Background for 1/29/2013 Roundtable
I hope people can “attend” the upcoming roundtable. Roundtable attendees or others might benefit from seeing some of the materials sent to conference attendees teeing up the issues. You are welcomed but not required to browse through the materials. The roundtable will focus primarily on two issues:
- How and when is the concept of control applied in accounting?
- What are the appropriate conditions for derecognizing assets or liabilities?
With regard to the first issue, control appears in the following:
- The conceptual framework (FASB Con 6 para 25) defines an asset as a “probable future economic benefit obtained or controlled by a particular entity . . . .”
- The revenue recognition proposal suggests that revenue should be recognized when the customer gains control of the asset or service being sold.
- Accounting principles related to consolidation mandate that the assets and liabilities of an investee be added to the balance sheet of the acquirer if the acquirer can control the investee.
Are the notions of control the same or different in these three circumstances? Is the notion of control well understood and consistently used in accounting? If the answers are no, is this okay or does it create problems for users and preparers? If it creates problems, can standard setters improve their guidance?
Some specific conference cases will help illustrate these problems:
- Case 1 on page 10 of the materials considers a case where a company has an option to acquire an asset – does the company control the asset via option? Alternatively, suppose a company owns 49% of the voting stock of an entity and holds options to acquire another 2% – does the company control the entity? In general, are there any circumstances where holding an option on an asset or entity provides the option holder control over the asset or entity?
- Case 4 on page 12: Suppose a Seller transfers a physical asset to the Buyer, but the Seller promises unconditionally to repurchase the asset in the future for a fixed price. After transfer but before repurchase, does the Seller or Buyer control the asset? Currently, this transaction is likely to be accounted for as a lease. Suppose Seller promises to unconditionally purchase an similar asset that it has never, ever owned. Does the forward contract give Seller control over this asset that it has not yet owned?
The last question above links to the second issue (derecognition). The FASB could decide to derecognize an asset whenever the entity gives up control. This approach is not followed in a number of FASB standards. In particular, many standards seem to have a high hurdle for derecognition. Consider the transfer of financial assets. Retaining an option to repurchase transferred financial assets would often preclude derecognition. But purchasing an option to acquire an asset would seldom be sufficient for initially recognizing the underlying as an asset. This apparent conflict is often described as “history matters,” and it arises when the seller has continuing involvement with the asset being transferred. What purposes are served by considering past ownership in deciding whether options, forwards, and similar contracts provide control of an asset?
In regard to derecognizing financial assets, bloggers might be interested in “Should Repurchase Transactions be Accounted for as Sales or Loans?” by Chircop, Kiosse, and Peasnell in the December 2012 Accounting Horizons. It looks at the legal structure of repo transactions like those at Lehman Brothers and concludes that secured borrowing accounting does not align well with the economics of the transaction.
If we have time, some related issues might arise:
- In some cases, the derecognition of an asset occurs simultaneously with recognition of revenue. Is giving up control of inventory sufficient for revenue recognition? Can we have cases where an entity no longer controls the inventory but also does qualify for revenue recognition? If so, are we using different notions of control in defining assets versus recognizing revenue? Or is the delayed revenue recognition due to some issue other than control?
- Instead of using control in determining asset recognition and derecognition, we could use a risks and rewards approach. If the entity has the risks and rewards of an asset, then the entity recognizes the asset. Do we get substantially different looking balance sheets if we apply a control approach versus a risks and rewards approach? How should risks and rewards enter into the recognition/derecognition decisions, if at all.
These issues are quite interesting and difficult. I used some of these examples in my Masters Accounting class last fall, and we had some great discussions. In keeping with the mission of FASRI, if you know of any past academic research on these topics, please feel free to mention them during the roundtable or respond to this post. If you are currently pursuing these topics, please share your findings once the paper is complete.