Financial Accounting Standards Board Update

1
Financial Accounting Standards Board Update

• American Accounting Association
• Financial Accounting and Reporting Section
• 2007 Midyear Meeting
• January 19, 2007
• Thomas J. Linsmeier
• Financial Accounting Standards Board

The views expressed in this presentation are my
own and do not represent positions of the
Financial Accounting Standards Board. Positions
of the FASB Board are arrived at only after
extensive due process and deliberations.
2
Presentation Overview

• Major Impact Projects
• Financial Statement Presentation
• Conceptual Framework
• Fair Value Measurements
• Use of Formal Research at FASB
• New Initiatives
• Questions and Answers Relating to Remaining
  Agenda Items

3
Financial Statement Presentation Background
Scope

• Joint project with the IASB (since 2004)
• Formerly known as Performance Reporting Project
• Purpose establish a common, high-quality
  standard for presentation of information in the
  financial statements
• Scope
• All business entities (public and private)
• All financial statements
• Form, content, classification and display
• Aggregation into totals and subtotals
• Address non-financial institutions first
  financial institutions next

4
Financial Statement Presentation Outside the
Project Scope

• Recognition and measurement guidance
• Current footnote disclosure requirements
  pertaining to individual line items
• Will address new footnote disclosure pertaining
  to financial statements as a whole
• Management discussion and analysis
• Pro forma measures
• Segment reporting requirements (at least so far)
• Financial ratios (except per-share amounts)
• Forecasts of information
• Nonfinancial ratios or other nonfinancial
  information
• Financial statements for specific industries

5
Financial Statement Presentation Project
Objective

• To present information in the financial
  statements in ways that improve the ability of
  investors, creditors, and others to
• Understand an entitys present and past financial
  position
• Understand the past operating, financing, and
  other activities that caused an entity's
  financial position to change
• Use that financial statement information (along
  with information from other sources) to assess
  the amounts, timing, and uncertainty of an
  entitys future cash flows

6
Financial Statement Presentation Project Phases

• Phase A (Completed)
• Complete set of financial statements
• Comparative information
• Phase B (Currently deliberating)
• Categories in each financial statement
• Totals, subtotals
• Other comprehensive income (and recycling)
• Statement of cash flows (direct vs. indirect
  method)
• Phase C (No work done yet)
• Interim financial information

7
Phase A Decisions

• What constitutes a complete set of financial
  statements?
• Statement of financial position
• at the beginning and at the end of the period
• Statement of earnings comprehensive income
• Statement of cash flows
• Statement of changes in equity
• All shown with equal prominence

8
Phase A Decisions

• How many years have to be presented in
  comparative financial statements?
• A minimum of two annual periods of complete
  financial statements
• What per-share information needs to be presented?
  
• No change to EPS requirements (yet)

9
Phase A Status

• The IASB published an Exposure Draft on Phase A
  decisions in March 2006
• Decided to permit comprehensive income to be
  presented in either one or two statements
• Similar to FASB Statement No. 130, Reporting
  Comprehensive Income
• IASB redeliberations began in November
• FASB to expose Phase A decisions at the same time
  as Phase B decisions

10
Phase B Working Principles

• Financial statements should present information
  in a manner that
• Portrays a cohesive financial picture of an
  entity
• Separates an entitys financing activities from
  its business and other activities
• Helps a user access the liquidity of an entitys
  assets and liabilities
• Disaggregates line items if that disaggregation
  enhances the usefulness of that information in
  predicting future cash flows
• Helps a user understand
• how assets and liabilities are measured
• the uncertainty and subjectivity in measurements
  of individual assets and liabilities
• what causes a change in reported amounts of
  individual assetsand liabilities

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Phase B - Tentative Decisions

• Cohesiveness is the governing principle
• Same sections and categories on each financial
  statement
• Classification of assets and liabilities will
  drive classification of related changes in
  statement of cash flows and comprehensive income
  statement
• Benefit To clarify relationships between
  statements facilitating financial analysis

12
Phase B - Working Format

• Two primary sections Business and Financing
• Business further broken down into Operating and
  Investing categories
• Financing further broken down into Financing,
  Treasury, and Equity
• Benefit distinguish between an entitys value
  creating and funding activities

13
Phase B - Working Format
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The Financing Section

• Treasury assets
• Generally will include cash and cash equivalents,
  especially for nonfinancial institutions
• Other financial assets that are invested in as
  internal sources of financing
• Financing liabilities
• Financial liabilities providing sources of
  financing
• Pensions?
• Excludes operating liabilities
• Equity
• All equity items

15
The Business Section

• Investment category
• Possibly include equity method investments and
  other financial assets that are not managed on a
  daily basis directly toward achieving current
  operating objectives
• Real estate held as investment
• Operating assets and liabilities
• Remaining assets and liabilities
• Short-term and long-term sub-categories
• Short-term to be based on either a one-year
  notion or an operating-cycle notion

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Working FormatAdditional Sections
17
Income Taxes Section

• Considers taxes a discrete managerial function
  often unrelated (or only arbitrarily related) to
  specific line items
• Consequences
• No more intraperiod tax allocation
• Discontinued operations and other comprehensive
  income items shown on a pretax basis
• Additional footnote disclosures
• Effective tax rate reconciliation

18
Discontinued Operations Section

• Viewed as separate from on-going business
  activities
• Single line in separate section of each statement
• Assets and liabilities shown net
• Total cash flows
• Profit (loss) gain (loss) on disposal
• More information in the notes
• Need to converge definitions in SFAS 144 and
  IFRS 5

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New Footnotes Relating to Financial Statements as
a Whole

• Footnote describing measurement attributes used
  in each balance sheet line item
• Footnote reporting measurement uncertainties
  relating to each balance sheet line item
• Footnote indicating how changes in balance sheet
  items affect items reported in comprehensive
  income and cash flow statements
• Will separately identify changes relating to
  cash, accruals, fair values and other
  remeasurements
• Also may reconsider segmental reporting

20
Phase B Tentative Decisions

• Disaggregation
• Comprehensive Income Statement
• Present line items by function
• Example Sales to customers, Sales to third
  parties, Cost of Sales, RD, Marketing
• Further break down by nature of items important
  in understanding the business (possibly in notes)
• Example Labor, Materials, Depreciation,
  Amortization, Pension costs

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Phase B Tentative Decisions

• Disaggregation (continued)
• Present items on a gross basis except when it
  provides no additional information
• General guidance regarding other line items that
  should be presented separately
• Extraordinary Items
• Eliminate the concept from U.S. GAAP
• General presentation principles should apply
  equally to both financial and nonfinancial
  institutions
• Troublesome areas include consistency in
  classifications of cash and cash equivalents,
  reporting of liquidity information and whether
  there should be general consistency in
  classifying other items into business and
  financing sections across the two types of
  entities
• May raise issues about how to present the
  financial statements of entities with both
  significant financial and nonfinancial components

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Phase B Vexatious Issues

• To achieve cohesiveness principle, should equity
  distributions be deducted in statement of
  comprehensive income or should equity be treated
  as category separate from business and financing?
• Answer may be driven by developments in
  conceptual (CF) framework and liabilities and
  equity (L/E) projects
• There is currently an inconsistency in approaches
  taken in L/E project and current CF regarding
  primacy of liability and equity elements
• L/E project define equity, liabilities are
  residual
• Current CF define liabilities, equity is
  residual
• Has lead FASB staff to propose examining new
  approaches to L/E classification that may result
  in either one (claims) or more than two (
  liabilities, equity, dequity) right hand side
  elements in the financial statements
• Alternately, could Statement of Changes in Equity
  be viewed in combination with the Statement of
  Comprehensive Income as providing cohesiveness
  with balance sheet and cash flows statements?

23
Presentation Overview

• Major Impact Projects
• Financial Statement Presentation
• Conceptual Framework
• Fair Value Measurements
• Use of Formal Research at FASB
• New Initiatives
• Questions and Answers Relating to Remaining
  Agenda Items

24
Conceptual Framework Project -Background

• Objective
• To develop an improved and common conceptual
  framework that will provide a sound foundation
  for the development of accounting standards
• The project is
• Focusing on changes in the environment since the
  original frameworks were issued and omissions in
  the original frameworks
• Giving priority to cross-cutting issues that are
  likely to yield benefits in the short term
• Initially considering concepts applicable to
  business entities in both the public and private
  sector

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Conceptual Framework Project - Project Plan

• The project is being conducted in eight phases
  with separate exposure of decisions in each
  phase
• A. Objectives of financial reporting and
  qualitative characteristics of financial
  reporting information
• Preliminary Views document issued in June 2006
• B. Elements of financial statements and
  recognition
• C. Measurement
• D. Reporting entity
• E. Presentation and disclosure, including
  reporting boundaries
• F. Purpose and status in GAAP hierarchy
• G. Applicability to the not-for-profit sector
• H. Entire framework

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Tentative Decisions Objectives of Financial
Reporting

• Generally consistent with the Boards existing
  frameworks, financial reporting should
• Focus on general purpose reporting to external
  users who cannot prescribe the information they
  need (entity view)
• Provide information
• Useful in making investment, credit, and similar
  resource allocation decisions (the objective)
• Useful in assessing an entitys net cash flow
  prospects
• About an entitys economic resources, claims to
  those resources, and effects of events that
  change those resources and claims
• Information directed at these objectives also are
  useful in assessing managements stewardship and
  accountability

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Tentative Decisions Qualitative Characteristics

• Qualities of decision-useful information
• Relevance
• Faithful representation
• Comparability
• Understandability
• Constraints
• Benefits that justify costs
• Materiality

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Tentative Decisions Qualitative Characteristics
(QCs)

• Much the same QCs, one change in terminology
• Faithful representation will replace reliability
• Changes in how the Boards will deal with the
  relationships between QCs
• The QCs will be considered sequentially in a
  process that results in decision-useful financial
  reporting
• Identify most relevant attribute first decide
  how it can be faithfully represented if faithful
  representation not possible consider alternate
  attribute
• Previous frameworks tried to deal with
  relationships between QCs by ranking them in a
  hierarchy or making trade-offs between
  characteristics

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Some Issues Raised in Comment Letters

• Entity vs. Proprietorship View
• Neutrality vs. Conservatism
• Should Stewardship be Separated from Decision
  Usefulness?
• Should Auditability be a Dimension of Faithful
  Representation?

30
Tentative Decisions Reporting Entity

• The Boards decided that
• The reporting entity concept should focus on
  determining the boundaries of the reporting
  entity for both an individual entity and a group
  of entities
• An entity for financial reporting purposes should
  not be limited to a legal entity
• A parent-only entity could be a reporting entity
• Control, in the context of one entity having
  control over another entity, should be defined at
  the conceptual level
• The definition should include notions of power
  and benefits
• The Boards have not decided on the role of
  control in defining a reporting entity
• Preliminary efforts suggest using control alone
  may not be solution

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Tentative Decisions Definition of an Asset

• An asset of an entity has three essential
  characteristics
• There is a present economic resource
• The entity has rights or other privileged access
  to the economic resource
• The present economic resource and the rights or
  other privileged access both exist at the
  financial statement date
• Recognition criteria (to determine what assets
  are recognized in financial statements) and
  measurement will be considered at future meetings

32
Tentative Decisions Definition of a Liability

• A liability of an entity has three essential
  characteristics
• There is a present economic burden
• The entity is obligated to meet the economic
  burden
• The present economic burden and the obligation
  both exist at the financial statement date
• Liability definition is derived from asset
  definition
• This tentative approach remains inconsistent with
  liability/equity project
• Leading to its potential reconsideration as
  discussed previously

33
Tentative Decisions Measurement

• At April 2006 joint meeting, the Boards discussed
  the plan for the measurement phase, recognizing
  constituents potential concerns about these
  deliberations. They agreed with the staff plan
  to
• Conduct the measurement phase in three
  milestones
• Milestone 1 Describe and define properties of
  potential measurement bases
• Milestone 2 Evaluate measurement bases using the
  qualitative characteristics
• Milestone 3 Derive conceptual conclusions from
  Milestones 1 and 2
• Hold public consultations and issue discussion
  documents

34
Presentation Overview

• Major Impact Projects
• Financial Statement Presentation
• Conceptual Framework
• Fair Value Measurements
• Use of Formal Research at FASB
• New Initiatives
• Questions and Answers Relating to Remaining
  Agenda Items

35
Fair Value Measurements

• SFAS 157 issued in September 2006
• Explains intent of fair value measurements for
  financial reporting
• Exit price in orderly transaction in most
  advantageous market
• Use quoted prices, where available, for identical
  items (or similar items, with adjustment)
• If no prices available, use models, techniques
  and assumptions that marketplace participants
  would use
• Goal of this guidance is to increase the
  consistency and comparability of fair value
  measurements
• Discusses techniques used by valuation
  professionals (market approach, income approach,
  cost approach)
• Enhanced disclosures about the nature and source
  of fair value measurements
• Separate recurring from periodic remeasurements
• Explain how fair values were determined
• Standard does not extend use of fair value
  measurements

36
Fair Value Measurements for Financial Reporting
Fair value The price that would be received to
sell an asset or paid to transfer a liability in
an orderly transaction between market
participants at the measurement date.

• Key attributes of fair value
• Focus on exit (not entry) value
• Uses a market participant, not an entity
  perspective
• Need not be based on an actual transaction no
  requirement that a market exist
• Price represents highest or best use for
  particular asset or lowest price to transfer (not
  settle) a particular liability
• Transfer assumed to be an orderly (non-forced)
  exchange in principal (or most advantageous)
  market
• Measurement is based on information that is
  current as of the measurement (reporting) date

37
Fair Value Measurements Required Disclosures

• Provide information about Level of inputs used
  to make recurring and nonrecurring fair
  value measurements in the financial statements
• Level 1 Quoted prices in active markets, for
  identical items
• Level 2 Observable market inputs other than
  quoted prices
• Examples prices for similar items, interest
  rates, yield curves, volatilities, prepayment
  speeds, credit risks, foreign exchange rates,
  published indexes
• Level 2 inputs might not be directly observable
  for the item being valued. Instead, they might
  be derived (e.g., via correlation analysis) from
  observable inputs
• Level 3 Inputs that are not observable in the
  marketplace (they are developed by the entity and
  are not derived from or corroborated by market
  inputs)
• Level 3 subject to special disclosure
  requirements
• Provide information in annual financial
  statements, about valuation techniques used.

38
Fair Value Measurements

• Intended to increase the relevance of reported
  numbers
• Only measurement attribute for certain
  derivatives
• Incorporates information on measurement date, not
  on the original transaction date
• Alternatives, such as allocations of the original
  transaction amount, also require judgment and
  estimation
• Some question the reliability of fair values
  based on estimates and measurements (not actual
  transactions)
• What is the actual reliability of fair value
  measures?
• How reliable are fair value measures compared to
  other measures based on estimates and judgments?
• What are the auditing considerations?
• What are the causes of unreliable measures?

39
Key Attribute Fair Value Measurements
Measure is not intended to capture the most
likely settlement amount. Fair value measurement
is not consistent with the perspective in SFAS 5
Example an arrangement that will settle for 100
or for 0 Probability of 0 Probability of
100 Date 1 .70 .30 Date 2 .50 .50 Date
3 .20 .80

• Questions to consider
• Ignoring time value and risk, what is the
  (approximate) fair value at dates 1, 2 and 3?
• What do changes in fair value reflect?
• What amounts would be recognized by applying SFAS
  5?
• Which accounting treatmentfair value or
  application of SFAS 5 is more relevant and
  representationally faithful?

40
Fair Value Measures Reliability
Reliability gt users of financial reports can
depend on reported numbers to represent economic
conditions they purport to represent

• Representational faithfulness gt correspondence
  between the measure and the phenomenon being
  measured
• Verifiability gt consensus among various
  measurers
• Implies low dispersion of independent
  measurements
• Although consensus can be achieved by confirming
  to an external source, the definition does not
  require this
• Key issues
• Making this reliability construct operational for
  auditors
• Analyzing reliability considerations for fair
  value measures
• Fair value is typically not a settlement amount
• Fair value typically changes over time

41
Use of Estimates Generally in Financial Reports

• Financial reporting issues
• SEC requirement to discuss critical accounting
  policies
• Requiring difficult, complex or subjective
  judgments/estimates
• Number of items to be estimated may be large
• Time period covered may be extensive
• Important to the portrayal of results

• Lucent's 2005 annual report lists the following
  "more important" estimates and assumptions that
  affect financial condition and results of
  operations
• Revenue recognition
• Pension and postretirement benefits
• Income taxes
• Legal contingencies
• Intangible assets
• Receivables and customer financing
• Inventories
• Restructuring
• Warranties

42
Use of Estimates Generally in Financial Reports

• What causes unreliable outcomes when judgment or
  estimation is involved?
• (Honest) forecasting errors and errors of
  judgment
• Error from models (including assumptions and
  simplifications)
• Information systems do not capture necessary data
  items
• Management manipulations ("earnings management")
• Lack of expertise (a function of education are
  you ready?)

Question to consider Are these considerations
different between fair value estimates and other
estimates?
43
Fair Values FASB Activities

• Extensions of fair value measurements
• Statement 155 (issued Feb 2006) permits free
  choice between fair value measurement of
  financial instruments with embedded derivatives
  and application of SFAS 133
• Hybrids with embedded derivatives that would
  otherwise require bifurcation are eligible to be
  carried at fair value, with changes included in
  income
• The choice is made instrument by instrument
• Eases implementation, because of complexities
  associated with identifying and bifurcating
  embedded derivatives
• Statement 156 (issued March 2006) allows entities
  to (re)measure servicing rights at fair value.
• Prior GAAP treatment is amortization and LOCOM,
  so this change would allow entities to apply fair
  value measures when fair value gt original
  carrying value
• The choice would be made by class of servicing
  rights

44
Fair Values FASB Activities

• Fair Value Option (Phase One) - Exposure Draft
  issued April 2006 final document expected this
  month
• This standard will allow entities to elect (on a
  instrument-by-instrument basis) to account for a
  financial instrument at fair value with the
  change in fair value recorded in income
• Intent is to alleviate the most problematic
  outcomes associated with a mixed attribute
  measurement model
• Will it or will it create different problems?
• Effective date will be fiscal years beginning
  after December 15, 2006. Election to apply the
  Option will require adoption of the Fair Value
  Measurements Standard as of that date

Question to consider This treatment alternative
would increase noncomparability, as do the
treatment alternatives on previous slide. What
is best way to mitigate the problems associated
with noncomparability? Potential answer Fair
value all financial instruments
45
Presentation Overview

• Major Impact Projects
• Financial Statement Presentation
• Conceptual Framework
• Fair Value Measurements
• Use of Formal Research at FASB
• New Initiatives
• Questions and Answers Relating to Remaining
  Agenda Items

46
Objectives of New FASB Research Initiative

• Identify existing research pertinent to Board
  projects/mission performed by academics,
  regulators (e.g., Fed, SEC), businesses, analysts
  and proxy firms
• Review quality research and translate in terms
  relevant to standard setting
• Liaise with key constituencies performing
  research to inform them about standard setting
  issues and to gain knowledge of (and influence)
  related research currently underway
• Organize sessions inviting lead researchers with
  cutting edge ideas to present their work to Board
  and staff

47
Objectives of New FASB Research Initiative

• Evaluate circumstances where new research could
  inform FASB process. Act as catalyst to encourage
  such research. This research could include
• Accumulating descriptive statistics or survey
  evidence to help FASB understand the significance
  and/or pervasiveness of an issue
• Working with research project teams to facilitate
  timely completion of relevant research (e.g.,
  conducting rigorous field studies assessing the
  costs-benefits of a new standard in facilitating
  security prices/credit ratings and eliciting
  feedback from constituents in how the proposed
  standard could be improved)
• Report on results of Board-related research
  activities to key constituents (including
  academics, FASAC and other advisory bodies) to
  help frame dialogue with the Board

48
Current and Future Roles for Academics with FASB

• Academic Fellows
• Next year Bob Lipe, Oklahoma University 1st
  FASB Academic Research Fellow.
• Current year and next year Jeff Wilks, BYU
  Project Manager on Revenue Recognition Project
• (Potential) Financial Accounting Standards
  Research Program
• Proposed Director of Overall Program Rob
  Bloomfield, Cornell
• Proposed Leader of Survey Research Team Mark
  Nelson, Cornell (other initial participants Siva
  Rajgopal, Washington)
• Proposed Leader of Experimental Research Team
  Pat Hopkins, Indiana (other initial participants
  Frank Hodge, Washington Jeff Wilks)
• Proposed Leader of Controlled-Economy Research
  Team Rob Bloomfield (other initial participants
  Marlys Lipe, Oklahoma)
• Former Professors on FASB Staff Todd Johnson
  Kevin McBeth. Both are members of the CF team
  seeking another.
• FASB Board Member

49
Presentation Overview

• Major Impact Projects
• Financial Statement Presentation
• Conceptual Framework
• Fair Value Measurements
• Use of Formal Research at FASB
• New Initiatives
• Questions and Answers Relating to Remaining
  Agenda Items

50
Current FASB AgendaProjects with IASB

• Joint Projects
• Revenue Recognition
• Business Combinations
• Leases
• Financial Statement Presentation
• Conceptual Framework
• Modified Joint Projects
• Liabilities and Equity (FASB leading)
• Insurance Products (IASB leading)
• Convergence Specific Projects
• Income Taxes
• Earnings per Share
• Research Development

51
Current FASB AgendaFASB Only Projects

• Derivative Disclosures
• Combination of Not-for-Profit Organizations
• Postretirement Benefit Obligations Phase Two
• Fair Value Option Phase Two
• Statement 140 Transfer of Financial Assets
• Insurance Risk Transfer
• Subsequent Events
• Financial Guarantee Insurance
• FSPs, EITF and DIGs

52
Current FASB AgendaOther Activities

• GAAP Codification and GAAP Hierarchy
• Improving Focus on Potential Differences for
  Private Companies
• Valuation Guidance for Financial Reporting

53
Closing Remarks

• I will provide these slides to the conference
  organizers so that they can make them available
  on the conference website
• Thanks for your attention!