Assurance Principal Jennifer Goodman presented "What Was the FASB Thinking?," a discussion and examples of unusual accounting rules, at the 2013 Decosimo Accounting Forum hosted by the University of North Alabama on July 19.

1. A Global Reach with a Local Perspective
www.decosimo.com
UNIVERSITY OF NORTH ALABAMA
2013 ACCOUNTING SEMINAR
WHAT WAS THE FASB THINKING?
JENNIFER GOODMAN | July 19, 2013

2.  Examples of unusual accounting rules
 Common sense might not prevail!
 The Rule with “The Kicker” – An Example – Discuss
What was the FASB thinking?
 Don’t believe me, I wouldn’t either
 Business card with # of unusual accounting rule and I
will email standard
OVERVIEW

3.  Accrue cost in connection with exit or disposal of
operating lease or other contract
 Recognize cost to officially terminate contact before
end of term as a liability at fair value upon termination
 Recognize continued cost without economic benefit at
cease use date as a liability at fair value
#1 Contract Termination Costs – The Rules

4.  Measuring fair value of operating lease
 FV is based on the remaining lease rentals reduced
by actual or estimated sublease rentals
 “The Kicker”: Sublease rental income included in the
FV determination even if the entity does not intend to
enter into a sublease
#1 Contract Termination Costs – The Rules

5.  Operating lease rentals of $100,000 per year for 10
years
 After six years, the entity commits to an exit plan
 Remaining lease rentals will be $400,000
 Market rentals for similar property, sublease $75,000
per year
 The entity decides not to sublease the facility (or
otherwise terminate the lease) at the cease use date
#1 Contract Termination Costs – Example

6.  Expected net cash flows of $100,000 ($100,000
outflow for 4 years less $75,000 inflow for 4 years)
 Discount using a credit-adjusted risk-free rate of 8%
 The fair value is $89,000 using an expected present
value technique
Explain this to the board of directors!
Actual cash outflow over 4 years $400,000
Recorded liability $89,000
#1 Contract Termination Costs – Example

7.  Entity receives economic benefit not to sublease.
 The entity will recognize the impact of deciding not
to sublease the property over the period the property
is not subleased.
#1 What was FASB thinking?

8.  Other costs associated with exit or disposal should be
recognized at fair value in the period the liability is
incurred
 Liabilities - probable future sacrifices of economic benefits
arising from present obligations to transfer assets or
provide services in the future as a result of past
transactions or events
 Generally corresponds to the period in which the goods or
services associated with the activity are received
 “The Kicker”: Commitment to an exit or disposal plan by
management does not, by itself, result in the incurrence
of a liability
# 2 General Exit or Disposal Costs–The Rule

9.  Board approves a plan on 12/1/12 to close Line 5; line 5
moved to line 2 April 2013
 Management prepares an estimate of cost that will be
incurred with includes:
 $250k be paid in 2013 to engineering consultants
 $250k internal wages to shut line down and move to Line 1
 $1M relocation cost to be paid to third party to move
usable equipment to Line 1 and set-up
 $2M impairment of unusable equipment
Exit cost accrual at 12/31/12 = $0, Impairment of assets held
for sale $2M
# 2 General Exit or Disposal Cost - Example

10. The Board decided to address the accounting and
reporting for costs associated with exit or disposal
activities because entities increasingly are engaging
in exit and disposal activities and certain costs
associated with those activities were recognized as
liabilities at a plan (commitment) date that did not
meet the definition of a liability.
#2 What was FASB thinking?

11. If a period of time is required in order to construct or
carry out other activities necessary to bring an asset
to usable condition, interest cost incurred during
that period shall be capitalized as a part of the
historical cost of that asset.
“The Kicker”: Interest cost to be capitalized includes
interest on debt that is not related to the project.
#3 Capitalizing Interest – The Rules

12.  Two methods:
 An overall borrowing rate shall be used based on
rates applicable to borrowings outstanding during the
period
 However, if a loan is obtained specifically to fund an
entire project, it is usually appropriate to use the
interest rate from that loan
 This is true even if the rate on the specific construction debt
is lower than interest rates on other debt
 Don’t capitalize more interest than actually incurred
#3 Capitalized Interest – The Rules

13. Qualifying assets $1M times 12.3% = Capitalized Interest $123,000
Construction loan 12% 750,000
Unsecured bank note 16% 150,000
Capitalized leases 9% 400,000
Equity 500,000
Rate Calculation:
Specific debt 750,000 75% 12%*75%=9%
Unsecured bank note 150,000 15% 16%*15%=2.4%
Capitalized leases 100,000 10% 9%*10%=.9%
Total 1,000,000 100% 12.3%
#3 Capitalized Interest - Example

14. Acquisition cost should reflect the total investment in
the asset AND should charge a cost that relates to
the acquisition to future periods where revenues are
generated.
#3 What was the FASB thinking?

15.  Before ASU 2010-24, health care entities used the
following methods to present malpractice claims or
similar liabilities and related insurance recoveries:
(1) Netted insurance recoveries with the estimated accrual
for related claims (allowed by industry guidance), or
(2) Presented the claim liability separately from insurance
recovery consistent with ASC 210-20 (asset and liability
offsetting guidance).
 FASB now requires health care entities to follow the same
rules as other industries for balance sheet offsetting i.e.
requirements of ASC 210-20 must be met.
#4 Insurance Recoveries – The Rules

16.  Under ASC 210-20, offsetting of conditional or
unconditional liabilities with anticipated insurance
recoveries from third parties is generally not
permissible.
“The Kicker” - The presentation guidance applies to
other similar contingent liabilities such as workers’
compensation claims, employee health claims and
officers’ and directors’ claims.
#4 Insurance Recoveries – The Rules

17.  Health Company, Inc. has a gross liability for
malpractice claims of $1M of which $700k has been
submitted to the insurance carrier.
 The insurance agent deals with ALL aspects of the
claim including paying the settlement.
 Current practice – accrue liability of $300k
 Revised practice – accrue liability of $1M and
receivable of $700k
#4 Insurance Recoveries – Example

18.  Do the rules apply when the entity’s insurer deals
with all aspects of the claims, including settlement?
 The entity is still the primary obligor for payment of
the claim.
 Unless offsetting is allowed (ASC 210-20-45-2), the
entity should record the claims liabilities separately
from the receivable for insurance recoveries.
#4 Insurance Recoveries – Example

19. Gross presentation reflects that the entity remains
obligated for the claim and that the entity is exposed
to credit risk from the insurer.
#4 What was the FASB thinking?

20.  Current liabilities:
 Expected to be paid/liquidated in a short period of
time i.e. 12 months
 Expected to require use of existing current assets or
incur other current liabilities
 Not intended to include long term obligations
expected to supplement working capital for long
periods of time
#5, #6, #7 Debt Classification – The Rules

21.  Issue – An entity has long term debt. A debt
covenant has been violated and a waiver has been
obtained from the lender. How should the debt be
classified on the balance sheet?
 “The Kicker” – A waiver from the lender may not
automatically provide a entity with the ability to
classify the debt as noncurrent.
#5 Loan Covenant Waivers - The Issue

22.  Lender may waive right to call debt for period greater
than one year but retain right to act on covenant
violations occurring after the waiver
 Debt should be classified as noncurrent unless:
 Violation occurred at the balance sheet date or would
have without the parties agreeing to modify the loan,
AND
 It is not probable borrower will be able to comply with
covenant requirements within next 12 months.
#5 Loan Covenant Waivers - The Rules

23.  Borrower has long-term debt and must comply with
loan covenants quarterly.
 Incompliance at 12/31/12, however probable not in
compliance at 3/31/13.
Current or Noncurrent classification at 12/31/12?
 Noncurrent – but disclose in 12/31/12 financials
probable 3/31/13 violation.
#5 Loan Covenant Waivers – Example 1

24.  Borrower has long-term debt and must comply with loan
covenants quarterly
 Not in compliance at 12/31/12 however waiver obtained
for 12 months and 1 day. Lender retains rights to act on
violations after waiver date.
 Not probable borrower will meet 3/31/13 covenants but
probable will meet 6/30/13, 9/30/13 and 12/31/13.
 Interim financials are not audited and do not contain full
disclosures
Current or Noncurrent classification at 12/31/12?
 Current - violation occurred at 12/31/12 AND not probable
meet covenants within next 12 months.
#5 Loan Covenant Waivers – Example 2

25.  Issue – In poor economic times, the likelihood that a
subjective acceleration clause (SAC) will be
exercised by a lender is higher.
 “The Kicker” – Beware if your loan agreements
include subjective language such as “material
adverse change.” It could impact the classification of
your debt especially if you have a traditional lockbox
arrangement.
#6 Subjective Acceleration – The Issue

26.  When a SAC is included in a debt agreement the
classification of the liability depends on the
likelihood of the lender exercising its rights.
 Likelihood is remote = noncurrent
 Likelihood is more than remote = borrower must
consider if current classification and/or disclosure is
required
#6 Subjective Acceleration – The Rules

27.  Agreement states lender can accelerate payment if
1) borrower fails to maintain satisfactory operations
or 2) a material adverse change occurs
 If acceleration clause is exercised repayment of loan
is due in 120 days
 Borrower provides documentation that asserts
likelihood is remote
Current or Noncurrent classification at 12/31/12?
 Noncurrent – just because there is an SAC does not
mean loan must be classified as current
#6 Subjective Acceleration – Example

28.  Issue – Lockbox arrangements, subjective
accelerations clauses and springing lockbox
arrangements can cause complexity when
determining proper classification of liability.
 “The Kicker” – Borrowings under a line of credit with
a lockbox arrangement will be classified as current
liabilities regardless of the line of credit due date
because borrowings are repaid from current assets
(need to meet exception otherwise).
#7 Revolving Credit Agreement – The Issue

29.  If borrowings are due when the underlying short-
term notes roll over, determine if short-term notes
automatically replace other short-term notes upon
maturity and if the rollover extends beyond one year.
 If so, classify borrowings as noncurrent if agreement
meets criteria in ASC 470-10-45-14b
 These are the criteria used to classify a short-term
obligation that the borrower intends to refinance on a
long-term basis as noncurrent
#7 Revolving Credit Agreement – The Rules

30.  If the agreement includes a lockbox and it is at the
borrower’s discretion, the existence of a lockbox
does not impact classification.
 Does the lockbox arrangement require lockbox
deposits to be used to repay the loan without
another event occurring (happens automatically)?
 If so, classify as current unless exception in 470-10-
45-14b met.
 If agreement contains a SAC, it will fail criteria in 470-
10-45-14b automatically regardless if the SAC is
exercised.
#7 Revolving Credit Agreement – The Rules

31.  Does the arrangement call for deposits to be
automatically applied to loan only if another event
occurs? i.e. springing lockbox arrangement
 If so, existence of lockbox arrangement does not
impact classification.
 Does it also have a SAC? If so, determine if
acceleration is remote or more than remote.
#7 Revolving Credit Agreement – The Rules

32. Lockbox SAC Current or Noncurrent Classification
None None Noncurrent
None Yes Noncurrent if it is remote lender will exercise its right
Traditional None Noncurrent only if 470-10-45-14b exception is met
Traditional Yes
Current because 470-10-45-14b exception will not
be met
Springing Yes Noncurrent if remote lender will exercise its right
#7 Revolving Credit Agreement – The Rules

33.  Agreement dated March 1, 2012 for $30M 4-year revolver
 Agreement permits a series of renews of 90 days each
until the end of the 4-year period
 Lender requires all customer payments to be submitted
to lockbox which are used to pay down revolver
Current or Noncurrent classification at 12/31/12?
 Noncurrent - Absent the revolver meeting the conditions
of 470-10-45-14b borrower would classify as current
because payments are being made from use of current
assets. However agreement meets requirement of 470-
10-45-14b for classification as noncurrent because of the
intent to refinance on long-term basis.
#7 Revolving Credit Agreement – Example

34.  Agreement dated March 1, 2012 for $30M 4-year revolver
 Agreement permits a series of renews of 90 days each
until the end of the 4-year period
 Lender requires all customer payments to be submitted
to lockbox which are used to pay down revolver
 Lender can require borrower to pay all outstanding
amounts within 30 days if material adverse change.
Current or Noncurrent classification at 12/31/12?
 Current - One of the requirements of 470-10-45-14b is that
the agreement may only be cancelable within 1-year of
the borrower’s balance sheet date if borrower violates an
objectively determinable provision.
#7 – Lockbox Arrangements – Example

35.  Debt agreements can have terms that can cause
surprising classification issues
 Why do we care so much about debt classification?
 Debt covenants may contain requirements for working
capital therefore debt classification is critical
 Auditors may consider liquidity in assessment of
going concern
 Potential lenders will assess borrower’s liquidity
#7 What was the FASB thinking?

36.  Should be amortized over the shorter of their economic
lives or the term of the lease
 Lease term includes fixed noncancellable term plus:
 Periods covered by bargain renewal options
 Periods where the lessee’s failure to renew the lease
imposes a material penalty whereby renewal is
reasonably assured
 Renewal or extension periods that are at the option of
the lessor
 Periods covered by ordinary renewal options
preceding the date in which a BPO can be exercised
#8 Amortization of LHI – The Rules

37.  10 year Noncancellable lease signed on Sept 1, 2005
with terms beginning Jan 1 2006
 One renewal option for additional 5 years
 Property in desirable location; market for space tight
 If exercised renewal requires market rate adjustment
 No cash penalty to lessee if renewal not exercised
 Lessee invests $3M during remainder of 2005 with
useful life of 25 years
 Leassee occupied space January 3, 2006
#8 Amortization of LHI – Example

38.  Amortize over the shorter of estimated useful life of
assets (25 years) or lease term.
 Would lessee suffer an “economic detriment” upon
termination at the end of initial term w/o renewal?
 Lack of alternative space in the market, coupled with
the abandoned LHI, would constitute a penalty such
that at the inception of the lease, renewal is
reasonable assured.
 Lease term would be 15 years (plus 3 months???).
#8 Amortization of LHI – Example

39.  FTB 85-3, Accounting for Operating Leases with
Scheduled Rent Increases, stipulate that rent expense
for operating leases with rent-free periods or scheduled
increases must be accounted for on a straight-line basis
over the lease term, including the related holiday period
 Unless another systematic and rational method is more
representative of the lessee’s pattern of use over time.
 Treatment assumes that lessee takes possession of or
controls the property at the inception of the lease.
#9 Rent Holidays – The Rules

40.  LHIs made by the tenant but funded by the landlord
under an operating lease
 Should be recorded by lessee as LHI assets and
amortized
 Incentive should be recorded as deferred rent and
amortized over straight line basis as a reduction in
rent expense
 The treatment considers the incentive to be
inseparable element of overall agreement recognized
along with other lease provisions.
#10 Landlord/tenant Incentives – The Rules

41.  January 1, 2006 lessee signed 10 year operating
lease
 Fixed monthly rent of $20k with no renewal or rent
holiday
 Lessee needs to make improvements to space to
satisfy business requirements
 Lessor agrees to reimburse lessee 25% of first $1M
of improvements
 January 1 through June 30 lessee spent $1.5M and
received $250k from lessor
 Lessee occupies space on July 1, 2006
#10 Landloard/tenant Incentives – Example

42.  LHI $1.5M amortized over 10 years = $150k/year
 Deferred rent $250k over 10 years = $25k/year
 Rent expense = $240k/year
 Therefore Year 2
 Rent expense $215k ($240k-$25k)
 Amortization expense $150k
Don’t reduce the LHI by the incentive!
#10 Landloard/tenant Incentives – Example

43.  In a February 7, 2005, SEC staff letter to the AICPA’s
Center for Public Company Audit Firms (CPCAF),
clarity on the application of three key issues for
lessees:
 The proper amortization period for leasehold
improvements;
 Accounting for rent holidays; and
 The treatment of construction incentives received
from landlords.
 The resulting wave of restatements highlighted the
diversity in long-standing industry practices and the
misapplication of existing GAAP in these areas.
#8,9,10 What was the FASB thinking?

44. Questions

45. JENNIFER GOODMAN, CPA
Assurance Principal | jennifergoodman@decosimo.com
Jennifer Goodman is an assurance principal with more
than 15 years experience in public accounting.
Jennifer provides audit and assurance services, including audits
of internal control over financial reporting, to privately held
businesses, public companies, not-for-profit organizations and
manufacturing and distribution clients. She contributes to the
firm’s manufacturing and distribution team by providing cost
accounting expertise, insights into best practices and specialized
advice regarding internal control issues. Her experience also
includes financial statement audits, audits of internal control over
financial reporting and limited scope consulting engagements for
foreign firms performing assurance engagements for foreign
SEC filers.