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The Rundown: A Guide to Busy Season 2023

Newsletter

February 8, 2023

Standard setters were relatively inactive this past year. The Financial Accounting Standards Board (FASB) issued only six new Accounting Standard Updates (ASUs) and the Government Accounting Standards Board (GASB) issued only three new GASB Statements in 2022. The latest issue of the Rundown features a summary of the new standards issued in the fourth quarter 2022. For summaries of standards issued in the first three quarters, view our previous rundowns here. In addition, we’ve got a comprehensive listing of all standards newly effective for calendar year-end December 31, 2022 for public business entities, private entities and governments.

Fourth Quarter 2022 Newly Issued Standards

LDTI and Transition for Sold Contracts

ASU 2022-05

In August 2018, the FASB issued ASU 2018-12 Financial Services—Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts (LDTI), which required an insurance entity to apply the retrospective transition method. Resulting stockholder feedback stated that applying the LDTI guidance to contracts that were derecognized because of a sale or disposal before the LDTI effective date, would not provide decision-useful information and would result in significant costs to apply. For example, without this update, an insurance entity might be required to reclassify a portion of previously recognized gains or losses to the LDTI transition adjustment. This would also result in the entity having to communicate why previously recognized gains or losses have changed. As a result, the FASB issued ASU 2022-05 which amends the LDTI transition guidance to allow an insurance entity to make an accounting policy election on a transaction-by-transaction basis to exclude contracts that meet certain criteria from applying the amendments in ASU 2018-12. ASU 2018-12’s is effective for public business entities for fiscal years beginning after December 15, 2022, or December 15, 2024, for all other entities.

To qualify for this policy election, as of the effective date of ASU 2018-12, the insurance contract:

  • Must have been derecognized because of a sale or disposal; and
  • The entity has no significant continuing involvement with the derecognized contract.

Effective Date and Transition Requirements:

Public business entities (excluding SRCs): Fiscal years beginning after December 15, 2022, including interim periods within those years

All other entities (including SRCs): For fiscal years beginning after December 15, 2024, and interim periods within fiscal years beginning after December 15, 2025

The amendments in this Update should be applied retrospectively and early application is permitted so long as ASU 2018-12 is also adopted.

Deferral of the Sunset Date for Reference Rate Reform Relief

ASU 2022-06

In 2012 the world learned of what became known as the “LIBOR  scandal.” London Interbank Offered Rates (LIBOR) are based on daily estimates from a group of financial institutions as to how much they would expect to pay or to borrow funds from each other for a range of currencies and periods. LIBOR was also an important rate used in many of these financial institutions’ products, so several major financial institutions colluded with each other to manipulate it. As a result, in July 2017 the United Kingdom’s Financial Conduct Authority (FCA) announced that it would no longer require banks to submit LIBOR. Many agreements including, but not limited to, loans, SWAPs and leases include LIBOR as the reference rate that payments are based on. Therefore, the cessation of LIBOR will require amendments to these agreements to change the reference rate.

However, under U.S. GAAP, the amendment of a loan can result in a complex and costly exercise of determining whether the amendment constitutes a Troubled Debt Restructuring (TDR), debt extinguishment or debt modification accounting. Likewise, if a SWAP is amended, this can result in loss of special hedge accounting treatment. Similarly, an amendment to a lease agreement can result in a complex and costly determination on how to treat the modification. As a result, in March of 2020 the FASB issued ASU 2020-04 Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, which provided entities with an option to essentially treat contract amendments that replaced LIBOR with another reference rate as a non-recognized event for accounting purposes and would not require these complex and costly determinations. ASU 2020-04 was unique in that most ASUs have an effective date that dictates when an ASU must be adopted. However, due to the nature of LIBOR cessation, ASU 2020-04 instead had a sunset provision, an effective date that dictated when the ASU could no longer be used. At the time that ASU 2020-04 was issued, the FCA had established it would no longer persuade or compel banks to submit to LIBOR after December 31, 2021. As a result, the ASU 2020-04 sunset provision was set for December 31, 2022, which was12 months after the originally expected cessation date of LIBOR. However, in March 2021, the FCA announced that the intended cessation date of USD LIBOR would be June 30, 2023, which at that time, was beyond the current sunset date of ASU 2020-04. As a result, the FASB issued ASU 2022-06 which defers the sunset date of ASU 2020-04 from December 31, 2022 to December 31, 2024.

PRACTICE INSIGHT:

  • ASU 2022-06 and its predecessor ASUs do not give a green light to amend any aspect of an agreement that contains LIBOR as the reference rate and to avoid determining the accounting implications. Instead, any amendment must only change the LIBOR reference rate or, as stipulated in ASU 2021-01: Reference Rate Reform Scope, amend terms that might not directly reference LIBOR but nonetheless are impacted by LIBOR cessation, such as interest rates used for margining, discounting or contract price alignment. If your entity amends an agreement and changes more than just the LIBOR reference rate, you should carefully consider the requirements in ASU 2021-01 and related ASUs to determine if amendments to your agreements may still be treated as a non-event for accounting purposes.
  • If you have an agreement(s) that contains LIBOR as a reference rate, then read the agreement(s) for any “fallback” language that describes the rate(s) used if LIBOR is unavailable. If your agreement(s) do not contain such a “fallback,” then inquire of the counterparty to determine what replacement rate they plan on using. A switch to a different reference rate might mean a higher overall rate. It’s important for entities to be proactive and negotiate a fair replacement rate if such “fallback” language doesn’t exist.

Effective Date and Transition Requirements:

ASU 2022-06 and other LIBOR reference rate reform ASUs are immediately effective for all entities and may be applied on either a full retrospective or prospective basis to any amendment to an agreement which occurred after ASU 2020-04’s issuance (March 12, 2020) through December 31, 2024. The ASUs must be applied consistently to all eligible contracts within the same Codification Topic, except excluded components, fair value hedges and cashflow hedges may be applied on a contract-by-contract basis.

List of Newly Effective Standards This Busy Season

Calendar Year-end Public Companies

The following ASUs are effective for public companies for calendar year 2022:

Calendar Year-end Private Companies

The following ASUs are effective for private companies for calendar year 2022:

Calendar Year-end Governmental Entities

The following GASB standards are effective for governmental entities for calendar year 2022:

  • GASB Statement 87: Leases
  • GASB Statement 91: Conduit Debt Obligations
  • GASB Statement 92: Omnibus 2020 (certain portions)
  • GASB Statement 99: Omnibus 2022 (certain portions)

Practice Insight for Newly Effective Standards

ASU 2016-02 & GASB 87

ASC 842 & GASB 87 Leases

Don’t Forget About Embedded Leases (Especially Governments)

Under legacy lease accounting guidance, contracts that contained embedded leases were often processed and accounted for the same as non-leases. This was because, unless in the rare situation the embedded lease was a capital lease, there often was no difference in accounting. As a result, entities did not invest resources to identify and separately account for embedded leases. However, because of ASU 2016-02 Leases (Topic 842) and GASB 87 Leases, entities are now generally required to record a lease asset and lease liability. To avoid misstatements under ASC 842 or GASB 87, it is important for entities to identify whether a contract contains an embedded lease. This becomes especially challenging when management of contracts is handled by a department other than accounting.

Service contracts are the most likely to contain an embedded lease. For example, a transportation service contract may require the supplier to use a specifically identifiable truck. Or if your organization has a security services contract that includes hardware, the contract may list each item with a specific identification number. Logistics, transportation, warehousing and data center service contracts are among the most common places to look for embedded leases.

Unfortunately, it’s not as easy as searching all your contracts for the words “lease” or “rent” because agreements with embedded leases rarely contain these words. If processing contracts and payments at your organization is decentralized, then we recommend training the various business units or departments on the new lease standard and what to look for, such as red flags to look for and which contracts are more likely to contain an embedded lease. In addition, review payments made to outside vendors that occur consistently on a periodic schedule and for the same or similar amounts to identify additional contracts to analyze. Once a contract has been identified as potentially containing an embedded lease, search for language such as “exclusive use,” “solely,” “identification number,” etc. as these are red flags that a potential embedded lease may exist.

There are some key differences between ASC 842 and GASB 87 that could result in more embedded leases for governments than for their commercial counterparts. First, under ASC 842 a lease only exists if the potential lessee has uninterrupted control of the asset. However, this requirement does not exist under GASB 87. For example, if your organization rents a piece of equipment for only one day a week, with another organization renting it for the other six, under ASC 842, it is not a lease because you are only obtaining 20% of the lease’s service capacity. Under GASB 87, however, the lessee can have a lease component in which they only utilize the assets for certain portions of a time. Secondly, GASB 87 allows for substitution rights, whereas under ASC 842 substitution rights might preclude the existence of a lease if the substitution right is practical and the supplier would benefit economically from substituting the underlying asset.

ASU 2021-07

Determining the Current Price of an Underlying Share for Equity-classified, Share-based Awards

Rebuttable presumption that a valuation expert will be used. Also, do not use a valuation older than one year.

ASU 2021-07 was issued in October 2021 and was effective for grants of share-based compensation in fiscal years beginning after December 15, 2022. The ASU was a product of the Private Company Council aiming to provide nonpublic entities with a practical expedient to determine the current price of their shares when measuring share-based compensation. Share-based payments are measured at fair value and the most common valuation technique used to estimate fair value is the Black-Scholes-Merton model (BSM). This option pricing model requires various inputs, the most onerous of which for nonpublic entities is the current price of the entity’s underlying share. ASU 2021-07 introduced a practical expedient that allows nonpublic entities to determine the current price of their shares using a “reasonable application of a reasonable valuation method.” The ASU described the factors that would be considered when applying a “reasonable application of a reasonable valuation method” including:

  • The value of the entity’s tangible and intangible assets
  • The present value of the entity’s anticipated future cash flows
  • The market value equity interests in similar entities engaged in similar businesses
  • Recent arm’s-length transactions involving the sale or transfer of the entity’s equity interests
  • Other relevant factors, such as control premiums or discounts for lack of marketability
  • Consistent use of particular valuation methods

Critically, ASU 2021-07 stated that a valuation by an independent appraiser was not required and that valuations conducted by internal personnel could qualify if they met the characteristics described in the practical expedient. Some practitioners incorrectly interpreted this as a green light not to use a valuation expert. However, as ASU 2021-07 states, the characteristics used to describe a “reasonable application of a reasonable valuation method” are the same characteristics used for purposes of valuing share-based compensation for income tax purposes under IRC Section 409A. It’s important to note that the rules governing IRC Section 409a are complex and subjective. Mistakes can result in additional taxes and penalties and preparers should consult with their Cherry Bekaert tax professional. However, there are certain “safe harbor” valuation methods under IRC Section 409A, the most common of which is the use of an independent appraiser. Finally, and most importantly, ASU 2021-07 states that it is expected that an independent appraisal will often be the method used by nonpublic entities electing the practical expedient.

In addition, we sometimes see practitioners use outdated valuations. ASU 2021-07 explicitly states that a previous valuation by an independent appraiser is not reasonable as of the later of:

  • The previous calculation fails to reflect subsequent information that may materially change the value (e.g., acquisition, material litigation, issuance of a patent).
  • The previously calculated value was for a measurement date that is more than 12 months earlier than the current measurement date.

So, despite the Private Company Council’s best efforts to reduce the costs and complexity of accounting for share-based compensation, the need to obtain an independent appraiser is still likely necessary.

Standards Not Yet Effective*, but That You Should Consider Early Adopting

*Not yet effective for private entities

ASU 2020-06

Accounting For Convertible Instruments and Contracts in an Entity’s Own Equity

BCFs are gone, but a fair value determination is still necessary. In addition, private entities that concluded derivative accounting did not apply because their shares are not readily convertible into cash need to reconsider.

Adoption of this amendment will simplify the accounting associated with certain financial instruments with characteristics of both liabilities and equity, and amends certain disclosure requirements. The Update eliminates the beneficial conversion (BCF) and cash conversion model, reducing the number of accounting models available for convertible debt instruments and convertible preferred stock, which is aimed to result in fewer embedded conversion features being separately recognized from the host contract when compared to current GAAP. Additionally, the Update makes certain changes to EPS guidance.

Entities that will see the most impact from early adopting are those who:

  • Hold convertible instruments with beneficial conversion or cash conversion features
  • Hold contracts in their own equity, specifically freestanding instruments and embedded features that are currently accounted for as derivative liabilities

For entities that hold contracts in their own equity, the ASU removes the following conditions that were required for equity classification:

  • Settlement must be in unregistered shares
  • There is no requirement in the contract to post collateral
  • No counterparty rights rank higher than shareholder rights

PRACTICE INSIGHT:

The new disclosure requirements created by ASU 2020-06 are often overlooked and they could thwart some of the perceived benefits. ASU 2020-06 requires the following additional disclosures for convertible instruments:

  • Condition or events that may cause conversion or changes to conversion terms
  • Which party controls conversion rights
  • Fair value disclosures to be presented at the individual convertible instrument level, rather than in aggregate

Requiring the fair value of convertible instruments to be disclosed indirectly means that although a BCF or cash conversion feature might not be separately accounted for, the costly exercise of determining their fair value is not alleviated.

For some private entities, the most consequential but easily overlooked impact of this ASU is that it clarifies that all financial instruments that are freestanding and potentially settleable in an entity’s own stock are required to be assessed under ASC 815-40 Contracts in Entity’s Own Equity, regardless of whether the instrument has all the characteristics of a derivative instrument. Some private entities took the view that because their stock is not actively traded (i.e. “readily convertible into cash”), any instrument potentially settleable in their stock did not meet the net settlement criterion required under the definition of a derivative. Thus, any such instrument would not have to be analyzed under ASC 815-40 at all, or that if the instrument was analyzed under ASC 815-40 and found to not meet the equity classification criteria, it would not be subsequently remeasured at fair value like other derivative liabilities because it did not meet the definition of a derivative. This ASU clarifies that any freestanding instrument, regardless of whether the instrument would meet the definition of a derivative, must be assessed under ASC 815-40 and, if found to either not be considered indexed to the entity’s own stock or did not meet the equity classification criteria, then said instrument must be classified as a liability and remeasured at fair value at each reporting period.

This concern was explicitly mentioned in Basis for Conclusions paragraph 103 as follows:

A few comment letter respondents observed that the fair value requirement may include contracts that were previously not measured at fair value. The Board acknowledges that because of a lack of guidance, there may be a population of these instruments that are currently being accounted for at cost and, therefore, an entity should transition to fair value measurement under the amendments in this Update. The Board concluded that this amendment mostly affects freestanding instruments issued by private companies. For example, a freestanding warrant on the share of a private company may not meet the definition of a derivative because it requires physical settlement or cannot be net settled because the underlying equity is not readily convertible to cash.

This clarification could result in some private entity instruments that were previously not classified as a liability and/or remeasured subsequently at fair value to be classified as a liability and remeasured subsequently at fair value. This could result in restatements and/or costly valuations of those private entities.

Effective Date and Transition Requirements:

Public business entities (excluding SRCs): Fiscal years beginning after December 15, 2021, including interim periods within those years

All other entities (including SRCs): For fiscal years beginning after December 15, 2023, including interim periods within those years

The amendments in this Update should be applied using the modified or full retrospective method. Early adoption is permitted, however, all private entities, regardless of whether they early adopt this Update or not, should consider this ASU’s clarification that freestanding financial instruments potentially settleable in an entity’s own stock are required to be assessed under ASC 815-40 Contracts in Entity’s Own Equity, regardless of whether the instrument meets the definition of a derivative.

ASU 2021-08

Accounting for Contract Assets and Contract Liabilities From Contracts With Customers

Don’t “lose” revenue in a business combination.

Prior to the adoption of ASU 2021-08, whenever a business combination occurs, the acquirer is required to account for any preexisting contract assets and liabilities related to revenue contracts acquired from the acquiree in accordance with ASC 805 Business Combinations, which requires the contract assets and liabilities be measured at fair value. Often this results in “lost revenue” because the fair value of deferred revenue is generally measured using the “cost build-up approach,” which estimates the costs incurred to satisfy the performance obligation, plus a normal profit margin. For entities with low variable costs to provide services to additional customers or for entities forced to defer revenue for services that have largely already been performed due to accounting rules (e.g., not distinct), this can result in a significant reduction or “haircut” to acquiree’s carrying value of deferred revenue. This is particularly impactful to the technology, software and telecommunication industries. When significantly reduced to fair value, deferred revenue is subsequently recognized into revenue and the originally recorded revenue is “lost.”

The amendments in this Update require that an acquirer recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606. At the acquisition date, an acquirer should account for any contract asset or liability related to a preexisting revenue contract of the acquiree in accordance with Topic 606, as though the acquirer had originated the contract. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements. However, there may be circumstances in which the acquiree’s carrying value would not be used such as:

  • The acquiree did use Generally Accepted Accounting Principles (GAAP)
  • The acquirer is unable to assess or rely on how the acquiree applied Topic 606
  • There were errors identified in the acquiree’s accounting
  • There are changes required to conform with the acquirer’s accounting policies

Importantly, the amendments in this Update do not affect the accounting for other assets or liabilities acquired in a business combination (e.g., refund liabilities, customer-related intangible assets, intangible assets for off-market terms, etc.).

Effective Date and Transition Requirements:

Public business entities: For fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.

All other entities: For fiscal years beginning after December 15, 2023.

The amendments in this Update should be applied prospectively to business combinations occurring on or after the effective date of the amendments.

Early application is permitted, including adoption in an interim period. An entity that early adopts in an interim period should apply the amendments retrospectively to all business combinations that occurred during that fiscal year and prospectively to all future business combinations.

ASU 2022-03

Fair Value Measurement of Equity Securities Subject To Contractual Sale Restrictions

A DLOM might no longer be necessary.

This amendment does not change current GAAP, but rather clarifies those principles when measuring fair value and reduces the diversity in practice. The amendments in this Update clarify that if an equity security has contractual sale restrictions, this is not to be considered part of the unit of account and is therefore not considered when measuring the security’s fair value, which is often referred to as a liquidity discount for lack of marketability (DLOM) which can require a costly valuation.

Disclosure Changes:

The amendment in this Update requires an entity who holds equity securities subject to contractual sale restrictions to disclose the following:

  • Fair value of equity securities subject to contractual sale restrictions reflected in the balance sheet
  • Nature and remaining duration of the restriction(s)
  • Circumstances that could cause a lapse in the restriction(s)

PRACTICE INSIGHT:

It is often misunderstood that this ASU eliminates the need for ever obtain a DLOM. This ASU only applies to contractual restrictions that are not part of characteristics of the underlying equity security, but rather only applies to contractual restrictions that are based on who holds the equity security. For example, a lock up on shares of a publicly traded company that recently completed an IPO would be considered a contractual restriction on the holder of the security, and no discount for the lock up would be allowed under this ASU. This is a change from the way many entities currently account for this type of restriction. In current practice, many investment companies calculate a discount on the publicly traded price of the security when determining fair value of a share under a lock-up agreement. This discount would no longer be allowed under the new guidance. Juxtapose this to restrictions on shares issued through a private placement, or other unregistered shares (e.g., Rule 144) that are legally restricted from being sold until they have been registered, or the conditions necessary for exemption from registration have been met. This restriction would be considered a characteristic of the underlying equity security and should be part of the unit of account. Therefore, this characteristic would be considered in measuring the fair value of the security and a DLOM would be applied.

Effective Date and Transition Requirements:

Public business entities: For fiscal years beginning after December 15, 2023, including interim periods within those fiscal years.

All other entities:  For fiscal years beginning after December 15, 2024, including interim periods within those fiscal years.

Early adoption is permitted for both interim and annual financial statements that have not yet been issued.

Investment company under Topic 946: The amendments in this Update should be applied to those applicable equity securities executed or modified on or after the date of adoption. Those equity securities executed before the date of adoption should continue to be accounted for under the accounting policy applied before the adoption of the amendments until the contractual restrictions expire or are modified.

All other entities: The amendments in this Update should be applied prospectively, with any adjustments recognized in earnings and disclosed.

Standards Not Yet Effective*, but That You Should Be Aware Of

*Not yet effective for private entities

ASU 2016-13

Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (Current Expected Credit Loss or CECL)

Effective for non-public business entities (including SRCs) for fiscal years beginning after December 15, 2022

For private entities and SRCs, prior to the adoption of CECL, impairment of financial instruments was recognized once a loss became probable (i.e., “incurred credit losses”). For example, a loan receivable becoming significantly overdue. CECL eliminates the probable recognition threshold and requires an estimate of the expected losses over the life of the financial instrument to be recorded at the time the instrument is initially recorded. CECL also states that an entity shall not rely solely on the past to estimate losses. An entity shall consider if historical information should be adjusted to reflect current conditions and forward-looking data such as expected GDP, unemployment rates, property values, commodity values or other factors that are associated with credit losses for that type of financial instrument. In addition, CECL requires an entity to evaluate financial assets that share similar risk on a collective basis, rather than individually.

PRACTICE INSIGHT:

There is a common misconception that CECL only impacts financial institutions. While CECL impacts financial institutions more acutely, CECL will impact virtually all entities. The most common example of this is trade receivables. Trade receivables are financial instruments and thus CECL must be applied to them. For entities that currently do not have a general reserve applied to all receivables, regardless of their delinquency status, the adoption of CECL will most likely result in an increase in the allowance for uncollectable accounts. This is true even if the entity has historically not experienced any write-offs. This is because CECL requires an entity to consider some possibility of default, even if that risk is remote. For example, while an entity may have no history or expectation of a loss for a particular customer, corporate bond default studies demonstrate that there is always a risk of default, even for highly rated customers. We and other firms believe that it will be challenging for an entity to assert a zero expected credit loss. ASU 2016-13 included an example (326-20-55-48 Example 8) of when a zero expected credit loss might be appropriate. That example assessed that a zero expected loss might be appropriate for an entity which invested in U.S. treasuries. Although the example states that it is not only applicable to U.S. treasuries, the example included several criteria that U.S. treasuries met, but are not present in most other financial instruments and thus would suggest that under CECL, most receivables would require some amount of allowance.

For example, the entity in Example 8 concluded that its U.S. treasuries had a zero expected credit loss because U.S. treasuries:

  • Receive a consistently high credit rating by rating agencies
  • Have a long history with no credit losses
  • Are explicitly guaranteed by a sovereign entity, which can print its own currency
  • Have currency that is routinely held by central banks, used in international commerce and commonly viewed as a reserve currency

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