Operating the lease - a discussion paper

The FASB is looking to overhaul its 35 year old standard on Leases - FASB 13. This overhaul looks to have been directed with the convergence of the FASB and the IASB.

Both the bodies have recently issued a discussion paper on changing the way we account for operating leases. The discussion paper higlights the rationale to change the way we account for a "right to use assets" as described in EITF 01-08 or my earlier blog on embedded leases.

Under the current rule, Companies record finance lease obligations on the balance sheet while disclosing the operating lease obligations in the notes to accounts.

Under the discussion paper, the new rule will require companies to record operating lease obligations on the balance sheet as a liability and capitalise the right to use the asset as an asset, thereby making Companies look highly leveraged.

Broadly the implications of such a rule will have a bearing on the following

1. Balance sheets look highly leveraged (an estimate pegs the operating lease obligations for SEC listed companies at $1.25 trillion
2. Financial reporters will have to test for impairment on the capitalized operating lease assets in case of non-cancellable lease obligations
3. Operating lease obligations will be required to be recorded at fair values
4. In case of contingent rentals for operating lease assets, computing the value of the assets and obligations will be a nightmare
5. Periodic reassessment of the lease classifcation in case of constant renewal options/modifications coming in the agreement
6. Rental expenses now will be broken into rental expenses and interest costs (for the imputed value of the lease obligation)
7. A nightmare of companies who outsource work say for a period of 2 years under a non-cancellable lease - splicing the agreement into services and assets would take some doing

I welcome FASB's stance on recording the obligations and recording the assets on the balance sheet. This will make reporting more structured by ensuring stakeholders get to know as to whether an asset taken on an operating lease is impaired or not and the leverage of the balance sheet.

For instance financials of Airlines companies who lease planes on operating leases do not have any planes as assets on their balance sheets nor any liabilities. This is strange considering that from a going concern perspective airline companies cannot live without these planes. The new rule will reflect a clearer picture of the financial position of such companies.

The real problem will come to accountants when they address issues on contingent rentals, renewal clauses etc. These will be highly subjective from one company to the other and will render the purpose of meaningful comparasions among different companies baseless.

Well the proposed change is in mid 2011, hopefully by then we will have a lot more brightlines to easily account for the new OPERATING LEASE REGIME.

FASB issues statements 166 and 167

The FASB recently published Financial Accounting Statements No. 166, Accounting for Transfers of Financial Assets, and No. 167,Amendments to FASB Interpretation No. 46(R), which change the way entities account for securitizations and special-purpose entities. The new standards will impact financial institution balance sheets beginning in 2010. The impact of both new standards has been taken into account by regulators in the recent “stress tests.”

These projects were initiated at the request of investors, the SEC, and The President’s Working Group on Financial Markets. Copies of the new standards are available at theFASB’s website, along with a concise briefing document.

Statement 166 is a revision to Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and will require more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures.

Statement 167 is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance.

Robert Herz, chairman of the FASB, said:

“These changes were proposed and considered to improve existing standards and to address concerns about companies who were stretching the use of off-balance sheet entities to the detriment of investors. The new standards eliminate existing exceptions, strengthen the standards relating to securitizations and special-purpose entities, and enhance disclosure requirements. They’ll provide better transparency for investors about a company’s activities and risks in these areas.”

Both new standards will require a number of new disclosures. Statement 167 will require a company to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A company will be required to disclose how its involvement with a variable interest entity affects the company’s financial statements. Statement 166 enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and a company’s continuing involvement in transferred financial assets.

Both Statements 166 and 167 will be effective at the start of a company’s first fiscal year beginning after November 15, 2009, or January 1, 2010 for companies reporting earnings on a calendar-year basis.

Fair Valuations - can they propel the next bull run

FASB on April 9, laid to rest atleast a controversial subject on marking assets in distressed economic conditions.

The FASB via FSP157-4 issued its position on defining illiquid markets for assets and giving a leeway that the management can rely on their internal valuation models instead of using the external factors.

The rule revision applies to all assets and liabilities within the scope of accounting pronouncements that either require or permit fair value measurements.

The FSP provides that a reporting entity should evaluate a battery of factors to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability when compared with "normal market activity" for the asset or liability. These factors include, but are not limited to, the following: 

• There are few recent transactions;
• Price quotations are not based on current information;
• Price quotations vary substantially either over time or among market makers;
• Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability;
• There is a significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the reporting entity's estimate of expected cash flows for the asset or liability;
• There is a wide bid/ask spread;
• There is a significant decline or absence of a market for new issuances for the asset or liability; and
• Little information is released publicly.

This move is a welcome step and will definetly aid a lot of banks in shoring up their balance sheets. No wonder, that post April 9, most of the markets are on a bull run and have started factoring this change in the swing in the balance sheets of various financial institutions.

The FASB must also be appreciated for relenting under pressure to delineate mark-market to accounting forever and has come out with the correct decision considering the economic scenario.

Will wait and wonder what will be FASB's position in a reverse scenario, when markets are in prime bull position and prices are overvalued, will they come out with a new FSP to FAS 157....????

Read all our earlier articles on Fair value accounting

Bond conversions now weigh on your EPS

With the change of an old accounting rule of APB 14-1 "Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion" coming into effect this quarter, companies may start seeing a dip in the EPS reported. The rule which was amended last year, requires companies which settle their bonds (liabilities) in the form of part equity and part cash, now will have to take an additional charge to the income statement on account of interest expense, thereby lowering the EPS

The interest expense will be the differential between the value of the equity shares as on the date of the conversion and the maturity value of the debt.

This rule does not affect straight convertible debt that must be settled with the corporate issuer's stock, convertible preferred shares classified as equity, convertible debt with embedded options that are recorded as derivatives, and convertible bonds that require cash settlement for fractional shares when converted.

Separating the settlement into cash and shares requires the use of so-called split accounting to record the transaction. That is, the issuer must book the debt and equity components of the bond separately. It's the split that results in a higher interest expense on the income statement that tugs the EPS ratio down. Here's why.

A convertible bond is attractive to issuers because the interest paid to bondholders is lower than the market rate for most other borrowing. On the other hand, the low-interest bond attracts investors because of the conversion option, which allows the bondholder to turn the debt into equity if market conditions are favorable. For many, convertible bonds were seen as a win-win situation.

But FASB wanted to make sure that companies issuing convertible debt reflected the economic reality of the instrument — that is, the risk associated with the bond — on their financial statements. In the board's opinion, companies that issued convertible bonds had a tendency to inflate their EPS because the interest expense associated with the potential cash payout was under-reported.

The new rule, however, forces companies to record a higher interest expense — or a higher depreciation expense in the case of debt used for capital improvements — because the debt is calculated as if there were no conversion option, and will be settled in cash. That assumed cash payout includes the additional interest expense.

FASB also is requiring that the rule be applied retrospectively to 2008 financial statements. That means that if issuing companies report a material adjustment to their income statement, they must restate their financial results accordingly, going back two or three years, depending on how many years of comparison reporting they included in their 2008 filings.

Involuntary terminations - filling the GAAP

Layoffs are unpleasant and every accountant would wish they are never exercised for in his Company.

 At March 31, 20xx (year end), your company has approved a termination plan to exit a part of its operations. Under the plan,  the Company will close 2 of its branches, which will result in 100 employees being terminated in the next 60 days. 

 Your Company has announced a VRS scheme of Rs. 10lakhs per employee , given to employees on a first come first basis. In case, less than 100 employees opt for  theVRS, then the Company will involuntarily terminate the employment of the balance employees and give them Rs. 8lakhs each. 

 As the year end, what will be your accounting treatment.... 

• will you accrue for the entire liability of Rs. 10 crores (ie. 100* 10 lakhs) and take a P&L hit
• you will do nothing with it, the liabilty arises in the next year as employees will be terminated in the subsequent year
• you will disclose the liabilty in the notes to the accounts

On the Indian GAAP front, there have been no clear guidance on accounting for involuntary terminations, while on voluntary terminations or more popularly known as VRS schemes, the cost of such terminations  is recognized in the period in which the offer is accepted by the employee. So do we by the same principles account for costs on involuntary terminations, in the period in which the pink slip is handed over to the employee....

 

FAS 146 (earlier EITF 94-3) addresses this issue...

 FAS 146 requires managements to record liabilities at fair value in the period in which it is incurred. The following events should have occurred to conclude that a liability should be recorded and recognized immediately

 The board has approved the termination plan and has been adopted, in case shareholder approvals are required, then at the time of shareholder approval

1. The plan has identified the number of  employees, their job classification, their functions, location and expected completion date
2. The termination benefits are clearly documented stating the quantum for everydesignation of employee
3. The plan is communicated to the employees (not necessarily naming them specifically)
4. It is highly unlikely that points 1 to 3 will be withdrawn or there will major changes in the plan

Once all the above factors, exist the management will be required to account for the liability of involuntary termination benefits at its fair value.

 So going by the above guidance, our accounting treatment will be as under; 

• Take Rs.8 crores to P&L (i.e. 100 * Rs. 8 lakhs) being the value of termination benefits which the management has committed to as at March 31, 20xx
• Account for the increment liability of Rs. 2 lakhs in case of VRS in the period in which the employee opts for the scheme
• Disclose the facts in the notes to accounts.
• Disclose the facts to the actuary, so that provisions can be trued up to make for leaveencashment and gratuity accruals more accurate

PS  - In case a company knows that the profitability of the current accounting year is bad, and wishes to book a lot of expenses in the current year in order to make the next year look more profitable, all it needs to do, is to arrange for documentation, have a board resolution in hand and book the expense. All of this can be done in the last week prior to the year end.....  

On the contrary, a Company may have announced this in the last week of the year end and may just chose not to account for it...... if numbers are big.....and your auditor doesn't catch it...just hope nobody else does...

Is Raju playing the Green Goblin of Spiderman

Vengeance has become the buzzword this season with the release of Ghajini, so is Raju playing the same game aka the Green Goblin of Spiderman...............

I called up some of contacts both in PWC and Satyam's finance and internal audit functions, to get their views.

Predictably the response from PWC was more muted on account of a gag order. 

A chat with a core member of the accounting function at Satyam reflected a sense of disbelief,  he wasn't willing to believe any of the contents of the Raju letter was true. Same was when I spoke with the member of the internal audit team, the reaction was the same. At both quarters they were unwilling to digest that cash and cash equivalents could have been inflated by such magnanimous proportions.

Interestingly, both of the the Satyam's contacts i spoke to had an inner feeling that this revelation comes at a time when Raju himself had no stock in the Company as his shares were pledged and, this disclosure by Raju manifests in an opportunity to get himself or through his benami shareholders a back door entry in Satyam by acquiring the stock at cheap prices.

Another point of note is that most of the FII's were able to offload a majority of their stake in Satyam on both the trading sessions on Wednesday and Friday... well then someone should have been buying this stock... but why would any sane person buy this stock, knowing fully well that Rs. 80 on Satyam's stock price was only attributable to the book value of the inflated cash position in Satyam alone....

On a closer introspection of the "priceless" letter released by Raju, the first para of the letter reminisces a more USGAAP language, where he takes of the inflated cash and cash equivalents, receivables etc, the remaining portion of the letter seems to have been carefully drafted by a lawyer. If rumour mongers are to be believed then the letter seems to have been drafted by a US based law firm close to Raju.

The Green Goblin of Spiderman wanted his vengeance after he was ousted from his own Company by the board, is Raju also doing the same...... only time will tell

Satyam Shivam Sundaram - alias Satyam Ramalingam Srinivas

Srinivas Talluri is a worried man, having spent 20 years in the accounting profession, he would have wished the 7th day of the new year would never had happened. He is now guilty of certifying and giving a clean chit to the three golden rules of audit reports on Satyam's financials.... how he wished his last certification on Satyam's would have looked like this

Reproduction of Satyam's audit report (changed for our readers)

In our opinion and to the best of our information and according to the explanations given to us, the said financial statements together with the notes thereon and attached thereto give in the prescribed manner the information required by the Act and give a Satyam (true) and fair view in conformity with the accounting principles generally accepted in RAJUGAAP

(i) in the case of the Balance Sheet, of the state of affairs of the Company as at March 31, 2008; excepting for cash balances which have been overstated by Rs. 5000 crores, based on explanations and informations given by the management, the corresponding credit might have been shown as a loan payable to Maytas or the offset could lie in reserves and surplus

(ii) in the case of the Profit and Loss Account, of the profit for the year ended on that date; excepting for only excel based workings given on interest accrued of Rs. 376 crores on the above cash balances and no confirmations or orders were found for revenues invoiced of Rs. 500 crores resulting in higher debtors, however the resulting higher profits have been offset by taxes booked against the same

(iii) in the case of the Cash Flow Statement, of the cash flows for the year ended on that date excepting for grossing up the financing activities where the offset to the cash balances of Rs. 5000 crores were shown as loans received.

Sgd Srinivas Talluri
April 21, 2008
PriceWaterhouseCoopers

Having worked in the audit profession, i can picture the scene at PWC's office in Hyderabad and Kolkatta, these is what it could look like

• The entire audit team of PWC would have been redeployed on Satyams e-audit workpapers, all scheduled leaves, vacations and other audit assignments would have been called off, beleive me, its worse than army deployments (PWC was the first to go on electronic audit documentation in India)
  
• Article clerks will be given the mundane tasks of scanning the documents given by the seniors, seniors will be sharing confidential papers with the managers, managers will be wondering what to shred and what not to
• There will be a set of article clerks who will be filling out the checklists including questions on Integrity of management, fraud checklist, accounting standard checklists etc
• There will be a huge demand for green and red pens, after all linking of all audit work papers would need to be done...
• Audit confirmations will be treated like GOLD, seniors would be combing the postal section of PWC's office to trace if at all any banks/debtors had confirmed balances. on PWC's stationary...... senior managers will be telling the seniors ..." I told you not to rely on email confirmations"
  
• Someone, would definitely be searching for the management rep letter if at all signed by Raju
• Managers and Senior Managers will now be recasting the reasons used in the variance analysis - a very popular tool used to audit balance sheet items..... imagine the answers which would have been documented for increase in cash balances, receivables and for non-increase in liabitlites......
• And finally, someone will cast the schedules given (this practice has been done away with)... good chances are that someone will discover that higher bank balances of Rs. 5K crores were a result of casting errors i.e 10 FD of Rs. 100,000,000 would have been shown as Rs. 10,000,000,000 on the excel schedule (with an extra 0) and the totals would have been a number entered on the cell, rather than a formula on the cell..... well if this happens to be the case, there is no audit negligence right..........
  

Well i beleive at the end of the day, no amount of form i.e. checklists etc) can hide the substance of the transaction..... Substance is truly greater than form

SEC releases study on fair value accounting

To round up a tumultuous 2008, with the entire industry particularly banks, up against fair value accounting, comes the SEC's report mandated by Congress on the use of fair value accounting. 

While for starters the SEC supports the continued use of fair value accounting standards while also making eight recommendations to improve application of the standards. The suggested changes include reconsidering accounting for impairments of financial instruments and developing more guidance for determining the fair value of investments in inactive markets.

The SEC recommends against the suspension of fair value accounting standards and finds that investors believe fair value accounting generally increases financial reporting transparency and facilitates better investment decision making. The 211-page report by the SEC’s Office of the Chief Accountant and the Division of Corporation Finance finds that mark-to-market accounting did not appear “to play a meaningful role in bank failures occurring during 2008.” Rather, the report says, the bank failures “appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence.”

The improvements outlined in the SEC report include:

·         Development of additional guidance and tools for determining fair value when relevant market information is unavailable in illiquid or inactive markets, including consideration of the need for guidance to assist companies and auditors.

·         Enhancement of existing disclosure and presentation requirements related to the effect of fair value in the financial statements.

·         Educational efforts, including those to reinforce the need for management judgment in the determination of fair value estimates.

·         Examination by FASB of the impact of liquidity in the measurement of fair value, including whether additional application and/or disclosure guidance is warranted.

·         Assessment by FASB of whether the incorporation of credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided currently in practice.

 

The report also recommends that FASB reassess impairment accounting models for financial instruments, including consideration of narrowing the number of models under U.S. GAAP. The report finds that under existing accounting requirements, information about impairments is calculated, recognized and reported on bases that often differ by asset type.

The report recommends improvements, including: reducing the number of models used for determining and reporting impairments; considering whether the usefulness of information available to investors would be improved by providing additional information about whether current declines in value are consistent with management expectations of the underlying credit quality; and reconsidering current restrictions on the ability to record increases in value when market prices recover.

 Read all our articles on fair value accounting by clicking here