The quarter close - Fourth quarter 2017

Dec 01, 2017

This edition of The quarter close focuses on timely accounting and reporting information that can help you prepare for year-end reporting. Get up to speed on the top issues for financial reporting this quarter on our webpage - easy to read on your phone, tablet or computer.

What's covered in this edition of The quarter close

Accounting hot topics

We cover three areas outside of top line revenue that will be impacted by the new revenue standard and highlight the accounting issues to consider when assessing the impact of natural disasters.

Regulatory update

Find out more about the requirements of the recently approved auditor reporting model.

On the Horizon

Prepare for the adoption of the upcoming current expected credit loss standard by reviewing our summary of recent discussions from the FASB and other key stakeholders.

Appendix

Find out when the new accounting standards are effective for your company in the Appendix.

Accounting hot topics

Revenue impacts flow downstream

The new revenue standard will impact several areas of business. This includes accounting and financial reporting outside of top line revenue. Here are three areas that will also be impacted by the new guidance:

The new revenue standard: Compensation arrangements, Income taxes, Registration statements

Compensation arrangements

Many stock compensation awards include conditions for vesting based on revenue or other metrics that are driven by revenue, such as net income, EBITDA and earnings per share. If an award granted in previous years contains a multi-year performance target, the adoption of the new revenue standard may impact whether the target will be achieved because the new standard can change the pattern of revenue recognition or the amount of revenue recognized. Companies may need to amend these targets to provide appropriate incentives for employees. Amending awards may impact expense recognition.

The first step in determining the accounting is to understand the original terms of the award. For example, a stock compensation plan may include a specific requirement for measuring the performance target using audited financial statements or using the GAAP in existence at the grant date or in the year of measurement. The stock compensation plan may contemplate a change in the accounting guidance and require the company to keep the employee "whole" in the event of such a change. On the other hand, the plan may be silent as to the required GAAP to be used to measure the target, which may require a legal assessment.

If the company is required or able to continue to measure the award under the current revenue accounting, the company might choose to do so. However, if the company is required or chooses to change the performance target to better align it with its projections under the new revenue standard, modification accounting will be required. The impact on the timing and amount of compensation will depend on the changes made, the legal requirements and the terms of the original award.

Income taxes

The new revenue standard may change the timing of revenue recognition for book purposes, which may differ from when revenue is recognized for tax purposes.

Companies need to think about whether this timing difference generates new deferred taxes that need to be recorded. If so, they need to assess the nature of the deferred taxes to determine whether they are "direct" or "indirect" effects of adoption. Direct effects are those items that are necessary to effect a change in accounting principle. Direct effects are recorded as a cumulative effect adjustment or retrospectively, depending on the transition method adopted for the new revenue standard. Alternatively, indirect effects are those items that change current or future cash flows based on adoption of the standard. Indirect effects are recorded in the income statement in the year of adoption.

Others items to consider include the effects on outside basis differences and the calculation of earnings and profits, the availability of tax accounting method changes (e.g., electing to capitalize commission costs for tax purposes) and the impact on transfer pricing agreements.

Registration statements

If a company is planning to raise capital after filing its 2018 first quarter Form 10-Q, certain registration statement requirements will impact which periods need to reflect the new revenue standard in the registration statement.

In a new registration statement (e.g., Form S-3), companies that use the full retrospective transition method should assess if the impact of the adoption is material under the securities laws. If the impact is deemed to be material, the 2017 Form 10-K will need to be recast to reflect adoption of the new standard. As a result, an additional year (i.e., 2015) would be required to be recast for purposes of the registration statement because it is the earliest period presented in the 2017 Form 10-K. This period would not otherwise be required to be recast when the company files its 2018 annual financial statements.

The analysis would be different if a company conducts an offering as a takedown from an existing shelf registration statement. In that case, a company would not need to recast prior year information unless it concludes the adoption of the new revenue standard represents a "fundamental change," which is a legal determination.

For more information

For more information on the modification of stock based compensation, see our Stock-based compensation guide, Section 1.13, Modifications. For more information on the tax implications of the new revenue standard, see Tax accounting services: Tax considerations when adopting the new revenue standard. For more information on potential registration statements, see The new revenue recognition standard - FAQs about SEC reporting and transition. See our guidance on specific revenue topics in the following videos.

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Guidance effective in 2018 for calendar year-end PBEs

The January 1, 2018 effective date of the new revenue standard for calendar year-end public business entities (PBEs) is quickly approaching. While we know that you are working hard to adopt that standard, don’t forget about the other guidance that is also effective in 2018.  

 

For detailed information, refer to the Appendix.


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Quarter close quick cuts

In October, the AICPA published questions and answers to help companies understand the definition of a public business entity. For more information, see Recently Issued Technical Questions and Answers.


Recovering from natural disasters

This hurricane season brought several significant storms that caused flooding, wind damage and power outages. Other natural disasters, such as earthquakes and wildfires, have also resulted in loss of property. We highlight a few accounting issues to consider when assessing the impact of such natural disasters.

Accounting issues to consider when assessing the impact of natural disasters

Accounting issues to consider when assessing the impact of natural disasters: Asset impairments, Insurance claims, Subsequent events

 

Asset impairments

Companies may need to assess whether an asset impairment has occurred as a result of a natural disaster. In some cases, buildings or other assets may have been damaged or destroyed. In other cases, a company's operations may be significantly affected by the loss of a significant supplier, customer or other event.

When assessing impairment, a company should distinguish between assets that are destroyed or damaged (e.g., buildings and inventories) and those whose fair value is adversely impacted by lower projected cash flows as a result of the disaster (e.g., goodwill and receivables). Assets that are destroyed should be written off to expense. Assets that are damaged may need to be written down or their useful lives may need to be shortened. Assets with adverse changes in cash flows may need to be tested for impairment. For example, a store in a hurricane ravaged area may have lost a number of its customers, which may be an impairment indicator for certain of its assets.

Insurance

The recent natural disasters have caused significant damage to property, requiring repairs and replacements. For many companies, business has been interrupted and operations may be reduced for some time. Many companies have insurance policies. These policies may cover property, casualty, and business interruption claims. Consideration should be given to the accounting for insurance recoveries, as the recognition of proceeds will depend on the nature of the recovery.

For property and casualty claims, if recovery is probable, companies would recognize a receivable for the amount expected to be recovered up to the amount of the related loss recognized. An insurance recovery asset cannot be recorded if coverage is in dispute or if the policy is unclear as to the calculation of the reimbursable amount. The amount of the claim in excess of the loss incurred is treated as a gain contingency.

Business interruption claims that represent recovery of lost profits or revenues would also be gain contingencies. Gain contingencies would not be recognized until the insurance recovery contingency is considered realized (e.g., cash has been received or a signed agreement containing settlement terms has been executed and collectability is assured).

Subsequent events

Companies need to consider subsequent events when preparing their financial statements. If information becomes available after year-end that provides additional evidence about conditions, such as an impairment, that existed as of the balance sheet date, the financial statements are adjusted.

For more information

For more information on the accounting after a natural disaster, see In depth 2017-21, Accounting and disclosure implications of Hurricanes Harvey and Irma, and our insurance recoveries video.

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Asset groups – How low should you go?

Based on triggering events, like the recent natural disasters, companies may be testing long-lived assets for impairment this quarter. This may also be a good time to review the determination of asset groups to ensure that long-lived asset impairment testing is performed at the appropriate level. When assets are "held and used," the asset group tested for impairment must represent the lowest level of identifiable cash flows that are largely independent of the cash flows of other asset groups. Net cash flows from one asset group should not be affected by the net cash flows of another asset group. For example, retail stores may generate their own cash flows independent of other store locations, which may indicate that each store is its own individual asset group.

Relevant facts and circumstances

The determination of a company's asset groups involves a significant amount of judgment. All relevant facts and circumstances should be considered when making this determination. For example, a number of company-specific operating characteristics may be assessed. These include the interdependency of revenues between asset groups and shared cost structures. Here are some common relevant factors to consider when determining asset groups.

  • Availability of information - Use available cash flow information to determine the lowest level that independent cash flows are available.
  • Interdependent revenue - If discontinuation of revenue of one group of assets would adversely impact the revenue of another group of assets, it may be appropriate to aggregate these assets into a larger asset group.
  • Separate revenue contracts - A separate long-term revenue contract with a customer supported via a single asset may indicate that the single asset is an asset group.
  • Existence of shared assets or shared costs - A tradename may support multiple asset groups for different product lines and the value of the tradename may need to be allocated into separate asset groups for testing. However, if there are significant shared costs among a group of assets, a broader asset group including all of the costs may be appropriate.
Common factors to consider when determining asset groups: Availability of information, Interdependent revenue, Separate revenue contracts, Existence of shared assets or shared costs

For more information

For more information on asset group determination, see our Property, plant, equipment and other assets guide, Section 4.2.1, Determining the asset group.


Stay on track with valuation allowances
 

Evaluating a valuation allowance on deferred tax assets (DTAs) requires significant judgment and is highly subjective. A key reminder when evaluating a valuation allowance is to consider all positive and negative evidence. This includes weighing the evidence based on the extent to which it is objectively verifiable. A valuation allowance is needed when it is more-likely-than-not (a greater than 50% probability) that the deferred tax assets will not be realized.

The following are some factors to consider as you prepare your assessments this year.

  • Cumulative and/or current losses are a significant piece of negative evidence that can be difficult to overcome. Sometimes companies with a strong earnings history are able to prove that they had unusual or infrequent costs that indicate that a loss was an aberration. However, unusual or infrequent gains in the same period also need to be considered.
  • Even if a company records no goodwill impairment, it might still need a valuation allowance on its DTAs. Although both assessments should start with the same forecasts, only the portion of the forecast that is objectively verifiable can be used to support future taxable income projections in a valuation allowance assessment. Keep in mind that goodwill impairment and valuation allowance assessments are different and could produce different results.
  • If a company has a net operating loss (NOL) carryforward that does not expire, a valuation allowance may still be needed. For example, companies may still need a valuation allowance when there is not enough evidence to support that there will be future taxable income in the foreseeable future to realize the DTAs.
  • A company with a net deferred tax liability (DTL) could still need a valuation allowance against its deferred tax assets. This is because DTLs may not reverse into taxable income in a period that allows for realization of the benefit from a DTA. For example, in the case of an indefinite-lived intangible asset, the deferred tax may only reverse in the event of a future impairment or sale, so reversal cannot be anticipated. Therefore, while a DTL may exist, a company would generally not be able to rely on it as a future source of taxable income. That is, these DTLs would not support the realization of the DTAs.
The following are some factors to consider as you prepare your assessments this year: Cumulative and/or current losses, Objectively verifiable forecasts, Indefinite-lived carryforwards, Reversal timing of DTLs

For more information

For more information on assessing the need for a valuation allowance, see our Income taxes guide, Chapter 5 - Valuation allowance.


State aid investigations – consider the latest developments

The European Commission (EC) State aid investigations have been in the headlines again and more developments are likely in the near term. As with all tax positions, companies operating in the European Union (EU) need to monitor the latest developments as they finalize their year-end accounting.

State aid. Companies operating in the European Union need to continually assess the latest developments.

What is State aid?

EU member countries set and administer their own tax law. They may grant favorable tax rates, subsidies, exemptions, or other concessions to companies. Many of the high-profile EC State aid investigations relate to concessions granted by certain EU member states (including Luxembourg, Ireland and the Netherlands). The EC has questioned whether these decisions constitute unlawful State aid—when a company receives discretionary governmental support through which it receives an unfair advantage over its competitors. If so, the EC typically requires the country involved to recoup taxes related to specific State aid from the company named in the investigation.

Accounting for potential State aid exposures

In many cases, State aid assessments fall under the accounting guidance related to uncertain tax positions. Companies should assess the potential effect of continuing developments on existing uncertain tax positions, and amounts owed for periods previously considered closed. State aid should also be a consideration when establishing any new tax positions.

On the other hand, other accounting standards, such as the contingency guidance, may apply to some forms of unlawful State aid, including non-income based incentives, such as tariff reductions. It is important for companies to understand the nature of the State aid issue to determine whether other guidance may be applicable.

 

Regulatory update

Auditor reporting model finalized

On October 23, the SEC approved the PCAOB's new auditor reporting model, which sets forth the most significant changes to the auditor's report in over 70 years. Some of the provisions will be effective for 2017 calendar year-end audits. These changes include: disclosure of auditor tenure, changes to clarify the auditor's role and responsibilities, and changes to standardize the form of the report, making it easier to read. Under Phase 2, communication of critical audit matters (CAMs) is required for audits of large accelerated filers for years ending on or after June 30, 2019. CAMs will need to be included in reports for other companies to which the requirements apply in years ending on or after December 15, 2020.

In the SEC's order approving the standard, the Commission acknowledged that communicating CAMs will be a significant change in practice for auditors, companies and audit committees. The SEC called on the PCAOB to take steps to closely monitor the implementation of the new standard. Companies should discuss these requirements with their auditors.

For more information

For more information, please see In depth 2017-29, SEC approves PCAOB standard changing the auditor reporting model, and watch our video.
 

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SEC staff comment letter trends

Through analysis of the SEC staff comment letters made public during the 12 months ended June 30, 2017, we have noted a decrease in the overall number of comments issued by the SEC staff in most sectors compared to the prior year. While most of the SEC staff's focus areas this year have remained consistent, there was an increase in the volume of comments related to the use of non-GAAP financial measures, which now ranks as the most frequent comment area. This is consistent with our expectations given the SEC staff’s 2016 update to its Compliance and Disclosure Interpretations and other public comments about their focus in this area.

The other most frequent focus areas include:

  • Management's discussion and analysis
  • Internal control over financial reporting
  • Business combinations
  • Impairments
  • Revenue recognition
  • Income taxes
  • Segments

Understanding the SEC staff focus areas will help improve the quality of your year-end financial reporting.

For more information

For information on these and other recent SEC comment letter trends, see our industry-specific SEC comment letter trends.

Disclosure trends

With the adoption dates for the new standards on revenue recognition, leases and credit impairment approaching, companies should consider their SAB 74 disclosures. These disclosures should become more specific as the effective date of a standard nears.

Below is a summary of the potential impact of adopting the revenue, leases and credit losses standards as disclosed in annual and quarterly filings by the Fortune 500 between October 1, 2017 and November 14, 2017.

Below is a summary of the expected method of adoption of the revenue standard as disclosed by the same companies.

 

On the horizon

Recent developments in current expected credit loss guidance

The FASB and other stakeholders, including representatives from the SEC, FDIC, Federal Reserve Bank and Office of the Comptroller of the Currency have discussed several open questions relating to the current expected credit loss (CECL) guidance. CECL will be effective January 1, 2020 for calendar year public business entities. The results of those discussions will allow companies to move forward with more certainty in their implementation efforts.

Estimating lifetime expected credit losses

The CECL model requires entities to use historical data adjusted for current conditions and reasonable and supportable forecasts to estimate expected credit losses over the life of an instrument (after consideration of prepayments). For the period beyond which management is able to develop a reasonable and supportable forecast, the new standard states that an entity should revert to unadjusted historical loss information either at an individual input level or at the overall estimate level. At the 2017 AICPA National Conference on Banks and Savings Institutions, a number of stakeholders shared insights on how entities should approach estimating lifetime expected credit losses. Some of the key messages included:

  • The output of management's estimation process should reflect management’s best efforts in estimating expected credit losses.
  • The allowance under the CECL model is an accounting estimate and will require judgment. To the extent that reversion to historical data is a component of this estimate, the timing and method of reversion is not an accounting policy election. Similarly, the selection of historical loss information that an entity will “revert to” is not an accounting policy election. Management should retain documentation supporting the estimate.
  • The reasonable and supportable forecast period is dynamic and may change over time. An entity is not expected to perform backtesting on the forecast period to validate the accuracy and length of the forecast.

Zero credit losses

Some companies have questioned whether there are other asset classes (in addition to US Treasuries) for which an expectation of non-payment of zero may be appropriate. To date, some key stakeholders have not objected to a view that Ginnie Mae, Fannie Mae (FNMA) and Freddie Mac (FHLMC) pass-through mortgage-backed securities can qualify for zero expected credit losses under the new framework. The factors considered in reaching this conclusion include the long history of zero credit losses, the explicit guarantee by the US government (although limited for FNMA and FHLMC securities), and yields that, while not risk-free, generally trade differently than a risk-free rate based on market views of prepayment and liquidity risk (not credit risk). However, management should continually re-evaluate whether an assumption of zero credit losses is appropriate for these instruments.


Recent developments in recognition and measurement guidance

In September, the FASB issued several technical corrections to the new guidance for the recognition and measurement of financial instruments. Several of these corrections focus on an accounting alternative available for equity investments without a readily determinable fair value, known as the measurement alternative. The technical corrections clarified that the prospective transition approach for equity instruments that do not have a readily determinable fair value is only appropriate for investments for which the measurement alternative has been elected.

For more information

For more information on the recent developments in these areas, see In depth 2017-30, Recent developments in financial instruments.


Appendix

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Beth Paul
US Strategic Thought Leader, National Professional Services Group
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Partner, National Professional Services Group
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Director, National Professional Services Group
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