The Financial Accounting Standards Board (FASB) has released four major updates to U.S. Generally Accepted Accounting Principles (GAAP) since 2014 that will go into effect in the next few years. These sweeping changes — combined with plans to reform the tax code and reduce federal regulations under the Trump administration — have created a volatile environment for CFOs and controllers.
But there is good news amidst the volatility. The FASB has promised to refrain from issuing any more major changes to GAAP while companies and other affected entities update their policies and systems to meet the deadlines for the recent updates. In addition, the standards’ implementation dates will be staggered, and not every change will affect every entity. The impact of each standard on your organization will vary, depending on the nature of its operations.
Here’s a summary of what’s changing and when the changes, if applicable to you, will affect your financial statements.
1. Not-for-profit standard (effective 2018)
Accounting Standards Update (ASU) No. 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, applies to a wide variety of organizations, including charities, educational institution foundations, and cultural, religious and trade-related nonprofits. Most notably, the updated standard will reduce the number of net asset classes from three to two: 1) net assets with donor restrictions, and 2) net assets without donor restrictions.
The updated standard also includes important changes related to reporting liquidity, financial performance and cash flows. One of the biggest changes is the requirement for disclosing more information about the cash that not-for-profits can access quickly. The disclosures must be presented in two formats:
- A narrative explanation about the entity’s policies on managing funds to meet day-to-day needs, and
- Numerical details about actual liquid assets available to meet general expenditures within one year of the balance sheet date.
The FASB is allowing flexibility in how entities disclose the numerical details, as long as the methods are applied consistently and reported transparently. Larger organizations (like major research universities) might present the numbers in tables or charts, but smaller organizations might need to provide nothing more than a few simple lines.
The update also requires an enhanced analysis of an organization’s expenses by nature and function. Under the revised standard, most organizations will have to break out expenses at least by salaries and benefits for employees. Others will have separate line items for expenses for different programs or for employee travel.
In terms of cash flow statement presentation, the standard gives not-for-profits more flexibility in choosing between the direct and indirect cash flow methods. Although the update scraps the requirement to reconcile the two methods, few entities are planning to switch to the less familiar direct method.
Additionally, when an endowment’s fair value falls below the original endowed gift amount, the update requires entities to classify these “underwater” endowments as net assets with donor restrictions, along with providing expanded disclosures about the amount that’s underwater and policies for addressing the shortfall. Under current practice, underwater endowments are classified as unrestricted net assets.
ASU 2016-14 is effective for annual financial statements in 2018 and a year later for interim periods. Early adoption is permitted.
2. Revenue recognition standard (effective 2018 / 2019)
ASU No. 2014-09, Revenue from Contracts with Customers, is expected to have a big impact on entities such as construction contractors, software companies, media companies, telecommunications providers, manufacturers, distributors and asset managers with other industries such as banking, insurance and healthcare moderately affected. This standard primarily affects the timing of revenue recognition.
In a nutshell, the revised standard substitutes about 80 industry-specific revenue recognition rules with a basic principle — that companies should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the payment that it expects to be entitled to in exchange for the goods or services. The standard calls for a five-step process when reporting revenue:
- Identify the contract with a customer.
- Identify the company’s performance obligations (or promises) under the contract.
- Determine the transaction price (including the effects of any variable payment or significant financing components).
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) performance obligations are satisfied.
Tax versus GAAP
The tax rules for recognizing revenue, which are based on an “all events” test, currently remain unchanged. For some entities, this discrepancy could result in temporary book-to-tax differences. The IRS is currently researching this issue to determine whether, as companies implement the new accounting standard, they should automatically be allowed to follow their book method of accounting for tax purposes.
Some companies may not notice a significant change to the top line of their income statements when they implement ASU 2014-09, but almost all companies will be affected by the standard’s expanded disclosure requirements. Required disclosures include information about the nature, amount, timing and uncertainty of revenue that’s recognized.
The updated revenue recognition standard goes into effect for public companies starting in 2018. Private companies’ annual statements must comply with it in 2019, but they have until 2020 for quarterly statements. Private companies can also elect to adopt these changes in 2018.
Additionally, the Securities and Exchange Commission (SEC) recently offered a reprieve to certain companies that qualify as public business entities (PBEs). SEC Deputy Chief Accountant Sagar Teotia recently announced that an entity that meets the definition of a PBE solely because its financial statements or financial information is included in another entity’s SEC filing can have an extra year to implement the revenue recognition standard. In other words, these PBEs can adopt ASU 2014-09 at the same time as private companies.
3. Lease standard (effective 2019 / 2020)
ASU No. 2016-02, Leases, is expected to add more than $1.2 trillion in off-balance-sheet leases to public companies’ balance sheets. Under current practice, many lease obligations (typically for real estate, vehicles or equipment) have no balance sheet impact as they are accounted for as operating leases with their payments included in an entity’s income statement as rent expense and disclosed in the notes.
For all leases with terms of more than 12 months, the revised standard requires right-to-use assets to be added to the assets section of the balance sheet and the present value of the related lease obligations to be included as liabilities. These changes could make lessees appear significantly more leveraged and cause unprepared entities to violate their loan covenants.
The updated standard provides that the recognition, measurement and presentation of expenses and cash flows arising from a lease will continue to depend largely on its classification as a capital or operating lease:
Capital leases. Lessees will amortize right-to-use assets separately from interest on the lease liability on the statement of comprehensive income. Their repayments of the principal portion of the lease liability will be classified within financing activities, and their payments of interest on the lease liability and variable lease payments within operating activities, in the statement of cash flows.
Operating leases. Lessees will recognize a single total lease cost, computed to allocate cost of the lease over the lease term on a generally straight-line basis. All cash payments will be classified within operating activities in the statement of cash flows.
The updated guidance also requires lessees to make additional disclosures to help users of financial statements better understand the amount, timing and uncertainty of cash flows related to leases. They must disclose qualitative and quantitative requirements, including information about variable lease payments and options to renew and terminate leases.
Under the updated guidance, some long-term leasing arrangements, such as service contracts and contracts with third party manufacturers, may be difficult for entities to identify and assess who’s in control. The new standard will require management to make subjective judgments about these complex transactions.
You can elect to adopt the lease standard early. Otherwise, it is effective for public companies in 2019. The SEC is also allowing a one-year reprieve (similar to the exception for the revenue recognition standard) for an entity that meets the definition of a PBE solely because its financial statements or financial information is included in another entity’s SEC filing. In other words, these PBEs can also adopt the lease standard at the same time as private companies.
Private companies’ and not-for-profit entities’ financial statements must comply with ASU 2016-02 in 2019. These groups have until 2020 to apply the changes in their interim reports.
In addition, the standard allows several optional “practical expedients.” Entities that elect to apply these practical expedients will generally be allowed to continue to account for their leases that began before the applicable effective date under previous GAAP unless the lease is modified. However, lessees must recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.
4. Credit loss standard (effective 2020 / 2021)
ASU No. 2016-13, Financial Instruments — Credit Losses: Measurement of Credit Losses on Financial Instruments, is narrow in scope. It applies primarily to banks, credit unions and other companies that provide financing to customers. Beyond traditional loans, the revised standard will affect such assets as debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures and reinsurance receivables.
Existing GAAP requires companies to report the amortized cost of credit losses using an “incurred loss” model. That model delays recognition until it’s “probable” that the financial institution has incurred a loss.
The updated standard adopts a current expected credit loss (CECL) model that requires financial institutions to immediately record the full amount of expected credit losses in their loan portfolios, instead of waiting until the losses qualify as “probable.” The FASB expects the shift to the CECL model to produce more timely and relevant information.
The standard doesn’t mandate a specific technique for estimating credit losses; it allows companies to exercise judgment to determine the method that’s appropriate for their circumstances. Moreover, the updated guidance permits companies to continue to use many of the loss estimation techniques already employed, such as loss rate methods, probability of default methods, discounted cash flow methods and aging schedules. The inputs to those techniques will, however, change to account for the full amount of expected credit losses.
Public companies have until 2020 to switch to the new CECL model. Private companies have an extra year to make the changes. Early application is permitted for all companies in 2019.
More resources required than management originally expected
Organizations that have already started implementing these major updates report that compliance takes more resources than management originally expected. Retroactively modifying your accounting systems and collecting data can be cumbersome. A head start helps reduce implementation headaches, especially for entities that issue comparative financial statements.
Start the implementation process by identifying which of these standards is most likely to affect your organization and then contact us. We can help explain the mechanics of the new standards, suggest ways to update your policies and systems to capture the requisite financial data, and help you decide whether early adoption makes sense for your organization.
For more information on these accounting rule changes, or to learn how Baker Tilly specialists can help, contact our team.