SEC Comment Letter Watch -- Segment Reporting

Segment reporting is one of the SEC's most common areas of comment. The SEC often asks for specifics of documents that the Chief Operating Decision Maker (CODM) reviews on a regular basis. Companies need to be cautious when answering similar questions since the next request from the SEC might be "please provide us with all regular reports that the CODM review on a regular basis." If the SEC sees something different in those CODM reports from the answer provided previously, that spells trouble. Here is a sample from a letter to Charter Communications:

SEC's question:
We note your response to comment 4. Please provide us additional information about all of the “certain operating metrics”, such as “CPE” and plant maintenance, that management, in particular the CODM, relies on to assess performance and allocate resources.

Describe for us what these non-financial business and operational data represent, at what level of detail does the CODM review them (e.g.KMA or lower), and how the CODM uses them to assess performance and allocate resources.

Company's answer:
Our CEO, as CODM, receives and reviews information at the consolidated level, whether financial or non-financial in nature, and uses that information to assess performance and allocate resources on a consolidated basis. The CEO routinely receives consolidated operating metrics that include customers by product (video, Internet, and phone), sales and disconnects by product, customer net gains, penetration of estimated passings, bundled customer statistics, sales channel performance, call center and truck roll statistics and headcount. In addition, the CEO receives certain statistics related to the quality of physical transactions occurring at a local level, specifically truck roll data and ratios which use the number of customer connections, disconnections and average customers by service to calculate service level ratios. These statistics assist with the review of activity in the field at the local level, but are not the primary data used for resource allocation. Our CEO makes resource allocation decisions to specific operating strategies that impact the performance of the consolidated company. Furthermore, he assesses the performance of the Company on a consolidated level as a result of the implementation of the company-wide operating strategies. The execution of those strategies is carried out by levels below the CODM.

Resources allocated to our strategic initiatives of enhancing the customer experience and increasing customer growth are driven on a consolidated basis by our CODM. One such example would be CPE procurement, which is budgeted based on a certain number of connects and devices per connect, both estimated for the entire company. Consequently, CPE is purchased on a company-wide basis in order to maximize scalability during negotiations with our vendors and to meet estimated connects on a company-wide basis. Plant maintenance is another example. The allocation of corporate resources to plant maintenance is based on the strategy to improve the performance and reliability of the network. Levels below the CODM are then tasked with execution of the strategy and ensuring resources are provided where they are needed. A third example is our strategy of our all-digital network roll-out. Again, the amount of resources required for the all-digital roll-out is based upon an allocation of resources to implement the roll-out company-wide. In executing the all-digital roll-out, managers below the CODM carry out the initiative within our footprint based upon the potential immediate impact on our customers. Other overall resource allocation examples include, but are not limited to, implementation of a back office system to support customer growth or a decision to change the type of modem used, both of which would be on a company-wide basis.

Cleaning Up OCI

Accounting ‘Dumping Ground’ Headed For Clean Up

International accounting rulemakers may focus on cleaning up rules for “other comprehensive income,” a category in a company’s earnings statement that can obscure the true profit and loss picture, the chairman of the International Accounting Standards Board said this week.

The board may restart its efforts to improve financial statement presentation guidance in this area and bring more “discipline” to the way companies decide what is classified as profit and loss or other comprehensive income, IASB Chairman Hans Hoogervorst said in a speech in Tokyo.

More than 100 countries use International Financial Reporting Standards, which are set by the IASB. The U.S. does not use them for domestic companies, but allows foreign companies to file their results with U.S. regulators under these standards. U.S. multinational companies often have to use these standards for foreign subsidiaries.

Other comprehensive income, which includes items initially excluded from net income in a particular accounting period, has gotten a reputation as a sort of dumping ground where companies are allowed store information that would be too damaging to earnings.

For example, he said passing employee benefit expenses through other comprehensive income, rather than earnings, has dis-incentivized companies from dealing with large liabilities head-on.

“In the last decade, some big American car manufacturers and airline companies were brought to their knees by employee benefits that had been building up over the years,” Mr. Hoogervorst explained. Such liabilities may not have been taken as seriously because they were in other comprehensive income, he said.

The other comprehensive income figure is crucial because it can distort common valuation techniques used by investors, such as the price-to-earnings ratio. If the profit and loss statement and earnings are the primary indicators of a company’s performance, they need “to be robust and tinker-free,” Mr. Hoogervorst said.

Mr. Hoogervorst said he’d been approached by Japanese accounting stakeholders about improving and clarifying other rules, as well as differences of opinion from other countries, such as Canada.

In an interview with CFO Journal, Dr. Nigel Sleigh-Johnson, head of financial reporting for the Institute of Chartered Accountants of England and Wales said Thursday, “At the moment there is no clear and consistent basis for,” other comprehensive income.

Accounting rulemakers should try to make it easier for companies to decide what items need to be recognized in profit and what has to go into other comprehensive income, he said.

The U.S. Financial Accounting Standards Board has also been working to clarify rules for other comprehensive income in the past few years and make the rules more transparent to investors.  The board issued new guidance on how companies should present the figures in 2011 and updated accounting standards on items reclassified out of accumulated other comprehensive income last February.

 Article by Emily Chasan, at the Wall Street Journal

Can Companies Smooth-Talk Investors?

Investors Prove Wise at Judging Self-Serving Earnings Explanations

Investors have proven to be sophisticated enough to dismiss implausible explanations from companies of their quarterly earnings results, according to a new study.

For example, a utility company might attribute their lower earnings to “warm weather and higher propane products costs,” while an insurance company might explain a good quarter by touting its “continued efforts on cost containment and operational efficiencies.” Self-serving attributions such as these, which typically blame outside factors for negative developments and claim that their own internal initiatives led to positive results, are a traditional part of corporate earnings reports and press releases. But that doesn’t mean investors generally believe them.

According to a new study in The Accounting Review, a journal of the American Accounting Association, market response to self-serving attributions depends in large part on two key tests of plausibility—how badly the company’s industry peers are doing and what the study calls “commonality,” the extent to which market or industry forces drive a company’s earnings.

The difference proved to be dramatic when those two key tests were applied to the 94 companies in the study, which was conducted by Michael D. Kimbrough of the University of Maryland and Isabel Yanyan Wang of Michigan State University. Firms with average positive earnings surprises who made the highest-plausibility attributions had three-day above-market returns of 4.77 percent on average, whereas those that offered the lowest-plausibility reasons actually averaged a slight decline of 0.79 percent. Meanwhile, among firms with average negative surprises, those with the lowest-plausibility attributions sustained average declines of 5.11 percent, while those with the highest-probability excuses had declines of only 1.42 percent.

“Firms which provide defensive attributions to explain earnings disappointments experience less severe market penalties when 1) more of the their industry peers also release bad news, and 2) their earnings share higher commonality with industry- and market-level earnings,” said the paper. “On the other hand, firms that provide enhancing attributions to explain good earnings news reap greater market rewards when 1) more of their industry peers release bad news, and 2) their earnings shares lower commonality with industry- and market-level earnings.”

 “Collectively, our results suggest that investors neither completely ignore seemingly self-serving attributions nor accept them at face value, but use industry- and firm-specific information to assess their plausibility,” the professors added. “Further analyses reveal that investors’ use of industry peer performance and earnings commonality information appears justified because investors’ perceptions are consistent with the association between the plausibility measures and the ex post actual persistence of earnings surprises.”

In sum, “investors are somewhat sophisticated when interpreting these narrative disclosures,” Kimbrough and Wang wrote:

“Our findings ought to be of value to both investors and corporate leaders,” said Wang in a statement. “Hopefully it will disabuse those executives who are counting on the naiveté of investors to let them get away with empty words or phony excuses in their public communications. For investors, it provides standards they will need to meet to keep up with the investment community at large.”

“The tools needed to apply those standards are certainly available to institutional investors, even though determining commonality is probably beyond the reach of individual stock-pickers,” said Kimbrough. “Still, even they should have the means to stack up the claims of a given company against its industry peers, which can go a long way in assessing the plausibility of the firm's performance narrative.”

The study's findings are based on an analysis of press releases and earnings reports of 94 randomly chosen firms, a roughly equal mix of small, medium and large, over a seven-year period. Sufficient data was obtained for a total of 1,790 firm quarters, 1,023 of which featured self-serving attributions and 767 of which did not. The self-serving classification was assigned to quarters when companies attributed their success in meeting or beating consensus forecasts to internal factors, such as management strategies or introduction of new products, or blamed a negative earnings surprise on external factors, such as bad weather or rising costs or regulatory actions. Firm-years in the self-serving category featured at least one such attribution and an average of three to four in a given earnings press release.

The authors found a significant relationship between the plausibility of self-serving attributions, as determined by industry performance and commonality, and the market-adjusted cumulative return of firms' stocks in the three days centered on earnings announcements. In reaching that conclusion, they controlled for an array of factors likely to affect the market’s response to earnings announcements, including the size of companies, the volatility of their stock, and their book-to-market ratio.

What kind of companies are likely to issue suspect attributions? Preliminary evidence suggests, in the words of the study, “Firms which provide less plausible attributions are larger and have higher likelihood of insider trading around earnings announcements, higher analyst following, higher institutional ownership, higher return volatility, and lower book-to-market ratio. These findings imply that managers with insider trading incentives and those facing greater capital market scrutiny are more likely to offer seemingly self-serving attributions even if they lack plausibility, consistent with the ‘opportunistic behavior’ view of capital markets.”

This view, according to the paper, finds “that capital-market scrutiny combined with the linking of manager compensation with stock prices creates pressure for managers to prop up prices by biasing financial reporting. To the extent capital-market pressure is greater for firms with higher analyst following and/or institutional ownership, the ‘opportunistic behavior’ argument suggests that greater analyst following and/or institutional ownership may increase managers’ tendency to provide implausible attributions to either mitigate market reactions to negative earnings surprises or to increase market rewards to positive surprises.”

Still, given the hazards of implausible attributions, as revealed by the new study, why would managers make them? It’s a matter of what they believe, Wang and Kimbrough wrote. “If managers believe there is a chance that investors might be persuaded by their implausible seemingly self-serving attributions, they are more likely to offer them even if ex post it turns out that investors can see through them.”

This article is by Michael Cohn in Accounting Today. The study, “Are Seemingly Self-Serving Attributions in Earnings Press Releases Plausible? Empirical Evidence,” appears in the March/April issue of The Accounting Review, published six times a year by the American Accounting Association.

More on Less Complexity in Financial Reporting

Want simpler financial reporting? If you believe the SEC’s public statements, reduction in complexity may be on the way.

Edith Orenstein has posted the following in the FEI Financial Reporting Blog. Here is her full post:

One recent development at the SEC that ties into FASB’s “combating complexity” goal cited further above, is that noted by SEC Chairman Mary Jo White concurrent December 20, 2013 issuance of the SEC staff report, Report on Review of Disclosure Requirements in Regulation S-K. The report was conducted by the SEC as requested by Congress under the JOBS Act.

Importantly, as noted in the SEC's press release, White stated:

“This report [on Reg S-K] provides a framework for disclosure reform. As a next step, I have directed the staff to develop specific recommendations for updating the rules that dictate what a company must disclose in its filings. We will seek input from companies about how we can make our disclosure rules work better for them and will solicit the views of investors about what type of information they want and how it can best be presented. The ultimate objective is for the Commission to improve the disclosure regime for both companies and investors.”

Keith Higgins, Director of the SEC’s Division of Corporation Finance stated:

“Updating our rules is only one step – albeit an important one – in improving company disclosures. For their part, companies should examine how they can improve the quality and effectiveness of their disclosures and how our rules can be improved to facilitate clear and effective communications to investors. Better disclosure benefits everyone in the marketplace, and we plan to work with companies and investors to achieve this common goal.”

The press release also noted that:

“The SEC’s Office of the Chief Accountant will coordinate with the Financial Accounting Standards Board to identify ways to improve the effectiveness of disclosures in corporate financial statements and to minimize duplication with other existing disclosure requirements.”

Chairman White led up to this initiative in remarks given at the NACD’s annual conference in November, 2013, as we noted in this post, SEC’s White Calls for ‘A Meaningful Review of Disclosure Requirements.’ 

Commissioner Dan Gallagher also focused on the need for disclosure reform in a speech at the 2nd Annual Institute for Corporate Counsel on December 6, 2013, excerpted below:

“We can’t foster capital formation in fair and efficient capital markets through private investment unless the critically important information about public companies is routinely and reliably made available to investors. We need to take seriously however, the question whether there can be too much disclosure. Justice Louis Brandeis famously stated that sunshine is the best disinfectant. As my friend and former colleague Troy Paredes pointed out some years ago, though, it is possible to create conditions in which investors are 'blinded by the light.' That is to say that from an investor's standpoint, excessive illumination by too much disclosure can have the same effect as obfuscation - it becomes difficult or impossible to discern what really matters ...”

“I often hear from investors that disclosure documents are lengthy, turgid, and internally repetitive. In their present state, they are, in other words, not efficient mechanisms for transmitting the most critically important information to investors — especially not to ordinary, individual investors. They are not the sort of documents most people are likely to read, even if doing so is in their financial self-interest. For that reason, today’s disclosure documents raise questions of what their purpose actually is and whether they are meeting it.”

“Here, it seems to me, we must acknowledge a dilemma. The good we have done in shaping a detailed disclosure regime to assist and protect investors has, in fact, led to some potential but, I submit, avoidable harm. Corporate disclosure filings didn’t naturally evolve into their present convoluted state. Rather, the rules that require periodic corporate reporting and the detailed instructions that implement them, as well as the staff interpretations and guidance that supplement those rules and instructions, have been the principal forces shaping modern corporate disclosure filings.”

“But other, external forces have played a role as well, most notably the risk of litigation -- much of it absolutely frivolous and solely for the benefit of plaintiffs’ lawyers, not investors. The failure to disclose anticipatorily is often enough to prompt a shareholder lawsuit based on the assertion of a material omission. It is rational, in other words, for those who prepare corporate disclosure documents to prepare for the worst, thus perversely prioritizing the need to avoid the penalties that accompany claims of insufficient disclosure, it seems, over rendering the required disclosure in a manner intelligible to the average investor. In sum, the Commission has cause for self-examination where the question of the utility and lucidity of corporate disclosures arises.”

“And in that process we cannot ignore the impact of excessive and frivolous litigation.”

“Here, we come to a fundamental fork in the road. Should we jump in with both feet to begin a comprehensive review and possible overhal of SEC-imposed disclosure requirements under the securities laws, or should we take a more targeted approach, favoring smaller steps towards our ultimate reforming goals? Ordinarily, I would argue for a comprehensive approach to the solution of almost any problem. Where securities regulation is concerned, we often find that actions we take in one area have unforeseen and unintended effects in others.”

“However, disclosure reform may be the exception. Although I've publicly called on multiple occasions for a holistic, comprehensive review of market structure issues, I believe, on balance, that with disclosure reform it is better to start addressing discrete issues now rather than risk spending years preparing an offensive so massive that it may never be launched. On this point, I was very pleased to see the recent remarks by Chair White (citing NACD speech). I hope and expect that, under her stewardship, the Commission will begin to make real headway on disclosure reform. I am genuinely enthusiastic about the prospect of solving some of the real-world problems that have become obvious to all who focus on this area. In short, it’s time to get practical and time to get started.”

Inquiring minds may ask: why have I not put “disclosure reform” as the highest priority item for 2014 as relates to the SEC, instead of “Enforcement”? Well, it’s not just because “Disclosure Reform” is two words, and “Enforcement” is one. I truly believe that with so much messaging from the highest levels of the SEC of a “get tough” attitude that we will see some illustrations of that attitude. We have seen that messaging from the Chairman, the Director of Enforcement, and in speeches from the Office of the Chief Accountant, and although preparers and auditors may prefer to see “disclosure reform” I believe that is a longer term project, and that in the shorter term, specifically 2014, attention should be paid to dotting the I’s and crossing the t’s as well as the big picture, substance over form, etc. with an eye toward Enforcement.

Slimming Down Disclosures: SEC Speaks Out

A targeted, step-by-step approach is the best way for the SEC to review and overhaul its financial disclosure requirements under securities laws, SEC Commissioner Daniel Gallagher said Monday.

In a speech at the Forum for Corporate Directors in California, Gallagher said he hopes the SEC can “make real headway” in its initiative to reduce unnecessary disclosures. And he said a piece-by-piece approach is preferable to addressing the issue in a comprehensive fashion.

“I would prefer to address discrete issues now rather than risk spending years preparing an offensive so massive that it may never be launched,” Gallagher said.

In December, SEC Chairman Mary Jo White instructed the commission’s staff to develop recommendations for updating what companies should be required to disclose in public filings. Gallagher said it’s time to get started on disclosure reform even though the SEC has yet to complete about 60 rules mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203.

Here are some of the issues Gallagher said the SEC may need to focus on:

Layering disclosures. This would mean making key information easily available in a standardized format, while making additional details available elsewhere. Gallagher said material information, such as a company’s financial statements, could be treated differently from information that he said is not material, such as the Dodd-Frank pay-ratio disclosures the SEC is developing.

Streamlining Form 8-K disclosures. “Does each of the categories of information now required to be disclosed on Form 8-K really require almost immediate disclosure when a change occurs?” Gallagher asked.

Location, location. Authoritative guidance can be provided, Gallagher said, about where issuers must disclose or need not disclose particular types of information, enabling analysts and others to easily find the information or identify its absence.

Streamlining proxy and registration statements. Permitting some required financial information to be included in an appendix to the proxy would aid investors and preparers, Gallagher said. He also said it could be helpful if the SEC permits forward incorporation by reference in Form S-1 registration statements. This could simplify the registration process by allowing reference to previous forms.

The potential of technology. Gallagher suggested testing a standardized system that would require one-time online disclosure of basic corporate information, mandating that it be updated as necessary with changes tracked. “We have not come anywhere close to realizing the potential technology holds for improving our disclosure system,” Gallagher said.

Improving guidance. SEC disclosure guidance could be more reliable and authoritative if significant guidance was issued only with the explicit endorsement of the commission, rather than as staff guidance, Gallagher said.

Opposing politically driven disclosures. The SEC’s newly required conflict minerals disclosures were cited by Gallagher as an example of “ill-advised anomalies” that should not be the realm of an independent, bipartisan agency.

“From an investor’s standpoint, excessive illumination by too much disclosure can have the same effect as inundation and obfuscation—it becomes difficult or impossible to discern what really matters,” Gallagher said.

By Ken Tysiac a Journal of Accountancy senior editor.

What have IASB and FASB convergence efforts achieved?

What have IASB and FASB convergence efforts achieved?


Paul Pacter CPA, Ph.D. served as a member of the International Accounting Standards Board (IASB) from July 2010 to December 2012. At the end of his term on the Board, he wrote the following article.

EXECUTIVE SUMMARY

In this opinion piece, former International Accounting Standards Board (IASB) member Paul Pacter describes the accomplishments of the convergence project undertaken in 2002 by the IASB and FASB. He says many standards have converged, and IFRS have been improved as a result of the process.

On a standard-by-standard basis, results of convergence have been mixed, Pacter says. Some standards have been improved. Some have not changed because the boards couldn’t agree on a converged solution. And a few—revenue recognition, leases, and financial instruments—remain under development.

According to Pacter, although progress has been made through convergence, adoption of IFRS for U.S. financial reporting is the ultimate goal. He says adoption is the best approach for any jurisdiction.

For nearly 40 years, the International Accounting Standards Board (IASB) and its predecessor, the International Accounting Standards Committee (IASC), have been working to develop a set of high-quality, understandable, and enforceable International Financial Reporting Standards (IFRS) to serve equity investors, lenders, creditors, and others in globalized capital markets. When the IASB took over from the IASC in 2001, few countries had adopted International Accounting Standards (as IFRS were then called) even for cross-border public sales of securities, let alone for domestic public companies.

That all changed—and quite dramatically—with two events. First, in 2000, the International Organization of Securities Commissions (IOSCO) endorsed IFRS for cross-border securities offerings in the world’s capital markets. Then, in 2002, the European Union made the bold decision to require IFRS for all companies listed on a regulated European stock exchange starting in 2005. Those events started a snowball rolling, to the point where today roughly 100 countries require IFRS or a national word-for-word equivalent for all or most listed companies.

Almost from the outset, a key goal of the IASB and the IFRS Foundation, under which the IASB operates, has been to bring the United States on board. In a plenary address at the World Congress of Accountants in 2002, Paul Volcker, the first chairman of the Foundation’s trustees, said: “I do not think it reasonable today, if it ever was, to take the position that U.S. GAAP should, de facto, be the standards for the entire world. Rather, the International Accounting Standards Board, whose oversight trustees I chair, is now working closely with national standard setters throughout the world to develop common solutions to the accounting challenges of the day. The aim is to find a consensus on clearly defined principles, and I am delighted that the American authorities appear sympathetic to that objective.”

In October 2002, the IASB and FASB signed a memorandum of understanding that has come to be known as the “Norwalk Agreement.” The two boards pledged to use their best efforts to (a) make their existing financial reporting standards “fully compatible as soon as is practicable” and (b) “to coordinate their future work programs to ensure that once achieved, compatibility is maintained.” “Fully compatible” was generally understood to mean that compliance with U.S. GAAP would also result in compliance with IFRS. That is, the standards would be aligned though not identical.

With the Norwalk Agreement, the boards launched a series of both short-term and longer-term convergence projects aimed at eliminating differences in the two sets of standards. The two boards agreed that where either IFRS or U.S. GAAP had the clearly preferable standard, the other board would adopt that standard. And where both boards’ standards needed improvement, the boards would work jointly on an improved standard.

The Norwalk Agreement has been updated several times since 2002, but always with the objective of two sets of standards that were converged in principle if not in words. The IFRS-U.S. GAAP convergence approach has been repeatedly endorsed by global financial leaders such as the G-20 as an important step on the path toward a single set of global accounting standards.

In November 2007 an important milestone was achieved toward use of IFRS in the United States when the SEC eliminated the requirement that a foreign issuer using IFRS must present a reconciliation of IFRS measures of profit or loss and owner’s equity to amounts that would have been reported under U.S. GAAP. In their comment letter on the SEC proposal that led to removal of the reconciliation, FASB and the Financial Accounting Foundation wrote:

Investors would be better served if all U.S. public companies used accounting standards promulgated by a single global standard setter as the basis for preparing their financial reports. This would be best accomplished by moving U.S. public companies to an improved version of International Financial Reporting Standards (IFRS).

So, where are we today after 10 years of convergence work? Some convergence projects have been completed successfully as envisioned—aligned principles even if the words differed. Others have been completed with partial success—some progress toward converged standards, but some differences remain. And some convergence projects either were discontinued or resulted in different IASB and FASB standards because, in the end, the two boards just could not agree. Some convergence projects continue to this day, including such major projects as revenue recognition, leases, and financial instruments.

At this point, it is reasonable to sit back and ask two fundamental questions about each of those convergence projects:

1. Have IFRS and U.S. GAAP been converged?

2. Even if convergence was not successfully achieved, has IFRS been improved?

The accompanying table, “Results of Convergence,” sets out my admittedly subjective views about the success of convergence and the resulting improvements to IFRS for each of the projects listed in the various agreements between the IASB and FASB. As a final thought, I would add that convergence may have been the most realistic way to initiate the use of IFRS in the United States, but such an arrangement is not sustainable in the long term. Rather, the best approach for any jurisdiction is outright adoption of IFRS. As the trustees of the IFRS Foundation said recently in the report of their 2011 Strategy Review:

As the body tasked with achieving a single set of improved and globally accepted high quality accounting standards, the IFRS Foundation must remain committed to the long-term goal of the global adoption of IFRSs as developed by the IASB, in their entirety and without modification. Convergence may be an appropriate short-term strategy for a particular jurisdiction and may facilitate adoption over a transitional period. Convergence, however, is not a substitute for adoption. Adoption mechanisms may differ among countries and may require an appropriate period of time to implement but, whatever the mechanism, it should enable and require relevant entities to state that their financial statements are in full compliance with IFRSs as issued by the IASB.

Adoption is the only way to achieve a single set of global financial reporting standards—an objective that both the IASB and FASB have publicly endorsed on many occasions.

Click here to read "Results of Convergence: A Look at the Outcome of Key Joint IASB/FASB Projects"

2012 AICPA National Conference on Current SEC and PCAOB Developments

The AICPA Conference summaries are always a source of information that will keep companies out of trouble in financial reporting.

Following is Ernst & Young's brief summary of their longer documnet.

 

Representatives of the SEC, the Public Company Accounting Oversight Board (PCAOB), the FASB and the IASB shared their views on various accounting, auditing, and reporting issues at the three-day AICPA National Conference on Current SEC and PCAOB Developments (Conference) in December 2012 in Washington D.C.

 

Highlights of their comments included: 

• The SEC is continuing to evaluate whether further analysis relative to whether and, if so, when and how to incorporate IFRS into the US financial reporting system is necessary. SEC officials advised stakeholders to “stay tuned.” Various SEC and FASB speakers discussed the importance of the US setting its own accounting standards while continuing to work with the IASB to improve comparability and narrow differences in the standards.
• Various speakers commended the outreach performed by the FASB and IASB and their progress on the convergence projects. Several speakers focused on the need for coordination when developing implementation guidance (e.g., on revenue recognition). Speakers from the FASB stressed the need for timely interpretive guidance to help during implementation and post-implementation.
• SEC and PCAOB officials stressed the importance of audit quality to the capital markets and the relevance of inspection findings, particularly findings pertaining to internal control over financial reporting (ICFR). Some inspection findings could have implications for preparers in their own evaluations of ICFR. PCAOB officials also said they are considering feedback on mandatory audit firm rotation while taking other steps to improve auditor independence, objectivity and professional skepticism.
• The SEC staff discussed year-end financial statement considerations and the staff’s areas of focus in its reviews of filings, including revenue recognition disclosures, the valuation of deferred tax assets and observations related to the new fair value disclosures.
• Various panelists commented on the need to evaluate disclosure requirements, particularly the dividing line between the footnotes to the financial statements and the rest of the financial reporting package (e.g., MD&A). SEC Acting Chief Accountant Paul Beswick said he plans to host a roundtable in 2013 to better understand these concerns.

EY's publication, 2012 AICPA National Conference on Current SEC and PCAOB Developments, discusses the Conference in detail.

Future of IFRS

Recently the IASB published a paper on its future priorities.

In their “feedback statement”, the IASB lists input it received from the public on the future of IFRS. They organized the responses into five broad themes from the more than 240 comment letters it received. 

1. Provide a period of calm after a decade of almost continuous change in financial reporting.
2. Prioritize work on the Conceptual Framework, which would provide a consistent and practical basis for standard setting.
3. Make some targeted improvements in the needs of new adopters of IFRS.
4. Pay greater attention to the implementation and maintenance of the Standards.
5. Improve the way in which the IASB develops new standards, by conducting more rigorous cost-benefit analysis and problem definition earlier on in the standard-setting process. 

The Board also set out five priority near-term research projects. These are:

 

• Emissions Trading Schemes;
• Business Combinations under Common Control;
• Discount Rates;
• Equity Method of Accounting;
• Intangible Assets; Extractive Activities; and Research & Development Activities;
• Financial Instruments with the Characteristics of Equity;
• Foreign Currency Translation;
• Non-financial Liabilities (amendments to IAS 37); and
• Financial Reporting in High Inflationary Economies.

 

You can read the full report here.

Disclosure Overload: FASB Project Comments

A lot of recent commentary exists on the subject of disclosure overload.

 

Recently the FASB has begun to focus on this topic. "Streamlining Disclosures" has become subject of various initiatives, including a recent round-table discussions this conducted by FASB and the Center for Audit Quality.

 

FASB has also initiated a Disclosure Framework project "to improve the effectiveness of disclosures in notes to financial statements by clearly communicating the information that is most important to users of each entity’s financial statements. Although reducing the volume of notes to financial statements is not the primary focus, the Board hopes that a sharper focus on important information will result in reduced volume in most cases."

 

"Boilerplate" and non-material disclosure have been said to be "noise" that obscures the real information that readers of financial information really need.

 

FASB published an Invitation to Comment (ITC) on this topic last July 12. They asked stakeholders to comment on whether and how disclosures in the footnotes to financial statements can be made more effective. The comment period ended Nov. 16.

Some of the questions:

• Do the decision questions in this chapter and the related indicated disclosures encompass all of the information appropriate for notes to financial statements that is necessary to assess entities’ prospects for future cash flows?
• Do any of the decision questions or the related indicated disclosures identify information that is not appropriate for notes to financial statements or not necessary to assess entities’ prospects for future cash flows?

Commentors said unnecessary disclosures can prevent users from finding the information they need, obscure the real information and waste prepares' time, money, and create undesirable environmental outcomes, i.e. too much paper.  

The FASB received 83 comment letters. Some comments: 

 

• Issuers should only provide relevant disclosures
• Disclosures should have a narrower focus that "could be useful to investors"
• Concern over the risk of litigation or regulatory action because preparers omit information previously provided. 
• Avoid using the term "relevance" 
• Watch the SEC's requirements, i.e. no point to reducing GAAP disclosures if the SEC imposes more specific requirements
• "The uses of boiler plate disclosures and reliance on checklists have inundated both the public and private sector as the volume and complexity of reporting requirements have increased significantly over the years. We believe having the flexibility to apply professional judgment will substantially reduce unnecessary disclosures."
• "We believe that preparers' judgment should instead be focused on what is material to the company based on a set of flexible disclosure requirements. Enabling flexibility, based upon materiality, would result in the right balance of providing relevant information while maintaining comparability."


• "Disclosure overload and complexity are the two aspects of financial reporting that financial statement users and preparers, large or small, agree on: There is too much of both."

This will be interesting to watch over the next few years. Don't expect a quick reduction in disclosures for this year's 10-Ks!

 

 

500 Foreign Firms Still use U.S. GAAP U.S. Regulatory Filings

Good article by Emily Chasan of the WSJ.


The Big Number: 500

That’s the approximate number of foreign firms that use U.S. accounting standards in U.S. regulatory filings.

Some foreign companies that file financial reports with U.S. securities regulators are having trouble freeing themselves from U.S. accounting standards.

Five years ago the Securities and Exchange Commission voted to let U.S.-listed foreign companies that use International Financial Reporting Standards stop having to reconcile their financial statements with U.S. Generally Accepted Accounting Principles. But about 500 companies, or roughly half of the 1,000 foreign companies listed on a U.S. exchange, still submit their filings using the U.S. standards.

Some companies still must reconcile their home country’s accounting rules with U.S. GAAP, “but that number is shrinking in favor of companies that switch” to IFRS, Craig Olinger, deputy chief accountant in the SEC’s Division of Corporation Finance, said recently at a Financial Executives International conference.

More than 100 countries currently use IFRS. European companies, which have been using those standards since 2005, are the largest group using international rules for U.S. filings. Canada, which accounts for the biggest number of foreign SEC-registered companies, should soon have more companies using international rules for their U.S. filings after switching to IFRS last year. Some of the 340 Canadian companies that file with the SEC still reconcile their results to U.S. GAAP, Mr. Olinger said.

U.S. regulators still haven’t decided whether U.S. companies should be able to report using IFRS, and the successor to SEC Chairman Mary Schapiro will play a large role in that discussion. A widely anticipated study by the SEC’s staff earlier this year didn’t make any formal recommendations on the matter. Mr. Olinger said the SEC staff stays up to speed on trends in IFRS and performs reviews of filings in international standards at the same level that it inspects those done in U.S. GAAP

Significant vs Material

Often the terms “significant” and “material” are used interchangeably. This can course a lot of confusion. The SEC once took a company to task asking why they used this explanation of a contingency:

“You disclose...that you do not expect the ultimate conclusion of any of the proceedings to which you are a party to have a “significant adverse effect” on your financial statements and you have not disclosed the contingent liabilities associated with these claims either because they cannot be “reasonably” estimated or because such disclosure could be prejudicial to the conduct of the claims. Please revise your future filings...to more clearly confirm that you believe the ultimate conclusion of any of the proceedings to which you are a party will not have a “material” adverse effect to your results of operations, cash flows, or financial position.


Why the distinction between "material" and "significant"? To help with understanding the difference between "significnant" and "material" , the following comes from a paper on the IASB 2008 Annual Improvements Process, Comment Letter Analysis:

Significant vs Material

As mentioned above...some respondents asked for further clarification of the Board’s intentions in changing material to significant.

According to paragraph 30 of the Framework:

“Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.”

“Significant, on the other hand, is not a defined term in IFRSs but is used throughout IFRSs to denote the degree of importance or relevance, eg significant costs (IAS 16) significant increase in turnover rates (IAS 19), significant period of time (IFRS 2).”

“Some respondents questioned whether it is possible to have a material change in the number of employees that is not significant. The staff notes that it is not meaningful to say there is a ‘material’ change in the number of employees in IAS 19 since the standard does not require that number to be disclosed in the financial statements.”

Clear as mud?

US GAAP Requirement for Push Down Accounting

Had a recent comment that push down accounting wasn not mandatory under USGAAP, rather is was simply permitted in certain circumstances. In response to that previous comment, the FASB requirement for push down accounting is 805-50-S99-1. Readers of this part of the Codification will need to pay careful attention to the answer in question1, and not jump to conclusions that push down accounting is allowed (see question 2).

Following is the text of SAB Topic 5.J, New Basis of Accounting Required in Certain Circumstances.
Facts: Company A (or Company A and related persons) acquired substantially all of the common stock of Company B in one or a series of purchase transactions.

Question 1: Must Company B's financial statements presented in either its own or Company A's subsequent filings with the Commission reflect the new basis of accounting arising from Company A's acquisition of Company B when Company B's separate corporate entity is retained?

Interpretive Response: Yes. The staff believes that purchase transactions that result in an entity becoming substantially wholly owned (as defined in Rule 1-02(aa) of Regulation S-X) establish a new basis of accounting for the purchased assets and liabilities.

When the form of ownership is within the control of the parent the basis of accounting for purchased assets and liabilities should be the same regardless of whether the entity continues to exist or is merged into the parent's operations. Therefore, Company B's separate financial statements should reflect the new basis of accounting recorded by Company A upon acquisition (i.e., "pushed down" basis).

Friendly Accounting at Facebook

This post is courtesy of the Accounting Onion


U. S. Senator Carl Levin recently spoke on the Senate floor, referencing the discrepancy between tax and accounting treatment of stock options in the (then upcoming) Facebook IPO:


"According to its filings, when Facebook goes public, Mr. [Mark] Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg's shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion.


Here's where the tax loophole comes in. Under current law, Facebook can – perfectly legally – tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share – that's the expense shown on the company's books. [This is wrong – see later.] But the company can also – perfectly legally – later file a tax return claiming that those same options cost the company something close to what the shares actually sell for later on – perhaps $40 a share. And the company can take a tax deduction for that far large [sic] amount. So the books show a highly profitable company – profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books. …


Now, the end result is that a profitable U.S. corporation – a success story – could end up paying no taxes at all for years, even decades."
To Levin, the Facebook IPO is a dramatic illustration of an inequitable "loophole" in the tax law. As Levin and Sherrod would have it, Facebook's tax deduction for using stock options to compensate executives – as opposed to any other form of compensation – would be essentially zero (that's probably a little dramatic on my part, but the point is the same); yet, Zuckerberg's tax liability when he exercises the options could be somewhere in the area of $3 billion.


The strong implication of Levin's narrative is that the extra amount of expenses would have wiped out every dollar of Facebook's reported net income that it had ever 'earned.' On top of that, there could be other outstanding options held by Zuckerberg and other employees extending way down the organization, which are going to have the same effect on future reported net income.


Which brings me to my second question: For all practical purposes, could Zuckerberg be taking Facebook public at this point in time with no history of profitability, perhaps negative shareholders' equity, and perhaps no hopes for earnings for some for years to come?


My inclination is to say "no," but I can only speculate. So, I will answer that question with another question: Since the FASB's rules understate the economic cost of options granted to employees, did the FASB provide a perverse incentive to Facebook to grant more options (or at terms overly favorable) to employees than it should have?


If one accepts the maxim that "what gets mismeasured gets mismanaged," then the answer to that question should be "YES." The stock option problem lies not with the tax rules that eventually recognize the full cost of the options to shareholders, but with the financial reporting rules that allowed Facebook to grant options without recording their full cost.


Surely, the senators can see that different accounting rules would have wrought different compensation policies from Facebook. Senator Levin would not have had a story to tell and Mark Zuckerberg would be a few billion dollars poorer.


Footnote: It is my distinct pleasure to provide Senator Levin (and his staff) with yet another accounting lesson. The amount of expense to be reported by Facebook is not, as the senator claims, the exercise price of the options (i.e., 6 cents per share). Assuming that the options were issued without any intrinsic value, then their "grant-date present value" (i.e., the amount upon which periodic option expense is measured) could end up being more or less than 6 cents per share. Although this technical correction to Senator Levin's story it doesn't fundamentally change the message, it once again reveals a lack of understanding that makes one question if Senator Levin has an adequate grasp on the issues.

Industry Expert: When and How to Adopt New Standards and IFRS

Bob Laux, Microsoft's accounting guru did a long and interesting interview with Bloomberg. Worth a read for his thoughts on all of the critical upcoming accounting standards changes, including timing of adoption.

In a wide-ranging interview with Bloomberg BNA, Robert Laux, senior director of financial accounting and reporting at Microsoft Corp., laid out the major issues in accounting rulemaking—with a particular focus on their potential impacts on multi-national companies. The main topics included the SEC decision on U.S. domestic use of IFRS, and top projects of the standard-setters, including revenue-recognition, financial instruments, lease accounting, and intangible assets. Steve Burkholder, a Bloomberg BNA staff correspondent, conducted the interview—an edited version of which follows.

Bloomberg BNA: The Financial Accounting Standards Board and the International Accounting Standards Board continue their long-running work to converge on a single set of accounting rules for global use.

Concurrently, many U.S. companies, audit firms, and investors await a highly-anticipated decision by the Securities and Exchange Commission on whether and, if so, how to incorporate international financial reporting standards into the reporting system for U.S. public companies.

If the SEC decides on some form of an officially prescribed use of IFRS in this country, what kind of an impact might that have on a large U.S.-based multinational company such as Microsoft?

Laux: Let me try and speculate on what may be the decision coming from the SEC although of course I don't know anything more than anybody else. The SEC had a staff paper that they produced, which talked about a dual process, if you will, of endorsement and convergence. In a speech at the AICPA's SEC [developments conference] a couple of years ago, one of the SEC staff used the word "condorsement." I think that's a good word because it aptly describes this process which is a combination of endorsement by the FASB with some convergence work. And no matter what the decision is—unless it's a decision not to go down a path of international standards (which I don't think would be the answer) —I think we need to do something to incorporate international standards in U.S. [generally accepted accounting principles, or GAAP]. If that does happen, it probably will be, in my opinion, like a condorsement [approach].

That would have quite a big impact on U.S. companies. Under this approach, the IASB will be taking on new projects and the FASB will be heavily involved, and then will have an endorsement mechanism that is given to them [the FASB] by the power of the SEC to endorse what the IASB does.

Convergence: Longer Than 5-7 Years.

Laux: I don't think that's going to have a really big impact on companies, maybe elongating the process a little bit. I think the bigger impact is on the so-called convergence area. These are like legacy accounting issues that we have in U.S. GAAP that may be in IFRS but the answers are slightly different, or there's just not IFRS guidance applicable or on point. The SEC staff paper indicated maybe a five- to seven-year time period for the FASB to look at these differences and try to incorporate the IFRS standards. However, I believe that may take longer than five to seven years— that's where there can be a somewhat big impact on companies.

Let me give you two examples. One is stock-based compensation, a joint project, but there are some differences between the U.S. GAAP and IFRS standards. One standard has to do with graded vesting and the other has to do with the way income taxes are recognized on stock-based compensation. Those can be significant differences, and if a company needs to change, that could have a significant impact.

Another issue is component depreciation, or depreciation in general.

Under IFRS, component depreciation is required. Under U.S. GAAP, it's an option that most companies do not take on—that could be a significant change. For instance, FinREC, which used to be [the Accounting Standards Executive Committee, of the American Institute of Certified Public Accountants], did a project—it's almost 10 years-plus ago—I was actually on the committee at the time–which considered having a requirement for component depreciation. Our feedback was that people were opposed to the idea.

So I think you're going to have those same kinds of discussions with these legacy differences, I call them, with U.S. GAAP versus IFRS that I think will have somewhat of an impact, to a big impact, on U.S.-based multinational companies.

Big, Tough Decision for SEC.

Laux: I think the SEC has a big, tough decision on their hands. We'll talk about that a little later in this interview. But the issue with that is— the ultimate goal—and it was in the SEC staff paper [of November 2011]—was incorporating IFRS in U.S. GAAP, with the aim to say after so many years (and I believe it's going to be more than seven years), the goal was to say that if you're in conformity with U.S. GAAP, you're also in conformity with IFRS. And that's difficult to do because of [some possible] so-called grandfathering-type of items. Maybe something could be done with what's called IFRS 1 [First-time Adoption of International Financial Reporting Standards] and the way of adopting international standards. Perhaps international standards can be slightly changed.

But some of these things that people think should be grandfathered—this is what makes it so difficult. And some would argue that, if you had these grandfathered items, then you truly do not have a global set of accounting standards if we're using different rules in the U.S. versus internationally.

I'm still a proponent of [the notion] that the world of business, of finance is international in nature, and we need to move towards a goal of having one set of high-quality global accounting standards. It's going to take us time to get there—probably a long time. And a lot of work's already been done on that.

For instance, when you bring up these grandfathering issues—yes, there are challenges and we may never get to the perfect answer. But that's not an excuse, in my opinion, for not striving to get more comparability on a global basis.

Revenue Recognition: `Going Pretty Well.'

Bloomberg BNA:As you know, one of the main standard-setting projects that the FASB and the IASB are working on is revenue recognition. How is that going, and how is the recently re-issued—and revised—proposal likely to affect companies?

Laux: I think the revenue recognition project is actually going pretty well. I'll have to go back to when it first started a number of years ago. As you know, standard-setting is difficult. People have a lot of opinions, and it takes time. But this has been on the agenda for a while now [Editor's note: It was added to FASB's and IASB's agendas in 2002]. But I remember when there were discussions of first doing this. And one of the main motivations, I believe, was to be able to converge U.S. GAAP with IFRS. U.S. GAAP has a lot of literature on revenue recognition, a lot of it [is] industry-specific. I don't know the number of references or standards on it, but people have said it's close to 200, if not over 200.

In international standards, it's really two standards and interpretations that go with them. And if you look at multiple-element arrangements, and you're not looking at the construction industry, some could argue that international accounting standards have one or two paragraphs on it.

So, this could almost be the poster child for convergence. But the point I'm trying to make is, with all that literature in U.S. GAAP, my first opinion was there's no way they're going to be able to pull this off. There's just no way that they'll come up with a general standard, or one standard, on revenue recognition. But I'll have to give the standard-setters credit here—they pretty much have been able to do that with slight disagreement with a few things in the standard. I'd also like to say that, this is probably—and I'll use the term again—poster child by the FASB staff and the IASB staff of the best way a project can be run. The staff did an outstanding job.

So, to get to your question, I think it's actually gone pretty well. The exposure draft that's out now is kind of unique, based on my experience, in that, when you have an exposure draft, you write comment letters indicating what you think about it.

Well, this exposure draft, many people and companies, including us at Microsoft are seeing it as very close to final. We are considering the implications for Microsoft, and what needs to be done? Our belief is that the rule will have a big impact on how we look at revenue recognition, when it's recognized. Also there may be more of an impact on our processes and procedures to make sure we're in compliance with the new standard.

But the point I'm trying to make is that, I think it's getting very close to what the final [standard] may look like. There is discussion on some issues. The two big issues that I know of, that people are really discussing, are the disclosure requirements and the transition provisions.

Bloomberg BNA: That's interesting, because as you know, it's been a common refrain at the FASB that sometimes the board's constituents don't follow standards during their formation as closely as they could until they see something cast in stone, or as a final standard. But this is perceived, as you say, as being close to final.

Laux: And, as you know, on the first exposure draft, there were close to a thousand comment letters, I believe. It just shows the amount that people have been engaged. Again, I'm not trying to sugar-coat it, or be self-serving, I really believe—especially in this project—the FASB and the IASB staff did a tremendous job of outreach, understanding industry-specific issues. And also outreach to users [of financial statements]. So there's been a lot of comment. And I think it's due to that we're in this shape that I described. It looks like it's close to final, in my opinion.

Resigned to On-Balance Sheet Lease Accounting.

Bloomberg BNA: Another joint FASB-IASB project with potentially big impact is leases. Basically, how is the draft standard being received? What kind of impact will that have on Microsoft? Going further, how might that impact compare with that on firms such as airlines, banks with many branches, shipping companies, and the big equipment leasers?

Laux: I think it's being received with mixed emotions. As you know, an exposure draft was issued, and the standard-setters are redeliberating the issues. We're expecting another exposure draft to come out.

I'll speak from the lessee side, because Microsoft is not a major lessee, but we're not much of a lessor, in essence. Our licensing of our software is under the revenue recognition standards. So we are a lessor in certain circumstances, but it's really on the lessee side. It's not going to have as much of an impact on Microsoft as [the planned standard would have] on the airlines, on banks with many branches, or, let's say, a grocery store chain with many locations or fast-food or restaurant chains that do a lot of leasing.

I believe people are resigned— I'm not sure resigned is the best word—but accept the fact that, in general, that leases will come on balance sheet. The SEC staff did a paper as a requirement, I believe, of [the Sarbanes-Oxley Act of 2002] to look at off-balance-sheet financing, and leases was one of the larger issues that came up. The people understand that maybe it does provide more information to users if they're on balance sheet.

I know there are still some people who are strongly in disagreement with that. But I would say, in my opinion, most people are resigned.

On the lessee side, the big issue right now is the expense recognition. And under lessee accounting—and it's really operating lease accounting—today, for the most part, in very general terms, you have straight-line rent expense. I'm renting something for $1,000 a month; I'll show $1,000 of expense a month. The way the exposure draft came out is that there would be a front-loading of that expense. I don't think we need to get into the details or the technicalities of how that occurs. It's looking at the liabilities separately from the asset, if you will. There's been a lot of feedback on that. The standard-setters are taking another look at that and it's my understanding they're doing outreach to constituents this month, to get prepared to talk about it soon—on the right way to approach this issue. So, that up-front expense recognition, instead of straight-line, could have a big impact on companies.

Let me just say, from a Microsoft perspective, as I said, we're not a big lessor. So we haven't been following it as closely as it doesn't have as much of an impact on us. But it looks like the lessor model is very complicated. I think—and I could be wrong—in that once people dig into that, you may be hearing more discourse from constituents saying, "Boy, this is pretty complicated. It may be a lot of work to actually implement in practice." And hopefully there will be discussions, if that is the case. When I look at it, and say, it's not really going to impact us to any great extreme, not in a material amount, but, boy, it looks awfully complicated, the model that's being presented for lessors.

Accounting for Financial Instruments: The Challenge Continues.

Bloomberg BNA: Another of the highest-priority projects of the FASB and IASB is financial instruments. That project has been a challenge overall. What is the outlook for convergence on that and what kind of effect would that have on banks as well as non-banking companies?

Laux: As you said, it has been a challenge overall. It's a difficult and complicated area, as you know. One of the problems, in my opinion, is that the standard-setters were starting from different points—they were leapfrogging each other,—in discussing the issue. That makes it very difficult to get one converged standard for financial instruments, when the IASB is working on something before the FASB, or vice-versa.

You can really see three areas they're working on. The first one is classification and measurement. The second one, impairment [or accounting for loan, or credit, losses]. The third one, hedging. And both the FASB and the IASB are in different spots.

This is going to be tough. You can almost look at those three components, as three separate, huge projects in and of themselves. So this shows how challenging this project is.

On recognition and measurement, what makes it even more challenging is that the IASB already has a standard out there, IFRS 9, on recognition and measurement [of financial instruments]. They delayed the effective date on it for a couple of more years —I believe, until 2015—and the European Commission has not even endorsed the standard. But there are other constituents, from what I understand, for instance, Australia, where companies have actually adopted it early. I don't have first-hand knowledge of this.

So you can see that that's a difficult proposition for the IASB. They want to work on convergence and work with the FASB, but if some of their constituents have already adopted the standard, you have to have some sympathy for the IASB and those who adopted, saying, "We adopted this. You're going to make us change again?"

But the IASB has said, in the spirit of convergence and how important this part of it is, that they would do limited reopening of IFRS 9—most of it, I believe, for the impact on insurance companies and different things like that. So, both boards are working on that issue.

The Securities Microsoft Holds: Where Are Fair Value Changes to Go?

Laux: When I'm breaking these up into these three categories: This one [on recognition and measurement], where currently the IASB rules are, and where the FASB is heading, actually would have a potentially significant impact on Microsoft.

We have a lot of investments in equity instruments—ownerships in companies, given our cash portfolio and investment portfolio. Currently under U.S. GAAP, any mark-to-market changes, fair value adjustments are shown as a component of other comprehensive income. Well, under the proposal, they would be shown as components of net income. And given the way the market moves, and our investment portfolio, we could have some potentially significant variability in net income.

We're a little concerned about that and have disagreements about the way the standard-setters are looking at, thinking about instruments. I don't think it's necessary for us to get into detail, but they're looking at both the characteristics of a financial instrument. We think that maybe the business model is really the important thing—of what companies are doing with these securities— we hold them, for the most part, for long-term strategic purposes.

Microsoft believes that a user should be informed of fair-market value changes. It's an economic event, phenomenon. But especially with the new standard on the presentation of other comprehensive income, we think it will be transparent to users. I can't speak for users. They need to speak for themselves, and can expertly speak for themselves. The volatility that goes through net income, I just fear that there may be a lot of users who will strip that out and say, that is not really what we want to see for your results for this quarter, for thinking about, predicting future share prices, and we're going to strip that out.

So it's just kind of a conundrum. Do you really want that volatility to go through the income statement? We want it to be transparent, but believe it's transparent currently in other comprehensive income.

Let me quickly go to the other two, impairment and hedging. Impairment has been difficult, as you know. The FASB and the IASB are working together and trying to come up with a converged solution. This three-bucket approach still needs a lot of meat on the bones for a lot of us to understand it, but they are working on it.

Hedging, I perceive they're even further apart. The IASB has a project that they're probably going to finalize soon, if they haven't already. And I think the finalization [involves] putting a staff draft for people to [study]. But it's really kind of a business-model type of thought process for hedging, or having hedge accounting, and it's quite different from what the FASB has been looking at or what their proposal was in their original financial instruments exposure draft [Editor's Note — That first FASB proposal was issued in May 2010]. So, they're quite a ways away in that, in my opinion.

If I go through the three [elements of the joint instruments project], I give them credit again, because they're working on trying to converge. On recognition and measurement, there's a lot of convergence there. They're working around the edges, if you will. You've heard my or Microsoft's disagreement with some of their conclusions, but the conclusions are what they are. Impairment, a little farther apart, but they're working hard on it. Hedging, I think they've got a ways to go.

Just to comment on the last part of your question. Obviously, [there would be] a significant impact on banks, financial institutions. That's their business. Just as revenue recognition is potentially going to have a significant impact on companies like Microsoft, it's just obvious that [the planned financial instruments standard] will have a big impact on financial institutions.

Financial Instruments: Potentially Big Effect on Non-Banking Firms.

Laux: The point that I try to make, however, is also that it will have a potentially big impact on non-banking companies, like Microsoft. Sometimes I get a little concerned that there's not enough attention paid to that issue. And it really goes back to the issue I discussed previously. This tentative conclusion that you've made [on investments in equity securities] could potentially have a significant impact on the variability of Microsoft's net income due to market changes. Is that really the best way to inform users of our financial statements?

And there are other sub-issues, like how complicated is the impairment model going to be? Are you making it a model based on the way financial institutions work? Or are you looking at actual non-banking companies and how they think about it, and making sure you don't make it overly complex for them? That's another one of my concerns.

At times, it feels that maybe they're just focusing too much on the banking industry and financial institutions. It's very important to them. I understand why that is, but it's important to point out that it will also have significant impacts on non-banking companies and they need to keep that in mind.

End-Dates for Key Projects, and Rules' Effective Dates.

Bloomberg BNA: For the projects we just talked about, what might be the end-dates for them, if you can prognosticate? That would be the three highest-priority projects for both boards, excluding insurance contracts, which is a topic of more immediate concern for the IASB. And what do we know about possible effective dates for the planned final standards?

Laux: Again, we're talking about revenue recognition, leases and financial instruments. I'm leaving off what some call the fourth project, insurance. On revenue recognition, I believe they're very close. The comment letters are in. Roundtables are coming up. The one at the FASB is [set for April 26]. So they are going to get that feedback, and they need to do redeliberations. [Editors' Note—He cited reported statements by FASB Chairman Leslie Seidman and by IASB Chairman Hans Hoogervorst on work plans]. And maybe the schedule [for completion of the revenue effort] is by year end. It could leak over into the beginning of calendar year 2013, in my opinion, but probably not much. I think that's close to being finalized by the end of the year, or close to the end of the year.

If we go project-by-project, and just talk about this one [revenue recognition], its effective date, a lot of people believe will be no earlier than three years from now. You need to give people at least three years to implement a standard. And the math on this—and let's say it's finalized by Jan. 1, 2013—then it would be, we believe, no earlier than January of 2016, at the earliest. In essence, both standard-setters have signaled that when they said [last year] that these standards would be effective no earlier than 2015—as we know, that schedule slipped a little bit, and I would say no earlier than 2016.

Leasing Standard: `At Least Another Year Away.'

Laux: That's a description of revenue recognition, which is the closest [to completion]. If I were prognosticating, I would say leases is at least another year away. So let's say a possibility—and this is just me guessing—of it being finalized in 2013. Let's say by Jan. 1, 2014, with maybe an effective date of 2017.

As for financial instruments, especially when you think of the three [parts of the project], there's a lot of work still to be done, so I couldn't even guess on that one.

Let me just make one final comment. We're struggling here at Microsoft, and it was actually in our comment letter on revenue recognition, and it's been a few years now, looking at what the possible implication would be if Microsoft adopted IFRS, or IASB standards. And that was in the context, as you know, if we go back three to four years, five years. It seemed at the time there was more momentum for an actual, pure adoption of the IASB standards. So, we looked at a project of what that impact would be. And, as you know from other companies, it would have been a significant undertaking.

But what we learned, when we did very high-level work, was how difficult it is to go back in history and redo the accounting for something. What the point we're making here at Microsoft is that—especially on revenue recognition, as an example—we think there could be potentially significant process, and procedural changes, system changes, that we need to make. And we think it's important that those systems and procedures and processes are in place before we make the entry.

Preparing Systems for Retrospective Application.

Laux: Let me describe this to you, because it's kind of weird to describe. It has to do with looking at the adoption technique of a standard, whether its going to be prospective or retrospective. If you go retrospective, you need to restate two years. In that context, we would like to have a system in place, prior to having to restate those two years, so that we can have parallel systems. If you do the math on that, it's more than three years, because you're talking about getting your systems in place, which, as we know in companies, is a very difficult proposition and could take up to two years. Then if you have to restate for two additional years, you're at four, close to five years.

I know the standard-setters want to get these out and get them effective. They're important standards that we need to do new accounting on. But there is that issue with the transition method. And, if there is, maybe [under] a modified prospective type of treatment, I think companies would have the ability to implement these within the time line of this three years that the standard-setters may be looking at. Even though three years sounds like a lot of time, given the requirement to do retrospective adoption and restating two additional back years, it's going to be very difficult, in my opinion, for companies to get there in a three-year time period.

SEC Staff's `Condorsement' Idea: `An Elegant Solution.'

Bloomberg BNA: These questions pertain to how the Securities and Exchange Commission might proceed on the big question of incorporation of IFRS in the U.S. reporting system. You already touched on this back in the earlier minutes of this interview. Do you have a sense of the how —if the SEC does make a definitive decision on IFRS use in this country—and the when?

Laux: Just like anyone else, I don't have any extra insight. You know that as well as I know that. I'll tell you what I would like to see, speaking personally, not for Microsoft. I am a proponent of what we discussed as "condorsement" [in] the SEC staff paper. The Financial Accounting Foundation [the parent group of the FASB and the Governmental Accounting Standards Board] has made some comments on that and, in my opinion, generally accepted what the SEC [staff] said, with some suggestions for some potential changes. But not overhauling the entire thing, or disagreeing with it.

I think it's a somewhat elegant solution. And it gets back to the issue that I'm a firm believer that the economy is world-wide in nature. We're interconnected. Just look at the contagion issues we have, where something may happen in Greece, or [elsewhere] in Europe, and the impact that could have on us in the United States.

SEC Needs to Give a Signal—`Soon.'

Laux: I strongly believe that the SEC needs to give some kind of indication of where their thinking is and needs to do it soon, just because of the uncertainty in a number of different areas. Uncertainty from a company's perspective about what we should be doing. Uncertainty from the IASB's perspective, where they have other constituents, saying, "Why all this U.S. stuff? It seems like you're ignoring us at times." (I use those terms loosely).

So, if I had my druthers, I think that the condorsement or an endorsement mechanism with further convergence on legacy-type standards that the FASB would look at is the way to go. I seriously believe that the SEC needs to come out with some indication of that within this calendar year, preferably within a couple of months. And you well know what the chief accountant at the SEC, Jim Kroeker, has indicated.

I'll go on a little bit of a tangent. I hear some people saying, well, it's an election year. While I understand that, this issue hasn't – thankfully, in my opinion – got into the presidential election debate. And I don't think it deserves to be in that debate. We have much bigger issues, in my humble opinion. I generally do not see the president and the presidential candidates on the Republican side talking about U.S. adoption of international standards. I don't think I've heard them mention it once. I would really like to see an indication from the SEC, this year, sooner rather than later. I think it's important for the U.S. It's important for the international community. It's important for the IASB.

Bloomberg BNA: Where do you think that indication might come from, if it does come from the SEC? They have their due process considerations, of course. Would it come from the commission or come from the staff?

Laux: I'm probably not the one to answer that, but I'll try to answer, based on my layman understanding of the issue. It's such an important decision, and such a big decision, that of course you have to have the commissioners weighing in on it. And I think you need to have due process.

Even the staff coming out with a paper that says, "We had the previous paper— the condorsement paper. We received feedback. And here's our current thinking that we're sharing with the commissioners and we're getting the commissioners' feedback on that." And I also think that, just like with anything else the SEC does, it will be subject to due process. Not knowing the rules of procedure like the back of my hand, when they issue something, there's always due process— that people can comment on and I think they'll encourage comment on this. I don't know the technicalities or nuances. Is it technically required that the commission actually vote to do something?

It's such a big decision, a critical decision that I think all of us would want the commissioners' opinion on it. Now it may not be a formal vote but I don't know the rules of procedure that well to definitively comment.

At FASB, Which Projects Off the Back Burner?

Bloomberg BNA: On the FASB and its potential agenda, at its March 23 meeting, the board's Financial Accounting Standards Advisory Council held lengthy breakout discussion sessions to home in on which out of the so-called "back-burner projects" should be the next major efforts of the U.S. board – that is, once the high-priority joint projects make it into the home stretch. Pension accounting and financial instruments with traits of liabilities and equity were high on the lists of a majority of participants. What do you believe should be on the FASB's new, short, must-do-next list and why?

Laux: It's a difficult issue because we have these big convergence projects and then, once they're completed, we need to look at what's going to be done next. I'll go on the assumption that a given is to complete the convergence projects, and it's really only after those, FASB will consider what's next.

Just as a sidelight, the IASB came out with an agenda consultation asking this question formally, probably similar to what FASAC discussed in their meeting. I'll give you Microsoft's comments. We did think that [financial instruments with traits of] liabilities/equities may be an issue that needs to be looked at. It's a very difficult practice issue for the standard-setters to handle. We thought that was important.

We don't have a pension here at Microsoft. So I have to tell you that it may not be high on our radar screen, so we didn't mention [accounting for pensions]. I could understand that comment, and we didn't put it in our letter to the IASB. It would not be a high-priority project for us, but the IASB is doing work on that, and the FASB is looking at it, so there could be some convergence there. I understand that.

Seeking a Better Definition of OCI.

Laux: One other one—and I'm not sure if this came out of FASAC's discussion—but what a lot of people are talking about is that the standard-setters need to become more definitive on the definition of other comprehensive income.

Bloomberg BNA: That did come out actually. That was high on the list.

Laux: It's kind of connected with the conceptual framework project. You could say that this is part of the conceptual framework project. Even, you could say, a disclosure framework project may be part of that. And I know that's on people's radar screens. We also said other comprehensive income and trying to define that. That said, that's going to be a very difficult project. Very difficult to come up with a definition, because, once you define it, you say, "Well, what about things we've done in the past that are in other comprehensive income? Do we change them? Do we put more in there?" So, I think that's a tougher project than even liabilities and equity.

For Microsoft, Intangible Assets Important.

Laux: Also on the agenda paper, when you used the term "short," I think you meant it as a small number of items. One item that we're kind of passionate about here at Microsoft is intangible assets. We believe, speaking generally, we're in an information economy. We've moved from the manufacturing economy, if you will. And we're not sure what the right [accounting policy] answer is there. I don't believe we're proponents of capitalizing a lot more intangible assets. That's kind of a double-entry thought process, if that makes sense.

Bloomberg BNA: And here you're talking about R&D, for example?

Laux: Yes, for research and development. And maybe just more information on intangible assets. What we suggested—and this would be a longer-term project—we believe it's important that, because intangible assets and intellectual capital, especially for a company like Microsoft, have a significant impact on our value—it is our most significant value driver—the accounting standards really have not kept up with that change in the economy. So we believe it's important for the standard-setters to look at that.

What we didn't want to do is prejudge what the answer is, because it could be disclosure. It could be going into areas like key performance indicators, which is difficult for the standard-setters to go in, especially in the U.S., because the SEC is the keeper, if you will, of management's discussion and analysis, not the FASB. But even in the disclosure framework project, the FASB, as a second part of that, has said that they'll look at possible integration of management's discussion and analysis with the financial statements and footnotes.

Now, of course, you need the FASB and the SEC and other constituents to cooperate. I'm a strong proponent that we need to go in that direction. To answer your question definitively, the third [topic] that we pointed out here at Microsoft is intangible assets. So, in summary, agree on liabilities and equity; understand that pensions is not an issue for us; other comprehensive income; conceptual framework; disclosure framework. And as a longer-term project, and maybe it's a research project, intangible assets.

Bloomberg BNA: You have been active for many years on the Committee of Corporate Reporting of Financial Executives International. Do you have any indication of what projects CCR would like to see the FASB tackle next?

Laux: First, I wanted to be careful [and say] I'm not speaking for FEI or the Committee on Corporate Reporting. But I'll give you my opinion from interacting with the group. I think it's somewhat similar to what was discussed at FASAC. And, as you know, there are members of FEI and the Committee on Corporate Reporting that are actually members of FASAC. For the CCR and FEI, the disclosure framework and disclosure issues are a big issue. Conceptual framework is a high[-priority] issue. There's a belief that we need to finalize and update the conceptual framework so there is a blueprint, if you will, of how to go about in setting standards and what to think about. I would say definition of other comprehensive income is important, and the FEI/CCR commented on that in their response to the proposal on the display of other comprehensive income.

I believe pension accounting is important to some CCR companies, and that would come up. So I think it's pretty consistent.

The one thing I want to add, and this also came up in the IASB's agenda paper, is with these huge convergence projects that we're working on—revenue recognition, leases and financial instruments—there's a lot of change going on. And maybe a period of calm is necessary for companies to actually implement these and make sure that they're implemented correctly and consistently, which by necessity, groups will need to talk about the right way to implement things.

Bloomberg BNA: Back when the IASB first saw its standards being adopted by the European Union countries, through the European Commission, they talked about having a "stable platform."

Laux: That's the term. So maybe we need a mini-stable platform for a number of years because what we're working on right now are just significant changes. So I would say that's another, in my opinion, another commentary that you'll hear from FEI and CCR.

Bloomberg BNA: One FASB project on which the board's chairman, Leslie Seidman, as well as the SEC staff, have mentioned recently in public discussion is the disclosure framework. The aim and primary focus of that effort are to make footnotes to the financial statements more effective. Over the years, companies have complained about what they call "disclosure overload." Do you see that disclosure overload is a problem? Do you believe the focus in that project is an appropriate focus?

Laux: I like to use a slightly different term—instead of disclosure overload, I like to use the term disclosure effectiveness. Sometimes the term disclosure overload has some baggage. People read into it and have some negative associations. When I go into disclosure overload, what I get concerned about is there's so much disclosure, that maybe the really important items that are being disclosed may be getting lost in a sea of information. In our day-to-day lives, it's almost information overload. It really gets to disclosure effectiveness. My opinion is this should be priority one.

There's a lot of complaints that some of what we're doing in financial reporting seems like a compliance exercise, not a communication exercise which we can't let happen to our profession. Our profession's responsibility to the world is to communicate transparently. That means we need a lot of work in disclosures.

I'm encouraged that the FASB has a project on their agenda. They're working with [the European Financial Reporting Advisory Group], the group that advises the European Commission. The IASB is also following this closely. I am actually a member of the Disclosure Framework Working Group. I believe it's important that the FASB is looking at it.

I believe it's also important that its not just the standard-setters looking at it but also the constituents should be heavily involved in the process. I think that is FASB's intention. I would like to see that happen sooner rather than later. So we're going to have to see, when their document [a discussion paper, scheduled for release in the second quarter] comes out, what it says. I am a little cautious that this is just such a big issue, and people were looking for significant change here. I'm not necessarily saying that there will be a decrease in disclosures, but there will be, I hope, a much more effective disclosure package. There's such a lot of expectations resting on this project so it's very, very important that constituents are intensely involved. We as preparers; users – and really the purpose of financial reporting is for the users – and, to a slightly lesser extent, but they're also involved, the auditing community, we experience this first-hand every day and have a lot of real-life experiences as preparers, users and auditors. I think we can add a lot to this project and help standard-setters really think about this issue. I think that's happening and I'd like to see more of that.

Bloomberg BNA: Wrapping up here, are there any other issues you'd like to comment on or questions you'd like to raise?

Laux: I touched on this in a couple of my comments, and I don't want to come over as self-serving or sugar-coating it. That truly is not my intention. I did an industry fellowship at the FASB, so I actually worked there for two years. And it was a great experience. I just want to give the FASB and the IASB, and the standard-setters credit. At times I don't think they get the credit they deserve in a very difficult job, and of trying to incorporate everybody's disparate and strongly held views. It was really an eye-opener for me, being on the other side and working there.

That said, at times, the standard-setters may get isolated in their theoretical world and need to really work hard on seeing what's going out in the day-to-day operations of what users are doing with the information, and what's going on at companies. They're trying hard at that. They just need to constantly try harder on that.

But the point I'm trying to make is, I just feel, and having worked there, that at times it's a thankless, very difficult job. And I just wanted to say that they deserve some credit for what they've done.