The Financial Accounting Standards Board recently launched a Simplification Initiative with two goals: reduce complexity of financial reporting and improve (or at least maintain) its decision usefulness.
The Simplification Initiative also addresses issues that were not in conformity with the Statements of Financial Accounting Concepts. Some of these financial reporting issues could be viewed as holdovers from practice that had wide acceptance, but were not conceptually sound. Unlike many accounting pronouncements, most of these simplification projects are limited in scope and relatively short in duration [FASB 2015]. Financial statement users and preparers will need to incorporate these changes soon. As a side benefit, for many of the projects U.S. GAAP now converges with International Financial Reporting Standards (IFRS). The following items provide an overview of several simplification projects from 2015.
II. Elimination of Extraordinary Items
For over a half century, the accounting profession has been debating whether the income statement should focus on the results of current operations or should take an all-inclusive approach. The concept of extraordinary items was a compromise solution. It allowed the income statement to present current operating results first, followed by other items that would not be considered part of current operations.
Prior to Accounting Standards Update 2015-01, an event or transaction was presumed to be an ordinary and usual activity of the reporting entity unless evidence clearly supported its classification as an extraordinary item. Paragraph 225-20-45-2 of the Codification [FASB 2015] specified that extraordinary items must be both unusual in nature and infrequently occurring.
Based upon input from stakeholders, the concept of an extraordinary item causes uncertainty since it is unclear when an item should be considered both unusual and infrequent. Some stakeholders indicated that although they found information about unusual or infrequent events and transactions useful, they did not need the extraordinary item presentation to identify those events and transactions. Moreover, it is extremely rare in current practice for a transaction or event to meet the requirements to be presented as an extraordinary item [FASB 2015].
Accounting Standards Update 2015-01 eliminates the concept of extraordinary items from GAAP, saving time and reducing costs for preparers. They will no longer be required to assess and document whether a particular event or transaction event is extraordinary. It also reduces uncertainty for preparers, auditors, and regulators as there will be no follow-up evaluation to determine if the preparer treated the item appropriately. There will be no loss of information since the presentation and disclosure guidance for items that are unusual in nature or occur infrequently will be retained and will now include the items that were formerly classified as extraordinary items [FASB 2015].
This Update will result in a further convergence of GAAP and IFRS. IAS 1, Presentation of Financial Statements, prohibits extraordinary items.
The elimination of extraordinary items is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The effective date is the same for all entities (public and non-public). An entity may apply this amendment retrospectively (restating all prior periods presented in the financial statements) or prospectively (no restatement of prior years, the impact is presented in current and future periods). Early adoption is allowed. [FASB 2015]
III. Debt Issue Costs
To simplify the presentation of debt issuance costs, the costs related to a recognized debt liability are required to be presented on the balance sheet as a direct deduction from the carrying amount of the debt liability. “This is consistent with the guidance in Concepts Statement 6, which states that debt issuance costs are similar to a debt discount and in effect reduce the proceeds of borrowing, thereby increasing the effective interest rate. Concepts Statement 6 further states that debt issuance costs are not assets because they provide no future economic benefit. This presentation also improves consistency with IFRS, which requires that transaction costs be deducted from the carrying value of the financial liability and not recorded as separate assets” [FASB2015]. Thus, the new approach prohibits debt issue costs from being presented on the balance sheet as an asset or deferred charge.
Because the debt issue costs will now be deducted to obtain the net proceeds of the debt, the effective rate of interest will be recalculated. For instance, assume a reporting entity issued $2,000,000 of 6%, 10 year bonds when the market interest rate was 6.5%. Interest is paid semiannually. The bonds would sell for $1,927,303, resulting in a discount on the bond issue. If there are $39,963 of bond issue costs incurred, the net proceeds would be further reduced to $1,887,340. The effective interest rate for the bond issue would now be 6.785%. The result on the income statement will be that the bond issue costs are amortized using the effective interest method. Prohibiting debt issue costs from being recorded as an asset and requiring it to be included in the effective interest on the debt also increases the convergence of GAAP with IFRS.
For public business entities, these reporting requirements are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. For all other entities, these reporting requirements are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within fiscal years beginning after December 15, 2016. Early adoption is permitted for financial statements that have not been previously issued.
An entity should apply the new guidance on a retrospective basis (the balance sheet of each individual period presented should be adjusted to reflect the period-specific effects of applying these reporting requirements.)
In the period of transition, an entity is required to comply with the applicable disclosures for a change in an accounting principle. Disclosures include the nature of and reason for the change in accounting principle, the transition method, a description of the prior-period information that has been retrospectively adjusted, and the effect of the change on the financial statement line items (that is, debt issuance cost asset and the debt liability). [FASB 2015]
IV. Income Tax Accounting
A. Classification of Deferred Tax Assets and Liabilities
In November 2015, FASB issued Accounting Standards Update 2015-17 Income Taxes (Topic 740), Balance Sheet Classification of Deferred Taxes. This new standard requires all deferred tax assets and liabilities to be classified as noncurrent on the balance sheet. GAAP currently requires that firms classify deferred tax assets and liabilities as current or noncurrent, based on how the related assets or liabilities are classified. If a deferred tax asset or liability is not related to an asset or liability for financial reporting purposes (e.g., a deferred tax asset related to a net operating loss carryforward), the deferred tax asset or liability is classified as current or noncurrent based on the expected reversal date of the associated temporary difference.
Stakeholders indicated that the requirement to divide deferred income tax assets and liabilities into current and non-current portions resulted in little or no benefit to users of financial statements since this classification does not generally align with the time period in which the recognized deferred tax amounts are expected to be recovered or settled [FASB 2015]. If there is any cost involved, the classification of deferred tax assets and liabilities into current and non-current portions would not meet the cost-benefit test.
Since the deferred tax liability or asset will be classified as non-current, any valuation allowances would likewise be classified as noncurrent. Thus the change results in a further simplification by eliminating the need to allocate the valuation allowances between current and noncurrent portions.
Simplifying deferred tax balance sheet classification will increase convergence with IFRS. IAS 1, Presentation of Financial Statements, requires deferred tax assets and liabilities to be classified as noncurrent in a classified statement of financial position [FASB 2015].
For public business entities, this requirement would be effective for annual periods (including interim periods within those annual periods) beginning after December 15, 2016. For all other entities, the effective date would be annual periods beginning after December 15, 2017, as well as interim periods the following year.
Earlier application is permitted for all entities as of the beginning of an interim or annual reporting period. This standard may be applied either prospectively to all deferred tax liabilities and assets or retrospectively to all periods presented. If an entity applies the guidance prospectively, the entity should disclose in the first interim and first annual period of change, the nature of and reason for the change in accounting principle and a statement that prior periods were not retrospectively adjusted. If an entity applies the guidance retrospectively, the entity should disclose in the first interim and first annual period of change the nature of and reason for the change in accounting principle and quantitative information about the effects of the accounting change on prior periods [FASB 2015].
B. Tax Effects of Intra-Entity Asset Transfers
Current GAAP requires comprehensive recognition of current and deferred income taxes. However, paragraph 740-10-25-3 of the Accounting Standards Codification provides a number of exceptions to the requirement of comprehensive recognition of current and deferred income taxes. One such exception is that recognition of current and deferred income taxes on intra-entity transfers is not allowed until the asset is transferred to an external entity [FASB 2015].
Outreach activities to stakeholders revealed that the exception does not provide useful information to financial statement users because the exception requires deferral of the income tax consequences of an intra-entity asset transfer. Since the exception does not provide useful information, the Board proposes to eliminate the exception in GAAP that prohibits recognizing current and deferred income tax consequences for an intra-entity asset transfer until the asset or assets have been sold to an outside party. In other words, the proposed change would require that an entity recognize the current and deferred income tax consequences of an intra-entity asset transfer when the transfer occurs [FASB 2015].
Requiring the recording of current and deferred income taxes on intra-entity transfers would further the convergence of IFRS (IAS 12 Income Taxes) and GAAP.
For public business entities, the proposed amendments would be effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2016. Early adoption would be prohibited for public business entities. For all other entities, the proposed amendments would be effective for annual periods beginning after December 15, 2017, and interim periods in annual periods beginning after December 15, 2018. Early adoption would be permitted, but not before annual periods ending after December 15, 2016.
All entities would be required to apply the proposed amendments on a modified retrospective basis. This approach would require a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption for the recognition of the income tax consequences of intra-entity asset transfers occurring before the effective date. In addition, an entity would be required to disclose at the date of transition the nature of and reason for the change in accounting principle, as well as quantitative information about the effects of the accounting change [FASB 2015].
V. Debt Classification
The Board received input from stakeholders that guidance on balance sheet classification of debt is unnecessarily complex. FASB tentatively decided to simplify the debt classification guidance in Accounting Standards Codification (ASC) 470-10-451 by replacing it with a cohesive principle for determining whether debt should be classified as current or noncurrent on the balance sheet. The Board directed the staff to draft guidance in a proposed Accounting Standards Update for vote by written ballot, with a comment period of 60 days.
Work on the proposal to date stipulates that an entity should classify a debt as noncurrent if one or both of the following criteria are met as of the balance sheet date:
- The liability is contractually due to be settled more than 12 months (or operating cycle, if longer) after the balance sheet date
- The entity has a contractual right to defer settlement of the liability for at least 12 months (or operating cycle, if longer) after the balance sheet date.
Thus, decisions about the classification of debt will be made based on facts and circumstances that exist as of the reporting date (that is, as of the balance sheet date). The guidance would apply to all debt arrangements, including convertible debt and mandatorily redeemable financial instruments that are accounted for as liabilities [FASB 2015]. This treatment would eliminate the reclassification from current to noncurrent of current liabilities expected to be refinanced in the upcoming accounting period. Since IFRS has no provision for current liabilities expected to be refinanced, this change would increase convergence with IFRS.
In the first interim and annual financial statements following the effective date, an entity would apply the proposed amendments on a prospective basis to all debt that exists as of that date. The following transition disclosures should be required: the nature of and reason for the change in accounting principle, and the effect of the change on affected financial statement line items in the current period [FASB 2015]. An effective date has not been specified, but will be forthcoming when the Board votes on the final proposal.
VI. Inventory Valuation
A long-standing accounting requirement is that inventories be valued at the lower of cost or market as of balance sheet date. Currently, market is defined as the median value among replacement cost, net realizable value, or net realizable value less a normal profit margin. FASB will simplify the lower of cost or market analysis by requiring that inventory should be measured at the lower of cost or net realizable value. Thus, reporting entities would no longer consider replacement cost or net realizable value less an approximately normal profit margin when applying the lower of cost or market rule. Inventory measured using the last-in, first-out (LIFO) and retail inventory methods would be exempt from this requirement. This change increases the convergence of GAAP and IFRS with respect to the measurement of inventory [FASB 2015].
Public business entities will be required to apply the amendments in annual reporting periods beginning after December 15, 2016, including interim reporting periods within those annual reporting periods. Entities other than public business entities would be required to apply the amendments in annual reporting periods beginning after December 15, 2016, and interim reporting periods within annual reporting periods beginning after December 15, 2017.
Prospective application of this standard is required. An entity may early adopt this standard as of the beginning of any interim or annual reporting period [FASB 2015].
VII. Transition to the Equity Method of Accounting
Many businesses hold investments in other entities, for a variety of reasons ranging from short-run returns to control of a subsidiary. Accounting for the investment depends on the level of ownership and ability to influence the investee. When the level of ownership or influence increases, the accounting treatment for the investment may also need to change. Currently, when an investment previously accounted for using fair value (i.e. available for sale security) now qualifies for equity method treatment, the transition to the equity method requires retroactive application of the equity method. Thus, the equity method is applied on a step-by-step basis as if it had been in effect for all previous periods in which the investment was held.
During a review of this treatment, stakeholders commented that assimilating the information to apply the equity method retroactively is both costly and time-consuming, but provides little benefit to the financial statement user. The FASB further indicated that often the investor does not have ready access to data for prior periods and that the resulting information on the financial statement may be inaccurate. Even if the information was readily available to account for the change retroactively, the FASB agreed that retroactive application did not pass the cost-benefit test.
Accordingly, the amendments in this Update eliminate retroactive application of the equity method when the degree of ownership or of control increases to the point that a change from fair value treatment to equity method accounting is required. Instead, the equity method investor adds the cost of acquiring the additional interest to the current basis of the investment. The equity method is then adopted as of the date the investment qualified for equity method accounting.
In addition, for investments previously accounted for as available for sale, the unrealized holding gains or losses in accumulated other comprehensive income will be recognized in earnings at the date the investment qualifies for the use of the equity method. The changes in these amendments increase convergence of US GAAP and IFRS. Unrelated to the Simplification Initiative, the FASB has also issued Accounting Standards Update No. 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Liabilities. This update will eliminate the inclusion of investment holding gains/losses in other comprehensive income. All investment holding gains and losses will go to earnings. Thus, the question of how to treat the holding gains/losses at transition is a temporary issue, until adoption of Update 2016-01.
The amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016 for both public and non-public companies. Earlier application is permitted, and the amendments will be applied prospectively.
Summary of the Simplification Initiative
The FASB’s Simplification Initiative intends to provide financial reporting that is more understandable and transparent, as well as less costly to prepare. The specific projects presented above will streamline reporting for these various topics, often based on input from financial statement users. Although convergence with IFRS is not a stated goal of the Simplification Initiative, more uniform financial reporting standards is yet another type of simplicity that is desirable. While somewhat modest in scope, these financial reporting changes are evidence of a responsive, proactive standard-setting body. Financial statement users and preparers will need to keep these changes and their effective dates in mind as they go forward into 2016.
Financial Accounting Standards Board, Financial Accounting Codification, ¶ 225-20-45-2
Financial Accounting Standards Board, Accounting Standards Update 2015-01, Income Statement—Extraordinary and Unusual Items, (Subtopic 225-20), Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items, pg. 1-2, January 2015.
Financial Accounting Standards Board, Accounting Standards Update 2015-01, Income Statement—Extraordinary and Unusual Items (Subtopic 225-20), Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items, January 2015, pg. 2.
Financial Accounting Standards Board, Accounting Standards Update No. 2015-03, Interest—Imputation of Interest (Subtopic 835-30), Simplifying the Presentation of Debt Issuance Costs, April 2015. pg. BC4
Financial Accounting Standards Board, Accounting Standards Update 2015-17, Income Taxes (Topic 740) Balance Sheet Classification of Deferred Taxes, November 2015, pg 1.
Ibid. pg. 1.
Financial Accounting Standards Board, Financial Accounting Codification, ¶ 740-10-25-3-e.
Financial Accounting Standards Board, Proposed Accounting Standards Update, Income taxes (Topic 740), Intra-Entity Asset Transfers, File reference No 2015-200, January 2015, pg 1.
Financial Accounting Standards Board, Proposed Accounting Standards Update, Income taxes (Topic 740), Intra-Entity Asset Transfers, File reference No 2015-200, January 2015, pg 2.
Financial Accounting Standards Board, Project Update, Simplifying the Balance Sheet Classification of Debt.
Financial Accounting Standards Board, Financial Accounting Update, No. 2015-11, Inventory (Topic 330), Simplifying the Measurement of Inventory, July 2015, pg. 1.
About the Authors
Dr. Thomas H. Oxner, Ph.D., CPA (inactive)
Professor, University of Central Arkansas
Tom earned his accounting doctorate at the University of Georgia. He has taught accounting for over 35 years, focusing primarily on financial accounting, accounting theory, and systems. Tom has published extensively in practitioner-oriented journals and has often served as a CPE presenter to local professionals.
Dr. Karen M. Oxner, DBA, CPA
Assistant Professor, University of Central Arkansas
Karen earned her accounting doctorate at Southern Illinois University at Carbondale. She has prior experience in public accounting as well as internal auditing. Her teaching and research is focused on financial accounting and auditing. Karen is active in the Arkansas Society of CPAs, serving on the Student Education Fund Board.