Bracing for Tidal Wave of Accounting Changes

Financial reporting executives, prepare yourselves: Rough seas lie ahead for corporate accounting.

The habit in recent years of churning out narrow changes to accounting standards, usually focused on the financial crisis, are coming to a close. In coming months a slew of new proposals will emerge from the Financial Accounting Standards Board that promise to transform financial reporting fundamentally—and all will be coming at once.

Scott Taub, a former acting chief accountant at the Securities and Exchange Commission and now a Compliance Week columnist, warned attendees at Compliance Week 2010 last week that they can expect to see FASB adopt a dozen major new accounting standards adopted by the end of 2011. “Everybody is looking ahead to what is being called a tidal wave,” he said. “There’s a lot of attention focused on what’s coming down the road.”

Taub appeared with Doug Parker, a professional accounting fellow at the SEC, and Steve Jacobs, associate chief accountant in the SEC’s Division of Corporation Finance. All three predicted big changes ahead.

Parker said he believes the wave of major exposure drafts emerging from FASB will be the largest that any accounting rulemaker has ever issued. The SEC staff spends a fair amount of time meeting with various constituent groups, he said, and staffers often hear the same concern: The changes are too much, coming too quickly.

People also often ask what the SEC might do about the flood of new rules, Parker said, but the SEC’s standard response is to remind them that its job as FASB’s overseer is to assure that FASB follows its due process in developing standards; the SEC generally does not interfere with the standards themselves or steer them to a certain outcome.

“As hard as it sounds with the sheer number of exposure drafts that are out there, it’s absolutely critical to get your voice heard,” he said. “My job consists largely in following this stuff and I have a hard time doing it, but it has to be done … Without those comments [to FASB on emerging proposals], your point of view is likely not to be heard.”

In truth, the SEC is one of numerous bodies that have prodded FASB and its global counterpart, the International Accounting Standards Board, to converge their rules to facilitate a U.S. move to adopt International Financial Reporting Standards. In February the SEC published a statement continuing its promise for a final vote on adopting IFRS sometime in 2011, and Parker said the agency is following a work-plan laid out in February to study the most appropriate path for U.S. capital markets. SEC Chairman Mary Schapiro said in a recent speech that the SEC would publish an update to that plan in October.

SEC staffers are gleaning some insights about applying IFRS from studying the filings of foreign private issuers, which are allowed to file their financial statements in IFRS without reconciling to U.S. Generally Accepted Accounting Principles. They’re finding that the trouble spots in IFRS are areas like revenue recognition, consolidation, and financial instruments—many of the same problematic areas in GAAP.

Scott Taub, left, listens as SEC Professional Accounting Fellow Doug Parker talks about financial reporting.

Part of the issue is to what extent companies follow their own nation’s “flavor” of IFRS, Parker said, and that’s a concern the SEC has raised about IFRS before. The agency has long contended that for financial statements to be truly comparable under IFRS, the standards must be followed without national carve-outs or exceptions.

Taub said companies should look for exposure drafts in coming months on major changes to revenue recognition, lease accounting, liabilities and equity, financial instruments, and the presentation of financial statements. Generally the new standards will be based on objectives or principles (the essence of IFRS) rather than prescriptive requirements (the essence of GAAP), he said. That will require companies to use more judgment, rely on more estimates, and engage in more valuation exercises.

“Flexibility means you can’t be at the back end saying, ‘The law didn’t specifically say you can’t do this, so therefore it should be OK’,” he said. “That will be quite a tension point going forward. It’s going to put pressure on accounting judgments.”

What Comes First

In more immediate matters, Taub said companies are digesting new rules for revenue recognition for “bundled products,” such as products sold with accompanying service contracts or promises of future upgrades. The new guidance requires companies to estimate pricing for individual elements of a bundled product and recognize revenue for each one as it is delivered.

“In the past, if you didn’t have strong evidence of the value of unrecognized items, you didn’t have revenue recognition,” he said. “If you didn’t meet that threshold, the answer was zero.” That threshold was established at a time when policy-makers worried companies would get too aggressive in recognizing revenue for such arrangements, he said.

Steve Jacobs, associate chief accountant at the SEC Division of Corporation Finance.

Jacobs said the SEC staff is just starting to study the first-quarter filings under the new approach. The staff is focused on not only compliance with the standard, but also on how companies are describing the transition so investors can compare current results with earlier periods. “We’re still getting our feet wet ourselves looking at these filings,” he said.

Parker said SEC staff is not aware of any significant implementation problems so far, but they have fielded questions about how to handle classifications on the income statement based on the requirements of Regulation SX. That rule says companies must separately disclose elements of revenue that are attributable to products versus services, he said; bundled products are often some combination of the two.

Companies are wondering whether they should change their method for meeting the Regulation SX requirements in light of the change in accounting requirements, Parker explained. “We don’t have an official, definitive view,” he said. “Our view for now is continue doing what you’re doing.” If the accounting changes lead to dramatically different results for Regulation SX purposes, “that might be something you want to come talk to us about,” he said.

The SEC is also scrutinizing how companies are handling new rules on consolidation; those rules eliminate the notion of a qualified special purpose entity, forcing companies to bring any hidden assets onto the balance sheet. Parker said the SEC is on the lookout for ways companies might try to circumvent the new rules and continue to justify off-balance-sheet approaches. “We’re being aggressive in that area,” he said.

“Everybody is looking ahead to what is being called a tidal wave. There’s a lot of attention focused on what’s coming down the road.”

—Scott Taub,

Former Chief Accountant,

Securities and Exchange Commission

Taub said he had an exchange recently with someone who was studying how the consolidation standard will work going forward. The new standard requires companies to bring an entity onto the corporate balance sheet if the company has control over the significant activities of the entity.

“So you’re telling me in order not to consolidate, I have to actually give up control?” Taub recalled the person saying. “Yes, that is what I’m telling you. That’s what the accounting standard says as well.”

The new standard is a foreshadowing of the exposure drafts that will be coming in the future as well, he added: focusing on the economic substance of a transaction to determine how it should be portrayed in financial statements.

Accounting standards are not focused on “telling you what contract language you need to use to get what you want,” Taub said. “If we do this right, it is the economic substance that drives the accounting. To the extent you’re trying to mask the substance … I certainly hope we at least get better disclosure in this area.”