The new leases standard is effective for calendar year-end public business entities (PBEs) on January 1, 2019. The FASB has issued and proposed several practical expedients to help companies apply the new standard, all of which are discussed in further detail below.
The new leases standard requires a lessor to separate lease components from nonlease components in a contract. The lease components should be accounted for in accordance with the new leases guidance, and the nonlease components should be accounted for under other applicable guidance (e.g., revenue guidance). However, in March 2018, the FASB tentatively approved a new practical expedient, which may change how lessors account for contracts with both lease and nonlease components. If approved as proposed, lessors will have the option to aggregate the nonlease components with the associated lease component of a contract if the following conditions are met:
If a lessor elects this practical expedient, it would account for the combined component based on its predominant characteristic. If the nonlease component is predominant, a lessor would account for the combined component as revenue. However, the lessor would account for it as an operating lease if the lease component is predominant. This practical expedient is required to be elected by class of underlying asset. Further, if elected, the expedient will need to be applied consistently to all components that meet the stated criteria.
The new practical expedient should make the application of the new leases standard easier and more cost effective for many lessors. For example, lessors with eligible operating real estate leases that also provide maintenance services could elect to not separate the nonlease maintenance services component from the real estate lease component. These components would otherwise need to be separated based on their standalone selling prices. Lessors will need to apply judgment to determine the predominant characteristic of the combined component when applying this practical expedient.
Further, the FASB tentatively agreed to another practical expedient that will allow lessors to make accounting policy elections to exclude sales taxes, property taxes, and insurance from contract consideration when those costs are paid directly by the lessee and the amount to be paid is uncertain. This is a change from the new leases guidance, as currently written, which would require lessors to quantify these lessor costs and report them gross as revenue and expense in the income statement.
The proposed improvements to the presentation of certain lessor costs will be exposed for public comment.
In addition to the lessor practical expedients discussed above, there are a number of transition-related practical expedients for lessees and lessors to consider when adopting the standard, including the "package" of practical expedients. The "package" refers to the following three expedients that must be adopted together:
For additional insights, see our video on the "package" of practical expedients:
Other practical expedients permit lessees and lessors to elect to:
For more information, watch our video on these other leasing practical expedients:
In addition, for more information on the new leases standard, please refer to In brief US2017-31, FASB proposes to simplify the new leases guidance, In depth US2018-07, Assessing land easements under the leases standard, and PwC's CFOdirect Podcast series, Episode 33: Leasing - recent proposals, impairment and subleases. Also, see our video library on CFOdirect.com for guidance on adopting the new leases standard, including our recent videos on embedded leases, lease term and the incremental borrowing rate.
Even as PBEs are absorbing the impacts of adopting new standards during 2018, they should be gearing up for the adoption of the new standards effective for calendar year-end PBEs in 2019. There are six new standards effective for calendar year-end PBEs on January 1, 2019.
The following graphic identifies the FASB guidance effective in 2019 for calendar year-end PBEs. In the section that follows the graphic, we highlight the new guidance related to down round features.
For further information about the new accounting guidance, including additional PwC resources, refer to the following links.
Down round features reduce the strike price of an instrument when an issuer sells shares of its stock (or issues equity-linked instruments) for amounts less than the current strike price (or with strike prices less than the current strike price). These features are most often found in warrants and conversion options included in debt or preferred equity instruments issued by private entities, but they may also be included in instruments issued by public companies.
If a warrant or embedded conversion option that is not clearly and closely related to the host instrument meets the definition of a derivative, it should be measured at fair value with changes in fair value reported in current earnings unless it qualifies for the derivatives scope exception for contracts in an entity’s own equity. To qualify for this scope exception, the warrant or conversion option must be considered solely indexed to an entity’s stock and meet additional conditions to be classified in stockholder’s equity. Under current guidance, an instrument cannot be considered solely indexed to an entity’s own stock if it includes a down round feature. This is no longer the case under the new guidance. Further, the new guidance adds a definition of a down round feature, which is explicit and intended to include a very specific type of feature. Instruments issued by companies can contain many features that may seem to be a down round, but fall outside of the specific definition.
The extent of effort required for implementation of the new guidance should not be underestimated. Companies considering early adoption should understand that the FASB allotted 12-24 months to implement the standard because adoption could require significant effort depending on the number and the complexity of financial instruments issued.
For more information, read In depth US2018-04, Adopting the new guidance on down round features.
Although the January 1, 2018 effective date of the new accounting standards for calendar year-end PBEs has come and gone, many topics related to the newly-effective guidance continue to generate interest. These include SEC reporting requirements related to the new revenue standard and specific considerations related to the new guidance on the statement of cash flows, the definition of a business, and derecognition of nonfinancial assets. These specific considerations are discussed in further detail below.
The following graphic identifies the FASB guidance effective in 2018 for calendar year-end PBEs:
For further information about the new accounting guidance, including additional PwC resources, refer to the following links.
Most calendar year-end PBEs adopted the new revenue standard on January 1, 2018. As companies continue to focus on executing the processes and control activities implemented as a result of adopting the new standard, other events, such as an acquisition, may occur during the year that may impact a company’s accounting treatment and trigger certain SEC reporting requirements.
If a company makes an acquisition and adopted the new revenue guidance as of a different date and/or under a different transition method than its acquiree, the company is not required to conform the date and method of adoption of the acquired business for purposes of the significance tests under SEC rules. However, a company should conform the acquiree's date and method of adoption for purposes of preparing the pro forma financial information required by SEC rules and by the disclosure requirements of the business combination guidance.
In addition, companies should remember that SEC rules require both the annual and interim period disclosures to be provided in each interim reporting period in the initial year of adoption. Therefore, companies should continue to include the interim and annual disclosures related to the adoption of the new revenue standard in their second and third quarter Form 10-Qs.
For more information, see In transition US2017-01, The new revenue recognition standard - FAQs about SEC reporting and transition.
The new cash flows guidance prescribes a specific presentation for payments of deeply discounted debt, which is debt with either a zero coupon interest rate or a coupon interest rate that is insignificant in relation to the borrowing's effective interest rate. Under the new guidance, cash payments for the settlement of deeply discounted debt should be split between two classifications on the statement of cash flows:
For example, if a zero coupon bond with a par value of $100 is issued for $90, when the $100 is repaid at settlement, the $10 of accreted interest would be presented as an operating cash outflow and the repayment of the $90 received at issuance would be presented as a financing cash outflow.
Questions have arisen as to whether certain instruments, specifically (1) cash convertible debt instruments and (2) debt instruments where the interest is required or permitted to be paid-in-kind (PIK notes), are in the scope of this guidance.
A cash convertible debt instrument allows the obligation to be settled, in whole or in part, in either cash or stock. For accounting purposes, the bond is separated into a debt component and an equity component at issuance. For example, assume a company issues three-year cash convertible debt with a $100 principal amount and a stated coupon rate of 1%. At issuance, the equity conversion option is valued at $45 and is recorded in equity, resulting in a debt discount of $45. This results in an effective interest rate of 23%.
We believe that cash convertible debt instruments are in the scope of the deeply discounted debt cash flows guidance because once any embedded feature (e.g., the equity conversion option) is separated from the debt, the discounted debt becomes its own unit of account. Therefore, the stated coupon rate must be compared to the effective rate to determine if the debt is deeply discounted. In this example, we believe that the stated coupon rate of 1% is insignificant in relation to the effective rate of 23% as it represents only 4% of the effective rate. As a result, the debt would be considered deeply discounted. While there are no bright lines, we believe using 10% as a rule of thumb is a reasonable way to assess whether the stated coupon rate is insignificant in relation to the effective interest rate.
The terms of certain debt instruments either permit or require the borrower to satisfy interest payments on the debt by issuing additional PIK notes having identical terms as the original debt (instead of paying in cash). In both a PIK note and a zero coupon bond, the interest due on the original principal amount of debt is accrued and added to the debt balance. Therefore, we believe the cash flows guidance for deeply discounted debt should be followed for payments made to extinguish PIK notes as well. However, if the borrower has the option to pay cash or issue additional PIK notes, classification of subsequent payments on the new PIK notes as financing activities may also be acceptable.
For example, if debt with a $100 principal amount was issued at par value and the issuer satisfied $15 of interest through the issuance of PIK notes, the borrower would pay $115 in cash at maturity. $100 of that amount would be classified as a financing cash outflow because it is attributable to the proceeds received at issuance, and the remaining $15 would be classified as an operating cash outflow because it is attributable to accreted interest.
For more information, refer to section 22.214.171.124 of our Financial statement presentation guide.
The new definition of a business requires an initial screen test to determine whether an acquisition should be accounted for as an asset acquisition or a business combination. If substantially all of an acquisition's value is concentrated in a single asset or a group of similar assets, the acquisition is an asset acquisition. While it is not a bright line, “substantially all” is commonly considered to be approximately 90%. If the screen test is not met, the analysis must continue through the full framework.
To apply the screen test, a company should first identify whether it has acquired any assets that should be grouped as one or more “single assets.” A single asset for purposes of the screen test may include assets that are classified separately for financial reporting because the screen test guidance requires that:
After identification of the single assets acquired, a company should consider if a single asset should be grouped with other similar assets based on their nature and risk characteristics. It will require judgment to determine if similar assets should be grouped. The guidance contains examples of this evaluation and includes specific assets that would not qualify as similar for purposes of the screen test (e.g., a financial asset and a nonfinancial asset). For example:
Identifying a single asset
First, the company should identify the single assets acquired. The combined land, houses, property improvements and in-place leases at each of the ten properties would be a single asset because:
However, for financial reporting purposes, the in-place leases, land, houses and property improvements should be accounted for under the guidance applicable to each asset class and may be presented separately in the company's financial statements.
Identifying similar assets
Next, the company would determine whether the ten single assets acquired should be grouped as similar assets to apply the screen test. After considering all relevant facts (e.g., class of customer, neighborhood, and type of property), the ten single assets would likely be considered similar assets for purposes of the screen test. Although the homes are different in size and layout, the nature of the assets (all residential homes) and the risks associated with operating the properties are similar since the class of customer, neighborhood and types of property are not significantly different.
For more information, please refer to In depth US2017-01, The FASB's new definition of a business, In the loop, The new business definition: Why it matters, and section 1.3 of our Business combinations and noncontrolling interests guide.
The new derecognition guidance (ASC 610-20) addresses sales, partial sales and transfers between parties of nonfinancial assets. One of the most significant impacts of the new guidance is the elimination of rules specifically addressing real estate sales. While this primarily affects the real estate industry, other industries that typically have material real property balances (e.g., power and utilities) may be impacted as well.
The new derecognition of nonfinancial assets guidance requires that the sale of an equity method investment be accounted for as a financial asset sale regardless of whether the investee's assets are predominately real estate or in-substance real estate. Previously, the sale of financial assets guidance excluded any sale of an investment that was the sale of real estate or in-substance real estate. The sale of financial assets guidance incorporates a control-based framework and can be complex, especially if the seller retains any form of continuing involvement with the transferred asset.
During the first quarter of 2018, companies spent a significant amount of time evaluating the impacts of tax reform on their year-end financial statements and assessing the accounting implications for 2018 and beyond. In the Q1 2018 edition of The quarter close, we provided insights into the accounting implications of tax reform that companies would face for the first time this year. Through the first quarter of 2018, many companies accounted for the effects of the change in tax law on a provisional basis under Staff Accounting Bulletin No. 118 (SAB 118). As companies finalize their accounting for the impacts of tax reform, it is important to consider other SEC reporting requirements beyond SAB 118 that may be impacted by tax reform.
For example, non-GAAP measures included in a company’s SEC filings continue to be an area of focus for the SEC staff. SEC rules require a reconciliation between the non-GAAP financial measure disclosed and the most comparable financial measure or measures calculated and presented in accordance with GAAP. At the March 2018 SEC Regulations Committee meeting, the SEC staff reiterated that companies that adjusted their non-GAAP measures for the impacts of tax reform in the period of enactment should make the same adjustments in all subsequent periods. Additionally, the adjustments to non-GAAP measures should be balanced (i.e., both positive and negative impacts should be considered). For example, it would not be appropriate to adjust reported earnings for the deemed repatriation transition tax but not adjust for a benefit recorded upon remeasurement of deferred taxes to reflect the lower tax rate. This is important for a company that previously adjusted its non-GAAP measures for certain impacts of tax reform but is reporting additional impacts for the first time this quarter.
Cryptocurrency is a type of digital token that is designed to be a medium of exchange. Under US GAAP, cryptocurrencies may be accounted for as indefinite-lived intangible assets. However, some stakeholders are concerned that the existing accounting as indefinite-lived intangible assets will not appropriately reflect the economics associated with these assets. For more information, please see our Point of view, Cryptocurrencies: Time to consider plan B.
With the adoption dates for the new standards on leases and credit impairment approaching, companies should consider their SAB 74 disclosures, which should become more specific as the effective date of a standard nears.
Below is a summary of the disclosures of the potential impact of adopting the leases and credit losses standards in annual and quarterly filings of S&P 500 companies between April 1, 2018 and May 10, 2018.
On May 25, 2018, the General Data Protection Regulation (GDPR) came into effect, representing the biggest change to data protection regulation in the European Union (EU) in the last 20 years. GDPR was put in place by the EU to update and harmonize data protection laws throughout the EU, replacing the current legal framework in its entirety. There are a number of factors that incent organizations to make compliance an ongoing priority, including:
Although GDPR is an EU regulation, many US companies are impacted by the new laws. Not only does GDPR apply to companies that have EU operations (including employing EU staff), but the rules also apply if a company targets products or services towards EU residents or monitors the behavior of or profiles EU residents (for example through online profiling or customer segmentation).
GDPR significantly impacts affected companies' operations and data handling practices. Companies should consider:
For additional information, refer to PwC's dedicated GDPR page.
In February 2018, the SEC issued interpretive guidance to assist companies in the preparation of disclosures regarding cybersecurity risks and incidents. The guidance highlights the importance of maintaining policies that effectively address the fact that cybersecurity risks and incidents can constitute material, nonpublic information and emphasizes the importance of maintaining sufficient disclosure controls and procedures. Compliance with the interpretive guidance will ensure a company timely informs investors about the material cybersecurity risks and incidents that it has faced or is likely to face. In response to the new guidance, most companies should expect to have increased disclosures in their SEC filings with respect to board risk oversight and cyber breaches, threats, and potential risks. These disclosures may impact many areas of a company's filing, including Risk Factors, Management Discussion & Analysis, and the financial statements. Companies should also consider filing a Form 8-K relating to any material cybersecurity incidents.
For additional information, see our video and In brief US2018-07, SEC issues interpretive guidance on cybersecurity disclosures.
Beginning in mid-2019 for audits of financial statements of large accelerated filers, auditors will be required to communicate critical audit matters (CAMs) in their audit reports. CAMs are any matters arising from the audit of the financial statements communicated, or required to be communicated, to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment.
Management and audit committees may be interested in engaging with auditors on CAM reporting requirements in advance of the effective date. We have provided an illustrative road map to help accomplish that goal.
For more information, refer to our Point of view, Auditor reporting: Changes coming and In depth US2017-29, SEC approves PCAOB standard changing the auditor reporting model.
We understand that later in June the FASB is expected to effectively eliminate the separate guidance applicable to share-based payments to nonemployees, such as vendors and consultants. The existing guidance for share-based payments to employees will apply for all share-based payment awards, except for the attribution of compensation cost. Nonemployee award cost will be recognized in the same manner as if cash had been paid, whereas employee awards will continue to follow the existing guidance, which generally requires compensation cost to be recognized over the vesting period.
Under the new guidance, equity-classified share-based payment awards issued to nonemployees will be measured on the grant date, instead of being remeasured through the performance completion date (generally the vesting date), as required under the current guidance. The new guidance will also require recognition of compensation cost for awards with performance conditions when achievement of those conditions are probable, rather than upon their achievement. Further, the new guidance will eliminate the requirement to reassess the classification of nonemployee awards under the financial instruments literature upon vesting. These changes will align the accounting for employee and nonemployee share-based payment awards and should reduce complexity.
We understand that while the new guidance will not be effective until 2019 for calendar year-end PBEs, early adoption will be permitted.
The guidance is expected to be issued in June. Once released, companies should consider the provisions of the final standard.
US companies are holding record sums of cash on their balance sheets. At the end of 2017, US non-financial companies held approximately $1.9 trillion of cash and liquid investments, up from $1.68 trillion in 2015. Tax reform may add to these amounts as it reduced the corporate tax rate from 35% to 21% for most companies. Although tax reform also introduces a new repatriation "toll charge" on foreign subsidiaries' undistributed earnings and profits, this amount can be paid over eight years.
With additional cash on their balance sheets, the natural question facing companies is how best to use their capital. A number of companies have announced actions intended to share the benefits of tax reform with employees, such as bonuses, increases to 401(k) matching rates and hourly wage increases. Many companies have also announced increases to their share repurchase plans and/or dividends.
At the same time, shareholder activism continues to be pervasive. Activists often pressure companies to increase share repurchases and/or dividends. As a result, companies are scrutinizing their capital allocation strategies to avoid becoming activist targets.
Ultimately, companies need an effective capital allocation strategy that is well thought-out, linked to their overall strategy and clearly communicated. The strategy also needs to take into account stakeholders' expectations, company-specific circumstances and the overall economic environment. A key element of this strategy is whether, and/or how, cash is returned to shareholders.
Share repurchases and dividends may be a key element of returning capital to shareholders. Before adopting a share repurchase or dividend plan, companies should consider the following questions:
Refer to PwC's The capital allocation dilemma: Thinking through share repurchases and dividends in the new environment for more insights. This paper offers additional considerations to help boards evaluate capital allocation decisions.
Partner, National Professional Services Group, PwC US
Senior Manager, National Professional Services Group, PwC US