieve an outcome or the service is the outcome itself (e.g., the issuance of a report with recommendations). The control indicators may be challenging to apply to consulting services arrangements. This may result in revenue being recognized in different periods than current practice.
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. Revenue may be deferred in instances where a specific act is much more significant than any other acts. Potential impact: Entities will need to determine whether the performance obligation is the service provided to achieve an outcome or the service is the outcome itself (e.g., the issuance of a report with recommendations). The control indicators may be challenging to apply to services arrangements. This may result in revenue being recognized in different periods than current practice.
11
Example 8
Facts: Assume a computer consultant enters into a three month fixed-price contract to track a companys software usage in order to help the company decide which software packages it should upgrade in the future. The customer specifies and directs the services to be provided throughout the contract. The consultant will share his findings on a monthly basis, or more frequently if requested by the company. The consultant will provide a summary report of the findings at the end of three months. The company will pay the consultant $2,000 per month, and the company can direct the consultant to focus on the usage of any systems it wishes to throughout the contract. How should the consultant account for the transaction? Discussion: The customer has an unconditional obligation to pay throughout the contract as evidenced by the nonrefundable progress payments. The customer specifies the nature of services to be provided throughout the contract and hence, directs the nature of the services to be performed, which affects the entitys final report. The customer can also receive benefit from the services as they are performed. Consequently, control transfers continuously over time (i.e., the entitys performance obligation is to provide the customer with services continuously during the 3 monthcontract).
Example 9
Facts: Assume a vendor provides two customers (Customer A and Customer B) IT implementation services over a twoyear period. Both arrangements include similar terms and the installation includes customization specific to each customers network. The work is completed at the customers site and the rights to all work in progress are transferred as the services are provided (i.e., continuous transfer of the outputs occur as the services are provided). However, one arrangement (Customer A) contains a customer acceptance provision while the other arrangement (Customer B) does not. How should vendor account for the transactions? Discussion: Control transfers continuously as the services are provided because each customer has the right to work in progress. Substantive customer acceptance provisions may delay when control of the assets transfers to the customer. Customer acceptance may be considered a formality that does not affect when the customer obtains control if the vendor can objectively determine that the good or service has been transferred to the customer in accordance with the contract specifications. If the vendor in the above example has a history of providing similar IT implementation services that met all of the customer-specified criteria noted in the contract, the vendor might determine that recognition of revenue as the services are provided is appropriate. This guidance may result in different accounting for Customers A and B although the transactions otherwise appear similar.
12
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 buyers desire to mitigate the risk related to the products purchased and the sellers desire to promote goodwill with its customers.
Proposed standard Right of return The sale of goods with a right of return should be accounted for similar to todays failed sale model. That is, revenue should not be recognized for goods expected to be returned and a liability recognized for the expected amount of refunds to customers using a probability-weighted approach. 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.
Current US GAAP Currently, returns are estimated based upon historical experience with an allowance recorded against sales. If an entity is unable to estimate the potential returns, revenue is not recognized until the return rights lapses. Potential impact: Technology companies that are deferring revenue because they do not meet the strict criteria to estimate the return rights under current guidance may be significantly affected by the proposed standard. The less restrictive criteria will result in revenue being recognized earlier. Technology companies that are currently estimating returns and recording a sale allowance may not be affected except for a gross up of the balance sheet for the refund obligation and the asset for the right to the returned goods.
Current IFRS Currently, returns are estimated based upon historical experience with an allowance recorded against sales. If an entity is unable to estimate the potential returns, revenue is not recognized until the return rights lapses. Potential impact: Technology companies that are deferring revenue because they cannot estimate the return rights under current guidance are unlikely to be affected. Technology companies that are currently estimating returns and recording a sale allowance may not be affected except for a gross up of the balance sheet for the refund obligation and the asset for the right to the returned goods.
Example 10
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. Historically, Vendor has 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 (i.e., 10 percent) as a failed sale. Vendor should record a contract liability for 1,000 gaming systems and derecognize the associated inventory. Vendor should record an asset (an intangible) for the right to the gaming system assets expected to be returned with a corresponding credit to cost of goods sold. The intangible 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 asset is assessed if there are indicators of impairment. The transaction price associated with the 9,000 gaming systems that are not expected to be returned are recorded as revenue once control transfers to the customer.
13

Many technology companies provide multiple products or services to their customers as part of a single arrangement
and may have anticipated losses on one performance obligation but an overall profitable contract. Anticipated losses on executory contracts are generally not recognized under current USGAAP and are accrued only if the overall contract is
onerous under current IFRS. Companies may be significantly affected under the proposed standard because they will need to recognize expected losses for each performance obligation.
Proposed standard Onerous performance obligations Performance obligations are not remeasured after contract inception unless those obligations become onerous. A performance obligation is onerous when the direct costs to satisfy a performance obligation exceed the consideration allocated to it. The excess should be recognized as a contract loss with a corresponding liability that is remeasured at each reporting period.
Current US GAAP Anticipated losses on executory contracts (onerous contracts) generally should not be recognized, unless specific authoritative guidance provides for such recognition, because those anticipated losses have not yet been incurred. An accounting policy choice may exist in some situations when there is a loss on the first element of a multiple-element arrangement. When there is a loss on the first element but a profit on the second element of an arrangement (and the overall arrangement is profitable), an entity has an accounting policy choice if performance of the undelivered element is both probable and in the companys control. Specifically, there are two acceptable ways of treating the loss incurred in relation to the delivered unit of accounting. The company 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 (i.e., recognize the loss) upon delivery of that element.
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. When there is an apparent loss on the first element of a multiple element arrangement, an accounting policy choice may exist as of the date the contract was entered into. When there is a loss on the first element, but a profit on the second element of an arrangement (and the overall arrangement is profitable), a company may elect an accounting policy to recognize a loss if performance of the undelivered element is both probable and in the companys control.
continued
14
Current US GAAP Potential impact: Onerous contracts are rarely recognized under existing US GAAP other than in relation to construction contract accounting. This may significantly affect entities not following construction contract accounting. The proposed standard may cause a significant change for other entities as the onerous contract assessment will be performed at the performance obligation level as opposed to the contract level.
Current IFRS Any expected losses on construction contracts are recognized immediately when it is probable that contract costs will exceed contract revenue. Potential impact: The current IFRS guidance requires an assessment of onerous provisions at the contract level, not the performance obligation level. The proposed guidance may lead to an increase in onerous contract provisions, resulting in losses being recorded even in situations in which the overall contract is profitable.
15
USGAAP Convergence & IFRS Revenue recognition: Telecommunications industry supplement

March 2011
Revenue recognition . . . full speed ahead Telecommunications industry supplement

Whats inside: Overview Accounting for multiple performance obligations Uncertain or variable consideration/determining the transaction price Collectability Allocation of the transaction price and establishing stand-alone selling prices Equipment installation revenues Recognition of revenueImpact on advertising and phone directory activities Contract costs
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 long-distance), 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 entities network and facilities. Access revenues are typically billed one month in advance and recognized when the services are provided. Usage revenues (services provided in excess of the customers 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. This paper addresses how the exposure draft, Revenue from contracts with customers, issued on June 24, 2010, 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 guidance as set out in the exposure draft; any conclusions are subject to further interpretation and assessment based on the final standard. For a more comprehensive description of the model refer to PwCs Dataline 201028 or visit www.fasb.org.
Reprinted from: Dataline 201028 (Supplement) January 13, 2011
Revenue recognition: Telecommunications industry supplement

Performance obligations are defined as an enforceable promise to deliver goods or perform services. Determining when and how to separately account for performance obligations within a contract is important as performance obligations affect how the transaction price is allocated and the timing of revenue recognition. Management will need to determine whether performance obligations within customer contracts should be accounted for separately from other performance obligations within the arrangement. The proposed separation criteria may result in
more performance obligations being identified (such as warranties, gifts, etc.) than under todays standards. A performance obligation might be explicit in a contract, or implicit, arising from customary business practices. We expect that applying the proposed separation principle might be challenging in some circumstances due to the significant number of customers and multiple, various offerings included within bundledpackages. Telecom entities regularly enter into contracts with customers that bundle the sale of telecom services, activation/ connection services, and equipment (for example, handsets, modems, etc.). The sale of equipment is a separate earnings process from the sale of telecom services
under current USGAAP, as the equipment has stand-alone value. Activation/connection services do not have standalone value and therefore are not considered 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 only sold bundled with other products or services or telecom services sold separately). Telecom entities will have to carefully assess their contracts with customers to identify and separate the performance obligations. Tracking these obligations (and the satisfaction of each obligation) could be a time-consuming process forsome entities.
Proposed standard The proposed standard 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 is accounted for separately: if the entity, or another entity, sells an identical or similar good or service separately; or if not sold separately, the good or service has a distinct function and the cost of delivering the performance obligation can be separately identified.
Current US GAAP The following criteria are considered to determine whether elements included in a multiple-element arrangement are accounted for separately: The delivered item has value to the customer on a stand-alone basis
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 transactions substance. The customers perspective is important in determining whether the transaction has a single element or multiple elements.
If a general return right exists for the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially When elements in a single contract are in the control of the vendor accounted for separately, the transaction price should be allocated to the separate Third-party evidence (TPE) of fair value elements of the arrangement. Entities are is used to separate deliverables when not precluded from separating elements vendor specific objective evidence in a single contract if the elements are (VSOE) of fair value is not available. Best not sold separately. estimate of selling price is used if neither VSOE nor TPE exist. Telecom entities that have separated the equipment from service for revenue recognition purposes typically apply the residual method for allocating consideration to the various elements of the transaction. continued
Current US GAAP Potential impact: Management will need to assess whether telecom contracts include multiple performance obligations. The separation criteria in the proposed standard are less restrictive than current guidance, which may result in more performance obligations being accounted for separately. This may accelerate the timing of revenue recognition. The proposed standard states that activation services are an example of nonrefundable upfront fees. Although activation service relates to activity that the entity is required to undertake at or near contract inception to fulfill the contract, the activity does not result in the transfer of a promised good or service to the customer. The payment for the activation service is an advance payment of future telecom services. The activation fee would therefore be recognized over the contract period consistent with todays accounting model for activation fees. Telecom entities will have to carefully consider outsourcing and network IT contracts, various types of activation/connection services and other upfront non-refundable fees (for example, connecting customers to their network or laying physical line to the customers premises) charged to customers to determine if these services meet the definition of a separate performance obligation.
Current IFRS Potential impact: Management will need to assess whether telecom contracts include multiple performance obligations. The proposed standard states that activation services are an example of nonrefundable upfront fees. Although activation service relates to activity that the entity is required to undertake at or near contract inception to fulfill the contract, the activity does not result in the transfer of a promised good or service to the customer. The payment for the activation service is an advance payment of future telecom services. The activation fee would therefore be recognized over the contract period consistent with todays accounting model for activation fees. Telecom entities will have to carefully consider outsourcing and network IT contracts, various types of activation/connection services and other upfront non-refundable fees (for example, connecting customers to their network or laying physical line to the customers premises) charged to customers to determine if these services meet the definition of a separate performance obligation.
Insight: The exposure draft is expected to have significant impact in some markets where traditionally handsets and service have not been accounted for separately under current practice. Telecom entities also have complex product portfolios and typically manage millions of customer contracts. Estimating and then allocating the transaction price to each combination of performance obligations might require significant effort, and the capability of existing IT systems to capture relevant information might need to be addressed. Telecom entities current revenue systems are based on billing events for services rendered to customers (at prices that are linked to the contract). These events are not necessarily aligned to the obligations in the contract. Entities will need financial processes that identify the different performance obligations in each contract and pinpoint when and how those obligations are fulfilled as telecom entities will account for revenue based on fulfillment of the contractual obligations they have with customers.
Example 1Identifying 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, a handset for $100 and an activation fee of $30. 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. Equipment provided with the sale of service is distinct, even if the telecom entity (or other entities) does not sell the service and the equipment separately, as the equipment has a distinct function and a distinct profit margin. Activation/connection fees are not distinct performance obligations but are advance payments for future communicationservices.
Example 2Installation fees

Question: A telecom entity enters into a contract to provide telecom services (voice and data) 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 customers 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. If the entity, or another entity, sells the laying of physical line without the sale of telecom services, it could be a distinct performance obligation. If the entity, or other telecom entities, only sell the laying of physical line with telecom services, it will need to determine whether the laying of the line has both a distinct profit margin and function (that is, has utility on its own or with other goods and services) to qualify as a separate performance obligation. In this example, other telecom entities can provide services on the same physical line, so the service has a distinct function; it is therefore a distinct performance obligation.
Uncertain or variable consideration/ determining the transaction price

The transaction price is the consideration the vendor expects to receive in exchange for satisfying its contractual performance obligations. Determining the transaction price is straightforward when the contract price is fixed; it becomes more complex Proposed standard
when it is not fixed. Discounts, rebates, refunds, credits and price concessions may cause the amount of consideration to be uncertain. Mail-in rebates and refunds on a portion of the sales price offered with the sale of equipment (for example, handsets and accessories) are common in the telecom industry. Entities that receive consideration from a customer and expect to refund some or all of that consideration will recognize a refund liability, reducing the transaction price. Current US GAAP
The proposed standard is likely to have limited impact on the accounting for mail-in rebates, except as it relates to measuring the liability. However, management should assess all contractual arrangements that require all or a portion of the consideration received to be refunded to customers, as the refund amounts directly affect the revenue ultimately recognized.
Current IFRS 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. A liability is recognized based on the expected levels of rebates and other incentives that will be claimed. If no reliable estimate can be made, the liability should reflect the maximum potential amount. Potential impact: Telecom entities will need to use a probability weighted average to determine the refund liability when they expect to refund all or a portion the consideration received. Using the probability weighted average will likely result in measurement differences from the deferred refund liability (or deferred revenue) calculated under todays practices. The refund liability reduces the total transaction price to be allocated among the performance obligations within a customers contract.
Uncertain or variable consideration Variable consideration is included in The sellers price must be fixed or contract revenue using a probabilitydeterminable in order for revenue to weighted approach when such payments be recognized. can be reasonably estimated. Certain sales incentives entitle the If an entity receives consideration from a customer to receive a reduction in the customer and expects to refund some or price charged for a product or service by all of that consideration to the customer, submitting a form or claim for a refund the entity recognizes a refund liability. or rebate of a specified amount. The The entity measures that liability at the vendor recognizes a liability for those probability-weighted amount of considsales incentives based on the estimated eration that the entity expects to refund refunds or rebates that will be claimed to the customer. by customers. The refund liability is updated at each reporting period for changes in circumstances. Management should consider several factors in assessing whether circumstances may change significantly, 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. If the future rebates or refunds cannot be reasonably and reliably estimated, 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). Potential impact: Telecom entities will need to use a probability weighted average to determine the refund liability when they expect to refund all or a portion the consideration received. Using the probability weighted average will likely result in measurement differences from the deferred refund liability (or deferred revenue) calculated under todays practices. The refund liability reduces the total transaction price to be allocated among the performance obligations within a customers contract.
Example 3Refund liability

Question: A telecom entity enters into a contract with a customer to provide telecom services (voice, data, etc.) for $50 per month, equipment for $200, and activation services for $30. The customer receives a mail-in rebate of $100 related to the purchase of the equipment. Mail-in rebates are funded by the entity. How should management account for thistransaction? Discussion: If the telecom entity expects to refund all or a portion of the consideration received from the customer, it will need to measure the refund liability based on the probability-weighted amount. Assume, based on the telecom entitys most recent history for similar mail-in rebate programs (that is, similar products and refund amounts), it estimates the refund liability using the followingprobabilities: Amount $ 0 100 Probability 25% 75% Probability-weighted amount $ 0 75 $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.
Collectability
A key performance indicator in the telecom industry is average revenue per user (ARPU). The proposed standard might negatively impact this indicator, as collectability will affect the measurement Proposed standard In determining the transaction price, an entity reduces the amount of promised consideration to reflect the customers credit risk (the customers ability to pay the amount of promised consideration). Entities only recognize revenue at the probability-weighted amount of consideration expected to be received. Once the receivable has been recorded, the effects of changes in the assessment of credit risk associated with that right to consideration are recognized as income or expense (that is, an adjustment to bad debt expense) rather than an adjustment to revenue.
of the transaction price and therefore revenue. The exposure draft proposes that the transaction price be adjusted to reflect customers credit risk. Only the consideration expected to be received, on a probability-weighted basis, will berecognized.
Current US 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; then the amount of the impairment is measured based on the present value of expected cash flows.
Potential impact: Collectability is no longer a criterion for revenue recognition. Customers credit risks will reduce the transaction price and therefore reduce the amount of revenue recognized. This will cause a Potential impact: decline in revenue per user or subscriber. Collectability is no longer a recognition criterion. Revenue is reduced at Management will also need to deterthe outset for any expected bad debt. mine a practical method to measure the Management will have to determine a probability-weighted amounts expected practical method to measure the probato be collected from customers to deterbility-weighted amounts expected to be mine the transaction price. collected from customers in determining the transaction price. Consistent with todays practice, management will need to update its Consistent with todays practice, assessments to reflect subsequent management will need to update its changes to customers credit risk, assessments to reflect subsequent which will affect the amount of bad debt changes to customers credit risk, expense or other income recorded. which will affect the amount of bad debt expense or other income recorded.
Insight: Significant effort will be required to assess customers credit risk (that is, collectability). It may simplify the process to consider broad types of customers, but there will be added complexity in territories where, historically, there has been less vigorous enforcement of contracts or collection efforts.
Example 4Collectability
Question: A telecom entity enters into a two-year contract with a customer to provide telecom services (voice, data, etc.) for $40 per month, a wireless handset for $200, and activation services for $30. Payment for the handset and activation services is due at delivery (date of the sale); payment for the first month of service of $40 is due one month after activation. The total promised consideration is $1,190. How should the arrangement be accounted for? Discussion: Assume, based on recent credit history of this customer and other similar customers (for example, consideration of credit history, geography and plans), management estimates the transaction price for the promised consideration using the probability-weighted method as follows: Possible collections $ 0 230 710 1,190 Probability
Example 5Collectability, subsequent measurement

Question: Continuing with the example above, the telecom entity later determines the customers outstanding receivable balance of $120 is impaired by an estimated $40 due to further deterioration in the customers credit risk. What is the accounting impact? Discussion: At each reporting period, management will need to assess for any changes to the customers credit risk. Receivable impairments are recognized by recording an allowance against the receivable and bad debt expensenot a decrease in revenue. The customer recognizes an allowance for doubtful accounts for $40 with a charge for bad debt expense.
Example 6Collectability, subsequent measurement

Question: The customers financial condition improves and the telecom entity collects more than the estimated transaction price. What is the accountingimpact? Discussion: Amounts recognized in excess of the estimated transaction price are recognized in another component of income rather than as revenue.
Probability-weighted amount 0% 5% 50% 45% $ 0.0 11.5 355.0 535.5 $902.0
Based on the results of the probabilityweighted assessment, the telecom entity would reduce the total transaction price to $902. Management will also need to update this original assessment for any changes to the customers credit risk, recognizing any changes as income or expense, and not as an adjustment torevenue.
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 single arrangement. These arrangements usually consist of the sale of telecom services over a contracted period of time, the sale of equipment (wireless handset, modem, etc.) and activation services. 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. The proposed standard Proposed standard The transaction price is allocated to separate performance obligations in a contract based on relative stand-alone selling prices. 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 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: Cost plus a reasonable margin Standalone selling prices of the same or similar products or service, if available Cash flow model or other valuation techniques
requires the transaction price be allocated to each performance obligation in proportion to the stand-alone selling price of the good or service. Determining the allocation may be straightforward for a single customer with one or two deliverables; it becomes more complex for millions of customers all with different deliverables and different price plans. In many markets, telecom entities do not sell the equipment (handset, dongle, CPE, etc.) on a stand-alone basis. The equipment is sold in conjunction with a service contract. Equipment sold on a stand-alone basis is typically a replacement provided under insurance contacts where the customer has lost or damaged its equipment and in some markets, telecom entities have limited evidence of the standalone selling price of the equipment.
The proposed standard will significantly change how telecom entities allocate the transaction price in arrangements that offer multiple products and services. The transaction price is allocated based on the relative stand-alone selling price of the performance obligation, so entities are likely to allocate more revenue to equipment and therefore, recognize more revenue upfront or at the delivery of the equipment, and attribute less revenue toservice. Management will need to estimate the stand-alone selling price where it does not have experience selling the goods and services on a stand alone basis. High-level estimation or a portfolio approach might be needed in determining telecom entities reported revenues.
Current US GAAP Arrangement consideration is allocated to each unit of accounting based on the units proportion of the fair value of all of the units 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 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. However, consideration allocated to the delivered items is limited to the amount that is not contingent upon the delivery of additional items or meeting a specified performance condition (the non-contingent amount).
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 arms 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.
continued
Current US GAAP Telecom entities typically account for the sale of the equipment and telecom services in a single arrangement as separate units of accounting. Telecom services are 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 contingent on the entity providing telecom services. Therefore, the revenue that can be recognized on the delivery of the handset is limited to the cash received at the time of the equipment delivery. Handset revenue is recognized for the amount equal to the cash received for the handset and/or activation service, with the telecom service revenue and activation fee recognized as the service is provided, which is consistent with the monthly amounts subsequently billed, adjusted for accruals and/ or deferrals. Potential impact: Management will need to exercise significant judgment to determine the stand-alone selling price for each of the performance obligations in a customer contract (that is, telecom services, equipment, etc.). Determining the estimated stand-alone selling prices of each performance obligation and the relative allocation of the transaction price might require assessments performed on a portfolio basis due to the variation in tariffs, the customer types, contract lengths, telecom plans and equipment purchased. A portfolio approach is still likely to be challenging due to the large volume of customer contracts and multiple contract variations. Management might need to make changes to processes, procedures and systems in order to estimate and then account for the allocation of the transaction price.
Current IFRS Potential impact: There are a significant number of different combinations of service plans and devices for many entities. The stand-alone selling price of the equipment and, in some cases, service might not be directly observable in the market. Management will need to exercise significant judgment to determine the stand-alone selling price for each of the performance obligations in a customer contract (that is, telecom services, equipment, etc.). Determining the estimated stand-alone selling prices of each performance obligation and the relative allocation of the transaction price might require assessments performed on a portfolio basis due to the variation in tariffs, customer types, contract lengths, telecom plans and equipment purchased. A portfolio approach is still likely to be challenging due to the large volume of customer contracts and multiple contract variations. Management might need to make changes to processes, procedures and systems in order to estimate and then account for the allocation of the transaction price.
Insight: In some markets there is a good level of price transparency between telecom equipment and the associated service. But in many markets, telecom entities charge customers little, if anything, for the equipment. Significant judgment might be needed in estimating the stand-alone selling price of each of the performance obligations in that situation. Systems and processes often are not set up to support this analysis or accounting. Changes to systems may be required to reflect the obligations arising from contracts. Entities 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.
10
Example 7Allocation of transaction price

Question: A wireless entity enters into sales arrangements with two different customersCustomer A and Customer B. Each customer purchases or receives the same handset and selects the same telecom service plan. The stand-alone selling price for both phones is $300 and the standalone selling price of the telecom service plan is $40 per month. Customer A purchases a handset for $300 and enters into a cancellable contract to receive telecom services (voice and data) for $40 per month. Customer A also pays an activation fee of $30.
Customer B enters into a 24-month contract for $50 per month and receives a free wireless handset. Customer B also pays an activation fee of $30. In summary: Fair value of handset Fair value of services Fair value of the contract Customer A transaction price Customer B transaction price $300 $960 $1,260 $330 $1,230 ($300 handset + $30 activation fee) ($1,200 services + $30 activation fee) Revenue is recognized on the sale of the handset at delivery, as the customer has gained control of the handset. Service revenue is recognized ratably over the contract service period, as control of the service transfers continuously to the customer over the contract period. The tables on page 12 compares the affect of applying the allocation guidance in the proposed standard with that of the current guidance (example excludes time value ofmoney). ($40 x 24 months)
Discussion: Entities need to identify and separate performance obligations within customer contracts. The sales of telecom services and handsets are separate performance obligations and the activation services are not distinct. Revenue is recognized when a promised good or service is transferred to the customer. An entity transfers a promised good or service when the customer obtains control of that good or service.
11
Current guidanceexisting US GAAP guidance Customer Customer A Customer B Total Day 1 $300 * $ 30 *** $330 Month 1 $41 ** $50 $91 Month 2 $41 ** $50 $91 Month 3 $41 ** $50 $91
* Recognize revenue for the sale of the handset ($300). ** Stand-alone selling price of the telecom services ($40) and recognition of the activation fee ($30) over
the estimated customer relationship period.
*** Recognize revenue for the sale of the handset (delivered item) for the amount of consideration received
that is not contingent upon the delivery of additional items or meeting a specified performance condition (the non-contingent amount).
Revenue recognition under IFRS is not restricted to the non-contingent cash received for the delivered items. IFRS allows the use of the residual method. Proposed guidancerevenue recognized (without considering collectability) Customer Customer A Customer B Total Day 1 $300 $293 ** $593 Month 1 $41 * $39 *** $80 Month 2 $41 * $39 *** $80 Month 3 $41 * $39 *** $80
* Includes the recognition of the activation fee over the estimated customer relationship period. ** Handset: $293 = ($300/$1,260) x $1,230. *** Monthly service revenue: $39 = ($960/$1,260) x $1,230 = $937/24.
12
Proposed guidancerevenue recognized for Customer B considering collectability Based on recent credit history of this customer and other similar customers (for example, consideration of credit history, geography and plans), management estimates the transaction price for the promised consideration using the probability-weighted method as follows: Possible collections $ 0 30 630 1,230 Total transaction price Probability 0% 5% 50% 45% Probability-weighted amount $ 0.0 1.5 315.0 553.5 $870.0
Customer Customer B
Day 1 $207 *
Month 1 $28 **
Month 2 $28 **
Month 3 $28 **
* Handset: $207 = ($300/$1,260) x $870. ** Monthly service revenue: $28 = ($960/$1,260) x $870 = $663/24 months
13
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 USGAAP, using either the completed-contract method or the percentage-of-completion
method. Revenue will be recognized under the proposed standard on the satisfaction of performance obligations, which occurs when control of an asset (good or service) transfers to the customer. Control can transfer either at a point in time or continuously over the contract period. Telecom entities will have to carefully determine when control of the service is transferred to customers.
Proposed standard Equipment installation Revenue is recognized on 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 continuously over the contract period. Determining when control transfers might require a significant amount of judgment. Factors to consider include, but are not limited to: 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. This list is not intended to be a checklist or all-inclusive; these are only factors, and no one factor is determinative on a stand-alone basis.
Current US 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. Potential impact: The change to a control transfer model will require careful assessment as to when management can recognize revenue, specifically when control of the goods and services transfer. Management will have to carefully consider the contract terms, including the level of customization, payment terms and the customers rights to the goods and services over the contract period.
Current IFRS Revenue is recognized for installation contracts using the percentage-ofcompletion method when reliable estimates are available. When reliable estimates cannot be made, but no loss is expected to 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. Potential impact: Demonstrating the transfer of control is expected to change the timing of recognition of revenue on contracts. IFRS reporters will need to carefully assess the terms of contracts and determine when the transfer of control has occurred.
14
Recognition of revenueImpact 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, under USGAAP, is typically Proposed standard Revenue is recognized on the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer.
recognized over the life of the directory (usually 12 months) for both hard copy and online publications. Under IFRS, revenue is recognized for hard copy publications when delivery has occurred. If there are multiple deliveries for a publication, revenue recognized is based on a percentage of completion methodology. Revenue recognition for online publications under IFRS is consistent with USGAAP. The proposed standard is likely to accelerate the timing of revenue recognition for US Current US 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.
entities to the delivery date or publication date, for hard copy publicationsthe date on which the performance obligation is satisfied. Revenue recognition associated with online publication is less likely to change, as the publisher has the obligation to continue to display the advertisement over the contractual period. Publishing entities will have to carefully assess the performance obligations in their advertising contracts and determine when these obligations are settled. 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 standard is similar where an entitys performance obligation is to make the advertisement available to the public over a 12-month period, for example, on line. Where the obligation is to include the advertisement in the publication, revenue is recognized when the advertisement appears or upon delivery of the publications, which is similar to the proposed standard.
Control can transfer at a point in time or continuously over the contract period. Determining when control transfers might require a significant amount of judgment. Delivery methodrevenue is recognized based on the percentage of Factors to consider include, but are not publications/books delivered (that is, limited to: a proportionate performance model). The customer has an unconditional Deferral methodrevenue is recogobligation to pay. nized ratably over the contractual The customer has legal title. circulation period. The customer has physical Potential impact: possession. The customer specifies the design or The proposed standard is likely to eliminate the use of the deferral method function of the good or service. and require publishing entities to apply This list is not intended to be a checklist the delivery method. This will accelerate or all-inclusive; these are only factors, revenue recognition. and no one factor is determinative on a Management will have to apply judgment stand-alone basis. in estimating the total number of publications/books to be delivered, including the number of primary deliveries and secondary deliveries.
15
Example 8recognizing revenue from advertising and phone directory activities

Question: An entity publishes and distributes a wide range of periodicals and phone directories in both paper (hard copy publication) and internet formats (online publication). 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. After delivery of the directories, the entity has completed its obligations for hard copy directories (that is, no other services are required). It has properly separated and allocated the fee between the two performance obligations (hard copy publication and online publication) based on the relative stand-alone 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 transfer of services occurs continuously and evenly over time). The entity satisfies the performance obligation upon delivery of the hard copy publication, rather than over the contract period. Management will, however, need to consider what additional services are required, if any, after primary 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 secondary deliveries.
16
Contract costs
Telecom
Some telecom entities defer the cost of activating customer contracts (that is, labor and equipment cost), under USGAAP. 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. Some wireless entitiespredominately wireless entities that report under IFRScapitalize customer acquisition cost (for example, dealer commissions) as an intangible asset. These costs relate to commission amounts paid Proposed standard Telecom All costs of obtaining a contract, costs relating to satisfied performance obligations and costs related to inefficiencies are expensed as incurred. Other direct costs incurred in fulfilling a contract are expensed as incurred unless they are within the scope of other standards (for example, inventory, intangibles, fixed assets), in which case the entity accounts for such costs in accordance with those standards. If not, the 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.
to independent third-party distributors or dealers for connecting customers to the network. Entities with design-and-build arrangements sometimes defer set-up and transformational-type costs qualifying as assets under IFRS that are necessary investments to support the ongoing delivery of the contract. The exposure draft includes guidance on accounting for contract costs. This may impact a number of different arrangements in the sector. The accounting for contract costs will change under the proposed standard. Costs incurred to obtain a customer contract are expensed, while costs to fulfill the contract are capitalized under the Current US GAAP Costs that are directly related to the acquisition of a contract and that would not have been incurred but for the acquisition of that contract (incremental direct acquisition costs) are typically deferred and charged to expense in proportion to the revenue recognized. All other costssuch as costs of services performed under the contract, general and administrative expenses, advertising expenses and costs associated with the negotiation of a contract that is not consummatedare charged to expense as incurred. Incremental direct costs incurred to install services relating to the acquisition or origination of a customer contract relating to, for example, nonrefundable up-front fees, may be either expensed as incurred or deferred and charged to expense in proportion to the revenue recognized. Potential impact: Margins are likely to fall, as activation revenues will be recognized over the expected life of the customers contract while the related activation costs would be expensed immediately.
scope of other standards or if they meet specific requirements under the proposed standard. 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 cost over the contract period. The cost, consistent with the recognition of revenue described above, is likely to be expensed immediately upon delivery of the directories. Current IFRS Many of the costs of connecting customers form part of the operators network and the costs are capitalized as property, plant and equipment. Costs of acquiring customer contacts have been capitalized by some telecom entities as intangible assets and amortized over the customer contract period. Potential impact: Costs of acquiring wireless customer contracts (for example, dealer commissions) might not qualify for capitalization. Other costs that are capitalized (for example, network infrastructure) and contract set-up costs that support the ongoing delivery of the contract may not be affected by the proposals if the criteria for capitalization are met.
17
Proposed standard Publishing Direct costs incurred in fulfilling a contract are expensed as incurred unless they are within the scope of other standards (for example, inventory costs) or meet the specific criteria described above.
Current US GAAP Costs incurred to create directories (that is, graphics, printing, bindings and direct contract-acquisition costs) are capitalized as deferred publishing cost in inventory. Under the delivery method, the deferred costs would be recognized based on the proportional performancein line with the corresponding percentage of total revenue recognized upon primary delivery.
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 and recognized at delivery. Potential impact: Publishing entities will recognize cost and revenue at delivery.
Management will need to apply judgment in estimating the total number of publications/books to be delivered, including the Under the deferred method, costs would number primary deliveries and secondary be recognized ratably over the circulation deliveries. period of the periodical/book. Potential impact: Publishing entities will recognize cost and revenue at delivery. Management will need to apply judgment in estimating the total number of publications/books to be delivered, including the number primary deliveries and secondary deliveries in order to determine cost to be recognized at each delivery.
Example 9Customer acquisition cost

Question: A telecom entity enters into a contract with a customer to provide telecom services. The operator pays a third-party dealer to connect customers to its network. The customer signs an enforceable contract for a period of 18 months. Currently, the telecom entity capitalizes the dealer commission and amortizes the amount over the 18-month contract term. Will this accounting treatment be appropriate under the proposed standard?
Discussion: Costs of obtaining a contract, such as dealer commissions, might need to be expensed as incurred under the proposed standard. This could be a significant change for some telecom entities that are able to capitalize these costs as an intangible asset under existingguidance.
18
USGAAP Convergence & IFRS Revenue recognition: Transportation and logistics industry supplement
March 2011
Revenue recognition . . . full speed ahead Transportation and logistics industry supplement
Whats inside: Overview Transportation revenue and costs Customer loyalty programs frequent flyer programs Onerous performance obligations Change fees Variable consideration Multiple-element arrangements
Overview
The Transportation and Logistics sector 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 items in the transportation industry may be significantly affected by the proposed revenue recognition standard. This paper, examples, and related assessments are based on the Exposure Draft, Revenue from Contracts with Customers, issued on June 24, 2010. 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 PwCs Dataline 201028 or visit www.fasb.org.
Reprinted from: Dataline 201028 (Supplement) November 16, 2010
Revenue recognition: Transportation and logistics industry supplement
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 that will require careful consideration to determine when an entity can recognizerevenue. Proposed standard Transportation revenue Revenue is recognized upon 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 continuously over the service period. Factors to consider in assessing control transfer include, but are not limited to: 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 This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a stand-alone basis. Current US GAAP 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, and (2) allocate revenue between reporting periods based on relative transit time in each period with costs recognized as incurred (the proportionate performance method). Current IFRS Revenue is recognized for service transactions, such as freight services, based on the stage of completion of the transaction. Costs are recognized as incurred.
continued
Proposed standard continued from previous page Transportation costs All costs of obtaining a contract, costs relating to satisfied performance obligations, and costs related to inefficiencies (i.e., abnormal costs of materials, labor, or other costs to fulfill) are expensed as incurred. Other direct costs incurred in fulfilling a contract are expensed as incurred unless they are within the scope of other standards (e.g., inventory, intangibles, fixed assets) or if other specified criteria are met. Costs that are in the scope of other standards are accounted for in accordance with those standards. An asset is recognized for costs outside the scope of other standards when the costs relate directly to a contract, relate to future performance, and are probable of recovery under a contract. These costs are then amortized as control of the goods or services to which the asset relates is transferred to the customer.
Current US GAAP
Current IFRS
Impact: Management will need to determine whether the service being performed is transporting the goods-in which case the entity might conclude the service is provided (and control transferred) continuously-or the service is to transport goods to a specific destination-and thus control transfers and revenue is recognized upon delivery. Freight costs are expensed as incurred unless they can be capitalized under another standard or they relate directly to a contract, generate or enhance resources of the entity that the entity will use to satisfy performance obligations in the future, and are expected to be recovered. This might allow, in certain situations, direct costs of a contract to be capitalized until delivery if revenue is recognized upon delivery. Costs to obtain a contract (e.g., selling costs) as well as abnormal amounts of wasted contract fulfillment costs are expensed as incurred.
Example 1
Facts: A freight railway entity enters into a contract with a customer to ship goods from point A to point B for $1,000. 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. The transportation services are provided specifically for the customer. When should the entity recognize revenue from this contract?
Discussion: The performance obligation may not be satisfied until the goods reach point B. The indicators of control transfer are difficult to apply to certain service transactions and further clarification of the guidance may be needed to make the assessment of when control transfers. The expenses incurred need to be evaluated to determine if they are eligible for capitalization until the performance obligation is satisfied. The proposed standard focuses on recognition of revenue when control transfers to the customer rather than on the entitys activities. Judgment will be required to determine when control transfers for service transactions typical in the transportation and logistics industry.
Customer loyalty programsfrequent 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 not supplied by the entity. The most common customer loyalty programs in the industry are the frequent flyer programs offered by airlines.
Proposed standard Customer loyalty programsfrequent flyer programs Performance obligations 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 stand-alone selling price of each obligation. Revenue relating to the award credits is deferred until the obligation is satisfied (when the award credits are redeemed or expire).
Current US 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. Most entities use the incremental cost model and recognize revenue relating to the flight when the flight occurs. The cost of fulfilling award credits is treated as an expense and accrued. Other entities use the multiple-element model and allocate revenue to the award credits based on relative fair value. Revenue allocated to the award credits is deferred and recognized when the award credits are redeemed or expire.
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.
Measurement (breakage) The stand-alone selling price for a The fair value of the award credits customers option to acquire additional is not reduced for expected goods or services (loyalty awards) is not forfeitures (breakage). usually directly observable and must typically be estimated. That estimate should reflect the discount the customer would obtain when exercising the option, adjusted for discounts readily available without the option and the likelihood that the option will be forfeited (breakage).
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).
continued
Proposed standard continued from previous page Principal versus agent The airline recognizes revenue in the amount of consideration received (gross) when the airline redeems the award credit for goods or services that it provides. The airline recognizes revenue in the amount of any fee or commission received (net) when the airline arranges for another party to provide those goods or services.
Current US GAAP
Current IFRS
An entity determines whether it is acting as a principal or an agent in the arrangement based on certain criteria.
An entity determines whether it 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. Impact: The proposed standard is consistent with the current IFRS guidance and the effect will therefore be limited.
Impact: Award credits issued under customer loyalty programs will likely be accounted for as separate performance 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 use the multiple-element model today. An entity will need to determine whether it 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.
Example 2
Facts: Airline A has a frequent flyer customer loyalty program rewarding 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 the time value of money and breakage)? Discussion: The transaction price of $500 is allocated between the ticket and award credits based on the relative stand-alone selling prices of $500 for the ticket and $50 for the award credits as follows: Ticket: Award credits: $455 ($500 x $500/$550) $45 ($500 x $50/$550)
Example 3
Facts: Assume the same facts as in Example 2 above, except that the airline expects redemption of 80% of award credits earned (i.e. 20% breakage) based on the airlines 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 (ignoring the time value of money)? Discussion: The transaction price of $500 is allocated between the ticket and award credits based on the relative stand-alone selling prices of $500 for the ticket and $40 for the award credits as follows: Ticket: Award credits: $463 ($500 x $500/$540) $37 ($500 x $40/$540)
Example 4
Facts: Assume the same facts as in Example 3 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 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 (ignoring the time value ofmoney)? 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 asfollows: Dr. Contract Liability Cr. Revenue Cr. Cash $37 $3.70 $33.30
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 awardcredits.
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 awardcredits.

The proposed standard requires that each performance obligation be assessed to determine whether a loss will be incurred relating to that obligation. Proposed standard Current US GAAP 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; thus, an onerous provision is recognized.
Onerous performance obligations Management will need to assess whether Anticipated losses on executory performance obligations are onerous. A contracts (onerous contracts) generally performance obligation is onerous when should not be recognized. the present value of the direct costs to satisfy a performance obligation exceeds the consideration allocated to it. The excess is recognized as a contract loss with a corresponding liability that is remeasured at each reporting period.
Impact: More provisions for onerous obligations are likely to be recognized under the proposed standard than currently recognized under both US GAAP and IFRS. Broader application will create more onerous provisions under US GAAP, and the need to perform the onerous loss assessment at the performance obligation level rather than the contract level will create more onerous provisions under both IFRS and US GAAP. The proposed standard may cause a significant change for entities, such as airlines, where excess capacity is sold at deeply discounted prices. Deeply discounted tickets may be onerous performance obligations at the time sold and require accrual of the expected loss. This would be the case if the selling price of a discounted ticket did not exceed total allocated costs of the flight, even though the ticket may be sufficient to cover the related incremental costs and contributes to the overall profitability of the flight.
Change fees
Change fees are common in the airline industry. The predominant industry practice under USGAAP 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 (i.e., paying the change fee instead of the price of a new ticket). Under this view, the change fee is deferred and recognized when the travel occurs. The proposed standard will require management to consider whether the change fee is a separate contract or one that should be combined with the original sales transaction. Contracts that are priced interdependently will need to be combined, while contracts priced independently are accounted for separately. It may be challenging to conclude that change fees are independently priced as the change fee is generally agreed at the time of the original ticket sale.
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 be more complex 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, performance bonuses, and time value of money. 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. Management will need to determine the probability weighted estimate of consideration to be received and adjust the transaction price. The same accounting treatment applies to performance bonuses.
Proposed standard Volume discounts Volume discounts are generally receivable by the customer when specified cumulative levels of revenue are earned during a defined period. If an entity receives consideration from a customer and expects to refund some or all of that consideration, the entity recognizes a refund liability. That liability is measured at the probability-weighted amount of consideration that the entity expects to refund to the customer. Revenue is measured using a probability-weighted approach when payments can be reasonably estimated. The amounts can be reasonably estimated when the seller has experience with such volume rebates and the experience is relevant to the contract. Otherwise, revenue is limited to the amount of consideration that management can reasonably estimate.
Current US GAAP Volume discounts are recognized as a reduction of 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.
Current IFRS 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.
Impact: Revenue is measured based on the probability-weighted average estimated consideration to be received after adjusting for expected discounts. The probabilityweighted approach in the proposed standard may change the timing of revenue recognition compared to the best estimate approach used today.
Proposed standard Time value of money In determining the transaction price, an entity shall adjust the amount of promised consideration to reflect the time value of money if the contract includes a material financing component (whether explicitly or implicitly). Management uses a discount rate that reflects a separate financing transaction between the entity and its customer, and factors in credit risk.
Current US GAAP The discounting of revenues is required only in limited situations, for example, receivables with payment terms greater than one year.
Current IFRS
Discounting of revenues to present value is required in instances where the effect of discounting is material. In such instances, an imputed interest rate is used to determine the amount of revenue When discounting is required, the interest to be recognized immediately, as well as component is calculated based on the the separate interest income component stated rate of interest in the instrument or to be recorded over time. a market rate of interest if the stated rate is considered unreasonable. Impact: We do not expect a significant change to current practice for most transportation and logistics entities (excluding airlines) in connection with the time value of money, because payment terms often do not vary significantly from the timing of contract performance. Contracts with payment terms that vary significantly from the timing of contract performance, such as prepayments for flights and customer loyalty programs, might be affected (see Example 6).
Example 5
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. How should the railway entity record revenue from this contract? Discussion: Based on past experience, the railway entity believes there is a 70% probability that the customer will ship 10,000 loads and earn the discount of $100 per load. The railway entity will record revenue of $930 per load based on the probability-weighted amount of consideration it expects to receive [(0.70 x $900) + (0.30 x $1,000)].
Example 6
Facts: An airline sells a non-refundable ticket to a customer with payment due at the time of booking, which is one year before the reserved flight. The ticket price is $500. How should the airline record revenue from this contract? Discussion: The airline will record a contract liability of $500 when the customer pays. The airline determines that a 5% discount rate is appropriate based on the one year term and its credit characteristics. The airline recognizes interest expense of $25 ($500 x 0.05) during the year before the flight with a corresponding increase to the contract liability. The airline records revenue of $525 when the reserved flight is taken. This accounting treatment is a significant change from current practice.
10
Multiple-element arrangements
Many transportation entities provide multiple services to their customers as part of a single contract. Determining when to separately account for performance obligations under the proposed standard is a key determination and will require a significant amount of judgment. Proposed standard Multiple-element arrangements The proposed standard states that a single contract may have numerous performance obligations. When these performance obligations are distinct they should be accounted for separately. A good or service is distinct, and should be accounted for separately, if the entity, or another entity, sells an identical or similar good or service separately. Performance obligations could be distinct if not sold separately if the good or service has a distinct profit margin and a distinct function. For performance obligations that require separate accounting, contract revenue is allocated to each performance obligation based on relative actual or estimated stand-alone selling prices. Current US GAAP Current guidance requires deliverables in contracts to be accounted for separately if each deliverable has stand-alone value and there is objective and reliable evidence of fair value of the undelivered element. When fair value does not exist for delivered elements, the residual method of allocation is permitted. The lack of objective and reliable evidence of fair value of the undelivered element often limits the separation of deliverables in a multiple-element arrangement. Current IFRS The revenue recognition criteria are applied to each separately identifiable component of a single transaction to reflect the transactions substance. Fair value is used to allocate the transaction price to the separate elements of a contract. The price that is regularly charged when an item is sold separately is the best evidence of the items fair value. A cost-plus-reasonable-margin approach to estimating fair value is also acceptable. The use of the relative fair value method, residual method and, under rare circumstances, the reverse residual method, is acceptable to allocate arrangement consideration.
New multiple element guidance (required to be adopted for calendar year end companies effective January 1, 2011) requires deliverables in contracts to be Entities might separate elements in a accounted for separately if each deliversingle contract even if the elements are able has stand-alone value. At the incep- not sold separately. tion of the arrangement, consideration is allocated to all deliverables based on the relative selling price. The residual method is no longer permitted.
11
Proposed standard
Current US GAAP Impact: Management will need to determine whether transportation or logistics contracts include more than one performance obligation. The separation criteria in the proposed standard are less restrictive than current guidance. This might result in more performance obligations being accounted for separately, thereby changing the timing of revenue recognition. For example, entities that provide a complete solution including completion and filing of necessary transportation paperwork (e.g., customs forms) should consider whether the individual services are distinct performance obligations. The residual method of allocation is not permitted under the proposed standard.
Current IFRS Impact: The proposed separation and allocation methodology is similar to current guidance, although more performance obligations might be identified. The residual and reverse residual methods of allocation will no longer be acceptable.
Example 7
Facts: A trucking entity enters into a contract with a customer for maintenance services and emergency roadside assistance. The services are not typically sold on a stand-alone basis. Assume the performance obligations are each distinct and will be delivered at different times. How should the trucking entity allocate revenue to the performance obligations?
Discussion: The entity will need to consider observable prices of services, when available, in estimating the standalone selling price of each of the services. Stand-alone selling prices of the maintenance services and the emergency roadside assistance will be estimated because they are not sold separately by the entity. The entity might use a cost-plusreasonable-margin approach or any other reasonable and reliable method to estimate stand-alone selling price as long as that method is consistent with stand-alone selling prices that maximize observable inputs. The arrangement consideration is allocated to each performance obligation on a relative basis. Revenue is recognized as the performance obligations aresatisfied.
12
US GAAP Convergence & IFRS Leases

March 2011
Table of contents
Leasing
FASB and IASB agree on changes that will reduce complexity of the proposed leasing standard
10Minutes on the future of lessee accounting Leasing

The responses are in . . .
6 12
A new approach to lease accounting

Proposed rules would have far-reaching implications
26
The overhaul of lease accounting

Catalyst for change in corporate real estate
43
Leasing FASB and IASB agree on changes that will reduce complexity of the proposed leasing standard
Whats inside: Overview Status of redeliberations The path forward
In August 2010, the FASB and IASB (the boards) jointly issued an exposure draft of a proposed accounting standard for leases (the ED). The proposals would change the accounting for lease transactions and have significant business implications. The comment period ended on December 15, 2010 and the boards have begun redeliberating the ED. The boards have considered the extensive feedback received that the ED was overly complex and, in some areas, inconsistent with the economics of the underlying transactions. The proposed changes address some of the specific concerns raised and should make implementation of the standard more operational and less costly and complex. Thus far, the boards have made tentative decisions to change the proposals in the ED with respect to the definition of lease term (threshold for inclusion of extension options) and inclusion of variable or uncertain cash flows (i.e., contingent rent), and have instructed the staff to conduct additional outreach with respect to their tentative decision concerning variable or uncertain cash flows. The boards are also considering changes in the definition of a lease, profit and loss recognition patterns and the lessor accounting model. However, no decisions in these areas have yet been reached and the staff will conduct additional outreach.
The main details

1. In January 2011, the boards issued
a preliminary redeliberation plan that identified five key areas for discussion: Definition of a lease (including embedded leases) Lessor accounting Definition of lease term (including extension options) Variable/uncertain cash flows Profit and loss recognition pattern
change the scope and direction of the project. The staff also identified a more extensive list of other areas and application issues to be addressed once the boards address the main concerns listed above.
3. The boards have discussed each of

these items in their redeliberation meetings and have identified possible alternative approaches which may reduce complexity and address certain application issues. For several of these areas, the boards have directed their staff to conduct targeted outreach and prepare additional analysis.
2. Decisions made during redeliberation

of these items could significantly
4. In the paragraphs that follow, we have

summarized the decisions reached at the January and February 2011 joint meetings, as well as the status of discussions for each of the remaining key areas. We have also included PwC observations on the potential implications of these issues.
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.
5. As the boards have not yet completed

their redeliberations or issued a final standard, all FASB and IASB 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 FASBs website at www. fasb.org or the IASBs website at www. ifrs.org.
8. 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 and economic penalties if the lease is not renewed (for example, direct penalty payments, tenant improvements with significant value that would be forfeited, or a lessees guarantee of lessor debt related to the leased property). Under the revised approach, management intent and past business practice would not be included as part of the evaluation.
balance sheet than would have resulted under the ED. The revised threshold is more consistent with todays treatment of including renewal periods in the lease term only when they are reasonably certain 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.
Variable or uncertain payments
6. For more information on key aspects

of the ED and how it may impact you, refer to Dataline 201038, A new approach to lease accounting Proposed rules would have far reaching implications (which provides an overview and various insights into the ED), Dataline 201105, Leasingthe 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).
11. Many respondents to the ED believed

that certain types of contingencies should be included in the lessees liability to make lease payments and the lessors 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 leases could be structured such that lease payments appear entirely contingent, but where both parties expect significant payments to be made.
9. 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 such that the lessee would then either have, or no longer have, an economic incentive to exercise an option or terminate the lease.
10. 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. PwC observation: The higher threshold for including extension options would generally result in shorter lease terms and lower amounts recognized on the
Status of redeliberations
Key decisions reached
Lease term

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
7. The boards have tentatively decided

to raise the threshold for inclusion of extension options in the lease
Leases
Any contingency that is a disguised minimum lease payment (i.e., an anti-abuse provision) Any portion of residual value guarantees that are expected to be paid Any other contingencies (i.e., usage or performance) that are reasonably certain (as that term is used in IFRS) or probable (as that term is used in USGAAP) of being paid
that some constituents were looking for. Significant practical application issues remain in this area to be debated prior to the issuance of a final standard, including the profit and loss recognition pattern to be utilized for any contingent amounts recognized.
transactions that were not financing transactions in nature.
17. In their redeliberations, the boards

have been discussing whether there should be a fundamental distinction between those leases that are primarily financing transactions in nature and those that are other than financing. The boards may conclude that there is a fundamental difference and while all leases would be on balance sheet, the profit and loss recognition pattern may be different for different types of leases.
Status of discussions on other key areas

Profit and loss recognition pattern

any contingent amounts would be included using a best estimate approach rather than the probabilityweighted approach proposed in the ED. The boards also tentatively concluded that term option penalties should be included or excluded in a manner that is consistent with the thresholds for including extension options.
15. The ED implicitly treats all leases

as financing transactions with an accelerated profit and loss recognition pattern more commonly associated with financing transactions. Many respondents across a wide range of industries had significant concerns about this approach.
18. If the boards ultimately adopt this

approach, those leases that are primarily financing transactions in nature would have a recognition pattern similar to a financed purchase. Those that are deemed to be other than financing would have a recognition pattern more closely aligned with todays straight line rent under an operating lease. The boards tentatively agreed that distinguishing between these two types of leases would be based on two new sets of indicators and have instructed the staff to conduct additional targeted outreach in this area.
16. Many respondents did not believe

the proposed recognition pattern was consistent with the economics of many types of lease transactions that are not priced like financing transactions, but rather in reference to other market transactions (e.g., by reference to market rent rates, not interest rates). They also observed that while many users of financial information (such as analysts and rating agencies) make adjustments to the balance sheet of lessees, they are not making adjustments to the income statement as they are generally satisfied with the current income statement recognition pattern and characterization of most leases. As a result, many were concerned about the continued usefulness of the income statement as a measure of performance under the ED with respect to leasing
14. The boards have not yet discussed

the reassessment of contingencies or how contingent rents included in the measurement would impact the profit and loss recognition pattern. The staff will be conducting additional targeted outreach on these topics. PwC observation: The boards revised proposal strikes a balance between the complexity of including contingencies and the structuring concerns if all contingencies were excluded. The elimination of the requirement to use a probabilityweighted approach will also improve operationality. When coupled with the revised threshold for inclusion of extension options, this approach will reduce complexity as compared to the ED, though not to the extent
19. While some may argue that this

approach for other than financing leases would represent a significant theoretical departure from the recognition patterns of other assets and liabilities, the boards have acknowledged that it may be necessary given the unique nature of leases, through which the asset and liability are inextricably linked. PwC observation: If the boards ultimately conclude that a dual model by lessees for financing
and other than financing leases is appropriate, this may alleviate many of the concerns about the project. However, we believe that the boards have substantial work remaining in this areain particular, describing the lease characteristics under each model and how each model would be applied.
lease (so called embedded leases) and non-lease elements would be much more important.
recognition patterns may significantly reduce the concerns raised about embedded leases.
23. The definition of a lease contained

in the ED was 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. The boards have been discussing potential revisions to the definition that may help clarify when transactions are leases or service contracts or both. The boards have also discussed how to apply the definition to a number of practical examples (such as rail cars) where there may be questions as to whether there is a specified asset or whether control of the asset has been conveyed to the lessee. The boards have also begun exploring whether they should exclude embedded leases in arrangements that are predominantly service contracts or where the embedded lessee asset is merely incidental to the delivery of a service such as a cable TV set-top box. The boards also briefly discussed whether certain types of executory costs should be excluded from the measurement when the transactions are predominantly leases.
Lessor accounting
25. Many respondents to the ED

(including many in the user community) did not believe that the proposed lessor model in the ED represented sufficient improvement to warrant the substantial additional costs to implement and apply the new proposals.
Definition of a lease
20. The ED predominantly carried forward

the definition of a lease contained in existing leasing guidance. Perhaps most surprising to many is the level of concern raised regarding the fundamental question of whether an arrangement contains a lease, both in relation to the current accounting for leases and the proposed model.
26. In response to this feedback, the

boards have discussed the possibility of allowing the current lessor accounting guidance to continue (with the potential exception of eliminating leveraged lease accounting in the US). 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 will be contained in the final standard.
21. The boards have acknowledged that

there may be many more multipleelement arrangements that contain an embedded lease than originally expected, which would substantially increase the complexity and costs of applying the proposed standard. Conversely, some respondents indicated that many transactions characterized as a lease within an agreement may not be a lease for accounting purposes under the proposed definition.
27. It is expected that the issue of lessor

accounting will be revisited as soon as decisions in the other key areas have been finalized.
28. The boards have also clearly indicated that they will be focused on making sure that the other current joint projects, most notably revenue recognition, are based on consistent core principles.
24. The boards have instructed the staff to

conduct additional targeted outreach in this area and to return to the boards with detailed proposals. PwC observation: There remains a significant amount of discussion to be held in this area. We anticipate that the boards will make further progress on these discussions in the near term. We also observe that the changes in lease term described previously and the potential changes in profit and loss
22. Feedback received by the boards has

also indicated that under current practice, whether an arrangement contains a lease often does not have a significant accounting impact if any lease identified would be an operating lease. However, under the ED, the difference in accounting could be very significant and, as a result, the judgments about whether or not a lease exists and the allocation between
The path forward

29. The boards will continue redeliberations in the coming months. A final standard remains targeted for issuance in mid-2011. We will continue to keep you informed of the significant redeliberation decisions.
Leases
10Minutes on the future of lessee accounting
Whats inside: Highlights How new lessee accounting changes your companys financial picture How changing financial metrics could impact ability to borrow Where the proposals raised the most concern Considerations for companies that use leases What should your company be doing now?
Highlights
Adding leased assets and obligations to balance sheets will affect measures of financial strength (e.g., debt-to-equity ratios), net income, and other performance metrics. Agreements tied to these measures may be affected, such as performancebased compensation plans and debt covenants. Accounting for contingent rents and renewal options will require significant 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.
Reprinted from: 10Minutes on the future of lessee accounting February 2011 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
How new lessee accounting changes your companys financial picture

1. Leasing arrangements satisfy a wide
variety of business needs, from shortterm 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.
3. 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.
4. 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.
2. 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.
Companies should begin preparing

5. 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.
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. lease terms are generally not re-assessed, except when there is a change in the terms or a binding exercise of an extension option. 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.
6. 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
Changes lie ahead. Under the proposed rules:*
How changing financial metrics could impact ability to borrow

7. 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.
Based on the proposals in the exposure draft published in August 2010. Certain provisions may change upon redeliberation.
New baselines for financial metrics

8. 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 interestbearing 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.
Leases
Impacts on financial metrics vary by industry PwC assessed the impact of the leasing proposals on the financial statements and key financial ratios of a sample of approximately 3,000 listed companies across a range of industries worldwide. Industries Average percentage** increase Leverage** 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 Interestbearing debt 213 51 95 23 158 25 101 34 50 68 30 27 3 58 EBITDA* 55 25 44 16 27 13 30 21 13 14 10 15 6 18
Where the proposals raised the most concern

14. 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 leasesIn 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.
* 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
9. 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.
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.
12. 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.
10. 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.
13. 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.
Likely impacts on financing

11. For some companies, it may be
more than just getting used to new
The proposed rules result in frontloading of rent expense
$3,300
$2,800
$2,300 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.
$1,800
$1,300
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. 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.
Current economic conditions

19. 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.
Alternative approaches may emerge
15. The proposals are still being debated

and substantial changes could be incorporated into the final rules that will be issued in mid-2011.
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.1
20. Also, some companies may benefit
16. 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.
Considerations for companies that use leases

18. 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
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.
21. These could become important factors

in re-assessing existing contracts, potential re-negotiations, and new lease-versus-buy decisions.
17. Weve offered a number of suggestions that do this and also reduce complexity while addressing potential application challenges and costs. For
1 PwC, Letter to the International Accounting Standards Board and Financial Accounting Standards Board, 30 November 2010.
Leases
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 flexibility in real estate and equipment procurement? How do federal, state, and local taxes factor into your lease-versus-buy decisions?
Regulatory and contracting factors

22. 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.
What should your company be doing now?

25. 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.

Educate key business leaders in the company about the leasing change Create a cross-functional steering committee to address the proposed standard and transition Inventory your leases; understand what assets are leased and where the data resides Identify contracts likely to include embedded leases Consider modeling the transition impact on certain significant leases (or sample from a variety of lease types) Summarize existing systems, control processes, and potential gaps Analyze potential income and other tax considerations (including federal, state, and foreign taxes) Identify contracts affected (e.g., financial covenants, compensation agreements, and earnout agreements), the potential implications, and how terms should be modified to maintain the original intent Identify regulatory issues such as implications for regulatory capital and cost plus government contracts Consider potential changes in leasing strategy; for example, lease/buy, shorter versus longer terms, options, contingent rents, etc. Consider if terms of existing leases should be renegotiated
Tax considerations
23. 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

24. 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.2
2 PwC, The overhaul of lease accounting: catalyst for change incorporate real estate, November 2010.
10
Assess the potential impact early on

26. 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.
Rally the people who need to act

29. 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.
Conduct strategic reviews

32. 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?
27. 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.
Consider new systems and controls

30. 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.
33. Review debt agreements with lenders

and credit agreements with suppliers. Evaluate employment contracts to assure proper alignment of performance metrics with anticipated financial results.
28. Based on the information gathered,

prepare a preliminary impact study and update it as needed. Monitor changes in the proposed standards.
Communicate in advance with your stakeholders

34. 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.
31. 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.
Leases
11
Leasing The responses are in . . .
Whats inside: Overview Background Preliminary redeliberation plan Comment letters
The FASB and IASB (the boards) received over 770 comment letters in response to their August 17, 2010 Exposure Draft, Leases (the ED). The comment period closed on December 15, 2010. The boards have also performed direct outreach with users and preparers, and held public roundtable discussions in London, Hong Kong, Chicago and Norwalk. We noted a number of recurring themes in the comment letters and roundtable discussions, even across industries. While a majority of the respondents are supportive of the need for the project in general, especially as it relates to lessee accounting, most respondents have significant concerns about many aspects of the proposals contained in the ED, and strongly encourage the boards to take the time necessary to produce a standard that is both high quality and operational. In addition to comments about the technical application of the proposed standard, many respondents have also expressed concerns around the operationality, cost/benefit and potential for unintended business implications. The boards are targeting to issue the final standard in the second quarter of 2011 but have acknowledged that substantial work remains. A final standard would likely have an effective date no earlier than 2014.
Reprinted from: Dataline 201105 January 27, 2011 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
12
Summary of comments
1. The following table summarizes the comment letter themes by major topic.
Major area Scope exclusions Summary of comments While there was general agreement that most arrangements accounted for as leases today should be governed by the standard, many have encouraged the boards to revisit the proposals on short-term leases and leases of intangibles. Many respondents supported the right-of-use model for lessees, at least with respect to the balance sheet implications for simple leases. However, many disagreed with the measurement provisions for more complex leases. In addition, many expressed concern about the deemed financing premise and resultant accelerated expense recognition pattern in the ED. Views on lessor accounting are more diverse. The ED proposes a hybrid model under which certain leases are accounted for under a performance obligation approach while others would be required to use a derecognition approach. Many believe that the case has not yet been made that the proposed hybrid model for lessor accounting represents a significant enough improvement from the current model to warrant a change. Some believe that a hybrid model is necessary to deal with different business models (e.g., financing models vs. contracts to use) while others believe a hybrid model is not consistent with concepts in the revenue recognition exposure draft and that only a derecognition approach is warranted. Almost all respondents disagreed with the definition of lease term as the longest possible term more-likely-than-not to occur. They believe this may result in recognition of amounts for extension periods that do not meet the definition of a liability. They also believe this approach would be highly subjective in application, result in significant volatility and be subject to manipulation in practice. While most respondents believe that some extension options should be included, there were differing views regarding the threshold at which respondents believe they should be recognized. The ED requires that contingent payments generally be included in the amounts recorded using a probabilityweighted approach. Most respondents were critical of a probability-weighted approach and believe a best estimate approach is more appropriate. Some respondents also believe that certain types of contingencies (usage, performance, or index-based) should be treated differently although there were differing views as to which types should be included and why.
13
Lessee accounting
Lessor accounting
Extension options
Contingent payments
Leases
Major area
Summary of comments
Profit and loss The ED includes an inherent financing element in the rightrecognition pattern of-use model. This model results in a recognition pattern for the lessee that changes the expense recognition pattern of operating leases from rental expense to a combination of amortization and interest expense. It will also typically result in the acceleration of expenses compared to todays operating lease accounting and the timing of cash payments. Many respondents questioned the usefulness of this model. Purchase options The ED proposes that purchase options should be accounted for only when exercised. Many respondents believe they should be considered as part of the lease model. The ED includes guidance for distinguishing a lease from an in-substance sale/purchase and from a service contract. It also includes guidance for identifying the service components of an arrangement that contains a lease. Many respondents (both lessee and lessor) had concerns about accounting for an embedded lease in a multiple-element arrangement in which the vendor can replace the underlying asset or there is no specific asset identified in the contract. Multiple-element contracts that include a lease and a service arrangement represent a significant concern to many, especially for real estate leases. 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 under the revenue recognition exposure draft. Many respondents have also raised concerns about the potential volume of embedded leases which now could have a significant accounting impact on multiple-element arrangements. The ED provides for reassessment of significant assumptions if facts and circumstances indicate there would be a significant change in the amounts from a previous reporting period. Many respondents raised concerns about the operationality and cost/benefit of this approach. These respondents indicated that an annual reassessment may be appropriate while others suggested a trigger-based reassessment. The ED provides for a simplified retrospective approach and does not allow for early adoption. While many respondents supported this approach for cost/benefit reasons, others observed that it creates an artificial and nonrecurring expense pattern. Many respondents also asked for more guidance on transition issues in general (e.g., use of hindsight) and for specific issues (e.g., sale leasebacks, leveraged leases and build-to-suit leases). Most respondents supported the overall disclosure objectives, but believe that preparers should be allowed to exercise judgment in determining the volume of disclosures and financial statement presentation.
Multiple-element contracts, executory costs and service arrangements
Reassessment
Transition
Disclosure
14
Background
2. Leasing arrangements satisfy a wide
variety of business needs, from shortterm asset rentals to long-term asset financing. Leases allow companies to use assetsfrom office and retail space to hotel rooms, equipment, cars, and aircraftwithout having to make large initial cash outlays. Sometimes, leasing is the only option to obtain the use of property when it isnt available for purchase.
5. As part of their global convergence

efforts, the boards added the joint project to their agendas in 2007 and have been working to create a single, global 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 boards issued similar discussion papers in March 2009 and the recent exposure drafts were issued in August 2010.
Comment letters
9. The boards received over 770 comment
letters from respondents in more than 30 countries. The large number of responses is reflective of the significance and prevalence of leasing as a fundamental business tool.
10. The respondents included preparers,

industry trade organizations, professional organizations, local standard setters/regulators, individuals, auditors, consultants, academics and users. The respondents included both lessees and lessors in a wide range of industries including financial services, real estate, retail, automotive, aircraft, telecommunications, industrial products and utilities. At the public roundtables, concerns were raised about the relatively low volume of feedback from the user community and the need for more outreach by the boards/staffs to that group.
3. Many observers have long believed

that the current lessee accounting model is not consistent with the conceptual framework, which provides the underpinnings for accounting rules. They argue that current guidance allows lessees to structure lease transactions to achieve operating lease classification, resulting in off-balance sheet treatment. Critics also point out that the current guidance can result in something as seemingly illogical as a commercial airline company avoiding recognition of any airplanes on its balance sheet.
6. Refer to Dataline 201038 for a

detailed discussion of the key aspects of the proposed standard, as well as PwCs response letter submitted to the boards on November 30, 2010.
Preliminary redeliberation plan

7. The IASB/FASB staffs are in the
process of preparing a redeliberation plan and have preliminarily identified five main areas that will likely be the initial main areas of focus in upcoming redeliberations meetings. The five main areas are: Definition of a lease Lessor accounting Lease term (i.e., extension option issues) Variable lease payments Profit and loss recognition pattern
11. The respondents were disproportionally from North America and Europe as well as from international organizations (such as major multinational companies or international accounting firms). Some speculated at the roundtables that the disproportionate North American response may be the result of the fact that (i) USGAAP does not have the equivalent of Small and Medium-sized Entities accounting in IFRS and, therefore, the new standard would apply to a much broader group of entities (i.e., both public and private) and (ii) the US does not currently have an investment property standard thereby scoping in all real estate lessors.
4. In June 2005, the Securities and

Exchange Commission 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 revised, primarily to eliminate off-balance sheet accounting by lessees.
8. Decisions made during redeliberation

of these main areas could significantly change the scope and direction of the project. The staffs also identified a more extensive list of other areas and application issues to address once the boards address these main concerns.
Leases
15
12. Many of the respondents addressed

only certain aspects of the proposed ED and did not respond to the detailed questions provided in the ED. Therefore, it is not possible to give precise percentages to measure how respondents reacted to particular issues. Accordingly, the discussion in this Dataline uses terms such as majority, many, several, or some to try and convey the perceived prevalence of a particular view on an issue expressed in comment letters or at the public roundtable discussions.
comments we provided to the boards in our response letter.
Defining and identifying a lease

15. Perhaps most surprising to many who
have been following this project is the level of concern raised regarding the fundamental question of whether an arrangement contains a lease, both in relation to the current accounting model and the proposed model. Some respondents indicated that many transactions legally identified as a lease may not be a lease for accounting purposes under the proposed definition. Others have indicated that certain other contracts, although called something else, may be fundamentally a lease such as power purchase contracts. Still others have raised significant concerns that there may be many more multipleelement contracts than originally expected that contain an embedded lease, which would substantially increase the complexity of applying the proposed standard.
be substantially different under the proposed model. Accordingly, the evaluation of whether all or part of an arrangement is a lease and the appropriate allocation of consideration between the multiple elements becomes more significant.
17. Many respondents also requested

guidance on how and at what level to evaluate whether an asset has been specified in applying the definition in situations where the lessor could replace the physical asset or where the lessee does not control the asset. Many observed that parties often enter into master-leases without knowing which physical asset, or even how many, will be leased. Respondents also cited a number of specific examples in various industries (e.g., computers, copiers and rail cars) with respect to the lessors ability to replace and control the asset.
13. While the majority of respondents

supported the projects overall objectives, they had a number of concerns about some of the key provisions, including: Defining and identifying a lease Scope exclusions Lessee accounting Lessor accounting Extension options Contingent payments Profit and loss recognition pattern Purchase options Multiple-element contracts, executory costs and service arrangements Reassessment Additional guidance requested Transition Disclosure Operationality and cost/benefit Tax/regulatory implications
18. Many respondents also raised

concerns about some of the difficulty today in applying the current leasing guidance regarding whether an arrangement contains a lease (formerly EITF 01-8 and IFRIC 4). This guidance was essentially carried forward into the proposed standard. PwC observation: We have urged the boards to take this opportunity to consider the scope holistically and also address many of the known issues with existing guidance (e.g., the former EITF 01-8 and IFRIC 4) in the final standard. The boards should also provide guidance on how to identify lease elements or so-called embedded leases. In addition, the boards should provide guidance on how to apply the concept of specified
16. The ED defines 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. Many respondents expressed concerns that this definition will be difficult to apply in practice. While this definition is consistent with the current accounting models, the existing accounting for an operating lease is not substantially different from the accounting for an executory contract in most cases. In contrast, the accounting for the lease element of an arrangement can
14. In the paragraphs that follow we have

summarized respondents comments on the above topics. We have also included in PwC observations the
16
asset in situations where the lessor can replace the asset or has control over the asset.
Scope exclusions
19. The scope of the project received only
limited attention during the exposure draft and the discussion paper phases. To a large degree, this was based on the widely held expectation that the scope of the project should be consistent with the range of transactions for which the existing lease accounting standards are applied today. Under IFRS, IAS 17 applies to certain intangibles transactions, but under USGAAP , the current lease standards do not apply to leases of intangibles. Many respondents observed this inconsistency and requested that the boards address these issues either separately or by expanding the scope of the lease project.
fair value in accordance with IAS 40 and urged the FASB to complete its investment property project, which would presumably result in a similar scope exemption under USGAAP. They urged the FASB to consider the timing of such a project to allow for simultaneous adoption of both standards. Many also encouraged the FASB to provide a scope exclusion for pension funds and certain real estate investment fund entities that currently account for investment real estate on a fair value basis.
Lessee accounting
23. Most respondents supported the
overall right-of-use model, at least with respect to the balance sheet implications for simple leases. However, most respondents raised concerns around how to account for extension options and contingent payments. Many also were concerned with the proposed expense characterization and profit and loss recognition pattern. These key areas of concern are discussed in more detail later in this Dataline. PwC observation: We believe that the proposed right-of-use approach accomplishes the boards aim to develop a model where assets and liabilities arising under a simple lease are recognized in a principled manner. We agree that a lessee should recognize an asset representing the right to use an underlying asset during the lease term (the right-of-use asset) and a liability to make lease payments. However, we disagree with the boards on the measurement of the right-of-use asset and liability to make lease payments for more complex leases that contain options and contingent payments. We also have concerns regarding the profit and loss recognition patterns usefulness to users (see discussion later in this Dataline).
22. Several respondents also suggested

that the boards revisit the possibility of excluding leases of non-core assets (e.g., computers, copy machines) from the scope of a new standard. PwC observation: We support the simplified accounting by lessors for short-term leases which does not require the recognition of lease assets and liabilities. We observe that the stated goal of the standard is to provide users with more information on the long-term obligations of a reporting entity. We believe that there is little incremental value provided by grossing up the lessees balance sheet to include short-term lease assets and liabilities. While we agree with the boards that short-term leases may be significant in the aggregate, we do not believe that they are normally material to the economic decisions made by users. We also support the scope exclusion for real estate carried at fair value (both internationally and in the US) and believe that convergence with IFRS for investment property should be a significant goal.
20. Short-term leases: Most respondents

support the proposed simplifications for short-term leases. While most respondents agree with the boards proposed simplifications for shortterm leases for lessors, many do not believe the proposals for lessees go far enough. These respondents believe the burden for a lessee is the cost of identifying and tracking a large number of short-term leases (e.g., identifying each employee using a hotel room or rental car at the end of each reporting period), which is not commensurate with the value to users of having this information.
Lessor accounting
24. Many respondents indicated that they
did not believe that the current lessor accounting model was fundamentally broken. Many also noted they needed
21. Real estate: Many respondents

supported the boards proposed scope exclusion from lessor accounting for investment properties measured at
Leases
17
more time and/or more guidance on how certain provisions should be applied in order to coherently comment on the potential implications. For example, it was not clear to many respondents how to apply the criteria in making the choice of the appropriate approach (derecognition vs. performance obligation approach).
27. Many respondents indicated they

do not believe the proposed hybrid model represents a significant enough improvement from todays guidance and believe that lessor accounting should continue in its current form until the boards have had sufficient time to more fully vet lessor issues raised and potentially re-expose and/ or field test the lessor model.
something other than fair value) and time charter shipping. We agree with the boards acknowledgement that lessee accounting is of greater concern to users than lessor accounting. Although we would prefer the boards look at lessor and lessee accounting at the same time, we do not believe the proposed hybrid model is a sufficiently significant improvement to current guidance to justify the substantial cost of change. Accordingly, we recommend that lessors continue to apply the existing lease guidance until the boards are able to develop a lessor approach that is consistent with both lessee accounting and accounting for leases/licenses of intangible assets. In the meantime, we are aware that there is currently diversity in accounting for licenses of intangible assets; we therefore accept that these be dealt with through the model proposed in the revenue recognition exposure draft as a pragmatic interim solution to accounting for leases/licenses of intangible assets.
25. In addition, there were some respondents who raised concerns about the appropriateness of revenue recognition under the derecognition model if that model were selected in certain circumstances. Specifically, these respondents were concerned that inclusion of extension options in the expected term of the lease could lead to an inappropriate conclusion that the lessor is not exposed to significant risks of the underlying asset, which is not consistent with the true risk exposure.
28. Respondents also differ on the path

forward and questioned whether lease accounting by lessees should move forward separately from lease accounting by lessors. Many suggested that the timing of the entire project be extended to address both sides of the accounting in a consistent manner and with a consistent framework. PwC observation: Although we agree with the boards aim to develop a consistent model for both lessees and lessors, we do not believe that the hybrid model to lessor accounting achieves this aim. We believe that the performance obligation approach is not consistent conceptually with the proposals for lessee accounting. The derecognition approach is a better fit with the right-of-use approach, but applying it to all leases would be inconsistent with the boards proposed accounting for leases/licenses of intangible assets as set forth in their recent revenue recognition exposure draft. We are also aware of a number of practical issues in applying the derecognition approach for certain types of leases such as real estate leases (when measured at
26. Many respondents believe that a hybrid

model as proposed in the ED is the only potential solution given the divergent views that are predicated on different business models. For example, many equipment manufacturer lessors shift substantially all the risks and rewards to the lessee except for credit risk and some relatively minor residual-value risk. As a result, these lessors fundamentally view the transaction as a sale and concurrent financing and believe the accounting should reflect that economic view. On the other hand, lessors leasing a portion of an asset (e.g., one floor in an office building) or an asset for only a portion of its life (e.g., a 10-year lease of a property with a 40-year life) do not believe they have sold the asset and, accordingly, do not believe they have financed a sale.
Extension options
29. Fundamentally, the ED first measures
the asset, including extension options that could represent assets under the current conceptual framework definition, and then the corresponding liability matches the computed asset. However, most respondents believe it is more appropriate to start with determining the amount of the liability. In these cases, most
18
extension options, purchase options and some forms of contingent payments would generally not meet the definition of a liability under the current conceptual framework.
32. Several respondents also observed

that including any assessment of probability of exercise adds an element of subjectivity and potential for accounting manipulation which is undesirable and will reduce comparability.
30. Looking at measurement from a

liability perspective, most respondents therefore believe that the more-likely-than-not threshold (i.e., > 50% probability) contained in the ED for inclusion in the lease term of periods covered by extension options is too low. However, while the majority disagrees with the threshold contained in the ED, there are diverse views on what the appropriate threshold should be.
with actual business decisions (e.g., closer to end of lease term, or when a decision to make significant new improvements to a property such as in expectation of renewing). More-likely-than not (>50% probability). Many respondents were concerned about the inherent subjectivity of a threshold set at this level, the practical issues of applying this threshold and the potential for significant volatility resulting from reassessments. Include all extension options. Few respondents have this view.
33. The varying views of where the

threshold should be are as follows, from highest threshold to lowest: Exclude all options, non-cancellable term only. Respondents with this view argue for a strict definition of a liability. Virtually assured/certain (e.g., >99% probability). Respondents with this view argue for consistency with the definition of a liability but acknowledge that some extension options may be assured of exercise, effectively making the option non-substantive. Virtually assured extension options effectively provide for very little, if any, discretion to avoid. Respondents with this view observe that this threshold would be relatively easy to understand and apply. Reasonably assured/certain (e.g., >75% probability). This threshold requires the preparer to consider economic factors (both direct and indirect) that would impact the exercise of the extension option. Respondents with this view observe that it is consistent with the current model and is generally understood and would, therefore, be easy to understand and apply. They note that changes in the probability around lease extension option exercise were likely to be more closely aligned
34. Several respondents (especially those

leasing real estate) also observed that in many cases extension options were in practice more of a right to negotiate which provides a level of control of the asset to the lessee. These respondents observed that, while a lessee may continue to use the asset after the initial term, the rents during renewal periods are frequently negotiated to be different from the rents specified for the extension period contained in the original contract. These respondents are concerned about recognizing assets and liabilities on the basis of contract provisions if historically they have not actually applied these provisions in practice. PwC observation: Defining whether the lease term should include periods covered by some or all extension options or only the noncancellable term has significant ramifications to the magnitude of the amounts recognized on the balance sheet and the recognition pattern in the income statement.
31. In general, there was tension between

raising the threshold to make the proposed standard easier to apply and a concern that raising the threshold too high invites significant structuring opportunities to achieve desired accounting results (e.g., converting a twenty-year lease into a lease for a day with a series of daily extension options aggregating twenty years). Many respondents indicated concerns about structuring were exaggerated. These respondents indicated natural market tensions between lessees and lessors and the need for lessors to recover their investments would inherently price in optionality costs that would make such abnormally short leases uneconomic. These respondents believe that the concerns about potential structuring abuses are better dealt with through anti-abuse provisions that would require the application of judgment around any exceptions, not through rules in the general standard adversely affecting normal market transactions.
Leases
19
We agree that accounting for lease options should not be separated from the underlying lease contract. However, we believe that payments that would become due if an option were to be exercised should only be recognized if the definition of a liability is met in the case of lessees and the definition of an asset is met in the case of lessors. We believe an option is fundamentally different from an asset and liability. As with other options in financial accounting, we believe lease term extension options should not be accounted for as if they were already exercised. We therefore believe that establishing the threshold at a virtually certain level is a better solution to this tension than either adopting the more-likely-than-not standard described in the exposure draft or retaining the current threshold of reasonably certain/assured. Establishing the threshold at this higher level also results in further benefits. Specifically, at the higher threshold, there will be less frequent need to remeasure and therefore, less associated volatility. It will also reduce the amount of estimates and judgments (e.g., for contingent rent and option periods) involved in determining the right-ofuse asset and lease obligation for lessees and, as a result, reduce the preparers costs of implementing the new standard.
probability-weighted approach, excluding minimum lease payments for assumed option periods. Most respondents were critical of a probability-weighted approach which they believe would be unduly complex and impractical, especially for a large number of leases.
36. Many observed that determining the

possible scenarios and estimating their probabilities would be highly subjective and arbitrary. Frequently, these assessments would likely be constructed to arrive at what one expects to pay. These respondents believe a best estimate approach is more appropriate for any contingent payments to be included in the recognized amounts.
create lease terms that on their face were contingent, but that were not consistent with the expected arrangement between the two parties. Taken to the extreme, this would result in leases with no base lease payments and all contingent rent. Excluding contingent rents in such a fact pattern would result in no current accounting for these leases. These respondents observed that for many of these leases there are clearly expectations of substantial payments that would be made by the lessee, which the lessee has little, if any, discretion to avoid. These respondents, therefore, believe the definition of a liability has been met in some cases.
37. Many respondents observed that the

subjectivity in the estimation process was further magnified by the need to reassess estimates on an ongoing basis, and the inclusion of extension options in the lease term based on the proposed more-likely-than-not threshold.
40. Some respondents also believe that

different types of contingencies (e.g., usage, performance, or index-based) should be treated differently, although there were differing views as to which ones should be excluded and why.
41. The varying views regarding certain

types of contingent payments can be summarized as follows: Usage-based contingencies (e.g., payments based on mileage). Most respondents who commented on this type of contingency indicated that these types of provisions were more like extension options, whereby if they are reasonably within the lessees power to avoid they should be excluded. Performance-based contingencies (e.g., payments based on lessee sales or profits). There were conflicting views from respondents who commented on this type of contingency. Some believe that these types of provisions should be excluded because
38. Many respondents believe that

most contingent amounts should be excluded on a basis consistent with the current lease model. They believe that the requirement to estimate these payments would be unduly complex and costly, while not adding substantial benefit to users of the financial statements. Some also believe contingent amounts do not meet the definition of a liability until the contingency is resolved (e.g., when specified sales levels are met).
Contingent payments
35. The ED requires that all contingent
payments be estimated and included in the amounts recorded using a
39. On the other hand, some respondents expressed concern that exclusion of contingent payments would invite structuring opportunities to
20
they are avoidable. Other respondents believe that these should be included as this approach would be consistent with accounting for the operation as a going concern. These respondents also observed that other accounting guidance on financial liabilities (e.g., IAS 32) clearly states that contingencies such as turnover and net income are not within the control of the contracting party and therefore, these elements represent liabilities that should be recorded. Index-based contingencies (e.g., payments based on changes in CPI or LIBOR). Most respondents indicated that these types of provisions were outside of the control of the lessee and that amounts related to these provisions should be included in the lease asset and liability. Residual value guarantees. Most respondents who commented on this type of contingency indicated that such payments should be included if they were expected to be paid. PwC observation: We believe that only those contingent payments that are not within the control of the lessee should be included in the calculation of the lease asset and liability. Contingent payments that are within the control of the lessee should not be included in the lease payments. We believe contingent payments based on usage should be excluded but that performancebased, index-based and residual value guarantees should be included.

42. Many respondents observed that the
ED effectively views lease transactions fundamentally as the purchase of a right to use an asset with seller financing. These respondents were therefore accepting of the resultant accelerated expense recognition pattern caused by the financing element.
(suggesting either the continuation of the operating lease accounting model or a model which reflects leases on balance sheet but has an expense recognition pattern consistent with current operating lease accounting).
45. Many respondents also observed that

the acceleration of expense recognition was further magnified by lower thresholds for inclusion of extension options and inclusion of contingent rent. PwC observation: We agree that if the right-of-use model is adopted, a lessee should recognize amortization of the right-of-use asset and interest on the liability to make lease payments. However, the application of the proposal in the ED might reduce the income statements usefulness to many users. We understand that some users may therefore continue to make adjustments to reported amounts. We acknowledge that the proposals in the ED will result in front-loading of expenses and that some users may continue to adjust the reported numbers as a result.
43. Others, however, believe that certain

types of leases are not inherently financings, or they believe that leases are fundamentally different from other forms of financing because they are inextricably linked to the right to use the asset. As a result, these respondents were very concerned about the expense recognition pattern. Some respondents believe that it is more appropriate for lessees to apply an expense recognition approach for the combined earnings charge that more closely follows the economics (i.e., cash), while others support recognizing expense on some normalized basis (i.e., straight line). Some of these respondents suggest the utilization of a linked approach or sinking fund depreciation methods for the depreciation of the asset as a potential way to accomplish this goal.
Purchase options
46. The ED proposes that a contract be
accounted for as a purchase (by the lessee) and a sale (by the lessor) when the purchase option is exercised. Many respondents indicated that purchase options should be considered as part of the lease model. Some of these respondents believe that in essence purchase options represent a way for the lessee to control the underlying asset on a long-term basis
44. Several respondents observed that

certain types of leases (e.g., many equipment leases) were more like financing transactions while other types of leases (e.g., leases of real estate) were fundamentally different. These respondents either questioned the implicit assertion in the ED that leases include a significant financing element or suggested that a dual model approach was appropriate
Leases
21
similar to how many utilize extension options as a right to negotiate. Some respondents indicated that to exclude purchase options would invite structuring opportunities. PwC observation: We believe that purchase options should be accounted for in a similar fashion to extension options. If purchase options are considered prior to exercise, application guidance should be provided.
would likely be greater and therefore, the identification and accounting for leases in a multiple-element arrangement would take on substantially greater significance.
such as real estate taxes. Accordingly, these respondents believe these costs should also not be capitalized under lease accounting.
48. Many respondents raised concerns

about how service and executory costs should be evaluated in specific fact patterns, particularly in leases of real estate. It is unclear if common real estate service/executory costs would meet the distinct service definition contained in the ED (originally from the revenue recognition exposure draft). For example, it would be difficult to conclude that real estate tax reimbursement, or payments made by a tenant in a multi-tenant building for a pro rata portion of landscaping or snow removal meet the definition of a distinct service. In addition, items that might meet the definition of a distinct service might be combined with those that do not meet the definition. For example, rents may change based on increases or decreases in a pool of real estate costs; increases in the cost of some individual services may be offset by decreases in others. In this case, the costs related to services that are not distinct could be considered to make the whole pool of costs non-distinct.
50. Respondents expressed similar views

related to services provided in connection with equipment leases. Many respondents believe that a service that is provided over time should be separated from the use of the asset and not capitalized in the assets cost. They believe that the value of most services can be estimated, and they should be excluded from the measurement of the asset. They do not believe such services should have to meet the definition of distinct services included in the ED. PwC observation: We believe that more discussion and guidance on how to separate service elements from the lease contract amounts should be provided in a final standard. We also believe the boards should either change the model or clarify that executory/common operating costs are also considered distinct for purposes of applying the proposed standard. We believe this is consistent with the boards view that leasing is a form of financing.
Multiple-element contracts, executory costs and service arrangements

that more guidance was needed with respect to how to evaluate whether there was an embedded lease and how to allocate amounts among multiple elements in an arrangement, when appropriate. These respondents have observed that, while some of these issues exist today, the accounting implications have not been substantial if the lease element was classified as an operating lease. This assertion is based on the observation that there are no balance sheet ramifications and the profit and loss recognition pattern for the lease element and the service element are often the same under the current guidance. In fact, because of the limited impact to the financial statements, if any lease identified would be an operating lease, many preparers today would ignore a potential embedded lease and not account for it as a separate element. Under the proposed model, the accounting implications of an embedded lease
49. Notwithstanding that these service

and executory costs may not meet the definition contained in the exposure draft, most respondents believe that they should be excluded from the lease asset and obligation, because including these costs would not put leasing on parity with owning the asset. For example, when purchasing a real estate asset outright, an entity does not capitalize the present value of expected future operating costs
Reassessment
regarding the reassessment requirements, not only with respect to the administrative burden and cost but also because of the volatility created when changes in estimates occur. Some lessors are also concerned with the feasibility of reassessing
22
individual leases and suggested lease assumptions only be reassessed if there is an expected significant change in the cash flows of a portfolio of leases. PwC observation: We agree that there should be reassessment of estimates of both lease term and contingent payments. We agree with the boards assessment in the basis of conclusion that users of financial statements receive more relevant information when entities reassess the lease term at each reporting date because reassessment reflects current market conditions and not reassessing could lead to misleading results. However, we observe that the lower the threshold ultimately selected by the boards for inclusion in the lease term of periods covered by renewal options, the greater the complexity of the reassessment, resulting in more frequent revisions and more volatility. We believe our proposal for including only those lease extension options that are virtually certain to be exercised still meets the aim of providing relevant and current information while minimizing the cost and complexity for preparers. We do not believe the proposal to require reassessment where there has been a significant change in each leased asset is useful. Given the level of judgment involved in assessing what is significant, we propose, similar to impairment analysis, that the requirement should be supplemented by a
presumption that reassessment should occur based on certain triggering or reconsideration events and, at a minimum, on an annual basis. This will help reduce the risk that changes are recorded in an incorrect accounting period.
Sale leasebacks and other derecognition and leaseback transactions (e.g., lease-in-lease-out or spinoff leasebacks) Interaction with impairment guidance Interaction with leasehold improvements Treatment of asset retirement obligations pursuant to a lease Build-to-suit leases Intercompany leases and other lease transactions within a consolidated group
Additional guidance requested

52. Many respondents indicated that they
believe additional guidance should be provided prior to issuance of a final standard in many areas which had either not been addressed at all or additional clarification was needed. These areas included: Discount rates/incremental borrowing rates to be used (100% financing option may not exist in the market nor be consistent with how a lessee would finance asset acquisitions) Fair market value cap on right-ofuse asset Foreign currency/exchange accounting and whether the lease obligation should be treated as a monetary obligation under ASC 830 Subleases guidance (especially if lessor accounting is deferred or modified) Change in obligation value due solely to the passage of time between lease inception and commencement Lease modifications/terminations Lease incentives (including key money and free rent periods)
53. Many respondents asked that the final

standard provide more examples and practical application guidance.

over the lack of exposure of required consequential amendments to other existing guidance, including guidance related to investment property and business combinations. PwC observation: We observe that many of these issues were either not addressed or insufficiently addressed in the ED. We believe some of these issues are pervasive and significant and should be fully addressed in the final standard so that the new standard can be adopted in a consistent and objective manner across a wide range of affected industries.
Transition
55. Many respondents indicated a
simplified retrospective approach
Leases
23
to transition was a cost-effective adoption approach for many affected parties. Many also believe that companies should be permitted to apply a full retrospective approach if desired.
56. Some respondents observed that

some of the front-end loaded expense recognition pattern in the ED is mitigated over a portfolio of leases in different stages of their lease life. However, they also observed that for lessees that enter into a significant number of leases, the simplified retrospective approach effectively treats the lease portfolio at the initial date of application as if the entire portfolio were new leases at that date. Therefore, the entire portfolio of leases would have a higher level of expense as compared to the impact resulting from the long-term application of the standard. These respondents observe that for lease portfolios with a longer average lease life, the number of periods until normalization occurs may be extreme. These respondents believe that full retrospective transition should be allowed for those parties that are willing to undertake the additional cost and effort to do so.
in the pre-tax lease accounting. Some respondents expressed the opposing view that the leveraged lease accounting model is a much more accurate depiction of the real economics of these transactions, which are fundamentally dependent on both the leverage and tax characteristics. These same respondents believe that even if leveraged lease accounting were to be eliminated, existing arrangements should be grandfathered.
PwC observation: We agree that a simplified approach to transition is necessary. However, we do not believe the proposed simplified retrospective approach is as simplified as it should be, nor necessarily the best presentation in all cases. While we believe that the simplified retrospective approach may be appropriate and cost effective for many, we do not believe that a full retrospective approach should be precluded, as it would represent a more faithful comparative presentation of the economics for those willing to undertake the exercise. Because we believe that the new guidance would be an improvement in financial reporting by lessees, we believe that preparers should be allowed to adopt early if they wish.
59. The ED also precludes early adoption.

Some respondents indicated early adoption should be permitted.
60. Many respondents requested additional transitional guidance prior to issuance of a final standard including: Adoption guidelines on how hindsight should be factored into making estimates of lease term and contingent payments Treatment of previously deferred gains on sale-leaseback transactions Application of additional rules on historical sale leasebacks Practical issues arising upon the elimination of leveraged lease accounting Potential elimination of US grandfathering by EITF 01-8 for transactions entered into before an entitys next reporting period beginning after May 28, 2003 (the original transition date of EITF 01-8) and not subsequently modified1
Disclosure
61. The majority of respondents
supported the overall disclosure objectives of requiring lessees and lessors to disclose quantitative and qualitative information that (i) identifies and explains the amounts recognized in the financial statements arising from leases and (ii) describes how leases may affect the amount, timing and uncertainty of future cash flows. Most respondents were also supportive of disclosures which explained key terms and assumptions used as well as a reconciliation of opening and closing amounts of lease assets and liabilities. However, many believe preparers should be allowed to exercise judgment in determining (i) the volume of disclosures considering
57. Some respondents suggested that

there be grandfathering of existing leases or only prospective application.
58. Many respondents agreed with the

boards that a separate accounting model for leveraged leases should not be provided. These respondents observed that there is no similar model under IFRS today and that most other areas of accounting do not allow for netting of obligations and assets, or including tax characteristics
1 The equivalent IFRS standard, IFRIC 4, did not permit grandfathering.
24
the significance of leasing transactions to the company and (ii) whether to separately present amounts related to leases on the face of the financial statements or within the footnotes.
Operationality and cost/ benefit

64. Most respondents expressed concerns
over both the operationality and cost/benefit relationship of the proposed new model for both lessees and lessors. Many of these concerns are driven by the significant judgments and estimates required by the proposed new lease standard with regard to both renewal options and contingent paymentsboth at inception and in subsequent reassessments. These respondents observe that for large portfolios of leases, these judgments and estimates can change significantly over time, resulting in significant adjustments, volatility, and reduced comparability.
62. Many respondents expressed a view

that these disclosure requirements should be subject to judgment as to the appropriate level of disclosure, and that the new standard should not mandate burdensome disclosures that do not provide useful information.
We do not support the proposed hybrid model for lessors in the exposure draft, as it fails to meet users needs and does not represent a significant enough improvement over the existing model to justify the costs of implementation.
Tax/regulatory implications
67. Many respondents requested that,
given the potential implications of adopting the new model, outreach occur to various tax and regulatory authorities to mitigate unintended economic consequences. These include: Risk-based capital requirements for banks and other financial institutions Federal, state and international tax implications Government cost-plus contracts where rent expense may be recoverable, but amortization and interest expense may not Implications on independence rules for public accounting firms (these rules currently have certain exclusions for operating leases) PwC observation: We believe all of these areas will need to be addressed in a timely fashion with appropriate parties as soon as practical and in any event prior to adoption of a final standard.
63. Many respondents suggested that

example disclosures would be useful. PwC observation: We agree with the disclosure objectives outlined in the ED and believe that they could enhance the information provided to users compared to the current requirements. However, we observe that the list of qualitative and quantitative information required in the exposure draft is extensive and if it were made mandatory, without regard to the significance of the leases to a particular lessee or lessor, it could result in boilerplate disclosure of information that is not relevant or material to a user of the financial statements. We believe it is important that the overarching requirement of disclosure be consistent with the boards objective that an entity provides sufficient disclosure to allow a user to understand the amounts, timing and uncertainty of the cash flows arising from its lease portfolio.
65. Many respondents also observed that

for lessees, both the operationality and the cost/benefit relationship would improve if certain suggested changes were made, most significantly raising the threshold for inclusion of option periods and the elimination of various types of contingent payments from the lease asset and obligation.
66. Many also observed that for lessors,

the improvement of the new model over the current model (if any) does not warrant the extensive costs of implementing the new guidance likely to be incurred. PwC observation: Many of our recommendations made to the boards (for example, how to treat extension options) would help to improve the operationality and cost/benefit relationship for lessee accounting.
Leases
25
A new approach to lease accounting Proposed rules would have far-reaching implications
Whats inside: Overview Scope Lessee accounting Lessor accounting Other topics Timing for comments Specific insights Appendix Reprinted from: Dataline 201038 September 16, 2010 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
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 lessees rights and obligations under all leases existing 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

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.
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.
2. This Dataline updates the discussion in Dataline 201009 to reflect the proposals in the FASB and IASBs 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, straight-line rent expense will generally be replaced by amortization of the
4. The exposure draft does not include

any grandfathering of existing leases. Companies would need to assess and record all existing leases
26
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.
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: US 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 noncore assets

8. The boards considered excluding
short-term leases and leases of noncore 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.
5. The boards conclusions in the exposure draft are tentative and subject to change until a final standard is issued.
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 maximum possible term (including all extension options) of twelve months or less, lessees could use a simplified lease accounting approach on a leaseby-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
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.
Leases
27
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.
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.
separately because it has a distinct function and a distinct profit margin. 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.
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 lessees balance sheet in accordance with the exposure draft. Unlike the limited grandfathering that
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 FASBs 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
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
28
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 201028, Revenue RecognitionFull Speed Ahead.
Lessee accounting
The basic model
14. The boards have proposed a right-ofuse 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.
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).
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
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.
15. The boards believe that the rightof-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
17. Present values would be determined using the lessees incremental
Leases
29
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.
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 leases term would be re-examined if facts and circumstances indicate that there would be a significant change in the liability since the previous reporting period.
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.
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 lessees 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.
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.
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 probabilityweighted 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
30
Exhibit 1: Comparison of the proposed model, current model and cash payments $2,600
$2,400
$2,200
$2,000 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.
$1,800
$1,600
5 Year
10
Cash rent
Current model
Proposed model
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 lessees obligation due to a reassessment of the lease term would be recognized through an adjustment of the right-of-use asset.
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.
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.
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,
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 lessees right-of-use asset. For
28. Under the proposed model, rent

expense would be replaced with interest and amortization expense.
Leases
31
Exhibit 2: Comparison of timing recognition of optional renewal periods
$3,300
$2,800
$2,300
Lessor accounting
$1,800
The basic models

32. The boards proposed to use a
1 2 3 4 5 6 7 8 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 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.
$1,300
The expense will be front-end loaded with more expense recognized in the beginning of the lease term and less at the endsimilar to a mortgage. For a lease that includes escalating rents, the cash payments will be directionally the inverse of what the expense will belower in the earlier years and higher in the later years.
The proposed modelassuming 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 modelassuming 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 yearsthis results in a saw tooth recognition pattern, thereby adding increased volatility to the income statement.
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.
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.
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 re-leasing 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.
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.
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.
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 noncancellable term.
32
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 lessors balance sheet. The lessor recognizes a lease receivable, representing the right to receive 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.
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 gross-up in that approach. Others supported up-front recognition of manufacturer and dealer profit.
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.
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
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 lessors lease receivable would

be measured similarly to the lessees 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
41. Subsequent measurement of the

lessors receivable would be at amortized cost using the effective interest method, resulting in interest income.
Leases
33
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).
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.
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

approach, changes in the lessors 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.
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 leases early years compared to the current straightline recognition of an operating leases 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
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 sale-leaseback accounting while others would be accounted for as financings. The different accounting would

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
34
be based on whether the transaction meets the proposed leasing standards 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.
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.
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.
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 US 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

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.
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.

approach, lessors would present the
Leases
35
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.
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.

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.
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.
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 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
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.
61. Lessees would measure the lease

obligation at transition at the present value of the lease payments discounted using the lessees 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.
58. Specific disclosures required would

include a description of the nature of an entitys leasing arrangements,
36

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.
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.
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.
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.
65. This simplified transition approach

reflects the reality that, for many longterm 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. PwC observation: The lack of grandfathering for existing leases will mean that extensive
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 high-quality final standard.
Timing for comments

67. Comments on the exposure draft
are due by December 15, 2010. We encourage management to engage
Leases
37
Appendix Examples of revised financial statement format
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 exampleperformance obligation approach Lessor simple examplederecognition approach
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
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 lessees incremental borrowing rate is 7%. The lease has no extension options, residual value guarantees, or contingent rent.
The following example of a real estate lease is provided to demonstrate how the lessee model would be applied in practice.
Balance sheet implications (in thousands)
Initial recognition
Year 1
Year 2
Balance at end of year 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 the lease A $1,554 1,058 $2,612 $1,554 989 $2,543 $15,540 (15,540) $13,986 (14,598) Year 1 $12,432 (13,547) Year 2
Current accounting model (straight line):
$2,190
$2,190
Differencecurrent period Differencecumulative
A-B
$422 422
$353 775
Cash (paid in monthly installments) Cumulative cash
$2,000 2,000
$2,040 4,040
38
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.
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Balance at end of year $10,878 (12,377) Year 3 $9,324 (11,079) Year 4 $7,770 (9,644) Year 5 $6,216 (8,061) Year 6 $4,662 (6,318) Year 7 $3,108 (4,403) Year 8 $1,554 (2,302) Year 9 Year 10 $Total
$1,554 911 $2,465
$1,554 825 $2,379
$1,554 730 $2,284
$1,554 625 $2,179
$1,554 509 $2,063
$1,554 382 $1,936
$1,554 242 $1,796
$1,554 89 $1,643
$15,540 6,360 $21,900
$2,190
$2,190
$2,190
$2,190
$2,190
$2,190
$2,190
$2,190
$21,900
$275 1,050
$189 1,239
$94 1,333
($11) 1,322
($127) 1,195
($254) 941
($394) 547
($547) -
$2,081 6,121
$2,123 8,244
$2,165 10,409
$2,208 12,617
$2,252 14,869
$2,297 17,166
$2,343 19,509
$2,391 21,900
Leases
39
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 exampleperformance 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 Year 1 Year 2
Balance sheet implications (in thousands)
Initial recognition
Balance at end of year Lease receivable Underlying asset Performance obligation 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 B B $2,190 (500) $1,690 $2,190 (500) $1,690 A $1,058 1,554 2,612 (500) $2,112 $989 1,554 2,543 (500) $2,043 $15,540 20,000 ($15,540) $14,598 19,500 ($13,986) Year 1 $13,547 19,000 ($12,432) Year 2
Differencecurrent period Differencecumulative Cash (paid in monthly installments) Cumulative cash

40
A-B
$422 422 $2,000 2,000
$353 775 $2,040 4,040
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.
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Balance at end of year $12,377 18,500 ($10,878) Year 3 $11,079 18,000 ($9,324) Year 4 $9,644 17,500 ($7,770) Year 5 $8,061 17,000 ($6,216) Year 6 $6,318 16,500 ($4,662) Year 7 $4,403 16,000 ($3,108) Year 8 $2,302 15,500 ($1,554) Year 9 $0 15,000 $0 Year 10 Total
$911 1,554 2,465 (500) $1,965
$825 1,554 2,379 (500) $1,879
$730 1,554 2,284 (500) $1,784
$625 1,554 2,179 (500) $1,679
$509 1,554 2,063 (500) $1,563
$382 1,554 1,936 (500) $1,436
$242 1,554 1,796 (500) $1,296
$89 1,554 1,643 (500) $1,143
$6,360 15,540 21,900 (5,000) $16,900
$2,190 (500) $1,690
$2,190 (500) $1,690
$2,190 (500) $1,690
$2,190 (500) $1,690
$2,190 (500) $1,690
$2,190 (500) $1,690
$2,190 (500) $1,690
$2,190 (500) $1,690
$21,900 (5,000) $16,900
$275 1,050 $2,081 6,121

Leases
$189 1,239 $2,123 8,244
$94 1,333 $2,165 10,409
($11) 1,322 $2,208 12,617
($127) 1,195 $2,252 14,869
($254) 941 $2,297 17,166
($394) 547 $2,343 19,509
($547) $2,391 21,900

41
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 examplederecognition 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. $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
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 Credit
Carrying value equals fair value Debit $90,823 $90,823 $90,823 $9,177 $100,000 Credit
42
The overhaul of lease accounting Catalyst for change in corporate real estate
Whats inside: Overview Executive summary Preparing for the change AppendixSummary of the exposure draft
The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) recently issued Exposure Drafts of a proposed accounting model that would significantly transform lease accounting. The model, if adopted as proposed, would affect almost every company, but is especially relevant to those that are significant users of real estate. Under the proposed model, a lessees rights and obligations under all leasesexisting and newwould be recognized on its balance sheet. The Boards expect to issue final standards in mid-2011. The effective date, which has not been determined, could be as early as 2013; however, it is more likely to be 2014 or 2015. Upon adoption of the new standard, prior comparative periods will be restated.
Reprinted from: The overhaul of lease accounting: Catalyst for change in corporate real estate November 2010 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/us/ jointprojects) where you will find an electronic version of the original publication along with subsequent updates.publication along with subsequent updates.
Executive summary
Proposed standard
1. An overview of the proposed lease
accounting standard is as follows: The proposal would eliminate off-balance sheet accounting for leases; essentially all assets currently leased under operating leases would be brought on balance sheet. Income statement geography and timing of recognition would significantly change because straight-line rent expense would be 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 front-end loaded. Financial performance ratios may no longer be useful for their historical purposes, and other operating metrics may evolve as a result of adoption of the new standard.
The new lease assets and liabilities would be recognized based on the present value of payments to be made over the term of the lease and would be carried at amortized cost. 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 payments used to drive the initial value of the asset and liability would include contingent amounts, such as rent based on a percentage of a retailers sales and rent increases linked to the Consumer Price Index (CPI), for example. Lease renewal periods and contingent rents would need to be continually reassessed and the related estimates trued up as facts and circumstances changeagain, substantially different than todays model, which is largely set it and forget it.
43
Leases
The proposed lease accounting model would require significant systems and process changes at adoption date and maintenance on an ongoing basis. Preexisting leases are not expected to be grandfathered.
2. At a minimum, compliance with the

proposed standard may drive companies to consider significant upgrades, replacements, or overhauls of their legacy accounting systems, processes, and controls. Importantly, the proposed standard would also have a significant impact on a companys operating results, financial ratios, and potentially its debt covenants. The scale of adoption extends well beyond accounting, and many companies are already starting to plan for the coming changes.
model if adopted will eliminate the off-balance sheet accounting for operating leases, it will also eliminate the perceived accounting advantages of leasing. Thus, the proposed standard, coupled with change from other current economic, tax, and business issues, may be an impetus to overhaul their real estate strategies. Changes to strategy may include lease-versus-buy decisions and structuring of lease terms and common provisions (e.g., fixed rent steps rather than contingent rent based on sales or CPI changes).
contingent rents that may no longer be beneficial under the new model.
8. A detailed summary of the key provisions of the proposed leasing standard, as well as a practical example, have been provided in the Appendix.
Significant impacts
9. The new model will have pervasive
business and accounting impacts if adopted. For example: Expense recognition patterns will change. Cash payments versus expense recognition will further diverge. Management judgments concerning renewal options and contingent rents may produce significant income statement volatility. All leases will generate a liability. Analysts and credit agencies are underestimating the significance of the liability when adding back debt-like items for operating leases. Decision points and data needs will change. Operating leases are dead. Structuring consideration will change to focus on liability and volatility reduction as opposed to obtaining operating lease treatment. Data needs for ongoing reporting will change significantly. Lease-versus-buy decisions should be revisited. Possible complacency in lease-versus-buy decisions, based upon reliance on operating-lease treatment, should be addressed. Transition could be as early as 2013; however, it is more likely to be 2014 or 2015. Industrywide
6. For many significant users of real

estate (e.g., retail companies), managing investor and other user relations during the transition will be critical. The issuance of the Exposure Draft has created a significant buzz, and analysts and shareholders are likely to start raising questions about the potential impact. Traditional operating metrics such as EBITDA used as proxies for free cash flow may no longer be relevant and will likely need to be replaced. Longer term, the inherent volatility in the income statement and balance sheet will require thoughtful communication, in addition to significant changes in presentation and metrics.
3. For most companies, real estate

represents one of their most significant costs. Yet the existing corporate real estate function may have been designed to support a very different operational structure from what exists today or that was originally motivated by financing or tax considerations that no longer apply.
4. For some companies, the proposed

lease accounting standard represents just another compliance exercise, but its one likely to entail significant cost and complexity that will need to be managed. Expected costs are likely to include education of all key stakeholders, robust systems upgrades, and implementation of new controls.
7. Because no existing leases will be

grandfathered at the time of adoption, companies entering into leases of any significant duration today should consider the implications of the new standard for these transactions in the future and potentially change their negotiation strategies. Many leasing strategies employed today inherently consider accounting biases around lease term, extension options, and
5. For others, the compliance exercise

will serve as a much-needed catalyst for change in their overall corporate real estate strategies. Because the
44
neglect of leasing software and systems may necessitate upgrades and enhancements, which will require a significant runway to adequately prepare for transition. Asset recognition may change state tax liability. Income apportionment among states may change, potentially attracting additional income to higher-tax jurisdictions. State capital and net worth taxes will increase as a result of an increasing balance sheet. Timing of sales and use tax payments may accelerate, and state property taxes may increase.
12. By some estimates, real estate leasing

accounts for nearly two-thirds of all leasing activity (estimated at more than $2 trillion) of US companies. As part of our discussions with client and industry representatives on the changes that may be coming with the new lease accounting standard, we are beginning to see senior executives at many companies target their corporate real estate strategy and operations for a major renovation and update. Their reasons for doing so are to prepare for the new GAAP requirements and to be more nimble in the current economic climate.
What changes will your company need to make to manage the process? Do your companys existing systems have the capabilities necessary to apply the proposed lease standard?
The stakeholders
14. Corporate real estate activity affects a
number of key functional areas. Any reconsideration of your approach should include, at a minimum, members of each of the following key constituencies: Accounting/reporting Treasury Legal/regulatory Operations Tax planning and reporting Information/systems Human resources (e.g., impact on compensation agreements)
Opportunity
10. The last five years have seen a host
of changes for corporate real estate organizations. From cost management to outsourcing, from systems changes to designing the workplace of the future, the role of the corporate real estate department has never been more complex. Nevertheless, the departments role as a strategic function within the enterprise has been overlooked. Simply put, many senior executives and boards of directors have not viewed their corporate real estate department as a material element in driving the success of the organization.

Some fundamental questions
13. As you assess your current corporate real estate strategy, a number of fundamental questions should be asked, such as: Why does your company lease or own in particular situations? What are the alternatives to leasing? What are current market opportunities (e.g., lease rates/purchase prices), and how would they affect your real estate strategy? How do federal, state, and local taxes factor into your corporate real estate decisions? How does your company manage occupancy costs today? What is the potential impact of the proposed lease model on your company?
15. Each of these stakeholders will be

impacted by the accounting standard if it is adopted. Accordingly, many companies that are significant users of real estate are creating a steering committee composed of individuals from each of these constituencies to help them consider the implications. A joint approach in the planning stages is vital to ensure unexpected implementation issues are identified early in the process.
11. At best, corporate real estate departments are viewed as a necessary, but largely administrative, function or cost center that has little bearing on the overall success or failure of the company. However, if effectively addressed, corporate real estate can be a key or contributing driver in the success of many operations.
16. Many companies quickly identify

some of the more significant transition impacts, such as the change in financial reporting or the impact on debt covenants. However, other less obvious impacts also exist for
Leases
45
Economic conditions Operational issues Corporate real estate strategy change Financing issues
particular companies or industries. For example, recording significant additional assets may affect state tax payments, while changes to key metrics may alter incentive compensation payments or earnouts and perhaps even impact legal or regulatory capital. Additionally, the time and effort associated with executing leases will increase as both sides of the transaction negotiate to achieve the most desirable accounting impact. Accordingly, it is essential for companies to seek broad participation in the process of identifying and addressing the potential impacts of the proposed lease accounting standard.
Regulatory issues
Tax considerations
Government budgetary issues
Effective managment of corporate real estate
(e.g., eliminate certain contingent rent provisions) Evaluate regulatory impact including regulatory capital, cost plus contracts, etc. Evaluate tax impact including federal, state, local, and foreign taxes
Factors that impact corporate real estate strategy

17. The proposed standard will be the
catalyst for companies to take a fresh look at factors that influence corporate real estate strategy. Many of these factors drive the decision to lease a particular asset versus buying it.
the new model so it can create various strategies for major classes of transactions and then be able to apply those to specific situations as they arise.
Operational issues
19. A companys need for corporate real
estate is driven in large part by both its current and planned physical requirements. Space needs can change dramatically over time with such changes driven by a variety of factors including growth/contraction plans, potential acquisitions, productivity improvements, and physical obsolescence of space. Further, local demographics may change needs for particular locations. These issues vary significantly from company to company and by property type. The following examples help illustrate the diversity of potential issues based on a companys operations:
18. Many companies are looking for a

simple answer to the question how should we change our real estate strategy? Unfortunately, the answer is, It depends. As we will discuss further, the decisions around when and how to lease are affected by a large number of factors including need to control particular assets, operational flexibility, availability of alternatives, common industry practices, tax and regulatory impacts, and expectations of management. Careful consideration of the impacts and the companys specific circumstances will be required. It is not a one size fits all evaluation for all companies or for different types of transactions. Rather, management should be armed with an understanding of the impacts of
New considerations for corporate real estate strategy

Reassess lease-buy decision criteria where buying is feasible Consider negotiation strategy around lease termcontrolling space/economics versus accounting effect Consider pricing implications of option periods versus longer terms Consider common terms, and modify where appropriate what is the new normal?
Example 1Retail company

A retail company typically requires several types of property for its
46
operations including (i) store locations, (ii) warehouse locations, and (iii) key corporate offices in central business districts.
circumstances, we may begin to see an expansion of service options that may allow incentivized property management to be done on a contract basis.
26. Today, in many cases, companies

outsource their corporate real estate lease administration because commercial real estate service providers offer this service relatively inexpensively (to gain access to more lucrative transaction activity such as leasing commissions). Outsourcing may be more cost effective than doing such administration in-house. However, the additional information needed to account for leases under the proposed lease model (such as the expectation of exercising renewal options or projections of retail store sales and the impact of same on percentage rents to be paid) may be sensitive to the companys lease negotiating position. Companies may be hesitant to allow such interested parties to have the necessary access to the information to prepare the required accounting documentation.
Example 2Bank
Banks normally maintain a variety of property locations for their operations including (i) bank branches, (ii) processing operations (often in fungible office space in suburban markets), and (iii) key corporate offices in central business districts.
23. Overriding operational considerations are often the impact of market practice or practical availability of property for purchase. Certain types of properties (e.g., retail store locations) may be unique and not generally available for purchase, whereas commercial office space may be more fungible and, in some cases, also more available for purchase.
20. Generally, a company is more likely to

lease real estate when its long-term property needs are unclear, operational flexibility is highly desirable, and expected access to acceptable alternatives is good. Leasing has also historically carried the added advantage of providing companies with a form of off-balance sheet financing.
24. With the loss of off-balance sheet

accounting, companies that presently lease may instead opt to own. Companies with low leverage and high credit ratings may have a substantially lower cost of capital that may create a capital arbitrage benefit.
25. We have already begun to hear

of increasing potential purchase transactions involving single-tenant office buildings. It is possible that the conversion of certain property types as condominiums may also increase as a result of the proposed lease model. However, this trend will be affected by why the companies are leasing, as discussed previously. It is also likely to vary significantly by property type. For example, this is more likely to occur in more physically static situations such as individual floors or blocks of floors in large office buildings or with single-tenant retail sites, both of which may be functionally independent. It is less likely to occur with partial floors or in malls/ strip centers, which are not functionally independent and may frequently require reconfiguration of space to accommodate a different tenant mix.
21. Conversely, a company is more likely

to buy when the companys long-term property needs are clear, the need for specific properties is expected to be stable and long-term, specific assets are needed, and/or there are concerns with respect to the availability of acceptable alternatives.
Economic conditions
27. Recent economic turmoil has significantly affected property values, and in many cases, market rents have declined dramatically. Vacancy rates in some property types and markets are risingsometimes significantly, but not uniformly across markets. Further, many property owners are struggling with declining cash flow from operations, liquidity issues, and near-term debt maturities. As a consequence, landlords may be more willing to discuss asset sales and lease modificationssometimes trading a lower rent in exchange for a longer lease (i.e., so-called blend and extend transactions).
22. There are also many operational

reasons why companies rent rather than own that may be unrelated to the accounting or even to the economics. One such reason frequently cited is that leasing allows tenants to avail themselves of professional property management. Does a bank, for example, want to maintain a staff of engineers, maintenance, or other personnel necessary to address the day-to-day issues surrounding management of real estate? In these
Leases
28. Accordingly, the current environment

presents both potential challenges and
47
opportunities for users of corporate real estate. Current rents being paid pursuant to existing leases may be significantly above current market asking rents, and property owners will likely be resistant to changing current terms. In certain cases, opportunities to buy assets at favorable prices may exist, while in other cases, negotiating rent concessions currently or through blend and extend transactions may yield lower all-in occupancy costs. Although these market issues exist irrespective of the potential impact of the new lease accounting model, the impacts of the new lease accounting project are acting to focus a spotlight on these issues as companies consider the implications of the accounting proposals.
and credit quality of the tenant or tenants occupying the property. In some cases, the property owner cannot effectively fund property improvements necessary for the current operation of the property. A corporate real estate user may have a better credit profile and lower cost of capital compared with a particular property owner or the average credit in a pool of tenants at a site. If the user is committed to a longer-term use of the property, such user may benefit from obtaining financing using its own credit rating versus the landlords, which may be lower as a result of current market difficulties.
Tax considerations
31. The proposed standard would reduce
the difference in the accounting effects of leasing versus owning an asset, and companies may be more inclined to purchase assets than lease them. As companies take a fresh look at future real estate investment decisions and model the proposed accounting standard for existing leases, they may reevaluate previous decisions or identify assets that no longer meet their needs. The proposed accounting standard is unlikely in and of itself to cause significant disposition of assets; however, a reexamination of the portfolio may result in asset disposition.
range of transactions the parties may be willing to consider. In addition, the economic issues affecting either side of a transaction may have radically changed since the time when the decisions were made. A company with net operating loss carryovers may be more willing to undertake substantial restructuring to accelerate benefits or utilize the carryovers before they expire. One with expiring capital loss carryovers may be seeking opportunities to generate gains. Tax-sensitive or tax-oriented transactions by entities with significant owned real estate are generating more interest once again including sale-leasebacks, joint ventures, spin-offs, and real estate investment trust (REIT) conversion transactions.
Financing issues
29. For many industries or individual
companies, alternative financing options to leasing may be limited or too expensive. As a result, leasing, historically, may have been the only option available, or it may have been cheaper than other sources of financing available to the company. In many cases, this will not change irrespective of the accounting ramifications.
33. In most cases, federal taxes will

remain unchanged. However, significant federal deferred tax adjustments may need to be tracked as the related book amounts change.
34. For state income tax purposes, business income of a company is apportioned among the states by means of an apportionment formula. For states that utilize a property factor in the apportionment formula, the proposed lease standard may affect the amount of business income apportioned to a state. In general, a property factor includes all real and tangible personal property owned or leased by the company and used during the tax period in the regular course of business. In most states, property owned by a taxpayer is valued at its original cost, and property leased by the taxpayer is valued typically at eight times its net annual rental rate. Certain states tax codes
30. However, depending on the credit

quality of the company, corporate real estate departments may now want to reconsider purchasing assets that were previously subject to a lease. When underwriting the amount and terms of a commercial mortgage to a property owner, lenders will consider factors such as debt yields, coverage ratios, loan-to-value, the length of lease terms, likelihood of renewal,
48
32. Federal and state tax considerations

often played a significant role in many corporate real estate strategic decisions. A clear understanding of the tax motivations and implications for both counterparties in a transaction is critical as these factors may significantly affect the pricing as well as the
provide that federal income tax rules apply when determining the property factor. Others, such as New Jersey, do not follow the federal income tax treatment and determine property factor values based on book value. Companies doing business in these states may have historically used financial statement rent expense when calculating the annual rental rate. In such instances, the proposed change in lease accounting may affect the calculation of the property factor.
also calculated under GAAP principles. As a result, net worth taxes in certain states may increase because of the increased value of property as reflected on the balance sheet.
40. Even where tax does not follow the

proposed lease accounting model (as in the United States), management may see an increase in the challenges of managing and accounting for newly originated temporary differences impacting deferred taxes in the financial statements.
37. There also may be other types of state

and local tax issues associated with the proposed lease standard, such as sales tax or property tax consequences. Companies may need to evaluate the unique tax provisions found in each state and locality to determine the various consequences for their particular case under the proposed leasing standard.
41. Timely assessment and management

of the potential tax impact will help optimize the tax position by enabling entities to seek possible opportunities and/or reduce tax exposures.
35. Depending on the facts and circumstances of the companys specific portfolio, the impact could be an increase in state taxes if the relative allocation moves from lower-tax jurisdictions to higher ones. Of course, the reverse could also be true if the relative allocation moves from higher-tax jurisdictions to lower ones. Unfortunately, however, the states with higher rental rates (and therefore higher rental assets under the new model) also generally happen to be the states with higher taxesthereby creating an expectation that in many cases a state tax increase will be the result of the change in apportionment. Accordingly, a detailed analysis to consider these state tax impacts using the companys fact pattern may be necessary to devise a plan to minimize their implications.
Regulatory issues
42. In some cases, the decision to lease
was driven by regulatory issues particular to certain industries. For example, reimbursement rates paid on some government contracts are based on GAAP reporting. Today, for some contracts, the government will reimburse 100% of the cost of rent but does not reimburse for capital-related items such as interest and amortization/depreciation of owned real estate. With the proposed elimination of the operating lease model (where rent is replaced by amortization and interest), government contracts and/or reimbursement rules may need to be modified to ensure that the intended economics of the arrangement continue.
38. Internationally, the proposed lease

accounting model may have other impacts on the tax treatment of leasing transactions. In many jurisdictions outside the United States, tax accounting for leasing is often based on accounting used for book purposes. Given that there is no uniform leasing concept for tax purposes, the effect of the proposed lease accounting model will vary significantly, depending on the jurisdiction.
39. Items that may be impacted include

the applicable depreciation rules, specific rules limiting the tax deductibility of interest (for example, thin capitalization rules and percentage of earnings before interest, taxes, depreciation, and amortization [EBITDA] rules), existing transfer pricing agreements, sales/indirect taxes, and existing leasing tax structures (in territory and cross-border). A reassessment of existing and proposed leasing structures should be performed to ensure continued tax benefits and management of tax risks.
36. State franchise/net worth taxes may

also be impacted by a change in the leasing standard. Certain states, such as Illinois, determine the value of a company for franchise tax purposes using generally accepted accounting principles (GAAP). In addition, this value may be apportioned to the state by use of a property factor, which is
43. Since the standard is still in a proposal

phase, additional regulatory effects may emerge when the standard is final and its effects are better understood. What is uncertain at this point is how regulatory agencies will react to the impacts this change will have on risk-based capital requirements and other key regulatory metrics.
Leases
49
The change could be very significant to banks/broker-dealers and other regulated entities whose capital ratios and/or other metrics are closely monitored and which would be adversely affected in many cases if computed under the proposed model. Historically, banking regulators have not provided much relief for the impacts of such accounting changes.
46. Under the proposed lease standards,

these intercompany transactions will need to be reflected on each consolidated subsidiarys books and thereby affect them from a regulatory standpoint (e.g., subsidiary broker-dealers may be inadequately capitalized). The documentation of the arrangement is likely to be much more important since it will drive the value of assets and associated liabilities for entities reporting on a stand-alone basis.
44. While the lessor operations of

many banks will not be significantly affected, those with large leveraged lease portfolios and significant lessee activity (e.g., bank branches, headquarters buildings, processing centers, and ATM locations) may be.
they expect to utilize for a substantial portion of their livesinstead of paying much higher implicit rates in leases would be accretive to earnings long term. However, because existing leasing activity under todays operating leases may not be visible to corporate treasury departments, this alternative use of cash may not be in focus, and these opportunities may be missed.
Governance, budgetary issues, and investment alternative issues

47. Some historical decisions to lease
versus buy may have been driven by approval protocols and budgetary factors. For example, where a company is growing rapidly, it might have been faster and more efficient to execute a lease of real estate or equipment rather than going through the process to approve the purchase of a capital asset. In addition, internal budgeting may have led to a leasing bias since the upfront cash outlay is much lower than with a purchase. If the approval rules follow the new lease model, an operating lease may now need the same level of approval as an outright purchase.
Managing corporate real estate

49. In many organizations, the corporate
real estate department is viewed as more of an administrative function or cost center than a part of a strategic function or a competitive advantage. Further, corporate real estate departments are frequently understaffed and often do not have the infrastructure or systems to effectively track and manage the real estate for which they are responsible. Additionally, in many cases the information necessary to make various decisions, estimates, and periodic remeasurements has not previously been reported to the corporate real estate department on a timely basis (such as changing expectations of renewals or changing expectations of future contingent rents).
Intercompany issues
45. Many heavy corporate real estate
users utilize a central real estate holding entity for owned and leased in property and then provide for intercompany charges to the consolidated subsidiaries. In some cases, the structures have been created (1) to take advantage of beneficial pricing (allowing companies to aggregate subsidiary needs to take bigger spaces), (2) to obtain operating synergies and negotiate better terms, and (3) for operational ease (allowing corporations with multiple subsidiaries to be flexible in allocating space between these units). It also may be driven by tax considerations (e.g., private REITs with beneficial state tax impacts). In some cases, companies executed intercompany leases, but in others, no formal arrangement existed and costs were allocated through an intercompany expense charge.
48. In addition, some decisions to lease

may have been driven by a companys prior alternative investment options for available cash. Today, many companies are holding significant cash balances that are earning only nominal returns. In the near term, using some of this cash to buy certain types of assetsespecially ones that
50. Further, many companies that

operate as a group of decentralized subsidiaries (either domestically or internationally) or ones that have grown larger through acquisition with significant legacy systems used in many places are often balkanized, thus limiting managements ability to understand and manage real estate
50
on a companywide or even countrywide basis. Such systems are neither optimal for a companys current operations nor fully integrated into the larger enterprisewide systems, including accounting and reporting. In addition, because of the length of a typical real estate lease, current management may not be aware of the original rationale for specific decisions, some of which may have changed with the circumstances. Moving this environment to a more centralized one may require significant cultural changes that may not be easy to accomplish.
are often freestanding and utilized more for management purposes, with no integration with the companys accounting systems.
55. Given all of the above, these changes

will necessitate potentially significant cultural changes as well as significant operational ones.
53. Management of the changes may be

possible for some companies without significant upgrades or integration, but to do so may miss an excellent opportunity to automate a previously labor-intensive activity and free up employees for other more productive uses. Few companies track property, plant, and equipment in an automated fashion, and the lack of ongoing reevaluation and measurement, as well as the need to split and track nonlease items, makes leasing a prime target for systems support.
Internal controls and processes

56. Many entities in the past have
not needed robust processes and controls for leases, other than those surrounding their initial classification. In addition, the existing lease accounting model (absent a modification or exercise of an extension) does not require leases to be periodically revisited. The new standard would require that leases be remeasured for changes in estimates (for example, for changes in expected lease term or expected contingent rent payments) and would require entities to design or redesign processes and controls to ensure proper management and accounting of all lease agreements.
51. In some cases, corporate real estate

departments may have the responsibility for tracking the real estate but not enough resources and focus to (1) identify and manage excess capacity, (2) identify and seek reimbursement for overcharges for lease operating costs (e.g., CAM and bill back overcharges), and/or (3) minimize other cash real estate occupancy costs. Finally, for many companies, existing tracking systems are informal, incomplete, or inaccurate. These tracking systems might be nothing more than a drawer for storing copies of leases, a notebook containing lease abstracts, spreadsheets, or nonintegrated or outof-date software applications.
54. The new lease accounting model

would require many judgments in its application and significant changes in the calculations prospectively (including new amortization schedules). From a long-term sustainability perspective (for companies with substantial leasing activities), spreadsheet-based accounting will not be practical because of the significant maintenance required and resultant susceptibility to error. High-volume corporate real estate users will likely need new systems/processes to create a documentation trail of the judgments and changes in estimates made. The system will also need to be largely automated to make the necessary computational adjustments resulting from changes in estimates. Full integration into the companys control structure and accounting systems will be necessary, as will the ability to create extensive quantitative disclosures that are mandated in the new accounting model.
57. Initial recording on balance sheet

and annual reassessment of lease terms and payment estimates may require significant and complex changes to existing processes and internal controls, including support for significant management assumptions. Monitoring and evaluating the estimates and updating the balances may also require more personnel resources than required by the current accounting.
52. With respect to asset management

systems, many companies are still accounting for their leases of corporate real estate using spreadsheets and accounts payable systems with no formal corporate real estate asset management system. Even for the more sophisticated corporate real estate groups that have asset management systems, these systems
58. Timely assessment and management

of the impact on processes, controls, and resource requirements will help reduce reporting risks. This approach includes the related areas of tenant improvements, impairment valuation, and tax accounting.
Leases
51
IT and lease accounting systems

59. Information technology and lease
accounting systems in the marketplace are based on the existing risks and rewards concept. They will need to be modified to the proposed rightof-use concept. Systems designed to meet the needs of this potential standard do not exist. Development and implementation of suitable new modules or systems are likely to have a significant lead time. Lessees will have to account for and manage lease agreements differently (including existing operating lease agreements). They may need to implement contract management systems for lease agreements and integrate these with existing accounting systems. Lessees will need to identify and implement IT and accounting solutions that meet their future needs. In addition, if a company also has significant subleases, additional complexities will arise, as the company will be applying both lessor and lessee accounting.
integration of the accounting for the new lease standard and potential controls thereon. However, such discussions are only at their conceptual and planning phases.
Financial reporting and impact on ratios

62. The financial statements will require
restatement for the effect of the changes. The effects of the proposed lease accounting model should be clearly communicated to analysts and other stakeholders in advance.
the underlying cash flows or business activity. In addition, continuous remeasurement will increase volatility in these key ratios. These ratios may no longer be useful for their historical purposes, and other operating metrics may evolve as a result of adoption of the new standard.
66. Timely assessment of the proposals

impact on covenants and financing agreements will enable management to start discussions with banks, rating agencies, financial analysts, and other users of the entitys financial data. Entities anticipating capital market transactions should consider the effects on their leverage ratios. There is speculation that new metrics will be created for debt service coverage ratios that neutralize these effects, although it will likely take some time for these changes to take effect. Other agreements based on (entity-specific) key performance indicators will require reassessment and, potentially, adjustment (for example, compensation agreements). Companies in the process of negotiating new or existing agreements should seek provisions in the agreements that specify how changes in GAAP impact financial covenants (i.e., whether covenant calculations are always based on then-current GAAP or on GAAP that was in effect when the agreements were signed).
63. Ongoing accounting for leases may

require incremental effort and resources as a result of an increase in the volume of leases recognized on balance sheet. There is also likely to be a need for regular reassessment of the lease term, contingent rentals, residual value guarantees, or the impact of purchase options.
64. The impact of the change will not

be restricted to external reporting. Internal reporting information, including financial budgets and forecasts, will also be affected.
60. Lessees may expect lessors to provide

them with the necessary information to comply with the proposed standard. However, lessors may not have, or may be unwilling to provide, data required by lessees. Consequently, lessees will need to capture such information themselves and may need to modify their systems accordingly.
65. The proposed lease model will change

both balance sheet and income statement presentation. Leverage and capital ratios may suffer from the gross-up of balance sheets. Rent expense will be replaced by depreciation and interest expense. In addition, the expense recognition pattern will change significantly. This will negatively influence some performance measures, such as interest cover, but perversely improve others, such as EBIT/EBITDA and cash flow from operations, all with no change in
61. Timely assessment and management of

the impact on IT and lease accounting systems will help reduce business and reporting risks. We understand that some of the Enterprise Resource Planning (ERP) systems providers are in the process of evaluating upgrades and solutions that will allow for an
52
Next steps
67. The proposed lease standard is not
expected to allow for grandfathering of existing leases, with the exception of certain capital leases. Accordingly, prior to adoption, management will need to catalogue existing leases and gather data about lease term, renewal
Proposed timeline Exposure draft (August 2010) Final standard (2011) Effective date (2014?)
Phase I Training/awareness Preliminary assessment Strategic planning for the future Process and technology readiness
Phase II Issues resolution Business strategy change System changes/upgrade Execution Planning for the future
Phase III Go live with business as usual Reporting updates Ongoing monitoring
US GAAP today
Project management, communication, knowledge transfer Establish policies and prepare financial results
US GAAP tomorrow
Assess impact and determine strategy
Embed the new standard
options, and payments to measure the amounts to be included on balance sheet. Gathering and analyzing the information could take considerable time and effort, depending on the number of leases, the inception dates, and the availability of records. In many cases, original records may be difficult to find or may not be available. Other factors such as embedded leases that had not been a focus before will need to be identified and recorded.
the steps needed to prepare the organization for the change.
70. The chart that follows depicts a potential transition plan with respect to evaluating the effects of the proposed lease model. Incremental corporate real estate strategy and systems changes would be performed concurrently with this plan.
71. In addition to changes in the technical

accounts, operations, and systems outlined in this document, we predict that changes to your corporate real estate role will also be needed, and the lease accounting changes being proposed should provide the catalyst for change in corporate real estate. Beginning the process early can ensure that implementation of a future standard is orderly and well controlled and that data on new leases written before implementation of the changes is captured from the outset. In addition, timely action may allow entities to consider potential adoption and negotiation strategy changes for new leases and the potential renegotiation of existing agreements to reduce the impact at adoption.
68. In addition, companies with international operations may need to deal with leases written in different languages and with the potential impact of local statutes in applying the standard. For example, in France, certain local statutes provide the lessee with an automatic rentcontrolled renewal option irrespective of whether one is contained in the lease agreement itself.
69. Though the adoption of the new

standard remains at least three years away, organizations are well advised to begin considering the impact of these changes nowand to put into motion
Leases
53
How can PwC help? PwC has multidisciplinary teams of specialists who can assist you with the aspects of your corporate real estate journey. Real estate strategy and accounting advisory Training, planning and implementation assistance with regard to the new lease standard Analysis of needs and market trends Analysis of, or assistance with, evaluating financial and strategic impact of the new lease standard Tax and transaction support Analysis of tax implications and structuring opportunities with respect to the new lease standard Sale-leaseback transactions REIT spin-offs of corporate real estate to unlock shareholder value Federal and state tax planning transactions Systems and processes Process/control change consulting/implementation planning with respect to impact of the new lease standard Strategic information systems planning Gap analysis and system selection Technology integration and implementation Where to find additional information If you would like further information on the proposed lease accounting model or assistance in determining how it might affect your business, please speak to your regular PwC contact. A list of PwC contacts has also been provided on the back cover of this publication. Operational effectiveness and cost containment Lease expense audits for potential recovery Process redesign and leading practices in corporate real estate Benchmarking and performance monitoring Spend analysis, strategic sourcing, and outsourcing effectiveness Operational and organizational effectiveness Valuation/market analysis Real estate and lease portfolio valuation Market studies Valuation analyses in conjunction with accounting requirements (i.e., FAS 141)
54

Educate key business leaders about the issue Create a cross-functional steering committee to address the standard and transition Perform an inventory of your lease portfolio; understand what types of assets are leased and where the data resides Identify contracts likely to include embedded leases Consider modeling the transition impact on certain significant leases (or sample from a variety of lease types) Summarize existing systems and potential gaps Summarize existing control processes and potential gaps Analyze potential income and other tax considerations (including federal, state, and foreign taxes) Identify contracts affected by the change in accounting (e.g., financial covenants, compensation agreements, and earnouts), the potential implications, and how terms should be modified in the future Identify regulatory issues affected by the change in accounting (e.g., regulatory capital implications and cost plus government contracts), the potential implications, and how terms should be modified in the future Consider potential changes in real estate leasing strategy ( e.g., lease/buy, shorter versus longer leases, modify common terms, etc.)
Leases
55
Key takeaways on transition

Be strategic: Planning your transition will go much more smoothly if you have concrete data to work with. Modeling selected leases will give you relevant data to share with internal constituents. It will also help you understand what data you have, what data you need, and how your leasing strategy may need to change to minimize the adverse accounting impact of the standard.
Manage market reaction: For many significant users of real estate (e.g., retail companies), managing investor and other user relations during the transition will be critical. The issuance of the Exposure Draft has created a significant buzz, and analysts and shareholders are likely to start raising questions about the potential impact. Traditional operating metrics such as EBITDA used as proxies for free cash flow may no longer be relevant and will likely need to be replaced. Longer term, the inherent volatility in the income statement and balance sheet, in addition to significant changes in presentation and metrics, will require thoughtful communication.
Dont wait: In our discussions with clients, many expect adoption to take from 12 to 24 months. While the adoption timetable will vary by company, most believe adoption will be complex and time consuming. Targeted steps today will help you understand the complexity and duration of the transition effort and, more importantly, what steps you can take today to modify existing or planned leases to minimize the effort of complying with the new rules.
The table on the following pages describes common terms in lease agreements and the current and proposed accounting for these items.
Impact on common real estate lease provisions

Terms Co-tenancy clauses Example There are various types of co-tenancy clauses. One example is for key tenants whom other tenants believe are critical to the successful operation of the location. If a key tenant departs, the property owner has time to cure the issue but until cured, rent may be reduced. Existing accounting Reflect any reductions in period they occur but do not project them in considering minimum lease payments. New accounting Potential strategy impact
Reflect any reductions Likely no changes in in period they occur but strategy. do not project them in considering minimum lease payments.
56
Terms CPI escalations
Example Office tenant has a rent escalation each anniversary date based on the change in the published Consumer Price Index.
Existing accounting Treated as contingent rent which is not included in minimum lease payments used for straight line rent purpose but rather the expense is recognized in each annual period based on actual increase in that period.
New accounting The new standard would require the office tenant to use a probability weighted approach to estimate its future payments under these provisions for whatever lease term is utilized (including potential extension options) and include them in the calculations.
Potential strategy impact CPI escalation provision features will no longer have an advantageous accounting for lessees and we expect that the use of such provisions may be reduced in practice if for no other reason than to reduce complexity. Further, from a risk standpoint, if a tenant that expects 3% inflation can get similar accounting for a fixed rent step of 3%, all other things being equal, they would lower their risks and complexity by moving to a fixed rent strategy. Largely economic business practices in this area likely not to change.
Free rent periods
Retail tenant given sixmonth free rent period in connection with 10year lease.
Current lease model would apply a straight line rent method whereby expense is reflected based on a mathematical average of the aggregate minimum lease payments over the period from commencement of the lease through end of lease term. This model does not compensate for the economic impacts of the timing of payment.
The new model would have no cash out-flows in the present value calculation for first six months. As a result, initially the right of use asset and lease obligation would be lower. The obligation would increase over the free rent period as the obligation is remeasured using a constant effective yield with interest being added to the balance during the free rent period (i.e., like a negative amortizing loan). The accounting for a tenant allowance for improvements considered tenant assets is the same as described under lease inducement below. There is no change from existing accounting for a tenant allowance for improvements considered to be property owner assets.
Lease allowance
Property owner pays tenant $1.0 million for part or all of the improvements to the leased property.
If the tenant allowance is for improvements considered tenant assets, the accounting is the same as described under lease inducement below. If the tenant allowance is for improvements considered to be property owner assets, the payment is treated as a reimbursement for the cost of a lessor asset with no additional accounting over the lease term.
Likely no changes in strategy.
Leases
57
Terms Lease inducement
Example Property owner pays tenant $1.0 million to enter into a lease that may be used for any purpose.
Existing accounting Treated as negative rent payment and reduction in minimum lease payments to be reflected using straightline method over lease term.
New accounting Treated as reduction in lease obligation and, therefore, the asset at inception. As a result, the amortization (generally straight-line method) over the lease term (including potential extension options) would be lower. The new standard would require the retailer to use a probability-weighted approach to estimate its future payments under additional rent terms for whatever lease term is utilized (including potential extension options) and include them in the calculations.
Potential strategy impact Accounting impact is the same if lease term is the same$1 million amortized on a straightline basis to the income statement. If extension options included, amortization period may be different. Likely no changes in strategy. It depends. For more predictable operations, percentage rent features will no longer have an advantageous accounting for lessees and we expect that the use of such provisions may be reduced in practice if for no other reason than to reduce complexity. For less predictable operations, for example a new concept store or one in an uncertain market location, we expect that such provisions will continue in use.
Percentage rent
Retail tenant pays additional rent of 4% of annual sales at the location in excess of $10.0 million.
Treated as contingent rent which is not included in minimum lease payments used for straight line rent purpose but rather the expense is recognized based on actual sales when it becomes probable annual sales will exceed $10.0 million.
Perpetual leases
In some jurisdictions, by statute the tenant may have the right to renew the lease indefinitely. For example, in France, many retail leases are automatically renewable by the tenant in three-year increments.
Today these are straight-lined for each three-year period.
If tenants have the Likely no changes in unilateral right to renew strategy. by contract or statute, the lease term may be longer than the current term. This evaluation would be based on the probability of renewal. If renewals are assumed, in many cases the rent would need to be estimated, which may be complex. New model would recognize an asset and a liability for the payments. Since the prepayment is made at inception, it would not have a present value discount. The rightof-use asset would amortize on a straightline basis. Interest on the obligation would be reduced or eliminated (depending on whether partially prepaid of fully prepaid). Likely no changes in strategy.
Prepaid rent or uneven rent
Lessee prepays a significant amount of rent at the inception of the lease.
Rent recognized over the term of the lease on a straight-line basis.
58
Terms Security deposit
Example At the beginning of the lease term, tenant pays property owner $1 million, which is approximately two months of rent due under the lease agreement. The amount protects the property owner from a default by the tenant or damage to the leased property caused by the tenant and is refundable if neither occurs. At the beginning of the lease term, tenant pays to improve the space.
Existing accounting Treated as a liability by the property owner and as an asset by the tenant until returned to the tenant or used by the property owner in the event of default or damage to the leased property.
New accounting Same as existing accounting.
Potential strategy impact Likely no changes in strategy.
Tenant improvements
Treated as separate asset amortized over the lesser of the life of the improvement or the assumed term of the lease.
Treated as separate asset amortized over the lesser of the life of the improvement or the assumed term of the lease. However, under the proposed model, the lease term may now be longer if option periods are included. There should be consistent assumptions between amortization period and lease term.
Likely no changes in strategy.
Termination rights
A retail tenant is uncertain about the potential viability of a location. They sign a 10-year lease with the right to terminate the lease after two years.
Frequently, these are considered 10-year leases because of the penaltieseither direct penalties or economic ones from having to walk away from the tenant improvements.
Lease term probably Likely no changes in similar to that of today. strategy. A similar lease could be structured as a twoyear lease with a right to extend for 8 years. The new model will evaluate the expected term as either two years or 10 years based on the probability of the lease running for those periods.
Leases
59
Discussion paper issued March 2009
Comment period ended July 2009
Redeliberations began October 2009
Exposure draft issued August 2010
Redeliberations expected to begin Q4 2010
Final standard expected in 2011
Effective date to be determined
2009
2010
2011
2012 and beyond
AppendixSummary of the exposure draft

Detailed discussion of proposed leasing standard from lessees perspective Status of the new leasing standard
72. This Appendix summarizes the
FASB and IASBs Exposure Draft, Leasing, issued on August 17, 2010. The comment letter period ends on December 15, 2010, whereupon the Boards will redeliberate with a target date for issuance of a final standard in 2011. The provisions of the proposed standard are subject to change until a final standard is issued. Adoption date has not been discussed but could be as early as 2013; however, it is more likely to be 2014 or 2015.
throughout the lease term under current GAAP.
75. Many observers have long believed

that the current lease accounting model is not consistent with the conceptual framework, which provides the underpinnings for accounting rules. They also argue that current guidance allows lessees to structure lease transactions to result in operating lease classification, resulting in off-balance sheet treatment. Critics also point out that the current standards permit something as illogical, for example, as a commercial airline company reporting no airplanes on its balance sheet.
determined, could be as early as 2013; however, it is more likely to be 2014 or 2015.
The timeline
78. The project timeline and reasonable reaction periods for tenants and property owners to evaluate potential impacts are shown above.
Key provisions
79. We will discuss the following expected
key provisions of the standard and provide examples of the impact on a real estate user (lessee) in a hypothetical lease scenario.
76. 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 need to be rewritten.
Scope
80. 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). Accordingly, those items, in the aggregate, would be subject to the proposed accounting. 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.
Background
73. Leasing is an important and widely
used source of financing. It enables entities, from start-ups to multinationals, to acquire the right to use property, plant, and equipment without making large initial cash outlays.

efforts, the Boards have been working 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 Boards issued a joint discussion paper in March 2009 that included possible changes to lease accounting, followed by the Exposure Drafts of the proposed model in August 2010. They expect to issue final standards in 2011. The effective date, which has not been
74. Lessees currently account for leases

as operating leases or capital leases. Lease classification is based on complex rules. Though many operating leases provide nearly the same risks and rewards as outright ownership, neither the leased asset nor the obligation to pay for it is recorded on the balance sheet. Rather, rent expense is recorded on the income statement on a straight-line basis
81. The Boards also propose to exclude

from the scope (1) leases to explore
60
for or use natural resources (such as minerals, oil, and natural gas); (2) leases of biological assets; and (3) lessor accounting for leases of investment property measured at fair value under International Accounting Standard (IAS) 40, Investment Property. PwC observation: US GAAP does not currently have an investment property accounting model similar to IAS 40. However, at its July 24, 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). The Boards current efforts are focused on defining which entities would be included in the scope of the investment property guidance to determine whether those entities investment properties would be required to be carried at fair value and excluded from the proposed leases guidance. One alternative that the Board discussed at an Education Session on November 3, 2010, was to include only entities whose primary business is investing in real estate (real estate investment companies). The Board will be discussing this alternative, as well as the specific characteristics of such entities, at a later meeting. An Exposure Draft on investment property could be issued in the first quarter of 2011. If a new investment property standard is completed, it is expected that the FASB would adopt it concurrently with adopting a final
leasing standard. This would result in the exclusion of investment property owned by lessors from the lease standard. This does not affect how the lessee would account for the lease of such property for its own operations.
Short-term leases and noncore assets

82. The Boards considered excluding
short-term leases and leases of noncore assets from the scope of the proposed leasing standard. Factors considered included 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 onto the balance sheet.
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. Payments to the lessor would reduce the obligation.
Lessee accounting
The basic model
84. The Boards have proposed a rightof-use model for lessee accounting. This model would require the lessee to recognize at the commencement of the lease (usually upon, for example, the tenant taking possession of the property) 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 purchases would be accounted for in a similar manner; the classifications of capital and operating leases used today would be eliminated.
83. Although the Boards decided against

short-term lease exclusion, they did propose a simplified method for lessees to ease the burden of accounting for such leases. For leases with a maximum possible term (including all extension options) of 12 months or less, a simplified lease accounting approach could be used 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, presumably as amortization. PwC observation: Because of the short duration of leases that would qualify for the simplified approach,
85. The Boards believe that the rightof-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
Leases
61
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. For example, 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. With respect to 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 to maintain operating flexibility, or the specific asset may be available only through leasing (e.g., a specific retail location). Leasing may also be more appropriate for space users that occupy only a small portion of a larger facility (e.g., tenant in a regional mall) or for a period that is substantially shorter than the useful life of the asset (e.g., five years for an office building with a useful life of 40 years or more).
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.
use the rate the lessor is charging in the lease rather than determine its incremental borrowing rate. As indicated above, for real estate leases, the implicit rate would rarely be known or useful. The lessee would then use a discount rate commensurate to 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 assumed extension options considered more likely than not to be exercised). 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 property in Chicago. This rate would not subsequently change even if the expected term changes because of changes in judgments of the likelihood of exercise of extension options.
87. 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, and costs incurred in 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.
88. Present values would be determined using the lessees 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 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. 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
Service costs/executory costs

89. The Exposure Draft indicates that
where lease payments also contain service costs, the combined payments would need to be allocated between distinct services and lease rentals associated with the lease of the asset. If allocation is not possible, the entire arrangement would be accounted for as a lease.
Initial measurement
86. Lessees would initially measure the
obligation to pay rentals at cost computed at the inception of the lease, which would generally be the date the lease is signed. Cost is defined as the present value of the
90. For this purpose, the Exposure Draft

utilizes the distinct service definition being considered in the revenue
62
recognition project. Under this definition, a service component is considered distinct if either: The entity, or another entity, sells an identical or similar service separately The entity could sell the service separately because the service has both a distinct function and a distinct profit margin.
or such costs are paid directly by the tenant. In such leases, the tenant bears the risk and rewards of all of the downside and upside changes in executory costs.
Modified gross or base year lease

These leases are common for office property where the tenants rent is set during the first year of the lease (i.e., the base year), which includes executory costs (on a pro rata basis for multitenant leases). In subsequent years, the tenant pays additional amounts for executory costs to the extent they exceed the tenants pro rata share of the aggregate of those expenses in the base year. In these leases, tenants bear all the aggregate downside in the case of rising prices, and the lessor gets any benefits of aggregate efficiencies that reduce overall costs.
91. While this definition would likely

work for services provided by the landlord for the space (e.g., cleaning services for the office space being rented), it is not clear how it would be applied to many other common real estate terms.
PwC observation: Many believe that executory costs should be excluded from the payments the lessee uses in measuring the lease obligation when applying the proposed standard. However, it is not clear that these costs would meet the distinct service definition. For example, it would be very difficult to say that real estate tax reimbursement or the pro rata portion of landscaping or snow removal in multitenant buildings meets the distinct service definition. Further, in many cases, items that might meet the definition of a distinct service are intertwined with those that do not meet the definition. For example, the cost reimbursement for an increase in a base year lease is not for each individual expense but rather for the entire pool of expenses, and increase in some may be offset by decreases in others. Assuming the final standard indicates that these service/executory costs should be excluded, companies would then need to segregate out the portion of these included in the rent amounts under base year and gross leases. Stripping out executory costs is not significant in many cases under the current lease accounting model but will become significant under the proposed leasing model. Therefore, management may need to obtain information with respect to service/ executory costs from property owners or find ways of estimating them.
92. The concept of excluding executory/

common costs was not carried over from the existing lease accounting model into the proposed model. Executory costs in todays accounting include insurance, maintenance, and taxes. In practice, this term is often also applied to other common cost allocations, including common area maintenance, utilities, snowplowing, security, landscaping, etc. These costs are frequently included in the quoted lease terms (especially for real estate). There are several different types of leases that are common with respect to real estate, and each may have some unique issues. Some of these are described below:
Gross lease
Gross leases have historically been very simple. The quoted base rent includes all executory costs. In such leases, the lessor bears the risk of all the upside/downside associated with cost changes. In many cases, especially for real estate, a tenant neither knows nor cares what these executory costs areits focus is solely on the all-in cost of occupancy.
93. The Exposure Draft indicates that

costs for services meeting the definition of distinct services would need to be removed from the lease payments used to measure the initial rightof-use asset and liability. The costs associated with distinct services are operating period costs and should be reflected in the period incurred.
Net lease
These types of leases are common for retail/industrial property and single-tenant property where either the tenant is billed by the lessor for executory costs incurred (on a pro rata basis for multitenant properties)
Leases
63
94. The Boards proposed that the right-ofuse asset be subsequently measured at amortized cost. Amortization for real estate assets would generally be recognized on a straight-line basis. The expense recorded would be presented as amortization expense rather than rent expense.
does not need the space immediately and, accordingly, negotiates for a forward start date. The Exposure Draft does not address the accounting for the change in present value of the obligation when significant time passes between lease inception and lease commencement. The remeasurement of the obligation at commencement date will be higher than the amount at lease inception date. A question arises in applying the guidance in the proposal as to whether this increase results in an immediate interest charge or an adjustment to the asset. We believe that the asset and liability should be adjusted at commencement to eliminate this differential at lease commencement.
98. Under the proposed model, the lease

term is defined as the longest possible term that is more likely than not to occur. In estimating the lease term, the party should consider all relevant factors, including contractual, noncontractual, 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 since the probability is 100% that the lease will cover at least the initial five-year period. The lessee would also need to consider whether the 10- or 15-year terms available because 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.
95. The lessees obligation to pay rentals

would be subsequently measured at amortized cost using the effective interest method, under which payments would be allocated between principal and interest over the lease term. Interest expense determined under this method would be higher in the early years of a lease compared with the current straight-line treatment for rent expense under an operating lease. PwC observation: 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 to the lessee). It is not uncommon for there to be six months or even several years between the signing of a real estate lease (lease inception) and the tenants taking possession of the space (lease commencement). This can occur for a number of reasons including asset construction, the space not being available until a later date (e.g., existing tenant term has not yet expired), or the tenant
Lease term
96. Under existing standards, optional
extension periods are considered part of the lease term if the lessee concludes at lease inception that exercise of such options is reasonably assured (ASC 840, Leases) or reasonably certain (IAS 17, Leases) for the additional periods.
Purchase options
99. The Boards have 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.
97. 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. The term would be reexamined if facts and circumstances indicate that there would be a significant change in the liability to make lease payments since the previous reporting period.
64

100. 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.
approach for most contingent rents and a forward curve for contingent rents based on an index. PwC observation: Rather than a best estimate of what a lessee expects to pay, the Boards approach may be difficult if not impossible to apply. Multiple scenarios for percentage rent calculations may be arbitrary, and there is no published source of some of the more common indexbased contingency clauses, such as CPI. We believe a best estimate approach would be better and still meet the Boards goals.
105. For example, consider a lessee that

enters into a 10-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 determining net income. Changes in the obligation from the updated forecast in sales for years three through ten would be recognized as an adjustment to the right-of-use asset.
101. The Boards have proposed using

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 probabilityweighted 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 have 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 nonrecognition of payments due the lessor and could result in structuring opportunities to avoid recognizing an obligation.
106. The Boards also considered whether

the discount rate should be updated when a remeasurement is required because of 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 with 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.
Changes in estimates and remeasurements

103. The Boards proposed that lessees
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 lessees obligation because of a reassessment of the lease term would be recognized through an adjustment of the rightof-use asset.
104. 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 determining net income. All other changes would be recognized as an adjustment to the lessees right-of-use asset.
102. The Boards indicated that lessees

should use a probability-weighted
Lessee example
Exhibit 1 graphically illustrates the
Leases
65
Exhibit 1: Comparison of the proposed model, current model and cash payments $2,600
$2,400
$2,200
$2,000 effect of the proposed standard on expense recognition for a fixed 10-year lease with rental payments that increase 2% per year (see detailed calculations at the end of the Appendix). The current accounting model reflects rent expense for operating leases on a straight-line basis over the noncancellable lease term. Historically, critics of todays model have observed that this model does not consider the time value of money and is sufficiently divergent with the cash due under the contract such that it does not reflect economic reality. Though the proposed model clearly factors in the time value of money, the new approach diverges even further from the cash due under the contract. Under the proposed model, rent expense would be replaced with interest and amortization expense. The expense would be front-end loaded, with more expense recognized in the beginning of the lease term and less at the endsimilar to a mortgage. For a lease that includes escalating rents, the cash payments will directionally be the inverse of what the expense will belower in the earlier years and higher in the later years. When a lease contains optional periods or contingent payments, additional volatility may be introduced into the income statement because the lessee would be required to revisit the original estimates of lease term and contingent rentals as facts and circumstances change. Exhibit 2, Comparison of timing recognition of optional renewal periods, takes the lease depicted in Exhibit 1 and assumes there are two
$1,800
$1,600
5 Year
10
Cash rent
Current model
Proposed model
optional five-year renewal periods. The rents during the option periods continue the same pattern, escalating 2% per annum. Exhibit 2 on the next page 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 steptype recognition pattern for each noncancellable 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. 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 on an assessment of 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.
Other areas of difficulty

Sale and leaseback transactions 107. Some 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 standards criteria for an in-substance sale. 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.
66
Exhibit 2: Comparison of timing recognition of optional renewal periods
$3,300
$2,800
$2,300
$1,800
$1,300
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
108. If the transaction qualifies as a sale,

a gain or loss 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. PwC observation: This would be a significant change under US 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 so-called build to suit transactions under 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 qualify for sale treatment would be less cumbersome. However, for sale 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. Fundamentally, for long-term leasebacks, there is a concern that recognition of this gain may not be appropriate since most of the gain relates to the period of continued use rather than to what is fundamentally the sale of the residual interest.
performance obligation approach would likely be required for the lessor. To avoid the double grossup 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, be presented together on the asset side of the balance sheet at gross amounts with a net subtotal. The obligation to the head lessor would be presented separately in liabilities.

111. For lessee accounting, the Boards
proposed that assets, liabilities, amortization, and interest related to leases be presented in the financial statements based on the nature of the leased 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 breakout of the amounts 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.
Subleases
109. As expected, the accounting for
subleases builds on both 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.
112. Specific disclosures required would

include a description of the nature of an entitys leasing arrangements, the existence and terms of optional renewal periods, contingent rentals, and information about assumptions and judgments. In addition, any restrictions imposed by lease
110. Presentation of the assets and liabilities will differ depending on which of the two lessor models is followed. In most cases, there will be sufficient continuing involvement that the
Leases
67
arrangements, such as dividends and additional debt, should also be disclosed.

115. Lessees would apply the proposed
standard by recognizing assets and liabilities for all outstanding leases at the initial application date.
different phases of life will smooth out some of the front-end loading.
113. 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. 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.
117. Lessees would measure the lease

obligation at transition at the present value of the lease payments discounted using the lessees 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.
116. The Boards expect to issue a final

standard in 2011. They have not discussed the effective date of the standard. Presumably, it would be no earlier than 2013; however, it is more likely to be 2014 or 2015. Given the potential impact of the proposed changes on accounting and operations, as well as 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. 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 to all leases that exist at that date (even if they had expired or were terminated prior to the 2014 adoption period). Fundamentally, this exacerbates the front-end loading issue because it treats all leases that exist at the initial application date as if they were new leases. Over time, a portfolio of leases in
118. The Boards have proposed an exception for simple capital leases, those leases currently classified by lessees as capital leases that 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.
114. Additional disclosures would apply if

(a) the simplified option for shortterm leases is elected, (b) significant subleases exist, or (c) there is a saleleaseback transaction. PwC observation: Because of 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.
119. 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.
68
PwC observation: While the new standard provides that a lessee would adjust the asset at inception for prepaid or accrued rent, it is unclear if this is on a contractual accrual basis only or whether this adjustment would also include the accumulated deferred rent asset/liability resulting from the pre-adoption application of the straight-line accounting for an operating lease under current accounting. We believe the asset should also be adjusted for these amounts; otherwise, the aggregate pre- and post-adoption recognized costs would be different than the total amount of cash paid under the contract. 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 will be needed 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 can 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. The Exposure Draft does not contain any discussion of transition implications for existing sale-leasebacks. For example, there is no discussion as to what happens with prior deferred gains from transactions that occurred before the initial application date or between the initial application date and adoption date (i.e., in the restated periods).
Timing for comments

120. 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.
Example
121. The example on the following page
is provided to demonstrate how the lessee model would be applied in practice.
Leases
69
Example: Lessee simple example

The lease is for a 100,000-square-foot building with a 10-year fixed term; initial annual rent is $20 per square foot (paid in equal monthly payments) with rent escalating by 2% per year. The lessees 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 $15.5 million (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 method. This results in a total expense of $2.6 million in the first year, which is $612,000 higher than the cash rent and $422,000(approximately 20%)
higher than expense under the straightline 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) Right to use asset Lease obligation
Initial recognition $15,540 ($15,540)
Year 1 $13,986 ($14,598)
Year 2 $12,432 ($13,547)
Cash (paid in monthly installments) Cumulative cash Income statement implications (in thousands) Proposed accounting model Amortization of right to use asset (straight-line method) Interest expense on lease obligation (effective interest method) Combined expense related to the lease A
$2,000 $2,000 Year 1
$2,040 $4,040 Year 2
$1,554 $1,058 $2,612
$1,554 $989 $2,543
Current accounting model Rent expense (straight-line method) B $2,190 $2,190
Differencecurrent period Differencecumulative
A-B
$422 $422
$353 $775
70
Year 3 $10,878 ($12,377)
Year 4 $9,324 ($11,079)
Year 5 $7,770 ($9,644)
Year 6 $6,216 ($8,061)
Year 7 $4,662 ($6,318)
Year 8 $3,108 ($4,403)
Year 9 $1,554 ($2,302)
Year 10 $0 $0
Total
$2,081 $6,121 Year 3
$2,123 $8,244 Year 4
$2,165 $10,409 Year 5
$2,208 $12,617 Year 6
$2,252 $14,869 Year 7
$2,297 $17,166 Year 8
$2,343 $19,509 Year 9
$2,391 $21,900 Year 10
$21,900
Total
$1,554 $911 $2,465
$1,554 $825 $2,379
$1,554 $730 $2,284
$1,554 $625 $2,179
$1,554 $509 $2,063
$1,554 $382 $1,936
$1,554 $242 $1,796
$1,554 $89 $1,643
$15,540 $6,360 $21,900
$2,190
$2,190
$2,190
$2,190
$2,190
$2,190
$2,190
$2,190
$21,900
$275 $1,050
$189 $1,239
$94 $1,333
($11) $1,322
($127) $1,195
($254) $941
($394) $547
($547) $0
$0
Leases
71
US GAAP Convergence & IFRS Leases: Updated October 31, 2011

October 31, 2011
Table of contents
FASB and IASB make significant decisions related to lessor accounting and transition Transition decision postponedwill this delay re-exposure of the Leases exposure draft? FASB and IASB agree to re-expose leasing ED and agree on one lessor accounting model Leases: FASB and IASB change course Redeliberations of the leasing project: Some new twists Defining a lease: FASB and IASB suggest changes to the Leases exposure draft IASB/FASB leasing redeliberations March 2011 (third March meeting) FASB and IASB propose additional changes to the Leases exposure draft
6 8
10
28
30
32
FASB and IASB make significant decisions related to lessor accounting and transition
Whats inside: Whats new? What are the key decisions? Whats next?
Whats new?
The FASB and IASB (the boards) met last week and reached tentative decisions on (1) an expansion of lessors 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.
Reprinted from: In brief 2011-44 October 24, 2011

Expansion of lessors 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 IPEs 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
2
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.
Lessee and lessor transition Whats next?

It was tentatively decided that lessees and lessors should have the option of applying either a modified or a full retrospective approach to transition. 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.
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.
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.
Leases: Updated October 31, 2011
Transition decision postponedwill this delay re-exposure of the Leases exposure draft?
Whats inside: Whats new? What are the key decisions? Whos affected? Whats the effective date? Whats next?
Whats 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, which will likely put additional pressure on the boards target of publishing a revised exposure draft in 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 finalstandard. A complete summary of the boards decisions on the leases project is available on the FASBs website at www.fasb.org or the IASBs website at www.ifrs.org.
Reprinted from: In brief 2011-40 September 30, 2011

Scopeinventory
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.
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 to measure the lease receivable at fair value where such lease receivables are held for salesuch as through a planned securitization. This issue is expected to be revisited at a futuremeeting. 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
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) Topic310, Receivables, or IAS 39, Financial Instruments: Recognition and Measurement, as appropriate) to assess impairment of the lease receivable; and (c) the lease standard
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 financialstatements. 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 and lessor transition guidance back for discussion at a future board meeting.
Whos 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 before2015.
Whats 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.
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
FASB and IASB agree to re-expose leasing ED and agree on one lessor accounting model
Whats inside: Whats new? What are the other key decisions? Whos affected? Whats the effective date? Whats next?
Whats 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 FASBs website at www.fasb.org or the IASBs website at www.ifrs.org.
Reprinted from: In brief 2011-31 July 26, 2011
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).
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 lessees rightof-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. 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.
Whos affected?
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.

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.
Whats 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.
Leases FASB and IASB change course
Whats inside: Whats new? What are the key decisions? Whos affected? Whats the effective date? Whats next?
Whats 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 FASBs website at www.fasb.org or the IASBs website at www.ifrs.org.

A summary of this weeks 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 companys 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 otherthan-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 todays operating leases) which would be characterized as rent. The mechanics on how to apply the concept of other-thanfinancing 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.
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.
Whos affected?

The boards have yet to decide on an effective date, but it likely will not be before 2014.
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
Whats 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.
1 IAS 17, Leases
Redeliberations of the leasing project: Some new twists
Whats inside: Overview Status of redeliberations The path forward Appendices
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 re-expose 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.
Reprinted from: Dataline 201121 May 6, 2011
10
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: Does the transaction represent a lease or does it contain a lease? (See paragraphs 6-22 of this Dataline)
Start
No
Apply other accounting guidance
Yes
Is the Lease a short-term lease as defined? (See paragraphs Yes 4346 of this Dataline) (Optional)
Apply existing operating lease accounting model
No
Apply finance lease accounting
No
Is the Lease an other-thanfinance lease? (See paragraphs 2329 of this Dataline)
Yes
Apply other-thanfinance lease model: recorded on balance sheet but straight-line rent in income statement
11
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.
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.
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 FASBs website at www.fasb.org or the IASBs website at www.ifrs.org.
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.
5. For more information on key aspects

of the ED, refer to Dataline 201038, A new approach to lease accounting Proposed rules would have far reaching implications (provides an overview and various insights into the ED), Dataline 201105, 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 todays accounting with less complexity and less cost
12
Status of redeliberations
Key decisions reached
Definition of a lease
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 purchase arrangements).1
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
1 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.
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.
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). 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).
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 customers 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
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
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
13
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.
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.
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.
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 customer is providing the raw materials (e.g.,
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.
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.
21. If use of the asset cannot be separated

from the services performed, the customer has not obtained control
14
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.
considered finance leases or not) would be recorded on the balance sheet, with the exception of shortterm 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.
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.
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.
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. 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 lessees 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 non-leased 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.
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.
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.
Variable or uncertain payments
30. Many respondents to the ED believed

that certain types of contingencies should be included in the lessees liability to make lease payments and the lessors right to receive lease payments. However, they were
26. The boards decided that all leases

(irrespective of whether they are
15
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.
redeliberated issues on the potential reassessment of contingencies and the impact on the profit and loss recognition pattern.
which they pertain, similar to the approach under todays guidance.
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 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
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.

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
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 lessees guarantee of lessor debt related to the leased property). Under the revised approach, managements 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.
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).
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.

any contingent amounts would be included using a best estimate approach rather than the probabilityweighted approach proposed in the ED. The boards have not yet
16
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 todays 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. 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)?
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 straightline 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
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
17
for lessees would also be applied to lessors, presumably also with reassessment, where appropriate. This would represent a significant change to todays model even if the rest of the core provisions of current guidance for lessors are largely retained. 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.
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 shortterm 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 shortterm 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 shortterm 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.
of identifying and tracking shortterm leases at each reporting period, and may alleviate the need to determine if certain shortterm 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.
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.
Tentative decisions in other areas

Short-term leases
43. The ED provided a simplified method

to ease the burden of accounting for short-term 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-bylease 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-by-lease basis not to recognize assets or liabilities
46. The boards confirmed that a shortterm 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
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
18
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 multipleelement 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 nonlease components based on the allocation method in the proposed revenue recognition standard.
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.
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).
In-substance sales and purchases
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.
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.
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.
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
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.
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
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
19
it in accordance with existing guidance.2 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.
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.
Discount rate
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.
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.
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.
Lease incentives
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.
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.
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.

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.
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.
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 lessees incremental borrowing rate, the rate implicit in the lease or, for leases of property, the yield on the property.
IAS 37, Provisions, Contingent Liabilities and Contingent Assets, or ASC 450, Contingencies
65. From a lessor perspective, amounts

paid to lessees that meet the definition
69. The boards also tentatively agreed

that if a lessee determines it has a
20
significant economic incentive to exercise the purchase option, the right-ofuse asset would be amortized over the economic life of the asset rather than over the lease term.
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.
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
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 840-4025, 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.
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.
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
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):
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.
21
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 arrangements 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.
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.
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 3Power 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
Example 1Equipment 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 customers 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
Example 2Real 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 between 8 a.m. and 5 p.m. The tenant also has discretion over the activities performed within
22
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.
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 manufacturers specifications. All output from this equipment will be purchased by the manufacturer. 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 suppliers 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 customers 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 customers consent (i.e., supplier could use any 25 rail cars of a particular specification to transport the customers 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 customers 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 customers location when not in use.
Example 4Captured 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
23
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 fiveyear 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.
24
Appendix B Financial statement impact of finance and other-than-finance leases

The example below illustrates the difference between the finance and otherthan-finance lease models for a lease of a 100,000 square foot building with a 10-year 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 lessees 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 otherthan-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 todays operating lease accounting model. It also results in a similar cash flow statement presentation as cash flows will be included within the operating section.
25
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 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) Differencecurrent period Differencecumulative Cash (paid in monthly installments) Cummulative cash $ B A-B $ $ $ 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 A $ 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 $ $ $ $ (422) $ $ (775) $ $ (1,050) $ $ (1,239) $ 15,540 (15,540) $ 14,408 (14,598) $ 13,207 (13,547) $ 11,928 (12,377) $ 10,563 (11,080) Inception $ 15,540 (15,540) Year 1 $ 13,986 (14,598) Year 2 $ 12,432 (13,547) Year 3 $ 10,878 (12,377) Year 4 $ 9,324 (11,080)
26
Year 5 $ 7,770 (9,645)
Year 6 $ 6,216 (8,062)
Year 7 $ 4,662 (6,318)
Year 8 $ 3,108 (4,403)
Year 9 $ 1,554 (2,302)
Year 10 $ 0 0
9,103 (9,645)
7,538 (8,062)
5,857 (6,318)
4,049 (4,403)
2,101 (2,302)
0 0
$ $
(1,333) -
$ $
(1,322) -
$ $
(1,195) -
$ $
(941) -
$ $
(547) -
$ $
0 -
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 $ $ $ 1,460 730 2,190 94 1,333 $ 2,165 10,408 $ $ $ $ 1,565 625 2,190 (11) 1,322 2,208 12,616 $ $ $ $ 1,681 509 2,190 (127) 1,195 2,252 14,869 $ $ $ $ 1,808 382 2,190 (254) 941 2,297 17,166 $ $ $ $ 1,948 242 2,190 (394) 547 2,343 19,509 $ $ $ 2,101 89 $2,190 (547) 2,391 21,900 $ $ 15,540 6,360 21,900
27
Defining a lease FASB and IASB suggest changes to the Leases exposure draft
Whats new?
Last week, the FASB and IASB (the boards) discussed three key areas in their leasing project. Those areas include (1) definition of a lease, (2) variable lease payments, and (3) profit and loss recognition pattern. The decisions reached last week would significantly change their proposals in the Leases Exposure Draft issued in August 2010. 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 FASBs website at www.fasb.org or the IASBs website at www.ifrs.org.
Reprinted from: In brief 201115 April 19, 2011

The tentative decisions made last week are summarized as follows: Area Definition of a lease Summary of decisions The boards affirmed their decision 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. In addition, the boards have tentatively decided to revise the guidance for distinguishing a service from a lease. Existing guidance in this area 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). The new guidance will define a specified asset as an asset that is uniquely identified or identifiable. They further agreed that a physically distinct portion of a larger asset can be a specified asset. However, access to the capacity of a larger asset would not be a specified asset. For example, two floors of a six floor building would meet the criteria of physically distinct, whereas a portion of the capacity of a pipeline would not. The boards also decided that the concept of control should be revised to be consistent with the revenue recognition project. The final standard will provide indicators to assess when the right to control exists for the use of a specified asset. These indicators will be based on whether the customer has the ability to direct the use of, and receive benefits from, the asset.
28
Area Accounting for variable lease payments
Summary of decisions The boards revisited certain aspects of accounting for variable payments (contingent rent). They tentatively agreed that variable lease payments that are usage or performance based (e.g., tenant sales based) would not be considered in measuring the lease asset and liability unless the variable lease payments are in-substance fixed lease payments (i.e., anti-abuse provision). This decision reverses a portion of their tentative conclusions reached in February 2011. Previously, the boards had decided to include usage or performance contingencies that are reasonably assured (IFRS) or probable (US GAAP) to be paid. Other aspects of the earlier tentative decisions remain unchanged, such as the decision to include all contingencies that are based on a rate or an index and any portion of residual value guarantees that are expected to be paid.
With respect to lessee accounting, 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 tentatively agreed to use indicators similar to those in IAS 17, Leases, as the basis for distinguishing between the two categories of leases. While the boards decided that all leases would be on balance sheet, they concluded that the expense recognition pattern may be different for each type of lease. Those leases that are primarily financing transactions would have a recognition pattern similar to a financed purchase, as proposed in the exposure draft. Those that are not primarily financing in nature would have a recognition pattern more closely aligned with todays straight line rent under operating lease accounting. The boards expect to further discuss the mechanics of the straight line expense recognition pattern in the coming weeks.
The boards jointly issued the exposure draft on Leases, with no major areas of divergence. They are jointly redeliberating the exposure draft, and convergence is expected to be achieved.

Whats next?
The boards will continue redeliberations over the coming months. The boards will continue to discuss how to distinguish between the two types of leases for lessees, the profit and loss recognition pattern, 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.
Whos affected?
29
IASB/FASB leasing redeliberations March 2011 (third March meeting)
Whats inside: What is the issue? Sale and leasebacktentative decision Contracts that contain a lease tentative decision Initial recognition and measurementtentative decision Determination of the discount ratetentative decision Initial direct coststentative decision
What is the issue?

The boards met this week with yet another long list of secondary re-deliberation issues, namely: sale and leaseback; contracts that contain a lease; initial recognition and measurement; determination of the discount rate; and initial direct costs. Tentative decisions were made on each of these issues (summarised below). The next step is for the staff to bring back the remaining key redeliberation issues to the board for decisions in April, following the completion of the consultation efforts.
Reprinted from: Straight away March 25, 2011
Sale and leaseback tentative decision

In a change from the exposure draft proposals, the boards have tentatively decided that a transaction should be accounted for as a sale and leaseback transaction when a sale occurs, using the control criteria in the proposed revenue recognition standard. They also confirmed that the seller/lessee can record a sale upon sale of the whole asset. Where the sale criteria are not met, the transaction would be accounted for as a financing lease. The additional risk and rewards assessment proposed in the exposure draft has been removed. The boards confirmed their original proposal that, when consideration for the underlying asset is at fair value, any gains or losses arising from the transaction should not be deferred. Where the consideration is not at fair value, the assets and liabilities and gains or losses recognised should be adjusted to reflect current market rentals.
Contracts that contain a leasetentative decision

The boards discussed the issue of multiple element contracts and which components should be separated when a lease contract also includes non-lease components. The boards have tentatively decided that all non-lease components, including services and other executory costs, should be separated and accounted for in accordance with applicable guidance. For lessors, it was tentatively agreed that they should be required to allocate all payments required by the contract between the lease and non-lease components, consistent with an allocation method in the revenue recognition project. For lessees, it was tentatively decided that they should be required to allocate between lease and non-lease components based on their relative stand-alone purchase price. However, where the purchase price of only one component is
30
observable, a lessee is permitted to use the residual method to allocate the price to the component for which there is no observable price. It was also clarified that a lessee does not have to hunt for observable prices. Where there are no observable prices for any of the components, the entire contract should be treated as a lease.
Determination of the discount rate tentative decision

The boards tentatively decided that a lessee should use the incremental borrowing rate or the rate the lessor charges the lessee if readily determinable, as proposed in the exposure draft. The boards have clarified that if both rates are available, the lessee should use the rate the lessor charges the lessee; however, a lessee would not be expected to use extreme measures to determine the rate the lessor charges the lessee. The boards also tentatively decided that a lessor should use the rate charged in the lease. Additional guidance will be provided in the standard on how to apply the discount rate to specific circumstancesor example, for property leases, determining the yield on property.
Initial recognition and measurement tentative decision

It was tentatively decided that a lessee and lessor should recognise and initially measure lease assets and liabilities at the date of commencement of the lease. This is a change from the exposure draft, where it was proposed that measurement would be at the date of inception of the lease and recognised on the date of commencement. It was also tentatively decided that a lessee should use its incremental borrowing rate calculated at the date of commencement when using that rate to measure the liability to make lease payments. Any costs incurred by the lessee before the date of commencement relating to the construction of the underlying asset would be outside the scope of the lease standard (common with build-tosuit leases). The lessee will apply other relevant standards when accounting for such construction costs. The boards also tentatively decided that lease payments made prior to the lease commencement date should be recognised as a pre-payment. This pre-payment balance would be transferred to the rightto-use asset on the date of commencement.
Initial direct costs tentative decision

The boards confirmed that the definition of initial direct costs will be costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made. This is consistent with the proposed definition in the exposure draft, except for the removal of the notion of recoverable; it was felt that this was implicit in the definition. Initial direct costs should be included in the amount recognised for the lessees right-to-use asset and the amount recognised for the lessors lease receivable.
31
FASB and IASB propose additional changes to the leases exposure draft
Whats new?
The FASB and IASB (the boards) have met twice in March to discuss their joint project on leasing and have additional meetings planned throughout the remainder of March. The focus of the most recent meetings was to discuss and reach tentative decisions on several items in a long list of secondary redeliberation issues including: (1) short-term lease accounting, (2) guidance for distinguishing a lease from a purchase or sale, (3) accounting for purchase options, and (4) scope. 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 FASBs website at www.fasb.org or the IASBs website at www.ifrs.org.
Reprinted from: In brief 201110 March 18, 2011

The tentative decisions made this month thus far are summarized as follows: Area Short-term lease accounting Summary of decisions 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 in the exposure draft. The boards re-confirmed that a short-term lease is defined as a lease that, at the date of commencement of the lease, has a maximum possible lease termincluding any options to renew or extendof 12 months or less. The short-term lease guidance will be an accounting policy choice made on an asset class basis. The boards also confirmed that the lease payments for short-term leases should be recognized by a lessee and a lessor on a straight-line basis in the income statement unless another systematic and rational basis better represents the time pattern in which use is derived from the underlying asset. This is similar to existing guidance for operating leases.
32
Area Guidance for distinguishing a lease from a purchase and sale
Summary of decisions The boards tentatively decided that the final lease accounting standard will not include guidance for distinguishing a lease of an underlying asset from an in-substance purchase or sale of the asset. They have agreed that a contract should be accounted for in accordance with the lease standard where the definition of a lease is met. Where the definition of a lease is not met, the contract should be accounted for in accordance with other applicable standards, such as revenue recognition by lessors and PP&E by lessees, where there is a sale or purchase of the underlying asset. The boards have tentatively agreed that lessees and lessors should account for purchase options consistent with their tentative decision on renewal options that is, purchase options should be included in the measurement of lease payments where there is significant economic incentive to exercise the option, such as a bargain purchase option. The staff has been instructed to conduct targeted outreach to determine whether reassessment of such options would be very common in practice and to obtain more information on the costs and benefits of reassessment. The boards confirmed that the scope of the leasing standard would be the same as the scope described in the exposure draft.
Accounting for purchase options
Scope
The boards jointly issued the exposure draft on Leases, with no major areas of divergence between the boards. They are jointly redeliberating the exposure draft, and convergence is expected to be achieved.

Whats next? Whos 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 will continue redeliberations throughout the remainder of March and over the coming months. The FASB staff and IASB staff are performing targeted outreach. A final standard remains targeted for mid-2011. We will continue to keep you informed of the significant redeliberation decisions.
33
US GAAP Convergence & IFRS Fair value measurement

March 2011
FASB and IASB joint project near completion
Whats inside: Overview Key provisions Differences between US GAAP and IFRS Next steps
The FASB and IASB are close to completing their joint project on fair value measurement. Except for effective dates and transition, the boards have completed their redeliberations and plan to finalize their new, respective standards in March 2011. The joint project is part of the Memorandum of Understanding between the FASB and IASB. The objective of the project is to bring together as closely as possible the fair value measurement and disclosure guidance of the two boards. On June 29, 2010, both boards issued exposure drafts of proposed changes to their standards to achieve this goal. The IASBs exposure draft reflects significant changes to the proposed disclosures set out in its May 2009 exposure draft. In response to feedback on its ED, the FASB decided to make certain changes and clarifications to its proposal. Similar changes are also expected in the IASBs final standard. Although many of the changes to existing USGAAP will not have a significant effect on practice, some will.
This Dataline is based on the information in Dataline 2010-33, FASB and IASB propose changes to fair value measurements and disclosures. It summarizes key aspects of the ED and decisions reached by the FASB and IASB during redeliberations conducted subsequent to the issuance of their exposure drafts. Although all decisions are tentative until a final standard is issued, there is currently no indication that any of the boards key tentative decisions on this project will be revisited.
The main details

1. Since 2008, entities that report under
US generally accepted accounting principles (USGAAP) 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 USGAAP. Facing potential divergence between International Financial Reporting Standards (IFRS) and USGAAP as a result of the comments received by the IASB, 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 is part of the Memorandum of Understanding between the boards.
2. The boards have agreed on many

aspects of the project, 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 offsetting risks), and disclosures. Certain of the proposed changes 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 will not be resolved through this project. Those differences 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) and the valuation of certain investments that report a net asset value (NAV).
3. This Dataline describes the key

proposed changes, as well as other notable clarifying guidance included in the FASBs proposals, updated to reflect the results of the boards redeliberations. It also highlights certain similarities and differences between the proposed changes to USGAAP and to IFRS. The comment periods for the boards proposals ended on September 7, 2010 and the boards are currently expected to finalize their respective standards in March 2011. Except for effective dates and transition, the boards have finalized their redeliberations. Those remaining discussions are expected to occur in March 2011. PwC observation: Key issues raised during the comment process focused on the need for
clarification or reconsideration of the measurement uncertainty disclosure, the elimination of the highest and best use concept, which establishes the valuation premise, for all fair value measurements other than for nonfinancial assets, and the proposals regarding blockage factors and other premiums and discounts. The boards have decided to make certain clarifications and deal with the proposed measurement uncertainty analysis disclosure in a separate phase of the project. However, those changes may not fully address the concerns raised by many constituents. For example, we expect that the final standard issued by the FASB will continue to require certain quantitative disclosures about unobservable inputs as well as qualitative disclosures about the sensitivity inherent in Level 3 fair value measurements. These disclosures may, similar to the requirement proposed in the ED, be time consuming and costly to prepare with limited benefit.
valuation premise and the concept of highest and best use which establishes that premise. Under existing USGAAP, the valuation premise incorporates two approaches for determining the highest and best use of an asset: in-use and in-exchange. In-use 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 standalone basis.
6. The FASB proposed to eliminate

the terms in-use and in-exchange. Instead, the objectives of the valuation premise would be described such that an asset or a liability would be used either in combination with a group of assets, with a group of liabilities, or with a group of assets and liabilities (formerly in-use), or on a standalone basis (formerly in-exchange).
7. Of greater consequence however,

is the FASBs (and IASBs) proposal that the concepts of the valuation premise and highest and best use are only relevant when measuring the fair value of nonfinancial assets (and therefore would not apply to financial assets or any liabilities). During redeliberations, the boards reaffirmed this principle as proposed. This will result in a significant change to ASC 820, which 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. The proposal therefore prohibits the grouping of financial
Key provisions
4. The following FASB key provisions
are consistent with what the IASB currently plans to issue.
Primary changes
Valuation premise and highest and best use
5. One of the most significant areas

of proposed change involves the
instruments for purposes of determining their fair values and requires that their fair values be measured at the level of the unit of account as specified in other guidance.
8. The boards reached this conclusion

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 non-financial assets, such as land. Therefore, the fair value of financial assets would need to be measured based on the unit of account of the underlying item. For example, aggregating individual financial assets (such as a block position of a particular equity security) into a pool of securities or block position would no longer be permitted in arriving at a valuation, but rather measurement would have to be based on the value of the individual security consistent with the unit of account defined by other guidance. This would 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 or insurance policy risks. Eliminating it for financial instruments has the potential to 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.
Measuring portfolios of financial instruments
9. The boards proposed an exception

to the valuation premise when an entity manages its market risks and/ or counterparty credit risk exposure within a group (portfolio) of financial instruments on a net basis. This exception would also apply to portfolios of derivatives that are managed on a net basis and recorded at fair value on a recurring basis. In these circumstances, this exception would allow 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 would be measured under the proposed guidance, which would require measurement of each security within the portfolio on its own (that is, on a gross basis).
hold financial instruments manage financial assets and financial liabilities in this manner (that is, based on the net long or net short position for a particular market risk or counterparty credit risk). The ED articulates that the net risk exposure of a group of financial assets and financial liabilities is a function of the instruments the entity decides to hold and its tolerance for risk relative to a position (that is, entity-specific decisions that would not normally form part of a fair value measurement). The boards recognized that market participants holding the same group of financial instruments would likely price them in the same way. Therefore, this exception is intended to result in financial reporting that provides more information about the relationship between a reporting entitys business strategy and the fair value of the financial instruments that are in a portfolio with offsetting risks, while addressing a practical issue for entities that manage their portfolios in this manner.
11. In order to qualify for either the

exception related to market risks or credit risk, the ED proposed four overall criteria that the reporting entity must meet as follows: 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
10. This exception to the valuation

premise was proposed based on the results of outreach performed by staff of the FASB and IASB. The results indicate that many financial institutions or similar entities that
example, commodity price risk for commodity derivatives). It provides information on that basis about the group of financial assets and financial liabilities to management (for example, the reporting entitys board of directors or chief executive officer). It manages the net exposure (to a market risk or counterparty credit risk) in a consistent manner from period to period. 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.
market risks that are being offset be substantially the same in order for the entity to use the exception to measuring fair value at the level of the unit of account (paragraph 9 above). Further, 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 entitys net exposure to those market risks). The adjustments applied to the net position would then need to be allocated among the positions in the portfolio to arrive at their individual fair values. 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. During board redeliberations, discussions were held about what is meant by substantially the same. These discussions seemed to suggest the availability of the exception may be narrow as compared to the current practice of offsetting risks in the marketplace.
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 would be applied to the net position based on the counterpartys credit risk in the case of a net asset position or the reporting entitys 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 prohibited for Level 2 and Level 3 fair value measurements under ASC 820.
12. As a result of feedback from constituents, the boards decided to remove the requirement contained in the third bullet above, recognizing that portfolios are not static. Since the composition of a portfolio changes continually due to rebalancing and as an entity changes its risk exposure preferences over time, this requirement would have limited an entitys ability to use the exception. Therefore the boards decided to clarify that the reporting entity must make an accounting policy decision to use the exception and must meet the remaining listed criteria. The boards also decided to provide some guidance about how an entity may consider allocating its bid-ask and credit portfolio adjustments among the positions within the portfolio.
16. The ED proposed to continue to

prohibit the application of blockage factors for Level 1 fair value measurements but also to eliminate the application of blockage factors for all levels in the fair value hierarchy, on the basis that the incurrence of a blockage factor is an entity-specific decision (which does not form part of a fair value measurement). The boards have since decided to clarify that a fair value measurement that is not a Level 1 measurement may include premiums or discounts when market participants would do so when pricing the asset or liability given the unit of account specified in other guidance. In the absence of the unit of account
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 have a legally enforceable right to set off with the counterparty in the event of default (for example, through a master netting agreement). In a portfolio of financial assets and liabilities (including derivatives) within a master netting agreement,
Offsetting market risks

outlined in paragraphs 11 and 12 above, the proposal requires that
being defined within USGAAP, an entity would apply premiums or discounts if market participants would do so to maximize the fair value of an asset or minimize the fair value of a liability, on the basis of how market participants would enter into a transaction for the asset or liability. Adjustments to the inputs for assets or liabilities deemed to be within Level 1 of the fair value hierarchy would continue to be precluded (that is, if a fair value measurement is a Level 1 fair value measurement, additional premiums or discounts could not be applied to the Level 1 input(s)).
17. The boards also decided to clarify

that the concept of value maximization is fundamental to the fair value measurement of financial instruments because market participants would enter into transactions that maximize fair value. The concept of value maximization would therefore apply as follows: If the unit of account is specified in other guidance, the concept of value maximization would apply when determining fair value at the level of the unit of account. If the unit of account is not specified in other guidance, fair value would be determined including the use of premiums and discounts as appropriate, applying the concept of value maximization.
individual instrument. As a result, control premiums will not be applicable when the unit of account is the individual instrument. Instead, application of control premiums would be permitted only in the case of a unit of account that is specified in USGAAP and provides a greater level of aggregation than the individual security or when the unit of account is not specified in USGAAP and aggregation would be consistent with market participant assumptions. This may be the case with a reporting unit for which fair value is applied in connection with a business combination or goodwill impairment testing. PwC observation: The guidance regarding premiums and discounts may require changes to current practice for investments held in blocks owned by private equity or investment companies. In such cases, if a block of securities was purchased at a premium, this change may result in the immediate recognition of losses because fair value could no longer be determined using a control premium. Conversely, immediate gain recognition may occur if a block of securities was purchased at a discount.
regarding Level 3 fair value measurements will be required. The new disclosures that the boards agreed to are described below.
20. For Level 3 fair value measurements,

quantitative information about unobservable inputs and assumptions used, a description of the valuation control processes in place, and a qualitative discussion about the sensitivity of recurring Level 3 fair value measurements will be required. These disclosures will 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. In response to cost/benefit concerns raised by constituents regarding the proposed measurement uncertainty analysis disclosure, the boards determined that additional outreach and field testing would be performed as a separate phase of the overall fair value measurement project. PwC observation: Although the boards agreed to perform additional work before requiring the proposed measurement uncertainty analysis disclosure, it is unclear whether the alternative disclosures that will be required will be any more or less complex and costly to prepare. While the specific requirement for Level 3 fair value measurements will not be known until the final standards are released, the requirement to include quantitative information as well as qualitative information about sensitivity and
Disclosures
18. The unit of account of the asset or

liability being measured determines the premiums or discounts that can be applied. For example, control premiums are applied in the context of a controlling interest and not in the context of a holding of securities where the unit of account is the
19. The ED includes some new and

revised disclosure requirements. During redeliberations, the boards decided to retain most of the proposed disclosures with some clarifications. However, the proposed measurement uncertainty disclosure was deferred pending further outreach and field testing. Certain additional disclosures
inter-relationships between unobservable inputs may continue to draw similar cost/benefit concerns from constituents.
under the market participant principles in ASC 820, but the entity is using the asset differently in its business, it will be required to disclose that fact and the reason(s) why.
Other new or clarifying guidance

Instruments classified within shareholders equity
21. The FASB has also proposed a subtle,

yet potentially significant, change to existing disclosure requirements for transfers of fair value measurements among levels in the fair value hierarchy. Currently, USGAAP requires disclosure of any significant transfers between Level 1 and Level 2, including the reasons for those transfers. The FASB will now require that public companies disclose any such transfers, whether significant or not, including the reasons for those transfers. While this proposed change has not been highlighted by the FASB as a key change, the requirement to disclose any such transfers is broader than the current requirement, which focuses on significant transfers, and may be more operationally difficult to apply in practice.
23. The ED 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 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).
25. 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. The proposed 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. The boards decided during redeliberations that an entity may apply the guidance on measuring the fair value of liabilities when measuring instruments classified within shareholders equity at fair value. This proposed guidance is not expected to result in a change in practice under USGAAP for the valuation of instruments classified in shareholders equity. However, some entities could experience a difference if they have historically used another method to value these instruments.
Disclosure exceptions for nonpublic entities
22. Also included in the proposals is a

new 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, it would be required to disclose the reason(s) why the asset is being used differently. This would be 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
24. No exceptions to the principles of fair

value measurement will be 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.
Principal (or most advantageous) market
26. The IASB received comments indicating a lack of clarity about the concept of principal market in its original fair value measurements exposure draft. Therefore, the boards jointly deliberated and concluded that a clarification on how the principal
market is determined should be provided. The ED 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 change from existing USGAAP, since currently ASC 820 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 ED 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. The boards decided to retain the guidance proposed in the ED. 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.
Application to liabilities
28. Two clarifications proposed to the

guidance for measuring the fair value of liabilities were reaffirmed by the boards during their redeliberations. The first requires that transfer restrictions on liabilities should 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.
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 USGAAP 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.
Effective date and transition

30. The FASB has yet to determine the
effective date. Within its overall request for feedback on effective dates and transition methods as part of the joint project by that name, the IASB specifically requested feedback from constituents about the fair value measurement project (whereas the FASB did not). The FASB has determined that it will consider the responses that the IASB receives specific to the fair value measurement project for purposes of finalizing the effective date for that project.
29. The second clarification pertains to

the income approach for liabilities. When measuring the fair value of a liability using a present value technique, USGAAP currently requires that a reporting entity include the compensation that a market participant would require for taking on that obligation. The boards have agreed 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
27. In addition to the clarification of

the principal market, the ED 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 would continue to incorporate transportation costs but would exclude transaction costs unless specifically required by other U.S.GAAP. This does not represent a difference from how USGAAP is applied today.
31. The FASB is expected to finalize

transition guidance concurrently with the effective date. The ED proposed that the new guidance would be effective as of the beginning of the period of adoption, with a cumulative effect adjustment to beginning retained earnings in the period of adoption. That cumulative effect
adjustment would reflect differences in fair value measurements resulting from applying the new guidance. New disclosures would be required prospectively upon adoption.
the following in newly proposed 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.
Differences between USGAAP and IFRS

32. The impetus for this joint project
was convergence of the fair value measurement and disclosure guidance between USGAAP and IFRS. Based on the proposals and board redeliberations, 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, two key differences between the fair value measurement and disclosure guidance under USGAAP and IFRS would continue to exist, as described below.
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.
34. In contrast, certain standards within

IFRS contain guidance restricting day one gains and losses when the fair value measurement is based on inputs that are not observable. This guidance will remain in place, for example, within IAS 39, Financial Instruments: Recognition and Measurement, as carried forward by IFRS 9, Financial Instruments. The IASB has not addressed whether it will change that guidance.
37. The FASB retained this guidance in

its proposal. However, under IFRS, there currently is no 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.
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 assets and liabilities.
Next steps
38. The FASB and IASB expect to finalize
their standards in March 2011, after completing their redeliberations on transition and effective dates. PwC observation: While many of the proposed changes to US 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 new required disclosures) could have a significant impact on current practice. Reporting entities should familiarize themselves with the proposals and the boards decisions coming out of redeliberations, and consider the potential impact on their financial reporting.
Day one gains and losses

33. The issuance of ASC 820 resulted in
a difference between USGAAP 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 ED confirmed that guidance by adding
Measuring the fair value of alternative 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
July 2011
USGAAP Convergence & IFRS Fair value measurement: Updated July 31, 2011
Table of contents

FASB and IASB complete joint project
FASB and IASB issue final fair value guidance
10
Fair value measurement FASB and IASB complete joint project

Whats inside: Overview Key provisions Effective date andtransition Differences between USGAAP andIFRS Next steps
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 USGAAP andIFRS. Many of the changes in the US 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 US guidance is effective for interim and annual periods beginning after December 15, 2011. For nonpublic companies that apply US 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 annualperiods.
Reprinted from: Dataline 201123 June 9, 2011
The main details

1. Since 2008, entities that report under
US generally accepted accounting principles (USGAAP) 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 USGAAP. Facing potential divergence between International Financial Reporting Standards (IFRS) and USGAAP, the FASB and the
2
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 USGAAP 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 USGAAP and is a new standard underIFRS.
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 disclosurerequirements.
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.
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 in-exchange 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.
Key provisions
5. The following key provisions are
consistent between USGAAP andIFRS.
4. This Dataline describes the key

changes to USGAAP as well as other notable clarifying guidance included in the ASU. It also highlights key differences that will remain between USGAAP 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
Primary changes toUSGAAP

Highest and best use and the valuation premise
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 in-use), or on a standalone basis (formerly in-exchange). An example of a
6. Under existing USGAAP, the valuation premise incorporates two approaches for determining the highest and best use of an asset: in-use and in-exchange. In-use refers to a valuation premise for an asset that provides maximum value
Fair value: Updated July 31, 2011
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 non-financial 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.
orcredit 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 tomanagement. It is required to or has elected to measure the financial assets and financial liabilities at fair value in the balance sheet at each reportingdate.
Measuring portfolios of financialinstruments
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).
12. The reporting entity must make an

accounting policy decision to use the exception and apply it consistently from period to period for theportfolio.
Offsetting market risks

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 entitys net exposure to those market risks). The adjustments applied to the net position will then need to be
11. In order to qualify for either the

exception related to market risk(s)
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).
liabilities separately. The adjustment will be applied to the net position based on the counterpartys credit risk in the case of a net asset position or the reporting entitys own credit risk in the case of a liability position.
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, withoutadjustment).
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.
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 entity-specific 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
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
Offsetting credit risks

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
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.
result in significant differences inmeasurement.
20. The new guidance also requires

that US 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 USGAAP, which focuses on significant transfers, and may be more operationally difficult to apply in practice.
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 nonpublicentities
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 onlydisclosed. 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.
21. Also included in the new guidance is a

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. 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 originally-proposed 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
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.
Other new or clarifyingguidance

Principal (or most advantageous)market
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 disclosureonly in accordance with ASC 825) be categorized in the fair value hierarchy with disclosure of that categorization.
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 change from existing USGAAP, 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 entitytransacts.
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.
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
28. 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 participant assumptions. This new guidance is not expected to result in a change in practice under USGAAP. However, some entities could experience a difference if they have historically used another method to value these instruments.
27. The second clarification pertains to

the income approach for liabilities. When measuring the fair value of a liability using a present value technique, USGAAP 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 USGAAP requires that reporting entities include market participant
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 USGAAP. This does not represent a difference from how USGAAP is applied today.
Application to liabilities
26. 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
Effective date andtransition

29. 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. Thenew guidance requires prospective application.
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 USGAAP and IFRS will continue to exist, as described below.
Financial Instruments: Recognition and Measurement, and IFRS 9, Financial Instruments. The IASB has not addressed whether it will change thatguidance.
34. 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 andliabilities.
Day one gains and losses

32. The issuance of ASC 820 resulted in
a difference between USGAAP 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 specifiesotherwise.
Measuring the fair value of certain investments

35. 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 alternativeinvestments.
30. 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, ifpracticable.
Differences between USGAAP and IFRS

31. The impetus for this joint project
was convergence of the fair value measurement and disclosure guidance between USGAAP and IFRS. Based on the new guidance, a high degree of convergence should be achieved for the measurement and disclosure
33. 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,
36. 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.
Next steps
38. 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.
Certain disclosures
37. 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. USGAAP does not contain such a requirement; it requires only the quantitative and qualitative disclosures for Level 3 fair value measurements described above.
39. PwC will issue a supplementary

Dataline in the near future to address specific application issues inmoredepth. PwC observation: While many of the changes to US 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.
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 USGAAP 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 USGAAP and is a new standard under IFRS.

The new guidance results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between USGAAP and IFRS. While many of the amendments to USGAAP 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 USGAAP are described below.

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.
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.
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)
10
and/or counterparty credit risk exposures of a group (portfolio) of financial instruments on the basis of the entitys net 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.
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 valueis disclosed.

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 prospectiveapplication.
Instruments classified Is convergence achieved? within shareholders equity Although the new guidance is substantially
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. 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 USGAAP, 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 USGAAP for the measurement of certain investments that report a net asset value.
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.
Disclosures
The disclosure requirements have been enhanced, with certain exceptions for US non-public 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
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.
11
US GAAP Convergence & IFRS Statement of comprehensive income

March 2011
Statement of comprehensive income
The FASB is expected to allow one continuous statement, or separate consecutive statements of net income and other comprehensive income
Whats inside: Overview Key provisions of the FASBs requirements Comparison with the IASBs requirement Effctive date and transition Reprinted from: Dataline 201108 February 15, 2011 Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
The FASB and IASB (the Boards) issued proposals, in May 2010, to require companies to issue a single continuous statement of comprehensive income. Together the FASB and IASB received over 200 comment letters on the proposed new primary financial statement. Based on their re-deliberations, the Boards are expected to amend their proposals. They have tentatively decided to require 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 would be eliminated. Both Boards are expected to issue final standards incorporating the tentative conclusions by the end of the first quarter of 2011. The new requirements would generally be effective in fiscal years beginning after the end of calendar-2011. Early adoption would be permitted.
The main details

1. In May 2010, the FASB issued a
proposal to require most entities to provide a new primary financial statement, referred to as the statement of comprehensive income. Under the May proposal, all components of net income and other comprehensive income would be reflected in one continuous statement of comprehensive income. The Boards worked jointly on this project, and the IASB concurrently issued a similar proposed amendment to IAS 1, Presentation of Financial Statements. PwC observation: The proposals were consistent with the Boards 2008 discussion paper titled Preliminary Views on Financial Statement Presentation. Although the Boards had intended to propose this new statement as part of their financial statement
presentation projects, they decided to accelerate this change because of the increased use of other comprehensive income that both Boards are considering under other proposals. For example, under the FASBs proposal to revise the accounting for financial instruments (also issued in May 2010), entities would be permitted to recognize in other comprehensive income changes in the fair values of certain financial assets and liabilities that are held for the collection or payment of contractual cash flows. (See Dataline 201025 for more information.) Similarly, the IASB issued IFRS 9, Financial Instruments, which permits an entity to make an irrevocable election to present in other comprehensive income changes in the fair value of any investment in equity instruments that are not held for
trading. And, in April 2010, the IASB issued an Exposure Draft titled Defined Benefit Plans proposing that actuarial gains and losses be recognized in the balance sheet in full through a charge or credit to other comprehensive income in the periods in which the gains and losses occur. Those amounts would not be subject to subsequent amortization into net income, as is currently required under US GAAP. (See Dataline 201023 for more information.)
preferred not to delay finalizing this project until they had developed a conceptual basis for other comprehensive income. The Boards are expected to consider later this year whether to add a project to address those questions.
non-owner transactions that affect an entitys equity.
5. The Boards are expected to issue their

respective final standards before the end of the first quarter 2011. It is anticipated that the new requirements would become effective in 2012 with full retrospective application required. Early adoption would be permitted.
3. The Boards have considered constituents feedback on their proposals and have tentatively decided not to require a single continuous statement of comprehensive income. Instead, they will allow entities to present items of net income and other comprehensive income either in one continuous statement or in two separate, but consecutive, statements. Most other aspects of their May 2010 proposals were reaffirmed. This Dataline reflects the decisions that we anticipate will be formalized in a soon to be issued FASB accounting standards update.
Key provisions of the FASBs requirements

Scope
6. The new presentation requirements
would apply to all entities that provide a full set of financial statements to report financial position, results of operations, and cash flows. The requirements would also apply to investment companies, defined benefit pension plans, and other employee benefit plans that are exempt from reporting a statement of cash flows under ASC 230, Statement of Cash Flows. An entity that is deemed a notfor-profit entity under ASC 958, Not for Profit Entities, would be outside the scope of the requirements. In addition, an entity would continue 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 would also apply to investment companies, defined benefit pension plans and other employee benefit plans, those entities typically do not have items of other comprehensive income and therefore this requirement would not impact most of them.
2. The FASB and IASB received over 70

and 150 comment letters, respectively, on their May 2010 proposals. PwC observation: The majority of preparers who responded opposed the proposal to require one continuous statement of comprehensive income. They believe that the new statement would de-emphasize the importance of net income, the presentation of two measures of income in the same statement could confuse financial statement users, and there is no compelling reason for the proposed changes. Some significant investor groups, however, supported the proposed change on the basis that it appropriately raises the profile of comprehensive income. Furthermore, many constituents called for the Boards to address the conceptual basis for items to be included in other comprehensive income and what items should be subsequently recycled to net income. While the Boards generally agreed with the longer term need to address those questions, they
4. The new requirements would 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 would not change; it would continue to be based on net income. Nevertheless, the Boards felt that these presentation changes were needed because of the potential for more items to be reflected in other comprehensive income under other proposals. The requirements are intended to enable easier comparability of entities reporting between the two sets of standards and to provide a more consistent method of presenting
The alternatives
7. An entity would be able to elect to
present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. An entity would be required to display each component of net income and each component of other comprehensive income under either alternative. In addition, totals would need to be displayed under either alternative for comprehensive income and each of its two partsnet income and other comprehensive income.
9. Reclassification adjustments between

net income and other comprehensive income would have to be shown on the face of the statement(s). The current option to disclose reclassification adjustments in the footnotes would be eliminated.
Accumulated balances
12. The components of accumulated
other comprehensive income would need to be displayed separately from retained earnings on the statement of changes in equity or in the footnotes. Currently, entities have the option to present these accumulated balances on the statement of financial position, the statement of changes in equity, or in the footnotes.
10. An entity would, if applicable,

continue to separately disclose items of net income and comprehensive income attributable to its parent and any non-controlling interest. In addition, the requirement would 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
Statement of changes in equity

13. Entities would continue to be able to
present accumulated other comprehensive income components either gross or net of the related tax effects on the statement of changes in equity.
8. Under either alternative, the

statement(s) would be required to be presented with equal prominence as the other primary financial statements. The current alternative option to report other comprehensive income and its components in the statement of changes in equity would be 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 lead some 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.
Example presentation Tax effects

11. The option to present components
of other comprehensive income net of the related tax effects or before the related tax effects with one amount reported for the tax effects of all other comprehensive income items would continue to be available. Entities would still be 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 for reclassification adjustments.
14. The examples on pages 4 and 5 illustrate some of the alternative presentation requirements:
Example 1: Single statement

Statement of comprehensive income For years ended Dec. 31 2012 Revenues Expenses Gains (losses) on sales of available-for-sale securities Income from operations before tax Income tax expense Income before extraordinary item Extraordinary item, net of tax Net income Other comprehensive income, net of tax: Foreign currency translation adjustments Unrealized gains (losses) for the period Less: reclassification adjustment for (gains) losses included in net income Unrealized gains on available-for-sale securities Prior service cost of the period Net loss for the period Less: amortization of prior service cost included in net periodic pension cost Defined benefit pension plan Other comprehensive income Comprehensive income 5,000 450,000 (150,000) 300,000 10,000 (70,000) (5,000) (65,000) 240,000 $ 1,640,000 $ (20,000) 60,000 (50,000) 10,000 5,000 (120,000) (5,000) (120,000) (130,000) 720,000 $ 3,550,000 (2,100,000) 600,000 2,050,000 (600,000) 1,450,000 (50,000) 1,400,000 2011 $ 3,300,000 (1,950,000) (250,000) 1,100,000 (250,000) 850,000 850,000
Example 2: Two separate, but consecutive, statements

Income statement For years ended Dec. 31 2012 Revenues Expenses Gains (losses) on sales of available-for-sale securities Income from operations before tax Income tax expense Income before extraordinary item Extraordinary item, net of tax Net income After page break: Statement of comprehensive income For years ended Dec. 31 2012 Net income Other comprehensive income, net of tax: Foreign currency translation adjustments Unrealized gains (losses) for the period Less: reclassification adjustment for (gains) losses included in net income Unrealized gains on available-for-sale securities Prior service cost of the period Net loss for the period Less: amortization of prior service cost included in net periodic pension cost Defined benefit pension plan Comprehensive income 5,000 450,000 (150,000) 300,000 10,000 (70,000) (5,000) (65,000) 240,000 $ 1,640,000 (20,000) 60,000 (50,000) 10,000 5,000 (120,000) (5,000) (120,000) (130,000) $ 720,000 $ 1,400,000 2011 $ 850,000 $ 3,550,000 (2,100,000) 600,000 2,050,000 (600,000) 1,450,000 (50,000) $ 1,400,000 $ 2011 $ 3,300,000 (1,950,000) (250,000) 1,100,000 (250,000) 850,000 850,000
Comparison with the IASBs requirement

15. The IASBs amendment to IAS 1,
Presentation of financial statements, is expected to be similar to the FASBs final standard. However, some terminology and other differences are anticipated between the two final standards. 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, would continue to allow entities to use other titles for the primary financial statements.
profit or loss in future periods (for example, cash flow hedges and the cumulative translation adjustment) be presented separately from those that will not be recycled (for example, revaluations of property, plant and equipment, and actuarial gains and losses). This distinction does not exist under USGAAP, where all items included in other comprehensive income are subject to recycling.
19. An entity that elects to show items in

other comprehensive income before tax would be 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.
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 final standard will have 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.
20. The IASB is not expected to eliminate

the option to present the components of accumulated other comprehensive income on the face of the statement of financial position. In addition, the IASB is expected to retain the option to disclose reclassification adjustments in the notes to the financial statements. As noted above, the FASB would eliminate those options.
17. Consistent with the FASB, the IASB

decided not to change the items that constitute net profit or loss or other comprehensive income. Earnings-pershare will continue to be based on net profit or loss. Also, entities would continue to have the option to present items of other comprehensive income either gross or net of tax.

21. The new requirements would be
effective as of the beginning of a fiscal year that begins after December 15, 2011 for USGAAP and for fiscal years that begin on or after January 1, 2012 for IFRS. Early adoption would be permitted.
18. The IASB will require that items

included in other comprehensive income that may be recycled into
22. Full retrospective application will

be required under both sets of accounting standards.
US GAAP Convergence & IFRS Statement of comprehensive income: Updated November 30, 2011
November 2011
Table of contents
FASB issues proposal to defer new presentation requirement for other comprehensive income reclassifications Presentation of comprehensive income FASB issues a final standard (and IASB issues an amendment) on the presentation of other comprehensiveincome
2 4
10
FASB issues proposal to defer new presentation requirement for other comprehensive income reclassifications
Whats inside: What is the reason for the proposal? Is convergence achieved? Whos affected? Whats the effective date? Whats next?
Whats new?
On November 8, 2011, the Financial Accounting Standards Board (FASB) issued a proposal to defer the new requirement to present reclassifications of other comprehensive income on the face of the income statement. Companies would still be required to adopt the other requirements contained in the new accounting standard for the presentation of comprehensive income.1
Reprinted from: In brief 201148 November 9, 2011
What is the reason for the proposal?

Issued in June 2011, the new standard on comprehensive income changed the requirement for presentation of reclassification adjustments from other comprehensive income to net income. The new guidance requires reclassification adjustments from other comprehensive income be measured and presented by income statement line item in net income and also in other comprehensive income. This new presentation requirement was made in response to calls from some investors for greater clarity about the impact of reclassification adjustments on net income. However, a number of constituents have highlighted some concerns with this new requirement. 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 FASB had issued its new standard on comprehensive income with the aim of enhancing comparability between entities that report under US GAAP and those that report under IFRS. The standard also eliminated the option to report other comprehensive income and its components in the statement of changes in equity. Instead, companies would be required to present items of net income and other comprehensive income in one continuous statementreferred to as the statement of comprehensive incomeor in two separate, but consecutive, statements. This change would be unaffected by the deferral.
The new standard on the presentation of comprehensive income was a result of a joint project between the FASB and the IASB. However, the new IASB standard did not include a similar requirement to measure and present reclassification adjustments from other comprehensive income by income statement line item in net income and also in other comprehensive income.
1 Accounting Standards Update 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, issued on June 16, 2011
Whos affected?
All entities that report items of other comprehensive income could be affected.
Whats next?
Comments on the proposal are due November 23, 2011. A final standard is expected in late December 2011. The temporary deferral allows the FASB time to further research the matter, including additional outreach to investors and considering alternatives for presenting this information.

If finalized as proposed, the deferral would be effective at the same time that the new standard on comprehensive income is adopted. Entities will still be required to adopt either the single continuous statement or the two-statement approach required by the new standard. However, they would continue to report reclassifications out of accumulated other comprehensive income consistent with the requirements in effect before adoption of the new standard (i.e., 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 new standard is effective for public entities as of the beginning of a fiscal year that begins after December 15, 2011 and for nonpublic entities for fiscal years ending after December 15, 2012 and interim and annual periods thereafter. Early adoption is permitted but full retrospective application is required.
Statement of comprehensive income: Updated November 30, 2011
Presentation of comprehensive income The FASB issues final standard on presenting other comprehensive income
Whats inside: Overview Key provisions of the FASBs requirements Comparison with the IASBs requirement Effective date and transition
The FASB has issued a final standard 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 other comprehensive income will be broadly aligned with IFRS. The new requirements 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.
Reprinted from: Dataline 201124 June 28, 2011
The main details

1. On June 16, 2011, the FASB issued
Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income, requiring most entities to present items of net income and other comprehensive income either in one continuous statementreferred to as the statement of comprehensive incomeor in two separate, but consecutive, statements of net income and other comprehensive income.
report under IFRS. The standards are also intended to provide a more consistent method of presenting non-owner transactions that affect an entitys equity and increase the prominence of items reported in other comprehensiveincome.
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 FASBs tentative proposed classification and measurement approach for financial instruments contemplates changes in the use of other
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 USGAAP and those that
comprehensive income and the IASBs recent amendment to pension accounting requires greater use of other comprehensive income.
4. The new requirements 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 for their 2012 year-end financial statements and their interim and annual periods thereafter. Early adoptionispermitted.
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.
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.
The alternatives
6. 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.
8. If an entity elects the two statement

approach, the second statementthe statement of other comprehensive incomemay begin with net income. The FASB decided not to require an entity to present 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 twostatements.
Key provisions of the FASBs requirements

Scope
5. 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 flows1. Not-forprofit entities2 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
9. Reclassification adjustments between

net income and other comprehensive income must be shown on the face of the statement(s). The previous option to disclose reclassification adjustments in the footnotes has beeneliminated.
7. 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 report other comprehensive income and its components in the statement of changes in equity iseliminated. 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
10. If applicable, an entity will continue

to separately present items of net income and comprehensive income attributable to its parent and any noncontrolling interest. In addition, the requirement does not change: The items that constitute net income and other comprehensiveincome When an item of other comprehensive income must be reclassified to net income The earnings-per-share calculation
1 Refer to ASC 230, Statement of Cash Flows 2 As defined by ASC 958, Not-for-Profit Entities
Tax effects
11. 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 reclassificationadjustments.
Accumulated balances
12. 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
13. The examples on pages 5-6 illustrate some of the alternative presentationrequirements:
Example 1: Singlestatement
Statement of comprehensive income For years ended December 31 2012 Revenues Expenses Prior service cost amortization reclassified from other comprehensive income Gains (losses) on sales of securities Gains reclassified from other comprehensive income 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 Other comprehensive income, before tax3: 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 periodic pension cost 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 $3,550,000 (2,095,000) (5,000) 450,000 150,000 2,050,000 (600,000) 1,450,000 (50,000) 1,400,000 (280,000) 1,120,000 2011 $3,300,000 (1,945,000) (5,000) (300,000) 50,000 1,100,000 (250,000) 850,000 850,000 (170,000) 680,000
3 Alternative presentation is to show net oftax.
Example 2: Two separate, but consecutive, statements

Statement of net income For years ended December 31 2012 Revenues Expenses Prior service cost amortization reclassified from other comprehensive income Gains (losses) on sales of securities Gains reclassified from other comprehensive income 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 $3,550,000 (2,095,000) (5,000) 450,000 150,000 2,050,000 (600,000) 1,450,000 (50,000) 1,400,000 (280,000) $1,120,000 2011 $3,300,000 (1,945,000) (5,000) (300,000) 50,000 1,100,000 (250,000) 850,000 850,000 (170,000) $ 680,000
Statement of comprehensive income For years ended December 31 2012 Net income Other comprehensive income, before tax :
4
2011 $850,000 (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
$1,400,000 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
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 periodic pension cost 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
4 Alternative presentation is to show net of tax.
Comparison with the IASBs requirement

14. The IASBs amendment to IAS 1 is
similar to the FASBs final standard. However, some terminology and other differences exist between the two finalstandards.
17. 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 USGAAP, where all items included in other comprehensive income might subsequently be reclassified into netincome.
or loss and other comprehensive income. Both the FASB and the IASB, however, continue to allow entities to use other titles for the primary financialstatements.
15. 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.

21. The new US GAAP requirements 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.
18. 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.
16. Consistent with the FASBs final

standard, the IASB standard does not change the items that constitute net profit or loss or other comprehensive income. Earnings-per-share 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.
19. The IASB has retained the option to

disclose reclassification adjustments in the notes to the financial statements. As noted above, the FASB has eliminated that option.
22. Full retrospective application is required under both accountingstandards.
20. The one continuous performance

statement alternative is referred to by the IASB as the statement of profit
FASB issues a final standard (and IASB issues an amendment) on the presentation of other comprehensiveincome
Whats new?
On June 16, 2011, the FASB issued Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income. This standard eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. 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 USGAAP and those that report under IFRS, and to provide a more consistent method of presenting nonowner transactions that affect an entitys equity.

Two presentation alternatives
An entity can elect to present items of net income and other comprehensive income in one continuous statementreferred to as the statement of comprehensive incomeor in two separate, but consecutive, statements. Each component of net income and each component of other comprehensive income, together with totals for comprehensive income and its two partsnet income and other comprehensive income, would need to be displayed under either alternative. The statement(s) would need to be presented with equal prominence as the other primary financial statements.
Many things will notchange

While the options for presenting other comprehensive income change under the standards, many items would not change,including: The items that constitute net income and other comprehensiveincome When an item of other comprehensive income must be reclassified to net income The earnings-per-share computation (which will continue to be based on netincome)
10
While the FASB and IASB jointly developed the standards, the new guidance would not make any changes to those components that are recognized in net income and those components that are recognized in other comprehensive income under either accounting framework. In that regard, convergence is not achieved. The IASB standard also requires that items included in other comprehensive income that may be recycled into net income in future periods be presented separately from those that will not be recycled. This distinction does not exist under USGAAP, as all components of other comprehensive income are subject to recycling.

The new USGAAP requirements are effective for public entities as of the beginning of a fiscal year that begins after December 15, 2011 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, but full retrospective application is required under both sets of accounting standards.
Whats next?
We will soon update Dataline 201108 for the issuance of the FASBs final standard.
Whos affected?
All entities that report items of other comprehensive income could be affected.
11
US GAAP Convergence & IFRS Balance sheet offsetting

March 2011
Balance sheet offsetting The FASB and IASB proposal
Whats inside: Overview The main details
On January 28, 2011, the FASB and the IASB (the Boards) jointly issued an exposure draft, Offsetting Financial Assets and Financial Liabilities. Entities that historically elected to present derivatives assets and liabilities subject to master netting arrangements on a net basis will be required to report them gross in their statement of financial position. This could significantly impact the balance sheet of many reporting entities that currently apply an accounting policy election to net these amounts. Entities will have to evaluate the method of settlement for any transactions processed through an exchange or clearinghouse in order to ascertain whether a financial asset and financial liability are to be simultaneously settled. The exposure draft proposes new disclosure requirements for financial assets and liabilities subject to offset.
The main details

1. Under the proposed guidance, an
entity will be required to offset a recognized financial asset and recognized financial liability if (and only if) it has an unconditional and legally enforceable right of offset and intends to either settle the asset and liability on a net basis or realize the asset and settle the liability simultaneously.
of one of the counterparties to a contract.
3. Under current USGAAP, an entity has

the ability to elect gross or net presentation for derivatives and related collateral postings subject to master netting agreements. The ability to elect net presentation under USGAAP is an exception to the existing offsetting criteria. These master netting agreements generally include only a conditional right of offset and as a result, net presentation would not be permitted under the proposed guidance. The elimination of this exception could significantly impact the balance sheet of many reporting entities that currently apply an accounting policy election to net these amounts. Under IFRS, derivative assets and liabilities are not presented on a net basis as there is no exception to the existing offsetting criteria. PwC observation: The Boards discussion about conditional
1
Unconditional and legally enforceable right of setoff

2. The proposed guidance defines an
unconditional right of offset as a right of offset that is enforceable in all circumstances, including, but not limited to, default or bankruptcy of the counterparty. Conversely, a conditional right of offset is defined as a right of offset that is only enforceable upon the occurrence of a future event, such as the default or bankruptcy
and unconditional right of offset, although drafted more broadly, was focused on the standard provisions of the International Swap Dealers Association (ISDA) master agreement. ISDAs master agreement is the industry standard utilized for derivative instruments. These agreements provide for netting of amounts owed against amounts due in the event of bankruptcy or default of one of the counterparties to the arrangement. Under the proposed guidance, these terms would represent a conditional right of offset. The Boards reasoned that requiring offsetting on the basis of what might or might not happen in the future would not be appropriate. The FASBs historic position on permitting derivative asset and liabilities (and related collateral amounts) to be reported on a net basis was driven by a view that this most accurately portrayed the credit risk the reporting entity was exposed to. In their deliberations, the Boards specifically noted that the statement of financial position is not intended to represent the aggregation of credit risk of an entity.
Under the proposed standard, these amounts can only be offset if the criteria described above are met.
Intention to settle net or settle simultaneously

5. In order to offset a financial asset and
financial liability, an entity must have the intention to settle net or settle simultaneously the asset and liability. The entitys intentions may be demonstrated through past practice, usual operating practices, or by reference to documented risk management practices.
However, the analyses previously performed under US GAAP are not necessarily sufficient to conclude that the agreements are simultaneously settled. Entities will need to obtain a detailed understanding of the method of settlement for each of the exchanges or clearinghouses that their transactions are settled or processed on in order to determine whether they are simultaneously settled. Some of the factors to consider include: How is the settlement of transactions processed? Do they process them all simultaneously or are they processed in batches? Is there a continuous net settlement (CNS) process? How long does the processing of daily settlements take? How does the securities transfer system interact and process entries with the related securities repository?
6. In order for settlement to be considered simultaneous, the realization of the asset and settlement of the liability must occur at the same moment (i.e., there is exposure only for the net amount). As a result, if settlement takes place over a period of time, it is not simultaneous settlement. PwC observation: Many constituents are evaluating what impact this provision will have on an entitys current ability under US GAAP to elect to net repurchase and reverse repurchase agreements settled on the same day and transacted through a securities transfer system. The current US GAAP model is based on a conclusion that certain securities transfer systems that meet specified requirements (focused on their design, operations, and ability to perform) achieved effective net settlement even though their processes required gross settlement of individual transactions.
Multilateral setoff arrangements

7. The proposed standard allows an
entity to offset an amount owed to one party against an amount due from a second party if the contractual right exists and that right is enforceable in all circumstances. These circumstances are infrequent in practice, but the Boards did not see any reason to exclude these arrangements if they otherwise meet all of the criteria for offsetting.
4. The proposed standard also eliminates certain industry-specific offsetting guidance, including: Contractors: Advances on cost plus contracts Broker and dealers: Trade date receivables and payables Depository and lending: Reciprocal account balances
Disclosures
8. The Boards concluded that information about rights of setoff and related arrangements (such as collateral agreements) are necessary to enable users of financial statements to understand the effect of those rights and arrangements on the entitys financial position. As a result, the Boards decided an entity shall disclose, at a minimum, the following information about rights of setoff and related arrangements associated with derivatives and financial assets and financial liabilities: a. The gross amounts b. Shown separately:
1. Amounts offset in accor-
e. Net amount of eligible assets and eligible liabilities after taking into account above items f. For cash or other collateral obtained or pledged:
1. The amount of cash collat-
eral (excluding the amount in excess of the net amount presented in the statement of financial position)
2. The fair value of other finan-
amounts offset in the statement of financial position and portfoliolevel adjustments for credit risk of the counterparties. Portfolio-level adjustments made to incorporate the credit risk of the counterparties are typical in derivative valuation processes and have not historically been disclosed separately, as they have been considered a component of valuation as opposed to an offsetting adjustment.
cial instruments (excluding the amount in excess of the net amount presented in the statement of financial position) g. The net amount after taking into account the previous items

10. The Boards decided to require retrospective application to all periods presented at transition. The Boards believe that prospective application could be misleading to investors. The Boards are seeking feedback regarding the time and effort that would be involved in implementing the proposed requirements. In addition, they will be considering the feedback associated with the effective dates and transition of other planned new standards. They will use that information to determine an appropriate effective date.
dance with the established criteria to determine the net amounts presented in the statement of financial position
2. Portfolio-level adjustments
9. The Boards decided that the proposed

disclosures should be provided in tabular format, unless another format is deemed to be more appropriate. The Boards also concluded that to the extent offsetting information is provided in other notes to the financial statements, the information described above should be cross-referenced to that information. PwC observation: The proposed disclosures are extensive and require the disclosure of a considerable amount of information that is not disclosed under current US GAAP. Preparers will likely have to implement new procedures to capture this information so that it can be reported. The gross amounts used as the starting point in this disclosure are amounts before taking into account
made in the fair value measurement to reflect the entitys net credit exposure (or the impact of the entitys own credit risk)
3. The net amount presented
in the statement of financial position c. Amounts that the entity has an unconditional and legally enforceable right to set-off, but does not intend to settle net d. Amount that the entity has a conditional right to set-off, identified separately by each type of conditional right
Whats next?
11. The comment period on the exposure
draft ends April 28, 2011. A roundtable discussion is being planned for the first quarter of 2011 and a final Accounting Standards Update is expected to be issued during the second quarter of 2011.
US GAAP Convergence & IFRS Balance sheet offsetting: Updated June 30, 2011
June 2011
FASB and IASB take separate paths on derivatives netting rules

Whats inside: Whats new? What did each board decide? Is convergence achieved? Whos affected? Whats the effective date? Whats next?
Whats new?
At the June 14, 2011 FASB/IASB joint board meeting, the boards discussed their project on offsetting financial assets and financial liabilities, specifically considering whether to 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 these items under USGAAP. The IASB, however, unanimously decided not to permit a similar exception under IFRS.
What did each board decide?

FASB vote
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 January 2011 joint proposal 1). 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 USGAAP, 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.
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 futuremeetings. 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 IFRSrequirements.
1 FASB Proposed Accounting Standards Update, Balance SheetOffsetting, and IASB Exposure Draft, Offsetting financial assets and liabilities
Balance sheet offsetting: Updated June 30, 2011
The existing differences in offsetting requirements under USGAAP and IFRS account for the single largest quantitative difference in a balance sheet under USGAAP 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 USGAAP and IFRS.
Whos affected?
The requirements of the January 2011 joint proposal would have significantly changed the USGAAP 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 previouslyproposed.

The January 2011 joint proposal did not specify a target effective date.
Whats next?
The FASB and IASB are expected to work together on new disclosures. It is not yet clear when final standards will be issued.
US GAAP Convergence & IFRS Pensions and postemployment benefits

March 2011
Pension/OPEB accounting Understanding changes expected from the IASB

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 USGAAP. 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.
been the deferred recognition techniques that enabled changes in the value of the benefit obligation and plan assets to be recognized on a delayed basis under both IFRS1 and USGAAP.2 Under that approach, and prior to 2006, the amount reported on the employers 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
2. One of the primary causes of

complexity in the accounting has
1 International Accounting Standard 19, Employee Benefits. 2 FASB Statements No. 87, 88, 106, and 132(R) (codified in ASC 715).
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.
that grant additional benefits attributable to employees prior service) and gains and losses, should be recognized currently in determining an employers net income.
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 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 US GAAP entities but not permitted under IFRSpresenting OCI within the
3. In 2006, the FASB began requiring

the funded status of a plan (i.e., the current value of benefit obligations less plan assets) to be reported on the balance sheet.3 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.
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.
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
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 USGAAP treatment of such amounts. However, unlike USGAAP, where such amounts are subsequently amortized from accumulated other comprehensive income (AOCI) into benefit expense, the IASB proposed no such recycling of these amounts.
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).
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.
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.
of remeasurements of benefit obligations and plan assets is conceptually appropriate and will more faithfully present the employers 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 employees 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 IASBs 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 US GAAP, IFRS does not restrict
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.
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
11. The IASBs rationale for eliminating

deferred recognition is based on the following: Immediately recognizing the effect
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 USGAAP, 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 US GAAP. The FASB has acknowledged that its ultimate goal is convergence with the IASBs standard and appears to be waiting for the outcome of the IASBs project. Accordingly, US employers and other US stakeholders may wish to consider what impact the IASBs planned amendments could have if they are incorporated into US GAAP.
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 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 USGAAP) or (2) separately display those components.
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 USGAAP). 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 USGAAP 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.
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 IASBs 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
Presentation
13. The ED proposed requiring employers
to display separately the components of pension and OPEB cost (service cost, finance cost, and
Remeasurement component
20. The following are some of the

expected disclosures: Characteristics of the defined benefit planthe 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 nonroutine settlements Explanation of amounts in the financial statementsdisaggregation 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 flowsa 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
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 netof-tax basis in OCI.
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 employers 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)
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.
Disclosure
19. The ED proposed several new required
disclosures, which were generally consistent with disclosures already required under USGAAP. 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.
Multi-employer plans
21. The IASBs planned amendments will
not change the accounting requirements for employers that participate in a multi-employer benefit plan.
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 postemployment 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.
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.
promises, including cash balance plans) Assumptionshow key assumptions, such as the discount rate, should be determined Multi-employer planshow to account for participation in multiemployer plans

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. 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.
Items not addressed

25. Other aspects of accounting for
pensions and OPEB will not be addressed by the planned amendments. For example, contributionbased promises, which were a significant focus in the IASBs 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 IASBs (and FASBs) project include: Measurementhow the measurement of the retirement benefit obligation should be performed (which likely would resolve key questions related to contribution-based
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
27. The effective date for the amendments will not be before January 1, 2013 with early application allowed.
US GAAP Convergence & IFRS Pensions and postemployment benefits: Updated October 15, 2011
October 15, 2011
Table of contents
FASB issues final standard to enhance disclosures for multiemployer pension plans; effective for public companies in 2011 IASB issues amendments to IAS 19, Employee benefits
FASB issues final standard to enhance disclosures for multiemployer pension plans; effective for public companies in 2011
Whats inside: Whats new? When is the revised standard effective? What are the key provisions? Is convergence achieved?
Whats new?
On September 21, 2011, the FASB (the Board) issued Accounting Standards Update No. 2011-09, CompensationRetirement BenefitsMultiemployer 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 employers 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 incircumstances.
Reprinted from: In brief 201139 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 theplan The amount of employer contributions made to each significant plan and to all plans in the aggregate
An indication of whether the employers contributions represent more than 5% of total 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 employers contribution to a plan as a percentage of totalcontributions.
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 pensionplans.
Pensions and postemployment benefits: Updated October 15, 2011
IASB issues amendments to IAS 19, Employee benefits
Whats 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.

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 othermarkets. 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 multiemployer plans. The objectives and principles underlying disclosures are provided; these are likely to require more extensive disclosures and more judgment to determine what isrequired. Distinction between short-term and other long-term benefits: The distinction between short- and longterm 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 actuarialcalculations.
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.
Whos 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 ofdisclosures.

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.
Whats 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 disclosurerequirements. 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.
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.
Pensions and postemployment benefits: Updated October 15, 2011
US GAAP Convergence & IFRS Insurance contracts

March 2011
Table of contents
Insurance contracts
Comment letter themes being addressed in fast-paced redeliberations
Insurance contracts
Fundamental accounting changes proposed
11
Insurance contracts Comment letter themes being addressed in fastpaced redeliberations

Whats inside: Overview Comment letter themes and redeliberations by topic
Several key issues surfaced from the comment letters, three public roundtable discussions, and other outreach efforts regarding the IASBs July 2010 exposure draft (ED) and the FASBs related September 2010 discussion paper (DP) setting out proposed changes to insurance accounting. The proposals would fundamentally change the accounting by insurers and other entities that issue contracts with insurance risk, and cover recognition, measurement, presentation, and disclosure for insurance contracts. The Boards have been redeliberating the issues, and the IASB seems intent on continuing at a rapid pace to meet its targeted June 2011 date for issuance of a final standard. No official timetable has been published by the FASB on its next steps, but comments have been made at recent FASB meetings about the potential for an exposure draft to be released around the same time as the IASB final standard. Respondents preferences on the overall measurement model were mixed, with US constituents tending to support the FASB approach (in the event of a converged standard), and a clear majority of non-US constituents supporting the IASB approach. Given the potential impact of the changes being considered, management should keep abreast of this rapidly developing project and consider assessing the implications of the possible changes on existing contracts and its current business practices.
Reprinted from: Dataline 201114 February 25, 2011 (Revised March 4, 2011*) Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
The main details

1. Several key issues surfaced from the
comment letters, three public roundtable discussions, and other outreach efforts regarding the IASBs July 2010 exposure draft (ED) titled Insurance Contracts and the FASBs related September 2010 discussion paper (DP) entitled Preliminary Views on Insurance Contracts. The issues involve
the discount rate, cash flows, acquisition costs, the risk adjustment and margins, unbundling, the modified approach for short-duration contracts, financial statement presentation, and transition.
2. The Boards began redeliberating

some of these issues in January and plan further discussions in March through May. The IASB seems intent
*The At a glance (third bullet), Building block approach (paragraphs 26 and 27 and PwC observation), Discount rate (paragraphs 42 and 43), and Simplified method for short duration contracts (paragraph 47 and PwC Observation) sections were revised to reflect the Boards decisions at their March 12 joint meeting.
on continuing at a rapid pace to meet its targeted June 2011 date for issuance of a final standard. This is likely because comprehensive guidance on insurance accounting does not currently exist under IFRS, and thus there is greater urgency for the IASB to adopt some version of its exposure draft as a final standard.
regulatory requirements (such as the explicit risk adjustment and discount rate approaches).
6. Conversely, some in the United States

(particularly property and casualty companies) questioned whether the proposed models would be an improvement to existing USGAAP, particularly if convergence is not achieved. Many US respondents, both preparers and some users, believe that the current short-duration accounting model used by property and casualty companies is well understood and appropriately reflects their business model, and therefore do not believe a change from current GAAP is needed.
3. At a February Board meeting, the

FASB announced its decision to continue deliberating the issues in this project jointly with the IASB. Although USGAAP has an existing comprehensive accounting model for insurance accounting, the FASBs ultimate objective is to improve upon existing USGAAP for insurance contracts. It also has an objective to converge USGAAP with IFRS.
and users wanting to see, gross revenue and expense information for both life and non-life contracts on the face of the financial statements. Users note that new business written is a key metric and a driver in predicting future profitability, and other gross information is needed to derive key metrics, such as loss ratios. Many expressed concern over the number and degree of disclosures including detailed account roll-forwards and sensitivity analyses.
9. Other areas where there is some

alignment across territories include acquisition costs, unbundling, and transition. Many respondents believe that allowing only acquisition costs that are incremental at the individual contract level to be included in contract cash flows and thus effectively deferred is not reflective of the insurers business model. They believe both incremental and certain directly allocable costs should be included, such as salaried sales force and underwritingsaid another way, costs that are incremental at the portfolio level.
7. From a life insurer perspective, the

item causing the most controversy among US preparers is the requirement that cash flows be discounted at a risk free rate plus an illiquidity adjustment, updated each period. There are several criticisms with the discount rate: that the prescribed rate does not fully reflect the characteristics of the liability and how insurers price their product, that updating of the discount rate each period is inconsistent with the long-term hold strategy for the liabilities, and that the lack of an established methodology for determining the required illiquidity adjustment to the risk free rate makes it questionable whether reliable, comparable estimates can be achieved.
4. Despite the urgency for the IASB,

many respondents commented that both boards should take the time to field test their proposals, given the fundamental changes being proposed and the extensive process and systems changes that will likely be required for entities to properly apply the proposed standards.
5. Respondents preferences on the

overall measurement model were mixed, with US constituents tending to support the FASB composite margin approach (in the event of a converged standard), and a clear majority of non-US constituents supporting the IASB explicit risk adjustment approach. In general, respondents in Europe and other non-US territories tended to support the provisions in the IASB proposal that are consistent with their existing or proposed
10. With respect to unbundling, there is

wide agreement that the proposed guidance is unclear and in parts inconsistent. Many Europeans prefer the non-unbundled approach, while views are somewhat mixed in the US. Some in the US view the insurance contract as an integrated set of components. Others seem to prefer unbundling of certain account balances and embedded derivatives if measurement outside the insurance model could lead to a significantly different result.
8. Amongst the feedback received by the

Boards there is a common theme on one key issuepresentation. There is limited support for a summarized margin approach as proposed, with most preparers wanting to display,
Insurance contracts
11. There was overwhelming objection to

the transition provisions suggested in the IASB ED. Those provisions would effectively eliminate any residual margin and related subsequent income amortization on all in-force business at transition. This would distort future periods income recognition for years to come for longer duration contracts.
insurance provided by employers. The accounting by policyholders (other than reinsurance) entering into insurance contracts is not addressed.
an explicit asset. All other acquisition costs would be expensed as incurred.
19. Under both proposals, account

balance, embedded derivative, and certain service components would be required to be unbundled and accounted for separately if they are not closely related to the insurance coverage.
14. Both proposals would require an

insurer to measure its insurance contracts using a current measurement model, where estimates of the present value of cash flows are remeasured each reporting period. The estimated cash flows would be discounted at risk-free interest rates, adjusted for differences between the liquidity characteristic of the insurance contracts and corresponding risk-free instruments.
20. The IASBs proposal requires shortduration contracts of approximately 12 months or less to be measured using a simplified approach. The FASB did not include a specific proposal on this.
Comment letter themes and redeliberations by topic

12. The following provides a brief
summary of the FASB DP and IASB ED, followed by a detailed analysis of the comments received on both the DP and ED for major issues, as well as the steps the Boards have taken through February to address constituent observations and concerns. For a detailed discussion of the FASB DP and IASB ED provisions, refer to PwC Dataline 201039, Insurance contractsFundamental accounting changes proposed.
21. Under both proposals, the income

statement presentation would be driven by the measurement model. Issuers would not recognize premiums as revenue (except where the shortduration simplified approach is used) but would separately show an underwriting margin and changes in cash flow estimates and experience variances. Supplemental disclosures would provide premium and claim information.
15. The IASB approach would include an

explicit risk adjustment for the uncertainty about the amount and timing of future cash flows that would be separately estimated and remeasured each period. The FASB approach would not.
16. At contract inception, both proposals

would defer and amortize any excess of expected cash inflows over outflows to eliminate any initial profit recognition, but would recognize any losses immediately. This amount is referred to as the composite margin under the FASB approach and as the residual margin under the IASB approach.
22. The IASB proposed a modified

retrospective approach to transition under which the opening balance for in-force contracts at the transition date would be limited to the present value of cash flows plus the risk adjustment, with no residual margin. This transition approach could significantly reduce future profits on long-duration contracts, particularly for life insurers.
Background
13. Both the IASBs positions in its ED and
the FASBs preliminary views in its DP (the proposals) would apply to all entities that issue insurance contracts, not just insurers. The Boards would utilize a broad definition of insurance contracts that could result in contracts issued by non-insurers being subject to the guidance, such as certain financial guarantee contracts, loans with waivers upon death, certain types of warranty contracts, and, under the FASB proposal, health
17. Cash flows under both proposals would

be measured from the issuers perspective (rather than a market participant perspective), although any marketrelated variables would be consistent with observable market prices.
18. Incremental contract acquisition

costs (such as commissions) would be included in the net cash flows, effectively deferring and amortizing them over future periods, although not as
Building block approach

23. There is general support for the
building block approach, and constituents see the fulfillment value
objective as an improvement over the IASBs former current exit value approach. However, three main issues commented on by constituents include: the requirement to use probabilityweighted cash flows; the types of costs to be included in expected cash flows; and the types of acquisition costs that should be included in expected cash flows.
24. While most constituents support the

objective of expected value of future cash flows rather than a single, most likely outcome, many believe that the Boards should clarify that the objective is to arrive at the mean value. Given that the ED and DP focused on probability-weighted cash flows, some constituents are concerned that the proposal is mandating a full stochastic approach and consideration of every remote scenario.
25. During February redeliberations, the

Boards agreed with a staff recommendation that the measurement objective of expected value is the mean value, and that there is no need for all possible scenarios to be quantified in all circumstances. Some Board members believe an education session on the different actuarial methodologies for arriving at a mean is necessary, as it is not clear whether some methodologies may give rise to issues in calculating a risk margin.
being implicitly included in the residual margin. In their February redeliberations, the Boards decided that costs to be included in the cash flows should be those that relate directly to the fulfillment of the contracts in the portfolio (such as payments to policyholders and claim handling costs) as well as those costs that the staff describes as directly attributable and allocable to fulfilling that portfolio of contracts. Some understood the latter type of costs to include rent for space occupied by the claims handling department and IT technology costs associated with that function, and to exclude indirect costs such as the CEOs salary and corporate headquarters. Some Board members continue to be concerned that too wide a definition would allow general overhead to be included in the liability measurement. The staff reiterated that the types of direct and indirect costs to be included are intended to be consistent with those in IAS 2, Inventories, and they will draft implementation guidance consistent with that standard and present it to the Board.
should be included as contractual cash flows of the insurance contract. The FASB would limit costs to successful efforts (similar to the guidance on accounting for deferred acquisition costs in ASU 201026, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts), while the IASB believes that costs for unsuccessful efforts should also be included. The two Boards have also not reached agreement on which categories of allocable acquisition costs, other than sales force and underwriter salaries, should be included in the contract measurement. For example, the IASB appears more open to including certain other indirect costs, such as rent and software associated with the selling function, which they believe is consistent with their general position on cash flows noted in paragraph 26 above. PwC observation: Items requiring further follow-up in this area include a potential education session on the alternative actuarial methods used in practice as a proxy for the mean. In addition, clarification is needed on the types of overhead that would be included in contract cash flows. It is uncertain how the Boards disagreement on the components of acquisition costs to be included in cash flows will be resolved. The FASB position is consistent with its recently updated guidance on insurance acquisition costs, which is effective for 2012. On the other hand, the IASB position to include both unsuccessful efforts and certain indirect costs is more in line with US GAAP in effect for 2010.
27. Many constituents commented

that the definition of acquisition costs is too narrow and opposed its restriction to costs incremental at the contract level rather than the portfolio level. The IASB and FASB redeliberated this issue in February and early March, with both Boards agreeing by a narrow margin that acquisition costs that are direct and incremental at the portfolio level (rather than the contract level) for sales force contract selling, underwriting, medical, inspection, policy issuance, and processing functions
26. Some constituents commented that

overhead costs should be included in expected cash flows, as they are costs that are included in pricing and would be more accurately reflected as expected cash flows rather than
Insurance contracts
Risk adjustment
28. The most significant difference
between the FASB and IASB proposed models relates to the use of an explicit risk margin. Only the IASBs model includes an explicit risk adjustment for uncertainty about the amount and timing of future cash flows. This amount would be separately estimated and remeasured, along with the present value of cash flows each period.
32. In February redeliberations, many

Board members agreed that at a conceptual level an explicit risk margin provides useful information to users and would be understandable. Whether a risk adjustment can be determined in a verifiable way, would be comparable across companies, and pass a cost-benefit analysis, will be the subject of a future meeting.
some noting that amortization of the residual margin based on the expected timing of incurred claims and benefits, or based on the premiums/claims paid formula in the FASB composite margin, was not consistent with the economics of the contracts. Under the model, much of the composite margin recognition would be delayed until claim/benefit payments were made.
33. With regard to remeasurement of the

residual or composite margin, suggestions were made by respondents that the margin either be recalibrated when building block estimates are subsequently revised, or that the margin be used as a shock absorber against current period losses due to non-financial and possibly financial input changes. Locking in the margin seemed to many to be inconsistent with the rest of the current value model. Constituents noted that using the residual or composite margin as a shock absorber, at least for nonfinancial estimate changes, would avoid current period losses followed by profits in the future as the margin is unwound.
36. Alternatives offered by respondents

included prescribing a principlesbased approach rather than a single method for amortization. Some suggested that the composite margin should be amortized over the coverage period only for those types of coverages where there was minimal risk and claim settlement efforts later in the contract.
29. Most respondents are predominantly

in favor of the explicit risk adjustment approach rather than the composite margin approach, with notable exceptions being most US insurers and US users. Non-US supporters note that an explicit risk adjustment allows for a current measure of the insurers risk and therefore is more transparent and useful, is consistent with proposed Solvency II requirements in Europe, and is already being measured in several territories, including Australia and Canada.
37. Decisions on remeasurement and

amortization methods for residual margins (ED model) and composite margins (FASB DP model) are expected at future meetings. PwC observation: The Boards are in the exploratory phase of redeliberations on the risk adjustment. It is the key difference between the IASB and FASB models, and has been the subject of much debate. Within each of the Boards, there have been split views on this issue. From a constituent perspective, all but US respondents seem to generally embrace the explicit risk adjustment.
30. There are disagreements with some of

the detailed provisions of the explicit risk adjustment, with respondents arguing that it should not be limited to 3 prescribed methods, and that disclosure of the confidence level equivalent is not useful and does not result in cost efficient information.
34. In February redeliberations, the

Boards indicated that they are willing to explore a floating residual/ composite margin approach that remeasures the margin for favorable and unfavorable changes in non-financial estimates, but need to consider whether the residual margin could be negative (essentially reducing the risk adjustment).
31. Opponents of the explicit risk adjustment believe that it would involve substantial set up costs, is prone to subjectivity, manipulation, and non-comparability, is not observable and therefore not verifiable, and is inconsistent with a fulfillment value approach.
35. Constituents expressed their dissatisfaction with the amortization methods for both margins, with
Discount rate
38. Most US life insurer respondents
disagreed with the IASB ED and FASB
DP requirement to utilize a risk-free rate plus a premium for illiquidity to present value the cash flows of an insurance contract for several reasons. They noted an inconsistency between the proposal and the implicit rate credited to policyholders under the contract, particularly for many long-duration life insurance contracts, which could result in non-economic day one losses. In addition, US as well as non-US life insurers commented that short-term fluctuations in insurance liabilities due to changes in market discount rates are not reflective of their business models. As a result, they would support either a discount rate locked-in at the inception of the contract or recognition of interest rate changes in other comprehensive income rather than income.
up approach. This assumed that both expected defaults and the reward for default risk, as well as any other components in the asset rate but not relevant to the liability rate, would be subtracted to arrive at a rate that is consistent with the bottom up risk free rate plus illiquidity adjustment.
41. The Boards agreed in February that

the standard should not prescribe a rate or method for determining the discount rate but instead should explain that the objective is to adjust future cash flows for the time value of money and reflect the characteristic of the insurance contract liability. The rate should be consistent with observable current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability, excluding the effect of the insurers own non-performance risk. The rate should exclude the effect of risks and uncertainties included in the cash flows or the risk adjustment, and should exclude any factors that influence the observed rates but are not relevant to the insurance liability (such as investment risk not passed along to the policyholder).
at inception, the Boards rejected this view during early March redeliberations. The staff provided a comparison of insurance liabilities to other measurements, such as financial liabilities, financial assets, and leases. The staff view, supported by the Boards, is that due to the higher variability in cash flows of insurance contracts versus the other instruments, they are not analogous. The staff believes that in the current value model proposed in the insurance ED and DP, which reestimates cash flows each period, it would be inconsistent to lock in the discount rate. PwC observation: On balance, while the Boards recent decisions focus on stating a principle rather than prescribing a method, and thus seem to address constituents concerns regarding estimating the illiquidity adjustment, concerns expressed about day one losses and accounting mismatches remain.
39. Most agreed with excluding an insurers non-performance risk, but some suggested using a rate that includes the market price of credit (but not the price of credit for the specific liability), such as a high quality corporate bond rate. Others suggested an asset-based rate, adjusted for the risk of defaults (a top down approach that starts with an asset portfolio rate, rather than the ED bottom up approach that starts with the risk free rate). Many, including users, raised concerns regarding the feasibility, objectivity, and comparability of an illiquidity adjustment that is not observable in the market.
42. Despite concerns expressed by various

Board members with obtaining deep and liquid corporate bond market rates and making an adjustment for credit risk, the Boards also agreed to explore further the possibility of whether and under what circumstances a practical expedient (such as a high quality bond rate) would be allowable, at least for smaller insurers.
Simplified method for short duration contracts

44. The proposals call for a simplified
approach for contracts with terms no longer than a year. Many respondents, including most users, supported the proposal to develop a modified approach for short-duration contracts. However, most objected to the strict one-year cut-off. Many noted that the modified approach in the IASB ED is over-engineered in its requirement to discount premiums, accrete interest in the pre-claim period, include a risk adjustment in the onerous contract
40. In February, after having heard

proposals from several constituents on top down approaches, Board members seemed to support this methodology as an acceptable alternative to the EDs proposed bottom
43. While some constituents believe that

the discount rate for at least certain types of contracts should be locked in
Insurance contracts
test, and perform the test at a lower level than is currently done in practice under existing GAAP.
45. Many, if not most, US property/casualty insurers as well as health insurers favored maintaining the current USGAAP accounting model for shortduration contracts as they believe it better depicts their business model, which is focused more on underwriting risk as the principal risk rather than investment risk. Many US nonlife insurers believe that the incremental cost and effort of discounting outweigh the benefits for coverages that have short payout periods, such as physical car damage and health insurance. In addition, for some long-tail exposures, such as asbestos and product liability, they believe the amount and timing of cash flows is so unpredictable that discounting is not appropriate, and should only be applied in those limited instances where cash flows are fixed and reliably determinable.
in which it is questionable if the insurer will have to pay, when it will have to pay, and how much it will have to pay. Their rationale is that if the model requires that an insurer estimate an amount for uncertain claim payments, it is no more difficult to then estimate the potential timing of such payment on a portfolio basis. It was noted that any uncertainty in the timing of payment should be captured in the risk adjustment. The Boards also tentatively agreed that discounting should not be required when the effect of discounting would be immaterial. As part of future redeliberations on the modified approach, the staff is expected to draft guidance for determining when discounting a short-tail claim would be considered immaterial. PwC observation: The Boards latest decisions are likely to be unpopular with US property/casualty writers who believe strongly that property/casualty liabilities should generally not be discounted unless the payment streams are fixed and reliably determinable.
complex, and will have unintended consequences. For example, as written, universal life account balances would not be unbundled, while throughout the Boards discussions such balances were one of the most common examples of components that many Board members believed should be unbundled. With regard to the general principle of unbundling, response in the US was mixed, with many suggesting that their views could change depending on where the Boards land on other issues, such as discount rates.
50. Some would prefer to see items such

as account balances in universal life products and embedded derivatives unbundled if measurement outside the insurance model could lead to a significantly different measurement that would be more in line with related assets (e.g., amortized cost for account balance liabilities).
51. Health insurers believe that certain

of their contracts that are principally administrative services only with stop loss protection should be split between the service and insurance components, while others are insurance contracts with integrated service components.
46. In contrast, Australia, Canada,

and Japan already discount nonlife reserves. Further, the IASB staff outreach revealed that most European non-life direct and reinsurer respondents were comfortable with the modified approach proposed in the ED. This included using the full building block model, with discounting, for incurred claims.
Unbundling
48. Under the proposals, some components of insurance contracts would be unbundled (that is, separately accounted for under other guidance). Those components would include certain account balances, embedded derivatives, and goods and services not closely related to insurance coverage.
52. Many Europeans who will be subject

to Solvency II prefer the non-unbundled approach, which is consistent with that proposed regulation. Opponents to unbundling also point to the complexity of identifying and separating the various components, which are typically designed and priced on an integrated basis. They note that arbitrary allocations of fees and costs would be needed, which could lead to subjective splits between
47. In early March, both Boards tentatively agreed that all long-tail non-life claims (i.e., those with a claims settlement period of greater than a year) should be discounted. This would apply where the expected payout patterns are reasonably determinable, as well as for long-tail claims
49. Many commented that the guidance

as written is unclear, unnecessarily
components and therefore reduce comparability. They believe that the proposed insurance model (a current value model) is an acceptable model for deposit components of insurance contracts, and, for embedded derivatives, is also substantially consistent with a fair value model given the requirement to use observable market inputs. PwC observation: The Boards expect to debate unbundling issues over the next several months. At an education session in February, the Boards heard different perspectives on unbundling, after which they noted that if the objective is to present the risk from the underwriting activities separately from the investment activities, it would lead to unbundling. The Boards also acknowledged the level of judgment that will be involved in allocating among contract components if contracts were required to be unbundled. But they also acknowledged that some amount of allocation will be needed, even absent unbundling, to determine the appropriate rate at which to discount certain cash flows associated with the contract.
A modified measurement approach and a more traditional earnings presentation is proposed for certain short-duration contracts that meet specified criteria.
revenue and expenses in what is essentially a balance sheet focused measurement model.
54. Most respondents were uncomfortable eliminating information about premiums and claims from an insurers income statementconsidered a key performance metric. They believe that a decreasing revenue line, which is a consequence of the proposal, could distort a users view of the magnitude of a companys operations.
Transition
56. The IASB proposed a modified
retrospective approach to transition, which drew little to no support. The FASB did not address transition in its DP, but was supportive of the IASBs proposals during deliberations. The ED proposed that the opening balance for in-force contracts at the transition date be limited to the present value of cash flows plus the risk adjustment, with no residual margin. This would eliminate income from residual margin amortization that would typically be present under the ED model. This transition approach could significantly reduce future profits on long-duration contracts, particularly for life insurers.
55. As a result of comments from

constituents, the Boards are reconsidering other alternatives, such as the expanded margin approach, the written premium approach (traditional life model), and the earned premium allocation approach (traditional non-life model). Variations of these approaches would include a model that incorporates information on both a traditional and margin basis, and one that unbundles contracts for performance reporting. The Boards understand that above all, the presentation model developed should address the needs of users such that insurers could reduce the number of non-GAAP measures presented. PwC observation: The staff is currently exploring various alternative approaches to the summarized margin approach, and several groups have committed to provide the staff with alternate presentation formats. It remains to be seen whether an approach can be developed that can overcome the complexity involved in grossing up the margin presentation for both
57. Since the issuance of the IASB ED, the

IASB has concluded that its transition proposal was flawed and is seeking alternatives. Most constituents acknowledge the challenges associated with a full retrospective adoption. Respondents suggested several complex alternatives for consideration, but it is unknown whether they will gain traction due to their complexity.
Presentation
53. The summarized margin approach
proposed in the IASB ED and FASB DP would reflect the release of margins and changes in estimates in the income statement. Under this approach, premium revenue would no longer be presented. Instead, margin, changes in estimate, and experience adjustments would be shown.
Other issues
Reinsurance
58. Reinsurance is significant to the

industry, yet little guidance on it exists in the proposals. Issues where respondents think additional guidance is
Insurance contracts
needed include whether risk transfer should only be assessed at inception, how/whether related contracts executed contemporaneously should be assessed, and accounting for loss portfolio transfers, commutations, and funds withheld arrangements. There were also concerns with day 1 recognition of cedant gains, especially among users and regulators, and how to measure the reinsurance contract when the coverage period for the reinsurance contract does not match that of the underlying contracts (e.g., whether the modified approach be used on the reinsurance if applicable to the underlying contracts). The staff agreed to spend more time on reinsurance, and bring this issue back to the Boards for redeliberation.
Recognition
Contract boundary
59. Most insurers disagree with recognizing insurance contracts on the earlier of the date the insurer is bound or the date it is first exposed to risk, which is particularly difficult for contracts with open enrollment, such as health insurance. They question whether the benefits outweigh the operational costs and whether this is useful information, for example, in situations where reinsurance is recognized before the underlying insurance contracts are even written.
60. Setting the contract boundary as the

point where the insurer has the right or practical ability to reassess the risk is troublesome to health insurers and certain property/casualty insurers where regulatory restrictions on pricing exist. This requirement could potentially extend the accounting life of the contracts beyond their contractual term and require projection of long range premium and claim cash flows that would be very difficult to estimate.
10
Insurance contracts
Fundamental accounting changes proposed
Whats inside: Overview Key provisions Timing for comments AddendumProject status update
The FASB has issued a discussion paper seeking comments on its preliminary views on accounting for insurance contracts that would fundamentally change the accounting by insurers and other entities that issue contracts with insurance risk. The discussion paper is an outgrowth of the IASB and FASBs joint efforts to develop a single converged insurance standard. The FASBs release of the discussion paper follows the IASBs late July issuance of an exposure draft containing its proposals on the same topic. Both documents address recognition, measurement, presentation, and disclosure for insurance contracts. The discussion paper compares the IASBs proposal to the FASBs preliminary views to date and to current USGAAP. The FASB is asking constituents to consider whether the FASB should ultimately adopt some version of the IASBs proposal or whether targeted changes to existing USGAAP would be sufficient. There is greater urgency for the IASB to adopt some version of its exposure draft as a final standard since comprehensive guidance on insurance accounting does not currently exist under IFRS; a final IASB standard is expected in mid-2011. Given the potential impact of the changes being considered, management should consider assessing the implications of the possible changes on existing contracts and its current business practices and commenting on both documents. The comment letter period on the FASB discussion paper ends on December 15, 2010 (or November 30, 2010 for roundtable participants). The comment period for the IASBs exposure draft ends on November 30, 2010.
Reprinted from: Dataline 201039 September 23, 2010 (Revised February 16, 2011*) Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
*The AddendumProject status update in paragraph 63 of this Dataline was added on February 16, 2011 to briefly summarize the Board activities that have taken place since the FASB discussion paper was issued and the expected timetable for completion of the IASB and FASB projects.
Insurance contracts
11
The main details

1. The FASB issued a discussion paper,
Preliminary Views on Insurance Contracts, on September 17, 2010 as part of the IASB and FASBs joint efforts to develop a single converged insurance standard. This followed the IASBs issuance of an exposure draft, Insurance Contracts, on July 30, 2010. The main details are as follows. Both the IASB exposure draft and FASB preliminary views (the proposals) would apply to all entities that issue insurance contracts, not just insurers. The boards would utilize a broad definition of insurance contracts that could result in contracts issued by non-insurers being subject to the guidance, such as certain financial guarantee contracts, loans with waivers upon death, certain types of warranty contracts, and, under the FASB proposal, health insurance provided by employers. The accounting by policyholders (other than reinsurance) entering into insurance contracts is not addressed. Both proposals would require an insurer to measure its insurance contracts using a current measurement model, where estimates of the present value of cash flows are re-measured each reporting period. The estimated cash flows would be discounted at riskfree interest rates, adjusted for differences between the liquidity characteristic of the insurance contracts and corresponding riskfree instruments.
The IASB approach would include an explicit risk adjustment for the uncertainty about the amount and timing of future cash flows that would be separately estimated and remeasured each period. The FASB approach would not. At contract inception, both proposals would defer and amortize any excess of expected cash inflows over outflows to eliminate any initial profit, but would recognize any losses immediately. This amount is referred to as the composite margin under the FASB approach and as the residual margin under the IASB approach. Cash flows under both proposals would be measured from the issuers perspective (rather than a market participant perspective), although any market-related variables would be consistent with observable market prices. Incremental contract acquisition costs (such as commissions) would be included in the net cash flows, effectively deferring and amortizing them over future periods, although not as an explicit asset. All other acquisition costs would be expensed as incurred. Under both proposals, account balance, embedded derivative, and certain service components would be required to be unbundled and accounted for separately if they are not closely related to the insurance coverage. The IASBs proposal requires short duration contracts of approximately 12 months or less
to be measured using a simplified approach. The FASB has not settled on a view on this matter. Under both proposals, the income statement presentation would be driven by the measurement model. Issuers would not recognize premiums as revenue (except where the short duration simplified approach is used) but would separately show an underwriting margin and changes in cash flow estimates and experience variances. Supplemental disclosures would provide premium and claim information. The IASB expects to issue a final standard in mid-2011. An effective date has not been proposed yet, although it is expected that the IASB standard would not be effective before 2013. The FASBs next step, after gathering comments from constituents on the discussion paper and at the public roundtables planned with the IASB in December, will be to determine whether its exposure draft of a proposed standard should use some version of the model described in its discussion paper or instead make targeted changes to existing USGAAP. PwC observation: The FASBs decision to issue a discussion paper reflects the fact that it has had less time to debate the issues. US GAAP also currently has specific accounting guidance for insurance contracts and so the need to address the accounting for insurance contracts is not as urgent as
12
for IFRS preparers. A key difference between the FASB and IASB approaches is the IASBs preference to include a specific risk adjustment on a current measurement basis and a residual margin compared to the FASBs preference for a single locked in composite margin.
Key provisions
Definition and scope
2. Both the FASB and IASB proposals
would apply to all entities that issue insurance contracts, not just insurers. Both approaches utilize the IFRS 4 definition of an insurance contract, i.e., a contract under which one party accepts significant insurance risk from another party by agreeing to compensate the policyholder if a specified uncertain future event adversely affects the policyholder.
which they would be affected by the proposals will depend on the unbundling rules, as discussed later in this Dataline. Financial guarantee insurance, mortgage guarantee insurance, trade credit insurance, and some letters of credit often issued by banks would be within the scope of the proposals. However, contracts that pay out regardless of whether the counterparty holds the underlying debt instrument or on a change of credit rating or credit index would continue to be accounted for as financial instruments. The scope of the discussion paper is generally consistent with existing US GAAP as it relates to insurers, but may result in changes in banks accounting for certain types of instruments.
5. The boards approaches would exclude

fixed fee service contracts that expose the service provider to risk because the level of service depends on an uncertain event (such as maintenance contracts where specified equipment is repaired after a malfunction). However, the proposals note that an insurer should apply the proposals to insurance contacts in which the insurer provides goods and services to the policyholder to compensate the policyholder for insured events. PwC observation: The boards intended for fixed fee service contracts (such as roadside assistance contracts and repair services) to be outside of the scope of the proposals. However, the wording in the scope paragraphs includes contracts where the insurer provides goods or services to compensate the policyholder for insured events, which seem to include such contracts given the definitions within the proposals. Some contracts are not specifically mentioned in the guidance, and thus it is unclear whether they would be covered by the approaches under consideration. Although medical coverage was not addressed in much detail during the FASB and IASB deliberations, the IASB ED references insurance against medical costs as being within the scope of its proposed guidance. This includes payments to be made in kind in which the insurer provides goods or services to the policyholder to settle the obligation. An example given in the proposed IASB application guidance is when an insurer uses its
4. The proposals would exclude from

the scope of the guidance certain contracts that meet the definition of insurance contracts. The exemptions carried forward from IFRS 4 include: Product warranties issued by a manufacturer, dealer or retailer Residual value guarantees provided by a manufacturer, dealer or retailer as well as a lessees residual value guarantee embedded in a finance lease Contingent consideration payable in a business combination Employers assets and liabilities under certain employee benefit plans Insurance contracts that an entity holds as a policyholder (although a cedant will apply the proposals to reinsurance contracts that it holds)
3. As in IFRS 4, insurance risk is defined

as any risk other than financial risk where financial risk is the risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. PwC observation: Some banks issue loans that include a waiver of the outstanding loan balance upon the death or disability of the customer. These contracts are likely to meet the definition of an insurance contract, but the extent to
Insurance contracts
13
own hospitals and medical staff to provide medical services covered by the contracts. In addition, while the IASB proposes to exclude from the scope all employer assets and liabilities under employee benefit plans, including health insurance plans, the FASB has not reached a preliminary view as to whether employer provided health insurance should be excluded. If employer provider health coverage is included in the scope, this could greatly expand the number of non-insurance companies that would need to implement the FASB proposal, as many companies directly offer health benefits to employees. In contrast, in those situations where the employer is merely providing employees access to a third party health insurer and not taking on insurance risk, the employer would not be subject to the proposal.
Whether an insured event will occur When the insured event will occur (timing risk) How much the insurer will need to pay if the insured event occurs (underwriting risk)
8. While USGAAP for reinsurance

transactions (and, by analogy, for insurance transactions) requires both underwriting and timing risk, IFRS 4 and the proposals require only one or the other. However, the proposals would amend IFRS 4 guidance slightly to note that certain timing delays might be so significant so as to disqualify a contract from risk transfer because the delays could eliminate or significantly reduce uncertainty of cash flows.
significant insurance risk if there is not a scenario that has commercial substance in which the present value of net cash outflows can exceed the present value of the premiums. Given this revised guidance, it is unclear whether certain contracts that guarantee a return of premium would meet the definition of an insurance contract.
10. The significant insurance test is

required to take into consideration the time value of money. In addition, unlike existing USGAAP, the risk transfer test can be met even if the insured event is extremely unlikely or even if the expected (i.e., probabilityweighted) present value of contingent cash flows is a small proportion of the expected present value of all the contractual cash flows from the insurance contract. PwC observation: The proposed guidance differs somewhat from existing US GAAP, which requires the presence of both timing and underwriting risk, no timing delays, and a risk transfer test (at least for reinsurance) that focuses on the reasonable possibility of significant loss as measured by a comparison of contractual cash flows to contractual premium.
9. The proposed guidance, taken from

IFRS 4, notes that insurance risk is significant if an insured event could cause an insurer to pay significant additional benefits in any scenario, as compared to the benefits that would be payable if the insured event did not occur. The focus in IFRS 4 is on whether there is variability in the amount of claim/benefit payments that could be paid whereas USGAAP focuses on the significance of the potential claim benefit payments in relation to the premium received. PwC observation: FASB members and some IASB members were uncomfortable with the application of insurance accounting for contracts that had no chance of loss to the insurer. As a result, late changes to the proposals borrow from US GAAP by noting that a contract would not transfer
6. The scope of the IASB ED includes

financial instruments containing discretionary participating features, while the FASB preliminary view is that such contracts are financial instruments that should be excluded from the scope of insurance contract accounting. These are considered further in the section on discretionary participating features below.
7. Within the definition of an insurance

contract is the requirement that there be an uncertain future event. IFRS 4 (and the FASBs and IASBs proposals) requires that at least one of the following be uncertain at the inception of an insurance contract:
Measurement model
would require a single measurement model for all insurance contracts that portrays a current assessment of the amount and timing of the future cash flows that the insurer expects
14
Composite margin
Residual margin Risk adjustment
Time value of money
Time value of money
its existing insurance contracts to generate as it fulfills its rights and obligations under the contract. This measure consists of the following building blocks: An explicit, unbiased and probability weighted estimate (i.e., expected value) of future cash outflows less future cash inflows A discount rate applied to those cash flows to reflect the time value of money The IASB approach would also include a third building block, an explicit risk adjustment to reflect the estimate of the effects of uncertainty about the amount and timing of those future cash flows, while the FASB proposal would not.
Current unbiased probability weighted estimates of future cash flows
Figure 1: FASB Measurement model
Figure 2: IASB Measurement model
be recognized when expected cash outflows are greater than the expected cash inflows. In the IASB model, a loss may be recognized in situations where in the FASB model it would not because the FASB model does not include an explicit risk adjustment in the measurement of expected cash flows.
13. Both the FASB and the IASB propose

that an insurer treat insurance contracts in a foreign currency as monetary items when applying foreign currency transaction guidance. In the FASB model, the requirement applies to all insurance contract cash flows and the composite margin. Similarly, in the IASB model, the requirement applies to all insurance contract cash flows, the risk adjustment, and the residual margin. PwC observation: This will eliminate the accounting mismatches that arise under US GAAP and IFRS 4 when unearned premiums and deferred acquisition costs are treated as non-monetary items by property and casualty insurers.
12. The boards believe that there should

be no day one profit recognition for insurance contracts, which would be consistent with the proposals in the revenue recognition project. As a result, if the present value of cash flows (plus the risk adjustment in the IASB model) gives rise to an asset, a composite margin (or residual margin in the IASB model) is added to eliminate any day one gain and therefore the contract is measured initially at nil. If the present value of the cash flows (plus the risk adjustment in the IASB model) is greater than zero, the insurer recognizes that present value as a loss, as it represents a loss on an onerous contract. Subsequent changes in the present value of cash flows (and the risk adjustment in the IASB model) could create an insurance asset or liability. PwC observation: In the FASB model, a loss on day one would
estimate of the incremental future cash outflows less future cash inflows that will arise as the insurer fulfills the insurance contract. This expected value is determined by considering the range of scenarios that reflects the full range of possible outcomes. Each scenario specifies the amount and timing of the cash flows for the particular outcome and the estimated probability of that outcome. The cash flows from each outcome are discounted and weighted by the probability factor to drive the expected present value. Unlike many current accounting models, which develop a single best estimate, all probabilities (even remote ones) are considered and weighted. The application guidance notes that not all cases will require the development of explicit scenarios. However, in cases where there are complex underlying factors that behave in a non-linear fashion, sophisticated stochastic modeling may be needed. PwC observation: The expected value is based on an evaluation of all possible outcomes, considering the amount and timing of the cash flows for a particular outcome, and the estimated probability of that outcome. The use of probability-weighted cash flows, while increasingly common in more recent accounting standards, is not an explicit element
Cash flows
14. The cash flows included in both

the FASB and IASB versions of the measurement model are an explicit, unbiased, and probability weighted
Insurance contracts
15
of current estimates of life and non-life insurance liabilities in the US. The objective of this approach is to incorporate variability in the estimate of cash flows by identifying all possible scenarios and making unbiased estimates of the probability of each scenario. Such an approach results in a statistical mean, rather than a best estimate or most likely outcome. Some believe that the actuarial central estimate commonly used by property and casualty actuaries in their development of estimates of unpaid losses is consistent with the proposed approach. Whether the objective of the new measure can be achieved with existing methodologies and systems or whether major changes will be required to both remains to be seen.
notes that the use of a portfolio of replicating assets (a replicating asset is one whose cash flows exactly match the contract cash flows) would be an appropriate way of incorporating market variables.
16. Cash flows to be included in the

building block measurement will include only those cash flows generated as the insurer fulfills the existing contract. Many contracts contain features such as extension or termination features or re-underwriting options, which make it difficult to determine the length of the contract. Thus, it is necessary to draw a contract boundary for these cash flows. The proposals would require that estimated cash flows be included to the point at which an insurer either is no longer required to provide coverage or has the right or the practical ability to reassess the risk of the particular policyholder and can set a price that fully reflects that risk. PwC observation: The definition of the contract boundary could have an impact on certain health insurance and other contracts where a regulator imposes constraints on re-pricing for individual policyholders. In some territories these contracts are currently treated as short-duration contracts, but under the proposals the expected cash flows may extend beyond the one year boundary if the insurer cannot fully re-price and re-underwrite the individual policy. The FASB is seeking input from constituents on the implications of the recent US healthcare reform provisions on the definition of the contract boundary. Alternatively, there may
be contracts that are currently treated as long term in some territories where the proposals for the contract boundary will result in only cash flows for a shorter period being taken into account (for example if the contracts can be re-priced for a change in risk). If these contracts have significant acquisition costs that are recovered from cash flows in later periods beyond the contract boundary, this could lead to an initial loss being recognized.
17. Insurance contracts often include

embedded options and guarantees, such as guarantees of minimum investment returns, maximum charges for mortality, surrender options, or options for the policyholder to reduce or extend coverage. The proposed measurement model requires the expected cash flows to reflect expected policyholder behavior, including features that allow policyholders to take actions to change the amount, timing or nature of the benefits they will receive. PwC observation: In some countries insurers issue policy loans to customers secured against the insurance contracts. Insurers would need to consider whether these loans represent cash flows under the insurance contract or are separate financial instruments that would be accounted for under financial instruments accounting.
15. The cash flows should include all

incremental cash inflows and outflows arising from a portfolio of insurance contracts. A portfolio is defined as insurance contracts that are subject to broadly similar risks and managed together as a single pool. Cash outflows will include direct costs and systematic allocations of costs that relate directly to the contract or contract activities. These cash flows will include policy administration and maintenance costs but will exclude general overhead and income tax payments and receipts, which are recognized and measured under income tax accounting guidance. Cash flows should be current and reflect the perspective of the insurer, except for market variables, which should be consistent with observable market prices. The application guidance
Discount rate
18. The discount rates applied in the

building block model should be
16
consistent with observable current market prices for instruments with cash flows whose characteristics match those of the insurance liability in terms of timing, currency, and liquidity. Those characteristics are not reflected by using discount rates based on expected returns on actual assets backing those liabilities. For contracts where the cash flows do not depend on the performance of specific assets, the discount rates should reflect the yield curve for instruments that are essentially risk free with an appropriate adjustment for illiquidity. For contracts where the cash flows do depend wholly or partly on the performance of specific assets, the measurement of the insurance contracts should reflect that dependence. The present value of the fulfillment cash flows should not reflect the risk of non-performance of the insurer. PwC observation: The recent credit crisis highlighted the difficulty in distinguishing between illiquidity and credit risk within market prices. In valuing insurance liabilities, there will be contracts that are clearly liquid due to policyholder surrender options and other contracts, for example, annuities, where the cash flows are predetermined and not flexible and hence illiquid. The challenge will be to determine when it is appropriate to apply an adjustment for illiquidity for contracts that fall in between these two extremes. There also will be complexities in the use of an interest rate curve instead of a single discount rate. In some situations, multiple curves may be required for contracts with different benefits, some of which
are based on investment returns and others that are not. By using current rates, investment asset and liability mismatches, such as duration and credit characteristics, will be measured in the financial statements at current assumptions as opposed to long-term assumptions used in many models today. The boards are asking for specific comments on whether the fulfillment cash flows should reflect the non-performance risk of the insurer. In responding to this proposal insurers will need to consider the impact of financial instruments accounting on the measurement of financial assets backing the insurance contracts. In particular, will accounting mismatches arise if changes in the fair value of financial assets due to changes in the market price of credit risk are reflected in the income statement but the measurement of the liability excludes some of this market movement if it is attributed to the risk of non-performance by the insurer?
building block measurement while the FASB decided that it should not.
20. The IASB proposal therefore includes

an explicit risk adjustment for the effects of uncertainty about the amount and timing of future cash flows from the perspective of the insurer rather than from the perspective of a market participant. The risk adjustment is the maximum amount the insurer would rationally be willing to pay to be relieved of the risk that the ultimate fulfillment cash flows exceed those expected. The risk adjustment is required to be included in the building block model in an explicit way, separate from the estimates of discounted future cash flows and separately disclosed. The IASB application guidance notes that care will be needed to ensure that risks are not duplicated. For example, if cash flows are measured using a replicating portfolio or other market observable inputs, then the measurement will already include the associated risk adjustment for these cash flows.
21. In order to address concerns over

comparability and reliability, the IASB guidance limits the range of permitted techniques for calculating the risk adjustment to the confidence-level technique (value at risk), the conditional tail expectation technique (tail value at risk), or the cost of capital technique. Some application guidance on each of these approaches is given, including in what circumstances each technique might be appropriate. In addition, entities will be required to disclose the confidence level to which the risk adjustment corresponds, even
Risk adjustment
19. One of the most controversial issues in

this project is whether, in addition to the probability weighted cash flows, an additional amount (referred to as an explicit risk adjustment), should be included in measuring the contract liability to reflect the effects of uncertainty inherent in the estimated future cash flows. After much deliberation, the IASB decided that an explicit risk adjustment should be part of the
Insurance contracts
17
if a cost of capital or conditional tail expectation technique has been used.
22. The IASB proposal requires the risk

adjustment to be measured at a portfolio level. The adjustment will therefore allow for risk diversification within that portfolio but not between different portfolios within a group. PwC observation: The cost of capital technique may differ from that used to price the contract or used for solvency purposes. The benefits of the explicit risk adjustment is that it reflects an explicit amount for risk included in the liability at each reporting period, reflects subsequent changes in risk, and ensures that an insurance liability includes a margin. An explicit risk adjustment is consistent with the pricing of financial instruments and written options as well as the proposals in the IAS 37 exposure draft on liabilities of uncertain timing or amount. It also reduces the amount of the residual margin that is amortized. The challenge for insurers to reliably and consistently measure the risk adjustment will vary from territory to territory depending on whether similar risk adjustment techniques are used for capital management or solvency requirements. The emergence of profit under each of the techniques will vary, as well as the drivers influencing the risk adjustment, for example, the price of capital will affect the cost of capital technique.
adjustment and instead decided on a composite margin approach. Under the composite margin approach, any positive difference between the present value of expected cash inflows and outflows calculated under the building block approach is recorded as the initial composite margin amount and amortized over the coverage and claim settlement period. Any negative amount is immediately expensed. The composite margin is presented as part of the insurance contract liability. PwC observation: The inclusion of an explicit risk adjustment in the insurance liability estimate is an unfamiliar concept in non-fair value measurements of insurance liabilities (or similar types of uncertain liabilities) in the US today. While some see the need for an explicit margin to reflect the level of uncertainty inherent in a particular set of cash flows, many are concerned that estimating an explicit risk margin may reduce the reliability and comparability of the measure, while adding additional complexity and subjectivity to what is already a subjective estimate. In contrast, European companies will use a cost of capital approach in the regulatory construct of Solvency II to calibrate risk margins, and Australian property and casualty companies have had some experience with estimating risk margins for financial reporting purposes. Opponents of an explicit risk adjustment, which includes a majority of the FASB, have expressed concerns with the appropriateness of an explicit risk adjustment in a non-fair value
measure and with the reliability and consistency of calculation methodologies for this risk adjustment. In addition, they note that there is no single technique for calculating the adjustment that is universally accepted and used, resulting in a potential comparability issue across insurers. Opponents note that even if a particular method is used, there is still much subjectivity in selecting the parameters of measurement, such as the appropriate confidence level. In addition, unlike other estimates, such as claims estimates, it is not possible to perform direct tests to assess retrospectively whether a particular risk adjustment is reasonable.
Subsequent measurement and the residual margin (IASB approach) or composite margin (FASB approach)
24. Under the IASB approach, at the end

of each reporting period, the insurance liability would be measured as the sum of the present value of fulfillment cash flows, including the risk adjustment, and the remaining residual margin. Therefore, at each reporting period, the liability will reflect current estimates of cash flows, current discount rates, and a risk adjustment that reflects the remaining risk of uncertainty about the amount and timing of those cash flows. Any changes in the estimates are recognized immediately in the income statement. PwC observation: Recognizing changes in estimates in the income statement will lead to an increase in volatility of reported results for
Composite margin (FASB approach)
23. A majority of the FASB rejected

the inclusion of an explicit risk
18
Residual margin Risk adjustment Time value of money
amount initially recognized is unwound but not remeasured
updated for current estimates
updated for market rates
many insurers that currently use fixed assumptions. Under the IASB proposal, changes in estimates would not be recognized in other comprehensive income (OCI). Some argue that this could result in accounting mismatches where assets are measured on an amortized cost basis and equities are measured at fair value through OCI. Another criticism of the proposals is that a gain on initial recognition would not be permitted to be recognized in the income statement, yet if there is a positive change in the estimates of cash flows on day two, it would be recognized immediately in the income statement.
Figure 3: Subsequent measurementIASB Approach
26. The residual margin is not adjusted

when there are changes in estimates of both financial variables (such as discount rates and equity prices) and other estimates (such as expenses and lapses) unless a contract terminates. The residual margin accretes interest at the discount rate used at inception. PwC observation: The IASB did not consider an alternative method for the subsequent measurement of the residual margin by recalibrating the residual at each reporting date considering all current information. Under this alternative, the residual margin could be restated at inception of the contract using updated experience (up to the reporting date) and assumptions of future cash flows. This would lead to part of the change in estimates being recognized immediately in the income statement and the remainder adjusting the unamortized portion of the residual margin and recognized over the remaining coverage period. However, such an approach would be complex to model for long term contracts.
adjustment) and the remaining composite margin. The composite margin would be amortized over both the coverage and claims handling period according to the following formula: Premium allocated to date + Claims and benefits paid to date Total expected contract premiums + Total expected claims and benefits All of the amounts in the above formula would be undiscounted. Although the composite margin amount calculated at inception would not be re-measured to reflect any changes in risk and uncertainty, the amounts used in the formula above would be re-measured based on current estimates at each period end. As a result of this retrospective catch-up type of approach, the amortization pattern for the composite margin would be altered as changes in estimates in the ratio occur. Interest would not be accreted on the composite margin. PwC observation: Supporters of the composite margin approach argue that this approach avoids the concern that a risk adjustment is inconsistent with the fulfillment objective of the proposal. The advantage of the approach is that it avoids the concern over comparability and consistency of different ways of calculating and calibrating a
19
25. The residual margin is calibrated at

inception to an amount that avoids a gain being recognized when an insurer enters into the insurance contract. The residual margin is determined within a portfolio by date of inception and by length of the contract. The residual margin is recognized over the coverage period in a systematic way that reflects the exposure from providing insurance coverage. This is on the basis of time or, if claims are expected to be incurred in a different pattern, on the basis of the timing of expected claims. PwC observation: It is not clear in the proposal whether the pattern of amortization of the residual margin in the income statement can change. For example, it is unclear whether the residual margin can be released if the occurrence of a claim means that the risk of any further claim is reduced or eliminated.
Insurance contracts
27. The FASBs alternative model would

have a single composite margin on inception of the contract. Under this approach the insurance liability at each reporting date would be the sum of the present value of probabilityweighted cash flows (with no risk
Composite margin
amount initially recognized is unwound but not remeasured
Time value of money
updated for market rates
Figure 4: Subsequent measurementFASB Approach
Simplified measurement model for pre-claims liability of short-duration contracts

29. The IASB proposal requires that for
short-duration contracts of approximately one year or less that do not contain any embedded derivatives or options, the pre-claims obligation would be measured as the premium received at initial recognition plus the expected present value of future premiums that are within the boundary of the contract less the incremental acquisition costs of issuing the contract. For balance sheet purposes, this obligation will be offset by the expected present value of premiums and referred to as the pre-claims liability. Any claims that arise on these contracts would be measured at the present value of the fulfillment cash flows using the building block model (including the risk adjustment), as for all other insurance contracts.
risk adjustment. It is also likely to be easier and less costly to implement.
Acquisition costs
28. Under both the FASB and IASB
proposals, acquisition costs that arise from and are incremental to an individual contract are included in the present value of fulfillment cash flows. These are defined as the costs of selling, underwriting, and initiating an insurance contract that would not have been incurred if the insurer had not issued that particular insurance contract. The inclusion of these costs in the fulfillment cash flows will reduce the composite margin (under the FASB approach) and the residual margin (under the IASB approach) on initial recognition of the contract. All other acquisition costs are expensed when they are incurred. PwC observation: The restriction to incremental acquisition costs is consistent with the treatment of transaction costs in IFRS on financial instruments (IAS 39). However, it is more restrictive than current accounting in many territories, which may allow an element of allocated direct costs or overhead to be treated as deferred acquisition costs. Even under the newly revised definition of acquisition costs under US GAAP, both
20
incremental costs as well as certain direct costs of acquisition, such as the portion of internal salaried sales force, underwriting, and policy issue costs relating to successful contract sales, are capitalizable. The proposals would mean that the distribution model may affect reported profits. Insurers that use independent intermediaries (or pay their internal sales force on a commission basis) are likely to incur a commission, which is usually incremental at the contract level and so will be a fulfillment cash flow in the building block approach. This treatment will result in the reduction of the recognized composite margin (FASB) or residual margin (IASB) on day one. When the commission is paid, it will be treated as a contract cash flow reducing the liability with no impact on the income statement. However, insurers that perform direct marketing or have a salaried in-house sales force will likely have lower acquisition costs that are considered incremental to a specific insurance contract. Thus, they will have a larger composite margin (FASB) or residual margin (IASB) for a contract that is recognized over the coverage period and will expense most of their acquisition costs immediately, which could give rise to an initial loss.
30. An onerous contract test (which is

similar in concept to the current liability adequacy or premium deficiency test) would be required under the IASB simplified approach for the pre-claims liability. At initial recognition and subsequently, a contract is onerous if the present value of fulfillment cash flows (including the risk adjustment) exceeds the carrying amount of the pre-claims obligation. In this case the insurer would recognize an additional liability for this difference and recognize an expense in the income statement. This onerous contract test would be performed at the portfolio level of contracts with a similar date of inception.
PwC observation: The performance of the onerous contract test for a portfolio of contracts with a similar date of inception may be at a lower level than current accounting practice would require. The definition of a portfolio may be open to different interpretations.
allowed/required to release any pre-claims liability in the event that the occurrence of a claim curtails any of the remaining insurance coverage. It is also not clear whether the pattern of release of the pre-claims liability can change if the expectation of claim and benefit payment patterns change. An assuming reinsurer that commits to reinsure policies written by an insurer in the next twelve months may not meet the short-duration contract criteria if the coverage period of the underlying contracts is considered to be the coverage period for the reinsurance contract.
31. Under the IASB proposal, the preclaims obligation would be reduced over the coverage period in a systematic way that reflects the exposure from providing insurance coverage. Similar to the residual margin in the IASB version of the building block model, this would be amortized based on the passage of time or the expected timing of incurred claims and benefits, if that pattern differs significantly from the passage of time. Interest would accrete on the preclaims liability at the current rate. PwC observation: The IASB has proposed that the simplified measurement approach be used for the pre-claims liability of short-duration contracts that meet stipulated criteria. This means that property and casualty insurers may have to apply two different measurement models for similar contracts where only the contract term is different. The IASB considered whether to permit the use of the simplified approach rather than require it, given that it can be seen as a practical short cut. To enhance comparability the IASB decided to require the simplified approach if contracts meet the specified conditions. The IASB ED is unclear about whether an insurer would be
coverage period, combined with the exclusion of a composite margin in the post-coverage period, would result in accelerated recognition of profit when compared to the composite margin building block approach. This would also typically result in accelerated recognition of profit compared to the current USGAAP model in which claim liabilities are not discounted.
Reinsurance
require that reinsurance business assumed be measured using the same building block measurement approach as for other insurance contracts. Ceding commission paid to the ceding company would be treated as a reduction in premium.
32. During the joint deliberations,

the FASB discussed the simplified measurement method proposed by the IASB but did not conclude on whether and when a simplified approach might be appropriate. In its discussion paper, the FASB asks constituents whether a modified approach might be appropriate and how the scope for such an approach should be defined. For example, should the scope be based on the duration of the coverage period, the duration of the claims payment period, the type of insurance, or current guidance?
35. For the ceding insurer, if the net

cost of a ceded reinsurance contract exceeds the expected value of the recovery (including a risk adjustment in the IASB model), this excess would be recognized as a composite margin (residual margin in the IASB model) in the reinsurance asset. However, if the net cost of the reinsurance is less than the expected value of the recovery (including a risk adjustment in the IASB model), this would be recognized as an immediate gain. Ceding commission would be treated as a reduction of the premium ceded to the reinsurer.
33. The FASB discussion paper does not

address how the modified approach might be applied to claims in the context of the FASBs composite margin approach. For example, one issue to consider would be how claim liabilities would be calculated under the FASBs version of a modified approach, i.e., with or without allocation of a composite margin. Use of an earned premium approach during the
36. The risk of non-performance by the

reinsurer should be included on an expected value basis when estimating the fulfillment cash flows of the reinsurance asset.
37. As provided in existing USGAAP and

IFRS 4, an insurer would not offset
Insurance contracts
21
reinsurance assets against insurance contract liabilities in the statement of financial position or offset income or expense from reinsurance contracts against the income or expense from insurance contracts. PwC observation: While issuing a direct insurance contract cannot give rise to recognition of an initial profit, the proposals do allow a profit to be recognized when purchasing a reinsurance contract. Some argue that this is inconsistent with the treatment for financial instruments and with revenue recognition guidance. The proposals do not provide any more guidance than current US GAAP and IFRS 4 on whether insurance companies providing fronting arrangements of linked insurance and reinsurance contracts should treat the inwards and outwards contracts as separate transactions or as a single contract for the purpose of applying the definition of insurance contracts and assessing the significance of insurance risk transfer. The IASB application guidance notes that contracts entered into simultaneously with a single counterparty, or contracts that are otherwise interdependent, form a single contract. There may not be symmetry between the measure of the reinsurance asset by the cedant and the insurance liability as measured by the reinsurer for quota share reinsurance. Differences may arise from the assessment of the explicit risk adjustment due to the level
of risk diversification reflected or other entity specific assumptions. In addition, the reinsurer may include cash flows for contracts not yet written by the cedant.
Unbundling
38. An insurer would be required to
unbundle components of a contract that are not closely related to the insurance coverage specified in that contract. In particular, under the FASB and IASB proposals the following components would be unbundled: Policyholder account balances that are credited with an explicit return where the crediting rate is based on the performance of a specified pool of assets. The crediting rate must pass on all investment performance and so the imposition of a ceiling on the return would not meet these criteria. Embedded derivatives that are separated from the host contract in accordance with existing bifurcation requirements for derivatives. Goods and services provided under the contract that are not closely related to the insurance coverage but have been combined for reasons that have no commercial substance. PwC observation: Unbundling is an important aspect of the proposed accounting as the insurance measurement model differs from other measurement models (i.e., financial instrument and service revenue models). The unbundling
requirements are not accompanied by application guidance and hence policyholder account balances, charges and other assessments, cross subsidies, and other terms used in the proposals, including closely related, will be open for interpretation. It is also unclear how any acquisition costs would be allocated between the different components. Further, the boards discussions seemed to include an intention to unbundle universal life contracts into separate insurance and financial instrument components. However, some interpret the crediting rate criteria to preclude unbundling account balances that do not receive all the investment return from the associated assets.
39. The proposals require that in unbundling an account balance, an insurer regard all charges and fees assessed against the account balance as belonging to either the insurance component or another component, but not the investment component. The crediting rate used to determine the account balance is calculated after eliminating any cross-subsidy between that rate and charges or fees assessed against the account balance. PwC observation: It is assumed that the account balance could be an asset such that loans under which the outstanding balance is waived upon death or disability could be unbundled into the loan balance (within the scope of financial instruments accounting) and an insurance element (within the scope of the insurance proposals) if they meet the crediting rate criteria.
22
Discretionary participating features

40. The IASB and FASB proposals include
within their scope insurance contracts issued by insurers that provide the policyholder with both guaranteed benefits (for example, a death benefit) and a right to participate in the favorable performance of the relevant class of contracts, related assets, or both discretionary participation features. The proposals note that payments arising from the participating feature should be included in the measurement of insurance contracts in the same way as any other contractual cash flows (i.e., on an expected present value basis).
assets, the measurement of the insurance contract should reflect that interdependence and this could be through the use of a replicating portfolio technique. It is assumed that guarantees included in contracts with participating features will be measured on a market consistent basis. This could result in a fairly significant liability attaching to the guarantees compared to the measurement under existing accounting policies.
Recognition and derecognition

44. The IASB and FASB proposals are
consistent with regard to recognition and derecognition of insurance contracts. An insurer would recognize an insurance contract at the earlier of when the insurer is bound by the terms of the contract or when the insurer is exposed to the risk under the contract. PwC observation: Whether an insurer is bound by an insurance contract will depend on the legal requirements in the territories in which it operates. The period an insurer is exposed to the risk under the contract may not be the same as the insurance coverage period. The recognition criteria will change the way many insurers, especially reinsurers, account for insurance contracts, as contracts will be recognized earlier than the date on which the insurance coverage commences. During the period between the recognition date and the date coverage commences, the insurer would be required to remeasure its obligations using current estimates, including changes in discount rates, and record changes in those obligations in the financial statements. For contracts measured using the simplified approach, the insurer would be required to perform a liability adequacy test, which could result in recognizing a loss in the income statement. The insurer would not commence the amortization of the composite margin (or residual margin) until the coverage period commences.
23
42. If investment contracts with discretionary participating features are within the scope of the insurance contracts standard, the boundary of the contract is the point at which the contract holder no longer has a contractual right to receive benefits from the participating features in that contract.
41. Insurers also issue investment

contracts with participating features that are not insurance contracts, but give the policyholder guaranteed benefits and additional benefits, which are, to a varying degree, at the discretion of the insurer. The IASB ED includes these contracts in its scope if there are also insurance contracts that provide similar contractual rights to participate in the performance of the same insurance contracts, the same pool of assets, or the profit of the same company, fund, or other entity. Otherwise such contracts would be within the scope of the financial instruments standard. The FASB would include all investment contracts with discretionary participating features within the financial instruments standard. PwC observation: Participating contracts often include guarantees. The proposals acknowledge that where cash flows depend on the performance of particular
Insurance contracts
43. Under the IASB ED, the residual

margin on investment contracts with discretionary participating features is recognized in the income statement over the life of the contract on a systematic basis (passage of time or on the basis of the fair value of the assets under management if that pattern differs significantly from the passage of time). PwC observation: The guidance in the exposure draft suggests that the expected cash flows would include payments to current or future policyholders as a result of participation features. It is not clear how future contracts would be within the boundary of existing contracts and what the implications of this would be for mutual insurers or inherited estates.
45. An insurer would derecognize an

insurance contract liability (or a part of an insurance contract liability) when it is extinguished. This is when the obligations in the contract are discharged, cancelled, or expire. At this point the insurer is no longer at risk and is no longer required to transfer any economic resources to satisfy the insurance obligation. PwC observation: Reinsurers that write treaties covering a cedants insurance contracts to be issued in the upcoming year at a constrained price would be required to recognize the contract in accordance with the measurement model, i.e., estimating expected cash flows for underlying direct contracts that have not yet been written. However, entering into a reinsurance agreement does not result in derecognition of the insurance contract liability unless there is a novation of the direct contract. Unlike US GAAP and existing IFRS in respect of financial instruments, the proposals do not contain any guidance on when a substantial modification to an insurance contract should be accounted for as an extinguishment of the contract.
transaction. In this case the excess of the consideration over the present value of the fulfillment cash flows (including a risk adjustment in the IASB model) establishes the composite margin (or the residual margin in the IASB model) at initial recognition; or The present value of the fulfillment cash flows (including a risk adjustment in the IASB model). If the present value of the fulfillment cash flows exceeds the consideration received, the excess results in a loss, which is recognized immediately in the income statement.
a separate asset for the value of business acquired (VOBA or PVIF) would be eliminated.
Unit-linked contracts
48. A unit-linked contact (sometimes
called a separate account or variable contract) is one where some or all of the benefits are determined by the price of units in an internal or external investment fund. Under the IASB and FASB proposals, unitlinked assets and liabilities would be presented as separate line items in the statement of financial position and not comingled with the insurers other assets and liabilities. Income and expense from unit-linked contracts would be presented as a single line item in the income statement. Income and expense from pools of assets underlying these contracts would be presented as a single line item as well, not commingled with income and expense from the insurers other assets.
47. A portfolio of insurance contracts

acquired in a business combination will be measured at the higher of: The fair value of the portfolio. In this case the excess of fair value over the present value of fulfillment cash flows (including a risk adjustment in the IASB model) establishes the composite margin (or the residual margin in the IASB model); or The present value of the fulfillment cash flows (including a risk adjustment in the IASB model). If this amount exceeds the fair value of the portfolio, the excess would increase the amount of goodwill. PwC observation: The proposals deviate from the principles in US GAAP and IFRS business combination guidance in that the insurance contracts may not be measured at fair value in some instances but instead would be subject to the same principles as applied to other insurance contracts issued by the insurer. The current practice of recognizing
49. In proposed amendments to IFRS 9,

IAS 32, and IAS 16, the IASB would require entities to recognize treasury shares and owner occupied property at fair value with changes in fair value recognized in profit or loss to the extent those fair value changes relate to the interest of unit-linked contract holders in the pool of assets. While the FASB had agreed to this accounting during deliberations, there is no discussion of this issue in the FASB DP. PwC observation: Both insurance contracts and other financial instruments can meet the unit-linked
Portfolio transfers and business combinations

46. The FASB and IASB proposals require
an insurer to measure a portfolio of insurance contracts acquired in a portfolio transfer at the higher of: The consideration received after adjusting for any other assets or liabilities acquired in the same
24
contract definition. It is unclear how the unbundling rules for account balances link with the presentation requirements for unit-linked contracts. The boards intent seemed to be for this presentation to apply to the account balance of a unit-linked contract. However, the proposals require any unbundled account balances within unit-linked contracts to be accounted for under the financial instruments standard. Similarly, the single line presentation would also not apply to unitlinked investment contracts unless a similar requirement were to be included in financial instruments guidance. Further, the proposed amendments to IFRS 9, IAS 32, and IAS 16 refer to treasury shares issued by and property occupied by an insurer. It is not clear whether these amendments would apply only to insurance contracts or whether they would also apply to unit-linked investment contracts.
at initial recognition, disaggregated in the income statement or the notes into losses on portfolio transfers, gains on buying reinsurance, and day one losses. Non-incremental acquisition costs. Experience adjustments and changes in estimates, disaggregated in the income statement or the notes into experience adjustments, changes in cash flow estimates and discount rates, and reinsurance impairment losses. Interest on insurance liabilities (presented to highlight the relationship with investment return on assets backing those liabilities).
51. Under the IASB proposal, for the

pre-claim liability when the shortduration contract approach is used, the insurer should present: Underwriting margin (disaggregated in the income statement or the notes into premium revenue, being the reduction in the preclaim liability from providing insurance coverage, claims incurred, expenses incurred, and amortization of incremental acquisition costs). Changes in liability for onerous contracts.
measurement model. For many insurers, the proposed statement of comprehensive income will be a significant change from the way insurers present their results today. Property and casualty insurers that write contracts accounted for under the simplified measurement approach and also write contracts measured under the building block measurement model will not be able to show premium income on all insurance contracts on the face of the income statement. Conglomerate groups will also need to consider how they will present their combined results. It is unclear how subsequent changes in the claims liability would be presented in the simplified measurement approach underwriting margin, as these liabilities are under the building block measurement model. Management, analysts, and investors will need to be educated in the new presentation format and the implications of the building blocks approach on reported earnings. It will take some time to become accustomed to not having premiums, claims, incremental acquisition costs, and administrative expenses (to the extent they are included in the building block cash flows) presented on the face of the income statement.
Presentation: Statement of comprehensive income

50. The following minimum line items
would be required to be presented in the statement of comprehensive income under both the FASB and IASB proposals: Underwriting margin (i.e., the release of the composite margin under the FASB model). Under the IASB model, the underwriting margin would comprise both the change in the risk adjustment and the release of the residual margin, disaggregated in the income statement or the notes. Gains and losses
Insurance contracts
52. Other than for the pre-claim liability

as noted above, premiums, claims expenses, and other expenses included in the measurement of the liability are not presented in the statement of comprehensive income but are treated as deposit receipts/ payments under both the FASB and IASB proposals. PwC observation: The presentation model is driven by the
Disclosure
53. Under the FASB and IASB proposals
an insurer would disclose qualitative and quantitative information about the amounts recognized in the financial statements and the nature and
25
extent of risks arising from insurance contracts to help users understand the amount, timing, and uncertainty of future cash flows arising from those contracts. An insurer should aggregate or disaggregate information so that useful information is not obscured. The proposed disclosure requirements build on the current IFRS 4 requirements and have been amended to also require the following disclosure that flows from the measurement model.
Income and expenses recognized in profit or loss Amounts relating to portfolio transfers or business combinations Net exchange differences arising from translation of foreign currency amounts
the insurer operates, for example, minimum capital requirements or required interest rate guarantees.
59. The proposed disclosure requirements

would retain the IFRS 4 requirement to present claims development tables, initially for at least 5 years. After adoption of the standard, claims development tables would be built up to 10 years. The requirement would not apply to claims that are settled within one year. PwC observation: The proposed disclosure requirements are more detailed than currently required and may significantly impact the system requirements of insurers. Systems will have to be able to capture and produce information sufficient to present the reconciliation of movements in the insurance and reinsurance balances.
56. An insurer should disclose the methods

used and processes for determining the inputs to the fulfillment cash flows. Under the IASB proposal, an insurer should also disclose the methods and inputs to determine the risk adjustment, including disclosure of the confidence level to which the risk adjustment corresponds (when the insurer uses the conditional tail expectation or cost of capital methods).
54. The proposals require a reconciliation from the opening to the closing aggregate insurance and reinsurance balances for each of the following: (a) Insurance contract liabilities and assets (b) Risk adjustments included in (a) (c) Residual (or composite) margins included in (a) (d) Reinsurance assets arising from reinsurance contracts held as cedant (e) Risk adjustments included in (d) (f) Residual (or composite) margins included in (d) (g) Impairment losses recognized on reinsurance assets
57. The proposals also include a requirement to disclose a measurement uncertainty analysis of the inputs that have a material effect on the measurement. If changing one or more of the inputs in the building blocks to a different amount that could reasonably have been used in the circumstances would have resulted in a materially different measurement, the insurer would be required to disclose that effect. In determining this effect the insurer should ignore remote scenarios but include the effect of correlation between inputs. Significance is judged with reference to profit or loss and total assets or total liabilities.
Transition
60. Because the FASB proposal is merely
a discussion paper rather than an exposure draft, no transition guidance is provided. However, the IASB ED envisages retrospective application for all in-force contracts with no grandfathering of past practices. At the beginning of the earliest period presented, an insurer would: Measure each portfolio of insurance contracts at the present value of the fulfillment cash flows (including a risk adjustment), which would exclude any residual margin Derecognize any existing balance of deferred acquisition costs
55. Each reconciliation as required above

should show at a minimum: The carrying amount at the beginning of the period New contracts recognized during the period Premiums received Payments with separate disclosure of claims, expenses, and incremental acquisition costs Other cash paid
58. The disclosure about the nature and

extent of risks arising from insurance contracts are similar to current IFRS 4 requirements for insurance contracts but would be expanded to require disclosure about information on the regulatory framework in which
26
Derecognize any intangible assets arising from insurance contracts assumed in previous business combinations (excluding customer relationships/lists that relate to future contracts)
61. At the start of the earliest period

presented, when the insurer would first apply the proposed standard, insurers would be permitted to redesignate a financial asset as measured at fair value with changes in fair value recognized in profit and loss but not to redesignate a financial asset that is currently measured at fair value with changes in fair value recognized in profit or loss to amortized cost. PwC observation: The extent of the opening retained earnings adjustment on the initial application of the IASB standard will be influenced by many factors, including the profitability of the business written as well as the previous accounting policies applied (including the level of prudence in those previous measurements). Insurers that write longer term contracts are likely
to be concerned that profit in excess of the risk adjustment that would have been recognized in the income statement in future periods will now be recognized in equity on transition. As a result of these transition provisions, contracts in-force at transition will have less profit in future periods than new business due to the lack of a residual margin being recognized at transition. The proposed standard does not allow insurers to implement the proposals in full retrospectively.
to engage in the comment letter process and respond formally to the boards on the questions included in both the FASB discussion paper and the IASB exposure draft.
AddendumProject status update

63. The Boards heard input from
constituents at the three joint roundtables held in December 2010. In addition, over 250 comment letters were received by the IASB on its exposure draft, and over 70 letters were received by the FASB on its discussion paper. Key issues identified include the discount rate, margins, the modified approach for short-duration contracts, financial statement presentation, acquisition costs and unbundling. The proposed timetable calls for redeliberations through May 2011 with the IASB projecting issuance of a final standard by June 2011 and with a potential FASB exposure draft issued at or around the same time.
Timing for comments

62. The comment period on the FASB
discussion paper ends on December 15, 2010 (or November 30, 2010 for roundtable participants). The comment period for the IASBs exposure draft ends on November 30, 2010, and a final IASB standard is expected in mid-2011. Given the potential impact of the proposed changes, we encourage management
Insurance contracts
27
USGAAP Convergence & IFRS Insurance: Updated August 15, 2011

August 2011
Table of contents
Sharing insights on key industry issues IASB/FASB Board MeetingInsurance Contracts

PwC Summary of MeetingsJuly 21, 2011
3 6 10
IASB/FASB Board MeetingInsurance Contracts

PwC Summary of MeetingsMay 31, 2011
IASB/FASB Insurance ContractsProject

PwC Summary as of May 31, 2011

26 31


47

51 54


PwC Summary of MeetingsApril 27, 2011
68 72

PwC Summary as of April 14, 2011

PwC Summary of MeetingsApril 12, 2011
85

PwC Summary of MeetingsMarch 29, 2011
88

PwC Summary of MeetingsMarch 2122, 2011
91

PwC Summary of MeetingsMarch 14-15, 2011
98
IASB/FASB Board Meeting Insurance Contracts PwC Summary of Meetings July 21, 2011
Whats inside: Highlights Outreach with US investors Premium allocation approach
Highlights
The IASB and FASB held a joint Board meeting on July 21, 2011 where they discussed the outcome of the outreach effort the staff had undertaken with US insurance analysts. The Boards also discussed the modified or simplified approach for short duration contracts (now termed the premium allocation approach) and whether it is an approximation of the building block model or a separate model. The debate centered around which contracts should be eligible for the premium allocation approach. No decisions were made. Questions about the detailed methodology of the premium allocation approach, for example if it should be permitted or required, whether amounts should be discounted, and how it should be presented were not discussed at this meeting. The topic of unbundling had been included in the agenda papers but was not discussed at this meeting.
Reprinted from: Sharing insights on key industry issues July 21, 2011 Note: Since a variety of viewpoints are discussed at FASB and IASB meetings, and it is often difficult to characterize the FASB and IASBs tentative conclusions, these minutes may differ in some respects from the actions published in the FASBs 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.
Outreach with US investors

The staff summarized the main points that were raised by US insurance analysts in their recent outreach. Some users felt that US GAAP for insurers (particularly for non-life contracts) was not broken and therefore the need for change needed to be better justified. In addition, there were concerns that the significant amount of historical US GAAP data for trend analysis would be lost moving to a new standard. However other users noted that a common insurance standard would be beneficial. Other concerns were expressed about whether the proposed accounting model focused too much on regulatory needs, the increased reporting of volatility in earnings and the different income statement presentation for insurance contracts which could discourage investors from investing in the insurance sector. While many sell side US analysts thought there was too much unlocking and preferred a cost over a current value measurement, buy side analysts seemed to prefer the latter. Some analysts commented that adding a
discounting factor for non-life liabilities was too subjective, while others considered time value to be an integral component of the measurement model. One of the IASB Board members recommended that the staff involve general investors in their outreach and not only focus on specialist insurance analysts. Another IASB member suggested that the staff bring together investors from the US and from Europe with the aim of finding some common ground. In addition, one of the IASB Board members strongly emphasized the different starting points of the US compared to the IFRS community. He pointed out that it is very important to the IFRS community to develop an insurance standard but he questioned whether a converged position was needed if US GAAP was currently felt to work for the US. Another IASB member agreed and noted that in many emerging countries the insurance industry was still developing and needed an insurance standard. Some IASB members and staff also challenged the view of some analysts that the proposed model focused on regulatory objectives.
Insurance: Updated August 15, 2011
Staff explained that the outreach with the US specialist analysts was the beginning of their planned outreach and that they would be talking to analysts in other parts of the world and would endeavor to include non specialist analysts.
Premium allocation approach (modified approach for short duration contracts)

The staff noted that the terminology in the latest staff papers was changed from the IASB exposure draft and FASB discussion paper (ED/DP) to clarify the components of the approach. The modified or simplified approach would now be referred to as the premium allocation approach, the pre-claims liability would be replaced with the liability for remaining coverage,, and the claims liability would be termed the liability for incurredclaims. The staff presented two papers setting out different staff views on the premium allocation approach. The staff explained that although the premium allocation approach had generally been welcomed by respondents to the ED/DP, many commentators had criticized the proposals as being over-engineered. In addition there had been criticism of the fact that the premium allocation approach was required rather than permitted. The IASB staff recommended that the premium allocation approach should be viewed as a simplified approximation of the full building block model (one model approach). They explained that contracts would be eligible for the premium allocation approach when that approach
resulted in a reasonable approximation of the building block model. In addition, this condition would be deemed to be met without further investigation when the coverage period was approximately one year or less and the contract does not contain any embedded options or derivatives that significantly affect the variability of cash flows (after unbundling any embedded derivatives). This approach would be permitted and not required. In a change from the Boards views expressed in drafting the ED, guidance would be added to avoid overly restrictive interpretations of approximately one year, clarifying that contracts could meet the definition even if they are several months longer than one year and even if there are a few longer-duration contracts within a portfolio of predominantly one-yearcontracts. The FASB staff recommended that premium allocation approach be viewed as a separate model from the building blocks as non life contacts were economically different from life contracts (two model approach). Contracts should be eligible for the premium allocation approach where: the compensation to the policyholder is based on the incurred loss and not a specified amount, the period between the premium receipt and the date of loss is insignificant and the pricing of the premiums excludes risks relating to future renewal periods. The FASB staff indicated that a key challenge, in particular for US insurers, of the one model approach would be the need to prove that the premium allocation approach is an approximation of the building block model. This would require entities to perform calculations under both the building block and the premium allocation models.
An IASB member asked the staff to explain which contracts would be caught by the different eligibility criteria of the two approaches. The staff indicated that a very high percentage (say 90%) of contracts would be equally eligible for the premium allocation approach irrespective of which set of eligibility criteria were used The chair of the IASB questioned the rationale behind the different staff perspectives about one versus two models when there was such a high degree of overlap in the eligible contracts. A FASB member agreed that in his view the main question was the eligibility for the premium allocation approach rather than whether there were one or two models. Although he supported the FASB staff concerns regarding the need to prove approximation to the building blocks, he had some reservations about the implications of having two different models for other aspects of insurance accounting such as discounting claim liabilities andreinsurance. In the resulting discussion several members of both Boards expressed their confusion as to the objective of the eligibility criteria and whether they aimed toidentify: a distinction between contracts that could be viewed as economically different or with greater/lesser importance of underwriting results (that is, life and non-life contracts), contracts with a significant degree of financing (that is short versus long duration contracts), or contracts with different degrees of variability in cash flows.
Members of the Boards expressed divergent views about there being a significant
difference in the underlying economics of life and non life contracts and therefore whether there should be one or two models. There was no poll of views but a majority of the FASB members who expressed an opinion tended to believe that there were two models but a majority of the IASB members who expressed an opinion favoured there being one model. One of the IASB Board members stated her view that the premium allocation approach was primarily a different presentation model (rather than a different measurement model) and disagreed strongly that there was a significant difference between the importance of investment returns for life and non-life business. As evidence that non-life companies also consider investment return as well as underwriting, she noted that non-life companies often, in presentations to analysts, describe that while they may have a loss ratio over 100%, their business is still profitable because the interest inherent in collected premiums will cover the shortfall. An IASB member queried whether an annual travel insurance policy that paid out variable amounts for property claims such as lost baggage, but also paid fixed amounts for specified injuries or death would fall outside the criteria of the two model approach and therefore be accounted for using the full building block approach or be bifurcated into two components. The FASB staff indicated that their intention was not to bifurcate contracts in this way. A member of the FASB questioned how the premium allocation approach could be viewed as an approximation of the building block approach since the building block approach results in one insurance
liability and a net margin in the income statement whereas the premium allocation approach results in recognising two separate liabilities (one effectively a performance obligation with related revenue and the other a claim liability that is treated as an expense). In his view this represented a fundamental difference between the twomodels. One of the IASB members stated his preference to have coverage periods up to one year (for contracts that do not contain embedded derivatives) as the initial eligibility criteria. No proof of approximation to the building block model was required for these contracts, however insurers could still use the premium allocation approach for longer duration contracts if they proved it was a reasonable proxy. The IASB staff indicated that this had been theirintention. Despite the different views expressed, some members of both Boards reiterated the need to focus on arriving at a converged set of criteria given the 90% overlap in the relevant contracts that would be eligible for the premium allocation approach. The chair of the FASB reminded Board members that questions about the premium allocation model itself, for example if it should be permitted or required or if amounts should be discounted would be discussed in latermeetings. No decisions were taken. The staffs were asked to identify types of contracts where the two sets of eligibility criteria would give different results, then bring this analysis back to the Boards.
IASB/FASB Board Meeting Insurance Contracts PwC Summary of Meetings May 31, 2011
Whats inside: Highlights Risk transfer for reinsurance contracts Interdependent contracts Recognition of Reinsurance contracts Ceded risk adjustment Treatment of gain or loss on reinsurance Cession of residual/composite margin on underlying insurancecontracts Treatment of cedingcommissions Credit risk of reinsurer
Highlights
The IASB and FASB held a joint Board meeting on May 31, 2011 where they discussed 8 of the 14 issues identified to date relating to reinsurance. With many topics to cover in a relatively short period of time, the Boards addressed the issues at a very high level, with few examples or the chance to reflect on potential unintended consequences. Interpreting the implications of the Boards decisions for various reinsurance structures and applying some of the Boards conclusions to actual reinsurance transactions may prove challenging. The Boards tentatively agreed to clarify that if the economic benefit to the reinsurer for its respective portion of the underlying policies is virtually the same as the ceding companys economic benefit, the reinsurer has assumed substantially all the insurance risk related to the reinsured policies. Therefore the reinsurance contract is deemed to transfer significant insurance risk. The Boards also tentatively agreed that the assessment of significance of insurance risk should be done contract by contract, and that contracts entered into with a single counterparty (or related counterparties) for the same risk or that are otherwise interdependent should be considered a single contract. The Boards agreed that revised wording was needed to the staff proposal on recognition for ceded reinsurance. Conceptually, for many contracts (such as risk attaching quota share) the cedant should recognize a reinsurance asset when the underlying direct contract liability is recognized rather than at the beginning of the reinsurance coverage period. This would avoid recording a reinsurance asset prior to recording an underlying direct liability. However, for other types of coverage such as aggregate excess of loss coverage, recognition would be at the beginning of the reinsurance coverage period. The Boards agreed with the staff proposal to clarify that in calculating a risk adjustment on ceded reinsurance, the ceded portion of the risk adjustment should represent the risk being removed from the direct insurer by the use of reinsurance. The Boards also agreed with the staff proposal that the guidance should not specify whether the risk adjustment should be calculated on a gross basis or arrived at by performing a with and without reinsurance calculation of the netexposure. The staff proposal that the Boards tentatively agreed to at the May 31 meeting differs from the ED and DP proposal to record day 1 gains immediately but defer losses upon initial recognition of a ceded reinsurance contract. The FASB and a large majority of the IASB supported the staff proposal to recognize losses immediately relating to reinsurance of past events. The FASB also agreed with the staff proposal to defer amounts paid or payable for prospective reinsurance coverage in excess of fulfillment cash inflows, as did a slight majority of the IASB. The FASB and a large majority of the IASB also supported the staffs proposal to defer any day 1gains.
Reprinted from: Sharing insights on key industry issues May 31, 2011 Note: Since a variety of viewpoints are discussed at FASB and IASB meetings, and it is often difficult to characterize the FASB and IASBs tentative conclusions, these minutes may differ in some respects from the actions published in the FASBs 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.
The FASB and all but one IASB member agreed with the staff proposal that the cedants estimate of the present value of the fulfillment cash flows for the reinsurance contract should be done excluding the residual/composite margin on the underlying direct contracts. The Boards discussed but did not conclude on whether the ED proposal to treat ceding commissions received as a reduction of the premium ceded to the reinsurer should be retained. The Boards decided that this was a presentation issue and therefore should be discussed when presentation and the modified approach areredeliberated. The Boards also seemed to be leaning toward an approach whereby guidance on recording an impairment allowance for the risk of nonperformance by the reinsurer would be aligned with the Boards ultimate conclusions on impairment in the financial instrument project rather than developing guidance specific toinsurance.
and whether each of those contracts transferred risk. This idea was ultimately rejected on the basis that it would be too difficult to do for non-proportional reinsurance coverage and would require allocations of the reinsurance premium to individual underlying contracts, which would be operationally challenging. An IASB member noted that if existing IFRS4 risk transfer guidance were retained, (where there is no requirement that there be at least one scenario where the insurer suffers a loss), this new stepping into the shoes provision would not be required, but reluctantly agreed that the guidance was now needed. Another IASB member suggested that perhaps the guidance should say that if the economic benefit to the reinsurer for its respective portion of the underlying policies is virtually the same as the ceding companys economic benefit, then the reinsurer has assumed substantially all the insurance risk related to the reinsured policies and thus the reinsurance contract is deemed to transfer significant insurance risk. Both Boards seemed to agree with this approach, subject to going back to insurers applying IFRS to determine if this notion was current practice. The FASB chair remarked that is was already an existing USGAAPprovision.
Risk transfer for reinsurance contracts

The staff noted that some respondents were concerned that the proposed criteria for risk transfer, which requires that there must be at least one scenario where the insurer suffers a loss, would be problematic for certain types of reinsurance coverage. The staff gave examples of two types: historically profitable quota share reinsurance and catastrophe reinsurance coverages with high severity but low frequency claims. However, given that the IFRS4 risk transfer criteria are met even if an insured event is extremely unlikely, it would appear that most quota share reinsurance contracts and catastrophe covers should pass the risk transfer test unless they lack commercial substance. There may be isolated situations where the direct contracts are so highly profitable that reinsurance of those contracts is not expected to generate any net losses to thereinsurer. Nevertheless, to eliminate concerns raised by constituents as noted above, the staff
proposed that the definition be clarified to add wording similar to the stepping into the shoes of the cedant wording in existing USGAAP literature. This provision notes that if substantially all of the insurance risk relating to the reinsured portions of the underlying insurance contracts has been assumed by the reinsurer, the reinsurance contract is deemed to transfer significant insurance risk. The provision is necessary in USGAAP given the higher threshold for assessing risk transfer (i.e., there must be a reasonable possibility of significant loss to thereinsurer). Several FASB members seemed uncomfortable with the staff wording as currently proposed as it seemed rather broad, with one Board member noting that because it referred to having substantially the same risks but not substantially the same premium, a reinsurer could charge a different premium (e.g., higher) and therefore actually have less risk. Another FASB member proposed that perhaps the guidance should provide for looking through to the underlying direct contracts
Interdependent contracts
The staff presented its proposal that contracts entered into with a single counterparty (or related counterparties) for the same risk or that are otherwise interdependent should be considered a single contract for insurance and reinsurance risk transfer analysis.
Several Board members asked that the guidance be clarified to emphasize that the combination of contracts would only be applied where contracts are with the same party or a related party, but that contracts executed with unrelated parties would not be combined. For example, if a fronting company accepted risk from one company, and then retroceded that risk on a 100% basis to a totally unrelated party, each of those two contracts would be evaluated separately for risk transfer. On the other hand, an operating entity may transfer risk to an independent insurer which then passes the risk back to a captive insurer in the same consolidated group as the operating entity. The entities should consider these arrangements together to determine risk transfer. The discussion did not specifically cover other issues raised by constituents outside of reinsurance relating to interdependent contracts. For example, it was not clear whether this guidance would apply to situations where a bank that issues a loan for which its insurance subsidiary contemporaneously issues a policy to the borrower that would waive the loan upon death and therefore require the bank to combine the loan and the insurance policy into one contract for accounting purposes in its consolidated accounts.
attaching contract). The issue with such a contract is whether it should be recognized and measured at the start of the reinsurance coverage period, even though this may be prior to recognizing the underlying direct contracts, which are not yet in existence. The staff and Boards seemed to agree with the goal of avoiding the recording of a reinsurance asset prior to recording an underlying direct liability. The Boards therefore agreed with the general staff direction of recognizing a reinsurance asset when the underlying direct contract liability is recognized rather than at the beginning of the reinsurance coverage period. However, for other types of coverage such as aggregate excess of loss coverage, recognition would be at the beginning of the reinsurance coverageperiod. It was unclear from the limited discussion how ceded residual/composite margin on the reinsurance contract would be calculated if recognition occurs as each underlying contract is written rather than at a single point in time. In addition, while the approach seems as if it may be more straightforward to apply for the IASBs modified approach, application to the modified approach was not discussed.
The staff noted that theoretically, the calculation should be the same in either approach if both calculations are done at the same portfolio level. However, respondents indicated that the gross less net equals ceded approach was operationally easier to apply, especially in situations involving aggregate excess of loss contracts.
Treatment of gain or loss on reinsurance

The ED and DP proposal would have recorded day 1 gains immediately and deferred losses upon initial recognition of a ceded reinsurance contract. However, the revised staff proposal agreed to by the FASB and narrowly by the IASB is to recognize losses immediately relating to reinsurance of past events and to defer amounts paid or payable for prospective reinsurance coverage in excess of fulfillment cash inflows. Under the revised staff proposal, any day 1 gains would bedeferred. The staff revised its view based on comments from many respondents (both cedants and assuming companies) to the ED and DP and outreach efforts. The amounts deferred relating to prospective coverage would be equivalent to prepaid insurance premiums. The staff and most Board members believe that while amounts should be deferred relating to prospective coverage, such amounts paid for adverse development coverage of past events should not be deferred. There was no discussion during the meeting as to why this USGAAP distinction between prospective and retroactive coverage with different deferral treatment to each was being applied. This seems inconsistent with the IFRS4
Recognition of Reinsurance contracts

The staff reminded the Boards of their previous decision that direct insurance contacts should be recognized at the start of the coverage period (unless onerous). A ceded reinsurance contract may start on January 1, and provide coverage for all direct contracts expected to be written in the upcoming year (referred to as a risk
Ceded risk adjustment

The staff noted that some constituents interpreted the ED as requiring a gross less ceded equals net approach to determining the risk adjustment associated with ceded reinsurance, whereas many suggested a gross less net equals ceded approach. The staff noted that they do not intend to be prescriptive in the approach, and would allow the use of either method. The Boards agreed with the staff proposal.
definition of insurance which explicitly acknowledges that some insurance contracts cover events that have already occurred, but whose financial effect is still uncertain. The FASB and a large majority of IASB members also agreed that there should be no immediate gain upon entering into a reinsurance contracts, consistent with the notion of no immediate gain when entering into an insurance contract. However, several IASB members disagreed, noting that the accounting should be aligned between the accounting for the direct contract liability and the reinsurance contract asset. An IASB member countered that he supported the staff position, commenting that an exchange price is different from how one would recognize the liability. Another IASB member agreed with the staff proposal to defer the gain, but questioned whether it would be appropriate to defer a loss on prospective coverage if the cedant paid more for the reinsurance coverage than he received as premium on the direct business. The staff commented that it would be rare to have a loss on day 1 on a prospective cover, but it could be more common for reinsurance purchased on in-force business. It was noted that taking an immediate gain would be inappropriate for several reasons, one being that entering into a reinsurance contract does not extinguish the underlying liability (unlike a novation) and therefore the earnings process is not complete and there is uncertainty in themeasurement.
Cession of residual/ composite margin on underlying insurancecontracts

The FASB and all but one IASB member agreed with the staff proposal that the cedants estimate of the present value of the fulfillment cash flows for the reinsurance contract should be done excluding the residual/composite margin on the underlying direct contracts. The dissenting IASB member noted her concern with the odd results that could occur if the residual margin in the direct contracts is ignored in quota sharecessions.
contracts. For this reason, the staff recommended that any excess amounts above those included in the direct contract cash flows should be recorded as a reduction of the premium ceded to thereinsurer. After some debate and requests for clarification of the staffs proposal, the Boards decided that this was an income statement presentation issue and not a measurement or timing of income recognition issue. and therefore should be discussed when presentation and the modified approach are redeliberated. It was also clarified that the staff was not proposing any offsetting reinsurance ceding commission or expense allowance cash flows against direct liability cash flows (i.e., there would be no balance sheet offsetting between the reinsurance contract and underlying direct contracts).
Treatment of cedingcommissions
The Boards discussed but did not conclude on whether the ED proposal to treat ceding commissions received as a reduction of the premium ceded to the reinsurer should beretained. The staff noted that some constituents had requested that the Boards reconsider this issue, believing that the gross presentation of premiums, ceding commission, and expense allowances is important to enable the determination of key metrics such as loss ratios and, expense ratios and underwriting profit ratios between direct and net business. The staff realizes that ceding commission and expense allowance amounts included in a reinsurance contract may not match the actual acquisition costs and costs to fulfill the insurance contract that the cedant has included in the expected cash flows of the underlying insurance
Credit risk of reinsurer

There was some discussion of how an impairment model might work in the context of the reinsurance market, where impairment would tend to be analyzed on an individual reinsurer basis, and how the application of an incurred versus an expected loss model might work. The FASB chair noted that it was her understanding that the staff was merely asking for confirmation that the impairment model should not be comingled with the insurance expected loss estimate rather than asking for a separate impairment model for insurance. The Boards seemed to be leaning toward an approach whereby guidance on recording an impairment allowance for the risk of nonperformance by the reinsurer would be aligned with the Boards ultimate conclusions on impairment in the financial instrument project rather than developing guidance specific to insurance.
IASB/FASB Insurance ContractsProject PwC Summary as of May 31, 2011
Reprinted from: PwC Summary May 31, 2011 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, 2010 as well as PwC knowledge gained from attendance at IASB and FASB meetings through May 31, 2011.
Component
IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB FASB Discussion paper (DP) issued September 2010
Boards redeliberation status
Status
Exposure draft (ED) issued July 2010
Joint redeliberations began January 2011 Target date for IASB final standard and FASB exposure draft is end of 2011
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 policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder. 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.
Reaffirmed ED/DP position May try to clarify insurance definition to distinguish insurance from service contracts.
Significant insurance risk
Some constituents (principally IFRS) commented that present value clarification and requirement for at least one possible loss outcome not necessary.
Risk transfer analysis should focus on the variability of Reaffirmed ED/DP position. 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. Scope 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 residual value (but stand-alone residual value guarantees not addressed by other projects are in Insurance Contracts scope). Continued IASB changed position from ED for financial guarantee contracts; will retain existing IFRS 4/IAS 39 scope guidance in the short term.
10
Component
IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB FASB
Continued from previous page 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 combination. FASB will deliberate whether financial guarantee contracts (including mortgage guarantee) should be included in scope in conjunction with financial instruments project. Both Boards reaffirmed scope exclusions noted in ED/DP.
Boards reaffirmation of scope exclusions includes FASB decision that employers account for employer-provided healthcare benefits to their employees under License fees, royalties, contingent lease payments and employee compensation guidance similar items rather than impute a premium Direct insurance contracts an entity holds as policyholder and account for them as issued (except for cedant accounting) insurance contracts. Employers assets and liabilities under employee benefit plans and retirement benefit obligations reported by defined benefit plans. Unbundling 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 associated with insurance contracts (e.g., GMABs and GMWBs) which could lead to different results Reaffirmed ED/DP position to separate embedded derivatives as defined in IFRS and US GAAP, respectively, and account for as derivatives at fair value. Staff to consider whether IFRS 4 embedded derivative implementation guidance should be carried forward. Intention is to develop unbundling criteria for goods and services and explicit account balances in insurance contracts based on criteria being developed for identifying separate performance obligations in the revenue recognition project. Criteria include whether the good or service has a distinct function or the account balance has a distinct value. Criteria also include whether or not the account balance is integrated with the remainder of the contract (i.e., whether the amount of insurance risk the insurer is exposed to is significantly affected by the investment performance of the account balance). Will consider further whether explicit account balance exists only when policyholder can withdraw account balance without loss of insurance cover. FASB questioned how inflows/ outflows would be allocated to components.
11
Component
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.
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.
De-recognition of insurance liabilities
Insurer should derecognize an insurance liability (or part of Not expected to be redeliberated 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 for that obligation 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. *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. 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.
Measurement 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)
Clear majority of IASB in favor of explicit risk adjustment approach; FASB rejected it. Risk adjustment objective changed to: the compensation the insurer requires to bear the risk that ultimate cash flows could exceed those expected. Continued
12
Component
Continued from previous page Risk adjustment: Explicit risk adjustment approach 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 inception. Risk adjustment: Composite margin approach (Alternative view in IASB Basis of Conclusions) Composite margin approach: 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 composite margin. Composite margin at initial recognition is the difference between the present value of expected value of cash inflows 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. FASB supports this approach but will consider whether an onerous contract test should also be applied; IASB rejected it. Application guidance will note that amount reflects both favorable and unfavorable outcomes and reflects the point at which insurer is indifferent between holding the insurance liability and a similar liability not subject to uncertainty.
13
Component
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).
Reaffirmed that in general measurement will be done at the portfolio level (e.g., estimate of cash flows and risk adjustment). Have not yet discussed level of measurement for other components such as residual margin and onerous contract test under modified approach.
Use of inputs
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.
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. 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.
14
Component
Definition of contract boundary
Insurer should include premiums and other cash flows Tentatively changed position such resulting from those premiums only if the insurer can compel that contract boundary is point the policyholder to pay premiums, or the premiums are when insurer is no longer required within the boundary of the contract. to provide coverage or when the existing contract does not Contract boundary is the point at which the insurer: confer any substantive rights to (1) is no longer required to provide coverage OR policyholder. (2) has the right or practical ability to reassess the risk of the Not a substantive right when insurer has right or practical ability to reassess risk of particular In making this assessment, insurer should ignore restrictions policyholder and as result can set a that have no commercial substance (i.e., no discernible price that fully reflects that risk. effect on economics of contract) particular policyholder and, as a result, can set a price that fully reflects that risk. If insurer is constrained in the pricing to below market levels, For contract where pricing of premium does not include this would be within the contract boundary. 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.
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.
Not yet specifically discussed
15
Component
Discount rates
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.
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 Discount rates should exclude any factors that influence the top-down approach as long as observed rates but are not relevant to the insurance contract objective achieved). liability (e.g., differences in liquidity between government bonds and certain insurance contracts). Top-down approach may start with yield curve based on actual or Present value of cash flows should not reflect risk of nonreference asset portfolio. performance 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). Types of adjustments expected in top-down approach include 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 insurers own credit standing. Tentatively decided not to allow lock in of discount rate. 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. Accretion of interest on residual margin or composite margin 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). Not yet specifically discussed
16
Component
Subsequent treatment of residual margins under explicit risk adjustment 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.
Exploring whether residual margin should be adjusted for changes in cash flow estimates. May explore alternative amortization terms and patterns.
Subsequent treatment of composite margin under composite margin approach (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.
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 Composite margin to which ratio is applied would not be variability in cash flows determined remeasured (no change to initial inception amount). using an adjusted baseline ratio Composite margin would not be adjusted directly for of actual claims reported to changes in cash flow estimates, i.e., not a shock absorber. total expected cash outflows each period. But allocation pattern/term could change based on components of ratio in formula changing FASB may consider onerous Composite margin would be included as part of the insurance liability. contract test in situations where risk expected to increase.
17
Component
Unearned premium approach for certain shortduration insurance contracts
An unearned premium measurement approach (simplified/modified measurement approach) for pre-claim liabilities for certain shortduration 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 has not yet concluded Constituents commented that on what they refer to as approach is not simplified and that modified measurement one year criterion is too restrictive. and presentation approach Many US constituents believe nonand which insurance life requires a separate model and contracts should apply that existing US GAAP model should approach rather than the be retained. building block approach. Boards not yet agreed on the objective of and eligibility criteria for modified approach; IASB views it as proxy for building block approach; FASB sees it as separate model (revenue recognition model). Boards would not require discounting of future premiums as long as financing element in a contract is not significant. Boards have not yet concluded on whether modified approach should be optional or required. Boards have reaffirmed revenue recognition pattern over coverage period. Boards split on acquisition costs; IASB wants consistency with building block approach, FASB wants consistency with revenue recognition project. Onerous contract test using qualitative factors as indicators. Boards have only discussed preclaims period and have not yet discussed whether claim liability measurement should be building blocks or other.
18
Component
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.
Changed position from ED and DP and tentatively decided that contract cash flows should include those acquisition costs that relate to a portfolio of insurance contracts. But differences exist as to the types of costs to be included. FASB currently supporting an approach consistent with recently issued changes to US GAAP that would include incremental direct costs at contract level such as commissions, plus direct costs at portfolio level such as sales force contract selling, underwriting, medical and inspection, and policy issuance and processing functions relating only to successful acquisition efforts. IASB would include acquisition costs for both successful and unsuccessful efforts to acquire a portfolio of insurance contracts and may also include some overhead, using the same principles as other fulfillment cash flow costs (i.e., consistent with IAS 2), such as sales force office rent expense and software associated with the selling function. Staff to draft guidance and discuss with Boards.
Business combinations and non-business 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.
Not yet discussed
19
Component
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. 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.
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/composite margin. 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. A cedant should recognize an onerous contract liability in the precoverage period. 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/ composite 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. Continued
20
Component
Continued from previous page Reinsurance 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 cedants economic benefit. An insurance contract is treated as a monetary item, Not yet discussed 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). Participating features in insurance contracts Include all cash flows that arise from a participating feature in an insurance contract in the measurement of the 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 policyholders. FASB: measure liability at current value of contractual obligation to policyholder; consider adjusting value of the backing assets to reflect measure of the liability. IASB: Measure on same basis as underlying items in which policyholder participates. Reflect, using a current measurement basis, any asymmetric risk-sharing between insurer and policyholder in the contractually linked items arising from a minimum guarantee. 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). Amounts expected to be paid to future policyholders not yet discussed.
Insurance contracts denominated in a foreign currency
21
Component
Participating investment contracts
Include in scope of Include in scope of financial insurance contracts instruments standard 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.
Not yet discussed
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 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.
Comments from almost all preparers and users that volume information such as premiums and claims considered a key performance metric. Staff have developed alternative approaches to the pure summarized margin approach for Boards consideration: Summarized margin with volume disclosure on the face Expanded margin As written (expected cash flows) Dual statement 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). However, given proposed liability measurement approach, presenting results on an earned premium basis noted by staff as being challenging and would effectively require a second model be developed to estimate amount of revenue to be recognized. Boards suggested outreach to users and preparers to determine information that is critical for them. Continued
22
Component
Continued from previous page Statement of Comprehensive Income Boards will consider at future meeting a staff proposal that insurer 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, if it would eliminate or substantially reduce an accounting mismatch. IASB reaffirmed it would not reopen IFRS 9 to reconsider the accounting for financial instrument assets generally, and will not introduce new requirements specifically for assets held to back insurance contract liabilities 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 insurers 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 insurers 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 insurers 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 insurers other insurance contract liabilities. Income and expense from pool of assets underlying unit-linked contracts presented as a single line item, not commingled with income or expense from insurers 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. IASB: Apply same measurement approach as participating insurance contracts and proceed with ED proposal to fair value treasury shares and owner occupied property to eliminate accounting mismatch. FASB: measure liability at current value of contractual obligation to policyholder; consider adjusting value of the backing assets to reflect measure of the liability.
23
Component
Disclosures
Extensive disclosure requirements based on IFRS 4 and IFRS 7 existing disclosure requirements, with some enhancements, including: 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. Effect of the regulatory framework in which the insurer operates.
Not yet discussed
24
Component
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. Effective date of IASB standard not expected to be earlier than 2015.
25
Whats inside: Highlights Explicit risk adjustment approach Composite margin approach Comparison of composite margin to explicit risk adjustmentexamples Insurance working group meeting
Highlights
The IASB and FASB held a joint Board meeting on May 1718, 2011 where they discussed a series of issues leading up to the ultimate question of whether the building block approach should include an explicit risk adjustment with a residual margin, or alternatively, a composite margin. The staff developed examples comparing the composite margin run-off to the explicit risk adjustment as requested by the Boards during the meeting on May 17, 2011. After extensive discussion of the two models, a clear majority of the IASB voted in favor of an explicit risk adjustment approach. The FASB Board supported the composite margin approach without any subsequent remeasurement of the composite margin. The FASB would however consider an onerous contract test under the composite margin approach going forward. The Boards asked the staff to develop some disclosure with the aim of reconciling the composite margin approach to the risk adjustment approach. The Boards also asked the staff to keep the examples current going forward based on tentative decisions in order to be able to compare the risk adjustment and composite margin approaches. The Boards did not discuss the paper on reinsurance due to time constraints and this will be discussed at a future meeting. The staff also provided a brief summary of the Insurance Working Group meeting held on May 16.
Explicit risk adjustment approach

The staff introduced the discussion noting that insurance is characterized by uncertainty, and as a result of this the revenue recognition model was generally not well suited for insurance contracts, prompting the need for a different model. While the IASB favors an explicit risk adjustment, the FASB prefers an implicit depiction of the risk within the compositemargin. The staff noted that there is a geographic split on this issue, with the US preparers and users especially supportive of the composite margin approach, while non US-users and preparers who are required to include an explicit risk adjustment
for regulatory purposes are generally supportive of the explicit risk adjustment approach. Opponents of the explicit risk adjustment approach believe the calculation can be arbitrary, complex to understand and apply, and results in excessive prudence. Another staff member later noted that views were split among regulators, preparers, and users in territories such as Korea, China, andJapan. The staff noted that FASB Concept Statement 7 acknowledges the need to include a measure of uncertainty in computing present value measurements. They provided an example of two contracts, one contract having a 100% chance of a payment of $500, and the other having a 50% chance of a zero
26
payment and 50% chance of a $1,000 payment. Both contracts have the same mean of $500, but the latter has more uncertainty in the range of outcomes. An insurer who is indifferent to risk would value the outflows of the two contracts at the same amount, while an insurer who is risk adverse would demand a higher payment as compensation to fulfill the obligation. This, they argued, is the concept behind the risk adjustment, a concept that the IASB staff noted is appropriate for a fulfillment valueapproach. An IASB member asked whether the debate was split between life and non-life. The staff responded that it seemed to be a geographical divide, not a life/non-life split, but also pointed out that in life insurance contracts, the risk adjustment was not expected to be very significant (aside from investment risk), and would tend to have a narrower distribution than property/ casualty risk. A FASB member noted that both the staff paper supporting the risk adjustment and the staff paper supporting the composite margin each suggested that users supported that approach and asked for clarification. The staff noted that in terms of users, a small percentage had responded, and of those that did, the split between those supporting the risk adjustment versus composite margin was based in part on geography. The explicit risk adjustment approach is supported by those users in Europe who have more familiarity with risk models due to the implementation of Solvency II, and by those users with insurance expertise versus general users. An IASB member noted that the staff had analogized the insurance measurement to a Level 3 unobservable measurement under fair value guidance and asked
how the calculation of the explicit risk adjustment in the insurance model would compare to the calculation of a risk adjustment in a Level 3 fair value measurement. One staff member noted that fair value requires the use of market participant assumptions, versus the insurance model which uses entity-specific assumptions. Several IASB members noted that the use of entity-specific assumptions was a key concern in that different insurers (or the old versus the new CEO of the same company) could come up with different risk adjustments depending on their level of risk aversion. They thought the objective of the risk adjustment needed to be better articulated. However, another staff member noted that in practice, a Level 3 measurement would most likely use entityspecific assumptions as well, given the lack of observable market inputs. Another IASB member noted that there is substantial support for the inclusion of an explicit risk adjustment in the building block approach (other than in the US), and that while there were subjectivity, comparability, and systems cost concerns, these are no different than concerns faced in Level 3 and IAS 37 contingent liability measurements. However, he thought that one answer to reduce the concern raised by the other IASB members about potentially different levels of risk aversion being used in entity-specific measures would be to instead require an exit value objective for the risk adjustment (but leaving cash flows as entity-specific). Another IASB member asked how different the two approaches would be in terms of day 2 accounting, with the staff replying that the risk adjustment resulted in a remeasurement each period, up or down, while the composite margin would be run off over time. For some risks, the explicit
risk adjustment would lessen over time, while for other types of latent exposures, such as asbestos, it could increase, while the composite margin would not increase. A court ruling in one period could cause cash flows to increase substantially but put an end to uncertainty, reducing the remaining risk adjustment. However, in another situation, indications of oncoming court cases with uncertain outcomes could increase both the estimate of future cash flows as well as the risk adjustment. A FASB member suggested that perhaps the risk adjustment could be disclosed in the notes rather than explicitly calculated in the liability measurement, and only recorded when the cash flows significantly increased as a component of an onerous contract. An IASB member seemed supportive of this approach, describing this as a path toward a convergedapproach.
Composite margin approach

The FASB staff started the discussion of the composite margin by describing its new proposed methodology for recognising the amortisation of the composite margin. This would be based on the expected release from risk rather than the formulaic approach based on premiums and paid claims that was proposed in the FASB discussion paper (DP). An insurer would recognise profit from the single margin as it satisfied its obligation to stand ready to compensate the policyholder in the event of the occurrence of an insured event. Therelease from risk would be evidenced by the reduction in the variability of cash flows. In some types of business, such as life insurance, this could occur through the passage of time. In other lines of business,
27
where the variability in cash flows could be due to the frequency and severity of an event, the release could occur as the insurer is released from the variability in cash flows. This could be determined by using an adjusted baseline ratio of actual claims reported to total expected cash outflows each period. A question was raised as to how the composite margin approach would deal with situations where the degree of uncertainty of the cash flows increased over time. The staff noted that this could be handled through application of an onerous contract test or the recalibration of the margin. The FASB staff characterized the proposed approach as yielding results that would not be that far off from the explicit risk adjustment approach but simpler to apply. Several IASB members challenged that assertion for various reasons. One noted that using an adjusted ratio of actual claims reported to total expected claims, updated each period for loss development experience as the staff had described, and applying that adjusted ratio to the remaining composite margin balance would only be an appropriate depiction of the remaining risk in certain scenarios. As illustrated in a previous example, in some lines of business, the expected variability in cash flows could actually increase overtime. An IASB member asked what would be done in the case of an onerous contract, would the calculation include an explicit risk adjustment? The staff member responded that he thought it would not, but would only consist of expected cash flows. A FASB member responded that perhaps a risk adjustment could be included in the onerous contract test. Another IASB member suggested that the run-off methodology proposed by the FASB staff seemed too complex, and that
there is a weakness in the model in that even with recalibration, one could change the quantum of risk but not the price of risk. In addition, he was against amortisation of the margin based on the release from risk, noting that in many lines of business, such as certain life insurance, there is little risk, and mostly profit to cover other costs or investment management activities. For these reasons, he prefers to separate the risk and residual margin components. The FASB staff responded that perhaps the composite margin could be divided between the portion related to risks that run off based on passage of time from that which runs off based on reduction in cash flow variability. An IASB member noted that he had doubts as to whether the release from risk approach proposed in the composite margin approach was actually simpler. He pointed to the staff paper provision whereby a qualitative assessment could be necessary in some instances to adjust the initial baseline ratio used to amortise the margin in situations where the insurers past experience indicates that exposure to variability in cash flows continues between the claim reporting date and the end of the contract. Several FASB members commented that the staff paper was a good starting point for the proposed composite margin approach, but that more work was needed, especially to deal with situations where there could be increased risk exposure in periods subsequent to contract inception. One FASB member reiterated his view that the model could work by requiring a remeasurement of the margin when a significant event occurred rather than the continuous remeasurement proposed by the explicit risk adjustment
model. He suggested that perhaps the explicit risk adjustment model would in practice not result in a continuous remeasurement of the risk adjustment in most situations anyway, and thus that an onerous contract test could be sufficient. He disagreed with a prior comment that the risk component and other profit component should be separated for subsequent recognition purposes and instead prefers an approach that recognises the margin based on the predominant factor. The IASB chair suggested that it would be worthwhile for the staff to prepare a simple example that compared the explicit risk adjustment approach with the composite margin approach to see how similar or dissimilar the two approaches might be. The fact pattern would be one in which the initial estimate of the risk adjustment would be 10 units of risk, would change to 6 units in year 1 and 9 or 11 units in year 2. The example would also include increases in expected cash flows in a subsequent period. This illustration would show how each of the models reacted to changes in the quantum of risk, including an increase beyond the risk estimate at inception.
Comparison of composite margin to explicit risk adjustment examples

During the meeting on May 18, the staff presented the examples of the composite margin run-off compared to the re-measurement of the risk adjustment as requested by the Boards during the previous days meeting. With regards to the examples, the staff mentioned that they have not analyzed whether any of
28
the examples are theoretically sound, meaningful, or meet the objectives the Boards intended for the composite margin. The examples were prepared over night in a short space of time and therefore may have inherent limitations. The examples show how the composite margin run-off compares to the remeasurement of the explicit risk adjustment in four differentscenarios. In the base case a coverage period of 1 year and claims run-off period of 5 years were assumed. The example shows that the explicit risk adjustment reduces in line with the decrease in standard deviation (risk) of the insurance liability on a straight-line basis over time. The residual margin is recognized over the coverage period being the first year. The Boards noted that the present values of the cash flows are assumed to be unchanged in this example. In the composite margin approach, the entire margin is run off on a straight line over the five years. The Boards noted that the main difference that arises is as a result of the treatment of the residual margin. An IASB member noted that the residual margin component in the composite margin is an amalgamation of elements and that its run off is arbitrary and not directly related to risk. He questioned why this was amortized over the claims period in the composite margin model. The FASB staff noted that the entire composite margin model is seen as profit and the profit on the contract is only determined once all the claims have been settled. Another IASB member observed that she struggled to see how the inclusion of deferred profit element in the composite margin fits into the measurement of the insurance contract liability. A FASB member later responded that under both models the liability measurement includes deferred income on day 1.
An IASB member questioned whether the run-off pattern of the composite margin could be other than straight-line. The staff noted workers compensation contracts as an example where the pattern of release of the composite margin could change over the long duration of the claims run-off period, given the inherent uncertainty of cash flows for this type of business. A FASB member noted that if the insurance contract liability is seen as a performance obligation, the inclusion of the residual margin element in the composite margin would be consistent with the principles in the revenue recognition project. He noted that the IASB views the model being developed more as a liability measurement model but inclusive of a profit element which is deferred on day 1 as part of the residual margin. An IASB member questioned if the residual margin element of the composite margin is seen as a performance obligation, why the FASB would not recognize it over the coverage period during which the insurer stands ready to pay claims. An IASB member questioned how the composite margin would react to increases in the variability of cash flows during the claims run-off period noting that the explicit risk adjustment would be increased to make allowance for this. The staff responded that if the composite margin is not remeasured, this increase would only be reflected in the change of the prospective amortization pattern of the composite margin. The discussion was then focused on the second example where the risk in the contract cash flows increases beyond initial estimates (but without a change to the mean cash flows) and it reflects the treatment of the composite margin with and
without re-calibration of the composite margin. It was noted that in the scenario with no recalibration, there would be a loss recognized using the explicit risk adjustment approach when the risk increases above the initial levels coupled with an increased subsequent release of the risk adjustment to profit and loss. In the composite margin approach there would be no loss recognized but the income statement would not reflect any composite margin release in such a period. It was noted by the Board members that the overall profit over the 5 year period would remain the same under bothmodels. Should the composite margin be re-calibrated, it was noted that the total liability would also change under the composite margin approach as the margin is now re-calibrated to include the higher risk in the variability of the cash flows. This approach would be more in line with the explicit risk adjustment approach but would still differ on account of the recognition of the residual margin over the coverage period under the explicit risk adjustment approach. An IASB member observed that for contract liabilities such as asbestos, there may be scenarios under the composite margin approach where too much margin has been recognized but the insurer becomes aware of increased uncertainty about claims. He noted that under such a scenario, an onerous contract test/ recalibration would be required for the composite margin model while the risk adjustment approach would automatically reflect the increased risk in the contract. A FASB member noted that in such a scenario where the variability of cash flows increases, an onerous contract test may need to be considered. However he later expressed his reservation about increasing
29
the liability for the increased variability of the cash flows when this will be released to profit and loss in future periods. Another FASB member also disagreed that an additional liability should be recognized for an onerous contract when the mean cash flows remain unchanged. An IASB member noted that for life insurance contracts, the risk adjustment component is expected to be much less than the residual margin element and he questioned whether the release of risk would be an appropriate driver for the release of the composite margin. He also noted that under the explicit risk adjustment approach, there should be restraint over changes to the confidence level applied in determining the risk adjustment. He noted that if the level of confidence is kept consistent, the risk adjustment and composite margin approaches would provide consistentresults. Many IASB members noted that if the risk component and the residual margin component of the composite margin are run off using different drivers, the two models being considered should result in a fairly consistent measurement of the insurance contract liability. The last example reflected the treatment of changes in the mean cash flows which is treated consistently under both models. A FASB member observed that the FASB is currently only considering the above treatment of the composite margin for life/ long duration contracts where the risk adjustment is expected to be relatively small due to the FASBs current view that the modified model is a separate measurement model. In a vote, only two IASB Board members supported the composite margin
approach. However, five of the FASB members supported the composite margin approach with no recalibration of the compositemargin. The FASB noted that their preference for the composite margin approach is driven by their outreach to US investors who clearly prefer this method. The IASB chair floated the idea of possibly allowing both approaches in a final IFRS on insurance contracts with explaining disclosures to reconcile the two approaches but this was met with strong opposition from another IASB member who indicated the need for a common high quality reporting standard throughout the world and he noted that any choices between approaches would not be beneficial to industry and users of financial statements. The FASB staff noted that the FASB would consider an onerous contract test under the composite margin approach. The Boards asked the staff to develop some disclosure with the aim of reconciling the composite margin approach to the risk adjustment approach. The Boards also asked the staff to keep the examples current going forward based on tentative decisions in order to be able to compare the risk adjustment and composite marginapproaches.
generally supportive of the latest proposal that uses criteria from the revenue recognition project, with the staff noting that there would be very little unbundling. On application of the modified approach, the staff observed that a geographic split exists as to whether this approach should merely be a proxy for the building block approach (the IASB view) or a separate model similar to revenue recognition (the FASB view). Those supporting the latter view suggested that perhaps the claims period (in addition to the pre-claims period) should be subject to thisseparatemodel. With regard to OCI, working group members commented on the importance of a converged standard, and noted that single sided OCI, i.e., adjusting only the insurance liability for changes in the discount rate through OCI, but not reporting fair value changes in assets through OCI, would not work. Members commented that they would prefer the current/current approach through OCI, or, as a possible second choice, a disaggregation of presentation within the income statement. On the subject of participating and unit-linked contracts, the working group noted that the IASB proposal to measure the participation feature in insurance contracts on the same basis as the measurement of the underlying items in which the policyholder participates is a step in the right direction. However, some were concerned with the move away from measuring the insurance contract using a building block approach. In addition, questions were raised as to whether the approach would be extended to contracts where there wasnt a contractual link with specified assets.
Insurance working group meeting

The staff noted that items discussed at the working group included unbundling, the modified approach for non-life insurance contracts, the use of other comprehensive income (OCI), and participating contracts. With regard to unbundling, the staff noted that working group members seemed to be
30
Component
IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB FASB Discussion paper (DP) issued September 2010.
Status
Exposure draft (ED) issued July 2010.
Joint redeliberations began January 2011 Target date for IASB final standard and FASB exposure draft is end of 2011.
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 policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder. 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 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.
Reaffirmed ED/DP position. May try to clarify insurance definition to distinguish insurance from service contracts.
Some constituents (principally IFRS) commented that present value clarification and requirement for at least one possible loss outcome not necessary. Reaffirmed ED/DP position.
31
Component
Scope
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 residual value (but stand-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 combination. Employers 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. Direct insurance contracts an entity holds as policyholder (except for cedant accounting).
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 guarantee contracts (including mortgage guarantee) should be included in scope in conjunction with financial instruments project. Both Boards reaffirmed scope exclusions noted in ED/DP. Boards reaffirmation of scope exclusions includes FASB decision that employers account for employer-provided healthcare benefits to their employees under employee compensation guidance rather than impute a premium and account for them as issued insurance contracts.
32
Component
Unbundling
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.
Reaffirmed ED/DP position to separate embedded derivative as defined in IFRS and US GAAP, respectively, and account for as derivatives at fair value. Staff to consider whether IFRS 4 embedded derivative implementation guidance should be carried forward.
Intention is to develop unbundling criteria for goods and services embedded derivatives that are separated under existing and explicit account balances bifurcation requirements. in insurance contracts based contractual terms relating to goods and services provided on criteria being developed for under the contract that are not closely related to insurance identifying separate performance coverage but have been combined in a contract with that obligations in the revenue coverage for reasons that have no commercial substance. recognition project. Where unbundling is not required it is prohibited Criteria include whether the good or service has a distinct function IFRS and US GAAP have different requirements for or the account balance has a separation of certain embedded associated with insurance distinct value. contracts (e.g., GMABs and GMWBs) which could lead to different results Criteria also include whether or not the account balance is integrated with the remainder of the contract (i.e., whether the amount of insurance risk the insurer is exposed to is significantly affected by the investment performance of the account balance). Will consider further whether explicit account balance exists only when policyholder can withdraw account balance without loss of insurance cover. FASB questioned how inflows/ outflows would be allocated to components.
33
Component
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.
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 for that obligation. Measurement approach should portray a current assessment of the contract, using the following building blocks:
Not expected to be redeliberated.
Reaffirmed the concept of a building block model using expected value and a discount explicit, unbiased, probability-weighted average (expected rate to incorporate the time value value) of future cash outflows less future cash inflows that of money. will arise as insurer fulfills the insurance contract. Clarified that measurement a discount rate to incorporate of time value of money. objective of expected value refers a margin*. to the mean. These building blocks should be used to measure the Clarified that not all possible combination of rights and obligations arising from an scenarios need to be identified and insurance contract rather than to measure the rights quantified provided the estimate separately from the obligations. is consistent with the mean That combination of rights and obligations should be measurement objective. presented on a net basis. Reaffirmed no gain at inception, but immediate recognition of any *Two different margin approaches proposed are explicit risk day one loss. 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.
34
Component
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 Risk adjustment objective changed to: the compensation the insurer market participant. requires to bear the risk that ultimate cash flows could exceed 2) An amount that eliminates any gain at inception of the those expected. contract (residual margin). Application guidance will note that amount reflects both favorable Explicit risk adjustment is the maximum amount insurer and unfavorable outcomes and would rationally pay to be relieved of the risk that the ultimate reflects the point at which insurer fulfillment cash flows exceed those expected. is indifferent between holding the insurance liability and a similar Explicit risk adjustment would be updated (remeasured) each liability not subject to uncertainty. reporting period. Risk adjustment: 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 inception.
Clear majority of IASB in favor of explicit risk adjustment approach; FASB rejected it.
35
Component
Risk adjustment: Composite margin approach (Alternative view in IASB Basis of Conclusions)
Composite margin approach: 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 composite margin. Composite margin at initial recognition is the difference between the present value of expected value of cash inflows 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.
FASB supports this approach but will consider whether an onerous contract test should also be applied; IASB rejected it.
36
Component
Use of inputs
Consider all current available information that represents Reaffirmed that costs directly fulfillment of the insurance contract from perspective of the attributable to contract activity entity, but for market variables, be consistent with observable as part of fulfilling portfolio of market prices. contracts that can be allocated to portfolio should be included in Types of data that may be useful include, but are not limited cash flows. 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. Reaffirmed that inventory costing guidance in IAS 2 should be used as basis for types of costs to be included in cash flows. 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.
Insurer should include premiums and other cash flows Tentatively changed position such resulting from those premiums only if the insurer can compel that contract boundary is point the policyholder to pay premiums, or the premiums are within when insurer is no longer required the boundary of the contract. to provide coverage or when the existing contract does not Contract boundary is the point at which the insurer: confer any substantive rights to (1) is no longer required to provide coverage OR policyholder. (2) has the right or practical ability to reassess the risk of the Not a substantive right when particular policyholder and, as a result, can set a price insurer has right or practical ability that fully reflects that risk. to reassess risk of particular 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 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.
37
Component
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
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).
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 top-down approach include 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 insurers own credit standing. Tentatively decided not to allow lock in of discount rate. 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.
38
Component
IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB FASB Do not accrete interest on the residual margin (under the explicit risk adjustment approach) or on the composite margin (under the composite margin approach).
Accretion of interest on residual margin or composite margin
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.
Not yet specifically discussed.
Subsequent treatment of residual margins under explicit risk adjustment 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.
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. Composite margin would be included as part of the insurance liability.
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. FASB may consider onerous contract test in situations where risk expected to increase.
39
Component
An unearned premium measurement approach (simplified/modified measurement approach) for pre-claim liabilities for certain shortduration 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 has not yet concluded Constituents commented that on what they refer to as approach is not simplified and that modified measurement one year criterion is too restrictive. and presentation approach Many US constituents believe nonand which insurance life requires a separate model and contracts should apply that existing US GAAP model should approach rather than the be retained. building block approach. Boards not yet agreed on the objective of and eligibility criteria for modified approach; IASB views it as proxy for building block approach; FASB sees it as separate model (revenue recognition model). Boards would not require discounting of future premiums as long as financing element in a contract is not significant. Boards have not yet concluded on whether modified approach should be optional or required. Boards have reaffirmed revenue recognition pattern over coverage period. Boards split on acquisition costs; IASB wants consistency with building block approach, FASB wants consistency with revenue recognition project. Onerous contract test using qualitative factors as indicators. Boards have only discussed preclaims period and have not yet discussed whether claim liability measurement should be building block or other.
40
Component
Acquisition costs
Not yet discussed.
41
Component
Reinsurance
Not yet discussed.
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).
Not yet discussed.
42
Component
Participating features in insurance contracts
Include all cash flows that arise from a participating feature FASB: measure liability at current in an insurance contract in the measurement of the insurance value of contractual obligation to liability on an expected present value basis. policyholder; consider adjusting value of the backing assets to Cash flows include payments that will be generated reflect measure of the liability. by existing contracts but are expected to be paid to future policyholders. IASB: Measure on same basis as underlying items in which policyholder participates. Reflect, using a current measurement basis, any asymmetric risk-sharing between insurer and policyholder in the contractually linked items arising from a minimum guarantee. 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). Amounts expected to be paid to future policyholders not yet discussed.
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 Not yet discussed. instruments standard
43
Component
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 Staff have developed alternative be shown on face or in notes): approaches to the pure summarized margin approach for Underwriting margin (change in risk adjustment, release of Boards consideration: residual margin) Gains/losses at initial recognition (loss at inception, loss 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). Summarized margin with volume disclosure on the face Expanded margin As written (expected cash flows) Dual statement
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 Interest on insurance contract liabilities performance reporting of insurers on a basis that is Summarized margin approach would be supplemented by comparable to other industries additional information including a reconciliation of changes in (i.e., classic revenues earned and the liability and volume of business written. expenses incurred). In simplified unearned premium approach only: However, given proposed liability Underwriting margin (premium revenue, gross of measurement approach, presenting incremental acquisition cost amortization, claims results on an earned premium incurred, expenses incurred, amortization of incremental basis noted by staff as being acquisition costs) challenging and would effectively Changes in additional liabilities for onerous contracts require a second model be developed to estimate amount of No offsetting of income and expense from reinsurance revenue to be recognized. contracts against expense or income from insurance contracts. Boards suggested outreach to users and preparers to determine information that is critical for them. Boards will consider at future meeting a staff proposal that insurer 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, if it would eliminate or substantially reduce an accounting mismatch. IASB reaffirmed it would not reopen IFRS 9 to reconsider the accounting for financial instrument assets generally, and will not introduce new requirements specifically for assets held to back insurance contract liabilities.
44
Component
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 insurers 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 insurers 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 insurers 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 insurers other insurance contract liabilities. Income and expense from pool of assets underlying unit-linked contracts presented as a single line item, not commingled with income or expense from insurers 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.
IASB: Apply same measurement approach as participating insurance contracts and proceed with ED proposal to fair value treasury shares and owner occupied property to eliminate accounting mismatch. FASB: measure liability at current value of contractual obligation to policyholder; consider adjusting value of the backing assets to reflect measure of the liability.
Disclosures
Extensive disclosure requirements based on IFRS 4 and IFRS 7 existing disclosure requirements, with some enhancements, including: 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. Effect of the regulatory framework in which the insurer operates.
Not yet discussed.
45
Component
Effective date will be determined taking into account the significance of the changes required and methods of transition. Effective date of IASB standard not expected to be earlier than 2015.
46
Whats inside: Highlights Measurement of policyholder participation Reducing accounting mismatches through presentation Assets backing insurance liabilities
Highlights
The IASB and FASB held a joint Board meeting on May 11, 2011 where they discussed the measurement of policyholder participation contracts. The IASB agreed with the staff proposals, which represented a change from the IASB Exposure Draft (ED) and FASB Discussion Paper (DP), to measure the participation feature in insurance contracts on the same basis as the measurement of the underlying items in which the policyholder participates (e.g., amortized cost). However, the FASB favored an approach of measuring the liability at the current value of the contractual obligation to the policyholder and would consider adjusting the measurement of the assets the policyholder participates in to fair value to better match the liability measurement. The Boards will discuss at a future meeting whether the expected cash flows should include those generated by existing contracts but are expected to be paid to future policyholders. On May 12, an IASB only meeting was held where the Board had an educational session, discussing the ways that accounting mismatches between assets held to back insurance contract liabilities and the related insurance liabilities could be alleviated through presentation, either through disaggregation in the income statement or using other comprehensive income (OCI) for changes in the insurance contract liability arising from changes in the discount rate. In addition, the Board reaffirmed that it would not reopen IFRS9 at this time to reconsider the accounting for financial instrument assets generally, and voted not to introduce new requirements specifically for assets held to back insurance contract liabilities.
Measurement of policyholder participation

The staff introduced the discussion noting that the proposal refers to a subset of participating contracts and that it is not intended to cover universal life contracts which will be discussed at a later meeting. The staff recommended that the fulfillment cash flows include the cash flows expected to result from the policyholder participation on the same basis as the measurement of the underlying items the policyholder participates in. This could be assets and liabilities, the performance of
an underlying pool of insurance contracts or the performance of the entity. They proposed that the measurement of the participating contract should also reflect the asymmetric risk sharing between the insurer and the policyholder in the contractually linked items that exists because of minimum return guarantees. The staff proposed that the presentation of the changes in the insurance contract liability in the statement of comprehensive income should be consistent with the presentation of the changes in the linked items (i.e., profit or loss, or other comprehensive income). Finally the staff proposed that the same measurement
47
approach should apply to unit-linked and participating contracts and consequently they proposed that the Boards should not proceed with the proposals in the IASBs exposure draft (ED) for consequential amendments relating to treasury shares and owner occupied property held in unitlinked funds. A FASB member observed that the above proposal would also apply where only some of the benefits paid to the policyholder contractually depend on the performance of assets held by the insurer, liabilities of the insurer, a pool of insurance contracts of the insurer or even the entire performance of the insurer and noted that this would result in the mixed measurement of the two different components. He indicated that he would want to unbundle the two different components, valuing the participating feature with reference to the underlying assets etc. and the insurance element with reference to the building blocks model. Many FASB members observed that the liability should be measured at a current value of the contractual obligation to the policyholder and questioned why the asset value would be an appropriate proxy for this amount. If measuring the liability at a current value gave rise to an accounting mismatch due to the asset being measured at cost, they believe it would be more appropriate for the insurer to apply fair value measurement to the assets to reduce this mismatch. The staff noted that in order to eliminate all accounting mismatches, insurers would have to follow a full fair value approach for the entire balance sheet and this was not consideredpractical. There was much debate on what values are used to determine the contractual policy benefits to policyholders. It was
noted that some jurisdictions use book values that could include assets measured at amortized cost, others use statutory values and others could use fair value. A FASB member observed that he could accept using book values if assets are typically disposed of in order to pay the policy benefits (in which case a gain would be recognized on disposal simultaneous to recognizing it as an obligation to the policyholder) but he noted that this does not happen in practice (for example owner occupied property) and therefore he would require the liability to be measured at a current value. The staff clarified that the proposal related to the participating element in the contract. They noted that a typical participating contract includes a guaranteed amount, an implicit put-option and the participation element. The guaranteed amount and the implicit put-option are measured using the building blocks model and only the participating element would be measured using the proposals in the staff paper. If the participation element was based on assets that are measured at fair value, the measurement would not be problematic but given current accounting rules, for example deferred tax, not all assets can be measured at fair value and therefore measuring some assets at fair value will not eliminate all the accounting mismatches. The staff also noted that the default treatment in IFRS9 would require amortized cost measurement for some debt securities. Measuring the liability at a current value (and not with reference to the value of the backing assets) would force the insurers to use the fair value option to avoid accounting mismatches. An IASB member observed that he preferred the IASB ED proposal of measuring the obligation to the
policyholder at a current value but indicated that he could accept the proposal due to the accounting mismatch that the ED proposal creates when the policyholders contractually share in, for example, the performance of the insurer. However, he would support keeping the ED proposal to allow the fair value option for treasury shares and owner occupied properties. He also noted that if the staff proposal is accepted, the Boards should require disclosure of the insurers obligation to pay policy benefits based on the value of those assets. Disclosing the fair value of the assets without explaining to users that the insurer has the obligation to pass that value on to policyholders would be misleading. Another IASB member noted that the proposal was not a substantial departure from the building blocks model. She noted that the proposal would require the same cash flows to be included in the building blocks model but it only changes the value attributed to these cash flows. She preferred this approach above the ED proposal of allowing the fair value option for some items. An IASB member raised a concern that if the payout to the policyholder is based on the fair value of owner occupied property that was accounted for at cost, a loss would be recognized when the policy benefits are paid. It was noted that the issue does not arise if the asset is liquidated at the same time the policy benefits are paid but as owner occupied property is not usually disposed of, a mismatch would arise. Other IASB members supported the staffs proposals noting that it was a solution that measured the liability commensurate with the value of the assets as this is the contractual relationship. The Board members noted that
48
they would be requesting input from the Insurance Working Group at their meeting nextweek. Another IASB member noted his support for the ED proposals indicating that the fair value option would be available to reduce the accounting mismatches. He cautioned that the staff was working too hard at eliminating accountingmismatches. A FASB member questioned whether the objective should be to measure the liability appropriately (at a current value) or to measure equity correctly (by eliminating all the accounting mismatches as proposed by the staff). He noted that equity is the residual of assets less liabilities and hence he would focus on the appropriate measurement of the liability based on the current value of the contractual benefits due to the policyholder. He noted that if the policyholder benefits are based on a statutory value, it is impossible to eliminate all the mismatches between the backing assets and the liabilities. The staff alluded to the accounting principle in IFRS3 relating to indemnification assets which their proposal is based on. Under IFRS3, indemnification assets are recognized and measured on the same basis as the underlying liability thereby eliminating any accounting mismatch. In a vote, all the FASB members rejected the proposals to recognize and measure the participation feature in insurance contracts on the same basis as the backing assets. Nine of the 14 IASB members voted in favor of the staff proposals (with oneabstention). The IASB chair noted that the main purpose of the staff proposal was to eliminate the accounting mismatch and asked the FASB how they envisaged addressing
the mismatch that arises. The FASB noted that they would consider adjusting the value of the backing assets to reflect the measure of the liability. The staff noted that their proposal is just the converse of the current treatment for indemnification assets.
Reducing accounting mismatches in profit or loss through presentation

The staff presented a paper for discussion purposes only, with formal discussion expected later in May after the insurance working group meeting. The staff proposal is that an insurer 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. This option would only be permitted if it would eliminate or substantially reduce an accounting mismatch. Several Board members stated their disagreement with the staff proposal to permit OCI treatment. One Board member noted that during redeliberations the Board has already dealt with volatility concerns raised by constituents for example, by clarifying the discount rate and with the most recent decision on participating contracts. He noted that the Board has said in a number of instances that OCI is not an appropriate treatment for many transactions, including derivatives, and he did not believe it appropriate for insurance contracts. Several others agreed, while one disagreed, noting that the discounting impact of pension liabilities, a similar situation in his view, is in OCI.
Several other Board members also disagreed with the staff proposal, with one noting that an insurer could use the fair value option for assets to reduce mismatches. Several noted that if users see a need to separate volatility, this could be achieved through disaggregated presentation within the income statement. One noted that under the staff proposal the equity number would be meaningless, and that a better solution would be a currentcurrent approach (assets marked to fair value and insurance liabilities marked to current building block value through the income statement). Several Board members supported the staff treatment to permit OCI treatment for changes in the insurance liability caused by discount rate changes. One noted that a significant change in a long tail insurance liability in a particular quarter caused merely by a change in interest rates was not good predictive information for users. Another reiterated that OCI is used elsewhere in the accounting guidance and should be used here as a means to settle the debate about volatility, which hasnt been solved to date through measurementprinciples. The staff also provided background to the Board on related issues that would need to be addressed if OCI treatment were permitted. One issue is whether an insurer should be permitted to present in OCI rather than in income the changes in the time value and intrinsic value of embedded interest rate guarantees that are out of the money at inception if it elects to use OCI to present interest rate changes in the insurance liability. A Board member questioned whether this would be consistent given that the option would be an economic mismatch rather than an accounting mismatch, to which the staff
49
responded that rationale would be that the options would follow the treatment of the insurance liability to which the option wasattached. Another issue is whether an onerous contract test needed to be applied, i.e., should an insurer unlock the discount rate used to determine interest expense in the income statement if it appears unlikely that the assets backing the insurance contract will provide returns sufficient to support the liability? On this latter issue, there was some support expressed for such a test, due to the linkage between the assets and the insurance liabilities. However, the staff noted that similar linkage (i.e., asset/liability duration matching) could be said to exist for other financial institutions that record financial liabilities at amortized cost, and yet there is no onerous contract test applied.
Assets backing insurance contract liabilities

The staff paper prepared for this discussion described concerns raised by some constituents about income statement volatility that could arise when financial assets held to back insurance liabilities are measured at fair value through profit and loss, even when the related insurance liabilities are measured at current value through profit and loss. For example, for changes in credit risk on the invested assets, there would be no offsetting changes in credit risk on the insurance contract liability because credit risk is not a component of the proposed liabilitymeasurement. The staff noted that some constituents had requested that IFRS9 be reopened to reintroduce the notion of available for sale financial assets with changes in fair value recorded in OCI. Another proposal was to develop specific requirements only for insurance contracts, whereby fair value gains and losses on assets backing insurance contracts would be excluded from IFRS9 presentation requirements and instead recorded in OCI (along with related market movements in insurance contract liabilities).
The Board reaffirmed that it would not reopen IFRS9 at this time to reconsider the accounting for financial instrument assets generally, and voted not to introduce new requirements specifically for assets held to back insurance contract liabilities. A Board member did note, however, that if the Board ultimately decided to permit OCI treatment for changes in the insurance liability arising from changes in the discount rate, it would make sense at that point to reconsider whether OCI should be used for the assets as well (for all industries, not just insurance contracts). Various Board members described their rationale for rejecting these proposals, which included the recent issuance of IFRS9 that eliminated the OCI classification for debt instruments in an attempt to reduce complexity, the fact that many jurisdictions were already applying the new IFRS9 guidance, the difficulty in identifying the specific assets backing insurance contracts that would be eligible for an insurance specific application, and the impression that would be created that special treatment was being granted to a particular industry.
50
Whats inside: Highlights Detailed discussions Unbundling goods and services Unbundling investment components
Highlights
The IASB and FASB held a joint Board meeting on May 4, 2011 where they discussed the potential unbundling of two non-insurance components sometimes present in an insurance contract-goods and services and investment balances. The Boards had recently discussed another component, embedded derivatives, tentatively agreeing that they should be separated using existing closely related criteria. The Boards generally agreed with the staff proposals to develop unbundling criteria for goods and services and explicit account balances in insurance contracts based on those criteria being developed for identifying separate performance obligations in the revenue recognition project. However, after some issues were raised over whether all the same criteria were appropriate for insurance contracts, the Boards asked the staff to attempt to combine and align the criteria for goods and services and account balances with the proposals in the revenue recognition project. These proposals will be taken to the Insurance Working Group meeting on May 16, 2011 to obtain input from preparers and users on the proposals. The Boards did not discuss participation features due to time constraints and will bring those papers to the Boards at a future meeting.
Detailed discussions
The staff briefly took the Boards through supporting background material on unbundling, noting that the project plan for unbundling included analyzing each of the three major components of unbundling and then reviewing the model in total and answering ancillary questions. One such question is whether, in addition to being required if specified criteria are met, additional unbundling should be permitted. An IASB member observed that throughout the papers reference is made to non-insurance services although insurance services are not specifically defined. A FASB member observed that the implicit intention was to not separate any services that are integral to providing insurance cover. For example, claims handling costs would be considered part of the insurance activity needed to fulfill the insurance obligation and not a separate service. This key point was reiterated throughout the ensuing discussion.
Unbundling of goods and services

The staff recommended that goods and services should be unbundled from an insurance contract in accordance with the principles to identify separate performance obligations in the revenue recognition project and once separated, those goods and services should be measured in accordance with relevant requirements of IFRSs and USGAAP. The staff believes consistency with the revenue recognition model is superior to the closely related criteria noted in the IASB exposure draft (ED) and FASB discussion paper (DP), which constituents said was not clearly defined. They also considered but rejected an alternative of only unbundling components that are added to an insurance contract for reasons that have no commercial substance as it resulted in too little unbundling.
51
The staff highlighted that the key difference between the insurance model and the revenue recognition model was the presentation of revenue and expenses (gross presentation in the revenue model as opposed to net presentation in the insurance model) and the treatment of changes in assumptions about future fees and expenses (under the insurance ED and DP these are recognized in the current period whereas under the revenue recognition proposal these are recognized as revenue and expenses change). The discussion focused on the proposed revenue recognition criterion that requires an entity to account for a promised good or service as a separate performance obligation if (i) the pattern of transfer of the good or service is different from the pattern of transfer of other promised goods or services in the contract and (ii) the good or service has a distinct function. FASB and IASB members indicated their general agreement with no longer using the closely related principle as proposed in the ED and their preference to use criteria consistent with that developed in the revenue recognition project. However, FASB members and some IASB members disagreed with the criterion that a promised good or services should not be treated as a separate performance obligation if the pattern of transfer of the good or service is not different from the pattern of transfer of other promised goods or services in the contract. The concern is that service and insurance components with similar patterns of transfer could remain bundled even though they may have a distinct function. A FASB member suggested that the requirement to separate a service with a distinct function was sufficient and that this additional pattern of transfer criterion was not needed. This led to a lengthy
debate on whether the claims administration service that is combined in an agreement with a stop loss provision should be treated as a distinct service or considered as a deductible on the insurance component and considered an integrated insurance activity. The IASB staff from the revenue recognition project noted later in the meeting that the pattern of transfer criterion was a practical expedient in the revenue recognition project and later upgraded to a criterion to avoid preparers unnecessarily separating contract elements if it would make no difference in the revenue being recognized. A FASB member noted that for contracts in the scope of the revenue recognition standard, if an element has the same pattern of transfer as another element, it makes no difference whether it is separated or not. However, it would make a difference for insurance contracts as unbundled elements would be measured using a different model. As a result, FASB members argued that while the criterion/practical expedient was appropriate for revenue recognition, it was not appropriate for insurance contracts. The vote on the insurance staff proposal was taken prior to the IASB revenue recognition staffs clarification that the pattern of transfer was really a practical expedient and not a criterion. A majority of the IASB members agreed with the staff proposals including the criterion on the transfer of goods and services. The FASB agreed with the staff recommendation subject to excluding the criterion on the pattern of transfer of goods or services. Both Boards agreed that the proposal to use the revenue recognition criteria should be tested against actual products to ensure it does not result in any unexpectedoutcomes.
The IASB chair later noted sympathy with the FASB concerns regarding the pattern of transfer criterion and indicated that the proposals would be taken to the Insurance Working Group meeting scheduled for 16 May to obtain input on the proposals. He also emphasized the objective of the Boards to achieve consistency with the revenue recognition standard and asked the staff to work closely with the revenue recognition staff to attempt to combine and align the criteria for goods and services and account balances with the proposals in the revenue recognitionproject. Other comments made by members during the goods and services discussion included the following: An IASB member questioned whether the revenue recognition criteria were easier to apply than the closely related principle proposed in the ED. However, he acknowledged the benefits of aligning to the requirements in the revenue recognition project. An IASB member questioned whether the criteria would set the minimum requirement of elements that should be unbundled and whether insurers would be allowed to unbundle more elements. The staff indicated that this would set the minimum requirement but that they would be asking the Boards at a future meeting whether insurers should be allowed to unbundle more components. Another IASB member noted his support for the staff proposal indicating that it would not result in many elements being unbundled from insurance contracts. He noted that if one element influenced another element in the contract then he would not want to unbundle the differentelements.
52
Another IASB member asked the staff to consider whether the criterion in the revenue recognition proposal that was meant to address construction contracts should be deleted from the insurance proposal as it could be misinterpreted. This criterion says that an entity should account for a bundle of promised goods or services as one performance obligation if the entity provides a service of integrating those goods or services into a single item. A FASB member questioned, once it is determined that components should be separated, how inflows and outflows would be allocated between the different components. An IASB member also noted that external presenters on unbundling at the February meeting had commented that this allocation would be difficult, costly, and arbitrary. Another FASB member noted that difficulties could result not only from transaction price allocation, but also from differences in how acquisition costs and variable consideration are accounted for between the insurance and revenue recognition models. The staff noted that they are planning to bring a separate paper to the Boards at a future meeting on how to allocate consideration, costs, etc. to the different contract components.
explicit return based on the value of the account balance. The insurer may have the ability to vary the fees and assessments that are charged. The policyholder may have the right to withdraw cash and pay for insurance coverage, depending on the contractterms. The Boards first discussed how explicit account balances should be defined. A FASB member questioned how one would distinguish the intended explicit account balances from cash surrender values included in contracts. The staff responded that the cash surrender value was not dependent on actual investment performance. An IASB member questioned why the staff placed emphasis on the communication of the account balance to policyholders in order to define explicit account balances and noted that if it was determinable, it should also be considered an explicit account balance. A FASB member questioned whether you would make the cut for those amounts that could be withdrawn without affecting the insurance cover under the contract. The IASB and FASB generally supported the description for an explicit account balance as an amount which is explicitly known, with returns credited based on the account balance and which could be withdrawn without terminating or amending the terms of the insurance component or requiring an insured event. The Boards asked the staff to develop this principle and to obtain input from the Insurance Working Group. The IASB agreed that explicit account balances in insurance contracts should be separated from an insurance contract based on those criteria being developed for identifying separate performance obligations in the revenue recognition project. The FASB, on the other hand, while seeming to agree with the general
direction of the staff proposal, asked a number of questions on how the revenue recognition criteria would be applied to explicit account balances to determine if they were distinct versus integrated with the insurance component. A FASB member emphasized that the criteria for goods and services as well as account balances should be combined to ensure a contract is only evaluated once to identify components that require separation. He noted the importance of testing the proposals against actual contracts that contain explicit account balances to ensure the proposals will produce the expected results. On the issue of measurement, the IASB supported the staff proposal to measure any unbundled explicit account balances in accordance with relevant financial instrument guidance, whereas the FASB noted that they could not completely respond to this proposal given that they had the same questions on allocation as they did in the goods and servicesdiscussion. An IASB staff member asked the FASB whether they had at least ruled out the alternative rejected by the staff to measure all explicit unbundled account balances at face value (which the staff paper described as consistent with the current requirements under USGAAP for universal life insurance contracts). A FASB member responded that he didnt understand the difference between this alternative proposal and the staff proposal. The staff member explained that the main difference was that under the face value proposal, all fees would be ascribed to the insurance component rather than allocated between the insurance and account balance components. In addition, the face amount would not be a fair value allocation, and would exclude items such as acquisition costs.
Unbundling of investment components

The staff proposed that explicit account balances in insurance contracts that meet specified criteria should be unbundled. The specified criteria were also adapted from those that are being developed for identifying separate performance obligations in the revenue recognition project. The staff described explicit account balances as account balances that are regularly communicated to the policyholder and to which the insurer credits an
53
Component
IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB FASB Discussion paper (DP) issued September 2010.
Status
Exposure draft (ED) issued July 2010.
Joint redeliberations began January 2011. Target date for IASB final standard and FASB exposure draft is end of 2011.
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 policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder. 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.
Reaffirmed ED/DP position May try to clarify insurance definition to distinguish insurance from service contracts.
Some constituents (principally IFRS) commented that present value clarification and requirement for at least one possible loss outcome not necessary.
Risk transfer analysis should focus on the variability of Reaffirmed ED/DP position. 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.
54
Component
Scope
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:
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 Residual value contracts offered by a manufacturer, financial guarantee contracts dealer, or retailer and lessee guarantees of residual value (including mortgage guarantee) (but stand-alone residual value guarantees not addressed should be included in scope by other projects are in Insurance Contracts scope). in conjunction with financial Manufacturer, dealer, and retailer warranty contracts instruments project. (but unrelated third party warranties are in Insurance Both Boards reaffirmed scope Contracts scope). exclusions noted in ED/DP. Fixed-fee service contracts that have as their primary Boards reaffirmation of scope purpose the provision of services, for example exclusions includes FASB decision maintenance contracts in which the service provider that employers account for agrees to repair specified equipment after a malfunction. employer-provided healthcare Contingent consideration payable or receivable in a benefits to their employees under business combination. employee compensation guidance Employers assets and liabilities under employee benefit rather than impute a premium plans and retirement benefit obligations reported by and account for them as issued defined benefit plans. insurance contracts. License fees, royalties, contingent lease payments and similar items. Direct insurance contracts an entity holds as policyholder (except for cedant accounting) Unbundling 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 associated with insurance contracts (e.g., GMABs and GMWBs) which could lead to different results. Reaffirmed ED/DP position to separate embedded derivatives as defined in IFRS and US GAAP, respectively, and account for as derivatives at fair value. Staff to consider whether IFRS 4 embedded derivative implementation guidance should be carried forward. Attempting to strike a balance between (1) comments that unbundling is too complicated, requires arbitrary allocation, and may not be worth cost if insurance measurement is close to other GAAP measurements with (2) view that similar transactions should be accounted for in similar manner. Some constituents may want unbundling to get amortized cost treatment for deposit component. Continued
55
Component
Continued from previous page Unbundling Latest proposal is to develop unbundling criteria for goods and services and explicit account balances in insurance contracts based on criteria being developed for identifying separate performance obligations in the revenue recognition project. Criteria include whether the good or service has a distinct function or the account balance has a distinct value. Criteria also include whether or not the account balance is integrated with the remainder of the contract (i.e., whether the amount of insurance risk the insurer is exposed to is significantly affected by the investment performance of the account balance). 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 for that obligation. Not expected to be redeliberated. 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.
56
Component
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. *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.
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. Have not yet concluded on explicit versus composite margin.
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.
Have not yet concluded on whether model should include an explicit risk adjustment or composite margin. Have tentatively decided that if techniques exist that can faithfully represent the risk inherent in insurance liabilities, inclusion of explicit risk adjustment in insurance contract measurement would provide relevant information to users. Have yet to discuss whether explicit risk adjustment can be measured in reliable way that promotes comparability and is cost beneficial. Continued
57
Component
Continued from previous page Risk adjustment: Explicit risk adjustment approach (continued) 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 inception. Risk adjustment: Composite margin approach (Alternative view in IASB Basis of Conclusions) Composite margin approach: 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 composite margin. Composite margin at initial recognition is the difference between the present value of expected value of cash inflows 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. Have not yet concluded on whether model should include an explicit risk adjustment or composite margin. Risk adjustment objective changed to: the compensation the insurer requires to bear the risk that ultimate cash flows could exceed those expected. Application guidance will note that amount reflects both favorable and unfavorable outcomes and reflects the point at which insurer is indifferent between holding the insurance liability and a similar liability not subject to uncertainty. Have yet to redeliberate prescribed methods for calculating the risk adjustment.
58
Component
Use of inputs
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.
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. 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.
59
Component
Insurer should include premiums and other cash flows Tentatively changed position such resulting from those premiums only if the insurer can compel that contract boundary is point the policyholder to pay premiums, or the premiums are when insurer is no longer required within the boundary of the contract. to provide coverage or when the existing contract does not Contract boundary is the point at which the insurer: confer any substantive rights to (1) is no longer required to provide coverage OR policyholder. (2) has the right or practical ability to reassess the risk of the Not a substantive right when particular policyholder and, as a result, can set a price insurer has right or practical ability that fully reflects that risk. to reassess risk of particular 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 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. 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 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. 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. Not yet specifically discussed.
Tentatively decided not to prescribe a method for determining the rate (i.e., may use bottom-up or Discount rates should exclude any factors that influence the top-down approach as long as observed rates but are not relevant to the insurance contract objective achieved). liability (e.g., differences in liquidity between government bonds and certain insurance contracts). Top-down approach may start with yield curve based on actual or reference asset portfolio. Continued
60
Component
Continued from previous page Discount rates 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). Types of adjustments expected in top-down approach include 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 insurers own credit standing. Tentatively decided not to allow lock in of discount rate. 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. Accretion of interest on residual margin or composite margin 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. Subsequent treatment of residual margins under explicit risk adjustment 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. Exploring whether residual margin should be adjusted for changes in cash flow estimates. May explore alternative amortization terms and patterns. Do not accrete interest on the residual margin (under the explicit risk adjustment approach) or on the composite margin (under the composite margin approach). Not yet specifically discussed.
61
Component
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. Composite margin would be included as part of the insurance liability.
Exploring whether composite margin should be adjusted for changes in cash flow estimates. May explore alternative amortization terms and patterns.
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.
FASB has not yet concluded on what they refer to as modified measurement and presentation approach and which insurance contracts should apply that approach rather than the building block approach.
Constituents commented that approach is not simplified and that one year criterion is too restrictive. Many US constituents believe nonlife requires a separate model and existing US GAAP model should be retained. Boards not yet agreed on the objective of and eligibility criteria for modified approach; IASB views it as proxy for building block approach; FASB sees it as separate model (revenue recognition model). Boards would not require discounting of future premiums as long as financing element in a contract is not significant. Boards have not yet concluded on whether modified approach should be optional or required. Boards have reaffirmed revenue recognition pattern over coverage period. Boards split on acquisition costs; IASB wants consistency with building block approach, FASB wants consistency with revenue recognition project. Onerous contract test using qualitative factors as indicators. Continued
62
Component
Continued from previous page Unearned premium approach for certain shortduration insurance contracts 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. 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. Changed position from ED and DP and tentatively decided that contract cash flows should include those acquisition costs that relate to a portfolio of insurance contracts. But differences exist as to the types of costs to be included. FASB currently supporting an approach consistent with recently issued changes to US GAAP that would include incremental direct costs at contract level such as commissions, plus direct costs at portfolio level such as sales force contract selling, underwriting, medical and inspection, and policy issuance and processing functions relating only to successful acquisition efforts. IASB would include acquisition costs for both successful and unsuccessful efforts to acquire a portfolio of insurance contracts and may also include some overhead, using the same principles as other fulfillment cash flow costs (i.e., consistent with IAS 2), such as sales force office rent expense and software associated with the selling function. Staff to draft guidance and discuss with Boards. Boards have only discussed preclaims period and have not yet discussed whether claim liability measurement should be building blocks or other.
63
Component
Not yet discussed.
Reinsurance
Not yet discussed.
An insurance contract is treated as a monetary item, Not yet discussed. 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).

64
Include all cash flows that arise from a participating feature in an insurance contract in the measurement of the insurance liability on an expected present value basis.
Not yet discussed.
Component
Include in scope of financial Not yet discussed. instruments standard.
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 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.
Comments from almost all preparers and users that volume information such as premiums and claims considered a key performance metric. Staff have developed alternative approaches to the pure summarized margin approach for Boards consideration: Summarized margin with volume disclosure on the face Expanded margin As written (expected cash flows) Dual statement 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). However, given proposed liability measurement approach, presenting results on an earned premium basis noted by staff as being challenging and would effectively require a second model be developed to estimate amount of revenue to be recognized. Boards suggested outreach to users and preparers to determine information that is critical for them.
65
Component
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 insurers 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 insurers 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 insurers 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 insurers other insurance contract liabilities. Income and expense from pool of assets underlying unit-linked contracts presented as a single line item, not commingled with income or expense from insurers 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. Disclosures Extensive disclosure requirements based on IFRS 4 and IFRS 7 existing disclosure requirements, with some enhancements, including: 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. Effect of the regulatory framework in which the insurer operates.
Not yet discussed.
Not yet discussed.
66
Component
Effective date will be determined taking into account the significance of the changes required and methods of transition. Based on recent indications from IASB comments, effective date of IASB standard not expected to be earlier than 2015.
67
IASB/FASB Board Meeting Insurance Contracts PwC Summary of Meetings April 27, 2011
Whats inside: Highlights Short duration contracts: modified approach
Highlights
The IASB and FASB held a joint Board meeting on April 27, 2011 where they discussed the modified measurement approach for short duration contracts. In the meeting it was clear that the two Boards had different views on whether the modified approach for short duration contracts was a simplification of the building blocks approach or whether it was a different measurement model. The FASB is of the view that the modified approach is a different measurement model. The majority of the IASB is of the view that the modified approach is only a simplification and a proxy for the building blocks approach and not a separate measurement model. As a result, the IASB views the modified approach as a liability measurement model whereas the FASB views the modified approach to be in line with the revenue recognition proposals. The FASB and IASB would not require discounting of future premiums as long as the financing element in a contract was not significant. The FASB was in favor of accounting for acquisition costs in accordance with the requirements in the revenue recognition project (incremental at contract level) and recognizing the acquisition costs as a separate deferred acquisition cost (DAC) asset. The IASB reconfirmed that an insurer should deduct from the pre-claims obligation measurement the amount of acquisition costs as previously tentatively decided by the respective Boards for other insurance contracts. Both Boards agreed that the pre-claims liability should be reduced in line with the requirements as contained in the IASB exposure draft (ED) on the basis of time or the basis of expected timing of incurred claims and benefits if that pattern differs significantly from the passage of time. Both Boards agreed to use qualitative factors as indicators to consider whether a liability adequacy test would have to be performed and not to require a liability adequacy test to be performed at each reporting period. Due to the different positions on the modified approach, the staff did not ask the Boards to discuss whether the modified approach should be required or optional. The staff will bring the objective and the eligibility criteria of the modified measurement approach back to the Boards for discussion at a future meeting.
Reprinted from: Sharing insights on key industry issues April 27, 2011 Note: Since a variety of viewpoints are discussed at FASB and IASB meetings, and it is often difficult to characterize the FASB and IASBs tentative conclusions, these minutes may differ in some respects from the actions published in the FASBs 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.
Short duration contracts: modified approach

The staff recommended that an insurer be permitted, but not required to apply the modified approach to contracts that (i) do not include a significant financing element, and (ii) do not contain embedded
68
options or other derivatives that significantly affect the variability of the cash flows, after unbundling any embedded derivatives. Under the staff proposals a contract does not include a significant financing element if (i) the time between the receipt of premium and the provision of coverage is insignificant and (ii) the amount of premium charged is not
substantially different if the policyholder paid at the beginning of the coverage period. As a practical expedient, a contract is not considered to include a significant financing element if the coverage period is one year or less. For insurance contracts to which the modified approach is applied, the staff proposed that an insurer measure its preclaims obligation at initial recognition as (i) the premium, if any, received at initial recognition, plus the undiscounted value of expected future premiums, if any, that are within the boundary of the existing contract; less (ii) the acquisition costs as tentatively decided by the FASB and IASB respective boards (additional alternatives are provided in the analysis below). Subsequently, the insurer would reduce the pre-claims obligation as the insurer provides insurance coverage (i) on the basis of time, but (ii) on the basis of the expected timing of incurred claims and benefits if that pattern differs significantly from the passage of time. The staff proposed that an insurer should assess if the present value of the expected cash outflows exceeds the carrying amount of the pre-claims obligation if the following factors indicate that a contract may be onerous: (i) the combined loss ratio exceeds100%, (ii) there is a significant increase in the severity or frequency of claims, or (iii) there is a change in the characteristics of the risk profile. If, on that assessment, the present value of the expected cash outflows exceeds the carrying amount of the pre-claims obligation, the insurer shall recognize an additional liability for that excess.
Eligibility criteria
The Boards first discussed the eligibility criteria for the modified approach. A FASB member questioned why the staff proposed that the modified approach should be permitted but not required. The staff noted that it would allow for the comparability and consistency of accounting for insurance contracts within a single reporting entity but would however not result in consistency between different reporting entities. However, the staff was of the view that if the building blocks approach was followed, comparability could be achieved throughdisclosure. There was much debate on the eligibility criteria to be applied to determine whether the modified approach should/ may be used with some FASB members supporting the criteria proposed by respondents and not the criteria as proposed by the staff. These suggestions included criteria which focus on (a) the significance of the investment income potential over the coverage period to the business model, (b) the significance of the period of time between premium receipt and date of loss and (c) the nature of the contract which is primarily based on risk protection and therefore focuses on underwriting results as opposed to investment management. Many FASB members noted their confusion with the staffs proposed criteria that contracts should not include a significant financing element. The Board members do not consider a difference in timing between the inflow of premiums and the payment of claims as a financingelement. A FASB member expressed his view that the proposal for the modified measurement approach was not a simplification of the building blocks approach but instead a
different/second measurement model. The IASB chair asked the staff whether they see the modified approach as a different measurement model or as a proxy for the building blocks approach. The FASB staff noted that they view the modified approach as a different approach for the measurement of the pre-claims liability indicating that modeling performed indicates that the contract measurement could be notably different when using the modified approach instead of the building blocksapproach. An IASB member noted that as long as the difference in the measurement result between the modified and building blocks approach is not significantly different, the modified approach could still be considered a proxy for the building blocks approach. He emphasized the importance to agree on the objective of the modified approach and noted his disagreement with the unstated objective of having two different measurement models. He noted the importance of considering the variability in the cash flows of the pre-claims liability and, consistent with the proposed treatment for embedded derivatives, if there could be variability in the cash flows of the pre-claims liability, the building blocks approach should berequired. An IASB member observed that he did not agree with the criteria proposed by respondents as referred to above and noted that the main driver for the proposals was to avoid discounting of short duration contracts to be in line with current requirements for such contracts in the US. Many IASB members agree d with the view that the modified approach for short duration contracts was a proxy for the building blocks approach and not a different measurement model applied to these contracts.
69
An IASB member questioned whether a modified approach was needed as a practical expedient if the pre-claims period had to be of short duration (and hence one would not expect much variability in the pre-claims obligation cash flows). She also noted that one of the main differences between the building blocks model and the modified approach was presentation. Under the building blocks approach a single contract position was presented whereas under the modified approach a pre-claims liability and a contract receivable were presented. Another IASB member noted that the proposal in the ED was for a single measurement model and noted that one of the main reasons for including the modified approach for short duration contracts was to keep the presentation of certain key performance metrics intact that are used today by many users. He noted his agreement with the observations of other IASB members with regards to the variability in the cash flows and noted that for many contracts there would not be variability in the cash flows if the coverage period was approximately one year and hence he would continue to support the eligibility criteria as proposed in the ED. A staff member noted the overwhelming support by respondents for the continued use of the unearned premium approach as used by many insurers today. He noted that the focus should not be on whether the modified approach is a separate model or a proxy for the building blocks approach and suggested that the eligibility criteria and the proposed measurement model should be considered in tandem. He noted that the building blocks approach works well for contracts with a number of different contract elements such as insurance coverage and investment management services indicating that all elements are treated consistently in the building blocks
70
model. He observed that the proposed modified approach is similar to the treatment of service contracts under the proposals in the revenue recognition project and noted that this treatment works well for those contracts that do not include a number of different contractelements. A FASB member voiced his agreement with some of the IASB members that the Boards should decide whether they are developing a single measurement model or two different models. He noted that the FASB is of the view that the modified approach is a different model and hence is developing two different models whereas the IASB views it as a single model with the modified approach being a proxy for the building blocks model. He noted that for many non-life contracts the underwriting results were far more volatile than for life contracts and noted that a distinguishing difference is the fact that for life contracts asset returns are needed over time to accumulate the required funds to be able to pay the fixed contractual benefit. For nonlife contracts the adequacy of premium income to pay claims is more important. Another FASB member noted the tension between a liability measurement model (building blocks approach) and a model in line with the proposals in the revenue recognition project (modified approach). The staff later emphasized that for many non-life contracts (especially motor business in Europe), very little underwriting profit is achieved and insurers rely on the investment returns generated during the contract term and so using this as a distinguishing feature would be difficult. The FASB chair noted in summary that the FASB was of the view that there should be a simplified model for some contracts and that the FASB saw the building blocks model and the modified approach as two
different measurement models. The IASB chair summarized the IASB position that the modified approach is a simplification of and a proxy for the building blocks approach and not a different measurement model. The staff will bring the objective and the eligibility criteria of the modified measurement approach back to the Boards for discussion at a future meeting.
Time value of money

The Boards next discussed whether the expected future premiums should be discounted in determining the pre-claims liability. A FASB member noted that he would not require discounting for contracts with a coverage period of 12 months or less. He also noted that if the cash paid on contracts with an upfront premium is different compared to the total cash amount when the premium is paid monthly, he would also require discounting of the premium. Another FASB member noted that he would support using the three factors as tentatively agreed in the revenue recognition project of when a contract contains a financing element that would require the discounting of the contract. The IASB chair noted that most of the IASB members would be in favor of not requiring discounting if the financing element in a contract was insignificant using the guidance as developed for the revenue recognition project. A majority of FASB members appeared to have a similarview.
Acquisition costs
The Boards next discussed the treatment of acquisition cost in the modified approach. A FASB member noted that if the modified approach is more in line with the requirements in the revenue recognition project (as it is currently proposed), he would support
applying the revenue recognition projects principles to acquisition costs (incremental cost at contract level). He noted that if the principles in the revenue recognition project do not work for insurance contracts, the Boards should reconsider the appropriateness of these principles in the revenue recognition project. However, if the measurement for short duration contracts is a liability measurement model, he would support the tentative decision for acquisition costs for other insurance contracts. Most FASB members were in favor of accounting for acquisition costs in accordance with the requirements in the revenue recognition project and recognizing the acquisition costs as a separate deferred acquisition cost (DAC) asset. The FASB chair noted that the Boards should consider the appropriateness and consistency of their decisions on acquisition cost in different projects when considering sweep issues (leases, revenue recognition and insurancecontracts). An IASB member noted his strong disagreement with the FASB view to recognize the acquisition costs on these contracts as a DAC asset. He noted that the Boards previously agreed that
acquisition costs were a contract cash flow and questioned how the DAC could be supported as an asset for contracts where the premium is paid up front. Nine of the ten IASB members reconfirmed that an insurer should deduct from the pre-claims obligation measurement the amount of acquisition costs as previously tentatively decided by the respective Boards for other insurance contracts.
Amortization of the preclaims obligation

Both Boards agreed with the principle that the pre-claims liability should be reduced in line with the requirements as contained in the ED (on the basis of time or the basis of expected timing of incurred claims and benefits if that pattern differs significant from the passage of time).
and that insurers would have priced their expectation of insurance losses into the premium that is charged on contracts. He also indicated that if the modified measurement approach is in line with the revenue recognition model, no risk adjustment should be included to be consistent with the revenue recognition project. Other FASB members noted that they would support the use of qualitative factors to consider whether a liability adequacy test is required to be performed, consistent with the impairment requirement in other standards. Both Boards generally agreed with using qualitative factors to consider whether a liability adequacy test would be required. An IASB member noted that for short tail contracts, retrospective indicators might be appropriate but for long tail business, more weight should be placed on indicators that are prospective in nature. Due to the different position on the objective of the modified approach, the Boards did not discuss whether the modified approach should be required or optional but will consider it when the Boards discuss the objective of the modified approach at a future meeting.
Onerous contract
The Boards next discussed the proposals for an onerous contract test. A FASB member noted that the Boards should not develop a new liability adequacy test
71
IASB/FASB Insurance ContractsProject PwC Summary as of April 14, 2011
Reprinted from: PwC Summary April 14, 2011 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, 2010 as well as PwC knowledge gained from attendance at IASB and FASB meetings through April 14, 2011. Component IASB Exposure draft (ED) and FASB Discussion paper (DP) views IASB Status Exposure draft (ED) issued July 2010. FASB Discussion paper (DP) issued September 2010. Joint redeliberations began January 2011. IASB final standard and FASB exposure draft expected by end of 2011. 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 policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder. 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 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. Reaffirmed ED/DP position. May try to clarify insurance definition to distinguish insurance from service contracts. Boards redeliberation status
Some constituents (principally IFRS) commented that present value clarification and requirement for at least one possible loss outcome not necessary. Reaffirmed ED/DP position.
72
Component
Scope
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 residual value (but stand-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 combination. Employers 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. Direct insurance contracts an entity holds as policyholder (except for cedant accounting).
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 guarantee contracts (including mortgage guarantee) should be included in scope in conjunction with financial instruments project. Both Boards reaffirmed scope exclusions noted in ED/DP.
Unbundling
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 associated with insurance contracts (e.g., GMABs and GMWBs) which could lead to different results
Reaffirmed ED/DP position to separate embedded derivative as defined in IFRS and US GAAP, respectively, and account for as derivatives at fair value. Staff to consider whether IFRS 4 embedded derivative implementation guidance should be carried forward. Boards to discuss account balances and service elements at future meeting. Some Board members expressed preliminary thoughts that unbundling too complicated, requires arbitrary allocation, and may not be worth cost if insurance measurement is close to other GAAP measurements. Other Board members believe similar transactions should be accounted for in similar manner (e.g., deposits components as financial instruments) and deposits should not be shown as premium revenue. Some constituents may want unbundling to get amortized cost treatment for deposit component.
73
Component
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.
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 for that obligation. Measurement approach should portray a current assessment of the contract, using the following building blocks:
Not expected to be redeliberated.
Reaffirmed the concept of a building block model using expected value and a discount rate explicit, unbiased, probability-weighted average (expected to incorporate the time value of value) of future cash outflows less future cash inflows that money. will arise as insurer fulfills the insurance contract. Clarified that measurement a discount rate to incorporate of time value of money. objective of expected value refers a margin*. to the mean. These building blocks should be used to measure the Clarified that not all possible combination of rights and obligations arising from an scenarios need to be identified and insurance contract rather than to measure the rights quantified provided the estimate separately from the obligations. is consistent with the mean That combination of rights and obligations should be measurement objective. presented on a net basis. Reaffirmed no gain at inception, but immediate recognition of any *Two different margin approaches proposed are explicit risk day one loss. adjustment approach and composite margin approach. Both approaches eliminate any gain at inception. The IASB ED Have not yet concluded on explicit includes the explicit risk adjustment approach, while the FASB versus composite margin. 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.
74
Component
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 Have tentatively decided that if market participant. techniques exist that can faithfully represent the risk inherent in 2) An amount that eliminates any gain at inception of the insurance liabilities, inclusion contract (residual margin). of explicit risk adjustment in Risk adjustment: insurance contract measurement would provide relevant information Explicit risk adjustment is the maximum amount insurer to users. would rationally pay to be relieved of the risk that the ultimate fulfillment cash flows exceed those expected. Have yet to discuss whether explicit risk adjustment can be Explicit risk adjustment would be updated (remeasured) each measured in reliable way that reporting period. promotes comparability and is cost Under the explicit risk adjustment approach, the range of beneficial. permitted techniques that can be used is limited to the Risk adjustment objective changed following three: the confidence level technique (Value at to: the compensation the insurer Risk), the Conditional Tail Expectation technique (Tail Value requires to bear the risk that at Risk), and the Cost of Capital technique (using economic ultimate cash flows could exceed rather than regulatory capital). those expected. Although the risk adjustment is included in the measurement Application guidance will note that as conceptually separate from other building blocks (cash amount reflects both favorable flows and discount rate), this is not intended to preclude and unfavorable outcomes and replicating portfolio approaches. To avoid double counting, reflects the point at which insurer the risk adjustment does not include any risk captured in the is indifferent between holding the replicating portfolio. insurance liability and a similar Residual margin: liability not subject to uncertainty. 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 inception. Have yet to redeliberate prescribed methods for calculating the risk adjustment.
Have not yet concluded on whether model should include an explicit risk adjustment or composite margin.
Risk adjustment: Composite margin approach (Alternative view in IASB Basis of Conclusions)
Composite margin approach: 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 composite margin. Composite margin at initial recognition is the difference between the present value of expected value of cash inflows 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.
Have not yet concluded on whether model should include an explicit risk adjustment or composite margin.
75
Component
Reaffirmed that in general measurement will be done at the portfolio level (e.g., estimate of cash flows and risk adjustment). Have not yet discussed level of measurement for other components such as residual margin.
Use of inputs
Consider all current available information that represents Reaffirmed that costs directly fulfillment of the insurance contract from perspective of the attributable to contract activity entity, but for market variables, be consistent with observable as part of fulfilling portfolio of market prices. contracts that can be allocated to portfolio should be included in Types of data that may be useful include, but are not limited cash flows. 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. Reaffirmed that inventory costing guidance in IAS 2 should be used as basis for types of costs to be included in cash flows. 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.
76
Component
Insurer should include premiums and other cash flows Tentatively changed position such resulting from those premiums only if the insurer can compel that contract boundary is point the policyholder to pay premiums, or the premiums are within when insurer is no longer required the boundary of the contract. to provide coverage or when the existing contract does not Contract boundary is the point at which the insurer: confer any substantive rights to (1) is no longer required to provide coverage OR policyholder. (2) has the right or practical ability to reassess the risk of the Not a substantive right when particular policyholder and, as a result, can set a price insurer has right or practical ability that fully reflects that risk. to reassess risk of particular 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 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. 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 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). Reaffirmed objective to adjust cash flows for the time value of money and reflect characteristics of the insurance contract liability. 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). Staff working on application guidance to clarify the types of adjustments expected in top down approach. Reaffirmed that measurement of the liability should not reflect changes in the insurers own credit standing. Continued
Insurance: Updated August 15, 2011 77
Component
Continued from previous page Discount rates 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). Accretion of interest on residual margin or composite margin 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. Subsequent treatment of residual margins under explicit risk adjustment 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. Subsequent treatment of composite margin under composite margin approach (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. Composite margin would be included as part of the insurance liability.
Tentatively decided not to allow lock in of discount rate. 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.
Do not accrete interest on the residual margin (under the explicit risk adjustment approach) or on the composite margin (under the composite margin approach).
Exploring whether composite margin should be adjusted for changes in cash flow estimates. May explore alternative amortization terms and patterns.
Component
An unearned premium measurement approach (simplified 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 required. Income statement presentation permits gross revenue, claims, and expenses.
FASB has not yet concluded Will redeliberate at future meeting. on what they refer to as Constituents commented that modified measurement approach is not simplified and that and presentation approach one year criterion is too restrictive. and which insurance contracts should apply that Many US constituents believe non-life requires a separate model approach rather than the and that existing US GAAP model building block approach. should be retained.
79
Component
Acquisition costs
Not yet discussed.
80
Component
Reinsurance
Not yet discussed.
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).
Not yet discussed.
Include all cash flows that arise from a participating feature Not yet discussed. in an insurance contract in the measurement of the insurance liability on an expected present value basis.
81
Component
Include in scope of financial Not yet discussed. instruments standard
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 Staff have developed alternative be shown on face or in notes): approaches to the pure summarized margin approach for Underwriting margin (change in risk adjustment, release of Boards consideration: residual margin). Gains/losses at initial recognition (loss at inception, loss 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 with volume disclosure on the face. Expanded margin. As written (expected cash flows). Dual statement.
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 Summarized margin approach would be supplemented by on a basis that is comparable additional information including a reconciliation of changes in to other industries (i.e., classic the liability and volume of business written. revenues earned and expenses In simplified unearned premium approach only: incurred). Underwriting margin (premium revenue, gross of However, given proposed liability incremental acquisition cost amortization, claims measurement approach, presenting incurred, expenses incurred, amortization of incremental results on an earned premium acquisition costs) basis noted by staff as being Changes in additional liabilities for onerous contracts. challenging and would effectively require a second model be No offsetting of income and expense from reinsurance developed to estimate amount of contracts against expense or income from revenue to be recognized. insurance contracts. Boards suggested outreach to users and preparers to determine information that is critical for them.
82
Component
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 insurers 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 insurers 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 insurers 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 insurers other insurance contract liabilities. Income and expense from pool of assets underlying unit-linked contracts presented as a single line item, not commingled with income or expense from insurers 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.
Not yet discussed.
Disclosures
Extensive disclosure requirements based on IFRS 4 and IFRS 7 existing disclosure requirements, with some enhancements, including: 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. Effect of the regulatory framework in which the insurer operates.
Not yet discussed.
83
Component
Effective date will be determined taking into account the significance of the changes required and methods of transition. Based on recent indications from IASB comments, effective date of IASB standard not expected to be earlier than 2015. FASB exposure draft possible 2nd half 2011.
84
IASB/FASB Board Meeting Insurance Contracts PwC Summary of Meetings April 12, 2011
Whats inside: Highlights Top down approaches to discount rates
Highlights
The staff opened the meeting with an announcement that the timetable has been revised such that June will be a working month. The official IASB timetable now shows issuance of a final standard in the 2nd half of 2011, and the FASB timetable shows the issuance of an exposure draft in the 3rd quarter 2011. The main purpose of the meeting was to clarify the application of the top down approach to estimating the discount rate used to present value cash flows in the insurance model. The staff presented a paper clarifying the types of adjustments that would be needed to either a reference portfolio or actual portfolio of assets to arrive at a discount rate that reflects only the characteristics of the liability. Those adjustments would include adjustments for differences between the timing of cash flows of the assets in a portfolio and the timing of the liability cash flows as well as risks inherent in the assets that are not inherent in the liabilities such as credit risk, market risk and other price risk. The staff identified differences in liquidity that are inherent in the asset cash flows versus the liquidity inherent in the liability cash flows as the third conceptual difference that could be challenging to quantify. They described what they believed was the Boards previous decision that an insurer applying the top down approach need not adjust for this difference as a practical expedient. The Boards generally agreed with the staffs analysis and directed the staff to proceed with drafting application guidance, with consideration of the several points raised by various Board members as described more fully below.
Reprinted from: Sharing insights on key industry issues April 12, 2011 Note: Since a variety of viewpoints are discussed at FASB and IASB meetings, and it is often difficult to characterize the FASB and IASBs tentative conclusions, these minutes may differ in some respects from the actions published in the FASBs 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.
Top down approaches to discount rates

The Boards had decided at their February meeting that the final guidance should not prescribe a rate or method for determining the discount rate but instead should explain that the objective is to adjust future cash flows for the time value of money. The rate should be consistent with observable current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability, excluding the effect of the insurers own non-performance risk. The rate should exclude the effect of risks and uncertainties included in the cash flows or the risk adjustment, and should exclude any factors that influence the
observed rates but are not relevant to the insurance liability (such as investment risk not passed onto the policyholder). At the February meeting, the Boards discussed how either a bottom up or top down approach could potentially satisfy the objective of the discount rate. The rate described in the IASB exposure draft (the ED) is a bottom up approach that starts with the risk free rate on liquid assets such as government bonds and then adds back a component to capture the less liquid nature of an insurance contract liability to arrive at the liability discount rate. Due to concern with the lack of a standardized method for determining the illiquidity adjustment, many constituents noted their preference for a top down approach,
Revenue recognition: August 15, 2011
85
which starts with an asset rate and then subtracts out components not relevant to the liability characteristics such as expected defaults and the related premium for bearing that risk. At this meeting, the staff noted that subsequent to the February meeting they had received requests from various constituents to clarify the adjustments that would be made in the top down approach, and as a result had prepared the current staff paper. The paper provides application guidance for determining the discount rate using a top down approach, clarifying the types of adjustments that would be needed to either a reference portfolio or actual portfolio of assets to arrive at a discount rate that reflects only the characteristics of the liability. Adjustments for differences between the timing of cash flows of the assets in a portfolio and the timing of the liability cash flows are referred to as Type I adjustments. Risks inherent in the assets that are not inherent in the liabilities and thus need to be adjusted out such as credit risk, market risk and other price risk are referred to as Type II adjustments. Differences in liquidity between asset cash flows and liability cash flows are referred to as Type III adjustments. The staff described their understanding of the Boards previous decision that an insurer applying the top down approach need not adjust for the liquidity difference as a practical expedient due to the difficulty in determining this amount. Board members had various comments and questions regarding the staffs proposed application guidance. Two IASB Board members were surprised by the staffs introductory remarks that some people had misinterpreted the February Board discussion of the top down approach as implying that an asset rate could be
86
used as the discount rate. These Board members as well as the staff reiterated that it was not an asset based approach; the asset rate is merely the starting point that after adjustment theoretically arrives at a rate that reflects the characteristics of the liability, the same objective as the ED. One FASB Board member commented that while the estimation of a discount rate might be routine for insurers, it would not be for non-insurers who might be subject to the insurance contract accounting due to its wide scope. He suggested that a practical expedient to the discount rate be permitted for non-insurers (which would need to be defined) or that the scope be revised to exclude them. An IASB Board member suggested that a definition of reference portfolio was needed, to which the staff replied that it was not meant to be a replicating portfolio but instead should closely resemble the cash flow characteristics of the liability. Another IASB Board member commented that if one started with a reference portfolio, given the staffs definition, there would be no need for a Type I adjustment. The staff clarified that an adjustment might still be needed if, for example, a reference portfolio was only available for say, 30 years, while the liability cash flows were estimated to be 50 years. A FASB Board member questioned whether there was symmetry between the top down and bottom up approach in terms of being able to use a practical expedient. That is, if differences in liquidity between the asset starting point and the liability could be ignored in the top down approach, could it also be ignored in the bottom up approach to allow a pure risk free rate as the discount rate? The staff said that the illiquidity adjustment could not be ignored in the bottom up approach, and explained
that in the top down approach, the point wasnt to exclude a liquidity adjustment but merely to recognize that it might be too difficult to measure. It was the staffs expectation that a company would select an asset portfolio that had characteristics, including perhaps liquidity characteristics, that were similar to those of the liability, and thus the difference might not be that significant anyway. Another FASB Board member said that he did not believe he voted in February to tell insurers that they neednt make an illiquidity adjustment in all cases in a top down approach. If an insurer starts with a portfolio of debt securities that are very liquid, and the liability is not liquid, he believes an adjustment for this liquidity difference would be needed. He suggested that perhaps the guidance should state that if the liability is illiquid, an illiquid asset would also need to be used as the starting point in the top down approach. Several IASB Board members and a staff noted the potential difficulty with determining adjustments from the top down rate where equity securities and/ or real estate are used as the assets in the portfolio. The staff commented that due to the difficulty in determining the necessary adjustments, it would seem easier to use a reference portfolio rather than an actual asset portfolio in such situations. An IASB Board member noted that in certain territories, especially in developing countries such as India, an insurers asset portfolio might be dictated by regulators, and might be limited to government securities. In that situation, using the risk free rate as the starting rate in the top down approach presented a dilemma, as the risk free assets would typically be more liquid than the insurance liabilities they are supporting. Would insurers in these
territories be permitted to use the risk free rate as the practical expedient, even though, if using a bottom up approach, an adjustment for illiquidity would be required? This question even when posed again later to the staff, was not explicitlyanswered. One IASB Board member commented that more application guidance is needed to ensure a more faithful representation of the split of the market spread between the credit component and the liquidity component. In his view, without this guidance, insurers would be likely to treat almost all changes in market spread from period to period as liquidity changes rather than credit changes to get the answer they want (presumably a better matching with changes on the asset side). He believes guidance and perhaps examples should indicate that not all changes in rates relate to liquidity. A FASB Board member commented that the goal of the discount rate is more important than the steps and that she does not
believe that detailed numerical examples such as those presented in the staff paper are appropriate, noting that during the financial crisis the Boards did not issue detailed numerical guidance for determining the liquidity and credit components of rate changes. An IASB Board member partially agreed, noting that the Boards should provide a solid principle and not get caught up in granular calculations of items that are so subjective anyway. However, they did still need to recognize both bottom up and top down approaches given the different markets that exist worldwide. The additional disclosures of information such as the yield curve suggested at the February meeting would help deal with some of thesubjectivity. Another FASB Board member noted that the Type II adjustment for investment risk would cover not only credit risk (both expected defaults and the market risk premium for the uncertainty of defaults), but also other investment risks such as the potential variability in cash flows from a variable rate instrument and the related
market risk premium for uncertainty in those cash flows. This made the top down approach appear rather complicated, and as a result the Board member suggested that perhaps the bottom up approach was actually less complicated, as only an illiquidity adjustment needed to be calculated. It was his understanding that the insurance industry actuaries were coming up with at least five different approaches for measuring the illiquidity adjustment. An IASB Board member responded that it was his understanding that most of the approaches for calculating the illiquidity adjustment actually started with a top down approach anyway. At the end of the discussion, the Boards noted their general agreement with the staffs analysis and directed the staff to proceed with drafting application guidance, with consideration of the several points raised by various Board members as described above.
87
IASB/FASB Board Meeting Insurance Contracts PwC Summary of Meetings March 29, 2011
Whats inside: Highlights Unlocking the margin Summary from insurance working group meeting
Highlights
The IASB and FASB held a joint Board meeting on March 29, 2011 where the staff provided background information to the Boards for their future consideration as to whether the residual or composite margin should be locked in at inception or unlocked over the life of the contract. The staff expressed a leaning toward unlocking prospectively for favorable and unfavorable changes in non-financial inputs relating to future estimate changes. While the staff had noted at the start that no vote would be taken, the IASB chair asked IASB members to indicate how many would potentially support the direction the staff was moving toward. The IASB seemed to support the general direction, but agreed that they needed to see the whole picture before concluding. The FASB was not prepared to vote, but the chair reiterated that she was very concerned with a deferral mechanism, given that this was a current value model with current estimates, and struggled with the idea of finding ways to support smoothing income. It should be noted that the latest IASB work plan published this week has the insurance contracts standard balloted in June but not published until the second half of 2011.
Reprinted from: Sharing insights on key industry issues March 29, 2011 Note: Since a variety of viewpoints are discussed at FASB and IASB meetings, and it is often difficult to characterize the FASB and IASBs tentative conclusions, these minutes may differ in some respects from the actions published in the FASBs 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.
Unlocking the margin

The purpose of the meeting was to provide background information to the Boards for their future consideration as to whether the residual or composite margin should be locked in at inception, as proposed in the IASB exposure draft (the ED) and the FASB discussion paper (the DP), or unlocked over the life of the contract. The staff noted at the beginning of the meeting that they were not asking for conclusions at this meeting. The staff noted that some constituents were against the lock in principle for the residual or composite margin, noting that it was inconsistent with the requirement to remeasure all other components of the model (the building block, risk adjustment and discount rate). In addition, commentators noted that it did not make sense to record losses currently due to unfavorable changes in estimates and then continue to
amortize the residual or composite margin in the future. The staff pointed out that the Boards made decisions in February and March to include more acquisition costs in cash flows and include all costs the insurer incurs that are directly attributable to acquiring and fulfilling contracts. As a result, the size of the residual or composite margin would decrease, potentially significantly, and the remainder would include other costs priced into the premium, such as general business risk and other overheads not easily identifiable. The staff suggested this as a reason why the residual or composite margin could not easily be remeasured subsequent to inception as had been suggested as an alternative to lock in by some constituents. They also noted that since there is no transaction price subsequent to inception, there is no way to truly remeasure the margin (which by definition is a function of transactionprice.)
88
Therefore, the latest staff paper concentrated instead on unlocking the margin by either (1) consuming the margin (meaning to reduce it for unfavorable changes in the carrying amount of the liability) or (2) floating the margin (meaning adjusting it for changes, both favorable and unfavorable in the value of the other building blocks without limiting it to the amount initiallyrecognized). The staff noted that if unlocking is eventually chosen by the Boards (either by consuming or floating the margin), other considerations would include: whether the margin should be used for changes in only non-financial variables, only financial variables, or both; whether the changes should be those related only to changes in future estimates, or also to changes between current period actual activity and estimates; and whether such adjustment to the margin should be made retrospectively or prospectively.
In response to a question by an IASB Board member, the staff noted that Australia uses the floating method, unlocking the composite margin on its life business for non-financial changes, adjusting the margin on a prospective basis. An Australian representative on the Insurance Working Group believes that this unlocking is well understood and does not present issues in terms of practicalapplication. In response to an IASB members question on the staff paper which indicated that unlocking of the margin for only nonfinancial inputs would avoid accounting mismatches, the staff responded that their point was that if assets are recorded at fair value through income, less mismatch would result if changes in the discount rate on the liability were also taken through income rather than adjusting the margin. On the other hand, if assets were recorded at amortized cost, less of a mismatch would result if the change in discount rate were taken against the margin. An IASB member remarked that he did not understand the connection between asset changes and the margin on insurance contracts. He also asked why the staff analysis did not distinguish between the residual and composite margin, as the two differ, and he would find it easier to accept unlocking for the residual margin than for the composite margin. The staff noted that a separate staff paper will bring the residual and composite margin approaches closer together. The staff understands that the decision on unlocking may depend on whether there is an explicit risk adjustment or not, and recognize that any input they receive from the Boards now will be preliminary, pending reaching conclusions on this and other issues.
A FASB member asked whether it was operational to distinguish between various components of changes in estimate, and between current and future period effects. In addition, she asked how the current paper would dovetail with the staffs future paper that would potentially propose putting certain financial input changes through other comprehensive income. If the margin absorbs changes in non-financial variables, and other comprehensive income is used for financial variables such as changes in the interest rate, what would be left to be recognized in the income statement? If the insurance business is subject to volatility, and the model they have built is a current value model, does it make sense to recognize all changes outside the income statement? Other IASB and FASB members agreed that further discussion and consideration of the FASB members points were warranted before taking a final view on this issue. A FASB member commented that they needed to decide what they wanted to portray in the performance statement, and whether it necessarily needed to show the results of all changes to the liability measurement as portrayed in the balance sheet within the current period performance statement. An IASB member noted that if it is appropriate to unlock the risk adjustment, perhaps it is also appropriate to unlock the residual margin. Another IASB member remarked that he could live with lock in or unlocking. He noted that on insurance company earnings calls he has heard, analysts are typically interested in understanding changes to non-financial inputs and their impact on income, and thus such information would need to be presented somewhere in the financialstatements.
The staff noted that those who view the margin as an allocation of profit would tend to view unlocking as sensible, while those who view it more as a plug in a liability model would see it as a mechanism to smooth income. They noted that input from the Insurance Working Group in the prior week was mixed, but that some supported a floating form of unlocking (with the majority supporting unlocking for non-financial inputs) and noted that retrospective adjustment would be complex and burdensome to implement. The staff expressed a leaning toward unlocking prospectively for favorable and unfavorable changes in non-financial inputs relating to future estimate changes.
89
A number of IASB Board members expressed hesitancy with the staff proposal to unlock, noting concerns with complexity, and noting that the margin is just a plug to the transaction price (and implicitly covered items such as overhead and other future costs), and so remeasuring that at a future date seemed inappropriate. There was a general sentiment that further study of the calculations (and other issues such as the use of other comprehensive income) was needed before a decision could be made. An IASB member remarked that at a prior meeting, someone raised the idea that unlocking would lessen the distinction between the explicit risk adjustment and the composite margin methods, but he was not clear on how this would be so. It appeared the staff was working on a further explanation of this, but in the meantime was looking for direction from the Boards. While the staff had indicated at the start that no vote would be taken, the IASB chair asked IASB members how many would potentially support the direction the staff was moving toward (unlocking). Nine of 13 seemed to support the general direction, but agreed that they needed to see the whole picture before concluding. The FASB was not prepared to vote, but the chair reiterated that she was very concerned with a deferral mechanism, given that this was a current value model with current estimates, and struggled with the idea of finding ways to support smoothing income. The IASB chair agreed with her comments.
Summary from Insurance Working Group meeting

In a brief summary of the prior weeks Insurance Working Group meeting, the staff noted that generally the group was in favor of bringing the project to a close after 14 years. They were interested in an approach that would record at least a portion of the change in the discount rate in other comprehensive income. In terms of presentation, they seemed interested in some sort of expanded margin approach combined with the ability to disaggregate various components of the insurance liability. Concern was expressed with the potential complexity of the model; the Boards should try to keep it simple.
90
IASB/FASB Board Meeting Insurance Contracts PwC Summary of Meetings March 2122, 2011
Whats inside: Highlights Unbundlingoverall considerations Unbundlingembedded derivatives Objective of the explicit risk adjustment Discounting ultra long duration cash flows Education session on explicit risk adjustment Contract boundary
Highlights
The IASB and FASB held a joint Board meeting on March 2122, 2011 where they discussed the pros and cons of unbundling various components of insurance contracts. They reached a tentative decision on one aspect of unbundling, agreeing to carry forward the existing separation requirements in IFRS4 and IAS39/IFRS9 and Topic 815 under USGAAP for derivatives embedded in insurance contracts. They expect to continue the unbundling discussion at a future meeting. The Boards agreed to amend the objective of the explicit risk adjustment after taking into consideration constituent concerns that the IASB exposure draft (ED) reference to the amount the insurer would pay to be relieved of the risk implied an exit value notion rather than a fulfillment value notion and the maximum amount suggested the application of conservativism. The objective was revised during the meeting to the compensation the insurer requires to bear the risk that the ultimate fulfillment cash flows exceed those expected. The Boards will continue their discussion of the risk adjustment and whether it should be part of the model (versus a composite margin) at a future meeting. The staff introduced a paper proposing that the effects of changes in the discount rate for ultra-long duration cash flows would be presented in other comprehensive income (OCI). The amount would reflect all changes in measurement attributable to changes in the unobservable part of the yield curve. The Boards general reaction to the proposal was that the use of OCI for insurance contracts should be looked at more holistically than just for one piece of the discount rate. The Boards suggested that the staff reach out to preparers and users as well as insurance working group members later this week to gather views on OCI presentation for certain components of the change in the insurance liability. The staff proposed that a contract renewal should be treated as a new contract when the insurer is no longer required to provide coverage or when the existing contract does not confer on the policyholder any substantive rights. Both Boards agreed that contracts for which the pricing of the premium does not include risks relating to future periods, no substantive rights are conferred on the policyholder when the insurer has the right or the practical ability to reassess the risk of the portfolio the contract belongs to and, as a result, can set a price that fully reflects the risk of that portfolio.
91
Unbundlingoverall considerations
The staff noted that with regard to unbundling, the ED and FASB discussion paper (DP) proposal was that components not closely related should be separated, a concept consistent with IFRS9 and ASC 815. However, constituents noted that they were uncertain how to apply the guidance for deposit and service components, and feedback varied on whether preparers wanted to unbundle or not. The staff believes that a clearer objective needs to be developed for unbundling and asked the Boards their views on this. One IASB member noted that in one place, the staff paper said that unbundling would get rid of arbitrage, but in another section it said it could result in arbitrage. The staff noted that the first reference was talking about eliminating arbitrage between different industries by requiring that the same types of instruments be treated in a similar manner (e.g., as financial instruments, whether issued as part of an insurance contract or separately), while the latter reference was referring to ways an individual company could use unbundling for its benefit, for example to get amortized cost accounting for a portion of an insurance contract. An IASB member commented that it is not worthwhile to unbundle if the measurement outcome is not expected to be materially different, given the complexity, time and effort needed to unbundle. An exception might be situations where presentation on a different basis would matter, or where the combination of components lacked commercial substance. He noted that one concern with the insurance project was the use of different discount rates between insurance contracts and
derivatives, which could result in material differences. Another IASB member stated his agreement with the above. He is not concerned with people throwing in a little insurance to get insurance accounting, and believes that the insurance model produces high quality information. He acknowledges that in some cases you may get a slightly better answer if you unbundle because you wont have as much of an asset/liability mismatch. However, as constituents noted, in many instances the components will be hard to allocate due to the integration of various provisions within the contract, adding complexity without adding much benefit. In summary, he would make the decision based on whether accounting would be significantly better with unbundling. He would not object to leaving an option to unbundle where it is straightforward to do and the product is built that way. Several other IASB members echoed these comments, noting that the objective should not be to search for as much unbundling as possible or delve too deeply, and that unbundling could lead to more arbitrage opportunities based on the somewhat arbitrary nature of the unbundling exercise in certain more integrated products. However, they acknowledged that in some cases unbundling for presentation purposes might produce more decision useful information, such as for deposit premiums and embedded derivatives. A FASB Board member noted that keeping the deposit component bundled wouldnt help the asset/liability mismatch issue. He indicated that subtle differences between current value (of insurance contracts) and fair value (of financial assets) may make this important, as commentators said that whether or not you have a credit component in the rate matters. He also
had concerns with not unbundling as to whether any revenue number presented in the statement of comprehensive income would actually represent revenue; as in some instances premiums are really justdeposits. An IASB member later agreed with the FASB member concern with bundling, noting that presentation matters. Another FASB member also agreed, noting that the more they talk to investors and analysts, the more they hear about concern with the black box issue that is insurance. As products get comingled with other industries, he believes it doesnt make sense to get different answers. Another IASB member agreed that insurance risk should be separated from other risks. An IASB member suggested to the staff that an outreach effort to investors and analysts on this issue would be helpful to gather information for a future meeting.
Unbundling embedded derivatives

The staff noted that not many constituents commented on the ED and DP proposal to require separation of embedded derivatives, and asked the Board members their views. The Boards reached a tentative decision to carry forward the existing separation requirements in IFRS4 and IAS39/ IFRS9 and Topic 815 under USGAAP for derivatives embedded in insurance contracts. The staff noted that some constituents had suggested that the cost of unbundling would outweigh the benefits, especially since the building block approach is a current value model that requires use of market observable data, where available. Thus, there would be no significant
92
difference between the insurance model valuation and fair value (other than perhaps the insurers own credit risk which is not considered in the insurance model). However, the Boards noted that there is already existing literature in place requiring bifurcation, and as a result there is also existing practice on how to unbundle embedded derivatives. In addition, several Board members noted the increased transparency that separation would yield. One FASB member asked whether bifurcation of embedded derivatives for insurance contracts would now be inconsistent with the IASB conclusion not to bifurcate embedded derivatives from assets. He also noted that the FASBs answer was contingent on decisions reached in their financial instrument project, for example, whether the clearly and closely related criteria would remain the same. An IASB member questioned why, for embedded derivatives, the view is that you are always required to unbundle, whereas for other components, such as deposit and service elements, the group had earlier suggested that whether or not you unbundle depended on how different the measurement was between the models. The staff plans on addressing deposit and service component unbundling issues at a future meeting. They will then circle back to consider the Boards decisions as a whole and whether there are internal inconsistencies that should be eliminated and whether an overall principle can bedeveloped.
with the concept that the risk adjustment conveys the uncertainty of the expected cash flows, they had issues with the clarity of the objective and the use of certain terminology. The ED notes that the risk adjustment shall be the maximum amount the insurer would rationally pay to be relieved of the risk that the ultimate fulfillment cash flows exceed those expected. Respondents noted that the risk adjustment would be affected by both favorable and unfavorable outcomes, and thus objected to the ED reference to the words exceed those expected. They also noted that the reference to amounts an insurer would pay to be relieved of the risk sounded more like an exit concept than a fulfillment value concept, and some thought that the reference to the maximum amount implied that a level of prudence or conservativism was supposed to be applied. As a result of these comments, the staff redrafted the objective of the risk adjustment and presented it to the Boards for discussion. They noted that the risk adjustment shall be the amount that makes the insurer indifferent between (a) undertaking or retaining the obligation to fulfill the insurance contract; and (b) undertaking or retaining an obligation to pay an amount equal to the expected present value of the cash flows that will arise as the insurer fulfills the liability. Many IASB and FASB members found the proposed staff words, laid out in a with and without type explanation, to be unclear and unnecessarily complex. Some found the suggestion made by the American Academy of Actuaries to be clearer: An equivalent amount where the insurer is indifferent between paying a certain amount (to eliminate the uncertainty) and keeping the uncertain cash flows.
A FASB member noted that although constituents objected to the risk that cash flows would exceed those expected wording, in his view this terminology is necessary because the concept behind the risk adjustment is a risk aversion notion, meaning that an amount is added to the mean to reflect the fact that people want to be compensated for the chance that the outcome could be worse than expected. In response to the FASB members remarks, the staff explained respondents views, noting that the fact that you are risk averse doesnt mean you ignore the good, you just concentrate more on the bad; but you consider both. By the end of the discussion, the Boards had settled on some draft wording for the objective of the explicit risk adjustment as follows: The risk adjustment shall be the compensation the insurer requires to bear the risk that the ultimate fulfillment cash flows exceed those expected. The staff will also include a follow on sentence to address constituent concerns with the exceed wording. One staff member expressed his view that the idea of indifference still needed to be included in the objective because without it, there is no way to indicate how much compensation the insurer would require.
Discounting ultra long duration cash flows

The staff introduced a paper whereby the effects of changes in the discount rate for ultra-long duration cash flows would be presented in other comprehensive income. The amount would reflect all changes in measurement attributable to changes in the unobservable part of the yield curve. It was suggested by the staff in light of
Objective of the explicit risk adjustment

The staff noted that while constituents responding to the ED generally agreed
93
constituent concerns with how to extrapolate the yield curve with reasonable accuracy beyond the period that observable long term discount rates are available. One IASB member commented that there are a lot of items that need to be estimated that are not observable in the insurance model, for example the risk margin, and questioned why this one particular piece of the model was being singled out for OCI treatment. Several other IASB members as well as FASB members echoed these concerns. One asked whether users would consider this an improvement, and whether preparers would think it would meet a cost/benefit test given the potential added burden and complexity of tracking this particular component. A FASB member noted that to the extent that liability payments occur in years beyond the point when there are duration matched assets, this is real economic volatility, i.e., a real mismatch and thus questioned why it should be shown in OCI rather than income. An IASB member noted that the user community was almost unanimous that they want to see economic volatility; they want it to be transparent. The staff responded that although this is real volatility that should be reported, the question is whether it should be reported in income versus OCI. Another FASB member noted that ultra long insurance contracts were no different than long dated derivatives. The insurer took the risk by writing the contract, and if the model requires the use of current data, then it should be measured as such. It was suggested by several IASB members that the staff should do an outreach to users as well as raising the issue with the insurance working group. Several FASB clarified that the OCI suggestion should
be raised more holistically and not just in regard to changes in the unobservable part of the yield curve.
mandatory disclosure of the probability of adequacy (PoA) of the insurance liabilities including the riskadjustment. Tony briefly noted that the accounting model for life insurance contracts does not require an explicit risk adjustment but follows a methodology more in line with the composite margin approach. He noted that the difference between previously expected and current year actual results is recognized in the income statement. However, the margin is unlocked and adjusted for changes in expected future non-financial estimates/assumptions. He noted a high-level classification of insurance business into (i) high frequency/ low severity business where the outcomes are relatively easy to predict (e.g., motor business), (ii) low frequency/high severity business where the outcomes are harder to predict reliably (e.g., earthquake business) and (iii) low outstanding claims risk (life business) versus high outstanding claims business (asbestoses). He explained the broad steps in the Australian model as follows: 1. Assess the expected cash flows of the liability for each class of business; 2. Assess the coefficient of variation of the liability (a measure of the inherent variability of a distribution); Select the appropriate distribution for the present value of claims (he noted that a log normal distribution was a good approximation for most classes of business); Select the PoA; Assess the risk adjustment by class of business before diversification.
Education session on explicit risk adjustment

Tony Coleman, from Lonergan, Edwards & Associates presented to the Boards on experience with the practical implementation of a risk adjustment in the Australian non-life insurance market. He noted that the Australian market was the 10th largest in the world and that both large and small insurance companies applied explicit risk adjustments. He noted that QBE, which is one of the larger writers in the local market, also has significant operations worldwide and all insurance subsidiaries are required to determine an explicit risk adjustment using Australian Accounting Standards for group reportingpurposes. He explained that the Australian model for non-life insurance is very similar to the proposals in the modified measurement model proposed in the ED. The model uses an unearned premium liability for the preclaims period and discounts the insurance liabilities at the risk free interest rate. The liability for outstanding claims is based on central estimates which he indicated was the same as the proposed expected cash flows in the ED and also requires the estimation of an explicit risk adjustment. A liability adequacy test has to be performed which includes an explicit risk adjustment. He also indicated that in terms of the standard for insurance companies, AASB 1023, all assets backing the insurance liabilities have to be measured at fair value. He noted that the local standard requires disclosure of the expected cash flows as well as the risk adjustment with
3.
4. 5.
In addition to the above steps which are in line with the ED proposals, the Australian model would allow for correlations and
94
diversification benefits and would adjust the overall risk adjustment for the whole portfolio of contracts. He then explained the application of this methodology with the use of a simplified example of a dice with 6 possible outcomes whereby you would have a claim in five of the six possible outcomes. He calculated the expected value, variance, standard deviation and coefficient of variation of the possible outcome of a 100 dice rolls. Using this example, he indicated at what level the risk adjustment would have to be set to achieve a 50%, 75% and 90% PoA for this example where you have a well known statistical distribution. He indicated that in his example, you would have a claim event in 5/6 of the possible dice rolls. He indicated that for a typical insurance policy the possibility of a claim would be more in line with a 1/6 chance of a claim and indicated that in such an example the variation would be much higher and the risk adjustment required to achieve the same PoA as in his example would be higher. He noted that a risk adjustment becomes particularly important for long tail business with significant outstanding claims liabilities where a change of 1% in the expected liability value could have a significant impact on the current year profit figure. He illustrated the impact that different outstanding claim distributions have on the required risk adjustment in order to achieve the same PoA. The higher the variation in possible outcomes, the higher the required risk adjustment would be. He presented a table of typical risk adjustments as a percentage of the insurance liability for the Australian market. He noted that for regulatory purposes where the PoA is set at 75%, a reasonable level of consistency has been achieved by the
industry (when compared on a liability weighted basis). He noted that the higher variation reflected by the simple average reflects the impact of the risk adjustment required by different sized companies (for small insurers the inherent variation in the portfolio of contracts is higher thereby requiring a higher riskadjustment). He concluded by noting that consistency in the determination of risk adjustments has improved over time due to the extensive disclosure requirements which include the PoA and claims development tables. He noted that more guidance have been developed in recent years and highlighted some of the benefits of applying a risk adjustment, notably the improved transparency of the results for insurance businesses have improved. Analysts are very interested in understanding the profit impact when insurers changed their PoA (quality of earnings) and indicated that the ED proposed this disclosure. A FASB member questioned whether investors/capital providers looked to Australian insurance groups more favorably compared to non-Australian insurers due to the transparency in the measurement of the insurance liabilities. Tony indicated that he believed they did due to the investors having a better understanding of the results of theseinsurers. A FASB member questioned whether the use of log normal distributions would be a gross simplification in the case of, for example, asbestos business. Tony noted that there is a spectrum of practice that has developed. Smaller companies tend to make use of log normal distributions more often due to the lack of credible own data but they do make use of consulting actuaries who have wider experience on the appropriateness of the distribution used in the calculation. He noted that
the larger insurers would typically use the distribution as derived from their own claims experience. Tony noted that reinsurance impacts on the net risk adjustment that is required for portfolios. In most cases reinsurance policies covers the risk of the tail and it is therefore not that difficult to estimate the risk adjustment for the net retained risk. Reinsurers are, however, exposed to the inherent difficulty in estimating the distribution of the tail exposure assumed through the reinsurance policies and they tend to make use of more complicatedmodels. An IASB member questioned what the impact of the risk adjustment and accompanying disclosures were on the premiums charged by insurers in Australia. Tony noted that the business is cyclical and noted that the premiums are impacted by many other factors too and that it would be hard to pin point its impact on the premiums charged by insurers. A FASB member noted that smaller companies tended to set PoA at higher levels than larger insurers and questioned how the different PoA applied by different management and changes to the PoA was assessed by auditors. Tony noted that the PoA set by the majority of companies were close to 90%, driven by the disclosure requirements and market forces. Another FASB member noted that he supported the enhanced comparability that the use of the PoA would bring to the results of insurers. He noted that the ED however allows the use of three different methods to determine the risk adjustment and questioned whether the results determine using the three different methods would be comparable. Tony indicated that in his view you would be able to compare the results presented on three different bases, especially for non-life business given that
95
sufficient information are disclosed. He reiterated the importance of disclosing thePoA. Mark Swallow and Leopoldo Camara from Swiss Re next presented on risk adjustments from the perspective of the economic value management (EVM) methodology used by Swiss Re to manage its diverse insurance business. They noted that EVM is used for pricing the reinsurance treaties, asset liability management and internal/external performance reporting. The EVM framework uses the cost of capital approach to calculate the required returns in the business. They noted that the cost of capital includes the groups estimate of the frictional cost of the capital held for taking on reinsurance risk and this equates to the risk adjustment as required by the ED. EVM is used for all their business to evaluate the economic value created by the business from an underwriting and investment activityperspective. In the EVM methodology, the expected premiums on a contract are compared to the production costs (determined on an expected cash flow basis) which include the frictional capital costs to write the business. This frictional capital cost reduces over time and is released to the income statement over time as the liability runs off. Under this methodology, gains are recognized on day one and the business performance for all businesses is reported indicating the result of new business written and that of prior years business. The impact of the release of capital costs are also presented separately. They noted that the total capital costs in EVM consist of the risk free return on capital (shareholders base cost of capital), the market risk premium (excess returns shareholders expect on market
risk exposure) and frictional capital costs (compensation for agency costs, cost of potential financial distress and regulatory/illiquidity costs). He noted that the frictional capital cost represented the risk adjustment as required by the ED. They noted that they typically charge a 4% frictional capital cost based on projected EVM capital required for their reinsurance treaties. They noted that the estimation of the allocation of the required frictional capital is the most complex aspect of the model and follows a method similar to that presented earlier under the Australian model. They took the Boards through the results of an actual small portfolio that was measured under this methodology and noted that the required EVM capital and run off pattern of the EVM capital is dependent on the nature of the tail of the business. They also presented the income statement and balance sheet which they use under this methodology. An IASB member noted that the EVM income statement format followed by Swiss Re is driven by the liability measurement model similar to the proposals in the ED. He questioned whether they believed volume information should be presented. The presenters responded that the disclosure of volume information is important. In the discussion that followed it was noted that different companies have different risk appetites and hence tend to hold different levels of capital to support the business. Reinsurers typically will tend to hold more capital but this result in the reduction in the cost of capital which has an offsetting impact on the value attributed to the risk adjustment. It was noted that the EVM results were supplementary to the financial reporting presented under Swiss GAAP.
Contract boundary
The staff recommended that contract renewals should be treated as a new contract (i) when the insurer is no longer required to provide coverage or (ii) when the existing contract does not confer on the policyholder any substantive rights. The second issue deals with the level at which that assessment is made. One staff view is that a contract does not confer on the policyholder any substantive rights when the insurer has the right or the practical ability to reassess the risk of the particular policyholder and, as a result, can set a price that fully reflects that risk. This principle is in line with the proposals in the ED, in which the assessment is made at the individual contract level. However, as an alternative proposal on the level question, some staff recommended the following alternative proposal: for contracts for which the pricing of the premiums does not include risks relating to future periods, no substantive rights are conferred on the policyholder when the insurer has the right or the practical ability to reassess the risk of the portfolio the contract belongs to and, as a result, can set a price that fully reflects the risk of that portfolio. The staff also recommended that all renewal rights should be considered in determining the contract boundary whether arising from contract, law orregulation. The staff noted that the alternative proposal above is the result of concerns raised by health insurers and that the consequence of moving the unit of account for the assessment of the contract boundary to the portfolio level could result in reducing the contract term for many contracts. It was noted that legal requirements sometimes dont allow insurers to price for pre-existing risks/conditions, however this risk is spread and priced
96
for across all policyholders at a portfolio level. Insurers often can exit business at a portfolio level. In the above scenario, the premiums charged for the portfolio represents the same aggregate premium that the insurer would have charged if policyholders were priced individually. The alternative staff view therefore proposes that if the premium charged on a policy does not include compensation for a future risk period (e.g., no deposit/financing element in the premium for future periods) it would trigger the contract boundary if assessed at a portfolio level. An IASB member questioned what the implication would be for other contracts such as term insurance and whether far more contracts would be classified as short duration contracts to which the modified measurement approach would have to be applied. The staff responded that for many term insurance contracts the premium charged in early years contains a financing element for later years and they believe under the alternative staff proposal these would still be considered long duration contracts. A staff member supporting the individual policyholder assessment proposal noted that the CFO Forum had done a lot of work on the contract boundary to come up with proposals which are similar to the contract boundary as proposed in the ED. The CFO Forum has raised concerns that changing the contract boundary principle could have implications which have not yet been identified. An IASB member noted that in some jurisdictions, health insurance contracts
are treated as long duration contracts and suggested that the alternative proposals should be tested with insurers in the major markets to ensure there are no unintended consequences. There was some concern raised with applying the contract boundary principle at a portfolio level in situations referred to as the death spiral. The concern is whether an insurer would always be able to reprice the whole portfolio in order to cover the risk of a particular bad risk in the portfolio and thus to satisfy the requirement that the insurer be able to reprice the portfolio to fully reflect that risk. In certain situations, policyholders within a particular portfolio who are good risks could decide to cancel their contracts as they could get the same cover at a better price elsewhere, leaving only bad risks in a portfolio, and raising the possibility that the insurer would not be able to fully reflect the risk at even the portfolio level. Board members were at first concerned that the risk of the alternative proposal for the contract boundary is that contracts could be treated as short duration even though economically the insurer is exposed to risk for a much longer period in such death spiral portfolios. However, a FASB member observed that at the point at which the insurer can no longer reprice to fully reflect the risk of the portfolio (e.g., the death spiral example or caps), analysis of the contracts would lead to the conclusion that the contracts were no longer short duration contracts, but instead were longer duration contracts
in which future years premiums and claims would be taken into account in the building block approach, such that the liability would not be understated. An IASB member asked whether this reassessment would violate the long standing position that classification of insurance contracts only be made at contract inception. However, it was pointed out that since the contracts were formerly short duration, this new assessment would be done at inception of the new contract period. The staff was asked to develop this concept further. In a vote, both Boards agreed that a contract renewal should be treated as a new contract when the insurer is no longer required to provide coverage or when the existing contract does not confer on the policyholder any substantive rights. The FASB unanimously agreed that this assessment of the contract boundary should be performed at a portfolio level only if the premium does not include risks relating to future periods as described in the alternative staff proposal above. The majority of the IASB members were also in favor of the alternative proposal, but with the caveat that the insurer be able to fully reflect the risk at the portfolio level. Both Boards agreed all renewal rights should be considered in determining the contract boundary whether arising from contract, law or regulation. Several Board members noted that it would be helpful for the staff to provide examples to them of how the death spiral situation and contracts with caps would be analyzed and accounted for.
97
IASB/FASB Board Meeting Insurance Contracts PwC Summary of Meetings March 14-15, 2011
Whats inside: Highlights Presentation models Composite margin Practical expedient for the discount rate Risk adjustment Alternative discount rate method Discount rateparticipating contracts Timing of initial recognition Definition of insurance contract
Highlights
The IASB and FASB held a joint Board meeting on March 1415, 2011 where they reached a tentative decision that a practical expedient discount rate should not be permitted and clarified the application of the discount rate principle to participating contracts. They also reaffirmed the IASB exposure draft (ED) and FASB discussion paper (DP) definition of an insurance contract, namely the IFRS4 definition, plus the requirement for at least one possible loss scenario and that the time value of money should be considered in the analysis. Guidance will be added that for reinsurance contracts, if the underlying individual contracts qualify as insurance, the reinsurance of a portfolio of such contracts will also be deemed to transfer insurance risk. The Boards changed their position from the ED and DP with regard to the timing of initial recognition of a contract, responding to constituent cost/benefit concerns. For practical purposes the Boards agreed to use the date that coverage begins as the starting point for contract recognition, with the earlier recognition of an onerous contract in the pre-coverage period. The Boards also discussed but were not asked to reach conclusions on both the presentation model and alternative amortization approaches for the composite margin. They heard presentations from outside speakers on the calculation and use of the risk adjustment in present practice and an alternative approach to the discount rate, the ALR (asset liability rate).
Presentation models
The purpose of the session was to present to the Boards alternative presentation approaches for the performance statement for insurance contracts. The staff did not ask the Boards for a decision on a definition of revenue or a presentation alternative as they first want to finalize other aspects of the measurement model before asking the Boards to conclude on the presentation format. The staff presented the following examples illustrating the alternative approaches to the pure summarized margin approach proposed in the ED: Summarized margin with volume disclosure on the face Expanded margin
As written (expected cash flows) Dual statement
A FASB member acknowledged the demand by users for volume information in order to have the performance reporting of insurers on a basis which is comparable to other industries. He noted that to be comparable to other industries the performance statement would have to be presented on an earned basis consistent with the revenue recognition project, but he acknowledged that an allocation of premium approach would be a challenging prospect within this liability measurement model. He would prefer a model that presents cash inflow and outflow information (the as written alternative) as this would be consistent with the measurement
98
model, providing interesting volume information without trying to look like another method. He noted that he found volume information presented as memo information in a box on the face of the performance statement confusing as this could not be related to any of the other information presented in the performance statement (underwriting margin). Several FASB members noted that they would potentially favor a separate model for long duration (perhaps a margin approach) and short-duration contracts (an unearned approach) subject to it being supported by users/preparers, to reflect the way that different products are analyzed. It was also noted that the unbundling decision would have a significant impact on the Boards ultimate decision on the most appropriate presentation model and that the deposit element would have to be properlydefined. An IASB member noted the difficulty in deciding between the different methods proposed by the staff. He indicated his preference to clearly present margin information on the face of the performance statement (this was also supported by other IASB members) although he acknowledged the need of users for the presentation of volume information. He noted that he could accept, in addition to the margin information, volume information being presented on the face of the performance statement as long as it was presented on a reasonable basis. He asked the staff to reach out to users and preparers to assess which of the methods proposed by the staff they would find most useful and whether the preparers would be able to prepare the information on a reasonable basis. Another IASB member noted the need to present margin information but noted that she was undecided whether this should be on the face of the
performance statement or presented in the notes since she would prefer a performance statement that is comparable to other industries. A IASB member noted the need to keep the presentation format simple to ensure that general users would also be able to understand the performance information presented, noting his preference for an earned model. An IASB member agreed with this indicating that it would then be consistent with the information presented under the revenue recognition project. He noted the inconsistent presentation of the interest accretion on insurance liabilities and noted a preference to present this with the investment income and not as part of the underwriting result as proposed by some of the staff examples. An IASB member noted that the sources of earnings information presented in the dual statement example was very useful information and noted that the Boards could consider a supplementary statement which contained this and margin information which would be presented with the primary statements as part of companies primary reporting. A number of IASB members favored the approach whereby volume information was presented in a box on the face of the performance statement. It was noted that the information presented was very similar to the expanded margin approach that the Boards considered as part of their deliberations on the ED and noted the difficulty the staff had in trying to develop this method. The staff indicated that allocating premiums on an earned basis could be challenging especially for annuity and stop loss contracts. The staff also noted that a presentation model consistent with the revenue proposals could work for simple insurance contracts but noted the
challenge for contracts which contained more complex features such as guarantees and options. They noted that it would not be ideal to require a second model to be developed to estimate the amount of revenue to be recognized in the performance statement. The staff also observed that the volume information presented in the box was not in line with the cohesiveness principle that is contained in the financial statement presentation project. AFASB member reiterated the importance of providing information that will be used by users and noted that the outreach to users/preparers should specifically addressthis. In summary the IASB was leaning towards an approach that included volume information in addition to the summarized margin information as proposed in the ED.
Composite margin
The purpose of the session was to present to the Boards alternatives on the amortization pattern for the composite margin in the statement of comprehensive income and for the Boards to provide guidance for the staff to further develop the models. The staff identified two alternatives for incorporating the principle for recognition of the composite margin into the recognition criteria. The first approach would be to provide only a principle for recognition, whereas the second approach would be to provide a principle with illustrative examples using recommended or required ratios for recognition. The staff did not ask the Boards to make any decisions. A FASB member requested the staff to apply the proposed examples to real life products to show how the principles would be applied. Another FASB member noted that it would be desirable to have
99
principles but noted that guidance was lacking for the period over which the composite margin should be recognized (e.g., coverage period only or both the coverage and claims period). Guidance should be developed in order to select the most appropriate amortization formula for the different types of insurance contract. A FASB member noted that the formula should amortize the composite margin on the basis of how the insurer is released from risk. He noted that risk is not necessarily correlated to the amount of specific claims and noted that if the formula uses claim values it could result in the deferral of revenue recognition to the latter part of the contract duration. He supported incorporating a principle for the recognition of the composite margin but would not necessarily require the use of specified formulas. He noted that factors that may be considered by actuaries and management in determining the weighting could include the entitys relative experience with the types of contracts, past experience in estimating expected cash flows, inherent difficulties in estimating expected cash flows, the relative homogeneity of the portfolio and within the portfolio, and past experience not being representative of future results. He was hesitant that if formulas were provided, preparers would only use those provided, even if an alternative approach would be more appropriate. An IASB member noted that these proposals for a risk based composite margin amortization would align the measurement proposal closer to the IASBs preferred risk adjustment approach. However, another IASB member later commented that the explicit adjustment would be remeasured each period using current estimates while the composite margin approach would merely amortize the original margin.
100
An IASB member observed that the proposed composite margin amortization formulas focused on the release from risk but noted that there are also other elements included in the composite margin such as reward for investment management services. He noted that the proposals did not make allowance for the other elements included in the composite margin. Sir David Tweedie noted that the proposal brought the two Boards closer with regards to the treatment of the composite margin/risk adjustment. An IASB member observed that the risk adjustment is remeasured at each reporting period whereas the FASB composite margin is not, and the FASB has not yet considered whether the composite margin would beunlocked.
on the scope of the future standard with regards to fixed fee service contracts. He would prefer a risk free rate if a practical expedient was introduced as this would be simpler than applying a top down approach. A minority of the FASB would be willing to explore a practical expedient for smaller entities. An IASB member noted that a practical expedient could be considered for certain types of insurance contracts and noted that it would be useful for non-life insurance contracts. Other IASB members disagreed noting the large variety of insurance contracts issued by insurers and noted that a specific rate such as risk free or high quality corporate bond rate should not be mandated. They noted that local associations in various territories would probably come up with local guidance on the appropriate discount rate to use to comply with the discount rate principles in the standard. Other than one IASB member, all voted in favor of the staff proposal not to provide a practical expedient for the discount rate. The FASB also generally supported the staff proposal but noted that they would consider it for fixed fee service contracts if these contracts were in the scope of the future insurance standard.
Practical expedient for the discount rate

At a previous joint Board meeting the staff was asked to explore the feasibility of providing a practical expedient to determining the discount rate for a particular subset of entities. Following this, the staff recommended in the meeting that the Boards should not provide a practical expedient for determining the discountrate. A FASB member noted his agreement with the staff proposal not to introduce a practical expedient and noted that the whole proposed measurement model is complex. He did not see compelling support to provide a practical expedient for just an element of the measurement model. In his view, a practical expedient would have to be provided for the entire model to be beneficial. He would however consider a practical expedient for insurance contracts issued by non-insurance entities depending on the final decision
Risk adjustment
The Boards heard the first of three expected presentations on the practical considerations in implementing an explicit risk adjustment approach in measuring insurance contracts. The presenter from Munich Re noted that the market consistent valuation of insurance liabilities (using an explicit risk adjustment) is deeply rooted in Munich Res key performance measures. Performance indicators
such as economic risk capital are the basis for all relevant management processes including risk strategy, value based management, product design and pricing, asset liability management and annual planning, and will be used in the future for Solvency II metrics. The presenter noted that Munich Re uses the cost of capital approach to measure risk, both for its life and property/casualty business. He noted that the key to having a risk measure which is useful is to employ consistency in application in terms of the specific time horizon selected to calculate risk and the confidence level chosen. In addition, avoidance of double counting of risk is important, for example, capital market dependent components would already have risk built into the market consistent stochastic scenarios generated to arrive at the expected cash flows in building block one, and thereby would not require an additional risk adjustment calculation, while non-hedgeable risks such as insurance cash flows would require a separate risk adjustment. An IASB Board member asked what the company is actually measuring in the risk margin; is it really risk, or is it profit? The presenter noted that if everything turns out as expected, the risk margin would in effect translate into a profit margin over time, but uncertainty matters at any point in time prior to ultimate settlement. He views the risk adjustment as determining the production cost of capital rather than the pricing cost of capital and noted that only where the premium exceeds the best estimate of cash flows plus the risk adjustment is there the creation of value(profit). A FASB member asked whether the estimation of expected cash flows was independent of the risk margin calculation. The Munich Re presenter noted that
in fact they were very dependent, noting that the same actuarial techniques used to determine the expected cash flows were used to determine the risk capital in the cost of capital approach. The FASB member also asked whether risk calculations could ever be comparable across companies based on the presenters previous remark that consistency in choices of time horizons and confidence levels was critical to year on year comparability within a company. The presenter noted that while transparency would be increased if all companies used the same bases, different calibrations could still be compared if their bases were disclosed, as certain elements of the cost of capital calculation are entirely proportional and thus easily adjustable. Picking up on the topic of comparability, an IASB member asked whether the presenter has seen convergence over time between methods used to estimate market consistent liabilities. The presenter noted that perhaps not to the degree he would like, due in part to dispersion in estimates of the risk free rate, the illiquidity premium, and the extrapolation of the yield curve for long dated contracts (e.g., does this occur beyond 15, 30, or 50years?). Another IASB member asked at what level diversification of risk was considered, and whether the ED portfolio level was appropriate. The presenter responded that the enterprise level in his view is the appropriate level to measure risk, as it is the purpose of the risk margin to measure the production cost of risk for the enterprise.
Deloitte on an alternative approach for determining the discount rate. The approach, referred to as the ALR (asset liability rate) approach, is meant to address concerns that when current discount rates are used in valuing insurance liabilities, and changes in credit spreads change on the assets that back them, this causes volatility in reported results. The approach essentially divides cash flows from insurance contracts into three categories and then assigns a discount rate to each category. Insurance contract cash flows for which the insurer currently holds assets that are expected to generate cash flows that match them in duration are discounted using a locked in discount rate determined at inception date, if the assets are recorded at amortized cost, or a current rate if the assets are at fair value. The rate is the risk free rate plus liquidity premium. For cash flows that are mismatched in duration, the approach assumes reinvestment at the current market forward rate for risk free investments plus a liquidity premium. Thus, economic mismatches would be reflected currently through income. Embedded options and guarantees, such as minimum interest rate guarantees, would be valued considering both the intrinsic and time value of these components, to yield essentially fair value measures through income. The presenters noted that they had field tested the model using participating contracts, but that theoretically, the approach could be used for non-participating contracts as well. Some Board members questioned the practicality of the application to non-participating contracts, noting that it might prove challenging to identify and segregate assets that arent contractually linked to liabilities for purposes of determining duration matched
Alternative discount rate method

The Boards heard a presentation by the French insurer CNP with assistance from
101
cash flows. The presenters noted that this might be even more difficult for property/ casualtycontracts. The presenters pointed out that an advantage of this approach is that for portfolios of participating contracts that are duration matched, changes in credit spreads will not cause unnecessary volatility in the income statement. This is true whether the assets are at fair value or amortized cost, because the discount rate on the insurance contracts would be based on either the current asset-based rate or a locked in asset-based rate, depending on the designation of the matched assets. At the same time, the economic volatility caused by duration mismatches and contract guarantees would be reflected currently. An IASB Board member noted that the model seemed rather complicated, as it required tracking of various categories of cash flows, and the setting of a new rate each time assets were sold and reinvested.
present in the liability, such as any investment risk taken by the insurer that cannot be passed to the policyholder. The intent of the Boards in writing the ED/ DP was that this same principle be used for participating contracts (including unitlinked or variable contracts, with-profits contracts in the UK, and universal life contracts). However, some constituents were confused by paragraph 32 of the ED, which to them suggested an entirely different approach for determining the discount rate for such contracts. Paragraph 32 noted that if the amount, timing or uncertainty of the cash flows arising from an insurance contract depends wholly or partly on the performance of specific assets, the measurement of the insurance contract should reflect that dependence. It noted that in some instances a replicating portfolio technique would be appropriate. The staff released a paper in November 2010 to clarify the Boards intent on thisissue. At the meeting, the staff again clarified that paragraph 32 was meant to build on the discount rate principle that the rate should reflect the characteristics of the liability, noting that in the case of participating contracts, to the extent there is linkage with the assets supporting the contracts, it should be reflected in the rate. Therefore, they proposed that wording be added to the standard to clarify that the objective of the discount rate used to measure participating and non-participating contracts should be consistent, and to provide guidance on how the insurer should adjust the cash flows in a participating contract using a discount rate that reflects any dependence that exists with the performance of specific assets. For example, where there is asymmetric risk sharing (such as a unit-linked contract that provides for 90% participation in the upside of asset returns but a minimum
guaranteed return), that risk retained by the insurer would need to be reflected in the measurement. The Boards supported the staff proposal, noting in addition that it should be made clear that a replicating portfolio could be used, but was not a requirement. Some questioned how a replicating portfolio would be appropriate in a contract that provided a pass through of the return of a specified pool of assets, but with a minimum guarantee. An IASB member noted, and a staff member agreed, that a replicating portfolio could be used, along with a put option, to measure such acontract. A FASB member asked what rate would be appropriate for a fully discretionary participating feature (for example sharing in the net income of a company) with little or no history. The staff noted that this would reduce the risk of having to provide a specified return, and, as a result, could result in projecting cash flows and discounting back at the same rate. However, she noted that many such contracts have minimum guarantees that also would need to be taken into account. The staff noted that they expected this issue would be discussed at the upcoming Insurance Working Group meeting and that feedback would be provided on this issue.
Discount rate participating contracts

The staff noted that at a previous meeting, the Boards had reconfirmed the principle with regard to the discount rate used to discount expected cash flows, namely that the rate should reflect the characteristics of the insurance liability, and should be a current rate, updated at each reporting period. The Boards had also decided not to prescribe a specific method for calculating the rate, meaning that the rate could be a bottom up approach as originally proposed in the ED and DP (risk free plus illiquidity premium), or a top down approach that started with an asset rate, as long as that rate was adjusted to take out risks present in the market rate for the asset but not
Timing of initial recognition

Certain staff proposed that the Boards reaffirm the ED and DP principle that an insurance contract should be recognized as an asset or liability from the date at which it becomes a party to the contract (which could sometimes be before the contract
102
coverage period begins). However, the staff noted that emphasis would be added that insurers need not change their accounting systems to implement this requirement if any gains or losses that arise before the start of the coverage period are not material to the financial statements. The staff believes the principle for recognition is consistent with the entire insurance model, which focuses on measuring obligations accepted by the insurer, rather than the revenue recognition model, which focuses on measuring performance. The staff also noted that changing initial recognition to the coverage date could have unintended consequences, including calling into question the proposals requirement to include future expected renewal premiums for which the insurer does not have the right to change the price in the building block measurement. While other staff recognize and accept the principle behind the main staff proposal, they believe that the high cost to implement system changes necessary to evaluate the impact to determine if it is immaterial outweigh the benefits. These staff recommend an alternative approach under which for practical purposes the insurer should recognize an insurance asset or liability at the start of the coverage period, but with earlier recognition of an onerous contract in the pre-coverage period if management becomes aware of an event occurring prior to the balance sheet date that would cause a portfolio of contracts in the pre-coverage period to have a material adverse impact on the financial statements. Examples noted by the staff where recognition prior to the coverage period would be difficult to apply include health insurance contracts that provide open enrollment periods for months prior to contract coverage, and reinsurance contracts that insure contracts to be written by the cedant over the upcoming annual period.
Both the Boards favored the alternative staff proposal to recognize an insurance contract at the start of the coverage period, some for practical reasons, and others for consistency with other projects such as revenue recognition and leasing. 10 of 15 IASB Board members supported this revised provision, as did all 7 FASB members.
additional criteria would force companies to redo their insurance contract analyses for all of their insurance contracts with little benefit. The requirement to consider the time value of money was less contentious, with many believing that this was either implied in IFRS4 or at least followed in practice. Other staff expressed their view that the two additional criteria were reasonable and necessary criteria to ensure that only insurance contracts would receive insurance accounting, and that contracts that were merely financings would be accounted for as financial instruments. They rejected the staff recommendation to eliminate these criteria and their suggestion that the potential structuring of financings as insurance could be avoided if unbundling of deposit elements wererequired. An IASB Board member reminded the group that one issue raised by constituents was that the revised definition might be problematic for certain reinsurance contracts that cover an entire pool of risks, where individual contracts in the pool would typically have significant insurance risk, but as a reinsured pool of contracts the chance of loss might be extremely remote. Both Boards agreed with a suggestion that the requirements be supplemented with guidance stating that risk transfer is deemed significant if the reinsurance contract transfers substantially all of the risk in the underlying contracts (consistent with an existing US GAAPprovision). The chair then called for a vote, whereby all 7 FASB members and 12 of 15 IASB members supported the alternative staff proposal to retain the two amendments to IFRS4 (with the supplemental guidance noted above for pools of reinsuredcontracts).
103
Definition of insurancecontract
The staff presented a recommendation to the Boards that they withdraw the ED/ DP proposal to add two additional criteria to the IFRS4 guidance on the definition of an insurance contract. In addition to carrying forward existing IFRS4 guidance on the definition of an insurance contract, the ED/DP proposal would (a) require that the insurer consider the time value of money in assessing risk transfer and whether additional benefits payable in any scenario are significant and (b) note that a contract does not transfer significant insurance risk if there is no scenario that has commercial substance in which the insurer can suffer a loss (i.e., no scenario where the present value of net cash outflows exceed present value of premiums). The latter requirement was added based on input from the FASB, as a means of reflecting what the FASB believes is the very essence of an insurance contract, the chance of loss, and which is a current US GAAP requirement for reinsurance contracts. The staff noted that while less than 30% of IASB respondents commented on this topic, most disagreed with revisions to the IFRS4 definition, noting that the current definition is well understood and has not generated any issues in practice. Some respondents believed that the second
104
US GAAP Convergence & IFRS Consolidation

March 2011
Coming into focus FASB proposes consolidation changes
Whats inside: Overview Upcoming changes to the consolidation model for asset managers Agent vs. principal a factors-based approach Expected changes are not limited to VIEs Reaction to the proposed changes Whats next?
Overview
The FASB has proposed changes to the guidance for evaluating whether a decision maker or service provider must consolidate a variable interest entity (VIE). These changes will have a considerable impact on asset managers. Several of the proposed changes incorporate feedback from asset managers on ways to better reflect the relationship they have with their investment products. However, it is likely that the new proposed changes will still generate a significant amount of discussion between the FASB and those in the asset management industry. The proposed changes are designed to replace the existing guidance on principal and agency relationships and to end the deferral of FAS 167, Amendments to FASB Interpretation No. 46(R)1, for certain investment entities. The FASB is also expected to propose amendments to the existing guidance for evaluating whether kick-out rights held by limited partners of voting interest entities (VOEs) are substantive. This is to align the control guidance for VOEs with the guidance for VIEs. As many asset managers granted simple majority kick-out rights to their investment funds to avoid consolidation, this change could result in these investment funds being consolidated. While changes to the principal and agency analysis would be consistent with the IASB model, the FASB has elected not to pursue a converged consolidation model. The FASBs exposure draft is expected to be issued before the end of the first quarter of 2011.
Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates. Refer also to the summary publication for a discussion of the consolidation for investment companies project.
Codified in ASC 810
Consolidation
Upcoming changes to the consolidation model for asset managers

Consolidation analyses for asset managers have been challenging as a result of standards being implemented or debated during recent years. Following the Enron revelations regarding off-balance sheet vehicles, the FASB introduced separate consolidation models for (1) economic risk and rewards and (2) voting rights, which led to wholesale changes in fund and partnership structures. More recently, as a result of lessons learned from the financial crisis, the FASB moved away from the economic risk and rewards model to more of a decision-making analysis for VIEs. However, once adopted, this new approach would have caused asset managers to consolidate many of the funds that they managedan unintended implication that caught many off-guard. Despite getting off to a late start, the asset management industry was able to convince the FASB of the need for a temporary deferral from applying this new VIE guidance to most investment funds. These experiences have spurred asset managers to become increasingly engaged in the standard-setting process. Recently, they were active participants in the November 2010 consolidation roundtable discussions held by the FASB. Their objective is simple: to encourage the accounting standard setters to arrive at a model that they feel best depicts the relationships between themselves and their products and investors. The focus of the most recent discussions has been what steps the FASB should take to address the temporary deferral of FAS
167. In January 2011, the FASB decided to propose targeted changes to the VIE consolidation model by introducing guidance on the factors to be considered in determining whether an asset manager is considered a principal or merely an agent performing its role on behalf of the investors. If the analysis indicates that the asset manager is acting in a principal role for a particular entity, then they will likely be required to consolidate that entity. In addition, the expected changes will likely seek to align the VOE consolidation guidance with the VIE guidance for evaluating whether removal (kick-out) and participating rights are substantive. These proposed targeted changes will be consistent with similar changes that will be finalized by the IASB this quarter.
to determine whether an entity is acting as a principal or an agent. For example, many believe that economic interests held by the asset manager may become the most important factor, but how to weigh that factor against factors such as whether an entity has an independent board or a highly-regulated product, such as a registered investment company, will likely generate much debate. This is especially relevant since the FASB is unlikely to provide any bright lines regarding how to apply the factors.
Decision-making authority
Assessing the scope of the asset managers decision-making authority is central to the analysis under the proposal. In particular, the FASB has indicated that for an entity that requires no significant ongoing decision-making or for whom decisionmaking is restricted by laws or regulations, the analysis should consider the design of the entity and who benefits from this design when determining which party may have power. The addition of this as a factor in the analysis is reflective of the asset managers feedback from comment letters and at the roundtables. Asset managers with highly regulated products, such as 1940 Act mutual funds, were keen to point out their decision-making rights were highly restricted due to the requirements of the regulations. While perhaps not as compelling, asset managers that advise private vehicles noted that investment guidelines are set up based on potential market demands or perceived needs of investors. Many noted that these investment guidelines and regulatory requirements suggest their role is more as an agent than a principal.
Agent vs. principala factors-based approach

The FASB has outlined four primary qualitative factors that would need to be considered in the analysis to determine whether the asset manager is acting as a principal or agent: (1) the scope of the asset managers decision-making authority, (2) the rights held by others, (3) the asset managers compensation, and (4) other interests held by the asset manager. These factors would replace the existing guidance in FAS 167. Many asset managers are supportive of the move to a more factors-based approach based on feedback from the recent roundtables. Some of the new factors appear to address several of the issues raised by industry participants, but still leave some questions unanswered. It will be important to understand the weight of each factor and its relationship with the other factors
Rights held by others

The conclusion that only single party kick-out rights are relevant to the consolidation analysis under FAS 167 received a significant amount of pushback from asset managers and continued to be an area of debate under the VIE model. In a significant change from the current VIE guidance; the expected proposal would require substantive kick-out rights held by more than one party to be considered in the analysis. However, the larger the group of investors required to exercise the kick-out rights, the less weight such rights will have in the analysis. While a positive move in the view of asset managers, we can anticipate further debate on the number of parties that can hold kick-out rights before such rights no longer would be considered a relevant factor. Likely much of the debate will focus on the examples expected in the proposal and at what level do substantive kick-out rights become too widely dispersed. Many in the industry will still promote the view that a simple majority represents the determinative factor as to who controls the entity regardless of the number of investors. Substantive kick-out rights held by only one party would continue to be determinative and result in consolidation by the holder of that right. In addition, the FASB reaffirmed its view that liquidation rights, but not redemption rights, would be viewed in a manner similar to kick-out rights. Again, many in the asset management industry have stated that redemption rights are also a key factor to consider in the analysis, as fees are derived from assets held in the fund. In their view, the ability to remove assets from the fund compels the asset manager to act in the best interests of the investors reinforcing the notion that this is an agency relationship.
Kick-out rights held by board of directors will also be a factor in the analysis. Removal rights held by a substantive independent board will likely be given greater weight in reaching a conclusion that consolidation is not required. The asset management industry views independent boards, and the ability of shareholders to elect their members, to be a key determination in the consolidation analysis. Consequently, industry participants will likely advocate for even more weight to be placed on the rights of shareholders and boards in the analysis.
would, alone or in combination with other factors, be sufficient to conclude that the asset manager is a principal. For economic interests in investment products, the analysis will only have to consider downside risk when fees and compensation are market-based. However, this makes larger investments by asset managers in their funds likely to tilt the analysis towards a principal conclusion. The FASB view is that the more exposure to downside risk, the more likely the asset manager will make decisions in its own interest. Asset managers will likely dispute this view, stating that economic interests in the fund better align their interests with that of investors and can even be required by those same investors. We can expect vigorous debate on this point. It is likely that many will desire additional guidance on what the tipping point will be in the analysis of economic interests. One impact of the new approach is that a fact pattern where the asset manager has a subordinated and/or performance fee and little to no investment in the fund may not lead to consolidation. As a result some collateralized debt obligation and collateralized loan obligation managers could potentially see some of their products deconsolidated under this proposed model. One area the FASB has not specifically discussed is the treatment of guarantees or other support provided by the asset manager, particularly for their money market funds. While many of these guarantees have expired as money market funds have stabilized, there remains the issue of whether asset managers will have to assess any implied guarantees for these types of products under the new proposal. It is presently unclear how much weight to place on these arrangements in the consolidation analysis.
Compensation and other interests

The FASB has indicated that an asset managers compensation together with its other economic interests in the VIE will be the most significant factors in the assessment under the new proposal. This is consistent with feedback from asset managers and one of the areas that received the most discussion at the roundtables. While not determinative, whether the compensation arrangement is above or below a typical market fee arrangement, coupled with the significance of the asset managers other interests in the entity would weigh heavily in the analysis. Assessment of manager fees has often been difficult in the current analysis. Many in the industry note that market-based fees align the interests of the asset managers with investors in the fund. Some view that non-receipt of fees, or said differently, expected reduction in fees from decreases in assets under management, should be included in the analysis; however, the FASB has stated that this will likely not be part of the analysis in the new proposal. What is uncertain at this time is whether the presence of a non-market based arrangement
Consolidation
Expected changes are not limited to VIEs

In order to improve consistency in the assessment of kick-out rights under all consolidation guidance, the proposal is expected to align the VOE approach with the approach under the VIE consolidation model. The presumption under the existing VOE consolidation model that a general partner controls a limited partnership can currently be overcome if a simple majority of limited partners can remove the general partner (i.e., kick-out rights) by means of a substantive vote. However, under the new proposal, simple majority kick-out rights may no longer be indicative of control by the holder of those rights. When the kick-out rights guidance was originally developed, many fund managers granted these rights to their limited partners to overcome the presumption that they have control, and avoid consolidation of the funds they manage. The proposed change to the kick-out rights guidance could cause many of the limited partnerships that currently fall within the VOE consolidation model to be evaluated as VIEs. This, in turn, would trigger a requirement to assess whether the manager is acting as a principal or as an agent, and could, in some situations, result in the fund manager having to consolidate.
Reaction to the proposed changes

Feedback from previous consolidation standard setting and the recent FASB roundtables suggest that the proposals are likely to have a significant impact on asset managers and financial institutions that issue structured products. While generally there is asset management industry support for a factors-based analysis for determining whether a manager is acting as a principal or an agent, some constituents believe that specific guidance will be needed to prevent inconsistent application of the standard. Many in the industry believe that there are other important factors that should form part of the analysis, including the existence and powers of boards, an assessment of whether performance-based fees are market-based, and an emphasis on downside risk exposure. Further, many are concerned with the proposal to align kick-out right under the VOE and VIE models because of the effect on many limited partnership structures that are prevalent today. Many of these structures are VOEs that are not consolidated by the asset manager (general partner) due to the existence of investor rights to remove the manager or liquidate the partnership by a simple majority vote. The move to a more qualitative assessment of the voting rights may lead to more entities being considered VIEs and subject to the more onerous consolidation analysis.
Whats next?
In early March the FASB will meet for a final time to discuss the changes before exposing the proposal for public comment by the end of March 2011. A final standard is expected before the end of the year. Separately, the FASB is also expected to issue an exposure draft on the definition of an investment company by the end of second quarter 2011. While the FASB has not yet indicated the planned effective date for either standard, it is likely that they will require the two standards to be adopted concurrently, because the current deferral of FAS 167 is dependent on the definition of an investment company.
US GAAP Convergence & IFRS Consolidation: Updated May 15, 2011

May 2011
IASB issues package of standards covering consolidation and joint venture accounting
Whats new?
This week the International Accounting Standards Board (IASB) issued a package of five standards consisting of (1) IFRS 10, Consolidated Financial Statements, (2) IFRS 11, Joint Arrangements, (3) IFRS 12, Disclosure of Involvement with Other Entities, (4) IAS 27, Separate Financial Statements, and (5) consequential amendments to IAS 28, Investments in Associates. IFRS 10 replaces all of the consolidation guidance in IAS 27, Consolidated and Separate Financial Statements, and SIC-12, ConsolidationSpecial Purpose Entities. However, the portion of IAS 27 that deals with separate financial statements will remain. IFRS 11 replaces IAS 31, Interests in Joint Ventures, and SIC-13, Jointly Controlled EntitiesNon Monetary Contributions by Venturers. IFRS 12 replaces the disclosure requirements currently found in IAS 28, Investments in Associates.

Consolidation
IFRS 10 changes the definition of control, such that the same consolidation criteria will apply to all entities. The revised definition focuses on the need to have both power and variable returns for control to be present. Power is the current ability to direct the activities that significantly influence returns. Variable returns can be positive, negative or both. The determination of power is based on current facts and circumstances (including substantive potential voting rights) and is continuously assessed. An investor with more than half the voting rights would meet the power criteria in the absence of restrictions or other circumstances. However, an investor could have power over the investee even when it holds less than the majority of the voting rights in certain cases. IFRS 10 provides guidance on participating and protective rights, and brings the notion
of de facto control firmly within the guidance. The standard also requires an investor with decision-making rights to determine if it is acting as a principal or an agent and provides factors to consider. If an investor acts as an agent, it would not have the requisite power and, hence, would not consolidate.
Joint ventures
IFRS 11 defines a joint arrangement as an arrangement where two or more parties contractually agree to share control. Joint control exists only when the decisions about activities that significantly affect the returns of an arrangement require the unanimous consent of the parties sharing control. All parties to a joint arrangement must recognize their rights and obligations arising from the arrangement. The focus is no longer on the legal structure of joint arrangements, but rather on how the rights and obligations are shared by the parties to the joint arrangement.
Consolidation: Updated May 15, 2011
IFRS 11 eliminates the existing policy choice of proportionate consolidation for jointly controlled entities. In addition, the standard categorizes joint arrangements as one of the following: Joint operations: Parties to the arrangement have direct rights to the assets and obligations for the liabilities. A joint operator will recognize its interest based on its involvement in the joint operation (i.e., based on its direct rights and obligations) rather than on the participation interest it has in the joint arrangement. A joint operator in a joint operation will therefore recognize in its own financial statements its: Assets, including its share of any assets held jointly Liabilities, including its share of any liabilities incurred jointly Revenue from the sale or use of its share of the output and its share of revenues earned jointly Expenses, including its share of any expenses incurred jointly
Disclosures
IFRS 12 sets out the required disclosures for entities reporting under IFRS 10 and IFRS 11. The objective of IFRS 12 is to require entities to disclose information that helps financial statement readers to evaluate the nature, risks, and financial effects associated with the entitys involvement with subsidiaries, associates, joint arrangements, and unconsolidated structured entities. Specific disclosures include the significant judgments and assumptions made in determining control as well as detailed information regarding the entitys involvement with these investees.
Whos affected?
IFRS 10 has the potential to affect all IFRS reporting entities that control one or more investees under the revised definition of control. It is not expected to result in widespread change in the consolidation decisions made by IFRS reporting entities, although some entities could see significant changes. Entities with existing joint arrangements or that plan to enter into new joint arrangements will be affected by IFRS 11. For example, entities that have been accounting for their interest in a joint venture using the proportionate consolidation method will need to account for their interest in the joint venture using the equity method.
The FASB is expected to issue a proposal in May 2011 to amend its consolidation guidance by incorporating the agent versus principal analysis contained in IFRS 10. However, other existing differences between the models such as de facto control and potential rights will not be converged at this stage.

The new standards are effective for annual periods beginning on or after January 1, 2013. Earlier application is permitted if the entire package of standards is adopted at the same time.
Joint ventures: Parties to the arrangement have rights to the net assets or outcome of the arrangement. A joint venturer does not have rights to individual assets or obligations for individual liabilities of the joint venture. Instead, joint venturers share in the net assets and, in turn, the outcome (profit or loss) of the activity undertaken by the joint venture. Equity accounting is required for joint venturers.
Whats next?
IFRS preparers should consider whether IFRS 10 will affect their control assessments and consolidation requirements. Those that are party to joint arrangements should also evaluate how the requirements of IFRS 11 will affect the way they account for their existing or new joint arrangements. The accounting changes may have a significant impact on an entitys financial results and financial position, which should be clearly communicated to stakeholders. Preparers should also consider whether IFRS 12 necessitates additional processes in order to compile the required disclosures.
US GAAP Convergence & IFRS Financial statement presentation

March 2011
A look at the FASB and IASBs Staff Draft
Whats inside: Overview Key provisions Comment letters, field tests, and research study Differences between FASB and IASB staff drafts Next steps Business implications Appendix: Examples of revised financial statement format
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).
Reprinted from: Dataline 201035 August 26, 2010 (Revised February 3, 2011*) Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
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.
* 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.
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 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.
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), Investorsthe boards have asked users (from various countries) to evaluate how the proposed changes would benefit their analysis and resource allocation decisions, and Field testthe 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.
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 entitys activities. The boards believe that the revised format will allow users of the financial statements to better understand an entitys performance by separating its financial position, changes in financial position, and cash flows between core
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
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: Generalto ensure that participants have a clear understanding
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 Disaggregation Investing category Financing section Debt category Equity category Income tax section Income tax section Income tax section Business section Operating category Operating finance subcategory Investing category Financing section Debt category Financing section Business section Operating category Investing category Statement of Cash Flows
Discontinued operations section
Other comprehensive income 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). 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, shortterm 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 entitys 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 entitys activities.
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 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

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
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.
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 entitys 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. 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
PwC observation: Most respondents to the boards Discussion Paper indicated that a financial statement users 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.
The staff draft proposes a revision to the cash flow netting guidance in both IFRS and USGAAP 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., sharebased 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
5
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
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.
Accounting allocations (e.g., depreciation) Accounting provisions and reserves (e.g., bad debts, obsolete inventory) Remeasurementswhich 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.
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
Roll-forward analysis
9. All entities (except nonpublic entities)
will be required to provide a rollforward presentation of changes in assets and liabilities that management regards as important for understanding the current period change in the entitys 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: 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)
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.
The total of the reportable segments operating profit or loss, operating asset, operating liabilities, and operating cash flows must be reconciled to the entitys 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 US GAAP. The IASB is requiring disaggregated information at the entity level (not by reportable segment).
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.)
decisions differ in the following significant ways: Minimum line item requirementsthe 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 reconciliationusers of financial statements usually refer to an analysis of changes in specific line items (all the line items in the debt category, cash, any short-term 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. Segmentsthe 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 disclosuresthe FASB and IASB differ slightly on what disclosures they will require in the notes related to various items.
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.
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
13. The majority of the respondents

supported the projects 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),
Differences between FASB and IASB staff drafts

15. While the Financial Statement
Presentation project is a joint project, the FASB and IASB tentative
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.
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 date for the final standard would provide sufficient time for reporting entities to prepare for and implement the proposed changes.
Disaggregationthe 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 proposalthe proposed changes could result in incremental costs to preparers.
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 Changesentities 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 Controlsentities may have to update processes and controls over financial reporting to address the changes required to comply with new financial statement presentation guidance.
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
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 Dec. 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 sharebasic Net income per sharediluted
3,487,600 (1,956,629) 1,530,971 (153,268) (469,754) 17,663 952,612 (33,235) 892,377 62,619 23,760 18,250 7,500 112,129 1,004,506
3,239,250 (1,816,903) 1,422,347 (130,034) (433,950) (2,025) (35,033) 821,305 (33,250) 788,055 55,500 22,000 7,500 3,250 88,250 876,305
(111,352) (111,352) 893,154 (333,625) 599,529 (32,400) 11,340 (21,060) 538,469 29,056 (11,863) 17,193 3,784 (1,959) 1,825 (1,404) 2,094 19,708 558,177 7.07 6.85
(110,250) (110,250) 766,055 (295,266) 470,789 (35,000) 12,250 (22,750) 448,039 20,150 (4,875) 15,275 3,503 (1,813) 1,690 (1,300) (1,492) 14,173 462,212 6.14 5.90
Reproduced from FASB staff draft issued July 1, 2010.
10
Example 2: Statement of Financial Position (Manufacturing Entity)2

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
11
Example 2 (continued)
20X1 20X0
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)
12
Example 3: Direct Method Statement of Cash Flows (Manufacturing Entity)3

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) 21,533
(80,000) (82,688) 78,000 150,000 250,000 315,312 (283,650) (193,786) (477,436)
(12,582) 3,210 12,161 61,941 74,102
(11,650) 1,027 (488,059) 550,000 61,941
Reproduced from FASB staff draft issued July 1, 2010
13
Example 3 (continued): Supplemental Cash Flow Information (Manufacturing Entity)4

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) 37,650 (54,000) (33,500) 407,709
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) (50,000) 344,538
330,000
14
Example 4: Statement of Comprehensive Income (Financial Services Entity)5

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
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
15
20X1 20X0
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
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
16
Example 5: Statement of Financial Position (Financial Services Entity) 6

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
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
17
20X1 20X0
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
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)
18
Example 6: Statement of Cash Flows (Financial Services Entity)7

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 paidinterest 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
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)
19
20X1 20X0
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
(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

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 55,080 8,000 86,400 (103,680) (25,000) 340 232,720
11,922 17,000 9,394 (4,260) 9,000 1,850 (87,090) (406) 162,493 16,300 5,000 (130,000) 51,000 10,000 80,000 (96,000) (25,000) 315 112,193
20
Example 7: Disaggregation of Expenses by Nature9

20X1 20X0
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
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) 22,650 (4,987) 17,663 925,612 (30,800) 13,200 (14,825) (810) (33,235) 892,377
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) (2,025) (35,033) (37,058) 821305 (2,800) 12,000 (16,500) (750) (33,250) 788,055
21
Example 8: Disaggregation of a Multisegment Entity10

For the Year Ended December 31, 20X1 Retail BUSINESS Operating Revenue Cost of goods sold Materials(a) 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 Total operating income(a) 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 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) (1,167,000) (130,000) (62,000) (67,500) (23,000) (1,449,500) (86,500) (75,000) (36,500) (198,000) (143,200) (53,000) (36,000) (232,000) (114,000) (39,900) (153,900) 511,800 (3,000) 50,000 (181,000) (50,000) (25,000) (14,000) (8,230) (278,230) (6,900) (6,900) (10,000) (5,900) (15,900) 348,970 142,202 (60,000) (30,000) (35,000) (30,000) (155,000) 650 (2,500) (3,000) (18,200) (23,050) (178,050) (135,000) (93,450) (1,348,000) (180,000) (87,000) (81,500) (31,230) (1,727,730) (86,500) (81,900) (36,500) (204,900) (143,200) (53,000) (36,000) (232,200) (184,000) (30,000) (35,000) (75,800) (324,800) 650 (2,500) (3,000) (18,200) (23,050) 682,720 4,202 50,000 (93,450) Fabrication Corporate Total
2,545,400
650,000
3,195,400
(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 Reproduced from FASB staff draft issued July 1, 2010

Example 9: Analysis of Changes in Select Significant Line Items (Roll-forward Analysis)11

Long-term debt Beginning balance, January 1, 20X0 (1,950,000) Short-term debt (250,000) Interest payable (85,001)
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
(250,000) 150,000 (2,050,000) (2,050,000)
(150,000)(a) (400,000) (162,000)(a) (562,000)
82,688 (110,250) (112,563) 83,514 (111,352) (140,401)
(a) Increases in short-term debt consist of amounts drawn on a short-term credit facility.
Accounts receivable, net Beginning balance, January 1, 20X0 Cash collections (a) Revenue accrual Remeasurement-loss on sale of receivables Amounts allocated for bad debts Remeasurement-change in estimate for bad debts (b) Amounts reclassified to discontinued operations Remeasurement-foreign exchange adjustment Ending balance, December 31,20X0 Cash collections (a) Revenue accrual Remeasurement-loss on sale of receivables Amounts allocated for bad debts Remeasurement-foreign exchange adjustment Ending balance, December 31, 20X1 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.
23
US GAAP Convergence & IFRS Contingencies

March 2011
Disclosure of certain loss contingencies

An analysis of the FASBs proposed changes
Whats inside: Overview Key provisions SEC staff views IASB loss contingencies project
In July 2010, the Financial Accounting Standards Board (FASB or the Board) issued an exposure draft of a proposed Accounting Standards Update, ContingenciesDisclosure 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 staffs 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.
Reprinted from: Dataline 201032 August 3, 2010 (Revised February 1, 2011*) Note: As developments in this area are ongoing, reference should also be made to this publications webpage (www.pwc.com/ us/jointprojects) where you will find an electronic version of the original publication along with subsequent updates.
*Sections entitled At a glance (third and fourth bullets), Background (paragraphs 4 and 5),Transition and effective date (paragraphs 1719), and IASB loss contingencies project (paragraph 26) have been revised and a new section entitled SEC staff views (paragraphs 2025) has been added to reflect the delayed timing of this project and incorporate relevant views expressed by the SEC staff.
Contingencies
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.
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 staffs 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.
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.
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: Guarantees (other than product warranties) Liabilities of insurance entities covered by specialized industry guidance Certain liabilities for employmentrelated costs, including stock issued to employees, pensions and other postemployment benefits Income tax uncertainties
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 companys case in legal proceedings. The comment period for the proposal ended in
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 200944 and 201022. 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
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-income-based tax uncertainties, and product warranties.
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 US may not have the same risk profile as a lawsuit involving similar claims in a non-US 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 principles
7. The Board decided on two overall
disclosure principles, summarized below: During early stages of a contingencys 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
to alert users about a companys vulnerability to a potential severe impact due to the contingencys 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.
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
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
Contingencies
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.
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 companys 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. 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, managements 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.
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 companys 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
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.
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 companys legal defense.
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.
Contingencies
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 managements 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.
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.
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.
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.
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.

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
SEC staff views

20. The SEC staff over the course of 2010
emphasized in comment letters, speeches, and a Dear CFO letter
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.
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 staffs 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 FASBs proposal.
IASB loss contingencies project

26. While the scope of the Boards
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 Boards project and the IASBs 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 US standards may have an interest in the IASBs proposal even though it is not part of a joint project with the FASB. With the trend towards having converged US and international standards, the decisions made by the IASB could influence any future project to reassess the accounting for loss contingencies under US standards.
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 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.
Contingencies
This publication is printed on Mohawk Options PC. It is a Forest Stewardship Council (FSC) certified stock using 100% post consumer waste (PCW) fiber and manufactured with renewable, non-polluting, wind-generated electricity.

US GAAP Convergence and IFRS (1) .PDF - Adobe Reader

Загружено:

Сведения о документе

Исходное описание:

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

US GAAP Convergence and IFRS (1) .PDF - Adobe Reader

Загружено:

Авторское право:

Доступные форматы

US GAAP Convergence & IFRS What you need to know about the FASB and IASBs joint projects

The heart of the matter

US financial reporting is poised to undergo an unprecedented level of change

What this means for your business

The heart of the matter

US financial reporting is poised to undergo an unprecedented level of change

The heart of the matter

* Reprinted from the March 4, 2011, edition of Setting the standard

Priority joint projects

Timeline for completion

US GAAP Convergence & IFRS

Joint projects timeline

Exposure draft issued or expected Final standard expected

US GAAP Convergence & IFRS

US GAAP Convergence & IFRS

Balance sheet offsetting

US GAAP Convergence & IFRS

US GAAP Convergence & IFRS

US GAAP Convergence & IFRS

Fair value measurement

US GAAP Convergence & IFRS

Financial statement presentation

US GAAP Convergence & IFRS

Exposure draft expected March 2011

Exposure draft expected second quarter 2011

Investment properties (see separate section)

Exposure draft expected second quarter 2011

Kick-out rights guidance for limited partnerships may be changing.

US GAAP Convergence & IFRS

US GAAP Convergence & IFRS

Pensions and postemployment benefits

Recognition of pension expense components under the IASB model

For more information:

Other comprehensive income

Other projects on the horizon

Next steps and timing

Financial instruments with characteristics of equity Emissions trading schemes

Exposure draft Q4 2011

US GAAP Convergence & IFRS

US GAAP Convergence & IFRS

What this means for your business

What this means for your business

November 11, 2011

The heart of the matter

US financial reporting is poised to undergo an unprecedented level of change

What this means for your business

The heart of the matter

US financial reporting is poised to undergo an unprecedented level of change

The heart of the matter

Project Classification and measurement

Board FASB IASB

Balance sheet offsetting Revenue recognition Leases

Joint projects status

Investment companies Investment property entities Lower priority projects1

US GAAP Convergence & IFRS

Component Principle for classification

Equity investments (not under equity method of accounting)

Equity method of accounting

US GAAP Convergence & IFRS

The boards latest impairment approach

Reserve expected losses for the forseeable future

Reserve full lifetime expected losses (portfolio level)