The Roundtable is scheduled at 4pm eastern time on Tuesday, February 26.

To participate in the Roundtable, please follow these instructions.

1) Go to http://intercall.webex.com anytime after 3:30 pm (New York time) on February 26.

2) Type in the following meeting number: 594-891-221 and click “Join Now”.

3) On the next page, fill in your name, email address, and the password “Fasri001” (case sensitive). Then click “Join”.

4) After joining the meeting, you will be prompted for your telephone number. Insert your telephone number and click the “Call Me” button. Your phone will ring, which you can use to hear and speak. Please remember to put yourself on mute when you are not speaking (can be done by clicking the mic next to your name).

1. How and when is the concept of control applied in accounting?
2. 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:

1. 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?
2. 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.

The Roundtable is scheduled at 4pm eastern time on Tuesday, January 29.

To participate in the Roundtable, please follow these instructions.

1) Go to http://intercall.webex.com anytime after 3:30 pm (New York time) on January 29.

2) Type in the following meeting number: 594-190-313 and click “Join Now”.

3) On the next page, fill in your name, email address, and the password “Fasri001” (case sensitive). Then click “Join”.

4) After joining the meeting, you will be prompted for your telephone number. Insert your telephone number and click the “Call Me” button. Your phone will ring, which you can use to hear and speak. Please remember to put yourself on mute when you are not speaking (can be done by clicking the mic next to your name).

5) If you experience trouble with the call-back feature, you can dial in yourself using the following numbers: 866-478-6348 or 224-554-0243.

The controversial impact of fair value accounting has been long debated, and the recent financial crisis further accentuates opponents’ concerns on its role in inducing volatility and market turmoil. However, there has been little empirical evidence on whether managers’ real economic decisions are actually adversely affected by fair value accounting. Using a context of risk management, we investigate whether fair value measurement of derivatives adversely influences managers’ hedging decisions. Our primary findings are that fair value accounting measurement causes managers to consider more accounting factors relative to economic factors, which in turn result in suboptimal hedging decisions. This effect is more likely when the price volatility is higher than when it is lower. We also propose two remedies to this effect.

In our study, we conduct two experiments using experienced accountants as participants. They were asked to make hedging decisions after reading a case material on hedging. In the first experiment, some participants were shown only the economic impact of hedging, while others were shown both the economic and accounting impact of hedging. The economic impact was positive, but the accounting impact indicated increased earnings volatility arising from the hedging decision. At the same time, we also varied the price volatility of the hedged asset—the price volatility was low in one instance, but high in another. In addition, we included a control condition where participants were provided with information on both the economic and historical cost accounting impact when price volatility was high and further told to assume that the company applied historical cost accounting to recognize derivatives. We found that participants were more likely to forgo economically sound hedging opportunities when both the economic and fair value accounting impact information was presented than when only the economic impact information was presented, or when both the economic and historical cost accounting impact information was presented. This adverse effect of fair value accounting was more likely when the price volatility of the hedged asset was higher—paradoxically, this was a situation where hedging was more beneficial. We also found that the effect was mediated by participants’ relative considerations of economic factors versus accounting factors (e.g., earnings volatility).

We conducted a second experiment to investigate the effectiveness of two simple debiasing mechanisms — altering the salience of accounting versus economic impact, and separately presenting net income not from fair value remeasurements — to mitigate any adverse impact of fair value accounting on managers’ decisions. In the experiment, we held constant the price volatility as high and provided the information on both the economic and accounting impact before asking for participants’ hedging decisions. We manipulated two presentation formats: 1) whether the economic impact information was presented first followed by accounting impact information, or the reverse order; and 2) whether the net income not from fair value remeasurements was reported in a separate column. The findings of the second experiment showed that notwithstanding managers’ concerns about the accounting impact of hedging, their propensity to hedge was increased by making them attend to the economic impact of hedging prior to their decisions, or by separately presenting net income not arising from fair value remeasurements.

The results of this study should be of interest to standard setters in their debate on the efficacy of fair value accounting. The study provides empirical evidence that, despite substantial economic benefits, managers actually abstain from hedging the risk because of their concerns over the fair value accounting impact (e.g., increased earnings volatility) and this effect of fair value accounting is magnified when price volatility of the hedged asset is higher. Our findings about the potential remedies to the negative effect of fair value accounting on managers’ hedging decisions should also be informative to managers and regulators.

I examine two implications of revenue recognition for companies with product return and pricing adjustment uncertainties. First, I examine whether the incidence of earnings management is higher for companies that recognize revenue before their product return and pricing adjustment uncertainties are resolved. This expectation is motivated by the fact that more opportunities exist to manage earnings when revenue is immediately recognized under the sell-in method compared to when at least some revenue recognition is deferred under the sell-through and combination methods. Specifically, managers using the sell-in method (1) maintain (and have opportunities to manipulate) product return and pricing adjustment accruals, and (2) can boost earnings through channel stuffing activities.

Second, I examine whether earnings informativeness (proxied for with the earnings response coefficient) differs among the revenue recognition methods used by companies with product return and pricing adjustment uncertainties. On one hand, immediate revenue recognition more quickly incorporates new accounting information into the financial statements. If this new information is useful to the market, earnings should be more informative under the sell-in method compared to the other revenue recognition methods. On the other hand, more opportunities exist for both intentional performance manipulations and unintentional estimation errors when revenue is immediately recognized. Thus, if earnings are (or are perceived to be) more inaccurate under the sell-in method, earnings informativeness should be higher when revenue recognition is deferred until distributors have resold products to end customers.

In order to study these research questions, I limit my sample to semiconductor companies because they sell to distributors and naturally face product return and pricing adjustment uncertainties due to rapid product obsolescence and declining prices over product life cycles. I find that sell-in companies are more likely to meet or beat analysts’ consensus earnings forecast compared to sell-through and combination companies, suggesting that earnings management is more likely when companies immediately recognize revenue for sales to distributors. I also find that the earnings response coefficient is significantly larger (meaning the returns-earnings relationship is stronger) for sell-through companies compared to sell-in and combination companies. This finding suggests that earnings are more informative when revenue recognition is deferred until the distributor has resold the product to end customers. Collectively, these results suggest that revenue recognition should be deferred until all product return and pricing adjustment uncertainties are resolved.

This study should be of interest to the FASB and IASB as they finalize a joint revenue recognition standard. The current exposure draft of the new standard states that revenue recognition should occur when the customer obtains control of the product or service. Control, as described in the exposure draft, is likely to be transferred when a manufacturer delivers product to a distributor except for cases where a consignment agreement exists. At the time control is transferred, the standard directs the manufacturer to estimate variable consideration (e.g., product returns and pricing adjustments), determine the transaction price, and recognize revenue so long as receipt of the estimated transaction price is reasonably assured. Recent technical briefs from the Big 4 accounting firms suggest that the new standard’s provisions regarding variable consideration may require many manufacturers that have historically used the sell-through method to change to the sell-in method. Such a shift is concerning as my findings suggest that earnings management is more likely and earnings informativeness is lower when revenue is recognized at sell-in.

The Board was sufficiently convinced by constituent feedback on ASU 2011-05 that the costs to preparers of detailing the effects of AOCI reclassifications can sometimes exceed the benefits.  In particular, when a reclassification goes from AOCI to the balance sheet, the capitalized amount losses all ties to AOCI and companies would need to significantly revise their information systems in order to continue tracking those numbers.

This problem is articulated in a comment letter from Gregg Nelson, a VP from IBM, as follows:

“… certain pension-related costs reclassified out of OCI are included in cost pools and subsequently capitalized as inventory or PP&E. These amounts immediately lose their nature, and the OCI portion related to capitalization is not tracked. Thus, when inventory is subsequently sold or PP&E is depreciated, a portion of the cost of sales / depreciation would include amounts previously reclassified from OCI. We are uncertain whether the intent of ASU 2011-05 … was for entities to track such amounts. If this is a requirement, we would certainly question the usefulness of this information and the cost/benefit of identifying and tracking this information. This capability does not exist in our financial systems today.”

Accordingly, the proposed ASU would require a company to provide a tabular disclosure of the effect of items reclassified from AOCI to net income line items only when the item is reclassified to net income in its entirety.  For other items that are not reclassified to net income in their entirety, the new tabular disclosure would require only a cross-reference to other disclosures currently required under U.S. GAAP related to those items.  The comment period is open until October 15.

Ball and Brown viewed this literature as providing a testable hypothesis – market participants should not be able to use earnings in a profitable manner.  Stated another way, knowing the amount of earnings that would be reported at the end of the year with certainty could not be used to profitably trade common stocks at the beginning of the year.  Evidence to the contrary would suggest the null that earnings are non-informative does not hold.

While the methods part of the paper is probably difficult for recent accounting archivalists to follow, Ball and Brown produce perhaps the single most famous graph in the accounting literature.  It shows stock returns trending up over the year for companies that ultimately report increases in earnings and trending down for companies that report decreases in earnings.  Thus they show that accounting numbers can be informative even if the aggregate number is not computed using a single unified measurement approach across transactions/events.  Subsequent research would show that numbers from the income statement have predictive ability for future earnings and cash flows.

As I sat listening to these two research icons, I could not help but think about some comments I have heard recently from a few standard setters and practitioners.  Those individuals express contempt for EPS in a mixed attribute world.  They appear to wish they could jump in a time machine and eliminate per share computations related to income. I readily admit that EPS does not explain much of the variance in returns over periods of one year or less ( e.g., Lev, JAR 1989). However the link is clearly significant, and over longer periods, the R²’s are quite high (Easton, Harris, and Ohlson, JAE 1992).  Can the standard setters make incremental improvements to increase usefulness of EPS?  I sure hope so, and maybe the recent paper posted by Alex Milburn will help.  But dismissing a reported number because it is not derived from a single consistent measurement attribute – be it fair value or historical cost – seems to revert back to pre-Ball and Brown views that are rejected by years of research.

The paper proposes a measurement framework that is reasoned from fundamental premises about economic business purposes, financial reporting objectives, and the role of markets and market prices. It sets out to demonstrate that substantial improvement in the conceptual underpinnings of financial reporting measurement is both possible and urgently needed. The paper’s proposals would have significant implications for financial reporting.

Copies of the paper can be downloaded free of charge from the CICA website: www.cica.ca/measurement. The CICA invites comments on the paper’s proposals with a suggested comment period ending on November 30 2012.

I have also set up a blog: http://measurementframework.blogspot.ca/ to encourage open discussion of the paper and financial reporting measurement issues generally. All who have an interest in the improvement of financial reporting measurement are encouraged to submit comments, questions, and ideas. In particular, the blog encourages academics to provide summaries of, and links to, relevant empirical and theoretical research articles and papers.

The paper and information about the blog are being given wide international distribution. The hope is that the paper and blog will serve as a stimulus for a long overdue rigorous re-examination of financial reporting measurement theory. I strongly believe that progress towards developing a coherent measurement foundation for financial reporting will be possible only through rigorous study and extensive sharing of evidence and arguments involving all stakeholders comprising the full range of viewpoints and relevant knowledge bases and areas of expertise.

An in depth analysis of comments received and the blog discussions will be provided to the IASB and FASB conceptual framework measurement projects, which we hope will be reactivated in the not-too-distant future.

Accounting academics are invited to visit the CICA website and my blog, study the paper, submit comments, and check out and participate in the blog discussions. I might add that there has been some interest in using the paper in advanced financial reporting courses.

J. Alex Milburn PhD, FCA

Leases is one of those projects that is currently floundering, and if I was back in my academic office, I would certainly be wondering, “What is the Board thinking?”  The original proposed standard was exposed back in 2010 and required that all leases be capitalized and the liability accounted for using the effective interest method.  That view is easy for me to understand and support.  Over two years later, the Board and staff have conducted extensive outreach with various constituents, and they still appear to be very far away from a new standard.  Depending on who they talk to, the Board and staff are getting very different messages.  Of course, this happens on many other projects too, so why are leases causing so much consternation?

I think the reason is due to the several unique features with leases.  First, it is sometimes difficult to distinguish between a lease and a contracted service.  The FAF contracts with an outside company for copying and other services.  The company brought several pieces of equipment into our building and when we need copying done, we simply hand in the originals to somebody here.  Most people would say this is a service.  But, since all the equipment was brought into our building, how different is this really from leasing the equipment?  In our Roundtable this week, Cullen Walsh brought up another good example with respect to leasing servers versus contracting for a “cloud” service.

The other major issue is that constituents can sometimes convincingly argue that their leases are more of a periodic rental expense (much of which are for services) instead of a purchase of an asset with a financing component.  Real estate is the best example.  Companies often will rent space within a building for a periodic fee and part of the fee is for daily services, such as, security, parking access, cleaning, insurance, etc.  The company has no obligation beyond the contracted term to stay in the building and when they leave, the value of the building is often the same or maybe even greater than the value of the beginning of the lease.  Thus, no asset has been “used up.”  Fundamentally, this seems like a different type of lease relative to leasing equipment.  This has led the Board to tentatively decide on a two-model approach for leases, which was described in our Roundtable.

However, after all the deliberations and consideration of numerous models, the current position doesn’t seem to be pleasing anybody.  The Board met with ITAC (their user-group advisory committee) this week to discuss various topics, including leases.  The views from this group on the tentative decisions were decidedly mixed.  Perhaps more telling is that even among users, there were diverse opinions as to how to account for leases.  Some even expressed an opinion that all leases should be accounted for as rent expense.  Others believed that the original exposure draft on leases should not be changed.  Still others believed that leases are simply a series of forward contracts and should be accounted for consistent with how we account for other forward contracts.  Hardly any support was expressed for the tentative two-model approach.

One of the reasons the leases project was placed on the Board agenda was based on feedback from users that they adjusted financial statements based on information in the leasing footnote.  This feedback is consistent with evidence from academic research suggesting that investors appear to adjust financial statements as if operating leases were capitalized.  The FASB wants to provide better information to users consistent with how they were using lease information under FAS 13.  But they need to be careful that users will not continue to adjust whatever is required by the new standard because in that case, the information would not be any better than the current state (and therefore, the benefits would not justify the costs of implementing a new standard).

Here is the sixth in a series of working papers that I am preparing to explain “Approach Y”—a lease-accounting model for entities that are lessees. The new working paper provides additional evidence that the “Interest and Amortization” (I&A) model (formerly known as “Approach A” or the “Accelerated” approach) does not represent the economics of leasing arrangements as faithfully as Approach Y does. In particular, this paper demonstrates that Approach Y exhibits a necessary characteristic of faithful representation that the I&A model lacks.

Please find the new paper attached.

Attachments

Approach Y – Working Paper 6 (PDF)

Working Paper 6 Analysis (Excel)

I welcome your feedback on the new working paper. I also invite you to watch for my concluding working paper.