FINANCIAL REPORTING UPDATE
Norman N. Strauss
Ernst & Young LLP
March 25, 1997
[Introductory note: Norman N. Strauss is a partner
of Ernst & Young LLP. He is the firm's National Director of
Accounting Standards and a member of the firm's Accounting and Auditing
Committee. His duties include consultation on accounting issues
and developing the firm's positions and publications on accounting
matters. He is a CPA and a member of the American Institute of Certified
Public Accountants. He has a B.B.A. ('63) and an M.B.A. ('69) from
Mr. Strauss is Ernst & Young's representative
on the FASB's Emerging Issues Task Force. He has previously served
as chairman of the AICPA's Accounting Standards Executive Committee
(AcSEC) and chaired or served on various other Task Forces of AcSEC,
including Task Forces on the Conceptual Framework of Accounting,
LIFO, and Accounting for Stock Options. He is also a member of the
Financial Reporting Committee of the Institute of Management Accountants
and the FASB's Impairment of Assets Task Force. He also was a member
of the FASB's Cash Flow Task Force. Mr. Strauss has frequently lectured
to many business organizations on various accounting topics, has
been published in the Journal of Accountancy and elsewhere,
and has taught at NYU's Stern Graduate School of Business Administration.
It is a pleasure for me to present an accounting update at Baruch
College tonight. The FASB and AICPA have been very busy for the past
few years, issuing quite a few new accounting and disclosure standards
and proposals. What I plan to do is update you on implementation issues
for the newest standards on earnings per share, stock compensation,
asset impairments, environmental remediation liabilities, and critical
FASB and AICPA projects currently under way, such as derivatives and
hedging, consolidations, segment reporting, comprehensive income,
and internal-use software, which may significantly affect corporate
reporting in the future. I'll finish with a discussion on the future
of financial reporting. Now, on to the first topic on financial instruments.
For eleven years, the FASB has been working on various aspects of
its Financial Instruments project. This year, it explicitly acknowledged
that its goal is to eventually require the recording of all financial
instruments at fair value. To move toward that goal, the Board worked
this year on hedging and derivatives and on transfers of financial
assets. As a result, it has given you plenty of material to absorb.
Let's start with derivatives. Risk management and hedging are common
activities through all of industry today, so the Board's project is
going to have a significant impact on many companies. Because problems
with derivatives continually make headlines, it's no surprise that
the FASB had to act to develop an accounting model on hedging and
derivatives. And the new approach the Board selected is extremely
complex and controversial.
The FASB issued its Exposure Draft last June, and it took 100 pages
to explain the proposed rules. Shortly after that, the FASB staff
had to issue twenty more pages of Questions and Answers to try to
explain it even better. The bottom line of its proposal is that it
will cause a significant change in the hedge accounting model that
is in use today.
In drafting the proposed accounting standard, the Board set out to
rectify four perceived problems with existing guidance for derivatives
- Incomplete accounting guidance. Existing accounting guidance
is limited and narrow in scope. FASB statements govern only the
accounting for futures contracts and foreign currency forwards
and similar types of contracts. In addition, the AICPA drafted
a paper discussing accounting for options more than ten years
ago, but it is not authoritative and it was never finalized. A
few EITF issues address some specific derivatives issues, but
there is no overall accounting model and there is no FASB guidance
that specifically addresses the most rapidly growing derivatives
market-interest rate swaps.
- Inconsistent accounting guidance. Despite the fact that
little guidance exists, what does exist is often contradictory.
In fact, accounting treatment may differ simply based on the type
of contract utilized, whether it be a foreign currency forward
or a futures contract or an interest rate swap.
- Complex accounting guidance. The lack of one comprehensive
accounting standard has resulted in the development of numerous
analogies to other guidance, which also has led to confusion,
- Lastly, the effects of derivatives are not transparent.
Different approaches result in different measurements of derivatives.
Some derivatives may be recorded on the balance sheet while others
may not. For example, interest rate swaps are not recorded as
assets or liabilities even though their values are changing all
the time because of fluctuating interest rates. Users of financial
statements say they find it difficult to figure out the related
effects of derivatives on a company's results.
The FASB believes its proposal will rectify each of these perceived
problems. The entire proposal is based on four key FASB decisions
- Derivatives are assets and liabilities and should be reported
in the financial statements because they are rights or obligations
that may be settled in cash.
- Fair value is the most relevant measurement of financial instruments
and the only relevant measurement for derivatives. Ultimately,
as I said, the Board expects that all financial instruments will
be recorded at fair value. The derivatives proposal is simply
an interim step on that road.
- Only assets or liabilities should be reported in the financial
statements. Bottom line: the FASB does not believe that deferral
accounting is appropriate for derivatives. In its view, deferring
a loss on the balance sheet as an asset violates its conceptual
framework, even though that loss may be part of a hedging strategy.
- Finally, the FASB will allow a form of special hedge accounting.
However, because special accounting provisions would permit companies
to delay the recognition of derivative gains and losses, the requirements
to meet the so-called "hedged criteria" are very strict.
Having set that foundation, the proposal would establish the accounting
and disclosure requirements for all companies for all hedging and
Before I get into the proposed rules, I should start by answering
the question, what is a derivative? Classically defined, a derivative
is a financial instrument that derives its value from the price movements
of an underlying index. That underlying index may be an interest rate,
foreign currency price, commodity price, or almost any other price
The proposal would refine that definition somewhat. First, the proposal
would continue the classic definition, stating that the holder (or
writer) of the derivative has the right (or obligation) to participate
in some or all of the price changes of a reference index. Under the
definition, any contract that requires ownership or delivery of the
underlying instrument would not qualify as a derivative. This is intended
to scope out plain purchase contracts for raw materials. On the other
hand, if settlement of the contract could result in a net cash
payment, it is a derivative.
The Board then went a little further, having observed that some securities,
such as structured notes, often act like derivatives by experiencing
big swings in value when the underlying indices change. So the proposal
includes many structured notes in the definition of a derivative.
As a result, even if the financial instrument meets no other criteria
for a derivative, it would be classified as a derivative if its cash
flows are subject to erratic changes. Those changes must result from
either using a multiple or some other means to magnify the effects
of a change in the price index. Consider an oil-indexed bond where
the interest payment is based upon a multiple of the change in the
price of a barrel of oil. Because of the multiplying feature, this
contract would be considered a derivative.
Now let's get into the accounting. The proposal would establish one
basic rule: all derivatives would be recognized and measured at fair
value regardless of the purpose or intent for holding the derivative.
This rule represents a dramatic change from current practice and is
intended to ensure that the effects of derivatives used by a company
are clearly visible to users of the financial statements. Thus, all
off-balance-sheet derivatives in practice today, such as interest
rate swaps, would be recorded as assets or liabilities and be carried
at fair value. Now, the big question is, how should those changes
in value be recorded?
Although the FASB probably would like to require that these changes
be recognized in income, it decided it couldn't go that far quite
yet. The FASB reluctantly recognized a need for some type of special
hedge-like accounting for those derivatives that are used as part
of risk management activities.
The FASB identified three different hedge relationships, and the
proposed accounting is different for each. Changes in fair value for
derivatives not qualifying for one of these three categories would
be recognized in income. The three hedging categories are:
- Hedges of changes in fair value;
- Hedges of changes in cash flow; and
- Hedges of a foreign currency exposure of a net investment in
a foreign operation.
A fair value exposure is a potential exposure to earnings resulting
from changes in the fair value of all asset or liability. A typical
example would be the change in value of a fixed-rate, long -- term
debt obligation. This could be hedged by swapping it to a variable
interest rate. A fair value hedge also can cover assets, such as investments
or inventories, and firm commitments.
A cash flow exposure is a potential exposure to earnings resulting
from future variable cash flows, for example, interest obligations
on a floating-rate debt obligation or a commercial paper program.
Interest rates could be swapped from variable to fixed. Other examples
would be the exposure to price changes for a commodity to be used
in a company's operations in the future or anticipated sales in a
foreign currency. These are referred to as forecasted transactions.
The foreign currency exposure of a net investment in a foreign subsidiary
represents risk that changes in the value of the investment in a foreign
subsidiary will be impacted by the changes in the foreign exchange
rate of the subsidiary's local (functional) currency as compared to
the parent's reporting currency.
Derivatives hedging fair value, cash flow, or foreign currency exposures
still would be recorded at fair value. However, the "special
accounting" rules would permit companies to reduce their impact
on earnings. But every benefit has a price. In order to use these
"special accounting" provisions, companies would be required
to meet several hurdles known as the "hedge criteria." So,
before I get into the accounting for hedging, I should first discuss
these criteria. There are all extensive number of hedge criteria,
including ten for fair value hedges and eight for cash flow hedges.
Many of the hedge criteria are somewhat generic, applying to each
of the three types of hedge situations. For example, each hedge transaction
would be required to be consistent with the company's established
risk management policy and would have to be formally documented, and
the change in fair value or cash flows of the derivative would have
to move substantially in all equal and opposite direction as the same
changes for the hedged item or transaction. Others are very specific,
such as a prohibition in most cases to use written options as a hedge.
And, most important, this is all optional; hedge accounting only applies
if management designates the derivative as a hedge at inception.
Now let's review the various accounting treatments. First, remember
that the derivative must always be measured and recorded at fair value.
The special accounting simply addresses how those fair values -- and
any changes in those fair value -- are recorded in earnings.
For fair value hedges, the related change in the unrealized gain
or loss on the derivative would be recognized immediately in earnings.
"Special accounting" would permit companies to simultaneously
recognize the gain or loss on the hedged item in earnings. But companies
would only be permitted to recognize the gain or loss on the hedged
item for the risk being hedged to the extent that it offsets the gain
or loss on the derivative.
The special accounting for cash flow hedges is also peculiar. The
derivative would still be recorded at fair value in the balance sheet.
But the related gain or loss would be recorded in equity rather than
earnings. The gains and losses on the derivative would only be recorded
in earnings when the forecasted transaction was originally projected
to occur. Thus, this approach may cause volatility in equity.
Not only are changes in values of the derivative recorded in equity,
but they also are considered to be a component of comprehensive income.
Later, we will talk about another FASB proposal that would require
that a Statement of Comprehensive Income be presented as a basic financial
statement. That proposal is perhaps even more controversial than this
In the third hedging category, the proposal also permits special
accounting for multinational companies that have foreign exchange
exposure related to their net investment in foreign operations. The
proposal generally continues current practice as defined by Statement
52. Accordingly, derivatives, as well as cash instruments, can continue
to be used to hedge net investments. Changes in their fair value arising
from foreign currency fluctuations will continue to be recognized
in the translation adjustment in stockholders' equity.
Well, those are the three hedging categories. But there is one more
category, and that's the "all other" derivative category.
Any derivative not qualifying for or designated as a hedge falls into
this category. This means that changes in fair value of these derivatives
are recognized immediately in income.
Any FASB statement would be incomplete without a multitude of disclosure
requirements, and this proposal is no exception. The approach in the
Exposure Draft is to require details, such as the objectives for holding
the derivative and gain or loss information by category. So, there
would be separate disclosures for fair value, cash flow, and net foreign
investment hedges, as well as for "all other" derivatives.
In addition, the SEC recently issued a new rule that would significantly
increase the disclosures about derivatives and other financial risks.
The FASB held public hearings on the proposal in November 
and plans to finalize the proposal in the second quarter of 1997.
They have recently been making several changes to the proposal, which
would retain some of the more traditional hedging approaches, but
it looks as if all derivatives will be going on the balance sheet
at fair value. As planned, the proposal would apply to all entities,
and all companies would have to adopt the proposal for years beginning
I have one more financial instrument topic to cover briefly. The
FASB has been developing accounting guidance for transfers of financial
assets and extinguishments of liabilities since late 1993. This effort,
commonly referred to as the Securitizations Project, resulted in the
issuance of Statement 125 last summer. It was effective January 1,
1997, but certain transactions impacting mostly broker-dealers were
deferred until 1998.
The Statement provides new accounting and reporting rules for the
sale, securitization, and servicing of receivables and other financial
assets. The basic issue is whether a transfer of financial assets
is a sale or a financing. Essentially, any transfer of a financial
instrument by any type of entity is included in the scope of Statement
125. As a result, the statement impacts transactions ranging from
the multibillion dollar market for credit card securitizations to
transfers of trade receivables by commercial and industrial companies.
Under the new rules, some transactions that are currently recorded
as sales of assets (and, therefore, are off balance sheet) will have
to be treated as financing transactions unless the transaction structures
are revised. The current requirements are basically in Statement 77,
which is superseded by Statement 125, and entirely new criteria are
replacing it. Statement 125 looks to control; if you no longer control
the receivables, take them off the books.
Sales are distinguished from financings under the new rules based
on whether the assets are legally placed beyond the reach of the seller
and, more importantly, beyond the reach of its creditors. Transfers
that do not meet this condition would be accounted for as financing
Additionally, the transferee must have the right to pledge or exchange
its interest in the transferred assets. If that right is restricted
by the seller, the transaction would be accounted for as a financing.
Finally, if a transferor maintains some control over the transferred
assets, the transfer could not be accounted for as a sale. Such a
control feature might include agreements requiring the transferor
to repurchase the assets.
The conditions just described must all be met for a transaction to
qualify for sales treatment.
These criteria are far more stringent than current practice, which
focuses on whether a transfer purports to be a sale and surrenders
control over the economic benefits of the receivables. Statement 125
places a much greater emphasis on legal and physical control over
a transferred asset.
Assuming a transfer can be recognized as a sale, the Statement requires
that the seller use a "financial components" approach to
measure the gain or loss on the transaction. Under this approach,
a seller would record at fair value whatever new instruments it obtains,
such as a recourse obligation or puts and calls to reacquire the receivables.
Then the seller would derecognize financial assets for which control
has been surrendered based on the relative fair value of the components
transferred and those retained. One impact of this accounting treatment
is that the gain or loss from the sale is likely to be different than
the amount determined under the old rules.
Statement 125 covers various other topics such as selling receivables
to a special purpose entity (which can be a sale when certain criteria
are met), loan participation transactions, repurchase agreements,
and security lending transactions. In addition, it clarifies when
debt is extinguished and it supersedes Statement 76 -- there will
be no more in-substance defeasances. The new rules are complex, and
companies that are involved in these type of transactions will have
to spend time learning them.
AGGREGATION AND DISAGGREGATION
In this section, I will first discuss aggregating or consolidating
financial statements, and then we will switch to disaggregating them
and presenting segment information. Besides derivatives, these are
the Board's two biggest projects. The basic standard on consolidations,
one of the oldest accounting standards, was issued in 1959, and even
though we may take how to consolidate for granted, the Board believes
radical change is necessary. Under present practice, majority ownership
is the threshold for consolidation. However, the Board, in an Exposure
Draft it issued in October 1995, proposes revising the old standard
and replacing it with a control-based consolidation policy. Under
the Board's approach, an investing company would consolidate all entities
it controls, even if it owns less than 50 percent of the stock, unless
control is temporary at the time an entity becomes a subsidiary. This
means more subsidiaries would be consolidated.
Control would be broadly defined as the power over another entity's
assets, that is, the power to use or direct the use of those assets
to achieve the objectives of the controlling entity. Under this definition,
each situation would require a subjective assessment of the specific
facts and circumstances to determine if effective control exists and
if consolidation is required. The Board received 125 comment letters
on the proposal, held public hearings, and is currently redeliberating
the issues and hopes to move the project along. However, because most
letters opposed the proposal, it is not clear at this time whether
the next step is a final statement, a revised Exposure Draft, a breakup
of the project into pieces, or discontinuance of the entire project.
With that introduction, let me summarize what the proposal calls for.
The Exposure Draft addresses both consolidation policy and procedures
and covers all businesses regardless of legal form, including partnerships,
special purpose entities, trusts, and not-for-profit entities. The
bottom line is that if the proposal is issued, it would increase the
number of subsidiaries that are consolidated.
Companies generally would be consolidated if they are legally controlled,
that is, over 50 percent of the voting common stock is owned by an
investor. That certainly isn't controversial. However, the Board is
introducing a new concept of effective control. The ED identifies
six circumstances that generally would lead to a presumption that
effective control over an entity exists. If any of those circumstances
are present and in the absence of evidence to the contrary, there
would be a presumption that the entity should be consolidated. Those
circumstances are as follows:
- Ownership of a large minority voting interest (approximately
40 percent) and no other party or organized group of parties has
a significant interest.
The proposed Statement would require consolidation of a 40-percent-owned
entity in circumstances where an investor has effective control
because no other party or group of parties has a significant interest
to override the decisions of the 40 percent investor. I believe
that if you own 40 percent, you don't really have control and
the over-50-percent ownership rule is much better. Why change
it if it's not broken?
- An ability demonstrated by a recent election to dominate the
process of nominating candidates for another entity's governing
- Unilateral ability to obtain a majority voting interest through
ownership of securities that may be converted into a majority
voting interest at the option of the holder.
Under the proposal, the unilateral ability to take control, say
by converting convertible debt, represents a current ability to
take control of another entity at will. Therefore, you might consolidate
a company even though you currently own no voting stock.
- A relationship with an entity that provides substantially all
future net cash inflows or other future economic benefits to its
This presumption relates to special purpose entities (SPEs), and
this is one area where I believe the FASB should provide additional
guidance because of all of the new SPEs being formed.
- A unilateral ability to dissolve an entity.
- Lastly, a sole general partnership interest in a limited partnership.
As a result of restrictions and limitations relating to the liabilities
of limited partners, a general partner usually is deemed to have
effective control of the limited partnership even if it has an
insignificant ownership interest. The Board believes even a one
percent general partner would consolidate the partnership if it
As if this isn't enough, effective control also may exist in circumstances
other than those in which a presumption of control exists. The ED
describes nine indicators that suggest that control can be exercised,
and these would have to be evaluated to see if consolidation is necessary.
That's the overall approach on consolidation policy. The proposal
would require many difficult judgment calls, and I believe it's much
too subjective to be operational. Now let's see what the Board wants
to do with the basic consolidation procedures.
One of the most controversial consolidation procedure issues relates
to the treatment of minority interest in the consolidated financial
statements. The Board decided that a minority interest, which most
companies present between liabilities and equity, should be classified
in the stockholders' equity section of the balance sheet. In addition,
in a major change in income statement reporting, minority interest,
which the Board has renamed "noncontrolling interest" (because
it may be more than 50 percent), would be presented as a deduction
after consolidated net income to compute "net income attributable
to the controlling interest." This income statement treatment
would be similar to that of dividends on preferred stock.
Intercompany transactions and gains and losses would continue to
be eliminated, and that's about the only thing the Board isn't trying
to change. The Exposure Draft would change the accounting for partial
acquisitions, and now the Board is thinking that goodwill would be
attributed to the controlling and noncontrolling interests. This means
that if you buy 60 percent of a company, the amount of goodwill you
record would approximate what it would have been if you bought 100
Furthermore, changes in a parent's ownership that occur after a subsidiary
is acquired that do not result in a loss of control would be accounted
for as transactions in the equity of the consolidated entity and no
gain or loss would be recognized. The same accounting would apply
if the subsidiary issues its stock to others. The amount of the change
in a parent's proportionate ownership interest in a subsidiary would
be reported as an increase or decrease in additional paid-in capital
and as a corresponding decrease or increase in the noncontrolling
I believe the existing consolidation rules are not broken and do
not need the FASB's proposed fix. Existing standards in this area
are not seriously flawed, and financial statement users have no pressing
need or desire for changes of the type being proposed by the FASB.
We will have to wait and see what happens.
Another hot topic on the FASB's agenda is the disaggregated disclosure
project. In January 1996, the Board issued an Exposure Draft on reporting
disaggregated information about a business enterprise. The proposed
statement would require that public business enterprises report financial
and descriptive information about their operating segments. The proposal
would replace the current industry segment disclosure requirements
contained in FASB Statement No. 14, Financial Reporting for Segments
of a Business Enterprise.
The proposal was developed in close coordination with the Accounting
Standards Board of the Canadian Institute of Chartered Accountants
that issued an essentially identical proposal in Canada. In addition,
the International Accounting Standards Committee issued a proposal
in December 1995, entitled Reporting Financial information by Segment,
but it is more like Statement 14 than the Board's proposal. The FASB
will continue to meet with the Canadian Board and the IASC to attempt
to minimize the differences between their proposals.
The FASB's proposed statement would be effective for fiscal years
beginning in 1997, and it hopes to issue a final statement in the
second quarter of 1997.
One main reason for this project is that many users of financial
statements have complained loud and clear that segment reporting needs
improvement. Let's take a look at the differences between the current
and proposed approach to reporting segment information. FASB Statement
14 requires annual disclosure of disaggregated information on two
bases: by industry and by geographic area. Statement 14 has been criticized,
primarily by analysts, who believe that many companies give inadequate
segment information, and too many enterprises contend that they are
in only one segment and thus not subject to segment reporting at all.
In addition, critics say that the current segment reporting approach
in the footnotes is (1) inconsistent with the way management describes
the business in the text of the annual report and MD&A, (2) that
it does not provide enough information, and (3) that segment information
is not provided on a quarterly basis.
Due to these criticisms, the Board decided that the industry segment
approach of Statement 14 can't be saved, and, therefore, it developed
a whole new approach. In what could be a radical change for some companies,
the FASB concluded that there should be much more detailed segment
reporting and that segment reporting should be driven by the way an
enterprise is managed rather than by defined industry segments. Under
this approach, commonly referred to as the "management approach,"
a company would disclose information about operating segments that
would correspond to the way the company is organized and the way financial
results are evaluated internally by management. In other words, internal
reporting would be the sole basis for external segment reporting.
The Board believes that this approach to segment reporting would allow
financial statement users to better understand the enterprise's performance,
better assess its prospects for future net cash flows, and make more
informed judgments about the enterprise as a whole.
Operating segments under the proposal are revenue producing components
of the enterprise for which separate financial information is produced
internally. These segments are subject to evaluation by the chief
operating decision maker, a new FASB term, in deciding how to allocate
resources. This means an operating segment could be a division, a
department or subsidiary. The decision maker may be an individual,
such as a CEO or COO, or a group, such as an executive committee,
if decision-making authority rests with that group. A business unit's
separate financial statements must be reviewed internally by the decision
maker and the unit must have an individual in charge who reports directly
to the decision maker (unless the decision maker is in charge of the
business unit) in order to qualify as an operating segment.
Under this approach, there will be much less comparability than in
current practice because many companies in the same business manage
themselves differently. For example, a company that is managed by
product line and a company that manages by geographic locations will
hardly report comparable segment information.
The "first level" of disclosures for each operating segment
would include detailed information about balance sheet and income
statement items. The level of detail to be disclosed depends on whether
the information is included in the financial report used by the decision
maker. Some of the disclosures would be new, such as significant non-cash
items, income tax expense, interest income, and interest expense.
In addition to all this disclosure, unfortunately, the Board also
has decided to require a "second level" of disclosure of
revenues by products and services for all segments that are not based
on products and services, even if this information was nor regularly
reviewed by the company's management. For example, if management reports
internally based on geographic locations, it still would have to provide
product information in the footnotes. And if it reports by product,
geographical information may be necessary.
And, in another important change, limited quarterly segment reporting
would be required. Analysts believe that this is the single most important
item needed to improve existing segment reporting, and the FASB is
giving it to them.
Conceptually, the management approach may seem logical. In fact,
many companies initially supported the management approach, but that
support faded because of the details required to be disclosed by the
proposal. I believe existing rules generally provide adequate guidance
for industry and geographic segment disclosures, and, in my view,
the proposed volume of disclosures is excessive. Furthermore, if the
management approach is really viable, it seems that a second level
of disclosure would not be necessary. If management does not need
the information to manage its business, users of financial statements
should not need it either.
I also believe every effort should be made by the Board to reconcile
differences with the IASC. If the two standard setters can't reconcile
differences on a disclosure standard, it suggests that there may not
be much hope for harmonizing other U.S. and international accounting
Based on where we are today, although there will be some changes,
it looks as if the FASB will be going forward with a final statement
adopting the management approach sometime in 1997.
OTHER ACCOUNTING RULES AND PROPOSALS
Now I'll go over several final rules and proposals. In late 1995
the FASB issued Statement No. 121, Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,
and it was effective for 1996. Statement 121 requires certain long-lived
assets to be classified in one of two categories: held-for-use or
to-be--disposed-of. All held-for-use assets, like property, plant,
and equipment, must be tested for impairment if there are indicators
that the assets are impaired. That recovery test is performed by comparing
the undiscounted cash flows expected from the asset to its carrying
amount. If the carrying amount is more than the undiscounted cash
flows, the asset is impaired and its carrying amount is reduced to
the fair value of the asset. If an asset is to-be--disposed-of and
its carrying amount is greater than the asset's fair value, then the
carrying amount is reduced to that fair value.
We surveyed companies that have already reported Statement 121 impairment
losses to see what kind of disclosures they have been making, and
much of it is what you might expect. For example, impairment indicators
that have been disclosed include weak sales, increased competition,
excess capacity due to restructurings, and operating results much
worse than expected.
Companies also commented on how they calculated fair value. Some
mentioned third-party appraisals and others stated they used the present
value of future cash flows. One company added that "considerable
management judgment is necessary to estimate future cash flows, and
actual results could vary."
On that last point, if a company's estimate of cash flows is just
a little more than book value, for instance, $10.1 million for an
asset with a book value of $10 million, and no loss is recorded, the
AICPA's SOP 94-6 on risks and uncertainties requires an "early
warning" signal that the company came pretty close, and who knows
what might happen next quarter.
Disclosure also is required that adopting Statement 121 caused an
accounting change. One company said it now measures impairment on
a property-by-property basis rather than in the aggregate. Another
mentioned using a retail store-by-store basis rather than larger groupings.
And, if the impact of adoption is material, expect a fourth paragraph
in the auditor's report mentioning the accounting change.
Regarding income statement presentation, many companies presented
the charge as a separate line item, using captions like "write-down
of equipment" or "impairment charges." One company
labeled the charge, as "carrying value reduction of property,
plant, and equipment," which is a subtle way to say the same
My last point on disclosure is that some companies managed to add
a positive note to the impairment by stating that the charge will
provide a noncash benefit in the future from reduced depreciation,
and they even quantified it.
Although Statement 121 hasn't been around very long, there have been
several implementation issues. Some were discussed by the EITF, but
a consensus wasn't reached, so the FASB added a project to its agenda
to address various impairment questions. Examples of the ten to fifteen
issues that may be addressed include:
- How to apply the Statement 121 approach for recognizing impairment
to all goodwill.
- Whether APB 30 on discontinued operations should be amended
to say that assets to be disposed of should be measured the same
as under Statement 121.
- When does an asset move from the held-for-use category to the
to-be-disposed-of classification? This is a potential problem
if the asset will be used for a while before being sold.
- Lastly, If you buy a business with three divisions and you
plan to sell one within a year, how do you do the lower of cost
or fair value calculations?
Another FASB standard that affected companies in 1996 is the FASB's
controversial Statement No. 123, Accounting for Stock-Based Compensation.
Under the Board's new fair value method, the fair value of stock options
are measured on the date of grant. This amount is then recognized
as compensation expense over the service period (generally the vesting
period). Fortunately, Statement 123 will let companies recognize that
amount in pro forma net income and earnings per share rather than
in the income statement.
To determine the fair value of a stock option, the standard requires
that an option pricing model, such as the Black-Scholes model or a
binomial model, be used to value options at the date of grant. The
calculations are complex, but fortunately computer software is available
to crunch the numbers.
Option pricing models require the use of several input variables.
Three of these input variables are easy to determine -- the current
price of the underlying stock, the exercise price of the option, and
the risk-free interest rate during the expected life of the option.
But the other three are subjective -- the expected life of the option,
that is, when the option holders are expected to exercise the option;
expected dividends on the stock during the option life; and the expected
volatility of the underlying stock price. Volatility of a stock rezlates
to how much a stock price might fluctuate. The greater the volatility,
the greater the value of an option.
Although the FASB is encouraging companies to apply the new fair
value method and recognize compensation expense in the income statement,
companies are still permitted to continue with the APB 25 measurement
approach, provided that they disclose pro forma net income and EPS
information "as if" the new fair value approach had been
adopted. The vast majority of companies stuck to the current accounting
under APB 25 and made the pro forma disclosures which are required
for 1995 as well as 1996 grants. In addition, pro formas are presented
for both 1995 and 1996. It will be interesting to see what the analysts
will do with the pro forma information or if disclosing significantly
lower pro forma earnings will impact stock prices.
On a brighter note, last month the FASB issued Statement 128 on earnings
per share in an effort to simplify the EPS calculation and promote
international harmonization for public companies. Under the FASB's
Statement, primary earnings per share will be replaced with a new,
simpler calculation called "basic earnings per share." Basic
EPS will be calculated by dividing income attributable to common shareholders
by the weighted average shares outstanding during the period. In a
significant change from current practice, it will not include the
effects of any dilutive securities such as stock options or convertible
debt. This will substantially reduce the complexity of the current
primary EPS calculation. The existing calculation of fully diluted
earnings per share will not change much but is renamed "diluted
earnings per share." This will reflect the dilutive impact of
options and convertible debt.
Generally, the new basic earnings per share calculation will produce
a higher earnings per share number than the present primary EPS calculation
because it does not reflect dilution from stock options and convertible
debt instruments. However, the new diluted earnings per share could
be similar to fully diluted earnings per share. One big question for
preparers is, which number will the investors and capital markets
focus on and what would be the effect on stock prices?
Statement 128 is effective December 31, 1997, and is essentially
the same as the new IASC Standard No. 33.
Now, let's move on to a new standard that was issued in late 1996
and will have an impact on companies in 1997. SOP 96-1, Environmental
Remediation Liabilities, was issued by the AICPA through its Accounting
Standards Executive Committee, or AcSEC. Like the FASB, AcSEC also
establishes accounting standards, but only if the FASB clears them.
While AcSEC often addresses industry-specific issues, such as banking,
real estate, and insurance, its new standard on environmental liabilities
will have a widespread impact on many companies.
The SOP consists of an overview of federal environmental laws, accounting
guidance on issues relating to the recognition, measurement, and disclosure
of environmental liabilities, and audit guidance. The objective of
the SOP is to improve and narrow the way existing accounting guidance
is applied to the recognition of the enormous costs of environmental
remediation, including the cleanup of superfund sites. This could
result in earlier recognition of environmental liabilities for many
Environmental remediation involves a sequence of events occurring
over a long period of time that are designed to clean up past contamination.
Because of the nature of this process, determining when to recognize
an environmental liability can be difficult. To help make that determination,
the SOP uses the current guidance in FASB Statement 5, Accounting
for Contingencies, as its framework. Consistent with Statement
5, the environmental claim must be asserted or be probable of assertion
in order to be accrued. Because of the legal framework of most remediation
claims, AcSEC concluded that if a company had any association with
a site, there is an expectation that the outcome of an asserted claim
or a probable unasserted claim will be unfavorable. In other words,
the company is going to have to pay something.
To promote consistency, the SOP also contains benchmarks to be considered
when evaluating the existence and amount of an environmental remediation
liability. Those benchmarks for a Superfund cleanup include six events
beginning with the identification and verification of a company as
a potentially responsible party (PRP) and ending with cleaning it
up and monitoring afterwards. The SOP tells you when to start recording
Even though a company may be unable to reasonably quantify the total
costs of the remediation effort, it should still record a liability
for part of it. Companies, in other words, should accrue the best
estimate of the costs to be incurred.
The SOP also tells us how to measure the liability. In addition to
incremental direct costs of the remediation effort, the SOP requires
the accrual of costs of compensation and benefits for employees who
are expected to devote time directly to the remediation effort.
The SOP also requires that measurement of the liability be based
on enacted laws and existing regulations. Discounting would be allowed
but only if the aggregate amount of the obligation and the amount
and timing of cash payments for a site are fixed or reliably determinable,
which is expected to be a rare occurrence. For the companies that
are one of several PRPs for a given site, the SOP also clarifies that
a company should determine its allocable share of the liability based
on its best estimate of the method and percentage that ultimately
will be allocated among the PRPs. Finally, the SOP provides guidance
on measuring recoveries. Insurance claims would have to be probable
of recovery before they could be recognized.
The SOP is effective beginning in 1997, and this will result in many
companies changing how they record environmental liabilities. The
effect of initially applying the SOP will be included in continuing
operations as a change in accounting estimate. Thus, companies that
have to record additional environmental cleanup liabilities will take
a hit to operating income in 1997.
Now let's discuss several proposed rules.
One of the FASB's most controversial proposals is on reporting comprehensive
income. Opposition has been overwhelming, and I'll discuss why.
First, a little background. Comprehensive income is defined in the
FASB conceptual framework as, essentially, all changes in shareholders'
equity exclusive of transactions with owners (such as capital investments
and dividends). Thus, comprehensive income includes net income plus
changes in certain assets and liabilities that are reported directly
in equity. Examples are unrealized gains and losses on available-for-sale
securities, translation adjustments on investments in foreign subsidiaries,
and certain changes in minimum pension liabilities. As I mentioned
before, the FASB's Exposure Draft on derivatives would require gains
and losses on hedges of forecasted transactions also to be included
in comprehensive income.
Although comprehensive income has been part of the FASB's conceptual
framework for years, the Board has not required that it be presented
separately. However, as the Board has added more items as direct adjustments
to stockholders' equity, some financial statement users have complained
about the difficulty of identifying these amounts.
In a radical change in practice, the Board would require that amounts
for total comprehensive income and comprehensive income per share
be reported in a basic financial statement with equal prominence as
net income and earnings per share. Those amounts could either be reported
in a single statement with net income or in a separate statement of
Many believe that presenting net income and comprehensive income
with equal prominence will cause substantial confusion for financial
statement users. For those reasons, all overwhelming majority of respondents
to the proposal (including Ernst & Young) vehemently oppose it.
As a result, the FASB has agreed to make significant changes before
it is finalized.
In another FASB project, what started out as accounting for nuclear
decommissioning costs by public utilities has turned into an Exposure
Draft on closure and removal obligations for everyone. Under the Exposure
Draft, closure and removal obligations incurred at the time all asset
is constructed or shortly thereafter, such as all offshore drilling
rig that has to be removed when there is no more oil left or cleaning
up a landfill, would be recorded as a liability using the present
value of the estimated cash flows. So, the estimated costs of closing
down a nuclear plant in 40 years would have to be recognized as a
liability up front. That liability would be capitalized as part of
the asset's basis and depreciated.
My next topic is accounting for costs of developing or obtaining
internal-use software. In recent years, organizations have spent tremendous
amounts of money and time on developing and acquiring internal use
software. However, there are no accounting rules on whether the costs
should be expensed or capitalized, and, as a result, recently AcSEC
issued a proposed standard addressing this issue. Under the proposed
rules, companies would be required to capitalize internal use software.
This would be a change in practice for the majority of companies that
expense these costs as incurred. Capitalized costs would include:
- External direct costs (such as purchased software);
- Payroll and payroll-related costs for employees directly associated
with and devoting time to the project; and
- Related interest costs.
However, allocated overhead and training costs could not be capitalized.
Capitalization would begin after management, with the relevant authority,
approves and commits funding to a computer software project and believes
that it is probable that the project will be completed and the software
will be used to perform the function intended. In addition, the project
would no longer be in the R&D stage.
The capitalized costs would be amortized over the estimated useful
life of the software in a systematic and rational manner. In a breath
of fresh air, the proposed rules would produce no new disclosure requirements.
If adopted as proposed, the rules would be effective for costs incurred
beginning in 1998.
While we're speaking of software costs, in July 1996 the EITF addressed
how to account for Year 2000 costs -- the costs required to make computers
functional when the ball drops at the stroke of midnight on New Year's
Year 2000 conversion costs are a business issue with which I'm sure
you are all familiar. Most computer systems based on two-digit years
(e.g., "96" for 1996) are not programmed to consider the
start of a new century, unless they have been recently modified. Systems
that process Year 2000 transactions with the year "00" may
encounter significant processing inaccuracies and even inoperability.
For example, systems that are not Year 2000 compliant could produce
accounts receivable aging reports that are inaccurate, miscalculate
the pay-out schedules on debt, or cause a vendor to miss a customer
product shipment because the shipping date is invalid.
Many companies will incur significant time and expense to fix this
software problem. Some analysts predict that expenditures will exceed
$400 billion worldwide. Now is the time for companies to address this
issue -- there will be no extending this deadline. The EITF concluded,
at the urging of the SEC, that Year 2000 costs should be expensed
as incurred. However, if a company buys a whole new system and throws
the old one out, then it is not covered by this consensus and may
follow its normal policy for software capitalization.
AcSEC also is working on accounting for start-up costs, which include
costs of opening new retail stores and developing new products. AcSEC
would require most kinds of start-up costs to be expensed as incurred.
AcSEC is also addressing such topics as software revenue recognition
and the movie industry. You'll need to keep an eye on AcSEC projects
to stay up to date.
In addition to the normal standard-setting activities, there have
been some developments that, In the long term, may significantly impact
the future of financial reporting. I'll briefly mention some of them
An Invitation to Comment was issued by the FASB to solicit views
on recommendations that were made to standard setters by the AICPA
Special Committee on Financial Reporting and the Association for Investment
Management and Research (AIMR). These recommendations deal with such
subjects as developing a comprehensive model of business reporting,
reporting separately core and noncore activities, associating auditors
with nonfinancial information, and promoting forward-looking disclosures.
While I do not support any fundamental change to the present financial
reporting model, I believe action is necessary to address the "disclosure
overload" problem that exists today. The FASB should take the
initiative in instituting a comprehensive review of existing disclosure
requirements with the objective of ensuring that only decision-critical
and cost-effective information is required to be disclosed.
In addition, the FASB and its parent organization, the Financial
Accounting Foundation (the "Foundation"), have undergone
some internal changes. In response to an SEC request in 1996, the
Foundation agreed to approve four more "public interest"
representatives with SEC approval of such appointees. For a while,
there was some concern about whether standard setting was going to
stay in the private sector, but this compromise settled things down
and perhaps will strengthen the Board's independence. Also, the FASB
has completed a review of its goals, objectives, and processes and
updated its strategic plan to try to enhance the standard-setting
process. Among other things, the strategic plan sets a goal to complete
projects within three years, which will be quite an undertaking for
the FASB. At the same time, it will attempt to promote international
Well, there sure were plenty of topics to cover. Users and preparers
contended with new rules on impairment of long-lived assets and stock
options, and in 1997 we have new rules on transfers of assets, environmental
remediation, and EPS. In addition, there are proposed rules on consolidation,
segments, comprehensive income, closure and removal costs, and internal-use
software, and, between the FASB and SEC, there is plenty happening
Because many of these projects will continue to be discussed, debated,
and finalized in 1997, I encourage you to keep an eye on them. They
could have a significant impact on financial reporting for many companies.
Thank you for attending today. I hope I helped you keep up to date
and that you have enjoyed the presentation.