The quarter close - Third quarter 2018
Sep 13, 2018
What's covered in this edition of The quarter close
Front and center
Find out more about the practical expedients issued and amendments proposed by the FASB to help companies apply the new leases standard.
Accounting hot topics
We offer key reminders about accounting for the impacts of tax reform and other guidance that is effective now and in the future.
Regulatory update
We share information about SEC staff comments on revenue disclosures and companies' SAB 74 disclosures related to the upcoming leases and credit impairment guidance.
Hot off the press
Learn more about the FASB's guidance clarifying the accounting for implementation costs in a cloud computing arrangement.
Most calendar year-end public companies are in the midst of preparing for adoption of the new leases standard on January 1, 2019. The FASB has issued several practical expedients and proposed others over the last few months to assist companies with the implementation of the standard. This issue of The quarter close includes details of the latest developments and highlights key considerations for companies as they prepare to adopt the new standard.
New guidance issued
In response to stakeholder feedback, the FASB issued new guidance on July 30, 2018 that will make adoption of the new leases standard easier and more cost effective. The new guidance includes the following items:
- A new transition method, whereby comparative periods presented in the financial statements in the period of adoption do not need to be restated
- A new practical expedient that allows lessors to avoid separating lease and associated nonlease components within a contract if certain criteria are met
Under the new optional transition method, amounts and disclosures prior to the date of adoption will continue to be presented under current US GAAP and will not need to be restated. To initially apply the new lease requirements at the effective date, companies would record a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The new transition method does not impact the manner of adoption; companies will still need to apply the modified retrospective transition approach when implementing the new guidance.
The new practical expedient also provides lessors with the option to aggregate nonlease components with the associated lease component of a contract, if certain conditions are met. If a lessor elects to aggregate, it will need to determine if the predominant characteristic of the combined component is the lease or nonlease component. This may require judgment and will determine whether the combined component should be accounted for under the new revenue standard or the new leases standard. Additional disclosures relating to the election of the practical expedient are required.
Refer to PwC's In brief US2018-18, Adopting the new leases standard just got easier, for more details on this new guidance.
Proposed guidance
On August 13, 2018, the FASB proposed several amendments to the leases standard for lessors related to:
- Accounting for sales taxes (and other similar taxes) collected from lessees: Allows lessors to make an accounting policy election to exclude from contract consideration sales taxes (and other similar taxes) collected from lessees.
- Certain lessor costs paid directly by lessees (e.g., property taxes and insurance): Requires lessors to exclude from contract consideration costs paid directly by lessees if the amounts are not readily determinable by the lessor.
- The recognition of variable payments for contracts with lease and nonlease components: Clarifies that variable payments allocated to nonlease components should be recognized in accordance with other guidance (e.g., revenue guidance).
The comment period closed on September 12, 2018. The FASB is expected to issue a final standard in the fourth quarter of 2018.
For more information on the new leases standard, refer to our on demand webcast, Leases: What you need to know as you prepare to adopt the new guidance, and read our In depth US2018-15, Lease accounting transition: Index or rate for measuring operating lease liability, about accounting for variable lease payments based on an index or a rate during transition. Also, see our video library on CFOdirect.com for additional guidance on adopting the new leases standard.
In assessing renewal and termination options, companies need to determine whether there is an economic incentive for the lessee either to exercise a renewal option or not to exercise a termination option. Examples of factors that could create economic incentives include:
- Pricing of a renewal option below market rates
- Significant leasehold improvements
- Significant lease termination or relocation costs
- Importance of the leased asset to the lessee’s operations
Determining the appropriate lease term is also important to assessing whether a lease qualifies for the short-term lease exception. Lessees are not required to apply the new recognition guidance to leases with terms at lease commencement of 12 months or less.
For additional insights, see our video on determining the lease term.
Discount rate
When discounting lease payments to determine the lease liability, the new leases guidance requires companies to use the rate implicit in the lease when it is readily determinable. Otherwise, a lessee should use its incremental borrowing rate (IBR). Under the new guidance, the IBR should reflect a fully secured rate for a loan with payment terms similar to those of the lease. Depending on a company’s existing financing structure and lease portfolio, obtaining a secured borrowing rate for a term and payment pattern similar to the lease may be challenging. As a result, companies may need to derive an appropriate rate. Some potential methods to determine the secured rate include:
- Start with an existing unsecured rate and then make adjustments to come to a secured rate
- Start with the term and pattern of payments under an existing borrowing and make adjustments to reflect the provisions of the lease
The process may vary depending on the circumstances and available information. For further information, watch our video on determining the discount rate.
Variable lease payments
Not all variable payments required by lease arrangements are included in calculating the lease liability. Variable payments that change based on an index or a rate, such as the consumer price index (CPI), or a benchmark interest rate, such as LIBOR, are included in the measurement and classification of a lease based on the index or rate that existed at lease commencement. Subsequent changes in rent from changes in indices or rates are period expenses when the index or rate changes. Lease arrangements often include variable payments based on usage, such as excess mileage in a car lease, or performance, such as a percentage of sales in a retail store. These types of variable payments are not included in the measurement of the lease liability and instead are recorded in the period in which the variability is resolved (i.e., once the payment amount is known).
The improper assessment of variable payments could have a significant impact on the lease liability recorded by a lessee.
For more information on evaluating variable lease payments, see our video.
As companies finalize their accounting for the impacts of tax reform, it is important to consider the following reporting requirements.
Accounting implications of lifting the indefinite reinvestment assertion
As a result of tax reform, previously undistributed foreign earnings were subject to a one-time federal tax, and current and future foreign earnings are now generally subject to a 100% dividend received deduction for federal purposes. If a company’s book basis in a foreign subsidiary exceeds the federal tax basis, a change in the indefinite reinvestment assertion could have accounting consequences.
Companies will need to consider the following accounting consequences of a decision to no longer assert indefinite reinvestment.
- Certain state jurisdictions may only tax earnings once they are repatriated. Therefore, for state tax purposes, a company's book basis may still be higher than its tax basis, requiring a deferred tax liability if the company is not asserting indefinite reinvestment.
- A foreign jurisdiction may assess a withholding tax upon earnings distribution. Since this withholding tax is the responsibility of the parent company, a deferred tax liability would need to be recorded at the US parent company level. Any withholding tax payable is likely due in a foreign currency, which means that any change in the foreign currency exchange rate will impact the withholding tax liability. Any such rate changes are recorded as a transaction gain or loss in the income statement.
- For US federal tax purposes, any movement in currency exchange rates between the date that the earnings were included in taxable income and the date those earnings are distributed may result in incremental deferred taxes associated with those currency-related gains/losses.
For more information, refer to Section 5 of In depth US2018-01, Frequently asked questions: Accounting considerations of US tax reform, and watch our video. Also, keep an eye out for our In depth on this topic, expected to be issued in the coming week.
Recording deferred taxes for Global Intangible Low-Taxed Income (GILTI)
In accordance with the SEC staff's guidance, companies are required to finalize their accounting for the impacts of tax reform no later than the period that includes December 22, 2018. The GILTI tax is one area in particular where many companies have yet to finalize their accounting.
A company may elect to treat GILTI as a period cost, or it may elect to record deferred taxes for basis differences that are expected to reverse as GILTI in future years. The FASB acknowledged that the current accounting guidance for income taxes is not clear as to the measurement of GILTI deferred taxes. However, there are aspects of the existing guidance that can provide some direction. We believe that measuring GILTI deferred taxes can, to a certain extent, be analogized to the accounting for foreign branches and to the accounting for outside basis differences. However, there are unique considerations that do not fit into either approach, including:
- How the 50% GILTI deduction should be accounted for with respect to GILTI deferred taxes;
- How the anticipated effects of GILTI foreign tax credits should be considered; and
- How the net deemed tangible income return should be taken into account. The net deemed tangible income return is calculated as 10% of the tax basis of tangible depreciable assets.
Before electing to treat GILTI as a period cost or record deferred taxes, companies should ensure that they fully understand the accounting ramifications under each alternative. Also, keep an eye out for our In depth on this topic, expected to be issued in the coming week.
Realizability of net operating losses for companies that are subject to GILTI
The inclusion of GILTI in a company's US taxable income may result in reduced (or no) cash tax savings from net operating loss carryforwards (NOL) due to the mechanics of the new tax law. As a result, companies are required to make an accounting policy election as to whether this reduction in cash tax savings from the utilization of their NOLs will be included in their valuation allowance assessments.
The FASB staff believes that the existing accounting guidance for income taxes supports two acceptable policies:
- Incremental cash tax savings approach
To conclude whether the related deferred tax asset for the NOL is realizable, a company would determine whether the NOL reduces expected cash taxes payable. Companies could determine whether the NOL provides cash tax savings through use of a with-and-without calculation. A valuation allowance would be required on any amount of the NOL deferred tax asset that does not provide incremental cash tax savings. - Tax law ordering approach
This approach does not consider the reduction in cash tax savings as part of the valuation allowance assessment. Instead, a company would follow the ordering of the tax law to determine whether the existing NOL deferred tax asset is expected to be realized. Under the tax law, NOLs are expected to reduce the GILTI inclusion before considering the effects of the available 50% GILTI deductions and foreign tax credits. The fact that the company will be unable to utilize the future unrecognized 50% deduction or foreign tax credits that may otherwise have been available in the absence of the NOL carryforward is irrelevant. Simply put, if the NOL will be used, it is realizable.
The two policies could yield significantly different valuation allowances on the same NOL deferred tax asset.
This accounting policy election applies to any US company with foreign subsidiaries that qualify as controlled foreign corporations for which a GILTI calculation must be prepared (regardless of whether it results in incremental taxes payable), and that has NOLs, or deferred tax assets that are expected to reverse and generate an NOL in the future. Companies should consistently apply their accounting policy election and make appropriate disclosure in the footnotes to their financial statements.
For more information, refer to our In depth US2018-10, Tax reform triggers need for new accounting policy - Assessing the impact of GILTI on realizability of NOLs, and watch our video.
Accounting in highly inflationary economy - Argentina
In May 2018, the International Practices Task Force of the Center for Audit Quality discussed the inflationary status of Argentina and categorized it as a country with a projected three-year cumulative inflation rate greater than 100%. As a result, calendar year-end companies should begin to account for operations in Argentina as highly inflationary no later than July 1, 2018.
For companies using IFRS, Argentina should be considered a hyper-inflationary economy for periods ending after July 1, 2018. Unlike US GAAP, when reporting under IFRS, the change in functional currency should be applied as if the economy had always been hyper-inflationary for comparative periods presented.
For more information, read In brief US2018-14, Monitoring inflation in Argentina, and refer to Chapter 6 of our Foreign currency guide.
Definition of a business quick cut
The guidance clarifying the definition of a business became effective this year for calendar year-end public business entities (PBEs), and will be effective in 2019 for all other entities. This new guidance impacts how companies assess the accounting for acquisitions and dispositions, the determination of reporting units in goodwill impairment testing, and certain other areas.
In Episode 39 of our CFOdirect podcast series, we provide clarity around some of the practical challenges faced when applying this new guidance. We also discuss a number of implications companies should be careful not to overlook. For example, US GAAP states that to be a reporting unit, a component of an operating segment must constitute a business or a nonprofit activity. Because of the change in the definition of a business, a company may have reporting units that no longer meet the definition of a reporting unit. This could impact the results of the goodwill impairment test.
The new credit impairment model
The standard addressing the new current expected credit loss (CECL) model is effective for calendar year-end PBEs beginning on January 1, 2020.
Assessing the impact of CECL
CECL requires companies to recognize an allowance for expected lifetime credit losses through earnings concurrent with the recognition of a financial asset measured at amortized cost (i.e., a day-one loss). This estimate of expected credit losses will be shown as a valuation allowance against the financial asset’s amortized cost, resulting in presentation of the net carrying value at the amount expected to be collected on the financial asset. The estimate of expected credit losses is required to be adjusted each reporting period over the life of the financial asset.
Developing an estimate of expected credit losses will require companies to make reasonable and supportable forecasts of expected future credit losses. Prior to adopting the new guidance, companies will need to determine an appropriate forecasting methodology (i.e., using a discounted or undiscounted cash flow methodology) and the period over which a reasonable and supportable forecast can be made. If a reasonable forecast cannot be made, the estimate should be based on historical loss data, as required by the guidance. Companies will also need to consider the effect of collateral that serves to mitigate credit losses.
The new guidance may have significant impacts on a company’s valuation processes (potentially requiring the use of valuation experts), systems, and controls. Financial services companies will be broadly impacted by the new credit loss guidance. Non-financial services companies also hold financial assets that will be subject to CECL, including trade receivables and financial guarantees.
Trade receivables and CECL
Currently, most non-financial services companies reserve for credit losses on trade receivables through the application of historical loss rates, by aging category, to the period-end trade receivables balance. Under CECL, companies will have to consider whether such historical loss data requires adjustment for reasonable and supportable forecasts of future losses both when initially recording a trade receivable and in subsequent reporting periods.
Guarantees and CECL
At the inception of a guarantee, a guarantor recognizes a guarantee liability on its balance sheet at fair value. CECL requires that a liability for the expected credit losses related to the guarantee be recognized at the same time as the guarantee liability. This results in the recognition of two separate liabilities at inception of the guarantee.
The guarantee liability (i.e., deferred revenue) would then be recognized in earnings upon settlement of the guarantee or amortized systematically over the life of the guarantee. Meanwhile, the estimate of expected credit losses would be independently adjusted each reporting period while the guarantee is outstanding. This results in guarantee revenue being presented separate from the related allowance provision on the income statement.
Accounting for the expected credit loss estimate is independent of the accounting for the guarantee liability. For example, the guarantee liability may be amortized ratably over the term of the guarantee whereas the credit loss estimate should be assessed periodically to reflect changes in default risk.
For more information on the new credit losses guidance, please refer to In depth US2018-08, How the credit impairment standard impacts non-financial services companies, In depth US2018-09, Transition Resource Group for Credit Losses: June 2018, In the loop, Preparing for the new credit loss model, and our Loans and investments guide. Also, watch our video about how guarantors should apply the CECL guidance related to guarantees.
Planned LIBOR phase-out
Interbank rates are widely used as interest rate indices in the global financial markets. For example, the London Interbank Offered Rate (LIBOR) is utilized in a number of US dollar denominated contracts. LIBOR is referenced in contracts globally for bonds, loans, derivatives (currency and interest rate swaps), and other financial agreements. LIBOR is calculated based on submissions from contributing banks. Following the financial crisis, questions arose around LIBOR due to the subjectivity of the professional judgment applied by the contributing banks in developing submitted rates, the lack of active underlying markets from which to derive such rates, and the potential for manipulation.
In July 2017, the Financial Conduct Authority, the UK regulator responsible for the oversight of LIBOR, announced that it would no longer require banks to participate in the LIBOR submission process and would cease oversight over the rate after the end of 2021. While not yet finalized, it is expected that successor rates to LIBOR will likely be agreed to in the near future. Various industry groups continue to discuss replacement benchmark rates, the process for amending existing LIBOR-based contracts, and the potential economic impacts of different alternatives. For example, in the US, a proposed replacement benchmark rate is the Secured Overnight Funding Rate (SOFR), which is an overnight rate based on secured financing. In contrast, LIBOR has a term structure and is based on unsecured financing. As a result, companies should consider updates to contract terms that reference a spread over the index rate to ensure the economic value remains similar or unchanged.
The replacement of LIBOR is expected to be a challenge for the financial markets and will impact various stakeholders, including financial instrument issuers and investors, administrators, financial institutions and end-users. Given the effort required and the potential impact on their financial instruments, companies should:
- Review contractual terms in arrangements to determine the impact on existing agreements;
- Evaluate the economic, legal, accounting, and tax ramifications of amending their agreements;
- Understand the implications when negotiating any new agreements; and
- Actively monitor and contribute to ongoing industry dialogue on the matter.
For more information, refer to PwC's dedicated LIBOR and reference rate reform page.
The following graphic identifies the FASB's recently released guidance, grouped into three categories — those standards that are effective for calendar year-end PBEs in 2018, 2019, and 2020.
Guidance effective now for calendar year-end PBEs
Guidance effective in 2019 for calendar year-end PBEs
Guidance effective in 2020 for calendar year-end PBEs
For further information on the new accounting guidance, including available PwC resources, refer to the following links.
Effective dates for new FASB guidance for calendar year-end public companies
Effective dates for new FASB guidance for calendar year-end nonpublic companies
Disclosure observations
Revenue: SEC comment letters
Many public companies adopted the new revenue standard in the first quarter of 2018. The new standard requires significantly more disclosure than the prior guidance. These qualitative and quantitative disclosures are intended to provide greater transparency about the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The SEC staff has been issuing comments on the new revenue disclosures as part of its financial statement review process. These comments are being issued to companies across multiple industries and cover a variety of topics.
The SEC staff’s questions and a company's responses generally become publicly available no earlier than 20 business days after the comment letter process is completed. Therefore, there is currently a limited population of publicly available comments. While it is still too early to identify trends, the following areas are among those addressed by the SEC staff’s comments:
- Performance obligations – the nature of performance obligations, why goods or services are distinct, and disclosure of remaining performance obligations
- Variable consideration – the determination of the transaction price and how a company estimates variable consideration
- Recognizing revenue – the timing of when control transfers, the method of recognizing revenue over time, and accounting for licensing arrangements
- Costs to obtain a contract – the determination of the appropriate costs to capitalize, the amortization period, and related disclosures (including election of practical expedients)
- Gross versus net presentation – judgments related to gross versus net presentation of revenue, including an assessment of whether the company controls the good or service being provided to the end customer
- Inconsistencies – disclosures that appear inconsistent with information provided in other parts of the filing or in other forums, such as investor presentations
Although the SEC staff's comments provide some insight into areas where disclosures could be improved, the SEC staff does not issue comments on every company’s financial statements or every disclosure within a filing. Importantly, the fact that the staff did not comment on a particular disclosure does not necessarily indicate that the disclosure is sufficient or compliant. We expect that disclosures related to the new revenue standard will continue to evolve as best practices emerge.
SAB 74
With the adoption dates for the new standards on leases and credit impairment approaching, companies should ensure their SAB 74 disclosures become more specific as the effective date of each 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 July 1, 2018 and August 10, 2018.
On August 29, 2018, the FASB issued guidance addressing a customer's accounting for implementation costs incurred in a cloud computing arrangement (CCA) that is considered a service contract.
Under the new guidance, implementation costs for a CCA should be evaluated for capitalization using the same approach as implementation costs associated with internal-use software. The capitalized implementation costs should be expensed over the term of the hosting arrangement, which includes any reasonably certain renewal periods. Capitalized implementation costs should be assessed for impairment similar to long-lived assets.
Under the new guidance:
- Capitalized implementation costs should be presented in the same line item on the balance sheet as amounts prepaid for the hosted CCA service, if any (generally as an "other asset").
- The amortization of capitalized implementation costs should be presented in the same income statement line item as the fees associated with the hosted CCA service. Accordingly, the amortization of capitalized implementation costs should not be included with depreciation or amortization expense related to property, plant, and equipment or intangible assets.
- Cash flows related to capitalized implementation costs should be presented as operating activities, consistent with the presentation of cash flows for the fees related to the hosted CCA service.
Companies are required to disclose the nature of the hosting arrangements that are service contracts and significant judgments made when applying the guidance. Additionally, companies are required to provide quantitative disclosures, including amounts capitalized, amortized, and impaired.
When is it effective?
The new guidance is effective for fiscal years beginning after December 15, 2019 for calendar year-end PBEs. Early adoption is permitted, including adoption in any interim period. Prospective adoption for eligible costs incurred on or after the date of adoption or retrospective adoption are permitted.
For more information, refer to In depth US2018-14, Cloud computing arrangements: Customer accounting for implementation costs, and watch our video.
Acquisition accounting for an assumed liability in a revenue contract
In March 2018, the FASB asked the EITF to address the recognition of a revenue contract with a customer that is acquired in a business combination after the company has adopted the new revenue standard. Currently, there are diverse views. Some believe that only legal obligations should be recognized as liabilities by the acquirer under the acquisition method. Others believe performance obligations, as defined in the new revenue standard, should be recognized as liabilities. Additionally, the FASB staff was directed to provide educational information on questions that may arise when measuring these assumed liabilities.
Further deliberation is expected on this topic at the September 27, 2018 EITF meeting. Please refer to EITF observer, Summary of the June 7, 2018 meeting, for more information on the EITF's discussions.
Simplifying the balance sheet classification of debt
In August 2018, the FASB met to discuss its project to simplify the balance sheet classification of debt. Under the proposed guidance, debt would be classified as current or noncurrent based on the contractual rights of the lender and the borrower at the balance sheet date. Debt would only be classified as noncurrent if it is contractually due to be settled more than one year from the balance sheet date or if the borrower has a contractual right to defer settlement for at least one year after the balance sheet date. The proposed guidance would prohibit the consideration of events occurring after the balance sheet date when determining the classification of debt, with the exception of waivers for debt covenant violations received after the balance sheet date but before the financial statements are issued.
One of the key proposed changes from current US GAAP impacts short-term debt refinanced on long-term basis after the balance sheet date. Currently, US GAAP permits noncurrent classification, provided certain conditions are met. This will no longer be permitted under the proposed guidance.
Another key change from current US GAAP relates to subjective acceleration clauses (SAC). Currently, US GAAP requires companies to consider the probability of future acceleration of the debt due to a SAC in determining classification. Under the proposed guidance, a SAC will only impact classification when it is triggered prior to or on the balance sheet date.
At its August 2018 meeting, the FASB tentatively concluded that any unfunded financing agreements that are in place as of the balance sheet date should not impact classification of funded debt instruments. In other words, classification of the funded debt instruments will be based solely on the contractual rights of those funded debt instruments at the balance sheet date.
As an example, assume a company has the following arrangements in place on its balance sheet date: $1 million of term debt maturing in six months, and an unfunded financing agreement that would permit the company to borrow $1 million on a long-term basis after the balance sheet date. Under the proposed guidance, the term debt would be classified as current, although the company has the unfunded financing agreement in place on its balance sheet date.
The guidance is expected to be issued later this year and would be effective for calendar year-end PBEs beginning in 2021.
Fair value measurement quick cut
On August 28, 2018, the FASB issued an update that amended the fair value measurement guidance by removing and modifying certain existing disclosure requirements, while also adding new disclosure requirements. The amendments are effective for all companies for fiscal years, and interim periods within those years, beginning after December 15, 2019. Early adoption is permitted for all amendments. Further, a company may elect to early adopt the removal or modification of disclosures immediately and delay adoption of the new disclosure requirements until the effective date.
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