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A number of significant new standards have been issued by the FASB over the last few years. Up next for adoption is the new credit losses standard. Given the variety of financial instruments that are within the scope of the new standard, both financial services and non-financial service companies will be impacted.
The main element of the new credit losses standard is a new accounting model for recognizing credit losses on certain financial instruments based on an estimate of “lifetime” expected credit losses. The current expected credit loss (CECL) model applies to a broad scope of financial instruments, including financial assets measured at amortized cost (including held-to-maturity debt securities), net investments in leases and certain off-balance sheet credit exposures. While available-for-sale (AFS) debt securities are not within the scope of CECL, the new credit losses standard also made several notable changes to the AFS impairment model.
The new standard will be effective on January 1, 2020 for calendar year-end public business entities (PBEs) that meet the definition of an SEC filer. Other PBEs will have an additional year to adopt the standard. All other entities will have two additional years for adoption. Early adoption of the standard is permitted beginning on January 1, 2019 for calendar year-end companies.
For many companies, the new credit losses standard will have a significant impact on systems, processes and controls surrounding financial reporting, and may require a considerable amount of time to implement. We have a number of resources that can help as companies continue to prepare for adoption of the new credit losses standard. Our podcast, The CECL standard - 5 things you need to know, outlines the CECL model and its impact on companies as they prepare for adoption. Further resources are available in our Loans and investments guide, In depth US2019-02, Frequently asked questions on the FASB's new credit losses standard, and In depth US2019-09, Additional FAQs on the FASB's new credit losses standard.
On April 25, 2019, the FASB issued amendments to the new credit losses, hedging and recognition and measurement standards (ASU 2019-04). The improvements to the credit losses standard address matters raised by stakeholders, including issues discussed at the Transition Resource Group for Credit Losses (TRG) meetings. Some of these amendments may have a significant impact on a company’s efforts to implement the new guidance. Topics addressed by the updates include:
For more information on the codification improvements related to the credit losses standard, refer to our In depth US2019-06, Recent amendments to the credit losses standard.
Other codification improvements to the financial instruments guidance
ASU 2019-04 also makes targeted improvements to the guidance relating to recognition and measurement of certain financial instruments and derivatives and hedging. For more information, refer to In depth US2019-07, Recent amendments to the hedging standard and In depth US2019-08, Recent developments in the recognition and measurement standard.
The CECL impairment model is applicable to lessors with net investments in leases associated with sales-type leases and direct financing leases. The FASB recognized that these receivables include both financial and non-financial elements, but concluded that the application of a single impairment model to the recognized lease asset would be preferable to assessing different components of a single asset under different impairment models.
The standard was recently amended to clarify that receivables arising from operating leases are not within the scope of CECL. The FASB noted that the new leases standard has a specific model to assess the collectability of operating lease payments and guidance on how to recognize lease income based on those payments that is operational and well understood.
The CECL model requires an allowance for credit losses to be recognized on the date that a sales-type lease or direct financing lease receivable is initially recognized. The guidance requires an entity’s estimate of expected credit losses to include a measure of the expected risk of credit loss even if that risk is remote. It also requires that the measurement of credit losses be on a collective (pool) basis when individual assets share similar risk characteristics.
In developing the CECL model, the FASB consciously allowed for a variety of acceptable techniques to estimate credit losses. Entities can utilize discounted cash flow models, undiscounted approaches, such as loss rate or probability of default/loss given default models, or other models. The application of the CECL model to net investments in leases involves some unique considerations. With respect to sales-type and direct financing lease receivables that have financial and non-financial components, entities should consider a number of factors in their analysis of estimated credit losses (e.g., rental payments, residual value of the leased asset, residual value guarantee, pooling of leases). For more information, refer to our In depth US2019-05, Application of CECL to leasing.
The new leases standard explicitly states that payments made for the use of assets under operating leases should be classified in the statement of cash flows as operating cash outflows. This classification is the same as it was prior to the adoption of the new leases standard. However, under previous guidance, when using the indirect method to prepare the statement, the difference between the straight-line lease expense and the cash paid for leases was presented as a non-cash reconciling item in operating cash flows. This treatment was consistent with the deferred/prepaid rent balance being presented as a single financial statement line item on the balance sheet.
Under the new leases standard, both a right-of-use (ROU) asset and lease liability are recorded as separate financial statement line items for virtually all operating leases. The combined change of the two accounts will generally equal the difference between the straight-line lease expense and the cash paid for leases. Some have questioned whether the single line presentation in the statement of cash flows is still appropriate given that there are now two balance sheet accounts for operating leases.
The new leases standard does not explicitly address this question and the statement of cash flows standard provides limited guidance on applying the indirect method. The statement of cash flows standard does, however, suggest that the reconciliation should separately report all major classes of reconciling items. Therefore, we believe that separately presenting the amortization of ROU assets and change in lease liabilities is consistent with the balance sheet presentation and the concept of separately reporting major classes of reconciling items. As a result, the amortization of the ROU asset would be presented as a non-cash item separate from the change in the lease liability due to cash payments.
Other views include presenting a single non-cash reconciling item similar to how it was presented under the previous guidance. Given the lack of explicit guidance, this is an acceptable alternative since the new leases standard does not characterize the single operating lease cost as the combination of two separately derived components.
The new leases standard impacts the accounting for acquired leases. The following is an overview of considerations when accounting for an acquired lease in a business combination and in an asset acquisition.
Accounting for an acquired lease in a business combination
The new leases standard amends the guidance for business combinations. In a business combination, the buyer retains the target’s previous lease classification unless the lease is modified. However, the lease liability is measured as if it were a new lease. In measuring the lease, the buyer would reassess the lease term, any lessee options to purchase the underlying asset, lease payments (e.g., amounts probable of being owed by the lessee under a residual value guarantee) and the discount rate for the lease. The ROU asset would be measured as the lease liability, adjusted for any favorable or unfavorable terms of the lease as compared to market terms. All terms of the lease (e.g., contractual rent payments, renewal or termination options, purchase options, lease incentives) would be taken into account when determining whether there are any favorable or unfavorable terms that require recognition. This includes terms that are not reasonably certain of being exercised (e.g., purchase or renewal options may have value even when not reasonably certain of exercise at the acquisition date).
The accounting for acquired leases may also be impacted by an accounting policy election specific to business combinations. If elected, leases with remaining lease terms of 12 months or less at the acquisition date would not be recognized (i.e., the buyer would not record the lease assets and liabilities). This accounting policy specifically precludes the recognition of intangible assets or liabilities related to favorable or unfavorable lease terms included within the unrecognized leases, effectively recording those leases in goodwill. The election is made by class of underlying asset and is applicable to all of a company’s acquisitions.
Accounting for an acquired lease in an asset acquisition
If an acquisition of a group of assets does not meet the definition of a business, the transaction is accounted for as an asset acquisition. Asset acquisitions are measured based on the cost to the buyer, which includes transaction costs. In an asset acquisition, goodwill is not recognized; any excess consideration transferred over the fair value of the net assets acquired is reallocated to the identifiable assets based on their relative fair values. This includes the ROU asset and any related intangibles. Keep in mind that the presence of excess consideration transferred may indicate that not all assets acquired have been recognized or that there are preexisting relationships being settled as a part of the acquisition that should be accounted for separately.
We believe a buyer should generally account for a lease acquired in an asset acquisition as a new lease under the new leases standard. Therefore, the buyer would reassess lease classification and the lease liability and ROU asset would be measured under the new leases standard as if the buyer entered into a new lease. In measuring a new lease, the ROU asset consists of the initial measurement of the lease liability and any adjustments for other items. However, the new leases standard does not have a specific provision related to the recognition of favorable or unfavorable terms of the lease. An intangible asset or liability should be recorded for favorable or unfavorable terms and generally classified separate from the ROU asset balance. The intangible asset or liability is then amortized over the term of the lease and included in lease expense. For more information on acquisition accounting for intangibles, refer to Chapter 4 of our Business combinations and noncontrolling interests guide.
Another consideration when recording leases in an asset acquisition is determining whether the buyer has previously elected the accounting policy to not apply the lease recognition requirements to short-term leases (i.e., a lease with an initial lease term of 12 months or less that does not include an option to purchase the underlying leased asset that the lessee is reasonably certain to exercise). If the short-term leases accounting policy has been elected, then the buyer would recognize the lease payments in net income on a straight-line basis over the lease term while variable lease payments would be recorded in the period in which the obligation for the payment is incurred. In an asset acquisition, however, an intangible asset or liability for any favorable or unfavorable lease terms would be recognized at the acquisition date because, unlike a business combination, there is not an accounting policy election that precludes the buyer from recording an intangible asset or liability.
For frequently asked questions related to acquisition accounting for operating leases, refer to In depth US2019-01, FAQ: Lessee accounting for right-of-use assets in operating leases.
Once companies have adopted the new revenue standard, they should be mindful of the day-to-day accounting under the new standard. One area of particular focus should be contract modifications. While prior guidance did not include a framework for modification accounting, the new standard introduced a model and established specific guidance to evaluate and account for contract modifications. The new model should be used when determining the accounting impact of changes to the scope and/or price of contracts with customers. Upon exercise, contract renewals will also need to be considered to determine whether they need to be accounted for as contract modifications.
When a revenue contract is modified, a company will need to determine whether the modification should be accounted for as a separate contract or the continuation of an existing contract. This analysis will center on which terms of the contract have changed.
Generally, contract modifications that are approved by both parties are accounted for as follows:
|Characteristics of the modification||Accounting|
|The modification adds distinct goods or services that are at a price that reflects standalone selling price||Account for the added items as a separate contract. The pre-modified contract will continue to be accounted for as it was prior to the modification. The modified element of the contract is effectively treated as a new contract and accounted for separate from the pre-modified contract.|
The modification adds goods or services that are not distinct from the goods or services already delivered under the pre-modified contract, or
The modification does not add goods or services, but the remaining goods or services are not distinct from those already delivered under the pre-modified contract
|Account for the modification as a continuation of the existing contract with a cumulative catch up, calculated by updating both the transaction price and measure of progress for the performance obligation (i.e., recognize the change as a cumulative catch-up to revenue).|
The modification adds distinct goods or services that are not at a price that reflects standalone selling price, or
The modification does not add goods or services, but the remaining goods or services are distinct from those already delivered under the pre-modified contract
|Account for the modification as a continuation of the existing contract with changes recorded prospectively by allocating the total remaining transaction price (unrecognized transaction price from the existing contract plus additional transaction price from the modification) to the remaining goods and services (i.e., those related to the existing contract and the modification).|
The Emerging Issues Task Force (EITF) started discussions on a topic recently added to its agenda related to the application of the new revenue standard to licensing arrangements, including certain aspects of accounting for renewals and other license modifications. Companies that modify contracts or often have contract renewals are encouraged to monitor the status of this project.
For more information on contract modifications, refer to Chapter 2.9 of our Revenue from contracts with customers guide.
The Treasury Department continues to work toward final regulations on various items related to 2017 tax reform. The Treasury released proposed regulations in 2018 on a number of topics, including global intangible low-taxed income (GILTI), interest deductibility limitations, and foreign tax credits. Some final regulations are expected to be released by the end of June 2019, while others may be finalized throughout the remainder of the year. Companies should keep an eye out for these final regulations, as well as others that may be issued from tax jurisdictions outside of the US. Any final regulations constitute a change in tax law and must be accounted for in the period they are enacted.
For more information on the accounting impacts of tax reform, refer to In depth US2018-01, Frequently asked questions: Accounting considerations of US tax reform. Q&A 6.3 specifically discusses the accounting for finalized tax regulations.
When there has been a significant decrease in market activity, a company needs to determine if a pricing input for an inactive security is “orderly” and representative of fair value based on available information. Assessments of whether or not transactions are orderly have recently been the subject of regulatory focus.
Although the fair value standards provide a list of factors to consider that may indicate a transaction is not orderly, we believe there is an implicit rebuttable presumption that observable transactions between unrelated parties are orderly. In our experience, such transactions are considered to be orderly in almost all instances. Therefore, the level of evidence necessary to conclude an observable transaction between unrelated parties is not orderly should be incontrovertible.
If a company does not have sufficient information to determine whether a transaction is orderly, it is still required to incorporate that transaction price when estimating fair value. In those circumstances, the transaction price may not be determinative (i.e., the sole or primary basis) for estimating fair value. For instance, when other known orderly transactions exist, there may be circumstances when less weight should be placed on transactions for which a company has insufficient information to conclude if the transaction is orderly.
Fannie Mae and Freddie Mac, together with the Federal Housing Finance Agency (FHFA), have a shared goal to develop one common mortgage-backed security. Currently, the period of time from when principal and interest payments are due on loans underlying a mortgage-backed security to when mortgage-backed security holders are paid (i.e., the remittance cycle) differs depending on the sponsored securities. Securities sponsored by Freddie Mac have a 45-day remittance cycle while Fannie Mae sponsored securities have a 55-day remittance cycle. FHFA has requested that the sponsors harmonize terms in order to achieve more parity in the two instruments. In doing so, Freddie Mac has provided investors with an opportunity to participate in a process under the Single Security Initiative that will economically modify, through an exchange of securities, the remittance cycle of existing single-class securities in order to align them with the remittance cycle of Fannie Mae’s existing single-class securities. The program began on June 3, 2019.
We believe it would be acceptable if an investor holding Freddie Mac securities applied the accounting model for modifications of receivables (ASC 310-20-35) when electing to participate in the exchange process. Under this guidance, if the new security’s effective yield is at least equal to the effective yield/market rate for newly-issued securities, and the modification is considered more than minor, then the transaction would result in derecognition of the security with the 45-day remittance cycle. Upon derecognition the investor would recognize the cash received to compensate for the ten day change in the remittance cycle and the new security at fair value. This may result in the recognition of a gain or loss in current earnings.
We understand that in most circumstances, given the anticipated size of the cash payments from Freddie Mac and because the amount of contractual cash flows (e.g., par amount and coupon) will not change, investors would likely conclude the modification is “minor” given only the timing of cash flows is being modified. However, investors should document their conclusions based on the facts of their specific transactions.
For more details, see In depth US2019-04, Freddie Mac single security exchanges.
On March 20, 2019, the SEC amended Regulation S-K to modernize and simplify certain reporting requirements for public companies, investment advisers and investment companies. The amendments were effective beginning May 2, 2019. Some of the key changes include:
For more information regarding these amendments, refer to In brief US2019-04, SEC adopts rules to simplify and modernize disclosure requirements.
On May 3, 2019, the SEC proposed significant changes to its financial disclosures required upon the acquisition or disposition of businesses. Key elements of the proposal include updating the significance test requirements, reducing the maximum number of years that audited financial statements are required and permitting the use of abbreviated financial statements under certain circumstances. Comments on the proposal are due by July 29, 2019. All interested stakeholders are encouraged to comment. For further information, see In brief US2019-06, Proposal to change SEC disclosures for businesses bought and sold.
The PCAOB’s new requirement for auditors to communicate critical audit matters (CAMs) is effective starting with audits of large accelerated filers for fiscal years ending on or after June 30, 2019. Other companies to which CAM reporting requirements apply will be required to communicate CAMs in 2020.
Although CAMs will only directly impact the report of the independent auditor, it is important for companies to be involved with their auditors to ensure that they understand the new CAM reporting requirements and how the requirements may affect their financial reporting processes. For many companies, this is being done through a “dry run” process in advance of implementing the standard. The objective of the dry run should be for management, the audit committee and the auditor to engage in early and ongoing dialogue regarding matters that could potentially be CAMs and integrate CAM reporting into the audit considering a company's specific facts and circumstances.
Many large accelerated filers participated in dry runs concurrent with their 2018 audits. Some key points noted thus far from the CAM implementation process include:
We expect further dialogue regarding CAM reporting as companies and auditors continue to learn from experience and investors begin to have access to these communications through public reporting.
For insights into the PCAOB’s expectations regarding CAM reporting, refer to their recently issued staff publications on the PCAOB's new auditor’s report implementation web page. Additionally, for further information on key considerations for CAM reporting requirements, watch our video.
Accelerated filer status for companies that have been public for at least 12 calendar months is determined based on the public float as of the last business day of the second fiscal quarter (e.g., June 30, 2019 for calendar year-end public companies). Registrants will be classified as large accelerated filers if their public float is $700 million or more, accelerated filers if their public float is $75 million or more but less than $700 million and non-accelerated filers if their public float is less than $75 million. Although filer status is based on the measurement of public float as of the second fiscal quarter, changes to filer status are not applicable until the year-end annual report. Changes to filer status can have significant impacts on financial reporting requirements, including Emerging Growth Company (EGC) status and the communication of CAMs in the audit report. Companies should work with their legal counsel to evaluate potential changes to their filer status and related impacts.
Proposed SEC amendments to the accelerated and large accelerated filer definitions
On May 9, 2019, the SEC proposed amendments to the accelerated filer and large accelerated filer definitions. The proposed amendments would exclude from the accelerated and large accelerated filer definitions an issuer that is eligible to be a smaller reporting company and has annual revenues of less than $100 million, increase the transition thresholds for accelerated and large accelerated filers becoming non-accelerated filers, and add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status, among other changes. As a result of these changes, certain low-revenue issuers would qualify as non-accelerated filers and be able to take advantage of reduced reporting requirements. The proposed changes are not expected to be effective for the 2019 determination of filer status. Comments on the proposal are due by July 29, 2019. All interested stakeholders are encouraged to comment. For additional information, refer to In brief US2019-07, SEC proposal targets capital formation by low-revenue companies.
Non-GAAP financial measures continue to be an area of focus by the SEC staff and one of the most frequent categories of comment letters received by registrants, sometimes resulting in requests to remove or substantially modify non-GAAP metrics. Focus areas have included:
For reminders on the definition and importance of non-GAAP financial measures, an overview of the SEC's rules and areas of focus and best practices for reporting non-GAAP financial measures, listen to our podcast: Non-GAAP financial measures: 5 things you need to know.
SEC Staff Accounting Bulletin (SAB) No. 74 requires a company to provide information on the status of its analysis and the impact that adoption of new standards is expected to have on its financial statements. With the 2020 adoption dates for the new credit losses standard and other new guidance approaching, companies’ SAB 74 disclosures should become more specific as the effective date of the new guidance nears.
Below is a summary of SAB 74 disclosures on the potential impact of adopting the new credit losses standard in annual and quarterly filings of companies in the S&P 500 between April 1, 2019 and May 15, 2019.
The following identifies the FASB's recently released guidance, grouped by effective date for calendar year-end PBEs.
For further information on the new accounting guidance for public companies, including available PwC resources, refer to:
For further information on the new accounting guidance for nonpublic companies, including available PwC resources, refer to:
Partner, National Professional Services Group, PwC US
Director, National Professional Services Group, PwC US