From the Editor
Frank M. Messina, DBA, CPA Alumni & Friends Endowed Professor of Accounting
UAB
Department of Accounting & Finance
Collat School of Business
CSB 319, 710 13th Street South Birmingham, AL 35294-1460 • (205) 934-8827
fmessina@uab.edu
It is summer and the roads and skies are full of travelers. Gas prices along with everything else keep going up and there are not many empty airplanes. Summer is a time for renewal and family. Most of us are seeking a private place to recharge. Take advantage of the opportunities and as my wife says – surprise your family with a trip and your devoted time somewhere!!
Try to join us for the 2023 Tax, Finance & Accounting Conference for Cooperatives (TFACC), in Portland, Oregon, July 23-26. TFACC is the only conference uniquely tailored to providing education, resources and connections to professionals involved in the financial management and planning of cooperatives. This highly anticipated conference offers proven strategies, tools, and resources to help your co-op increase efficiencies, improve financial controls, streamline regulatory compliance and make transactions manageable. This three-day program is offered in collaboration with NSAC, NRECA, and NTCA.
Remember, we too are always looking for you to share your knowledge since you may have some extra time on your hands (like others continue to do) with us through articles in The Cooperative Accountant. Feel free to contact me (fmessina@uab.edu) if you have any ideas or thoughts on a potential article contribution. Sharing knowledge is a wonderful thing for all!!! Knowledge can change our world!
That is why we must remember – “The Past is history; the Future is a mystery, but this Moment is a Gift – that’s why it’s called the Present.”
Positively Yours,
Frank M. Messina, DBA, CPA
Articles and other information which appear in The Cooperative Accountant do not necessarily reflect the official position of the NATIONAL SOCIETY OF ACCOUNTANTS FOR COOPERATIVES and the publication does not constitute an endorsement of views or information which may be expressed.
The Cooperative Accountant (ISSN 0010-83910) is published quarterly by the National Society of Accountants for Cooperatives at Centerville, Ohio 45459 digitally. The Cooperative Accountant is published as a direct benefit/ service to the members of the Society and is only available to those that are eligible for membership. Subscriptions are available to university libraries, government agencies and other libraries. Land Grant colleges may receive a digital copy. Send requests and contact changes to: The National Society of Accountants for Cooperatives, 7946 Clyo Road, Suite A, Centerville, Ohio 45459.
3 Summer 2023 | The Cooperative Accountant
Introduction
Rates are a tool for recovering electricity costs. Additionally, they can incentivize customers to invest in new technologies that can better enable them to manage their electricity consumption and related costs. They can also provide customers with price signals that can enable them to somewhat control their electric bill amount by controlling usage amounts and usage periods. Electricity costs include customer services, distribution services, transmission services, and power generation services. Historically, the costs of providing customer, distribution, and transmission facilities typically do not vary significantly. The costs of providing generation services can vary substantially over time and location. Generation costs change over time because electricity cannot be substantially stored, load requirements change from hour to hour, so different power generation sources with different fuel costs will be the marginal power source at different times. These generation costs can change by location due to the constraints that impact the cost to deliver the power to that location. Rates
vary from location to location, but for an electric distribution cooperative generally power costs approximate about 75% of a customer’s monthly utility bill, with Labor and Administrative costs about 10% and 15% respectively (Hissom, 2013, Why make these distinctions section, para. 1).
Olson et al. (2023) contend that “decarbonization and clean energy policy goals are fundamentally changing grid planning and operations” (p. 1). This is having a direct impact on cost drivers which are focused on resource adequacy, providing reliability during peak load hours, and time shifting of renewable electricity from periods of excess generation to periods where it can be consumed at less costly periods of lower demand. Rates and rate designs are changing dramatically as a result and are becoming increasingly more complex. The aforementioned authors recommend that electric companies adopt a multi-part rate design that aligns with both grid needs and environmental goals and includes the following:
1. a dynamic hourly energy rate that is low in most hours of the year when zero/low
4 Summer 2023 | The Cooperative Accountant
Peggy
Director, Finance 16262 Wax Road Greenwell Springs, LA 70739 Phone 225.262.3026 Cell: 239.887.0131 peggym@DEMCO.ORG
Editor & Guest Writer
Maranan, Ph.D. DEMCO
variable cost resources are abundant and on the margin;
2. either a size-based grid access charge, coincident demand charge, or hourly allocation of long-run marginal capacity costs that encourage reducing and shifting load out of a relatively small number of hours driving new investments in generation, transmission, and distribution capacity; and
3. non-bypassable customer charges designed for equity that recover utility embedded and unavoidable fixed costs.
(Opening section)
Principles of Rate Design
The pricing of electricity should reflect the cost of providing electricity to customers. This is a fundamental principle of rate design. Theoretically, rates designed around costs should lead to equity and fairness in recovery of costs incurred by the electricity provider; they should remove any unintentional subsidies of rates while also promote efficiency in the production and use of electricity. While recovering costs is key to a rate design, customer considerations may also lead to rate designs that are not entirely cost-based. These decisions could be based upon, for example, ease of implementation or understanding of the rate design, customer acceptance, and the distribution of rates amongst customers.
Electric rates are structured around a combination of three elements:
1. Variable charges – these are rates collected to reflect the variable components of cost of service over a billing period. These are typically a flat charge, expressed in cost/kWh, and are applied to total usage served in a billing period. They include items such as fuel charges, but can also include charges related to other costs. The volumetric charges to customers include a cost per kWh of total usage in a billing period. A kWh, kilowatt hour, is a measure of electrical energy equivalent to a power consumption of 1,000 watts for
one hour. With flat rates, customers are not incentivized to adjust consumption to varying times of the day when peak demands may be lesser, so time-of-use (TOU) rates can be adopted to incentivize customers to use more in times of lower peak demand. This would assist in controlling costs for both the electricity provider and the consumer. Being able to charge TOU rates would depend on having the required advanced technology in place for usage to be measured and usage data delivered to the consumer so that the consumer has the data to make decisions timely about adjusting electricity consumption behaviors.
2. Demand charges – these are rates collected with the goal of capturing the long-run costs of capital investments on the electric distribution system. These costs are intended to directly link customers who drive system maintenance and capacity requirements with the costs they cause or their cost impact to the electric service provider. Demand charges refer to how much energy is needed, or the specific demand at any one time, or the maximum amount of power (kW) consumed during a single point in time.
3. Fixed charge – these are rates collected to recover costs that do not vary with electricity usage or demand. Examples of these include meter and billing costs, customer care support, connection or service hookup costs, or costs sunk from prior investments. Fixed charges are usually represented in dollars/cents per day/month charges.
Trends in rate design
Rate design varies from electric company to electric company, the design is a reflection of the goals intended by that company and the customers it serves. And, those goals can change over time. Some of the common rate structures used historically in the industry have included, as offered by Faruqui et al. (2020):
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• Flat volumetric charge with modest fixed charge
• Large fixed charge with modest flat volumetric charge
• TOU energy charge with modest fixed charge
• Demand charge with modest fixed charge
Some of the emerging rate designs may incorporate the following:
• Fixed bill coupled with peak time rebate (PTR), energy efficiency, or demand response programs
• Critical peak pricing with fixed charge
• Locationally varying real-time prices (pp. 12-14)
Another trend for large commercial and industrial customers is increasing investments in self-generation as a way to offset electricity charges. Utilities are still required to provide power during unplanned outages, or during times where self-generation may need to be supplemented. In designing rates, the utility needs to charge self-generating customers to fully recover these costs from this segment of customers or these costs could inadvertently pass to other customers. To accommodate this situation, the utility may consider implementing standby rates to help ensure that there will be enough electricity capacity available should these loads be required to be serviced. Standby rates could include combinations of volumetric, demand, and fixed charges, and should apply to customers as long as they are connected to the grid. An exit fee is another rate tool that can be used to help offset costs should a customer leave the system before the electric company has had the chance to recover the costs of providing infrastructure investments and service to that customer.
Centolella (n.d.) contends that there are three important functions of electric rate design:
1. Communicating dynamic, efficient, and where feasible, market-based price signals that reflect the marginal cost and value of
electricity;
2. Equitably allocating transmission, distribution, and public policy costs that utilities cannot recover at market or marginal cost based rates; and,
3. Providing customers cost-effective options for managing high bills and the risks associated with variable electricity prices. (p. 2)
Cantolella notes that “more than 70% of U.S. households have advanced meters that enable two-way communications” (p.
3). With these technologies in place, electric companies have the ability to charge prices based on marginal cost or market cost whereby time and location-specific usage can be measured in near-real time. Once this measurement ability exists, it provides the option for customers to make more informed decisions about when and how much electricity they use. It also allows the customers to make more informed decisions about investments they might wish to make in adoption of distributed energy resources (DERs) such as solar, battery, or wind infrastructure. With the influx of smart thermostats, water heater controls, new innovations in demand management technologies, and electric vehicle charging, there is a large new category of flexible demand that can be managed to drive usage towards more efficiency and help in reducing costs. It has become increasingly important in rate design structures to address and accommodate for the influx of these technologies, working to put together the best rate structures that are equitable for all consumers, promote efficiency in use and demand of electricity, which ultimately helps to control costs.
Considerations of rate equity have become a hot topic. The definition of what is “equitable” could vary by perspective from company to company, customer to customer. But, Cantolella describes three types of equity to consider:
1) Allocation equity – regulators have discretion to identify different similarities
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and differences that may be relevant to the apportionment of common costs amongst customers.
2) Distributional equity – this reflects the regulatory consideration of impacts on low income and disadvantaged customers.
3) Transitional equity – this describes how changes in rates may interact with customer expectations and community standards of fairness. (p. 5)
This topic of equity is currently being widely discussed around the U.S. But, specifically, in California, it has been a widely debated topic. California has set aggressive goals in decarbonization, and is now getting over one-third of its power from renewable generation and nearly two-thirds from carbon-free sources. But, this has come at a cost. Borenstein et al. (2021) cite national data from the Federal Energy Regulatory Commission (FERC) showing that the average price of residential electricity in California’s three large investor-owned-utilities are out of line with the rest of the country, ranging from 45% to 89% higher than the rest of the country. The increase in renewable infrastructure has resulted in a high fixed cost percentage for these utilities as compared to other electric companies around the country. The result is that lower and averageincome households bear a greater burden of electricity rates. Additionally, many higher income households, in order to avoid high electricity rates, have invested in rooftop solar, something that the lower income population can not always afford. This is contributing to leaving utility fixed costs to be absorbed in greater proportion by the lesser income population. California is now attempting to grapple with this imbalance and determine ways to recover the higher fixed costs in a more equitable way. This could include varying the fixed costs charged according to income. Another consideration is implementing a state-wide tax that would help to recover some costs from those that can more easily afford it. There is no
resolution to this debate as of this writing. Finally, the rate design should provide for options available to customers for managing the risk of receiving a high bill. Some of the management tools used could be the option of budget payment programs, price hedges for larger customers, or other forms of insurance. Incentives for shifting flexible demand out of high peak price periods is another tool that is widely in use for those with advanced metering infrastructure (AMI) capabilities, and it is expected that this trend will continue to grow as more and more adoption of these advanced technologies continues throughout the country.
Summary
With the shift towards clean energy and renewable energy resources, these are only available when the weather is favorable, this leads to periods where there is an abundance of energy and periods where energy is scarce. The traditional historic rate models of the last 50 years need to now adapt from the prior scenario of having high marginal fuel costs (driven by fossil fuel combustion) to the new model whereby marginal costs will be lower but fixed costs will be higher. In the past, reduced consumption typically meant reduced costs. But, with the new higher fixed cost model, increasing consumption can lead to lower electricity rates. This new paradigm suggests that both financial and environmental benefits can be achieved by either decreasing or increasing consumption at specific times and places in order to both better manage costs and reduce harmful environmental impacts. And, unpredictability will continue to persist in managing required energy loads.
This puts those in a position of setting rates at electric cooperatives into a period of transition in rate setting design. The transition has started in the U.S., but is effecting electric cooperatives differently depending upon the unique situation of each cooperative. The best recommendation in rate planning is to develop plans for the
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near term, medium term, and long term strategies. Take a proactive approach as there may be no other cooperative that is in the exact same scenario when it comes to designing rates. Rely on rate consultants for assistance as they can bring invaluable industry knowledge to help navigate the trends. Geographic areas each have unique attributes and needs, and they will continue to evolve over time. As recommended by Beauchamp (2019), key objectives in any strategy should include objectives related to:
• Fairness to customers
• Social concerns and impacts on lowincome customers
• Environmental protections
• Financial stability of the utility
• Stable rates for customers
• Consistent price signals to promote desired investments by customers
• Economic development for the community
• Sending price signals consistent with the utility’s costs
• Providing customers greater control over their electric charges
• Providing reliable service to customers (p. 4)
As part of the steps in the modernization of one of it’s clients, The Brattle Group suggested this approach:
1. Define ratemaking objectives
2. Identify the most attractive rate designs
3. Conduct bill impact analysis
4. Assess customer understanding of the rates through market research
5. Assess consumer response to new tariff designs through empirical analysis (Faruqui et al., p. 28)
Braithwait et al. (2007) offer the following recommended pricing strategies:
1. To overcome concerns about potential revenue losses from adverse selection of voluntary rates by consumers who expect to achieve immediate bill savings, offer fairly priced voluntary rates but allow adjustments to standard flat rates to
ensure that they adequately cover the cost and risk of serving the remaining customers
2. To overcome concerns about fixedcost revenue recovery due to reduced consumption under voluntary timebased rates, move toward greater use of graduated customer charges to recover fixed costs or revenue adjustment mechanisms to track allowed revenue toward fixed costs
3. To provide utilities with a financial incentive to offer voluntary rates, allow sharing of net revenue gains resulting from customer load response under time-based rates
4. To overcome customer resistance to complexity and price risk of time-based rates, offer simple, fairly priced optional rates combined with standard rates that include appropriate risk premiums for guaranteed prices; market the rates effectively; and possibly combine them with communication and control technologies that facilitate consumers’ response to varying prices
5. To further mitigate the financial disincentives to utilities to offering voluntary rates in the presence of classwide standard rates, move toward greater refinement of rate classes to reduce the variability of within-class usage patterns, where the ultimate solution would be customized pricing for individual customers based on actual usage patterns measured with advanced metering equipment (pp. 33-34)
Generally, the most predominant residential rate design in the U.S. is currently a two-part design, one part fixed charge and another part a volumetric energy charge. For large industrial and commercial customers, a three-part rate is common where the addition of a demand charge is included. A substantial portion of the costs are recovered through volumetric charges. This does promote conservation of energy usage. But,
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it does not align well with grid costs or reflect the cost structure of electricity service. In periods of low consumption, fixed costs can be not fully recovered putting a burden on the net margins and cash flow of the electric cooperative. Additionally, high volumetric rates do not always encourage environmental goals as they can discourage electrification which can add higher charges for increasing electricity consumption. Examples where electrification may not be incentivized based upon rates might include the purchasing of an electric vehicle, investing in battery storage, and investing in electrification of heating as high volumetric rates will proportionately increase monthly electric bills. TOU rates do incentivize customers to shift consumption to off-peak, less expensive, times of the day in using electricity. But, these shifts may not necessary align with grid needs and may not shift to times that optimally avoid fixed costs incurred by the utility.
To align customer needs with most cost effective utility practices, more complex and multi-part rate design structures are recommended. As solar, wind and battery storage play an increasing part in the utilities power capacity, they are playing a major role in the shift from smaller variable costs to larger fixed costs for power systems. Additionally, there have been government subsidies over the last few years that have offset the total investment costs of some of these renewables, and as the subsidies
References
and tax credits expire and fall away this will also have upward pressure on fixed costs for renewable energy sources. As such, retail rates for customers with flexible loads and DER’s must become more complex and dynamic with automated responses. This can be accomplished through a dynamic hourly energy rate, a demand charge or hourly allocation of marginal capacity costs, and fixed customer charges based equitably amongst customer segments that recover unavoidable fixed costs.
The time has come for more accurate retail pricing, where pricing more accurately reflects costs and assigns rates to those that are driving and benefiting from the costs. In the past, the focus of rate-making was around (1) producing sufficient revenue for the utility to operate, and (2) the allocation of costs amongst customer segments. Rates using the fixed/variable ratio that were not reflective of how actual costs were derived, leaned more heavily on the volumetric rate as this was deemed more socially equitable and also to possibly incentivize conservation. This mindset had been prevalent in the industry and politically supported by many rate regulators. But, given the changing dynamics of the industry it has become clear that the industry is in the throws of a multi-decade change of how we need to approach ratemaking. We can take this as an opportunity to drive rate designs so as to achieve the strategic goals for our electric cooperative organizations and our members.
Beauchamp, M. (May-June 2019). Leadership in Rate Design: What a Long-Term Rate Strategy Should Address. American Public Power Association. Retrieved February 15, 2023 from the following website: https://www.publicpower.org/system/files/documents/Leadership-in-RateDesign.pdf
Borenstein, S., Fowlie, M., & Sallee, J. (February, 2021). Designing Electricity Rates for An Equitable Energy Transition. Energy Institute at Haas WP 314. Retrieved February 15, 2023 from the following website: https://haas.berkeley.edu/wp-content/uploads/WP314.pdf
Braithwait, S., Hansen, D., & O’Sheasy, M. (July, 2007). Retail Electricity Pricing And Rate Design In Evolving Markets. Christensen Associates Energy Consulting, LLC, prepared for the Edison Electric Institute. Retrieved February 15, 2023 from the following website: http://www. madrionline.org/wp-content/uploads/2017/02/eei_retail_elec_pricing.pdf
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Centolella, P. (n.d.). Rethinking Electric Rate Design: A Policy Summary. Retrieved February 15, 2023 from the following website: https://tcr-us.com/uploads/3/5/9/1/35917440/centolella_ rethinking_electric_rate_design_-_a_policy_summary_10_21_2021.pdf
Faruqui, A., Hledik, R., & Lam, L. (March 13, 2020). Modernizing Distribution Rate Design. The Brattle Group. Retrieved February 15, 2023 from the following website: https://www.brattle. com/wp-content/uploads/2021/05/18380_modernizing_distribution_rate_design.pdf
Hissom, R. (May 13, 2023). It’s easy to cut power costs, right? Utility Accounting & Rates Specialists. Retrieved February 15, 2023 from the following website: https:// utilityeducationinsights.com/electric-utility-rates/cut-electric-power-costs
Olson, A., Cutter, E., Bertrand, L., Venugopal, V., Spencer, S., Walter, K., & Gold-Parker, A. (March 2023). Rate Design for the Energy Transition. A White Paper from the Retail Pricing Task Force. Reston, VA: Energy Systems Integration Group. Retrieved February 15, 2023 from the following website: https://www.esig.energy/wp-content/uploads/2023/03/ESIG-Retail-Pricingdynamic-rates-E3-wp-2023.pdf
Additional Helpful Resources
Chitkara, A., Cross-Call, D., Li, B., & Sherwood, J. (May, 2016). A Review of Alternative Rate Designs: Industry Experience with Time-Based and Demand Charge Rates for Mass-Market Customers. Retrieved February 15, 2023 from the following website: https://rmi.org/wpcontent/uploads/2017/04/A-Review-of-Alternative-Rate-Designs-2016.pdf
Costello, K. W. (November 22, 2022). Today’s rate designs are defective. How can utilities better recover their fixed costs, and from whom? Retrieved February 15, 2023 from the following website: https://www.utilitydive.com/news/-utility-fixed-rate-design-demand-charge-solarcostello/634213/
Edison Electric Institute (EEI). (February, 2021). Electric Transmission: Enabling the Clean Energy Transformation. Retrieved February 15, 2023 from the following website: https://www.eei.org/-/ media/Project/EEI/Documents/Issues-and-Policy/Transmission_Enabling_Clean_Energy.pdf
Federal Energy Management Program. (n.d.). Evaluating Your Utility Rate Options. Retrieved February 15, 2023 from the following website: https://www.energy.gov/femp/evaluating-yourutility-rate-options
Fresh Energy. (November 28, 2022). Equitable electricity rates and our energy transition. Retrieved February 15, 2023 from the following website: https://fresh-energy.org/equitableelectricity-rates-and-our-energy-transition
Houghton, B., Salovaara, J., & Tai, H. (March 8, 2019). Solving the rate puzzle: The future of electricity rate design. Retrieved February 15, 2023 from the following website: https://www. mckinsey.com/industries/electric-power-and-natural-gas/our-insights/solving-the-rate-puzzle-thefuture-of-electricity-rate-design
Schitteekatte, T., Mallapragada, D., Joskow, P.L., & Schmalensee, R. (October 26, 2022). News Electricity Retail Rate Design in a Decarbonizing Economy: An Analysis of Time-of-Use and Critical Peak Pricing. Retrieved February 15, 2023 from the following website: https://climate. mit.edu/posts/news-electricity-retail-rate-design-decarbonizing-economy-analysis-time-use-andcritical-peak
Wolfram, J. (2016). Rate Designs for Changing Times. Retrieved February 15, 2023 from the following website: http://www.catalystcllc.com/articles/rate-designs-for-changing-times-2/
10 Summer 2023 | The Cooperative Accountant
By Greg Taylor
FASB ISSUES PROPOSED ASU ON INCOME TAXES (TOPIC 740) IMPROVEMENTS TO INCOME TAX DISCLOSURES
Issued on March 15, 2023, with a comment deadline of May 30, 2023, this proposed accounting standards update aims to enhance the transparency and usefulness of income tax disclosures. It addresses feedback from investors who have requested more information to better understand an entity’s tax rate, tax risks, tax planning, and potential opportunities. The amendments primarily focus on improving the rate reconciliation and income taxes paid disclosures. The main provisions of the proposed update include:
1. Rate Reconciliation: Public business entities would be required to disclose specific categories in the rate reconciliation and provide additional information for reconciling items that meet a certain threshold. This disclosure should help investors assess an entity’s exposure to tax legislation changes, cash flow forecasts, and potential opportunities for increasing future cash flows.
2. Income Taxes Paid: All entities would need to disclose the year-to-date amount of income taxes paid, disaggregated by federal, state, and foreign taxes. Furthermore, income taxes paid should be
disclosed by individual jurisdictions if they represent 5% or more of the total income taxes paid.
Other amendments include removing certain disclosure requirements, such as the nature and estimate of the range of possible changes in unrecognized tax benefits. The term “public entity” would also be replaced with “public business entity.”
The proposed amendments aim to provide consistent categories, greater disaggregation, and jurisdictional information in the rate reconciliation and income taxes paid disclosures. This would allow investors to better assess an entity’s tax risks and opportunities when making investment and capital allocation decisions. Additionally, some amendments align the disclosure requirements with U.S. Securities and Exchange Commission (SEC) regulations and eliminate disclosures that are no longer considered cost-effective or relevant.
The effective date and potential for early adoption will be determined based on stakeholder feedback. The proposed amendments would be applied retrospectively.
The FASB welcomes comments from individuals and organizations on various aspects of the proposed update, including the specific categories in the rate reconciliation, the 5% threshold, the
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GENERAL
Greg Taylor, Shareholder, D. Williams & Co., Inc. 1500 Broadway, Suite 400 Lubbock, TX 79401 (806) 785-5982 gregt@dwilliams.net
EDITOR
frequency of disclosure, and the clarity and operability of the proposed amendments. Private company considerations and transition requirements are also open for discussion. Feedback from both supporters and dissenters is encouraged, with suggested alternatives and supporting reasoning.
FASB ISSUES PROPOSED ASU ON INTANGIBLES-GOODWILL AND OTHERCRYPTO ASSETS (SUBTOPIC 350-60) ACCOUNTING FOR DISCLOSURE OF CRYPTO ASSETS
Issued on March 23, 2023, with a comment deadline of June 6, 2023, the Financial Accounting Standards Board (FASB) is proposing amendments to improve the accounting for and disclosure of certain crypto assets. Stakeholder feedback indicated that the current accounting for crypto assets as indefinite-lived intangible assets does not provide investors with relevant information. The proposed amendments would require entities to measure crypto assets at fair value and recognize changes in value in net income each reporting period. Transaction costs to acquire crypto assets would be expensed unless industry-specific guidance requires capitalization. The proposed amendments would also require enhanced disclosures about the types and changes in crypto asset holdings. The amendments would align the accounting for all holders of crypto assets and reduce the complexity of applying the current guidance. The effective date and transition requirements would be determined based on stakeholder feedback. The FASB invites comments on various aspects of the proposed amendments, including the scope, measurement, presentation, and disclosure requirements, as well as the benefits, costs, and auditability of the amendments.
FASB ISSUES PROPOSED ASU ON COMPENSATION-STOCK COMPENSATION (TOPIC 718) SCOPE APPLICATION FOR PROFITS INTEREST AWARDS
Issued on May 11, 2023 with a comment deadline of July 10, 2023, Summary: The Financial Accounting Standards Board (FASB) is proposing amendments to improve accounting principles related to profits interest awards. Profits interest awards are given to employees or service providers to align compensation with a company’s performance and provide them with a share in future profits and equity appreciation. Currently, there is diversity in practice regarding how to account for these awards. The proposed update includes an illustrative example that demonstrates how to determine whether a profits interest award should be accounted for under compensation-stock compensation standards. The example aims to reduce complexity and promote consistent accounting treatment.
The proposed amendments would apply to all reporting entities that account for profits interest awards as compensation for goods or services provided.
The main provision of the proposed update is the addition of an illustrative example that clarifies the scope conditions for accounting for profits interest awards. This example is designed to reduce complexity and address the existing diversity in practice.
The effective date of the amendments has not been determined yet. Entities would have the option to apply the amendments retrospectively to prior periods or prospectively to awards granted or modified after the effective date.
The FASB is seeking feedback from stakeholders on various questions related to the proposed amendments, including their applicability to different types of entities, the clarity and effectiveness of the illustrative example, the proposed transition provisions, and the necessary implementation time.
Plain English summary: The FASB wants to improve accounting rules for profits interest awards, which are given to employees to align their compensation with a company’s performance. Currently, there are different
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ways companies account for these awards. The FASB proposes adding an example to show how companies should decide if these awards should be accounted for as stock compensation. This will make the rules clearer and more consistent. The proposed changes will apply to all companies that give profits interest awards as compensation. The FASB wants feedback on the proposed changes and how they would affect different types of companies.
and those investments will now be accounted for using other generally accepted accounting principles (GAAP).
FASB
ISSUES ASU
ON INVESTMENTSEQUITY METHOD AND JOINT VENTURES (TOPIC 323) ACCOUNTING FOR INVESTMENTS IN TAX CREDIT STRUCTURES USING THE PROPORTIONAL AMORTIZATION MEHOD (a consensus of the EMERGING ISSUES TASK FORCE)
UPDATE 2023-02
This Accounting Standards Update (Update) by the Financial Accounting Standards Board (FASB), issued in March 2023, allows companies to consistently account for equity investments made primarily to receive income tax credits and other income tax benefits. Previously, there was an option to apply the proportional amortization method for investments in low-income-housing tax credit (LIHTC) structures, but this update extends that option to tax equity investments from other tax credit programs.
Stakeholders argued that investors in similar tax equity investments should have the same election as LIHTC investors to use the proportional amortization method. This method is preferred because it provides a better understanding of investment returns compared to other accounting methods. As a result, the FASB decided to allow reporting entities to elect the proportional amortization method for tax equity investments that generate income tax credits through different tax credit programs.
The update removes specialized guidance for LIHTC investments not accounted for using the proportional amortization method,
The amendments in this update apply to reporting entities that hold tax equity investments accounted for using the proportional amortization method or LIHTC investments not accounted for using the proportional amortization method but subject to certain LIHTC-specific guidance. It also includes disclosure requirements for investments that generate income tax credits and other income tax benefits from a tax credit program for which the proportional amortization method is elected.
Under the proportional amortization method, the initial cost of the investment is amortized proportionally to the income tax credits and other benefits received, with the amortization and the income tax credits being presented as a component of income tax expense (benefit). Several conditions must be met to qualify for the proportional amortization method.
The effective date of the amendments is based on the entity type, with public business entities adopting it for fiscal years beginning after December 15, 2023, and all other entities adopting it for fiscal years beginning after December 15, 2024. Early adoption is permitted.
The transition requirements depend on whether a modified retrospective or retrospective approach is chosen, and adjustments are made to reflect the application of the proportional amortization method from the date of investment. LIHTC investments no longer permitted to use specific guidance can transition using either a general transition method or a prospective approach.
Overall, the update allows companies to use the proportional amortization method for tax equity investments and provides consistent accounting guidelines for various tax credit programs.
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FASB ISSUES ASU ON LEASES (TOPIC 842) COMMON CONTROL ARRANGEMENTS UPDATE 2023-01
In March 2023, the FASB issued ASU 2023-01 to: respond to private company stakeholders’ concerns about applying Topic 842 to related party arrangements between entities under common control.
What Are the Main Provisions, How Do They Differ from Current Generally Accepted Accounting Principles (GAAP), and Why Are They an Improvement?
Issue 1: Terms and Conditions to Be Considered
Topic 842 requires that entities determine whether a related party arrangement between entities under common control (hereinafter referred to as a common control arrangement) is a lease. If the arrangement is determined to be a lease, an entity must classify and account for the lease on the same basis as an arrangement with an unrelated party (on the basis of legally enforceable terms and conditions). That represents a change from the requirements of Topic 840, Leases, which required that an entity classify and account for an arrangement on the basis of economic substance when those terms and conditions were affected by the related party nature of the arrangement. Private company stakeholders observed that determining the enforceable terms and conditions of a common control arrangement to apply Topic 842 often is difficult and costly. Specifically, private company stakeholders stated that determining the enforceable terms and conditions of those arrangements could necessitate obtaining a formal legal opinion in certain cases, which could be challenging because of the common control nature of the arrangement (even for written arrangements).
The amendments in this Update provide a practical expedient for private companies and not-for-profit entities that are not conduit
bond obligors to use the written terms and conditions of a common control arrangement to determine:
1. Whether a lease exists and, if so,
2. The classification of and accounting for that lease.
The practical expedient may be applied on an arrangement-by-arrangement basis. If no written terms and conditions exist (including in situations in which an entity does not document existing unwritten terms and conditions in writing upon transition to the practical expedient), an entity is prohibited from applying the practical expedient and must evaluate the enforceable terms and conditions to apply Topic 842.
The practical expedient is expected to reduce (1) the costs associated with implementing and applying Topic 842 to those arrangements and (2) diversity in practice by entities within its scope when applying lease accounting requirements to common control arrangements.
Issue 2: Accounting for Leasehold Improvements
Topic 842 generally requires that leasehold improvements have an amortization period consistent with the shorter of the remaining lease term and the useful life of the improvements, which is an approach that is largely consistent with legacy guidance. Lessees recognize leasehold improvements when they are the accounting owner of those improvements. Private company stakeholders noted that amortizing leasehold improvements associated with arrangements between entities under common control determined to be leases (hereinafter referred to as common control leases) over a period shorter than the expected useful life of the leasehold improvements may result in financial reporting that does not faithfully represent the economics of those leasehold improvements, particularly in common control leases with short lease terms. Those stakeholders further noted that this
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accounting, depending on the salvage value assigned to the leasehold improvements, may fail to recognize the transfer of value between the entities under common control when the lessee no longer controls the use of the underlying asset. Additionally, the Board noted that multiple methods of accounting for those improvements exist, causing diversity in practice.
The amendments in this Update require that leasehold improvements associated with common control leases be:
1. Amortized by the lessee over the useful life of the leasehold improvements to the common control group (regardless of the lease term) as long as the lessee controls the use of the underlying asset (the leased asset) through a lease. However, if the lessor obtained the right to control the use of the underlying asset through a lease with another entity not within the same common control group, the amortization period may not exceed the amortization period of the common control group.
2. Accounted for as a transfer between entities under common control through an adjustment to equity (or net assets for not-for-profit entities) if, and when, the lessee no longer controls the use of the underlying asset. Additionally, those leasehold improvements are subject to the impairment guidance in Topic 360, Property, Plant, and Equipment.
The amendments in this Update improve current GAAP by clarifying the accounting for leasehold improvements associated with common control leases, thereby reducing diversity in practice. Additionally, the amendments provide investors and other allocators of capital with financial information that better reflects the economics of those transactions.
Who Is Affected by the Amendments in This Update?
Issue 1: Terms and Conditions to Be Considered
The practical expedient is available to entities that are not:
1. Public business entities
2. Not-for-profit conduit bond obligors
3. Employee benefit plans that file or furnish financial statements with or to the U.S. Securities and Exchange Commission (SEC).
Issue 2: Accounting for Leasehold Improvements
The amendments in this Update affect all lessees that are a party to a lease between entities under common control in which there are leasehold improvements. The amendments apply to all entities (that is, public business entities, private companies, not-for-profit entities, and employee benefit plans).
When Will the Amendments Be Effective?
The amendments in this Update for both Issue 1 and Issue 2 are effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted for both interim and annual financial statements that have not yet been made available for issuance. If an entity adopts the amendments in an interim period, it must adopt them as of the beginning of the fiscal year that includes that interim period.
What Are the Transition Requirements?
Issue 1: Terms and Conditions to Be Considered
Entities adopting the practical expedient in this Update concurrently with adopting Topic 842 are required to follow the same transition requirements used to apply Topic 842.
All other entities are required to apply the practical expedient in this Update either:
1. Prospectively to arrangements that commence or are modified on or after the date that the entity first applies the practical expedient.
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2. Retrospectively to the beginning of the period in which the entity first applied Topic 842 for arrangements that exist at the date of adoption of the practical expedient. The practical expedient does not apply to common control arrangements no longer in place at the date of adoption of the amendments in this Update. Regardless of an entity’s transition approach, the entity is permitted to document any existing unwritten terms and conditions of a common control arrangement before the date on which the entity’s first interim (if applicable) or annual financial statements are available to be issued in accordance with the practical expedient in this Update.
Issue 2: Accounting for Leasehold Improvements
Entities adopting the amendments in this Update concurrently with adopting Topic 842 may follow the same transition requirements used to apply Topic 842 or may use either of the prospective approaches described below to avoid retrospectively accounting for leasehold improvements.
All other entities are required to apply the amendments in this Update using one of the following methods:
1. Prospectively to all new leasehold improvements recognized on or after the date that the entity first applies the amendments in this Update.
2. Prospectively to all new and existing leasehold improvements recognized on or after the date that the entity first applies the amendments in this Update, with any remaining unamortized balance of existing leasehold improvements amortized over their remaining useful life to the common control group determined at that date.
3. Retrospectively to the beginning of the period in which the entity first applied Topic 842, with any leasehold improvements that otherwise would not have been amortized or impaired
recognized through a cumulative-effect adjustment to the opening balance of retained earnings (or net assets of a notfor-profit entity) at the beginning of the earliest period presented in accordance with Topic 842.
RECENT ACTIVITIES OF THE PRIVATE COMPANY COUNCIL
The Private Company Council (PCC) met on Tuesday, April 25, 2023. Below is a summary of topics addressed by the PCC at the meeting:
• Accounting for and Disclosure of Software
Costs: FASB staff summarized the Board’s recent tentative decision to pursue the single model (formerly referred to as the initial development cost model) in which all direct software development costs are capitalized from the point at which it is probable that the software project will be completed and the software will be used to perform the function intended until the software project is substantially complete and ready for its intended use. PCC members discussed elements of the single model (specifically, the probable threshold, unit of account, maintenance and enhancements, and presentation and disclosure). Most PCC members supported the probable threshold supplemented with indicators to improve consistency in application. PCC members highlighted the challenge of determining the unit of account in an agile environment. Most PCC members emphasized the challenges in distinguishing between maintenance and enhancements. Some PCC members suggested providing a guiding principle for distinguishing between maintenance and enhancements rather than specifically defining each type of cost. PCC members who are users highlighted the importance of disclosures about software costs in assessing future cash flows and
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understanding capital allocation decisions made by management. Alternatively, other PCC members expressed concern about the level of detail and additional costs for the potential required disclosures.
• Accounting for and Disclosure of Crypto Assets: FASB staff summarized the main provisions of the proposed Update, Intangibles—Goodwill and Other—Crypto Assets (Subtopic 350-60): Accounting for and Disclosure of Crypto Assets, including scope, measurement, presentation, disclosure, effective date, and transition. Overall, PCC members mostly expressed support for the amendments in the proposed Update. However, PCC members provided mixed feedback on effective date and transition. Most PCC members stated that the effective date should be the same for both public and private companies. Alternatively, some PCC members expressed concern for having the same effective date for both public and private companies and suggested allowing additional time for private company adoption but permitting early adoption. One PCC member who is a preparer highlighted the importance of considering what interim disclosures would be required for private companies. Additionally, another PCC member indicated that there should not be a disclosure of the cost basis in addition to units held and fair value of crypto asset holdings.
• Stock Compensation Disclosures: FASB staff and members of the PCC’s stock compensation disclosures working group provided the PCC with an update on the working group’s progress and an overview of stakeholder feedback received from private company financial statement users. Working group members noted that the feedback received has been helpful and that they are planning additional user outreach with lenders. Additionally, working group members
noted that disclosures that certain users find relevant vary based on their respective backgrounds and type of analysis. The working group is also planning additional outreach with private company preparers and practitioners. A summary of all private company stakeholder feedback received will be presented to the PCC at a later date.
• Leases Implementation, including Leases—Common Control Arrangements: The PCC discussed the post-implementation review activities related to Topic 842, Leases, including Accounting Standards Update No. 2023-01, Leases (Topic 842): Common Control Arrangements, to improve the accounting for arrangements between entities under common control. PCC members commented that the amendments are responsive to stakeholder concerns and should assist with the implementation of Topic 842. Some PCC members advised that some stakeholders may not be aware of the amendments and suggested that the FASB increase educational efforts on the amendments in Update 2023-01. PCC members observed that the determination of lease commencement date can be challenging in certain circumstances, such as when the lessor engages the lessee to complete construction of the underlying asset. PCC members noted that standard setting may not be necessary to address those challenges but suggested the FASB consider providing additional education for stakeholders.
• Credit Losses—Implementation: PCC members discussed CECL implementation feedback obtained during a meeting that one PCC member recently coordinated with several peers representing nonpublic financial institutions. Participants discussed certain implementation challenges, such as the sufficiency of historical loss data and determining the allowance for off-
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balance-sheet credit exposure. However, most participants described their overall implementation experience as generally positive. The PCC Chair noted that her clients experienced similar implementation challenges.
• Disaggregation—Income Statement
Expenses: FASB staff summarized the Board’s recent decisions, including that the disclosure requirements would only apply to public business entities. Overall, PCC members supported the exclusion of private companies from the disclosure requirements.
• Joint Venture Formations: FASB staff summarized the key amendments that will be included in the final Accounting Standards Update, which is expected to be issued in the second half of 2023. One PCC member and the PCC Chair expressed their support for the Board’s decision made during redeliberations to allow a joint venture to apply the business combinations measurement period guidance.
• Other Business: The PCC will hold a twopart interactive, town-hall style forum at the annual AICPA ENGAGE conference scheduled for June 5, 2023. The FASB will hold its next semiannual webcast, IN FOCUS: FASB Update for Private Companies and Not-for-Profit Organizations, on June 12, 2023.
• The next PCC meeting is scheduled for Thursday, June 22, and Friday, June 23, 2023.
THE FOLLOWING ARE SELECTED TOPICS FROM THE DAILY ACCOUNTING HIGHLIGHTS PUBLISHED BY THOMSON REUTERS – FULL ATTRIBUTION TO SOYOUNG HO (SEC matters) and DENISE LUGO (FASB, AICPA matters), WHO WRITE THESE SUMMARIES FOR THOMSON
REUTERS
FASB Proposes to Introduce Illustrative Example of Profits Interest Awards in U.S. GAAP
May 17, 2023
Businesses have two months to weigh in on
a FASB proposal that provides an example to illustrate how to account for profits interest awards—a form of compensation to employees in return for goods or services. The board on May 11, 2023, issued Proposed Accounting Standards Update (ASU) No. 2023-ED300, Compensation—Stock Compensation (Topic 718) Scope Application of Profits Interest Awards, to clarify when profits interest awards should be reported as stock compensation.
The proposal aims to reduce reported complexity and eliminate accounting differences among businesses by clarifying whether profits interest and similar awards should be accounted for as a share-based payment arrangement within the scope of Topic 718, Compensation—Stock Compensation, according to proposed text.
Profits interests are popular among partnerships and Limited Liability Companies (LLCs), providing employees or other service providers that hold them with the opportunity to participate in future profits and/or equity appreciation of the business.
The proposal provides an example of four fact patterns that show how to evaluate common terms and characteristics of profits interest awards, including an employee’s forfeiture of an award that, upon termination of employment with the business, has vested according to the contract but does not meet the definition of vested in Topic 718.
The provisions could cause more profits interest awards to be reported under Topic 718 than previously, adding incremental costs for some entities, the proposal states.
If finalized, the guidance can be applied either retrospectively to all prior periods presented in the financial statements, or prospectively to profits interest awards granted or modified on or after the effective date. If a business applies the guidance prospectively, it will be required to disclose the nature of and reason for the change in accounting principle.
The comment period ends on July 10.
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Privately Held Companies Flagged the Topic
The topic was brought to the FASB by the Private Company Council (PCC), a panel that works with the board to develop and amend U.S. GAAP for privately held companies. Because profits interest holders only participate in future profits and/or equity appreciation and have no rights to the existing net assets of the partnership, the FASB said it heard that it can be complex to determine whether a profits interest award should be accounted for as a share-based payment arrangement under Topic 718, or as a cash bonus or profit-sharing arrangement under Topic 710, Compensation— General, or other Topics.
The PCC and others asked the FASB to provide clarifying examples for when paragraph 718-10-15-3 should be applied to profits interest awards.
Paragraph 718-10-15-3 applies to shares, share options or other equity instruments owed or paid to employees and customers that meet either of the following conditions: a) The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award of share-based compensation may be indexed to both the price of an entity’s shares and something else that is neither the price of the entity’s shares nor a market, performance, or service condition.); and b) The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.
Private Companies Getting a Pass from Coming FASB Proposal on Disclosure of Income Statement Expenses
April 28, 2023
Private companies should be exempted from the FASB’s coming proposal that aims to ratchet up disclosure rules for income statement expenses, the Private Company Council (PCC) said on April 25, 2023, aligning with the board’s recent decision.
In agreeing with the board’s decision, PCC members noted the strong role that the Private Company Decision-Making Framework (PCDMF) played in helping the FASB to decide to exclude private companies from the changes.
“I do think this was the right decision to make at this particular time, and monitoring is always appropriate to see how a standard is applied in practice and to see if there needs to be something done with the private company space,” PCC Chair Candace Wright said. “So appreciate the team doing a good job and analyzing the PCDMF and making this recommendation and the board listening – so thank you.”
Financial statement users on the PCC also agreed with the board’s decision, throwing support behind monitoring the issue for the private company sector.
“I think the factors are there for the exclusion of private companies but I appreciate the fact that we will monitor because as a user of the financial statements I think there is a level of disaggregation that would be useful in private company space; I just don’t know if it’s the same level of disaggregation that’s currently going to be included in this at the public level,” David Pesce, head of surety at Munich Re Specialty Insurance, said. “And I appreciate that we will watch it and reconsider it at a future date if it looks like it’s something we need to do.”
The PCC is an 11-member body that works with the FASB to develop rules for private companies, the largest business demographic in the U.S.
High-level Snapshot of Planned Proposal
The board plans to propose that public companies disaggregate expense captions presented on the face of the income statement into specified expenses categories (including employee compensation, depreciation and amortization), and further disaggregate inventory expense and other manufacturing expenses based on costs incurred in the current period.
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Under this approach, users of financial statements would receive quantitative information on, for example, how much employee compensation is charged to different expense captions such as cost of sales, selling, general and administrative expenses (SG&A) and research and development (R&D) when those captions are presented on the face of the income statement.
The proposal would also require companies to disclose the amount of inventory expense and other manufacturing expenses included in each expense caption, and then “to further disaggregate the amount of inventory expense and other manufacturing expenses into specified categories of cost incurred that are falling into inventory in the current period or expensed as incurred as part of the manufacturing process.” Those cost incurred categories would include inventory purchases, employee compensation, depreciation, and amortization.
The board decided that all additional disaggregation would be provided in footnote disclosures – i.e., not to change the requirements for what is presented on the face of the income statement. Moreover, the proposal would clarify descriptions of what would be considered depreciation and amortization for the standard, requiring prospective transition with a retrospective option. The guidance would apply to both interim and annual periods. Public companies will get 90 days to submit comments.
PCDMF Issues Weighed by the Board
In deciding to scope private companies out of the proposal, the FASB considered the PCDMF and balanced the relevance of information to users of private company financial statements, against the cost that would be incurred by private companies to provide that information, according to the discussions.
Specifically:
• the PCDMF specifies that if a disclosure provides relevant information at a reasonable cost, then generally no disclosure alternatives for that information should be considered. However, several FASB members questioned whether private companies could provide the disclosures at a reasonable cost;
• the PCDMF contemplates generally not requiring disclosure of quantitative details about the composition of certain income statement line items. If that information is relevant the PCDMF suggests narrative disclosure. However, the FASB decided that a narrative disclosure of the proposed requirements would not be as useful to users;
• while the PCDMF specifies that management access should not be considered a dominant factor, the FASB acknowledged that lenders that may be the typical users of private company financial statements generally do have a level of access to obtain additional information from management.
Fed Up with Lease Accounting Rules, Some Private Companies Turn to Tax Basis to File Statements
April 25, 2023
Some privately held companies are fed up and “exhausted” over adopting big new accounting standards, especially leases, and now have their sights set on using tax basis formats to file financial statements as opposed to U.S. GAAP, state CPAs said. The FASB issued Topic 842, Leases in 2016 but it took effect on Jan. 1, 2022, for private companies that are calendar year-end filers. But many privately held companies did not look at the standard until the end of last year and some are just getting to it now.
“The implementation of ASC 842 is an enormous undertaking,” said Allison Henry, vice president of professional & technical standards at Pennsylvania Institute of
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Certified Professional Accountants (PICPA).
“It looks so simple – frequently in training I hear ‘oh it’s just adding an asset and a liability and then you’re done, right?’ and I’ve said ‘wait no, let’s get through a good 50 minute session on this and then you can ask me the questions because it’s an enormous project management effort,’” she said on April 21, 2023.
The PICPA is the second-oldest CPA organization in the United States with more than 20,000 members, including practitioners in public accounting, industry, government, and education.
The organization found that businesses have been challenged over the past two years after COVID with Paycheck Protection Program (PPP) loan implementation coupled with resource constraints, said Henry. “We even appealed to the FASB – we wanted another year just to get to a baseline – a little bit of relief because we’ve also seen high turnover in the accounting space and so you have less people to do all of this work,” she said.
Tax-basis statements are a favorite among smaller private companies because they are able to use the same methods and principles as they do to file their federal income tax returns, according to CBIZ, a business services firm.
Generally, lenders do not favor that approach as the results differ from the GAAP, the gold standard of reporting that prevents companies from overstating profit and asset values. Some private company accountants have said that compliance with GAAP however can be costly and time consuming and more are using a special reporting framework, the most common of which is the income-tax basis format.
Leases Standard Was Deferred Several Times for Private Companies
The leases standard, a historic first for GAAP, is a substantial change that requires the full magnitude of companies’ long-term lease
obligations to be recorded on the balance sheet. The standard was deferred several times for private companies.
The FASB also amended the rules in narrow areas for private companies with the issuance of simplifications under Accounting Standards Updates (ASU) No. 202109, Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities, and recently ASU No. 202301, Leases (Topic 842): Common Control Arrangements.
There were two main hurdles those amendments addressed for private companies to adopt: the incremental borrowing rate and then the accounting for related party leases, said Emily Fish, senior manager, product accounting at LeaseQuery, a CPA-built accounting software company. “Those two [amendments] really lead privates to say ‘hey we’ve really got to do this and let’s do it now,” Fish said on April 24.
Others, however, maintain that ASU No. 2023-01 which addresses related-party leases under common control still holds challenges.
“At first blush I thought that was a really great solution and it just allows them to use the written documentation, but the challenge comes in when the written document says it’s a month-to-month lease, which if it’s been effective for the past 10 years, how is this even reasonable and how do you account for it?” said Henry. “The FASB allows you to use the written document but if the document says that it’s a month-to-month lease then how do you account for that and is it really a short-term lease? —it’s still a question,” she said. “We have heard that if the entity intends to continue to renew that then it could be considered to be an evergreen lease; at that point there’s more judgment in terms of how to account for it.”
Private Company Council Needs More Rigor
The leases standard and other big ticket rules
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such as credit losses have sparked rumblings in the private company arena that the Private Company Council (PCC), the panel that was established in 2012 to work with the FASB to develop private company rules, is not demonstrating sufficient rigor on behalf of private companies.
In its agenda consultation outreach more than a year ago, the FASB heard from some that companies would welcome a “GAAP for Small-to-Medium Size Entities (SMEs)” standard, a package that mimics the IASB’s IFRS for SMEs standard, which offers a tailored version of IFRS standards. The California Society of CPA’s (CalCPA) Accounting Principles and Assurance Services Committee, which made the suggestion, in a letter told the board that the PCC’s efforts have not made a significant difference, as rules the panel has developed are “layered on top of the existing GAAP” and small private companies struggle to comply with them. (See U.S.
Private Companies Should Get Own
Audit Regulatory Board Mum on Bank Failures as Critics Question Clean Audit Opinion for Silicon Valley Bank March
31, 2023
For now, the Public Company Accounting Oversight Board (PCAOB) will not publicly address recent bank collapses, triggered by the abrupt, stunning failure of Silicon Valley Bank (SVB) three weeks ago.
“I understand recent bank failures may be top of mind for many of you,” PCAOB Chair Erica Williams said at a meeting of the Standards and Emerging Issues Advisory Group on March 30, 2023.
“The PCAOB is acutely aware of concerns from investors, and I know there are outstanding questions that must be answered,” Williams continued. “But today’s meeting is not the forum for providing those answers, and it’s important we avoid speculation.”
GAAP
Like
Overseas Firms, State CPA Panel Says in the Nov. 1, 2021, edition of Accounting & Compliance Alert.)
The PICPA is of a similar view. When Topic 842 was issued, for example, although the FASB’s intension was simply to make sure that the financial statements were reflective of the assets and liabilities companies carry, that goal did not really pan out as the rules require an enormous amount of judgment, the CPA organization said.
“Imagine if you have hundreds of leases and you’re trying to manage all of these revisions constantly because you’re reassessing the lease term and you’re considering whether you’re going to renew or accommodate that lease,” said PICPA’s Henry. “For leases there are nuances that change all of the variables and to keep track of that is an enormous challenge and so you can see that it really was a very large project management challenge for many companies.”
When SVB failed, banking agencies quickly stepped in to try to prevent a wider financial meltdown. The adverse effects of its failure reverberated around the world.
Various reasons may have been at play that led to its demise, such as the bank’s business model which was more susceptible to runs when certain aspects of economic conditions deteriorate; a large portion of customers who were mainly in the tech sector had deposits of more than the FDIC-insured $250,000 limit; and the bank’s poor risk management, which the Federal Reserve warned about at least starting from 2019. The bank grew very quickly, but it did not have commensurate risk management controls intended for large financial institutions. The FDIC said the 10 largest deposit accounts at SVB in the aggregate was $13.3 billion, signaling concentration of risks that could impact the bank’s financial conditions in the near-term.
Before its collapse, Silicon Valley Bank was the 16th largest bank and the second largest failure in history. The largest failure was Washington Mutual in the 2008 financial crisis.
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Where Was the Auditor?
However, critics questioned whether its external auditor, KPMG LLP, did its job properly. It gave a clean audit opinion in February. Yet in a matter of few weeks, the bank collapsed. The Big Four firm had no comment.
And anytime a public company auditor is involved, fairly or not, some inevitably question what the audit regulatory board is doing or whether it can do a better job of supervising accounting firms that audit publicly-traded companies to protect investors and hold firms to account when they perform deficient audits.
The bank had reportedly not only poor risk management but also insufficient internal controls. But there is also a requirement for the auditor to disclose critical audit matters (CAMs) that investors should be aware. These are matters that have been communicated to the audit committee, are related to accounts or disclosures that are material to the financial statements and involved especially difficult judgment from the auditor.
The KPMG’s auditor’s report did not discuss weak risk management or internal controls. This could mean that the audit team allegedly might not have fully understood the banking business or the volatile macroeconomic environment as well as the current landscape of the information technology industry. Many of the banks’ customers were in the tech industry. The PCAOB routinely found problems with quality control at audit firms in the past, including those of KPMG.
“As you know, the PCAOB is prohibited from discussing specific inspection and enforcement matters, including whether or not enforcement matters or investigations have been initiated,” Chair Williams said.
“As a general matter, the PCAOB carefully monitors registered firms and will not hesitate to take action when rules or standards are violated,” PCAOB Chair Williams added. “Without speaking to any individual entity
or person, as I have said many times, the PCAOB is using every tool in our enforcement toolbox to pursue wrongdoing wherever we find it and impose significant sanctions against those who put investors at risk.”
However, former SEC chief accountant Lynn Turner, who is on the PCAOB’s advisory groups, believes the board should be more transparent to the public.
“The silence of the PCOAB with respect to the lack of information in audit reports provided to investors on these failed banks is quite deafening,” Turner said. KPMG also audited Signature Bank, which was shut down by banking agencies.
Going Concern Discussions
In the meantime, a few have also been questioning whether the current accounting and auditing standards on going concern—a company’s ability to pay when obligations come due—are appropriately set.
Currently, the PCAOB has going concern on its standard-setting agenda. The board is considering how its standard should be revised.
Today, there are requirements for management to disclose when there is a “substantial doubt” that it could survive when obligations come due during the next 12 months based on a “probable” threshold. Auditors also have to evaluate going concern but using a number of factors. Thus, there is a mismatch between the accounting and auditing literatures.
Following the 2008 financial crisis, investors said they want earlier warnings or just warnings about a poor financial health of a company, and they believe that the thresholds can be better calibrated.
But it would be tricky to develop a more useful standard. For example, critics believe that a threshold that is set too low could trigger unnecessary panic and exacerbate the situation.
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George W. Benson Counsel
McDermott Will & Emery LLP
444 West Lake Street, Suite 4000
Chicago, Illinois 60606-0029
tel: (312) 984-7529
fax: (312) 984-7700
e-mail: gbenson@mwe.com
Rev. Proc. 2022-39
By Geore W. Benson
Corporate taxpayers, particularly large corporate taxpayers, often become aware of errors in their tax returns after filing. Sometimes, they have second thoughts as to the strength of positions taken in or the adequacy of any disclosures made on their returns. Treas. Reg. § 1.6664-2(c) provides a procedure for avoiding certain accuracyrelated penalties in some situations by timely filing a “qualified amended return.” Generally, such a return must be filed before the IRS first contacts the taxpayer concerning an examination of the original return.
For many years, certain large corporate taxpayers have been given an opportunity to avoid the “qualified amended return” process by providing Exam soon after the commencement of an audit with a list of adjustments to their returns as filed including, where appropriate, adequate disclosure with respect to items or positions shown on those returns. Rev. Proc. 94-69, 1994-2 C.B. 804.1
Originally, the special process was available only for taxpayers subject to the Coordinated Examination Program (“CEP”).
Marlis Carson General Counsel
Vice President – Legal, Tax and Accounting
National Council of Farmer Cooperatives
50 F Street, N.W. – Suite 900
Washington, D.C. 20001
tel: (202) 879-0825
fax: (202) 626-8722
e-mail: mcarson@ncfc.org
When the CEP was replaced by the coordinated Industry Case Program (“CIC”) in 2000, the process was extended to CIC taxpayers. The rationale for the special process was practicality – it relieved taxpayers from the necessity of filing what in many cases might be multiple amended federal returns (and corollary amended state returns) and it simplified the audit process for the IRS by eliminating potentially confusing multiple amended returns. According to the IRS:
“Taxpayers in the CEP and CIC programs were unique in that, unlike most taxpayers,
1 They have also been spared the necessity of filing formal amended returns for affirmative adjustments if a similar manner. See, Large Business & International Examination Process, IRS Publication 5125, at 2.
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TAXFAX EDITOR
GUEST WRITER
they were generally subject to a continuous examination covering each year’s return; and as such, amendments to filed returns were best addressed as the examination of a particular year started through a disclosure to the examination team in lieu of filing a regular qualified return.” (Rev. Proc. 2022-39, Section 2.11).
In 2019, the IRS replaced the CIC Program with the Large Corporate Compliance Program (“LCC”). According to the IRS, “[u]nder the LCC, large corporate taxpayers are selected for examination based on their risk profiles and data analytics. Large corporate taxpayers are no longer subject to planned continuous examinations.” (Rev. Proc. 2022-39, Section 2.13). As part of this change, the IRS announced that the Rev. Proc. 94-69 procedure would continue to be available to certain large corporate taxpayers, but, because participation in the LCC no longer necessarily means continuous examinations, the IRS requested comments as to whether the procedure should continue to be available.
Numerous comments were received supporting continuation of the procedure. From them, the IRS determined: “… for a subset of large corporate taxpayers and large partnerships whose tax posture is likely to result in nearannual examinations, special procedures are appropriate for disclosure of errors on a return or items that may result in an underpayment but have a reasonable basis.” (Rev. Proc. 2022-39, Section 2.17).
The result is Rev. Proc. 2022-39, obsoleting Rev. Proc. 94-69, but largely continuing the procedure for “eligible taxpayers.” For this purpose, “eligible taxpayers” is defined to mean:
“… any taxpayer selected for examination under the LCC (or successor program) if, on the date on which the IRS first contacts
the taxpayer concerning an examination of an income tax return, at least four of the taxpayer’s income tax returns for the five taxable years preceding the taxable year at issue are (or were) under examination under the LCC, the CIC, or a successor program.” (Rev. Proc. 2022-39, Section 3.01).
This is probably a smaller universe of taxpayers than under Rev. Proc. 94-69. Taxpayers accustomed to continuous audits who have several years that are not audited under the LCC may find it necessary to file timely refund claims and/or qualified amended returns under the new procedure. The procedure is also available for large partnerships selected for examination under the relatively new Large Partnership Compliance Program.
Rev. Proc. 2022-39 sets standards for adequate disclosure, a new timeframe for making the disclosure at the commencement of an examination, and a new form to be used. Form 15307 (Post-Filing Disclosure for Specified Large Business Taxpayers). Rev. Proc. 202239 requires adequate disclosure of each separate item. “The description of an item is adequate if it consists of information that reasonably may be expected to apprise the IRS of the identity of the item, its amount, and the nature of the controversy or potential controversy.” (Rev. Proc. 2022-39, Section 4.02). If a taxpayer’s disclosure is inadequate, the taxpayer “will not receive penalty protection under this process with respect to the item or items inadequately disclosed with respect to the particular tax year.” (Rev. Proc. 2022-39, Section 4.06(2)). A properly completed Form 15307 is treated as a “qualified amended return.”
It is likely that very few cooperatives will qualify as “eligible taxpayers” for purposes of Rev. Proc. 2022-39. For such taxpayers, the revenue procedure summarizes alternatives:
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“Taxpayers not eligible for, or making disclosures beyond the scope of, the special procedures set forth in this revenue procedure have the opportunity to utilize existing methods to avoid the imposition of penalties, including by filing a qualified amended return as described in and satisfying the requirements of § 1.6664-2(c)(3), or by adequately disclosing the position on a properly completed Form 8275, Form 8275-R, or Schedule UTP, Uncertain Tax Position Statement, filed with a return and satisfying the requirements of § 1.6662-3(c).” (Rev. Proc. 2022-39, Section 3.02).
Taxation of Government Grants for Broadband
By Geore W. Benson
In the Winter 2022 TAXFAX column, Teree Castanias reported on changes to made by the Tax Cuts and Jobs Act of 2017 to the tax treatment of grants. See, Section 118, in particular, Section 118(b)(2). She noted that many Government grants that once qualified as nontaxable capital contributions are now taxable unless specifically provided otherwise. She described issues that this change may present for cooperatives.
In both the American Rescue Plan Act (“ARPA”) and the Infrastructure Investment and Jobs Act (“IIJA”), Congress authorized billions of dollars of federal funding for broadband deployment – $17+ billion in the ARPA and $65 billion in the IIJA. This funding is intended to bridge the digital divide, making reliable, high-speed internet available to everyone, including persons in rural areas which are currently underserved. Neither Act excluded broadband grants from income. When this became apparent, identical bills were introduced in the House and Senate late in 2022 (the Broadband Grant Tax Treatment Act (“BGTTA”)) to exempt “qualified broadband grants”
from income. For this purpose, “qualified broadband grants” includes ARPA and IIJA broadband grants as well as grants under several other programs. To avoid giving grant recipients a double benefit, the proposed legislation provides that a recipient of an excluded grant will not be permitted to claim a deduction for expenses paid with such funds or to increase the basis of assets purchased with such funds.
The 117th Congress adjourned without acting on the BGTTA. The Act was recently reintroduced in both Houses of the new 118th Congress. It enjoys bipartisan support. The press release announcing the reintroduction explains its purpose:
“Grants awarded for the purposes of broadband deployment are currently factored into a company’s income and are subject to taxation. This bipartisan, bicameral legislation moves to exclude broadband deployment grants … from an organization’s income, ensuring the entirety of federal dollars awarded to companies for the purpose of deploying broadband around the country can be used wholly for that purpose, rather than making their way back to the government through taxes.”
https://www.warner.senate.gov/public/ index.cfm/2023/2/bipartisan-legislationto-prevent-taxation-of-broadband-grantsreintroduced-in-the-senate-house
The fate of the reintroduced BGTTA of a number of other tax matters that were not addressed at the end of last year is uncertain. It will be interesting to see how the BGTTA will be scored. The potential cost, measured by foregone taxes on the billions of authorized grants, could be in the billions, making it difficult to obtain relief. How the BGTTA is scored may depend upon how the ARPA and IIJA scored the original grants – was the cost reduced by antic anticipated taxes on the recipients of the grants or not?
This legislation should be of interest
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to taxable rural electric and telephone cooperatives that receive broadband grants. As Teree notes in her article, exempt rural electric and telephone cooperatives have already obtained clarification that broadband grants will not enter into the determination of their compliance with the member income test. See, Section 501(c) (12)(J).
for each period) claiming a refund of the penalties asserting reasonable cause.
After the claims were filed, the IRS processed them.
Prepare Refund Claims with Care: Another Case Study
By Geore W. Benson
A prior TAXFAX column described some pitfalls to be avoided when preparing amended returns and refund claims. See, “Prepare Refund Claims with Care” in the Winter 2021 TAXFAX column. What might seem to be foot-faults can lead to procedural disputes and the merits of claims never being addressed.
A recent decision by the United States Court of Federal Claims provides another example of what can go wrong. Vensure HR, Inc. v. United States, 131 AFTR2d 2023645 (Ct. of Fed. Claims, 2023).
Vensure HR is a professional employer organization (PEO). The proximate cause of this dispute was the failure of one of Vensure’s clients to remit to Vensure some $4 million in employment taxes that Vensure had paid to the IRS on the client’s behalf. Vensure first sought to recover the taxes from the IRS, arguing that it was not, in fact, the employer of the client’s employees. It was able to recover $1 million, but that still left it short some $3 million. The customer’s failure triggered a “financial crisis” for Vensure causing it to be delinquent in filing and paying employment taxes for six quarters in 2014 and 2015.
The IRS asserted and Vensure paid $1,567,991.31 in failure to pay and failure to deposit penalties for those quarters. In 2016, Vensure filed six refund claims (one
The refund claims were signed by Vensure’s attorney, not by a corporate officer. The attorney had included the letters “POA” after his name (for “power of attorney”) when he signed two of the six claims. He had valid powers of attorney (on IRS Form 2848) for the years at issue, and the powers were on file in the IRS’s Central Authorization File (CAF) system. However, a copies of the powers were not attached to the claims.
After processing the claims, the IRS sent letters to Vensure’s attorney “under the provisions of your power of attorney or other authorization we have on file” denying the claims on the basis that Vensure did not “meet the reasonable cause exception for the abatement or refund of penalties.” The denial also faulted the claims for not specifying a dollar amount, but rather requesting a refund of “100% of assessed penalties.”
After receiving the denials, Vensure brought suit in the United States Court of Federal Claims.
The Government filed a motion for dismissal, asserting that the claims were defective. The Court agreed the claims were not “duly filed” and dismissed the claims with prejudice without addressing the underlying legal issue (i.e., whether there was reasonable cause).
The Court began its analysis by observing that Section 7422(a) prohibits suits for refunds “until a claim for refund or credit has been duly filed with the Secretary according to the provisions of law in that regard, and the regulations of the Secretary established in pursuance thereof.” (emphasis added). The Court treated this requirement as a “claims-processing” rather than a “jurisdictional” requirement
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(reclassifying the Government’s motion to dismiss accordingly) and then analyzed why, in its view, the claims were not “duly filed.”
The Court observed:
“… 26 C.F.R. § 301.6402-2(a)(2) states that ‘if a taxpayer is required to file a claim for credit or refund using a particular form, then the claim, together with appropriate supporting evidence, shall be filed in a manner consistent with such form, form instructions, publications, or other guidance found on the IRS.gov Web site.’ As relevant to this case, 26 C.F.R. § 301.6402-2(c) provides that ‘[a]ll claims by taxpayers for the refund of ... penalties ... that are not otherwise provided for’—like the penalties at issue here—’must be made on Form 843, Claim for Refund and Request for Abatement.’ The instructions to Form 843 explain that an authorized representative can file Form 843 on a taxpayer’s behalf, but ‘the original or copy of Form 2848, Power of Attorney and Declaration of Representative, must be attached,’ and the taxpayer ‘must sign Form 2848 and authorize the representative to act on [the taxpayer’s] behalf for the purposes of the request.’”
The Court concluded that Vensure’s claims were not “duly filed” since they were signed by Vensure’s attorney and not accompanied by a copy of the attorney’s power of attorney. The Court rejected Vensure’s argument that it had “substantially complied” with this requirement. In the Court’s view, it was not good enough that the IRS already had the powers of attorney on file in the CAF System and the original IRS denials of the claims were sent to the attorney under the powers of attorney.
Vensure also argued that the IRS waived the requirement that refund claims be “duly filed” when it processed and rejected the claims on their merits. The Court rejected the argument, concluding that the requirement was statutory and could not be
waived.
This result – the dismissal of Vensure’s claims without considering their merits –seems harsh, given the circumstances. It will be interesting to see whether Vensure appeals and, if there ultimately is an appeal, what the Court of Appeals for the Federal Circuit decides.
Should it hold in Vensure’s favor, the claims will be reinstated and the case will be sent back to the Court of Federal Claims to consider the merits of Vensure’s reasonable cause defense (where it would have been if the powers had been attached to the claims in the first place).
Taxpayers and their advisors should be very careful when filing refund claims to ensure that the claims comply with all procedural requirements. If they do not, the case may get bogged down in a dispute over procedure. The claims may never be considered on their merits or may be considered on the merits only after a lengthy detour into procedural issues.
Internal Revenue Service Data Book 2022
By Geore W. Benson
As in the past, this year’s IRS Data Book provides some information as to tax returns (Form 1120-C) filed by Subchapter T cooperatives. Internal Revenue Service Data Book 2022, Publication 55-B (March 2023).
The Data Book aggregates Form 1120C returns with other Form 1120 returns in the information it provides regarding the number of returns filed for fiscal years 2021 and 2022. So, it does not reveal the number of cooperative returns filed in those years in tables showing returns filed.
However, it does continue to list Form 1120-C returns separately in a series of tables showing audit rates for the returns filed for the years 2012 through 2020 for each year. The number of cooperative
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returns has remained steady. There have been anecdotal reports of very few audits in recent years, and the tables bear that out:
returns which were closed during the fiscal year ended September 30, 2022 (“FYE 2022”), all of which were field audits. These examinations collectively resulted in proposed deficiencies of $19,789,000. Detail is not provided on how much of this was agreed and how much unagreed. (Note this information is of audits closed. The audits likely covered returns originally filed in a variety of prior years.)
It is generally believed that a cooperative’s chances of getting audited increase if it files an amended return claiming a refund, probably significantly if a large refund is claimed.
Note that, at this point, the audit rate figures for returns filed in 2019 and 2020 likely understate the number of returns that will ultimately be audited before the statute of limitations runs on those years. Also, because of COVID, IRS audit activity has, in general, been down in recent years.
To put this information in perspective, it should be compared with the audit rate of regular corporate returns, which is much higher. For companies with balance sheet assets of $50 million to $1 billion, the audit rate for returns filed in 2018 (the last preCOVID year) was roughly 5%. It was 14.2% for corporations with assets of between $1 billion and $5 billion, 30.2% for corporations with assets between $5 billion and $20 billion, and 57.2% for corporations with assets greater than $20 billion.
According to the Data Book, the audits of cooperative returns that have taken place have generated relatively little additional revenue for the IRS. Total revenue generated has ranged between $4.4 million for returns filed in 2015 and $14.4 million for returns filed in 2014. This may, at least in part, explain why the IRS has chosen to audit so few cooperative returns.
The Data Book provides several other snapshots of audit activity. It shows that there were 19 examinations of cooperative
However, the Data Book does not contain the necessary information to confirm the validity of this belief. The information regarding the total number of examinations of amended returns closed during FYE 2022 where revenue is protected (i.e., the claimed refund is denied) is redacted. The Data Book does reveal that 5 examinations of amended returns closed during FYE 2022 resulting in refunds totaling $25,203,000. While the Data Book does not say, it is likely that the successful refund claims may have largely involved net operating loss carrybacks (from years when net operating losses could still be carried back).
The other bit of information contained in the Data Book relates to closures of Section 521 applications during FYE 2022. It reveals that no Section 521 application was denied during the year. However, information as to the number of requests processed and approved during the year has been redacted, and without that information knowing that no request was denied is not very useful.
It should be noted that the IRA dramatically increased IRS funding for future years. Much of this funding is earmarked to hiring more agents and increasing audit activity. So past low audit rates for cooperatives may change as the IRS uses its new funding to ramp up.
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TAXFAX Returns Returns Filed Audited (%) 2012 9,129 0.4 2013 9,352 0.3 2014 9,402 0.3 2015 9,516 0.3 2016 9,485 0.2 2017 9,362 0.2 2018 9,469 0.1 2019 9,487 0.1 2020 9,499 * *less than 0.05%
Washington Update
By Marlis Carson
By Barbara A. Wech
As a closely divided Congress grapples with the debt ceiling, hopes are slim for significant tax legislation moving this session. However, NCFC and its farmer cooperative members are keeping a close eye on several issues that could be addressed in this congressional session or the next.
TCJA Expiring Provisions. Many taxpayerfavorable provisions in the 2017 Tax Cuts and Jobs Act will expire on December 31, 2025. In response, lawmakers have begun introducing bills expressing their priorities. Ways and Means Vice Chairman Vern Buchanan (R-FL) has introduced the “TCJA Permanency Act” (HR 976), which would make the TCJA tax cuts permanent, including Section 199A. The bill has 90 cosponsors.
Estate and Gift Tax. For 2023 the estate and gift tax exemption is $25.84 million per married couple. That amount will be reduced by half at the end of 2025 unless Congress acts. Senator Thune (R-SD) recently reintroduced legislation that would permanently repeal the federal estate tax. The bill has 40 cosponsors.
R&D Amortization. The TCJA also removed the ability for taxpayers to expense research and development costs beginning in 2022. Many assumed that Congress would act to reinstate the provision, but that has not happened. Taxpayers must switch from deducting R&D expenses to amortizing them over five years – a costly change. The IRS is considering issuing a safe harbor for taxpayers implementing the new amortization requirements; however, substantive guidance on the new requirements likely will not be issued before the initial return deadline.
Senators Maggie Hassan (D-NH) and Todd Young (R-IN) have reintroduced the American Innovation and Jobs Act. The bipartisan bill would restore full deduction of R&D expenses. The bill would also raise the cap and expand eligibility for the refundable R&D tax credit for startups and small businesses.
Other changes set to occur at the end of 2025 include cutting the individual deduction in half and increasing the number of taxpayers subject to the Alternative Minimum Tax. On the bright side, the mortgage interest deduction will increase and the SALT deduction will no longer be capped at $10,000.
Global Minimum Tax. In addition to expiring TCJA provisions, tax practitioners are closely watching the implementation of the global minimum tax referred to as Pillar Two. The rules are scheduled to begin to go into effect in 2024 and 2025 and will apply to companies with more than approximately $800 million in revenues and that have a physical presence in a foreign country. The OECD/G20 has released technical guidance to assist governments with implementation of Pillar Two, which would impose a global 15 percent effective minimum tax on book income. NCFC’s Legal, Tax and Accounting Committee has formed a working group to explore the implications of Pillar Two, including the treatment of patronage dividends and nonqualified notices of allocation under the new regime. The group plans to meet with Treasury officials and submit comments.
Energy Incentives. The Inflation Reduction Act, enacted in the summer of 2022, contains numerous tax incentives for energy efficient fuels, manufacturing processes, vehicles, and buildings. NCFC’s Legal, Tax and Accounting Committee has formed a working group to explore the credits and their potential applicability to farmer cooperatives. The working group will submit comments to Treasury/IRS when appropriate. The Congressional Research Service has updated its report on renewable energy incentives. The report includes current federal programs providing grants, loans, loan guarantees, and tax credits for energy efficiency, energy conservation, and renewable energy research, development, demonstration, and deployment. See, https://crsreports. congress.gov/product/pdf/R/R40913.
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In February 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016-02, entitled Leases (Topic 842). The guidance in ASU 2016-02 establishes ASC Topic 842, entitled Leases and supersedes ASC Topic 840, entitled Leases. This guidance represents a complete overhaul of the existing lease accounting literature. Since the issuance of ASU 2016-02, the FASB has proactively responded to implementation issues raised by practitioners as part of the Post-Implementation Review (PIR) activities. In March 2023, the FASB issued ASU 202301 to address private company stakeholder concerns associated with applying the lease guidance to related-party arrangements between common controlled entities. The issues addressed in ASU 2023-01 relate to (1) the terms and conditions to be considered when evaluating a lease arrangement between common controlled entities and (2) accounting for leasehold improvements associated with leases between common controlled entities.
Identifying and classifying leases
The first issue relates to identifying and
EDITOR
Barbara A. Wech, Ph.D.
Department of Management, Information Systems, and Quantitative Methods
University of Alabama at Birmingham
COLLAT School of Business
710 13th St. South
Department of Management, Information
Systems, & Quantitative Methods
Birmingham, Alabama 35233 bawech@uab.edu
GUEST WRITER
Steve Grice, Ph.D., CPA Scholar-In-Residence
Troy University
Carr, Riggs, & Ingram, LLC grice@cricpa.com
Amanda Paul, CPA Assistant Professor
Troy University
classifying a related party lease between entities under common control. Pursuant to ASC Topic 842, reporting entities must determine whether a related-party arrangement between common controlled entities is a lease. Paragraph 842-10-15-3 indicates that a lease exists when a contract conveys the right to control the use of an identified asset during the lease term. Paragraph 842-1015-4 stipulates that the right to control an asset is conveyed to the customer when the customer has the right to (1) receive substantially all of the economic benefits from using the asset and (2) direct the use of the asset. Once it is established that a lease exists, the lessee must determine whether the lease is an operating or financing lease while the lessor must determine whether the lease is an operating, direct financing, or sales-type lease.
The pre-ASU-2023-01
guidance
in paragraph 842-10-55-12 of the implementation guidance indicates that leases between related parties should be
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classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. Additionally, the guidance indicates that the classification and accounting for related- party leases should be same as for leases between unrelated parties. The findings from the PIR activities indicated that this guidance is difficult to apply to leases between common controlled entities. For example, some practitioners indicated that determining the legally enforceable terms and conditions requires a formal legal opinion in certain cases.
The FASB generally proposes either an accounting alternative or a practical expedient when it is deemed that recognition and measurement differences between public and private companies are warranted. An accounting alternative is a different accounting method for recognizing or measuring a specific transaction or event. A practical expedient is not a different accounting method, but rather, is a less costly and less complex way to apply certain accounting guidance. ASU-2023-01 ushered in a practical expedient for private companies and not-for-profit entities that are not conduit obligors (entities obligated for the repayment of conduit debt securities, such as, municipal securities issued by state governments, on behalf of a 3rd-party).
The practical expedient allows the
use of the written terms and conditions of arrangements between common controlled entities to determine (1) whether a lease exists and (2) the classification of and accounting for that lease. The practical expedient may be applied on an arrangement-by-arrangement basis when written terms and conditions of the arrangements exist. The practical expedient allows the reporting entity to evaluate whether the written terms and conditions convey a practical right to control the leased asset as opposed to a legally enforceable right. However, the reporting entity must continue to use the legally enforceable terms and conditions to apply ASC Topic 842 when written terms and conditions of the arrangements do not exist. Note: The new guidance permits entities to document any existing unwritten terms and conditions of common control lease arrangements before the date on which the financial statements are available to issued.
Accounting for leasehold improvements
The second issue relates to the accounting for leasehold improvements related to leases between entities under common control.
The pre-ASU 2023-01 guidance in paragraph 842-20-35-12 requires reporting entities to amortize leasehold improvements over the shorter of the useful life of those leasehold improvements and the remaining lease term. The findings of the PIR activities indicated
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that amortizing leasehold improvements associated with common control lease arrangements may not faithfully present the economics or the common control nature of those leasehold improvements in the financial statements. For example, suppose there are significant leasehold improvements associated with a short-term (e.g., one year) common control lease arrangement. The commonly controlled lessee would likely continue to use the leased asset by extending the lease or entering a new lease. Also, the leasehold improvements will continue to benefit another commonly controlled entity when the lease expires. Thus, amortizing the leasehold improvements over a shorter period than the useful life is not representationally faithful for financial reporting purposes.
The provisions of ASU 2023-01 amends the guidance related to the amortization of leasehold improvements associated with common control lease arrangements. According to the new guidance in paragraph 842-20-35-12A, leasehold improvements associated with leases between common controlled entities must be:
• Amortized over the useful life (i.e., lease term is not considered) of the leasehold improvements to the commonly controlled group as long as the commonly controlled lessee maintains control of the leased asset through a lease. Note: The amortization period cannot exceed the amortization period of the commonly controlled group if the lessor obtains the right to control the leased asset through a lease with an entity outside the commonly control group.
• Accounted for as a transfer between common controlled entities as an adjustment to equity (or net assets) when the commonly controlled lessee ceases to control the use of the leased asset.
As an example, a company has leasehold improvements of $10,000 associated with a lease between itself and a common controlled entity. The leasehold improvements have a useful life commonly controlled group of ten years. The remaining lease term is five years. PreASU 2023-01 would require amortizing the leasehold improvements over five years, the shorter of the useful life and the remaining lease term. This would result in annual amortization of $2,000. ASU 202301 will require amortization of the leasehold improvements over the ten year useful life, resulting in $1,000 annual amortization, assuming the lessor does not obtain the right to control the leased asset through a lease with an entity outside the common control group.
Paragraph 842-20-50-7A requires the commonly controlled lessee to disclose the unamortized balance and the remaining useful life of the leasehold improvements to the commonly controlled group, as well as the remaining lease term, when the economic life of the leasehold improvements associated with common control lease arrangements exceeds the lease term. ASU 2023-01 also provides accounting guidance for situations in which there is a change in the control of the lessor or lessee after the commencement of a lease. According to paragraph 842-20-35-12C, when the lessor and lessee become commonly controlled or cease to be commonly controlled, any change in the amortization period for the leasehold improvements should be accounted for as a change in accounting estimate (i.e., prospectively).
Transition Requirements
For Issue 1, entities should follow the original transition provisions in ASC Topic 842 (i.e., ASU 2016-02) when concurrently adopting the provisions ASC Topic 842 and ASU 2023-01. For Issue 2, entities may
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Exhibit I Transitions Provisions (For Entities Not Concurrently Adopting)
Issue 1: Identifying and classifying leases Issue 2: Leasehold improvements
1. Prospectively to arrangements that commence (or are modified) on or after the date that the entity first applies the provisions of ASU 2023-01.
2. Retrospectively as of the beginning of the period in which the entity first applied Topic 842 for common control lease arrangements that exist at the date the entity first applies the provisions of ASU 2023-01. Note: ASU 2023-01 is not applicable to common control arrangements lease arrangements that ceased prior to the date the entity adopts ASU 2023-01.
1. Prospectively to new leasehold improvements recognized on or after the date that the entity first applies the provisions of ASU 2023-01.
2. Prospectively to new and existing leasehold improvements recognized on or after the date that the entity first applies the provisions of ASU 2023-01. Any remaining unamortized balance of existing leasehold improvements should be amortized over their remaining useful life to the commonly controlled group determined at that date.
3. Retrospectively as of the beginning of the period in which the entity first applied ASC Topic 842. Any leasehold improvements that otherwise would not have been amortized should be recognized through a cumulative-effect adjustment to the beginning retained earnings at the beginning of earliest period presented in the financial statements pursuant to the provisions of ASC Topic 842.
follow the original transition provisions in Topic 842 when concurrently adopting the provisions ASC Topic 842 and ASU 202301 or may use one of the prospective approaches described in Exhibit I below. Exhibit I describes the alternative transition provisions for those entities that are not concurrently adopting the provisions of ASC Topic 842 ASU 2023-01.
Effective Date
The provisions related Issue 1 and Issue 2
in ASU 2023-01 will be effective for fiscal years (including interim periods within those fiscal years) beginning after December 15, 2023. Early adoption is permitted for financial statements (interim and annual) that have not been made available for issuance. Note: The lease guidance in ASC Topic 842 became effective for nonpublic entities for fiscal years beginning after December 15, 2021 (i.e., calendar years ending December 31, 2022).
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By Peggy Maranan, CPA, MBA, Ph.D.
